Professional Documents
Culture Documents
3468corporate Reporting Volume - 1
3468corporate Reporting Volume - 1
Advanced Level
The Institute of Chartered Accountants of Bangladesh (ICAB)
ISBN : 978-0-85760-750-8
The Study materials have been prepared by the Education and Student Affairs Division of the
Institute of Chartered Accountants of Bangladesh (ICAB)
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.
. Introduction v
. Corporate Reporting vii
Reporting performance
9. Reporting financial performance 375
10. Reporting revenue 431
11. Earning per share 467
Financing
14. Leases, government grants and borrowing costs 591
iii
1 Introduction
CA Overview
The ICAB chartered accountancy qualification, the CA, is one of the most advanced learning and
professional development programmes available. Its integrated components provide you with an in-
depth understanding across accountancy, finance and business. Combined, they help build the
technical knowledge, professional skills and practical experience needed to become an ICAB
Chartered Accountant.
Each component is designed to complement each other, which means that students can put theory
into practice and can understand and apply what they learn to their day-to-day work. The
components are:
3/4
3-4
17
ICAB
Professional development
ICAB Chartered Accountants are known for their professionalism and expertise. Professional
development prepares students to successfully handle a variety of different situations that they
encounter throughout their career.
The CA qualification improves your ability and performance in seven key areas:
• Adding value
• Communication
• Consideration
• Decision making
• Problem solving
• Team working
• Technical competence.
Ethics and professional scepticism
Ethics is more than just knowing the rules around confidentiality, integrity, objectivity and
independence.
It’s about identifying ethical dilemmas, understanding the implications and behaving appropriately.
We integrate ethics throughout the CA qualification to develop students' ethical capabilities – so
they will always know how to make the right decisions and justify them.
3-4 years practical work experience
Practical work experience is done as part of articleship with one of the ICAB member in practice.
Students need to complete articleship for a period of three or four years. The knowledge, skills and
experience they gain as part of their articleship agreement are invaluable, giving them the opportunity to
put what they're learning into practice.
1 accountancy, finance and business modules
Each of the CA modules is directly relevant to the work that students do on a day-to-day basis. They will
gain in-depth knowledge across a broad range of topics in accountancy, finance and business.
Introduction v
There are 17 modules over three levels. These can be taken in any order with the exception of the Case
Study which has to be attempted last. Students must pass every exam (or receive credit) – there are no
options. This ensures that once qualified, all ICAB Chartered Accountants have a consistent level of
knowledge, skills and experience.
IT
Governance
Information
Technology
Certificate Level
There are seven modules that will introduce the fundamentals of accountancy, finance and business.
They each have a 2 hours examination except ‘Principle of Taxation’ which will be of 3 hours, and
Business Law, IT each will be 1.5 hours duration.. Students may be eligible for credit for some modules
if they have studied accounting, finance, law or business at degree level or through another professional
qualification.
Professional Level
The next seven modules build on the fundamentals and test your understanding and ability to use
technical knowledge in real-life scenarios. Each module has a 3 hour exam, which are available to sit
two times per year. These modules are flexible and can be taken in any order. The Business Planning:
Taxation and Business Strategy modules in particular will help you to progress to the Advanced Level.
Advanced Level
The Corporate Reporting and Strategic Business Management modules test students’ understanding
and strategic decision making at a senior level. They present real-life scenarios, with increased
complexity and implications from the Professional Level modules.
The Case Study tests all the knowledge, skills and experience gained so far. It presents a complex
business issue which challenges students’ ability to problem solve, identify the ethical implications and
provide an effective solution.
For more information on the CA qualification exam structure and syllabus, visit ICAB.org.bd/students
vi Corporate Reporting
2 Corporate Reporting
2.1 Module aim
To enable candidates to apply technical knowledge, analytical techniques and professional skills to
resolve compliance and business issues that arise in the context of the preparation and evaluation of
corporate reports and from providing audit services.
Introduction vii
viii Corporate Reporting
CHAPTER 1
Introduction
Introduction
Topic List
1 Using this Study Manual
2 The importance of corporate reporting
3 The role and context of modern auditing
4 Legal responsibilities of directors and auditors
5 International standards on auditing
6 Audit quality control
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
1
Introduction
Specific syllabus references for this chapter are: 2(a), 10(a), 10(b).
2 Corporate Reporting
1 Using this Study Manual
C
Section overview H
A
• This Section gives a brief outline of how this Study Manual is structured and why.
P
• The key point is that the Corporate Reporting paper is integrated, so financial reporting and
T
auditing must be studied together.
E
R
1.1 The importance of integration
The aim of the Corporate Reporting module is as follows:
'To enable candidates to apply technical knowledge, analytical techniques and professional skills to 1
resolve compliance and business issues that arise in the context of the preparation and evaluation
of corporate reports and from providing audit services.
Candidates will be required to use technical knowledge and professional judgement to identify,
explain and evaluate alternatives and to determine the appropriate solutions to compliance issues,
giving due consideration to the needs of clients and other stakeholders. The commercial context
and impact of recommendations and ethical issues will also need to be considered in making such
judgements.'
It is clear from this that the application of technical knowledge (financial reporting, audit, assurance and
ethics) is integrated, so it is appropriate that these areas are studied together where possible.
At earlier levels you will have tended to study subjects in isolation, but this is no longer appropriate at
Advanced Level, and indeed in the real world.
Introduction 3
example, related party disclosures, which has its own designated ISA and particular risks. These
sections allow scope for integrated examples or questions covering both corporate reporting and
auditing elements.
Finally the self-test questions at the end of chapters will contain integrated questions where relevant.
4 Corporate Reporting
2.1.2 Corporate reporting
Corporate reporting is a broader term than financial reporting, although the two are often used C
interchangeably. As will be evident from this Study Manual and the exam it prepares you for, corporate H
reporting covers reports other than financial statements, in particular audit reports, but also A
assurance, internal audit and environmental reports. P
PricewaterhouseCoopers state on their website: T
The exact definition of corporate reporting differs depending on who you speak to. However, E
throughout this web site we use the term 'corporate reporting' to refer to the presentation and R
disclosure aspects – as distinct from accounting/measurement – of the following areas of reporting:
• Integrated reporting
• Financial reporting 1
• Corporate governance
• Executive remuneration
• Corporate responsibility
• Narrative reporting
In the context of professional accountancy examinations, a Corporate Reporting paper is generally
higher level than a Financial Reporting paper. In the context of your examination, Corporate Reporting is
a more appropriate title because the paper is not just on financial reporting.
General principles relating to corporate reporting are set out in the IASB Conceptual Framework for
Financial Reporting (Conceptual Framework), which is covered in Chapter 2, together with regulatory
matters and selected International Financial Reporting Standards that set out principles and frameworks.
2.2 Entity
Most accounting requirements are written with a view to use by any type of accounting entity, including
companies and other forms of organisation, such as a partnership. In this Study Manual, the term
'company' is often used, because the main focus of the syllabus is on the accounts of companies and
groups of companies, but International Financial Reporting Standards generally refer to entities.
Introduction 5
A complete set of financial statements prepared under IFRS comprises:
• The statement of financial position
• The statement of profit or loss and other comprehensive income or two separate statements being
the statement of profit or loss and the statement of other comprehensive income (statements of
financial performance)
• The statement of changes in equity (another statement of financial performance)
• The statement of cash flows
• Notes to the financial statements
The notes to the financial statements include:
• Accounting policies, ie the specific principles, conventions, rules and practices applied in order to
reflect the effects of transactions and other events in the financial statements.
• Detailed financial and narrative information supporting the information in the primary financial
statements.
• Other information not reflected in the financial statements, but which is important to users in making
their assessments.
The individual elements that are included in the financial statements are covered in detail later in this
chapter.
6 Corporate Reporting
In Bangladesh, GAAP has no statutory or regulatory authority or definition (unlike some other
countries such as the United States). Also the use of the term is not common in Bangladesh accounting. C
H
2.6 Fair presentation A
IAS 1 Presentation of Financial Statements requires financial statements to 'present fairly' the financial P
position and performance of an entity. T
'Present fairly' is explained as representing faithfully the effects of transactions. In general terms this will E
be the case if IFRS are adhered to. IAS 1 states that departures from international standards are only R
allowed:
• In extremely rare cases
• Where compliance with IFRS would be so misleading as to conflict with the objectives of financial 1
statements as set out in the Conceptual Framework, that is to provide information about financial
position, performance and changes in financial position that is useful to a wide range of users.
Introduction 7
This objective can usually be met by focusing exclusively on the information needs of present and
potential investors. This is because much of the financial information that is relevant to investors will also
be relevant to other users.
8 Corporate Reporting
Information on the generation and use of cash is useful in evaluating the entity's ability to generate cash
and its need to use what is generated. C
Introduction 9
• Is the company managed effectively?
• Is there an adequate system of controls?
• Is the company susceptible to fraud?
Definition
True: The information in the financial statements is not false and conforms to reality.
In practical terms this means that the information is presented in accordance with accounting
standards and law. The financial statements have been correctly extracted from the underlying
records and those records reflect the actual transactions which took place.
Definition
Fair: The financial statements reflect the commercial substance of the company's underlying
transactions and the information is free from bias.
You will have come across examples of the application of substance over form in your financial
reporting studies eg the treatment of a finance lease.
The problem with making judgements such as these is that they can be called into question, particularly
where others have the benefit of hindsight. The major defence that the auditor has in this situation is to
show that the work was performed with due skill and care and that the judgements made about truth
and fairness were reasonable based on the evidence available at the time. We will look at quality control
in Section 6 of this chapter.
10 Corporate Reporting
C
H
A
P
T
E
R
Point to note:
ISA 260 requires the auditor to promote and engage in two-way communication with those charged with
governance throughout the audit process. In particular, auditors must:
• Communicate clearly with those charged with governance the responsibilities of the auditor in
relation to the financial statement audit, and an overview of the planned scope and timing of the
audit;
• Obtain from those charged with governance information relevant to the audit; and
• Provide those charged with governance with timely observations arising from the audit that are
significant and relevant to their responsibility to oversee the financial reporting process.
(ISA 260 paragraph 9)
ISA 200 requires that the audit should be planned and performed with an attitude of professional
scepticism. Professional scepticism is covered in detail in Chapter 5.
Introduction 11
4.2.1 Directors’ report
(1) There shall be attached to every balance sheet laid before a company in general meeting a report by
its Board of Directors, with respect to-
(2) The Board's report shall, so far as is material for the appreciation of the state of company's affairs by
its members, deal with any changes which have occurred during the financial years :-
(3) The Board shall also be bound to give the fullest information and explanations in its report aforesaid
on every reservation, qualification or adverse remark contained in the auditor's report.
(4) The Board report and any addendum thereto shall be signed by its Chairman if he is authorised in
that behalf by the Board, and where he is not so authorised &, shall be signed by such number of
director as are required to sign the balance sheet and the profit and loss account or the income and
expenditure account, of the company by virtue of sub-section (1) and (2) of section 189.
(5) If any person, being a director of a company, fails to take all reasonable steps to comply with the
provision of sub-section (1) to (3) or being the chairman, signs the Boards report otherwise than in
conformity with the provisions of sub-section (4), he shall, in respect of each offence, be liable to fine
which may extend to five thousand aka.
In compliance of BSEC corporate governance guidelines, listed companies in Bangladesh are required
to include the following additional statements in the Directors' Report -
12 Corporate Reporting
(xiv) International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS), as
applicable in Bangladesh, have been followed in preparation of the financial statements and any C
departure there-from has been adequately disclosed. H
(xv) The system of internal control is sound in design and has been effectively implemented and A
monitored. P
(xvi) There are no significant doubts upon the issuer company's ability to continue as a going concern. If T
the issuer company is not considered to be a going concern, the fact along with reasons thereof should E
be disclosed. R
(xvii) Significant deviations from the last year’s operating results of the issuer company shall be
highlighted and the reasons thereof should be explained.
(xviii) Key operating and financial data of at least preceding 5 (five) years shall be summarized. 1
(xix) If the issuer company has not declared dividend (cash or stock) for the year, the reasons thereof
shall be given.
(xx) The number of Board meetings held during the year and attendance by each director shall be
disclosed.
(xxi) The pattern of shareholding shall be reported to disclose the aggregate number of shares (along
with name wise details where stated below) held by:-
a) Parent/Subsidiary/Associated Companies and other related parties (name wise details);
b) Directors, Chief Executive Officer, Company Secretary, Chief Financial Officer, Head of Internal Audit
and their spouses and minor children (name wise details);
c) Executives;
d) Shareholders holding ten percent (10%) or more voting interest in the company (name wise details).
Explanation: For the purpose of this clause, the expression “executive” means top 5 (five) salaried
employees of the company, other than the Directors, Chief Executive Officer, Company Secretary, Chief
Financial Officer and Head of Internal Audit.
(xxii) In case of the appointment/re-appointment of a director the company shall disclose the following
information to the shareholders:-
a) a brief resume of the director;
b) nature of his/her expertise in specific functional areas;
c) names of companies in which the person also holds the directorship and the membership of
committees of the board.
4.2.3 Form and contents of balance sheet and profit and loss accounts
As per Companies Act 1994, all registered companies in Bangladesh are required to prepare, maintain
the followings:
(1) The balance sheet of a company shall contain a summary of the property and assets and of the
capital and liabilities of the company. giving a true and fair view of affairs as at the end of the financial
year, and it shall, subject to the provisions of this section be in the forms set out in Part-I of Schedule I.
or as near thereto as circumstance admit or in such other form as may be approved by the Government
either generally or in any particular case; and in preparing the balance sheet due regard shall be had, as
far as may be, to the general instructions for preparation of balance sheet under the heading "Notes" at
the end of the Part:
Provide that nothing contained in this sub-section shall apply to any insurance or banking company or
any company engaged in the generation or supply of electricity or to any other class of company for
which a form of balance sheet has been specified in or under the law governing such class of company.
(2) Every profit and loss account of a company shall gave a true and fair view of the profit and or loss of
the company for the financial year and shall, subject as aforesaid, comply with the requirements of Part
II of Schedule XI so far as applicable thereto:
Introduction 13
Provided that nothing contained in this sub-section shall apply to any insurance co or banking company
or any company engaged in the generation or supply of electricity or to any other class of company for
which a form of profit and loss account had been specified in or under the law governing such class of
company.
(3) The Government may, by notification the official Gazette, exempt any class of companies from the
requirements of Schedule XI if, in its opinion, it necessary to grant the exemption in the public interest;
and any such exemption may be granted either unconditionally or subject of such conditions as may be
specified in the notification.
(4) The Government may, on the application or with the consent of the Board of Directors of the
company, by order, modify in relation to that company of the requirement of this Act as to the matters to
be stated in the balance-sheet or profit and loss account for the purpose of adopting them to the
circumstances of the company;
(5) The balance sheet and the profit and loss account of a company shall not be treated as not
disclosing a true and fair view of the state of affairs of the company merely be reason of the fact that
they do not disclose-
(i) in the case of an insurance company, any matters which are not required to be disclosed by the
Insurance Act, 1938 (IV of 1938);
(ii) in the case of a banking company, any matters which are not required to be disclosed by the
(iii) in the case of a company engaged in the generation or supply of electrify, any matters which are not
required to be disclosed by the Electricity Act, 1910 (IX of 1910);
(iv) in the case of a company governed by any other law for the time being in force, any matters which
are not require to be disclosed by such law;
(v) in the case of any company, any matters which are not required to be disclosed by virtue of the
provisions contained in Schedule XI or by virtue of the notification issued under sub-section (3) or an
order issued under subsection (4).
(6) For the purposes of this section, except where the context otherwise requires any reference to
balances-sheet or to profit and loss account shall include any notes hereon or documents annexed
thereto, giving information required by this Act and allowed by this Act to be given in the form of such
noted or documents.
(7) If any such person as is referred to in sub-section (7) of section 181 fails to take all reasonable steps
to secure compliance by the company, as regards any accounts laid before the company in general
meeting, with this section and with the other requirements of this Act as to in the accounts, he shall, in
respect of each offence, be punishable with imprisonment for a term which may extend to six months or
with fine which may extend to five thousand taka or with both:
Provided that no person shall be sentenced to imprisonment for any such offence unless it was
committed willfully.In addition to the statutory requirement, the directors have an overriding responsibility
to ensure they have adequate information to enable them to fulfil their duty of managing the company's
business.
• Annual accounts
Directors have a number of responsibilities with regard to the annual accounts. The directors are
required to
– Select suitable accounting policies and apply them consistently
– Make judgements and estimates that are prudent
– State whether applicable accounting standards have been followed, subject to any material
departures disclosed and explained in the financial statements
– Prepare the financial statements on a going concern basis unless it is an inappropriate
assumption
– Ensure the financial statements are delivered to RJSC within the specified time.
14 Corporate Reporting
4.3 Directors' loans and other transactions
4.3.1 C
Provided that nothing in this section shall apply to the making of a loan or giving of any guarantee or
providing any security by a lending company. if--
(i) such company is a banking company or a private company not being a subsidiary of a public
company, or if such company as a holding company makes the loan or gives the guarantee or provide
the security to its subsidiary; and
(ii) the loan is sanctioned by the Board of Directors of any company and approved by the general
meeting and, in the balance sheet, there is a specific mention of the loan, guarantee or security, as the
case may be:
Provided further that, in no case the total amount of the loan shall exceed 50% of the paid up value of
the shares held by such director in his own name
(2) In the event of any contravention of sub-section (1) every person who is a party to such
contravention including in particular any person to whom a loan is made or on whose behalf a guarantee
is given to or security provided shall be punishable with the fine which extend to five thousand taka or
simple imprisonment for six months in lieu of fine and shall be liable jointly and severally to the lending
company for the repayment of such loan or for making good any sum which the lending company may
be called up to pay under the guarantee given or security provided by the lending company.
(3) this section shall apply to any transaction represented by a book debt which was from its inception in
the nature of a loan
As per section 213 of Companies Act 1994 followings are the power and duties of auditors:-
(1) Every auditor of a company shall have a right of access at all times to the books and accounts and
vouchers of the company, whether kept at the head office of the company or elsewhere and shall be
entitled to require from the officers of the company such information and explanation as the auditor may
think necessary for the performance of his duties as auditor.
(2) Without prejudice to the provisions of sub-section (1), the auditor shall, in particular inquire into
following namely:-
Introduction 15
(a) Whether loans and advances made by the company on the basis of security have been properly
secured and whether the terms on which they have been made are not prejudicial to the interests of the
company or its members:
(b) Whether transactions of the company which are represented merely as book-entries are prejudicial to
the interests of the company;
(c) where the company is not an investment company or a banking company, whether so much of the
assets of the company as consist of shares, debentures and other securities, have been sold at a price
less than at which they were purchased by the company;
(d) whether loans and advances made by the company have been shown as deposits;
(f) where it is stated in the books and paper of the company that any shares have been allotted for cash,
whether cash has actually been received in respect of such allotment, and if no cash has actually been
so received, whether the position as stated in the account books and the balance sheet is correct,
regular and not misleading.
3) The auditor shall make a report to be presented in the annual general meeting of the company on the
accounts, examined by him, and on every balance sheet and profit and loss account and on every other
document declared by this Act to be part of or annexed to the balance sheet or profit and loss accounts
which are laid before the company in general meeting during his tenure of office and the report shall
state whether, in his opinion and to the best of his information and according to the explanation given to
him, the said accounts give the information required by this Act in the manner so required and give a
true and fair view-
(a) in the case of the balance sheet, of the state of the company's affairs as at the end of its financial
year;
(b) in the case of the profit and loss account, of the profit or loss for its financial year.
(a) whether he has obtained all the information and explanation which to the best of his knowledge and
belief were necessary for the purposes of his audit;
(b) whether, in his opinion, proper books of account as required by law have been kept by the company
so far as appears from his examination of those books and proper returns adequate for the purposes of
his audit have been received from branches not visited by him;
(c) whether 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.
(5) There any of the matters referred to in clauses(a) and (b) of sub- section (3) or in clauses (a), (b) and
(c) of sub-section
(4) are answered in the negative or with a qualification, the auditors’ report shall state the reason for the
answer.
(6) The Government may, be general or special order, direct that in the case of such class or description
of companies as may be specified in the order, the auditors’ report shall also include a statement on
such matters as may be specified therein.
(7) The accounts of a company shall not be deemed as not having been and the auditors’ report shall
not state that those accounts have not been, properly drawn up on the ground merely that the company
has not disclosed certain matters, of-
16 Corporate Reporting
(a) those matters are such as the company is not required to disclose by virtue of any provision C
contained in this Act or any other law for the time being in force; and H
(b) those provisions are specified in the balance sheet and loss account of the company. A
P
The auditor also has a duty towards other information in documents containing audited financial T
statements in accordance with ISA 720A The Auditor's Responsibilities Relating to Other Information in E
Documents Containing Audited Financial Statements (see Chapter 8). R
Introduction 17
5 International standards on auditing
Section overview
• The International Auditing and Assurance Standards Board issues International Standards on
Auditing.
• The IAASB has reissued its ISAs as a result of its Clarity Project.
• These have been adopted by ICAB in Bangladesh as ISAs.
IAASB
Issues
ISA as used
by
ISA Bangladesh
Auditors
ICAB Adopts
18 Corporate Reporting
All International Auditing Practice Statements (IAPS) have now been withdrawn.
C
5.2.2 Authority of ISAs
H
ISAs are to be applied in the audit of historical financial information.
A
In exceptional circumstances, an auditor may judge it necessary to depart from an ISA in order to
P
more effectively achieve the objective of an audit. When such a situation arises, the auditor should be
T
prepared to justify the departure.
E
5.2.3 Working procedures R
The working procedures of the IAASB can be summarised as follows.
• Public Interest Activity Committee (PIAC) identifies potential new projects based on a review of
national and international developments. 1
• A project task force is established to develop a new standard based on research and consultation.
• There is transparent debate as the proposed standard is presented at an IAASB meeting which is
open to the public.
• Exposure drafts are posted on the IAASB's website for public comment.
• Comments and suggestions are discussed at a further IAASB meeting, which is open to the public
and if substantive changes are made a revised exposure draft is issued.
• The final ISA is issued after approval by IFAC's Public Interest Oversight Board, which reviews
whether due process has been followed and clears the ISA for publication.
Introduction 19
Many principles contribute to audit quality including good leadership, experienced judgement, technical
competence, ethical values and appropriate client relationships, proper working practices and effective
quality control and monitoring review processes.
The standards on audit quality provide guidance to firms on how to achieve these principles.
20 Corporate Reporting
These will cover the following issues:
• Recruitment • Performance evaluation C
• Capabilities • Competence H
• Career development • Promotion A
• Compensation • The estimation of personnel needs P
T
The firm is responsible for the ongoing excellence of its staff, through continuing professional
E
development, education, work experience and coaching by more experienced staff.
R
The assignment of engagement teams is an important matter in ensuring the quality of an
individual assignment.
This responsibility is given to the audit engagement partner. The firm should have policies and
1
procedures in place to ensure that:
• Key members of client staff and those charged with governance are aware of the identity of
the audit engagement partner
• The engagement partner has appropriate capabilities, competence, authority to perform the
role
• The responsibilities of the engagement partner are clearly defined and communicated to that
partner
The engagement partner should ensure that he assigns staff of sufficient capabilities, competence
and time to individual assignments so that he will be able to issue an appropriate report.
(5) Engagement performance
The firm should take steps to ensure that engagements are performed correctly, that is, in accordance
with standards and guidance. Firms often produce a manual of standard engagement procedures to
give to all staff so that they know the standards they are working towards. These may be electronic.
Ensuring good engagement performance involves a number of issues:
• Direction
• Supervision
• Review
• Consultation
• Resolution of disputes
Many of these issues will be discussed in the context of an individual audit assignment (see below).
The firm should have policies and procedures to determine when a quality control reviewer will be
necessary for an engagement. This will include all audits of financial statements for listed
companies. When required, such a review must be completed before the report is signed.
The firm must also have standards as to what constitutes a suitable quality control review.
In particular the following issues must be addressed:
• Discussion of significant matters with the engagement partner
• Review of the financial statements or other subject matter information of the proposed report
• Review of selected engagement documentation relating to significant judgments the
engagement team made and the conclusions it reached; and
• Evaluation of the conclusions reached in formulating the report and considering whether the
proposed report is appropriate
For listed companies in particular the review should include:
• The engagement team's evaluation of the firm's independence in relation to the specific
engagement
• Significant risks identified during the engagement and the responses to those risks
• Judgements made, particularly with respect to materiality and significant risks
• Whether appropriate consultation has taken place on matters involving differences of opinion
or other difficult or contentious matters, and the conclusions arising from those consultations
• The significance and disposition of corrected and uncorrected misstatements identified during
the engagement
• The matters to be communicated to management and those charged with governance and,
where applicable, other parties such as regulatory bodies
• Whether documentation selected for review reflects the work performed in relation to the
significant judgements and supports the conclusions reached
Introduction 21
(6) Monitoring
The standard states that firms must have policies in place to ensure that their quality control
procedures are:
• Relevant
• Adequate
• Operating effectively
In other words, they must monitor their system of quality control. Monitoring activity should be
reported on to the management of the firm on an annual basis.
There are two types of monitoring activity, an ongoing evaluation of the system of quality control
and cyclical inspection of a selection of completed engagements. An ongoing evaluation might
include such questions as, 'has it kept up to date with regulatory requirements?'
An inspection cycle would usually fall over a period such as three years, in which time, at least one
engagement per engagement partner would be reviewed.
The people monitoring the system are required to evaluate the effect of any deficiencies found.
These deficiencies might be one-offs. Monitors will be more concerned with systematic or repetitive
deficiencies that require corrective action. When evidence is gathered that an inappropriate report
might have been issued, the audit firm may want to take legal advice.
Corrective action
• Remedial action with an individual
• Communication of findings with the training department
• Changes in the quality control policies and procedures
• Disciplinary action, if necessary
Point to note:
All quality control policies and procedures should be documented and communicated to the firm's
personnel.
6.2.3 Practical application
The ICAEW Audit and Assurance Faculty publication Quality Control in the Audit Environment: A
practical guide for firms on implementing ISQC 1 recommends that firms take the following key steps to
give them confidence that they are compliant with ISQC 1:
• Document the operation of the quality control system
• Lead from the top giving a consistent message on the importance of quality control
• Always act ethically in accordance with relevant Standards and pronouncements
• Accept only those engagements where the firm is confident it can provide a service in compliance
with requirements with particular emphasis on integrity and competencies
• Recruit, develop and support capable and competent staff giving due attention to the firm's human
resources policies and procedures
• Deliver quality audits consulting when needed and meeting requirements for engagement quality
control review
• Monitor and seek continuous improvement of the firm's system of quality control and carry out a
periodic objective inspection of a selection of completed audit engagements
22 Corporate Reporting
– The objectives of the work to be performed
– The nature of the entity's business C
– Risk issues H
– Problems that may arise A
– Detailed approach to the audit engagement P
• Supervision T
Supervision includes: E
– Tracking the progress of the audit engagement R
– Considering the capabilities of individual members of the engagement team and that they
understand their instructions
– Addressing issues that arise and modifying the audit approach if appropriate 1
– Identifying matters for consultation or consideration by more experienced members of the
audit engagement.
• Review
Reviewing concerns the inspection of work by engagement members by more senior members of
the same engagement. This includes ensuring that:
– The work has been carried out in accordance with professional and regulatory requirements
– Significant matters have been raised for further consideration
– Appropriate consultations have taken place and have been documented
– Where appropriate the planned audit work is revised
– The work performed supports the conclusions
– The evidence obtained is sufficient and appropriate to support the audit opinion
– The objectives of the engagement have been achieved
Introduction 23
assurance review must be used. All firms or partners performing audits must be considered in the
selection process.
• Member bodies must require quality assurance review teams to follow procedures that are based
on published guidelines. The procedures should include reviews of audit working papers and
discussions with appropriate personnel.
• The quality assurance team leader must issue a written report upon completion of the review
assignment including a conclusion on whether the firm's system of quality control has been
designed to meet the relevant standards and whether the firm has complied with its system of
quality control during the review period. Reasons for negative conclusions should be given, with
recommendations for areas of improvement.
• Member bodies must require firms to make improvements in their quality control policies and
procedures where improvement is required. Corrective action should be taken where the firm fails to
comply with relevant professional standards. Educational or disciplinary measures may be necessary.
24 Corporate Reporting
6.6 Review of working papers
We shall briefly revise here the review of working papers. Review of working papers is important, as it C
allows a more senior auditor to evaluate the evidence obtained during the course of the audit for H
sufficiency and reliability, so that more evidence can be obtained to support the audit opinion, if required. A
It is an important quality control procedure. P
Work performed by each assistant should be reviewed by personnel of appropriate experience to T
consider whether: E
• The work has been performed in accordance with the audit programme R
• The work performed and the results obtained have been adequately documented
• Any significant matters have been resolved or are reflected in audit conclusions
• The objectives of the audit procedures have been achieved 1
• The conclusions expressed are consistent with the results of the procedures performed and
support the audit opinion
The following should be reviewed on a timely basis.
• The overall audit strategy and the audit plan
• The assessments of inherent and control risks
• The results of control and substantive procedures and the conclusions drawn including the
results of consultations
• The financial statements, proposed audit adjustments and the proposed auditors' report
In some cases, particularly in large complex audits, personnel not involved in the audit may be asked to
review some or all of the audit work, the auditors' report etc. This is sometimes called a peer review or
hot review.
Introduction 25
Explain to the junior why the evidence collected is insufficient, and detail the action necessary to complete the
audit procedures. Refer to your objectives in reviewing audit documentation as a format for your answer.
See Answer at the end of this chapter.
26 Corporate Reporting
Summary and Self-test
C
H
Summary A
P
T
E
R
Introduction 27
Self-test
1 Performance and position
Explain the terms 'performance' and 'position' and identify which of the financial statements will
assist the user in evaluating performance and position.
2 LaFa Ltd
The WTR audit firm has 15 partners and 61 audit staff. The firm has offices in three cities in one
country and provides a range of audit, assurance, tax, and advisory services. Clients range from
sole traders requiring assistance with financial statement production to a number of small Ltds –
although none is a quoted company.
LaFa Ltd is one of WTR's largest clients. Due to the retirement of the engagement partner from ill
health last year, LaFa has been appointed a new engagement partner. WTR provides audit
services as well as preparation of taxation computations and some advisory work on the
maintenance of complicated costing and inventory management systems. The audit and other
services engagement this year was agreed on the same fee as the previous year, although
additional work is required on the audit of some development expenditure which had not been
included in LaFa's financial statements before. Information on the development expenditure will be
made available a few days prior to audit completion “due to difficulties with cost identification” as
stated by the Finance Director of LaFa. LaFa's management were insistent that WTR could
continue to provide a similar level of service for the same fee.
Part way through the audit of WTR, Mr W, WTR's quality control partner, resigned to take up a
position as Finance Director in SoTee Ltd, LaFa's parent company. SoTee is audited by a different
firm of auditors. Mr W has not yet been replaced, as the managing board of WTR has yet to identify
a suitable candidate. Part of the outstanding work left by Mr W was the implementation of a system
of ethical compliance for all assurance staff whereby they would confirm in writing adherence to the
ICAB code of ethics and confirm lack of any ethical conflict arising from the code.
Requirement
Identify and explain the risks which will affect the quality control of the audit of LaFa. Suggest how
the risks identified can be reduced.
3 Bee5
You are the audit manager in charge of the audit of Bee5, a construction company. The client is
considered to be low risk; control systems are generally good and your assurance firm, Sheridan &
Co, has normally assisted in the production of the financial statements providing some additional
assurance of the accuracy and completeness of the statements.
During the initial planning meeting with the client you learn that a new Finance Director has been
appointed and that Bee5 will produce the financial statements this year; the services of your firm's
accounts department will therefore not be required. However, Bee5 has requested significant
assurance work relating to a revision of its internal control systems. The current accounting
software has become less reliable (increased processing time per transaction and some minor data
loss due to inadequate field sizes). The client will replace this software with the new Leve system in
the next financial year but requires advice on amending its control systems ready for this upgrade.
Requirement
Discuss the impact on the audit approach for Bee5 from the above information. Make specific
reference to any quality control issues that will affect the audit.
28 Corporate Reporting
Technical reference C
H
A
1 What is financial reporting? P
• Financial reporting is the provision of financial information about a reporting Concept Frame (OB2)
T
entity that is useful to existing and potential investors, lenders and other E
creditors in making decisions about providing resources to the entity. R
Corporate reporting is a broader concept, which covers other reports, such
as audit or environmental reports
• Financial statements comprise statement of financial position, statement of IAS 1 (10)
1
profit or loss and other comprehensive income, statement of changes in
equity, statement of cash flows and notes.
2 Purpose and use of financial statements
• Users' core need is for information for making economic decisions Concept Frame (OB2)
• Objective is to provide information on financial position (the entity's Concept Frame (OB12)
economic resources and the claims against it) and about transactions and
other events that change those resources and claims
• Financial position: Concept Frame (OB13)
– Resources and claims
– Help identify entity's strengths and weaknesses
– Liquidity and solvency
Concept Frame
• Changes in economic resources and claims: (OB15–16)
– Help assess prospects for future cash flows
– How well have management made efficient and effective use of the
resources
• Financial performance reflected by accrual accounting Concept Frame (OB17)
• Financial performance reflected by past cash flows Concept Frame (OB20)
3 ISA 200
• Purpose of an audit ISA 200.3
• General principles of an audit ISA 200.14–.24
4 ISQC 1
• Objective ISQC 1.11
• Elements of a system of quality control ISQC 1.16
• Importance of documenting procedures ISQC 1.17
• Leadership ISQC 1.18–.19
• Ethical requirements ISQC 1.20
• Independence ISQC 1.21
• Acceptance and continuance ISQC 1.26
• Human resources ISQC 1.29
• Engagement performance ISQC 1.32
• Monitoring ISQC 1.48
5 ISA 220
• Leadership responsibilities ISA 220.8
• Ethical requirements ISA 220.9
• Acceptance and continuance ISA 220.12
• Assignment of engagement teams ISA 220.14
• Engagement performance ISA 220.15
6 ISA 230
• Purposes of audit documentation ISA 230.2–.3
• Should enable an experienced auditor to understand the procedures ISA 230.8
performed, the results and evidence obtained and significant matters
Introduction 29
identified
• Auditors must document discussions of significant matters with management ISA 230.10
• Inconsistencies regarding significant matters must be documented ISA 230.11
• Departures from relevant requirements in ISAs must be documented ISA 230.12
• The identity of the preparer and reviewer must be documented ISA 230.9
30 Corporate Reporting
Answers to Self-test C
H
A
1 Performance and position P
Performance T
The financial performance of a company comprises the return it obtains on the resources it E
controls. Performance can be measured in terms of the profits and comprehensive income of the R
company and its ability to generate cash flows.
Management will be assessed on their skill in achieving the highest level of performance, given the
resources available to them. 1
Information on performance can be found in
• The statement of profit or loss and other comprehensive income
• The statement of changes in equity
• The statement of cash flows
Position
The financial position of the company is evaluated by reference to:
(i) Its economic resources and claims
(ii) Its capital structure, ie its level of debt finance and shareholders' funds
(iii) Its liquidity and solvency.
The user of the financial statements can then make assessments on the level of risk, ability to
generate cash, the likely distribution of this cash and the ability of the company to adapt to
changing circumstances.
The statement of financial position is the prime source of information on a company's position but
the statement of cash flows will also indicate a company's cash position over a period of time.
2 LaFa Ltd
Culture of WTR
The quality control auditing standard, ISQC 1, requires that the firm implements policies such that
the internal culture of the firm is one where quality is considered essential. Such a culture must be
inspired by the leaders of the firm, who must sell this culture in their actions and messages. In other
words, the entire business strategy of the audit firm should be driven by the need for quality in its
operations.
In the WTR audit firm, there appears to be a lack of leadership on quality control. Two issues give
rise for concern:
• First, the partner in quality control resigned during the audit of LaFa Ltd and has not been
replaced. This means that there is no one person in charge of maintaining quality control
standards in the audit firm. There is the risk that deficiencies of quality control will go
undetected.
• Second, WTR is under fee pressure from LaFa Ltd to complete the audit and provide other
services for the same fee as last year, even though the scope of the audit has increased.
There is the risk that audit procedures will not be fully carried out to ensure that the tight
budget is met. Lack of a comprehensive quality control review (the quality control partner
resigning as noted above) increases the risk of poor quality work.
The quality control partner should be replaced as soon as possible while the fee situation with LaFa
should be monitored – any potential cost overrun must be discussed with the client and where
necessary additional fees agreed.
Ethical requirements
Policies and procedures should be designed to provide the firm with reasonable assurance that the
firm and its personnel comply with relevant ethical requirements.
In WTR, it is not clear that staff will comply with the code. While professional staff will be members
of the ICAB or similar body, and therefore subject to the ethical requirements of their professional
body, precise implementation has not been confirmed within WTR. While it is unlikely that staff will
knowingly break the ethical code, there is still room for inadvertent breach. For example, partners
may not be aware of the full client list of WTR and hold shares in an audit client. Similarly, audit
staff may not be aware of WTR's policy on entertainment and therefore accept meals, for example,
over these guidelines.
Introduction 31
The guidelines should be circulated and confirmed by all staff as soon as possible.
Client acceptance
A firm should only accept, or continue with, a client where it:
• Has considered the integrity of the client and does not have information that the client lacks
integrity
• Is competent to perform the engagement and has the necessary time and resources
• Can comply with ethical requirements including appropriate independence from the client
While there is little indication that LaFa lacks integrity, the client is placing fee pressure on WTR.
The client has also indicated that information regarding development expenditure may not be
available during the audit and will be subject to a separate audit check just prior to the signing of
the financial statements and audit report. There could be an attempt to “force” an unmodified audit
report when WTR should take more time (and money) auditing development expenditure. There is
a risk therefore that LaFa management is losing some integrity and WTR need to view other
management evidence with increased scepticism.
The audit of LaFa Ltd this year includes development expenditure. As this is a new audit area, the
audit partner of LaFa should have ensured that the audit team, and WTR as a whole, had staff with
the necessary experience to audit this item. Lack of competence increases audit risk as the area
may not be audited correctly or completely.
Mr W accepting the position of Finance Director at SoTee appears to place the independence of
WTR with LaFa in jeopardy. As Finance Director of the parent company, Mr W will be in a position
to influence the management of LaFa, and potentially the financial information being provided by
that company. While SoTee is not an audit client, the audit partner in WTR must ensure that no
undue influence is being placed on LaFa. If, however, this is the case, then WTR must consider
resignation from the audit of LaFa.
Monitoring of audit
The audit firm must have policies in place to ensure that quality control procedures are
implemented and maintained.
Regarding the audit of LaFa, there is some risk that control quality regarding audit monitoring will
be compromised because:
• The audit partner is new, and may therefore not have extensive knowledge of the audit client,
and
• There appears to be a tight audit deadline for auditing development expenditure.
To decrease audit risk, it will be appropriate to maintain similar audit staff from last year (eg retain
the audit senior and manager) and WTR could consider a second partner review to ensure WTR
quality control standards have been followed.
3 Bee5
Client acceptance
In previous years Bee5 has required a standard audit from your assurance firm. However, this year
there is a request for additional assurance regarding the internal control systems. This work will not
only raise the amount of income generated from the client but will also require the use of specialist
staff to perform the work.
Before accepting the engagement for this year Sheridan & Co must ensure that:
• Income from Bee5 is not approaching 15% of the firm's total income. If income is approaching
this level then additional independence checks may be required such as a second partner
review.
• Ensure that staff familiar with the Bee5 internal control system are available to provide the
assurance work. If these skills are not available then Sheridan & Co must either hire staff with
those skills or decline the work on internal control systems.
Plan the audit – evaluate internal control
The current internal control system is due to be upgraded in the next financial year. There is
therefore no impact on the current year's audit as a result of this change. However, the reason
given by the client for the upgrade relates to reliability issues with the current control systems.
The control system used by Bee5 must still be evaluated to determine the extent to which the
system is still reliable. Where deficiencies are identified then control risk will increase. There will be
consequent impact on the audit approach as noted below.
Develop the audit approach
32 Corporate Reporting
An increase in control risk will cause detection risk to increase. The impact on the audit will be an
increased level of substantive testing to obtain sufficient confidence on assertions such as C
completeness and accuracy. H
There will be a further impact on the quality control of the audit. Commencing the audit with the A
expectation of finding control deficiencies means that audit staff must be selected carefully. It may P
not be appropriate to send junior trainees with restricted experience to the client unless their work T
is closely monitored and carefully reviewed. E
Audit internal control – tests of controls R
As noted above detailed tests of control on the accounting system will be limited. However, reliance
will still be obtained from the overall control environment.
Evaluate results 1
The higher risk associated with the audit this year means that a quality control review will be
appropriate for this client. Sheridan & Co needs to maintain the integrity of work performed as well
as ensuring that the audit opinion is correct. Part of the planning process will be to book time of the
quality control partner.
Introduction 33
Answers to Interactive questions
34 Corporate Reporting
(b)
C
Information Reasons
H
1 Administration A
P
Client name • Enables an organised file to be produced T
E
Year-end
R
Title
2 Planning
(i) Summary of different models of TVs • Enables auditor to familiarise himself with
and DVD players held and the different types of inventory lines
approximate value of each
(ii) Time and place of count • Audit team will not miss the count
(iv) Copy of client's inventory count • Enables an initial assessment of the likely
instructions and an assessment of reliability of Viewco's count
them
• Assists in determining the amount of
procedures audit team need to do
Introduction 35
Information Reasons
(vi) Details of any known old or slow • Special attention can be given to these at
moving lines count for example, include in test counts
(v) Note whether counters are in teams of • Evidence of independent checks may
two and whether any check counts are enhance reliability
performed
36 Corporate Reporting
Information Reasons
C
• From Viewco's count sheets to • Evidence to support the existence of H
physical inventory inventory recorded by Viewco A
P
For both of the above note inventory T
code, description, number of units and E
R
quality. Use a symbol to indicate
agreement with Viewco's records
(ii) Details of review for any old/obsolete • Details can be followed up at final audit and 1
• Last few despatch notes • Enables follow up at final audit to ensure cut-
• Last few goods received notes off is correct that is, goods despatched are
reflected as sales, goods received as
• Last few material requisitions
purchases and items in WIP are not also in
• Last few receipts to finished goods raw materials and finished goods
(v) Copies of client's inventory count • Enables follow up at final audit to ensure that
sheets (where number makes this Viewco's final sheets are intact and no
practical) alterations have occurred
Introduction 37
Answer to Interactive question 4
• Has the work been performed in accordance with the audit programme?
The non-current asset procedure of agreeing non-current asset details from the asset register to
the actual asset is to confirm the existence of the asset – in other words that the asset should be
included in the register. Agreeing physical asset details back to the register tests for the assertion
of completeness, not existence; that is all assets that should be recorded in the register are
recorded – not that assets in the register do exist. The audit procedure has therefore not been
completed in accordance with the audit programme.
I recommend that the existence test is completed as specified. However, where physical existence
of the asset cannot be determined by seeing the asset, then alternative evidence such as the log
book is obtained.
• Have the work performed and the results obtained been adequately documented?
Adequate documentation normally means that written representations by management are
recorded in writing, either in a paper document or use of email or other electronic communication
system that can be traced back to the client. Regarding the completeness of non-current assets, it
is unclear how the representation from the director was received – although it appears that this was
only verbal. The difficulty with verbal evidence is that it can be disputed at a later date.
I recommend that the director's representation is obtained in writing.
• Have any significant matters been resolved or are reflected in audit conclusions?
The fact that some vehicles were found obviously not in working order is cause for concern. While
your primary task was satisfying the assertions of existence and completeness, where assets are
obviously unusable, this fact needs to be recorded. The issue is that assets may well be over-
valued in the financial statements; in practice the asset values need to be compared to the carrying
amounts in the asset register and where the asset will no longer be used, complete write off or
disposal considered.
While no further action may be necessary on completeness and existence, I recommend that you
prepare a list of the assets which are in a poor state of repair so additional valuation procedures
can be performed on them.
• Have the objectives of the audit procedures been achieved?
As already noted, the objectives of audit procedures have not been achieved. There is still
insufficient evidence to confirm the existence and completeness of non-current assets.
I recommend that the procedures you were carrying out are completed as detailed in the audit
programme.
• Are the conclusions expressed consistent with the results of the work performed and support the
audit opinion?
The conclusion on the assertions of completeness and existence is incorrect. Your memo states
that assets were correctly stated and valued.
The point is not valid for two reasons:
First, audit procedures have not been completed correctly (see the point on completeness testing
for example) which means that the assertion of completeness cannot be confirmed.
Second, the audit procedures carried out do not relate to the valuation of those assets. Valuation
procedures include the auditing of depreciation and not simply ascertaining the condition of those
assets at the end of the reporting period.
I recommend that when audit procedures are complete that the conclusion is amended to match
the assertions being audited.
38 Corporate Reporting
CHAPTER 2
Principles of corporate
reporting
Introduction
Topic List
1 The regulatory framework
2 The IASB Conceptual Framework
3 Other reporting frameworks
4 IFRS13 Fair Value Measurement
5 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
6 Current issues in corporate reporting
Summary and Self-test
Technical reference
Answers to Self-test
Answer to Interactive question
39
Introduction
40 Corporate Reporting
1 The regulatory framework
Section overview
• Financial reporting is the provision of financial information to those outside the entity.
• The organisation responsible for setting IFRSs comprises the International Financial Reporting
Standards Foundation (IFRS Foundation), the Monitoring Board, the International Accounting
Standards Board (IASB), the IFRS Advisory Council (Advisory Council) and the IFRS
Interpretations Committee (Interpretations Committee).
• The process of setting IFRSs is an open dialogue involving co-operation between national and
international standard setters.
C
H
1.1 The IFRS Foundation A
IASCF was formed in March 2001 as a not-for-profit corporation and was the parent entity of the IASB. T
In 2010 it was renamed as the IFRS Foundation. The IFRS Foundation is an independent organisation E
and its trustees exercise oversight and raise necessary funding for the IASB to carry out its role as R
standard setter. It also oversees the work of the IFRS Interpretations Committee (formerly called the
International Financial Reporting Interpretations Committee (IFRIC)) and the IFRS Advisory Council
(formerly called the Standards Advisory Council (SAC)). These are organised as follows:
2
1.2 Membership
Membership of the IFRS Foundation has been designed so that it represents an international group of
preparers and users, who become IFRS Foundation trustees. The selection process of the 22 trustees
takes into account geographical factors and professional background. IFRS Foundation trustees
appoint the IASB members.
The Monitoring Board ensures that the trustees carry out their duties in accordance with the IFRS
Foundation Constitution.
Step 3
Following the receipt and review of comments, IASB would develop and publish an Exposure Draft for
public comment.
Step 4
Following the receipt and review of comments, the IASB would issue a final International Financial
Reporting Standard.
42 Corporate Reporting
The period of exposure for public comment is normally 120 days. However, in some circumstances,
proposals may be issued with a comment period of not less than 30 days. Draft IFRS Interpretations are
exposed for a 60-day comment period.
Section overview
The IASB Framework for the Preparation and Presentation of Financial Statements was the conceptual
framework upon which all IASs and IFRSs were based up to 2010. It is gradually being replaced by the
Conceptual Framework for Financial Reporting. The extant framework determines:
• How financial statements are prepared, and
• The information they contain.
44 Corporate Reporting
There are then four enhancing qualitative characteristics which enhance the usefulness of information that
is relevant and faithfully represented. These are: comparability, verifiability, timeliness and
understandability.
The key issues can be summarised as follows:
Qualitative characteristics
Faithful
Relevance representation
C
Complete Neutral Free from Substance
Nature of Materiality H
error over form
transaction (implied) A
T
Enhancing characteristics
E
R
Cost v benefit
2.4.2 Relevance
Relevant financial information can be of predictive value, confirmatory value or both. These roles are
interrelated.
Definition
Relevance: Relevant financial information is capable of making a difference in the decisions made by
users.
Information on financial position and performance is often used to predict future position and
performance and other things of interest to the user, eg likely dividend, wage rises. The manner of
presentation will enhance the ability to make predictions, eg by highlighting unusual items.
The relevance of information is affected by its nature and its materiality.
Definition
Materiality: Information is material if omitting it or misstating it could influence decisions that users make
on the basis of financial information about a specific reporting entity.
Information may be judged relevant simply because of its nature (eg remuneration of management). In
other cases, both the nature and materiality of the information are important. Materiality is not a
qualitative characteristic itself (like relevance or faithful representation), because it is merely a threshold
or cut-off point.
Definition
Faithful representation: A perfectly faithful representation should be complete, neutral and free from
error.
A complete depiction includes all information necessary for a user to understand the phenomenon
being depicted, including all necessary descriptions and explanations.
A neutral depiction is without bias in the selection or presentation of financial information. This means
that information must not be manipulated in any way in order to influence the decisions of users.
Free from error means there are no errors or omissions in the description of the phenomenon and no
errors made in the process by which the financial information was produced. It does not mean that no
inaccuracies can arise, particularly where estimates have to be made.
Substance over form
This is not a separate qualitative characteristic under the Conceptual Framework. The IASB says that
to do so would be redundant because it is implied in faithful representation. Faithful representation of
a transaction is only possible if it is accounted for according to its substance and economic reality.
Definition
Substance over form: The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.
Most transactions are reasonably straightforward and their substance, ie commercial effect, is the same
as their strict legal form. However, in some instances this is not the case as can be seen in the following
worked example.
46 Corporate Reporting
Other examples of accounting for substance:
• Leases
Accounting for finance leases under IAS 17 Leases (which is covered in Chapter 14) is an example
of the application of substance as the lessee includes the asset in its statement of financial position
even though the legal form of a lease is that of renting the asset, not buying it.
• Group financial statements
Group financial statements are covered in detail in Chapters 20 and 21. The central principle
underlying group accounts is that a group of companies is treated as though it were a single entity,
even though each company within the group is itself a separate legal entity.
• Assets • Income
• Liabilities • Expenses
• Equity • Other comprehensive income
Contributions from equity participants and distributions to them are shown in the statement of changes in
equity.
Asset A resource controlled by an entity as a result of Technically, the asset is the access to
past events and from which future economic future economic benefits (eg cash
benefits are expected to flow to the entity. generation) not the underlying item of
property itself (eg a machine).
Liability A present obligation of the entity arising from An obligation implies that the entity is
past events, the settlement of which is expected not free to avoid the outflow of
to lead to the outflow from the entity of resources.
resources embodying economic benefits.
Equity The residual amount found by deducting all of Equity = ownership interest = net
the entity's liabilities from all of the entity's assets. For a company, this usually
assets. comprises shareholders' funds (ie
capital and reserves).
Income Increases in economic benefits in the form of Income comprises revenue and gains,
asset increases/liability decreases not resulting including all recognised gains on non-
from contributions from equity participants. revenue items (eg revaluations of non-
current assets).
Expenses Decreases in economic benefits in the form of Expenses includes losses, including all
asset decreases/liability increases not resulting recognised losses on non-revenue items
from distributions to equity participants. (such as write-downs of non-current
assets).
Note the way that the changes in economic benefits resulting from asset and liability increases and
decreases are used to define:
• Income, and
• Expenses.
This arises from the 'balance sheet approach' adopted by the Conceptual Framework which treats
performance statements, such as the statement of profit or loss and other comprehensive income, as a
means of reconciling changes in the financial position amounts shown in the statement of financial
position.
These key definitions of 'asset' and 'liability' will be referred to again and again in these learning
materials, because they form the foundation on which so many accounting standards are based. It is
very important that you can reproduce these definitions accurately and quickly.
48 Corporate Reporting
2.5.3 Assets
We can look in more detail at the components of the definitions given above.
Assets must give rise to future economic benefits, either alone or in conjunction with other items.
Definition
Future economic benefit: The potential to contribute, directly or indirectly, to the flow of cash and cash
equivalents to the entity. The potential may be a productive one that is part of the operating activities of
the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to
reduce cash outflows, such as when an alternative manufacturing process lowers the cost of production.
2.5.4 Liabilities
Again we look more closely at some aspects of the definition.
An essential feature of a liability is that the entity has a present obligation.
Definition
Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or act
in an equitable manner.
2.5.5 Equity
Equity is the residual of assets less liabilities, so the amount at which it is shown is dependent on the
measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares.
Equity may be sub-classified in the statement of financial position providing information which is
relevant to the decision-making needs of the users. This will indicate legal or other restrictions on the
ability of the entity to distribute or otherwise apply its equity.
In practical terms, the important distinction between liabilities and equity is that creditors have the right
to insist that the transfer of economic resources is made to them regardless of the entity's financial
position, but owners do not. All decisions about payments to owners (such as dividends or share capital
buy-back) are at the discretion of management.
2.5.6 Performance
Profit is used as a measure of performance, or as a basis for other measures (eg earnings per share
(EPS)). It depends directly on the measurement of income and expenses, which in turn depend (in
part) on the concepts of capital and capital maintenance adopted.
Income and expenses can be presented in different ways in the statement of profit or loss and other
comprehensive income, to provide information relevant for economic decision-making. For example, a
statement of profit or loss and other comprehensive income could distinguish between income and
expenses which relate to continuing operations and those which do not.
Items of income and expense can be distinguished from each other or combined with each other.
Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity. (We will look at revenue in more detail in Chapter 10.)
Definition
Gains: Increases in economic benefits. As such they are no different in nature from revenue.
Gains include those arising on the disposal of non-current assets. The definition of income also includes
unrealised gains, eg on revaluation of non-current assets.
A revaluation gives rise to an increase or decrease in equity.
These increases and decreases appear in the statement of profit or loss and other comprehensive
income.
(Gains on revaluation, which are recognised in a revaluation surplus are covered in Chapter 12.)
50 Corporate Reporting
Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the
course of ordinary activities of an entity.
Definition
Losses: Decreases in economic benefits. As such they are no different in nature from other expenses.
Losses will include those arising on the disposal of non-current assets. The definition of expenses will
also include unrealised losses.
Points to note:
(1) Regard must be given to materiality.
(2) An item which fails to meet these criteria at one time may meet them subsequently.
(3) An item which fails to meet the criteria may merit disclosure in the notes to the financial statements.
(This is dealt with in more detail by IAS 37 Provisions, Contingent Liabilities and Contingent Assets
which is covered in Chapter 13).
Points to note:
(1) There is a direct association between expenses being recognised in profit or loss for the period
and the generation of income. This is commonly referred to as the accruals basis or matching
concept. However, the application of the accruals basis does not permit recognition of assets or
liabilities in the statement of financial position which do not meet the appropriate definition.
(2) Expenses should be recognised immediately in profit or loss for the period when expenditure is
not expected to result in the generation of future economic benefits.
(3) An expense should also be recognised immediately when a liability is incurred without the
corresponding recognition of an asset.
52 Corporate Reporting
2.8.1 Financial capital and capital maintenance
Definition
Financial capital maintenance: Under a financial concept of capital maintenance, such as invested
money or invested purchasing power, capital is synonymous with the net assets or equity of the entity.
Definition
Physical capital maintenance: Under a physical concept of capital, such as operating capability,
capital is regarded as the productive capacity of the entity based on, for example, units of output per
day.
This concept looks behind monetary values, to the underlying physical productive capacity of the
entity. It is based on the approach that an entity is nothing other than a means of producing saleable
outputs, so a profit is earned only after that productive capacity has been maintained by a 'capital
maintenance' adjustment. (Again, the capital maintenance adjustment is taken to equity and is treated
as an additional expense in the statement of profit or loss and other comprehensive income.)
Comparisons over 20 years should be more valid than under a monetary approach to capital
maintenance.
The difficulties in this approach lie in making the capital maintenance adjustment. It is basically a
current cost approach, normal practice being to use industry-specific indices of movements in non-
current assets, rather than go to the expense of annual revaluations by professional valuers. The
difficulties lie in finding indices appropriate to the productive capacity of a particular entity.
Financial capital
Financial capital maintenance
maintenance (constant purchasing Physical capital
(monetary terms) power) maintenance
CU CU CU
Revenue 250,000 250,000 250,000
Cost of sales
20,000 × 10 (200,000)
20,000 × 11.2 (224,000)
20,000 × 11.5 (230,000)
Profit 50,000 26,000 20,000
54 Corporate Reporting
2.9 Underlying assumptions
The term 'underlying assumptions' can have a specific or a general meaning:
(a) The 1989 Framework, now Chapter 4 of the revised Conceptual Framework, states that the going
concern assumption is the underlying assumption. Thus, the financial statements presume that
an entity will continue in operation indefinitely or, if that presumption is not valid, disclosure and a
different basis of reporting are required. (The Framework used to have accruals as a second
underlying assumption, but this is now in IAS 1, leaving going concern as the only underlying
assumption.)
(b) The term 'underlying assumption' may also overlap with 'fundamental accounting concepts', found
in IAS 1 Presentation of Financial Statements (accruals, going concern, consistency, materiality,
offsetting).
C
H
3 Other reporting frameworks A
T
Section overview E
R
• This Study Manual (and your exam) focuses on IFRS, but there are other reporting frameworks you
need to know about, particularly those that relate to smaller entities.
• The IASB issued an IFRS for small and medium-sized entities in 2010. It is designed to facilitate
financial reporting by small and medium-sized entities in a number of ways. 2
Possible solutions
There are two approaches to overcoming the big GAAP/little GAAP divide:
Differential reporting
Differential reporting may have drawbacks in terms of reducing comparability between small and larger
company accounts.
Furthermore, problems may arise where entities no longer meet the criteria to be classified as small.
3.3 International Financial Reporting Standard for Small and Medium-sized Entities
The IFRS for Small and Medium-Sized Entities (as adopted and called IFRS for SMEs in Bangladesh)
was published in July 2009. It is only 230 pages, and has simplifications that reflect the needs of users
of SMEs' financial statements and cost-benefit considerations. It is designed to facilitate financial
reporting by small and medium-sized entities in a number of ways:
(a) It provides significantly less guidance than full IFRS.
(b) Many of the principles for recognising and measuring assets, liabilities, income and expenses in full
IFRSs are simplified.
(c) Where full IFRSs allow accounting policy choices, the IFRS for SMEs allows only the easier option.
56 Corporate Reporting
(d) Topics not relevant to SMEs are omitted.
(e) Significantly fewer disclosures are required.
(f) The standard has been written in clear language that can easily be translated.
Scope
The IFRS is suitable for all entities except those whose securities are publicly traded and financial
institutions such as banks and insurance companies. It is the first set of international accounting
requirements developed specifically for small and medium-sized entities (SMEs). Although it has been
prepared on a similar basis to IFRS, it is a stand-alone product and will be updated on its own timescale.
There are no quantitative thresholds for qualification as an SME; instead, the scope of the IFRS is
determined by a test of public accountability. As with full IFRS, it is up to legislative and regulatory
authorities and standard setters in individual jurisdictions to decide who is permitted or required to use C
the IFRS for SMEs. H
A
Effective date T
The IFRS for SMEs does not contain an effective date; this is determined in each jurisdiction. The IFRS E
will be revised only once every three years. It is hoped that this will further reduce the reporting burden R
for SMEs.
Accounting policies
For situations where the IFRS for SMEs does not provide specific guidance, it provides a hierarchy for 2
determining a suitable accounting policy. An SME must consider, in descending order:
• The guidance in the IFRS for SMEs on similar and related issues.
• The definitions, recognition criteria and measurement concepts in Section 2 Concepts and
Pervasive Principles of the standard.
The entity also has the option of considering the requirements and guidance in full IFRS dealing with
similar topics. However, it is under no obligation to do this, or to consider the pronouncements of other
standard setters.
Omitted topics
The IFRS for SMEs does not address the following topics that are covered in full IFRS.
• Earnings per share
• Interim financial reporting
• Segment reporting
• Classification for non-current assets (or disposal groups) as held for sale
Examples of options in full IFRS not included in the IFRS for SMEs
• Revaluation model for intangible assets and property, plant and equipment
• Financial instrument options, including available-for-sale, held to maturity and fair value options
• Choice between cost and fair value models for investment property (measurement depends on the
circumstances)
• Options for government grants
Likely effect
Because there is no supporting guidance in the IFRS for SMEs, it is likely that differences will arise from
full IFRS, even where the principles are the same. Most of the exemptions in the IFRS for SMEs are on
grounds of cost or undue effort. However, despite the practical advantages of a simpler reporting
framework, there will be costs involved for those moving to IFRS– even a simplified IFRS– for the first
time.
SMEs in Bangladesh
Small and medium-sized enterprises (SMEs) are allowed to prepare their accounts in compliance with
the IFRSs for SMEs, originally issued by IASB, and adopted by ICAB.
58 Corporate Reporting
(b) The scope extends to 'non-publicly accountable' entities. Potentially, the scope is too wide
(c) The standard will be onerous for small companies
(d) Further simplifications could be made. These might include:
(i) Amortisation for goodwill and intangibles
(ii) No requirement to value intangibles separately from goodwill on a business combination
(iii) No recognition of deferred tax
(iv) No measurement rules for equity-settled share-based payment
(v) No requirement for consolidated accounts
(vi) All leases accounted for as operating leases with enhanced disclosures
C
(vii) Fair value measurement when readily determinable without undue cost or effort.
H
3.4 Auditing smaller entities A
T
At this point, it is useful to look at small and medium enterprises from an audit perspective.
E
R
3.4.1 International Standards on Auditing for small companies
Unlike the IFRSs, there are no separate auditing standards applying specifically to smaller entities. This
is based on the view that 'an audit is an audit' and that users who receive auditor's reports need to have
confidence in the auditor's opinions, whether they are in relation to large or small entity financial
2
statements.
However, there is an acknowledgement that small and medium enterprises do pose specific challenges
to the auditor in certain areas. Some of the ISA s that you have already studied highlight how their
requirements should be applied to small company audits.
60 Corporate Reporting
• That banks and other lenders may cease to support the entity
• The possible loss of a principal supplier, major customer, key employee, or the right to operate
under a licence, franchise or other legal agreement.
It is unlikely that budgets and forecasts will be available for the auditor to review. In many businesses
the principal source of finance may be a loan from the owner manager.
If an entity is in difficulty, its survival may depend on the owner manager subordinating his loan in favour
of banks or other financial institutions. In this case, the auditor would inspect sufficient, appropriate
evidence of the subordination.
If an entity depends on funds from the owner manager, the auditor will consider their current financial
position and may ask for a written representation to confirm the owner-manager's understanding.
C
H
4 IFRS 13 Fair Value Measurement A
T
Section overview E
R
• IFRS 13 Fair Value Measurement gives extensive guidance on how the fair value of assets and
liabilities should be established.
• IFRS 13 sets out to:
(a) Define fair value 2
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
• IFRS 13 defines fair value as 'the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the
measurement date'.
• Fair value is a market-based measurement, not an entity-specific measurement. It focuses on
assets and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date.
• IFRS 13 states that valuation techniques must be those which are appropriate and for which
sufficient data are available. Entities should maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.
4.1 Background
In May 2011 the IASB published IFRS 13 Fair Value Measurement. The project arose as a result of the
Memorandum of Understanding between the IASB and FASB (2006) reaffirming their commitment to the
convergence of IFRSs and US GAAP. With the publication of IFRS 13, IFRS and US GAAP now have
the same definition of fair value and the measurement and disclosure requirements are now aligned. A
standard on fair value measurement is particularly important in the context of a worldwide move towards
IFRS.
4.2 Objective
IFRS 13 sets out to:
(a) Define fair value
(b) Set out in a single IFRS a framework for measuring fair value
(c) Require disclosures about fair value measurements
Definition
Fair value: 'the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date'.
4.3 Scope
IFRS13 applies when another IFRS requires or permits fair value measurements or disclosures. The
measurement and disclosure requirements do not apply in the case of:
(a) Share-based payment transactions within the scope of IFRS 2 Share-based Payment
(b) Leasing transactions within the scope of IAS 17 Leases; and
(c) Net realisable value as in IAS 2 Inventories or value in use as in IAS 36 Impairment of Assets.
Disclosures are not required for:
(a) Plan assets measured at fair value in accordance with IAS 19 Employee Benefits
(b) Plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by
Retirement Benefit Plans; and
(c) Assets for which the recoverable amount is fair value less disposal costs under IAS 36 Impairment
of Assets
4.4 Measurement
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on assets
and liabilities and on exit (selling) prices. It also takes into account market conditions at the
measurement date. In other words, it looks at the amount for which the holder of an asset could sell it
and the amount which the holder of a liability would have to pay to transfer it. It can also be used to
value an entity's own equity instruments.
Because it is a market-based measurement, fair value is measured using the assumptions that market
participants would use when pricing the asset, taking into account any relevant characteristics of the
asset.
It is assumed that the transaction to sell the asset or transfer the liability takes place either:
(a) In the principal market for the asset or liability; or
(b) In the absence of a principal market, in the most advantageous market for the asset or liability.
The principal market is the market which is the most liquid (has the greatest volume and level of activity)
for that asset or liability. In most cases the principal market and the most advantageous market will be
the same.
IFRS13 acknowledges that when market activity declines an entity must use a valuation technique to
measure fair value. In this case the emphasis must be on whether a transaction price is based on an
orderly transaction, rather than a forced sale.
Fair value is not adjusted for transaction costs. Under IFRS13, these are not a feature of the asset
or liability, but may be taken into account when determining the most advantageous market.
Fair value measurements are based on an asset or a liability's unit of account, which is specified by
each IFRS where a fair value measurement is required. For most assets and liabilities, the unit of
account is the individual asset or liability, but in some instances may be a group of assets or liabilities.
62 Corporate Reporting
Worked example: principal or most advantageous market
An asset is sold in two active markets, Market X and Market Y, at CU58 and CU57, respectively. Valor
Co does business in both markets and can access the price in those markets for the asset at the
measurement date as follows.
Market X Market Y
CU CU
Price 58 57
Transaction costs (4) (3)
Transport costs (to transport the asset to that market) (4) (2)
50 52 C
H
Remember that fair value is not adjusted for transaction costs. Under IFRS13, these are not a feature of A
the asset or liability, but may be taken into account when determining the most advantageous market. T
If Market X is the principal market for the asset (ie the market with the greatest volume and level of E
activity for the asset), the fair value of the asset would be CU54, measured as the price that would be R
received in that market (CU58) less transport costs (CU4) and ignoring transaction costs.
If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair value
of the asset using the price in the most advantageous market. The most advantageous market is the
market that maximises the amount that would be received to sell the asset, after taking into account both 2
transaction costs and transport costs (ie the net amount that would be received in the respective
markets).
The maximum net amount (after deducting both transaction and transport costs) is obtainable in Market
Y (CU52, as opposed to CU50). But this is not the fair value of the asset. The fair value of the asset is
obtained by deducting transport costs but not transaction costs from the price received for the asset in
Market Y: CU57 less CU2 = CU55.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the asset or
liability, either directly or indirectly, eg quoted prices for similar assets in active markets or for
identical or similar assets in non active markets or use of quoted interest rates for valuation
purposes
Level 3 Unobservable inputs for the asset or liability, ie using the entity's own assumptions about
market exit value.
4.5.1 Valuation approaches
The IFRS identifies three valuation approaches.
(a) Income approach. Valuation techniques that convert future amounts (eg cash flows or income and
expenses) to a single current (ie discounted) amount. The fair value measurement is determined on
the basis of the value indicated by current market expectations about those future amounts.
64 Corporate Reporting
Blue Co will receive approximately CU11,700 in exchange for its promise. This is the present value of
CU20,000 in seven years at 8%.
4.8 Disclosure
An entity must disclose information that helps users of its financial statements assess both of the
following:
C
(a) For assets and liabilities that are measured at fair value on a recurring or non-recurring basis, the
H
valuation techniques and inputs used to develop those measurements.
A
(b) For recurring fair value measurements using significant unobservable inputs (Level 3), the effect T
of the measurements on profit or loss or other comprehensive income for the period. Disclosure E
requirements will include: R
(i) Reconciliation from opening to closing balances
(ii) Quantitative information regarding the inputs used
(iii) Valuation processes used by the entity
(iv) Sensitivity to changes in inputs 2
Advantages Disadvantages
• Relevant to users' decisions • Subjective (not reliable)
• Consistency between companies • Hard to calculate if no active market
• Predicts future cash flows • Time and cost
• Lack of practical experience/familiarity
• Less useful for ratio analysis (bias)
• Misleading in a volatile market
Advantages Disadvantages
• Reliable • Less relevant to users' decisions
• Less open to manipulation • Need for additional measure of
recoverable amounts (impairment test)
• Quick and easy to ascertain
• Does not predict future cash flows
• Matching (cost and revenue)
• Practical experience & familiarity
Section overview
• This is an overview of material covered in earlier studies.
66 Corporate Reporting
• An entity should disclose information relevant to assessing the impact of new IFRSs/IFRICs on
the financial statements where these have been issued but have not yet come into force.
5.4 Errors C
H
• Prior period errors: correct retrospectively where material. A
• This involves: T
E
(a) Either restating the comparative amounts for the prior period(s) in which the error occurred
R
(b) Or when the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for that period
so that the financial statements are presented as if the error had never occurred.
2
• Only where it is impracticable to determine the cumulative effect of an error on prior periods can
an entity correct an error prospectively.
Section overview
• This section covers several areas in which the IASB are developing new accounting standards.
Recent changes are ripe for examination if they are the subject of a full IFRS. While proposed
changes (EDs, Discussion Papers) will not be examined in detail, it is important to show an
awareness of them.
Tutorial note. Current issues are covered in this Study Manual within the chapters in which the topic
appears, so that the changes/proposed changes appear in context.
The most obvious change is that the term 'provision' is no longer used; instead it is proposed that the
term 'liability' is used. See Chapter 13 for more detail.
6.4 Leasing
The IASB has decided to undertake a leasing project with the objective of developing a single method of
accounting for leases that would not rely on the distinction between operating and finance leases. This is
covered in Chapter 14.
68 Corporate Reporting
6.7 Changes to group accounting
In 2011, the IASB published a revised version of IAS 27 and 28 and issued IFRSs 10 to 12. The new
and revised standards are covered in Chapter 20.
C
H
A
T
E
R
Summary
ICAB
70 Corporate Reporting
C
H
A
T
E
R
72 Corporate Reporting
Additionally, Vitaleque had acquired an entity on 30 November 20X2 and is required to fair value a
decommissioning liability. The entity has to decommission a mine at the end of its useful life, which
is in three years' time. Vitaleque has determined that it will use a valuation technique to measure
the fair value of the liability. If Vitaleque were allowed to transfer the liability to another market
participant, then the following data would be used.
Input
Labour and material cost CU2 million
Overhead 30% of labour and material cost
Third party mark-up – industry average 20%
Annual inflation rate 5%
Risk adjustment – uncertainty relating to cash flows 6%
Risk-free rate of government bonds 4%
C
Entity's non-performance risk 2%
H
Vitaleque needs advice on how to fair value the liability. A
T
Requirement
E
Discuss, with relevant computations, how Vitaleque should fair value the above asset and liability R
under IFRS 13.
The capitalised development costs related to a single project that commenced in 20X4. It has now
been discovered that one of the criteria for capitalisation has never been met.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, by what
amount should retained earnings be adjusted to restate them as at 31 December 20X6?
6 Hookbill
The Hookbill Company was updating its inventory control system during 20X7 when it discovered
that it had, in error, included CU50,000 in inventories in its statement of financial position as at year
to 31 December 20X6 relating to items that had already been sold at that date. The 20X6 profit
after tax shown in Hookbill's financial statements for the year to 31 December 20X6 was
CU400,000.
In the draft financial statements for the year to 31 December 20X7, before any adjustment for the
above error, the profit after tax was CU500,000.
Hookbill pays tax on profits at 25%.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, what figures
should be disclosed for profit after tax in the statement of profit or loss and other comprehensive
income of Hookbill for the year ended 31 December 20X7, for both 20X7 and the comparative year
20X6?
Requirement
Ignoring tax, determine the retained earnings figure for Carduus at 1 January 20X7 in the financial
statements for the year to 31 December 20X7 and the profit before tax for the year then ended after
adjusting for the change in amortisation according to IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.
8 Aspen
The Aspen Company was drawing up its draft financial statements for the year to 31 December
20X7 and was reviewing its cut-off procedures. It discovered that it had, in error, at the previous
year end, omitted from inventories in its statement of financial position a purchase of inventories
amounting to CU100,000 made on the afternoon of 31 December 20X6. The related purchase
transaction and the trade payable had been correctly recorded.
The retained earnings of Aspen at 31 December 20X6 as shown in its 20X6 financial statements
were CU4,000,000. In the draft financial statements for the year to 31 December 20X7, before any
adjustment of the above error, the profit after tax was CU800,000. Aspen pays tax on profits at
30%.
Requirement
According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, what figures
should be disclosed in the financial statements of Aspen for the year ended 31 December 20X7 for
profit after tax for the year and for retained earnings at 1 January 20X7?
9 Polson
The Polson Company appointed Rayner as finance director late in 20X7. One of Rayner's initial
tasks was to ensure a thorough review was carried out of Polson's accounting policies and their
application in the preparation of Polson's consolidated financial statements for the year ended 31
December 20X6. This review identified the following issues in relation to the 20X6 consolidated
financial statements which were approved for publication early in 20X7.
(1) The CU840,000 year-end carrying amount of a major item of plant in a wholly-owned
subsidiary comprised costs incurred up to 31 December 20X6. Depreciation was charged from
1 January 20X7 when the item was for the first time working at normal capacity. The
depreciation charge takes account of residual value of CU50,000 on 30 September 20Y4, the
end of the item's useful life. The overall construction and installation of the item was
completed on 30 September 20X6, when the item was first in full working order. Between 1
October and 31 December 20X6 the item was running below normal capacity as employees
learnt how to operate it. The year-end carrying amount comprises: costs incurred to 30
September 20X6 of CU800,000 plus costs incurred in October to December 20X6 of
CU50,000 less CU10,000 sales proceeds of the output sold in October to December.
(2) On 1 January 20X6 Polson acquired a 30% interest in The Niflumic Company for CU240,000,
which it classified in its consolidated financial statements as an available-for-sale investment
under IAS 39 Financial Instruments: Recognition and Measurement, despite Polson having
74 Corporate Reporting
representation on Niflumic's board of directors. Niflumic's shares are dealt in on a public
market and the year-end carrying amount of CU360,000 was derived using the market price
quoted on that date. The fair value increase of CU90,000 (360,000 – 240,000 less 25%
deferred tax) was recognised in an available-for-sale reserve in equity. In its year ended 31
December 20X6 Niflumic earned a post-tax profit of CU80,000 and paid no dividends.
(3) At 31 December 20X6 the total trade receivables in a 60% owned subsidiary was CU360,000
according to the accounting records, while the separate list of customers' balances totalled
CU430,000. The accounting records were adjusted by adding the difference to both the
carrying amount of trade receivables and revenue. It was revealed that the difference arose
from double-counting certain customers' balances when taking the list out.
The 20X6 consolidated financial statements showed CU400,000 as the carrying amount of retained
earnings at the year end. The effect of taxation is immaterial in respect of the item of plant and the C
trade receivables adjustment. H
A
Requirement
T
Determine the following amounts for inclusion as comparative figures in Polson's 20X7 E
consolidated financial statements after the adjustments required by IAS 8 Accounting Policies, R
Changes in Accounting Estimates and Errors.
