3468corporate Reporting Volume - 1

Corporate reporting
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)
First Edition: 2018
All rights reserved. No part of this publication may be reproduced in any form or by any means
or stored in any retrieval system, or transmitted in, any form or by any means, electronic,
mechanical, photocopying, recording or otherwise without prior permission of the publisher.
© The Institute of Chartered Accountants in England and Wales

Contents
. Introduction v
. Corporate Reporting vii
Principles and Regulations in Corporate Reporting and Auditing

1. Introduction 1
2. Principles of Corporate Reporting 39
Ethics and Governance

3. Ethics 85
4. Corporate Governance 127
The Modern Audit Process

5. The statutory audit : planning and risk assessment 171
6. The statutory audit : audit evidence 227
7. The statutory audit : evaluating and testing internal controls 305
8. The statutory audit : finalisation, review and reporting 333
Reporting performance
9. Reporting financial performance 375
10. Reporting revenue 431
11. Earning per share 467
Assets and Liabilities

12. Reporting of assets 503
13. Reporting of non-financial liabilities 563
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.
2.2 Specification grid

This grid shows the relative weightings of subjects within this module and should guide the relative study
time spent on each. Over time the marks available in the assessment will equate to the weightings
below, while slight variations may occur in individual assessments to enable suitably rigorous questions
to be set.
Weighting
Syllabus area (%)
Corporate Reporting - Compliance 55–65
Corporate Reporting – Financial statement analysis
Audit and Assurance 30–40
Ethics 5–10
100
Your exam will consist of three questions. Ethical issues and problems could appear in any of the three
questions.
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
Learning objectives Tick off
• Appraise and explain the role and context of auditing

• Explain the nature and purpose of quality assurance (both at the level of the firm and the
individual audit) and assess how it can contribute to risk management
• Comment on and critically appraise the nature and validity of items included in published
financial statements
Specific syllabus references for this chapter are: 2(a), 10(a), 10(b).
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
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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.
1.2 How this Study Manual is structured

1.2.1 Principles and regulations in financial reporting and auditing
This chapter and Chapter 2 cover the role and context of auditing and general principles of corporate
reporting. This will largely be revision, but some of the regulations and standards will have changed
since your earlier studies. The aim is to set the more specialised topics, and the integrated areas, in
context.
1.2.2 Ethics and governance

Chapters 3 and 4 look at ethics and corporate governance. These topics underpin corporate reporting
and auditing, and ethical matters come up in all kinds of contexts, both in the exam and in your working
life as a professional. It is necessary to cover all relevant audit principles first because in the later
chapters on reporting performance and position, the principles are applied in audit focus sections.
1.2.3 The modern audit process

In Chapters 5 to 8 we revise and build on the auditing material covered at the professional level. This will
put you in the position where you can consider the audit and assurance issues in relation to specific
financial reporting topics, the aim being to study financial reporting and auditing together.
1.2.4 Financial reporting chapters

Chapters 9 to 22 deal with the financial reporting and auditing of specific areas:
• Reporting performance
• Assets and liabilities
• Financing
• Remuneration
• Business combinations
• Reporting foreign activities
• Taxation
The financial reporting aspects are covered first, followed by an 'audit focus' section for each topic,
looking at the specific audit issues arising from the financial reporting of that area, generally with
examples and/or questions. For example, the chapter on share-based payment has at the end a section
on auditing share-based payment.
Audit focus sections may be in turn split into general and specific sections. For example, Chapter 9
Reporting Financial Performance covers general issues including creative accounting, for which auditors
need to be alert. However a more specific section will refer back to standards and the auditing of, for
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.
1.2.5 Financial analysis chapters

Once you have a thorough understanding of the financial reporting and related auditing issues, including
analytical procedures, you will be in a position to analyse and interpret the financial statements. You will
not have studied financial analysis before, so Chapter 23 provides an introduction, and Chapter 24 deals
with more advanced topics.
1.2.6 Assurance and other related services

The Study Manual concludes with coverage of assurance and related services, which can more easily
be understood in the context of the knowledge you have gained in the earlier chapters.
2 The importance of corporate reporting

Section overview
• Corporate reporting embraces financial reporting, and both are different from management
accounting.
• Financial statements are used to make economic decisions by a wide range of users.
• All users require information regarding:
– Financial position
– Financial performance, and
– Changes in financial position.
2.1 What is corporate reporting?

2.1.1 Financial reporting
Financial reporting is the process of identifying, measuring and communicating economic information
to others so that they may make decisions on the basis of that information and assess the stewardship
of the entity's management.
Financial reporting involves:
• Recording transactions undertaken by a business entity
• Grouping similar transactions together which are appropriate to the business
• Presenting periodic results.
Financial reporting focuses on the preparation of published financial information. Typically, this
information is made available annually or half-yearly (sometimes quarterly) and is presented in formats
laid down or approved by governments in each national jurisdiction.
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.
2.1.3 Management accounting

By contrast, management accounting or reporting is internal reporting for the use of the management
of a business itself. Internal management information can be tailored to management's own needs and
provided in whatever detail and at whatever frequency (eg continuous real-time information)
management decides is best suited to the needs of their business.
The distinction is not so clear-cut, in that management decisions may be affected by external reporting
issues, for example, if a director's bonus depends on profit. These matters are covered in Chapter 24 on
the more advanced aspects of financial analysis.
Interactive question 1: Management decisions [Difficulty level: Easy]

Can you think of another example of a way in which management decisions may be influenced by
external reporting requirements?
See Answer at the end of this chapter.
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.
2.3 Financial statements

The principal means of providing financial information to external users is the annual financial
statements. Financial statements provide a summary of the performance of an entity over a particular
period and of its position at the end of that period.
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.
2.4 Requirement to produce financial statements

Limited liability companies are required by law to prepare and publish financial statements annually.
The form and content may be regulated primarily by national legislation, and in most cases must also
comply with Financial Reporting Standards.
In Bangladesh, all companies must comply with the provisions of the Companies Act 1994 (CA 1994).
The key impact of this is as follows:
• Every registered company is required to prepare financial statements for each financial year
which give a true and fair view.
• The individual (and some group) financial statements may be prepared:
– In accordance with the CA 1994 (as regards format and additional information provided by
way of notes), and
– In accordance with International Financial Reporting Standards (IFRS).
2.5 Financial reporting standards

Company financial statements must also comply with relevant reporting standards. In Bangladesh these
are as follows.
• Accounting transactions treatments and format as stated in the Companies Act 1994.
• International Financial Reporting Standards (IFRS) for Small and Medium Enterprise (SME).
This brings together all the IFRSs (IFRSs issued by IASB) which Bangladesh SMEs are required
to follow in drawing up their financial statements.
• International Financial Reporting Standards (IFRS)
These are issued by the International Accounting Standards Board (IASB). As stated BSEC
rules, companies whose securities are traded in a regulated public market, eg the Dhaka Stock
Exchange, must prepare their accounts in accordance with IFRS.
These learning materials assume the preparation of financial statements in accordance with
IFRS.
Unincorporated entities are exempt from the above requirements but may need to follow other
regulation, eg charities must comply with the Charities Act. Incorporated charities must prepare their
financial statements in accordance with the CA 1994.
Point to note
The term Generally Accepted Accounting Practice (GAAP) refers to all the rules, from whatever
source, which govern Bangladesh accounting. In Bangladesh this is seen primarily as a combination of:
• Company law (mainly CA 1994)
• Stock Exchange requirements
• Accounting custom and practice
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.
2.7 Judgements and financial statements

Although IFRS narrow down the range of acceptable alternative accounting treatments, there are still
many areas which are left to the discretion of the directors of the company. On the whole, the concept of
faithful representation should result in transactions being 'presented fairly'. However, commercial and
financial considerations may result in pressure being brought to bear to account for and report
transactions in accordance with their strict legal form rather than their true substance. This can raise
ethical questions for a professional accountant.
2.8 Users of financial statements

The form and content of financial statements must be influenced by the use to which they are put. The
IASB Conceptual Framework emphasises that financial statements are used to make economic
decisions, such as:
• To decide when to buy, hold or sell an equity investment
• To assess the stewardship or accountability of management
• To assess an entity's ability to pay and provide other benefits to employees
• To assess security for amounts lent to the entity
• To determine taxation policies
• To determine distributable profits and dividends
• To prepare and use national income statistics
• To regulate the activities of entities
Much of the information needed for these different decisions is in fact common to them all. Financial
statements aimed at meeting these common needs of a wide range of users are known as 'general
purpose' financial statements.
We can identify the following users of financial statements:
• Present and potential investors
• Employees
• Lenders
• Suppliers and other trade payables
• Customers
• Governments and their agencies
• The public
Their specific information needs and how these needs may be addressed are covered in Chapter 23, the
first of two chapters on financial analysis. In most cases the users will need to analyse the financial
statements in order to obtain the information they need. This might include the calculation of accounting
ratios.
2.9 Objective of financial statements

The objective of financial statements is to provide information about the reporting entity's financial
position and financial performance that is useful to a wide range of users in making economic
decisions.
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.
2.10 Accountability of management

Management also has a stewardship role, in that it is accountable for the safe-keeping of the entity's
resources and for their proper, efficient and profitable use. Providers of risk capital are interested in
information that helps them to assess how effectively management has fulfilled this role, but again this
assessment is made only as the basis for economic decisions, such as those about investments and the
reappointment/replacement of management.
It is also the case that in a smaller entity the owner and manager can be the same individual.
Financial reporting helps management to meet its need to be accountable to shareholders, and also to
other stakeholders (eg employees or lenders), by providing information that is useful to the users in
making economic decisions.
However, financial statements cannot provide the complete set of information required for assessing the
stewardship of management.
2.11 Financial position, performance and changes in financial position

All economic decisions are based on an evaluation of an entity's ability to generate cash and of the
timing and certainty of its generation. Information about the entity's financial position, performance and
changes in financial position provides the foundation on which to base such decisions.
2.11.1 Financial position

An entity's financial position covers:
• The economic resources it controls
• Its financial structure (ie debt and share finance)
• Its liquidity and solvency and
• Its capacity to adapt to changes in the environment in which it operates
Investors require information on financial position because it helps in assessing:
• The entity's ability to generate cash in the future
• How future cash flows will be distributed among those with an interest in, or claims on, the entity
• Requirements for future finance and ability to raise that finance
• The ability to meet financial commitments as they fall due
Information about financial position is primarily provided in a statement of financial position.
2.11.2 Financial performance

The profit and the comprehensive income earned in a period are used as the key measures of an
entity's financial performance. Information about performance and variability of performance is useful in:
• Assessing potential changes in the entity's economic resources in the future
• Predicting the entity's capacity to generate cash from its existing resource base, and
• Forming judgements about the effectiveness with which additional resources might be employed.
Information on financial performance is provided by:
• The statement of profit or loss and other comprehensive income
• The statement of changes in equity.
2.11.3 Changes in financial position

Changes in financial position can be analysed under the headings of investing, financing and
operating activities and are presented in a statement of cash flows.
Cash flow information is largely free from the more judgemental allocation and measurement issues
(ie in which period to include things and at what amount) that arise when items are included in the
statement of financial position or performance statements. For example, depreciation of non-current
assets involves judgement and estimation as to the period over which to charge depreciation. Cash flow
information excludes non-cash items such as depreciation.
Cash flow information is therefore seen as being factual in nature, and hence more reliable than other
sources of information.
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
3 The role and context of modern auditing H

A
Section overview P
T
• The audit provides assurance to shareholders.
E
• The audit enables the auditor to form an opinion as to whether the financial statements give a true
R
and fair view.
• An expectation gap may exist between what shareholders expect the audit to achieve and what it
is designed to achieve.
1
• You should be familiar with the audit process from your earlier studies.
• All companies, except those meeting exemption criteria must have an annual external audit.
• The Companies Act sets down the responsibilities of the directors and auditors.
3.1 Purpose of the audit

Audits serve a fundamental purpose in helping to enforce accountability and promote confidence in
financial reporting. Directors are delegated responsibility for managing the affairs of the company by the
owners, in effect they act as trustees for the shareholders. The audit provides a mechanism for
shareholders to help ensure that the directors are acting in the company's best interests and therefore
plays a fundamental stewardship role.
ISA 200 Overall Objectives of The Independent Auditor and the Conduct of an Audit in Accordance with
International Standards on Auditing sets out the purpose of an audit as follows:
'The purpose of an audit is to enhance the degree of confidence of intended users in the financial
statements. This is achieved by the expression of an opinion by the auditor on whether the financial
statements are prepared, in all material respects, in accordance with an applicable financial
reporting framework.'
3.2 Part of the economic infrastructure

The audit is also a vital function of economic activity. For that economic activity to continue to flourish
there has to be trust.
While the audit has a crucial role to play in providing assurance to shareholders it cannot be seen in
isolation. For example, the directors of the company have a role to play in the preparation of financial
statements that show a true and fair view. The audit has to be seen in the context of a range of
interwoven laws, regulations, and guidance, all of which promote good corporate governance. (We will
look at corporate governance in detail in Chapter 4.)
3.3 The expectation gap

The primary role of the auditor is to perform an independent examination of the financial statements and
to form an opinion. You should be very familiar with this concept from your earlier studies. The audit
opinion will provide reasonable assurance that the financial statements give a true and fair view; it
does not provide a certificate that they are completely accurate and free from every error or fraud, no
matter how small. ISA 200 explains that absolute assurance is not possible due to inherent limitations of
the audit including those resulting from the following factors:
• The nature of financial reporting; many items involve judgement and assessments of uncertainties
• The use of selective testing
• Inherent limitations of internal control
• The fact that most evidence is persuasive rather than conclusive
• The impracticability of examining all items within a class of transactions or account balance
• The possibility of collusion or misrepresentation for fraudulent purposes
• The fact that the work undertaken by the auditor is permeated by judgement
In some instances an 'expectation gap' can lead to difficulties arising from the difference between what
shareholders expect an audit to achieve and what it is designed to achieve. The public increasingly
expect the following types of questions to be answered:
• Is the company a going concern?
Introduction 9
• Is the company managed effectively?
• Is there an adequate system of controls?
• Is the company susceptible to fraud?
3.4 The audit opinion

The key judgement made by the auditor is whether the financial statements give a true and fair view.
While there is no legal definition for these terms, 'true' and 'fair' are normally taken to mean the following:
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.
3.5 The audit process

You will have covered the audit process in your earlier studies. The following diagram summarises the
key points you should be familiar with. Chapters 5 – 8 of this study manual cover the audit in more detail.
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.
3.6 Statutory audit requirement

The basic principle is that all companies registered in Bangladesh should be audited as per the
Companies Act 1994.
4 Legal responsibilities of directors and auditors

4.1 Companies Act 1994
The legal responsibilities regarding directors and auditors are currently contained in the Companies Act
1994.
4.2 Directors' responsibilities

These duties are as follows:
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-
(a) the state of the company's affairs;

(b) the amount, if any, which the Board proposes to carry to any reserve in such balance sheet;
(c) the amount, if any, which the Board recommends should be paid by way of dividend;
(d) material changes and commitments, if any, affecting the financial position of the company which
have occurred between the end of the financial year of the company to which the balance sheet related
and the date of the report.
(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 :-
(a) in the nature of the company's business;

(b) in the company's subsidiaries or in the nature of the business carried on by them; and
(c) generally in the classes of business in which the company has an interest.
(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.
4.2.2 The Directors’ Report to Shareholders in accordance with BSEC notification
In compliance of BSEC corporate governance guidelines, listed companies in Bangladesh are required
to include the following additional statements in the Directors' Report -
(i) Industry outlook and possible future developments in the industry.

(ii) Segment-wise or product-wise performance.
(iii) Risks and concerns.
(iv) A discussion on Cost of Goods sold, Gross Profit Margin and Net Profit Margin.
(v) Discussion on continuity of any Extra-Ordinary gain or loss.
(vi) Basis for related party transactions- a statement of all related party transactions should be disclosed
in the annual report.
(vii) Utilization of proceeds from public issues, rights issues and/or through any others instruments.
(viii) An explanation if the financial results deteriorate after the company goes for Initial Public Offering
(IPO), Repeat Public Offering (RPO), Rights Offer, Direct Listing, etc.
(ix) If significant variance occurs between Quarterly Financial performance and Annual Financial
Statements the management shall explain about the variance on their Annual Report.
(x) Remuneration to directors including independent directors.
(xi) The financial statements prepared by the management of the issuer company present fairly its state
of affairs, the result of its operations, cash flows and changes in equity.
(xii) Proper books of account of the issuer company have been maintained.
(xiii) Appropriate accounting policies have been consistently applied in preparation of the financial
statements and that the accounting estimates are based on reasonable and prudent judgment.
(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.
4.3 Directors' loans and other transactions
4.3.1 C
103. Loan of Director— H

A
(1) No company, hereinafter in this section referred top as the lending company, shall make any loan or P
give any guarantee or provide any security in connection with a loan made by a third party to-- T
E
(a) any director of the lending company R
(b) any firm in which any director of the lending company is a partner;
(c) any private company of which any director of the lending company is a director or member; or
(d) any public company, the managing agent manager or director where of is accustomed to act in 1
accordance with the directions or instruction of any director of the lending company:
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
4.4 Auditors' responsibilities

Under the Companies Act 1994, it is the external auditor's responsibility to:
• Form an independent opinion on the truth and fairness of the financial statements
• Confirm that the financial statements have been properly prepared in accordance with the
relevant financial reporting framework and the Companies Act 1994
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;
(e) whether personal expenses have been charged to revenue account;
(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.
(4) The auditors’ report shall also state-
(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-
(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.
5.1 Interaction between FRC and IAASB Standards

The system in Bangladesh currently works as follows:
IAASB
Issues
ISA as used
by
ISA Bangladesh
Auditors
ICAB Adopts
5.2 International Auditing and Assurance Standards Board

5.2.1 Pronouncements
IAASB was set up by the International Federation of Accountants (IFAC), which nominates a majority of
its members – others are nominated by the forum of firms – to issue professional standards. It issues the
following standards:
• International Standards on Auditing (ISAs)
• International Standards on Assurance Engagements (ISAEs) (applicable to assurance
engagements which are not audits)
• International Standards on Related Services (ISRSs) (applicable to other, non-assurance
engagements)
• International Standards on Quality Control (ISQCs) (applicable to all engagements carried out
under any of the IAASB's standards)
• International Standards on Review Engagements (ISREs) (to be applied in the review of
historical financial information)
It also issues the following practice statements:
• International Auditing Practice Notes (IAPNs). This is a new category of pronouncement for use
in issuing non-authoritative material. They provide practical assistance to the auditor and may help
the auditor in:
– Obtaining an understanding of the circumstances of the entity, and in making judgements
about the identification and assessment of risks of material misstatement;
– Making judgements about how to respond to assessed risks, including judgements about
procedures that may be appropriate in the circumstances; or
– Addressing reporting considerations, including forming an opinion on the financial statements
and communicating with those charged with governance.
To date one IAPN has been issued, IAPN 1000, Special Considerations in Auditing Financial
Instruments. This is covered in Chapter 16.
• International Review Engagement Practice Statements (IREPSs), International Assurance
Engagement Practice Statements (IAEPSs), and International Related Services Practice
Statements (IRSPSs) are issued to serve the same purpose for implementation of ISREs, ISAEs
and ISRSs respectively.
Point to note:
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.
5.3 Clarity Project

In March 2009 the IAASB completed its Clarity Project, during which they reissued existing ISAs, with
the aim of making the requirements within them clearer.
Under this project, each ISA has:
• A stated overall objective
• Clarified obligations, by use of the word 'shall' where a requirement of the ISA is set out
• Less ambiguity
• Improved readability
These standards are effective for audits of financial statements for periods beginning on or after 15
December 2009.
Point to note:
Unless indicated otherwise this manual refers to the clarified ISAs.
6 Audit quality control

Section overview
• Quality control procedures should be adopted:
– At the firm level, and
– On an individual audit.
• Professional bodies also have a responsibility to develop quality control standards and monitor
compliance.
• Audit documentation is an important part of quality control.
• It provides evidence of work done to support the audit opinion.
• Significant matters must be documented.
• Audit working papers should be reviewed.
6.1 Principles and purpose

Audit quality is not defined in law or through regulations, nor do auditing standards provide a simple
definition.
Although each stakeholder in the audit will give a different meaning to audit quality, at its heart it is about
delivering an appropriate professional opinion supported by the necessary evidence and objective
judgements.
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.
6.2 Quality control at a firm level

The fact that auditors follow ISAs provides a general quality control framework within which audits
should be conducted. There are also specific quality control standards. ISQC 1: Quality Control for Firms
that Perform Audits and Reviews of Financial Statements and other Assurance and Related Services
Engagements deals with quality control at a firm level. You have studied ISQC 1 in Audit and Assurance
at the Professional level. A summary of the key points is provided below.
6.2.1 Objective of ISQC 1

The objective set by ISQC 1 is for the firm to establish a system of quality control designed to provide
it with reasonable assurance that the firm and its personnel comply with professional standards and
regulatory and legal requirements, and that reports issued by the firm or engagement partners are
appropriate in the circumstances.
6.2.2 Elements of a system of Quality Control

ISQC 1 identifies the following six elements of the firm's system of quality control:
(1) Leadership responsibilities for quality within the firm
The standard 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.
The firm's managing partners are required to assume ultimate responsibility for the firm's system of
quality control. They may appoint an individual or group of individuals to oversee quality in the firm.
Such individuals must have:
• Sufficient and appropriate experience and ability to carry out the job
• The necessary authority to carry out the job
(2) 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 and in particular independence
requirements.
The policies and procedures should be in line with the fundamental principles, which should be
reinforced by:
• The leadership of the firm
• Education and training
• Monitoring
• A process to deal with non-compliance
At least annually, the firm should obtain written confirmation of compliance with its policies and
procedures on independence from all firm personnel required to be independent by ethical
requirements.
(3) Acceptance and continuance of client relationships and specific engagements
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
• It is competent to perform the engagement and has the capabilities, including time and
resources, to do so
• It can comply with ethical requirements including appropriate independence from the client
(4) Human resources
The firm's overriding desire for quality will necessitate policies and procedures on ensuring
excellence in its staff, to provide the firm with 'reasonable assurance that it has sufficient
personnel with the competence, capabilities and commitment to ethical principles necessary to
perform engagements in accordance with professional standards and applicable and regulatory
requirements, and to enable the firm or engagement partners to issue reports that are appropriate
in the circumstances'.
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
6.3 Quality control on an individual audit

You will have studied ISA 220 Quality Control for an Audit of Financial Statements in the previous Audit
and Assurance paper. A summary of the key points is provided below.
6.3.1 Policies and procedures