(a) The carrying amount of the item of plant at 31 December 20X6
(b) The increase/decrease in equity at 31 December 20X6 in respect of the investment in Niflumic
(c) The carrying amount of retained earnings at 31 December 20X6 2
Point to note: The whole of the Conceptual Framework and Preface to International Financial Reporting
Standards is examinable. The paragraphs listed below are the key references you should be familiar
with.
• Objective is to provide information on financial position (the entity's Concept Frame (OB12)
economic resources and the claims against it) and about transactions and
other events that change those resources and claims
• Two fundamental qualitative characteristics are relevance and faithful Concept Frame (QC5)
representation
• Relevance = capable of making a difference to decisions Concept Frame (QC6)
• Costs (of preparing and analysing) financial information must be justified Concept Frame (QC35)
by the benefits of reporting it
5 Underlying assumption
76 Corporate Reporting
• Going concern Concept Frame (4.1)
• Asset: A resource controlled by the entity as a result of past events and Concept Frame (4.4)
from which future economic benefits are expected to flow to the entity.
• Liability: A present obligation of the entity arising from past events, the Concept Frame (4.4)
settlement of which is expected to lead to the outflow from the entity of
resources embodying economic benefits.
• Equity: The residual interest in assets less liabilities, that is net assets. Concept Frame (4.4)
C
• Income (comprising revenue and gains): Increases in economic benefits in Concept Frame (4.25, 4.29) H
the form of asset increases/liability decreases, other than contributions A
from equity. T
E
• Expenses (including losses): Decreases in economic benefits in the form Concept Frame (4.25, 4.33)
R
of asset decreases/liability increases, other than distributions to equity.
7 Recognition
• An asset or a liability should be recognised in financial statements if: Concept Frame (4.38) 2
– It is probable that any future economic benefits associated with the
item will flow to or from the entity, and
– Its cost or value can be measured with reliability
8 Measurement
• Current cost
• Realisable value
• Present value
9 Capital maintenance
– Monetary
– Constant purchasing power
• Physical capital
10 IASB
Preface (6)
• Objectives of IASB Preface (7–16)
• Scope and authority of IFRS Preface (17)
• Due process re IFRS development
Overview
IFRSfor SMEs
• There are many considerations as to whether the same or a different set of IFRSs should apply to
SMEs. The IFRS for SMEs applies to companies without public accountability (rather than using a size
test).
• The IFRS for SMEs retains the core principles of 'full' IFRSs, but reduces choice of accounting
treatments and introduces a number of simplifications to reduce the reporting burden on SMEs.
• Fair value is defined as the price that would be received to sell an asset IFRS13.9
or paid to transfer a liability in an orderly transaction between market
Prior period errors IAS 8.5, IAS 8.42 and IAS 8.49
78 Corporate Reporting
Answers to Self-test
*Notes
(i) Because Vitaleque currently buys and sells the asset in the African market, the costs of
entering that market are not incurred and therefore not relevant.
(ii) Fair value is not adjusted for transaction costs. Under IFRS13, these are not a feature of
the asset or liability, but may be taken into account when determining the most
advantageous market.
(iii) The North American market is the principal market for the asset because it is the market
with the greatest volume and level of activity for the asset. If information about the North
American market is available and Vitaleque can access the market, then Vitaleque
should base its fair value on this market. Based on the North American market, the fair
value of the asset would be CU17, measured as the price that would be received in that
market (CU19) less costs of entering the market (CU2) and ignoring transaction costs.
(iv) If information about the North American market is not available, or if Vitaleque cannot
access the market, Vitaleque must measure the fair value of the asset using the price in
the most advantageous market. The most advantageous market is the market that
maximises the amount that would be received to sell the asset, after taking into account
both transaction costs and usually also costs of entry, that is the net amount that would
be received in the respective markets. The most advantageous market here is therefore
the African market. As explained above, costs of entry are not relevant here, and so,
based on this market, the fair value would be CU22.
It is assumed that market participants are independent of each other and knowledgeable,
and able and willing to enter into transactions.
(b) Fair value of decommissioning liability
Because this is a business combination, Vitaleque must measure the liability at fair value in
accordance with IFRS13, rather than using the best estimate measurement required by IAS
37 Provisions, contingent liabilities and contingent assets. In most cases there will be no
observable market to provide pricing information. If this is the case here, Vitaleque will use the
expected present value technique to measure the fair value of the decommissioning liability.
If Vitaleque were contractually committed to transfer its decommissioning liability to a market
participant, it would conclude that a market participant would use the inputs as follows, arriving
at a fair value of CU3,215,000.
80 Corporate Reporting
Input Amount
CU'000
Labour and material cost 2,000
Overhead: 30% × 2,000 600
Third party mark-up – industry average: 2,600 × 20% 520
3,120
Inflation adjusted total (5% compounded over three years): 3,120 × 1.053 3,612
Risk adjustment – uncertainty relating to cash flows: 3,612 × 6% 217
3,829
Discount at risk-free rate plus entity's non-performance risk (4% + 2% = C
20X7: CU537,500
20X6: CU362,500
20X7 20X6
CU CU
Draft profit after tax 500,000 400,000
Inventory adjustment 50,000 (50,000)
Tax thereon at 25% (12,500) 12,500
Revised profit after tax 537,500 362,500
The comparative amounts for the prior period should be restated, per IAS 8.42.
Correction of opening inventory will increase profit for the current period, by the amount of the after
tax adjustment. Conversely, the closing inventory for the previous period is reduced, thereby
reducing profit by the after tax effect of the adjustment.
7 Carduus
Retained earnings: CU400 million
Profit before tax: CU58.0 million
The change in useful life is a change in an accounting estimate which is accounted for
prospectively (IAS 8.36). So retained earnings brought forward remain unchanged, at CU400m.
The carrying amount of development costs at 1 January 20X7 (half-way through their previously
estimated useful life) is (CU72m × 5/10) = CU36m. Writing this off over 3 years gives a charge of
CU12m per annum. So the profit before tax is CU70m – CU12m = CU58m.
8 Aspen
Profit after tax: CU730,000
Retained earnings: CU4,070,000
The comparative amounts for the prior period should be restated, per IAS 8.42.
The correction of opening inventories will decrease profit for the current period, by the after-tax
value of the adjustment. Thus current period profits are CU800,000 – (CU100,000 × 70%) =
CU730,000.
The closing inventories of the previous period are increased by the same amount. So retained
earnings are CU4,000,000 + (CU100,000 × 70%) = CU4,070,000.
Trade receivables, revenue, and therefore profit, were overstated by CU70,000 in respect of
the trade receivables. Polson's share is 60%, so end-20X6 retained earnings must be reduced
by CU42,000.
The share of Niflumic's profits is recognised in retained earnings, not in a separate reserve,
giving rise to an increase of CU24,000.
82 Corporate Reporting
Answers to Interactive questions
(a) Oak Ltd has purchased a patent for CU40,000. This is an asset, albeit an intangible one. There
The patent gives the company sole use of a is a past event, control and future economic
particular manufacturing process which will benefit (through cost saving).
save CU6,000 a year for the next five years. C
(b) Elm Ltd paid John Brown CU20,000 to set up a This cannot be classed as an asset. Elm Ltd has H
car repair shop, on condition that priority no control over the car repair shop and it is A
treatment is given to cars from the company's difficult to argue that there are future economic T
fleet. benefits. E
R
(c) Sycamore Ltd provides a warranty with every This is a liability. The business has an obligation
washing machine sold. to fulfil the terms of the warranty. The liability
would be recognised when the warranty is
issued rather than when a claim is made.
2
Ethics C
H
A
P
T
E
R
Introduction
Topic List
1 The importance of ethics
2 Ethical codes and standards
3 Ethics: financial reporting focus
4 Ethics: audit and assurance focus
5 Making ethical judgements
Appendix 1
Appendix 2
Summary and Self-test
Answers to Self-test
Answers to Interactive questions
Ethics 85
Introduction
Tick
Learning objectives
off
• Identify and explain ethical issues in reporting, assurance and business scenarios
• Explain the relevance, importance and consequences of ethical issues
• Evaluate the impact of ethics on a reporting entity, relating to the actions of stakeholders
• Recommend and justify appropriate actions where ethical issues arise in a given scenario
• Design and evaluate appropriate safeguards to mitigate threats and provide resolutions to
ethical problems
86 Corporate Reporting
1 The importance of ethics
Section overview
• Ethical behaviour is essential to maintain public confidence.
• Guidance is provided in professional codes of conduct and ethical standards.
1.1 Introduction
In general terms, ethics is a set of moral principles and standards of correct behaviour. Far from being
noble ideals which have little impact on real life, they are essential for any society to operate and function
effectively. Put simply, they help to differentiate between right and wrong, although their application often
involves complex issues, judgement and decisions. While ethical principles can be incorporated into law, in
many cases their application has to depend on the self-discipline of the individual. This principle can be seen
to apply to society as a whole, the business community and the accounting profession.
1.2 Ethics in business
Business life is a fruitful source of ethical dilemmas because its whole purpose is material gain, the making of
profit. Success in business requires a constant search for potential advantage over others and business
people are under pressure to do whatever yields such an advantage. As a result, organisations have become
increasingly under pressure to act, and to be seen to be acting, ethically. In recent years, many have
demonstrated this by publishing ethical codes, setting out their values and responsibilities towards
stakeholders.
In some instances, businesses may be forced to adopt a more ethical approach. In 2013, many bank chief
executives saw a pay cut for the first time in years. This was partly due to tightened regulations which now
require banks to align executive pay more closely to risks and performance. Arguably more forceful, however,
are the investor revolts arising as a result of shareholders' anger at rising pay in a time of falling profits and C
reduced dividend payouts. H
A
1.3 Ethics and the accounting profession P
T
The IESBA Code of Ethics for Professional Accountants (IESBA Code) states:
E
'A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public R
interest.'
The public interest is considered to be the 'collective well-being of the community of people and institutions the
professional accountant serves'. These include:
3
• Clients
• Lenders
• Governments
• Employers
• Employees
• Investors
• The business and financial community
• Others who rely on the work of the professional accountant
For the work of the accountant in practice or in business to maintain its value the accountant must be
respected and trusted. The individual professional accountant therefore has a duty and a responsibility to
maintain the reputation of the profession and the confidence of the public.
The devastating effect of the ethical choices of one individual can be seen in the following summary of the role
played by Betty Vinson, an accountant at WorldCom.
Ethics 87
Worked example: WorldCom
WorldCom the US long-distance telephone carrier is 'credited' with being responsible for a fraud that created
the largest bankruptcy in US history. This reportedly resulted in a fine of $500 million, which at the time was
the largest fine ever imposed by the Securities and Exchange Commission (SEC).
The problems began for WorldCom in mid-2000. Its operating costs were increasing sharply due to the fees
which it had to pay to other companies for use of their telephone networks. Its Chief Executive Officer and
Chief Financial Officer had had to inform Wall Street of lower than expected profits for the second half of the
year and there was increasing pressure to improve results. Betty Vinson was working for WorldCom at this
time as a senior manager in the corporate accounting division. She was asked by her boss to falsify the
accounts in order to increase profits. This was achieved primarily by capitalising line costs rather than treating
them as operating expenses. Whilst Betty Vinson considered resignation due to the pressure she was put
under to falsify the results, she continued to work for WorldCom until early 2002 and was promoted from
senior manager to director with an increase in salary of $30,000. Over an 18 month period she had helped to
falsify records at the request of her bosses increasing profits by $3.7 billion.
By March 2002 questions were being asked by internal audit. Vinson decided to disclose the details of the
falsified records to the FBI, the SEC and the US Attorney. She had hoped that her testimony could be
exchanged for immunity from prosecution, however this was not the case. In October 2002 she pleaded guilty
to two counts of conspiracy and securities fraud (carrying a maximum sentence of 15 years) and in October
2003 she was charged with entering false information on company documents (carrying a maximum sentence
of ten years).
Section overview
• The accounting profession has developed principles-based codes including the IESBA Code.
• The IESBA Code centres around five fundamental principles and a professional accountant is
responsible for recognising and assessing potential threats to these fundamental principles.
• Where threats are identified, a professional accountant must then implement safeguards to eliminate
these threats or reduce them to an acceptable level.
The IESBA Code provides ethical guidance internationally for IFAC members. The ICAB Code contains
additional guidance or requirements. Therefore compliance with the ICAB Code will be also a compliance with
the IESBA Code.
You should be familiar with the ICAB Code and IESBA Code from your previous studies and the remainder of
this section revises some of the key points covered at Professional Level.
The IESBA Code is principles-based and members are responsible for:
• Identifying threats to compliance with the fundamental principles
• Evaluating the significance of these threats
• Implementing safeguards to eliminate them or reduce them to an acceptable level.
88 Corporate Reporting
The guidance in the Code is given in the form of:
• Fundamental principles and
• Illustrations as to how they are to be applied in specific situations.
The ICAB Code is compliance -based and the Code applies to all members, students, affiliates, employees
of member firms and, where applicable, member firms, in all of their professional and business activities,
whether remunerated or voluntary.
It is important to note therefore that adhering to the Code is equally important for a member working in
business as it is for a member working in practice, even though the ethical codes are sometimes perceived to
be associated more with the accountant in practice.
The ICAB is committed to enforcing the Code through disciplining members who do not meet reasonable
ethical and professional expectations of the public and other members.
A copy of the ICAB code is included in the Member's Handbook and is available at www.icab.org.bd.
Section overview
• This section provides a summary of some key points covered in the ethics learning material in the
Financial Accounting and Reporting paper at Professional Level.
• Here we primarily consider the application of the ICAB Code to the accountant in business involved in
a financial reporting environment (we look at the accountant in practice in Section 4).
Ethics 89
4 Confidentiality
A professional accountant should:
• Respect the confidentiality of information acquired as a result of professional and business relationships
• Not disclose any such information to third parties without proper and specific authority (unless there is a
legal or professional duty to disclose)
• Not use such information for the personal advantage of himself or third parties.
The professional accountant must maintain confidentiality even in a social environment and even after
employment with the client/employer has ended.
A professional accountant may be required to disclose confidential information:
• Where disclosure is permitted by law and is authorised by the client or employer
• Where disclosure is required by law, for example
– Production of documents or other provision of evidence in the course of legal proceedings
– Disclosure to the appropriate public authorities of infringements of the law that come to light.
5 Professional behaviour
A professional accountant should comply with relevant laws and regulations and should avoid any action that
discredits the profession.
In marketing and promoting themselves professional accountants should not bring the profession into
disrepute. That is, they should not make:
• Exaggerated claims for the services they are able to offer, the qualifications they possess or experience
they have gained
• Disparaging references or unsubstantiated comparisons to the work of others.
3.2 Threats
Compliance with these fundamental principles may potentially be threatened by a broad range of
circumstances. Many of these threats can be categorised as follows:
A Self-interest threat the threat that a financial or other interest of a professional accountant or of an
immediate or close family member will inappropriately influence the professional accountant's judgment
or behaviour.
Examples of circumstances that may create such threats include:
• Financial interests, loans or guarantees
• Incentive compensation arrangements
• Inappropriate personal use of corporate assets
• Concern over employment security
• Commercial pressure from outside the employing organisation
B Self-review threat the threat that a professional accountant will not appropriately evaluate the results of
a previous judgement made by the professional accountant.
C Advocacy threat the threat that a professional accountant will promote a client's or employer's position
to the point that the professional accountant's objectivity is compromised.
D Familiarity threat the threat that due to a long or close relationship with a client or employer, a
professional accountant will be too sympathetic to their interests or too accepting of their work.
Examples of circumstances that may create such threats include:
E Intimidation threat the threat that a professional accountant will be deterred from acting objectively by
threats, either actual or perceived.
90 Corporate Reporting
Examples of circumstances that may create such threats include:
• A dominant personality attempting to influence the decision making process, for example, with
regard to the awarding of contracts or the application of an accounting principle.
3.3 Safeguards
There are two broad categories of safeguards which may eliminate or reduce such threats to an acceptable
level:
Safeguards created by the profession, legislation or regulation
Examples are:
• Educational, training and experience requirements for entry into the profession
• Professional standards
• External review by a legally empowered third party of reports, returns, communication or information
produced by a professional accountant C
H
• Effective, well-publicised complaints systems operated by the employing organisation, the profession or A
a regulator, which enable colleagues, employers and members of the public to draw attention to P
unprofessional or unethical behaviour
T
• An explicitly stated duty to report breaches of ethical requirements. E
R
Safeguards in the work environment
Examples are:
• Recruitment procedures in the employing organisation emphasising the importance of employing high
calibre, competent staff
• Leadership that stresses the importance of ethical behaviour and the expectation that employees will act
in an ethical manner
• Policies and procedures to implement and monitor the quality of employee performance
• Timely communication to all employees of the employing organisation's policies and procedures,
including any changes made to them, and appropriate training and education given on such policies and
procedures
• Policies and procedures to empower and encourage employees to communicate to senior levels within
the employing organisation any ethical issues that concern them without fear of retribution
Ethics 91
3.4 Ethical conflict resolution
When evaluating compliance with the fundamental principles, a professional accountant may be required to
resolve a conflict in complying with the fundamental principles.
A professional accountant may face pressure to:
• Issue, or otherwise be associated with, a financial or non-financial report that materially misrepresents
the facts, for example:
– Financial statements
– Tax compliance
– Legal compliance or
– Reports required by securities regulators
• Made public or
• Used by others inside or outside the employing organisation.
The accountant should:
• Prepare or present such information fairly, honestly and in accordance with relevant professional
standards
– Describes clearly the true nature of the business transactions, assets or liabilities
– Classifies and records information in a timely and proper manner
– Represents the facts accurately and completely in all material respects.
92 Corporate Reporting
3.7 Financial interests
An accountant may have financial interests, or may know of financial interests of immediate or close family
members, that could in certain circumstances, threaten compliance with the fundamental principles.
Examples of circumstances that may create self-interest threats, are if the accountant or family member:
• Holds a direct or indirect financial interest in the employing organisation and the value of that interest
could be directly affected by decisions made by the accountant
• Is eligible for a profit related bonus and the value of that bonus could be directly affected by a decision
made by the accountant
• Holds, directly or indirectly, share options in the employing organisation, the value of which could be
directly affected by decisions made by the accountant
• Holds, directly or indirectly, share options in the employing organisation which are, or will soon be,
eligible for conversion
• May qualify for share options in the employing organisation or performance-related bonuses if certain
targets are achieved.
Safeguards against such threats may include:
• Policies and procedures for a committee independent of management to determine the level or form of
remuneration of senior management
• Disclosure of all relevant interests and of any plans to trade in relevant shares to those charged with the
governance of the employing organisation, in accordance with any internal policies
• Consultation, where appropriate, with superiors within the employing organisation
• Consultation, where appropriate, with those charged with the governance of the employing organisation
or relevant professional bodies C
H
• Internal and external audit procedures
A
• Up-to-date education on ethical issues and the legal restrictions and other regulations around potential P
insider trading. T
E
R
3.8 Inducements
An accountant, or immediate or close family, may be offered an inducement such as: 3
• Gifts
• Hospitality
• Preferential treatment
• Inappropriate appeals to friendship or loyalty
An accountant should assess the risk associated with all such offers and consider whether the following
actions should be taken:
• Immediately inform higher levels of management or those charged with governance of the employing
organisation
• Inform third parties of the offer for example a professional body or the employer of the individual who
made the offer, or seek legal advice
• Advise immediate or close family members of relevant threats and safeguards where they are potentially
in positions that might result in offers of inducements (for example as a result of their employment
situation)
• Inform higher levels of management or those charged with governance of the employing organisation
where immediate or close family members are employed by competitors or potential suppliers of that
organisation.
Ethics 93
In 2005, the main board was tipped off by a former executive in Mexico. An internal investigation allegedly
revealed $24million in suspected bribery payments. However, the original investigation team was accused of
being too aggressive and dropped from the case. Responsibility for the investigation was transferred to one of
the Mexican executives alleged to have authorised bribes. This executive exonerated his fellow executives
and Wal-Mart's main board accepted this. Although a report was made at the time to the US Justice
Department, Wal-Mart played down the significance of the allegations. Executives in Mexico were not
disciplined – one was promoted to vice-chairman.
At the time of the investigation in 2005, Wal-Mart was facing pressure on its share price. The company's
Mexican operations were its biggest success, highlighted to investors as a model of future growth. The New
York Times said that there was evidence that main board directors were well aware of the devastating
consequences the allegations could have if made public.
Wal-Mart's shares fell by nearly 9% in the days after the New York Times published its allegations.The fall at
Wal-Mart also dragged down the whole Dow Jones Industrial Average. Wal-Mart faced the possibility of
massive legal liabilities under the US Foreign Corrupt Practices Act. One of Wal-Mart's institutional investors
began an action against executives and board members, and sought changes in the company's corporate
governance. A group of New York City pension funds said they would vote against re-electing five Wal-Mart
directors. One of Wal-Mart's managers started an on-line petition urging the company to undertake a thorough
and independent investigation. The manager claimed that most of the signatories were current and former
employees fed up with the philosophy of expansion at all costs.
Even only a few days after the story broke, there was evidence that Wal-Mart's strategic ambitions may have
been damaged by scandals. Its attempts to open stores in new areas and other dealings appeared to be
coming under increased scrutiny. It had been recently focusing on bigger cities where there was more
bureaucracy to overcome than in suburban and rural areas. The bribery scandal appeared to have made it
more difficult for Wal-Mart to proceed with its expansion plans.
94 Corporate Reporting
covering ethical dilemmas relevant to accountants – including a set of case studies specific to accountants in
practice.
Section overview
• This section focuses on ethical guidance most relevant to accountants in practice providing assurance
services and builds on the material covered in the Assurance paper at Certificate Level and the Audit
and Assurance Paper at Professional Level.
• It also provides detail of relatively recent changes to the relevant ethical codes and standards
– IESBA Code
– ICAB Code
– Ethical Standards for Auditors
• The key points from Certificate and Professional Levels are also summarised within this section with
additional information included at Appendices 1 and 2 to this chapter.
C
H
A
P
T
E
R
Ethics 95
Interactive question 2: Ethical risks [Difficulty level: Easy]
From your knowledge brought forward from your previous studies, and any practical experience of auditing
you may have, write down as many potential ethical risk areas concerning audit as you can in the areas
below. (Some issues may be relevant in more than one column.)
The Code has been revised to more comprehensively deal with a professional accountant's actions when
encountering a breach of the Code. The changes establish a robust framework for dealing with this
situation. In particular a firm is required to:
– Terminate, suspend or eliminate the interest/relationship that has caused the breach
– Evaluate the significance of the breach and determine whether action can be taken and is
appropriate in the circumstances to satisfactorily address the consequences of the breach
– Communicate all breaches with those charged with governance and obtain their concurrence that
action can be, or has been, taken to satisfactorily address the consequences of the breach
– Document, among other matters, the action taken and all the matters discussed with those charged
with governance
• Conflicts of interest
96 Corporate Reporting
Section 220 of the IESBA Code has been replaced with a revised version. The Code has established
more specific requirements and provides more comprehensive guidance to support professional
accountants in identifying, evaluating and managing conflicts of interest. The changes affect both
professional accountants in public practice and professional accountants in business, taking into account
their different circumstances.
The following key points are made:
– A conflict of interest may arise where a professional accountant provides a professional service
related to a particular matter for two or more clients or where the interests of the professional
accountant and a client are in conflict.
– The revised Code includes a number of examples of situations which would give rise to a conflict of
interest. Examples include:
– Providing a transaction advisory service to a client seeking to acquire an audit client
– Advising two clients at the same time who are competing to acquire the same company
– Providing services to both a vendor and a purchaser in relation to the same transaction
– Advising a client to invest in a business in which, for example, the spouse of the professional
accountant in public practice has a financial interest
– Advising a client on the acquisition of a business which the firm is also interested in acquiring
– The professional accountant must apply professional judgement when identifying and evaluating
potential conflicts of interest, taking into account whether a reasonable and informed third party
would be likely to conclude that compliance with the fundamental principles is not compromised.
C
– If the threat is not acceptable the professional accountant must apply safeguards to eliminate the H
threat or reduce it to an acceptable level. If safeguards cannot reduce the threat to an acceptable
A
level, the professional accountant must decline to perform or must discontinue professional
P
services that would result in the conflict of interest, or must terminate the relevant relationship or
T
dispose of the relevant interests to eliminate the threat or reduce it to an acceptable level.
E
Safeguards include: R
– Implementing mechanisms to prevent unauthorised disclosure of confidential information (eg using
separate engagement teams)
3
– Regular review of the application of safeguards by a senior individual not involved with the client
engagement or engagements
– Having an independent party review the work performed
– Consulting with third parties such as professional bodies, legal counsel or another professional
accountant
If a conflict of interest is identified the professional accountant must evaluate:
– The significance of the relevant interest/relationship
– The significance of the threats created by performing the professional service
In general the more direct the connection between the professional service and the matter on which
the parties' interests are in conflict, the more significant the threat to objectivity and compliance with
the other fundamental principles will be.
– It is generally necessary to disclose the nature of the conflict of interest and the related safeguards,
if any, to clients affected by the conflict and, when safeguards are required to reduce the threat to
an acceptable level, to obtain their consent to the professional accountant in public practice
performing the professional services.
– Where consent has been requested from a client and has been refused the professional accountant
must decline to perform or must discontinue professional services that would result in the conflict of
interest. Alternatively they may terminate the relevant relationship or dispose of the relevant
interests to eliminate the threat or reduce it to an acceptable level.
Ethics 97
• Change to the definition of 'engagement team'
'Engagement team' is now defined as: All partners and staff performing the engagement, and any
individuals engaged by the firm or network firm who perform assurance procedures on the engagement.
This excludes external experts engaged by the firm or network firm.
Importantly it also excludes individuals within the client's internal audit function who provide direct
assistance on an audit engagement when the external auditor complies with the requirements of ISA
610 (Revised 2013) Using the Work of Internal Auditors.
You should be aware of the following other details addressed by the IESBA Code:
• Independence requirements for audits of listed entities apply to all public interest entities. A public
interest entity is defined as follows:
(a) All listed entities; and
(b) Any entity (i) defined by regulation or legislation as a public interest entity or (ii) for which the audit
is required by regulation or legislation to be conducted in compliance with the same independence
requirements that apply to the audit of listed entities.
• Partner rotation requirements apply to all key audit partners. 'Key audit partner' is a new term introduced
by the revised code defined as 'the engagement partner, the individual responsible for the engagement
quality control review, and other audit partners on the engagement team, such as lead partners on
significant subsidiaries or divisions, who are responsible for key decisions or judgements on significant
matters with respect to the audit of the financial statements on which the firm will express an opinion'.
• A 'cooling off' period is required when a key audit partner or a firm's Senior or Managing Partner joins an
audit client that is a public interest company as either a director or officer of the entity or as an employee
in a position to exert significant influence over the preparation of the client's accounting records or the
financial statements. For the key audit partner independence would be deemed to be compromised
unless, subsequent to the partner ceasing to be a key audit partner, the entity had issued audited
financial statements covering a period of not less than twelve months and the partner was not a member
of the audit team with respect to the audit of those financial statements. For the Senior or Managing
Partner independence would be deemed to be compromised unless twelve months have passed since
the individual held that position.
• Key audit partners are prohibited from being evaluated on or compensated for selling non-assurance
services to their audit clients.
• Certain services in respect of preparation of accounting records and financial statements, valuation
services, tax services, internal audit services, IT systems services and recruiting services are prohibited
to audit clients which are public interest entities.
• Additional safeguards are required where fees from an audit client which is a public interest entity (and
its related entities) represent more than 15% of the total fees received by the firm for two consecutive
years. Prior to the issuance of the audit opinion on the second year's financial statements an
engagement quality control review is performed (a pre-issuance review). After the audit opinion on the
second year's financial statements has been issued, and before the issuance of the opinion on the third
year's financial statements an engagement quality control review is performed (a post-issuance review).
98 Corporate Reporting
The majority of threats fall into the following categories:
Threat Example
• Both the IESBA and ICAB Codes consider that there are two general categories of safeguard:
• Safeguards in the work environment may differ according to whether a professional accountant works in
public practice, in business or in insolvency.
• When evaluating safeguards, the auditor should consider what a reasonable and informed third party,
C
having knowledge of all relevant information, including the significance of the threat and the safeguards
H
applied, would conclude to be unacceptable.
A
P
4.4 Professional appointment T
Following procedures are applicable as per IESBA Code: E
R
• The prospective auditor should explain to the prospective client that they have a professional duty to
communicate with the existing auditor
• The client should be requested to confirm the proposed change to the existing auditor and to 3
authorise the existing auditor to co-operate with the prospective auditor
• Where this authorisation is received the prospective auditor should write to the existing auditor and
request the disclosure of any information which might be relevant to the successor's decision to
accept or decline the appointment
• The prospective auditor should then consider whether to accept or decline the appointment in the light
of the information received from the existing auditor
• The existing auditor is required to respond promptly to requests for information, however where
enquiries are not answered the prospective auditor should write to the existing auditor by recorded
delivery stating an intention to accept the appointment within a specified period of time
• The prospective auditor is allowed to assume that silence implies that there are no adverse
comments to be made. However the fact that no reply was received should be considered as part of the
overall decision-making process.
The ICAEW published an Ethics Helpsheet on Changes in a Professional Appointment and this gives some
practical guidance on how various types of information that might be obtained from the existing auditor could
affect the decision on whether to accept or decline the appointment, including this table:
Ethics 99
Matters which should not affect
Matters which should affect the Matters which might affect the
the decision to act but which
decision to act decision to act
might be helpful information
Where disclosure is permitted by law and is This might include circumstances where an employee has C
authorised by the client or the employer committed a fraud and the management are in agreement H
that the police should be informed. A
Where disclosure is required by law For example: P
T
• Production of documents or other provision of evidence
in the course of legal proceedings E
R
• Disclosure to the appropriate public authorities of
infringements of the law that come to light eg reporting
of suspected regulatory breaches to the Anti-Corruption
Commission. 3
Where there is a professional duty or right to In this instance disclosure can be made if it is in the 'public
disclose, when not prohibited by law interest' to do so.
Confidential information should not be used for personal advantage or the advantage of third parties eg insider
trading.
Applying this guidance will involve difficult judgements, particularly in making the decision as to whether
disclosure is in the public interest. Other specific matters which may need to be considered include:
– ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements
– ISA 250A – Consideration of Laws and Regulations in an Audit of Financial Statements
– Anti-Corruption laws.
• Notifying the affected parties of the conflict of interest and obtaining permission to act/continue to act
• Procedures to prevent access to information eg physical separation of teams and audit evidence
Ethics 101
• Clear guidelines for members of the engagement team on issues of security and confidentiality
• Regular reviews of the application of safeguards by a senior individual not involved with the relevant
client engagement
Where safeguards do not mitigate the risks sufficiently the professional accountant should not accept the
engagement or should cease to act for one of the parties.
Interactive question 3: Stewart Brice [Difficulty level: Intermediate]
You are the Ethics Partner at Stewart Brice, a firm of Chartered Accountants. The following situations exist.
Teresa is the audit manager assigned to the audit of Recreate, a large quoted company. The audit has been
ongoing for one week. Yesterday, Teresa's husband inherited 1,000 shares in Recreate. Teresa's husband
wants to hold on to the shares as an investment.
The Stewart Brice pension scheme, which is administered by Friends Benevolent, an unconnected company,
owns shares in Tadpole Group, a listed company with a number of subsidiaries. Stewart Brice has recently
been invited to tender for the audit of one of the subsidiary companies, Kermit Co.
Stewart Brice has been the auditor of Kripps Bros, a limited liability company, for a number of years. It is a
requirement of Kripps Bros' constitution that the auditor owns a token CU1 share in the company.
Requirements
Comment on the ethical and other professional issues raised by the above matters.
Identify the ethical and professional issues Stewart Brice would need to consider.
See Answer at the end of this chapter.
Section overview
• The application of ethical guidance requires skill and judgement and relies on the integrity of the
individual.
• The IESBA Code provides a framework for the resolution of ethical conflicts.
• In the exam, you will be expected to identify ethical issues and evaluate alternative courses of action.
Fundamental principles related to the This will involve reference to the relevant ethical guidance eg
matter in question IESBA Code.
What are the threats to the fundamental
principles?
Are there safeguards in place which can
reduce or eliminate the threats?
Established internal procedures The professional accountant may find it useful to discuss ethical
conflict issues with:
Does your organisation have policies and
procedures to deal with this situation? • Immediate superior C
How can you escalate concerns within • The next level of management H
your organisation? • A corporate governance body A
Is there a whistleblowing procedure? P
• Other departments eg legal, audit, human resources
T
Consideration should also be given to the point at which help is
E
sought from external sources eg ICAB. Generally it would be
preferable for the conflict to be resolved without external R
consultation.
Alternative courses of action The following should be considered:
3
Have all the consequences been • The organisation's policies, procedures and guidelines
discussed and evaluated? • Applicable laws and regulations
Will the proposed course of action stand • Universal values and principles adopted by society
the test of time?
• Long and short-term consequences
Would a similar course of action be
• Symbolic consequences
undertaken in a similar situation?
• Private and public consequences
Would the course of action stand scrutiny
from peers, family and friends?
Where the conflict is significant and cannot be resolved, the accountant would need to seek legal advice.
After exhausting all other possibilities and depending on the nature of the conflict, the individual may conclude
that withdrawal from the engagement team or resignation from the firm/employing organisation is appropriate.
Point to note:
Withdrawal/resignation would be seen very much as a last resort.
Ethics 103
management. You may also be asked to consider the issue from the point of view of the accountant in practice
and the accountant in business.
The following Interactive question demonstrates these points.
It provides a summary of the key points. It has been structured around the ethical issues as this is the way that
it will be examined at the Advanced Level.
Definitions
Integrity: This is a prerequisite for all those who act in the public interest. It is essential that auditors act, and
are seen to act, with integrity, which requires not only honesty but a broad range of related qualities such as
fairness, candour, courage, intellectual honesty and confidentiality.
Objectivity: This is a state of mind that excludes bias, prejudice and compromise and that gives fair and
impartial consideration to all matters that are relevant to the task in hand disregarding those that are not.
Objectivity requires that the auditors' judgement is not affected by conflicts of interest.
C
Independence: This is freedom from situations and relationships which make it probable that a reasonable
H
and informed third party would conclude that objectivity either is impaired or could be impaired. Independence
is related to and underpins objectivity. A
P
T
E
R
Ethics 105
1.2 Self-interest threat
Financial interests The parties listed below are not allowed to own a direct financial
interest or an indirect material financial interest in an audited entity:
• The audit firm
• Any partner in the audit firm
• Any person in a position to influence the conduct and outcome
of the engagement (eg, a member of the engagement team)
• An immediate family member of such a person
The following safeguards will therefore be relevant:
• Disposing of the interest
• Removing the individual from the team if required
• Keeping the audited entity's audit committee informed of the
situation
• Using an independent partner to review work carried out if
necessary
Close business relationships (eg Unless the financial interest is clearly immaterial and the
operating a joint venture between the relationship to the firm and the audited entity clearly insignificant:
firm and the client)
• The assurance provision must be ended or
• The other business relationship terminated.
Audited entities - there should be no close business relationships
with auditors other than that of the audit engagement except for the
purchase of goods on normal commercial terms and which are not
material to either party.
Employment with assurance client When a partner leaves the firm and is appointed as a director or to
a key management position with an audited entity, having acted as
audit engagement or engagement quality control reviewer/key
partner in relation to that audit at any time in the previous two
years:
• The firm shall resign as auditors
• The auditors shall not reaccept appointment until two years
have elapsed since that partner's involvement in the audit or the
former partner leaves the audit client, if earlier.
When any other former member of an engagement team joins an
audit client as director/key management within two years of being
involved with the audit, the firm shall consider whether the
composition of the audit team is appropriate.
Governance role The audit firm, a partner or employee of an audit firm shall not
perform a role as an officer or member of the board of an
audited entity.
Family and personal relationships When an immediate family member of a member of the audit team
is a director, an officer or an employee of the audited entity in a
position to exert direct and significant influence over the subject
matter information of the audit engagement, the individual should
be removed from the audit team.
Gifts and hospitality Unless the value of a gift is clearly insignificant, or hospitality is
reasonable in terms of its frequency, nature and cost, a firm or a
member of an engagement team should not accept them.
Loans and guarantees An audit firm or member of the engagement team should not enter
into any loan or guarantee arrangement with an audited entity
that is not a bank or similar institution.
Overdue fees Firms should guard against fees building up as the audit firm runs
the risk of effectively making a loan. Where the amount cannot be
regarded as trivial the engagement partner must consider whether it
is necessary to resign. Generally, the payment of overdue fees
C
H
A
P
T
E
R
Ethics 107
1.3 Self-review threat
Service with an assurance client Individuals who have been a director or officer of the client, or
an employee in a position to exert direct and significant
influence over the subject matter information of the assurance
engagement in the period under review or the previous two
years, should not be assigned to the assurance team.
The person should not be assigned to a position in which he or
she is able to influence the conduct and outcome of the audit for
two years following the date of leaving the audited entity.
Provision of other services BSEC CG Guideline states that firms should not provide other
non audit services for listed audited entities These include:
• Valuation services
• Taxation services
• Internal audit services
• Corporate finance services
• Information technology services
• Litigation support services
While in principle the provision of other services is allowed to
non- listed clients, the threat of self-review must be considered
particularly where the matter in question will be material to the
financial statements. Safeguards may mitigate the threats in
some circumstances. In particular, the service should not be
provided where the audit firm would undertake part of the role
of management.
Arises where the assurance firm is in a IESBA Code does not recommend the provision of legal
position of taking the client's part in a services to audited entity where it would involve acting as the
dispute or somehow acting as their solicitor formally nominated to represent the client in resolution
advocate. of a dispute or litigation which is material to the financial
statements.
Examples:
Long association All firms should monitor the relationship between staff and
established clients.
The IESBA Code states that for the audit of listed entities:
3
1.6 Intimidation threat
Arises when the audit firm undertakes • If there is informed management (ie management capable
work which involves making judgements of making independent judgements and decisions on the
and taking decisions that are the basis of the information provided) safeguards may be able to
Ethics 109
responsibility of the management mitigate the threat.
Point to note:
A given situation may give rise to more than one threat.
Summary
To ICAB
ICAB
C
H
A
P
T
E
R
Ethics 111
Self-test
1 Easter
You are a partner in a firm of chartered accountants. The following issues have emerged in relation to
three of your clients:
(1) Easter is a major client. It is listed on a major Exchange. The audit team consists of eight members,
of whom Paul is the most junior. Paul has just invested in a personal pension plan that invests in all
the listed companies on the Exchange.
(2) While listed, Easter has subsidiaries in five different European countries. Tax regimes in those
countries vary on the absolute rate of tax charged as well as expenses allowable against taxable
income. The Finance Director of Easter has indicated that the Easter group will be applying
management charges between different subsidiaries to take advantage of favourable tax regimes
with the five countries. The FD reminds you that another firm offering assurances services, Bunny &
Co, has already approved the management charges as part of a special review carried out on the
group and the FD therefore considers the charges to be legal and appropriate to Easter.
(3) You are at the head of a team carrying out due diligence work at Electra, a limited company which
your client, Powerful, is considering taking over. Your second in command on the team, Peter, who
is a manager, has confided in you that in the course of his work he has met the daughter of the
managing director of Electra, and he is keen to invite her on a date.
(4) Your longest standing audit client is Teddies, which you have been involved in for ten years, with
four years as engagement partner. You recently went on an extended cruise with the managing
director on his yacht.
(5) You are also aware that the executive directors of Teddies were recently voted a significant
increase in bonus by their audit committee. The financial statements of Teddies do show a small
improvement in net profit, but this does not appear to justify the extent of bonus paid. You are also
aware that the Finance Director of Teddies is also a non-executive director of Grisly, while the
Senior Independent Director of Teddies is the Finance Director of Grisly.
Requirement
Comment on the ethical and other professional issues raised by the above matters. (Note: your answer should
outline the threat arising, the significance of the threat, any factors you have taken into account, and, if
relevant, any safeguards you could apply to eliminate or mitigate against the threat.)
2 Saunders Ltd
Bourne & Berkeley is an assurance firm with a diverse range of audit clients. One client, Saunders Ltd, is
listed on the stock exchange. You are the engagement partner on the audit; you have been engagement
partner for four years and have an experienced team of eight staff to carry out the audit. The audit is
made slightly more complicated because Bourne & Berkeley rent office space from Saunders Ltd. The
total rental cost of that space is about 10% of the total income from Saunders Ltd. Office space is also
made available to other companies including Walker Ltd, another of your audit clients. You are aware
from the audit of Walker Ltd that the company is close to receivership and that the rent arrears is unlikely
to be paid by Walker to Saunders.
In an interesting development at the client, the Finance Director resigned just prior to the audit
commencing and the board asked Bourne & Berkeley for assistance in preparing the financial
statements. Draft accounts were available, although the final statutory accounts had not been produced.
As part of your review of the draft accounts you notice that the revenue recognition policy includes an
estimate of future revenues from the sale of deferred assets. One of the activities of Saunders Ltd is the
purchase of oil on the futures market for delivery and resale between 6 and 12 months into the future. As
the price of oil rises, the increase has been taken to the statement of profit or loss and other
comprehensive income. When queried, the directors of Saunders state that while the accounting policy is
new for the company, it is comparable with other firms in the industry and they are adamant that no
amendment will be necessary to the financial statements. They are certain that other assurance firms will
accept the policy if asked.
Requirement
Discuss the ethical and professional issues involved with the planning of the audit of Saunders Ltd.
Exhibit 1 C
H
Background information
A
Marden Ltd operates a fleet of 10 executive jets available for private hire. The jets are based in Malaysia, P
Singapore and Thailand, but they operate throughout the world. The company is resident in Bangladesh. T
E
The jets can be hired for specific flights, for short periods or for longer periods. For insurance purposes,
R
all planes must use a pilot employed by Marden. All the jets are owned by Marden.
Marden has an Alternative Investment Market listing. Ordinary share capital consists of 5 million, Tk1
shares. The ownership of share capital at 1 January 20X6 was:
3
Directors 25%
Financial institutions 66%
Crazy Jack Airlines Ltd 9%
The company uses an interest rate of 10% to discount the cash flows of all projects.
The accounting year-end is 31 December.
Exhibit 2
Interim audit issues
Prepared by Audit Junior: Henry Ying
In respect of the interim audit of the financial statements for the year to 31 December 20X6 the following
issues have arisen.
(1) Marden appears to have inadvertently filed an incorrect tax return for last year showing a material
understatement of its corporation tax liability for that year and has therefore paid significantly less
corporation tax than it should have. Our firm is not engaged as tax advisers. The directors are now
refusing to inform Tax authority of the underpayment as they say that “it is in the past now”. I am
not sure of our firm's obligations in this matter.
(2) One of the directors, Dick Tracey, owns a separate travel consultancy business. He buys unused
flying time from Marden to sell to his own clients. In the year to 31 December 20X6 to date he has
paid Marden Tk30,000 for 100 hours of flying time made available.
(3) On 16 September 20X6 a major customer, Stateside Leisure Inc, gave notification to Marden that
the service it had been receiving was poor and it was therefore considering terminating its long-
Ethics 113
term contract with the company. The contract amounted to 15% of Marden's revenue and 25% of
its profit in 20X5. The directors did not make an immediate announcement of this and so the share
price did not initially change. Four directors sold a total of 200,000 shares in Marden Ltd on 2
October 20X6. Stateside Leisure Inc terminated the contract on 1 November 20X6 and the
directors disclosed this to the Dhaka Stock Exchange the same day. The price per share then fell
immediately from Tk7.50 to Tk6.
(4) Our audit fee for the year to 31 December 20X5 is still outstanding and is now overdue by five
months.
(5) I have selected a sample jet to be physically inspected. I selected this jet because it does not
appear to have flown since December 20X5. The jet in question cost Tk6 million on 1 January
20W8 and has a useful life of 10 years with a residual value of Tk1 million. Each jet is expected to
generate Tk2 million income per year net of expenses.
The directors say that this jet is located in Singapore, but they have offered to fly a member of our
audit team out there in one of their executive jets. They insist that a jet needs to go there anyway so
there would be no cost to Marden by making transport available to us.
(6) On 28 August 20X6 Crazy Jack Airlines Ltd – a large, listed company which operates a discount
airline – acquired 1 million shares in Marden from financial institutions. On 20 October 20X6 Crazy
Jack Airlines Ltd announced to the Dhaka Stock Exchange that it intends to make a bid for the
entire share capital of Marden and at the same time requested that our firm, as Marden's auditors,
should carry out the due diligence work in respect of the bid.
1 Easter
(1) In relation to Easter, there is a threat of self-interest arising, as a member of the audit team has an
indirect financial interest in the client.
The relevant factors are as follows:
• The interest is unlikely to be material to the client or Paul, as the investment is recent and
Paul's interest is in a pool of general investments made in the Exchange on his behalf
• Paul is the audit junior and does not have a significant role on the audit in terms of drawing
audit conclusions or audit risk areas
The risk that arises to the independence of the audit here is not significant. It would be
inappropriate to require Paul to divest his interest in the audit client. If I wanted to eliminate all
elements of risk in this situation, I could simply change the junior assigned to my team, but such a
step is not vital in this situation.
(2) Regarding the management charges, there is a threat that the management charges are accepted
as correct, simply because another assurance firm has recommended those charges to Easter. To
query the charges could imply a lack of trust in Bunny, with the possible effect of bringing the
profession into disrepute. There is a risk that you as the assurance professional may not have the
necessary knowledge to determine whether or not Easter has been acting correctly. There is also
C
an intimidation threat in that the client is implying the charges are valid as another assurance firm
H
has recommended the changes.
A
The relevant factors to take into account include: P
• The legality or otherwise of the transactions. Information concerning the management charges T
must be obtained and compared to the law, not only of the individual countries, but also of the E
EU as a whole. It remains a possibility that Easter has acted in accordance with laws of R
individual jurisdictions, but not the EU overall.
• Your level of knowledge. Where necessary, specialist advice must be obtained from the
3
taxation department to determine the legality or otherwise of the transactions.
• The materiality of the management charges involved and the reduction in the taxation
expense. Given Easter is attempting to minimise its taxation charge, then the amounts are
likely to be material and therefore as the audit firm, the transactions will have to be audited.
• Your knowledge of Bunny & Co. The assurance firm may well be skilled in advising on this
type of issue, in which case there is likely to be less of an issue with the legality of the
charges. However, if the reputation of Bunny is suspect, then additional work on the
management charges may be required.
The intimidation threat is significant; it is unlikely that Easter would expect your firm to query the
charges as another professional firm has confirmed them. A discussion with the FD may be
required to confirm the purposes of the audit and the extent of evidence required to reach an audit
opinion. Material transactions affecting the financial statements and taxation charges must be
subject to standard audit procedures.
Your potential lack of knowledge is relatively easy to overcome. Specialist advice can be obtained
from the taxation department, with a tax manager/partner being present in any discussion with the
client to determine legality of the management charges.
(3) In relation to Powerful, two issues arise. The first is that the firm appears to be providing multiple
services to Powerful, which could raise a self-interest threat. The second is that the manager
assigned to the due diligence assignment wants to engage in a personal relationship with a person
connected to the subject of the assignment, which could create a familiarity or intimidation threat.
With regard to the issue of multiple services, insufficient information is given to draw a conclusion
as to the significance of the threat. Relevant factors would be matters such as the nature of the
Ethics 115
services, the fee income and the team members assigned to each. Safeguards could include using
different staff for the two assignments. The risk is likely to be significant only if one of the services
provided is audit, which is not indicated in the question.
• The assurance team member has a significant role on the team as second in command
• The other party is closely connected to key staff member at the company being reviewed
• Timing
In this situation, the firm is carrying out a one off review of the company, and timing is a key issue.
Presently Peter does not have a personal relationship which would significantly threaten the
independence of the assignment. In this situation, the safeguard is to request that Peter does not take
any action in that direction until the assignment is completed. If he refuses, then I may have to
consider rotating my staff on this assignment, and removing him from the team.
(4) In relation to Teddies, there is a risk that my long association and personal relationship with the
client will result in a familiarity threat. This is compounded by my acceptance of significant
hospitality on a personal level.
• I have been involved with the client for ten years and have a personal relationship with client
staff
• It is an audit assignment
The risk arising here is significant, but as the client is not listed, it is not insurmountable. However, it
would be a good idea to implement some safeguards to mitigate against the risk. I could invite a
second partner to provide a hot review of the audit of Teddies, or even consider requesting that I
am rotated off the audit of Teddies for a period, so that the engagement partner is another partner
in my firm. In addition, I must cease accepting hospitality from the directors of Teddies unless it is
clearly insignificant.
Other options that can be considered include rotation of the engagement partner and other senior audit
staff in an attempt to remove the conflict of interest. Finally, if the independence issue cannot be resolved
then the audit firm may also consider resigning from the audit of Teddies.
(5) It appears that there are cross-directorships between Teddies and Grisly. In other words, at least
one executive in Teddies assists in setting the bonuses of directors in Grisly, and at least one
executive in Grisly is involved in setting the bonuses of directors in Teddies. This issue provides an
independence threat for those directors, especially so if the FDs are members of a professional
body such as the ICAB.
There is a further point, that you as engagement partner are aware of the issue, but your
independence may be compromised by the cruise with the managing director. There is also the
issue of the lack of clear reporting obligations in this situation. Most codes of corporate governance
require the directors of the company to make statements of compliance with that code, and in many
situations cross-directorships are not explicitly banned.
• The level of bonuses awarded in Grisly. If these appear to be nominal then the issue of lack of
independence regarding the bonuses in Teddies is reduced.
• Whether Teddies has audit and remuneration committees and whether these are effective in
determining director remuneration and communicating concerns of the auditor to the board.
As auditor, you have access to the audit committee but not the remuneration committee. So
there is no precise way of raising concerns with the remuneration committee.
• To a certain extent, the association threat of being linked to a client where the code of
corporate governance may not be being followed.
As the engagement partner, it would be appropriate to mention the perceived lack of independence
with the Finance Director. This may be directly rather than via the audit committee due to the lack of
communication you have with the remuneration committee. The result of any communications must
be documented in the audit file, even where communication is simply verbal.
The association risk is probably minimal, although will increase where your firm also provide
assurance services to Grisly. Where there are significant and continued breaches of the code of
governance, then your firm may consider not acting for Teddies in the future. Provision of additional
C
disclosure is compromised by lack of reporting obligations and your independence issue with the H
managing director of Teddies. A
P
2 Saunders Ltd
T
E
(a) • The rental of the premises from an audit client represents a business relationship which poses
R
a potential threat to objectivity.
• In this case the rental income is likely to be material to the audit client as it represents 10% of
total income.
• The audit firm would need to take immediate steps to terminate either the client or the
business relationship.
(b) • BSEC corporate governance guideline prohibits accounts preparation work for listed company
audit clients in most cases.
• The key question is whether the work proposed simply involves the typing up of a set of
accounts or inserting client generated information into a standard accounts package without
being required to perform any additional calculations or make any judgements. If this were
genuinely the case it would be permissible.
• In this case it is likely that the preparation of the financial information will involve the auditor in
making subjective judgements as the internal reporting format will need to be converted into
Ethics 117
the statutory format. Decisions will need to be made for example, about the level and nature of
disclosures. This would constitute an accountancy service and would not be allowed.
(c) • There is a conflict of interest here. While it may be in the interest of Saunders Ltd for the
auditor to disclose the information regarding the recoverability of the debt this information is
confidential as it was obtained in the course of audit work performed for Walker Ltd.
Disclosure of this information to Saunders Ltd would breach the duty of confidentiality.
• Section 220 of the IESBA Code requires that the auditor should disclose a conflict of interest
to the parties involved. In this case however, the situation is complicated by the fact that the
conflict of interest has had a practical consequence rather than simply being a potential
problem. In addition, it may be difficult to make the communication without revealing
confidential information.
• The firm should consider whether there were sufficient procedures in place to prevent the
conflict of interest occurring in the first place.
• The IESBA Code states that the auditor should take steps to identify circumstances that could
pose a conflict of interest and to put in place any necessary safeguards eg use of separate
audit teams.
• If procedures were inadequate this may have implications for other clients.
• If the balance is not material further action is unlikely to be necessary. If the balance is
material the situation will need to be addressed.
• Saunders Ltd may be aware of the potential irrecoverability of the debt and an allowance for
an irrecoverable receivable may have been made in the financial statements.
• If an adjustment has been made and the auditor is in agreement with it no further action would
be required.
• Independent evidence may be available which would indicate that the debt was irrecoverable.
For example, there may have been correspondence between Saunders Ltd and Walker Ltd
concerning the payment of the balance. There may also be evidence in the public domain, for
example newspaper reports and the results of credit checks. However the auditor would need
to consider how this evidence was used, particularly if it was sought as a result of having the
confidential information.
• The audit manager could consider requesting Walker Ltd to communicate with Saunders Ltd.
• This may not be acceptable to Walker Ltd who may feel that any communication would not be
in their interest. It may also make any future relationship between the auditor and Walker Ltd
difficult.
• If the issue cannot be resolved and the balance is material the auditor will not be able to form
an audit opinion. Bourne and Berkeley will need to consider resigning as the auditor of
Saunders Ltd.
It appears that Saunders Ltd is attempting to implement a change in accounting policy which
increases revenue, while at the same time intimidating the auditors to accept this policy. There is an
• The materiality of the amounts involved. Given that the accounting policy is an attempt to
increase revenue, the amount is likely to be material – again it would be unlikely that the
directors would want to spend the time and effort if this was not the case.
• The accounting policies adopted by similar firms in the industry. The directors of Saunders
have noted that the income recognition policy is the same as other firms in the industry.
Accounts of similar firms need to be obtained and the accounting policies checked. If the
policies are the same as Saunders, and the technical department of Bourne and Berkeley
confirm that the policy follows GAAP, then no modification of the audit report will be required,
although audit evidence will be obtained to confirm the correct application of the policy. If the
revenue recognition policy is inappropriate, then additional discussion will be required with the
directors to determine whether they will continue with the policy, and risk a modified report, or
amend the policy.
• Whether the directors would actually seek to remove Bourne and Berkeley if the revenue
recognition policy does not follow GAAP and the audit report will be modified. The audit firm
need to document the situation and be prepared to provide a statement on why they are being C
H
removed in accordance with Companies Act requirements.
A
Bourne & Berkeley will find it difficult to remove the intimidation threat. Advice can be obtained from P
the ethics partner, although it is unlikely that the firm's position can be compromised by agreeing to T
E
an accounting policy if this does not follow GAAP. Bourne & Berkeley will need to maintain their
R
integrity by insisting that appropriate accounting policies are followed, even where this risks losing
an audit client.
3
Ethics 119
3 Marden Ltd
MEMORANDUM
The understatement of the tax liability is an illegal act by the client. Tuesday's meeting offers the
opportunity to attempt to persuade the client even at this late stage.
Consider whether a partner needs to be at the meeting given the ethical importance of the issue.
The key issue is the conflict between our duty to report and our duty of confidentiality.
Financial reporting
If there is a material unrecognised liability in the financial statements then we need to consider
whether the financial statements give a true and fair view. Any material understatement of the tax
provision would need to be disclosed in the audit report. The level of detail as to the cause of the
misstatement raises confidentiality considerations.
The audit issue in this case is that there is a potential conflict of interest between a director and the
body of shareholders.
Directors also have a fiduciary duty to act in the interests of all shareholders. Directors must not
place themselves in a position where there is a conflict of interest between their personal interests
and their duty to the company (Regal (Hastings) Ltd v Gulliver). In certain circumstances the
company may void such contracts.
More specifically, the audit risk in this case is that the price of Tk30,000 for the use of the jet might
not be an arm's length price in terms of an hourly rate for this type of hire. At Tk300 per hour
including the pilot's time there is a risk that the director, Dick Tracey, may be exploiting his position.
If there has not been knowledge and approval of the transactions by the other directors then there
may be an issue of false accounting by Dick Tracey.
Audit procedures
• Review provisions in Articles of Association regarding directors' contracts with the company
• Examine the terms of the contract(s) ascertaining the nature of the hire agreements
• Ascertain whether any similar arm's length hires took place and at what prices (see evidence
of such agreements where appropriate)
• Ascertain whether the other directors were aware of the nature and extent of the hire contracts
(eg review correspondence)
• Review board minutes to see if the hire contracts have been considered and formally
approved by the board
Financial reporting
Transactions involving directors are required to be disclosed in the financial statements by both the
Companies Act 2006 and also IAS 24 Related Party Disclosures. C
A director is part of key management personnel and thus is a related party of the company. H
According to IAS 24 the transaction should be disclosed irrespective of its materiality. The name of A
the director need not however be disclosed. P
T
As a result, the hire fees are likely to be deemed to be a related party transaction and thus the
following disclosures should be made: E
R
• Amounts involved
• Amounts due to or from the related party
• Irrecoverable debt write offs to or from the related party 3
• The failure to make a timely disclosure for personal gain by the directors
• The consequences of the underlying event of the loss of a major contract
The failure to announce the loss of the contract might leave the directors in breach of their fiduciary
duty to shareholders as they may have manipulated the market for their own gain.
Consider taking legal advice as to whether an illegal act has been committed, as the initial
communication from Stateside in September was only about poor service. The formal notification of
the contract being terminated by Stateside was immediately communicated to the LSE by the
directors.
Consider also taking advice as to whether stockmarket rules have been breached by the directors
individually and by the company. This might affect quality of markets and may be contrary to insider
trading laws.
Regarding the underlying event of the loss of a major customer, consideration needs to be given as
to whether going concern is affected by the loss of such a large contract (eg if the service is poor
will other major contracts be lost?).
Financial reporting
Ethics 121
Consider whether any provision is necessary once advice is received on whether the company has
committed an illegal act (as opposed to the directors themselves) or has been in breach of
regulations. Provisions might include fines or other penalties imposed by the courts or regulators.
If there has been a significant decline in activity, then impairment needs to be considered on the
jets if their value in use has decreased.
Consider recoverability of amounts outstanding from Stateside Leisure Inc.
• A review by an independent partner (perhaps the ethics partner) who is not involved in the
audit to agree that the objectivity of the engagement staff is not affected. This should really
have been completed before commencement of the audit so it is now a matter of urgency.
• If legal action is necessary to recover the fees it would not be possible for us to continue
acting for the client as Ethical Statement 4 forbids auditors acting for clients where there is
actual or potential litigation between the two parties.
Financial reporting
A provision should be made for the audit fee outstanding.
• The fact that one jet appears not to have been used
• The offer of 'free' transport on an executive jet may be deemed as a gift
The fact that a jet has not been used for some time may have a number of possible causes:
• Technical problems – the jet may not be serviceable. We need to establish whether this is the
case (eg hire an independent local aircraft engineer) then consider impairment testing.
• Lack of markets – there may be insufficient demand to warrant using the plane. This seems
less likely as the plane has not been used at all. Examine usage of other Marden planes in
Singapore.
• Unrecorded usage – the jet may be being used but the usage is unrecorded and income
understated. Alternatively, it might mean improper use is being made of the company's assets
(eg by management).
Regarding the 'free' flight, excessive gifts are not permitted. If however the flight were merely for the
purpose of the audit check and there were no added benefits (additional destinations, trips etc) then
it may be permissible if agreed by the ethics partner.
The carrying amount at 31 December 20X6 of the jet is Tk1.5m (ie Tk6m – [Tk5m × 9/10])
The value in use, if fully operational, (assuming year end operating cash flows and including the
residual amount) is:
(Tk2m + Tk1m)/1.1 = Tk2.73m
Thus, there is no impairment if the plane is fully operational (the fair value less costs of disposal
calculation is not necessary as the value in use exceeds the carrying amount).
However, if the plane is not operational then both next year's net operating inflow and the residual
value are likely to be affected. In this case an impairment charge of Tk1.5m (less the present value
of any residual value obtainable for a non operational jet) may be required.
Lack of markets – there may be insufficient demand to warrant using the plane. This will affect
value in use but perhaps not the residual value. Again, impairment testing may be needed as
according to IAS 36 value in use may be affected.
If the jet is not operational next year, but can be sold for a residual value of Tk1m next year
(although selling immediately would be a better option in this case) the impairment charge is: C
Tk1.5m – Tk1m/1.1 = Tk0.59m H
A
Unrecorded usage – this may mean that any depreciation based on the amount of flying time may
P
be understated.
T
Any impairment on this aircraft might have further implications for impairment of other aircraft if the E
cause is market-based rather than technically-based. R
• If the bid process is going into next year and the bid is to be defended then a provision may
need to be made for defence costs.
• If the bid process is going into next year then disclosure of the bid as a non-adjusting event
after the reporting date may be needed.
Ethics 123
Answers to Interactive questions
Undue dependence on an Auditor prepares the Actual litigation Any threat of litigation by
audit client due to fee levels accounts with a client the client
Overdue fees becoming Auditor participates in Threatened Personal relationships
similar to a loan management decisions litigation with a with the client
client
An actual loan being made to Provision of any other Hospitality
a client services to the client Client refuses to
Threat of other services
pay fees and
Contingency fees being provided to the client
they become
offered being put out to tender
long overdue
Accepting commissions from Threat of any services
clients being put out to tender
Provision of lucrative other
services to clients
Relationships with persons in
associated practices
Relationships with the client
Long association with clients
Beneficial interest in shares or
other investments
Hospitality
(1) Teresa is at present a member of the assurance team and a member of her immediate family owns a
direct financial interest in the audit client. This is unacceptable.
In order to mitigate the risk to independence that this poses on the audit, Stewart Brice needs to apply
one of two safeguards:
Teresa should be appraised that these are the options and removed from the team while a decision is
taken whether to divest the shares. Teresa's husband appears to want to keep the shares, in which case,
Teresa should be removed from the team immediately.
The firm should appraise the audit committee of Recreate of what has happened and the actions they
have taken. The partners should consider whether it is necessary to bring in an independent partner to
review audit work. However, given that Teresa's involvement is subject to the review of the existing
engagement partner and she was not connected with the shares while she was carrying out the work, a
second partner review is likely to be unnecessary in this case.
(2) The audit firm has an indirect interest in the parent company of a company it has been invited to tender
for by virtue of its pension scheme having invested in Tadpole Group. C
H
This is no barrier to the audit firm tendering for the audit of Kermit Co.
A
Should the audit firm win the tender and become the auditors of Kermit Co they should consider whether P
T
it is necessary to apply safeguards to mitigate against the risk to independence on the audit as a result of
E
the indirect financial interest.
R
The factors that the partners will need to consider are the materiality of the interest to either party and
the degree of control that the firm actually has over the financial interest.
3
In this case, the audit firm has no control over the financial interest. An independent pension scheme
administrator is in control of the financial interest. In addition, the interest is unlikely to be substantial and
is therefore immaterial to both parties. It is likely that this risk is already sufficiently minimal as to not
require safeguards. However, if the audit firm felt that it was necessary to apply safeguards, they could
consider the following:
(3) In this case, Stewart Brice has a direct financial interest in the audit client, which is technically forbidden
by ethical guidance. However, it is a requirement of any firm auditing the company that the share be
owned by the auditors.
The interest is not material. The audit firm should safeguard against the risk by not voting on its own re-
election as auditor. The firm should also strongly recommend to the company that it removes this
requirement from its constitution as it is at odds with ethical requirements for auditors.
Ethics 125
Answer to Interactive question 4
The issues to consider would include the following:
• Whether the management have made the decision to make the change in accounting treatment of a
proportion of the subscription income on a valid and ethical basis.
• Management are under pressure not to breach the loan covenants. With the change in timing of the
recognition the interest cover is only just achieved in both 20X7 and 20X8. This suggests that without
this change the covenant would be breached indicating that profit levels are sensitive.
• In this case the auditor would have a legal and moral responsibility to the venture capitalists who have
invested in Bellevue Ltd, to ensure that profits are fairly stated.
• The implications of the disagreement with the treatment by the audit manager in 20X7 which was over-
ruled by the partner. This is now of particular concern as the audit partner has left the firm abruptly. This
potentially raises questions about the integrity of the partner.
• Whether there is sufficient evidence to support the conclusion that some of the subscription fees are
consultancy in nature and should therefore be recognised up front rather than being recognised over the
duration of the contract.
• Whether fees treated as subscription fees in previous years should have been recognised as
consultancy fees resulting in the need for a prior-period adjustment.
• The basis on which the figure of 40% was established and whether there is evidence to support this
estimation, particularly as this is exactly the same % as applied in 20X7.
• The overall increase in audit risk due to the need to comply with the loan agreement.
Corporate governance
Introduction
Topic List
C
1 Relevance of corporate governance
H
2 Corporate governance concepts A
3 Bangladesh Corporate Governance P
4 Role of the board T
5 Associated guidance E
• Describe and explain the nature and consequences of corporate governance and
accountability mechanisms in controlling the operating and financial activities of entities of
differing sizes, structures and industries
• Explain the rights and responsibilities of the board, board committees (eg audit and risk
committees), those charged with governance and individual executive and non-executive
directors, with respect to the preparation and audit of financial statements
• Describe and explain the rights and responsibilities of stakeholder groups (eg executive
management, bondholders, government, securities exchanges, employees, public interest
groups, financial and other regulators, institutional and individual shareholders) with
respect to the preparation and audit of financial statements
• Explain and evaluate the nature and consequence of relevant corporate governance
codes and set out the required compliance disclosures
• Explain the respective responsibilities of those charged with governance and auditors for
corporate risk management and risk reporting
• Explain the respective responsibilities of those charged with governance and auditors in
respect of internal control systems
• Explain and evaluate the role and requirement for effective two-way communication
between those charged with governance and auditors
• Describe and explain the roles and purposes of meetings of boards and of shareholders
Section overview
• Concerns about the adequacy of financial reporting, a number of high profile corporate scandals in
the 1990s and concerns about excessive directors' remuneration highlighted the need for effective
corporate governance.
• Corporate governance can be defined as the system by which organisations are directed and
controlled.
1.1 Introduction
Corporate governance potentially covers a wide range of issues and disciplines from company
secretarial and legal through business strategy, executive and non-executive management and investor
relations to accounting and information systems.
Corporate governance issues came to prominence in Bangladesh from the late 1980s. The main drivers
associated with the increasing demand for developments in this area included the following:
• Financial reporting
Issues concerning financial reporting were raised by many investors and were the focus of much
debate and litigation. Shareholder confidence in what was being reported in many instances was
eroded. While corporate governance development is not just about better financial reporting
requirements, the regulation of creative accounting practices, such as off-balance sheet
financing, has led to greater transparency and a reduction in risks faced by investors.
• Corporate scandals
The early 1990s saw an increasing number of high profile corporate scandals and collapses
including Polly Peck International, BCCI, and Maxwell Communications Corporation. This prompted
the development of governance codes in the early 1990s. However, the scandals since then
including Enron, have raised questions about further measures that may be necessary. More
recently the financial crisis in 2008-2009 has triggered widespread reappraisal of governance
systems.
C
• Excessive directors' remuneration H
Directors being paid excessive salaries and bonuses has been seen as one of the major corporate A
issues for a number of years. While CEOs have argued that their packages reflect the global P
market, shareholders and employees are concerned that these are often out of step with the T
remuneration of other employees and do not reflect the performance of the company. E
R
The issue of directors' remuneration continues to be an issue. In June 2012 the shareholders of WPP
rejected the remuneration report which included a pay deal of £6.8m for the chief executive. Currently
shareholders votes are advisory ie they can be ignored, although this is due to change following the
announcement by the UK Business Secretary of new rules which will force publicly listed companies to
give shareholders three-yearly votes on executive pay.
Section overview
• Corporate governance concepts include:
– Fairness
– Openness/transparency
– Independence
– Probity/honesty
– Responsibility
– Accountability
– Reputation
– Judgement
One view of governance is that it is based on a series of underlying concepts. These are important as
good corporate governance depends on a willingness to apply the spirit of the guidance as well as the
letter of the law.
2.1 Fairness
The directors' deliberations and also the systems and values that underlie the company must be
balanced by taking into account everyone who has a legitimate interest in the company, and respecting
their rights and views. In many jurisdictions, corporate governance guidelines reinforce legal protection
for certain groups, for example minority shareholders.
2.2 Openness/transparency
In the context of corporate governance, transparency means corporate disclosure to stakeholders.
Disclosure in this context obviously includes information in the financial statements, not just the numbers
and notes to the accounts but also narrative statements such as the directors' report and the operating
and financial review. It also includes all voluntary disclosure, that is disclosure above the minimum
required by law or regulation. Voluntary corporate communications include:
• Management forecasts
• Analysts' presentations
• Press releases
• Information placed on websites
• Other reports such as stand-alone environmental or social reports.
The main reason why transparency is so important relates to the agency problem, that is the potential
conflict between owners and managers. Without effective disclosure the position could be unfairly
weighted towards managers, since they normally have far more knowledge of the company's activities
and financial situation than owners/investors. Reducing this information asymmetry requires not only
effective disclosure rules, but strong internal controls that ensure that the information that is disclosed is
reliable.
2.3 Independence
Independence is an important concept in relation to directors (as well as auditors). Corporate
governance reports have increasingly stressed the importance of independent non-executive
directors; directors who are not primarily employed by the company and who have very strictly
controlled other links with it. They should be free from conflicts of interest and in a better position to
promote the interests of shareholders and other stakeholders. Freed from pressures that could
influence their activities, independent non-executive directors should be able to carry out effective
monitoring of the company in conjunction with independent external auditors on behalf of shareholders
and other stakeholders.
2.5 Responsibility
For management to be held properly responsible, there must be a system in place that allows for
corrective action and penalising mismanagement. Responsible management should do, when
necessary, whatever it takes to set the company on the right path.
The board of directors must act responsively to, and with responsibility towards, all stakeholders of the
company. However the responsibility of directors to other stakeholders, both in terms of to whom they
are responsible and the extent of their responsibility, remains a key point of contention in corporate
governance debates.
2.6 Accountability
Corporate accountability refers to whether an organisation (and its directors) are answerable in some
way for the consequences of their actions.
The board of directors is accountable to shareholders (see Section 3). However making the
accountability work is the responsibility of both parties. Directors, as we have seen, do so through the
quality of information that they provide whereas shareholders do so through their willingness to exercise
their responsibility as owners, which means using the available mechanisms to query and assess the
actions of the board.
As with responsibility one of the biggest debates in corporate governance is the extent of management's
accountability towards other stakeholders such as the community within which the organisation
operates.
2.7 Reputation
In the same way directors' concern for an organisation's reputation will be demonstrated by the extent to
which they fulfil the other principles of corporate governance. There are purely commercial reasons for
promoting the organisation's reputation, that the price of publicly traded shares is often dependent on C
reputation and hence reputation can be a very valuable asset of the organisation.
H
A
2.8 Judgement P
T
Judgement means the board making decisions that enhance the prosperity of the organisation. This
E
means that board members must acquire a broad enough knowledge of the business and its
environment to be able to provide meaningful direction to it. This has implications not only for the R
attention directors have to give to the organisation's affairs, but also the way the directors are recruited
and trained.
4
The complexities of senior management mean that the directors have to bring multiple conceptual
skills to management that aim to maximise long-term returns. This means that corporate governance
can involve balancing many competing people and resource claims against each other.
2.9 Integrity
Definition
Integrity: Straightforward dealing and completeness. What is required of financial reporting is that it
should be honest and that it should present a balanced picture of the state of the company's affairs. The
integrity of reports depends on the integrity of those who prepare and present them.
Integrity can be taken as meaning someone of high moral character, who sticks to principles no matter
the pressure to do otherwise. In working life this means adhering to principles of professionalism and
probity. Straightforward dealing in relationships with the different people and constituencies whom
Section overview
• Bangladesh Securities and Exchange Commission (BSEC) has issued Corporate Governance
Guidelines.
• The Guidelines applies and required to be complied by all companies listed with two Stock
Exchanges.
• Bangladesh Corporate Governance Guideline includes five main principles.
• Bangladesh Corporate Governance Guideline includes a number of disclosure requirements.
3.1 Overview
BSEC Corporate Governance Guideline is set out based on series of principles, and all of which have
provisions. It contains three main principles:
Leadership - Board Of Directors;
Effectiveness- Duties of Chief Executive Officer (CEO), Chief Financial Officer (CFO), Head Of
Internal Audit and Company Secretary (CS);
Accountability - Audit Committee; Reporting and Compliance of Corporate Governance;
BOARD OF DIRECTORS:
The board and its committees should have the appropriate balance of skills, experience, independence
and knowledge of the company to enable them to discharge their respective duties and responsibilities
effectively.
The board should present a fair, balanced and understandable assessment of the company’s position
and prospects.
318
The board’s responsibility to present a fair, balanced and understandable assessment extends to:
Interim reports
Other price-sensitive public reports
Reports to regulators
The statutory financial statements
The board should establish arrangements that will enable it to ensure that the information presented is fair,
balanced and understandable.
The board should establish formal and transparent arrangements for considering how they should apply
the corporate reporting and risk management and internal control principles and for maintaining an
appropriate relationship with the company’s auditors.
3.1.6 Compliance
Bangladesh Corporate Governance Guideline applies to all listed companies although any company
can adopt it on a voluntary basis as a benchmark of best practice.
All companies incorporated and listed in Bangladesh must disclose in their annual reports how they
have applied the principles of the Code. The Guideline requires listed companies to make a
disclosure statement in two parts:
(1) The company has to report on how it applies the principles/ conditions. The form and content of
this part of the statement are prescribed.
(2) The company has either to confirm that it complies with the Guideline provisions or provide an
explanation where it does not.
Point to note:
This 'comply or explain' approach has been in operation for almost ten years, and the flexibility it offers C
has been widely welcomed both by company boards and by investors.
H
The introduction to the Corporate Governance Guidelines makes the following points: A
• An alternative to following a provision may be justified if good governance can be achieved by other P
means T
E
• When responding to disclosures shareholders should take the company's individual circumstances
R
into account
• Explanations should not be evaluated by shareholders in a mechanistic way
• Departures from the Guideline should not be treated automatically as breaches 4
Leadership
The role of the board Every company should be headed by an effective board which is collectively
responsible for the long-term success of the company.
The board should meet sufficiently regularly to discharge its duties
effectively. There should be a formal schedule of matters specifically
reserved for its decision.
Division of There should be a clear division of responsibilities at the head of the
responsibilities company between the running of the board and the executive responsibility
for the running of the company's business. No one individual should have
unfettered powers of decision. The roles of the chairman and chief
executive should not be exercised by the same individual.
The Chairman The chairman is responsible for leadership of the board and ensuring its
effectiveness on all aspects of its role. The chairman should promote a
culture of openness and ensure constructive relations between executive
and non-executive directors.
A chief executive should not go on to be chairman. If exceptionally this is
the case major shareholders should be consulted in advance.
Non-executive directors As part of their role as members of a unitary board, non-executive directors
should constructively challenge and help develop proposals on strategy.
Non-executive directors should scrutinise management performance and the
reporting of performance. They should satisfy themselves on the integrity of
financial information and that financial controls and systems of risk
management are robust.
They are also responsible for determining executive director remuneration
and appointing and removing executive directors.
The non-executive directors should appraise the chairman's performance at
least annually.
Effectiveness
Composition of the The board and its committees should have the appropriate balance of skills,
board experience, independence and knowledge of the company to enable them to
discharge their respective duties and responsibilities effectively.
The board should include an appropriate combination of executive and non-
executive directors such that no individual or small group of individuals can
dominate the board's decision taking.
Except for smaller companies non-executive directors should comprise at least half
of the board (excluding the chairman). A smaller company should have at least two
non-executive directors.
The board should determine whether non-executive directors are independent.
Appointments to There should be a formal, rigorous and transparent procedure for the
the board appointment of new directors to the board.
There should be a nomination committee, which should lead the process for
board appointments and make recommendations to the board. A majority of
members on the nomination committee should be independent non-executive
directors.
Non-executive directors should be appointed for specified terms. Any terms
beyond six years should be subject to rigorous review.
The annual report should include a description of the work of the nomination
committee including the board's policy on diversity (including gender).
Commitment All directors should be able to allocate sufficient time to the company to discharge
their responsibilities effectively.
The board should not agree to a full time executive director taking on more than
one non-executive directorship in a FTSE 100 company nor the chairmanship of
such a company.
Development All directors should receive induction on joining the board and should regularly
update and refresh their skills and knowledge.
Information and The board should be supplied in a timely manner with information in a form and of
support a quality appropriate to enable it to discharge its duties. The company secretary is
responsible for ensuring good information flows and for advising the board through
the chairman on all governance matters.
Evaluation The board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors. Evaluation of the
board of FTSE 350 companies should be externally facilitated at least every three
years. The identity of the facilitator should be disclosed in the financial statements.
Re-election All directors should be required to submit themselves for re-election at regular
intervals and at least once every three years. Directors of FTSE 350 companies
should be subject to annual election. Non-executive directors who have served
longer than nine years should be subject to annual re-election.
Accountability
Financial reporting The board should present a fair, balanced and understandable assessment of the
company's position and prospects.
The directors should explain in the annual report their responsibility for preparing
the annual accounts and an explanation of their business model. They must state
that they consider the annual report and accounts is fair, balanced and
understandable.
The annual report should also include a statement by the auditors about their
reporting responsibilities.
The directors should report that the business is a going concern with assumptions
or qualifications if necessary.
Risk management The board is responsible for determining the nature and extent of the significant
and internal risks it is willing to take in achieving its strategic objectives. The board should
control maintain sound risk management and internal control systems. The board should
at least annually, conduct a review of the effectiveness of the company's risk
management and internal control systems and should report to shareholders that C
they have done so.
H
Audit committees The board should establish formal and transparent arrangements for considering A
and auditors how they should apply the corporate reporting and risk management and internal P
control principles and for maintaining an appropriate relationship with the
T
company's auditor. The board should establish an audit committee of at least three
(two for smaller companies) independent non-executive directors. At least one E
member of the audit committee should have recent and relevant financial R
experience.
The main role and responsibilities of the audit committee should be set out in
written terms of reference. Where requested by the board the audit committee 4
should provide advice on whether the annual report is fair, balanced and
understandable.
The audit committee should monitor and review the effectiveness of internal audit
activities. Where there is no internal audit function the audit committee should
consider annually whether there is a need for one.
The audit committee should have primary responsibility for making a
recommendation on the appointment and removal of the external auditor.
The annual report should include a description of the work of the audit committee
including how it has assessed the effectiveness of the external audit, the approach
taken to the appointment/reappointment of the external auditor and an explanation
of how auditor objectivity and independence is safeguarded where non-audit
services are provided.
FTSE 350 companies should put the external audit contract out to tender at least
every ten years.
The level and Levels of remuneration should be sufficient to attract, retain and motivate directors
components of of the quality needed to run the company successfully, but companies should
remuneration avoid paying more than is necessary for this purpose. A significant proportion of
the remuneration of the executive directors should be structured so as to link
rewards to corporate and individual performance.
Assessing executive remuneration in an imperfect market for executive skills may
prove problematic. The remuneration committee should consider whether the
directors should be eligible for annual bonuses. If so, performance conditions
should be relevant, stretching and designed to promote long-term success.
Shares granted or other forms of deferred remuneration should not vest and
options should not be exercisable in less than three years.
Any new long-term incentive schemes should be approved by shareholders and
should not be excessive.
Consideration should be given to the use of provisions that permit the company to
reclaim variable components in exceptional circumstances of misstatement or
misconduct.
In general only basic salary should be pensionable.
Remuneration for non-executive directors should reflect the time commitment and
responsibilities of the role and should not include performance-related elements.
Procedure There should be a formal and transparent procedure for developing policy on
executive remuneration and for fixing remuneration packages of individual
directors. No director should be involved in setting their own remuneration.
A remuneration committee, made up of at least three (two for smaller
companies) independent non-executive directors, should make recommendations
about the framework of executive remuneration, and should determine specific
remuneration packages.
The board should determine the remuneration of non-executive directors.
Relations with
shareholders
Dialogue with There should be dialogue with shareholders based on the mutual understanding of
shareholders objectives. The board as a whole has responsibility for ensuring that a satisfactory
dialogue with shareholders takes place.
Constructive use Boards should use the AGM to communicate with investors and encourage their
of the AGM participation.
Notice of the AGM and related papers should be sent to shareholders at least 20
working days before the meeting.
The Chairmen of the key sub-committees (audit, remuneration) should be available
to answer questions and all directors should attend.
Shareholders should be able to vote separately on each substantially separate
issue.
Companies should count all proxies and announce proxy votes for and against on
all votes on a show of hands.
Point to note:
When the UK Corporate Governance Code was first issued it contained guidance regarding institutional
investors in a schedule. This guidance has now been replaced by the UK Stewardship Code (see
Section 5.1).
Statement of compliance with the main principles in the UK Corporate Governance Code
A narrative statement of how the company has applied the main principles set out in the UK Corporate
Governance Code, in a manner that enables shareholders to evaluate how the principles have been
applied.
Statement of compliance with the provisions in the UK Corporate Governance Code
A statement as to whether or not the company has complied with the relevant provisions in the Code,
disclosing any provisions not complied with throughout the period under review and the company's
reasons for non-compliance.
Section overview
• The board should be responsible for taking major policy and strategic decisions.
• Directors should have a mix of skills and their performance should be assessed regularly.
• Appointments should be conducted by formal procedures administered by a nomination
committee.
• Division of responsibilities at the head of an organisation is most simply achieved by separating
the roles of chairman and chief executive.
• Independent non-executive directors have a key role in governance. Their number and status
should mean that their views carry significant weight.
4.2.2 Commitment
On the appointment of the chairman the nomination committee should be responsible for reviewing the
time required for the role. Non-executive directors should undertake that they will have sufficient time to
meet what is expected of them. Other significant commitments should be disclosed to the board.
• Has been an employee of the company within the last five years
• Has, or has had within the last three years, a material business relationship with the company 4
either directly, or as a partner, shareholder, director or senior employee of a body that has such a
relationship with the company
• Receives additional remuneration from the company apart from a director's fee, participates in the
company's share option or a performance-related pay scheme, or is a member of the company's
pension scheme
• Has close family ties with any of the company's advisers, directors or senior employees
• Holds cross-directorships or has significant links with other directors through involvement in other
companies or bodies
• Represents a significant shareholder
• Has served on the board for more than nine years from the date of their first election.
Whenever a question scenario features non-executive directors, watch out for threats to, or questions
over, their independence.
5 Associated guidance
Section overview
• The UK Stewardship Code aims to enhance the relationship between companies and institutional
investors.
• The Turnbull report provides guidance on corporate governance regarding internal controls.
• The FRC has issued specific guidance on audit committees.
The UK Stewardship Code was revised in September 2012. The key changes were as follows:
• Clarification of the aim and definition of stewardship
• Clearer delineation of the varying responsibilities of different types of institutional investors
• Editing of the text to create greater consistency across the Code
• Provision of more information on how the Code is expected to be implemented
The seven Principles of the Code remain unchanged.
Section overview
• Corporate governance models differ around the world, but the following principles and legislation
are widely recognised:
– The OECD Principles of Corporate Governance (OECD Principles)
– The Sarbanes-Oxley Act in the US (Sox)
– The UK Corporate Governance Code (covered in earlier sections)
• The OECD Principles resulted from market pressure for standardisation of governance guidelines.
• The OECD Principles are non-binding but are intended to assist governments, stock exchanges,
investors and companies. They cover the following six areas:
– Ensuring the basis for an effective corporate governance framework
– The rights of shareholders
– The equitable treatment of shareholders
– The role of stakeholders
– Disclosure and transparency
– The responsibilities of the board
• The introduction of Sox in the US resulted from the Enron scandal.
• Sox is a 'rules based' rather than 'principles based' approach to improving corporate governance.
• The Act applies to all companies that are required to file accounts with the Securities and
Exchange Commission. This includes non-US companies who list their shares in the US and
therefore affects companies worldwide.
• Sox has resulted in increased compliance costs for companies.
6.2 Sarbanes-Oxley R
Section overview
• Turnbull emphasises that a risk-based approach to establishing a system of internal control should
be adopted.
• Directors should have a defined process for the review of effectiveness of control.
• International companies listed in the US must comply with Sarbanes-Oxley.
Section overview
• The auditor is required to review the statement of compliance with the Corporate Governance
Guidelines made by directors.
• This review includes the statement on control effectiveness.
• The auditor will need to perform procedures to obtain appropriate evidence to support the
compliance statement made by the company.
The Code requires that the board should at least annually, conduct a review of the effectiveness of
the company's system of internal controls and should report to shareholders that they have done
so. 4
Bulletin 2006/5 considers what auditors should do in response to this statement on internal controls by
the directors.
The guidance states that the auditors should concentrate on the review carried out by the board. The
objective of the auditors' work is to assess whether the company's summary of the process that the
board has adopted in reviewing the effectiveness of the system of internal control is supported by the
documentation prepared by the directors and reflects that process.
The auditors should make appropriate inquiries and review the statement made by the board in the
annual report and the supporting documentation.
Auditors will have gained some understanding of controls due to their work on the accounts; however
what they are required to do by auditing standards is narrower in scope than the review performed by
the directors.
Auditors therefore are not expected to assess whether the directors' review covers all risks and
controls, and whether the risks are satisfactorily addressed by the internal controls. To avoid
Section overview
• Auditors have to communicate various audit related matters to those charged with governance.
• This section summarises and builds on the important points covered by the Audit and Assurance
paper at Professional Level.
• In particular there have been some recent revisions to ISA 260 relating to the audit of entities
reporting on how they have applied the Corporate Governance Code.
9.1.1 Objectives
ISA 260 states that the objectives of the auditor are to:
• Communicate clearly with those charged with governance the responsibilities of the auditor in
relation to the financial statement audit and an overview of the planned scope and timing of the audit
• Obtain from those charged with governance information relevant to the audit
• Provide those charged with governance with timely observations arising from the audit that are
significant and relevant to their responsibility to oversee the financial reporting process
• Promote effective two-way communication between the auditor and those charged with governance
The auditor must communicate audit matters of governance interest arising from the audit of financial
statements with those charged with governance of an entity. The scope of the ISA is limited to matters
that come to the auditor's attention as a result of the audit; the auditors are not required to design
procedures to identify matters of governance interest.
The auditor must determine the relevant persons who are charged with governance and with whom audit
matters of governance interest are communicated.
The auditors may communicate with the whole board, the supervisory board or the audit committee
depending on the governance structure of the organisation. 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
Matters to be communicated
Matters that the auditor may consider in deciding whether deficiencies are significant include:
• Likelihood of the deficiencies leading to material misstatements in future
• Susceptibility to fraud of related assets and liabilities
• Subjectivity and complexity of determining estimated amounts, such as fair value estimates
• The financial statement amounts exposed to the deficiencies
• The volume of activity in the account balance or class of transactions
• The importance of the controls to the financial reporting process
• The cause and frequency of the exceptions detected
• The interaction of the deficiency with other deficiencies in internal control
Recap of key qualities of a report to management
• It should not include language that conflicts with the opinion expressed in the audit report.
• It should state that the accounting and internal control system were considered only to the
extent necessary to determine the auditing procedures to report on the financial statements and
not to determine the adequacy of internal control for management purposes or to provide
assurances on the accounting and internal control systems.
• It will state that it discusses only deficiencies in internal control which have come to the
auditor's attention as a result of the audit and that other deficiencies in internal control may exist.
• It should also include a statement that the communication is provided for use only by
management (or another specific named party).
• The auditors will usually ascertain the actions taken, including the reasons for those suggestions
rejected.
• The auditors may encourage management to respond to the auditor's comments in which case any
response can be included in the report.
C
H
A
P
T
E
R
Summary
1 SPV
(a) Role of board
Each individual board of directors will take on particular tasks peculiar to their own company
and these will be different from company to company. However there are three key tasks that
will be addressed by all boards of directors to one degree or another.
Strategic management
The development of the strategy of the company will almost certainly be led by the board of
directors. At the very least they will be responsible for setting the context for the
development of strategy, defining the nature and focus of the operations of the business and
determining the mission statement and values of the business.
Strategic development will also consist of assessing the opportunities and threats facing
the business, considering, developing and screening the strategic proposals and
selecting and implementing appropriate strategies. Some or all of this more detailed
strategic development may be carried out by the board, but also may be delegated to senior
management with board supervision.
In the case of SPV the board appears to have had inadequate involvement in the development
of strategy. Whilst the board may use advice from expert managers, the board should also
have challenged what they provided and carried out its own analysis; possible threats from
rivals appear to have been inadequately considered.
Control
The board of directors is ultimately responsible for the monitoring and control of the
activities of the company. They are responsible for the financial records of the company and
that the financial statements are drawn up using appropriate accounting policies and show a
true and fair view. They are also responsible for the internal checks and controls in the
business that ensure the financial information is accurate and the assets are safeguarded.
The board will also be responsible for the direction of the company and ensuring that the
managers and employees work towards the strategic objectives that have been set. This
can be done by the use of plans, budgets, quality and performance indicators and
benchmarking.
Again what has happened with the projects appears to indicate board failings. It seems that
the board failed to spot inadequacies in the accounting information that managers were
receiving about the new project, and did not ensure that action was taken by managers to
control the overruns in time and the excessive costs that possibly the accounting information
may have identified. The board also seems to have failed to identify inadequacies in the
information that it was receiving itself.
Shareholder and market relations
The board of directors has an important role externally to the company. The board is
responsible for raising the profile of the company and promoting the company's
interests in its own and possibly other market places.
The board has an important role in managing its relationships with its shareholders. The board
is responsible for maintaining relationships and dialogue with the shareholders, in
particular the institutional shareholders. As well as the formal dialogue at the annual general
meeting many boards of directors have a variety of informal methods of keeping
shareholders informed of developments and proposals for the company. Methods include
informal meetings, company websites, social reports, environmental reports etc.
The institutional shareholders' intention to vote against the accounts is normally seen as a last
resort measure, if other methods of exercising their influence and communicating their
concerns have failed. This indicates that the board has failed to communicate effectively
with the institutional shareholders.
Corporate governance requirements normally indicate that the board of directors should
comprise equal numbers of executive and non-executive directors. By having only two non-
executive directors, SPV may not be following requirements. SPV needs to appoint at least
one more non-executive director to the board.
There is also a lack of any relevant financial experience amongst the non-executive directors.
Corporate governance regulations normally suggest that at least one NED has financial
experience so they can monitor effectively the financial information that the board is reviewing.
Making the new appointee an accountant would help to fulfil this requirement.
Role of chairman/CEO
Corporate governance regulations normally require that the roles of the chairman (the person
running the board) and the CEO (the person running the company) are split. The reason for
this is to ensure that no one person has too much influence over the running of the company.
The roles of chairman and CEO at SPV should be split at the earliest opportunity.
The chairman of the board is normally allowed to sit on the audit and remuneration
committees to ensure that decisions made are in agreement with the overall objectives. Issues
that are not clear with the current structures relate to the composition of those committees.
Corporate governance requirements indicate these committees will normally comprise NEDs,
including the senior NED. This is to limit the extent of power of the executive directors. SPV
needs to ensure that this requirement is being followed.
Service contracts
Service contracts for NEDs should be for a specified term. Any term beyond six years should
be subject to rigorous review and should take into account the need for progressive refreshing
of the board. The duration of contracts is limited to ensure payments for early termination of
contracts are not excessive. The re-appointment provisions apply to ensure that new NED's
are being appointed as directors on a regular basis. NEDs who have been on the board for a
few years may become too familiar with the operations of the company and therefore not C
provide the necessary external independent check that they are supposed to do. H
Service contracts need to be limited and any over six years should be reviewed. A
P
Internal audit T
E
The internal audit department usually does not report to the financial accountant as that
R
person may have a vested interest in not taking any action on the reports, especially where
reports are critical of the accountant. In that sense, reporting to the board is acceptable.
However, the board as a whole may not have the time to review internal audit reports and may 4
be tempted to ignore them if they are critical of the board itself. Corporate governance
regulations indicate that the internal audit department should report to the audit committee
with reports being forwarded to the board. This ensures that the report is heard by the NEDs,
who can then ensure that internal audit recommendations are implemented where
appropriate, by the board.
In SPV, the internal auditor needs to report to the audit committee, for reasons already
mentioned above.
Management controls
Management controls are designed to ensure that the business can be effectively
monitored. Key management controls include the following.
(i) Monitoring of business risks on a regular basis
This should include assessment of the potential financial impact of contingencies.
(ii) Monitoring of financial information
Management should be alert for significant variations in results between branches or
divisions or significant changes in results. C
(iii) Use of audit committee H
A
The committee should actively liaise with the external and internal auditors, and report
on any deficiencies discovered. The committee should also regularly review the overall P
structure of internal control, and investigate any serious deficiencies found. T
E
(iv) Use of internal audit
R
Internal audit should be used as an independent check on the operation of detailed
controls in the operating departments. Internal audit's work can be targeted as
appropriate towards areas of the business where there is a risk of significant loss should 4
controls fail. As there is no internal audit department at present, the board will need to
establish one and define its remit.
The overall lack of controls is concerning, given the objective to obtain a listing. The
directors will need to implement the recommendations of the UK Corporate Governance
Code to ensure that a listing can be obtained.
C
H
A
P
T
E
R
Introduction
Topic List
1 Overview of the audit process
2 Audit planning
3 Professional scepticism
4 Understanding the entity
5 Business risk model
6 Audit risk model
7 Creative accounting
8 Materiality
9 Responding to assessed risks
10 Other audit methodologies
11 Information technology and risk assessment
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
171
Introduction
• Identify the components of risk and how these components may interrelate
• Analyse and evaluate the control environment for an entity based on an understanding of
the entity, its operations and its processes
• Evaluate an entity's processes for identifying, assessing and responding to business and
operating risks as they impact on the financial statements
• Appraise the entity and the potentially complex economic environment within which it
operates as a means of identifying and evaluating the risk of material misstatement
• Identify the risks arising from, or affecting, a potentially complex set of business processes
and circumstances and assess their implications for the engagement
• Identify significant business risks and assess their potential impact upon the financial
statements and the audit engagement
• Evaluate the impact of risk and materiality in preparing the audit plan, for example the
nature, timing and extent of audit procedures
• Evaluate the components of audit risk for a specified scenario, for example the interactions
of inherent risk, control risk and detection risk, considering their complementary and
compensatory nature
• Prepare, based upon planning procedures, an appropriate audit strategy and detailed
audit plan or extracts therefrom
• Explain and evaluate the relationship between audit risk and audit evidence
Section overview
• The audit is designed to enable the auditor to obtain sufficient, appropriate evidence.
1.1 Overview
While there may be variations between specific procedures adopted by individual firms the modern audit
process is a well-defined methodology designed to enable the auditor to obtain sufficient, appropriate
evidence.
This process can be summarised in a number of key stages:
In this chapter we will consider stages 1 to 4. In Chapter 6 we will consider stage 5, and in Chapter 8,
stages 6 and 7. However, it is important not to view the audit as a series of discrete stages and
individual audit procedures. For example, it can be argued that all audit procedures which provide
evidence are risk assessment procedures whether they are conducted during planning, control
evaluation, substantive testing or completion. The modern audit process will adopt a strategy where C
complementary evidence is acquired and evaluated from a range of sources. The process is repeated H
until the auditor has obtained sufficient, appropriate audit evidence which is adequate to form an opinion. A
P
T
2 Audit planning E
R
Section overview
• You should be familiar with the basic planning process. 5
• Understand the business, its control environment, its control procedures and its accounting system
• Determine materiality
• Develop an audit strategy setting out in general terms how the audit is to be carried out and the
type of approach to be adopted
• Produce an audit plan which details specific procedures to be carried out to implement the strategy
taking into account all the evidence and information collected to date.
You have already covered planning and risk assessment issues in your earlier studies. The relevant
ISAs are:
ISA 210 Agreeing the Terms of Audit Engagements
ISA 300 Planning an Audit of Financial Statements
ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity
and Its Environment
ISA 320 Materiality in Planning and Performing an Audit
ISA 330 The Auditor's Responses to Assessed Risks
A number of issues are developed in the remainder of this chapter, however it is assumed that you are
already familiar with the basic requirements of the above ISAs. A summary of these and other related
ISAs can be found in the technical reference section at the end of the chapter for revision purposes.
3 Professional scepticism
Section overview
• The auditor must maintain an attitude of professional scepticism throughout the audit.
3.1 Requirement
Definition
Professional scepticism: An attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.
• Information that brings into question the reliability of documents and responses to inquiries to be
used as audit evidence
• Circumstances that suggest the need for audit procedures in addition to those required by the ISAs
• The auditor may accept records and documents as genuine unless there is reason to believe the
contrary. Where there is doubt, for example where there are indications of possible fraud the
auditor must investigate further and determine whether to modify or increase the audit procedures.
• A belief that management and those charged with governance are honest and have integrity does
not relieve the auditor of the need to maintain professional scepticism.
The same points are re-iterated in ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit
of Financial Statements. This standard emphasises that where there are potential fraud issues the
auditor's professional scepticism is particularly important when considering the risks of material
misstatement.
3.3.2 Section 2 Exploring the roots of scepticism and identifying lessons for its role in the
conduct of an audit
5
Section 2 considers the philosophical origins of scepticism in ancient Greece and how it later influenced
scepticism in the scientific method that flourished in the 17th Century. The paper explains that the
following can be learnt from early Greek philosophical scepticism:
• In the face of doubt the sceptics would suspend their judgement about the truth.
• In its extreme form scepticism is not pragmatic as it may lead to the conclusion that no judgements
about the truth can be made.
Section 2 also looks at the relationship between doubt and trust in the context of scepticism. It argues
that where levels of both are low there is uncertainty which will either lead to the indefinite suspension of
judgement or stimulate inquiry to pursue the truth or falseness of the assertion. Only when trust or doubt
are sufficiently high will belief in the assertion be accepted or rejected.
• Critically appraise existing theories, actively looking for alternative plausible mechanisms of cause
and effect that are consistent with their rigorous assessment of the empirical (observed) evidence.
• Undertake experiments that are repeatable and transparent, to look for evidence that contradicts
rather than supports the validity of a given theory.
• Suspend judgment about the validity of any given theory (ie to defer making an active decision to
believe or disbelieve it) until it has both survived destructive testing and has been subjected to
critical experiments the evidence from which makes it possible to conclude that one theory is
superior to all other current plausible theories.
Whilst the subject matter of scientific and audit inquiry are different and there are limitations to the
analogy between the two, elements of the scientific method suggest critical audit activities which will
underpin appropriate scepticism in the audit:
• Empirical observation suggests developing a good understanding of the business of the audited
entity and the environment;
• Constructing falsifiable hypotheses suggests actively considering that material misstatements may
exist and designing audit tests to identify them, rather than only considering how well the evidence
obtained by management supports their conclusion that there are none; and
• There is the potential for auditors not to be sceptical or thought not to be sceptical because they
are engaged and paid by the company in a way that is relatively detached from shareholders. This
emphasises the need for strong governance generally and, in particular, the role of audit
committees in assessing and communicating to investors whether the auditors have executed a
high quality, sceptical audit.
• Auditors have strong working relationships with management and audit committees, which may
lead them to develop trust that may lead to either a lack of, or reduced scepticism.
• The audit firms' business model encourages a culture of building strong relationships with clients.
This introduces the risk of the auditor putting his or her interests ahead of those of the shareholders
and could lead the audit firm and the auditor to develop trust or self-interest motivations that may
compromise either their objectivity or willingness to challenge management to the extent required.
The auditor must lean against unjustified trust in management developing. There is also a risk that audit
committees' views may be seen too readily as a surrogate for those of the shareholders. Just addressing
the concerns of the audit committee does not necessarily amount to meeting the expectations of
shareholders.
• The auditor's risk assessment process should involve a critical appraisal of management's
assertions, actively looking for risks of material misstatement.
• The auditor develops a high degree of knowledge of the entity's business and the environment in
which it operates, sufficient to enable it to make its risk assessment through its own fresh and
independent eyes rather than through the eyes of management.
• This enables the auditor to make informed challenge of consensus views and to consider the
possible incidence of low probability high impact events. The traditional pyramid structure of the
audit team may not always be appropriate and different models may need to be explored, such as
including experienced business people on the team.
• The auditor designs audit procedures to consider actively if there is any evidence that would C
contradict management assertions not only to consider the extent to which management has H
identified evidence that is consistent with them. A
• The auditor must be satisfied that: P
T
– There has been sufficient inquiry and challenge E
– Sufficient testing of management's assertions has been undertaken R
– The quality of the resulting evidence obtained has been critically appraised and judged by the
auditor to be sufficiently persuasive
5
– Where there are plausible alternative treatments of an item in the financial statements (such
as different valuation bases) an assessment has been made as to whether one is superior and
whether sufficient disclosure of the alternatives has been given, in order to give a true and fair
view.
• The auditor's documentation of audit judgements is conclusive rather than conclusionary and
therefore always sets out not only the auditor's conclusion but also their rationale for the
conclusion.
3.3.6 Section 6 Fostering conditions necessary for auditors to demonstrate the appropriate
degree of professional scepticism
This section sets out the APB's views about the conditions that are necessary for auditors to
demonstrate the appropriate degree of professional scepticism. It highlights the APB's expectations of
individual auditors, engagement teams and audit firms as follows:
Individual auditors
• Assess critically the information and explanations obtained in the course of their work and
corroborate them
• Investigate the nature and cause of deviations or misstatements identified and avoid jumping to
conclusions without appropriate audit evidence
• Are alert for evidence that is inconsistent with other evidence obtained or calls into question the
reliability of documents and responses to inquiries
• Have the confidence to challenge management and the persistence to follow things through to a
conclusion
Engagement teams
• Actively consider in what circumstances management numbers may be misstated, whether due to
fraud or error
• Develop a good understanding of the entity and its business in order to provide a basis for
identifying unusual transactions and share information on a regular basis
• Partners and managers are actively involved in assessing risk and planning the audit procedures to
be performed
• Partners and managers actively lead and participate in audit team planning meetings to discuss the
susceptibility of the entity's financial statements to material misstatement
• Partners and managers are accessible to other staff during the audit and encourage them to
consult with them on a timely basis
• Engagement teams document their key audit judgements and conclusions, especially those
reported to the audit committee, in a way that clearly demonstrates that they have exercised an
appropriate degree of challenge to management and professional scepticism
• Partners and management bring additional scepticism to the audit by carrying out a diligent
challenge and review of the audit work performed and the adequacy of the documentation prepared
Audit firms
• Scepticism is embedded in the firm's training and competency frameworks used for evaluating and
rewarding partner and staff performance
• The firm requires rigorous engagement quality control reviews that challenge engagement teams'
judgments and conclusions
• Firm methodologies and review processes emphasise the importance of, and provide practical
support for auditors in:
– Developing a thorough understanding of the entity's business and its environment
– Identifying issues early in the planning cycle to allow adequate time for them to be
investigated and resolved
– Rigorously taking such steps as are appropriate to the scale and complexity of the financial
reporting systems, to identify unusual transactions
– Changing risk assessments, materiality and the audit plan in response to audit findings
– Documenting audit judgements in a conclusive rather than a conclusionary manner
– Raising matters with the Audit Committee regarding the treatment or disclosure of an item in
the financial statements where the auditor believes that the treatment adopted is different to
the perspective of the shareholders
– Ensuring that disclosures of such matters are carefully assessed.
This section also emphasises the supporting role that can be played by Audit Committees and
management.
Section overview
• The auditor obtains an understanding of the entity in order to assess the risks of material
misstatement.
• Information will be sought regarding the industry in which the business operates and the different
business processes within the entity itself.
4.1 Procedures
ISA 315 states that 'the objective of the auditor is to identify and assess the risks of material C
misstatement, whether due to fraud or error, at the financial statement and assertion levels, through H
understanding the entity and its environment, including the entity's internal control, thereby providing a A
basis for designing and implementing responses to the assessed risks of material misstatement'. P
T
E
R
Step 2
Evaluate whether the risks relate pervasively to the financial statements as a whole
Step 3
Relate the risks to what can go wrong at the assertion level
Step 4
Consider whether the risks are of a magnitude that could result in a material misstatement
Step 5
Consider the likelihood of the risks causing a material misstatement
Notice therefore that the stages of the planning process often take place simultaneously rather being
performed in sequence. For example, as the auditor learns more about the business certain risks will
come to light as a result. So the auditor is both gaining an understanding of the business and identifying
risk by adopting the same procedures. We will look at risk specifically in sections 5 and 6 of this chapter.
either area, as the problem is likely to be restricted to a few number of customers, and only a few
number of sales to those customers.
• Risk of fraud
• Its relationship with recent developments
• The degree of subjectivity in the financial information
• The fact that it is an unusual transaction
• It is a significant transaction with a related party
• The complexity of the transaction
Routine, non-complex transactions are less likely to give rise to significant risk than unusual transactions
or matters of director judgement because the latter are likely to have more management intervention,
complex accounting principles or calculations, greater manual intervention or there is a lower opportunity
for control procedures to be followed.
When auditors identify a significant risk, if they have not done so already, they should evaluate the
design and implementation of the entity's controls in that area.
4.2.1 Industry
The type of entity being audited will have a significant impact on the audit plan. For example:
Focus on salaried employees Many production staff based paid on hours worked
including various overtime and incentive schemes
Relatively little investment in plant and equipment; Large investment in plant and equipment; office
office space main building cost space relatively small in comparison to production
facilities
An understanding and appreciation of these differences will assist the auditor in identifying risk areas
and in developing an appropriate audit approach.
From the auditor's point-of-view, the different entities will result in a different audit approach for each
entity. For example, the lack of inventory in service industries will obviously mean less time will be
devoted to that area. Conversely, the use of complicated costing systems will require use of specialist
computer-auditors to identify, record and test various computerised systems.
An understanding of each process focuses the auditor's attention on specific parts of the business.
Financing Verification of new share issues / confirming current account and loan balances
and where necessary bank support for the business.
Human resources Audit of wages and salaries including bonuses linked to production or
commission on sales.
The actual audit approach will depend partly on the audit methodology used.
Section overview
• Business risk is the risk arising to the business that it will not achieve its objectives.
• Corporate governance guidelines emphasise the importance of risk management processes within C
a business. H
A
• The business risk model of auditing requires the auditor to consider the entity's process of
P
assessing business risk and the impact this might have in terms of material misstatement.
T
E
R
5.1 Business risk
Business risk is the risk arising to entities that they will not achieve their objectives. It includes risks at
all levels of the business. 5
• Financial risks
• Operating risks
Definitions
Financial Risks – are those risks arising from the company's financial activities (eg investment risks) or
the financial consequences of operations (eg receivables risks).
Examples: going concern, market risk, overtrading, credit risk, interest rate risk, currency risk, cost of
capital, treasury risks.
Operating Risks – are those risks arising from the operations of the business.
Examples: loss of orders; loss of key personnel; physical damage to assets; poor brand management;
technological change; stock-outs; business processes unaligned to objectives.
Compliance Risks – are those risks arising from non-compliance with laws, regulations, policies
procedures and contracts.
Examples: breach of company law, non compliance with accounting standards; listing rules; taxation;
health and safety; environmental regulations; litigation risk against client.
Business risk may be caused by many factors, or combination of factors including the following:
• Complex environment
• Dynamic environment
• Competitors' actions
• Inappropriate strategic decision making
• Operating gearing
• Financial gearing
• Lack of diversification
• Susceptibility to currency fluctuations
• Inadequate actual or contingent financial resources
• Dependence on one or few customers
• Regulatory change or violation
• Adequacy and reliability of suppliers
• Over-trading
• Developing inappropriate technology
• Macro-economic instability
• Poor management
• Identify significant risks which could prevent the business achieving its objectives
• Provide a framework to ensure that the business can meet its objectives
• Review the objectives and framework regularly to ensure that objectives are met
In practice each of these stages is complex.
C
H
A
P
T
E
R
• Objectives
• Business strategy
• Risk management procedures
• Industry environment
• Economic environment
This approach to the audit has been called a 'top-down' approach, because it starts with the business
and its objectives and works back down to the financial statements, rather than working up from the
financial statements which has historically been the approach to audit involving detailed tests of
transactions and balances. The BRM therefore looks at the 'big risks' that may significantly threaten the
valuation, profitability or even the going concern of the business. Those who support this approach
argue that the key audit risks are more likely to relate to the failure of the company's strategy than the
misstatement of a transaction.
The following table demonstrates the way in which business risks can have implications for the financial
statements and therefore the audit.
Product quality issues related to inadequate Inventory values – net realisable value and
control over supply chain and transportation inventory returns
damage
On 1 January 20X8 a steel production company has significant steel inventories with a total value of
CU20 million.
To protect the inventory from changes in value, the entity enters into a futures contract on a commodities
exchange to fix the selling price in 18 months' time. This is the first time that the entity has entered into
this type of transaction.
Requirements
(a) Identify the business risk in this situation
(b) Identify the issues which the auditor would need to consider
See Answer at the end of this chapter.
Tests of controls As the auditor pays greater attention to the high level controls used by
directors to manage business risks, controls testing will be focused on items
such as the control environment and corporate governance than the detailed
procedural controls tested under traditional approaches.
Analytical procedures Analytical procedures are used more heavily in a business risk approach as
they are consistent with the auditor's desire to understand the entity's
business rather than to prove the figures in the financial statements.
Detailed testing The combination of the above two factors, particularly the higher use of
analytical procedures will result in a lower requirement for detailed testing,
although substantive testing will not be eliminated completely.
You are using the business risk model in the statutory audit of a major international pharmaceutical
company.
You are told that the key determinant of profitability is the development of new types of drug, which are
superior to those of competitors. This is achieved by significant investment in R&D. You are also
informed, however, that such drugs may take as many as 10 years before gaining regulatory approval
for use. One major R&D project is a joint venture with another pharmaceutical company.
Requirements
Outline
C
(a) The key risks facing the company H
(b) Controls that management might use to mitigate such risks A
(c) Audit procedures to be carried out in respect of such risks P
T
See Answer at the end of this chapter.
E
R
KidsStuff Ltd imports children's toys from a supplier in the China into its warehouse in Chittagong and 5
distributes them to retailers throughout the Asia. The company was set up by Joseph Cooper 40 years
ago and is managed by Joseph and his two sons. The company had experienced reasonable growth
until the last five years, but recent performance has been poor and the company now relies on a
substantial overdraft. Joseph feels that the decline is due in part to the competitiveness of the market
Section overview
• Audit risk is the risk that the auditors may give an inappropriate opinion when the financial
statements are materially misstated.
• The risk of material misstatement is made up of inherent risk and control risk.
• The audit risk model expresses the relationship between the different components of risk as
follows:
• Business risk forms part of the inherent risk associated with the financial statements.
• Information gained in obtaining an understanding of the business is used to assess inherent risk.
• Assessment of control risk involves assessing the control environment and control activities.
Definitions
Audit risk: is the risk that auditors may give an inappropriate audit opinion when the financial
statements are materially misstated. Audit risk has two key components: risk of material misstatement in
financial statements (financial statement risk) and the risk of the auditor not detecting the material
misstatements in financial statements (detection risk). The risk of material misstatement breaks down
into inherent risk and control risk.
Inherent risk: is the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement that could be material, either individually or when aggregated with other
misstatements, before consideration of any related controls.
Control risk: is the risk that a misstatement:
Point to note:
The ISAs do not ordinarily refer to inherent risk and control risk separately but rather to the combined
'risks of material misstatement'. Firms may assess them together or separately depending on their
preferred methodology and audit techniques.
AR = IR × CR × DR
In using this model the auditor will follow three key steps:
1 The auditor will set a planned level of audit risk for each account balance or class of transaction
2 Inherent risk and control risk are assessed, either separately or in combination. This will involve an
assessment of business risk and the risk of material misstatement (due to fraud or error)
3 Detection risk is then set at an appropriate level by 'solving' the audit risk equation.
This approach can be demonstrated as follows:
This model will then assist in the determination of the extent and type of procedures to be performed.
For example, the higher the assessment of inherent and control risk, the lower the assessment of
detection risk resulting in more evidence being obtained from the performance of substantive
procedures.
Points to note:
• One of the criticisms of the ARM is the 'compensatory' approach it takes. In the table above, high
inherent and control risk is compensated for by low detection risk. Arguments have been put
forward that evidence should be complementary rather than compensatory.
• Inherent risk and control risk are either 'high' or 'low' in the above table. This 'all or nothing'
approach is adopted by some audit firms. Thus, for instance, where there is a significant risk event
with respect to an audit area, then the inherent risk would always be deemed to be high. Other C
audit firms may see risk as a spectrum with, for instance, an intermediate rating of 'moderate risk' H
where there would be some reliance gained from inherent assurance, despite there being some A
measure of risk observed. P
T
E
R
Source: Auditing and Assurance Services International Edition. Aasmund Eilifsen, William F. Messier Jr,
Steven M. Glover, Douglas F. Prawitt
Point to note:
Notice the relationship between business risk (which we looked at in detail above) and audit risk.
Business risk includes all risks facing the business. In other words, inherent audit risk may include
business risks.
In response to business risk, the directors institute a system of controls. These will include controls to
mitigate against the financial aspect of the business risk. These are the controls that audit control risk
incorporates.
Therefore, although audit risk is very financial statements focused, business risk does form part of the
inherent risk associated with the financial statements (ie is part of financial statement risk) not least,
because if the risks materialise, the going concern basis of the financial statements could be affected.
The following illustrates the link between business risk and financial statement risk:
Computer viruses could lead to significant loss of Uncertainties over going concern may not be fully
sales disclosed
Breaches of data protection law and other Provisions relating to breaches of regulations may
regulations could result in the company suffering be omitted or understated
financial penalties
The business may suffer losses from credit card Losses arising from frauds may not be recognised
fraud in the financial statements
• Inherent risk
Integrity and attitude to risk of directors and Domination by a single individual can cause
management problems
Management experience and knowledge Changes in management and quality of financial
management
Assets at risk of being lost or stolen Cash, inventory, portable non-current assets
(computers)
Fonesforall is a mobile phone network provider with its own retail outlets. It is currently offering the
5
following package for CU30 per month:
ZX4 mobile phone handset
12 month subscription to the network
300 'free' call minutes per month (for 12 months)
• An entity uses electronic data interchange to initiate orders; there will be no paper documentation
to verify.
• An entity provides electronic services to its customers eg an Internet Service Provider or
telephone company. No physical goods are produced with all information being collected and billing
carried out electronically.
• The test is for understatement.
Control environment
Within an entity, the control system works within the control environment. A poor control environment
implies that the control system itself will also be poor, because the entity does not place sufficient
emphasis on having a good control environment.
So, the control environment sets the philosophy of an entity effectively influencing the 'control
consciousness' of directors and employees. The importance of the enforcement of integrity and ethical
values was illustrated in July 2011 with the closure of the News of the World newspaper resulting from
phone-hacking allegations.
Factors affecting the control environment include:
Factor Explanation
Communication and An organisation should try to maintain the integrity and ethical standing
enforcement of integrity of the employees. Membership of a professional body helps enforce
and ethical values ethical standards for professional staff. Ethics in other areas are
maintained by ensuring rules do not encourage unethical conduct (eg
unrealistically high sales targets to earn commissions).
Commitment to Each job should have a job description showing the standards expected in
competence that job. Employees should then be hired with the competences to carry
out the job without compromising on the quality of work produced.
Involvement of those Those charged with governance should take an active role in ensuring
charged with governance ethical standards are maintained. For example, the audit committee
should ensure that directors carry out their duties correctly in the context
of the audit. Similarly, those charged with governance must ensure
appropriate independence from the company they are governing.
Management philosophy Management should set the example of following ethical and quality
standards. Where management establish a risk management system and
regularly discuss the effect of risks on an organisation then the auditor will
gain confidence that the overall control environment is effective.
Structure of the The structure of the organisation should ensure authority is delegated
organisation appropriately so that lower management levels can implement
C
appropriate risk management procedures. However, responsibility for risk
H
management overall is maintained by the board.
A
Reporting hierarchy Within the organisation's hierarchy, each level of management has P
responsibilities for risk included in their job description. There should also T
be a clear reporting system so that objectives for risk management are E
communicated down the hierarchy, while identified risks are R
communicated back up the hierarchy for action.
HR policies and HR policies should have appropriate policies for ensuring the integrity of
5
procedures staff, both for new employees and for continued training and development.
From a review of these factors, the auditor will form an opinion on the effectiveness of the control
environment. The auditor will also consider the means by which the entity monitors controls eg by the
Control Explanation
activity
Physical Controls to ensure the security of assets including data files and computer programs
controls (eg not simply tangible assets such as company motor vehicles).
Performance Reviews to check the performance of individuals are carried out on a regular basis.
reviews The review includes comparing actual performance against agreed standards and
budgets and accounting/obtaining reasons for any variances.
Information These are controls to check the completeness, accuracy and authorisation of the
processing processing of transactions. Two types of controls are generally recognised:
controls
• General controls – over the information processing environment as a whole, for
example to ensure the security of data processing operations and maintenance of
adequate backup facilities.
Where the auditor is satisfied regarding the ability of the control environment to process transactions
correctly and control activities to identify deficiencies in that processing, then control risk can be set to a
low figure. Obviously, where the control environment is weak, and control activities are missing, then
control risk will be set to a higher level.
Control activities for transaction assertions
Within each class of transactions, the auditor will ensure that specific audit assertions have been
achieved. Remember that for each assertion, a different 'mix' of control and substantive procedures may
be used.
For each of the audit assertions relevant to transaction testing, specific control activities are normally
available.
The assertions and control activities are summarised below:
• Daily/monthly reconciliation of
subsidiary records with an independent
review
Accuracy Amounts and other data relating to • Internal confirmation of amounts and
recorded transactions and events calculations
have been recorded appropriately
• Monthly reconciliation of subsidiary
records by an independent person
Cut-off Transactions and events have been • Procedures for the prompt recording of
recorded in the correct accounting transactions
period
• Internal verification of cut-off at year
end
Classification Transactions and events have been • Agreeing transactions against chart of
recorded in the proper accounts accounts
Monitoring controls
The auditor should also assess the means by which management monitors internal control over financial
reporting. In many entities internal auditors fulfil this function. You have studied ISA 610 Using the Work
of Internal Auditors in your earlier studies.
Forsythia is a small limited company offering garden landscaping services. It is partly owned by three 5
business associates, Mr Rose, Mr White and Mr Grass, who each hold 10% of the shares. The major
shareholder is the parent company, Poppy Ltd. This company owns shares in 20 different companies,
which operate in a variety of industries. One of them is a garden centre, and Forsythia regularly trades
with it. Poppy Ltd is in turn wholly owned by a parent, White Holdings Ltd.
7 Creative accounting
Section overview
• There is a spectrum of activity with respect to accounting policy choice. Creative accounting
attempts to change users' perceptions of the performance and position of a business.
• The consequences of creative accounting depend upon a range of factors that change over time
but are specific to individual companies.
• Red flags exist which may indicate that creative accounting practices have taken place.
• Empirical evidence supports the notion the creative accounting occurs on a widespread basis.
7.1 Introduction
One of the factors affecting the overall level of financial statement risk is the potential for creative
accounting.
Directors have choices and they may exercise those choices to recognise values that do not reflect
economic reality. A prime example is the choice of the cost model when an asset's fair value is
significantly higher than cost. (Note: if an asset's fair value and value in use were lower than cost,
then an impairment would be required under IAS 36 and directors would not have the discretion to
disclose at cost.) Directors are more likely to make use of their discretion to mislead financial
statement users if they have the opportunity (eg imprecise accounting regulations, weak auditors)
Definition
Creative accounting: The active manipulation of accounting results for the purpose of creating an
altered impression of the underlying financial position or performance of an enterprise by using
accounting rules and guidance in a spirit other than that which was intended when the rules were
written.
This well-documented practice is a potential problem for auditors in assessing the underlying
performance and position of a company and recent evidence suggests that it is one of the major issues
facing financial reporting.
Accounting measures involve a degree of subjectivity, choice and judgement and it would be wrong to
describe all such activity as creative accounting. Moreover, creative accounting normally falls within
permitted regulation and is not therefore illegal. It is thus often a question of fine judgement as to when
creative accounting is of such an extent that it becomes misleading.
The spectrum of creative accounting practices may include the following (commencing with the most
legitimate):
• Exercise of normal accounting policy choice within the rules permitted by regulation (eg FIFO or
average cost for inventory valuation).
• Judgement concerning the nature or classification of a cost (eg expensing or capitalising costs).
• Systematic selection of legitimate policy choices and estimations to alter the perception of the
position or performance of the business in a uniform direction.
• Systematic selection of policy choice and estimations that fall on the margin of permitted
regulation (or are not subject to regulation) in order to alter materially the perception of the
performance or position of the business.
• Fraudulent activities.
It can thus be a matter of fine judgement for an auditor as to where within this spectrum creative C
accounting becomes unacceptable. H
A
Companies may also seek to manipulate the perception of their performance and position by altering
P
underlying transactions, rather than just the way they are recorded. Accounting regulation seeks to limit
T
the effects of this behaviour in a number of ways as previously discussed. Nevertheless, while it may
E
seek to report faithfully transactions that actually take place, it cannot regulate for transactions which do
R
not take place, or which are delayed in order to manipulate the perception of performance or position.
These might include:
• Subjectivity – areas of subjectivity lend themselves to a greater degree of choice, judgement and
uncertainty.
• Complexity – complex industries and transactions are difficult to regulate precisely and give more
scope for manipulation.
• Insufficiently independent auditors – auditors may come under increased managerial pressure
to approve creative accounting practices.
• Imprecise regulations – where regulations are imprecise or inadequate, companies have greater
scope to exercise discretion, and auditors have a poor benchmark to challenge the selected
accounting procedures.
• Inadequate sources of information – where reliable sources of audit evidence exist (eg to
challenge management estimations) the scope for effective manipulation is more limited.
• Inadequate penalties – where creative accounting is discovered to have misled users, the
penalties for the company, and for the directors, are regarded by some as inadequate to provide
sufficient disincentives.
• Income smoothing – companies normally prefer to show a steady trend of growth in profits, rather
than volatility with significant rises and falls. Income smoothing techniques (eg declaring higher
provisions or deferring income recognition in good years) contribute to reducing volatility in reported
earnings.
• Achieving forecasts – where forecasts of future profits have been made, reported earnings may
be manipulated to tie in with these forecasts.
• Profit enhancement – this is where current year earnings are boosted to enhance the short-term
perception of performance.
• Maintain or boost share price – where markets can be made to believe that increased earnings
represent improved underlying commercial performance, then share price may rise, or at least be
higher than it would be in the absence of creative accounting.
• Accounting based contracts – where accounting based contracts exist (eg loan covenants, profit
related pay) then any accounting policy that falls within the terms of the contract may significantly
impact upon the consequences of that contract. For example, the breach of a gearing based debt
covenant may be avoided by the use of off-balance sheet financing.
• Incentives for directors – there may be personal incentives for directors to enhance profit in order
to enhance their remuneration. Examples might include: bonuses based upon EPS, or share
• Taxation – where accounting practices coincide with taxation regulations there may be an
incentive to reduce profit in order to reduce taxation. In these circumstances, however, it may
necessary to convince not only the auditor, but also Tax Authority.
• Regulated industries – where an industry is currently, or potentially, regulated then there may
be an incentive to engage in creative accounting to reduce profit in order to influence the
decisions of the regulator. This may include utilities where regulators may curtail prices if it is
perceived that excessive profits are being earned. It may also be relevant to avoid a reference to
the Competition Commission.
• Internal accounting – a company as a whole may have reason to move profits from division to
division (or subsidiary to subsidiary) in order to affect tax calculations or justify the
closure/expansion of a particular department.
• Losses – companies making losses may be under greater pressure to enhance reported
performance.
• Commercial pressures – where companies have particular commercial pressures to enhance the
perception of the company there is increased risk of creative accounting. For example, a takeover
bid, or the raising of new finance.
Thus, a range of stakeholders may have incentives to engage in creative accounting. In particular,
however, an appropriate degree of professional scepticism should be applied where benefits arise for
directors, as they are also the group responsible for implementing creative accounting practices.
• It enables an understanding of the motivations and reasons for the company's directors to
engage in the practice. (For instance, the existence and nature of a debt covenant that may be
affected by creative accounting.)
7.6 Sustainability
Some creative accounting practices are sustainable in the long term while others may only serve to
enhance the current year's profit, but only with the effect that future profits are correspondingly reduced.
Sustainable practices may include:
• Capitalisation of expenses – if, for instance, annual development costs are inappropriately
capitalised and amortised over ten years then, after that period, assuming constant expenditure,
the profit will be equivalent for either write off or amortisation policies (though not the statement
of financial position) as there will be 10 amounts of 10% amortisation recognised in profit or loss.
• Revenue recognition – bringing forward the recognition of revenues may initially enhance profit,
but at the cost of reducing future profits.
• Complex series of transactions may mean that markets fail to appreciate fully the impact of creative
accounting
Covert creative accounting is likely to include all the above effects but in addition, even where the
market is semi strong efficient, it cannot always 'see through' the creative accounting and shares could
be mispriced. This may result in shareholders suffering an undue loss.
Recent revelations regarding creative accounting have resulted in significant falls in the share prices of
the companies concerned providing evidence of previous mispricing. However, shares prices also fell in
other companies, as markets generally placed less trust on reported earnings and auditors were
perceived as being unable to prevent creative accounting.
Accounting based contracts
Whether creative accounting is covert or overt, it can affect the application of accounting based
contracts, so long as the selected accounting treatment falls within the terms of that contract. Typically, a
restrictive covenant on gearing, or interest cover, may be avoided by enhancing equity or earnings. This
may benefit one stakeholder (eg shareholders) but disadvantage another (eg debtholders).
• Cash flows – Operating cash flows are systematically out of line with reported operating profits
over time.
• Reported income and taxable income – Is financial reporting income significantly out of line with
taxable income with inadequate explanation or disclosure?
• Acquisitions – Where a significant number of acquisitions have taken place there is increased
scope for many creative accounting practices.
• Financial statement trends – Indicators include: unusual trends, comparing revenue and EPS
growth, atypical year end transactions, flipping between conservatism and aggressive accounting
from year to year, level of provisions compared to profit indicating smoothing, EPS trend, timing of
recognition of exceptional items.
• Ratios – Ageing analyses revealing old inventories or receivables, declining gross profit margins
but increased net profit margins, inventories/receivables increasing more than sales, gearing
changes.
• Changes of accounting policies and estimates – Is the nature, effect and purpose of these
changes adequately explained and disclosed?
• Actual and estimated results – Culture of always satisfying external earnings forecasts, absence
of profit warnings, inadequate or late profit warnings leading to 'surprises', interim financial
statements out of line with year end financial statements.
• Audit qualifications – Are they unexpected and are any auditors adjustments specified in the
audit report significant?
• Related party transactions – Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not suggested
that the above practices necessarily mean there is creative accounting, but where a number of these
factors exist simultaneously, then the auditor should be put 'on inquiry' to make further investigations.
8 Materiality
Section overview
• Materiality considerations are important at the planning stage.
• An item might be material due to its nature, value or impact on readers of financial statements.
Definition
ISA 320 Materiality in Planning and Performing an Audit states that the auditor's frame of reference for
materiality should be based on the relevant financial reporting framework. IAS 1 gives the following
definition:
Materiality: Omissions or misstatements of items are material if they could individually or collectively,
influence the economic decisions that users make on the basis of the financial statements. Materiality
depends on the size and nature of the omission or misstatement judged in the surrounding
circumstances. The size or nature of the item, or combination of both, could be the determining factor.
Materiality criteria
An item might be material due to its:
Nature Given the definition of materiality that an item would affect the readers of the
financial statements, some items might by their nature affect readers. Examples
include transactions related to directors, such as remuneration or contracts with
the company.
Value Some items will be significant in the financial statements by virtue of their size, for
example, if the company had bought a piece of land with a value which comprised
three-quarters of the asset value of the company, that would be material. That is why
materiality is often expressed in terms of percentages (of assets, of profits).
Impact Some items may by chance have a significant impact on financial statements, for
example, a proposed journal which is not material in size could convert a profit into a
Although there are general guidelines on how materiality might be calculated in practice, the calculation
involves the application of judgement. It should be reassessed throughout the course of the audit as
more information becomes available.
Users' needs
The auditor must consider the needs of the users of the financial statements when setting materiality.
The ISA indicates that it is reasonable for the auditor to assume that users:
• Have a reasonable knowledge of the business and economic activities and accounting and a
willingness to study the information in the financial statements with reasonable diligence
• Understand that financial statements are prepared and audited to levels of materiality
• Recognise the uncertainties inherent in the measurement of amounts based on the use of
estimates, judgement and the consideration of future events
• Make reasonable economic decisions on the basis of the information in the financial statements
Steps 1 and 2 would normally be performed as part of the planning process. Step 3 is normally
performed as part of the review stage of the audit when the auditor evaluates the audit evidence.
percentage factor is applied. Factors that may affect the identification of an appropriate benchmark
include the following:
• The nature of the entity, where it is in its life cycle and the industry and economic environment in
which it operates
Benchmark Threshold
Gross profit 1% – 2%
Profit before tax 5% – 10%
Total assets 1% – 2%
Equity 1% – 2%
Determining the level of materiality is a matter of professional judgement, rather than applying
benchmarks mechanically. In applying such judgements, the auditor should consider any relevant
qualitative factors, including:
• Overlook the fact that the aggregate of individually immaterial misstatements could cause the
financial statements to be materially misstated, and
• As a judgemental estimate to reduce the probability that the aggregate of uncorrected and
undetected misstatements exceeds the materiality for the financial statement as a whole, or
• Specific materiality levels may be set for particular classes of transactions, account balances or
disclosures that could have a particular influence on users' decisions in the particular
circumstances of the entity.
Different levels of materiality may therefore be used in the various audit procedures carried out.
Performance materiality should be used in both the planning and fieldwork stages of the audit. In the
November 2011 issue of the ICAEW Audit & Assurance Faculty newsletter, the article 'Living in a
material world' by David Gallagher usefully sets out four circumstances in which performance materiality
can be applied:
At the planning stage:
(a) To determine when no work is necessary, and where evidence is required, the extent of that
evidence.
(b) To help identify which items to test (for example, if a substantive test of detail approach is adopted,
the auditor may consider selecting all items above performance materiality first, and then consider C
whether any, and if so how many, further items to sample). H
At the fieldwork stage: A
P
(c) To help evaluate the results of sample tests (for example, if on a particular test the extrapolated T
difference of potential misstatements is less than materiality, the auditor may conclude that E
sufficient audit evidence had been obtained in this area).
R
(d) To help evaluate the results of analytical procedures (for example, if the results of a
reasonableness test produced a difference between the predicted and actual amounts which is less
than performance materiality, the auditor may conclude that sufficient audit evidence had been 5
obtained in this area).
Students who work in an audit practice may have come across tolerable misstatement (previously
called 'tolerable error') in carrying out audit engagements. Essentially, tolerable misstatement is an
You are the manager responsible for the audit of Albreda Ltd. The draft consolidated financial
statements for the year ended 30 September 20X6 show revenue of CU42.2 million (20X5 CU41.8
million), profit before taxation of CU1.8 million (20X5 CU2.2 million) and total assets of CU30.7 million
(20X5 CU23.4 million). In September 20X6, the management board announced plans to cease offering
'home delivery' services from the end of the month. These sales amounted to CU0.6 million for the year to
30 September 20X6 (20X5 CU0.8 million). A provision of CU0.2 million has been made at 30 September 20X6
for the compensation of redundant employees (mainly delivery van drivers).
Requirement
Comment upon the materiality of these two issues.
You are the auditor of Oscar Ltd and are in the process of planning the audit for the year ended 31
December 20X8. In the past the audit of this company has been straightforward. The following
information is available:
20X8 20X7
CU'000 CU'000
Total assets 1,800 1,750
Total revenue 2,010 1,900
Profit before tax 10 300
Materiality has been calculated by a colleague as follows:
Section overview
• Further audit procedures should be designed in response to the risks identified.
As a result of the auditor's risk assessment and assessment of materiality an audit strategy will be
developed in response. ISA 330 The Auditor's Responses to Assessed Risks makes the following points
in this context which you should be familiar with.
• Emphasising to the audit team the need to maintain professional scepticism in gathering and
evaluating audit evidence.
• Assigning more experienced staff, those with special skills or using experts.
C
• Providing more supervision. H
A
• Incorporating additional elements of unpredictability in the selection of further audit
P
procedures.
T
The auditor may also make general changes to the nature, timing or extent of audit procedures, for E
example, by performing substantive procedures at the period end instead of at an interim date. These R
decisions will take into account the auditor's assessment and understanding of the control
environment.
5
• The reasons for the risk assessment at the assertion level for each class of transaction, account
balance or disclosure.
• The likelihood of material misstatement due to the particular characteristics of the class of
transaction, account balance or disclosure involved.
• Whether the risk assessment takes account of relevant controls and so requires the auditor to
obtain evidence to determine whether the controls are operating effectively.
The auditor shall obtain more persuasive audit evidence the higher the assessment of risk.
The auditor will then determine the nature, timing and extent of further audit procedures. We will
look at this aspect of the audit in detail in Chapter 6.
9.4 Documentation
The ISA emphasises the need to document the link between the audit procedures and the assessed
risks. These matters should be recorded in accordance with ISA 230 Audit Documentation with which
you should be familiar from your earlier studies.
Section overview
• Other audit methodologies include:
– Systems audit
– Transaction cycle approach
– Balance sheet audit approach
10.1 Introduction
In this chapter we have looked in detail at the business risk model and the audit risk model. However
there are a number of other audit approaches which may be adopted.
C
H
A
P
T
E
R
Purchases cycle
Section overview
• A huge number of organisations now use computer systems to run their businesses and to process
financial information. C
H
• The main risks associated with using computerised systems include infection by viruses and access by
A
unauthorised users. Both these risks could potentially have a very damaging effect on the business.
P
• This means that a number of the controls which the directors are required to put into place to safeguard T
the assets of the shareholders must be incorporated into the computer systems.
E
• Auditors have to assess the effectiveness of the controls in place within computer systems and can do R
this by performing a systems audit as part of their initial assessment of risk during the planning stage of
the audit.
5
11.1 The use of information technology
Most organisations and businesses, even very small entities, now use information technology to some
degree. The first use of a computerised accounting system is thought to have been back in 1954 by General
Summary
• The military software usually takes at least three years to develop. The military insists on fixed
price contracts. Once the software has been authorised for use by the customer, Gates Ltd
supplies computer support services, which are charged on the time spent by the software
engineers on site.
• The 'off-the-shelf' packages are not sold to customers, but are issued under a licence giving
the right to use the software for a typical period of three years. The licence fee is paid up-front
by customers and is non-refundable. As part of the licence agreement Gates Ltd supplies
maintenance services without additional charge for the three year period.
Again, based on the above regarding the military software and the 'off-the-shelf' packages, please
can you also set out the audit issues arising.
Requirement
Respond to the partner's email.
2 Suttoner Ltd
Suttoner Ltd (Suttoner) operates in the food processing sector and is listed on the Dhaka Stock
Exchange. You are a member of its internal audit department. The company purchases a range of
food products and processes them into frozen or chilled meals, which it sells to major supermarkets
in Asia and Middle East.
The company structure
The company sells food through five subsidiaries, each of which is under the control of its own
managing director who reports directly to the main board. Each subsidiary has responsibility for,
and is located in, its own sales region. The regions are Bangladesh, the rest of South East Asia,
Middle East, Thailand and China. Food is produced in only two subsidiaries, Bangladesh and India.
Head office operates central functions, including the legal, finance and treasury departments.
C
The board has asked the managing directors of each subsidiary to undertake a risk assessment
H
exercise, including a review of the subsidiary's procedures and internal controls. This is partly due
A
to a review of the company's compliance with the provisions of the BSEC Corporate Governance
P
Guidelines (Internal control: Guidance to directors) and also because Suttoner has been severely
T
affected by two recent events and now wishes to manage its future risk exposure.
E
Recent events R
(1) In renegotiating a major contract with a supermarket Suttoner refused to cut its price as
demanded. As a result a major customer was lost.
5
(2) Later in the year the company had been cutting costs by sourcing food products from lower-
cost suppliers. In so doing it acquired contaminated beef which made several consumers ill. A
major health and safety inspection led to the destruction of all Suttoner's beef inventories
throughout Asia, due to an inability to trace individual inventories to source suppliers. More
1 ISA 210
• Agreement of terms of audit engagements ISA 210.9
2 ISA 300
• Preliminary engagement activities ISA 300.6
3 ISA 315
• Risk assessment procedures ISA 315.5–.10
4 ISA 320
• Definition of materiality ISA 320.2
5 ISA 330
• Overall responses to risk assessment ISA 330.5
C
H
A
P
T
E
R
1 Gates Ltd
Accounting issues
(a) Military contracts
Long-term contract accounting
The software development should be accounted for under IFRS 15 Revenue from Contracts
with Customers. Specifically, it is a fixed price contract, ie where the revenue arising is fixed at
the outset of the contract. Under such contracts there is an element of certainty about the
revenue accruing, but not about the costs which will arise. For a fixed price contract the
contractor should be able to measure reliably the total contract revenues and be able to
identify and measure reliably both the costs that have been incurred and those that will be
incurred to complete the project. The contractor should also assess whether it is probable that
payment will be received under the contract (IFRS 15).
As the contracts are fixed price there is an increased risk of the contracts being loss-making,
and such losses must be provided for in full.
Computer support
As the amount billed relates directly to the hours spent on site, it would be appropriate to
recognise this as revenue when charged.
(b) 'Off-the-shelf' packages
Licence and maintenance costs
There is an argument for recognising this revenue on receipt, given that it is non-refundable,
and paid after the development work has been completed and the costs incurred.
However, under IFRS 15 Revenue from Contracts with Customers it is generally not
appropriate to recognise revenue based on payments received under the contract, as stage
payments set out under the terms of the contract often bear little resemblance to the actual
services performed. Revenue relating to the licence should therefore be deferred over the
three year period.
The maintenance costs should be recognised on a basis that reflects the costs incurred which
might be based on the frequency of maintenance calls, probably related to the previous history
of maintenance calls.
Audit issues
Inherent risks
• Given the nature of the business and the military contracts, physical and electronic security
and controls are a major issue.
• Long-term contract accounting involves significant judgements with respect to future contract
costs. Judgement increases the likelihood of errors or deliberate manipulation. This area is
particularly difficult to audit given the specialised nature of the business, and we will need to
ensure that we have personnel with the right experience assigned to the audit.
• There is a risk with long-term contract accounting of misallocation of contract costs –
particularly away from loss-making contracts.
• The maintenance provision is an estimate and, again, susceptible to error.
Detection risks
• The nature of the military contracts may mean that we are unable to review all the information
because of the Official Secrets Act. This could generate a limitation on scope.
C
H
A
P
T
E
R
• Failure of internal R&D • Constant monitoring with exit • Review of failed projects, controls
projects. strategies. exercised and timing of exit.
• Write off of any capitalised R&D.
• Joint venture failure, • Clear contractual rights and • Review contractual arrangements
disagreement or decline. obligations. and technical progress.
• Transparency and
communication.
• Technical monitoring of
procedures similar to internal
systems above.
• Inadequate financial • Short term and long term • Consider actual and potential
resources to sustain R&D. financial budgets with actual financial resources.
and contingent financing
arrangements. • Evidence from bankers and other
finance providers or their agents.
• Changes in health spending • Monitor political statements • Review trends in health spending
or health regulation by and policies. and prospective regulation in key
governments in major markets.
geographical markets. • Political lobbying.
• Review client's governmental
• Consider impacts of changes monitoring procedures and
on profitability. information gained therefrom.
CHAPTER 6
Introduction
Topic List
1 Revision of assertions
2 Sufficient appropriate audit evidence
3 Sources of audit evidence
4 Selection of audit procedures
5 Analytical procedures
6 Audit of accounting estimates
7 Initial audit engagements – opening balances
8 Using the work of others
9 Working in an audit team
10 Auditing in an IT environment
11 Professional scepticism in the audit fieldwork stage
Appendix
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
• Evaluate, where appropriate, the extent to which reliance can be placed on expertise
from other parties to support audit processes
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and
tests of details
• Demonstrate how professional scepticism may be applied to the process of gathering
audit evidence and evaluating its reliability
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
• Evaluate, applying professional judgement, whether the quantity and quality of evidence
gathered from various audit procedures is sufficient to draw reasonable conclusions
• Recognise issues arising whilst gathering assurance evidence that should be referred to
a senior colleague
Section overview C
H
• Evidence is obtained in respect of each assertion used by the auditor.
A
P
T
1.1 Introduction
E
As we have seen audit work is about reducing risk – the risk that the financial statements include R
material misstatements. At the most basic level, the financial statements simply consist of information
about the:
• Revenues 6
• Costs
• Assets
• Liabilities and
• Capital
of the entity. These items will have certain attributes if they are included correctly in the financial
statements. These attributes are referred to as financial statement assertions.
Definition
Assertions: are the representations by management, explicit or otherwise, that are embodied in the
financial statements, as used by the auditor to consider the different types of potential misstatement that
may occur.
By approving the financial statements, the directors are making representations about the information
therein. These representations or assertions may be described in general terms in a number of ways.
For example, if the statement of financial position includes a figure for freehold land and buildings the
directors are asserting that:
• The property concerned exists
• It is either owned by the company outright or else the company has suitable rights over it
• Its value is correctly calculated
• There are no other items, of a similar nature, which ought to be included but which have been
omitted
• It is disclosed in the financial statements in a way which is not misleading and is in accordance with
the relevant 'reporting framework' eg international accounting standards
ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity
and its Environment states that 'the auditor shall identify and assess the risks of material misstatement
at the financial statement level and the assertion level for classes of transactions, account balances,
and disclosures to provide a basis for designing and performing further audit procedures'. It gives
examples of assertions in these areas. Depending on the nature of the balance, certain assertions will
be more relevant than others.
Assertions about Occurrence: transactions and events that have been recorded have occurred and
classes of pertain to the entity.
transactions and
Completeness: all transactions and events that should have been recorded have
events for the
been recorded.
period under audit
Accuracy: amounts and other data relating to recorded transactions and events
have been recorded appropriately.
Cut-off: transactions and events have been recorded in the correct accounting
period.
Classification: transactions and events have been recorded in the proper
accounts.
Assertions about Existence: assets, liabilities and equity interests exist.
account balances
Rights and obligations: the entity holds or controls the rights to assets, and
at the period end
liabilities are the obligations of the entity.
Completeness: all assets, liabilities and equity interests that should have been
recorded have been recorded.
Valuation and allocation: assets, liabilities, and equity interests are included in
the financial statements at appropriate amounts and any resulting valuation or
allocation adjustments are appropriately recorded.
Assertions about Occurrence and rights and obligations: disclosed events, transactions and
presentation and other matters have occurred and pertain to the entity.
disclosure
Completeness: all disclosures that should have been included in the financial
statements have been included.
Classification and understandability: financial information is appropriately
presented and described, and disclosures are clearly expressed.
Accuracy and valuation: financial and other information are disclosed fairly and
at appropriate amounts.
1.2.1 Summary
We have seen that there are 13 assertions applying in different ways to different items in the financial
statements.
You can summarise them in the following four questions:
• Should it be in the financial statements at all?
• Is it included at the right amount?
• Are there any more?
• Has it been properly disclosed and presented?
The following table shows how the assertions fit with these questions:
2.1 Importance
ISA 500 Audit Evidence states that the objective of the auditor is to obtain sufficient appropriate audit
evidence to be able to draw reasonable conclusions on which to base the auditor's opinion.
The importance of obtaining sufficient, appropriate audit evidence can be demonstrated in the Arthur
Andersen audit of Mattel Inc.
'The objective of the auditor is to … obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base the auditor's opinion.' (ISA 500.4)
Discuss the extent to which each of the following sources of audit evidence is appropriate and sufficient.
(a) Oral representation by management in respect of the completeness of sales where the majority of
transactions are conducted on a cash basis
(b) Flowcharts of the accounting and control system prepared by a company's internal audit
department
(c) Year-end suppliers' statements
(d) Physical inspection of a non-current asset by an auditor, and
(e) Comparison of revenue and expenditure items for the current period with corresponding information
for earlier periods.
See Answer at the end of this chapter.
Definition
Management's expert: an individual or organisation possessing expertise in a field other than
accounting or auditing whose work in that field is used by the entity to assist the entity in preparing
financial statements.
Certain aspects of the preparation of financial statements may require expertise such as actuarial
calculations (relevant to accounting for pensions) or valuations (where the fair value alternative is used
for non-current assets). The entity may employ such experts or may engage the services of external
experts. The redrafted ISA 500 includes guidance on the considerations that arise for the external
auditor in using this information as audit evidence.
If this work is significant to the audit the external auditor shall:
• Evaluate the competence, capabilities and objectivity of the expert
• Obtain an understanding of the work of the expert, and
• Evaluate the appropriateness of the expert's work as audit evidence for the relevant assertion
Note: Situations where the external auditor requires the assistance of an expert in obtaining audit
evidence are covered by ISA 620 Using the Work of an Auditor's Expert (see Section 8.1 of this
chapter).
2.4 Triangulation
Forming an audit opinion is a question of using professional judgement at all times and judgements
have to be made about the nature, the quality and the mix of evidence gathered. It is also essential that
individual items of evidence are not simply viewed in isolation but instead support other evidence and
are supported by other evidence. This approach views evidence from different sources as predominantly
complementary, rather than compensatory. This strategy of acquiring and evaluating complementary
evidence from a range of sources is referred to as triangulation in The 21st Century Public Company
Audit: Conceptual Elements of KPMG's Global Audit Methodology. This approach is an application of the
general principle that evidence obtained from different sources, that presents a consistent picture, is
mutually strengthening and gives greater reliance than merely increasing the amount of evidence from a
single source. The consequence of over-reliance on one specific type and source of evidence can be
seen in the case of the collapse of Parmalat.
Section overview C
H
• Sources of audit evidence include:
A
– Tests of controls (covered in Chapter 7) P
– Substantive procedures T
E
R
3.1 Tests of controls
You will have covered tests of controls in your earlier studies. We cover evaluation of controls and
tests of controls in more detail in Chapter 7, however a key point to remember is even if evaluated and 6
tested controls are considered strong enough to rely upon, there is still a need to carry out some
substantive testing.
Section overview
• Methods of obtaining audit evidence include:
– Inquiry
– Observation
– Inspection
– Recalculation
– Reperformance
– External confirmation
– Analytical procedures
The procedures used are selected according to the nature of the balance being audited and the
assertion being considered.
4.1.1 Inquiry
Definition
Inquiry: consists of seeking information of knowledgeable persons both financial and non-financial
within the entity or outside the entity.
Business focus
Common uses of inquiry are:
• Written representations – where management have information not available from any other
source.
• Asking employees about the internal control systems and effectiveness of the controls they are
operating.
Remember it is not normally sufficient to accept inquiry evidence by itself – some corroboration will be
sought. The USA court case of Escott et al. v Bar Chris Corporation (1968) ruled that the auditor was
negligent in not following up answers to management inquiries. The judge indicated that the auditor was
too easily satisfied with glib answers and that these should have been checked with additional
investigation.
4.1.2 Observation
Definition
Observation: consists of looking at a procedure or process being performed by others.
Examples
Observation is not normally a procedure to be relied on by itself. For example, the auditor may observe a
non-current asset, such as a motor vehicle. However, this will only prove the vehicle exists; other
assertions such as rights and obligations will rely on other evidence such as invoices and valuation
possibly on the use of specialist valuers or documentation.
Business focus
Observation is commonly used in the business processes of inventory management. After inventory has
been purchased, an organisation holds raw materials, work-in-progress and finished goods in its
warehouses and factories. Observation is used to determine that the inventory exists, it is valued
correctly (looking for old and slow moving inventory) and that inventory is complete in the organisation's
books. Note the link to audit assertions here.
Additionally, the auditor will be observing the internal control systems over inventory, particularly in
respect to perpetual inventory checking and any specific procedures for year-end inventory counting.
You should be familiar with the audit procedures in respect of attendance at an inventory count from
your Assurance studies.
Observation may also be used in the human resource business process. The auditor will observe
employees operating specific controls within the internal control system to determine the effectiveness of
application of those controls, as well as the ability of the employee to operate the control. However, the
act of observing the employee limits the value of the evidence obtained; many employees will amend
their work practices when they identify the auditor observing them.
Definition
C
Inspection: means the examination of records, documents or tangible assets. H
Examples A
P
By carrying out inspection procedures, the auditor is substantiating information that is, or should be, in T
the financial statements. For example, inspection of a bank statement confirms the bank balance for the
E
bank reconciliation which in turn confirms the cash book figure for the financial statements.
R
Business focus
6
Inspection assists with the audit of most business processes. For example:
• Financing: inspection of loan agreements to confirm the term and repayment details (part of the
completeness of disclosure in the financial statements)
• Purchasing: inspection of purchase orders to ensure that the order is valid and belongs to the
company (occurrence assertion amongst others)
• Human resources: inspection of pay and overtime schedules as part of wages audit
• Inventory management: inspection of the work-in-progress ledger confirming cost allocation to
specific items of work-in-progress (valuation assertion)
• Revenue: inspection of sales invoices to ensure that the correct customer has been invoiced with
the correct amount of sales (completeness and accuracy assertions)
Inspection of assets that are recorded in the accounting records confirms existence, gives evidence of
valuation, but does not confirm rights and obligations.
Confirmation that assets seen are recorded in accounting records gives evidence of completeness.
Confirmation to documentation of items recorded in accounting records confirms that an asset exists or
a transaction occurred. Confirmation that items recorded in supporting documentation are recorded in
accounting records tests completeness.
Cut-off can be verified by inspecting the reverse population, that is, checking transactions recorded after
the end of the reporting period to supporting documentation to confirm that they occurred after the end of
the reporting period.
Inspection also provides evidence of valuation/measurement, rights and obligations and the nature
of items (presentation and disclosure). It can also be used to compare documents (and hence test
consistency of audit evidence) and confirm authorisation.
4.1.4 Recalculation
Definition
Recalculation: consists of checking the arithmetical accuracy of source documents and accounting
records.
Examples
Recalculation obviously relates to financial information. It is deemed to be a reliable source of audit
evidence because it is carried out by the auditor.
Business focus
Recalculation relates to most business processes. For example:
• Financing: calculation of interest payments
• Purchasing: accuracy of purchase orders and invoices
• Inventory management: valuation of work-in-progress
• Revenue: re-calculation of sales invoices
4.1.5 Reperformance
Definition
Reperformance: means the auditor's independent execution of procedures or controls that were
originally performed as part of the entity's internal control.