ISA 220 states that the objective of the auditor is to implement quality control procedures at the
individual engagement level. The engagement partner is ultimately responsible for quality control on an
individual engagement.
The policies and procedures for quality control on individual audits parallel those for the firm outlined
above. For example ethical requirements must be considered. In addition, however, of particular
significance for individual audits are the procedures of direction, supervision and review.
• Direction
At the planning stage, but also during the audit, the engagement partner ensures that the members
of the engagement team are informed of:
– Their responsibilities
– 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
6.4 Assuring the Quality of Professional Services

IFAC Statement of Membership Obligations 1 (SMO 1) (revised) Quality Assurance sets out the
requirements of an IFAC member body (such as ICAB) with respect to quality assurance review systems
for its members who perform audits, review, other assurance and related services engagements of
financial statements. It covers many of the issues dealt with by ISQC 1 and ISA 220 but addresses them
largely from the perspective of the role of the professional bodies eg ICAB. SMO 1 was revised in
November 2012 and has an effective date of 1 January 2014. The revised SMO includes an applicability
framework that provides guidance on how to address obligations where organisations have varying
degrees of responsibility for meeting the requirements of the SMO:
• Where IFAC members have direct responsibility they must implement all the requirements of the
SMO.
• Where IFAC members have no responsibility for this area they must use their best endeavours to
encourage those responsible to follow the requirements of the SMO and assist in their
implementation if appropriate.
• Where responsibility is shared they must implement those that they are responsible for and use
their best endeavours to encourage those responsible for the remainder to follow the requirements
of the SMO.
In particular SMO 1 (revised) makes the following points:
IFAC believes that the following objectives have worldwide applicability and that member bodies should
strive to achieve them:
• Member bodies must identify and undertake actions to have ISQC 1 and other relevant standards
adopted and implemented and requirements established for firms to implement a system of quality
control in their jurisdiction. Firms are responsible for implementing policies and procedures that
comply with ISQC 1.
• Member bodies must assist their members to understand the objectives of quality control, and
implement and maintain appropriate systems of quality control. This assistance can take various
forms, such as Continuing Professional Development (CPD) guidelines, or implementing
programmes that enable firms to obtain an independent confidential assessment of their quality
control policies and procedures.
• Member bodies must develop quality review programmes designed to evaluate whether firms (or
an individual partner) have established appropriate quality control policies and procedures and are
complying with those. A cycle-based, risk-based or mixed approach for selecting firms for quality
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.
Interactive question 2: Addystone Fish [Difficulty level: Intermediate]

You are an audit senior working for the firm Addystone Fish. You are currently carrying out the audit of
Wicker Ltd, a manufacturer of waste paper bins. You are unhappy with Wicker's inventory valuation
policy and have raised the issue several times with the audit manager. He has dealt with the client for a
number of years and does not see what you are making a fuss about. He has refused to meet you on
site to discuss these issues.
The former engagement partner to Wicker retired two months ago. As the audit manager had dealt with
Wicker for so many years, the other partners have decided to leave the audit of Wicker largely in his
hands.
Requirement
Comment on the situation outlined above.
6.5 Audit documentation

Audit documentation is a key part of the overall quality control framework during the course of an audit.
All audit work must be documented: the working papers are the tangible evidence of all work done in
support of the audit opinion. ISA 230 Audit Documentation provides guidance on this issue.
In your previous studies, you have learnt the practical issues surrounding how audit papers should be
completed. The key general rule concerning what to include in a working paper to remember, is:
'What would be sufficient to enable an experienced auditor, having no previous connection with the
audit to understand the nature, timing, and extent of the audit procedures performed to comply with
the ISAs and applicable legal and regulatory requirements and the results of the audit procedures
and the audit evidence obtained, and significant matters arising during the audit and the
conclusions reached thereon, and significant professional judgements made in reaching those
conclusions.'
The key reason for having audit papers therefore is that they provide evidence of work done. They may
be required in the event of litigation arising over the audit work and opinion given.
The ISA sets out certain requirements about what should be recorded, such as the identifying
characteristics of the specific items being tested.
It also sets out points an auditor should record in relation to significant matters. These include:
• Discussions undertaken with directors and
• How the auditor addressed information that appeared to be inconsistent with his conclusions in
relation to significant matters.
If an auditor felt it necessary to depart from customary audit procedures required by audit standards, he
should document why, and how the different test achieved audit objectives.
The ISA also contains details about how the audit file should be put together and actions in the event of
audit work being added after the date of the audit report (for example, if subsequent events result in
additional procedures being carried out). You should be familiar with these points from your earlier
studies.
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.
Interactive question 3: Documentation (revision) [Difficulty level: Intermediate]

Viewco is a manufacturer of TVs and DVD players. It carries out a full physical inventory count at its
central warehouse every year on 31 December, its financial year-end. Finished goods are normally of
the order of CU3 million, with components and work in progress normally approximately CU1 million.
You are the audit senior responsible for the audit of Viewco for the year ending 31 December 20X1.
Together with a junior member of staff, you will be attending Viewco's physical inventory count.
Requirements
(a) Explain why it is necessary for an auditor to prepare working papers.
(b) State, giving reasons, what information the working papers relating to this inventory count
attendance should contain.
Interactive question 4: TrucksToGo Ltd [Difficulty level: Intermediate]

You are the audit senior on the audit of TrucksToGo Ltd. You are supervising the work of a relatively
inexperienced audit junior. The junior has been carrying out audit procedures on the assertions of
completeness and existence of non-current assets. According to the junior, audit procedures have been
completed and the memo below has been produced outlining some of the issues found during the audit.
Memo: Issues identified during audit
The directors have confirmed that there are no further non-current assets to include in the financial
statements. This representation was received in a meeting with the Finance Director and recorded on
the audit file at this time.
Part of the existence work on non-current assets included obtaining a sample of assets from the asset
register and then physically verifying those assets. Unfortunately, a significant number of assets were
not available for verification – the vehicles were in use by the company and therefore not on the
premises. As an alternative, vehicles on the premises were agreed back to the asset register.
A number of vehicles were noted on the company premises in a poor state of repair; for example,
engines missing. On enquiry, the vehicle manager confirmed that the vehicles were under repair. I am
therefore happy that the vehicles belonged to the company and no further action is necessary.
I have reached the conclusion that all non-current assets are correctly stated and valued in the financial
statements.
Requirement
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.
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.
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
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
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
Answer to Interactive question 1

Where IFRS allows a choice of accounting policy, directors may wish to select the policy that gives the
most favourable picture, rather than the one which is most useful to users of financial statements. For
example, they may wish to adopt the direct, rather than the indirect method of preparing a statement of
cash flows if they believe that gives a more favourable view of the company's liquidity and solvency in
the eyes of a lender such as a bank. Auditors need to be on the lookout for this kind of manipulation.

Several quality control issues are raised in the scenario:
Engagement partner
An engagement partner is usually appointed to each audit engagement undertaken by the firm, to take
responsibility for the engagement on behalf of the firm. Assigning the audit to the experienced audit
manager is not sufficient.
The lack of audit engagement partner also means that several of the requirements of ISA 220 about
ensuring that arrangements in relation to independence and directing, supervising and reviewing the
audit are not in place.
Conflicting views
In this scenario the audit manager and senior have conflicting views about the valuation of inventory. This
does not appear to have been handled well, with the manager refusing to discuss the issue with the senior.
ISA 220 requires that the audit engagement partner takes responsibility for settling disputes in
accordance with the firm's policy in respect of resolution of disputes required by ISQC 1. In this case, the
lack of engagement partner may have contributed to this failure to resolve the disputes. In any event, at
best, the failure to resolve the dispute is a breach of the firm's policy under ISQC 1. At worst, it indicates
that the firm does not have a suitable policy concerning such disputes as required by ISQC.

(a) Working papers are necessary for the following reasons:
• To assist the engagement team to plan and perform the audit.
• To assist members of the engagement team responsible for supervision to direct and
supervise the audit procedures, and to discharge their review responsibilities in accordance
with ISA 220.
• To enable the engagement team to be accountable for its work.
• As a record of matters of continuing significance to future audits.
• To enable the conduct of quality control reviews and inspections in accordance with ISQC 1.
• To enable the conduct of external inspections in accordance with applicable legal, regulatory
or other requirements.
(b)
C
Information Reasons
H
1 Administration A
P
Client name • Enables an organised file to be produced T
E
Year-end
R
Title
Date prepared • Enables papers to be traced if lost

1
Initials of preparer • Any questions can be addressed to the
appropriate person
• Seniority of preparer is indicated
Initials of senior to indicate review of junior's • Evidence that guidance on planning,

work controlling and recording is being followed
• Evidence of adherence to auditing standards
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
Summary of different types of raw

material held and method of counting
small components
Summary of different stages of WIP

identified by client
(ii) Time and place of count • Audit team will not miss the count
(iii) Personnel involved • Auditor aware who to address questions/

problems to
(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
• Enables compliance work to be carried out,

that is, checking Viewco staff follow the
instructions
(v) Plan of warehouse • To ensure all areas covered at count
• Clear where to find different models/

components
• Location of any third party/moving inventory

clear
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
(vii) Scope of test counts to be performed • Ensures appropriate amount of procedures

that is, number/value of items to be performed based on initial assessment
counted and method of selection. For
• Clear plan for audit team
Viewco probably more counting of
higher value finished goods
3 Objectives of attendance that is, to ensure • Reporting partner can confirm if

that the quantity and quality of inventory to appropriate/adequate procedures performed
be reflected in the financial statements is
materially accurate
4 Details of procedures performed • Provides evidence for future reference and

documents adherence to auditing standards
• Enables reporting partner to review the

adequacy of the procedures and establish
whether it meets the stated objective
A. Details of controls testing procedures • Enable reassessment of likely reliability of

performed – observing Viewco's counters Viewco's count
and ensuring they are following the
• Enables assessment of chances of items
instructions and conducting the count
being double-counted or omitted
effectively, for example,
(i) Note of whether the area was

systematically tidied
(ii) Note of whether or how counted goods

are marked
(iii) Note of how Viewco record and

segregate any goods still moving on
count day
(iv) Note of adequacy of supervision and • Enables assessment of overall standard of

general impression of counters count and hence likely accuracy
(v) Note whether counters are in teams of • Evidence of independent checks may
two and whether any check counts are enhance reliability
performed
B. Details of substantive procedures performed
(i) Details of items of raw materials or

finished goods test counted:
• From physical inventory to client's • Evidence to support the accuracy and

count sheet completeness of Viewco's count sheets
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
inventory for example, dusty/damaged the net realisable value investigated

boxes. Note code, description, number
of units and problem
(iii) Details of review of WIP
• Assessment of volume of part • Evidence in support of accuracy of quantity

complete items of each stage of WIP
• Assessment of appropriateness of • Details can be followed through at final audit

degree of completion assigned to to final inventory sheets
each stage by Viewco (could • Basis for discussion of any description
describe items at various stages)
(iv) Copies of:
• 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
5 Summary of results • Senior/manager can assess any
In particular: consequences for audit risk and strategy and

decide any further procedures needed
(i) Details of any problems encountered
• Provides full documentation of issues that
(ii) Details of any test count discrepancies
could require a judgemental decision and
and notes of investigation into their
could ultimately be the basis for a qualified
causes
opinion
(iii) Details of any representations by the
management of Viewco
6 Conclusion • Indicates whether or not the initial objective

has been met and whether there are any
implications for the audit opinion
Introduction 37
• 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.
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
Technical reference
Answer to Interactive question
39
Introduction
• Explain the impact of accounting principles and bases on measurement in corporate

reporting, for example fair value measurement
• Appraise corporate reporting regulations, and related legal requirements, with respect to
presentation, disclosure, recognition and measurement
• Explain and appraise accounting standards that relate to the impact of changes in
accounting policies and estimates
• Explain and evaluate the impact of underlying assumptions on financial statements
• Identify and explain current and emerging issues in corporate reporting
• Formulate, implement and evaluate accounting and reporting policies for single entities
and groups of varying sizes and in a variety of industries
• Explain how different methods of recognising and measuring assets and liabilities can
affect reported financial position
Specific syllabus references for this chapter are: 1(a) – (e), 2(c), 2(d)
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.
1.3 The IASB

The IASB is responsible for setting accounting standards. It is made up of 15 full-time members and has
no particular geographical dominance. Members have a variety of backgrounds and include:
• Auditors
• Preparers of financial statements
• Users of financial statements, and
• Academics
Principles of corporate reporting 41

1.4 Objectives of the IASB
The Preface to IFRSs states that the objectives of the IASB are as follows:
• To develop, in the public interest, a single set of high-quality, understandable, enforceable and
globally accepted financial reporting standards based on clearly articulated principles. These
standards should require high quality, transparent and comparable information in financial
statements and other financial reporting to help investors, other participants in the various capital
markets of the world and other users of the information to make economic decisions.
• To promote the use and rigorous application of those standards.
• In fulfilling the above objectives to take account of, as appropriate, the needs of a range of sizes
and types of entities in diverse economic settings.
• To promote and facilitate the adoption of IFRSs through the convergence of national accounting
standards and IFRSs.
1.5 The purpose of accounting standards

The overall purpose of accounting standards is to identify proper accounting practices for the
preparation of financial statements.
Accounting standards create a common understanding between users and preparers on how
particular items, for example the valuation of property, are treated. Financial statements should therefore
comply with all applicable accounting standards.
1.6 Application of IFRS

Within each individual country local regulations govern, to a greater or lesser degree, the issue of
financial statements. These local regulations include accounting standards issued by the national
regulatory bodies or professional accountancy bodies in the country concerned.
Over the last 25 years however, the influence of IFRS on national accounting requirements and
practices has been growing. For example:
• Since accounting periods commencing on or after 1 January 2005, all EU companies whose
securities are traded on a regulated public market, must prepare their consolidated accounts in
accordance with IFRS. (Note that although group financial statements must follow IFRS the
individual financial statements do not need to.)
• In Bangladesh listed companies are required to comply with IFRS as per the BSEC notification and
all other registered companies are also required to comply with IFRS due to the mandatory
statutory audit requirement.
1.7 Setting of IFRS

The overall agenda of the IASB is initially set by discussion with the IFRS Advisory Council. The process
for developing an individual standard involves the following steps.
Step 1
During the early stages of a project, IASB may establish an Advisory Committee or working group to
give advice on issues arising in the project. Consultation with the Advisory Committee and the Advisory
Council occurs throughout the project.
Step 2
IASB may develop and publish a Discussion Paper for public comment.
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.
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.
1.8 Scope and authority of IFRS

The Preface to IFRSs makes the following points:
• IFRS apply to all general purpose financial statements ie those directed towards the common
information needs of a wide range of users.
• The IASB's objective is to require like transactions and events to be accounted for and
reported in a like way. The IASB intends not to permit choices in accounting treatment. The
IASB is reconsidering those transactions and events for which IFRSs permit a choice of accounting
treatment with the objective of reducing the number of those choices. C
H
• Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the main A
principles, but both types have equal authority. T
• Any limitation of the applicability of a specific IFRS is made clear in that standard. E
R
1.9 Bangladesh regulatory framework

Bangladesh companies produce their financial statements in line with the requirements of:
2
• The Companies Act 1994, and
• Accounting standards, IFRS issued by the IASB and adopted by ICAB.
2 The IASB Conceptual Framework
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.
2.1 Conceptual Framework

The IASB Framework for the Preparation and Presentation of Financial Statements was produced in
1989 and is gradually being replaced by the new Conceptual Framework for Financial Reporting. This is
the result of an IASB/FASB joint project and is being carried out in phases. The first phase, comprising
Chapters 1 and 3, was published in September 2010. Chapter 2 entitled 'The reporting entity' has not
yet been published. The current version of the Conceptual Framework includes the remaining chapters
of the 1989 Framework as Chapter 4.
The Conceptual Framework for Financial Reporting is currently as follows:
Chapter 1: The objective of general purpose financial reporting
Chapter 2: The reporting entity (to be issued)
Chapter 3: Qualitative characteristics of useful financial information
Chapter 4: Remaining text of the 1989 Framework:
• Underlying assumption
• The elements of financial statements
• Recognition of the elements of financial statements
• Measurement of the elements of financial statements
• Concepts of capital and capital maintenance

In this chapter we have already introduced some of the concepts dealt with by the Conceptual
Framework.
We will now look specifically at each section in turn.
2.2 Introduction to the Conceptual Framework

The Introduction provides a list of the purposes of the Conceptual Framework:
(a) To assist the Board in the development of future IFRSs and in its review of existing IFRSs.
(b) To assist the Board in promoting harmonisation of regulations, accounting standards and
procedures relating to the presentation of financial statements by providing a basis for reducing the
number of alternative accounting treatments permitted by IFRSs.
(c) To assist national standard-setting bodies in developing national standards.
(d) To assist preparers of financial statements in applying IFRSs and in dealing with topics that have
yet to form the subject of an IFRS.
(e) To assist auditors in forming an opinion as to whether financial statements comply with IFRSs.
(f) To assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRSs.
(g) To provide those who are interested in the work of the IASB with information about its approach to
the formulation of IFRSs.
The Conceptual Framework is not an IFRS and so does not overrule any individual IFRS. In the (rare)
case of conflict between an IFRS and the Conceptual Framework, the IFRS will prevail.
2.3 Chapter 1: The objective of general purpose financial reporting

The Conceptual Framework states that:
'The objective of general purpose financial reporting is to provide information about the reporting entity
that is useful to existing and potential investors, lenders and other creditors in making decisions about
providing resources to the entity.'
These users need information about:
• The economic resources of the entity;
• The claims against the entity; and
• Changes in the entity's economic resources and claims
Information about the entity's economic resources and the claims against it helps users to assess
the entity's liquidity and solvency and its likely needs for additional financing.
Information about a reporting entity's financial performance (the changes in its economic resources
and claims) helps users to understand the return that the entity has produced on its economic
resources. This is an indicator of how efficiently and effectively management has used the resources of
the entity and is helpful in predicting future returns.
The Conceptual Framework makes it clear that this information should be prepared on an accruals
basis.
Information about a reporting entity's cash flows during a period also helps users assess the entity's
ability to generate future net cash inflows and gives users a better understanding of its operations.
2.4 Chapter 3: Qualitative characteristics of useful financial information

2.4.1 Overview
Qualitative characteristics are the attributes that make the information provided in financial statements
useful to users.
The two fundamental qualitative characteristics are relevance and faithful representation.
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
Comparability Verifiability Timeliness Understandability

2
Constraint
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.

2.4.3 Faithful representation
Financial reports represent economic phenomena in words and numbers. To be useful, financial
information must not only represent relevant phenomena but must faithfully represent the phenomena
that it purports to represent. The user must be able to depend on it being a faithful representation.
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.
Worked example: Sale and repurchase agreement

A Ltd sells goods to B Ltd for CU10,000, but undertakes to repurchase the goods from B Ltd in 12
months' time for CU11,000.
The legal form of the transaction is that A has sold goods to B as it has transferred legal title. To reflect
the legal form, A Ltd would record a sale and show the resulting profit, if any, in profit or loss for the
period. In 12 months' time when legal title is regained, A Ltd would record a purchase. There would be
no liability to B Ltd in A Ltd's statement of financial position until the goods are repurchased.
The above treatment does not provide a faithful representation because it does not reflect the economic
substance of the transaction. After all, A Ltd is under an obligation from the outset to repurchase the
goods and A Ltd bears the risk that those goods will be obsolete and unsaleable in a year's time.
The substance is that B Ltd has made a secured loan to A Ltd of CU10,000 plus interest of CU1,000. To
reflect substance, A Ltd should continue to show the goods as an asset in inventories (at cost or net
realisable value, if lower) and should include a liability to B Ltd of CU10,000 in payables. A Ltd should
accrue for the interest over the duration of the loan.
When A Ltd pays CU11,000 to regain legal title, this should be treated as a repayment of the loan plus
accrued interest.
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.
2.4.4 Enhancing qualitative characteristics

C
Comparability
H
Comparability is the qualitative characteristic that enables users to identify and understand similarities A
in, and differences among, items. Information about a reporting entity is more useful if it can be T
compared with similar information about other entities and with similar information about the same entity E
for another period or another date.
R
Consistency, although related to comparability, is not the same. It refers to the use of the same
methods for the same items (ie consistency of treatment) either from period to period within a reporting
entity or in a single period across entities.
The disclosure of accounting policies is particularly important here. Users must be able to distinguish 2
between different accounting policies in order to be able to make a valid comparison of similar items in
the accounts of different entities.
Comparability is not the same as uniformity. Entities should change accounting policies if those
policies become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over time.
Verifiability
Verifiability helps assure users that information faithfully represents the economic phenomena it
purports to represent. It means that different knowledgeable and independent observers could reach
consensus that a particular depiction is a faithful representation.
Timeliness
Information may become less useful if there is a delay in reporting it. There is a balance between
timeliness and the provision of reliable information.
If information is reported on a timely basis when not all aspects of the transaction are known, it may not
be complete or free from error.
Conversely, if every detail of a transaction is known, it may be too late to publish the information because it
has become irrelevant. The overriding consideration is how best to satisfy the economic decision-making
needs of the users.
Understandability
Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information diligently. Some phenomena are
inherently complex and cannot be made easy to understand. Excluding information on those
phenomena might make the information easier to understand, but without it those reports would be
incomplete and therefore misleading. Therefore matters should not be left out of financial statements
simply due to their difficulty as even well-informed and diligent users may sometimes need the aid of an
advisor to understand information about complex economic phenomena.
2.4.5 The cost constraint on useful financial reporting

This is a pervasive constraint, not a qualitative characteristic. When information is provided, its benefits
must exceed the costs of obtaining and presenting it. This is a subjective area and there are other
difficulties: others, not the intended users, may gain a benefit; also the cost may be paid by someone
other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers and users
should be aware of the constraint.

2.5 Chapter 4: The elements of financial statements
2.5.1 Overview
Transactions and other events are grouped together in broad classes and in this way their financial effects
are shown in the financial statements. These broad classes are the elements of financial statements.
The Conceptual Framework lays out these elements as follows.
Elements of financial statements
Financial position in the statement of Performance in the income statement and

financial position statement of comprehensive income
• 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.
2.5.2 Definitions of elements

Element Definition Comment
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.
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.
In simple terms, an item is an asset if: C

H
• It is cash or the right to cash in future, eg a receivable, or a right to services that may be used to A
generate cash, eg a prepayment.
T
or E
R
• It can be used to generate cash or meet liabilities, eg a tangible or intangible non-current asset.
The existence of an asset, particularly in terms of control, is not reliant on:
• Physical form (hence intangible assets such as patents and copyrights may meet the definition of
an asset and appear in the statement of financial position – even though they have no physical 2
substance).
• Legal ownership (hence some leased assets, even though not legally owned by the company,
may be included as assets in the statement of financial position. (See Chapter 14.)
Transactions or events in the past give rise to assets. Those expected to occur in future do not in
themselves give rise to assets.
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.
As seen above, obligations may be:

• Legally enforceable as a consequence of a binding contract or statutory requirement. This is
normally the case with amounts payable for goods and services received.
• The result of business practice. For example, even though a company has no legal obligation to
do so, it may have a policy of rectifying faults in its products even after the warranty period has
expired.
A management decision (to acquire an asset, for example) does not in itself create an obligation,
because it can be reversed. But a management decision implemented in a way which creates
expectations in the minds of customers, suppliers or employees, becomes an obligation. This is
sometimes described as a constructive obligation. This issue is covered more fully in Chapter 13 in
the context of the recognition of provisions.
Liabilities must arise from past transactions or events. For example, the sale of goods is the past
transaction which allows the recognition of repair warranty provisions.

Settlement of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. In practice, most liabilities will be met in cash but
this is not essential.
Interactive question 1: Asset or liability? [Difficulty level: Easy]
Question Fill in your answer
(a) Oak Ltd has purchased a patent for CU40,000.

The patent gives the company sole use of a
particular manufacturing process which will save
CU6,000 a year for the next five years.
(b) Elm Ltd paid John Brown CU20,000 to set up a
car repair shop, on condition that priority
treatment is given to cars from the company's
fleet.
(c) Sycamore Ltd provides a warranty with every
washing machine sold.
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.)
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.
2.6 Chapter 4: Recognition of the elements of financial statements

C
2.6.1 Meaning of recognised H
An item is recognised when it is included in the statement of financial position or statement of profit or A
loss and other comprehensive income. T
E
Definition R
Recognition: The process of incorporating in the statement of financial position or statement of profit or
loss and other comprehensive income an item that meets the definition of an element and satisfies the
following criteria for recognition:
• It is probable that any future economic benefit associated with the item will flow to or from the 2
entity, and
• The item has a cost or value that can be measured with reliability.
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).
2.6.2 Probability of future economic benefits

Probability here refers to the degree of uncertainty that the future economic benefits associated with
an item will flow to or from the entity. This must be judged on the basis of the characteristics of the
entity's environment and the evidence available when the financial statements are prepared.
The Conceptual Framework does not give a definition of 'probable'. A working definition is 'more likely
than not'.
2.6.3 Reliability of measurement

The cost or value of an item in many cases must be estimated. The use of reasonable estimates is an
essential part of the preparation of financial statements and does not undermine their reliability.
Where no reasonable estimate can be made, the item should not be recognised (although its existence
should be disclosed in the notes).
2.6.4 Recognition of items

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the
definition of recognition given above.
Item Recognised in When

Asset The statement of It is probable that the future economic benefits will flow to the entity
financial position and the asset has a cost or value that can be measured reliably.
Liability The statement of It is probable that an outflow of resources embodying economic
benefits will result from the settlement of a present obligation and

Item Recognised in When
financial position the amount at which the settlement will take place can be measured
reliably.
Income The statement of profit An increase in future economic benefits related to an increase in an
or loss and other asset or a decrease of a liability has arisen that can be measured
comprehensive reliably.
income
Expenses The statement of profit A decrease in future economic benefits related to a decrease in an
or loss and other asset or an increase of a liability has arisen that can be measured
comprehensive reliably.
income
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.
2.7 Chapter 4: Measurement of the elements of financial statements

For an item or transaction to be recognised in an entity's financial statements it needs to be measured
as a monetary amount. IFRSuses several different measurement bases but the Conceptual
Framework refers to just four.
The four measurement bases referred to in the Conceptual Framework are:
• Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time of their acquisition. Liabilities are
recorded at the amount of proceeds received in exchange for the obligation, or in some
circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected
to be paid to satisfy the liability in the normal course of business.
• Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently.
• Realisable (settlement) value.
– Realisable value. The amount of cash or cash equivalents that could currently be obtained by
selling an asset in an orderly disposal.
– Settlement value. The undiscounted amounts of cash or cash equivalents expected to be
paid to satisfy the liabilities in the normal course of business.
• Present value. A current estimate of the present discounted value of the future net cash flows in
the normal course of business.
Historical cost is the most commonly adopted measurement basis, but this is usually combined with
other bases, eg an historical cost basis may be modified by the revaluation of land and buildings.
2.8 Chapter 4: Concepts of capital and capital maintenance

The final section of the Conceptual Framework is devoted to a brief discussion of the different concepts
of capital and capital maintenance, pointing out that:
• The choice between them should be made on the basis of the needs of users of financial
statements.
• The IASB has no present intention of prescribing a particular model.
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.
The financial concept of capital is adopted by most entities.

This concept measures capital as the equity in the statement of financial position. Profit is only
earned in an accounting period if the equity at the end of the period is greater than it was at the
start, having excluded the effects of distributions to or contributions from the owners during the period.
Monetary measure of capital C
Financial capital is usually measured in monetary terms, eg Bangladesh Taka or US $. This is the H
concept applied in historical cost accounting. This measure can be quite stable over short periods of A
years, but is debased by even quite low rates of general inflation over longer periods, such as 20 years. T
So comparisons between capital now and capital 20 years ago are invalid, because the measurement E
instrument is not constant. R
Constant purchasing power
A variant on the monetary measure of financial capital is the constant purchasing power measure. On
this basis, the opening capital (ie equity) is uprated by the change in a broadly based price index,
often a retail prices index, over the year. Also, the transactions during the year are uprated by the 2
change in the same index. A profit is only earned if the capital at the end of the year exceeds these
uprated values. (The value of the uprating is taken to equity, but is not regarded as a profit, merely a
'capital maintenance' adjustment.) So this capital maintenance adjustment can be thought of as an
additional expense. Comparisons over a 20-year period will be more valid if the capital 20 years ago is
uprated for general inflation over that 20-year period.
However, there is no reason why inflation measured by a retail prices index should be at all close to the
inflation experienced by an individual company. The physical capital maintenance concept (see below)
seeks to address this.
2.8.2 Physical capital and capital maintenance
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.
Worked example: Capital maintenance concepts

Meercat Ltd purchased 20,000 electrical components on 1 January 20X7 for CU10 each. They were all
sold on 31 December 20X7 for CU250,000. On that date the replacement cost of an electrical
component was CU11.50. The general rate of inflation as measured by the general price index was 12%
during the year.

Profit could be calculated as follows:
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
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
3.1 Scope and application of IFRS

Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRSs are not
intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS lays
out its scope at the beginning of the standard.
Within each individual country local regulations govern, to a greater or lesser degree, the issue of
financial statements. These local regulations include accounting standards issued by the national
regulatory bodies and/or professional accountancy bodies in the country concerned.
IFRS concentrates on essentials and is designed not to be too complex, otherwise the standards
would be impossible to apply on a worldwide basis.
IFRS does not override local regulations on financial statements. Entities should simply disclose
whether IFRS is complied with in all material respects. Entities in individual countries will attempt to
persuade local authorities, where current regulations deviate from IFRS, that the benefits of
harmonisation make local change worthwhile.
3.2 Application of IFRS to smaller entities

In most countries the majority of companies or other types of entity are very small. They are generally
owned and managed by one person or a family. The owners have invested their own money in the
business and there are no outside shareholders to protect.
Large entities, by contrast, particularly companies listed on a stock exchange, may have shareholders
who have invested their money, possibly through a pension fund, with no knowledge whatever of the
company. These shareholders need protection and the regulations for such companies need to be more
stringent.
It could therefore be argued that company accounts should be of two types.
(a) 'Simple' ones for small companies with fewer regulations and disclosure requirements
(b) 'Complicated' ones for larger companies with extensive and detailed requirements
This is sometimes called the big GAAP/little GAAP divide.
Possible solutions
There are two approaches to overcoming the big GAAP/little GAAP divide:

1 Differential reporting, ie producing new reduced standards specifically for smaller companies, such
as the IFRS for SMEs (see below).
2 Providing exemptions for smaller companies from some of the requirements of existing standards.
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.
Exemptions from IFRS

Some IFRSs do not have any bearing on small company accounts, for example, a company with equity
not quoted on a stock exchange has no need to comply with IAS 33 Earnings per Share. Also an entity
with a small local market may find IFRS 8 Operating Segments to be superfluous.
Other standards always have an impact. In particular, almost all small companies will be affected by the
IFRSs on:
• Property, plant and equipment
• Inventories
• Presentation of financial statements
• Events occurring after the reporting period
• Taxes on income
• Revenue
• Provisions and contingencies
Does this mean that companies below a certain size should be exempt from other IFRSs? An alternative
approach would be to reduce the exposure of small companies to IFRSs on a standard by standard
basis. For those 'core' standards listed above, small companies would be required to follow all or most
of their provisions. For more complicated standards, small companies would face nothing but very brief
general obligations.
It is difficult to see how the IASB could impose any kind of specific size limits to define small companies
if such an approach were adopted. Instead, it might specify that size limits which are already given in
national legislation or standards could be adopted for the purpose.
Cost of compliance
If the cost of compliance exceeds the benefits to users, an entity may decide not to follow an IFRS. This
applies to all reporting entities, not just smaller ones. However, smaller entities are more likely to make
use of this exception.
For example, impairment reviews can be time-consuming and a smaller entity may not have sufficient
staff to spare to carry out these reviews.
Materiality
Another point to note is that IFRSs apply to material items. In the case of smaller entities, the amount
that is material may be very small in monetary terms. However, the effect of not reporting that item may
be material in that it would mislead users of the financial statements. A case in point is IAS 24 Related
Party Disclosures. Smaller entities may well rely on trade with relatives of the directors/shareholders and
this needs to be disclosed.
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.
(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.
Overlap with full IFRS

In the following areas, the recognition and measurement guidance in the IFRS for SMEs is like that in
the full IFRS.
• Provisions and contingencies
• Hyperinflation accounting
• Events after the end of the reporting period
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
Principal recognition and measurement simplifications

(a) Financial instruments

Financial instruments meeting specified criteria are measured at cost or amortised cost. All others
are measured at fair value through profit or loss. The procedure for derecognition has been
simplified, as have hedge accounting requirements.
(b) Goodwill and other indefinite-life intangibles
These are always amortised over their estimated useful life (or ten years if it cannot be estimated).
(c) Investments in associates and joint ventures
These can be measured at cost, but fair value must be used if there is a published price quotation.
(d) Research and development costs and borrowing costs must be expensed.
(e) Property, plant and equipment and intangibles
There is no need to review residual value, useful life and depreciation method unless there is an
indication that they have changed since the most recent reporting date.
(f) Defined benefit plans
All actuarial gains and losses are to be recognised immediately (in profit or loss or other
comprehensive income). All past service costs are to be recognised immediately in profit or loss.
To measure the defined benefit obligation, the projected unit credit method must be used. (Note
that IAS 19 has been revised and incorporated several of these simplifications.)
(g) Income tax
This follows the now withdrawn ED Income tax, which simplifies IAS 12.
(h) Available-for-sale assets
There is no separate available-for-sale classification; holding an asset or group of assets for sale is
an indicator of impairment.
(i) Biological assets
SMEs are to use the cost-depreciation-impairment model unless the fair value is readily
determinable, in which case the fair value through profit or loss model is required.
(j) Equity-settled share-based payment
If observable market prices are not available to measure the fair value of the equity-settled share-
based payment, the directors' best estimate is used.
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.
Advantages and disadvantages of the IFRS for SMEs

Advantages
(a) It is virtually a 'one stop shop'
(b) It is structured according to topics, which should make it practical to use
(c) It is written in an accessible style
(d) There is considerable reduction in disclosure requirements
(e) Guidance not relevant to private entities is excluded
Disadvantages
(a) It does not focus on the smallest companies
(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
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(vii) Fair value measurement when readily determinable without undue cost or effort.
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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
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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.
3.4.2 ISA 210 Agreeing the Terms of Audit Engagements

ISA 210 contains no special provisions for small company audits, but the owner of a small company
may not be aware of directors' and auditors' responsibilities, particularly if the accounts preparation is
outsourced. A primary purpose of the engagement letter is to clarify these responsibilities. The
engagement letter may include a reference to the expectation of written representations to be given. It is
common practice for auditors of small entities to include an illustration of the type of representation
required and the potential implications of the representations not being provided.
3.4.3 ISA 220 Quality Control for an Audit of Financial Statements

The audit of a smaller entity must still be compliant with ISAs. Most of these audits are conducted using
one audit partner, one manager and one audit senior, so although assignment and delegation are taking
place, it may be difficult to form an objective view on the judgements made in the audit.
The standard points out that firms must set their own criteria to identify which audits require a quality
review (in addition to audits of listed entities, where such reviews are mandatory). In some cases, none
of the firm's audit engagements may meet the criteria that would subject them to such a review.
3.4.4 ISA 230 Audit Documentation

A small audit team may have an excellent understanding of the audit client, but it is important to ensure
that working papers meet the standard required by the ISA and to prepare audit documentation that
can be understood by an experienced auditor, as the documentation may be subject to review by
external parties for regulatory or other purposes.
The standard does allow for:
• The documentation being less extensive than for the audit of a larger entity.
• Where the engagement partner performs all the audit work, matters that are normally documented
solely to instruct or inform members of the team, or to provide evidence of review will not be
included.
• Various aspects of the audit may be recorded together in a single document.

3.4.5 ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial
Statements
Within small companies, the lack of control procedures can contribute to a higher risk of employee
fraud and error. On the other hand, a smaller entity may not have a written code of conduct but may
have developed a culture of integrity and ethical behaviour through oral communication and
management example.
The presence of a dominant owner-manager can be an important factor in the overall control
environment with the need for management authorisation compensating for the lack of other controls.
This can however be a potential deficiency in internal control, due to the opportunity for management to
override controls.
ISA 240 requires discussion amongst the audit team of the susceptibility of the entity to material
frauds or errors. This discussion is still required for a small entity but is often overlooked due to the size
of the audit team.
In addition, ISA 240 requires auditors to ask management about their assessment of risk of fraud and
error. Even if management do not have a system of assessing risk, the inquiry should still be made as it
provides valuable information about the control environment, although in smaller entities management's
assessment may only focus on the risks of employee fraud or misappropriation of assets.
3.4.6 ISA 300 Planning an Audit of Financial Statements
Due to the lack of complexity, audit planning documentation may be scaled back for a small entity.
With a smaller team, co-ordination and communication are easier. A planning meeting or general
conversation may be sufficient, and notes made about future issues during last year's audit will be
particularly useful.
Standard audit programmes or checklists may be used, provided that they are tailored to the
circumstances of the engagement, including the auditor's risk assessments.
In the smallest audits, carried out entirely by the audit partner, questions of direction, supervision and
review do not arise. Forming an objective view on the appropriateness of judgements made in the
course of the audit can present problems in this case, and if particularly complex or unusual issues are
involved, it may be desirable to consult with other suitably experienced auditors or the auditor's
professional body.
3.4.7 ISA 320 Materiality in Planning and Performing an Audit

The standard highlights that in an owner-managed business the profit before tax for the year may be
consistently nominal as the owner may take most of the profits as remuneration, so it may be more
appropriate to use profit before remuneration as the basis for estimating materiality.
Another practical issue is that at the planning stage it is often difficult to calculate materiality as a
percentage of key figures, eg of assets, revenue or profit, as the draft accounts may be unavailable for a
small business. Trial balance figures may have to be used instead.
The auditor will need to use judgement in applying materiality when evaluating results.
3.4.8 ISA 550 Related Parties

In a small entity, related party transactions between the company and its directors and their families may
be significant but smaller entities may have no documented processes or controls for dealing with
related party relationships and transactions. The auditor will have to obtain an understanding of the
related party relationships and transactions through inquiry of management and observation of
management's oversight and review activities.
The auditor's in-depth knowledge of the smaller entity will assist in identification of related parties (for
example, other entities controlled by the owner management) which will also help the auditor to assess
the risk of any transactions being unrecorded or undisclosed.
3.4.9 ISA 570 Going Concern

The size of an entity may affect its ability to withstand adverse conditions. Small entities may be able to
respond quickly to exploit opportunities, but may lack reserves to sustain operations.
Risks of particular relevance to small entities are:
• 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.
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4 IFRS 13 Fair Value Measurement A
T
Section overview E
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• 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'.

The previous definition used in IFRS was 'the amount for which an asset could be exchanged, or a
liability settled, between knowledgeable, willing parties in an arm's length transaction'.
The price which would be received to sell the asset or paid to transfer (not settle) the liability is described
as the 'exit price' and this is the definition used in US GAAP. Although the concept of the 'arm's length
transaction' has now gone, the market-based current exit price retains the notion of an exchange
between unrelated, knowledgeable and willing parties.
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.
Illustration: Unit of account

A premium or discount on a large holding of the same shares (because the market's normal daily trading
volume is not sufficient to absorb the quantity held by the entity) is not considered when measuring fair
value: the quoted price per share in an active market is used.
However, a control premium is considered when measuring the fair value of a controlling interest,
because the unit of account is the controlling interest. Similarly, any non-controlling interest discount is
considered where measuring a non-controlling interest.
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
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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.
4.4.1 Non-financial assets

For non-financial assets the fair value measurement looks at the use to which the asset can be put. It
takes into account the ability of a market participant to generate economic benefits by using the asset in
its highest and best use.
4.5 Valuation techniques

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.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to measure
fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting
entity can access at the measurement date
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.

(b) Market approach. A valuation technique that uses prices and other relevant information generated
by market transactions involving identical or comparable (ie similar) assets, liabilities or a group of
assets and liabilities, such as a business.
(c) Cost approach. A valuation technique that reflects the amount that would be required currently to
replace the service capacity of an asset (often referred to as current replacement cost).
Entities may use more than one valuation technique to measure fair value in a given situation. A change
of valuation technique is considered to be a change of accounting estimate in accordance with IAS 8,
and must be disclosed in the financial statements.
Examples of inputs used to measure fair value
Asset or liability Input

Level 1 Equity shares in a listed Unadjusted quoted prices in an active market
company
Level 2 Licensing arrangement Royalty rate in the contract with the unrelated party at
arising from a business inception of the arrangement
combination
Cash generating unit Valuation multiple (eg a multiple of earnings or revenue or
a similar performance measure) derived from observable
market data, eg from prices in observed transactions
involving comparable businesses
Finished goods inventory at Price to customers adjusted for differences between the
a retail outlet condition and location of the inventory item and the
comparable (ie similar) inventory items
Building held and used Price per square metre derived from observable market
data, eg prices in observed transactions involving
comparable buildings in similar locations
Level 3 Cash generating unit Financial forecast (eg of cash flows or profit or loss)
developed using the entity's own data
Three-year option on Historical volatility, ie the volatility for the shares derived
exchange-traded shares from the shares' historical prices
Interest rate swap Adjustment to a mid-market consensus (non-binding)
price for the swap developed using data not directly
observable or otherwise corroborated by observable
market data
4.6 Measuring liabilities

Fair value measurement of a liability assumes that the liability is transferred at the measurement date to
a market participant, who is then obliged to fulfil the obligation. The obligation is not settled or otherwise
extinguished on the measurement date.
4.6.1 Entity's own credit risk

The fair value of a liability reflects the effect of non-performance risk, which includes but is not limited
to the entity's own credit risk. This may be different for different types of liabilities.
Illustration: Entity's own credit risk

Black Co and Blue Co both enter into a legal obligation to pay CU20,000 cash to Green Co in seven
years.
Black Co has a top credit rating and can borrow at 4%. Blue Co's credit rating is lower and it can borrow
at 8%.
Black Co will receive approximately CU15,200 in exchange for its promise. This is the present value of
CU20,000 in seven years at 4%.
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%.
4.7 IFRS 13 and business combinations

Fair value generally applies on a business combination. This topic is covered in Chapter 20, together
with some further examples.
4.8 Disclosure
An entity must disclose information that helps users of its financial statements assess both of the
following:
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(a) For assets and liabilities that are measured at fair value on a recurring or non-recurring basis, the
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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
4.9 Was the project necessary?