Examples
Auditors will often reperform some of the main accounting reconciliations, such as the bank
reconciliation or reconciliations of individual supplier balances to supplier statements. It is also deemed
to be a reliable source of audit evidence because it is carried out by the auditor.
Business focus
Reconciliations are a key control over many transaction cycles in the business, and if performed properly
are an effective means of identifying accounting errors or omissions. If they are performed by an
individual who is not involved in the day to day accounting for the underlying transactions they can be a
deterrent against fraudulent accounting.
Definition
External confirmation: is audit evidence obtained as a direct written response to the auditor from a
third party.
Examples
A typical example of confirmation evidence is obtaining a response from a debtors' circularisation (see
Appendix for revision on this area). The evidence obtained is highly persuasive as it comes from an
independent external source.
Your firm acts as auditors to Xantippe Ltd, a manufacturer of industrial components. You have been
presented with the financial statements for the year to 31 December 20X6, which include the following
information in connection with property, plant and equipment.
At At
1 January 31
December
20X6 Additions Disposals 20X6
CU CU CU CU
Cost
Freehold property 80,000 – – 80,000
Plant and machinery 438,000 62,000 (10,000) 490,000
Motor vehicles 40,500 13,000 – 53,500
558,500 75,000 (10,000) 623,500
At Charge At
1 January for 31
December
20X6 year Disposals 20X6
Depreciation CU CU CU CU
Freehold property 8,000 1,600 – 9,600
Plant and machinery 139,500 47,000 (3,000) 183,500
Motor vehicles 20,000 10,200 – 30,200
167,500 58,800 (3,000) 223,300
Requirements
(a) Explain the factors that should be considered in determining an approach to the audit of property,
plant and equipment of Xantippe Ltd.
(b) State the procedures you would perform in order to reach a conclusion on property, plant and
equipment in the financial statements of Xantippe Ltd for the year ended 31 December 20X6.
See Answer at the end of this chapter.
5 Analytical procedures
Section overview
• Analytical procedures are used as part of risk assessment and are required to be used as part of
the final review process.
• Analytical procedures may be used as substantive procedures.
Important Gross profit margins, in total and by product, area and months/quarter (if possible)
accounting Receivables ratio (average collection period)
ratios
Inventory turnover ratio (inventory divided into cost of sales)
Current ratio (current assets to current liabilities)
Quick or acid test ratio (liquid assets to current liabilities)
Gearing ratio (debt capital to equity capital)
Return on capital employed (profit before interest and tax to total assets less current
liabilities)
Related items Payables and purchases
Inventory and cost of sales
Non-current assets and depreciation, repairs and maintenance expense
Intangible assets and amortisation
Loans and interest expense
Investments and investment income
Receivables and irrecoverable debts expense
Receivables and sales
Ratios mean very little when used in isolation. They should be calculated for previous periods and for
comparable companies. The permanent file should contain a section with summarised accounts and
the chosen ratios for prior years.
In addition to looking at the more usual ratios the auditors should consider examining other ratios that
may be relevant to the particular client's business, such as revenue per passenger mile for an airline
operator client, or fees per partner for a professional office.
Line (1) in the diagram shows the actual sales made by a business. There is a clear seasonal fluctuation
before Christmas. Line (2) shows a level of sales with 'expected seasonal fluctuations' having been
stripped out.
In this analysis the seasonal fluctuations have been estimated. This analysis is useful however, because
the estimate is likely to be based on past performance, so that the conclusion from this is that there
might be a problem:
• Sales are below the levels of previous years
• Sales are below expectation
As at 31 March
Statement of financial position Draft 20X7 Actual 20X6
CU'000 CU'000
Non-current assets 2,799 2,616
Current assets 1,746 1,127
Trade payables 991 718
Other payables 514 460
Requirements
(a) State what observations you can draw from the extracts from the draft financial statements and
how they may affect your audit of trade payables.
(b) Indicate how audit software could be used in the audit of trade payables to achieve a more efficient
audit.
See Answer at the end of this chapter.
The suitability of particular analytical Substantive analytical procedures are generally more
procedures for given assertions applicable to large volumes of transactions that tend to be
predictable over time, such as analysis involving revenue and
gross profit margins.
The reliability of the data from which This will depend on factors such as:
the auditors' expectations are
developed • The source of the information
• The comparability of the data; industry comparison may
be less meaningful if the entity sells specialised products.
The detail to which information can be Analytical procedures may be more effective when applied to
analysed financial information or individual sections of an operation
such as individual factories or shops.
The nature of information Financial: budgets or forecasts.
Non-financial: eg the number of units produced or sold.
The relevance of the information Whether the budgets are established as results to be
available expected rather than as tough targets (which may well not be
achieved).
The knowledge gained during The effectiveness of the accounting and internal controls.
previous audits
The types of problems giving rise to accounting adjustments in
prior periods.
Reliance on the results of analytical procedures depends on the auditor's assessment of the risk that
the procedures may mistakenly identify relationships (between data) when in fact there is a material
misstatement (that is, the relationships, in fact, do not exist). It depends also on the results of
investigations that auditors have made if substantive analytical procedures have highlighted significant
fluctuations or unexpected relationships.
5.4.2 Substantive analytical procedures
In practical terms, the use of substantive analytical procedures involves four distinct steps:
• Firstly, formulate expectations
• Secondly, compare expected value with the actual recorded amount
• Thirdly, obtain possible reasons for variance between expected value and recorded amount
• Fourthly, evaluate impact of any unresolved differences between the expected and recorded
amounts on the audit and financial statements.
Each of these steps is explained below.
Formulate expectations
The auditor develops an expectation of figures in the financial statements using prior year financial
statements, budgets, industry information etc. The expectation should be developed so that any
material difference between this and the actual values in the financial statements indicates a potential
misstatement. The auditor must also evaluate whether the expectation is sufficiently precise to identify a
misstatement.
To carry out this procedure, the auditor will need access to industry data and environmental factors
affecting that industry. Access to the financial statements is not required at this time as this could
prejudice the expectations of the auditor.
Example
The auditor is confirming the accuracy of salary expense in the statement of profit or loss and other
comprehensive income.
The prior year salary figure can be obtained from the prior year financial statements. This year's salary
can be estimated using the average number of employees (from personnel records) and the average
salary again from personnel records. Changes in number of staff can be checked as reasonably
accurate from knowledge of the industry sector (expanding or declining?) and initial knowledge of the
client's business (expanding or contracting?). Average number of employees multiplied by average
salary should give an approximate salary cost for the financial statements.
Compare expected value with the actual recorded amount
The auditor compares the expected value with the actual amount in the financial statements. In making
this comparison, the auditor must decide the amount of deviation which will be allowed between the
expected and actual figures – in other words set a materiality limit. As assessed risk increases the
CU
Ordinary shares of 25p each 250,000
Reserves 350,000
7% preference shares of CU1 each 250,000
15% unsecured loan stock 150,000
1,000,000
The ordinary shares are currently quoted at 125p each, the loan stock is trading at CU85 per CU100
nominal, and the preference shares at 65p each.
Requirement
Advise the company.
See Answer at the end of this chapter.
Section overview
• Accounting estimates are a high risk area of the audit as they require the use of judgement.
ISA 540 Auditing Accounting Estimates, Including Fair Value Estimates, and Related Disclosures
provides guidance on the audit of accounting estimates contained in financial statements and requires
auditors to obtain sufficient, appropriate audit evidence regarding accounting estimates.
Definition
An accounting estimate: is an approximation of a monetary amount in the absence of a precise means
of measurement.
The ISA gives the following examples of estimates, other than fair value estimates:
• Allowances to reduce inventory and receivables to their estimated realisable value
• Depreciation method or asset useful life
• Provisions against the carrying amount of an investment where there is uncertainty regarding its
recoverability
• Provision for a loss from a lawsuit
• Outcome of construction contracts in progress
• Provision to meet warranty claims
Examples of fair value estimates are:
• Complex financial instruments, which are not traded in an active and open market
• Share-based payments
• Property or equipment held for disposal
• Certain assets and liabilities acquired in a business combination, including goodwill and intangible
assets
Directors and management are responsible for making accounting estimates included in the financial
statements. These estimates are often made in conditions of uncertainty regarding the outcome of
events and involve the use of judgement. The risk of a material misstatement therefore increases when
accounting estimates are involved.
Audit evidence supporting accounting estimates is generally less than conclusive and so auditors
need to exercise greater judgement than in other areas of an audit.
Accounting estimates may be produced as part of the routine operations of the accounting system, or
may be a non-routine procedure at the period-end. Where, as is frequently the case, a formula based
on past experience is used to calculate the estimate, it should be reviewed regularly by management (eg
actual vs estimate in prior periods).
If there is no objective data to assess the item, or if it is surrounded by uncertainty, the auditors should
consider the implications for their report.
Section overview
• Opening balances are those account balances which exist at the beginning of an accounting
period.
• The auditor will perform audit procedures to ensure that those balances are accurately stated.
• Specific procedures may be required where the opening balances were not audited by the current
audit firm.
7.2 Requirements
The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances
contain misstatements that materially affect the current period's financial statements by:
• Determining whether the prior period's closing balances have been correctly brought forward to the
current period or, when appropriate, have been restated;
• Determining whether the opening balances reflect the application of appropriate accounting
policies; and
• Performing one or more of the following:
(i) Where the prior year financial statements were audited, reviewing the predecessor auditor's
working papers to obtain evidence regarding the opening balances;
(ii) Evaluating whether audit procedures performed in the current period provide evidence
relevant to the opening balances; or
(iii) Performing specific audit procedures to obtain evidence regarding the opening balances.
When the prior period's financial statements were audited by another auditor, the current auditor may be
able to obtain sufficient, appropriate audit evidence regarding opening balances by reviewing the
predecessor auditor's working papers.
The nature and extent of audit procedures necessary to obtain sufficient appropriate audit evidence on
opening balances depends on matters such as the following.
• The accounting policies followed by the entity.
• The nature of the account balances, classes of transactions and disclosures and the risks of
material misstatement in the current period's financial statements.
• The significance of the opening balances relative to the current period's financial statements.
• Whether the prior period's financial statements were audited and, if so, whether the predecessor
auditors' opinion was modified.
If the auditor obtains audit evidence that the opening balances contain misstatements that could
materially affect the current period's financial statements, the auditor shall perform such additional audit
procedures as are appropriate in the circumstances to determine the effect on the current period's
financial statements.
• Observing a current physical inventory count and reconciling it back to the opening inventory R
quantities
• Performing audit procedures on the valuation of the opening inventory items
6
• Performing audit procedures on gross profit and cut-off
A combination of these procedures may provide sufficient appropriate audit evidence.
For non-current assets and liabilities, some audit evidence may be obtained by examining the
accounting records and other information underlying the opening balances. In certain cases, the auditor
may be able to obtain some audit evidence regarding opening balances through confirmation with third
parties, for example, for long-term debt and investments. In other cases, the auditor may need to carry
out additional audit procedures.
Section overview
• In certain situations the auditor will consider it necessary to employ someone else with different
expert knowledge to gain sufficient, appropriate audit evidence.
• If the auditor's client has an internal audit department, the auditor may seek to rely on its work.
Definition
Auditor's expert: An individual or organisation possessing expertise in a field other than accounting and
auditing, whose work in that field is used by the auditor in obtaining sufficient appropriate audit evidence.
An auditor's expert may be either an auditor's internal expert (a partner or staff of the auditor's firm, or a
network firm), or an auditor's external expert.
The ISA makes a distinction between this situation and the situation outlined in ISA 500 Audit Evidence
(see Section 2.3 of this chapter) where management use an expert to assist in preparing financial
statements.
When using the work performed by an auditor's expert, auditors should obtain sufficient appropriate
audit evidence that such work is adequate for the purposes of an audit.
The following list of examples is given by the ISA of areas where it may be necessary to use the work of
an auditor's expert:
• The valuation of complex financial instruments, land and buildings, plant and machinery, jewellery,
works of art, antiques, intangible assets, assets acquired and liabilities assumed in business
combinations and assets that may have been impaired.
• The actuarial calculation of liabilities associated with insurance contracts or employee benefit
plans.
• The estimation of oil and gas reserves.
• The valuation of environmental liabilities, and site clean-up costs.
• The interpretation of contracts, laws and regulations.
• The analysis of complex or unusual tax compliance issues.
When considering whether to use the work of an expert, the auditors should review:
• Whether management has used a management's expert in preparing the financial statements.
Objectivity Consider to whom internal audit reports (should be the board or the audit 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 (eg that it is not adequately resourced).
Technical Consider whether internal auditors are members of relevant professional bodies,
competence have adequate technical training and proficiency and whether there are established
policies for hiring and training internal auditors.
Due professional Consider whether internal audit is properly planned, supervised, reviewed and
care documented.
Effective The internal auditors should be free to communicate openly with the external auditors,
communication with meetings at appropriate intervals. The external auditor should have access to
between external relevant internal audit reports and should also inform the internal auditors of any
and internal significant matters that may affect the internal audit function.
auditors
The ISA states 'in order for the external auditor to use specific work of the internal auditors, the external A
auditor shall evaluate and perform audit procedures on that work to determine its adequacy for the P
external auditor's purposes'. T
E
The evaluation here will consider the scope of work and related audit programmes and whether the
original assessment of the internal audit function remains appropriate. R
Evaluation
Training and Have the internal auditors had sufficient and adequate technical training to carry out the 6
proficiency work?
Are the internal auditors proficient?
Supervision Is the work of assistants properly supervised, reviewed and documented?
Evidence Has adequate 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?
Plan Are any amendments to the external audit plan required as a result of the matters
identified by internal audit?
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
A service organisation is a third-party organisation that provides services to user entities that are part
of those entities' information systems relevant to financial reporting.
ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation provides guidance on
how auditors carry out their responsibility to obtain sufficient appropriate audit evidence when the audit
client (called the 'user entity' in the standard) uses such an organisation.
The use of service organisations will be discussed in detail in Chapter 7.
Section overview
• This section deals with working in an audit team.
The audit engagement partner (sometimes called the reporting partner) must take responsibility for
the quality of the audit to be carried out. He should assign staff with necessary competencies to the audit
team.
Some audits are wholly carried out by a sole practitioner (an accountant who practises on his or her
own) or a partner. More commonly, the engagement partner will delegate aspects of the audit work such
as the detailed testing to the staff of the firm.
As you should already know, the usual hierarchy of staff on an audit engagement is:
Audit assistants
9.1 Direction
The partner directs the audit. He or she is required by other auditing standards to hold a meeting with
the audit team to discuss the audit, in particular the risks associated with the audit. ISA 220 suggests
that direction includes informing members of the engagement team of:
(a) Their responsibilities (including objectivity of mind and professional scepticism).
(b) Responsibilities of respective partners where more than one partner is involved in the conduct of
the audit engagement.
(c) The objectives of the work to be performed.
(d) The nature of the entity's business.
(e) Risk-related issues.
(f) Problems that may arise.
(g) The detailed approach to the performance of the engagement.
9.2 Supervision
The audit is supervised overall by the engagement partner, but more practical supervision is given within
the audit team by senior staff to more junior staff, as is also the case with review (see below). It includes:
• Tracking the progress of the audit engagement.
• Considering the capabilities and competence of individual members of the team, and whether they
have sufficient time and understanding to carry out their work.
• Addressing significant issues arising during the audit engagement and modifying the planned
approach appropriately.
• Identifying matters for consultation or consideration by more experienced engagement team
members during the audit engagement.
9.3 Review
Review includes consideration of 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.
9.4 Consultation
ISQC 1 states:
'The firm shall establish policies and procedures designed to provide it with reasonable assurance that:
(a) Appropriate consultation takes place on difficult or contentious matters;
(b) Sufficient resources are available to enable appropriate consultation to take place;
(c) The nature and scope of, and conclusions resulting from, such consultations are documented and
are agreed by both the individual seeking consultation and the individual consulted; and
(d) Conclusions resulting from consultations are implemented.'
The partner is also responsible for ensuring that if difficult or contentious matters arise, the team carries
out appropriate consultation and that such matters and conclusions are properly recorded.
If differences of opinion arise between the engagement partner and the team, or between the
engagement partner and the quality control reviewer, these differences should be resolved according to
the firm's policy.
10 Auditing in an IT environment
Section overview
• The more an organisation uses e-commerce, the greater the risk associated with it. As a
consequence, there are special considerations for auditors performing the audit of companies who
use e-commerce.
10.1 Introduction
We looked at IT-specific risks in the context of carrying out an audit risk assessment in Chapter 5. Most
companies now have a presence on the worldwide web: there are few companies who do not engage in
some form of e-commerce nowadays.
E-commerce introduces specific risks. In this section, we will look at what this means for the auditor.
Definitions
Electronic data interchange: Electronic data interchange (EDI) is a form of computer to computer data
transfer. Information can be transferred in electronic form, avoiding the need for the information to be re-
inputted somewhere else.
Electronic mail: Electronic mail (email) is a system of communicating with other connected computers
or via the Internet in written form.
Electronic commerce: Electronic commerce (e-commerce) involves individuals and companies carrying
out business transactions without paper documents, using computer and telecommunications links.
There are a variety of business risks specific to a company involved in e-commerce, which will exist to a
greater or lesser degree depending on the extent of involvement.
• Risk of non-compliance with taxation, legal and other regulatory issues
• Contractual issues arising: are legally binding agreements formed over the internet?
• Risk of technological failure (crashes) resulting in business interruption
• Impact of technology on going concern assumption, extent of risk of business failure
• Loss of transaction integrity, which may be compounded by the lack of sufficient audit trail
• Security risks, such as virus attacks and the risk of frauds by customers and employees
• Improper accounting policies in respect of capitalisation of costs such as website development
costs, misunderstanding of complex contractual arrangements, title transfer risks, translation of
foreign currency, allowances for warranties and returns, and revenue recognition issues
• Over-reliance on e-commerce when placing significant business systems on the internet
Many of these issues have implications for the statutory audit and these are discussed in detail in the
next section.
An entity that uses e-commerce must address the business risks arising as a result by implementing
appropriate security infrastructure and related controls to ensure that the identity of customers and
suppliers can be verified, the integrity of transactions can be ensured, agreement on terms of trade can
be obtained, as well as payment from customers is obtained and privacy and information protection
protocols are established.
In its paper Across Jurisdictions in E-commerce, the ICAEW IT Faculty states that an e-trader must
ensure that it:
• Displays and uses accurate information electronically
• Complies with relevant regulations and laws
• Intentionally trades only with specific geographic markets and customers
• Has contracts to facilitate effective transactions
• Monitors its contract process
• Keeps audit trails
• Creates and maintains appropriate levels of security
• Takes appropriate insurance cover
Section overview
• We looked at professional scepticism in Chapter 5, in the context of audit planning. Professional
scepticism is central throughout the audit process, and therefore must remain at the top of the
agenda as the auditor gathers audit evidence and documents his/her work.
1.3.2 Timing
Ideally the confirmation should take place immediately after the year-end and hence cover the year-end
balances to be included in the statement of financial position. However, time constraints may make it
impossible to achieve this ideal.
In these circumstances it may be acceptable to carry out the confirmation prior to the year-end
provided that confirmation is no more than three months before the year-end and internal controls are
strong.
There is a dispute between the client and the customer. The reasons for the dispute would have to be
identified, and provision made if appropriate against the debt.
Cut-off problems exist, because the client records the following year's sales in the current year or
because goods returned by the customer in the current year are not recorded in the current year. Cut-off
testing may have to be extended.
The customer may have sent the monies before the year-end, but the monies were not recorded by
the client as receipts until after the year-end. Detailed cut-off work may be required on receipts.
Monies received may have been posted to the wrong account or a cash-in-transit account. Auditors
should check if there is evidence of other mis-posting. If the monies have been posted to a cash-in-
transit account, auditors should ensure this account has been cleared promptly.
Customers who are also suppliers may net off balances owed and owing. Auditors should check that
this is allowed.
Teeming and lading, stealing monies and incorrectly posting other receipts so that no particular
customer is seriously in debt is a fraud that can arise in this area. If auditors suspect teeming and lading
has occurred, detailed testing will be required on cash receipts, particularly on prompt posting of cash
receipts.
The most commonly requested information is in respect of balances due to or from the client entity on
current, deposit, loan and other accounts. The request letter should provide the account description
6
number and the type of currency for the account.
It may also be advisable to request information about nil balances on accounts, and accounts which
were closed in the twelve months prior to the chosen confirmation date. The client entity may ask for
confirmation not only of the balances on accounts but also, where it may be helpful, other information,
such as the maturity and interest terms on loans and overdrafts, unused facilities, lines of credit/standby
facilities, any offset or other rights or encumbrances, and details of any collateral given or received.
The client entity and its auditors are likely to request confirmation of contingent liabilities, such as
those arising on guarantees, comfort letter, bills and so on.
Banks often hold securities and other items in safe custody on behalf of customers. A request letter
may thus ask for confirmation of such items held by the bank.
The procedure is simple but important.
(a) The banks will require explicit written authority from their client to disclose the information
requested.
(b) The auditors' request must refer to the client's letter of authority and the date thereof.
Alternatively it may be countersigned by the client or it may be accompanied by a specific letter of
authority.
(c) In the case of joint accounts, letters of authority signed by all parties will be necessary.
(d) Such letters of authority may either give permission to the bank to disclose information for a
specific request or grant permission for an indeterminate length of time.
(e) Where practicable the request should reach the bank at least one month in advance of the
client's year-end. It is advisable to allow more time at busy periods such as those covering
December and March year ends. Fast track requests may be made where reporting deadlines
are tight. The request should state both the year-end date and the date of the authority to disclose.
(f) The auditors should themselves check that the bank response covers all the information in the
standard and other responses.
Practice Note 16 Bank Reports for Audit Purposes in the United Kingdom provides a number of
templates for auditor request forms to standardise procedures and information.
2 Sampling
Definition
Audit sampling: is defined by ISA 530 Audit Sampling, as:
The application of audit procedures to less than 100% of items within a population of audit relevance
such that all sampling units have a chance of selection in order to provide the auditor with a reasonable
basis on which to draw conclusions about the entire population.
3 Directional testing
Directional testing is a method of discovering errors and omissions in financial statements.
Directional testing has been discussed in your previous auditing studies. It is a method of undertaking
detailed substantive testing. Substantive testing seeks to discover errors and omissions, and the
discovery of these will depend on the direction of the test.
Broadly speaking, substantive procedures can be said to fall into two categories:
• Tests to discover errors (resulting in over- or under-statement)
• Tests to discover omissions (resulting in under-statement)
A test for the overstatement of an asset simultaneously gives comfort on understatement of other
assets, overstatement of liabilities, overstatement of income and understatement of expenses.
Summary
INTERNAL MEMORANDUM
To A Senior
From Charles Church (partner)
Date 24 July 20X2
Subject Strombolix audit
As you will be aware, Simban made a bid for Strombolix yesterday and this increases the
significance of the financial statements that we are currently auditing.
I am having a preliminary meeting with the finance director on August 1 to discuss the conduct of
the audit. I would like you to prepare notes for me of any audit and financial reporting issues that
have arisen in your work to date that may indicate potential problems. Also include any general
audit concerns you may have arising from the takeover bid.
Let me know what you intend to do about these matters and specify any questions that you would
like me to raise with the finance director.
Further information
The following issues have been reported to you from junior audit staff during the audit to date.
AUDIT ISSUES
(1) There appears to be a significant increase in trade receivables, due to the fact that many
wholesale customers are refusing to pay a total of CU50,000 for recent deliveries of a new
paint that appears to decay after only a few months of use. Some of the wholesale customers
are being sued by their own customers for both the cost of the paint and the related labour
costs. No recognition of these events has been made in the draft financial statements.
(2) A special retail offer of '3-for-2' on wallpaper purchased from an outside supplier during the
year has been incorrectly recorded, as the offer was not programmed into the company's IT
system. The sales assistants were therefore instructed by store managers to read the bar
codes of only two of the three items, and ignore the third 'free' item. The wallpaper sells for
CU6 per roll and cost CU5 per roll from the supplier. A total of 20,000 of these rolls were
processed through the IT system by sales assistants during the year.
The reason for the special offer was that a bonus payment of CU90,000 will be due to
Strombolix from the supplier if 40,000 of these rolls of wallpaper are sold by 31 December
20X2. Strombolix has taken 50% of this amount (ie CU45,000) into its draft statement of profit
or loss and other comprehensive income as revenue for the year to 30 June 20X2.
(3) One of the six superstores was opened on 30 May 20X2. The land had been purchased at a
cost of CU400,000 on 1 August 20X1, but it was only on 1 September 20X1 that the company
began to prepare an application for planning permission. This was granted and construction
commenced immediately thereafter, being paid for in two progress payments of CU1 million
each on 1 December 20X1 and on 1 June 20X2. Construction was completed, and the store
opened, on 30 May 20X2. All the costs were financed by borrowing at 8% per annum and all
the interest incurred up to 30 June 20X2 has been capitalised as part of the cost of the non-
current asset in the draft financial statements. There was no interest earned on surplus funds
from this loan.
Memorandum
To: Jeremy Wiquad
From: Paul Sykes
Date: 5 November 20X0
Subject: Year end audit of Tofalco Ltd – Outstanding points
Construction contracts
Tofalco Ltd's largest current project is the construction of a water pipeline under the Mediterranean Sea.
The project commenced late in 20X9 and completion is not expected until 20X6.
By 30 September 20X0, the following figures apply.
cu£m
Sales value of contract 8,500
Costs incurred to date 400
Estimated future costs 7,000
Sales value of work completed to date 560
The directors do not yet believe that the project is sufficiently far advanced for the outcome to be
assessed with any degree of certainty. The company's accounting policy is to take attributable profit on
the basis of the sales value of the work completed.
Environmental and other provisions
Tofalco Ltd has a number of long-term obligations arising from the local laws on the environment.
Tofalco is obligated to dispose of its scrap machinery in a particular way which minimises the damaging
effect on the environment.
Related parties
Tofalco Ltd purchases significant quantities of raw materials from Sandstone Ltd, a company whose
Finance Director is also a shareholder in Tofalco Ltd. During the year ended 30 September 20X0 alone,
Tofalco Ltd purchased CU230 million worth of raw material from Sandstone Ltd with a credit payment
period of 3 months. The normal credit period provided within the industry is 2 months.
Requirement
Respond to Paul Sykes' request.
1 ISA 210
• Terms of audit engagements ISA 210
2 ISA 402
• Definition ISA 402.8
3 ISA 315
• List of audit assertions ISA 315.A111
4 ISA 500
• Sufficient and appropriate audit evidence ISA 500.A1–.A6
5 ISA 501
ISA 501.9–.12, .A17–
• Procedures regarding litigation and claims
.A25
6 ISA 505
• Considerations in obtaining external confirmation evidence ISA 505.2–.3
7 ISA 510
• Need to obtain audit evidence ISA 510.3
8 ISA 520
• Definition ISA 520.4
9 ISA 530
• Definitions ISA 530.5
ISA 530.A10–.A13, ,
• Sample size
Appendix 2
13 ISA 620
• Definition ISA 620.6
• Determining the need to use the work of an auditor's expert ISA 620.7
• Competence, capabilities and objectivity of the auditor's expert ISA 620.9, A14–A20
1 Strombolix Ltd
BRIEFING NOTE
To Charles Church (partner)
From A Senior
Date 25 July 20X2
Subject Strombolix audit
Issues on the audit to date
(1) Trade receivables
Issues arising
One type of paint has suffered problems of decay after only a short period of use, and
customers are refusing to pay for recent deliveries. If these claims are valid (as would be
indicated by the fact that the complaints are coming from several different independent
sources) this creates a number of issues.
• The most obvious issue is assessing the need to make provision against, or write-off, the
CU50,000 of receivables relating to the claim. If the claim is valid the receivables should
be written off immediately.
• Given that the decay only occurs after a few months, at least some of the paint is likely to
have been paid for already: thus repayment in respect of these sales is due. Under
ISA37 Provisions, Contingent Liabilities and Contingent Assets an obligating event has
occurred (the sale of faulty paint) and there is a probable transfer of economic benefits
which can be reasonably estimated.
• Provision will also need to be made against any inventories that may be held of this type
of paint as they cannot be sold if faulty. This should include any disposal costs.
• If wholesale customers of Strombolix are being sued by their own customers, it is very
probable that they will in turn consider litigation against Strombolix. Part of any claim will
be for the paint itself for which provision is to be made as suggested above. Additionally,
however, there is likely to be a claim for the labour cost involved for the removal of the
old paint, in applying new paint and for disruption. Consideration should be given to
making provision for these amounts, but they are more uncertain in their nature, not least
because there does not currently appear to be any such legal claim against Strombolix.
The situation will need to be monitored up to the time of audit clearance to reassess the
situation at that date.
• If wholesale customers of Strombolix are being sued for the faulty paint, consideration
should also be given to making similar provisions in respect of the sales by Strombolix of
the paint to its own retail customers.
• The necessary provisions are specific provisions and would be allowable for taxation.
The tax charge for the year would therefore need to be adjusted to the extent of any
provisions made. The deferred tax charge would need to be adjusted accordingly.
Audit procedures
The key audit issue is to establish whether there is a technical fault in the paint. If there is, as
seems likely, then it will be necessary to establish the extent of the problem by ascertaining
the following in respect of this particular paint.
• The amount of receivables outstanding.
• Total sales to date to wholesale and retail customers.
• Amount of the paint in inventories.
• Review any correspondence on the issue.
It would appear that the interest capitalised in respect of the new superstore is as follows. T
E
Period Payment for Calculation capitalised Interest R
CU CU
1.8.X1 – 30.6.X2 Land 11
12
× CU400,000 × 29,333
8% 6
1.12.X1 – 30.6.X2 Progress payment 7
12
× CU1m × 8% 46,667
1.6.X2 – 30.6.X2 Progress payment 1
12
× CU1m × 8% 6,667
82,667
Assuming that commencement of preparation for planning permission was the earliest date at
which the company commenced to 'get the asset ready for use', then the correct interest to be
capitalised is as follows.
Period Payment for Calculation Interest
capitalised CU
CU
1.9.X1 – 30.5.X2 Land 9
12
× CU400,000 × 24,000
8%
1.12.X1 – 30.5.X2 Progress payment 6
12
× CU1m × 8% 40,000
– Progress payment – –
64,000
The difference of CU18,667 (82,667 – 64,000) should be treated as a cost for the year in the
statement of profit or loss and other comprehensive income under 'finance costs'. There
should also be a corresponding deduction from the cost of the asset in the draft financial
statements.
The amount of borrowing costs that must be capitalised is limited by the requirement that the
total value of the asset (including borrowing costs) should not exceed the asset's recoverable
amount.
The following disclosure should be made where interest is capitalised within non-current
assets.
• Aggregate finance costs included in non-current assets.
• Finance costs capitalised in the year (including CU64,000 in respect of this transaction).
• Finance costs recognised in profit or loss (including CU18,667 in respect of this
transaction).
• Capitalisation rate used (8%).
Audit procedures
• Loan agreement to be inspected for interest rate and other terms.
• Contract for building the superstore and associated documentation to be inspected –
particularly for amounts and dates in this context.
• Evidence of the date on which activity commenced to 'get the asset ready for use' to be
inspected, eg preparation for planning permission.
• Evidence of the date on which the asset was ready for use to be gathered (eg builder's
reports and other correspondence).
Cuts & Curls is not clear cut. For it to be a related party Gillian Milton would need to be in a
position to control Cuts & Curls and then due to her relationship with Alexander Milton her
company would come under the related party umbrella. Gillian only holds 50% and therefore
holds joint control with her mother.
• The amounts due to or from the related party at the end of the year
• Any other element of the transaction necessary for an understanding of the financial
statements
(b) Notes for staff training sessions:
(i) We are required to assess the risk of undisclosed related party transactions and to
design our audit procedures in response to that risk. A logical place to start the audit of
related party transactions would be to identify all possible related parties. This would
always include:
• Directors and shadow directors
• Group companies
• Pension funds of the company
• Associates
It is likely that the other related parties would include:
• Key management (perhaps identified by which staff have key man cover)
• Shareholder owning > 20% of the shares
• Close relatives and associates of any of the above
All related party transactions must be disclosed. Related party transactions do not
necessarily have to be detrimental to the reporting entity, but those which are will be
easier to find. Features which may indicate this may include:
• Unusually generous trade or settlement discounts
• Unusually generous payment terms
• Recorded in the nominal ledger code of any person previously identified as a related
party (for example, director)
• Unusual size of transaction for customers (for example, if the company were paying
a suspiciously high legal bill for a building company)
(ii) Audit procedures to identify related party transactions are as follows:
Risk assessment procedures:
• Discussion by the audit team of the risk of fraud-related misstatements
• Inquiries of management
• Obtaining an understanding of the controls in place to identify related party
transactions
Other procedures might include:
• Identification of excessively generous credit terms by reference to aged trade
accounts receivable analysis.
• Identification of excessive discounts by reference to similar reports.
• Future audits will need to include procedures that address the fact that investment activities C
are outsourced to Investo. H
A
• In reaching preliminary risk assessments, assessments will need to be made of the inherent,
P
detection and control risks related to the investments balance and the terms of reference the
T
client has with Investo Ltd.
E
• Controls and processes carried out by Tofalco in relation to Investo's services will need to be R
documented and tested (and if the risk is great enough, those present at Investo also).
• The investments balance may also require substantive testing and so the need to obtain
6
underlying source documentation from Investo Ltd.
Ethical considerations
• There appears to be non-compliance with the law with regard to environmental regulations
and the disclosure of remuneration paid to related parties. These issues are non-negotiable
and will lead to a modified audit opinion if not addressed by management.
• We should consider whether it is appropriate for us to accept this assignment given the
problems outlined above. If we do decide to resign, we need to follow legal and professional
procedures – eg submitting a statement of circumstances to an AGM, addressing the AGM
(if we wish) etc.
Appropriate – Reliable
Reliability of audit evidence depends on the particular circumstances but the standard offers three
general presumptions
• Documentary evidence is more reliable than oral evidence.
• Evidence obtained from independent sources outside the entity is more reliable than that secured
solely from within the entity.
• Evidence originated by the auditor by such means as analysis and physical inspection is more
reliable than evidence obtained by others.
(a) The oral representations by management would be regarded as relatively unreliable using the
criteria in the standard, as they are oral and internal. In the absence of any external or auditor-
• Other payables have risen by 12% – this • Payables for purchases may be misclassified
does not seem consistent with a as other payables.
reduction in the number of shops.
• To cast the trade payables ledger file balances for comparison of the total with the
balance on the control account in the general ledger.
• To compare the current year balances with the prior year balances of the major suppliers
at each year end, and report any significant changes for further review.
• To determine the percentage increase or decrease for each account and in total.
(iii) Selection of data for substantive procedures
• To select, from inventory records, receipts immediately prior to the year end for matching
to goods received not invoiced accruals/trade payables.
• To identify unusual transactions (eg relating to capital acquisitions through hire purchase
agreements).
• Of purchases – to test whether they are properly authorised and matched to goods
received notes.
• To print requests for statements, monitor replies and produce second requests.
(vi) Cut-off
Debt
Gearing =
Debt + Equit y
250,000 + 150,000
= 40%
400,000 + 600,000
CU
Equity (V e ) 1,000,000 × 125p 1,250,000
1,540,000
162,500 + 127,500
= 18.8%
1,540,000
Comment
There is a significant difference between the book and market values. In particular, the market
obviously places value on the equity of the business, showing a potential confidence in the
company's future. On a market-based measure, gearing appears to be low and would seem
acceptable, although we have no external data to validate this.
150,000
Receivable days = × 365 = 27 days
2,000,000
The jewellery is sold 27 days (on average) before payment is received. Given the high value of
items, there is a high risk of bad debt. Care must be taken to ensure that credit is granted only to
creditworthy clients.
100,000
Payable days = × 365 = 30 days
1,200,000
Harrison Ltd pays its suppliers after 30 days (on average). This seems a reasonable amount of
time, and there seems to be no pressure on liquidity from this perspective.
Inventory days seem high at 73 days. However, a wide range of different items need to be
displayed in order to attract customers into the shop.
Many items, however, will be made to order, and this should be encouraged – it will help to reduce
the number of inventory days.
Introduction
Topic List
1 Introduction
2 Respective responsibilities of those charged with governance and auditors
3 Evaluating and testing internal controls
4 Service organisations
5 Internal controls in an IT environment
6 Communicating and reporting on internal control
Summary and Self-test
Technical reference
Answers to Self-test
Answer to Interactive question
• Explain the respective responsibilities of those charged with governance and auditors in
respect of internal control systems
• Analyse and evaluate the control environment for an entity based on an understanding of
the entity, its operations and its processes
• Evaluate an entity's processes for identifying, assessing and responding to business and
operating risks as they impact on the financial statements
• Appraise an entity's accounting information systems and related business processes
relevant to corporate reporting and communication
• Analyse and evaluate strengths and weaknesses of preventative and detective control
mechanisms and processes, highlighting control weaknesses
• Explain and appraise the entity's system for monitoring and modifying internal control
systems
Section overview
• An entity's system of internal controls informs the auditor's assessment of audit risk and the nature
of the audit procedures that would be undertaken during the audit fieldwork stage.
• In addition to the auditing standards, corporate governance codes (such as the BSEC Corporate
Governance Guidelines and the Sarbanes-Oxley Code) also prescribe the respective
responsibilities of the auditor and those charged with governance with regards to internal controls.
Internal control is an essential aspect of the entity about which the auditor must gain an understanding at
the start of the audit. The effectiveness of the system of internal controls informs the auditor's risk C
assessment, and consequently, the audit procedures to be carried out at the audit fieldwork stage. H
Therefore, internal control will have to be considered throughout the audit life cycle – from planning to
A
finalisation and reporting.
P
In this chapter, we will revise the auditor's responsibilities with regards to the system of internal control T
and the consideration of internal controls at different stages of the audit. We will then have a closer look E
at the implications of service organisations, and the risks and benefits of internal controls in an IT R
environment.
As you will have seen already, internal control is central to corporate governance. Therefore, we will
regularly refer back to our discussions on corporate governance in Chapter 4. 7
Section overview
• Auditors are responsible for obtaining audit evidence that provides reasonable assurance that the
financial statements are free of material misstatements, 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.
Definitions
Those charged with governance are the person(s) or organisation(s) (for example, a corporate
trustee) with responsibility for overseeing the strategic direction of the entity and obligations related
to the accountability of the entity. This includes overseeing the financial reporting process. For some
entities in some jurisdictions, those charged with governance may include management personnel, for
example, executive members of a governance board of a private or public sector entity, or an owner-
manager.
(Often, those charged with governance are management. This is not always the main board, as there
may be an audit committee in place, but they should be those who are responsible for ensuring the
entity achieves its objectives, produces financial reports and reports externally.)
Section overview
• Sources of audit evidence include tests of controls.
Step 1
Initially, the auditor must determine which controls are relevant to the audit. There is a direct
relationship between an entity's objectives and the controls it implements to provide reasonable
assurance about their achievement. Many of these controls will relate to financial reporting, operations
and compliance, but not all of the entity's objectives and controls will be relevant to the auditor's risk
assessment.
The following factors will inform the auditor's judgement about whether a control is relevant to the audit:
• Materiality
Implementation of a control means that the control exists and that the entity is using it.
Audit evidence about the design and implementation of a relevant control cannot come from inquiries of 7
management only. It must involve other procedures, such as:
• Observing the application of the control,
• Inspecting documents and reports, and
• Tracing transactions through the information system.
Note that obtaining audit evidence at one point in time on the entity's controls is not sufficient to test the
controls' operating effectiveness, unless there is some automation that ensures the controls operate
consistently.
For example, the audit evidence gathered on the implementation of a manual control does not
demonstrate that the control is operating effectively throughout the period under audit. However, the
audit procedures performed in respect of the implementation of an automated control may serve as a
test of that control's operating effectiveness, because IT processing is inherently more consistent.
Step 3
Having determined which controls are relevant, and are adequately designed to aid in the prevention of
material misstatements in the financial statements, the auditor can then decide whether it is more
efficient to place reliance on those controls and perform tests of controls in that area, or to perform
substantive testing over that area.
Step 4
If the controls are not adequately designed, the auditor needs to perform sufficient substantive testing
over that financial statement area in light of the apparent lack of control and increased risk. Any
deficiencies are noted and, where appropriate, these will be communicated to management.
(f) Observation of controls to consider the manner in which the control is being operated.
Auditors should consider: 7
• How controls were applied
• The consistency with which they were applied during the period
• By whom they were applied
Tests of controls are distinguished from substantive procedures which are designed to detect material
misstatements in the financial statements.
Deviations in the operation of controls (caused by change of staff etc) may increase control risk and
tests of control may need to be modified to confirm effective operation during and after any change.
Audit procedures will include the test of control and then other procedures (eg substantive and/or
analytical procedures) to confirm the operating effectiveness of that control. Overall, audit procedures
may be limited where automated processing is involved as control errors are less likely eg computers
tend to make fewer mistakes than humans after a given procedure has been correctly programmed.
The use of computer assisted audit techniques (CAATs) is referred to in Section 5 below.
Please also refer back to Chapter 4 for the auditor's responsibilities for the evaluation of internal controls
from a corporate governance perspective.
Section overview
• Where the auditor's client uses a service organisation, the auditor may need to obtain evidence of
the accuracy of processing systems within a service organisation.
Definition
A service organisation is a third-party organisation that provides services to user entities that are part
of those entities' information systems relevant to financial reporting.
ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation provides guidance on
how auditors carry out their responsibility to obtain sufficient appropriate audit evidence when the audit
client (called the 'user entity' in the standard) uses such an organisation.
The ISA mentions the following service organisation services that may be relevant to the audit (this is
not an exhaustive list):
• Maintenance of accounting records
• Other finance functions, such as the tax compliance function
• Management of assets
• Undertaking or making arrangements for transactions as agents of the user entity
Definition
A user auditor is an auditor who audits and reports on the financial statements of a user entity.
The ISA states that the objective of the auditor is 'to obtain an understanding of the nature and
significance of the services provided by the service organisation and their effect on the user entity's
internal control relevant to the audit, sufficient to identify and assess the risks of material misstatement'.
The ISA requires the auditor to understand how the user entity uses the services of the service
organisation. In obtaining an understanding of the entity, the auditor shall consider:
• The nature of the services provided by the service organisation.
• The nature and materiality of the transactions processed or accounts or financial accounting
processes affected by the service organisation.
• The degree of interaction between the activities of the service organisation and those of the user
entity.
• The nature of the relationship between the user entity and the service organisation including the
contractual terms.
• In the UK, if the service organisation maintains all or part of a user entity's accounting records,
whether those arrangements impact the work the auditor performs to fulfil reporting responsibilities
in relation to accounting records. (The wording of UK company law raises a particular issue as the
wording appears to be prescriptive, requiring the company itself to keep accounting records.
Whether a company 'keeps' records will depend upon the particular terms of the outsourcing
arrangement.)
When obtaining an understanding of internal control the auditor shall:
• Evaluate the design and implementation of controls at the user entity that relate to the services
provided by the service organisation.
The availability of a report on internal controls generally depends on whether the provision of such a
report is part of the contractual terms between the user entity and the service organisation.
Before placing reliance on the report, the user auditor shall:
• Consider the service auditor's professional competence and independence from the service
organisation.
• Consider the adequacy of the standards under which the report was issued.
• Evaluate whether the period covered is appropriate for the auditor's purposes.
• Evaluate the sufficiency and appropriateness of the report for the understanding of the internal
controls relevant to the audit.
• Determine whether the user entity has implemented any complementary controls that the service
organisation, in the design of its service, has assumed will be implemented.
5.1 Introduction 7
We looked at IT-specific risks in the context of carrying out an audit risk assessment in Chapter 5, and
introduced the use of CAATs in Chapter 6. Here, we will consider IT controls in more detail, along with
how to audit them.
As you should know by now, the internal control activities in a computerised environment fall within two
categories: general controls and application controls.
General controls
The auditors will wish to test some or all of the above general controls, having considered how they
affect the computer applications significant to the audit.
General IT controls that relate to some or all applications are usually interdependent controls, ie their
operation is often essential to the effectiveness of application controls. As application controls may be
useless when general controls are ineffective, it will be more efficient to review the design of general IT
controls first, before reviewing the application controls.
General IT controls may have a pervasive effect on the processing of transactions in application
systems. If these general controls are not effective, there may be a risk that misstatements occur and go
undetected in the application systems. Although deficiencies in general IT controls may preclude testing
certain IT application controls, it is possible that manual procedures exercised by users may provide
effective control at the application level.
Application controls
Controls over input: Programs to check data fields (for example value, reference number, date) A
accuracy on input transactions for plausibility P
T
Digit verification (eg reference numbers are as expected)
E
• Reasonableness test (eg sales tax to total value) R
• Existence checks (eg customer name)
• Character checks (no unexpected characters used in reference)
7
• Necessary information (no transaction passed with gaps)
• Permitted range (no transaction processed over a certain value)
Manual scrutiny of output and reconciliation to source
Agreement of control totals (manual/programmed)
Controls over input: Manual checks to ensure information input is
authorisation
• Authorised
• Input by authorised personnel
Controls over Similar controls to input must be in place when input is completed, for
processing example, batch reconciliations
Screen warnings can prevent people logging out before processing is
complete
Controls over master One-to-one checking
files and standing data
Cyclical reviews of all master files and standing data
Record counts (number of documents processed) and hash totals (for
example, the total of all the payroll numbers) used when master files are
used to ensure no deletions
Controls over the deletion of accounts that have no current balance
Control over input, processing, data files and output may be carried out by IT personnel, users of the
system, a separate control group and may be programmed into application software.
Manual controls If manual controls exercised by the user of the application system are capable
exercised by the user of providing reasonable assurance that the system's output is complete,
accurate and authorised, the auditors may decide to limit tests of control to
these manual controls.
Controls over system If, in addition to manual controls exercised by the user, the controls to be
output tested use information produced by the computer or are contained within
computer programs, such controls may be tested by examining the system's
output using either manual procedures or CAATs. Such output may be in the
form of magnetic media, microfilm or printouts. Alternatively, the auditor may
test the control by performing it with the use of CAATs.
Programmed control In the case of certain computer systems, the auditor may find that it is not
procedures possible or, in some cases, not practical to test controls by examining only
user controls or the system's output. The auditor may consider performing
tests of control by using CAATs, such as test data, reprocessing transaction
data or, in unusual situations, examining the coding of the application
program.
Section overview
• Auditors are required to report to those charged with governance on material deficiencies in
controls which could adversely affect the entity's ability to record, process, summarise and report C
financial data potentially causing material misstatements in the financial statements.
H
A
The specific responsibilities of the auditor in relation to communicating deficiencies in internal control are P
set out in ISA 265 Communicating deficiencies in internal control to those charged with governance and
T
management. The auditor is required to report significant deficiencies in internal controls, where they
E
have been identified, to those charged with governance.
R
Definition
A deficiency in internal control exists when: 7
(i) A control is designed, implemented or operated in such a way that it is unable to prevent, or detect
and correct, misstatements in the financial statements on a timely basis; or
(ii) A control necessary to prevent, or detect and correct, misstatements in the financial statements on
a timely basis is missing.
Significant deficiency in internal control: Significant deficiencies in internal control are those which in
the auditor's professional judgement are of sufficient importance to merit the attention of those charged
with governance.
The auditor's responsibilities with regards to communicating deficiencies in internal control to TCWG and
management have been discussed in Chapter 4.
Summary
1 ISA 315
• Risk assessment procedures ISA 315.5–.10
2 ISA 330
• Overall responses to risk assessment ISA 330.5
New competitor
• A new competitor has • Advertising • Review gross profit margins to assess if
set up in major cities campaigns and there has been a major impact on sales.
within the vicinity of promotional gifts.
Dodgy Burgers Ltd. • Discuss with the directors and review
• New staff member the national press to identify what
• This constitutes an employed to visit impact this competition is likely to have
operational risk (could rivals. and whether or not they are aiming for
lead to going concern the same market.
problems and,
ultimately, closure). • Review the advertising expenses
account to ensure that adverts have
• The instigation of a been bought and paid for.
major advertising
campaign itself • Review correspondence from the
constitutes a Advertising Standards Authority to
compliance risk ensure no complaints have been logged
(Advertising as a result of the advert.
Standards need to be • Review contracts with the television
complied with). companies to ensure that prime time
• The campaign and slots had been given.
promotion gifts leads • Review sales accounts to establish that
to financial risk (large sales have increased in the period
cash outlay). during or following the advertising
campaigns.
• Review the employment records to
ensure that the staff member has been
employed on a part time basis and
review the contract/job description.
• Review the reports sent to the board to
establish if suitable observations have
been made and have been acted upon.
Cash controls
• Risk of theft of cash • New controls • Review returns from branches to head
takings (financial risk). implemented to set office on a sample basis.
till floats and provide
reconciliations to • Discuss the differences identified with
head office on a head office staff and review the action
daily basis. taken.
Limited seating
• Lack of seating in • No strategy has There is therefore no control as such to rely
most branches during been put in place on but there are potential going concern
peak times due to cost/benefit issues.
(operational risk – considerations but
• Discuss with branch managers the
loss of customers). takeaway discount
number of customers at peak times, and
at peak times may
the level of complaints re the lack of
be considered in the
seating area.
future. C
• Discuss with the directors the impact H
this may have in the future if
A
competitors are close by to the
P
branches, loss of customer may
increase. T
E
• Spot check the branches on a sample R
basis to establish the customers leaving
without purchasing to confirm the extent
of problem highlighted by the directors.
7
Recycled products
• A lack of confidence • The use of recycled • Review the contracts with the suppliers
from the public in packaging. to ensure that recycled packages are
Dodgy Burgers Ltd's clearly specified and the price is
environmental policies • Waste separations comparable to the original prices of non-
and collections.
(operational and recycled products.
compliance risk).
• Review the branch returns to ensure
that delivery notes have been signed for
the waste collection and the receipts
match the tonnage collected. Ensure
that these are in line with expectations
from the preliminary analytical
procedures on the accounts.
• Review the new packaging for evidence
that the recycled symbols have been
correctly displayed.
• Discuss with the branch managers if
any further costs have been incurred
from having to separate the waste for
collection, or whether separate bins
have been provided in the branches for
the public to use.
Introduction
Topic List
1 Review and audit completion
2 Subsequent events
3 Going concern
4 Comparatives
5 Written representations
6 The auditor’s report
7 Other reporting responsibilities
Appendix
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
• Review and evaluate, quantitatively and qualitatively, for example using analytical
procedures, the results and conclusions obtained from audit procedures
• Draw conclusions on the nature of the report on an audit engagement, and formulate an
opinion for a statutory audit, which are consistent with the results of the audit evidence
gathered
• Draft suitable extracts for reports (for example any report to the management or those
charged with governance issued as part of the engagement)
Section overview
• Towards the end of an audit, a series of reviews and evaluations are carried out.
• This is an important aspect of quality control.
1.1 Introduction
Auditing initially may be carried out on components, with opinions being formed on elements of the
financial statements in isolation. However, it is essential that auditors step back from the detail and
assess the financial statements as a whole, based on knowledge accumulated during the audit process.
In particular, the following procedures will need to be performed at the review and completion stage of
the audit:
Review and reporting issues have been covered in the Assurance and Audit and Assurance Study
Manuals at the Professional level. The following ISAs are relevant to this stage of the audit:
C
ISA 260 (Revised October 2012) Communication with Those Charged with Governance H
ISA 520 Analytical Procedures A
P
ISA 560 Subsequent Events T
ISA 570 Going Concern E
R
ISA 700 (Revised October 2012) The Auditor’s Report on Financial Statements
ISA 705 (Revised October 2012) Modifications to Opinions in the Independent Auditor’s Report
8
ISA 706 (Revised October 2012) Emphasis of Matter Paragraphs and Other Matter Paragraphs in the
Independent Auditor’s Report
ISA 710 Comparative Information – Corresponding Figures and Comparative Financial Statements
ISA 720 (Revised October 2012) Section A The Auditor’s Responsibilities Relating to Other Information
in Documents Containing Audited Financial Statements
ISA 720 Section B The Auditor’s Statutory Reporting Responsibility in Relation to Directors’ Reports
In the remainder of this chapter we will look at a number of key aspects of these ISAs in more detail. A
summary is also provided in the technical reference at the end of the chapter.
• The work has been carried out in accordance with professional and regulatory requirements
• A proper evaluation of the firm’s independence was carried out
• Significant matters are given further consideration
• Appropriate consultations have taken place and been documented
• Where appropriate the planned work is revised
(a) The information presented in the financial statements is in accordance with local/national
statutory requirements.
(b) The accounting policies employed are in accordance with accounting standards, properly
disclosed, consistently applied and appropriate to the entity.
An important consideration in assessing the presentation of the financial statements is the adequacy of
disclosure. In addition to the basic Companies Act requirements and compliance with accounting
standards the entity may also need to satisfy the requirements of the Corporate Governance Code
and/or Sarbanes-Oxley.
• Whether any departures from applicable accounting standards are necessary for the financial
statements to give a true and fair view
• Whether the financial statements reflect the substance of the underlying transactions and not
merely their form
When compliance with local/national statutory requirements and accounting standards is considered, the
auditors may find it useful to use a checklist.
As at other stages, significant fluctuations and unexpected relationships must be investigated and
documented.
1.3.5 Summarising misstatements
During the course of the audit, misstatements will be discovered which may be material or immaterial to
the financial statements. It is very likely that the client will adjust the financial statements to take account C
of these during the course of the audit. At the end of the audit, however, some misstatements may still
H
be uncorrected and the auditors will summarise these uncorrected misstatements. An example is
A
provided below.
P
Worked example: Schedule of uncorrected misstatements T
E
Statement of Statement of Statement of Statement of
R
profit or loss financial position profit or loss financial position
(current period) (current period) (prior period) (prior period)
Dr Cr Dr Cr Dr Cr Dr Cr
8
CU CU CU CU CU CU CU CU
(a) ABC Ltd debt unprovided 10,470 10,470 4,523 4,523
(b) Opening/ closing inventory
under-valued* 21,540 21,540 21,540 21,540
(c) Closing inventory 34,105 34,105
undervalued
(d) Opening unaccrued expenses
Telephone* 453 453 453 453
Electricity* 905 905 905 905
(e) Closing unaccrued expenses
Telephone 427 427
Electricity 1,128 1,128
(f) Obsolete inventory write off 2,528 ______ ______ 2,528 3,211 ______ ______ 3,211
Total 36,093 35,463 35,463 36,093 9,092 21,540 21,540 9,092
*Cancelling items 21,540 21,540
453 453
______ 905 905 ______
14,553 34,105 34,105 14,553
The summary of misstatements will not only list misstatements from the current year (adjustments (c)
and (e)), but also those in the previous year(s). This will allow misstatements to be highlighted which are
reversals of misstatements in the previous year. For example, in this instance last year’s closing
inventory was undervalued by CU21,540 (adjustment (b)). Inventory in the prior year statement of
financial position should be increased (DR) and profits increased (CR). At the start of the current
accounting period the closing inventory adjustment is reversed out so that the net effect on the
All misstatements identified during the audit should be accumulated, other than those that are clearly
trivial. (The ISA explains that “clearly trivial” does not mean the same as “not material”; it implies
something of a wholly different – smaller – order of magnitude.) The auditor must document any
threshold used to define what has been considered to be clearly trivial.
(a) Specific misstatements identified by the auditors, including the net effect of uncorrected
misstatements identified during the audit of the previous period if they affect the current period's
financial statements
(b) Their best estimate of other misstatements which cannot be quantified specifically.
If the auditors consider that the aggregate of misstatements may be material, they must consider
reducing audit risk by extending audit procedures or requesting management to adjust the financial
statements (which management may wish to do anyway).
If the aggregate of the uncorrected misstatements that the auditors have identified approaches the
materiality level, the auditors should consider whether it is likely that undetected misstatements, when
taken with aggregated uncorrected misstatements, could exceed the materiality level. Thus, as
aggregate uncorrected misstatements approach the materiality level the auditors should consider
reducing the risk by:
The schedule will be used by the audit manager and partner to decide whether the client should be
requested to make adjustments to the financial statements to correct the misstatements.
2 Subsequent events
Section overview
• Auditors must review events after the reporting period and determine whether those events impact
on the year end financial statements.
• Events occurring between the period end and the date of the auditor's report
• Facts discovered after the date of the auditor's report
IAS 10 Events after the Reporting Period deals with the treatment in financial statement of events,
favourable and unfavourable, occurring after the period end. It identifies two types of event:
• Those that provide further evidence of conditions that existed at the period end
• Those that are indicative of conditions that arose subsequent to the period end
The extent of the auditor’s responsibility for subsequent events depends on when the event is identified.
These procedures should be applied to any matters examined during the audit which may be susceptible
to change after the year end. They are in addition to tests on specific transactions after the period end,
eg cut-off tests.
The ISA lists procedures to identify subsequent events which may require adjustment or disclosure.
They should be performed as near as possible to the date of the auditor’s report.
C
Procedures testing subsequent events H
When the auditor becomes aware of events which materially affect the financial statements, the auditor
should consider whether such events are properly accounted for and adequately disclosed in the
financial statements.
2.3 Facts discovered after the date of the auditor's report but before the
financial statements are issued
The financial statements are the management's responsibility. They should therefore inform the
auditors of any material subsequent events between the date of the auditor’s report and the date the
financial statements are issued. The auditors do not have any obligation to perform procedures, or
make inquiries regarding the financial statements after the date of their report.
If, after the date of the auditor's report but before the financial statements are issued, the auditor
becomes aware of a fact that, had it been known to the auditor at the date of the auditor’s report, may
have caused the auditor to amend the auditor’s report, the auditor shall:
• Extend the procedures discussed above to the date of their new report
• Issue a new auditor’s report dated no earlier than the date of approval of the amended financial
statements
If the auditor believes the financial statements need to be amended, and management does not amend
them:
• If the auditor's report has not yet been released to the entity, the auditor shall modify the opinion
in line with ISA 705 and then provide the auditor's report.
• If the auditor's report has already been released to the entity, the auditor shall notify those who
are ultimately responsible for the entity (the management or possibly a holding company in a
group) not to issue the financial statements or auditor’s reports before the amendments are made.
If the financial statements are issued anyway, the auditor shall take action to seek to prevent
reliance on the auditor's report. The action taken will depend on the auditor’s legal rights and
obligations and the advice of the auditor’s lawyer.
2.4 Facts discovered after the financial statements have been issued
Auditors have no obligations to perform procedures or make inquiries regarding the financial
statements after they have been issued. This includes the period up until the financial statements are
laid before members at the AGM.
When, after the financial statements have been issued, the auditor becomes aware of a fact which
existed at the date of the auditor's report and which, if known at that date, may have caused the auditor
to modify the auditor's report, the auditor should consider whether the financial statements need
revision, should discuss the matter with management, and should take the action as appropriate in the
circumstances.
The ISA gives the appropriate procedures which the auditors should undertake when management
revises the financial statements.
(b) Review the steps taken by management to ensure that anyone in receipt of the previously issued
financial statements together with the auditor’s report thereon is informed of the situation
The new auditor's report should include an emphasis of matter paragraph or other matter paragraph
referring to a note to the financial statements that more extensively discusses the reason for the revision
of the previously issued financial statements and to the earlier report issued by the auditor.
Where local regulations allow the auditor to restrict the audit procedures on the financial statements to
the effects of the subsequent event which caused the revision, the new auditor's report should contain a
statement to that effect.
Where the management does not revise the financial statements but the auditors feel they should be
revised, or if the management does not intend to take steps to ensure anyone in receipt of the previously
issued financial statements is informed of the situation, the auditors should consider taking steps to
prevent reliance on their report. The actions taken will depend on the auditor’s legal rights and
obligations and legal advice received.
Where the auditor becomes aware of a fact relevant to the audited financial statements which did not
exist at the date of the auditor’s report, there are no statutory provisions for revising the financial
statements. In this situation, the auditor discusses with those charged with governance whether they
should withdraw the financial statements. Where those charged with governance decide not to do so,
You are the auditor of Extraction Ltd, an oil company. You have recently concluded the audit for the year
ended 31 December 20X7 and the auditor’s report was signed on 28 March 20X8. The financial
statements were also authorised for issue on this date. On the 1st of April, you are informed that the
company has identified a major oil leak which has caused significant environmental damage.
Requirement
Identify and explain the implications of the information regarding the oil spill.
3 Going concern
Section overview
• The auditor will test the going concern assumption to ensure it applies to the audit client
If however, management determines that it intends to, or has no realistic alternative but to, liquidate the
entity or cease trading, then the financial statements should not be prepared on the going concern
basis. This is specified by IAS 10 Events After the Reporting Period. The entity should instead adopt a
basis of preparation that is considered more appropriate in the circumstances, although no specific
guidance is provided in IAS 10. In practice, the most obvious method is break-up value. Specific
accounting consequences will include the need to consider:
• Impairment of assets
• Recognition of provisions eg for onerous contracts
Disclosure of the change of basis of preparation should be provided in accordance with IAS 1
Preparation of Financial Statements.
• Raising capital
• The capital structure
• Financial consequences of an operation eg operating in an overseas environment
As a consequence of the original capital structure or subsequent operation, there may be a risk due to a
shortage of finance or an inability to manage finance in accordance with a company’s day-to-day
requirements.
ISA 570 Going Concern identifies events and conditions that may cast doubt about the going concern
assumption:
(a) Financial
• Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
• Inability to obtain financing for essential new product development or other essential
investments
(b) Operating
(c) Other
• Pending legal or regulatory proceedings against the entity that may, if successful, result in
claims that could not be met
(a) The effect of an entity being unable to make its normal debt repayments may be counterbalanced
by management's plans to maintain adequate cash flows by alternative means, such as by
disposal of assets, rescheduling of loan repayments, or obtaining additional capital.
(b) The loss of a principal supplier may be mitigated by the availability of a suitable alternative source
of supply.
Management’s responsibility
• ISA 570 states that when preparing accounts, management should make an explicit assessment
of the entity's ability to continue as a going concern. Most accounting frameworks require
management to do so.
• When management are making the assessment, the following factors should be considered.
– The degree of uncertainty about the events or conditions being assessed increases
significantly the further into the future the assessment is made.
– Judgements are made on the basis of the information available at the time.
– Judgements are affected by the size and complexity of the entity, the nature and condition
of the business and the degree to which it is affected by external factors.
C
Auditor’s responsibilities H
A
• When planning and performing audit procedures and in evaluating the results thereof, the auditor
P
shall consider whether there are events or conditions that may cast significant doubt on the entity’s
ability to continue as a going concern. T
E
• The auditor’s objectives are: R
– to obtain sufficient appropriate audit evidence regarding the appropriateness of the going
concern assumption
8
– to conclude, based on the audit evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt on the entity’s ability to continue
as a going concern
• The auditor shall remain alert for evidence of events or conditions and related business risks which
may cast doubt on the entity's ability to continue as a going concern throughout the audit. If such
events or conditions are identified, the auditor shall consider whether they affect the auditor's
assessments of the risk of material misstatement.
• Management may already have made a preliminary assessment of going concern. If so, the
auditors would review potential problems management had identified, and management's plans to
resolve them. Alternatively auditors may identify problems as a result of discussions with
management.
• The auditor shall evaluate management's assessment of the entity's ability to continue as a going
concern. The auditors shall consider:
• If management's assessment covers a period of less than twelve months from the end of the
reporting period, the auditor shall ask management to extend its assessment period to twelve
months from the end of the reporting period. If the directors have not considered a year from the
• Management shall not need to make a detailed assessment if the entity has a history of profitable
operations and ready access to financial resources. In this case, the auditor’s evaluation of the
assessment may be made without performing detailed procedures if sufficient evidence is available
from other audit procedures. The extent of the auditor’s procedures is influenced primarily by the
excess of the financial resources available to the entity over the financial resources that it requires.
• The auditor shall inquire of management as to its knowledge of events or conditions and related
business risks beyond the period of assessment used by management that may cast significant
doubt on the entity's ability to continue as a going concern.
• When events or conditions have been identified which may cast significant doubt on the entity's
ability to continue as a going concern, the auditor shall:
– Evaluate management's plans for future actions based on its going concern assessment;
– Where the entity has prepared a cash flow forecast and analysis of this is significant in the
evaluation of management’s plans for future action:
• Determine whether there is adequate support for the assumptions underlying the forecast
– Consider whether any additional facts or information have become available since the date of
management’s assessment.
– Seek written representations from management regarding its plans for future action and the
feasibility of these plans.
• When questions arise on the appropriateness of the going concern assumption, some of the normal
audit procedures carried out by the auditors may take on an additional significance. Auditors may
also have to carry out additional procedures or to update information obtained earlier. The ISA
lists various procedures which the auditors shall carry out in this context.
– Analyse and discuss cash flow, profit and other relevant forecasts with management
– Analyse and discuss the entity's latest available interim financial statements
– Read the terms of debentures and loan agreements and determine whether they have
been breached
– Read minutes of the meetings of shareholders, the board of directors and important
committees for reference to financing difficulties
– Perform audit procedures regarding subsequent events to identify those that either mitigate
or otherwise affect the entity's ability to continue as a going concern
– adequately describe the events and conditions that may cast significant doubt on the entity's
ability to continue as a going concern and management’s plans to deal with these, and
– disclose clearly that there is a material uncertainty which may cast significant doubt about
the company's ability to continue as a going concern.
• If adequate disclosure is made in the financial statements, the auditor shall express an
unmodified opinion but include an emphasis of matter paragraph that highlights the existence of a
material uncertainty relating to an event or condition that may cast significant doubt on the entity's
ability to continue as a going concern and draws attention to the note in the financial statements
that discloses the matter.
• In situations involving multiple material uncertainties that are significant to the financial statements
as a whole, the auditors may, in extremely rare cases, express a disclaimer of opinion.
• If adequate disclosure is not made in the financial statements, the auditor shall express a
qualified or adverse opinion, as appropriate. The report shall include explicit reference to the fact C
that there is a material uncertainty which may cast significant doubt about the company's ability to H
continue as a going concern.
A
Management unwilling to make or extend its assessment P
T
• If management is unwilling to make or extend its assessment when requested to do so by the E
auditor, the auditor shall consider the need to modify the auditor's report as a result of the inability R
to obtain sufficient appropriate evidence.
The document highlights the additional uncertainties that will arise in relation to:
(a) Bank lending intentions and the availability of finance more generally;
(b) The impact of the recession on a company’s own business; and
(c) The impact of the recession on counterparties, including customers and suppliers.
The guidance stresses that the auditor’s judgement on whether to draw attention to going concern
issues in the auditor’s report should be based on the facts and circumstances of the entity itself. The
general economic situation does not, of itself, necessarily mean that a material uncertainty exists about
an entity’s ability to continue as a going concern.
The responsibility for assessing the company’s ability to continue as a going concern and for disclosing
significant uncertainties rests with the directors.
Auditors need to take account of the current economic circumstances at all stages of the audit. In
planning the audit, risks relating to matters such as inventory obsolescence, goodwill impairments and
cash flows must be considered. Procedures must be performed to evaluate the adequacy of the means
by which the directors have satisfied themselves whether it is appropriate to adopt the going concern
basis. One specific issue noted in the Bulletin is that bankers may be reluctant to provide positive
Reasons for the bank’s reluctance that would not be a material matter regarding going concern include:
• The bank responding that in the current economic environment, as a matter of policy, it is not
providing such confirmations to its customers or their auditors
• The entity and its bankers are engaged in negotiations about the terms of a facility (eg the interest
rate), and there is no evidence that the bank is reluctant to lend to the company
• The bank renewed a rolling facility immediately prior to the date of the annual report and is
reluctant to go through the administrative burden to confirm that the facility will be renewed on
expiry
However, if the auditor concludes that an entity’s bankers are refusing to confirm facilities for reasons
that are specific to the entity, this could be a material matter and the auditor will need to consider the
significance of the fact and discuss with directors whether there are alternative strategies or sources of
finance that would justify the use of the going concern basis.
• Are realistic;
• Have a reasonable expectation of resolving any problems foreseen; and
• That the directors are likely to put the strategies into place effectively,
the auditor may decide that it is unnecessary to include an emphasis of matter paragraph in the auditor’s
report.
Point to note:
In June 2012 the Sharman Inquiry issued its Final Report and Recommendations. This includes
recommendations regarding going concern assessment and disclosure (see Chapter 4).
You are the senior on the audit of Truckers Ltd whose principal activities are road transport and
warehousing services, and the repair of commercial vehicles. You have been provided with extracts from
the draft accounts for the year ended 31 October 20X5.
Draft 20X5 Actual 20X4
CU'000 CU'000
Summary statement of profit or loss
Revenue 10,971 11,560
Cost of sales (10,203) (10,474)
Gross profit 768 1,086
Administrative expenses (782) (779)
Interest payable and similar charges (235) (185)
Net (loss) profit (249) 122
Summary statement of financial position
Non-current assets 5,178 4,670
Current assets
Inventory (parts and consumables) 95 61
Receivables 2,975 2,369
3,070 2,430
Current liabilities
Bank loan 250 –
Overdraft 1,245 913
Trade payables 1,513 1,245
Lease obligations 207 –
Other payables 203 149
3,418 2,307
Due to the reduction in the repairs business, the company has decided to close the workshop and sell
the equipment and spares inventory. No entries resulting from this decision are reflected in the draft
accounts.
During the year, the company replaced a number of vehicles funding them by a combination of leasing
and an increased overdraft facility. The facility is to be reviewed in January 20X6 after the audited
accounts are available.
The draft accounts show a loss for 20X5 but the forecasts indicate a return to profitability in 20X6 as the
managing director is optimistic about generating additional revenue from new contracts.
Requirements
(a) State the circumstances particular to Truckers Ltd which may indicate that the company is not a
going concern. Explain why these circumstances give cause for concern.
(b) Describe the audit procedures to be performed in respect of going concern at Truckers Ltd. C
Section overview
• ISA 710 provides guidance on corresponding figures and comparative financial statements. 8
• The auditor should obtain sufficient appropriate audit evidence that the corresponding figures meet
the requirements of the applicable financial reporting framework.
Comparatives are presented differently under different countries' financial reporting frameworks.
Generally comparatives can be defined as corresponding amounts and other disclosures for the
preceding financial reporting period(s), presented for comparative purposes. Because of these variations
in countries' approach to comparatives, the ISA refers to the following frameworks and methods of
presentation.
Corresponding figures are amounts and other disclosures for the prior period included as an integral
part of the current period financial statements, and are intended to be read only in relation to the
amounts and other disclosures relating to the current period (referred to as 'current period figures'). The
level of detail presented in the corresponding amounts and disclosures is dictated primarily by its
relevance to the current period figures. This is the usual approach in Bangladesh.
Comparative financial statements are amounts and other disclosures for the prior period included for
comparison with the financial statements of the current period but, if audited, are referred to in the
auditor’s opinion. The level of information included in those comparative financial statements is
comparable with that of the financial statements of the current period.
Comparatives are presented in compliance with the relevant financial reporting framework. The essential
audit reporting differences are that:
• For comparative financial statements, the auditor’s report refers to each period that financial
statements are presented.
ISA 710 provides guidance on the auditor’s responsibilities for comparatives (the audit procedures are
essentially the same for both approaches) and for reporting on them under the two frameworks. We will
concentrate on corresponding figures as this is the approach usually adopted in Bangladesh.
Audit procedures performed on the comparative information are usually limited to checking that the
comparative information has been correctly reported and is appropriately classified. Auditors must
assess whether:
• Accounting policies used for the comparative information are consistent with those of the current
period or whether appropriate adjustments and/or disclosures have been made.
• Comparative information agrees with the amounts and other disclosures presented in the prior
period or whether appropriate adjustments and/or disclosures have been made. In Bangladesh this
will include checking whether related opening balances in the accounting records were brought
forward correctly.
If the auditor becomes aware of a possible material misstatement in the comparative information while
performing the current period audit, then additional audit procedures should be performed to obtain
sufficient appropriate audit evidence to determine whether a material misstatement exists.
Written representations are required for all periods referred to in the auditor’s opinion and specific
representations are also required regarding any restatement made to correct a material misstatement in
prior period financial statements that affect the comparative information. In the case of corresponding
figures representations are requested for the current period only because the auditor’s opinion is on
those financial statements which include corresponding figures.
the incoming auditors assess whether the corresponding figures meet the conditions specified above
and also follow the guidance in ISA 510 Initial Audit Engagements – Opening Balances.
4.3 Reporting
When the comparatives are presented as corresponding figures, the auditor should issue an audit report
in which the comparatives are not specifically identified because the auditor's opinion is on the
current period financial statements as a whole, including the corresponding figures.
The auditor's report will only make any specific reference to corresponding figures in the circumstances
described below.
• When the auditor's report on the prior period, as previously issued, included a qualified opinion,
disclaimer of opinion, or adverse opinion and the matter which gave rise to the modification is
unresolved:
(a) If the effects or possible effects of the matter on the current period’s figures are material, the
auditor's opinion on the current period’s financial statements should be modified and the Basis
For Modification paragraph of the report should refer to both periods in the description of the
matter; or
(b) In other cases the opinion on the current period’s figures should be modified and the Basis of
Modification paragraph should explain that the modification is due to the effects or possible
• In performing the audit of the current period financial statements, the auditors, in certain unusual
circumstances, may become aware of a material misstatement that affects the prior period
financial statements on which an unmodified report has been previously issued. If the prior period
financial statements have not been revised and reissued, and the corresponding figures have not
been properly restated and/or appropriate disclosures have not been made, the auditor shall
express a qualified opinion or an adverse opinion in the report on the current period financial
statements, modified with respect to the corresponding figures included therein.
In situations where the incoming auditor identifies that the corresponding figures are materially
misstated, the auditor should request management to revise the corresponding figures or if management
8
refuses to do so, appropriately modify the report.
5 Written representations
Section overview
• Written representations are normally obtained towards the end of the audit as a letter written by
management and addressed to the auditor.
5.1 Representations
ISA 580 Written Representations covers this area and states that the objectives of the auditor are to:
• Obtain written representations from management and, where appropriate, those charged with
governance that they believe that they have fulfilled their responsibilities for the preparation of the
financial statements and for the completeness of the information provided to the auditor
• Support other audit evidence relevant to the financial statements or specific assertions in the
financial statements
ISA 580 requires the auditor to determine the appropriate individuals from whom to seek written
representations. In most cases this is likely to be management, as they would be expected to have
sufficient knowledge of the way in which the entity's financial statements have been prepared. However,
the ISA goes on to point out that in circumstances where others are responsible for the financial
statements, for example, those charged with governance then they should be requested to provide the
representations.
Where written representations are critical to obtaining sufficient appropriate evidence they should be
provided by those charged with governance rather than simply the entity’s management.
The ISA emphasises the need for management to make informed representations. In some cases the
auditor may request that management confirms that it has made appropriate inquiries to enable it to do
so.
• That management has fulfilled its responsibility for the preparation and presentation of the
financial statements as set out in the terms of the audit engagement
• Whether the financial statements are prepared and presented in accordance with the applicable
financial reporting framework
• That management has provided the auditor with all the relevant information
• That all transactions have been recorded and are reflected in the financial statements
• A description of management's responsibilities
However, the ISA stresses that written representations do not provide sufficient appropriate audit
evidence on their own. The fact that management has provided reliable written representations does
not affect the nature and extent of other audit evidence that the auditor obtains.
The auditor may also consider it necessary to obtain other representations about the following.