The IASB is already considering the matter of the measurement basis for assets and liabilities in
financial reporting as part of its Conceptual Framework project. It could therefore be argued that it was
not necessary to have a separate project on fair value. The Conceptual Framework might have been the
more appropriate forum for discussing when fair value should be used as well as how to define and
measure it.
However, it has been argued that a concise definition and clear measurement framework is needed
because there is so much inconsistency in this area, and this may form the basis for discussions in the
Conceptual Framework project.
The IASB has also pointed out that the global financial crisis has highlighted the need for:
• Clarifying how to measure fair value when the market for an asset becomes less active; and
• Improving the transparency of fair value measurements through disclosures about measurement
uncertainty.
4.9.1 Advantages and disadvantages of fair value (versus historical cost)
Fair value
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

Historical cost
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
5 IAS 8 Accounting Policies, Changes in Accounting

Estimates and Errors
Section overview
• This is an overview of material covered in earlier studies.
5.1 Fair accounting policies

• Accounting policies are determined by applying the relevant IFRS or IFRIC and considering any
relevant Implementation Guidance issued by the IASB for that IFRS/IFRIC.
• Where there is no applicable IFRS or IFRIC management should use its judgement in developing
and applying an accounting policy that results in information that is relevant and reliable.
Management should refer to:
(a) The requirements and guidance in IFRSs and IFRICs dealing with similar and related
issues.
(b) The definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the Framework.
Management may also consider the most recent pronouncements of other standard setting bodies
that use a similar conceptual framework to develop standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
• An entity shall select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless an IFRS or an IFRIC specifically requires or
permits categorisation of items for which different policies may be appropriate. If an IFRS or an
IFRIC requires or permits categorisation of items, an appropriate accounting policy shall be
selected and applied consistently to each category.
5.2 Changes in accounting policies

• These are rare: only if required by statute/standard-setting body/results in reliable and more
relevant information.
• Adoption of new IFRS: follow transitional provisions of IFRS. If no transitional provisions:
retrospective application.
• Other changes in policy: retrospective application. Adjust opening balance of each affected
component of equity, ie as if new policy has always been applied.
• Prospective application is not allowed unless it is impracticable to determine the cumulative
effect of the change.
• 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.
5.3 Changes in accounting estimates

• Estimates arise because of uncertainties inherent within them, judgement is required but this
does not undermine reliability.
• Effect of a change in accounting estimate should be included in profit or loss in:
– Period of change, if change affects only current period, or
– Period of change and future periods, if change affects both.
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.
Interactive question 2: Accounting errors [Difficulty level: Intermediate]

During 20X7 Lubi Co discovered that certain items had been included in inventory at 31 December
20X6, valued at CU4.2m, which had in fact been sold before the year end. The following figures for 20X6
(as reported) and 20X7 (draft) are available.
20X6 20X7 (draft)
CU'000 CU'000
Sales 47,400 67,200
Cost of goods sold (34,570) (55,800)
Profit before taxation 12,830 11,400
Income taxes (3,880) (3,400)
Net profit 8,950 8,000
Retained earnings at 1 January 20X6 were CU13m. The cost of goods sold for 20X7 includes the
CU4.2m error in opening inventory. The income tax rate was 30% for 20X6 and 20X7.
Requirement
Show the profit or loss section of the statement of profit or loss and other comprehensive income for
20X7, with the 20X6 comparative, and retained earnings.
5.5 Possible developments

IAS 8 has been relatively uncontroversial and has not been amended since 2005. However, the IASB
may replace it (and IAS 1 and 7) depending on the outcome of its deliberations on disclosure. The
emphasis is on improvement and simplification of disclosures.
A revised research project on financial statement presentation, conducted in parallel with the
IASB's conceptual framework project, focused on broader challenges associated with disclosure
effectiveness, which ultimately may lead to a replacement for IAS 1 Presentation of Financial
Statements, IAS 7 Statement of Cash Flows and IAS 8 Accounting Policies, Changes in Estimates
and Errors, in essence developing a disclosure framework for IFRS. (Source: IAS Plus)

6 Current issues in corporate reporting
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.
6.1 Fair value measurement

In May 2011, the IASB issued IFRS 13 Fair Value Measurement. This was covered in Section 4 of this
chapter.
6.2 Financial statement presentation

In June 2011, the IASB published an amendment to IAS 1 called Presentation of items of other
comprehensive income, changing the presentation of items contained in Other Comprehensive Income
(OCI) and their classification within OCI. This is covered in Chapter 9.
6.3 Proposed amendments to IAS 37

An Exposure Draft issued in June 2005 proposed amendments to IAS 37. These were supplemented
by a further Exposure Draft in January 2010. A full replacement of IAS 37 is expected.
(a) The Standard would be re-named 'Liabilities' and be extended to include all liabilities not covered
by other Standards.
(b) The terms contingent liability and contingent asset would be removed, and unconditional and
conditional obligations introduced.
(c) Expected values would be used.
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.
6.5 Financial instruments

IFRS 9 Financial Instruments, issued in 2009 and since amended, has replaced certain parts of IAS 39,
in particular with respect to the classification of financial assets. This standard is a work in progress and
in due course will be developed further to fully replace IAS 39. IFRS 9 and the ED on amortised cost and
impairment which will be incorporated into it, are covered in Chapter 16.
6.6 Simplification of pension accounting

In 2011, the IASB published a revised version of IAS 19 Employee Benefits. The main change is the
elimination of the 'corridor method' for recognition of actuarial gains and losses and the introduction of
interest on the net defined benefit liability or asset. The revised standard is covered in Chapter 18.
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
C
H
A
T
E
R

Self-test
IASB Conceptual Framework
1 What are the conditions which the Conceptual Framework identifies as necessary if the going
concern basis is to be used for the preparation of financial statements?
2 According to the Conceptual Framework what are the characteristics of information which is
faithfully represented?
IFRS for Small and Medium-sized Enterprises
3 Smerk
Smerk is a private pharmaceuticals company that meets the definition of a SME under national
legislation and wishes to comply with the IFRS for Small and Medium-sized Entities for the year
ended 31 December 20X6 (with one year of comparative data). The directors are seeking advice
on how to address the following accounting issues. The entity currently prepares its financial
statements under full IFRSs.
(a) Smerk has significant amounts of capitalised development expenditure in its financial
statements, CU3.2m at 31 December 20X5 (CU2.8m at 31 December 20X4), relating to
investigation of new pharmaceutical products. The amount has continued to rise during the
current year even after the amortisation commenced relating to some products that began
commercial production.
(b) Smerk purchased a controlling interest (60%) of the shares of a quoted company in a
similar line of business, Rock, on 1 July 20X6. Smerk paid CU7.7m to acquire the
investment in Rock and the fair value of Rock's identifiable assets and liabilities has been
calculated as CU9.5m at the date of acquisition. The value on the stock market of the non-
controlling interests that Smerk did not purchase was CU4.9m. The directors do not feel in
a position to estimate reliably the useful life of the goodwill due to the nature of the
business acquired.
(c) Smerk purchased some properties for CU1.7m on 1 January 20X6 and designated them
as investment properties under the cost model. No depreciation was charged as a real
estate agent valued the properties at CU1.9m at the year end.
Requirement
Discuss how the above transactions should be dealt with in the financial statements of Smerk for
the year ending 31 December 20X6, with reference to the IFRS for SMEs.
IFRS13 Fair Value Measurement

4 Vitaleque
Vitaleque, a public limited company, is reviewing the fair valuation of certain assets and liabilities in
light of the introduction of IFRS 13 Fair Value Measurement.
It carries an asset that is traded in different markets and is uncertain as to which valuation to use.
The asset has to be valued at fair value under International Financial Reporting Standards.
Vitaleque currently only buys and sells the asset in the African market. The data relating to the
asset are set out below.
Year to 30 November 20X2 North American market European African market

market
Volume of market – units 4 million 2 million 1 million
Price CU19 CU16 CU22
Costs of entering the market CU2 CU2 CU3
Transaction costs CU1 CU2 CU2
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.
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

2
5 Kamao
Statement of financial position extracts for the Kamao Company show the following.
31 December 20X7 31 December 20X6
CU'000 CU'000
Development costs 812 564
Amortisation (180) (120)
632 444
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?

7 Carduus
The Carduus Company manufactures motor boats. It has invested heavily in developing a new
engine design. As a result by 1 January 20X2 it had capitalised CU72 million of development costs,
which it was amortising over 10 years on a straight-line basis from that date.
Until 1 January 20X7, Carduus's new engine had been selling well and making substantial profits. A
new competitor then entered the market, however, such that revised estimates were that the new
engine would cease to generate any economic benefits after 31 December 20X9 and that the
remaining amortisation period should be to this date on a straight-line basis. The entry of the new
competitor led to an impairment review, but no impairment loss was identified.
Retained earnings at 31 December 20X6 were CU400 million. Profit before tax and any
amortisation charges was CU70 million for the year ended 31 December 20X7.
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
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

Technical reference
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.
1 What is financial reporting?

• Financial reporting is the provision of financial information about a Concept Frame (OB2)
reporting entity that is useful to existing and potential investors, lenders
and other creditors in making decisions about providing resources to the
entity
• Financial statements comprise statement of financial position, statement of IAS 1 (10)

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
• Changes in economic resources and claims: Concept Frame (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 Qualitative characteristics of useful financial information
• Two fundamental qualitative characteristics are relevance and faithful Concept Frame (QC5)
representation
• Relevance = capable of making a difference to decisions Concept Frame (QC6)
– Predictive and confirmatory values Concept Frame (QC7)

– Materiality Concept Frame (QC11)
• Faithful representation Concept Frame (QC12)
– Complete, neutral and free from error

• Four enhancing qualitative characteristics Concept Frame (QC19)
– Comparability, verifiability, timeliness and understandability
4 Cost constraint on useful financial reporting
• Costs (of preparing and analysing) financial information must be justified Concept Frame (QC35)
by the benefits of reporting it
5 Underlying assumption
• Going concern Concept Frame (4.1)
6 Elements of financial statements
• 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
• Historical cost Concept Frame (4.55)
• Current cost
• Realisable value
• Present value
9 Capital maintenance
• Financial capital: Concept Frame (4.57)
– 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.
IFRS 13 Fair Value Measurement
• 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

participants at the measurement date.
• Market-based measure IFRS13.2
• Three-level hierarchy IFRS13.72
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

IAS 8.7–13
Accounting policies
IAS 8.14–31
Change in accounting policies
• Retrospective application is applying a new accounting policy as if that policy

had always been applied
• If impracticable to determine the period-specific effects, apply prospectively
Changes in accounting estimates IAS 8.32–40
Prior period errors IAS 8.5, IAS 8.42 and IAS 8.49
IASB Conceptual Framework

1 Neither the intention nor the need to liquidate or curtail materially the scale of its operations
2 It should be complete, neutral and free from error
IFRS for Small and Medium-sized Enterprises
3 Smerk
(a) Development expenditure C
H
The IFRS for SMEs requires small and medium-sized entities to expense all internal research
A
and development costs as incurred unless they form part of the cost of another asset that
T
meets the recognition criteria in the IFRS. The adjustment on transition to the IFRS for SMEs
E
must be made at the beginning of the comparative period (1 January 20X5) as a prior period
R
adjustment. Thus the expenditure of CU2.8m on research and development should all be
written off directly to retained earnings. Any amounts incurred during 20X5 and 20X6 must be
expensed in those years' financial statements and any amortisation charged to profit or loss in
those years will need to be eliminated.
2
(b) Acquisition of Rock
The IFRS for SMEs requires goodwill to be recognised as an asset at its cost, being the
excess of the cost of the business combination over the acquirer's interest in the net fair value
of the identifiable assets, liabilities and contingent liabilities. Non-controlling interests at the
date of acquisition must therefore be measured at the proportionate share of the fair value of
the identifiable assets and liabilities of the subsidiary acquired (ie the 'partial' goodwill
method).
After initial recognition the acquirer is required to amortise goodwill over its useful life under
the IFRS for SMEs. If an entity is unable to make a reliable estimate of the useful life of
goodwill, the life is presumed to be ten years.
Goodwill will be calculated as:
CUm
Consideration transferred 7.7
Non-controlling interests (at %FVNA: 9.5 × 40%) 3.8
Fair value of identifiable net assets at acquisition (9.5)

2.0
Amortisation (2.0/10 years × 6/12) (0.1)
1.9
The amortisation of CU0.1m must be charged to profit or loss in 20X6.
(c) Investment properties
Investment properties must be held at fair value through profit or loss under the IFRS for
SMEs where their fair value can be measured without undue cost or effort, which appears to
be the case here, given that an estate agent valuation is available. Consequently a gain of
CU0.2m (CU1.9m – CU1.7m) will be reported in Smerk's profit or loss for the year.

IFRS13 Fair Value Measurement
4 Vitaleque
(a) Fair value of asset
North American
Year to 30 November 20X2 market European African market
market
Volume of market – units 4m 2m 1m
CU CU CU
Price 19 16 22
Costs of entering the market ( 2) ( 2) n/a*
Potential fair value 17 14 22
Transaction costs (1) ( 2) (2)
Net profit 16 12 20
*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.
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
6%): 3,829 ÷ 1.063 3,215 H

A
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors T
5 Kamao E
R
CU444,000
Per IAS 8.42 a correction of a material error should be applied retrospectively by restating the
opening balances of assets, liabilities and equity for the earliest prior period presented.
6 Hookbill 2
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.

9 Polson
(a) CU776,562
(b) (CU66,000)
(c) CU318,562
All these matters give rise to prior period errors which require retrospective restatement of financial
statements as if the prior period error had never occurred (IAS 8.5).
(a) Recognition of cost in the carrying amount of PPE should cease when it is in the condition
capable of being operated in the manner intended, so on 30 September 20X6, and
depreciation should begin on the same date (IAS 16.20 and 55). So gross cost should be
adjusted to CU800,000 (CU840,000 – CU50,000 + CU10,000) and depreciation, taking into
account overall useful life and residual value, charged for 3 months, so CU23,438
((CU800,000 – CU50,000) × 1/8 × 25%). The restated carrying amount is CU776,562
(CU800,000 – CU23,438).
(b) The investment in The Niflumic Company is an associate and should be accounted for
according to IAS 28, not IAS 39.
The value of the investment will therefore increase by 30% of Niflumic's post-tax profit rather
than according to fair values.
CU
Amount recognised in available-for-sale reserve 90,000
30% x Niflumic's profit after tax (retained earnings) 24,000
Adjustment to equity (66,000)
(c)
CU
Draft retained earnings 400,000
(1) Reduction in carrying value of plant (CU840,000 – CU776,562) (63,438)
(2) Niflumic's earnings (CU80,000 × 30%) 24,000
(3) Error in trade receivables (CU70,000 × 60%) (42,000)
318,562
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.

Question Answer
(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

20X6 20X7
CU'000 CU'000
Sales 47,400 67,200
Cost of goods sold (W1) (38,770) (51,600)
Profit before tax 8,630 15,600
Income tax (W2) (2,620) (4,660)
Profit for the year 6,010 10,940
Retained earnings
Opening retained earnings
As previously reported 13,000 21,950
Correction of prior period
error (4,200 – 1,260) – (2,940)
As restated 13,000 19,010
Closing retained earnings 19,010 29,950
WORKINGS
(1) Cost of goods sold 20X6 20X7
CU'000 CU'000
As stated in question 34,570 55,800
Inventory adjustment 4,200 (4,200)
38,770 51,600
(2) Income tax 20X6 20X7
CU'000 CU'000
As stated in question 3,880 3,400
Inventory adjustment (4,200 × 30%) ( (1,260) 1,260
2,620 4,660

CHAPTER 3
Ethics C
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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
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
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.
1.4 Ethics and the individual

While legislation and professional bodies have their part to play through issuing guidance, the importance of
the integrity of the individual cannot be overestimated. Its ethical consequences are potentially very
significant in deciding for example, whether to whistleblow on questionable practice at work, despite pressure
from colleagues or superiors or negative consequences of doing so.
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).
Interactive question 1: Ethics and the individual [Difficulty level: Intermediate]

List the factors which you think may have affected Betty Vinson's decision to make the fraudulent entries.
What other courses of action could she have taken?
2 Ethical codes and standards
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.
2.1 IESBA and ICAB Codes

As a key aspect of reputation and professionalism is ethical behaviour the accounting profession has
developed ethical codes of conduct. These include:
• The IESBA Code of Ethics

• ICAB Code of Conduct (Schedule C)
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.
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.
3 Ethics: financial reporting focus
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).
3.1 Fundamental principles C

H
Professional accountants are expected to follow the guidance contained in the fundamental principles in the
IESBA Code in all of their professional and business activities. The professional accountant should also follow A
the requirements in the illustrations. However, he/she should be guided not just by the terms but also by the P
spirit of the Code. T
The Code sets out five fundamental principles, the spirit of which must always be complied with: E
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1 Integrity
A professional accountant should be straightforward and honest in all professional and business relationships.
A professional accountant should not be associated with reports, returns, communications or other information 3
where they believe that the information:
• Contains a materially false or misleading statement
• Contains statements or information furnished recklessly
• Omits or obscures information required to be included where such omission or obscurity would be
misleading.
2 Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of others to override
professional or business judgements.
3 Professional competence and due care
A professional accountant has an obligation to:
• Maintain professional knowledge and skill at the level required to ensure that a client/employer receives
competent professional services based upon current developments in practice, legislation and
techniques
• Act diligently and in accordance with applicable technical and professional standards.
Professional competence may be divided into two separate phases:
• Attainment of professional competence – initial professional development
• Maintenance of professional competence – continuing professional development (CPD)
Diligence encompasses the responsibility to act in accordance with the requirements of an assignment,
carefully, thoroughly and on a timely basis.
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.
• A professional accountant in business, who is in a position to influence financial or non-financial

reporting or business decisions, where an immediate or close family member would benefit from
that influence
• Long association with business contacts influencing business decisions
• Acceptance of a gift or preferential treatment, unless the value is clearly insignificant.
E Intimidation threat the threat that a professional accountant will be deterred from acting objectively by
threats, either actual or perceived.
• Threat of dismissal or replacement in business, of yourself, or of a close or immediate family

member, over a disagreement about the application of an accounting principle or the way in which
financial information is to be reported.
• 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
• Continuing professional development requirements
• Corporate governance regulations
• Professional standards
• Professional or regulatory monitoring and disciplinary procedures
• 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
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Safeguards in the work environment
Examples are:
• The employing organisation's systems of corporate oversight or other oversight structures 3
• The employing organisation's ethics and conduct programmes
• Recruitment procedures in the employing organisation emphasising the importance of employing high
calibre, competent staff
• Strong internal controls
• Appropriate disciplinary processes
• 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
• Consultation with another appropriate professional accountant.
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:
• Act contrary to law or regulation
• Act contrary to technical or professional standards
• Facilitate unethical or illegal earnings management strategies
• Lie to, or otherwise mislead, others in particular:

– The auditor of the employing organisation
– Regulators
• 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
3.5 Preparation and reporting of information

Accountants will often be involved in the preparation and reporting of information that may be:
• 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
• Present financial statements in accordance with applicable financial reporting standards
• Maintain information for which (s)he is responsible in a manner which:
– 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.
3.6 Acting with sufficient expertise

An accountant should only undertake significant tasks for which (s)he has, or can obtain, sufficient specific
training or expertise.
Circumstances that threaten the ability of the accountant to perform duties with the appropriate degree of
professional competence and due care include:
• Insufficient time for properly performing or completing the relevant duties

• Incomplete, restricted or otherwise inadequate information for performing the duties properly
• Insufficient experience, training and/or education
• Inadequate resources for the proper performance of the duties.
Safeguards that may be considered include:
• Obtaining additional advice or training
• Ensuring that there is adequate time available for performing the relevant duties
• Obtaining assistance from someone with the necessary expertise
• Consulting where appropriate with:
– Superiors within the employing organisation
– Independent experts, or
– ICAB
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
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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.
Worked example: Wal-Mart

In April 2012, the New York Times published details of an alleged bribery scandal at retail giant Wal-Mart. The
paper alleged that back in 2005, executives in Wal-Mart's Mexican subsidiary had given pay-offs to local
officials in return for help getting permits to build new Wal-Mart stores in Mexico. Top executives in Mexico
had known about these payments but had concealed them from Wal-Mart's main board.
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.
3.9 Conflicts of interest

An accountant should take reasonable steps to identify circumstances that could pose a conflict of interest.
Examples might be:
• An accountant in public practice, competing directly with a client, or having a joint venture or similar
arrangement with a major competitor of a client
• An accountant performing services for clients whose interests are in conflict
• Clients are in dispute with each other in relation to the matter or transaction in question.
Safeguards should include:
• Notifying the client of the firm's business interest or activities that may represent a conflict of interest, and
obtaining their consent to act in such circumstances
• Notifying all known relevant parties that the professional accountant is acting for two or more parties in
respect of a matter where their respective interests are in conflict and obtaining their consent to so act
• Notifying the client that the accountant does not act exclusively for any one client in the provision of
proposed services and obtaining their consent to so act.
3.10 General duty to report

Under the ICAB's Bye-laws it is the duty of every member where it is in the public interest to do so, to report to
the Institute any facts or matters indicating that a member and/or firm or provisional member may have
become liable to disciplinary action. In determining whether it is in the public interest to report such facts or
matters, regard shall be had to such guidance as the Council shall give from time to time.
3.11 Practical significance

Accountants working within a financial reporting environment can come under pressure to improve the
financial performance or financial position of their employer. Finance managers who are part of the team
putting together the results for publication must be careful to withstand pressures from their non-finance
colleagues to indulge in reporting practices which dress up short-term performance and position. Financial
managers must be conscious of their professional obligations and seek appropriate assistance from
colleagues, peers or independent sources.
Visit www.ccab.org.uk and click Press & Publications > Discussion papers and Guidance. On that webpage,
under the heading 'Ethical Dilemmas Case Studies' are links to a number of very useful, practical case studies
covering ethical dilemmas relevant to accountants – including a set of case studies specific to accountants in
practice.
4 Ethics: audit and assurance focus
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.
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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.)
Personal interests Review of your own work Disputes Intimidation
4.1 Development of the IESBA Code

The 2013 edition of the IESBA Code contains changes in three areas as follows:
• Breach of a requirement of the Code
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
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).
4.2 ICAB Code

Ethical codes applicable for ICAB members are based on the IESBA Code, ICAB Code of Conduct and IFAC
Ethical Standards.
4.3 Threats and safeguards

The IESBA Code, the ICAB Code and the Ethical Standards for Auditors are based on the principle that
integrity, objectivity and independence are subject to various threats and that safeguards must be in place to
counter these.
The majority of threats fall into the following categories:
Threat Example
Self-interest threat Undue dependence on total fees from a client

Self-review threat Reporting on the operation of financial systems after being involved in their
design or implementation
Advocacy threat Acting as an advocate on behalf of an assurance client in litigation or disputes
with third parties
Familiarity or trust threat A member of the engagement team having a close or immediate family
relationship with a director of the client
Intimidation threat Being threatened with dismissal or replacement in relation to a client
engagement
• Both the IESBA and ICAB Codes consider that there are two general categories of safeguard:
(1) Safeguards created by the profession, legislation or regulation

(2) Safeguards within the work environment
• 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
Fraud Client fails or refuses to permit Fee dispute.

predecessor permission to discuss
his/her affairs.
Accounting irregularities Predecessor fails to respond to Client willing but unable to settle
correspondence. outstanding fees.
Tax/VAT evasion Client has been economical with Predecessor subject of complaint
the truth in the past. by client.
Client has demonstrably misled Work obtained by improper Non-professional client traits (eg
predecessor means. religious beliefs contrary to your
own).