– Plans or intentions that may affect the carrying value or classification of assets and liabilities
– Liabilities, both actual and contingent
– Title to, or control over, assets, the liens or encumbrances on assets, and assets pledged as
collateral
– Aspects of laws, regulations and contractual agreements that may affect the financial
statements
• That management has communicated to the auditor all deficiencies in internal control of which
management is aware
Because written representations are audit evidence, the auditor’s report cannot be dated before the date
of the written representations.
Where a representation about a specific issue has been obtained during the course of the audit the
auditor may request an updated written representation.
Appendix 2 of ISA 580 provides an illustrative example of a representation letter. It is not a standard
letter, and representations will vary from one period to the next and from one company to another.
C
5.6 Doubts as to reliability H
Where the auditor has concerns about the competence, integrity and ethical values of the A
management the auditor must consider the effect this will have on the reliability of both oral and written P
representations. T
E
In particular, if written representations are inconsistent with other audit evidence the auditor will need to
R
perform audit procedures in an attempt to resolve the matter. If the situation remains unresolved, the
auditor will need to consider the potential effect on the audit opinion.
Where the auditor concludes that representations about management's responsibilities regarding the 8
preparation and presentation of financial statements and information provided to the auditor are not
reliable, the audit opinion will be a disclaimer.
You are an audit manager reviewing the completed audit file of Leaf Oil Ltd.
(a) There have been no events subsequent to the period end requiring adjustment in the financial
statements.
(b) The company has a policy of revaluing properties on an annual basis. A large revaluation gain has
been recorded for two properties in the year, on the basis that the directors believe that the
property market is going to boom next year. However, the directors have not provided supporting
Comment on whether you would expect to see these matters referred to in the written representation
letter.
Section overview
• Auditors must provide clear and understandable auditor’s reports on the financial statements
audited.
• As well as the standard auditor’s report, the wording of the report may be changed to express a
modified opinion, or an emphasis of matter or other matter paragraph may be added to the report.
• Modifications result either from material misstatements (disagreements) in the financial statements
or from an inability to obtain sufficient appropriate audit evidence (limitation on scope).
• The auditor must ensure that other information in documents containing financial statements is
consistent with the information in the financial statements.
• Auditors must form, and then critically appraise, their audit opinion on the financial statements.
• Auditor’s reports can be made available electronically; in this situation the auditor must ensure that
their report is not misrepresented.
The communication problem is caused by a number of different problems that can be identified under
three headings, although some of the problems are broadly linked between categories. The three
problematic areas are:
• Understandability
• Responsibility
• Availability
6.2.2 Understandability
Although the essence of the auditor’s role is simple, in practice it is surrounded by auditing standards
and guidance as it is a technical art. It also involves relevant language, or 'jargon' that non-auditors
may not understand.
6.2.3 Responsibility
Connected with the problem of what the audit is and what the audit opinion means is the question of
what the auditors are responsible for. As far as the law is concerned, auditors have a restricted number
of duties. Professional standards and other bodies, such as the Financial Conduct Authority, put other
duties on auditors.
Users of financial statements, and the public, may not have a very clear perception of what the auditors
are responsible for and what the audit opinion relates to, or what context it is in.
The issue of auditor’s liability ties in here. Auditor’s reports are addressed to shareholders, to whom
auditors have their primary and legal responsibility. However, audited financial statements are used by
significantly more people than that. Should this fact be addressed in the auditor’s report?
6.2.4 Availability
The fact that a significant number of people use audited financial statements has just been mentioned.
Auditor’s reports are publicly available, as they are often held on public record. This fact alone may add
to any perception that exists that auditors address their report to more than just shareholders.
The problem of availability is exacerbated by the fact that many companies publish their financial
statements on their website. This means that millions of people around the world have access to the
auditor’s report.
When financial information is available electronically, auditors must ensure that their report is not
misrepresented. 8
Reporting electronically
ISA 720 Section A (Revised October 2012) – The Auditor’s Responsibilities Relating to Other
Information in Documents Containing Audited Financial Statements includes an appendix to help the
auditor respond properly to a request to publish the auditor’s report electronically.
The ISA implies that the directors should obtain the consent of the auditors to publish the auditor’s
report on a website. The matter should ideally be referred to in the letter of engagement between the
parties.
• The auditors should ensure that their report is worded so that it is appropriate for inclusion on a
website. This will include reference to specific financial statements rather than the use of page
numbers, for example.
• Where the auditor’s report is to be published electronically, the auditors should carry out a series of
checks:
– They should review the process for deriving the electronic information from the hard copy
financial statements
– They should check that the electronic copy is identical to the hard copy
– They should check that the presentation has not been distorted (ie that certain items have
not been given greater emphasis in the new presentation)
• The auditor should take steps to ensure that the auditor’s report is not inappropriately associated
with unaudited information that users may see on the website. They should satisfy themselves that
the directors have also taken appropriate steps to distinguish audited information from unaudited
information. This could include:
The auditor must read the other information to identify material inconsistencies with the audited financial
statements. If, as a result of reading the other information, the auditor becomes aware of any apparent
misstatements therein, or identifies any material inconsistencies with the audited financial statements,
the auditor should seek to resolve them. In accordance with the revised ISA (section 6-1) the auditor is
now also required to read the other information to identify any information that is apparently materially
incorrect based on, or materially inconsistent with, the knowledge acquired by the auditor in the course
of performing the audit.
An inconsistency: exists when other information contradicts information contained in the audited
financial statements. A material inconsistency may raise doubt about the audit conclusions drawn from
audit evidence previously obtained and, possibly, about the basis for the auditor’s opinion on the
financial statements.
A misstatement of fact: in the context of this standard is where other information that is unrelated to
matters appearing in the audited financial statements is incorrectly stated or presented. A material
misstatement of fact may undermine the credibility of the document containing audited financial
statements.
Point to note
In accordance with the revised ISA other information that is incorrectly stated or presented includes
other information that is apparently incorrect based on, or inconsistent with, the knowledge acquired by
the auditor in the course of performing the audit or that is otherwise misleading.
Auditors have no responsibility to report that other information is properly stated because an audit is only
an expression of opinion on the truth and fairness of the financial statements. Auditors read the other
information with a view to identifying significant misstatements or matters which are inconsistent with the
financial statements. However, they may be engaged separately, or required by statute, to report on
elements of other information. In any case, the auditors should give consideration to other information as
inconsistencies with the audited financial statements may undermine their report.
Some countries require the auditors to apply specific procedures to certain other information, for
example, required supplementary data and interim financial information. If such other information is
omitted or contains deficiencies, the auditors may be required to refer to the matter in their report.
When there is an obligation to report specifically on other information, the auditor’s responsibilities are
determined by the nature of the engagement and by local legislation and professional standards.
When such responsibilities involve the review of other information, the auditors will need to follow the
guidance on review engagements in the appropriate standards.
If an amendment is necessary in the other information and the entity refuses to make the amendment,
the auditor shall communicate this to those charged with governance and:
(a) Include in the auditor's report an other matters paragraph describing the material inconsistency in
accordance with ISA 706; or
The actions taken by the auditors will depend on the individual circumstances and the auditors may
consider taking legal advice. The auditor may also consider exercising the right to be heard at the AGM
or resigning from the engagement.
Section overview
• Auditors may have to report on entire special purpose financial statements or simply one element
of those financial statements.
7.1.2 Overview
The ISA aims to address special considerations that are relevant to complete sets of financial
statements prepared in accordance with another comprehensive basis of accounting.
The aim of the ISA is simply to identify additional audit requirements relating to these areas. To be clear,
all other ISAs still apply to the audit engagement.
• To avoid the possibility of the auditor’s report being used for purposes for which it was not
intended, the auditor may wish to indicate in the report the purpose for which it is prepared
and any restrictions on its distribution and use.
• Tax basis of accounting for a set of financial statements that accompany an entity’s tax return
• Cash receipts and payments basis of accounting for cash flow information that an entity may be
requested to prepare for creditors
• The financial reporting provisions of a contract, such as a bond, indenture, a loan agreement,
or a project grant.
The auditor’s report in these circumstances should include a statement that indicates the basis of
accounting used or should refer to the note to the financial statements giving that information. The
opinion should state whether the financial statements are prepared, in all material respects, in
accordance with the identified basis of accounting.
7.1.5 Special Considerations – Audits of Single Financial Statements and Specific Elements,
Accounts or Items of a Financial Statement
ISA 805 Special Considerations – Audits of Single Financial Statements and Specific Elements,
Accounts or Items of a Financial Statement relates to individual elements of financial statements
such as the liability for accrued benefits of a pension plan or a schedule of employee bonuses.
Many financial statement items are interrelated. Therefore, when reporting on a component the auditor
will not always be able to consider it in isolation and will need to examine other financial information.
This will need to be considered when assessing the scope of the engagement and determining whether
the audit of a single statement or single element is practicable.
The auditor’s report should indicate the applicable financial reporting framework adopted or the basis of
accounting used, and should state whether the component is prepared in accordance with this.
Reporting considerations
C
Engagements that involve reporting • The auditor shall express a separate opinion for each H
on a single statement or specific A
• The auditor shall ensure that management presents the single
element in conjunction with
financial statement or element in such a way that it is clearly P
auditing the entity’s complete set
differentiated from the complete set of financial statements T
of financial statements
E
The auditor’s opinion on the entity’s • The auditor must determine whether this will affect the opinion R
complete set of financial on the single financial statement or element
statements is modified or includes
an emphasis of matter or other
matter paragraph 8
The auditor has expressed an • The auditor must not include an unmodified opinion on a
adverse opinion or disclaimed an single financial statement or element that forms part of those
opinion on the entity’s complete financial statements in the same report (as this would
set of financial statements contradict the adverse opinion or disclaimer on the complete
set of financial statements)
• The auditor must not express an unmodified opinion on a
single financial statement of a complete set financial
statements even if the report on the single financial statement
is not published with the auditor’s report containing the
adverse opinion or disclaimer
Form of report Unless law specifies otherwise, the wording should be:
• The summary financial statements are consistent in
all material respects with the audited financial
statements, in accordance with (the applied criteria);
or
• The summary financial statements are a fair summary
of the audited financial statements, in accordance
with (the applied criteria).
When the auditor’s report on the audited If the auditor is satisfied that an unmodified opinion, as
financial statements contains a qualified above, is appropriate for the summary financial
opinion, an emphasis of matter or other statements, the report must:
matter paragraph • State that the auditor’s report on the audited financial
statements contains a qualified opinion, an emphasis
of matter or other matter paragraph, and
• Explain the basis for the qualified opinion or
emphasis of matter or other matter paragraph in the
auditor’s report on the audited financial statements,
and
• The effect on the summary financial statements if
any.
When the auditor’s report on the audited The auditor must:
financial statements contains an adverse • State that the auditor’s report on the audited
opinion, or a disclaimer
financial statements contains an adverse opinion or
disclaimer of opinion
• Explain the basis for the adverse opinion or
disclaimer; and
• State that it is inappropriate to express an opinion on
the summary financial statements
Modified opinion on the summary financial If the summary financial statements are not consistent in
statements all material respects with the audited financial statements
(or not a fair summary of the audited financial
statements) and management does not agree to make
changes, the auditor shall express an adverse opinion.
7.2 Distributable profit
The issue of distributable profits is dealt with by Companies Act 1994. Accounting terminology referred
to by the Act is therefore Bangladesh terminology.
Definition
Profits available for distribution are accumulated realised profits (which have not been distributed or
capitalised) less accumulated realised losses (which have not been previously written off in a reduction
or reorganisation of capital).
The word 'accumulated' requires that any losses of previous years must be included in reckoning the
current distributable surplus.
A profit or loss is deemed to be realised if it is treated as realised in accordance with generally accepted
accounting principles. Hence, financial reporting and accounting standards in issue, plus generally
accepted accounting principles (GAAP), Companies Act 1994 should be taken into account when
determining realised profits and losses.
Depreciation must be treated as a realised loss, and debited against profit in determining the amount
of distributable profit remaining.
Effectively there is a cancelling out, and at the end only depreciation that relates to historical cost
will affect dividends.
If, on a general revaluation of all non-current assets, it appears that there is a diminution in value of any
one or more assets, then any related provision(s) need not be treated as a realised loss.
The Act states that if a company shows development expenditure as an asset in its accounts, it must
usually be treated as a realised loss in the year it occurs. However, it can be carried forward in special
circumstances (generally taken to mean in accordance with accounting standards).
C
7.2.1 Dividends of public companies H
A
A public company may only make a distribution if its net assets are, at the time, not less than the
aggregate of its called-up share capital and undistributable reserves. The dividend which it may P
pay is limited to such amount as will leave its net assets at not less than that aggregate amount. T
E
Undistributable reserves are defined as: R
(a) Share premium account
(c) Any surplus of accumulated unrealised profits over accumulated unrealised losses (known as
a revaluation reserve). However, a deficit of accumulated unrealised profits compared with
accumulated unrealised losses must be treated as a realised loss
(d) Any reserve which the company is prohibited from distributing by statute or by its articles.
The dividend rules apply to every form of distribution of assets except the following:
A company may produce interim accounts if the latest annual accounts do not disclose a sufficient
distributable profit to cover the proposed dividend. It may also produce initial accounts if it proposes to
pay a dividend during its first accounting reference period or before its first accounts are laid before the
company in general meeting. These accounts may be unaudited, but they must suffice to permit a
proper judgement to be made of amounts of any of the relevant items.
If a public company has to produce initial or interim accounts, which is unusual, they must be full
accounts such as the company is required to produce as final accounts at the end of the year. They
need not be audited. However the auditors must, in the case of initial accounts, satisfy themselves that
the accounts have been 'properly prepared' to comply with the Act. A copy of any such accounts of a
public company (with any auditor’s statement) must be delivered to the Registrar for filing.
Summary
C
H
A
P
T
E
R
[AGU2]
You are an audit partner. Your firm carries out the audit of Branch Ltd, a listed company. Because
the company is listed, you have been asked to perform a second partner review of the audit file for
the year ended 30 June 20X7 before the audit opinion is finalised. Reported profit before tax is
CU1.65 million and the statement of financial position total is CU7.6 million.
You have read the following notes from the audit file:
The company has disclosed both basic and diluted earnings per share. The diluted earnings per
share has been incorrectly calculated because the share options held by a director were not
included in the calculations. Disclosed diluted earnings per share are 22.9p. Had the share options
held by the director been included, this figure would have been 22.4p. This difference is immaterial.
The directors have currently not amended certain financial performance ratios in this statement to
reflect the changes made to the financial statements as a result of the auditor’s work. The
difference between the reported ratios and the correct ratios is minimal.
Opinion
You have noted that there is no evidence on the audit file that the corporate governance statement
to be issued as part of the annual report has been reviewed by the audit team. You are aware that
the company does not have an audit committee.
You are also aware that the director exercised his share options last week.
Requirement
Comment on the suitability of the proposed audit opinion and other matters arising in the light of
your review. Your comments should include an indication of what form the audit report should take.
(15 marks)
2 SafeAsHouses Ltd
SafeAsHouses Ltd (SAH) was incorporated and commenced trading on 1 June 20X0 to retail small
household electronics products via free magazines inserted into newspapers. It has established a
presence in the market, but the early years of business have been a struggle with low profitability
as it has sought to create market share. On 1 June 20X2 it set up a 100% owned subsidiary, eSAH,
with a view to re-directing the business to Internet-based sales in the hope of reducing printing and
physical distribution costs of its free magazine. SAH plans to obtain an AIM listing in the near
future.
Your firm acts as auditors to both companies and you have recently been drafted into the audit
because the existing senior has been taken ill. Exhibit 1 comprises draft statements of financial
position and notes for both companies. Exhibit 2 comprises audit file notes prepared by the
previous audit senior.
The audit manager has asked you to take over the detailed audit work and to identify for her in a
briefing note those issues arising in the work to date that are likely to be problematic. Given the late
stage of the audit, and the consequent delays because of audit staff sickness, only the major
issues are to be highlighted in your briefing note to the manager. The audit manager is concerned
that, because the FD is new, the retention of the audit is potentially at risk and that there should be
no further delay in the audit. The FD is pressing for these matters to be finalised and the accounts
to be signed quickly.
Requirement
The draft statements of financial position of SAH (parent company only) and eSAH at 31 May 20X3
are as follows.
SAH eSAH
CU'000 CU'000 CU'000 CU'000
Non-current assets at cost 1,895 408
Less Depreciation (400) (25)
1,495 383
Current assets
Inventories 422 –
Receivables 550 225
Bank – 5
972 230
Current liabilities (662) (313)
Net current assets/(liabilities) 310 (83)
1,805 300
Non-current liabilities
8% debentures (1,000) –
805 300
Financed by
Issued ordinary share capital 200 300
Share premium account 100 –
C
Retained earnings 505 –
H
805 300
A
Notes P
T
(1) Current liabilities
E
SAH eSAH R
CU'000 CU'000
Bank overdraft 92 –
Trade payables 430 300 8
Other payables 40 –
Accruals 100 13
662 313
(2) Property in SAH had been revalued during the year. The revaluation amounted to CU0.5m.
(3) Debentures were issued at par on 1 June 20X0 and are due for redemption at par on
31 December 20X4.
Exhibit 2
(1) eSAH has received CU120,000 as a payment on account from a customer on 27 May 20X3
for delivery of goods to the customer by SAH in the following months. eSAH has a confirmed
contract for this and has recorded the amount in revenue for the year.
(2) eSAH has capitalised software development costs to the amount of CU408,000 during the
year. There are no specific details as yet, but it appears to relate almost entirely to the
development of new e-based sales systems. CU186,000 of the capitalised amount related to
computers and consulting support staff time bought and brought-in specifically to help test the
new system. eSAH is adopting its standard five year, straight-line depreciation policy with
respect to the CU408,000.
(4) SAH is planning to pay a dividend for the first time this year of about CU50,000. This has yet
to be finalised and has not been provided for in the financial statements. The FD said he
would get back to me once the figure has been finalised.
(5) The FD has suggested that the format of the business of eSAH is completely different from
that of SAH and is insisting on not consolidating the results of eSAH on the grounds that it
would undermine a true and fair view of the financial statements.
(6) There are some debt covenants relating to the debenture (in SAH) of which we should be
aware. I have not done any work on these, as yet.
(iii) Receivables days and payable days not to exceed 180 days each. Calculations to be
based on year end figures.
(iv) Bank consent is required for any significant changes in the structure of the business.
(v) I understand that a breach of any of these conditions converts the debenture into a loan
repayable on demand.
When eSAH was incorporated, bank consent was obtained in accordance with the covenants.
Consent was obtained on the basis that the covenants would now apply on a consolidated
basis.
ISA 260
ISA 265
ISA 450
ISA 520
C
• Analytical procedures at the end of the audit ISA 520.6,.A17-.A19 H
A
• Investigating unusual items ISA 520.7
P
ISA 560 T
E
• Auditor’s duty ISA 560.6 R
• Events after date of audit report but before date financial statements issued ISA 560.10 - .13 8
• Events after date financial statements have been issued ISA 560.14 - .17
ISA 570
ISA 580
ISA 700
ISA 705
ISA 706
ISA 710
ISA 720
ISA 800
• Reports on financial statements prepared in accordance with a special ISA 800.11-.14 &
purpose framework Appendix
ISA 805
• Reports on a single financial statement or specific element of a financial ISA 805.11-.17 &
statement Appendix
ISA 810
1 Branch Ltd
The problem in the EPS calculation relates to share options held by a director. As they are held by
a director, it is unlikely that they are immaterial, as matters relating to directors are generally
considered to be material by their nature. The fact that EPS is a key shareholder ratio which is
therefore likely to be material in nature to the shareholders should also be considered.
As the incorrect EPS calculation is therefore material to the financial statements, the audit report
should be modified in this respect, unless the directors agree to amend the EPS figure. This would
be an 'except for' modification, on the grounds of material misstatement (disagreement).
Share options
The share options have not been included in the EPS calculations. The auditors must ensure that
the share options have been correctly disclosed in information relating to the director both in the
financial statements and the other information, and that these disclosures are consistent with each
other. If proper disclosures have not been made, the auditor will have to modify the audit report due
to lack of disclosure in this area.
The financial performance statement forms part of the other information that the auditor is required 8
to review under ISA 720. The ISA states that the auditors should seek to rectify any apparent
misstatements in this information. The ratio figures are misstated, and the auditor should
encourage the directors to correct them, regardless of the negligible difference.
The ISA refers to material items. The ratios will be of interest to shareholders, being investor
information and this fact may make them material by their nature. However, as the difference is
negligible in terms of value, on balance, the difference is probably not sufficiently material for the
auditors to make any modifications or explanations in their audit report.
For the company to meet Stock Exchange requirements, the auditors must review the corporate
governance statement. For our own purposes, we should document that we have done so. As
having an audit committee is a requirement of the Corporate Governance Code and the company
does not have one, the corporate governance statement should explain why the company does not
comply with the Code in this respect.
We would not modify our audit opinion over the corporate governance statement, although we
might like to include a reference to it in an other matter paragraph, if we do not feel the disclosure is
sufficient in respect of the non-compliance with the requirement to have an audit committee.
This other matter paragraph would be presented after the opinion on the truth and fairness of the
financial statements has been given. The opinion would not be modified in this respect. We are
also required to report by exception if we have identified information that is
Overall conclusion
None of the matters discussed above, either singly or seen together are pervasive to the financial
statements. The auditor’s report should be modified on the material matter of the incorrect EPS
calculation. We should ensure that all the other disclosures are in order and also review the
corporate governance statement. If the corporate governance statement does not adequately
address the issue of the company not having an audit committee, we will need to include an other
matter paragraph in the opinion section of our report. Our audit opinion will not be modified in this
respect.
2 SafeAsHouses Ltd
To Audit Manager
There are a host of issues that need to be addressed. Some are important, and these are those I
have highlighted for your attention.
While there may now be some urgency with respect to completing the audit it is not acceptable for
us to be rushed in forming our judgement. This creates a threat to our objectivity through possible
intimidation.
The financial statements are incorrectly stated for SAH. There is no revaluation reserve and it
seems, after looking at the retained earnings in the analytical procedures, that the revaluation has
been credited to profit or loss. Retained earnings should therefore be CU5,000 and the revaluation
reserve balance should be CU500,000. (The revaluation would also be recognised as other
comprehensive income in the statement of profit or loss and other comprehensive income.) The
implication of this is that the company has insufficient distributable reserves to pay the proposed
dividend. There also appears to be little cash to pay any dividend given the overdraft in SAH.
The intention not to consolidate the 100% subsidiary is unlikely to be allowed. IFRS 10
Consolidated Financial Statements does not allow exclusion of a subsidiary from consolidation on
the basis of differing activities.
The company does not appear to have established a sinking fund for the redemption of the
debenture. There is not enough cash in the financial statements to approach the figure required
and the profitability of SAH is not sufficient to generate the amount required in the months
remaining. eSAH does not appear to be generating any cash at all. Nevertheless, the company
appears to have had or raised CU300,000 to launch eSAH.
Moreover, in SAH, revenue and profit margins have been falling since 20X1. We will need to
ascertain why this has happened and consider any explanations received in conjunction with
available forecast figures.
I am seriously concerned at the levels of receivables and payables in both companies. Not enough
cash is coming into the businesses and not enough, it appears, is being used to pay the payables.
There is a solvency issue pending which may well be crystallised when one considers the debt
covenants.
These stand at CU310,000 for SAH and are clearly positive which satisfies the constraint in place
from the debt covenant. However, there are some issues in eSAH that indicate that its net current
assets figures (already negative) may have to be further adjusted downward.
(2) This means that the provisional revenue figure for eSAH of CU500,000 should be reduced by
CU120,000 to CU380,000. There is also an intra-group element that requires adjustment in
that SAH still presumably holds the inventory to which the amount of CU120,000 relates.
(3) In general, the inventory figure in SAH looks large and we will have to prepare an audit
programme that challenges this figure in order to establish its accuracy. Given its central role
in relation to the covenants, this will be important.
Other issues
(1) The development costs of the software seem to be correctly treated under IAS 38 Intangible
Assets in that an intangible asset may be recognised as arising from development (or from the
development phase of an internal project) if the following can be demonstrated.
(a) The technical feasibility of completing the intangible asset so that it will be available for
use or sale
(b) The entity’s intention to complete the intangible asset and use or sell it
This would also appear to relate to the testing costs since they meet the criteria of
development activities under the standard (“the design, construction and testing of a chosen C
alternative for new or improved materials, devices, products, processes, systems or services”,
H
para 59).
A
More generally, the testing costs of CU186,000 look substantial in relation to the overall P
CU408,000 spent. This may have indicated some problems with the software. We should T
establish why the testing costs were so high and, if there were problems, obtain assurance of E
their resolution. R
(2) The depreciation provision in eSAH’s accounts does not seem to accord with its stated policy.
They have charged only CU25,000 out of a maximum of CU81,600 (CU408,000 ÷ 5). This
would imply a charge only relating to 3.6 months of the year. We will need to ascertain what is 8
the depreciation policy and exactly what capitalised costs have been incurred.
(3) I am suspicious that eSAH has made a nil profit in the year. It looks too coincidental and may
have been the result of an arbitrary calculation on, say, depreciation with which I have some
doubts anyway.
(4) The investment in the subsidiary eSAH has not been separately presented in SAH’s accounts.
CU300,000 will need to be recorded as a non-current asset investment once it has been
identified where the incorrect debit has been recorded (possibly in the “non-current assets”
total figure).
(5) Overdraft. Unless we see a cash flow forecast demonstrating a dramatic improvement I
cannot see how breaching the overdraft condition can be avoided. Two forces are at work in
relation to this. First, the debenture interest at 8% suggests a repayment schedule of
CU130,000 per annum. Allied to significant investment in the subsidiary, cash flow may well
be strained in the forthcoming year. Second, unless a refinancing package is agreed, I cannot
see how the company can redeem its debenture. I cannot see any course of action, at this
stage, other than to require disclosures on the grounds of going concern.
550 + 225
Receivables: × 365 = 212 days (assuming revenues are all on credit)
900 + (550 − 120)
With inventory remaining constant in SAH (and no inventory values in eSAH), then cost of sales is
equivalent to purchases. Assuming these are all on credit then
430 + 300
Trade payables: × 365 = 228 days
990 × 83% + (550 − 120) × 90%
The covenant is exceeded. Once this is reported, the debenture holders will be able to enforce the
conversion of the debenture into a loan repayable on demand.
I consider it highly likely that the company SAH will become insolvent. It will then be up to the
debenture holders to assess if a reorganisation plan is viable. In particular we will need to
• See and investigate what projections are available for SAH with a view to considering the
viability of the business.
These projections will have implications for the plans for a listing in the near future which look
too ambitious as there is likely to be too much uncertainty for the business to be floated
successfully.
• Assess if there are any refinancing arrangements in place or proposed that would underpin
the survival of the company.
• The accounting treatment of the oil spill depends on when the event (ie the oil spill) took place.
• If the oil spill took place before the financial statements were authorised for issue the spill is an
event after the reporting period. The key question then is whether it should be treated as an
adjusting or non-adjusting event in accordance with IAS 10.
• Although the spill has only come to light on 1st April, it is possible that the leak was present at
the reporting date but was not detected at this time. If this were the case, then the event would
be an adjusting event and the financial statements should include a provision for the costs of
rectifying the damage including that caused to the environment. If it can be demonstrated that
the leak occurred after the year end and that the effects are material, which is probable in this
case, the nature of the event and an estimate of the financial effect should be disclosed.
• If the leak took place after 28 March ie when the financial statements were authorised for
issue, the event would not be recognised in the financial statements for 20X7 but would be
recognised in 20X8. C
H
• It is likely that expert evidence would need to be sought to determine how the leak has
A
occurred and therefore to estimate when the leak might have started.
P
(2) Auditor’s responsibility T
E
• Once the auditor’s report has been signed, the auditor does not have any responsibility to
R
perform audit procedures regarding subsequent events. However, the fact that the oil spill is
revealed so soon after the signing of the auditor’s report may call into question whether the
directors were attempting to conceal information and avoid a provision being made in the
current year financial statements. It also calls into question whether all other relevant 8
information has been given to the auditors up to this date.
• As the financial statements have not been issued, the auditor should consider the need to
amend the financial statements. This will depend on the application of IAS 10 as described
above. If the financial statements are amended to provide for an adjusting event or disclose a
non-adjusting event additional audit procedures will be required and a new audit report would
be issued.
20X5 0.87 The company has loan and lease commitments which
possibly may not be met.
Increasing reliance on short-term This does not secure the future.
finance
Summary – If the company is not a going concern the financial statements would be truer and
fairer if prepared on a break-up basis. Material adjustments may then be required to the financial
statements.
(b) • Analyse post-reporting date sale proceeds for non-current assets, inventory, cash received
from customers.
• Review the debt ageing and cash recovery lists. Ask directors if outstanding amounts from lost
customer are recoverable.
• Discuss the optimistic view of likely future contracts with the MD. Orders in the post-reporting
date period should be reviewed to see if they substantiate his opinion.
• Review bank/loan records to assess the extent to which the company has met its loan and
lease commitments in the post-reporting date period.
• Review sales orders/sales ledger for evidence of additional lost custom in post-reporting date
period.
– Agree budgets to any actual results achieved in the post-reporting date period
– Assess reasonableness of assumptions in the light of the success of the achievement of
the company's budgets set for 20X5. Discuss with the directors any targets not achieved
– Reperform calculations
– Ensure future budgeted profits are expected to meet likely interest charges
• Review bank records to ensure that the company is operating within its overdraft facility in the
post-reporting date period. Review bank certificate for terms and conditions of the facility.
Review bank correspondence for any suggestion the bank is concerned about its current
position.
• Ask management whether the new vehicle fleet is attracting new contracts as anticipated.
Scrutinise any new contracts obtained and check improved gross profit margins will be
achieved.
• Obtain written representation as to the likelihood of the company operating for 12 months from
the date of approval of the financial statements.
(b) This should not appear on a written representation letter, even though management opinion is
involved. This indicates an incorrect accounting treatment which the auditors should be in
disagreement with the directors over.
(c) This should not appear on a written representation letter as there should be sufficient alternative
evidence for this matter. The auditor should be able to obtain registered information about
Subsidiary Ltd from the companies' registrar.
(d) This should not appear on a written representation letter. The auditors should be able to obtain
evidence from Leaf Oil Ltd that the inventory belongs to them.
There are two issues here. The first is whether Russell Ltd’s policy of revaluations is correct and
the second is whether Russell Ltd should capitalise re-fit costs.
The most important thing to consider is materiality as only material items will affect the audit
opinion. The revaluations and refit total is material to the statement of financial position. It is
possible that any revaluation of the factory premises would also be material.
(ii) Refits
Assets should be held at cost or valuation as discussed above. However, in some cases, IAS
16 allows the cost of refits to be added to the original cost of the asset. This is when it is
probable that future economic benefits in excess of the originally assessed standard of
performance of the existing asset will flow to the entity. A retail shop will be subject to refitting
and this refitting may enhance its value. However, it is possible in a shop that such refitting
might be better classified as expenditure on fixtures and fittings. Russell Ltd’s policy should be
consistent and comparable, so if they have followed a policy of capitalising refits into the cost
of the shop in the past, this seems reasonable.
Conclusion
The issues relating to non-current assets were material and could have affected the auditor’s
report. However, having considered the issues, it appears that there are no material misstatements
relating to these issues. As there appears to have been no problem in obtaining sufficient
appropriate evidence in relation to non-current assets, the audit opinion would be unmodified in
relation to these issues.
The key question is the nature of the revenue earned by Russell Ltd on the internet sales. Russell
Ltd is acting as an agent for Cairns Ltd. At no point do the risks and rewards of ownership of the
goods sold on the internet pass to Russell Ltd. This is evidenced by the fact that goods are sent
directly to the customer by Cairns Ltd and they are responsible for all after-sales issues. The
revenue earned by Russell Ltd is therefore the commission on sales generated rather than the
sales price of the goods sold. Equally there will be no recognition of cost of sales or inventory in
respect of these items. Therefore the current treatment in the financial statements is incorrect.
Conclusion
The financial statements should be revised as they do not comply with IFRS 15. If management
refuse to adjust the financial statements the auditor will need to qualify the audit opinion on the
grounds of a misstatement (disagreement) which is material but not pervasive.
Reporting financial
performance
C
H
A
Introduction P
Topic List T
1 IAS 1 Presentation of Financial Statements E
• Compare the performance and position of different entities allowing for inconsistencies in
the recognition and measurement criteria in the financial statement information provided
• Calculate and disclose, from financial and other data, the amounts to be included in an
entity's financial statements according to legal requirements, applicable financial reporting
standards and accounting and reporting policies
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 2(a), 2(b), 2(c), 2(d), 14(f)
Section overview
• IAS 1 Presentation of Financial Statements sets down the format of financial statements,
containing requirements as to their presentation, structure and content.
IAS 1 was amended in 2011, changing the presentation of items contained in other comprehensive
income (OCI) and their classification within OCI.
You may still see the old names (balance sheet, etc), as these new titles are not mandatory.
Owner changes in equity arise from transactions with owners in their capacity as owners, eg dividends
paid and issues of share capital. These are presented in the statement of changes in equity.
IAS 1 requires disclosure of comparative information in respect of the previous period. It also requires
inclusion of a statement of financial position as at the beginning of the earliest comparative period when
an entity:
In effect this will result in the presentation of three statements of financial position when there is a prior
period adjustment.
Total comprehensive income is the change in equity during a period resulting from transactions and
other events, other than those changes resulting from transactions with owners in their capacity as
owners. It includes all components of profit or loss and of 'other comprehensive income'.
Other comprehensive income includes income and expenses that are not recognised in profit or loss,
but instead recognised directly in equity. It includes:
• Remeasurements (actuarial gains and losses on defined benefit plans recognised in accordance
with IAS 19 Employee Benefits (revised 2011)) (Chapter 18).
• The effective portion of gains and losses on hedging instruments in a cash flow hedge (Chapter
17).
Background
The blurring of distinctions between different items in OCI is the result of an underlying general lack
of agreement among users and preparers about which items should be presented in OCI and which
should be part of the profit or loss section. For instance, a common misunderstanding is that the split
between profit or loss and OCI is on the basis of realised versus unrealised gains. This is not, and has
never been, the case.
This lack of a consistent basis for determining how items should be presented has led to the somewhat
inconsistent use of OCI in financial statements.
Change
Entities are required to group items presented in other comprehensive income (OCI) on the basis of
whether they would be reclassified to (recycled through) profit or loss at a later date, when specified
conditions are met.
The amendment does not address which items are presented in other comprehensive income or which
items need to be reclassified.
Income tax
IAS 1 requires an entity to disclose income tax relating to each component of other comprehensive
income. This is because these items often have tax rates different from those applied to profit or loss.
C
This may be achieved by either
H
• Presenting individual components of other comprehensive income net of the related tax, or A
P
• Presenting individual components of other comprehensive income before tax, with one amount T
shown for the aggregate amount of income tax relating to those components. E
Presentation R
2 A statement displaying components of profit or loss plus a second statement beginning with profit
or loss and displaying components of other comprehensive income (statement of profit or loss and
other comprehensive income).
The recommended format of a single statement of profit or loss and other comprehensive income is as
follows:
Alternatively, components of OCI could be presented in the statement of profit or loss and other
comprehensive income net of tax.
Tutorial note:
Throughout this text, income and expense items which are included in the 'top half' of the statement of
profit or loss and other comprehensive income are referred to as recognised in profit or loss, or
recognised in the income statement.
Income and expense items included in the 'bottom half' of the statement of profit or loss and other
comprehensive income are referred to as recognised in other comprehensive income.
For exam purposes, you must ensure that you clarify where in the statement of profit or loss and other
comprehensive income an item is recorded, by referring to recognition:
Non-owner transactions are not permitted to be shown in the statement of changes in equity other than
in aggregate.
OLIVE GROUP: STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 30 JUNE 20X9
AFS Revalua- Non- 9
Share Retained financial tion controlling Total
capital earnings assets surplus Total interest equity
CUm CUm CUm CUm CUm CUm CUm
Balance at
1 July 20X8 14,280 10,896 384 96 25,656 1,272 26,928
Share capital issued 1,320 1,320 1,320
Dividends (216) (216) (120) (336)
Total comprehensive
income for the year (1,296) 72 48 (1,176) 528 (648)
Balance at
30 June 20X9 15,600 9,384 456 144 25,584 1,680 27,264
Section overview
IFRS 8 is a disclosure standard.
– Past performance
– Risks and returns
– Informed judgements
• The standard gives guidance on how segments should be identified and what information
should be disclosed for each.
It also sets out requirements for related disclosures about products and services, geographical
areas and major customers.
2.1 Introduction
Large entities produce a wide range of products and services, often in several different countries.
Further information on how the overall results of entities are made up from each of these product or
geographical areas will help the users of the financial statements. This is the reason for segment
reporting.
Risks and returns of a diversified, multi-national company can be better assessed by looking at the
individual risks and rewards attached to groups of products or services or in different geographical
areas. These are subject to differing rates of profitability, opportunities for growth, future prospects and
risks.
Only entities whose equity or debt securities are publicly traded (ie on a stock exchange) need
disclose segment information. In group accounts, only consolidated segmental information needs to be
shown. (The statement also applies to entities filing or in the process of filing financial statements for the
purpose of issuing instruments.)
(a) That engages in business activities from which it may earn revenues and incur expenses (including
revenues and expenses relating to transactions with other components of the same entity)
(b) Whose operating results are regularly reviewed by the entity's chief operating decision maker to
make decisions about resources to be allocated to the segment and assess its performance, and
2.4 Aggregation
Two or more operating segments may be aggregated if the segments have similar economic
characteristics, and the segments are similar in all of the following respects:
(b) Segment profit or loss ≥ 10% of the profit of all segments in profit (or loss of all segments
making a loss if greater), or
At least 75% of total external revenue must be reported by operating segments. Where this is not the
case, additional segments must be identified (even if they do not meet the 10% thresholds).
2.6 Disclosures
2.6.1 Segment disclosures 9
Disclosures required by the IFRS are extensive and best learned by looking at the example and pro
forma, which follow the list. Disclosure is required of:
Reporting of a measure of profit or loss by segment is compulsory. Other items are disclosed if
included in the figures reviewed by or regularly provided to the chief operating decision maker.
• External revenue by each product and service (if reported basis is not products and services)
• Geographical information:
Notes:
(2) Non-current assets excludes financial instruments, deferred tax assets, post-employment
benefit assets, and rights under insurance contracts.
• Information about reliance on major customers (ie those who represent more than 10% of
external revenue).
The hypothetical company does not allocate tax expense (tax income) or non-recurring gains and losses
to reportable segments. In addition, not all reportable segments have material non-cash items other than
depreciation and amortisation in profit or loss. The amounts in this illustration, denominated as dollars,
are assumed to be the amounts in reports used by the chief operating decision maker.
Endeavour, a public limited company, trades in six business areas which are reported separately in its
internal accounts provided to the chief operating decision maker. The results of these segments for the
year ended 31 December 20X5 are as follows.
Section overview
• IFRS 5 requires assets and groups of assets that are 'held for sale' to be presented separately
on the face of the statement of financial position and the results of discontinued operations to be
presented separately in the statement of profit or loss and other comprehensive income. This is
required so that users of financial statements will be better able to make projections about the
financial position, profits and cash flows of the entity based on continuing operations only.
Definition
Disposal group: a group of assets to be disposed of, by sale or otherwise, together as a group in a
single transaction, and liabilities directly associated with those assets that will be transferred in the
transaction. (In practice a disposal group could be a subsidiary, a cash-generating unit or a single
operation within an entity.) (IFRS 5)
A disposal group could form a group of cash-generating units, a single cash-generating unit or be part of
a cash-generating unit.
The disposal group should include goodwill if it is a cash-generating unit (or group of cash-generating
units to which goodwill has been allocated under IAS 36). Only goodwill recognised in the statement of
financial position can be included in the disposal group. If a previous GAAP allowed goodwill to be
recorded directly in reserves, this goodwill does not form part of a disposal group. C
H
A disposal group may include current and non-current assets and current and non-current liabilities. A
However, only liabilities that will be transferred as part of the transaction are classified as part of the
P
disposal group. If any liabilities remain with the vendor, these are not included in the scope of IFRS 5.
T
IFRS 5 does not apply to certain assets covered by other accounting standards: E
R
• Deferred tax assets (IAS 12)
• Investment properties accounted for in accordance with the fair value model (IAS 40)
• Agricultural and biological assets that are measured at fair value less estimated point of sale costs
(IAS 41)
(a) The asset must be available for immediate sale in its present condition.
(b) Its sale must be highly probable (ie, significantly more likely than not).
(iii) The asset must be marketed for sale at a price that is reasonable in relation to its current fair
value.
(iv) The sale should be expected to take place within one year from the date of classification.
(v) It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.
An asset (or disposal group) can still be classified as held for sale, even if the sale has not actually taken
place within one year. However, the delay must have been caused by events or circumstances
beyond the entity's control and there must be sufficient evidence that the entity is still committed to
sell the asset or disposal group. Otherwise the entity must cease to classify the asset as held for sale.
If an entity acquires a disposal group (eg, a subsidiary) exclusively with a view to its subsequent
disposal it can classify the asset as held for sale only if the sale is expected to take place within one year
and it is highly probable that all the other criteria will be met within a short time (normally three months).
Abandoned assets
An asset that is to be abandoned should not be classified as held for sale. This is because its carrying
amount will be recovered principally through continuing use. However, a disposal group that is to be
abandoned may meet the definition of a discontinued operation and therefore separate disclosure may
be required (see below).
On 1 December 20X3, a company became committed to a plan to sell a manufacturing facility and has
already found a potential buyer. The company does not intend to discontinue the operations currently
carried out in the facility. At 31 December 20X3 there is a backlog of uncompleted customer orders. The
subsidiary will not be able to transfer the facility to the buyer until after it ceases to operate the facility
and has eliminated the backlog of uncompleted customer orders. This is not expected to occur until
spring 20X4.
Requirement
An impairment loss should be recognised where fair value less costs to sell is lower than carrying
amount. Note that this is an exception to the normal rule. IAS 36 Impairment of Assets requires an entity
to recognise an impairment loss only where an asset's recoverable amount is lower than its carrying
value. Recoverable amount is defined as the higher of net realisable value and value in use. IAS 36
does not apply to assets held for sale.
Non-current assets held for sale should not be depreciated, even if they are still being used by the
entity.
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of:
(a) Its carrying amount before it was classified as held for sale, adjusted for any depreciation that
would have been charged had the asset not been held for sale.
(b) Its recoverable amount at the date of the decision not to sell.
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical
area of operations, or
Component of an entity: operations and cash flows that can be clearly distinguished, operationally and
for financial reporting purposes, from the rest of the entity.
An entity should present and disclose information that enables users of the financial statements to
evaluate the financial effects of discontinued operations and disposals of non-current assets or
disposal groups.
An entity should disclose a single amount on the face of the statement of profit or loss and other
comprehensive income (or statement of profit or loss where presented separately) comprising the total
of:
(b) The post-tax gain or loss recognised on the measurement to fair value less costs to sell or on
the disposal of the assets or disposal group(s) constituting the discontinued operation.
An entity should also disclose an analysis of the above single amount into:
(a) The revenue, expenses and pre-tax profit or loss of discontinued operations.
(c) The gain or loss recognised on the measurement to fair value less costs to sell or on the disposal
of the assets or the discontinued operation. C
H
(d) The related income tax expense.
A
This may be presented either on the face of the statement of profit or loss and other comprehensive P
income or in the notes. If it is presented on the face of the statement of profit or loss and other T
comprehensive income it should be presented in a section identified as relating to discontinued E
operations, ie separately from continuing operations. This analysis is not required where the R
discontinued operation is a newly acquired subsidiary that has been classified as held for sale.
An entity should disclose the net cash flows attributable to the operating, investing and financing
activities of discontinued operations. These disclosures may be presented either on the face of the 9
statement of cash flows or in the notes.
Gains and losses on the remeasurement of a disposal group that is not a discontinued operation but is
held for sale should be included in profit or loss from continuing operations.
On 20 October 20X3 the directors of a parent company made a public announcement of plans to close a
steel works. The closure means that the group will no longer carry out this type of operation, which until
recently has represented about 10% of its total revenue. The works will be gradually shut down over a
period of several months, with complete closure expected in July 20X4. At 31 December 20X3 output
had been significantly reduced and some redundancies had already taken place. The cash flows,
revenues and expenses relating to the steel works can be clearly distinguished from those of the
subsidiary's other operations.
Requirement
How should the closure be treated in the financial statements for the year ended 31 December 20X3?
(a) Assets and liabilities held for sale should not be offset.
(b) The major classes of assets and liabilities held for sale should be separately disclosed either on
the face of the statement of financial position or in the notes.
(c) Any gain or loss recognised when the item was classified as held for sale.
(d) If applicable, the segment in which the non-current asset (or disposal group) is presented in
accordance with IFRS 8 Operating Segments.
Where an asset previously classified as held for sale is no longer held for sale, the entity should
disclose a description of the facts and circumstances leading to the decision and its effect on results.
Section overview
• The objective of IAS 24 is to ensure that an entity's financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position, and/or profit or loss may
have been affected by the existence of related parties or by related party transactions.
IAS 24 requires disclosure of related party transactions, and outstanding balances, in the separate
financial statements of:
• A parent
• A venturer or
• An investor
A related party is a person or entity that is related to the entity that is preparing its financial statements.
(a) A person or a close member of that person's family is related to a reporting entity if that person:
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which means that each
parent, subsidiary and fellow subsidiary is related to the others).
(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of
a member of a group of which the other entity is a member).
(iii) Both entities are joint ventures of the same third party.
(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third
entity.
(v) The entity is a post-employment defined benefit plan for the benefit of employees of either the
reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a
plan, the sponsoring employers are also related to the reporting entity.
(vii) A person identified in (a)(i) has significant influence over the entity or is a member of the key
management personnel of the entity (or of a parent of the entity).
Exclusions
(a) Two entities simply because they have a director or other key management in common
(notwithstanding the definition of related party above, although it is necessary to consider how that
director would affect both entities).
(b) Two venturers, simply because they share joint control over a joint venture.
(c) Certain other bodies, simply as a result of their role in normal business dealings with the entity
• Compensation, being the consideration in exchange for their services, received by key
management personnel.
• Disclosures required about related parties only if transactions have taken place between them
during the period:
– The nature of the relationship (but remember this must always be disclosed in respect of a
parent).
– If an amount has been provided against or written off any outstanding balance due.
• Disclosure of the fact that transactions are on an arm's length basis. (The term 'arm's length'
continues to be used in the context of IAS 24, even though it has been removed from the definition
of fair value in IFRS 13 (see Chapter 2, Section 4).)
P owns S and a number of other subsidiaries. The following details relate to amounts due to the key
management personnel (KMP) of P and of S for the year ended 31 December 20X5.
CU
Salaries and related taxes payable by S to its KMP for services rendered to S 500,000
Salaries and related taxes payable by P to S's KMP for services rendered to S 60,000
Salaries and related taxes payable by S to its KMP for services rendered to P 20,000
Pension benefits accruing within the group-wide pension scheme to S's KMP for 50,000
services rendered to S
Share options granted under the group-wide share option scheme to S's KMP for 28,000
services rendered to S
658,000
Requirement
What transactions should be disclosed as key management personnel compensation in the financial
statements of S?
• Two entities simply because they have a director (or other member of key management
personnel) in common, or because a member of key management personnel of one entity has
significant influence over the other entity.
• Two venturers simply because they share joint control over a joint venture.
• Providers of finance, trade unions, public utilities and government departments and agencies of a
government that does not control, jointly control or significantly influence the reporting entity simply
by virtue of their normal dealings with an entity.
• A customer, supplier, franchisor, distributor, or general agent, with whom an entity transacts a
significant volume of business, simply by virtue of the resulting economic dependence.
(a) Person A owns 30% of Entity B and Entity C owns 40% of Entity B
Person A is a related party under definition (a)(ii) and Entity C is a related party under
definition (b)(ii)
Person A is a related party under definition (a)(i) and Entity B is a related party under definition
(b)(ii)
Person A falls within the definition of Entity B's key management personnel and is a related
party under definition (a)(iii)
Person A is a related party under definition (a)(i) and Entity C is a related party under
definition (b)(vii)
Person A falls within the definition of Entity C's key management personnel and is a related
party under definition (b)(iii)
Section overview
• IFRS 1 gives guidance to entities applying IFRS for the first time.
C
The adoption of a new body of accounting standards will inevitably have a significant effect on the
H
accounting treatments used by an entity and on the related systems and procedures. In 2005 many
countries adopted IFRS for the first time and over the next few years other countries are likely to do the A
same. P
T
In addition, many Alternative Investment Market (AIM) companies and public sector companies adopted E
IFRS for the first time for accounting periods ending in 2009 and 2010. US companies are likely to move
R
increasingly to IFRS, although the US Securities and Exchange Commission has not given any definite
timeline for this in its 2012 work plan.
IFRS 1 First-time Adoption of International Financial Reporting Standards was issued to ensure that an 9
entity's first IFRS financial statements contain high quality information that:
(a) Is transparent for users and comparable over all periods presented;
(b) Provides a suitable starting point for accounting under IFRSs; and
(c) Can be generated at a cost that does not exceed the benefits to users.
An entity's first IFRS financial statements are the first annual financial statements in which the entity
adopts IFRS by an explicit and unreserved statement of compliance with IFRS.
Any other financial statements (including fully compliant financial statements that did not state so) are
not the first set of financial statements under IFRS.
An entity may apply IFRS 1 more than once, for example if a UK company adopted IFRS, then reverted
to UK GAAP, then moved to IFRS again.
Generally, this will be the beginning of the earliest comparative period shown (ie full retrospective
application). Given that the entity is applying a change in accounting policy on adoption of IFRS 1, IAS 1
Presentation of Financial Statements requires the presentation of at least three statements of
financial position (and two of each of the other statements).
Transition
date
Preparation of an opening IFRS statement of financial position typically involves adjusting the amounts
reported at the same date under previous GAAP.
All adjustments are recognised directly in retained earnings (or, if appropriate, another category of
equity) not in profit or loss.
5.3 Estimates
Estimates in the opening IFRS statement of financial position must be consistent with estimates made at
the same date under previous GAAP even if further information is now available (in order to comply
with IAS 10).
The entity should select accounting policies that comply with IFRSs effective at the end of the first
IFRS reporting period.
These accounting policies are used in the opening IFRS statement of financial position and
throughout all periods presented. The entity does not apply different versions of IFRS effective at
earlier dates.
Previous GAAP statement of financial position may contain items that do not qualify for recognition
under IFRS.
Eg IFRS does not permit capitalisation of research, staff training and relocation costs.
Eg deferred tax balances and certain provisions such as environmental and decommissioning
costs.
Eg compound financial instruments need to be split into their liability and equity components.
(e) Measurement
• Fair value/previous GAAP revaluation may be used as a substitute for cost at date of transition
to IFRSs.
• For items requiring a cost measure for IFRSs, the carrying value at the date of the business
combination is treated as deemed cost and IFRS rules are applied from thereon.
• Items requiring a fair value measure for IFRSs are revalued at the date of transition to IFRSs.
• The carrying value of goodwill at the date of transition to IFRSs is the amount as reported
under previous GAAP.
• Unrecognised actuarial gains and losses can be deemed zero at the date of transition to
IFRSs. IAS 19 is applied from then on.
If a subsidiary, associate or joint venture adopts IFRS later than its parent, it measures its assets
and liabilities:
• Either: At the amount that would be included in the parent's financial statements, based on C
the parent's date of transition H
• Or: At the amount based on the subsidiary (associate or joint venture)'s date of A
transition. P
T
Disclosure E
(a) A reconciliation of previous GAAP equity to IFRSs is required at the date of transition to IFRSs R
and for the most recent financial statements presented under previous GAAP.
(b) A reconciliation of profit for the most recent financial statements presented under previous 9
GAAP.
(a) Accurate assessment of the task involved. Underestimation or wishful thinking may hamper the
effectiveness of the conversion and may ultimately prove inefficient.
(b) Proper planning. This should take place at the overall project level, but a detailed task analysis
could be drawn up to control work performed.
(c) Human resource management. The project must be properly structured and staffed.
(d) Training. Where there are skills gaps, remedial training should be provided.
(e) Monitoring and accountability. A relaxed 'it will be all right on the night' attitude could spell
danger. Implementation progress should be monitored and regular meetings set up so that
(f) Achieving milestones. Successful completion of key steps and tasks should be appropriately
acknowledged, ie what managers call 'celebrating success', so as to sustain motivation and
performance.
(g) Physical resources. The need for IT equipment and office space should be properly assessed.
(h) Process review. Care should be taken not to perceive the conversion as a one-off quick fix. Any
change in future systems and processes should be assessed and properly implemented.
(i) Follow-up procedures. Good management practice dictates that follow-up procedures should be
planned and in place to ensure that the transfer is effectively implemented and that any necessary
changes are identified and implemented on a timely basis.
(j) Contractual terms may be affected, such as covenants related to borrowing facilities based on
statement of financial position ratios. The potential effect of the new Standards on these
measurements should be assessed and discussed with the lenders at an early stage.
Europa is a listed company incorporated in Molvania. It will adopt International Financial Reporting Standards
(IFRSs) for the first time in its financial statements for the year ended 31 December 20X8.
The directors of Europa are unclear as to the impact of IFRS 1 First-time Adoption of International
Financial Reporting Standards.
Requirement
(a) The procedure for preparing IFRS financial statements for the first time (as required by IFRS 1).
(b) The practical steps that the company should take in order to ensure an efficient transfer to
accounting under IFRS.
(c) In its previous financial statements for 31 December 20X6 and 20X7, which were prepared under
local GAAP, the company:
(i) Made a number of routine accounting estimates, including accrued expenses and provisions,
and
(ii) Did not recognise a provision for a court case arising from events that occurred in September
20X7. When the court case was concluded on 30 June 20X8, Europa was required to pay
$10 million and paid this on 10 July 20X8, after the 20X7 financial statements were authorised
for issue.
In the opinion of the directors, the company's estimates of accrued expenses and provisions under local
GAAP were made on a basis consistent with IFRSs.
Requirement
Discuss how the matters above should be dealt with in the financial statements of Europa for the year
ended 31 December 20X8.
Section overview
• IAS 34 recommends that publicly traded entities should produce interim financial reports,
and for entities that do publish such reports, it lays down principles and guidelines for their
Definitions
Interim period is a financial reporting period shorter than a full financial year.
Interim financial report means a financial report containing either a complete set of financial
statements (as described in IAS 1) or a set of condensed financial statements (as described in this
Standard) for an interim period.
• To provide an interim financial report for at least the first six months of their financial year (ie a
half year financial report).
• To make the report available no later than 60 days after the end of the interim period.
Thus, a company with a year ending 31 December would be required as a minimum to prepare an
interim report for the half year to 30 June and this report should be available before the end of August.
• A complete set of financial statements at the interim reporting date complying in full with IFRSs, or
• A condensed interim financial report prepared in compliance with IAS 34.
The rationale for allowing only condensed statements and selected note disclosures is that entities need
not duplicate information in their interim report that is contained in their report for the previous financial
year. Interim statements should focus more on new events, activities and circumstances.
The condensed statement of financial position should include, as a minimum, each of the major
components of assets, liabilities and equity as were in the statement of financial position at the end of
The condensed statement of profit or loss and other comprehensive income should include, as a
minimum, each of the component items of total comprehensive income as were shown in the statement
of profit or loss and other comprehensive income for the previous financial year, together with the
earnings per share and diluted earnings per share.
The condensed statement of cash flows should show, as a minimum, the three major sub-totals of
cash flow as required in statements of cash flows by IAS 7, namely: cash flows from operating activities,
cash flows from investing activities and cash flows from financing activities.
The condensed statement of changes in equity should include, as a minimum, each of the major
components of equity as were contained in the statement of changes in equity for the previous financial
year of the entity.
• A statement that the same accounting policies and methods of computation have been used
for the interim statements as were used for the most recent annual financial statements. If not, the
nature of the differences and their effect should be described. (The accounting policies for
preparing the interim report should only differ from those used for the previous annual accounts in a
situation where there has been a change in accounting policy since the end of the previous
financial year, and the new policy will be applied for the annual accounts of the current financial
period.)
• Explanatory comments on the seasonality or 'cyclicality' of operations in the interim period. For
example, if a company earns most of its annual profits in the first half of the year, because sales
are much higher in the first six months, the interim report for the first half of the year should explain
this fact.
• The nature and amount of items during the interim period affecting assets, liabilities, capital, net
income or cash flows, that are unusual, due to their nature, incidence or size.
• The issue or repurchase of equity or debt securities.
• Nature and amount of any changes in estimates of amounts reported in an earlier interim report during
the financial year, or in prior financial years if these affect the current interim period.
• Dividends paid on ordinary shares and the dividends paid on other shares.
• Segmental results for entities that are required by IFRS 8 Operating Segments to disclose
segment information in their annual financial statements.
• Any significant events since the end of the interim period.
• Effect of changes in the composition of the entity during the interim period including the acquisition
or disposal of subsidiaries and long-term investments, restructurings and discontinued operations.
• Any significant change in a contingent liability or a contingent asset since the date of the last
annual statement of financial position.
Changes in the business environment such as changes in price, costs, demand, market share and
prospects for the full year should be discussed in the management discussion and analysis of the
financial review.
The entity should also disclose the fact that the interim report has been produced in compliance with
IAS 34 on interim financial reporting.
Give some examples of the type of disclosures required according to the above list of explanatory notes.
Solution
The following are examples:
• Write-down of inventories to net realisable value and the reversal of such a write-down
• Recognition of a loss from the impairment of property, plant and equipment, intangible assets, or
other assets, and the reversal of such an impairment loss
• Litigation settlements
• Any debt default or any breach of a debt covenant that has not been corrected subsequently
• Statement of financial position data as at the end of the current interim period, and comparative
data as at the end of the most recent financial year.
• Statement of profit or loss and other comprehensive income data for the current interim period C
and cumulative data for the current year to date, together with comparative data for the H
corresponding interim period and cumulative figures for the previous financial year. A
• Statement of cash flows data should be cumulative for the current year to date, with comparative P
cumulative data for the corresponding interim period in the previous financial year. T
E
• Data for the statement of changes in equity should be for both the current interim period and for R
the year to date, together with comparative data for the corresponding interim period, and
cumulative figures, for the previous financial year.
6.5 Materiality 9
Materiality should be assessed in relation to the interim period financial data. It should be recognised
that interim measurements rely to a greater extent on estimates than annual financial data.
This means, for example, that a cost that would not be regarded as an asset in the year-end statement
of financial position should not be regarded as an asset in the statement of financial position for an
interim period. Similarly, an accrual for an item of income or expense for a transaction that has not yet
occurred (or a deferral of an item of income or expense for a transaction that has already occurred) is
inappropriate for interim reporting, just as it is for year-end reporting.
The standard goes on, in an appendix, to deal with specific applications of the recognition and
measurement principles. Some of these examples are explained below, by way of explanation and
illustration.
Year-end bonus
A year-end bonus should not be provided for in an interim financial statement unless there is a
constructive obligation to pay a year-end bonus (eg a contractual obligation, or a regular past practice)
and the size of the bonus can be reliably measured.
Requirement
Holiday pay
The same principle applies here. If holiday pay is an enforceable obligation on the employer, then any
unpaid accumulated holiday pay may be accrued in the interim financial report.
Depreciation
Depreciation should only be charged in an interim statement on non-current assets that have been
acquired, not on non-current assets that will be acquired later in the financial year.
Tax on income
An entity will include an expense for income tax (tax on profits) in its interim statements. The tax rate to C
use should be the estimated average annual tax rate for the year. For example, suppose that in a H
particular jurisdiction, the rate of tax on company profits is 30% on the first CU200,000 of profit and 40%
A
on profits above CU200,000. Now suppose that a company makes a profit of CU200,000 in its first half
P
year, and expects to make CU200,000 in the second half year. The rate of tax to be applied in the
interim financial report should be 35%, not 30%, ie the expected average rate of tax for the year as a T
whole. This approach is appropriate because income tax on company profits is charged on an annual E
basis, and an effective annual rate should therefore be applied to each interim period. R
As another illustration, suppose a company earns pre-tax income in the first quarter of the year of CU30,000,
but expects to make a loss of CU10,000 in each of the next three quarters, so that net income before tax for
the year is zero. Suppose also that the rate of tax is 30%. In this case, it would be inappropriate to anticipate 9
the losses, and the tax charge should be CU9,000 for the first quarter of the year (30% of CU30,000) and a
negative tax charge of CU3,000 for each of the next three quarters, if actual losses are the same as
anticipated.
Where the tax year for a company does not coincide with its financial year, a separate estimated
weighted average tax rate should be applied for each tax year, to the interim periods that fall within that
tax year.
Some countries give entities tax credits against the tax payable, based on amounts of capital
expenditure or research and development, etc. Under most tax regimes, these credits are calculated and
granted on an annual basis; therefore it is appropriate to include anticipated tax credits within the
calculation of the estimated average tax rate for the year, and apply this rate to calculate the tax on
income for the interim period.
Requirement
Under IAS 34 what should the taxation charge be in the interim financial statements?
Solution
The taxation charge in the interim financial statements is based upon the weighted average rate for the
year. In this case the entity's tax rate for the year is expected to be 30%. The taxation charge in the
interim financial statements will be CU1.8 million.
The Alshain Company's profit before tax for the six months to 30 September 20X6 was CU4 million.
However, the business is seasonal and profit before tax for the six months to 31 March 20X7 is almost
certain to be CU8 million. Profit before tax equals taxable profit for this company.
Alshain operates in a country where income tax on companies is at a rate of 25% if annual profits are
below CU11 million and a rate of 30% where annual profits exceed CU11 million. These tax rates apply
to the entire profit for the year.
Under IAS 34 Interim Financial Reporting, what should be the income tax expense in Alshain's interim
financial statements for the half year to 30 September 20X6?
Inventory valuations
Within interim reports, inventories should be valued in the same way as for year-end accounts. It is
recognised, however, that it will be necessary to rely more heavily on estimates for interim reporting than
for year-end reporting.
In addition, it will normally be the case that the net realisable value of inventories should be estimated
from selling prices and related costs to complete and dispose at interim dates.
Requirement
How should the value of the inventories be reflected in the interim financial statements?
Solution
The value of the inventories in the interim financial statements at 30 June 20X4 is the lower of cost and
NRV at 30 June 20X4. This is:
• Inventories. An entity might not need to carry out a full inventory count at the end of each interim
period. Instead, it may be sufficient to estimate inventory values using sales margins.
• Provisions. An entity might employ outside experts or consultants to advise on the appropriate
amount of a provision, as at the year end. It will probably be inappropriate to employ an expert to
make a similar assessment at each interim date. Similarly, an entity might employ a professional
valuer to revalue non-current assets at the year end, whereas at the interim date(s) the entity will
not rely on such experts.
• Income taxes. The rate of income tax (tax on profits) will be calculated at the year end by applying
the tax rate in each country/jurisdiction to the profits earned there. At the interim stage, it may be
sufficient to estimate the rate of income tax by applying the same 'blended' estimated weighted
average tax rate to the income earned in all countries/jurisdictions.
• Classification of current and non-current assets and liabilities. The investigation for classifying
assets and liabilities as current and non-current may be more thorough at annual reporting dates
than at interim ones.
• Pensions. IAS 19 Employee Benefits encourages the use of a professionally qualified actuary in
the measurement of the plan's defined benefit obligations. For interim reporting purposes reliable
estimates may be obtained by extrapolation of the latest actuarial valuation.
• Contingencies. Normally the measurement of contingencies may involve formal reports giving the
opinions of experts. Expert opinions about contingencies and uncertainties relating to litigation or
assessments may or may not be needed at interim dates.
• Revaluations and fair value accounting. Where an entity carries assets at fair value such as
non-current assets in accordance with IAS 16 Property, Plant and Equipment or investment
properties in accordance with IAS 40 Investment Property, it may rely on independent professional
valuations at annual reporting dates, though not at interim reporting dates.
• Specialised industries. Interim period measurement in specialised industries may be less precise
than at year end due to their complexity, and the cost and time investment that is required. C
H
The principle of materiality applies to interim financial reporting, as it does to year-end reporting. In A
assessing materiality, it needs to be recognised that interim financial reports will rely more heavily on
P
estimates than year-end reports. Materiality should be assessed in relation to the interim financial
T
statements themselves, and should be independent of 'annual materiality' considerations.
E
6.8 IFRIC 10 Interim Financial Reporting and Impairment R
This IFRIC, issued in 2006, addresses the apparent conflict between IAS 34 and the requirement in
other standards on the recognition and reversal in financial statements of impairment losses on goodwill
9
and certain financial assets.
IFRIC 10 states that any such impairment losses recognised in an interim financial statement must not
be reversed in subsequent interim or annual financial statements.
Section overview
• The auditor must consider the risk of fraud in general, and the risk of creative accounting in
ISA 200 Overall objectives of the independent auditor and the conduct of an audit in accordance with the
International Standards on Auditing states the auditor's overall objectives as follows:
(a) To obtain reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error, thereby enabling the auditor to express an
opinion on whether the financial statements are prepared, in all material respects, in accordance
with an applicable financial reporting framework; and
(b) To report on the financial statements, and communicate as required by the ISAs, in accordance
with the auditor's findings.
Note that the auditor is concerned with material misstatements arising both as a result of error, and as a
result of fraud.
We looked at creative accounting, a form of fraudulent financial reporting, in Chapter 5. We will look at
the audit approach to fraud and creative accounting in more detail in Chapter 24.
Another point which is worth drawing out is the need for the auditor to report and communicate as
required by the ISAs. As ISA 200 makes clear, the auditor must fully understand and comply with
all of the ISAs relevant to the audit.
Section overview
• This section looks at some of the audit issues related to certain financial reporting treatments
covered earlier in this chapter.
Auditors are required to obtain sufficient appropriate audit evidence regarding the presentation and
disclosure of segment information by:
(i) Evaluating whether such methods are likely to result in disclosure in accordance with the
applicable financial reporting framework, and
(b) Performing analytical procedures or other audit procedures appropriate in the circumstances.
When the ISA talks about obtaining an understanding of management's methods, the following may be
relevant:
• Comparisons with budgets and other expected results, for example, operating profits as a
percentage of sales.
• Consistency with prior periods, and the adequacy of the disclosures with respect to inconsistencies.
Robinson Ltd has a balance of CU250,000 in respect of assets classified as held for sale in the financial
statements for the year ended 31 December 20X7. This is in respect of two assets as follows:
(1) CU70,000 relates to production machinery used for a product which is to be withdrawn. Production
will be run down until the end of January 20X8 so that outstanding orders can be completed. The
plant will then be serviced and uninstalled in early February.
(2) CU180,000 relates to a piece of land which was classified as held for sale on 1 October. (You
should assume that the IFRS 5 criteria are satisfied.) On this date the land's fair value was
estimated to be CU210,000 with costs to advertise the asset as being available for sale estimated
at CU6,000. The CU180,000 represents the carrying value of the land on the basis that it is lower
than fair value less costs to sell. Robinson Ltd has adopted a revaluation policy for land. C
H
Requirements A
P
For each of the above assets:
T
(a) Identify the key audit issue E
(b) State the audit procedures which would be performed to address this issue R
The overall aim of ISA 550 Related Parties is to enhance the auditor's consideration of related parties and
related party transactions with a focus on risk assessment including the recognition of fraud risk factors. The
auditor must establish an approach that requires the auditor to assess the risks of misstatement and design
audit procedures to address these. In particular the ISA includes the following:
• Clearer responsibilities for the auditor, with a distinction being made between circumstances where
the accounting framework includes disclosure and other reporting requirements for related parties,
and circumstances where either there are no such requirements or they are inadequate.
• Clearer distinction between the risk assessment procedures and the further audit procedures.
Readers will also normally assume that a company is owned by a number of shareholders and is not
subject to control or significant influence by any one person or company unless told otherwise, eg
through disclosure of the identity of the parent company and significant shareholdings disclosure.
Where a company does business with 'related parties', for instance with shareholders or directors, these
assumptions may not be valid.
ISA 550 is applicable whether or not IAS 24 Related party disclosures is a requirement of the reporting
framework for the entity concerned. ISA 550, therefore, applies to private companies as well as
listed companies. ISA 550 provides the following definition.
Definition
Related party: A party that is either:
(b) Where the applicable financial reporting framework establishes minimal or no related party
requirements:
(i) A person or other entity that has control or significant influence, directly or indirectly through
one or more intermediaries, over the reporting entity
(ii) Another entity over which the reporting entity has control or significant influence, directly or
indirectly through one or more intermediaries; or
(iii) Another entity that is under common control with the reporting entity through having:
However, entities that are under common control by a state (ie a national, regional or local government)
are not considered related unless they engage in significant transactions or share resources to a
significant extent with one another.
8.5.2 Responsibilities
Management is responsible for the identification of related parties and the disclosure of transactions
with such parties. Management should set up appropriate internal controls to ensure that related
parties are identified and disclosed along with any related party transactions.
The auditor has a responsibility to perform audit procedures to identify, assess and respond to the risks
of material misstatement arising from the entity's failure to appropriately account for or disclose related
party relationships, transactions or balances.
There is an increased risk that the auditor may fail to detect material misstatements in the context of
related parties because:
• Related party relationships may present a greater opportunity for collusion, concealment or
manipulation by management.
8.5.3 Risks
The following audit risks may arise from a failure to discover a related party.
• The reliance on a source of audit evidence may be misjudged. An auditor may rely on what is
perceived to be third party evidence when in fact it is from a related party. More generally, reliance
on management assurances may be affected if the auditor were made aware of non-disclosure of a
related party.
• The motivations of related parties may be outside normal business motivations and thus may be
misunderstood by the auditor if there is non-disclosure. In the extreme, this may amount to fraud.
The risk of failure to detect a related party transaction (RPT) may depend upon the following.
• Whether there has been no charge made for a RPT (ie a zero cost transaction).
• Where disclosure would be sensitive for directors or have adverse consequences for the company.
• Where RPTs are not with a party that the auditor could reasonably expect to know is a related
party.
• Management have concealed, or failed to disclose fully, related parties or transactions with such
parties.
C
Point to note:
H
The term 'arm's length' continues to be used in the context of IAS 24 even though it has been removed A
from the definition of fair value in IFRS 13. P
T
8.5.4 Risk assessment procedures E
In planning the audit, the auditor needs to consider the risk of undisclosed related party R
transactions. This is a difficult area because IAS 24 does not have consideration for materiality. Thus,
even small RPTs should be disclosed by a company. Indeed, related party relationships where there is
control (eg a subsidiary) need to be disclosed even where there are no transactions with this party. 9
Matters to be addressed would include the importance of maintaining professional scepticism and
circumstances which may indicate the existence of related party relationships or transactions that
management has not identified.
• Make inquiries of management about the identities of related parties and any RPTs.
Where the applicable financial reporting framework establishes related party requirements
information should be readily available to management as the entity's information system should
record related party relationships and transactions.
• Obtain an understanding of controls established to identify, account for and disclose RPTs and to
authorise and approve significant transactions with related parties / outside the normal course of
business.
The auditor is also required to be alert for related party information when reviewing records or
documents. In particular, the auditor must inspect bank and legal confirmations and minutes of
meetings of the shareholders and those charged with governance. Where these procedures
reveal significant transactions outside the entity's normal course of business, the auditor must
enquire of management about the nature of these transactions and whether a related party could
be involved.
• Inquiries of and discussion with management and those charged with governance
• Inquiries of the related party
• Inspection of significant contracts with the related party
• Background research eg internet
• Review of employee whistle-blowing reports
If the auditor identifies related parties or significant related party transactions that management has not
previously identified or disclosed to the auditor the auditor must:
• Promptly communicate the relevant information to the other members of the engagement team.
• Where the applicable reporting framework establishes related party requirements request
management to identify all transactions with the newly identified related parties and inquire as to
why the entity's controls have failed to identify and disclose the transaction.
• Perform appropriate substantive audit procedures.
These might include making inquiries regarding the nature of the entity's relationships with the
newly identified related party, conducting an analysis of accounting records for transactions with
the newly identified related party and verifying the terms and conditions of the newly identified
related party transaction.
• Reconsider the risk that other unidentified related parties or significant related party transactions
may exist.
• If the non-disclosure by management appears intentional and therefore indicates possible fraud
evaluate the implications for the rest of the audit.
Identified significant related party transactions outside the entity's normal course of business
Where significant related party transactions outside the entity's normal course of business are identified
the auditor must:
• Obtain audit evidence that transactions have been appropriately authorised and approved.
If management has made assertions in the financial statements to the effect that a related party
transaction was conducted on terms equivalent to those prevailing in an arm's length transaction, the
auditor must obtain evidence to support this. The nature of the evidence obtained will depend on the
support management has obtained to substantiate their claim but may involve:
• Verifying the source of internal and external data supporting the assertion and testing it for
accuracy, completeness and relevance.
• Evaluating the reasonableness of any significant assumptions on which the assertion is based.
An entity may require its management and those charged with governance to sign individual
declarations in relation to related party matters. It may be helpful if any such declarations are addressed
jointly to a designated official of the entity and also to the auditor.
8.5.8 Documentation
The auditor is required to include in the audit documentation the identity of related parties and the nature
of related party relationships.
Point to note:
The law regarding transactions with directors was covered in Chapter 1 of this Study Manual.
C
8.6 Related parties: practical application H
The ICAEW Audit faculty has produced updated guidance in its publication The Audit of Related Parties A
in Practice. This proposes a five point action plan as follows: P
T
• Plan your work on the audit of related party relationships and transactions thoroughly. E
• Focus on the risk of material misstatement that might arise from related party transactions. R
• Understand the internal controls at the company to identify related parties and to record related
party transactions.
9
• Design procedures to respond to risks identified.
• Perform completion procedures.
Auditing the financial statements of a company adopting IFRS for the first time poses a special challenge
to the auditor, as set out in ISA 710 Comparative information: corresponding figures and comparative
financial statements. We have discussed the auditing of comparatives in detail in Chapter 8.
(a) The comparative information agrees with the amounts and other disclosures presented in the prior
period or, when appropriate, have been restated; and
(b) The accounting policies reflected in the comparative information are consistent with those applied
in the current period or, if there have been changes in accounting policies, whether those changes
have been properly accounted for and adequately presented and disclosed.
If the auditor identifies any possible misstatement, he/she should carry out additional audit procedures to
obtain sufficient appropriate audit evidence about whether a material misstatement actually exists.
In addition, auditors must obtain written representations for all the periods referred to in the auditor's
report. This means that written representations must be obtained for the restated period, as well as the
current period.
It is possible for different audit opinions to be expressed for each period. Where a modified audit opinion
is given for the restated period, an Other Matter paragraph should be included, explaining the reason
for the modification.
Summary
C
H
A
P
T
E
R
1 AZ
AZ is a quoted manufacturing company. Its finished products are stored in a nearby warehouse
until ordered by customers. AZ has performed very well in the past, but has been in financial
difficulties in recent months and has been reorganising the business to improve performance.