4.5 Access to information by successor auditors
Some of the key points in this guidance are:
• The request should be made after the successor has been formally appointed
• The successor should consider whether to make a request and the extent of that request
• The request should be as specific as possible. There are specific references to reviewing a
predecessor's audit work in:
– ISA 510 Initial Engagements – Opening Balances
– ISA 710 Comparative Information – Corresponding Figures And Comparative Financial Statements
– ISA 300 Planning an Audit of Financial Statements
• The predecessor should be prepared to assist the successor by providing oral or written explanations
• It is reasonable for the successor to make notes of its review
• There is no obligation to allow copying of papers, but it would be reasonable to allow copying of extracts
of the books and records of the client, analyses of financial statement figures and documentation of the
client's systems and processes
• Providing access to working papers in this way is not a breach of confidentiality because it is done in
order to comply with auditing standards. (A letter from the predecessor to the successor should be
copied to the client as a matter of courtesy.)
4.6 Confidentiality
Information received in confidence should not be disclosed except in the following circumstances:
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.
4.7 Conflicts of interest

Conflicts of interest and confidentiality are related matters. Where a conflict of interest arises, one of the key
issues is whether it will be possible to keep information confidential.
IESBA Code states that there is nothing improper in a firm having two clients whose interests are in conflict
provided that adequate safeguards are in place which ensure that the work performed for one client does not
disadvantage another.
Safeguards would include:
• Notifying the affected parties of the conflict of interest and obtaining permission to act/continue to act
• Using separate engagement teams
• 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
• The use of confidentiality agreements signed by employees
• 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.
5 Making ethical judgements
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.
5.1 Resolving ethical conflicts

Although there are a number of sources of ethical guidance, resolving ethical issues can be complex. As you
have seen in your earlier studies (also see Appendices 1 and 2) there are some specific rules which can be
applied.
IESBA code is primarily principle based. The application of these principles requires a degree of skill and the
onus is placed on the integrity and judgement of the individual in weighing up the facts of the situation. In
addition, it may mean that in certain circumstances there is more than one acceptable outcome.
• The client's requirements and

• The public interest.
Where these are in conflict the public interest should take priority.
The IESBA Code sets out a framework that accountants can follow when faced with these issues, which you
may find useful when considering ethical problems in the exam. The resolution process should consider the
following:
Relevant facts This may involve:

Do I have all the relevant facts? • Referring to the organisation's policy, procedures, code of
conduct and previous history
Am I making assumptions?
• Discussing the matter with trusted managers and
Is it my problem or can anyone else help?

employees.
Relevant parties These may include those directly affected eg shareholders,
employees and employers but may also include the community
Who are the individuals, organisations and at large.
key stakeholders affected?
How are they affected?
Are there conflicts between different
stakeholders?
Who are your allies?
Ethical issues involved These include:
Would these ethical issues affect the • Professional ethical issues
reputation of the accountancy profession? • Organisational ethical issues
Would they affect the public interest? • Personal ethical issues
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.
5.2 Exam context

Ethical issues will have been examined in earlier papers. However, at the Advanced Level you will be faced
with more complex situations. More emphasis will be placed on your ability to use your judgement in the
light of the facts provided, rather than testing your knowledge of the ethical codes and standards in detail. In
some instances the correct action may be uncertain and it will be your ability to identify the range of possible
outcomes which will be important rather than concluding on a single course of action.
You should also be aware that the term 'ethics' will be used in a much broader sense than it has been in the
earlier Assurance and Audit & Assurance papers. It is likely to be combined with financial reporting and
business issues where you may be required to assess the ethical judgements made by others including
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.
Interactive question 4: Revenue recognition [Difficulty level: Exam standard]

You are the auditor of Bellevue Ltd for the year ended 31 December 20X8. The company provides information
to the financial services sector and is run by the managing director, Toby Stobbart. It has a venture capital
investment of which part is in the form of a loan. The investment agreement details a covenant designed to
protect the loan. This states an interest cover of 2 is required as a minimum ie the company must be able to
cover interest and loan principal repayments with profits at least twice.
70% of the revenue of the business is subscription based and contracts are typically three years in duration.
30% of the revenue is for consultancy work which is billed on completion of the work. Consultancy projects are
for a maximum of two months.
During the previous year the management performed a review of the subscription revenue and concluded that
40% of this represented consultancy work and should therefore be recognised in the first year of the contract
rather than being recognised over the duration of the contract as had previously been the case. The audit file
for 20X7 indicates that this treatment had been questioned vigorously by the audit manager but had been
agreed with the audit partner, James Cowell. James Cowell subsequently left the firm abruptly.
You have received a copy of the 20X8 draft accounts which show an interest cover of 2.02 for 20X7 and 2.01
for 20X8. You have also been told that a similar review of subscription income has been made for 20X8 with
40% being reclassified as consultancy work as in the previous year.
What are the issues that you as auditor would need to consider in this situation?

Appendix 1
1 Integrity, objectivity and independence
1.1 Exam focus

You will have covered the ethical guidance on integrity, objectivity and independence in your earlier studies. At
the Advanced Level however, a greater emphasis will be placed on your ability to apply this knowledge.
Ethical dilemmas which you may be required to deal with will be less clear-cut and the requirements of the
question will not always specifically indicate that ethical issues need to be considered. Instead information will
typically be embedded within the question and you will need to demonstrate your skill in identifying the ethical
issue and its implications.
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

should be required before the assurance report for the following
year can be issued.
Percentage or contingent fees ICAB Code - An audit cannot be undertaken on a contingent fee
basis.
High percentage of fees IESBA Code states that where total fees for both audit and non-
audit services will regularly exceed 15% the firm should apply
safeguards.
Lowballing IESBA Code/ ICAB Code - Where the fee quoted is significantly
lower than would have been charged by the predecessor firm the
engagement partner must be satisfied that:
• The appropriate staff and time are spent on the engagement
• All applicable assurance standards, guidelines and quality
control procedures have been complied with
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.
Preparing accounting records and financial Safeguards include:

statements
• Using staff members other than assurance team members to
carry out work
• Implementing policies and procedures to prohibit the

individual providing such services from making any
managerial decisions on behalf of the audited entity
• Requiring the source data for the accounting entries to be

originated by the assurance client
• Requiring the underlying assumptions to be originated and

approved by the assurance client
BSEC CG Guideline states that firms should not prepare
accounts for financial statements for listed audited entities.
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.

1.4 Advocacy threat
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:
• If the firm carried out corporate finance

work for the client; eg if the audit firm
were involved in advice on debt
restructuring and negotiated with the
bank on the client's behalf.
• If the firm offered legal services to a

client and, say, defended them in a
legal case.
1.5 Familiarity threat
Long association All firms should monitor the relationship between staff and
established clients.
The IESBA Code states that for the audit of listed entities:
• The engagement partner and individuals responsible for

C
engagement quality control review should be rotated after a
pre-defined period, normally no more than seven years, and H
should not return to the engagement until a period of two A
years has elapsed. P
T
Recruitment BSEC CG guideline states that an audit firm should not
E
undertake an engagement to provide recruitment services in
R
relation to a key management position of the audited entity
listed with stock exchanges.
3
1.6 Intimidation threat
Litigation Generally, assurance firms should seek to avoid litigation eg

where a client threatens to sue or does sue. If this type of
situation does arise the following safeguards should be
considered:
• Disclosing to the audit committee the nature and extent of

the litigation
• Removing specific affected individuals from the engagement

team
• Involving an additional professional accountant on the team

to review work.
Other examples include:
• Being threatened with dismissal or replacement
• Being pressured to reduce inappropriately the extent of work

performed in order to reduce fees
1.7 Management 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.
• If there is no informed management it is unlikely that the

threat can be avoided if the work is undertaken.
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.

3 Marden Ltd
At 6pm on Sunday evening a text message arrives for you from your audit manager, John Hanks,
stating:
'Please check your email urgently'
On checking your email, you find the following message:
I hope you had a good weekend. Instead of coming into the office tomorrow morning I would like
you to go to a client called Marden Ltd. I know you have not worked on this client before so I am
emailing you some background information (Exhibit 1). One of our audit juniors, Henry Ying, was at
Marden's head office last week working on the interim audit and he has come up with a schedule of
issues that are worrying me (Exhibit 2). Henry does not have the experience to deal with these, so
I would like you, as a senior, to go out there and prepare a memorandum for me which sets out the
financial reporting implications of each of these issues. I would also like you to explain in the
memorandum the ethical issues that arise from these issues and the audit procedures required for
each of the matters on Henry's schedule. I will visit Marden on Tuesday to speak to the directors.
John
Requirement
Prepare the memorandum requested by your audit manager.
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.
In relation to the second issue, the relevant factors are these:
• 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.
The relevant factors are:
• I have been involved with the client for ten years and have a personal relationship with client
staff
• The company is not a listed or public interest company
• 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.
Factors to consider include:

• Whether the directors are members of a professional body. If so, the engagement partner could
tactfully ask whether there are independence conflicts and how these will be resolved.
• 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.
• If the arrangement is:

3
– In the ordinary course of business
– On an arm's length basis
– Not material to either party
then Bourne and Berkeley would be able to continue to act.
• 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.
(d) Revenue recognition policy
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

implied threat that Bourne and Berkeley will be removed from office if the accounting policy is not
accepted.
Factors to consider include:
• 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
To: Audit manager

From: x
Date: x-x-xx
Subject: Accounting issues of Marden Ltd
(1) Understatement of tax liability
Audit and ethics
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.
According to ICAB ethical requirements in terms of reporting this may be:
• Where there is a duty to disclose

• Where there is a right to disclose
Suggested actions if the client continues to refuse to disclose to Tax Authority
• Our views should be put in writing to the client

• Report to the audit committee if there is one
• Refer the matter to senior personnel in our firm – eg the ethics partner
• The firm must consider whether to cease to act for the client
• Consider whether this is a 'whistle blowing' incident in the public interest
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.
(2) Related party transaction
Audit and ethics
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.

The Companies Act imposes restrictions on the dealings of directors with companies in order to
prevent directors taking advantage of their position. This applies even where the directors are
shareholders, but particularly where the interests of non-controlling, or outside, shareholders may
be damaged.
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
(3) Directors' share trading

Audit and ethics
There are two issues in this case:
• 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.
(4) Audit fee outstanding

Audit and ethics
It may be that the matter of the overdue fees can be resolved amicably at Tuesday's meeting.
If, however, the fee remains outstanding, it may be a threat to our independence. This may be
because it biases our opinion against the client. Alternatively, it may be we do not wish to put the
client's going concern at risk as this may reduce the likelihood of us receiving payment.
In effect, the overdue fee may be similar to a loan to the client which is not permitted.
Actions may include:
• 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.
(5) Physical inspection of jets

Audit and ethics
There are two issues here:
• 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.

Alternatively, a local firm of auditors could be used. The check might not just be the physical
verification of the asset but also usage records (eg flying logs, pilots' time etc).
Financial reporting
The jet has not been used for some time and therefore impairment testing needs to be considered.
Technical problems – the jet may not be fully serviceable in which case it needs to be reviewed for
impairment according to IAS 36 as both fair value and value in use may be affected.
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
(6) Due diligence assignment 3

Audit and ethics
Acceptance of the due diligence assignment is not permitted as there would be a conflict of interest
between our role as auditor of Marden and a due diligence role for the bidder for Marden, Crazy
Jack Airlines Ltd.
The acquisition of 1 million shares would take Crazy Jack Airlines to a 29% holding (tutorial note:
30% is the maximum permitted by the Stock Exchange before an offer needs to be made to all
shareholders). The offer is therefore for the remaining shares. This is a key audit risk as directors
still hold a significant amount of the shares and this may influence their financial reporting, as the
share price will be affected by the bid.
It might be noted that the announcement was made during the period that the share price was
artificially inflated due to the Stateside Leisure Inc announcement, and this may ultimately affect the
bid.
Financial reporting
There is no direct effect on the financial statements, however, consider:
• 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

Factors
• The request was made by her superiors

• Financially she may have felt pressure to keep her job
• Potential prospect of being rewarded through promotion and pay rises
• Inability to decide how to deal with the situation
Other courses of action

She could have:
• Refused to make the adjustments

• Brought the matter to the attention of other senior members of staff eg internal audit
• Resigned
• Sought advice from her relevant professional body
• Sought legal advice
• Reported the matter to the relevant authorities eg SEC at an earlier stage
Personal interests Review of your own work Disputes Intimidation
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:
• Ensure that the connected person divests the shares

• Remove Teresa from the engagement team
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:
• Notifying the audit committee of the interest

• Requiring Friends Benevolent to dispose of the shares in Tadpole Group
(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
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.
• The auditor's responsibility to stakeholders.
• 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.

CHAPTER 4
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
6 Corporate governance: international impact R
7 Corporate governance and internal control

8 Evaluation of corporate governance mechanisms
4
9 Communication between auditors and those charged with governance
Technical reference
Corporate governance 127

Introduction
• 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
• Evaluate and appraise appropriate corporate governance mechanisms
• Explain and evaluate the nature and consequence of relevant corporate governance
codes and set out the required compliance disclosures
• Explain the OECD principles of corporate governance
• 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

1 Relevance of corporate governance
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
Worked example: Directors' remuneration

It has been reported in the press (October 2007) that Stan O'Neal the CEO of Merrill Lynch, the US
4
investment bank received more than $200 million in shares, stock options and retirement benefits in
spite of the bank reporting its biggest quarterly loss in its 93-year history. These losses were the result of
an $8.4 billion write down covering sub-prime mortgage bonds.
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.
1.2 What is corporate governance?

There are a number of different definitions of corporate governance. The following definition is taken
from the Cadbury Report and is still relevant in the context of the Corporate Governance Code. (We will
look in more detail at corporate governance reports in Sections 3 and 5.)

Definition
Corporate governance: The system by which organisations are directed and controlled.
An alternative definition is:
Corporate governance: The set of processes, customs, policies, laws and institutions affecting the way
in which an entity is directed, administered or controlled. Corporate governance serves the needs of
shareholders, and other stakeholders, by directing and controlling management activities towards good
business practices, objectivity and integrity in order to satisfy the objectives of the entity.
In essence corporate governance:

• Involves the management and reduction of risk
• Specifies the distribution rights and responsibilities among different participants in the
corporation, such as the board, managers, shareholders and other stakeholders
• Spells out the rules and procedures for making decisions on corporate affairs
• Provides the structure through which objectives are set
• Provides the means of attaining the objectives and monitoring performance
It can be argued that good corporate governance:
• Provides a framework for an organisation to pursue its strategy in an ethical and effective way
and offers safeguards against the misuse of resources, human, financial, physical or intellectual
• Can attract new investment into companies, particularly in developing nations
• Underpins capital market confidence in companies
1.3 Features of poor corporate governance

The scandals over the last 25 years have highlighted the need for guidance to tackle the various risks
and problems that can arise in organisations' systems of governance.
1.3.1 Domination by a single individual

A feature of many corporate governance scandals has been boards dominated by a single senior
executive with other board members merely acting as a rubber stamp. Sometimes the single individual
may bypass the board to action his own interests. Even if an organisation is not dominated by a single
individual, there may be other weaknesses. The organisation may be run by a small group centred round
the chief executive and chief financial officer, and appointments may be made by personal
recommendation rather than a formal, objective process.
1.3.2 Lack of involvement of board

Boards that meet irregularly or fail to consider systematically the organisation's activities and risks are
clearly weak. Sometimes the failure to carry out proper oversight is due to a lack of information being
provided.

1.3.3 Lack of adequate control function
An obvious deficiency is a lack of internal audit.
Another important control deficiency is lack of adequate technical knowledge in key roles, for example
in the audit committee or in senior compliance positions. A rapid turnover of staff involved in accounting
or control may suggest inadequate resourcing, and will make control more difficult because of lack of
continuity.
1.3.4 Lack of supervision

Employees who are not properly supervised can create large losses for the organisation through their
own incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the employee
whose trading losses caused the collapse of Barings bank was not challenged because he appeared to
be successful. Leeson was able to run up losses because he was in charge of dealing and settlement, a
systems deficiency or lack of segregation of key roles that was featured in other financial frauds.
1.3.5 Lack of independent scrutiny

External auditors may not carry out the necessary questioning of senior management because of fears
of losing the audit, and internal audit do not ask awkward questions because the chief financial officer
determines their employment prospects. Often corporate collapses are followed by criticisms of external
auditors, such as the Barlow Clowes affair where poorly planned and focussed audit work failed to
identify illegal use of client monies.
1.3.6 Lack of contact with shareholders

Often board members may have grown up with the company but lose touch with the interests and views
of shareholders. One possible symptom of this is the payment of remuneration packages that do not
appear to be warranted by results.
1.3.7 Emphasis on short-term profitability

Emphasis on success or getting results can lead to the concealment of problems or errors, or
manipulation of accounts to achieve desired results.
1.3.8 Misleading accounts and information

Often misleading figures are symptomatic of other problems (or are designed to conceal other problems)
C
but clearly poor quality accounting information is a major problem if markets are trying to make a fair
H
assessment of the company's value. Giving out misleading information was a major issue in the UK's
Equitable Life scandal where the company gave contradictory information to savers, independent A
advisers, media and regulators. P
T
E
1.4 Risks of poor corporate governance
R
Clearly the ultimate risk is of the organisation making such large losses that bankruptcy becomes
inevitable. The organisation may also be closed down as a result of serious regulatory breaches, for
example misapplying investors' monies.
4
Worked example: News International

Poor corporate governance is believed to be at the heart of the phone hacking scandal that engulfed
News International in July 2011 leading to the closure of the News of the World newspaper.
Worked example: JP Morgan Chase & Co

In June 2012 Jamie Dimon, CEO of JP Morgan Chase & Co, had to defend the company's disclosure of
a $2 billion trading loss as questions were being asked about whether the bank misled investors.

2 Corporate governance concepts
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.

2.4 Probity/honesty
Hopefully this should be the most self-evident of the principles, relating not only to telling the truth, but
also not misleading shareholders and other stakeholders by presenting information in a biased way.
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

you meet is particularly important; trust is vital in relationships and belief in the integrity of those with
whom you are dealing underpins this.
This definition highlights the need for personal honesty and integrity of preparers of accounts. This
implies qualities beyond a mechanical adherence to accounting or ethical regulations or guidelines. At
times accountants will have to use judgement or face financial situations which aren't covered by
regulations or guidance, and on these occasions integrity is particularly important.
Integrity is an essential principle of the corporate governance relationship, particularly in relation to
representing shareholder interests and exercising agency. As with financial reporting guidance, ethical codes
don't cover all situations and therefore depend for their effectiveness on the qualities of the accountant. In
addition, we have seen that a key aim of corporate governance is to inspire confidence in participants in the
market and this significantly depends upon a public perception of competence and integrity.
3 Bangladesh Corporate Governance
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:
3.1.1 Leadership: the role of the board

The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent
and effective controls which enables risk to be assessed and managed. The board should:
 Set the company’s strategic aims.
 Ensure that the necessary financial and human resources are in place for the company to meet its
objectives.
 Review management performance.
 Set the company’s values and standards and ensure that its obligations to its shareholders and
others are understood and met.
 All directors – both executives and non-executives – must act in what they consider to be the best
interests of the company, consistent with their statutory duties (these are set out in s90-115
Companies Act 1994 and are not examinable in Business and Finance).
3.1.2 Effectiveness: the composition 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 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.

3.1.3 Accountability: financial and business reporting
The board should present a fair, balanced and understandable assessment of the company’s position
and prospects.
318
3.1.4 Principles supporting financial and business reporting
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.
3.1.5 Accountability: audit committee and auditors
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
3.2 Principles of UK corporate governance

The UK Corporate Governance Code is based on five main principles of:
• Leadership
• Effectiveness
• Accountability
• Remuneration
• Relations with shareholders
These are supported by supporting principles and more detailed Code provisions.
The key details of the UK Corporate Governance Code are summarised below. Section 4 of this chapter
looks at the role of the board in more detail.
Leadership

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.

Effectiveness
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.

Remuneration
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).

3.3 Disclosure requirements of the UK Corporate Governance Code
The disclosure requirements are as follows:
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.
The role of the board

A statement of how the board operates
The names of the chairman, the chief executive, the senior independent director and the chairmen and
members of the board committees
Number of meetings of the board and individual attendance by directors
The chairman
The reasons for the appointment of chief executive as chairman
The composition of the board
The names of the non-executive directors whom the board determines to be independent
Appointments to the board
Description of the work of the nomination committee including the process used for board appointments
Evaluation
A statement of how performance evaluation of the board, its committees and its directors has been
conducted
Financial and business reporting
An explanation from the directors of their responsibility for preparing the accounts and a statement by
C
the auditors about their reporting responsibilities
H
A statement that the directors consider the annual report and accounts is fair, balanced and A
understandable
P
An explanation by the directors of the business model T
A statement from the directors that the business is a going concern E
R
Risk management and internal control
A report that the board has conducted a review of the effectiveness of the company's risk management
and internal control systems
4
Audit committees and auditors
The reasons for the absence of an internal audit function where there is none
A description of the work of the audit committee
An explanation of how, if the auditor provides non-audit services, objectivity and independence is
safeguarded
The levels and components of remuneration
A description of the work of the remuneration committee where an executive director serves as a non-
executive director elsewhere
Dialogue with shareholders
The steps the board has taken to ensure that the board, particularly non-executive shareholders develop
an understanding of the views of major shareholders about their company

Interactive question 1: BSEC Corporate Governance Guidelines[Difficulty level: Intermediate]
Compliance with the BSEC Corporate Governance Guidelines is a requirement for listed companies. It is
recommended for other companies. Some argue that the code should be mandatory for all companies.
Requirements
(a) Discuss the benefits of the Corporate Governance Guidelines to shareholders and other interested
users of financial statements.
(b) Discuss the merits and drawbacks of having such provisions in the form of a voluntary guideline.
4 Role of the board
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.
4.1 Scope of role

The guidance in the UK Corporate Governance Code is developed in the FRC publication Guidance on
Board Effectiveness. If the board is to act effectively, its role must be defined carefully. The Code
suggests that the board should have a formal schedule of matters specifically reserved to it for
decision. Some would be decisions such as mergers and takeovers that are fundamental to the
business and hence should not be taken just by executive managers. Other decisions would include
acquisitions and disposals of assets of the company or its subsidiaries that are material to the
company and investments, capital projects, bank borrowing facilities, loans and their repayment,
foreign currency transactions, all above a certain size (to be determined by the board).
Other tasks the board should perform include:
• Monitoring the chief executive officer
• Overseeing strategy
• Monitoring risks and control systems
• Monitoring the human capital aspects of the company in regard to succession, morale, training,
remuneration etc
• Ensuring that there is effective communication of its strategic plans, both internally and externally
Worked example: Role of the board

For the voluntary sector, the UK's Good Governance, A Code for the Voluntary and Community Sector
stresses the board of trustees' role in ensuring compliance with the objects, purposes and values of the
organisation and with its governing document. The Code stresses that the Board must ensure that the
organisation's vision, mission, values and activities remain true to its objects.
The Code also lays more stress than the governance codes targeted at listed companies on trustees
focusing on the strategic direction of their organisation and not becoming involved in day-to-day
activities. The Chief Executive Officer should provide the link between the board and the staff team, and
the means by which board members hold staff to account. Where in smaller organisations trustees need
to become involved in operational matters, they should separate their strategic and operational roles.

4.2 Attributes of directors
In order to carry out effective scrutiny, directors need to have relevant expertise in industry, company,
functional area and governance. The board as a whole needs to contain a mix of expertise and show a
balance between executive management and independent non-executive directors. New and
existing directors should also have appropriate training to develop the knowledge and skills required.
4.2.1 Nomination committee

In order to ensure that balance of the board is maintained, the board should set up a nomination
committee, to oversee the process for board appointments and make recommendations to the board.
The UK Corporate Governance Code recommends that a majority of the committee members should be
independent non-executive directors.
The nomination committee needs to consider the balance between executives and independent non-
executives, the skills and knowledge possessed by the board, the need for continuity and succession
planning and the desirable size of the board. Recent corporate governance guidance has laid more
stress on the need to attract board members from a diversity of backgrounds.
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.
4.3 Possession of necessary information

As we have seen above, in many corporate scandals, the board were not given full information. The UK
Corporate Governance Code states that the chairman is responsible for ensuring that the directors
receive accurate, timely and clear information. Directors should seek clarification where necessary.
4.4 Performance of board

Appraisal of the board's performance is an important control over it. The performance of the board
should be assessed once a year. (For FTSE 350 companies this should be externally facilitated every
C
three years). Separate appraisal of the chairman and chief executive should also be carried out, with
links to the remuneration process. H
A
P
4.5 Board membership and division of responsibilities T
All reports acknowledge the importance of having a division of responsibilities at the head of an E
organisation. The simplest way to do this is to require the roles of chairman and chief executive to be R
held by two different people.
The Code states that the chief executive would only become chairman in exceptional circumstances.
The board should consult major shareholders in advance and should set out its reasons to shareholders 4
at the time of the appointment and in the next annual report.

Worked example: Director influence
Another area of concern is whether individual directors are exercising disproportionate influence on the
company. For example Boots prohibited the chairman of the remuneration committee from serving on
the audit committee and vice versa.
4.6 Non-executive directors

Non-executive directors have no executive (managerial) responsibilities.
Non-executive directors should provide a balancing influence, and play a key role in reducing
conflicts of interest between management (including executive directors) and shareholders. They
should provide reassurance to shareholders, particularly institutional shareholders, that management is
acting in the interests of the organisation.
Worked example: Sources of non-executive directors

Non-executive directors may come from a number of sources:
• Companies operating in international markets could benefit from having at least one non-executive
director with international experience
• Lawyers, accountants and consultants can bring skills that are useful to the board
• Listed companies should consider appointing directors of private companies as non-executive
directors
• Including individuals with charitable or public sector experience but strong commercial awareness
can increase the breadth of diversity and experience on the board
4.6.1 Role of non-executive directors

The role of non-executive directors can be summarised as follows:
• Strategy: non-executive directors should contribute to, and challenge the direction of, strategy.
• Performance: non-executive directors should scrutinise the performance of management in
meeting goals and objectives, and monitor the reporting of performance.
• Risk: non-executive directors should satisfy themselves that financial information is accurate and
that financial controls and systems of risk management are robust.
• Directors and managers: non-executive directors are responsible for determining appropriate
levels of remuneration for executives, and are key figures in the appointment and removal of senior
managers and in succession planning.
4.6.2 Advantages of non-executive directors

Non-executive directors can bring a number of advantages to a board of directors.
• They may have external experience and knowledge which executive directors do not
possess. The experience they bring can be in many different fields. They may be executive
directors of other companies, and thus have experience of different ways of approaching corporate
governance, internal controls or performance assessment. They can also bring knowledge of
markets within which the company operates.
• Non-executive directors can provide a wider perspective than executive directors who may be
more involved in detailed operations.
• Good non-executive directors are often a comfort factor for third parties such as investors or
creditors.
• It has been suggested that there are certain roles non-executive directors are well-suited to play.
These include 'father-confessor' (being a confidant for the chairman and other directors), 'oil-can'
(intervening to make the board run more effectively) and acting as 'high sheriff' (if necessary taking
steps to remove the chairman or chief executive).

• The most important advantage perhaps lies in the dual nature of the non-executive director's role.
Non-executive directors are full board members who are expected to have the level of knowledge
that full board membership implies. At the same time they are meant to provide the so-called
strong, independent element on the board. This should imply that they have the knowledge and
detachment to be able to assess fairly the remuneration of executive directors when serving on the
remuneration committee, and to be able to discuss knowledgeably with auditors the affairs of the
company on the audit committee.
4.6.3 Problems with non-executive directors

Nevertheless there are a number of difficulties connected with the role of non-executive director.
• In many organisations, non-executive directors may lack independence. There are in practice a
number of ways in which non-executive directors can be linked to a company, as suppliers or
customers for example. Even if there is no direct connection, potential non-executive directors are
more likely to agree to serve if they admire the company's chairman or its way of operating.
• There may be a prejudice in certain companies against widening the recruitment of non-
executive directors to include people proposed other than by the board or to include stakeholder
representatives.
• High-calibre non-executive directors may gravitate towards the best-run companies, rather than
companies which are more in need of input from good non-executives.
• Non-executive directors may have difficulty imposing their views upon the board. It may be easy
to dismiss the views of non-executive directors as irrelevant to the company's needs. This may
imply that non-executive directors need good persuasive skills to influence other directors.
Moreover, if executive directors are determined to push through a controversial policy, it may prove
difficult for the more disparate group of non-executive directors to oppose them effectively.
• It has been suggested that not enough emphasis is given to the role of non-executive directors in
preventing trouble, in warning early on of potential problems. When trouble does arise, non-
executive directors may be expected to play a major role in rescuing the situation, which they may
not be able to do.
• Perhaps the biggest problem which non-executive directors face is the limited time they can devote
to the role. If they are to contribute valuably, they are likely to have time-consuming other
commitments. In the time they have available to act as non-executive directors, they must contribute
as knowledgeable members of the full board and fulfil their legal responsibilities as directors. They C
must also serve on board committees. Their responsibilities mean that their time must be managed H
effectively, and they must be able to focus on areas where the value they add is greatest. A
P
4.6.4 Independence of non-executive directors T
Various safeguards can be put in place to ensure that non-executive directors remain independent. A E
number of factors will be considered including if the director: R
• 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.

4.6.5 Current developments and further reading
The Code continues to evolve, as the financial crisis, the public outcry over disproportionate executive
remuneration and the growing focus on shareholder participation all make the need for effective
corporate governance codes more topical than ever.
The ICAB has published numerous articles and thought-leadership projects on the Corporate
Governance. We would recommend that you use this ICAB website to keep abreast of the current
Bangladesh and international developments around corporate governance.
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.
5.1 The UK Stewardship Code

5.1.1 Introduction
The UK Stewardship Code, issued in July 2010, aims to enhance the quality of engagement between
investors and companies to help improve long-term returns to shareholders and the efficient exercise of
governance responsibilities. The FRC views this as complementary to the UK Corporate Governance
Code. The Stewardship Code sets out good practice contained in seven Principles to which institutional
investors should aspire. As with the UK Corporate Governance Code, the Stewardship Code should be
applied on a 'comply or explain' basis. This involves providing a statement on the institution's website
that contains:
• A description of how the principles of the Stewardship Code have been applied
• Disclosure of specific information as required under the Principles
• An explanation of the elements of the Stewardship Code which have not been complied with.
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.
5.1.2 The Principles of the Code

The seven Principles of the UK Stewardship Code are as follows:
• Institutional investors should publicly disclose their policy on how they will discharge their
stewardship responsibilities.
Stewardship activities include monitoring and engaging with companies on matters such as
strategy, performance, risk, capital structure, and corporate governance, including culture and
remuneration.
Disclosure should include how investee companies will be monitored, the strategy on intervention,
internal arrangements, the policy on voting and the policy on considering explanations made in
relation to the UK Corporate Governance Code.
• Institutional investors should have a robust policy on managing conflicts of interest in relation to
stewardship and this policy should be publicly disclosed.
An institutional investor's duty is to act in the interests of all clients and/or beneficiaries when
considering matters such as engagement and voting.

• Institutional investors should monitor their investee companies.
Investee companies should be monitored to determine when it is necessary to enter into an active
dialogue with their boards. This monitoring should be regular, and the process checked periodically
for its effectiveness.
Institutional investors should consider carefully explanations given for any departure from the UK
Corporate Governance Code and be prepared to enter a dialogue if they do not accept the
company's position.
• Institutional investors should establish clear guidelines on when and how they will escalate their
activities as a method of protecting and enhancing shareholder value.
Instances where institutional investors may want to intervene include when they have concerns
about the company's strategy and performance, its governance or its approach to the risks arising
from social and environmental matters. If companies do not respond constructively to investor
intervention they should consider the need to escalate their action.
• Institutional investors should be willing to act collectively with other investors where appropriate.
Collaborative engagement may be most appropriate at times of significant corporate or wider
economic stress, or when the risks posed threaten the ability of the company to continue.
• Institutional investors should have a clear policy on voting and disclosure of voting activity.
Institutional investors should vote all shares held. They should disclose publicly voting records. If
they abstain or vote against a resolution they should inform the company in advance.
• Institutional investors should report periodically on their stewardship and voting activities.
Those that act as agents should regularly report to their clients details of how they have discharged
their responsibilities. These reports are likely to comprise qualitative and quantitative information.
5.2 The Turnbull Report

In 1999 the Internal Control Working Party of the ICAEW, chaired by Nigel Turnbull (Finance Director of
Rank Group plc), issued guidance for directors of UK listed companies building on the concept that
companies needed “a sound system of internal control to safeguard shareholders' investment and
the company's assets”. The detailed provisions require annual review of all the company's internal
controls, including financial, operational and compliance controls and risk management. Potential threats C
to the company include environmental, ethical and social risks. H
A
Although the Turnbull Report predates the UK Corporate Governance Code, its principles are still
relevant. The guidance is now contained in the FRC publication Internal control: Guidance to Directors. P
T
The Turnbull report is considered in more detail in Section 7 which covers corporate governance and E
internal control.
R

6 Corporate governance: international impact
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.
6.1 OECD Principles of Corporate Governance

6.1.1 Convergence of international guidance
Because of increasing international trade and cross-border links, there is significant pressure for the
development of internationally comparable practices and standards. Accounting and financial reporting
is one area in which this has occurred. Increasing international investment and integration of
international capital markets has also led to pressure for standardisation of governance guidelines, as
international investors seek reassurance about the way their investments are being managed and
the risks involved.
6.1.2 OECD guidance
The Organisation for Economic Co-operation and Development (OECD) has carried out an extensive
consultation with member countries, and developed a set of principles of corporate governance that
countries and companies should work towards achieving. The OECD has stated that its interest in
corporate governance arises from its concern for global investment. Corporate governance
arrangements should be credible and should be understood across national borders. Having a common
set of accepted principles is a step towards achieving this aim.
The OECD developed its Principles of Corporate Governance in 1998 and issued a revised version in
April 2004. They are non-binding principles, intended to assist governments in their efforts to evaluate
and improve the legal, institutional and regulatory framework for corporate governance in their countries.
They are also intended to provide guidance to stock exchanges, investors and companies. The focus is
on stock exchange listed companies, but many of the principles can also apply to private companies and
state-owned organisations.
The OECD Principles deal mainly with governance problems that result from the separation of
ownership and management of a company. Issues of ethical concern and environmental issues are
also relevant, although not central to the problems of governance.

Between February 2009 and February 2010 the OECD issued a number of documents regarding the
corporate governance lessons which can be learnt from the recent financial crisis.
6.1.3 OECD Principles

The OECD Principles are grouped into six broad areas:
(i) Ensuring the basis for an effective Corporate Governance Framework
The corporate governance framework should promote transparent and efficient markets, be
consistent with the rule of law and clearly articulate the division of responsibilities among different
supervisory, regulatory and enforcement authorities.
(ii) The rights of shareholders
Shareholders should have the right to participate and vote in general meetings of the company,
elect and remove members of the board and obtain relevant and material information on a
timely basis. Capital markets for corporate control should function in an efficient and timely
manner.
(iii) The equitable treatment of shareholders
All shareholders of the same class of shares should be treated equally, including minority
shareholders and overseas shareholders. Impediments to cross-border shareholdings
should be eliminated.
(iv) The role of stakeholders
Rights of stakeholders should be protected. All stakeholders should have access to relevant
information on a regular and timely basis. Performance-enhancing mechanisms for employee
participation should be permitted to develop. Stakeholders, including employees, should be able
to freely communicate their concerns about illegal or unethical relationships to the board.
(v) Disclosure and transparency
Timely and accurate disclosure must be made of all material matters regarding the company,
including the financial situation, foreseeable risk factors, issues regarding employees and other
stakeholders and governance structures and policies. The company's approach to disclosure
should promote the provision of analysis or advice that is relevant to decisions by investors.
(vi) The responsibilities of the board
The board is responsible for the strategic guidance of the company and for the effective C
monitoring of management. Board members should act on a fully informed basis, in good faith, H
with due diligence and care and in the best interests of the company and its shareholders. A
They should treat all shareholders fairly. The board should be able to exercise independent P
judgement; this includes assigning independent non-executive directors to appropriate tasks. T
E
6.2 Sarbanes-Oxley R
6.2.1 The Enron scandal

The most significant scandal in America in recent years has been the Enron scandal, when one of the 4
country's biggest companies filed for bankruptcy. The scandal also resulted in the disappearance of
Arthur Andersen, one of the Big Five accountancy firms who had audited Enron's accounts. The main
reasons why Enron collapsed were over-expansion in energy markets, too much reliance on derivatives'
trading which eventually went wrong, breaches of federal law, and misleading and dishonest behaviour.
However enquiries into the scandal exposed a number of weaknesses in the company's governance.
• A lack of the transparency in the accounts
This particularly related to certain investment vehicles that were not recognised in the statement of
financial position. Various other methods of inflating revenues, offloading debt, massaging quarterly
figures and avoiding taxes were employed.
• Ineffective corporate governance arrangements
The company's management team was criticised for being arrogant and over ambitious and there
were potential conflicts of interest.

• Inadequate scrutiny by the external auditors
Arthur Andersen failed to spot or failed to question dubious accounting treatments. Since
Andersen's consultancy arm did a lot of work for Enron, there were allegations of conflicts of
interest.
• Information asymmetry
That is the agency problem of the directors/managers knowing more than the investors. The
investors included Enron's employees. Many had their personal wealth tied up in Enron shares,
which ended up being worthless. They were actively discouraged from selling them. Many of
Enron's directors, however, sold the shares when they began to fall, potentially profiting from them.
• Executive compensation methods
These were meant to align the interests of shareholders and directors, but seemed to encourage
the overstatement of short-term profits. Particularly in the USA, where the tenure of Chief Executive
Officers is fairly short, the temptation is strong to inflate profits in the hope that share options will
have been cashed in by the time the problems are discovered.
6.2.2 The Sarbanes-Oxley Act 2002

In the US the response to the breakdown of stock market trust caused by perceived inadequacies in
corporate government arrangements and the Enron scandal was the Sarbanes-Oxley Act 2002. The
Act applies to all companies that are required to file periodic reports with the Securities and Exchange
Commission (SEC). The Act was the most far-reaching US legislation dealing with securities in many
years and has major implications for public companies. Rule-making authority was delegated to the SEC
on many provisions.
Sarbanes-Oxley shifts responsibility for financial probity and accuracy to the board's audit committee,
which typically comprises three independent directors, one of whom has to meet certain financial literacy
requirements (equivalent to non-executive directors in other jurisdictions).
Along with rules from the Securities and Exchange Commission, the Sarbanes-Oxley Act (Sox) requires
companies to increase their financial statement disclosures, to have an internal code of ethics and to
impose restrictions on share trading by, and loans to, corporate officers.
Effectively the Sox legislates that companies and their boards must comply with provisions derived from
principles similar to the OECD Principles and those contained in the UK Corporate Governance Code.
However, this rules based approach has drawn criticism for its 'one size fits all' approach and there have
been concerns that it unnecessarily burdens smaller entities.
Unlike the UK Corporate Governance Code, which adopts a 'comply-or-explain' approach, the Sox is
strictly rule-based, with penalties imposed for non-compliance. There is a continuing debate around
which approach is the more effective. It is argued that the UK's more flexible model:
• Provides best practice guidance that can be applied to the varying circumstances of different
companies
• Prevents the development of a mechanistic, 'box-ticking' approach to decision-making and the use
of legalistic loopholes to avoid compliance with guidance
• Focuses on the spirit of the guidance and encourage responsibility and the exercise of professional
judgement
On the other hand, supporters of a rules-based approach argue that compliance with such guidance is
easier since the requirements are prescriptive and leave little room for misunderstanding. Furthermore,
rules-based approaches are easier to enforce.

6.2.3 Detailed provisions of the Sarbanes-Oxley Act
These are as follows:
• Public Oversight Board
The Act set up a new regulator, The Public Company Accounting Oversight Board (PCAOB) to
oversee the audit of public companies that are subject to the securities laws.
The Board has powers to set auditing, quality control, independence and ethical standards for
registered public accounting firms to use in the preparation and issue of audit reports on the
financial statements of listed companies. In particular, the Board is required to set standards for
registered public accounting firms' reports on listed company statements on their internal control
over financial reporting. The Board also has inspection and disciplinary powers over firms.
• Auditing standards
Audit firms should retain working papers for at least seven years and have quality control
standards in place such as second partner review. As part of the audit they should review internal
control systems to ensure that they reflect the transactions of the client and provide reasonable
assurance that the transactions are recorded in a manner that will permit preparation of the
financial statements in accordance with generally accepted accounting principles. They
should also review records to check whether receipts and payments are being made only in
accordance with management's authorisation.
• Non-audit services
Auditors are expressly prohibited from carrying out a number of services including internal audit,
bookkeeping, systems design and implementation, appraisal or valuation services, actuarial
services, management functions and human resources, investment management, legal and expert
services. Provision of other non-audit services is only allowed with the prior approval of the
audit committee.
• Quality control procedures
There should be rotation of lead or reviewing audit partners every five years and other procedures
such as independence requirements, consultation, supervision, professional development, internal
quality review and engagement acceptance and continuation.
• Auditors and audit committee C
H
Auditors should discuss critical accounting policies, possible alternative treatments, the
management letter and unadjusted differences with the audit committee. A
P
• Audit committees T
Audit committees should be established by all listed companies. E
R
All members of audit committees should be independent and should therefore not accept any
consulting or advisory fee from the company or be affiliated to it. At least one member should be
a financial expert. Audit committees should be responsible for the appointment, compensation
and oversight of auditors. Audit committees should establish mechanisms for dealing with 4
complaints about accounting, internal controls and audit.
• Corporate responsibility
The chief executive officer and chief finance officer should certify the appropriateness of the
financial statements and that those financial statements fairly present the operations and financial
condition of the issuer. If the company has to prepare a restatement of accounts due to material
non-compliance with standards, the chief finance officer and chief executive officer should forfeit
their bonuses.
• Off balance sheet transactions
There should be appropriate disclosure of material off-balance sheet transactions and other
relationships (transactions that are not included in the accounts but that impact upon financial
conditions, results, liquidity or capital resources).

• Internal control reporting
Annual reports should contain internal control reports. We look at this aspect in more detail in
Section 7 when we consider internal control.
• Whistleblowing provisions
Employees of listed companies and auditors will be granted whistleblower protection against
their employers if they disclose private employer information to parties involved in a fraud claim.
6.2.4 Impact of Sarbanes-Oxley in America

The biggest expense involving compliance that companies are incurring is fulfilling the requirement to
ensure their internal controls are properly documented and tested. US companies had to have efficient
controls in the past, but they are now having to document them more comprehensively than before, and
then have the external auditors report on what they have done.
The Act also formally stripped accountancy firms of almost all non-audit revenue streams that they used
to derive from their audit clients, for fear of conflicts of interest.
For lawyers, the Act strengthens requirements on them to whistleblow internally on any wrongdoing they
uncover at client companies, right up to board level.
6.2.5 International impact of Sarbanes-Oxley

The Act also has a significant international dimension. About 1,500 non-US companies, including
many of the world's largest, list their shares in the US and are covered by Sarbanes-Oxley. There were
complaints that the new legislation conflicted with local corporate governance customs, and following an
intense round of lobbying from outside the US, changes to the rules were secured. For example,
German employee representatives, who are non-management, can sit on audit committees, and audit
committees do not have to have board directors if the local law says otherwise, as it does in Japan and
Italy.
Also as America is such a significant influence worldwide, arguably Sarbanes-Oxley may influence
certain jurisdictions to adopt a more rules-based approach.
6.2.6 Criticisms of Sarbanes-Oxley

Sarbanes-Oxley has been criticised in some quarters for not being strong enough on certain issues,
for example the selection of external auditors by the audit committee, and at the same time being over-
rigid on others. Directors may be less likely to consult lawyers in the first place if they believe that
legislation could override lawyer-client privilege.
In addition, it has been alleged that a Sarbanes-Oxley compliance industry has sprung up focusing
companies' attention on complying with all aspects of the legislation, significant or much less important.
This has distracted companies from improving information flows to the market and then allowing the
market to make well-informed decisions. The Act has also done little to address the temptation provided
by generous stock options to inflate profits, other than requiring possible forfeiture if accounts are
subsequently restated.
Most significantly perhaps there is recent evidence of companies turning away from the US Stock
markets and towards other markets such as London. An article in the Financial Times suggested that
this was partly due to companies tiring of the increased compliance costs associated with Sarbanes-
Oxley implementation. In addition, the nature of the regulatory regime may be an increasingly
significant factor in listing decisions.

7 Corporate governance and internal control
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.
7.1 The Turnbull Report

7.1.1 Introduction
We looked briefly at the Turnbull Report in Section 5.2.
As discussed earlier, although the Turnbull Report predates the UK Corporate Governance Code, its
principles are still relevant and form the basis of the FRC publication Internal control: Guidance to
Directors. This publication sets out best practice on internal control for UK listed companies.
7.1.2 Objectives of the Turnbull Report

The objectives of the Turnbull Report are to encourage companies to adopt a risk-based approach to
establishing a system of internal control, ie to manage and control risk appropriately rather than
eliminate it. The guidance given in Turnbull outlines broad principles that require directors to use their
judgement when applying them. This should enable companies to achieve their own business objectives
rather than merely 'ticking boxes'.
Turnbull constantly emphasises the importance of an embedded and ongoing process of identifying and
responding to risks. Thus a company must:
• Establish business objectives
• Identify the key risks associated with these
• Agree the controls to address the risks
• Set up a system to implement the decision, including regular feedback.
C
The Turnbull Report emphasises that the guidance aims to reflect sound business practice, as well as to H
help companies comply with the internal control requirements of the Code.
A
P
7.1.3 Responsibilities of Directors, Management and Employees
T
The responsibilities of directors, management and employers to integrate the Turnbull Report are as E
follows: R
Directors
• Have a defined process for the review of effectiveness of internal control
4
• Seek regular assurance that the system is functioning
• Review the effectiveness of internal control
• Make disclosures on internal controls in the annual report and accounts
• Will be expected to apply the same standard of care when reviewing the effectiveness of internal
control as when exercising their general duties.
Management
• Implement board policies on risk and control
• Identify and evaluate the risks faced by the company
Employees
• Necessary knowledge, skills, authority etc to establish, operate and monitor the system of internal
controls.