The trial balance for AZ at 31 March 20X3 was as follows:
$'000 $'000
Sales 124,900
Cost of goods manufactured in the year to
31 March 20X3 (excluding depreciation) 94,000
Distribution costs 9,060
Administrative expenses 16,020
Restructuring costs 121
Interest received 1,200
Loan note interest paid 639
Land and buildings (including land $20,000,000) 50,300
Plant and equipment 3,720
Accumulated depreciation at 31 March 20X2:
Buildings 6,060
Plant and equipment 1,670
Investment properties (at market value) 24,000
Inventories at 31 March 20X2 4,852
Trade receivables 9,330
Bank and cash 1,190
Ordinary shares of $1 each, fully paid 20,000
Share premium 430
Revaluation surplus 3,125
Retained earnings at 31 March 20X2 28,077
Ordinary dividends paid 1,000
7% loan notes 20X7 18,250
Trade payables 8,120
Proceeds of share issue 2,400
214,232 214,232
Additional information provided:
(i) The property, plant and equipment are being depreciated as follows:
(iii) Income tax for the year to 31 March 20X3 is estimated at $976,000. Ignore deferred tax.
(iv) The closing inventories at 31 March 20X3 were $5,180,000. An inspection of finished goods
found that a production machine had been set up incorrectly and that several production
batches, which had cost $50,000 to manufacture, had the wrong packaging. The goods
cannot be sold in this condition but could be repacked at an additional cost of $20,000. They
could then be sold for $55,000. The wrongly packaged goods were included in closing
inventories at their cost of $50,000.
(vi) The restructuring costs in the trial balance represent the cost of a major restructuring of the
company to improve competitiveness and future profitability.
(vii) No fair value adjustments were necessary to the investment properties during the period.
(viii) During the year the company issued 2m new ordinary shares for cash at $1.20 per share. The
proceeds have been recorded as 'Proceeds of share issue'.
Requirement
Prepare the statement of profit or loss and other comprehensive income and statement of changes
in equity for AZ for the year to 31 March 20X3 and a statement of financial position at that date.
Notes to the financial statements are not required, but all workings must be clearly shown.
2 Viscum
The Viscum Company accounts for non-current assets using the cost model.
On 25 April 20X6 Viscum classified a non-current asset as held for sale in accordance with IFRS 5
Non-current Assets Held for Sale and Discontinued Operations. At that date the asset's carrying
amount was CU30,000, its fair value was estimated at CU22,000 and the costs to sell at CU3,000.
On 15 May 20X6 the asset was sold for net proceeds of CU18,400.
Requirement
In accordance with IFRS 5, what amount should be included as an impairment loss in Viscum's
financial statements for the year ended 30 June 20X6?
3 Reavley
The Reavley Company accounts for non-current assets using the cost model.
On 20 July 20X6 Reavley classified a non-current asset as held for sale in accordance with IFRS 5
C
Non-current Assets Held for Sale and Discontinued Operations. At that date the asset's carrying
H
amount was CU19,500, its fair value was estimated at CU26,500 and the costs to sell at CU1,950.
A
The asset was sold on 18 October 20X6 for CU26,000. P
T
Requirement
E
In accordance with IFRS 5, at what amount should the asset be stated in Reavley's statement of R
financial position at 30 September 20X6?
4 Smicek
9
The Smicek Company classified an asset as being held for sale on 31 December 20X6. The asset
had been purchased for a cost of CU1.2 million on 1 January 20X4, and then had a 12 year useful
life. On 31 December 20X6 its carrying amount was CU900,000, its fair value was CU860,000, and
the expected sale costs were CU20,000.
On 31 December 20X7 the board of Smicek, having failed to sell the asset during 20X7, decided to
reverse their original decision and therefore use the asset in the business. At 31 December 20X7
the asset had a fair value of CU810,000 and expected sale costs of CU20,000. The directors
estimate that annual cash flows relating to the asset would be CU200,000 per year for the next 6
years. The effect of discounting is not material.
Requirement
What is the effect on profit or loss of Smicek's ceasing to classify the asset as held for sale,
according to IFRS 5 Non-current Assets Held for Sale and Discontinued Operations?
The Ndombe Company classified a group of assets as held for sale on 31 December 20X6. Their
fair value less costs to sell was CU1,180,000.
During 20X7 the company decided that one of the assets, a polishing machine, should no longer be
treated as an asset held for sale. The sale of the other assets was delayed due to events beyond
the control of Ndombe and the company remains committed to their sale, which is highly probable
in 20X8.
Under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations what are the
amounts that should be shown under assets on the statement of financial position at 31 December
20X6 and 31 December 20X7?
6 Sapajou
The Sapajou Company bought a property with a useful life of 10 years for CU1,200,000 on 1
January 20X4.
On 1 July 20X6 the board of Sapajou made a decision to sell the property, and immediately
vacated it and advertised it for sale. At this date fair value less costs to sell was estimated at
CU880,000. Negotiations with a buyer appeared successful, and a sale was provisionally agreed
for 1 August 20X7 for CU880,000. At the last minute the buyer withdrew and Sapajou had to re-
advertise the property.
A new buyer was found in November 20X7 and a new price was agreed at fair value less costs to
sell of CU995,000. The sale is scheduled to take place in February 20X8.
Requirement
What are the amounts that should be included in profit or loss for the years ending 31 December
20X6 and 31 December 20X7?
7 Sulafat
The Sulafat Company has a 70% subsidiary Vurta and is a venturer in Piton, a joint venture
company. During the financial year to 31 December 20X6, Sulafat sold goods to both companies.
Consolidated financial statements are prepared combining the financial statements of Sulafat and
Vurta.
Requirement
Which transactions should be disclosed under IAS 24 Related Party Disclosures, in the separate
financial statements of Sulafat for 20X6?
8 Phlegra
In the year ended 31 December 20X7, the Phlegra Company undertook transactions with the
following entities to the value stated.
(b) The Chub Company, which sources 100% of its raw materials requirements from Phlegra
CU190,000.
Requirement
Under IAS 24 Related Party Disclosures, what is the total amount to be disclosed in respect of
transactions with related parties in Phlegra's financial statements for the year ended 31 December
20X7?
9 Mareotis
The Mareotis Company is a partly-owned subsidiary of the Bourne Company. In the year ended
31 December 20X7 Mareotis undertook transactions with the following entities to the value stated.
(a) The Hayles Company, in which the Wrasse Company holds 55% of the equity. Bourne holds
40% of the equity of Wrasse and has the power to appoint 3 out of the 5 members of Wrasse's
board of directors: CU300,000.
(b) The Galaxius Company, which is controlled by Danielle (the aunt of Agnes, a member of
Mareotis's board of directors): CU500,000.
Requirement
Under IAS 24 Related Party Disclosures, what is the total amount of transactions with related
parties to be disclosed in Mareotis's financial statements for the year ended 31 December 20X7?
10 Anteater
The Anteater Company operates a saleroom in a city centre from premises which it leases from the
Moreno Company under an operating lease according to IAS 17 Leases. Anteater's accounting
year end is 31 December each year and it is currently preparing half-yearly interim financial
statements for the six months to 30 June 20X7.
The lease agreement on the store premises contains a clause for contingent lease payments as
C
follows:
H
'If the revenue of Anteater in any year to 31 December exceeds CU123 million then an additional A
lease rental of CU4.2 million becomes payable in respect of that year to Moreno on 31 March of the P
following year.' T
Anteater's business is seasonal due to high sales around the Christmas period. Only about one E
third of annual sales are normally earned in the first six months of the year. In January 20X7 a R
refurbishment of the premises was carried out and this is attracting more customers than had been
budgeted for.
9
Relevant information is as follows:
CUm
Budgeted sales for the six months to 30 June 20X7 39
Budgeted sales for the year to 31 December 20X7 117
Actual sales for the six months to 30 June 20X7 49
The budgets were set in December 20X6 and have not been changed.
Requirement
According to IAS 34 Interim Financial Reporting, what amount should be recognised in profit or loss
for Anteater for the six months to 30 June 20X7 in respect of the contingent lease payment clause?
11 Marmoset
During 20X7 the directors drew up a plan to introduce a new bonus scheme for all junior
consultants in order to provide incentives and improve retention. The details of the scheme were
announced to employees the day before the interim financial statements were released on 15
August 20X7. Under the planned scheme any bonus would be paid on 31 March 20X8.
The bonus will be equal to 1% of profit before tax (calculated prior to recognising the bonus) of the
year ended 31 December 20X7.
The business is seasonal such that 60% of the annual profit before tax is earned in the first 6
months of the year. The profit before tax in the interim financial statements for the six months to 30
June 20X7 is CU6 million.
Requirement
What amount should be recognised in profit or loss for Marmoset for the six months to 30 June
20X7 in respect of the bonus, according to IAS 34 Interim Financial Reporting?
12 Aconcagua
The Aconcagua Company sells fashion shoes, the price of which varies during the year. Its
accounting year ends on 31 December and it prepares half-yearly interim financial statements.
At 30 June 20X7 it has inventories of 2,000 units which cost CU30 each. The net realisable value of
the inventories at 30 June, when the shoes are out of season, is CU20 each. No sales are
expected in the period to 31 December 20X7, but the expected net realisable value of the shoes at
that date (when they are about to come back into season) is CU28 each.
Requirement
Should any changes in inventory values be reflected in the interim financial statements of
Aconcagua for the six months ending 30 June 20X7 and for the six months ending 31 December
20X7, according to IAS 34 Interim Financial Reporting?
• Presentation and disclosure rules apply only to material items IAS 1.31 and IAS 1.7
• Requires an entity to report its operating segments based on the data IFRS 8 Paragraph
reported internally to management. Geographical disclosures of external 20–22
revenue and non-current assets are also required.
• The minimum disclosure is of profit/loss by segment.
Discontinued operations
• Disclosures on the face of the statement of profit or loss and other IFRS 5.33(a)
comprehensive income:
• Periods for which interim financial statements are required to be presented IAS 34.20
• An entity should apply the same accounting policies in its interim financial IAS 34.28
statements as are applied in its annual financial statements, except for
accounting policy changes made after the date of the most recent annual
financial statements that are to be reflected in the next annual financial
statements. However, the frequency of an entity's reporting (annual, half-
yearly, or quarterly) should not affect the measurement of its annual results.
To achieve that objective, measurements for interim reporting purposes
should be made on a year-to-date basis.
• Revenues that are received seasonally, cyclically, or occasionally within a IAS 34.37
financial year shall not be anticipated or deferred as of an interim date if
anticipation or deferral would not be appropriate at the end of the entity's
financial year.
• Costs that are incurred unevenly during an entity's financial year shall be IAS 34.39
anticipated or deferred for interim reporting purposes if, and only if, it is also
appropriate to anticipate or defer that type of cost at the end of the financial
year.
ISA 501
ISA 710
C
H
A
P
T
E
R
AZ
Statement of financial position as at 31 March 20X3
$'000
Non-current assets
Property, plant and equipment (W2) 48,262
Investment properties 24,000
72,262
Current assets
Inventories (5,180 – (W3) 15) 5,165
Trade receivables 9,330
Cash and cash equivalents 1,190
15,685
87,947
Equity
Share capital (20,000 + (W4) 2,000) 22,000
Share premium (430 + (W4) 400) 830
Retained earnings (28,077 – 1,000 + 2,930) 30,007
Revaluation surplus (3,125 + 4,000) 7,125
59,962
Non-current liabilities
7% loan notes 20X7 18,250
Current liabilities
Trade payables 8,120
Income tax payable 976
Interest payable (1,278 – 639) 639
9,735
87,947
WORKINGS
(1) Expenses
Cost of Distribution Admin Other
sales
$'000 $'000 $'000 $'000
Per TB 94,000 9,060 16,020 121
Opening inventories 4,852
Depreciation on buildings (W2) 1,515
Depreciation on P&E (W2) 513
Closing inventories (5,180 – (W3) 15) (5,165)
94,200 9,060 17,535 121
(2) Property, plant and equipment
Land Buildings P&E Total
$'000 $'000 $'000 $'000
Cost b/d 20,000 30,300 3,720 54,020
Acc'd depreciation b/d – (6,060) (1,670) (7,730)
20,000 24,240 2,050 46,290
Depreciation charge for year: C
• $30,300 × 5% – (1,515) (1,515) H
• ($3,720 – $1,670) × 25% (513) (513) A
20,000 22,725 1,537 44,262 P
Revaluation (balancing figure) 4,000 – – 4,000 T
Carrying amount c/d 24,000 22,725 1,537 48,262 E
(3) Inventories R
$'000
Defective batch:
9
Selling price 55
Cost to complete: repackaging required (20)
∴NRV 35
Cost (50)
∴Write off required (15)
(4) Share issue
The proceeds have been recorded separately in the trial balance. This requires a transfer to
the appropriate accounts:
$'000
DR Proceeds of share issue 2,400
CR Share capital (2,000 × $1) 2,000
CR Share premium (2,000 × $0.20) 400
2 Viscum
CU11,000
IFRS 5.15 requires assets classified as held for sale to be measured at the time of classification at
the lower of (i) the carrying value (CU30,000) and (ii) the fair value less costs to sell (CU19,000).
IFRS 5.20 requires recognition of the resulting impairment loss (CU30,000 – CU19,000). The gain
or loss on disposal is treated separately per IFRS 5.24.
3 Reavley
CU19,500
IFRS 5.15 requires that a non-current asset held for sale should be stated at the lower of (i) the
carrying amount (CU19,500) and (ii) the fair value less costs to sell (CU24,550).
4 Smicek
CU40,000
At the end of the current year, a non-current asset that has ceased to be classified as held for sale
should be valued at the lower of:
(i) The carrying amount had it not been recognised as held for sale, ie to charge a full year's
depreciation of CU100,000 for 20X7 and reduce the carrying amount from CU900,000 at
31 December 20X6 to CU800,000.
(ii) The recoverable amount, which is the higher of the CU790,000 fair value less costs to sell
(CU810,000 less CU20,000) and value in use (the cash flows generated from using the asset)
of CU1,200,000.
Therefore the asset should be carried at CU800,000 in the statement of financial position at
31 December 20X7.
At the end of the prior year, when the asset was classified as held for sale, the asset would have
been carried at the lower of carrying amount (CU900,000), and fair value less costs to sell of
CU840,000 (CU860,000 less CU20,000). Therefore the asset has fallen in value from CU840,000
to CU800,000 in the current year, giving a charge to profits of CU40,000.
5 Ndombe
31 December 20X6 the assets should be shown in the statement of financial position at a value of
CU1,140,000.
31 December 20X7 the assets should be shown in the statement of financial position at a value of
CU1,040,000.
At the end of 20X6 the assets are classified as held for sale. The assets should be measured at the
lower of carrying amount and fair value less costs to sell (IFRS 5.15). The carrying amount was
CU1,140,000 and the fair value less costs to sell was CU1,180,000 so they were measured at
CU1,140,000.
At the end of 20X7, it is still possible to classify the 'other' assets as held for sale as the company is
still committed to the sale (IFRS 5.29). These assets would be measured at fair value less costs to
sell of CU880,000 as this is lower than the carrying amount of CU900,000.
However the polishing machine should be valued at the lower of CU160,000 carrying amount had
classification as held for sale not occurred (CU400,000 × 2/5) and the higher of fair value less costs
to sell (CU190,000) and value in use (CU170,000) (IFRS 5.27). This gives a value of CU160,000.
An expense of CU20,000 is shown in the profit or loss part of the statement of profit or loss and
other comprehensive income for the year ended 31 December 20X6.
Income of CU20,000 is shown in the profit or loss part of the statement of profit or loss and other
comprehensive income for the year ended 31 December 20X7.
Under IFRS 5.15 an asset classified as held for sale is measured at the lower of carrying amount
immediately prior to the reclassification of CU900,000 (CU1,200,000 – 2.5 × CU120,000), and fair
value less costs to sell of CU880,000. The CU20,000 impairment loss is charged to profits (IFRS
5.20).
In the following year, the increase in fair value less costs to sell is CU115,000, but only CU20,000
of this can be recognised in profit (IFRS 5.21) as this is the reversal of the previous impairment
loss.
7 Sulafat
Both Vurta and Piton: disclosure is required of transactions with both Vurta and Piton. See IAS
24.3, which states that entities under both direct and common control are related parties.
8 Phlegra
Nil under IAS 24.11 (a) Two entities are not related parties simply because they have a director in
common, nor per IAS 24.11 (b) simply because the volume of transactions between them results in
economic dependence.
9 Mareotis
CU300,000. Under IAS 24.9, Hayles is a related party of Mareotis. Bourne 'controls' Wrasse (by
virtue of the power to appoint the majority of directors) and Wrasse 'controls' Hayles (by virtue of
holding the majority of the equity). So Bourne 'controls' both Mareotis and Hayles, which are
therefore related parties as a result of being under common control.
C
Being an aunt does not make Danielle a close member of Agnes's family, so although Galaxius is
controlled by a relative of Agnes, the relationship is not close enough to make Galaxius a related H
party of Mareotis. So only transactions with Hayles have to be disclosed. A
P
IAS 34 Interim Financial Reporting T
10 Anteater E
R
CU2.1 million
Interim reports should apply the normal recognition and measurement criteria, using appropriate
estimates under IAS 34.41. 9
There is a constructive obligation in relation to the contingent lease payments, which should be
measured by reference to all the evidence available. As the trigger level of sales is expected to be
achieved, then under IAS 34 App.B B7 the amount to be recognised is CU4.2m × 6/12.
11 Marmoset
Nil
Interim reports should apply the normal recognition and measurement criteria, using appropriate
estimates under IAS 34.41.
There is no legal or constructive obligation at the interim reporting date to pay the bonus as no
announcement had been made at this date. Under IAS 34 App B B6 no expense is required.
12 Aconcagua
Interim reports should apply the normal recognition and measurement criteria, using appropriate
estimates under IAS 34.41. IAS 34 App B B25-B26 link these general principles to inventories by
requiring them to be written down to net realisable value at the interim date; the write-down is then
reversed at the year end, if appropriate.
So the profit decrease in the six months to 30 June 20X7 is 2,000 × (CU30 – CU20) = CU20,000,
while the profit increase in the six months to 31 December 20X7 is 2,000 × (CU28 – CU20) =
CU16,000.
(a) Its reported revenue is 10% or more of the combined revenue (external and internal) of all
operating segments, or
(b) The absolute amount of its reported profit or loss is 10% or more of the greater of the combined
profit of all operating segments that did not report a loss and the combined reported loss of all
operating segments that reported a loss, or
(c) Its assets are 10% or more of the combined assets of all operating segments.
Profit or loss as % of
Revenue as % of total profit of all segments Assets as % of total
revenue (CU238m) in profit (CU29m) assets CU336m
* The chemicals segments are aggregated due to their similar economic characteristics
At 31 December 20X5 four of the six operating segments are reportable operating segments: C
H
Chemicals
A
All size criteria are met P
T
Pharmaceuticals wholesale
E
All size criteria are met R
Pharmaceuticals retail
The Pharmaceuticals retail segment is not separately reportable as it does not meet the quantitative 9
thresholds. It can, however, still be reported as a separate operating segment if management believes
that information about the segment would be useful to users of the financial statements. Alternatively,
the group could consider amalgamating it with the Pharmaceuticals wholesale segment, providing the
two operating segments have similar economic characteristics and share a majority of the 'aggregation'
criteria, which, excluding the type of customer, may be the case. Otherwise it would be disclosed in an
'All other segments' column.
Cosmetics
The Cosmetics segment does not meet the quantitative thresholds and therefore is not separately
reportable. It can also be reported separately if management believes the information would be useful to
users. Alternatively the group may be able to amalgamate it with the Body care segment, providing the
operating segments have similar economic characteristics and share a majority of the 'aggregation'
criteria. Otherwise it would also be disclosed in an 'All other segments' column.
The Hair care segment is separately reported due to its profitability being greater than 10% of total
segments in profit.
Body care
Note:
IFRS 8.15 states that at least 75% of total external revenue must be reported by operating segments.
This condition has been met as the reportable segments account for 82% of total external revenue
(158/192).
(i) Identify accounting policies that comply with IFRSs effective at 31 December 20X8 (the
reporting date for the first IFRS financial statements).
(ii) Restate the opening statement of financial position at 1 January 20X7 (the date of transition)
using these IFRSs retrospectively, by:
(1) Recognising all assets and liabilities whose recognition is required by IFRSs.
(2) Not recognising items as assets or liabilities if IFRSs do not permit such recognition.
(3) Reclassifying items that were recognised under previous GAAP as one type of asset,
liability or component of equity, but are a different type of asset, liability or component of
equity under IFRSs.
(4) Measuring all recognised assets and liabilities in accordance with IFRSs.
(iii) Explain the effect of the transition from previous GAAP to IFRSs, by presenting:
(1) A reconciliation of equity reported under previous GAAP to equity under IFRSs at the
date of transition and at the last previous GAAP reporting date; and
(2) A reconciliation of the profit or loss reported under previous GAAP to profit or loss
reported under IFRSs for the last period presented under previous GAAP.
If Europa presented a statement of cash flows under previous GAAP, it should also explain any
material adjustments to the statement of cash flows.
Although the general rule is that all IFRSs should be applied retrospectively, a number of
exemptions are available. These are intended to cover cases in which the cost of complying fully
with a particular requirement would outweigh the benefits to users of the financial statements.
Europa may choose to take advantage of any or all of the exemptions.
(b) Changing from previous GAAP to IFRSs is likely to be a complex process and should be carefully
planned. Although previous GAAP and IAS/IFRS may follow broadly the same principles there are
still likely to be many important differences in the detailed requirements of individual standards.
If Europa has foreign subsidiaries outside Molvania it will need to ensure that they comply with any
previous reporting requirements. This may mean that subsidiaries have to prepare two sets of
financial statements: one using their previous GAAP; and one using IFRSs (for the consolidation).
(i) The differences between previous GAAP and IFRSs as they affect the group financial
statements in practice. The company will need to carry out a detailed review of current
accounting policies, paying particular attention to areas where there are significant differences
between previous GAAP and IFRSs. These will probably include deferred tax, business
combinations, employee benefits and foreign currency translation. It should be possible to
estimate the effect of the change by preparing pro-forma financial statements using IFRSs.
(ii) The level of knowledge of IFRSs of current finance staff (including internal auditors). It will
probably be necessary to organise training and the company may need to recruit additional C
personnel. H
A
(iii) The group's accounting systems. Management will need to assess whether computerised P
accounting systems can produce the information required to report under IFRSs. They will
T
also need to produce new consolidation packages and accounting manuals.
E
Lastly, the company should consider the impact of the change to IFRSs on investors and their R
advisers. For this reason management should try to quantify the effect of IFRSs on results and
other key performance indicators as early as possible.
9
(c) (i) Accounting estimates
Estimates under IFRSs at the date of transition must be consistent with those made at the
same date under previous GAAP (after adjustments to reflect any difference in accounting
policies). The only exception to this is if the company has subsequently discovered that these
estimates were in error. This is not the case here and therefore the estimates are not adjusted
in the first IFRS financial statements.
The treatment of this depends on the reason why Europa did not recognise a provision under
previous GAAP at 31 December 20X7.
If the requirements of previous GAAP were consistent with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets, presumably the directors concluded that an outflow of
economic benefit was not probable and that the recognition criteria were not met. In this case,
Europa's assumptions under IFRSs are consistent with its previous assumptions under
If the requirements of previous GAAP were not consistent with IAS 37, Europa must determine
whether it had a present obligation at 31 December 20X7. The directors should take account
of all available evidence, including any additional evidence provided by events after the
reporting period up to the date the 20X7 financial statements were authorised for issue in
accordance with IAS 10 Events After the Reporting Period.
The outcome of the court case confirms that Europa had a liability in September 20X7 (when
the events that resulted in the case occurred), but this event occurred after the 20X7 financial
statements were authorised for issue. Based on this alone, the company would not recognise
a provision at 31 December 20X7 and the $10m cost of the court case would be recognised in
the 20X8 financial statements. If the company's lawyers had advised Europa that it was
probable that they would be found guilty and suggested the expected settlement amount
before the financial statements were authorised for issue, the provision would be recognised
in the 20X7 financial statements reporting under IFRS for that amount.
The tax rate for the entire year is applied to the profits for the interim period.
(a) In this case the key issue is whether or not the asset should be classified as held for sale. In
accordance with IFRS 5 a held for sale asset must be available for immediate sale. In this instance
this does not appear to be the case as the asset is still required for production purposes until after
the year end. It should only be classified as held for sale at the end of January 20X8 when it has
been serviced and uninstalled. Relevant audit evidence would include orders to be fulfilled
compared to goods made by this machine compared to available inventory, budgets, inquiries of
production staff.
• Discuss with management intentions to run down production and the time scales involved.
• If material, agree with the management the reclassification of the asset as part of plant and
machinery.
• Consider whether an impairment adjustment is required as the asset will no longer be used for
its current purpose.
Land
(a) The key issue is the valuation of the land. As the entity has adopted the revaluation model the land
should have been revalued to fair value (CU210,000) immediately before being reclassified as held
for sale. Any gain would be recognised in the revaluation surplus and disclosed as other
comprehensive income in the statement of profit or loss and other comprehensive income. On
reclassification the CU6,000 costs to sell would be recognised in profit or loss as an impairment
loss resulting in a carrying value of the asset of CU204,000 (CU210,000 – CU6,000).
• Review the process of estimating the fair value of the land on 1 October and the necessary
advertising costs.
• Discuss with management why the land was not revalued on classification as held for sale.
Reporting revenue
Introduction
Topic List
1 Revenue recognition
2 Construction contracts
3 Criticisms and current developments
4 Audit focus
Summary and Self-test C
H
Technical reference
A
Answers to Self-test
P
Answers to Interactive questions T
E
R
10
• Explain how different methods of recognising and measuring assets and liabilities can
affect reported financial performance
• Explain and appraise accounting standards that relate to reporting performance: in respect
of […] revenue; construction contracts
• Calculate and disclose, from financial and other data, the amounts to be included in an
entity’s financial statements according to legal requirements, applicable financial reporting
standards and accounting and reporting policies
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 1(e), 2(a), 2(b), 2(d), 14(c), 14(d), 14(f)
Section overview
• IFRS 15 Revenue from Contracts with Customers governs the recognition of revenue in general
and in specific (common) types of transaction. Generally, recognition should be when it is probable
that future economic benefits will flow to the entity and when these benefits can be measured
reliably.
• Income, as defined by the IASB’s Conceptual Framework, includes both revenues and gains.
Revenue is income arising in the ordinary course of an entity’s activities and it may be called
different names, such as sales, fees, interest, dividends or royalties.
• There are problems associated with revenue recognition, and proposals to remedy those problems
are being considered.
• The entity has transferred the significant risks and rewards of ownership of the goods to the
buyer
• The entity has no continuing managerial involvement to the degree usually associated with
ownership, and no longer has effective control over the goods sold
• It is probable that the economic benefits associated with the transaction will flow to the entity
Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably, the
associated revenue should be recognised by reference to the stage of completion of the transaction at
the reporting date.
The outcome of a transaction can be estimated reliably when:
• It is probable that the economic benefits associated with the transaction will flow to the entity C
H
• The stage of completion of the transaction at the reporting date can be measured reliably
A
• The costs incurred for the transaction and the costs to complete the transaction can be measured P
reliably T
E
When services are performed by an indeterminate number of acts over a period of time, revenue should
R
normally be recognised on a straight-line basis. If one act is of more significance than the others, then
the significant act should be carried out before revenue is recognised.
When the outcome of the transaction involving the rendering of services cannot be estimated reliably, 10
revenue is recognised only to the extent of the expenses recognised that are recoverable.
• Accounting policies
IFRS 15 is generally agreed to be out of date. It does not address the relatively complex transactions that now
take place, for example, barter transactions, transactions involving options, sales of licences for the use of
computer software. This lack of specific guidance has led to aggressive earnings management: creative
accounting techniques whereby revenue is recognised before it has been earned.
The IASB has a current project to develop a new standard, but this is at an early stage. In the meantime the
general principles of IFRS 15 and of the IASB Framework should be applied.
At Advanced level, revenue recognition may relate to issues of off-balance sheet finance, substance over form
or creative accounting.
Given that prudence is the main consideration, discuss under what circumstances, if any, revenue might be
recognised at the following stages of a sale.
(a) Goods are acquired by the business which it confidently expects to resell very quickly.
(b) A customer places a firm order for goods.
(c) Goods are delivered to the customer.
(d) The customer is invoiced for goods.
(e) The customer pays for the goods.
(f) The customer’s cheque in payment for the goods has been cleared by the bank.
Caravans Deluxe is a retailer of caravans, dormer vans and mobile homes, with a year end of 30 June. It is
having trouble selling one model – the CU30,000 Mini-Lux, and so is offering incentives for customers who
buy this model before 31 May 20X7:
(a) Customers buying this model before 31 May 20X7 will receive a period of interest free credit, provided
they pay a non-refundable deposit of CU3,000, an instalment of CU15,000 on 1 August 20X7 and the
balance of CU12,000 on 1 August 20X9.
(b) A three-year service plan, normally worth CU1,500, is included free in the price of the caravan.
On 1 May 20X7, a customer agrees to buy a Mini-Lux caravan, paying the deposit of CU3,000. Delivery is
arranged for 1 August 20X7.
As the sale has now been made, the sales director of Caravans Deluxe wishes to recognise the full sale price
of the caravan, CU30,000, in the financial statements for the year ended 30 June 20X7.
Requirement
Advise the director of the correct accounting treatment for this transaction. Assume a 10% discount rate. Show
the journal entries for this treatment.
Service concession arrangements are arrangements whereby a government or other body grants contracts for
the supply of public services – such as roads, energy distribution, prisons or hospitals – to private operators.
The objective of IFRIC 12 is to clarify how certain aspects of existing IASB literature are to be applied to
service concession arrangements.
(a) In one, the operator receives a financial asset, specifically an unconditional contractual right to
receive cash or another financial asset from the government in return for constructing or upgrading
the public sector asset.
(b) In the other, the operator receives an intangible asset – a right to charge for use of the public sector
asset that it constructs or upgrades. A right to charge users is not an unconditional right to receive
cash because the amounts are contingent on the extent to which the public uses the service.
IFRIC 12 allows for the possibility that both types of arrangement may exist within a single contract: to
the extent that the government has given an unconditional guarantee of payment for the construction of
the public sector asset, the operator has a financial asset; to the extent that the operator has to rely on
the public using the service in order to obtain payment, the operator has an intangible asset.
(b) The shortfall, if any, between amounts received from users of the public service and specified or
determinable amounts, even if payment is contingent on the operator ensuring that the
infrastructure meets specified quality or efficiency requirements.
(b) The amount of proceeds allocated to the award credits is measured by reference to their fair value,
that is, the amount for which the award credits could have been sold separately.
10
(c) The entity shall recognise the deferred portion of the proceeds as revenue only when it has fulfilled
its obligations. It may fulfil its obligations either by supplying the awards itself or by engaging (and
paying) a third party to do so.
(e) If IFRS 15 causes an entity to change its accounting policy for customer loyalty awards, IAS 8
applies.
To recognise revenue in line with IFRIC 13, this should be apportioned by taking the number of points
redeemed in the period over the total number of points expected to be redeemed. The revenue to be
recognised in the year is CU3,125,000 (125,000/520,000), leaving CU9,875,000 (CU13,000,000 –
CU3,125,000) as a deferred revenue liability at the year end.
In 2009, the IASB issued some improvements to various IFRS , most of which are minor. The change
which is relevant here is the additional guidance in the appendix to IFRS 15 Revenue from Contracts
with Customers on determining whether an entity is acting as an agent or principal. The new guidance
is as follows:
Acting as principal
An entity is acting as a principal when it is exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. Features that indicate that an entity is acting as a principal
include (individually or in combination):
(a) Primary responsibility for providing goods or services to the customer or for fulfilling the order
(b) The entity having the inventory risk before or after the customer order, during shipping or on return
(c) Discretion in establishing prices (directly or indirectly) eg providing additional goods or services
Acting as agent
An entity is acting as an agent when it is not exposed to the significant risks and rewards associated with
the sale of goods or rendering of services. One feature that indicates that an entity is an agent is that the
amount the entity earns is predetermined eg fixed fee per transaction or percentage of amount billed to
the customer.
Solution
Williams bears the risk of loss in value of the handset, as the dealer may return any handsets before a
service contract is signed with a customer. In addition, Williams sets the price of the handset. Therefore
the dealer, in this case, is acting as an agent for the sale of the handset and service contract. The
handset cannot be sold separately from the service contract, so the two transactions must be taken
together because the commercial effect of either transaction cannot be understood in isolation. Williams
earns revenue from the service contract with the final customer, not from the sale of the handset to the
dealer.
IFRS 15 does not deal directly with agency, but implies that revenue for an agent is not the amounts
collected on behalf of the principal, but the commission earned for collecting them. From Williams's point
of view revenue is not earned when the handsets are sold to the dealer, so revenue should not be
recognised at this point. Instead the net payment of CU130 (commission paid to the agent less cost of
the handset) should be recognised as a customer acquisition cost, which may qualify as an intangible
asset under IAS 38. If it is so recognised, it will be amortised over the twelve month contract. Revenue
from the service contract will be recognised as the service is rendered.
2 Construction contracts
Section overview
• The key issue regarding construction contracts is how to recognise revenue and profits over the
period of contract activity.
• IFRS 15 explains what is meant by a construction contract and the two main types of contract.
• Revenue and costs relating to a contract should be recognised using the stage of completion
method, if the outcome of the contract can be measured reliably.
• If it cannot be measured reliably, revenue should only be recognised to the extent of costs
recoverable from the customer.
• If it is estimated that a loss will be incurred on a contract, that loss should be recognised
C
immediately.
H
A
2.1 Context
P
In some industries entities will make or build substantial assets for sale, such as aeroplanes or car T
assembly lines, which will often take a number of years to complete. E
R
The accounting problem is that if a profitable construction contract spans a number of accounting
periods:
IFRS 15 requires revenue and costs (and therefore profit) to be recognised as contract activity
progresses. The measurement of contract activity can require a significant amount of judgement in the
assessment of the progress to date, and the ultimate outcome, of the contract. Professional skills and
IFRS 15 applies to construction contracts, that is the entities constructing the assets. The customer
should account for the asset in accordance with IAS 16 Property, Plant and Equipment.
Contract revenue and contract costs should only be recognised in profit or loss when the outcome of the
contract can be estimated reliably.
Contract revenue should be built up over the life of the contract as revenue due under the originally
agreed contract plus any subsequent changes or variations that have been agreed; all these component
parts should be measured at the fair value of the consideration receivable.
In the early stages of a contract the contract revenue will often be an estimate of the final amount as it
may be dependent upon future events.
Any variations to the original estimated contract revenue should only form part of contract revenue
when:
IFRS 15 sets out a list of costs which directly relate to a specific contract. These are basically the same
sort of variable costs as can be capitalised when plant and equipment is manufactured. More careful
judgements of the amounts attributable to a specific contract are needed when allocating costs incurred
in contract activity in general, such as:
• Insurance
• Costs of design and technical assistance not directly related to the specific contract
• Construction overheads, such as the costs of payroll administration for construction staff.
Overhead costs should be allocated to individual contracts on a systematic basis, based on normal
levels of activity.
Points to note:
1 When entities seek contracts with public bodies they incur quite substantial contract negotiation
costs. These should be treated in a way quite similar to development expenses under IAS 38
Intangible Assets:
• They should be recognised as an expense up to the time when it first becomes probable that
the contract will be won.
• Negotiation costs subsequent to that time should be included in contract costs.
• Negotiation costs already expensed cannot subsequently be added to contract costs.
2 Finance costs should be included in contract costs under IAS 23 Borrowing Costs.
An entity is involved in a number of construction contracts extending over long periods and has incurred
the following costs in respect of construction contracts during the year ended 31 March 20X7.
CU'000
Labour 632
Materials 1,325
Design costs for specific contracts 463
Research costs 321
General administration costs 121
Borrowing costs 56
Selling costs 106
What is the total amount of costs which should be allocated to construction contracts in accordance with
IFRS 15 in the year ended 31 March 20X7?
10
2.4.3 Stage of completion
As a simple example, if a contract is half complete at the year end then half the revenue and half the
costs attributable to the contract should be recognised in profit or loss for that year.
The effect is to recognise half the profit, but IFRS 15 consistently talks about recognising revenue and
costs.
IFRS 15 illustrates two methods that can be used to measure an entity’s progress towards complete
satisfaction of a performance obligation satisfied over time in accordance with para 35-37 include the
following:
1 Cash received from the customer is usually a poor indicator of the stage of completion.
2 Any exam question will contain somewhere within it information about how to measure the stage of
completion.
The criteria to be met for reliability depend upon the type of contract.
• It is probable that the economic benefits associated with the contract will be received by the entity, and
• Total costs can be clearly identified and reliably measured.
20X5 20X6
CU'000 CU'000
Contract costs incurred to date 100 150
The outcome of the contract can be estimated reliably at both year ends.
Solution
The best approach is:
• In the first year, to identify the costs to be recognised in cost of sales, calculate the profit and then
insert revenue as the balancing figure.
• In subsequent years, to do the same on a cumulative basis and then deduct amounts recognised
in previous years.
For 20X5 cost of sales is CU100,000 and profit CU20,000 (20% thereof). So revenue is CU120,000.
For 20X6 the amounts to date are cost of sales CU150,000, profit CU30,000 (20% thereof) and revenue
CU180,000. Deducting 20X5 amounts gives figures of CU50,000, CU10,000 and CU60,000
respectively.
The following information relates to a fixed price contract of CU500,000 obtained in 20X5 by a business
with a 30 June year end.
20X5 20X6 20X7
CU'000 CU'000 CU'000
Contract costs incurred to date 100 300 410
Estimated costs to complete 300 120 –
Total contract costs – estimated in 20X5 and 20X6, actual in 20X7 400 420 410
Profit – estimated in 20X5 and 20X6, actual in 20X7 100 80 90
The outcome of the contract can be estimated reliably at all three year ends.
Requirement
Calculate the amounts to be recognised in profit or loss for each of the three years.
• Contract revenue should only be recognised to the extent that it is probable that the costs are
recoverable from the customer.
• No profit is recognised prior to the outcome of the contract being reliably estimated C
• A loss is recognised immediately if costs incurred cannot be recovered from the customer. H
A
2.7 Expected losses P
T
When the process of estimating the outcome of a contract results in an overall loss being forecast, the
loss should be recognised immediately. E
R
Point to note:
Such a loss should be recognised even if work on the contract has not yet commenced.
10
Worked example: Expected loss
The following details relate to one of an entity’s construction contracts:
CU'000
Estimated contract revenue 400
Solution
On the basis of the estimated costs to complete, the contract will be loss-making:
The difference between costs incurred and cost of sales (CU240,000 – 258,000 = CU18,000) should be
recognised as a provision for losses and become part of the gross amounts due from/to customers, as
shown in Section 2.9.
Point to note:
If the contract is profitable, it is often the case that revenue is the balancing figure; if it is loss-making,
then cost is often the balancing figure.
• The combining of contracts into a single contract. If there are two contracts, one profitable, the
other loss-making, combining them into a single contract will result in the loss being offset against
the profit. Management should be careful not to combine contracts solely to avoid the immediate
recognition of the loss on the loss-making contract.
• The costs to be incurred in the future – any understatement will result in an overstatement of the
profit recognised in the current period.
• Any additional revenue which will be recovered from the customer as a result of variations to the
contract – at the end of the current reporting period there may be uncertainty as to whether the
customer will agree that additional amounts are a cost to the customer rather than to the contractor.
Without a consistent approach, there is a risk that estimates may be made to achieve a current period
total profit to suit management, rather than one which can be regarded by users of financial statements
as a faithful representation of the profit actually earned.
• The aggregate of the costs incurred and profits less losses recognised to date. These are the
cumulative figures for uncompleted contracts.
• The advances received from customers, that is the amounts paid by them in advance of the related
work being performed. These show the extent to which customers are financing the business by
lending money in advance of work being done on their behalf.
• Retentions, being the amounts held back by customers as security for any remedial work.
• Gross amounts due from customers and due to customers, calculated as:
CU
Costs incurred to date X
Add: profit recognised X
Less: losses recognised on contract (X)
Less: progress billings made (X)
X/(X)
If the total is positive, it is the amount due from customers and is recognised as a current asset in
the statement of financial position.
If the total is negative, it is the amount due to customers (excess billings) and is recognised as a
current liability in the statement of financial position.
These provide information by which users of financial statements can assess the current profitability and
make estimates of profitability in the future.
Section overview
• IAS 18 Revenue and IAS 11 Construction Contracts have both been criticised, and changes are
made through IFRS 15 .
(a) Discuss the reasons why it is relevant to take into account credit risk and the time value of money
in assessing revenue recognition.
(b) (i) Petra enters into a contract with a customer to provide computers at a value of CU1 million.
The terms are that payment is due one month after the sale of the goods. On the basis of
experience with other contractors with similar characteristics, Petra considers that there is a
5% risk that the customer will not pay the amount due after the goods have been delivered
and the property transferred. Petra subsequently felt that the financial condition of the
customer has deteriorated and that the trade receivable is further impaired by CU100,000.
(ii) Petra has also sold a computer hardware system to a customer and, because of the current
difficulties in the market, Petra has agreed to defer receipt of the selling price of CU2 million
until two years after the hardware has been transferred to the customer.
Petra has also been offering discounts to customers if products were sold with terms whereby
payment was due now but the transfer of the product was made in one year. A sale had been
made under these terms and payment of CU3 million had been received.
Requirement
Discuss how both of the above transactions would be treated in subsequent financial statements
under IAS 18 and also whether there would be any difference in treatment if the collectability of the
debt and the time value of money as per IFRS 15 were taken into account.
4 Audit focus
Section overview
• This section looks at audit procedures relevant when considering the appropriateness of the
accounting treatment adopted for construction contracts.
• Determine whether the outcome of the contract can be measured reliably, in particular the
assessment of the directors that payment will be received under the contract
• Where this is not the case, confirm that revenue is recognised only to the extent that costs are
recoverable
• Check the calculation of the overall expected outcome for the project (ie profitable/loss making)
• Review the calculation of costs to complete and assess the validity of any assumptions made by
management. Where possible, compare the overall expected profitability with other similar projects
• Assess the basis on which profit is recognised eg stage of completion method. Establish the
way in which the stage of completion has been measured (eg by surveyor and determine whether it
appears reasonable)
• Confirm that any costs accounted for as contract work in progress are recoverable under the
contract
• Assess the likelihood of recovery of revenue recognised but not yet received (may represent a bad
debt)
C
H
A
P
T
E
R
10
Construction Ltd has entered into a fixed price contract to construct an office block. Construction
commenced on 1 September 20X6 and is expected to take 36 months. You are auditing the financial
statements for the year ended 31 December 20X7.
At the end of 20X6 the contract was assessed as being 30% complete and at the end of 20X7 60%
complete. Draft financial statements show that the following amounts have been recognised:
20X7 20X6
CU'000 CU'000
Revenue 192 192
Profit 42 51
Requirements
Summary
IFRS 15
IFRS 15
Revenue from
C
H
A
P
T
E
R
10
According to IFRS 15 Revenue from Contracts with Customers , what revenue should the club
recognise in its financial statements for the year ended 31 December 20X7 in relation to the
CU300,000 membership fees?
5 Pears
The Pears Company operates a mobile phone network. On 1 January 20X7 it introduced a new
retail package which combined a ‘free’ mobile phone, an annual airtime subscription to the network
and 80 ‘free’ minutes per month. Customers will pay CU140 per quarter payable in advance on the
first day of each quarter.
The mobile phone has a retail value of CU220 and the annual airtime subscription to the network is
sold separately at CU50.
Pears has detailed historical records of ‘free’ minute usage on other price plans. On average 720 of
‘free’ minutes are used each year by customers. Each ‘free’ minute has an average call charge
value of CU1 if paid for separately. The expected usage of ‘free’ minutes by quarter is as follows:
Quarter Minutes
January to March 175
April to June 125
July to September 190
October to December 230
720
Requirement
In accordance with IFRS 15 Revenue from Contracts with Customers , calculate the following
amounts for a customer who subscribes to a retail package on 1 January 20X7.
(a) The revenue recognised in respect of the mobile phone sale on 1 January.
(b) The revenue recognised for the airtime subscription and ‘free’ minutes in the six months to
30 June 20X7.
(c) The asset or liability recognised in the statement of financial position of Pears on 30 June
20X7 in respect of the contract.
6 Eco-Ergonom
Eco-Ergonom Ltd is a DSE quoted company which manufactures ergonomic equipment and
furniture and environmentally friendly household products. You are the Financial Controller, and the
accounting year-end is 31 December 20X7.
It is now 15 March 20X8, and the company’s auditors are currently engaged in their work. Deborah
Carroll, the Finance Director, is shortly to go into a meeting with the Audit Engagement Partner,
Brian Nicholls, to discuss some unresolved issues relating to company assets. To save her time,
she wants you to prepare a memorandum detailing the correct accounting treatment. She has sent
you the following email, in which she explains the issues:
C
To: Financial Controller H
From: Deborah Carroll A
Date: 15 March 20X8 P
T
Subject: Assets
E
As a matter of urgency, I need you to prepare a memorandum on the correct accounting treatment R
of the items below, so that I can discuss this with the auditors.
Stolen lorries
10
As you know, we acquired a wholly owned subsidiary, a small road-haulage company, on 1
January 20X7 to handle major deliveries once we start producing larger items. So far, it has proved
more profitable to hire out its services to other companies, so the company is a cash-generating
unit. We paid CU460,000 for the business, and the value of the assets, based on fair value less
costs to sell, at the date of acquisition were as follows:
You will also know that, on 1 January 20X7, Eco-Ergonom acquired 100% of Homecare, a private
limited company manufacturing household products. Eco-Ergonom intends to develop its own
brand of environmentally friendly cleaning products. The shareholders of Homecare valued the
company at CU25 million based upon profit forecasts which assumed significant growth in the
demand for the 'Homecare' brand name. We took a more conservative view of the value of the
company and estimated the fair value to be in the region of CU21 million to CU23 million of which
CU4 million relates to the brand name 'Homecare'. Eco-Ergonom is only prepared to pay the full
purchase price if profits from the sale of 'Homecare' goods reach the forecast levels. The agreed
purchase price was CU20 million plus a further payment of CU5 million in two years on 31
December 20X8. This further payment will comprise a guaranteed payment of CU2 million with no
performance conditions and a further payment of CU3 million if the actual profits during this two
year period from the sale of Homecare goods exceed the forecast profit. The forecast profit on
Homecare goods over the two-year period is CU3 million and the actual profits in the year to 31
December 20X7 were CU0.8 million. Eco-Ergonom did not feel at any time since acquisition that
the actual profits would meet the forecast profit levels. Assume an annual discount rate of 5.5%.
Requirement
7 Henley Co
Negotiations for the contract commenced at the start of August 20X4 and contract preparation and
negotiation costs of CU170,000 have been incurred up to June 20X5. Negotiations progressed to
the point that, on 1 April 20X5, Henley Co judged that it was probable it would be awarded the
contract. The contract was signed and building work commenced on 1 July 20X5. The contract
was still in progress at the year end.
Costs in the twelve months ended 31 December 20X5 were incurred evenly over the year unless
otherwise stated, and were as follows:
• Eight supervisors were employed in the year at a cost of CU300,000. Three of these eight
were engaged in the contract for Astronaut Co.
• Design staff cost CU100,000 to employ. These staff split their time approximately evenly
throughout the year on four contracts, including the Astronaut contract.
• CU50,000 was spent on research and development as part of an ongoing drive to improve
efficiency.
C
• General management costs of CU400,000 were incurred. H
A
• CU1,200,000 was spent on casual labour on the Astronaut contract.
P
• Depreciation on construction machinery was CU600,000 in the year. 30% of the equipment T
was allocated to the Astronaut contract. E
R
• It cost CU80,000 to move machinery to the Astronaut construction site.
• CU3,200,000 was spent on materials for the Astronaut contract. Of this, CU600,000 remains
unused at the year-end and could possibly be used on other contracts.
Calculate the amounts which should be classified as contract costs in the year to 31 December
20X5 in respect of the Astronaut contract.
8 Pardew Ltd
On 1 April 20X7, Pardew Ltd, a construction company, began work on a project which was
expected to take 18 months to complete. The contract price was agreed at CU21 million and total
contract costs were estimated to be CU16 million. Pardew Ltd uses independent quantity
surveyors to certify the cumulative sales value of construction work at the end of each month. The
accounting policy of Pardew is to consider the outcome of contracts to be capable of reliable
estimation when they are at least 40% complete.
CU’000
Certified sales value of work completed 14,700
Invoices raised to customer 13,000
Progress payment received 11,500
Contract costs incurred 12,000
Estimate of additional contract costs to complete 6,000
Requirements
(a) Explain, with calculations where appropriate, how the amounts in respect of this contract
should be presented in the statement of profit or loss and statement of financial position of
Pardew Ltd for the year to 31 December 20X7 if the stage of completion of the contract is
calculated by reference to:
(ii) the certified sales value of the work completed as a proportion of the total contract price.
(b) Explain briefly why the two accounting policies result in different amounts in the 20X7 financial
statements.
9 Prideaux Ltd
Prideaux Ltd (Prideaux), a construction company with a 31 December year end, measures the
stage of completion on its contracts by the costs incurred as a proportion of total costs method.
During 20X6 Prideaux tendered for the construction of a large building on land owned by the
customer. The building would replace one recently demolished and the project was expected to
take three years to complete.
In 20X6 Prideaux incurred costs of CU0.5 million on preparing its initial quotation, CU0.3 million on
modifying it once the company had been included on the short list of four tenderers and CU0.1
million on finalising it once the contract had been awarded. The contract price was agreed at CU40
million and Prideaux estimated its construction costs at CU34.2 million. By the end of 20X6
construction costs incurred were CU2.8 million, costs to complete were estimated at CU31.4
million, progress invoices of CU2 million had been raised and the customer had paid CU1.5 million.
In 20X7 further construction costs of CU10.1 million were incurred and at 31 December 20X7 costs
to complete were estimated at CU19 million, progress invoices to date totalled CU11 million and
the customer had paid a total of CU8 million.
In 20X8 further construction costs of CU15 million were incurred and at 31 December 20X8 costs to
complete were estimated at CU14 million, progress invoices to date totalled CU27 million and the
customer had paid a total of CU25 million. The 20X8 construction costs included CU5 million
incurred as a result of problems with the foundations of the final part of the building. Prideaux
claimed that because these problems resulted from mistakes made during the demolition of the old
building, the contract price should be increased by CU6 million. The customer is arguing that the
problems resulted from poor materials used by Prideaux and has thrown the CU6m claim out.
Requirement
Calculate, with explanations where appropriate, the amounts in respect of this contract to be
presented in the statement of profit or loss and statement of financial position of Prideaux Ltd for
each of the four years to 31 December 20X9.
C
H
A
P
T
E
R
10
– Probable that future economic benefits will flow to the entity and
• Disclosure IFRS 15
1 Laka
CU4,016
Under IFRS 15 the selling price must be analysed between the finance income and the sale of
goods income, discounting future receipts at the rate of interest for an issuer with a similar credit
rating to that of the customer.
The finance income is calculated by reference to the amount outstanding after the deposit has
been paid:
CU
Initial deposit (CU4,400 × 20%) 880
Sale of goods (CU4,400 × 80%) / 1.082 3,018
Finance income CU3,018 × 3.923%* 118
4,016
* the interest rate is √(1 + the full year %) – 1, so √(1.08) – 1= 3.923%.
2 Renpet
CU25,600
– CU7,600 (40%) of equipment is delivered this financial year when the contract is signed.
Therefore this amount is recorded as revenue.
– CU11,400 (60%) of equipment is delivered in the next financial year; this revenue is
therefore deferred.
When subsequent services are priced below the total of cost and a reasonable profit, that part
of the initial fee which represents the difference is spread over the period of those services,
therefore
– CU3,000 must be allocated to the second contract to increase the CU9,000 fee to the fair
value of the services CU12,000
CU3,720,000
10
• According to IFRS 15, media commission revenue is recognised when the advertisement appears
before the public. So revenue is 2 advertisements × 15 broadcasts × CU40,000 × 10% =
CU120,000.
4 Health club
CU295,200
When a fee entitles a member to purchase equipment at a reduced rate, the revenue should not be
recognised immediately in full but on a basis which reflects the timing, nature and value of the
benefit (IFRS 15). So the relevant proportion is spread over the period during which discounted
purchases may be made.
= CU4,800
5 Pears
(a) CU124
(b) CU184
(c) CU28
IFRS 15 requires the recognition criteria to be applied to the separately identifiable components of
a single transaction in order to represent the substance of the transaction. IFRS 15 does however,
specifically state how an entity should unbundle such contracts that each component should be
recognised at its stand-alone price or fair value and only recognised when it meets the specific
criteria. If the fair value of the individual components is greater than the overall price paid for the
bundled contract, the discount should be allocated to each component on a reasonable basis.
Typically the discount will be allocated to each component on a pro-rata basis.
(a) The total revenue over the contract period is CU560 (4 quarters × CU140). The fair value of
the separate components is CU990 (CU220 + CU50 + (720 × CU1)). The discount of 43.43%
should be spread across each element. The revenue recognised on the telephone sale will be
CU124 (CU220 × 56.57%).
(b) The revenue recognised in the first six months will be:
CU
Airtime subscription CU50 × 6/12 × 56.57% 14
’Free’ call revenue (175 mins + 125 mins) × CU1 × 56.57% 170
184
(c) Total revenue recognised in the first six months will be CU308 (CU124 + CU184) whilst the
amount of cash received is CU280 (2 × CU140). The difference will be a receivable in the
statement of financial position.
In practice, estimates should also be revisited throughout the year against actual usage.
6 Eco-Ergonom
MEMORANDUM
As requested, this memorandum sets out the appropriate accounting treatment for the non-current
assets detailed in today's email.
The three lorries that were stolen should be written off at their NBV first and then the impairment
test should be performed.
Recoverable
NBV Impairment amount
CU'000 CU'000 CU'000
Goodwill 80 (80) –
Intangibles 60 (2.5) 57.5
Vehicles (240-60) 180 (7.5) 172.5
Sundry net assets 80 80
Total 400 (90) 310 Higher of VIU and NFV
CU80,000 is set against goodwill and the remaining CU10,000 is split pro rata between the other
two relevant assets: CU2,500 against intangibles (CU10,000 × 60,000/(60,000+180,000)) and
CU7,500 against vehicles (CU10,000 × 180,000/(60,000+180,000)). There is no need here to
restrict the impairment of the intangibles.
Tutorial note
The calculation of the impairment loss is based on the carrying amount of the business including
the trade payables. Recoverable amount is the fair value less costs to sell of the business as a
whole, with any buyer assuming the liabilities. Otherwise, the impairment test would be based on
the carrying amount of the gross assets (IAS 36.76).
An impairment review will be carried out because of the losses and the haulage business problems.
IAS 38 Intangible Assets divides a development project into a research phase and a development
phase. In the research phase of a project, an entity cannot yet demonstrate that the expenditure
will generate probable future economic benefits. Therefore expenditure on research must be C
recognised as an expense when it occurs. H
(d) That the asset will generate probable future economic benefits
10
(e) The availability of adequate technical, financial and other resources to complete the
development and to use or sell it
(f) Its ability to reliably measure the expenditure attributable to the asset.
8 Pardew Ltd
(a) Although contract costs originally estimated at CU16 million are now estimated at CU18 million (12,000 +
6,000), the contract is still estimated to generate a profit of CU3 million (21,000 – 18,000). Contract
revenue and expenses should be recognised by the stage of completion method.
(i) Using the contract costs method, the contract is 2/3 (12,000 as a proportion of 18,000) complete, in
excess of the 40% cut-off point. So 2/3 of contract revenue and contract profit should be
recognised in profit or loss, so CU14 million (2/3 × 21,000) and CU2 million (2/3 × 3,000)
respectively.
In the statement of financial position, gross amounts due from customers should be presented as
contract costs incurred plus recognised profits less invoices raised to customers (see below for
calculations). Trade receivables should include CU1.5 million (13,000 invoiced less 11,500
payments received).
(ii) Using the certified sales value method, the contract is 70% (14,700 as a proportion of 21,000)
complete, in excess of the 40% cut-off point. So contract revenue of CU14.7 million should be
recognised in profit or loss, together with cost of sales of CU12 million (the costs incurred). A profit
of CU2.7 million should be recognised.
In the statement of financial position, gross amounts due from customers should be presented in
the same way as for the contract costs method (see below for calculations) and trade receivables
should include the same CU1.5 million.
Point to note:
Over the life of the contract, the profit is the same under both methods; it is just its allocation to the
reporting periods in which work is done which is different.
9 Prideaux Ltd
1 The only tendering costs which can be included in contract costs are those costs incurred after it is
probable that the contract will be won. So the CU0.5 million and CU0.3 million should be recognised as
an expense in 20X6.
Contract costs total CU2.9 million (0.1 + 2.8). The contract is only 8.5% (2.9 as a % of (2.9 + 31.4))
complete, too early to be able to estimate its outcome reliably. Contract costs incurred should be
recognised as an expense within cost of sales, with revenue of the same amount being recognised (the
costs being recoverable from the customer).
2 Contract costs incurred are CU13 million (2.9 +10.1). The contract is 40.63% (13 as a % of (13 + 19))
complete, so it is likely that its outcome can be estimated reliably. Cumulatively, 40.63% of the CU40
million contract price should be recognised, so CU16.25 million (and 16.25 – 2.9 = 13.35 in the year).
With cost of sales of CU10.1 million (the costs incurred in the year), the profit in the year is CU3.25 million
(40.63% × the estimated profit of CU8 million (40 – 32)).
3 Revenue for variations should only be recognised if it is probable that the customer will approve the
variation, so Prideaux should not recognise any benefit from its claim.
Contract costs incurred are CU28 million (13 b/f + 15 in the year). The contract is 2/3 complete
(28 as a % of (28 + 14)). But with total revenue still CU40 million, an overall loss of CU2
million is now estimated; this should be recognised immediately. As the profit to date brought
forward is CU3.25 million, a loss of CU5.25 million should now be recognised. Cumulative
revenue should be measured at CU26.667 million (40 × 2/3) so CU10.417 million (26.667 –
16.25) in the year. Cost of sales for the year is the balancing figure of CU15.667 million.
4 Revenue for the year is CU19.333 million ((27 billings b/f + 19 billings in the year) – 26.667),
cost of sales is CU14.833 million ((28 b/f + 15.5 incurred in the year) – 28.667 cost of sales to
end-20X8), so profit in the year is CU4.5 million, and CU2.5 million (4.5 – 2 loss b/f) over the
contract as a whole (excluding the CU0.8 million tendering costs)
(b) A sale must never be recognised when the customer places an order. Even though the order will be
for a specific quantity of goods at a specific price, it is not yet certain that the sale transaction will
go through. The customer may cancel the order, the supplier might be unable to deliver the goods
as ordered or it may be decided that the customer is not a good credit risk.
(c) A sale will be recognised when delivery of the goods is made only when:
(i) the sale is for cash, and so the cash is received at the same time; or
(ii) the sale is on credit and the customer accepts delivery (eg by signing a delivery note).
(d) The critical event for a credit sale is usually when the customer accepts delivery (see (c)(ii)). At this
point, or shortly afterwards, an invoice is usually despatched to the customer. There is then a
legally enforceable debt, payable on specified terms, for a completed sale transaction.
(e) The critical event for a cash sale is when delivery takes place and when cash is received; both take
place at the same time.
It would be too cautious or ‘prudent’ to await cash payment for a credit sale transaction before
recognising the sale, unless the customer is a high credit risk and there is a serious doubt about his
ability or intention to pay.
(f) It would again be over-cautious to wait for clearance of the customer’s cheques before recognising
sales revenue. Such a precaution would only be justified in cases where there is a very high risk of
the bank refusing to honour the cheque.
The receipt of cash in the form of the CU3,000 deposit must be recognised. However, while the deposit
is termed ‘non-refundable’, it does create an obligation to complete the contract. The other side of the
entry is therefore to deferred income in the statement of financial position.
The sales revenue recognised in respect of the caravan will be a balancing figure.
Note: This question is rather fiddly, so do not worry too much if you didn’t get all of it right. Read through
our solution carefully, going back to first principles where required.
WORKINGS
CU'000
Labour 632
Materials 1,325
Design costs 463
Borrowing costs 56
2,476
Research costs, general administration costs and selling costs should be recognised as expenses in
profit or loss as they are incurred.
The amounts relating to this contract which should be recognised in profit or loss for each of the three
financial years are:
In general a customer’s credit risk is not considered to be material and revenue is recognised at
the invoiced amount, subject to the entity performing its obligations. However, it might be
appropriate to take account of the possibility of default by a customer or customers. For example,
if an entity sells goods to 100 customers, it may consider that three of these customers will default.
Other standards, for example IAS 37 in respect of warranties, adopt a probability-weighted
approach, and it might be considered appropriate to apply this to revenue by calculating an
expected value of the amount of consideration to be received.
In many transactions, the time value of money is immaterial because the revenue is received
soon after the good or service is provided. In other cases, however, it could be appropriate to
consider the effects of the time value of money when determining the transaction price –
particularly under long-term contracts or those that give rise to customer payments at significantly
IAS 18 treatment
Under IAS 18, revenue of CU1m would be recognised on the sale of the computers and a
trade receivable of CU1m set up. The trade receivable would be reviewed periodically for
impairment, and the deteriorating financial situation of the customer would be seen as an
indicator of impairment. An impairment of CU100,000 would be recognised. However, no
recognition would be made, under current rules of the 5% risk that the customer would default.
This is not 5% of the revenue – if it were, a receivables expense of CU50,000 would be
required – but a 5% risk that none of the revenue can be collected, for which current
standards make no arrangements.
If credit risk is taken into account in the recognition of revenue, the amount recognised on the
sale would be reduced by the 5% likelihood of default, meaning that only 95% of the revenue,
ie CU950,000 would be recognised. The impairment of CU100,000 would still be recognised
as an expense, not as a reduction in revenue.
IAS 18 treatment
Under IAS 18, where payment is deferred, the substance of the arrangement is that there
is both a sale and a financing transaction. The treatment of the CU2m deferred receipt is
the same whether IAS 18 or IFRS 15 standard is applied, in that the fair value of the
consideration is the consideration discounted to present value.
Receipt of the selling price of CU2m is deferred for two years. Using a 4% discount rate, the
present value of the consideration is CU2m/1.042 = CU1.85m. The unwinding of the discount
would be credited to profit or loss (finance income) over the two year period. Alternatively, if
Petra sells the same goods to other customers for cash, normally at a discount, the cash
price of those goods could be used in determining fair value.
Regarding the CU3m payment in advance, revenue would not be recognised immediately;
instead a deferred income liability would be set up:
During the year to the date of transfer of the product, an interest expense would be recognised
10
of
(CU3m × 1.04) – CU3m = CU120,000, and the liability would be increased to CU3.12m:
• Revenue recognised to date includes a proportion of the incentive payment. This would only
be appropriate if it is probable that this income will be received.
• Total costs to complete have been increased during the year due to rectification costs. There
is a risk that there may be other rectification costs which have yet to be identified.
• Whether the accounting treatment of the profit recognition is in accordance with IFRS 15. The
current figure of CU42,000 appears to be based on 60% of the expected total profit at 31
December 20X7 (640-570 × 60%). The recognition of profit must be calculated on a
cumulative basis. In this case as CU51,000 has already been recognised in 20X6, the
financial statements for 20X7 should show a loss of CU9,000 so that cumulatively over the two
years CU42,000 profit is recognised.
• Agree the contract price and incentive payment to the sales contract.
• Discuss with management the basis on which they have recognised the incentive payment
and review their performance on other similar contracts to determine the likelihood of the
contract being completed on time.
• Establish the basis on which the % completion of 60% has been determined. If a surveyor has
been used to make this estimate assess the extent to which his evidence can be relied on.
• Discuss with management the nature of the rectification costs and assess the likelihood of
other similar additional costs being incurred. Obtain a schedule of these and agree to
supporting documentation.
• Review management calculations regarding costs to complete and seek corroboration for any
assumptions made.
• Discuss with management the profit recognition policy adopted. If material to the financial
statements the figures should be revised in accordance with IFRS 15.
Introduction
Topic List
IAS 33 Earnings per Share
1 EPS: overview of material covered in earlier studies
2 Basic EPS: weighted average number of shares
3 Basic EPS: profits attributable to ordinary equity holders
4 Diluted earnings per share
5 Diluted EPS: convertible instruments
6 Diluted EPS: options
7 Diluted EPS: contingently issuable shares
8 Retrospective adjustments and presentation and disclosure
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
467
Introduction
• Explain and appraise accounting standards that relate to reporting performance: in respect
of […] EPS
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 2(b), 2(d), 14(c), 14(d), 14(f)
• Profit attributable to the ordinary equity holders is based on profit after tax after the deduction
of preference dividends and other financing costs in relation to preference shares classified as
equity under IAS 32. Whether an adjustment is needed depends on the type of preference share:
Shares should generally be included in the weighted average number of shares from the date the
consideration for their issue is receivable.
• An entity is required to calculate and present a basic EPS amount based on the profit or loss for the
period attributable to the ordinary equity holders of the parent entity. If results from 'continuing
operations' or 'discontinued operations' are reported separately, EPS on these results should also
be separately reported.
• For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss
attributable to ordinary equity holders of the parent entity, and the weighted average number of
shares outstanding for the effects of all dilutive potential ordinary shares.
Presentation
• Basic and diluted EPS figures for profit or loss from continuing operations should be presented on
the face of the statement of comprehensive income with equal prominence.
• Where changes in ordinary shares occur during the accounting period, an amendment is necessary
to the number of shares used in the EPS calculations. In some situations, the EPS in prior periods
will also have to be adjusted.
A company has issued CU100,000 4% redeemable non-cumulative preference shares. Should the
dividend be subtracted from the reported profit after tax figure for the calculation of EPS?
Section overview
• This section deals with certain adjustments to the number of shares used for the calculation of
basic earnings per share.
IAS 33 requires that a time-weighted average number of shares should be used in the denominator of
the earnings per share calculation. The basic idea of how to calculate such a weighted average has
been covered at Professional level. In this section we deal with issues relating to the treatment of share
repurchases, partly paid shares, bonus and rights issues and the impact of consolidation.
The weighted average number of ordinary shares outstanding during the period is the number of
ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary shares
bought back or issued during the period multiplied by a time-weighting factor.
• Ordinary shares issued in exchange for cash are included when cash is receivable.
• Ordinary shares issued as a result of the conversion of a debt instrument to ordinary shares are
included from the date that interest ceases to accrue.
• Ordinary shares issued in place of interest or principal on other financial instruments are included
from the date that interest ceases to accrue.
• Ordinary shares issued in exchange for the settlement of a liability of the entity are included from
the settlement date.
• Ordinary shares issued as consideration for the acquisition of an asset other than cash are
included as of the date on which the acquisition is recognised.
• Ordinary shares issued for the rendering of services to the entity are included as the services are
rendered.
• Ordinary shares issued as part of the cost of a business combination are included in the weighted
average number of shares from the acquisition date. This is because the acquirer incorporates into
its results the acquiree's profits and losses from that date.
• Ordinary shares that will be issued upon the conversion of a mandatorily convertible instrument are
included in the calculation of basic earnings per share from the date the contract is entered into.
Calculate the weighted average number of shares in issue during the year.
Solution
The calculation can be performed on a cumulative basis:
Weighted
average
1 Jan X1 – 30 May X1 1,700 × 5/12 708
Share issue 800
31 May X1 – 30 Nov X1 2,500 × 6/12 1,250
Share purchase (250)
1 Dec X1 – 31 Dec X1 2,250 × 1/12 188
2,146
or alternatively each issue or recall treated separately:
Weighted
average
1 Jan X1 – 31 Dec X1 1,700 x 12/12 1,700
31 May X1 – 31 Dec X1 800 x 7/12 467
1 Dec X1 – 31 Dec X1 (250) x 1/12 (21)
2,146
To the extent that partly paid shares are not entitled to participate in dividends during the period they are
treated as the equivalent of warrants or options in the calculation of diluted earnings per share. The
unpaid balance is assumed to represent proceeds used to purchase ordinary shares. The number of
shares included in diluted earnings per share is the difference between the number of shares subscribed
and the number of shares assumed to be purchased.
Calculate the weighted average number of shares for the year ended 31 December 20X5.
Solution
The new shares issued should be included in the calculation of the weighted average number of shares
in proportion to the percentage of the issue price received from the shareholding during the period.
Weighted
Shares Fraction average
issued of period shares
1 January 20X5 – 31 August 20X5 900 8/12 600
Issue of new shares for cash, part paid (2/4 × 600) 300
1 September 20X5 – 31 December 20X5 1,200 4/12 400
Weighted average number of shares 1,000
2.4 The impact of bonus issues and share consolidations on the number of
shares
The weighted average number of ordinary shares outstanding during the period must be adjusted for
events that have changed the number of ordinary shares outstanding without a corresponding change in
resources. These include:
The number of ordinary shares outstanding before the event is adjusted for the proportionate change in
the number of ordinary shares outstanding as if the event had occurred at the beginning of the earliest
period presented. For example, on a two-for-one bonus issue, the number of ordinary shares
outstanding before the issue is multiplied by three to obtain the new total number of ordinary shares, or
by two to obtain the number of additional ordinary shares.
Where a bonus issue takes place after the reporting date but before the financial statements are
authorised for issue, the number of shares in the EPS calculation is adjusted for the current and prior
periods as though the bonus issue took place during the current year.
Requirement
Calculate the basic earnings per share for 20X6 and 20X7. 11
Solution
The bonus issue arose in the period after the reporting date. It should be treated as if the bonus issue
arose during 20X7, and EPS calculated accordingly:
cu£300
cu£0.50
=
(200 + 400)
Sometimes, however, shares are repurchased at fair value, and in this instance, there is a
corresponding reduction in resources. An example is a share consolidation combined with a special
dividend. In this case, the weighted average number of ordinary shares outstanding for the period is
adjusted for the reduction in the number of ordinary shares from the date the special dividend is
recognised.
Requirement
Calculate the weighted number of shares in issue for the year to 31 December 20X5.
Solution
The three million new shares issued at the time of the acquisition should be weighted from the date of
issue, but the consolidation should be related back to the start of the financial year (and to the start of
any previous years presented as comparative figures).
Requirement
Solution
(a) Share repurchase at fair value
20X7 20X6
CU CU
Profit for the year 4,000 4,000
Loss of interest as cash
paid out CU4,000 × 0.05 × 0.80* (160)
Earnings 3,840 4,000
Number of shares outstanding 18,000 20,000
Earnings per share 21.33p 20.00p
(b) Special dividend followed by share consolidation
20X7 20X6
CU CU
Profit for the year 4,000 4,000
Loss of interest on cash paid out as dividend
CU4,000 × 0.05 × 0.80* (160)
Earnings 3,840 4,000
The effect of share consolidation is to leave the total nominal value of outstanding shares the same, but
to reduce the number of shares from 20,000 to 18,000, and raising the market price of a share from CU2
to CU2.22.
20X7 20X6
Number of shares 18,000 20,000
Earnings per share 21.33p 20.00p
No adjustment to prior year's EPS is made for the share consolidation.
* 0.80 = (1 – tax rate)
The TERP is the theoretical price at which the shares would trade after the rights issue and takes into
account the diluting effect of the bonus element in the rights issue. It is calculated as:
Total market value of original sharespre rights issue + Proceeds of rights issue
TERP =
Number of sharespost rights issue
The adjustment factor is used to increase the number of shares in issue prior to the rights issue for the
bonus element.
Where the rights are to be publicly traded separately from the shares before the exercise date, fair value
for the purposes of this calculation is established at the close of the last day on which the shares are
traded together with the rights.
Rights issue: One new share for each five outstanding shares (100 new shares total)
Market price of one ordinary share immediately before exercise on 1 March 20X5: CU11.00
Requirement
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X4, 20X5
and 20X6.
Solution
Calculation of theoretical ex-rights value per share
No. Price Total
Pre-rights issue holding 5 CU11 CU55
Rights share 1 CU5 CU5
6 CU60
Therefore TERP = CU60/6 = CU10
(The TERP may also be calculated on the basis of all shares in issue, ie CU6,000/600 shares)
20X4
Alternatively the restated EPS may be calculated by applying the reciprocal of the adjustment factor to
the basic EPS as originally reported:
CU2.20 × 10/11 = CU2.00
20X5
20X6
cu£1,800
Basic EPS: = CU3.00
600 shares
• On 1 April 20X5, 4 million shares in consideration for the majority holding in another entity; and
• On 1 July 20X5 a rights issue of one for six at CU15 when the market price of the existing shares
was CU20. There were 18 million shares in issue at this date, another three million shares were
therefore issued.
A profit of CU17 million attributable to the ordinary equity holders was reported for 20X5 and CU14
million for 20X4.
Requirement
Calculate the earnings per share for 20X5 and restate the comparative for 20X4.
Solution
As the shares issued on the acquisition were issued at full fair value, a time apportionment adjustment
over the period they are in issue is required.
The rights issue shares require a time apportionment adjustment and an adjustment for the bonus
element in the rights. The latter adjustment should be applied to the shares issued on 1 April as well as
to those issued earlier. To adjust for the bonus element the theoretical ex-rights fair value per share is
required:
20X4 and earlier EPS figures would be adjusted by dividing the corresponding earnings figure by 1.037.
11
The weighted number of shares in issue in 20X5 is calculated as:
Adjusted
Number Weighting number
1 January to 31 March 14,000,000 × 20/19.29 3/12 3,628,823
Issue 1 April 4,000,000
1 April to 30 June 18,000,000 × 20/19.29 3/12 4,665,630
Rights issue 1 July 3,000,000
1 July to 31 December 21,000,000 6/12 10,500,000
Weighted average shares in issue 18,794,453
20X5 earnings per share:
CU17m / 18,794,453 shares = CU0.90
Section overview
• In this section we discuss the adjustments that are required to earnings as a result of preference
shares, in order to calculate profits attributable to ordinary shareholders (equity holders).
As we have seen in earlier studies, for the purpose of calculating basic earnings per share, we must
calculate the amounts attributable to ordinary equity holders of the parent entity in respect of profit or
loss.
• First the profit or loss which includes all items of income and expense that are recognised in a
period, including tax expense, dividends on preference shares classified as liabilities or non-
controlling interest is calculated according to IAS 1 Presentation of Financial Statements.
• In the second step the calculated profit or loss is adjusted for the after-tax amounts of preference
dividends, differences arising on the settlement of preference shares, and other similar effects of
preference shares classified as equity under IAS 32 Financial Instruments: Presentation.
• Financial liabilities or
• Equity under IAS 32
In both the above cases the treatment is the same, as in both cases the amounts are deducted from
profit attributable to ordinary shareholders. In the latter case the deduction will already have been made
in arriving at reported profit and loss, however in the former case an adjustment to reported profits is
required.
Turaco is a company listed on a recognised stock exchange. Given below is an extract from its
statement of comprehensive income for the year ended 31 December 20X6.
CU
Profit before tax 500,000
Tax 150,000
Profit after tax 350,000
The company paid an ordinary dividend of CU20,000 and a dividend on its redeemable preference
shares of CU70,000.
The company had CU100,000 of CU0.50 ordinary shares in issue throughout the year and authorised
share capital of 1,000,000 ordinary shares.
Requirement
What is be the basic earnings per share figure for the year according to IAS 33 Earnings per Share?
These are preference shares that provide for a low initial dividend to compensate an entity for selling the
preference shares at a discount, or an above-market dividend in later periods to compensate investors
for purchasing preference shares at a premium.