7.1.4 Review of Internal Financial Control
The Turnbull guidance stipulates that directors should have regard to a series of criteria under five key
headings.
(1) Control environment – the tone set from the top of the organisation.
(2) Risk assessment – process to identify major risks and assess their impact.
(3) Information systems – include monthly reporting, comparison with budgets etc as well as non-
financial performance indicators.
(4) Control procedures – internal controls to overcome risk (segregation of duties, authorisation, etc).
(5) Monitoring – procedures designed to assure the board that the system is managing risk (audit
committees, internal audit, etc).
Points to note:
These five headings are essentially the same as the five components of internal control identified in ISA
315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and
its Environment.
Many perceive the overall control environment as the key component of internal control. Its importance
can be seen in the following Worked example.
Worked example: Control environment

Imagine a hotel group whose management prides itself on being 'lean and mean'.
Head office puts in controls to match this obsession. Each hotel is a separate company. Every manager
has his targets. The group has budgets and is measured by those budgets. But the key target by which
the business is run is occupancy rates.
The managers make sure that the hotels are full by reducing the room rates quite substantially. These
low rates do not filter through the system until a long time later. So their management system leads to a
totally ineffective system where expectations are high and the important controls are not there at all –
because the control environment is inappropriate.
7.1.5 Disclosure of Compliance with the Turnbull Report

As a minimum, the Turnbull Report recommends that the annual report should contain a narrative
statement disclosing that there is an ongoing process for identifying, evaluating and managing the
significant risks faced by the company that is regularly reviewed by the board. The Turnbull guidance
also states that the board may wish to provide additional information to assist understanding of the
company's risk management process and system of internal control. The content of such narrative
statements is likely, therefore, to vary widely from company to company.
The Turnbull Report requires boards to confirm in the annual report that necessary action has been, or is
being, taken to remedy any significant failings or weaknesses identified from their review of the
effectiveness of the internal control system. The board should also include in the annual report such
information as is considered necessary to assist shareholders' understanding of the main features of the
company's risk management processes and system of internal control.
7.1.6 Example narrative statement

The following extract is an example of a narrative statement on internal control. It has been taken from
the corporate governance statement of SuperGroup plc presented as part of their Annual Report for
2012. SuperGroup plc is an international fashion retailer that is listed on the FTSE in the UK and
therefore are obliged to report on compliance with the UK Corporate Governance Code. The full
statement and related annual report and financial statements can be found on SuperGroup plc's
website at www.supergroup.co.uk.
Internal control
The board is ultimately responsible for the Group's systems of internal control and for reviewing its
effectiveness annually as set out in C.2.1 of the Code. Following the market update on 20 April 2012, a

full and comprehensive review of the adequacy of the existing internal controls is underway. This review
is being led by the Chief Operating Officer and the Chief Financial Officer.
In accordance with the revised guidance for directors on internal control (the 'Revised Turnbull
Guidance'), the board confirms that there is an ongoing process for identifying, evaluating and managing
the risks faced by the Group. This process was put in place prior to the IPO in March 2010 and has been
continually developed, and facilitated, by our Head of Business Assurance and Internal Audit Function.
This process was in place throughout the year under review up to the date of approval of the Annual
Report and Financial Statements. These systems are there to manage rather than eliminate risk, and
can provide only reasonable, and not complete assurance against material misstatement or loss.
In respect of our financial reporting process and the process for preparing the consolidated accounts,
management monitors the processes underpinning the Group's financial reporting systems through
regular reporting and review. Data for consolidation into the Group's financial statements is reviewed by
management to ensure that it reflects a true and fair view of the Group's results.
During the year of reporting, the audit committee continued to use the services of KPMG LLP as the
Group's internal auditors. KPMG LLP have continued a review of internal controls and have had in place
an internal audit plan for the year ahead. This internal audit plan has allocated responsibility for
identifying and evaluating significant risks to the relevant business area, on a continuing basis and this is
regularly reviewed by the audit committee in accordance with the Turnbull Guidance, (provision C.2.1).
7.1.7 Review of Turnbull Report

In 2011, the FRC held a number of meetings with companies, investors and advisers to discuss the
implementation of the principle in the UK Code of Corporate Governance that boards are responsible for
determining the nature and extent of the significant risks they are willing to take in achieving their
strategic objective. The Turnbull Report was generally considered still to be an effective framework for
the review of risk management and internal control systems. However, the FRC concluded that the
guidance should be reviewed. This review is yet to be completed.
7.2 International focus

As we discussed earlier, large international companies may be listed in the United States and are
required to comply with the American Sarbanes Oxley Act (Sox).
The key difference between Sox and the UK approach to corporate governance is that while the UK
Corporate Governance Code is principles-based, Sox is rules-based. By contrast to the UK's 'comply or
explain' approach, most of the Sox regulations are enshrined in legislation, with penalties for non- C
compliance. H
One area of this Act that has sparked widespread debate has been Section 404 relating to the A
assessment of internal control. Under Sox, management and the auditors must report on the adequacy P
of the company's internal control over financial reporting. Working to implement, document and test T
controls to the degree required to make an assertion that the controls are adequate can be a costly and E
time consuming process. R
Annual reports for companies affected by Sox should contain internal control reports that state the
responsibility of management for establishing and maintaining an adequate internal control structure
and procedures for financial reporting. Annual reports should also contain an assessment of the 4
effectiveness of the internal control structure and procedures for financial reporting. Auditors
should report on this assessment.
Companies should also report whether they have adopted a code of conduct for senior financial
officers and the content of that code.
7.2.1 Example of internal control report under Sox

The following extract has been taken from the annual report for 31 December 2012 of Coca-Cola
Enterprises, Inc.
INTERNAL CONTROL OVER FINANCIAL REPORTING
Management is also responsible for establishing and maintaining effective internal control over financial
reporting. Internal control over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of financial statements for external
purposes in accordance with U.S. generally accepted accounting principles. The Company's internal
control over financial reporting includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and

dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in accordance with U.S. generally
accepted accounting principles, and that receipts and expenditures of the Company are being made only
in accordance with authorizations of management and directors of the Company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the Company's assets that could have a material effect on the financial statements.
Management recognizes that there are inherent limitations in the effectiveness of any internal control
over financial reporting, including the possibility of human error and the circumvention or overriding of
internal control. Accordingly, even effective internal control over financial reporting can provide only
reasonable assurance with respect to financial statement preparation. Further, because of changes in
conditions, the effectiveness of internal control over financial reporting may vary over time.
In order to ensure that the Company's internal control over financial reporting is effective, management
regularly assesses such controls and did so most recently as of December 31, 2012. This assessment
was based on criteria for effective internal control over financial reporting described in Internal Control –
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission. Based on this assessment, management believes the Company maintained effective
internal control over financial reporting as of December 31, 2012. Ernst & Young LLP, the Company's
independent registered public accounting firm, has issued an attestation report on the Company's
internal control over financial reporting as of December 31, 2012.
The report above can be contrasted with the compliance statement in Section 7.1.6. Under Sox, a
positive statement that management believes the company maintained effective internal control is
needed. For the UK listed company, the disclosure is in relation to the existence of an ongoing process
for identifying, evaluating and managing risks and a summary of the process for reviewing internal
control effectiveness, and where necessary addressing control weaknesses.
8 Evaluation of corporate governance mechanisms
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.
8.1 Auditors' responsibilities

As we have seen in Section 3, companies are required to provide a two-part disclosure regarding
compliance with the provisions of the UK Corporate Governance Code. The Stock Exchange listing rules
require auditors to review parts of the statement which relate to certain provisions in the Code.

These include sections which deal with the following matters
• Respective responsibilities of directors and auditors (Code Section C.1.1)
• Review of the effectiveness of risk management and internal controls (Code Section C.2.1) (see
Section 8.2 below)
• Provisions relating to audit committees (Code Sections C.3.1 to C.3.8)
The listing rules also require auditors to review the annual statement by the directors that the business is
a going concern.
The auditor also needs to review that the following disclosures are made correctly, in relation to each
director:
• Amount of each element in the remuneration package and information on share options
• Details of long term incentive schemes for directors
• Money purchase schemes
• Defined benefit schemes
The auditor's report should then include details of any non-compliance with these requirements.
In order to conduct the review the auditor will need to obtain audit evidence to support the compliance
statement. Bulletin 2006/5 The Combined Code on Corporate Governance: Requirements of Auditors
Under the Listing Rules of the Financial Services Authority identifies the following general procedures as
those usually performed by the auditor:
• Reviewing the minutes of the meetings of the board of directors, and of relevant board committees
• Reviewing supporting documents prepared for the board of directors or board committees that are
relevant to those matters specified for review by the auditor
• Making inquiries of certain directors (such as the chairman of the board of directors and the
chairman of relevant board committees) and the company secretary
• Attending meetings of the audit committee at which the annual report and accounts, including the
statement of compliance are considered and approved for submission to the board of directors.
Points to note:
(1) Bulletin 2006/5 predates the introduction of the UK Corporate Governance Code and therefore still
refers to the Combined Code, its predecessor. C
H
(2) The guidance in Bulletin 2006/5 on directors' statements on going concern has been replaced by A
guidance in Bulletin 2009/4 Developments in Corporate Governance Affecting the Responsibilities
P
of Auditors of UK Companies (see Section 8.3 below).
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8.2 Internal control effectiveness R
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

misunderstanding on the scope of the auditors' role, the Bulletin recommends that the following wording
be used in the audit report.
'We are not required to consider whether the board's statements on internal control cover all risks
and controls, or form an opinion on the effectiveness of the company's corporate governance
procedures or its risk and control procedures.'
The Bulletin also points out that it is particularly important for auditors to communicate quickly to the
directors any material weaknesses they find, because of the requirements for the directors to make a
statement on internal control.
The directors are required to consider the material internal control aspects of any significant problems
disclosed in the accounts. Auditors' work on this is the same as on other aspects of the statement; the
auditors are not required to consider whether the internal control processes will remedy the problem.
The auditors may report by exception if problems arise such as:
(a) The board's summary of the process of review of internal control effectiveness does not reflect
the auditors' understanding of that process.
(b) The processes that deal with material internal control aspects of significant problems do not
reflect the auditors' understanding of those processes.
(c) The board has not made an appropriate disclosure if it has failed to conduct an annual review,
or the disclosure made is not consistent with the auditors' understanding.
The report should be included in a separate paragraph below the opinion paragraph. The Bulletin gives
the following example.
'Other matters
We have reviewed the board's description of its process for reviewing the effectiveness of internal
control set out on page x of the annual report. In our opinion the board's comments concerning ... do not
appropriately reflect our understanding of the process undertaken by the board because...'
Critics of recent developments have argued that listed company directors ought to be able to report on
the effectiveness of internal controls, and that this is part of the responsibility and accountability
expected of listed company directors. The debate is likely to continue over the next few years.
8.3 Going concern

The Listing Rules require the directors of certain listed companies to include in the annual financial
report a statement that the business is a going concern, prepared in accordance with Going Concern
and Liquidity Risk: Guidance for Directors of UK Companies 2009, published by the FRC in October
2009. Bulletin 2009/4 Developments in Corporate Governance Affecting the Responsibilities of Auditors
of UK Companies sets out the auditor's review responsibilities with respect to this statement as follows:
• Reviewing the documentation prepared by or for the directors which explains the basis of the
directors' conclusion with respect to going concern
• Evaluating the consistency of the directors' going concern statement with the auditor's knowledge
obtained in the course of the audit
• Assessing whether the directors' statement meets the disclosure requirements of the FRC
guidance.
The Bulletin also states that where the annual report includes a corporate governance statement the
auditor is required to form an opinion as to whether the information given is consistent with the financial
statements.
Point to note:
The FRC publication Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009
includes three key principles:
(1) Directors should make and document a rigorous assessment of whether the company is a going
concern
(2) Directors should consider all available information about the future. Their review should usually
cover a period of at least twelve months from the date of approval of financial statements

(3) Directors should make balanced, proportionate and clear disclosures about going concern
8.3.1 The Sharman Inquiry

In March 2011 the FRC announced the launch of an inquiry led by Lord Sharman to identify lessons for
companies and auditors addressing going concern and liquidity risk. In June 2012 The Sharman Inquiry
Final Report and Recommendations was issued. The panel made five recommendations. The key points
are as follows:
• The FRC should take a more systematic approach to learning lessons relevant to its functions
when significant companies fail or suffer significant financial or economic distress but nonetheless
survive
• The FRC should seek to engage with IASB and IAASB to agree a common international
understanding of the purposes of the going concern assessment and financial statement
disclosures about going concern
• The FRC should review the Guidance for Directors to ensure that going concern assessment is
integrated with the directors' business planning and risk management processes and:
– Includes a focus on both solvency and liquidity risks, whatever the business
– May be more qualitative and longer term in outlook in relation to solvency risk than in relation
to liquidity risk
– Includes stress tests both in relation to solvency and liquidity risks that are undertaken with an
appropriate level of prudence. Special consideration should be given to the impact of risks that
could cause significant damage to stakeholders, bearing in mind the directors' duties and
responsibilities under the Companies Act.
• The FRC should move away from a model where disclosures about going concern risks are only
highlighted when there are significant doubts about the entity's survival. The discussion of strategy
and principal risks should include the directors' going concern statement and how they arrived at it.
The audit committee report should illustrate the effectiveness of the process undertaken by the
directors to evaluate going concern by confirming that a robust assessment has been made and
commenting on or cross-referencing to information on the material risks to going concern which
have been considered.
• The FRC should consider inclusion of an explicit statement in the auditor's report as to whether the
auditor has anything to add or emphasise in relation to the disclosures made by the directors about
the robustness of the process and its outcome, having considered the directors' going concern C
assessment process. H
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Worked example: Audit procedures
T
The Code requires that the board should ensure that directors have access to independent professional E
advice at the company's expense where they judge it necessary to discharge their responsibilities as R
directors.
Audit procedures to determine whether this section of the Code has been complied with would be as
follows: 4
• Establish details of agreed procedures
• Inspect the board minutes recording adoption of these procedures, if these have been adopted this
year
• If procedures are not formally laid down in writing, confirm their existence with directors and
company secretary
• Consider by discussion with the directors and from our knowledge of the business, whether there
was a need for independent advice during the period and, if so, whether procedures have been
followed in practice.
From: Principles of Auditing: An Introduction to International Standards on Auditing by Rick Hayes,
Roger Dassen, Arnold Schilder, Philip Wallage 2nd edition 2005 published by Pearson Education Limited

9 Communication between auditors and those charged
with governance
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 Communication during the audit

Two standards are relevant here:
• ISA 260 (Revised October 2012) Communication with Those Charged with Governance
• ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and
Management
Definition
Governance: is the term used to describe the role of persons 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. Those charged with governance may include management
only when it performs such functions. (Those charged with governance include the directors (executive
and non-executive) and members of the audit committee. Management will not normally include non-
executive directors.)
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 would include:
The auditor's Including that:

responsibilities in
relation to the • The auditor is responsible for forming and expressing an opinion on the
financial statements financial statements
• The audit does not relieve management or those charged with governance of
their responsibilities
Planned scope and Including:
timing of the audit
• How the audit proposes to address the significant risks of material
misstatement from fraud or error
• The auditor's approach to internal control
• Application of materiality
• The extent to which the auditor will use the work of internal audit
• Matters those charged with governance consider warrant particular attention
Significant Including:
findings from the
audit • Selection of, or changes in, significant accounting policies
• The potential effect on the financial statements of any significant risks and
exposures, for example pending litigation, that are required to be disclosed in
the accounts
• Significant difficulties, if any, encountered during the audit (eg delays in
provision of required information, brief time in which to complete audit,
unavailability of expected information)
• Material deficiencies, if any, in the design, implementation or operating
effectiveness of internal control
• Written representations the auditor is requesting
• Other significant matters including material misstatements or inconsistencies
in other information that have been corrected C
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Auditor In the case of listed entities matters include:
independence A
• A statement that relevant ethical requirements regarding independence have P
been complied with T
• All relationships (including total fees for audit and non-audit services) which E
may reasonably be thought to bear on independence R
• The related safeguards that have been applied to eliminate/reduce identified

threats to independence
4
9.1.2 Communication process
The auditor must communicate with those charged with governance the form, timing and expected
general content of communications.
The communication process will vary with the circumstances including:
• The size and governance structure of the entity
• How those charged with governance operate
• The auditor's view of the significance of the matters to be communicated
For example, reports of relatively minor matters to a small client may be best handled orally via a
meeting or telephone conversation.
Before communicating matters with those charged with governance the auditor may discuss them with
management, unless that is inappropriate. For example, it would not be appropriate to discuss questions
of management's competence or integrity with management.

Written representation should be sought from those charged with governance that explains their reasons
for not correcting misstatements brought to their attention by the auditor.
9.1.3 Adequacy of the communication process

The auditor must evaluate whether the two-way communication with those charged with governance has
been adequate for the purpose of the audit and if not, must consider the effect on the assessment of the
risks of material misstatement and the ability to obtain sufficient appropriate evidence.
9.1.4 Revisions to ISA 260

The revised ISA issued in October 2012 includes additional material to give effect to the changes made
in corporate governance. Where entities report on how they have applied the Corporate Governance
Code, or why they have not, the auditor must communicate to the audit committee all the information
which they believe necessary to enable the board to fulfil its financial and business reporting
responsibilities (ie responsibility for preparing annual report, assessing whether they are fair, balanced
and understandable and provide sufficient information to shareholders to assess performance, the
business model and strategy). The auditor must also provide the audit committee with information to
enable the committee to understand the rationale and supporting evidence which the auditor has relied
on when making significant judgements during the audit and in forming an audit opinion.
If not already communicated through the application of other provisions in this ISA section 16–1 requires
the auditor to include the following views:
• About business risks relevant to the financial reporting objectives, the application of materiality and
the implications of their judgements in relation to these for the audit strategy, audit plan and
evaluation of misstatements
• On significant accounting policies
• On management's valuation of material assets/liabilities and related disclosures
• About the effectiveness of the entity's internal control system relevant to financial reporting and the
effectiveness of internal controls relating to other risks arising. The auditor however must not
express an opinion on the effectiveness of the entity's system of internal control as a whole
• Any other matter that might be relevant to the board or audit committee in fulfilling their
responsibilities.
Interactive question 2: Reporting responsibilities [Difficulty level: Intermediate]

Requirement
In each of the cases listed below identify to whom the auditor would initially report:
(1) The auditor has obtained evidence that the operations manager has committed a fraud against the
company
(2) The auditor has obtained evidence that the finance director has committed a fraud against the
company
(3) Disagreement with an accounting policy
(4) The auditor is suspicious that the board of directors are involved in money laundering activities
9.1.5 Reporting deficiencies in internal control

Auditors may also issue a report on control deficiencies to management. These reports were a key
element in your earlier studies in auditing. As part of the Clarity Project, the IAASB issued a new
standard, ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance
and Management. This was adopted by the APB.
ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and
Management specifies a threshold of significance at which deficiencies in internal control should be
communicated to those charged with governance.

Definition
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.
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.
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Summary

Self-test
1 SPV
SPV is listed on the stock exchange of a central European country. The company manufactures a
wide range of pharmaceutical products including modern drugs used in preventing and treating
diseases. SPV has three factories where drugs are produced and one research and development
facility.
The board of directors comprises the chairman/CEO, three executive and two non-executive
directors (NEDs). Separate audit and remuneration committees are maintained, although the
chairman has a seat on both of those committees. The NEDs are appointed for two and usually
three 4-year terms of office before being required to resign. The internal auditor currently reports to
the board (rather than the financial accountant) on a monthly basis, with internal audit reports
normally being actioned by the board.
There have recently been problems with the development of a new research and development
facility. On a number of occasions the project has fallen behind schedule and the costs have been
much greater than expected. Because of developments that have taken place elsewhere in the
pharmaceuticals industry while the project was being completed, concern has been expressed that
the facility cannot now represent value for money. A couple of large institutional investors have
raised concerns about this, and have indicated their intention to raise the issue at the annual
general meeting and possibly vote against the accounts.
Throughout the project one of the non-executive directors criticised the way the project had been
approved and monitored. She claimed that the board had been led by the senior managers in the
Research and Development department and had acted as no more than a rubber stamp for what
they wanted to do. She is threatening to resign at the annual general meeting on the grounds that
the board is failing to function effectively and she does not wish to be held responsible for decisions
on which she has had no effective input. As a result, the other non-executive director has also
raised questions about the way the board is functioning.
Requirements
(a) Explain the main responsibilities of the board, identifying the ways in which SPV's board
appears to have failed to fulfil its responsibilities.
(b) Evaluate the structures for corporate governance within SPV, recommending any
amendments you consider necessary to those structures.
2 Hammond Brothers C
Hammond Brothers, a road haulage company, is likely to be seeking a stock exchange listing in a H
few years' time. In preparation for this, the directors are seeking to understand certain key A
recommendations of the international corporate governance codes, since they realise that they will P
have to strengthen their corporate governance arrangements. In particular the directors require T
information about what the governance reports have achieved in:
E
(i) Defining the role of non-executive directors R
(ii) Improving disclosure in financial accounts
(iii) Strengthening the role of the auditor
(iv) Protecting shareholder interests
4
Previously the directors have received the majority of their income from the company in the form of
salary and have decided salary levels amongst themselves. They realise that they will have to
establish a remuneration committee but are unsure of its role and what it will need to function
effectively. The directors have worked together well, if informally; there is a lack of formal reporting
and control systems both at the board and lower levels of management. There is also currently no
internal audit department.
The directors are considering whether it will be worthwhile to employ a consultant to advise on how
the company should be controlled, focusing on the controls with which the board will be most
involved.
Requirements
(a) Explain the purpose and role of the remuneration committee, and analyse the information
requirements the committee will have in order to be able to function effectively.
(b) Explain what are meant by organisation and management controls and recommend the main
organisation and management controls that Hammond Brothers should operate.

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.

(b) Suggestions for corporate governance
Composition of the board
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.
Appointment and nomination committees
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.

2 Hammond Brothers
(a) Purpose and role of remuneration committee
The purpose of the remuneration committee is to provide a mechanism for determining the
remuneration packages of executive directors. The scope of the review should include not
only salaries and bonuses, but also share options, pension rights and compensation for loss of
office.
The committee's remit may also include issues such as director appointments and
succession planning, as these are connected with remuneration levels.
Constitution of remuneration committee
Most codes recommend that the remuneration committee should consist entirely of non-
executive directors with no personal financial interest other than as shareholders in the
matters to be decided. In addition, there should be no conflict of interests arising from
remuneration committee members and executive directors holding directorships in common in
other companies. Within Hammond, there is a requirement to first, appoint NEDs and then
ensure that the remuneration committee is comprised of these individuals. The current system
of the directors deciding on their own salary is clearly inappropriate; there is no independent
check on whether the salary levels are appropriate for the level of experience of the directors
or their salary compared to other similar companies.
Functioning of remuneration committee
The UK Corporate Governance Code states that remuneration should be set having regard to
market forces, and the packages required to 'attract, retain and motivate' the desired
calibre of director. The committee should pay particular attention to the setting of
performance-related elements of remuneration. Within Hammond, the vast majority of
remuneration is based on salary; there is little element of performance-related pay.
Governance guidelines indicate that remuneration should be balanced between basic salary
and bonuses. Hammond's remuneration committee need to increase the bonus element of
remuneration to focus directors more onto improving the performance of the company.
Conditions for receipt of performance related remuneration however should be designed to
promote the long-term success of the company. Consideration should be given to the
possibility of reclaiming variable components in exceptional circumstances of misstatement or
misconduct.
Reporting of remuneration committee
A report from the committee should form part of the annual accounts. The report should set
out company policy on remuneration and give details of the packages for individual
directors. The chairman of the committee should be available to answer questions at the
annual general meeting, and the committee should consider whether shareholder approval
is required of the company's remuneration policy. The remuneration committee will then
ensure that disclosure is correct.
Information requirements
In order to assess executive directors' pay on a reasonable basis, the following information will
be required.
(i) Remuneration packages given by similar organisations
The problem with using this data is that it may lead to upward pressure on
remuneration, as the remuneration committee may feel forced to pay what is paid
elsewhere to avoid losing directors to competitors.
(ii) Market levels of remuneration
This will particularly apply for certain industries, and certain knowledge and skills.
More generally the committee will need an awareness of what is considered a minimum
competitive salary.
(iii) Individual performance
The committee's knowledge and experience of the company will be useful here.
(iv) Organisation performance
This may include information about the performance of the operations which the
director controls, or more general company performance information such as
earnings per share or share price.