Under IAS 32 Financial Instruments: Presentation and IAS 39 Financial Instruments: Recognition and
Measurement any original issue discount or premium on increasing rate preference shares is amortised
using the effective interest method and treated as a preference dividend for the purposes of calculating
earnings per share.
All these elements should be deducted in arriving at the earnings attributed to ordinary equity holders.
There was, however, to be no dividend paid for the first three years after issue. In consideration of these
dividend payment terms, the class A preference shares were issued at CU81.63 per share, ie at a
discount of CU18.37 per share. The issue price can be calculated by taking the present value of CU100, 11
discounted at 7 per cent over a three-year period.
Requirement
Calculate the imputed dividends attributable to preference shares that need to be deducted from
earnings to determine the profit or loss attributable to ordinary equity holders.
Solution
Because the shares are classified as equity, the original issue discount is amortised to retained earnings
using the effective interest method and treated as a preference dividend for earnings per share
purposes. To calculate basic earnings per share, the following imputed dividend per class A preference
share is deducted to determine the profit or loss attributable to ordinary equity holders of the parent
entity.
An entity may achieve early conversion of convertible preference shares by improving the original
conversion terms or paying additional consideration.
Where this is the case, then the excess amount transferred as a result of the improvement of conversion
terms is treated as a return to the preference shareholders and so should be deducted in arriving at
earnings attributable to ordinary equity holders.
The convertible shares were converted at the beginning of 20X6 and no dividend was accrued in respect
of the year, although the previous year's dividend was paid immediately prior to conversion. The terms
of conversion were also amended and the revised terms entitled the preference shareholders to a total
additional 100 ordinary shares on conversion with a fair value of CU300.
Requirement
If the profit attributable to ordinary equity holders for the year is CU150,000 what adjustments need to be
made for the purpose of calculating EPS in 20X6?
• Where the fair value of consideration paid to preference shareholders exceeds the carrying value of
the preference shares repurchased, the excess is a return to the preference shareholders and must
be deducted in calculating profits attributable to ordinary equity holders.
• Where the carrying value of preference shares repurchased exceeds the fair value of consideration
paid, the excess is added in calculating profit attributable to ordinary equity holders.
In respect of preference shares that are classified as liabilities, the above adjustments, where these are
relevant, would have already been made in arriving at the profit or loss for the period.
Requirement
If the profit attributable to ordinary equity holders for the year is CU150,000, what adjustments should be
made for the purpose of calculating EPS?
Solution
CU
Profit for the year attributed to ordinary equity holders 150,000
Plus discount on repurchasing of preference shares 1,000
151,000
The discount on repurchase of the preference shares has been credited to equity and it must therefore
be adjusted against profit.
Had there been a premium payable on repurchase, the loss on repurchase would have been subtracted
from profit.
No accrual for the dividend on the 8% preference shares is required as these are non-cumulative. Had a
dividend been paid for the year it would have been deducted from profit for the purpose of calculating
basic EPS as the shares are treated as equity and the dividend would have been charged to equity in
the financial statements.
Profit or loss for the period is allocated to the different classes of shares and participating equity
instruments in accordance with their dividend rights or other rights to participate in undistributed 11
earnings.
1 Profit or loss attributable to ordinary equity holders of the parent entity is adjusted as previously
discussed.
2 The remaining profit or loss is allocated to ordinary shares and participating equity instruments to
the extent that each instrument shares in earnings as if all of the profit or loss for the period had
been distributed. The total profit or loss allocated to each class of equity instrument is determined
by adding together the amount allocated for dividends and the amount allocated for a participation
feature.
3 The total amount of profit or loss allocated to each class of equity instrument is divided by the
number of outstanding instruments to which the earnings are allocated to determine the earnings
per share for the instrument.
Dividends on preference shares paid CU33,000 (CU5.50 per share × 6,000 shares)
Dividends on ordinary shares paid CU21,000 (CU2.10 per share × 10,000 shares)
Requirement
Solution
Basic earnings per share is calculated as follows.
CU CU
Profit attributable to equity holders of the parent entity 100,000
Less dividends paid:
Preference 33,000
Ordinary 21,000
(54,000)
Undistributed earnings 46,000
Allocation of undistributed earnings
Let A be the allocation of undistributed earnings per ordinary share and B the allocation per preference
share. That is:
11,500A = CU46,000
A = CU46,000/11,500
A = CU4.00
Therefore B = CU1.00
Section overview
• This section deals with the adjustments required to earnings in order to take into account the
dilutive impact of potential ordinary shares.
The objective of diluted earnings per share is consistent with that of basic earnings per share; that is, to
provide a measure of the interest of each ordinary share in the performance of an entity taking into
account dilutive potential ordinary shares outstanding during the period.
• Various financial liabilities or equity instruments, including preference shares that are convertible
into ordinary shares.
• Options.
• Warrants.
• Shares that would be issued on satisfaction of certain conditions that result from contractual
arrangements, such as the purchase of a business or other assets.
The conversion of potential ordinary shares will lead in the future to an increase in the weighted average
number of ordinary shares outstanding by the weighted average number of additional ordinary shares
that would have been outstanding assuming the conversion of all dilutive potential ordinary shares.
Conversion may also lead to consequential changes in income or expenses. For example, the reduction
of interest expense related to convertible debt and the resulting increase in profit or reduction in loss
may lead to an increase in the expense related to a non-discretionary employee profit-sharing plan.
For the purpose of calculating diluted earnings per share, profit or loss attributable to ordinary equity
holders of the parent entity is adjusted for any such consequential changes in income or expense.
Definition
Antidilution: is an increase in earnings per share or a reduction in loss per share resulting from the 11
assumption that convertible instruments are converted, that options or warrants are exercised, or that
ordinary shares are issued upon the satisfaction of specified conditions.
In computing diluted EPS only potential ordinary shares that are dilutive are considered in the
calculations. The calculation ignores the effects of potential ordinary shares that would have an
antidilutive effect on earnings per share.
In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series of
potential ordinary shares is considered separately rather than in aggregate.
• Those individual EPS which exceed the entity's basic EPS are disregarded as they are antidilutive.
• Those individual EPS which are less than the entity's basic EPS are dilutive and are ranked from
most to least dilutive. Options and warrants are generally included first because they do not affect
the numerator of the calculation. These dilutive factors are added one by one into the DEPS
calculation in order to identify the maximum dilution.
The calculation showing each issue or series of potential ordinary shares being considered separately is
shown in the worked example in Section 5.
• Any dividends or other items related to dilutive potential ordinary shares deducted in arriving at
profit or loss attributable to ordinary equity holders;
• Any interest recognised in the period related to dilutive potential ordinary shares; and
• Any other changes in income or expense that would result from the conversion of the dilutive
potential ordinary shares.
After the potential ordinary shares are converted into ordinary shares, the dividends, interest and any
other expenses associated with the potential ordinary shares will no longer arise. Instead, the new
ordinary shares are entitled to participate in profit or loss attributable to ordinary equity holders of the
parent entity. The expenses associated with potential ordinary shares include transaction costs and
discounts accounted for in accordance with the effective interest method.
• Dilutive potential ordinary shares shall be deemed to have been converted into ordinary shares at
the beginning of the period or, if later, the date of the issue of the potential ordinary shares (ie
where the convertible instruments or options are issued during the current period).
• Potential ordinary shares are weighted for the period they are outstanding.
• Potential ordinary shares that are cancelled or allowed to lapse during the period are included in
the calculation of diluted earnings per share only for the portion of the period during which they are
outstanding.
• Potential ordinary shares that are converted into ordinary shares during the period are included in
the calculation of diluted earnings per share from the beginning of the period to the date of
conversion. From the date of conversion, the resulting ordinary shares are included in both basic
and diluted earnings per share.
• The number of ordinary shares that would be issued on conversion of dilutive potential ordinary
shares is determined from the terms of the potential ordinary shares. When more than one basis of
conversion exists, the calculation assumes the most advantageous conversion rate or exercise
price from the standpoint of the holder of the potential ordinary shares.
Section overview
• This section deals with the impact of convertible instruments on the diluted earnings per share.
• CU8 million of 8% convertible loan stock. These were issued on 1 January 20X5 and are
convertible at any time from 1 January 20X8. The conversion terms are one ordinary share for each
CU2 nominal of loan stock.
The split accounting required for compound financial instruments per IAS 32 resulted in a liability
element for the loan stock of CU7 million and an effective interest rate of 10%.
After charging income tax at 20%, the entity reported profit attributable to the ordinary equity holders of
CU15 million for its year ended 31 December 20X5.
Requirement
Calculate the basic and diluted earnings per share for 20X5.
The profit before interest and taxation for the year ended 31 December 20X6 amounted to CU1,050,000
and arose exclusively from continuing operations. The rate of tax is 30 per cent.
Requirement
• CU11 million of 6.5% convertible loan stock, convertible at any time from 1 January 20X7. The
conversion terms are one ordinary share for each CU2 nominal of loan stock, the 1 January
carrying amount of the liability component is CU10 million and the effective interest rate is 9%.
• CU9 million of 6.75% convertible loan stock, convertible at any time from 1 January 20X8. The
conversion terms are one ordinary share for each CU2 nominal of loan stock, the 1 January
carrying amount of the liability component is CU8 million and the effective interest rate is 8%.
• CU12.6 million of 9% convertible loan stock, convertible at any time from 1 January 20X9. The
conversion terms are one ordinary share for each CU6 nominal of loan stock, the 1 January
carrying amount of the liability component is CU12 million and the effective interest rate is 12%.
The entity reported profit attributable to the ordinary equity holders of CU4 million for its year ended
31 December 20X5.
Requirement
Earnings per
Earnings Number of share
CU shares CU
Shares already in issue 4,000,000 20,000,000 0.20
Including 6.75% convertible loan stock 4,640,000 24,500,000 0.189
Including 6.5% convertible loan stock 5,540,000 30,000,000 0.185
Including 9% convertible loan stock 6,980,000 32,100,000 0.217
The diluted earnings per share will be CU0.185. The 9% convertible loan stock is antidilutive since it
increases earnings per share, and it will not be taken into account in calculating diluted earnings per share.
Where this occurs, any excess consideration paid on redemption or conversion is attributed to those
shares which have been redeemed or converted.
Outstanding convertible preference shares are therefore tested for dilution as normal and without regard
to this excess.
Section overview
• This section deals with the impact of options on diluted earnings per share.
Definition
Options and warrants: are financial instruments that give the holder the right to purchase ordinary
shares.
• Generally, closing market prices are adequate for calculating the average market price. When
prices fluctuate widely, however, an average of the high and low prices usually produces a more
representative price.
• The method used to calculate the average market price must be used consistently unless it is no
longer representative because of changed conditions. For example, an entity that uses closing
market prices to calculate the average market price for several years of relatively stable prices
might change to an average of high and low prices if prices start fluctuating greatly and the closing
market prices no longer produce a representative average price.
At 31 December 20X6, the issued share capital of Entity A consisted of 3,000,000 ordinary shares of
20p each. Entity A has granted options that give holders the right to subscribe for ordinary shares
between 20X8 and 20X9 at 50p each. Options outstanding at 31 December 20X7 were 600,000. There
were no grants, exercises or lapses of options during the year. The profit after tax attributable to ordinary
equity holders for the year ended 31 December 20X7 amounted to CU900,000 arising from continuing
operations. The average market price of one ordinary share during year 20X7 was CU1.50.
Requirement
Calculate the diluted earnings per share for 20X7.
See Answer at the end of this chapter.
Employee share options give the right to the holder to acquire shares in the company at a price that is
fixed when the options are issued.
Employee share options can normally be exercised after a certain time, eg once the employee has
completed a period of service and within a certain period, eg over a period of five years after they
become exercisable.
Employee share options that can be exercised are vested options, whereas options that cannot yet be
exercised are unvested options.
Solution
The amount to be received on exercise is CU21 × 5m = CU105m
The number of shares issued at average market price is: CU105m / CU30 = 3.5m
The number of 'free' shares is: 5m issued – 3.5m issued at average market price = 1.5m
Diluted earnings per share:
CU30m / (60m + 1.5m) = CU0.49
Where shares are unvested, the amount still to be recognised in profit or loss before the vesting date
must be taken into account when calculating the number of 'free' shares.
• The amount to be recognised in relation to these options in the entity's profit or loss over future
accounting periods up to date of vesting, as calculated according to IFRS 2, is CU15m.
Section overview
• This section deals with the impact of contingently issuable shares on the number of ordinary
shares used in the calculation of diluted earnings per share.
Contingently issuable shares may also arise where senior staff members are issued shares as a
performance reward.
• Until the shares are issued (if indeed they ever are), they should not be taken into account when
calculating basic EPS.
• They should be taken into account when calculating diluted EPS if and only if the conditions
leading to their issue have been satisfied. For these purposes the end of the accounting period is
treated as the end of the contingency period.
• Contingently issuable shares are included from the beginning of the period (or from the date of the
contingent share agreement, if later).
Requirement
11
Determine the diluted EPS.
Solution
As the two million additional shares do not result in additional resources for the entity, they are brought
into the diluted earnings per share calculation from the start of the 20X5 reporting period. The diluted
earnings per share is therefore:
Future earnings
Achieving or maintaining a specified level of earnings for a particular period may be the condition for
contingent issue.
In this case, if the effect is dilutive, the calculation of DEPS is based on the number of ordinary shares
that would be issued if the amount of earnings at the end of the reporting period were the amount of
earnings at the end of the contingency period.
The number of ordinary shares contingently issuable may depend on the future market price of the
ordinary shares.
In this case, if the effect is dilutive, the calculation of DEPS is based on the number of ordinary shares
that would be issued if the market price at the end of the reporting period were the market price at the
end of the contingency period.
If the condition is based on an average of market prices over a period of time that extends beyond the
end of the reporting period, the average for the period of time that has lapsed is used.
The number of ordinary shares contingently issuable may depend on future earnings and future prices of
the ordinary shares.
In such cases, the number of ordinary shares included in the DEPS calculation is based on both
conditions (ie earnings to date and the current market price at the end of the reporting period).
Contingently issuable ordinary shares are not included in the diluted earnings per share calculation
unless both conditions are met.
Other conditions
In other cases, the number of ordinary shares contingently issuable may depend on a condition other
than earnings or market price (for example, the opening of a specific number of retail stores).
Cumulative targets
Note that where performance criteria involve a cumulative target, no dilution is accounted for until the
cumulative target has been met. For example, where the issue of shares is dependent upon average
profits of CU300,000 over four years, the cumulative target is CU1,200,000. No dilution is accounted for
until this cumulative target is met.
Requirement
What are basic and diluted EPS in each of the years 20X7 – 20X9?
Solution
The cumulative target of 3 years × 100,000 units is not met in 20X7 and 20X8, therefore no dilution is
accounted for.
In 20X9, the cumulative target is met as is the average target, therefore a DEPS is disclosed:
Under an agreement relating to a business combination, 12 million additional shares were to be issued each
time the entity's products were ranked in the top three places in a consumer satisfaction survey conducted by
a well-known magazine. A maximum of 36 million shares was issuable under this agreement and the
products appeared in the top three places in surveys dated 28 February and 30 September 20X5.
Requirement
Section overview
• This section deals with retrospective adjustments to EPS and the provisions of IAS 33 concerning
presentation and disclosure.
If these changes occur after the year end but before the financial statements are authorised for issue,
EPS calculations for all periods presented must be based on the new number of shares.
The fact that EPS calculations reflect such changes must be disclosed.
Basic and diluted earnings per share of all periods presented must be adjusted for the effects of errors
(IAS 8) and adjustments resulting from changes in accounting policies accounted for retrospectively.
DEPS
An entity does not restate diluted earnings per share of any prior period presented for changes in the
assumptions used in earnings per share calculations or for the conversion of potential ordinary shares
into ordinary shares.
8.2 Presentation
• Basic and diluted EPS for continuing operations must be presented on the face of the statement of
profit or loss and other comprehensive income with equal prominence for all periods presented.
• Where a separate statement of profit or loss is presented, basic and diluted EPS should be
presented on the face of this statement.
8.3 Disclosure
An entity shall disclose the following:
• The amounts used as the numerators in calculating basic and diluted earnings per share, and a
reconciliation of those amounts to profit or loss attributable to the parent entity for the period.
The reconciliation shall include the individual effect of each class of instruments that affects
earnings per share.
• The weighted average number of ordinary shares used as the denominator in calculating basic and
diluted earnings per share, and a reconciliation of these denominators to each other.
The reconciliation shall include the individual effect of each class of instruments that affects
earnings per share.
• Instruments (including contingently issuable shares) that could potentially dilute basic earnings per
share in the future, but were not included in the calculation of diluted earnings per share because
they are antidilutive for the period(s) presented.
• A description of ordinary share transactions or potential ordinary share transactions, other than
retrospective adjustments, that occur after the reporting date and that would have changed
significantly the number of ordinary shares or potential ordinary shares outstanding at the end of
the period if those transactions had occurred before the end of the reporting period.
• An issue of shares when the proceeds are used to repay debt or preference shares outstanding at
the reporting date
• The conversion or exercise of potential ordinary shares outstanding at the reporting date into
ordinary shares
• The achievement of conditions that would result in the issue of contingently issuable shares.
Earnings per share amounts are not adjusted for such transactions occurring after the reporting date
because such transactions do not affect the amount of capital used to produce profit or loss for the
period.
Financial instruments and other contracts generating potential ordinary shares may incorporate terms
and conditions that affect the measurement of basic and diluted earnings per share. These terms and
conditions may determine whether any potential ordinary shares are dilutive and, if so, the effect on the
weighted average number of shares outstanding and any consequential adjustments to profit or loss
attributable to ordinary equity holders. The disclosure of the terms and conditions of such financial
instruments and other contracts is encouraged, if not otherwise required (refer also to IFRS 7 Financial
Instruments: Disclosures in Chapter 15).
If a component of profit is used that is not reported as a line item in the statement of profit or loss and 11
other comprehensive income, a reconciliation shall be provided between the component used and a line
item that is reported in the statement of profit or loss and other comprehensive income.
Summary
IAS 33
1 Puffbird A
P
Puffbird is a company listed on a recognised stock exchange. Its financial statements for the year T
ended 31 December 20X6 showed earnings per share of CU0.95. E
Requirement
According to IAS 33 Earnings per Share, what figure for the 20X6 earnings per share will be shown 11
as comparative information in the financial statements for the year ended 31 December 20X7?
2 Urtica
During the year ended 31 December 20X6, the company had five million ordinary shares of CU1
and 500,000 6% irredeemable preference shares of CU1 in issue.
Profit before tax for the year was CU300,000 and the tax charge was CU75,000.
Requirement
According to IAS 33 Earnings per Share, what is Urtica's basic earnings per share for the year?
3 Issky
The following extracts relate to the Issky Company for the year ended 31 December 20X7.
In addition, the company had in issue throughout the year 1,800,000 share options granted to
directors at an exercise price of CU15. These were fully vested (ie conditions required before these
could be exercised were fulfilled and the options were exercisable) but had not yet been exercised.
The market price for Issky's shares was CU24 at 1 January 20X7, CU30 at 31 December 20X7,
and the average for 20X7 was CU27.
Requirement
What is the diluted earnings per share for 20X7 according to IAS 33 Earnings per Share?
4 Whiting
The Whiting Company has the following financial statement extracts in the year ended 31
December 20X7.
On 1 January 20X7, Whiting issued CU1.2m of 7% redeemable convertible bonds, interest being
payable annually in arrears on 31 December. The split accounting required of compound financial
instruments resulted in the following classification.
The tax regime under which Whiting operates gives relief for the whole of the charge based on the
effective interest rate and applies a tax rate of 20%.
Requirement
Based upon the total profit attributable to ordinary equity holders, what amount, if any, for diluted
earnings per share should be presented by Whiting in its financial statements for the year ended
31 December 20X7 according to IAS 33 Earnings per Share?
5 Garfish
The Garfish Company had profits after tax of CU3.0 million in the year ended 31 December 20X7.
On 1 January 20X7, Garfish had 2.4 million ordinary shares in issue. On 1 April 20X7 Garfish made
a one for two rights issue at a price of CU1.40 when the market price of Garfish's shares was
CU2.00.
Requirement
What is Garfish's basic earnings per share figure for the year ended 31 December 20X7, according
to IAS 33 Earnings per Share?
6 Sakho
The Sakho Company has 850,000 ordinary shares in issue on 1 January 20X7 and had the
following share transactions in the year ended 31 December 20X7.
Requirement
Indicate whether the following statements are true or false according to IAS 33 Earnings per Share.
(a) The basic earnings per share for the year ended 31 December 20X6 has to be adjusted by a
fraction of 5/6
(b) For the calculation of 20X7 basic earnings per share, the number of shares in issue prior to
the rights issue has to be adjusted by a rights fraction of 1.50/1.20
7 Sardine
The Sardine Company operates in Moldania, a jurisdiction in which shares may be issued at a
discount. It has profit after tax and before preference dividends of CU200,000 in the year ended 31
December 20X7.
On 1 January 20X7 Sardine has in issue 500,000 ordinary shares, and on 1 January 20X7 issues
CU300,000 of CU100 non-convertible, non-redeemable preference shares. Cash dividends of 8%
per annum will only start to be paid on the preference shares from 1 January 20X9, so the shares
are issued at a discount. The effective interest rate of the discount is 8%.
Requirement
According to IAS 33 Earnings per Share, what is the basic earnings per share for Sardine in the
year ended 31 December 20X7?
On 1 January 20X7 Citric issued CU2 million of 6% redeemable convertible bonds, interest being
payable annually in arrears on 31 December. The split accounting required of compound financial
instruments resulted in a liability component of CU1.75 million and effective interest rate of 7%. The
bonds are convertible on specified dates many years into the future at the rate of two ordinary
shares for every CU5 bonds.
The tax regime under which Citric operates gives relief for the whole of the effective interest rate
charge on the bonds and applies a tax rate of 25%.
Requirement
Determine the following amounts in respect of Citric's diluted earnings per share for the year ending
31 December 20X7 according to IAS 33 Earnings per Share.
(a) The number of shares to be treated as issued for no consideration (ie 'free' shares) on the
subscription of the warrants
(b) The earnings per incremental share on conversion of the bonds, expressed in pence (to one
decimal place)
(c) The diluted earnings per share, expressed in pence (to one decimal place)
Earnings
• Amounts attributable to ordinary equity holders in respect of profit or loss from IAS 33.12
continuing operations adjusted for the after tax amounts of preference
dividends.
Shares
• For the calculation of basic EPS the number of ordinary shares should be the IAS 33.26
weighted average number of shares outstanding during the period adjusted
where appropriate for events, other than the conversion of shares, that have
changed the number of ordinary shares outstanding without a corresponding
change in resources.
• For the purposes of calculating diluted earnings per share an entity shall adjust IAS 33.30
profit or loss attributable to ordinary equity holders and the weighted number of
shares outstanding for the effects of dilutive potential ordinary shares. IAS 33.31
• Potential ordinary shares shall be treated as dilutive when, and only when, their IAS 33.41
conversion to ordinary shares could decrease earnings per share or increase
loss per share from continuing operations.
Retrospective adjustments
• Basic and diluted EPS should be adjusted retrospectively for all capitalisations, IAS 33.64
bonus issues or share splits or reverse share splits that affect the number of
shares in issue without affecting resources.
Last year's EPS figure is adjusted by the reciprocal of the bonus fraction:
11
Number of sharespost issue 4
Bonus fraction = =
Number of sharespre issue 1
2 Urtica
3.9 pence
IAS 33 12 – 13 define earnings for basic EPS as after tax and after dividends on irredeemable
preference shares.
CU
Profit before tax 300,000
Tax (75,000)
Profit after tax 225,000
Preference dividend (CU500,000 × 6%) (30,000)
Profit attributable to ordinary equity holders 195,000
3 Issky
58.7 pence
Number of shares under option
Issued at average market price (CU15 ×1,800,000)/CU27 1,000,000
Issued at nil consideration (1,800,000 – 1,000,000) 800,000
12.6 pence
It is worth noting that per IAS 33.33 and App A A3 this must be calculated, even though it is
antidilutive of the basic EPS on the same basis of (CU1,200,000/9,600,000) = 12.5 pence.
5 Garfish
89.1 pence
Weighted average number of shares:
6 Sakho
(a) False
(b) True
MV of share 1.50
Rights adjustment factor = =
TERP 1.20
TERP: 5 shares @ CU1.50 =CU7.50
2 shares @ CU0.45 = CU0.90
7 CU8.40 therefore TERP = CU8.40 / 7 shares = CU1.20
cu£179,424
Basic EPS = = 35.9p
500,000 shares
11
As no dividend is payable on the preference shares in 20X7, the discount on issue is amortised
using the effective interest method and treated as preference dividend when calculating earnings
for EPS purposes (IAS 33.15).
The CU300,000 preference shares must be discounted at 8% for the two years between issue and
the date when dividends commence. A dividend is then calculated at 8% per annum compound on
that value.
8 Citric
(a) 476,000
(b) 11.5 pence
(c) 6.78 pence
The warrants (treated as issued for nil consideration) are more dilutive than the bonds, so are
dealt with first under IAS 33.44. As the 11.5 pence earnings per incremental share on
conversion of the bonds is antidilutive, under IAS 33.36 the conversion is left out of the
calculation of DEPS.
Being the total earnings CU350,000 divided by the number of shares in issue (200,000).
The redeemable preference share dividend is included as a finance cost and deducted in arriving at
profit before tax.
This is less than basic EPS and therefore the convertible loan stock is dilutive.
Reporting of assets
Introduction
Topic List
1 Review of material from earlier studies
2 IAS 40 Investment Property
3 IAS 41 Agriculture
4 IFRS 6 Exploration for and Evaluation of Mineral Resources
5 IFRS 4 Insurance Contracts
6 Audit focus points
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
503
Introduction
• Explain how different methods of recognising and measuring assets and liabilities can
affect reported financial position
• Explain and appraise accounting standards that relate to assets and non-financial liabilities
for example: property, plant and equipment; intangible assets, held-for-sale assets;
inventories; investment properties; provisions and contingencies
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 3(a), 3(b), 14(c), 14(d), 14(f)
Section overview
• You should already be familiar with the Standards relating to current and non-current assets from
earlier studies. If not, go back to your earlier study material.
– IAS 2 Inventories
– IAS 16 Property, Plant and Equipment
– IAS 38 Intangible Assets
– IAS 36 Impairment of Assets
C
Read the summary of knowledge brought forward and try the relevant questions. If you have any
H
difficulty, go back to your earlier study material and revise it.
A
Assets have been defined in many different ways and for many purposes. The definition of an asset is P
important because it directly affects the treatment of such items. A good definition will prevent abuse or T
error in the accounting treatment: otherwise some assets might be treated as expenses, and some E
expenses might be treated as assets. R
In the current accounting climate, where complex transactions are carried out daily a definition that
covers ownership and value is not sufficient, leaving key questions unanswered.
12
• What determines ownership?
• What determines value?
The definition of an asset in the IASB's Framework from earlier studies is given below.
Definition
Asset: A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity. (Framework)
This definition ties in closely with the definitions produced by other Standard-setters, particularly the
FASB (USA) and the ASB (UK).
A general consensus seems to exist in the standard setting bodies as to the definition of an asset which
encompasses three important characteristics.
• Residual value is the estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and in
the condition expected at the end of its useful life.
• Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. (Note that this definition
changed when IFRS 13 Fair Value Measurement came into force in January 2013 – see Chapter 2,
Section 4.)
• Carrying amount is the amount at which an asset is recognised after deducting any accumulated
depreciation and accumulated impairment losses.
– It is probable that future economic benefits associated with the item will flow to the entity
– The cost of the item can be measured reliably
• These recognition criteria apply to subsequent expenditure as well as costs incurred initially (ie,
there are no longer separate criteria for recognising subsequent expenditure).
– Directly attributable costs of bringing the asset to working condition for intended use
– Initial estimate of the unavoidable cost of dismantling and removing the item and
restoring the site on which it is located
IAS 16 also:
• Provides additional guidance on directly attributable costs including the cost of an item of property,
plant and equipment.
• States that income and related expenses of operations that are incidental to the construction or
development of an item of property, plant and equipment should be recognised in profit or loss for
the period.
• Specifies that exchanges of items of property, plant and equipment, regardless of whether the
assets are similar, are measured at fair value, unless the exchange transaction lacks commercial
substance or the fair value of neither of the assets exchanged can be measured reliably. If the
acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset
given up.
– Cost model: carrying asset at cost less depreciation and any accumulated impairment losses
– Revaluation model: carrying asset at revalued amount, ie fair value less subsequent
accumulated depreciation and any accumulated impairment losses. (IAS 16 makes clear that
the revaluation model is available only if the fair value of the item can be measured reliably.)
12
(a) Binkie Co has an item of land carried in its books at CU13,000. Two years ago a slump in land
values led the company to reduce the carrying amount from CU15,000. This was recorded as an
expense. There has been a surge in land prices in the current year, however, and the land is now
worth CU20,000.
(b) In the example given above assume that the original cost was CU15,000, revalued upwards to
CU20,000 two years ago. The value has now fallen to CU13,000.
(c) Crinkle Co bought an asset for CU10,000 at the beginning of 20X6. It had a useful life of five years.
On 1 January 20X8 the asset was revalued to CU12,000. The expected useful life has remained
unchanged (ie three years remain).
Requirements
• Cost
• Net realisable value
Allowable costs
Allowable costs
include:
• Cost of purchase
exclude:
• Cost of storage
• Cost of selling
Determining cost
• FIFO
• Weighted average cost
A production line results in two outputs, Product 1 and Product 2. Parts of the production process give
rise to indirect costs specifically identifiable with only one of these products, although other costs are not
separately identifiable.
During the month, costs were incurred in line with the budget, but due to a failure of calibration to a vital
part of the process, only 675 units of Product 2 could be taken into inventory. The remainder produced
had to be scrapped, for zero proceeds.
Requirement
An entity manufactures a particular type of machine tool, each of which costs CU36,000 to produce and
has a net realisable value of CU45,000.
The entity takes one of the tools out of inventories to use for demonstration purposes over the next three
years. This item will be reclassified as a non-current asset and recognised in accordance with IAS 16
Property, Plant and Equipment.
Requirement
Assuming the tool has a nil residual value at the end of the three years, find its carrying amount to be
recognised as part of non-current assets one year later.
• An intangible asset should be recognised if it is probable that future economic benefits attributable
to the asset will flow to the entity and the cost of the asset can be measured reliably.
• At recognition the intangible should be recognised at cost (purchase price plus directly attributable
costs). After initial recognition an entity can choose between the cost model and the revaluation
model. The revaluation model can only be adopted if an active market (as defined) exists for that
type of asset.
• An intangible asset (other than goodwill recognised in the acquiree's financial statements)
acquired as part of a business combination should initially be recognised at fair value.
• Expenditure incurred in the research phase of an internally generated intangible asset should be
expensed as incurred.
• Expenditure incurred in the development phase of an internally generated intangible asset must
be capitalised provided certain tightly defined criteria are met.
– Expenditure incurred prior to the criteria being met may not be capitalised retrospectively
• An intangible asset with a finite useful life should be amortised over its expected useful life,
commencing when the asset is available for use in the manner intended by management.
• Residual values should be assumed to be nil, except in the rare circumstances when an active
market exists or there is a commitment by a third party to purchase the asset at the end of its useful
life.
• An intangible asset with an indefinite life should not be amortised, but should be reviewed for
impairment on an annual basis.
– There must also be an annual review of whether the indefinite life assessment is still
appropriate
Requirements
• Inventories
• Deferred tax assets
• Employee benefit assets
• Financial assets
• Investment property held under the fair value model
• Biological assets held at fair value less estimated point-of-sale costs
• Non-current assets held for sale
• Property, plant and equipment accounted for in accordance with IAS 16 Property, Plant and
Equipment
• Some financial assets, namely subsidiaries, associates and joint ventures. Impairments of all
other financial assets are accounted for in accordance with IAS 39 Financial Instruments:
Recognition and Measurement
Issue
Assets should be carried at no more than their recoverable amount.
Recoverable Amount
= Higher of
Examples of costs of disposal are legal costs, stamp duty and similar transaction taxes, costs of
removing the asset, and direct incremental costs to bring an asset into condition for its sale. They
exclude finance costs and income tax expense.
Value in use
Cash flow projections are based on the most recent management-approved budgets/forecasts. They
should cover a maximum period of five years, unless a longer period can be justified.
• Net cash flows, if any, for the disposal of the asset at the end of its useful life
• Future overheads that can be directly attributed, or allocated on a reasonable and consistent basis
• Cash outflows relating to obligations already recognised as liabilities (to avoid double counting)
• The effects of any future restructuring to which the entity is not yet committed
• Cash flows from financing activities or income tax receipts and payments
Discount rate
C
The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s) current market H
assessments of:
A
• The time value of money; and P
• The risks specific to the asset for which future cash flow estimates have not been adjusted. T
E
Interactive question 5: Impairment loss [Difficulty level: Exam standard] R
An entity has a single manufacturing plant which has a carrying value of CU749,000. A new government
elected in the country passes legislation significantly restricting exports of the product produced by the
plant. As a result, and for the foreseeable future, the entity's production will be cut by 40%. Cash flow 12
forecasts have been prepared derived from the most recent financial budgets/forecasts for the next five
years approved by management (excluding the effects of general price inflation).
Year 1 2 3 4 5
(including
disposal
proceeds)
If the plant was sold now it would realise CU550,000, net of selling costs.
The entity estimates the pre-tax discount rate specific to the plant to be 15%, after taking into account
the effects of general price inflation.
Requirement
Calculate the recoverable amount of the plant and any impairment loss.
Impairment indicators
The entity should look for evidence of impairment at the end of each period and conduct an impairment
review on any asset where there is evidence of impairment. The following are indicators of
impairment.
• Significant decline in market value of the asset below that expected due to normal passage of time
or normal use
• Increased market interest rates or other market rates of return affecting discount rates and thus
reducing value in use
Internal
• Internal evidence available that asset performance will be worse than expected.
* Once the asset meets the criteria to be classified as 'held for sale', it is excluded from the scope of IAS
36 and accounted for under IFRS 5 Non-current Assets Held for Sale and Discontinued Operations.
Annual impairment tests, irrespective of whether there are indications of impairment, are required for:
• Intangible assets with an indefinite useful life/ not yet available for use
• Goodwill acquired in a business combination
Definition
Cash-generating unit: A cash-generating unit is the smallest identifiable group of assets that generates
cash inflows that are largely independent of the cash inflows from other assets or groups of assets.
If an active market exists for the output produced by an asset or a group of assets, this group of assets
should be identified as a CGU even if some or all of the output is used internally. If the cash inflows are
affected by internal transfer pricing, management's best estimates of future prices that could be
achieved in an orderly transaction between market participants at the measurement date are used in
estimating the CGU's value in use.
Requirement
Discuss whether the following items would be cash-generating units in their own right, or part of a larger
cash-generating unit.
(c) A monorail that takes fee paying visitors to a theme park from its car park.
(d) A monorail that transports fee paying commuters from a suburban part of town to the centre of
town.
Corporate assets
• Corporate assets are treated in a similar way to goodwill.
The CGU includes corporate assets (or a portion of them) that can be allocated to it on a
'reasonable and consistent basis'. Where not possible, the assets (or unallocated portion) are
tested for impairment as part of the group of CGUs to which they can be allocated on a reasonable
and consistent basis.
C
Recognition of impairment losses in financial statements H
A
• Assets carried at historical cost – in profit or loss P
• Revalued assets T
The impairment loss should be treated under the appropriate rules of the applicable IFRS. E
R
For example, property, plant and equipment first against any revaluation surplus relating to the
asset and then in profit or loss in accordance with IAS 16.
General rule
The carrying amount of an asset should not be reduced below the higher of its recoverable amount (if
determinable) and zero.
The amount of the impairment loss that would otherwise have been allocated to the asset should be
allocated to the other assets on a pro-rata basis.
Where not all assets or goodwill have been allocated to an individual CGU then different levels of
impairment tests are performed to ensure the unallocated assets are tested.
• Test the individual CGUs (including allocated goodwill and any portion of the carrying amount of
corporate assets that can be allocated on a reasonable and consistent basis)
• Test the smallest group of CGUs that includes the CGU under review and to which the goodwill
can be allocated/ a portion of the carrying amount of corporate assets can be allocated on a
reasonable and consistent basis
• Only the parent's share of total goodwill when valuing the non-controlling interest using the
proportion of net assets method
• Full goodwill (ie the parent's share plus the non-controlling interest share) when using the fair value
method
Where the share of net assets method is used to value the non-controlling interest, the carrying amount
of a CGU therefore comprises:
• The parent and non-controlling share of the identifiable net assets of the unit
• Only the parent's share of the goodwill
Part of the calculation of the recoverable amount of the CGU relates to the unrecognised share in the
goodwill.
For the purpose of calculating the impairment loss, the carrying amount of the CGU is therefore
notionally adjusted to include the non-controlling share in the goodwill by grossing it up.
The consequent impairment loss calculated is only recognised to the extent of the parent's share.
Where the fair value method is used to value the non-controlling interest, no adjustment is required.
Peter acquired 60% of Stewart on 1.1.20X1 for CU450m recognising net assets of CU600m, a non-
controlling interest (valued as a proportion of total net assets) of CU240m and goodwill of CU90m.
Stewart consists of a single cash-generating unit.
Due to adverse publicity, the recoverable amount of Stewart had fallen by 31.12.20X1. The depreciated
value of the net assets at that date was CU550m (excluding goodwill). No impairment losses have yet
been recognised relating to the goodwill.
Requirement
However, the carrying amount of an asset is not increased above the lower of:
Any amounts left unallocated are allocated to the other assets (except goodwill) pro-rata.
For example, an impairment loss reversal on property, plant and equipment first reverses the loss
recorded in profit or loss and any remainder is credited to the revaluation surplus (IAS 16).
Goodwill
• Immediately before initial classification as held for sale, the asset (or disposal group) is measured
in accordance with the applicable IFRS (eg property, plant and equipment held under the IAS 16 C
revaluation model is revalued). H
A
• On classification of the non-current asset (or disposal group) as held for sale, it is written down to
P
fair value less costs to sell (if less than carrying amount).
T
• Any impairment loss arising under IFRS 5 is charged to profit or loss (and the credit allocated to E
assets of a disposal group using the IAS 36 rules, ie first to goodwill then to other assets pro-rata R
based on carrying value).
• Non-current assets/disposal groups classified as held for sale are not depreciated/amortised.
12
• Subsequent changes in fair value less costs to sell: any subsequent changes in fair value less
costs to sell are recognised as a further impairment loss (or reversal of an impairment loss).
• However, gains recognised cannot exceed cumulative impairment losses to date (whether
under IAS 36 or IFRS 5).
Section overview
• An investment property is land or buildings or both that is held by an entity to earn rentals and/or
for its capital appreciation potential.
• Investment properties have been covered at Professional level and the section below is revision of
that material.
One of the distinguishing characteristics of investment property is that it generates cash flows largely
independent of the other assets held by an entity.
Owner-occupied property is not investment property and is accounted for under IAS 16 Property, Plant
and Equipment.
2.1 Recognition
Investment property should be recognised as an asset when two conditions are met.
• It is probable that the future economic benefits that are associated with the investment property
will flow to the entity.
(b) An entity has purchased a building that it intends to lease out under an operating lease.
(c) An entity has acquired a large-scale office building, with the intention of enjoying its capital
appreciation. Rather than holding it empty, the entity has decided to try to recover its running costs
by renting the space out for periods which run from one week to one year. To make the building
attractive to potential customers, the entity has fitted the space out as small office units, complete
with full-scale telecommunications facilities, and offers reception, cleaning, a loud speaker system
and secretarial services. The expenditure incurred in fitting out the offices has been a substantial
proportion of the value of the building.
(d) An entity acquired a site on 30 April 20X4 with the intention of building office blocks to let. After
receiving planning permission, construction started on 1 September 20X4 and was completed at a
cost of CU10 million on 30 March 20X5 at which point the building was ready for occupation.
The building remained vacant for several months and the entity incurred significant operating
losses during this period.
The first leases were signed in July 20X5 and the building was not fully let until 1 September 20X6.
Requirement
Do the buildings referred to in (a) – (d) above meet the definition of investment property?
Cost model
Where the cost model is adopted, the property should be accounted for in accordance with IAS 16
Property, Plant and Equipment.
Whatever policy the entity chooses should be applied to all of its investment property.
12
An entity with a 31 December year-end owns the freehold of an office block standing on a city centre site
on which there are four other similar buildings, none of which are owned by the entity. All the office
buildings were constructed at the same time as the entity's building and the floors in all five buildings are
let out on standard 25-year leases.
Requirement
Which of the following values could be used by the entity as a basis for estimating the fair value of its
office building at 31 December 20X5, according to IAS 40?
(1) The first of the other office buildings changed hands early in 20X5 for CU5 million as a result of an
auction which was widely publicised in the professional property press.
(2) The second of the other office buildings changed hands late in 20X5 for CU6 million as a result of a
sale to an entity, 55% of whose shares were owned by the seller.
(3) The third of the other office buildings changed hands late in 20X5 for CU4.5 million as a result of
sale to a financial institution to which the seller owed CU3.5 million. It is understood that the seller
had breached its banking covenants and had to raise cash by the end of 20X5.
(4) The fourth of the other office buildings changed hands late in 20X5 for CU5.5 million as a result of a
sale to an overseas institution which was seeking to establish its first foothold in the country's
property market. The offer of the office building was widely publicised in the professional property
press although it is understood that local institutions were only prepared to offer in the region of
CU4.9 million.
2.4 Derecognition
• When an investment property is derecognised, a gain or loss on disposal should be recognised in
profit or loss. The gain or loss should normally be determined as the difference between the net
disposal proceeds and the carrying amount of the asset.
An entity purchased an investment property on 1 January 20X3, for a cost of CU5.5m. The property has
a useful life of 50 years, with no residual value and at 31 December 20X5 had a fair value of CU6.2m.
On 1 January 20X6 the property was sold for net proceeds CU6m.
Requirement
Calculate the profit or loss on disposal under both the cost and fair value model.
An entity with a 31 December year-end purchased an office building, with a useful life of 50 years, for
CU5.5 million on 1 January 20X1. The amount attributable to the land was negligible. The entity used
the building as its head office for five years until 31 December 20X5 when the entity moved its head
office to larger premises. The building was reclassified as an investment property and leased out under
a five year lease.
Owing to a change in circumstances the entity took possession of the building five years later on
31 December 20Y0, to use it as its head office once more. At that date the remaining useful life of the
building was confirmed as 40 years.
Requirements
How should the changes of use be reflected in the financial statements on the assumption that:
(a) The entity uses the cost model for investment properties.
(b) The entity uses the fair value model for investment properties.
An entity with a 31 December year-end owns an office building which is recognised as an investment
property. The lift system is an integral part of the office building. The entity uses the fair value model for
measurement of investment properties.
The lift system was purchased on 1 January 20X0 for CU400,000 and is being depreciated at 12.5% per
annum on cost. Its carrying amount has been accepted as a reasonable value at which to include it
within the fair value of the office building as a whole.
Early in December 20X5 a professional valuer determined the fair value of the office building, including
the lift system, to be CU3 million. The lift system failed on 28 December 20X5 and was immediately
replaced on 31 December 20X5 with a new system costing CU600,000.
Requirement
How should the lift system be recognised?
See Answer at the end of this chapter.
An entity with a 31 December year-end owns an investment property which it measures using the fair
value model. At 31 December 20X4, the property's carrying amount is CU4 million. On 30 June 20X5, an
explosion close to the property causes major damage to the property. In July 20X5, the entity makes a
number of insurance claims as a result, one of which is for the rebuilding cost, estimated at CU3.7
million.
Although the property is repairable, the entity decides to sell it in its present state and buy a replacement
property. This decision is made on 30 September 20X5, on which date the damaged property meets the
criteria for classification as held for sale. Its fair value on that date is CU350,000 and the costs to sell are
CU35,000. The fair value does not change between 30 September 20X5 and 31 December 20X5. The
sale is completed in the middle of 20X6 for CU375,000, with selling costs of CU40,000.
On 1 March 20X6, the entity acquires a replacement property for CU3.8 million.
The entity's insurers contest the claim relating to the building on the basis of an exclusion clause. The
entity disagrees with the insurers' interpretation and in February 20X6 initiates legal proceedings.
Negotiations are protracted and it is not until the end of 20X7 that the insurers agree to settle for CU3.9
million.
Requirement
3 IAS 41 Agriculture
Section overview
• IAS 41 sets out the accounting treatment, including presentation and disclosure requirements, for
agricultural activity.
3.1 Definitions
Definitions
Agricultural activity: Agricultural activity is defined as the management of the biological transformation
of biological assets for sale, into agricultural produce, or into additional biological assets.
Agricultural activities include, for example, raising livestock, forestry and cultivating orchards and
plantations.
In its simplest form a biological transformation is the process of growing something such as a crop,
although it also incorporates the production of agricultural produce such as wool and milk.
Agricultural produce: Agricultural produce is the harvested produce of an entity's biological assets.
IAS 41 considers the classification of biological assets and how their characteristics, and hence value,
change over time. The Standard applies to agricultural produce up to the point of harvest, after which
IAS 2 Inventories is applicable. A distinction is made between the two because IAS 41 applies to
biological assets throughout their lives but to agricultural produce only at the point of harvest.
IAS 41 includes a table of examples which clearly sets out three distinct stages involved in the
production of biological assets. Examples include the identification of dairy cattle as the biological asset,
Calves and cows are biological assets as they are living animals whereas beef and milk are agricultural
produce. Apples are agricultural produce whereas the related trees and orchards are biological assets.
Agricultural activities may be quite diverse, but all such activities have similar characteristics as
described below.
• Capacity to change – living animals and plants are capable of changing. For example, a sapling
grows into a fruit tree which will bear fruit and a sheep can give birth to a lamb;
C
• Management of change – the biological transformation relies on some form of management input,
ensuring, for example, the right nutrient levels for plants, providing the right amount of light or H
assisting fertilisation; and A
P
• Measurement of change – the changes as a result of the biological transformation are measured T
and monitored. Measurement is in relation to both quality and quantity. E
R
Illustration: Agricultural activities
An entity is involved in the production and sale of raw materials for food products, in the sale of fish
reared at its own 'fish farms' and in the sale of fish caught in the Northern seas by ocean-going trawlers. 12
An analysis of the processes involved is as follows.
Fish farming
The entity leases a number of privately-owned lakes into which it puts underwater tanks for the rearing
of fish. This is an agricultural activity, because the fish are grown to the size suitable for sale and their
feed must be provided for them since the amount available naturally in the tanks will be insufficient.
Ocean fishing
The entity owns a number of trawlers. The trawlers go to sea in search of suitable fish. This is not an
agricultural activity. Although there is biological transformation on the part of the fish, there is no
management intervention in the process; neither is there any routine measurement of the amount of any
change which has taken place. The trawlers harvest what the seas yield naturally.
Into which category would the following items be classified according to IAS 41 Agriculture?
(a) Wool
(b) Vines
(c) Sugar
• It is probable that future economic benefits will flow to the entity, for example because the dairy
cattle will produce milk which can be sold or processed into cheese and sold; and
Costs to sell
Costs to sell do not include any costs that are necessary to get the asset to a market, for example
transport. These should, however, be deducted in determining fair value.
Fair value
Fair value is 'the price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date' – see Chapter 2, Section 4.
Where an active market exists for a biological asset the quoted price in the market is the appropriate fair
value.
Where an active market does not exist, then fair value may be derived by using:
• The most recent transaction in the market, assuming that similar economic conditions exist at the
time of the transaction and at the reporting date; or
• Market prices for similar assets with appropriate adjustments to reflect differences; or
IAS 41 includes the presumption that it will be possible to fair value a biological asset. But if fair value
cannot be measured reliably at the time of initial recognition then the biological asset should be
recognised at cost less accumulated depreciation and impairment cost (ie the decrease in the
recoverable amount of an asset). Fair value should then be used as soon as a reliable measurement
can be made.
At subsequent reporting dates a biological asset should continue to be measured at its fair value. Once
a biological asset has been measured at fair value it is not possible to revert to cost.
Which of the following expenses would be classified as costs to sell when valuing biological assets and
agricultural produce?
Requirement
How should the fair value less cost to sell be calculated?
Solution
The fair value less costs to sell is calculated as:
CU C
Market value 60.00 H
Transport to market costs (1.00) A
Fair value 59.00 P
Costs to sell T
Auctioneers' commission – 2% of CU60 (1.20) E
Government levy – 3% of CU60 (1.80) R
Fair value less costs to sell 56.00
12
3.2.4 Grouping assets
Grouping biological assets, or agricultural produce, according to significant attributes, such as age or
quality, may help to establish fair value. Such groupings should be consistent with attribute groupings
that are used in the market as a basis for pricing, for example, by wine vintage.
Some biological assets are physically attached to land, for example tree plantations, and it is necessary
to value the land and biological assets together as one asset, even though agricultural land is not within
the scope of IAS 41. To obtain the fair value of the biological assets, the fair value of the land element
should be deducted from the combined fair value.
A farmer wishing to value an apple orchard, in circumstances where there is no separate valuation for
the orchard from that for the land on which it is grown, would value it at the combined fair value of the
land and orchard, less the estimated fair value of land.
Gains or losses on the initial recognition of agricultural produce should also be included in profit or loss
in the period in which they arise. Such gains or losses may arise as a result of harvesting, because the
harvested crop may be worth more than the unharvested crop. In this case a gain would arise.
Requirement
The entity is encouraged to disclose separately the amount of the change in fair value less estimated
costs to sell arising from physical changes and price changes.
If it is not possible to measure biological assets reliably and they are instead recognised at their cost
less depreciation and impairment an explanation should be provided of why it was not possible to
establish fair value. A full reconciliation of movements in the net cost should be presented with an
explanation of the depreciation rate and method used.
Section overview
• IFRS 6 Exploration for and Evaluation of Mineral Resources is effective from 1 January 2006 and
essentially deals with two matters.
– Allows entities to use existing accounting policies for exploration and evaluation assets.
– Requires entities to assess exploration and evaluation assets for impairment. The recognition
criteria for impairment are different from IAS 36 but, once impairment is recognised, the
measurement criteria are the same as for IAS 36.
4.1 Scope
The Standard deals with the accounting of expenditures on the exploration for and evaluation of mineral
resources (that is, minerals such as gold, copper, etc, oil, natural gas and similar resources), except:
• Expenditures incurred before the acquisition of legal rights to explore.
• Expenditures incurred following the assessment of technical and commercial feasibility.
IAS 8 still applies to such industries in helping them determine appropriate accounting policies. Thus,
accounting policies must present information that is relevant to the economic decision needs of users.
Entities may change their policies under IFRS 6 as long as the new information comes closer to meeting
the IAS 8 criterion.
Entities must determine which expenditures to recognise and apply their policy consistently. Such
expenditure may include acquisition of rights to explore, exploratory drilling, sampling, studies and
activities relating to commercial evaluation.
Expenditure related to the development of mineral resources is outside the scope of IFRS 6. This
comes under IAS 38.
4.6 Impairment
The difficulty with respect to exploratory activities is that future economic benefits are generally very C
uncertain and hence forecasting future cash flows, for example, is difficult. IFRS 6 modifies IAS 36 to H
state that impairment tests are required: A
P
• When the technical and commercial viability of extraction is demonstrable, at which point IFRS 6 is
T
no longer relevant to the asset.
E
• When other facts indicate that the carrying amount exceeds recoverable amounts, such as: R
– There has been no success in finding commercially viable mineral resources and the entity 12
has decided to discontinue exploratory activities within a specific area
– Estimates suggest that the carrying amounts of assets are unlikely to be recovered in full
following successful development of the mineral resource
• The amounts relating to assets, liabilities, income and expense, and operating and investing cash
flows arising from exploration for and evaluation of mineral resources
Section overview
• IFRS 4 represents interim guidance, as the first phase of a bigger project on insurance contracts.
The objective of IFRS 4 is to make limited improvements to accounting practices for insurance
contracts and to require an issuer of insurance contracts to disclose information that identifies and
explains amounts arising from such contracts.
5.1 Background
IFRS 4 specifies the financial reporting for insurance contracts by any entity that issues such contracts,
or holds reinsurance contracts. It does not apply to other assets and liabilities held by insurers.
In the past there was a wide range of accounting practices used for insurance contracts and the
practices adopted often differ from those used in other sectors. As a result the IASB embarked on a
substantial project to address the issues surrounding the accounting for insurance contracts. Rather
than issuing one Standard that covered all areas, the IASB decided to tackle the project in two phases.
Although IFRS 4 sets out a number of accounting principles as essentially best practice, it does not
require an entity to use these if it currently adopts different accounting practices. An insurance entity is
however prohibited from changing its current accounting policies to a number of specifically identified
practices.
An uncertain future event exists where at least one of the following is uncertain at the inception of an
insurance contract:
Some insurance contracts may offer payments-in-kind rather than compensation payable to the
policyholder directly. For example, an insurance repair contract may pay for a washing machine to be
repaired if it breaks down; the contract will not necessarily pay monetary compensation.
In identifying an insurance contract it is important to make the distinction between financial risk and
insurance risk. A contract that exposes the issuer to financial risk without significant insurance risk
does not meet the definition of an insurance contract.
Definitions
Financial risk is where there is a possible change in a financial or non-financial variable, for example a
specified interest rate, commodity prices, an entity's credit rating or foreign exchange rates.
Insurance risk is defined as being a risk that is not a financial risk. The risk in an insurance contract is
whether an event will occur (rather than arising from a change in something), for example a theft,
damage against property, or product or professional liability.
Appendix B to IFRS 4, which forms an integral part of the Standard, includes an extensive list of
examples of insurance contracts including:
• Life insurance and prepaid funeral plans. It is the timing of the event that is uncertain here, for
example certain life cover plans only pay out if death occurs within a specified period of time;
• An insurance contract issued to a policyholder against the escalation of claims from faulty
motorcycles. The fault was discovered a year ago and the extent of total claims is yet to be
established. This is an insurance contract since the insured event is the discovery of the ultimate
cost of the claims.
It is important to distinguish between insurance contracts and other contracts that are not covered by
IFRS 4 but which might look like insurance contracts. To provide clarification IFRS 4 specifically
identifies a number of areas where its provisions do not apply, for example:
• The provision of product warranties given directly by the manufacturer, dealer or retailer;
• Employers' assets and liabilities in relation to employee benefit plans and obligations under a
defined benefit plan; C
H
• A contractual right, or obligation, that is contingent on the right to use a non-financial item, for
example some licences; A
P
• A finance lease that contains a residual value guaranteed by the lessee, ie a specified value for the T
asset at the end of the lease is guaranteed by the lessee; E
R
• Financial guarantees within the scope of IAS 39 Financial Instruments: Recognition and
Measurement;
• Requires a test for the adequacy of recognised insurance liabilities – referred to as the liability
adequacy test;
• Prohibits provisions for possible claims under contracts that are not in existence at the reporting
date (referred to as catastrophe or equalisation provisions);
• Requires an impairment test for reinsurance assets. An impairment is only recognised where after
the commencement of a reinsurance contract, an event has occurred that will lead to amounts due
under the contract not being recovered in full, and a reliable estimate of the shortfall can be
assessed; and
• Requires an insurer to continue to recognise insurance liabilities in its financial statements until
they are discharged, cancelled or expire, and to present such liabilities without offsetting them
against related reinsurance assets.
This provision should be reassessed at each reporting date and any identified shortfall should be
recognised immediately as part of profit or loss for the period. This is the so called liability adequacy
test.
The assessment should be based on current estimates for future cash flows under the insurance
contracts issued. If the recognised insurance liability is assessed as being adequate, then IFRS 4 does
not require any further action by the insurer. However, if the liability is found to be inadequate, then the
entire shortfall should be recognised in profit or loss.
If the accounting policies of an insurer do not demand that a liability adequacy test should be carried out,
as described above, then an assessment is still required of the potential net liability (ie the relevant
insurance liabilities less any related deferred acquisition costs). In these circumstances the insurer is
required to recognise at least the amount that would be required to be recognised as a provision under
the application of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
That is, if the carrying amount of the IAS 37 calculated provision is greater than that recognised, then the
insurer should increase the liabilities as appropriate.
Liabilities CUm
Assets
The entity's procedure for calculating the provision for claims is as follows.
• To use past experience to make a range of estimates of amounts ultimately payable to insured
persons in respect of claims for losses occurring by the reporting date and of the timing of the
payments;
• To select the most likely amount and timing as its central estimate;
• To discount the amount by reference to a risk-free rate;
• To use past experience to increase the discounted amount by a risk margin to reflect the inherent
uncertainty in this discounted estimate; and
• To increase the adjusted amount by an estimate, based on past experience and discounted, of the
internal costs (such as employee benefits and accommodation costs) which will be incurred in
handling the loss claims over the period up to their settlement.
The cost of the provision is recognised in profit or loss. As this procedure meets the requirements of
IFRS 4 no further action is necessary.
The entity also estimates on a similar basis the discounted total amount, including claims handling costs,
which will be payable in respect of insured losses arising after the reporting date over the period of cover
which generates the unearned premiums. The estimated amount is CU25 million.
As all the policies extend for one year, in 20X6 the whole of the CU30 million unearned premiums will
become earned. But in 20X6 the deferred acquisition costs of CU10 million will be charged against those
premiums. Against this net income of CU20 million, the estimated cost of claims is CU25 million. Hence,
there is a premium deficiency of CU5 million in 20X6, which should be recognised in profit or loss in
20X5.
This information should include the accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts.
More generally, the risk management objectives and policies of an entity should be disclosed, since this
will explain how an insurer deals with the uncertainty it is exposed to.
An entity is not generally required to comply with the disclosure requirements in IFRS 4 for comparative
information that relates to annual periods beginning before 1 January 2005. However, comparative
disclosure is required in relation to accounting policies adopted and the identification of recognised
assets, liabilities, income and expense arising from insurance contracts. C
H
6 Audit focus points A
P
T
Section overview E
(b) Whether the valuation is materially correct (either under the cost model or the FV model), and 12
Your earlier studies should give you a good understanding of the audit techniques, and the sources of
audit evidence, that an auditor can utilise in a range of different scenarios. Your knowledge of the
financial reporting standards will inform your specific approach in the exam.
Investment property is initially measured at its cost (including transaction costs and directly attributable
expenditure). After recognition it is measured at either depreciated cost or fair value.
Issue Evidence
Classification as an investment Confirm that all investment properties are classified in
property accordance with the IAS 40 definition. This will include:
• A building owned by the entity and leased out under one or
more operating leases
• A building that is vacant but is held to be leased under one
or more operating leases
Verify rental agreements, ensuring that the occupier is not a
connected company and that the rent has been negotiated at
arm's length
If the building has recently been built, check the architect's
certificates to ensure that cost/fair value is reasonable
Valuation If cost model adopted check compliance with IAS 16
If fair value model adopted:
• Check that fair value has been measured in accordance
with IFRS 13
• Where current prices in an active market are not available
confirm that alternative valuation basis is reasonable and in
accordance with IFRS 13
• Agree valuation to valuer's certificate
• Recalculate gain or loss on change in fair value and agree
to amount in statement of profit or loss and other
comprehensive income
• If fair value cannot be measured reliably confirm use of cost
model
Disclosure Confirm compliance with IAS 40/IFRS 13, for example:
• Disclosure of policy adopted
• If fair value model adopted disclosure of a reconciliation of
carrying amounts of investment property at the beginning
and end of the period
Point to note:
IAS 40 states that fair value should be measured in accordance with IFRS 13.
Interactive question 17: Investment property and fair value [Difficulty level: Intermediate]
Propertyco Ltd, an investment property company has a portfolio of properties including the following:
Requirements
C
H
A
P
T
E
R
12
Summary
12
12
IAS 39
IAS 2 Inventories
1 Reapehu
The Reapehu Company manufactures a single type of concrete mixing machine, which it sells to
building companies. Reapehu is currently considering the value of its inventories at 31 December
20X7. The following data are relevant at this date:
Cost per item CU
Variable production costs 200,000
Fixed production costs 40,000
240,000
There are 85 mixing machines held in inventory.
The company has a contract to sell 15 concrete mixing machines at CU225,000 each to a major
local building company in January 20X8. The normal selling price is CU260,000 per machine.
Selling costs are minimal.
Requirement
What is the value of Reapehu's inventory at 31 December 20X7, according to IAS 2 Inventories?
2 Utah
The Utah Company manufactures motors for domestic refrigerators. A major customer is The
Bushbaby Company, which is a major international electrical company making refrigerators as one
of its products.
Utah is currently preparing its financial statements for the year to 31 December 20X7 and it expects
to authorise them for issue on 3 March 20X8.
Utah holds significant inventories of motors (which are unique to the Bushbaby contract) as
Bushbaby require to be supplied on a just-in-time basis and has variable production schedules.
On 3 January 20X8, Bushbaby announced that it was fundamentally changing the design of its
refrigerators and that, while this had been planned for some time, it had not been possible to warn
Utah for reasons of commercial confidentiality. As a consequence, it would cease to use Utah's
motors from 30 April 20X8 and would reduce production prior to that date. Details for Utah are as
follows:
At what value should the inventories of motors be stated by Utah in its statement of financial
position at 31 December 20X7 according to IAS 2 Inventories, and IAS 10 Events after the
Reporting Period?
3 Niobium
The Niobium Company operates in the petrol refining industry. A fire at a competitor using similar
plant has revealed a safety problem and the government has introduced new regulations requiring
the installation of new safety equipment in the industry. The refinery had a carrying amount of
CU30 million prior to the installation of the safety equipment. The new safety equipment cost CU5
million and was fully operational at 31 December 20X7, but it does not generate any future
economic benefits. The refinery would, however, be closed down without such equipment being
installed.
C
At 31 December 20X7 the net selling price of the refinery was estimated at CU33 million. In
H
determining its value in use, the directors have determined that the refinery would generate annual
A
cash flows of CU3.2 million from next year in perpetuity, to be discounted at 10% per annum.
P
Requirement T
E
According to IAS 16 Property, Plant and Equipment, what is the carrying amount of the refinery in R
Niobium's statement of financial position at 31 December 20X7?
4 Oruatua
12
The Oruatua Company acquired a piece of machinery for CU800,000 on 1 January 20X6. It
identified that the asset had three major components as follows:
One of the three engines developed a fault on 1 January 20X7 and had to be sold for scrap for
CU40,000. A replacement engine was purchased at a cost of CU168,000 on 1 January 20X7, for
use until the end of the licence period, when dismantling costs on this engine estimated at
CU150,000 would be payable.
At a rate of 7% per annum the present value of CU1 payable in 15 years' time is 0.3624 and of CU1
payable in 14 years' time is 0.3878.
Requirement
Calculate the following figures for inclusion in Oruatua's financial statements for the year ended 31
December 20X7 according to IAS 16 Property, Plant and Equipment, and IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
5 Antimony
The Antimony Company acquired its head office on 1 January 20W8 at a cost of CU5.0 million
(excluding land). Antimony's policy is to depreciate property on a straight-line basis over 50 years
with a zero residual value.
On 31 December 20X2 (after 5 years of ownership) Antinomy revalued the non-land element of its
head office to CU8.0 million. Antinomy does not transfer annual amounts out of revaluation
reserves as assets are used: this is in accordance with the permitted treatment in IAS 16 Property,
Plant and Equipment.
In January 20X8 localised flooding occurred and the recoverable amount of the non-land element
of the head office property fell to CU2.9 million.
Requirement
What impairment charge should be recognised in the profit or loss of Antimony arising from the
impairment review in January 20X8 according to IAS 36 Impairment of Assets?
6 Sundew
The Sundew Company is a vertically integrated manufacturer of chain-saws. It has two divisions.
Division X manufactures engines, all of which are identical. Division Y assembles complete chain-
saws and sells them to third party dealers.
Division X, a cash-generating unit, sells to Division Y at cost price but sells to other chain-saw
manufacturers at cost plus 50%. Details of Division X's budgeted revenues for the year ending 31
December 20X7 are as follows:
Engines Price per engine
Sales to Division Y 2,500 CU1,000
Third party sales 1,500 CU1,500
Requirement
What are the 20X7 cash inflows which should be used in determining the value in use of Division X
according to IAS 36 Impairment of Assets?
7 Cowbird
The Cowbird Company operates in the television industry. It acquired a licence to operate in a
particular region for 20 years at a cost of CU10 million on 31 December 20X3. Cowbird's policy was
to amortise the fee paid for the licence on a straight-line basis.
By 31 December 20X5 it had become apparent that Cowbird had overpaid for the licence and,
measuring recoverable amount by reference to value in use, it recognised an impairment charge of
CU4.05 million, leaving a carrying amount of CU4.95 million.
At 31 December 20X7 the market place had improved, such that the conditions giving rise to the
original impairment no longer existed. The recoverable amount of the licence by reference to value
in use was now CU11 million.
What should be the carrying amount of the licence in the statement of financial position of Cowbird
at 31 December 20X7, according to IAS 36 Impairment of Assets?
8 Acetone
The Acetone Company is testing for impairment two subsidiaries which have been identified as
separate cash-generating units.
Some years ago Acetone acquired 80% of The Dushanbe Company for CU600,000 when the fair
value of Dushanbe's identifiable assets was CU400,000. As Dushanbe's policy is to distribute all
profits by way of dividend, the fair value of its identifiable net assets remained at CU400,000 on 31
December 20X7. The impairment review indicated Dushanbe's recoverable amount at 31
December 20X7 to be CU520,000. C
H
Some years ago Acetone acquired 85% of The Maclulich Company for CU800,000 when the fair
value of Maclulich's identifiable net assets was CU700,000. Goodwill of CU205,000 (CU800,000 – A
(CU700,000 × 85%)) was recognised. As Maclulich's policy is to distribute all profits by way of P
dividend, the fair value of its identifiable net assets remained at CU700,000 on 31 December 20X7. T
The impairment review indicated Maclulich's recoverable amount at 31 December 20X7 to be E
CU660,000. R
It is Acetone group policy to value the non-controlling interest using the proportion of net assets
method.
12
Requirement
(a) The carrying amount of Dushanbe's assets to be compared with its recoverable amount for
impairment testing purposes
(b) The carrying amount of goodwill in respect of Dushanbe after the recognition of any
impairment loss
(c) The carrying amount of the non-controlling interest in Maclulich after recognition of any
impairment loss
9 Titanium
On 1 January 20X7 The Titanium Company acquired the copyright to four similar magazines, each
with a remaining legal copyright period for 10 years. At the end of the legal copyright period, other
publishing companies will be allowed to tender for the copyright renewal rights.
At 31 December 20X7 the following information was available in respect of the assets:
Titanium uses the revaluation model as its accounting policy in relation to intangible assets.
Requirement
What is the total charge to profit or loss for the year ended 31 December 20X7 in respect of these
intangible assets per IAS 38 Intangible Assets?
The following issues have arisen in relation to business combinations undertaken by the Lewis
Company.
(a) Lewis acquired the trademark of a type of wine when it acquired 80% of the ordinary share
capital of The Calcium Company on 1 April 20X7. This wine is produced from a vineyard that
is exclusively used by Calcium.
(b) When Lewis bought a football club on 1 May 20X7, it acquired the registrations of a group of
football players.
(c) Lewis acquired a 75% share in the Stilt Company during 20X7. At the acquisition date Stilt
was researching a new pharmaceutical product which is expected to produce future economic
benefits.
Requirement
Indicate which of the above items should or should not be recognised as assets separable from
goodwill in Lewis's statement of financial position at 31 December 20X7, according to IAS 38
Intangible Assets.
11 Diversified group
(a) The Thrasher Company has signed a three-year contract with a team of experts to write
questions for a computer based examination on International Financial Reporting Standards.
The contract states that the experts cannot work on similar projects for rival entities. Thrasher
incurred costs of CU5,000 in training the experts to use the software, and believes that the
product developed by the team will be a market leader.
(b) The Curium Company has a loyalty card scheme for customers. Every customer purchase is
recorded in such a way that Curium is able to create a profile of spending amounts and habits
of customers, and uses this to target them with special offers and discounts to encourage
repeat business. The database has cost CU60,000 to create and Curium has been
approached by another company wishing to buy the contents of the database.
Requirement
Which of the above items should be classified as intangible assets per IAS 38 Intangible Assets?
12 Cadmium
The Cadmium Company produces a globally recognised dog food that is a market leader. The
trademark was established over 50 years ago and is renewable every eight years. The last renewal
was effective from 1 January 20X2 and cost CU65,000. Cadmium intends to continue to renew the
trademark in future years.
Cadmium uses the revaluation model where allowed for measuring intangible assets, in
accordance with IAS 38 Intangible Assets. A valuation of CU50 million was made by an
independent valuation expert on 31 December 20X7, who charged CU650,000 for the valuation
report.
Requirement
What is the carrying amount of the trademark in Cadmium's statement of financial position at 31
December 20X7 per IAS 38 Intangible Assets?
13 Piperazine
The Piperazine Company's financial reporting year ends on 31 December. It has adopted the
revaluation model for intangible assets and revalues them on a regular three-year cycle. For
intangibles with a finite life Piperazine transfers the relevant amount from revaluation reserve to
retained earnings each year.
At 31 December 20X7 Piperazine undertook its regular revaluation. On that date the licensing
authority announced that it would triple the number of licences offered to taxi operators and there
were transactions in the active market for licences with six years to run at CU4,500.
Requirement C
H
Determine the following amounts in respect of the revaluation reserve in respect of these taxi A
licences in Piperazine's financial statements according to IAS 38 Intangible Assets.
P
(a) The balance at 31 December 20X4 T
(b) The balance at 31 December 20X7 before the regular revaluation E
(c) The balance at 31 December 20X7 after the regular revaluation R
14 Which of the following properties fall under the definition of investment property and therefore 12
within the scope of IAS 40 Investment Property?
15 Boron
At 31 December 20X7 Boron adopted the fair value model. The fair value of the retirement home at
this date was CU700,000 and costs to sell were estimated at CU40,000.
Requirement
What amount should appear in the statement of profit or loss and other comprehensive income of
Boron in the year ending 31 December 20X7 in respect of the retirement home under IAS 40
Investment Property?
16 Acimovic
Requirement
17 Laburnum
The Laburnum Company is an investment property company. One of its properties is a warehouse
which has the specialist use of storing tropical plants at high temperatures. As a result, the central
heating system is an important and integral part of the warehouse building. Laburnum uses the fair
value model for investment properties.
The central heating system was purchased on 1 January 20X2 for CU80,000. It is being
depreciated at 10% per annum on cost and it has been agreed by the valuer that the carrying
amount of the central heating system is a reasonable value at which to include it in the fair value of
the entire warehouse.
In December 20X7 the valuer initially determined the fair value of the warehouse, including the
central heating system, to be CU1,250,000. Unfortunately, the central heating system completely
failed on 25 December 20X7 and was immediately scrapped and replaced with a new heating
system costing CU140,000 on 31 December 20X7.
Requirement
According to IAS 40 Investment Property, at what value should the warehouse, including the
heating system, be recognised in the financial statements of Laburnum in the year ending 31
December 20X7?
18 Ramshead
On 1 January 20X6 The Ramshead Company acquired an investment property for which it paid
CU3.1 million and incurred CU100,000 agency and legal costs. The property's useful life was
estimated at 20 years, with no residual value; its fair value at 31 December 20X6 was estimated at
CU3.45 million and agency and legal costs to dispose of the property at that date were estimated at
CU167,500.
On 1 July 20X7 Ramshead decided to dispose of the property. The criteria for being classified as
held for sale were met on that date, when the property's fair value was CU3.5 million. Agency and
legal costs to dispose of the property were estimated at CU160,000.
On 1 October 20X7 the property was sold for a gross price of CU3.7 million, with agency and legal
costs of CU165,000 being incurred.
Requirement
Calculate the following amounts in respect of Ramshead's financial statements for the year ended
31 December 20X7 in accordance with IAS 40 Investment Property, and IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations.
(a) The gain or loss arising in 20X6 from the change in carrying amount if the fair value model is
used to account for the property.
(b) The gain or loss on disposal arising in 20X7 if the cost model is used.
(c) The increase or decrease, compared with the cost model, in the gain or loss on disposal
arising in 20X7 if the fair value model is used.
IAS 41 Agriculture
19 Arapawanui
The Arapawanui Company keeps a flock of sheep on its land, selling the milk outputs. The day
after its production, the milk is collected on behalf of the purchasers and revenue from its sale is
recognised.
On 30 June 20X7 300 animals were born, all of which survived and were still owned by Arapawanui
at 31 December 20X7. 10,000 litres of milk were produced in the year to 31 December 20X7.
The production cost, including overheads, of the milk was CU0.08 per litre and the fair values were
CU0.13 per litre throughout 20X7 and CU0.14 per litre throughout 20X8. Costs to sell were
estimated at 4%.
Requirement
C
What gain should be recognised in respect of the newborn sheep and the milk in Arapawanui's
H
financial statements for the year to 31 December 20X7, according to IAS 41 Agriculture?
A
20 Tepev P
T
The Tepev Company bought a flock of 400 sheep on 1 December 20X7. The cost of each sheep
E
was CU80, which represented fair value at that date. Auctioneers' fees on sale are 5% of fair value,
R
and the cost of transporting each sheep to market is CU4.00. An agricultural levy of CU2.00 is
payable on each sheep sold.
At 31 December 20X7 all of the sheep are still held and fair value has increased to CU90 per 12
sheep. No other costs have changed. Tepev has a contract to sell the sheep on 31 March 20X8 for
CU100 each.
Requirement
What is the carrying amount of the flock in the statement of financial position at 31 December
20X7, according to IAS 41 Agriculture?
21 Saving
The Saving Company bought a flock of 500 sheep on 1 December 20X7. The cost of each sheep
was CU95, which represented fair value at that date. Auctioneers' fees on sale are 5% of fair value,
and the cost of transporting each sheep to market is CU3.00. An agricultural levy of CU2.00 is
payable on each sheep sold.
At 31 December 20X7 all of the sheep are still held and fair value has increased to CU107 per
sheep. No other costs have changed. Saving has a contract to sell the sheep on 31 March 20X8 for
CU119 each.
Requirement
What is the gain arising in relation to the flock between the date of initial recognition as an asset
and 31 December 20X7, according to IAS 41 Agriculture?
22 Monkey
The Monkey Company has the following information in relation to a cattle herd in the year ended
31 December 20X7.
CU'000
Cost of herd acquired on 1 January 20X7 (which equates to fair 1,800
value)
Auctioneers' sales fees 2% of sale price
Loan obtained at 8% to finance acquisition of herd 1,500
Fair value of herd at 31 December 20X7 2,500
Transport cost to market 35
Government transfer fee on sales – no fee on purchases 50
Requirement
What is the loss arising on initial recognition of the herd as biological assets and the gain arising on
its subsequent remeasurement under IAS 41 Agriculture, in the year ended 31 December 20X7?
23 Blackbuck
The Blackbuck Company has in issue unit-linked contracts which pay benefits measured by
reference to the fair value of the pool of investments supporting the contracts. The terms of the
contracts include the following.
(1) On surrender by the holder or on maturity, the benefits shall be the full fair value of the
relevant proportion of the investment.
(2) In the event of the holder's death prior to surrender or maturity, the benefits shall be 120% of
the full value of the relevant proportion of the investments.
Blackbuck's accounting policies do not otherwise require it to recognise all the obligations under
any deposit component within these contracts.
Blackbuck's financial controller is unclear whether these contracts should be accounted for under
IFRS 4 Insurance Contracts, or under IAS 39 Financial Instruments: Recognition and
Measurement.
Requirement
24 Traore
The Traore Company is organised into a number of divisions operating in different sectors. The
accounting policies applied in two of its divisions prior to the introduction of IFRS 4 Insurance
Contracts are as follows.
Accounting policy (1) In its car breakdown division, Traore offers unlimited amounts of
roadside assistance in exchange for an annual subscription. Although it
has always accepted that this activity is in the nature of offering
insurance against breakdown, it accounts for these subscriptions by
using the stage of completion method under IAS 18 Revenue, and
making relevant provisions for fulfilment costs under IAS 37 Provisions,
Contingent Liabilities and Contingent Assets.
Accounting policy (2) In its property structures insurance division, Traore makes a detailed
estimate for the cost of each outstanding claim but adopts the practice
of adding another 20% to the total on a 'just in case' basis.
Requirement
Which of these accounting policies is Traore permitted to continue to use under IFRS 4 Insurance
Contracts?
25 Give examples of circumstances that would trigger a need to test an evaluation and exploration
asset for impairment.
IAS 2 Inventories
• Cost = expenditure incurred, in bringing the items to their present IAS 2.10
location and condition, so the cost of purchase and the cost of
conversion
• Disclosures include accounting policies, carrying amounts and amounts IAS 2.36–38
recognised as an expense
• The way in which fair value is determined depends on whether there is a IAS 36.25–27
binding sale agreement and/or an active market
3 Value in use
• Calculation involves the estimation of future cash flows as follows: IAS 36.39
• These should reflect the current condition of the asset IAS 36.44
• Estimate recoverable amount of CGU if not possible to assess for an IAS 36.66
individual asset
• Goodwill should be allocated to each of the acquirer's CGUs that are IAS 36.80
expected to benefit
• Annual impairment review required for any CGU which includes goodwill IAS 36.90
• If the asset is held under the cost model the impairment should be IAS 36.60
recognised in profit or loss
• If the asset has been revalued the impairment loss is treated as a IAS 36.60
revaluation decrease
– To goodwill then
– To all other assets on a pro-rata basis
• An impairment loss recognised for goodwill should not be reversed IAS 36.124
7 Disclosures
2 IAS 41 Agriculture
Scope IAS 41.1
IAS 2 Inventories
1 Reapehu
CU20,175,000
IAS 2.31 requires that NRV should take into account the purpose for which inventory is held. The
NRV for the contract is therefore determined separately from the general sales, thus:
CU
Contract: NRV is lower than cost thus use NRV, so (CU225,000 × 15) = 3,375,000
General: Use cost as this is less than NRV, so (CU240,000 × (85-15)) = 16,800,000
20,175,000
2 Utah
CU64,000
IAS 2.30 requires the NRV of inventories to be calculated on the basis of all relevant information,
including events after the reporting period. This is supported by the example in IAS 10.9(b).
Thus:
CU
CU25 × 1,600 expected to be sold to Bushbaby: 40,000
CU10 × 2,400 remainder 24,000
Total 64,000
3 Niobium
CU33 million
IAS 16.11 requires the capitalisation of essential safety equipment even if there are no future
economic benefits flowing directly from its operation.
It does however subject the total value of all the related assets to an impairment test. In this case
the recoverable amount is CU33m, as the net selling price CU33m is greater than the value in use
CU32m (ie CU3.2m / 0.1). As this is less than the total carrying amount of CU35m (CU30m + 5m),
the assets are written down to CU33m.
4 Oruatua
(a) CU850,355
(b) CU(154,118)
(c) CU756,521
(a) The initial cost of the asset must include the dismantling cost at its present value, where the
time value of the money is material (IAS 16.16(c) and IAS 37.45). The present value of these
costs at 1 January 20X6 is CU173,952 (CU480,000 × 0.3624), making the total cost of the
engines CU623,952. Each part of the asset that has a cost which is significant in relation to
the total asset cost should be depreciated separately (IAS 16.43). Therefore, at the end of
20X6 the carrying amount of the asset is CU850,355 (CU110,000 × 4/5) + (CU240,000 × ¾) +
(CU623,952 × 14/15).
5 Antimony
CU0.7 million C
IAS 36.60 and 61 (also IAS 16.40) require that an impairment that reverses a previous revaluation H
should be recognised through the revaluation reserve to the extent of that reserve. Any remaining A
• Of this, CU3.5m is a reversal of the revaluation reserve, so only CU0.7 million is recognised
through profit or loss.
6 Sundew
CU6,000,000
IAS 36.70 requires that in determining value in use where internal transfers are made, then a best
estimate should be made of prices that would be paid in an orderly transaction between market
participants at the measurement date.
7 Cowbird
CU8.0 million
IAS 36.110 requires consideration of whether an impairment loss recognised in previous years has
reversed or decreased.
IAS 36.117 and 118 restrict the recognition of any such reversal to the value of the carrying amount
at the current reporting date had the original impairment not taken place. Thus:
8 Acetone
(a) CU750,000
(b) CU96,000
(c) CU99,000
CU
(a) Book value of Dushanbe's net assets 400,000
Goodwill recognised on acquisition
9 Titanium
CU672,500 12
IAS 38.94 deals with the identification of the useful life of an intangible asset arising from legal
rights.
The Dominoes publication has a useful life of six years, and so should be amortised over this
period. At the year end the carrying amount of CU750,000, (900,000 × 5/6), exceeds the active
market value, so an impairment of CU50,000 is required. This gives a total charge of CU200,000
(CU150,000 amortisation plus CU50,000 impairment charge)
The Billiards publication is initially amortised over the period of 10 years to the end of the copyright
arrangement, as there is no certainty that the company can publish the magazine after this date.
This gives a charge of CU120,000.
The Skittles publication is amortised over the period it is expected to generate cash flows of eight
years, giving a charge of CU212,500.
The Darts publication has an indefinite period over which it is expected to generate cash flows.
Under normal circumstances it would be automatically subject to an annual impairment review.
However, because the copyright arrangement does have a finite period, amortisation should take
place over 10 years, and so a charge of CU140,000 is required.
10 Lewis
(a) Recognised
(b) Recognised
(c) Recognised
(a) The vineyard trademark is not separable because it could only be sold with the vineyard itself.
But under IAS 38.36, the combination of the vineyard and the trademark should be
recognised.
(b) The footballers' registrations represent a legal right which meets the identifiability criterion in
IAS 38.12.
(c) The research project should be treated as a separate asset as on a business combination it
meets the definition of an asset and is identifiable (IAS 38.34).
(a) The training costs would not satisfy the definition of an intangible asset. This is because
Thrasher has insufficient control over the expected future benefits of the team of experts (IAS
38.15).
(b) The database would be classified as an intangible asset because the willingness of another
party to buy the contents provides evidence of a potential exchange transaction for the
relationship with customers and that the asset is separable (IAS 38.16).
12 Cadmium
CU16,250
The revaluation model cannot be used for this trademark, because for a unique item there cannot
be the active market required by IAS 38.75. (A professional valuation does not rank as a value by
reference to an active market.) IAS 38.81 requires the cost model to be applied to such an item,
even if it is in a class for which the revaluation model is used.
The cost of renewal should be treated as part of the cost of an intangible, under IAS 38.28(b), but
the valuation expenses should be charged directly to profit or loss, as administration overheads
(IAS 38.29(c)).
The trademark is therefore carried at the cost of renewal, depreciated for the six of the eight years'
life since last renewal, so CU65,000 × 2/8 = CU16,250.
13 Piperazine
(a) CU132,750
(b) CU88,500
(c) CU61,500
(a) Under IAS 38.21 the CU70,000 spent in 20X4 in applying for the licences must be recognised
in profit or loss, because the generation of future economic benefits is not yet probable. The
CU9,000 incurred in December 20X4 in registering the licences is treated as the cost of the
licences because the economic benefits are then probable. The carrying amount of the
licences under the revaluation model at 31 December 20X4 is CU141,750 (CU9,450 × 15), so
the balance on the revaluation reserve is the CU132,750 uplift (IAS 38.75 and 85).
(b) After three years the accumulated amortisation based on the revalued amount is CU47,250
(CU141,750 × 3/9), whereas the accumulated amortisation based on the cost would have
been CU3,000 (CU9,000 × 3/9). So CU44,250 will have been transferred from the revaluation
reserve to retained earnings (IAS 38.87). The remaining balance before the regular
revaluation is CU88,500 (CU132,750 – CU44,250).
(c) The carrying amount of the licences immediately before the revaluation is CU94,500
(CU141,750 – CU47,250). The revalued carrying amount is CU67,500 (CU4,500 × 15). The
deficit of CU27,000 is recognised in the revaluation reserve, reducing the balance to
CU61,500 (IAS 38.86).
(b) A building owned by an entity and leased out under an operating lease
(d) Land held for long-term capital appreciation
CU50,000
Under the fair value model IAS 40.33 requires investment properties to be measured at fair value,
while IAS 40.37 requires fair value to be determined excluding transaction costs that may be
incurred on sale or other disposal. IAS 40.35 requires changes in fair value to be recognised in
profit or loss.
IAS 40.20 requires transaction costs, such as legal costs, to be included in the initial measurement.
16 Acimovic
C
CU135,000 income H
A
IAS 40.25 requires that an investment property held under a finance lease should initially be
P
recognised according to IAS 17 Leases, which is at the lower of (i) fair value and (ii) present value
T
of minimum lease payments, so CU740,000.
E
Subsequent measurement is at fair value, per IAS 40.33. IAS 40.26 requires the subsequent fair R
value to relate to the property interest, not to the underlying property. So the CU875,000 fair value
of the property interest should be used.
12
The result is income of CU135,000 (ie CU875,000 - CU740,000).
17 Laburnum
CU1,358,000
IAS 40.19 and 68 require derecognition of the carrying amount of the failed system and inclusion of
the replacement.
18 Ramshead
(a) Transaction costs should be included in the initial measurement of investment properties (IAS
40.20). Under the fair value model an investment property is subsequently carried at fair value
without any deduction for costs to sell (IAS 40.33 and 5). The gain recognised in profit or loss
is CU250,000 (CU3.45m – (CU3.1m + CU0.1m)).
(b) Any asset classified as held for sale is measured in accordance with applicable IFRS
immediately before classification. So if the cost model is used, the carrying amount before
initial classification is cost less depreciation to the date of classification, so CU2.96m (CU3.2m
less 18 months' depreciation at 5% per annum). On initial classification, the property is
measured at the lower of this carrying amount and the CU3.34m (CU3.5m – CU160,000) fair
value less costs to sell (IFRS 5.15) so CU2.96m. There is no subsequent depreciation (IFRS
5.25), so the carrying amount will be the same at the date of disposal. The profit on disposal is
net disposal proceeds less the carrying amount (IAS 40.69), so net sales proceeds of
CU3.535m (CU3.7m – CU165,000) less CU2.960m gives a profit on disposal of CU575,000.
(c) If the fair value model is used, then the carrying amount immediately before initial
classification will be the CU3.5m fair value. The requirement to measure an asset 'held for
sale' at the lower of carrying amount at fair value less costs to sell does not apply to
investment properties measured at fair value (IFRS 5.5) and so the property continues to be
measured at fair value. IAS 40.37 states that costs to sell should not be deducted from fair
value, so the property continues to be measured at CU3.5m. Profit on disposal will be net
IAS 41 Agriculture
19 Arapawanui
The newborn sheep are biological assets and should be measured at fair value less costs to sell,
both on initial recognition and at each reporting date (IAS 41.12). The gains on initial recognition
and from a change in this value should be recognised in profit or loss (IAS 41.26). As the animals
are 6 months old at the year-end, the total gain in the year (being the initial gain based on a
newborn fair value of CU22 plus the year end change in value by CU4 to CU26) is CU7,644 (300 ×
CU26 × (100% – 1.5% – 0.5%)).
The milk is agricultural produce and should be recognised initially under IAS 41 at fair value less
costs to sell (IAS 41.13). (At this point it is taken into inventories and dealt with under IAS 2.) The
gain on initial recognition should be recognised in profit or loss (IAS 41.28). The gain is CU1,248
(10,000 litres × CU0.13 × (100% – 4)).
20 Tepev
CU33,400
Biological assets should be measured at fair value less costs to sell (IAS 41.12). Costs to sell
include sales commission and regulatory levies but exclude transport to market (IAS 41.14).
Transport costs are in fact deducted from market value in order to reach fair value. In this question
fair value of CU90 is provided; it is assumed that this is calculated as a market value of CU94 less
the quoted transport costs of CU4. Contracts to sell agricultural assets at a future date should be
ignored (IAS 41.16).
21 Saving
CU5,700
Biological assets should be measured at fair value less costs to sell, both on initial recognition and
at each reporting date (IAS 41.12). Costs to sell include sale commission and regulatory levies but
exclude transport to market (IAS 41.14). Transport costs are in fact deducted from market value in
order to reach fair value. Contracts to sell agricultural assets at a future date should be ignored
(IAS 41.16).
CU
FV at reporting date (CU107 – commission (CU107 × 5%) – levy CU2.00) 99.65
Initial FV per sheep (CU95 – commission (CU95 × 5%) – levy CU2.00) (88.25)
Gain per sheep 11.40
22 Monkey
On acquisition of the herd, the cattle are initially recognised as biological assets at fair value
less costs to sell (IAS 41.27), which in this case is less than cost by the costs to sell which are
immediately deducted (IAS 41.27). Acceptable costs to sell include autioneers' fees and
government transfer fees (IAS 41.14) but exclude transport to market costs (IAS 41.14). The
interest on the loan taken out to finance the acquisition is not a cost to sell (IAS 41.22).
C
(b) The value is then restated to fair value less costs to sell at each reporting date (IAS 41.12) H
CU'000 A
P
Fair value at 31 December 20X7 2,500
T
Costs to sell: auctioneers fees (CU2.5m × 2%) (50)
E
Government fees (50) R
Carrying value 2,400
Less initial recognition value (1,714)
Gain 686 12
23 Blackbuck
The extra payable on death prior to surrender/maturity should be accounted for under IFRS 4 and
the remainder under IAS 39.
Given the entity's accounting policies in relation to the recognition of obligations under the deposit
components, IFRS 4.10 requires the insurance component and the deposit component to be
unbundled; IFRS 4.12 requires the insurance component to be accounted for under IFRS 4 and the
deposit component under IAS 39.
24 Traore
IFRS 4.13 disapplies the provisions of IAS 8 Accounting Policies, Changes in Accounting Estimates
and Errors, in relation to selection of accounting policies where there is no IFRS. Entities are
therefore only required to change existing policies in the circumstances listed in IFRS 4.14.
Accounting policy (1) is not caught by this paragraph, so its continued use is permitted.
The application of Accounting policy (2) involves the use of excessive prudence. The continued use
of excessive prudence is permitted by IFRS 4.26.
25 (a) The expiration or anticipated expiration in the near future of the period for which the entity has
the right to explore the relevant area, unless the right is expected to be renewed.
(b) The lack of available planned or budgeted expenditure for further exploration and evaluation of
the specific area.
(c) A decision to discontinue evaluation activities in the exploration and specific area when
commercially viable resources have not been identified.
(c) On 1 January 20X8 the carrying value of the asset is CU10,000 – (2 × CU10,000 ÷ 5) = CU6,000.
For the revaluation:
The cost per unit therefore being CU207,000 / 690 = CU300 each.
The cost per unit therefore being CU225,000 / 900 = CU250 each.
The indirect costs not specifically identifiable with either product which are allocated to the scrapped
Product 2 cannot be recovered into the cost of Product 1.
• Computer software (other than operating systems which are accounted for under IAS 16)
• Patents and copyrights
• Motion picture films
• Customer lists, customer loyalty, customer/supplier relationships C
• Airline landing slots H
• Fishing licences A
• Import quotas P
T
• Franchises
E
(b) Employees can never be recognised as an asset; they are not under the control of the employer, R
are not separable and do not arise from legal rights.
The CGUs which appear to have cash flows independent of the other assets (and can therefore be
subject to reliable assessment of their recoverable value) are:
(a) and (c) are not generators of independent cash flows and are therefore too small to be CGUs in their
own right. In the case of (c) the CGU is the theme park as one entity.
Additionally (e) is a CGU in its own right as there is an external active market for its services, even
though these are not openly available (IAS 36.71).
(b) The building would qualify as an investment property under IAS 40 as the entity intends to earn
rentals from it under an operating lease.
(c) The provisions offered over and above the office space itself, fall within what IAS 40 describes as
'ancillary services'. Considering the nature and extent of these services, it would be unlikely that
they could be described as 'insignificant' in relation to the arrangements as a whole. The building is,
in essence, being used for the provision of serviced offices and therefore does not meet the
definition of an investment property.
Although the entity's main objective in acquiring the building is its potential capital appreciation, the
building should be recognised and measured in accordance with IAS 16 rather than IAS 40.
(d) The property should be recognised as an investment property on 30 March 20X5 when the offices
were ready to be occupied. Costs incurred, and consequently operating losses, after this date
should be expensed even though the entity did not start to receive rentals until later in 20X5.
Losses incurred during this 'empty' period are part of the entity's normal business operations and
do not form part of the cost of the investment property.
(2) The CU6 million value could not be used as a basis of fair value, because the sale transaction
cannot be presumed to be between market participants in an orderly transaction.
(3) The CU4.5 million value could not be used as a basis of fair value, because the sale transaction
would appear to have been made by a forced, not willing, seller, and therefore not an orderly
transaction.
(4) The CU5.5 million value could not be used as a basis of fair value, because the sale transaction
would appear to have been made to a buyer who was not knowledgeable of local market
conditions, and therefore not a market participant in an orderly transaction.
On 1 January 20X6 the property will be recognised as an investment property at its IAS 16 carrying
12
amount of CU4.95 million and will continue to be depreciated over its remaining 45-year life.
On 1 January 20Y1 the property will be recognised as property, plant and equipment at its IAS 40
carrying amount of CU4.4 million and will continue to be depreciated over its remaining 40-year life.
At 31 December 20X5, the building has a carrying amount of CU4.95 million in accordance with IAS 16
(as set out above).
On 1 January 20X6, the property will be recognised as an investment property. However, the property
should be revalued to fair value at 31 December 20X5, and any change in value should be recognised in
accordance with IAS 16.
The property will therefore be recognised at a carrying amount of CU6 million and the difference of
CU1.05 million should be recognised as a revaluation surplus (other comprehensive income).
During the period between 1 January 20X6 and 31 December 20Y0 the building is measured at fair
value with any gain or loss recognised directly in profit or loss. At the end of 20Y0 the cumulative gain is
CU1.5 million.
At 31 December 20Y0, the building has a carrying amount of CU7.5 million being its fair value and this is
the amount that should be recognised as its carrying amount under IAS 16. The carrying amount will be
depreciated over the building's remaining 40-year useful life.
(2) CU1.2 million is capitalised as the cost of the new system and will be depreciated over its
estimated useful life of 10 years
20X5
The property continues to be measured under the fair value model on classification as held for sale on
30 September. An impairment of CU3.65 million is recognised (CU4 million less CU350,000).
At 31 December the property is presented as held for sale within current assets at CU350,000.
20X6
The replacement property is recognised at a cost of CU3.8 million and a loss on disposal is recognised
of CU15,000 being (proceeds of CU375,000 less selling costs of CU40,000 less carrying amount of
property of CU350,000).
20X7
Note:
The requirement to measure an asset 'held for sale' and the lower of carrying amount and fair value less
costs to sell does not apply to investment properties measured at fair value (IFRS 5.5). IAS 40.37 states
that costs to sell should not be deducted from fair value.
Commissions to brokers and transfer taxes and duties are recognised costs to sell in the Standard.
Property A: As this property is owner occupied it does not fall within the definition of an
investment property in accordance with IAS 40 (IAS 40(9)).
Property B: While this property is not legally owned it is held under a finance lease and
therefore can be treated as an investment property (IAS 40(5)).
Property C: Although this property is currently vacant, on the basis that it is being held for
investment purposes it can be classified as an investment property (IAS 40(8d)).
Property D: This is an investment property as it is legally owned by Propertyco Ltd and is let C
out to a non-group company (IAS 40(5)). H
A
(ii) Valuation
P
Property A: Should be valued in accordance with IAS 16 ie cost less accumulated T
depreciation unless the revaluation model is to be adopted. E
R
Property B: Would have been recognised at the inception of the lease at the lower of fair
value and the present value of the minimum lease payments. After initial
recognition it would be valued at fair value in accordance with company policy in
respect of investment properties. 12
Property C: Should initially be recognised at cost including transaction costs. In this case the
asset should initially be recognised at CU3m. As the fair value model is adopted
by Propertyco the value will then be revised to fair value.
Property D: Should be recognised at fair value in accordance with IAS 40 and the accounting
policy adopted by Propertyco Ltd. Changes in fair value should be recognised in
profit or loss for the period.
• Evaluate the control environment and the process by which Propertyco Ltd establishes fair
values
• Determine the basis on which fair values have been calculated. (In accordance with IAS
40/IFRS 13 this should be the price that would be received to sell an asset in an orderly
transaction between market participants at the measurement date.) Current prices per square
metre in an active market for similar property in the same location and condition is likely to
provide the best evidence or observable market rents. (IAS 40 (40) states that the fair value
must reflect rental income from current leases and other assumptions that participants would
use when pricing investment property under current market conditions)
• Where external valuers have been used assess the extent to which they can be relied on in
accordance with the principles of using the work of a management's expert in ISA 500 Audit
Evidence
• If fair values have been based on discounted cash flows ie discounted future rental incomes
compare predicted cash flows to current rental agreements and assess whether this is the
most appropriate basis for estimating fair value in accordance with IFRS 13. Review the basis
on which the interest rate applied has been selected and any other assumptions built into this
calculation eg consider management's history of carrying out its intentions
13
Introduction
Topic List
1 IAS 10 Events After the Reporting Period
2 IAS 37 Provisions, Contingent Liabilities and Contingent Assets
3 Current issues
4 Audit focus
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
• Explain how different methods of recognising and measuring assets and liabilities can
affect reported financial position
• Explain and appraise accounting standards that relate to assets and non-financial liabilities
for example: property, plant and equipment; intangible assets, held-for-sale assets;
inventories; investment properties; provisions and contingencies
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 1(e), 3(a), 3(b) 14(c), 14(d), 14(f)
Section overview
• Events after the reporting period are split into adjusting and non-adjusting events. Those events
that may affect the going concern assumption underlying the preparation of the financial
statements must be considered further.
• The following is a summary of the material covered in earlier studies.
Non-adjusting events are events that are indicative of conditions that arose after the reporting date.
Disclosure should be made in the financial statements where the outcome of a non-adjusting event
would influence the economic decisions made by users of the financial statements. Examples are:
• A major business combination after the reporting date (IFRS 3 or the disposing of a major
subsidiary)
• Announcement of plan to discontinue an operation
• Major purchases and disposals of assets
• Classification of assets as held for sale
• Expropriation of assets by government
• Destruction of assets, for example by fire or flood
• Announcing or commencing the implementation of a major restructuring
• Major ordinary share transactions (unless these involve transactions such as capitalisation or
bonus issues where there is a change in the number of shares without an inflow or outflow of
resources, see adjusting events above. Such transactions require EPS to be restated as if the new
number of shares was in issue for the whole year).
• Decline in the market value of investments including investment properties after the reporting date.
These should reflect the fair value at the reporting date and should not be affected by hindsight.
Section overview
• The following is a summary of the material covered in earlier studies.
Definition
A provision is a liability where there is uncertainty over its timing or the amount at which it will be
settled.
Recognition
• A provision should be recognised when:
– An entity has a present obligation (legal or constructive) as a result of a past event;
– It is probable that there will be an outflow of resources in the form of cash or other assets; and
– A reliable estimate can be made of the amount.
• A provision should not be recognised in respect of future operating losses since there is no present
obligation arising from a past event.
Onerous contracts
• If future benefits under a contract are expected to be less than the unavoidable costs under it, the
contract is described as onerous. The excess unavoidable costs should be provided for at the time
a contract becomes onerous.
Restructuring costs
• A constructive obligation, requiring a provision, only arises in respect of restructuring costs where
the following criteria are met:
– A detailed formal plan has been made, identifying the areas of the business and number of
employees affected with an estimate of likely costs and timescales; and
– An announcement has been made to those who will be affected by the restructuring.
3 Current issues
Section overview
• This section covers proposed changes to IAS 37.
The most obvious change is that the term 'provision' is no longer used; instead it is proposed that the
term 'liability' is used.
Definition
A liability is a liability other than a financial liability as defined in IAS 32 Financial Instruments:
Presentation.
13
3.6.1 Rationale for proposed treatment
The Basis for Conclusions on the ED emphasises that the probability recognition criterion is used in the
IASB's Framework to determine whether it is probable that settlement of an item that has previously
been determined to be a liability will require an outflow of economic benefits from the entity. In other
words, the Framework requires an entity to determine whether a liability exists before considering
whether that liability should be recognised. The Basis notes that in many cases, although there may be
uncertainty about the amount and timing of the resources that will be required to settle a liability, there is
little or no uncertainty that settlement will require some outflow of resources.
3.7 Measurement
The obligation is measured as the amount the entity would rationally pay to settle the obligation at
the reporting date or to transfer it to a third party. This is the lower of:
• The present value of the resources required to fulfil an obligation
• The amount that an entity would have to pay to cancel the obligation and
• The amount that the entity would have to pay to transfer the obligation to a third party
Expected values would be used, whether measuring a single obligation or a population of items.
3.8 Reimbursement
IAS 37 states that when expenditure required to settle a provision is expected to be reimbursed by
another party, the reimbursement should be recognised when it is virtually certain that the
reimbursement will be received. Consistently with the revised analysis of a contingent asset, the ED
proposes that if an entity has an unconditional right to receive reimbursement, that right should
be recognised as an asset if it can be measured reliably.
Solution
There is a present obligation as a result of a past event, this being the operation in which negligence
occurred. Accordingly, a liability is recognised.
Measurement of the liability reflects the likelihood that the hospital will be required to pay compensation
because of the mistake, and the amount and timing of that compensation.
Section overview
• Auditors will carry out specific procedures on provisions and contingencies.
C
H
4.3 Procedures regarding events after the reporting period A
P
ISA 560 Subsequent Events sets out the audit requirements in relation to events occurring after the
T
reporting period. Please refer to Chapter 8 for a more detailed discussion.
E
R
13
Summary
1 Authorisation
• Process of authorisation of financial statements IAS 10.4
• Authorisation date is the date on which financial statements are authorised for IAS 10.5, 10.6
issue to shareholders
• The relevant cut-off date for consideration of events after the reporting period is IAS 10.7
the authorisation date
2 Adjusting events
• Amounts recognised in financial statements should be adjusted to reflect IAS 10.8, 10.9
adjusting events after the reporting date
• Examples of adjusting events include
– Outcome of court case that confirms obligation at reporting date
– Receipt of information on recoverability or value of assets
– Finalisation of profit sharing or bonus payments C
– Discovery of fraud or errors H
A
3 Non-adjusting events P
• An entity should not adjust amounts recognised in financial statements for non- IAS 10.10 T
adjusting events after the reporting period E
R
• An example is the subsequent decline of market value of investments
• Non-adjusting events may need to be disclosed IAS 10.10
• Dividends proposed or declared on equity instruments after the reporting date IAS 10.12 13
cannot be recognised as a liability at the reporting date
• Dividends proposed or declared after the reporting date should be disclosed IAS 10.13
5 Disclosure
• Date of authorisation to be disclosed IAS 10.17
• Disclosures relating to information after the reporting date to be updated in the IAS 10.19
light of new information
• For material non-adjusting events after the reporting period an entity shall IAS 10.21
disclose
– Nature of event
– Estimate of financial effect
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
• Scope IAS 37.1
IAS 37.70–72
• Restructuring
IAS 37.78–80
ISA 501
• Audit procedures in respect of litigation and claims ISA 501.9–12
The accounting entry to record the unwinding of the discount in 20X1 will be:
Dr Finance costs CU13,660
Cr Provisions CU13,660
Introduction
Topic List
IAS 17 Leases
1 Overview of material covered in earlier studies
2 Evaluating the Substance of Transactions Involving the Legal Form of a Lease –
SIC 27 and Operating Lease Incentives – SIC 15
3 Determining Whether an Arrangement Contains a Lease – IFRIC 4
4 Current developments/ IFRS 16 Leases
5 IAS 20 Accounting For Government Grants and Disclosure of Government
Assistance
6 IAS 23 Borrowing Costs
7 Statements of cash flows
8 Audit focus
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
591
Introduction
• Determine and calculate how different bases for recognising, measuring and classifying
financial assets and financial liabilities can impact upon reported performance and position
• Show, explain and appraise accounting standards that relate to an entity's financing
activities which include: financial instruments; leasing; cash flows; borrowing costs; and
government grants
• Appraise and evaluate cash flow measures and disclosures in single entities and groups
• Determine for a particular scenario what comprises sufficient, appropriate audit evidence
• Design and determine audit procedures in a range of circumstances and scenarios, for
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
• Demonstrate and explain, in the application of audit procedures, how relevant ISAs affect
audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 1(e), 4(a), 4(b), 4(d), 14(c), 14(d), 14(f)
Section overview
• IAS 17 Leases was the first Standard to address the problem of substance over form.
• The correct treatment of the transaction in the financial statements of both the lessee and the
lessor is determined by the commercial substance of the lease. The legal form of any lease is that
the title to the asset remains with the lessor.
• The approach to lessor accounting is very similar to that for lessee accounting, the key difference
being the inclusion of 'unguaranteed residual value'.
• The lease transfers ownership of the asset to the lessee at the end of the lease term
• The lessee has the option to purchase the asset at a price sufficiently below fair value at the
option exercise date, that it is reasonably certain the option will be exercised
• The lease term is for a major part of the asset's economic life even if title is not transferred
• Present value of minimum lease payments amounts to substantially all of the asset's fair value at
inception
Definitions
Lease term: is the non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset, with or
without further payment, when at the inception of the lease it is reasonably certain that the lessee will
exercise the option.
Minimum lease payments: are the payments over the lease term that the lessee is, or can be required,
to make (excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the
lessor) plus any amounts guaranteed by the lessee or by a party related to the lessee.
A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are to pay:
The fair value of the asset (equivalent to the present value of minimum lease payments) on 1 January
20X1 is CU80,000. Its useful life to the company is five years.
The interest rate implicit in the lease has been calculated as 10.0%.
Requirements
(a) Prepare the relevant extracts from the financial statements (excluding notes) in respect of the
above lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by the lessor:
As we have already seen, to qualify as a finance lease the risks and rewards of ownership must be
transferred to the lessee. One reward of ownership is any residual value in the asset at the end of the
primary period. If the asset is returned to the lessor then it is he who receives this reward of ownership,
not the lessee. This might prevent the lease from being a finance lease if this reward is significant (IAS
17 allows insubstantial ownership risks and rewards not to pass).
IAS 17 does not state at what point it should normally be presumed that a transfer of substantially all
the risks and rewards of ownership has occurred. To judge the issue it is necessary to compare the
present value of the minimum lease payments against the fair value of the leased assets. This is an
application of discounting principles to financial statements. The discounting equation is:
Note: Any guaranteed residual amount accruing to the lessor will be included in the minimum lease
payments.
You should now be able to see the scope for manipulation involving lease classification. Whether or
not a lease is classified as a finance lease can hinge on the size of the unguaranteed residual amount
due to the lessor, and that figure will only be an estimate. A lessor might be persuaded to estimate a
larger residual amount than he would otherwise have done and cause the lease to fail the test on
present value of lease payments approximating to the asset's fair value, rather than lose the business.
A company leased an asset to another company on 1 January 20X1 on the following terms.
Requirements
(a) Calculate the unguaranteed residual value and the net investment in the lease as at 1 January
20X1
(b) Prepare extracts from the financial statements of the lessor for the year ended 31.12.X1 (excluding
notes)
For many years an entity has owned a freehold building which it has recognised as an investment
property under the fair value model of IAS 40. This requires that the property is revalued to fair value at
each reporting date with any gains or losses recognised in profit or loss. At 31 December 20X4, the
carrying amount of the building was CU5 million.
On 1 January 20X5, the entity leased it out under a 40-year finance lease. The lease included a clause
transferring title to the lessee at the end of the lease; the lease was therefore recognised as a single
finance lease comprising both the land and building elements.
Requirement
How should the transaction be recognised on 1 January 20X5 and in the year ending 31 December
20X5?
• The cost of the leased asset to its manufacturer is its manufactured cost, while a dealer would
expect to acquire the leased asset at a substantial discount to its retail price. In neither case will
cost reflect the asset's fair value.
• Such entities generally offer assets either for outright purchase or for use under arrangements
whereby the entities themselves provide a form of financing.
Accounting treatment
– A normal selling profit as if from an outright sale, based on the normal selling price adjusted
for normal volume or trade discounts
• The revenue to be recognised at the lease commencement should be measured as the lower of
the fair value of the asset and the present value of the minimum lease payments computed at a
market interest rate. C
H
– The cost of sale to be recognised at the lease commencement should be measured as the
A
lower of cost of the asset, or its carrying amount if different, less the present value of any
P
unguaranteed residual value. This will be relevant where the dealer or manufacturer has
T
ownership of the asset at the end of the lease term and a residual value can be realised.
E
– The profit or loss should be recognised in accordance with the entity's normal accounting R
policy for sales transactions.
– A market rate of interest is applied to the minimum lease payments to ensure that where a
dealer or manufacturer quotes an artificially low rate of interest this does not result in an 14
artificially high profit being recognised immediately on the outright sale component.
A motor dealer acquires vehicles of a particular model from the manufacturer for CU21,000, a 20%
discount on the recommended retail price of CU26,250. It offers them for sale at the recommended retail
price with 0% finance over three years, provided three annual payments of CU8,750 are made in
advance. The market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an outright sale and a
finance lease. The present value of the minimum lease payments is treated as the consideration for the
outright sale and at 8% is calculated as follows:
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
The initial costs incurred by the dealer or manufacturer in negotiating and arranging the lease should not
be recognised as part of the initial finance receivable in the way that they are by other types of lessors.
Such costs are instead expensed at the start of the lease arrangement, because they are 'mainly related
to earning the manufacturer's or dealer's selling profit'.
• The accounting for a sale and finance leaseback results in any profit being recognised over the
lease term, not immediately.
• The accounting for a sale and operating leaseback depends on the relationship between the sale
price and fair value.
• Recognise the finance lease as asset and the associated liability in the normal way (at fair value or
the present value of the minimum lease payments, if lower)
The effect is to adjust the expense in profit or loss to an amount equal to the depreciation expense
before the leaseback transaction.
Interactive question 5: Sale and leaseback as finance lease[Difficulty level: Exam standard]
An entity recognises its ownership of a freehold building under the IAS 16 cost model. The annual
buildings depreciation charge is CU100,000, and at 31 December 20X4 the carrying amount is CU3.5
million.
On 1 January 20X5, the entity sells the building to an institution for CU5 million, the present value of the
minimum lease payments, and leases it back under a 40-year finance lease.
Requirement
How should the transaction be accounted for in the financial statements on 1 January 20X5 and in the
year ending 31 December 20X5?
Because of IAS 36's provisions in respect of impairment testing any excess of an asset's carrying
amount over recoverable amount should be recognised as an impairment loss before the sale and
finance leaseback transaction is recognised.
The substance of the transaction is that a sale has taken place both in terms of the legal transfer of
ownership and because the risks and rewards of ownership are not subsequently substantially re-
acquired when the leaseback is an operating lease. There is a genuine profit or loss to be recognised.
Accounting treatment
The rules about how this profit or loss should be recognised depend on the relationship between the
sale price and fair value.
• If the sale price is established at fair value, any profit or loss should be recognised immediately.
• If the sale price is below fair value and future lease payments are at market levels, any profit or loss
shall be recognised immediately.
– The sale price might be below fair value because the entity is desperate for cash, and so
accepts a low sale price to alleviate its liquidity problems. Under these circumstances it is C
appropriate that the whole loss on disposal should be immediately recognised. H
A
• If the sale price is below fair value and the loss is compensated for by future lease payments at P
below market price, the loss shall be deferred and amortised in proportion to the lease payments T
over the period for which the asset is expected to be used.
E
• If the sale price is above fair value, the excess over fair value shall be deferred and amortised over R
the period for which the asset is expected to be used.
Considering now the relationship between carrying amount and fair value, if the fair value at the time
14
of a sale and leaseback transaction is less than the carrying amount of the asset, a loss equal to the
amount of the difference should be recognised immediately.
The following table summarises these rules.
Sale price at fair value
Carrying amount Carrying amount Carrying amount
equal to fair value less than fair value above fair value
Profit No profit Recognise profit N/A
immediately
Loss No loss N/A Recognise loss
immediately
IAS 17 requires the carrying amount of an asset to be written down to fair value where it is subject to a
sale and leaseback.
Note 2
Profit is the difference between fair value and sale price because the carrying amount would have been
written down to fair value in accordance with IAS 17.
Section overview
• Entities sometimes enter into a series of structured transactions that involve the legal form of a
lease. These are addressed by SIC 27.
• In negotiating a new operating lease, the lessor may provide incentives to the lessee. These are
dealt with by SIC 15.
One example of this is a lease and leaseback arrangement where an entity leases an asset to an
investor and then leases the same asset back in order to continue using it.
Where there are a series of transactions that involve the legal form of a lease and they are linked they
should be accounted for as one transaction when the overall economic effect cannot be understood
without reference to the series of transactions as a whole.
Companies enter into such arrangements in order to gain tax advantages or cheaper financing, but
these considerations should not determine the financial reporting treatment.
All incentives for the agreement of a new or renewed operating lease should be recognised as an
integral part of the net amount agreed for the use of the leased asset, irrespective of the incentive's
nature or form or the timing of payments.
The Lessor
The lessor should normally recognise the aggregate cost of incentives as a reduction of rental income
over the lease term, on a straight-line basis.
The Lessee
The lessee should normally recognise the aggregate benefit of incentives as a reduction of rental
expense over the lease term, on a straight-line basis.
On 1 January 20X5, a lessor entered into a 21-year operating lease in respect of a retail unit. Leasing
payments were CU30,000 quarterly in advance. It had proved difficult to find a tenant, so the lessor had
to accept an initial rent-free period of 18 months. C
H
Requirement
A
How should the transaction be recognised in the financial statements? P
T
See Answer at the end of this chapter. E
R
Section overview
• Sometimes entities enter into transactions that may contain a lease even though they do not take
the legal form of a lease. These are addressed by IFRIC 4.
Background
An entity may enter into an arrangement, comprising a transaction or a series of related transactions,
that does not take the legal form of a lease, but conveys a right to use an asset in return for a payment
or series of payments.
Examples of arrangements in which one entity (the supplier) may convey such a right to use an asset to
another entity (the purchaser), often together with related services, include:
• Arrangements in the telecommunications industry, in which suppliers of network capacity enter into
contracts to provide purchasers with rights to capacity.
• Take-or-pay and similar contracts, in which purchasers must make specified payments regardless
of whether they take delivery of the contracted products or services (eg a take-or-pay contract to
acquire substantially all of the output of a supplier's power generator).
IFRIC 4 provides guidance for determining whether such arrangements are, or contain, leases that
should be accounted for in accordance with IAS 17. It does not provide guidance for determining how
such a lease should be classified under IAS 17.
The key features of IFRIC 4 in determining whether an arrangement is, or contains, a lease are as
follows.
Determining whether an arrangement is, or contains, a lease is based on the substance of the
arrangement and requires an assessment of whether:
• Fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and
Although a specific asset may be explicitly identified in an arrangement, it is not the subject of a lease if
fulfilment of the arrangement is not dependent on the use of the specified asset.
For example, if the supplier is obliged to perform building work and has the right and ability to carry out
the task using other assets not specified in the arrangement, then fulfilment of the arrangement is not
dependent on the specified asset and the arrangement does not contain a lease.
An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser (lessee)
the right to control the use of the underlying asset.
• The purchaser, while obtaining or controlling more than an insignificant amount of the asset's
output
– Has the ability to operate the asset or direct others to operate the asset or
– Has the ability or right to control physical access to the asset.
• There is only a remote possibility that parties other than the purchaser will take more than an
insignificant amount of the asset's output and the price the purchaser will pay is neither fixed per
unit of output nor equal to the current market price at the time of delivery.
The IFRIC's view is that where a purchaser is taking substantially all of the output from an asset it has
the ability to restrict the access of others to the output of that asset. In these circumstances, the
purchaser is seen as controlling access to the economic benefits of the asset even if it does not
physically control the asset.
The supplier has no access to any other electricity generating stations and maintains ownership and
control of the power station.
Requirement 14
Does the arrangement contain a lease within the scope of IAS 17 Leases?
Solution
Yes. The arrangement contains a lease within the scope of IAS 17 Leases.
The first condition, ie the existence of an asset (which in this case is specifically identified) is fulfilled.
The second condition is also fulfilled as it is remote that one or more parties other than the purchaser will
take more than an insignificant amount of the facility's output and the price the purchaser will pay is not
contractually fixed per unit of output nor equal to the market price at the time of delivery.
Section overview
• The IASB has decided to undertake a leasing project with the objective of developing a single
method of accounting for leases that would not rely on the distinction between operating and
finance leases.
The distinction between classification of a lease as an operating or finance lease has a considerable
impact on the financial statements, most notably on indebtedness, gearing ratios, ROCE and interest
cover. It is argued that the current accounting treatment of operating leases is inconsistent with the
definition of assets and liabilities in the IASB's Conceptual Framework.
The different accounting treatment of finance and operating leases has been criticised for a number of
reasons.
(a) Many users of financial statements believe that all lease contracts give rise to assets and
liabilities that should be recognised in the financial statements of lessees. Therefore these
users routinely adjust the recognised amounts in the statement of financial position in an attempt
to assess the effect of the assets and liabilities resulting from operating lease contracts.
(b) The split between finance leases and operating leases can result in similar transactions being
accounted for very differently, reducing comparability for users of financial statements.
(c) The difference in the accounting treatment of finance leases and operating leases also provides
opportunities to structure transactions so as to achieve a particular lease classification.
It is also argued that the current accounting treatment of operating leases is inconsistent with
the definition of assets and liabilities in the IASB's Conceptual Framework. An operating lease
contract confers a valuable right to use a leased item. This right meets the Conceptual
Framework's definition of an asset, and the liability of the lessee to pay rentals meets the
Conceptual Framework's definition of a liability. However, the right and obligation are not
recognised for operating leases.
Lease accounting is scoped out of IAS 32, IAS 39 and IFRS 9, which means that there are
considerable differences in the treatment of leases and other contractual arrangements.
There have therefore been calls for the capitalisation of non-cancellable operating leases in the
statement of financial position on the grounds that if non-cancellable, they meet the definitions of assets
and liabilities, giving similar rights and obligations as finance leases over the period of the lease.
Leasing had been on the IASB's agenda for some time when in May 2003 the IASB decided to actively
undertake a project with the objective of developing a single method of accounting for leases that is
consistent with the Framework. The single method would not rely on a distinction between operating and
finance leases.
It has subsequently been decided to scope lessor accounting out of the project and concentrate only on
lessee accounting initially. An exposure draft of the IASB's proposals was issued in August 2010. This
is not examinable, but is included here to give an awareness of how things are likely to develop.
Below are the main changes, which would affect both lessees and lessors unless otherwise stated:
(a) The current IAS 17 model of classification of leases would cease to exist.
(b) Lessees would no longer be permitted to treat leases as 'off-balance sheet' financing, but
instead would be required to recognise an asset and liability for all leases within the scope of the
proposed standard.
(c) For leases currently classified as operating leases, rent expense would be replaced with
amortisation expense and interest expense. Total expense would be recognised earlier in the
lease term.
(d) The lease liability would include estimates of contingent rentals, residual value guarantees, and
term option penalties. An expected outcome approach would be used.
(f) If the facts or circumstances indicate that there will be a significant change in lease payments and
renewal periods, then the estimates of these must be revised.
(g) The proposed standard has two accounting models for lessors:
(i) Performance obligation approach. This is used by lessors who retain exposure to significant
risks or benefits associated with the underlying asset.
(ii) Derecognition approach. This is used by lessors who do not retain exposure to significant
risks or benefits associated with the underlying asset.
• Lease terms would typically be shortened – optional periods are included only if there is a
significant economic incentive to extend.
• More non-lease costs would be separated from the lease, reducing amounts recognised on
the statement of financial position.
• Contingent rents based on performance and usage are excluded from lease payments.
Purchase option payments are included only when there is a significant economic incentive to
exercise.
• Lessees would have the option to apply current operating lease accounting to all short-term
leases.
Current status
The IASB and FASB re-exposed their proposals in May 2013 with comments to be received by
September 2013. C
H
Interactive question 7: Leasing proposals 1 [Difficulty level: Exam standard]
A
Sutton has leased plant for a fixed term of six years and the useful life of the plant is 12 years. The lease P
is non-cancellable, and there are no rights to extend the lease term or purchase the machine at the end T
of the term. There are no guarantees of its value at that point. The lessor does not have the right of E
access to the plant until the end of the contract or unless permission is granted by Sutton.
R
Fixed lease payments are due annually over the lease term after delivery of the plant, which is
maintained by Sutton. Sutton accounts for the lease as an operating lease but the directors are unsure
as to whether the accounting treatment of an operating lease is conceptually correct. 14
Requirement
Discuss whether the plant operating lease in the financial statements of Sutton meets the definition of an
asset and liability as set out in Conceptual Framework for Financial Reporting.
Sutton also owns an office building with a remaining useful life of 30 years. The carrying amount of the
building is CU120 million and its fair value is CU150 million. On 1 May 20X4, Sutton sells the building to
Brook, a public limited company, for its fair value and leases it back for five years at an annual rental
payable in arrears of CU16 million on the last day of the financial year (30 April). This is a fair market
rental. Sutton's incremental borrowing rate is 8%.
Requirement
(a) Show the accounting entries in the year of the sale and lease back assuming that the operating
lease is recognised as an asset in the statement of financial position of Sutton.
(b) State how the inflation adjustment on the short term operating lease should be dealt with in the
financial statements of Sutton.
IFRS 16 Summary
IFRS 16 Leases will replace IAS 17 Leases and will start to apply on all the financial years starting after
1st January, 2019.
The most obvious and impactful difference is how operating leases will be brought onto the balance
sheet. Under IAS 17, a lessee is not obligated to report assets and liabilities from operating leases on
their balance sheet and they are instead referred to in the footnotes. This has typically provided financial
statement users an inaccurate account of a company’s outstanding expenses, forcing them to estimate
the off balance sheet obligations, which often results in overestimations. Similarly, it is difficult to
compare businesses that lease assets with those that buy them as a clear indication of the operating
leases are left out of the equation.
IFRS 16 changes this by requiring a lessee to recognise arising right of use (ROU) assets and lease
liabilities on their balance sheet. Undoubtedly one of the biggest changes to leases accounting, the
consequences of recognising operating leases will see a large difference in various financial metrics.
Superseded Standards
IFRS 16 vs IAS 17
IAS 17 – Operating leases off-balance sheet as a single expense. Finance leases on balance sheet
IFRS 16 – Operating leases recognise assets and liabilities on balance sheet. Operating leases to report
depreciation and interest separately.
Why the difference? Improved comparability and transparency on balance sheet. Financial statement
users can clearly see the effect of operating leases and have a useful basis for comparability with other
companies. Currently, under IAS 17, it is difficult to compare companies who lease with those who buy.
• Financial report impact - As operating leases will be capitalised, there will be a shift in financial
metrics for businesses that have a particularly large number of this type of lease.
Asset turnover, equity and operating expenses will likely see a decrease. Conversely, liabilities,
reported debt, recorded assets, EBIT and EBITDA will all see an increase.
• Covenants and shareholder relationships - With a change in financial metrics, ratios and
liabilities, companies will need to take extra care with their disclosures to explain the shift
figures. This could lead to a possible breach of financial based agreements and contracts, both
internally (performance KPIs and metric based compensation payments/bonuses) and
externally (bank covenants, stakeholder relationships, investor relationships).
Definition of a lease
IAS 17 – Focus on whether lessee or lessor carries the risk and reward. Both lease and non-lease
components accounted off balance sheet.
IFRS 16 – More focus on who controls the ROU asset, linking with IFRS 15. Non-lease components still
excluded, but lease components will need to be reported on.
Why the difference? – Another change in lease classification affects what actually constitutes a lease
agreement as IFRS 16 contains a new lease definition. The actual wording of the definition in IFRS 16
does not change too much from the IAS 17 one. However, there is a greater emphasis and weight
surrounding how a lease differs from a service. This is aimed at improving the comparability of financial
statements, capturing useful material information on leases rather than additional components.
Potential impacts – Lessees are required to identify and separate non-lease components (i.e., services
components such as maintenance) to ensure only the necessary ones are accounted for on balance
sheet. This mean that Non-lease components will receive an increased focus in negotiation phases and
their separation from a lease is more important. However, IFRS 16 does permit an accounting policy
election (the practical expedient), whereby lessees can recognise the lease and non-lease comment as
a ‘single lease component' on the balance sheet. If lessees choose to utilise this election, this would in
effect, increase the lease obligations stated on balance sheet. (Note, if this expedient is adopted,
lessees are not permitted to account for the combined lease and non-lease component as a ‘service’).
Lessor interaction
Lessor accounting remains largely unchanged under IFRS 16. However, with operating leases losing
their off balance sheet accounting treatment, the types of agreements lessees favour may shift, as C
companies focus more on the operational benefits of leasing over accounting ones. Lessors typically use
H
operating leases as a tool to price more competitively.
A
IAS 17 – Focus on lease type from an operational perspective. Many lessees used operating leases to P
avoid balance sheet recognition. Others prefer the reduced risk and reward, as well as the competitive T
pricing that operating leases offer. E
R
IFRS 16 – Lease type has a lower impact from an accounting standpoint, however, a greater focus is
placed upon on the deal types that can be negotiated.
Why? – Although lease accounting is removing the operating lease and finance lease classification for 14
lessees, lessor accounting remains largely unchanged and the operational differences between
operating leases and finance leases remain. Businesses may look for more inventive ways to lease to
continue to get the most out of their assets.
Potential Impacts – Buy vs. lease becomes a more important decision if you rely on the off balance
sheet reporting capabilities of an operating lease. New types of lease arrangement may be created by
lessors to keep leasing competitive. Greater focus on the operational benefits vs. accounting benefits,
such as asset refresh, risk and reward etc.
IAS 17 – Finance leased assets and liabilities are measured at the fair value of the leased property or, if
lower the PV of the minimum lease payments. The discount rate to be used in calculating the PV of the
minimal lease payments is the implicit rate if known, otherwise, the lessee’s borrowing rate. Any initial
direct costs of the lessee are added to the value of the asset.
IFRS 16 is more specific as to the definition of the payment to be included in the measurement of the
lease liability. Lease payments included in lease liability include: a) Fixed payments; b) variable lease
payments dependent on an index or a rate, initially measured using the index or rate at the date of
commencement, c) amortisations expected to be payable by the lessee under residual value
guarantees; d) the exercise price of a purchase option if the lessee is reasonably certain to exercise the
option; and e) payments of penalties for terminating the lease.
The measurement of leased assets differs to IAS 17 whereby any lease incentives received may be
deducted and lease payments made at or before commencement date may be added; as too can an
estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset,
restoring the underlying asset to the condition required by the terms and conditions of the lease.
Why the difference? – One of the main aims of IFRS 16 is to provide a consistent view of lease
obligations in financial statements. To achieve this, the definitions of the leased asset and liability
measures need to be specifically defined to ensure a consistent measurement approach.
Potential Impact – The biggest impact is in the measurement of operating lease liabilities and assets
which did not previously have to be performed. This can be an onerous task and the data collation
exercise is key to ensuring all relevant measurement components are captured before the measurement
and recording task can begin.
Disclosures
IAS 17 – Disclosures cover the specific requirement of finance leases separate from operating leases.
IFRS 16 – Disclosures do away with the separate presentation of finance and operating leases for
lessees and instead requires disclosures of the right of use assets and liabilities. There are also
additional disclosures to specifically state whether the lessee has elected not to apply IFRS 16 to short-
term and low-value leases. Specifically, disclosures are required for short-term and low-value lease
express if these elections have been made, so too are variable lease payments not included in the
measurement of lease liabilities.
Why? – As IFRS 16 requires all the lessee leases to be shown on balance sheet, the distinction
between finance and operating leases is mute. It, therefore, makes sense to redefine the disclosure
requirements to give more information on the leasing activity to achieve the goal of lessees reporting on
a level playing field.
Potential Impact – When collating and measuring lease data it is important to bear in mind the
disclosure requirements and ensure you capture the data in such as fashion to enable you to fulfil the
disclosure requirement analysis with ease.
Section overview
• This section gives a very brief overview of the material covered in earlier studies.
Definitions
Government assistance: Action by government designed to provide an economic benefit specific to an
entity or range of entities qualifying under certain criteria.
Grants related to assets: Government grants whose primary condition is that an entity qualifying for
them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions may also
be attached restricting the type or location of the assets or the periods during which they are to be
acquired or held.
Grants related to income: Government grants other than those related to assets.
Forgivable loans: Loans which the lender undertakes to waive repayment of under certain prescribed
conditions.
Accounting treatment
• Recognise government grants and forgivable loans once conditions complied with and
receipt/waiver is assured.
• Grants are recognised under the income approach: recognise grants as income to match them
with related costs that they have been received to compensate.
• Grants for depreciable assets should be recognised as income on the same basis as the asset is
depreciated.
• Grants for non-depreciable assets should be recognised as income over the periods in which the
cost of meeting the obligation is incurred.
• A grant may be split into parts and allocated on different bases where there are a series of
conditions attached.
• Where related costs have already been incurred, the grant may be recognised as income in full
immediately.
• A grant in the form of a non-monetary asset may be valued at fair value or a nominal value.
• Grants related to assets may be presented in the statement of financial position either as C
deferred income or deducted in arriving at the carrying value of the asset. H
A
• Grants related to income may be presented in the statement of profit or loss and other
P
comprehensive income (in profit or loss) either as a separate credit or deducted from the related
T
expense.
E
• Repayment of government grants should be accounted for as a revision of an accounting estimate. R
Disclosure
IAS 20 suggests that there are two approaches to recognising government grants: a capital approach
(credit directly to shareholders' interests) and an income approach. IAS 20 requires the use of the
income approach.
Requirement
Section overview
• This section gives a very brief overview of the material covered in earlier studies.
• IAS 23 deals with the treatment of borrowing costs, often associated with the construction of self-
constructed assets, but which can also be applied to an asset purchased that takes time to get
ready for use/sale.
Definitions
Borrowing costs: Interest and other costs incurred by an entity in connection with the borrowing of
funds.
Qualifying asset: An asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
Until the IASB issued a revised IAS 23 in 2007, entities had the choice of whether to account for 'directly
attributable' borrowing costs as part of the cost of the asset or as an expense in profit or loss. The
revised IAS 23 removes the option of recognising them as an expense. It is mandatory for accounting
periods beginning on or after 1 January 2009.
The revised standard is now consistent with US GAAP and was developed as part of the convergence
project being undertaken with the US FASB. The IASB believes that the new standard will improve
financial reporting in three ways:
• The cost of an asset will in future include all costs incurred in getting it ready for use or sale
• Comparability is enhanced because the choice in previous accounting treatments is removed
• The revision to IAS 23 achieves convergence in practice with US GAAP
Accounting treatment
• Borrowing costs must be capitalised as part of the cost of the asset if they are directly attributable to
acquisition/construction/production. Other borrowing costs must be expensed.
• Borrowing costs eligible for capitalisation are those that would have been avoided otherwise.
Use judgement where a range of debt instruments is held for general finance.
• Amount of borrowing costs available for capitalisation is actual borrowing costs incurred less
any investment income from temporary investment of those borrowings.
• For borrowings obtained generally, apply the capitalisation rate to the expenditure on the asset
(weighted average borrowing cost). It must not exceed actual borrowing costs.
• Capitalisation is suspended if active development is interrupted for extended periods.
(Temporary delays or technical/administrative work will not cause suspension.)
• Capitalisation ceases (normally) when physical construction of the asset is completed. When an
asset is comprised of separate stages, capitalisation should cease when each stage or part is
completed.
• Where the recoverable amount of the asset falls below carrying amount, it must be written
down/off.
Disclosure
• Amount of borrowing costs capitalised during the period
• Capitalisation rate used to determine borrowing costs eligible for capitalisation
On 1 January 20X8 Rechno Co borrowed CU15m to finance the production of two assets, both of which
were expected to take a year to build. Production started during 20X8. The loan facility was drawn down
on 1 January 20X8 and was utilised as follows, with the remaining funds invested temporarily.
Asset X Asset Y
CUm CUm
1 January 20X8 2.5 5.0
1 July 20X8 2.5 5.0
The loan rate was 10% and Rechno Co can invest surplus funds at 8%.
Requirement
Ignoring compound interest, calculate the borrowing costs which must be capitalised for each of the
assets and consequently the cost of each asset as at 31 December 20X8.
Zenzi Co had the following loans in place at the beginning and end of 20X8.
1 January 31 December
20X8 20X8
CUm CUm
10.0% Bank loan repayable 20Y3 120 120
9.5% Bank loan repayable 20Y1 80 80
8.9% debenture repayable 20Y8 – 150
The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
On 1 January 20X8, Zenzi Co began construction of a qualifying asset, a piece of machinery for a hydro-
electric plant, using existing borrowings. Expenditure drawn down for the construction was: CU30m on C
1 January 20X8, CU20m on 1 October 20X8. H
Requirement A
P
Calculate the borrowing costs to be capitalised for the hydro-electric plant machine. T
See Answer at the end of this chapter. E
R
Section overview
• This section briefly revises single company statements of cash flows. Consolidated statements of
cash flows are revised in Chapter 20.
• Cash, as defined in IAS 7, includes not only cash itself but also any instrument that can be
converted into cash so quickly that it is in effect equivalent to cash.
• The cash flows from an entity's operating activities can be presented using two methods:
– The direct method, which discloses the major classes of gross cash receipts and payments;
or
– The indirect method, where the entity starts with the net profit or loss for the period and
adjusts it for non-cash transactions, deferrals or accruals of income and expenditure and items
that will form part of the entity's investing and financing activities.
• 'Investing activities' are acquisitions and disposals of long-term assets and investments, other than
cash and cash equivalents. Examples include: cash paid or received to acquire or sell an item of
property, plant or equipment, a receipt of cash from the sale of a business, and cash advanced as
a loan to another entity.
• 'Financing activities' are activities that change the amount and composition of an entity's equity
capital and borrowings. Examples include: cash proceeds from issuing shares, cash paid to repay
debt instruments, and the capital element in a finance lease payment.
• Investing and financing activities that do not impact on cash, for example the conversion of debt to
equity, should not be included in the statement of cash flows.
Interactive question 12: Operating and financing activities [Difficulty level: Intermediate]
On 1 January 20X5, an entity entered into a 20-year lease for land and buildings. The lease payments
are CU910,000 annually in advance, of which CU546,000 relates to the land which is classified as being
held under an operating lease and CU364,000 to the buildings held under a finance lease.
The 20X5 income statement showed a finance charge in respect of the finance lease of CU50,000. The
entity treats interest paid as relating to its operating activities.
Requirement
Show the amounts appearing in the statements of cash flows for 20X5 and 20X6.
8 Audit focus
Section overview
• Matters that the auditor should consider when auditing leases include:
– Whether the lease is classified according to the substance of the transaction (operating
lease/finance lease)
The table below summarises the areas of audit focus when auditing leases, and provides some
examples of audit evidence required.
Ascertaining that the Select a sample of entries in the lease expense account, and verify that they
operating lease relate to operating leases.
expenses have been Recalculate operating lease expenses, on a straight-line basis over the
correctly recorded in lease term.
profit or loss
C
H
A
P
T
E
R
14
Summary
C
H
A
P
T
E
R
14
14
1 Hypericum
On 31 December 20X7 The Hypericum Company leased from a bank three different machines, X,
Y and Z. Each lease is for three years.
CU100,000 is payable annually in advance for each machine on 1 January 20X8, 20X9 and 20Y0.
Hypericum uses its annual incremental borrowing rate of 10% to determine the present value of the
minimum lease payments.
Under the contract for machine Z, Hypericum is also required to pay a lease premium of CU50,000
on 31 December 20X7.
Requirement
Which of the machines should be recognised at its fair value in the statement of financial position of
Hypericum at 31 December 20X7, according to IAS 17 Leases?
2 Sauvetage
The Sauvetage Company enters into a sale and leaseback arrangement which results in an
operating lease for five years from 1 January 20X7. The agreement is with its bank in respect of a
major piece of equipment that Sauvetage currently owns. The details at 1 January 20X7 are as
follows.
CUm
Carrying amount of equipment 6.0
Proceeds generated from sale and leaseback 8.0
Fair value of equipment 7.2
The lease rentals are CU4.0 million per year.
Requirement
By how much should the pre-tax profit of Sauvetage be reduced in respect of the sale and
leaseback arrangement for the year to 31 December 20X7, according to IAS 17 Leases?
3 Mocken
The Mocken Company enters into a sale and leaseback arrangement which results in a finance
lease for five years from 1 January 20X7. The agreement is with its bank in respect of a major
piece of equipment that Mocken currently owns. The residual value of the equipment after five
years is zero.
The carrying amount of equipment at 1 January 20X7 is CU140,000. The sale proceeds are at fair
value at 1 January 20X7 of CU240,000. There are five annual rentals each of CU56,000 payable
annually in advance.
Mocken recognises depreciation on all non-current assets on a straight-line basis. Finance charges
on a finance lease are recognised on a sum of digits basis.
Requirement
What total amount should be recognised in the profit or loss of Mocken in respect of the sale and
leaseback arrangement for the year to 31 December 20X7 according IAS 17 Leases?
At 31 December 20X6 the carrying amount of a freehold property in The Szczytno Company's
financial statements was CU436,000, of which CU366,000 was attributable to the building which
had a remaining useful life of 36 years.
On 1 January 20X7 Szczytno sold the property to a financial institution for CU697,000 and
immediately leased it back under a 35-year lease at an annual rental of CU43,600 payable in
advance.
Land Building
Fair value of a 35-year interest CU90,000 CU607,000
The interest rate implicit in the lease is 6% per annum and the present value factor for a constant
amount annually in advance over 35 years is 15.368.
Requirements
Determine the following amounts for inclusion in Szczytno's financial statements for the year ended
31 December 20X7 in accordance with IAS 17 Leases.
(b) Excluding any profit on sale, the total effect on profit or loss for the year of the building
element of the lease
5 Bodgit
Bodgit Ltd started trading 16 years ago manufacturing traditional toys. On that date it acquired a
freehold factory (and land) in Warwick for CU200,000.
Bodgit Ltd has seen a significant decline in profitability due to falling demand for traditional toys as
a result of competition from more modern electronic toys and games.
Following a series of board meetings the management has decided to change its focus of
production to game consoles and computer games. This will require significant investment. C
In order to finance this investment the management is planning to enter into a sale and leaseback H
arrangement in respect of the Warwick property. It is expected that the property will fetch A
CU750,000 in sale proceeds and would be sold on 1 January 20X7. P
T
The property would then be leased back on a 20-year lease at an initial rental of CU95,000. Both
E
the sale and the rental are at market value, and the land element of the property represents one
R
fifth of these amounts.
IAS 17 Leases
1 Lease classification
• If substantially all of the risks and rewards of ownership are transferred to the IAS 17.4
lessee, then a lease is a finance lease (Note. 90% rule for US GAAP). Factors:
• Land and buildings elements within a single lease are classified separately IAS 17.15
(Note: Together, usually as operating lease, for UK GAAP)
• Can be a lease even if lessor obliged to provide substantial services IAS 17.3
2 Finance lease
• Non-current asset and liability for the asset's fair value (or PV of minimum lease
payments, if lower): IAS 17.20
• Depreciate asset over its useful life, or the lease term if shorter and no IAS 17.27
reasonable certainty that lessee will obtain ownership at end of lease
• Debit lease payments to liability, without separating into capital and interest
• Charge interest so as to produce constant periodic rate of charge on reducing IAS 17.25
liability – approximations allowed
• Disclosures:
– In the statement of financial position split the liability between current and IAS 17.23
non-current
– In a note, show analysis of total liability over amounts payable in 1, 2 to 5 IAS 17.31(b)
and over five years, both gross and net of finance charges allocated to
future periods
– General description of material leasing arrangements IAS 17.31(e)
• Charge lease payments to profit or loss on straight-line basis, unless some IAS 17.33
other systematic basis is more representative of users' benefit
• Disclosures:
4 Lessor accounting
Finance lease:
• Recognise a receivable measured at an amount equal to the net investment in IAS 17.36
the lease
• Net investment in the lease is the gross investment in the lease discounted at IAS 17.4
the interest rate implicit in the lease
• Include initial direct costs incurred but exclude general overheads IAS 17.38
• Finance income should be allocated on a systematic and rational basis IAS 17.40
Operating lease:
• The asset should be recorded in the statement of financial position according to IAS 17.49
its nature
C
• Operating lease income should be recognised on a straight-line basis over the IAS 17.50 H
lease term, unless another basis is more appropriate A
P
• Asset should be depreciated as per other similar assets IAS 17.53
T
• IAS 36 should be applied to determine whether the asset is impaired IAS 17.54 E
R
• Disclosures IAS 17.56
• Treatment depends on relationship between sale price and fair value: IAS 17.61
• Manner in which received does not affect accounting method adopted IAS 20 (9)
• Should be recognised as income over periods necessary to match with related IAS 20 (12)
costs
• Income approach, where grant is taken to income over one or more periods IAS 20 (13)
should be adopted
• Grants in recognition of specific expenses are recognised as income in same IAS 20 (17)
period as expense
• Grant received as compensation for expenses already incurred recognised in IAS 20 (20)
period in which receivable
• Non-monetary grants should be measured at fair value or a nominal amount IAS 20 (23)
• Either:
5 Government assistance
• The following forms of government assistance are excluded from the definition IAS 20 (34–35)
of government grants:
– Assistance which cannot reasonably have a value placed on it
– The statement of cash flows should show the historical changes in cash and
cash equivalents
– Cash comprises cash on hand and demand deposits IAS 7.6
– Cash equivalents are short-term, highly liquid investments that are readily IAS 7.6
convertible to known amounts of cash and which are subject to an insignificant
risk of changes in value
– Cash flows should be classified by operating, investing and financing activities IAS 7.10 C
H
– Cash flows from operating activities are primarily derived from the principal IAS 7.13–14
revenue-producing activities of the entity A
P
– Cash flows from investing activities are those related to the acquisition or IAS 7.16 T
disposal of any non-current assets, or trade investments together with returns
E
received in cash from investments (ie dividends and interest)
R
• Financing activities include: IAS 7.17
1 Hypericum
Machine Z
IAS 17.20 requires that assets under finance leases should be stated at the lower of the fair value
and the present value of the minimum lease payments. The latter amount is calculated as:
Machine X has a higher fair value, while Machine Y will be held under an operating lease – the
residual value indicates that plenty of reward has been retained by the lessor, so it cannot be
classified as a finance lease. This is confirmed by the useful life being substantially longer than the
lease period.
2 Sauvetage
CU2,640,000
The arrangement results in a profit of CU2.0m (proceeds CU8.0m less carrying amount 6.0m) of
which CU0.8m relates to the difference between proceeds and fair value and CU1.2m to that
between fair value and carrying amount.
IAS 17.61 requires that where the proceeds of a sale and leaseback re an operating lease are
above fair value, then the excess shall be deferred and matched over the period that the asset is to
be used. But any excess of the fair value over the carrying amount should be recognised
immediately, per IAS 17 Implementation Guidance Footnote 3.
Thus the charge to profit or loss is: CU'000
Rental 4,000
Immediate profit (1,200)
Release of deferred profit (CU0.8m / 5 years) (160)
2,640
3 Mocken
CU44,000 expense
IAS 17.59 and 60 require that where a sale and finance leaseback takes place and the sale
proceeds exceed the carrying amount then it shall not be recognised as profit but shall be deferred
and recognised over the lease term.
CU
Depreciation (CU240,000 / 5) 48,000
Release of deferred profit [(CU240,000 – CU140,000) /5] (20,000)
Finance charge 4/10 × [(CU56,000 × 5) – CU240,000] 16,000
Total 44,000
4 Szczytno
(a) CU26,886
(b) CU49,405
(c) CU578,286
The portion of the total profit on the sale of CU261,000 (CU697,000 – CU436,000) to be
recognised depends on the type of lease involved in the leaseback (IAS 17.58). The profit
attributable to the land operating lease is recognised immediately (IAS 17.61), but the profit
attributable to the building finance lease is spread over the lease term (IAS 17.59).
while since the lease payments are in advance, the finance charge is CU(583,523 – 37,970) ×
6% = CU32,733.
(c) The liability at the year end is CU583,523 – CU37,970 + CU32,733 interest = CU578,286.
5 Bodgit
C
Accounting H
A
Type of sale and leaseback
P
The transaction includes two elements: T
E
• Sale and leaseback of the property itself, and
R
• Sale and leaseback of the land on which the property stands.
In the case of the leaseback of the land on which the property stands, IAS 17 requires the lease to
be classified as an operating lease. 14
As regards the property, from the information provided, it would appear that Bodgit Ltd has entered
into a sale and finance leaseback.
• The lease term of 20 years. This is not a long period of time for property, so does not clarify
the situation.
• Rentals. The present value of discounted future rentals relating to the property is (4/5 ×
CU95,000) × 20-year annuity discount factor @ 12%, ie CU76,000 × 7.469 = CU567,644. This
is approximately 95% of fair market value of 4/5 × CU750,000 = CU600,000.
Accounting treatment
The land and building should be derecognised in Bodgit's accounts and a profit or loss calculated
based upon the difference between the proportion of the proceeds allocated to each element (land
Based on the original cost to Bodgit of the factory (including land) of CU200,000, this is likely to
result in a profit in both cases.
The sale is at fair value and IAS 17 therefore requires that the land is derecognised and the profit
made on the sale is recognised immediately.
The operating lease is then recorded in the normal way by spreading the annual rental amounts
over the lease term and recording them as an expense. The annual rental expense is therefore
1/5 × CU95,000 = CU19,000.
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides finance
to the lessee, with the asset as security. For this reason it is not appropriate to regard any excess
of sales proceeds over the carrying amount as income. The profit arising should therefore be
deferred and amortised over the term of the lease.
The finance lease is then recorded in the normal way, with the building asset and corresponding
liability both initially recognised at CU567,644, being the lower of the fair value (4/5 x CU750,000 =
CU600,000) and present value of minimum lease payments.
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X1 (EXTRACT)
CU
Depreciation [(80,000 + 2,000 – 8,000)/5)] 14,800
Finance costs (Working) 7,420
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
CU
Non-current assets
Leased asset [(80,000 + 2,000) – ((80,000 + 2,000 – 8,000)/5)] 67,200
Non-current liabilities
Finance lease liability (Working) 56,182
Current liabilities
Finance lease liability (Working) (65,620 – 56,182) 9,438
WORKING
Bal b/f Interest accrued at Payment 31 Bal c/f 31
10% Dec Dec
CU CU CU CU
80,000
(5,800)
20X1 74,200 7,420 (16,000) 65,620
20X2 65,620 6,562 (16,000) 56,182
(b) Treatment of guaranteed residual value
At the end of the lease, the lessee will have an asset at residual value of CU8,000 in its statement C
of financial position and a finance lease liability of CU8,000 representing the residual value H
guaranteed to the lessor. A
P
(i) If the lessor is able to sell the asset for more than the value guaranteed by the lessee, the
lessee has no further liability and derecognises the asset and lease liability: T
E
Dr Finance lease liability CU8,000 R
Cr Asset carrying amount CU8,000
(ii) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee has 14
a liability to make up the difference of CU8,000 – CU6,000 = CU2,000:
Recognise impairment loss on asset (as soon as known during the lease term):
Note that the net investment in the lease is equal to the fair value of the asset plus any costs incurred by
the lessor. In this case there were no such costs and therefore the fair value of the asset is the net
investment in the lease.
• Recognise deferred income of CU1,500,000 and release the profit over the lease term (CU37,500
per annum)
For the year ended 31 December 20X5, the entity will recognise:
The IASB Conceptual Framework defines an asset as 'a resource controlled by the entity as a result of
past events and from which future economic benefits are expected to flow to the entity'. Sutton's leased
plant would appear to meet this definition:
(a) Sutton has the right to use the leased plant as an economic resource, that is to generate cash
inflows or reduce cash outflows.
(b) Sutton can be said to control the resource because the lessor does not have the right of access to
the plant until the end of the contract without Sutton's permission.
(d) Future economic benefits are expected to flow to Sutton during the lease term.
The Conceptual Framework defines a liability as 'a present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits'. Applying this to Sutton's lease of plant:
(b) The lessor has no contractual right (unless Sutton breaches the contract) to take possession of the
plant before the end of the contract, and similarly, Sutton has no contractual right to terminate the
contract and avoid paying rentals.
(c) The obligation to pay rentals arises from a past event, namely the signing of the lease.
(d) The obligation is expected to result in an outflow of economic benefits in the form of cash
payments.
This is a sale and leaseback transaction involving an operating lease. It is assumed that the
operating lease is being treated as an asset, and will therefore be accounted for using the
same principles as IAS 17 currently uses for finance leases. It will be accounted for as follows
in the financial statements of Sutton for the year ended 30 April 20X5:
Being recognition of the leaseback at net present value of lease payments using 8% discount
factor (CU16m × 3.993)
Being recognition of depreciation of operating lease asset over five years (CU63.89m ÷ 5)
In Sutton's statement of financial position, the operating lease asset will be shown at a
carrying value of CU63.89m (initial recognition) less CU12.78m (depreciation) = CU51.11m.
Inflation adjustments are not included in the minimum lease payment calculations. Instead
they are effectively contingent rent, defined in IAS 17 Leases as 'that part of the rent that is
not fixed in amount, but based on the future amount of a factor that changes other than with
the passage of time'. They should be recognised in the period in which they are incurred.
Year 1
CU5 million
Year 2
Year 3
Capital approach
(a) The grants are a financing device, so should go through the statement of financial position. In the
statement of profit or loss and other comprehensive income they would simply offset the expenses
which they are financing. No repayment is expected by the Government, so the grants should be
credited directly to shareholders' interests. C
H
(b) Grants are not earned, they are incentives without related costs, so it would be wrong to record A
them in profit or loss.
P
Income approach T
E
(a) The grants are not received from shareholders so should not be credited directly to shareholders' R
interests.
(b) Grants are not given or received for nothing. They are earned by compliance with conditions and
by meeting obligations. There are therefore associated costs with which the grant can be matched 14
in the statement of profit or loss and other comprehensive income as these costs are being
compensated by the grant.
(c) Grants are an extension of fiscal policies and so as income and other taxes are charged against
income, so grants should be credited to income.
20X5 20X6
CU CU
Operating activities
Operating lease payments 546,000 546,000
Interest paid – (payments are made in advance, so there is no interest in the
January 20X5 payment) 50,000
Financing activities
Payments under finance leases 364,000 314,000