(b) Main concerns of board
The board's principal concern is with controls that can be classified as organisation or
management.
Organisation controls
Organisation controls are designed to ensure everyone is aware of their responsibilities,
and provide a framework within which lower level controls can operate. Key organisation
controls include the following.
(i) Structure
The board should establish an appropriate structure for the organisation and delegate
appropriate levels of authority to different grades.
(ii) Internal accounting system
The board should ensure that the system is providing accurate and relevant
information on a regular basis. Good quality information will enable the board to assess
whether targets are being met or losses are possible.
(iii) Communication
Communication of organisation policies and values through manuals and other
guidance to staff is essential. It is not clear from the scenario whether Hammond actually
have any of these controls in place; however, from the relatively informal basis in which
the company has been run, it is unlikely that detailed controls have been implemented.
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.


(a) Benefits of the Corporate Governance Guidelines
Shareholders
Of key importance to the shareholders are the suggestions that the Corporate Governance
Guidelines makes in respect of CG compliance audit and annual general meeting. In the past,
particularly for large listed companies, AGMs have sometimes been forbidding and unhelpful to
shareholders. The result has been poor attendance and low voting on resolutions.
(The UK Corporate Governance Code requires that separate resolutions are made for identifiably
different items which should assist shareholders in understanding the proposals laid before the
meeting. It also requires that director members of various important board committees (such as
the remuneration committee) be available at AGMs to answer shareholders' questions.)
Internal controls
Another important area for shareholders is the emphasis placed on directors monitoring and
assessing internal controls in the business on a regular basis. While it is a statutory requirement
that directors safeguard the investment of the shareholders by instituting internal controls, this
additional emphasis on quality should increase shareholders' confidence in the business.
Independent Directors
The requirements of the Guidelines make the appointment and activities of independent directors
more responsible, accountable to the shareholders. They are asked to make disclosure (as audit
committee) in the financial statements about their responsibilities in relation to preparing financial
statements and going concern.
Audit committee
Lastly, some people would argue that the existence of an audit committee will lead to
shareholders having greater confidence in the reporting process of an entity.
Other users
The key advantage to other users is likely to lie in the increased emphasis on internal controls as
this will assist the company in operating smoothly and increasing visibility of operations, which will
be of benefit to customers, suppliers and employees.
(b) Voluntary guidelines
Adherence to the BSEC Corporate Governance Guidelines is not a statutory necessity, although it
is possible that in the future, such Guidelines might become part of company law.
Advantages
The key merit of the Guideline being voluntary for most companies is that it is flexible. Companies
can review the Guideline and make use of any aspects which would benefit their business.
If they adopt aspects of the Guideline, they can disclose to shareholders what is being done to
ensure good corporate governance, and what aspects of the Guidelines are not being followed,
with reasons.
This flexibility is important, for there will be a cost of implementing such a Code, and this cost
might outweigh the benefit for small or owner-managed businesses.

Disadvantages
Critics would argue that a voluntary code allows companies that should comply with the Code to
get away with non-compliance unchallenged.
They would also argue that the type of disclosure made to shareholders about degrees of
compliance could be confusing and misleading to shareholders and exacerbate the problems
that the Code is trying to guard against.

(1) The auditor would report the matter to those charged with governance (ISA 260/240).
(2) The auditor would report the matter to any other member of the board, for example the chief
executive or the chairman. Where there is doubt about the integrity of those charged with
governance as a whole the auditor will need to seek legal advice as to the appropriate course of
action. This may include reporting to third parties eg police or a regulatory authority (ISA 240).
(3) This would be reported to and discussed with those charged with governance (ISA 260). If the
disagreement is material and is not changed the auditors will also report to the shareholders via the
modified opinion in the audit report.
(4) The auditor should report suspicions of money laundering activities to the firm's Board of Partners/
or the ICAB Technical Department.
C
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CHAPTER 5
The statutory audit: planning

and risk assessment
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
Technical reference
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
• Show professional scepticism in assessing the risk of material misstatement, having

regard to the reliability of management
• 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

1 Overview of the audit process
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
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2 Audit planning E
R
Section overview
• You should be familiar with the basic planning process. 5
The statutory audit: planning and risk assessment 173

2.1 Introduction
Auditors are required to plan their work to ensure that attention is paid to the correct areas of the audit,
and the work is carried out in an effective manner.
In order to produce this plan the auditor must:
• Understand the business, its control environment, its control procedures and its accounting system
• Assess the risk of material misstatement
• 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.
Professional scepticism includes being alert to:
• Audit evidence that contradicts other audit evidence
• Information that brings into question the reliability of documents and responses to inquiries to be
used as audit evidence
• Conditions that may indicate possible fraud
• Circumstances that suggest the need for audit procedures in addition to those required by the ISAs

ISA 200 Overall Objectives of The Independent Auditor and Conduct of an Audit in Accordance with
International Standards on Auditing requires that the auditor 'shall plan and perform an audit with
professional scepticism recognising that circumstances may exist that cause the financial statements to
be materially misstated'. Maintaining professional scepticism throughout the audit reduces the risks of
overlooking unusual circumstances, over generalising when drawing conclusions and using
inappropriate assumptions in determining the nature, timing and extent of the audit procedures and
evaluating the results. ISA 200 also makes the following points:
• 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.
3.2 Importance of professional scepticism

The importance of professional scepticism cannot be overemphasised. An effective and compliant audit
cannot be carried out without it.
Given that it is fundamental that professional scepticism is applied for all audits of financial statements,
the audit engagement partners of audit firms must lead by example and firms should ensure that
professional scepticism is given the degree of prominence it warrants during the training of audit staff.
Following the global financial crisis in 2008 and 2009 a common theme in a number of regulator reports
was that professional scepticism could have been more clearly demonstrated by auditors when looking
at a number of audit areas. It continues to be at the top of the agenda for regulators and standard
setters. In the FRC's annual report for 2012/2013, the importance of embedding the exercise of
professional scepticism in the culture of audit firms, and in audit work, is highlighted as key to improving
audit quality.
This section deals with the theoretical background of professional scepticism and the use of professional
scepticism in an audit planning context. We will look at professional scepticism again in the more
practical context of audit fieldwork in Chapter 6.
3.3 Briefing paper

In March 2012 APB (now FRC) issued a briefing paper, Professional Scepticism: Establishing a
Common Understanding and Reaffirming its Central Role in Delivering Audit Quality. This document is
unusual in comparison to other briefing papers as it is discursive in style and draws analogies from a
diverse group of areas. This approach has been adopted to encourage international debate on this
issue. The document is in seven sections. These are summarised below. C
H
3.3.1 Section 1 Introduction A
P
This aims to put the document into context. It states that the purpose of the document is to set out the
T
APB's considered views on the nature of auditor scepticism and its role in the audit, given the
E
significance of scepticism to the quality of individual audits.
R
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:

• The essence of scepticism is doubt and doubt stimulates informed challenge and inquiry. The
sceptics' doubt stimulated them to challenge conventional wisdom and inquire after a better
understanding of the nature of knowledge.
• 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.
3.3.3 Section 3 Scientific scepticism and the scientific method

This section seeks to provide insight into the mindset required to develop the audit strategy and plan and
to evaluate the audit evidence obtained by demonstrating how science has developed a sceptical
approach that now commands respect. It states that scientists are required to:
• 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
• Transparency and repeatability suggest the importance of documentation in underpinning

transparency and repeatability of the audit work to internal reviewers and to external inspectors.
3.3.4 Section 4 The origins of the modern audit

Section 4 seeks to provide further insight into the mindset of the auditor by considering the nature of the
agency relationships, and the resultant need for assurance that gave rise to early auditing traditions from
the 14th Century onwards. The origins of the modern audit can be seen in the tradition of auditing
household servants in manorial estates. This was then built on by the Joint Stock Companies Act of
1844 which included a default provision for auditors to be appointed.
Historically, the audit was essentially a check, carried out on behalf of a principal by their trusted
associate or agent, on the fidelity of the other agents to whom the principal's resources were entrusted.
The trust that existed between principal and auditor was a critical ingredient. The strong bond between
the principal and the auditor and the principal's need for assurance about the fidelity of those to whom
they had entrusted their assets would have determined the mindset of the auditor. That would have
guided the appropriate degree of scepticism in the auditor when questioning those entrusted with the
principal's assets.
This issue of fidelity remains an issue today, however the development and increased complexity of
business activity, the increased size and reach of businesses combined with the technological advances

mean that there are many other areas in relation to which shareholders (and other users) seek
information and reassurance. This suggests that whilst the sceptical mindset is a constant, the degree of
action taken by a sceptical auditor is a 'sliding scale', responsive to both the expectations of
shareholders (and other stakeholders) and to what emerges as the audit proceeds.
The paper also states that scepticism should embed the perspective of shareholders and other
stakeholders in the making of all audit judgements. Because of this the APB believes that when
undertaking a modern audit the following factors accentuate the need for the auditor to be especially
vigilant and aware of his or her responsibilities for the exercise of professional scepticism:
• 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.
3.3.5 Section 5 Conclusions about professional scepticism in the audit

Section 5 sets out the APB's conclusions from the foregoing analysis as to what a sceptical audit looks
like and suggests that professional scepticism is the cornerstone of audit quality. In particular it states
that in an appropriately sceptical audit:
• 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 approaches and documents audit judgements and audit review processes in a manner
that facilitates challenge and demonstrates the rigour of that challenge.
• 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
• Develop a good understanding of the entity and its business
• Have a questioning mind and are willing to challenge management assertions
• Assess critically the information and explanations obtained in the course of their work and
corroborate them
• Seek to understand management motivations for possible misstatements of the financial

statements
• 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
• Have good business knowledge and experience
• 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
• The culture within the firm emphasises the importance of

– Understanding and pursuing the perspective of the shareholders

– Coaching less experienced staff to foster appropriate scepticism
– Sharing experiences/consultation with others about difficult audit judgements
– Supporting audit partners when they need to take and communicate difficult audit judgements
• 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.
4 Understanding the entity
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
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Source: ICAEW Audit and Assurance Faculty: Auditing standards – All Change: a short guide to
selected International Standards on Auditing
You will have studied the financial statement assertions in your earlier studies and you will find a more
detailed recap in Chapter 6.
ISA 315 sets out various methods by which the auditors may obtain this understanding:
• Inquiries of management and others within the entity

• Analytical procedures
• Observation and inspection
• Audit team discussion of the susceptibility of the financial statements to material misstatement
• Prior period knowledge (subject to certain requirements)
The auditors must use a combination of the top three techniques, and must engage in discussion for
every audit. The auditor may use his prior period knowledge, but must carry out procedures to ensure
that there have not been changes in the year meaning that it is no longer valid.
The ISA sets out a number of areas of the entity and its environment that the auditor should gain an
understanding of. These are summarised as follows:
• Industry, regulatory and other external factors

• Nature of the entity
• The entity's selection and application of accounting policies, including reasons for any changes
• Objectives, strategies and related business risks
• Measurement and review of the company's performance
• Internal control relevant to the audit
The purpose of obtaining the understanding is to assess the risks of material misstatement in
the financial statements for the current audit. The ISA says that 'the auditor shall identify and
assess the risks of material misstatement at the financial statement level, and at the assertion level
for classes of transactions, account balances and disclosures'. It requires the auditor to take the
following steps:

Step 1
Identify risks throughout the process of obtaining an understanding of the entity
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.
Worked example: Ockey Ltd

The audit team at Ockey Ltd has been carrying out procedures to obtain an understanding of the
entity. In the course of making inquiries about the inventory system, they have discovered that
Ockey Ltd designs and produces tableware to order for a number of high street stores. It also
makes a number of standard lines of tableware, which it sells to wholesalers. By the terms of its
contracts with the high street stores, it is not entitled to sell unsold inventory designed for them to
wholesalers. Ockey Ltd regularly produces 10% more than the high street stores have ordered, in
order to ensure that they meet requirements when the stores do their quality control check. Certain
stores have more stringent control requirements than others and regularly reject some of the
inventory.
The knowledge above suggests two risks, one that the company may have obsolescent inventory, and
another that if their production quality standards are insufficiently high, they could run the risk of losing
custom.
We shall look at each of these risks in turn and relate them to the assertion level.
Inventory
If certain items of the inventory are obsolescent due to the fact that it has been produced in excess of
the customer's requirement and there is no other available market for the inventory, then there is a risk
that inventory as a whole in the financial statements will not be carried at the appropriate value. Given
that inventory is likely to be a material balance in the statement of financial position of a manufacturing
company, and the value could be up to 10% of the total value, this has the capacity to be a material
misstatement.
The factors that will contribute to the likelihood of these risks causing a misstatement are matters such
as: C
H
• Whether management regularly review inventory levels and scrap items that are obsolescent
A
• Whether such items are identified and scrapped at the inventory count
P
• Whether such items can be put back into production and changed so that they are saleable
T
Losing custom E
R
The long term risk of losing custom is a risk that in the future the company will not be able to
operate (a going concern risk). It could have an impact on the financial statements, if sales were
attributed to them that they dispute, revenue and receivables could be overstated, that is, not
carried at the correct value. However, it appears less likely that this would be a material problem in 5
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.

Again, review of the company's controls over the recording of sales and the debt collection
procedures of the company would indicate how likely these risks to the financial statements are to
materialise.
Some risks identified may be significant risks (indicated by the following factors), in which case they
present special audit considerations for the auditors.
• 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 Industries and processes

During the initial planning phase, the audit firm will need to obtain information about the specific nature
of the entity being audited and the different business processes within the entity itself.
4.2.1 Industry
The type of entity being audited will have a significant impact on the audit plan. For example:
Service Industry Manufacturing Industry
Little or no inventory Complex costing systems to allocate costs to

inventory and work in progress
Focus on salaried employees Many production staff based paid on hours worked
including various overtime and incentive schemes
Payment by commission May have payment by piece rates

Sales dependent on services provided Sales dependent on products sold
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.

4.2.2 Business processes
From the comments above, it is possible to identify the different business processes that the auditor will
need to focus on. The five main processes are summarised in the diagram below.
An understanding of each process focuses the auditor's attention on specific parts of the business.
Process Audit focus
Financing Verification of new share issues / confirming current account and loan balances
and where necessary bank support for the business.
Purchasing Audit of the purchases transaction cycle and payables balance.
Human resources Audit of wages and salaries including bonuses linked to production or
commission on sales.
Inventory Audit of work-in-progress systems including year-end inventory valuation and

management identification of inventory below cost price.
Revenue Audit of sales transaction cycle and receivables balance.
The actual audit approach will depend partly on the audit methodology used.
5 Business risk model
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
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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
Business risks can be classified into three categories:
• Financial risks
• Operating risks

• Compliance 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
5.2 Business risk management

Most working environments now have some form of risk management system. In Chapter 4 we
discussed the Corporate Governance Code and the Turnbull guidelines that highlight its importance.
Typically the process of risk management for the business is as follows:
• 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.
5.3 Audit methodology: business risk model

5.3.1 Principle behind the model
ISA 315 requires that auditors consider the entity's process for assessing its own business risks,
and the impact that this might have on the audit in terms of material misstatements. Auditors consider:

• What factors lead to the problems which may cause material misstatements
• What can the audit contribute to the business pursuing its goals
C
H
A
P
T
E
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The business risk audit approach tries to mirror the risk management steps that have been taken by the
directors. In this way, the auditor will seek to establish that the financial statement objectives have been
met, through an investigation into whether all the other business objectives have been met by the
directors.
The application of the business risk model (BRM) is therefore related to the client's:
• 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.
Principal risk Immediate Financial Statement implications
Economic pressures causing reduced unit sales Inventory values (IAS 2)

and eroding margins
Going concern
Economic pressures resulting in demands for Receivables recoverability

extended credit
Product quality issues related to inadequate Inventory values – net realisable value and
control over supply chain and transportation inventory returns
damage
Customer dissatisfaction related to inability to Going concern

meet order requirements
Customer dissatisfaction related to invoicing errors Receivables valuation

and transportation damage
Unacceptable service response call rate related to Going concern

poor product quality
Litigation – provisions and contingencies
Inventories – net realisable value
Out of date IT systems affecting management's Anywhere

ability to make informed decisions
Extensive use of freelance and contract labour Employees' NI (May be understated if

resulting in issues regarding their employment freelancers/contract workers are deemed to be
status employees)
Fines – provisions and contingencies

Interactive question 1: Financial risk [Difficulty level: Intermediate]
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
5.3.2 Impact on audit procedures

This can be summarised as follows:
Audit procedure Effect of business risk model
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.
Interactive question 2: Audit procedures [Difficulty level: Intermediate]
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
E
R
Interactive question 3: Identifying business risks [Difficulty level: Exam standard]
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

and the trend towards computer games. KidsStuff Ltd does not have a strong market presence in this
area but this is currently being addressed by Joseph's son, Neil, who is confident that performance has
improved.
You have received the following email from the engagement partner.
From Allan Partner
To Audrey Senior
Subject KidsStuff Ltd
I know you are about to start work on your planning of this audit. Can you make sure that you specifically
identify the business risks faced by KidsStuff Ltd and set out the effect of those on the audit. Can you
also make a list of the further information you need in order to plan the audit so that I can request it from
the directors.
Requirement
Respond to the engagement partner's email.
6 Audit risk model
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:
Audit Risk = Inherent Risk × Control Risk × Detection Risk
• 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.
6.1 Audit risk
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:
• Could occur in an assertion about a class of transaction, account balance or disclosure

• Could be material, either individually or when aggregated with other misstatements and
• Will not be prevented, or detected and corrected on a timely basis, by the entity's internal control.

Detection risk: is the risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements.
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.
6.2 Audit methodology: the audit risk model

The audit risk model (ARM) expresses the relationship between the different components of risk as
follows:
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:
Example Audit risk Inherent risk Control risk Detection risk
1 Acceptable High High Low

2 Acceptable Low High Moderate
3 Acceptable High Low Moderate
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
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6.2.1 The risk assessment process
This can be summarised as follows:
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:
Business risk 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
6.2.2 Inherent risk

As we saw in Section 6.1 the risk of material misstatement is made up of:
• Inherent risk

• Control risk
Inherent risk is the risk that items will be misstated due to characteristics of those items, such as the
fact they are estimates or that they are important items in the accounts. The auditors must use their
professional judgement and the understanding of the entity they have gained to assess inherent risk. If
no such information or knowledge is available then the inherent risk is high.
Factors affecting client as a whole
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
Unusual pressures on management Examples include tight reporting deadlines, or market

or financing expectations
Nature of business Potential problems include technological

obsolescence or over-dependence on single product
Industry factors Competitive conditions, regulatory requirements,

technology developments, changes in customer
demand
Information technology Problems include lack of supporting documentation,

concentration of expertise in a few people, potential
for unauthorised access
Factors affecting individual account balances or transactions
Financial statement accounts prone to Accounts which require adjustment in previous

misstatement period or require high degree of estimation
Complex accounts Accounts which require expert valuations or are
subjects of current professional discussion
Assets at risk of being lost or stolen Cash, inventory, portable non-current assets
(computers)
Quality of accounting systems Strength of individual departments (sales, purchases,

cash etc)
High volume transactions Accounting system may have problems coping
Unusual transactions Transactions for large amounts, with unusual names,

not settled promptly (particularly important if they
occur at period-end)
Transactions that do not go through the system, that C
relate to specific clients or processed by certain H

individuals A
P
Staff Staff changes or areas of low morale T
E
Interactive question 4: Inherent risks from financial reporting policies R
[Difficulty level: Exam standard]
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)

500 'free' texts per month (for 12 months)
Any unused call minutes or texts may be carried forward to the following month.
The fair value of this package is estimated to be CU500.
Requirement
Identify the risks associated with the treatment of revenue in relation to this package in the financial
statements of Fonesforall.
See Answer at the end of the chapter.
6.2.3 Control risk

Control risk is the risk that client controls fail to detect material misstatements. A preliminary
assessment of control risk at the planning stage of the audit is required to determine the level of
controls and substantive testing to be carried out.
In this respect, a key initial audit question is 'how does management control the business?' An
understanding of this issue is a key element in an initial assessment of control risk.
Substantive and reliance strategies
For an ongoing client, the auditor will already have significant information on file regarding the control
systems at the audit client. The audit strategy will therefore focus on updating this control information.
For a new client, a judgement on audit strategy will normally be deferred until after a more detailed
understanding of internal control is obtained. For the new client, the auditor will obtain information on
the control systems and then perform an initial testing of those controls to determine whether or not
they are working correctly. Where these risk assessment procedures indicate that controls are not
working correctly, then it is unlikely that the auditor will place reliance on those controls, as CR will be
set to maximum. Substantive procedures will be used instead. However, if the risk assessment
procedures indicate that controls are working correctly, then some reliance will be placed on internal
controls. CR may be set only as either 'high' or 'low' in an all or nothing approach, as previously noted.
Alternatively, there may be a possibility of setting control risk to an intermediate amount(s) within some
firms' audit methodologies.
So, providing an initial determination of the nature, timing and extent of audit procedures, two possible
audit strategies are normally identified:
• Substantive strategy – focusing on substantive testing (ie tests of details and analytical
procedures); and
• Reliance strategy – focusing on tests of controls and reliance from inherent assurance.
Points to note:
(1) There will not be one strategy for the entire audit. Each business process or specific audit assertion
will be allocated its own strategy. Similarly, each audit assertion may be allocated a different “mix”
of reliance and substantive strategy.
(2) Auditing standards do require some substantive testing for each material class of transactions,
account balances and disclosure, so the audit strategy for any one assertion will never be
completely a reliance strategy.
(3) It is possible, however (but unusual) that substantive testing may comprise entirely of analytical
procedures, without any tests of details being carried out.
An auditor is more likely to follow a reliance strategy where:
• 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.

An auditor is more likely to follow a substantive strategy where:
• There are no controls available for a specific audit assertion.

• The controls are assessed as ineffective.
• It is inefficient to test the effectiveness of the controls.
• The test is for overstatement.
Whichever strategy is chosen, the auditor will document the reasons for choosing that strategy and then
perform detailed auditing procedures in accordance with that strategy.
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

internal audit department. This in turn affects the opinion on how well the internal control systems will be
implemented and operated.
Control risk will also increase where specific events occur within an organisation. Events that tend to
increase control risk include:
• Use of new technology

• New or substantially amended information systems
• Hiring of new personnel, especially into key management roles
• Changes to the regulatory or operating environment
• Significant growth in the organisation
• Restructuring of the company or group
• Expansion of overseas operations
Control activities
Having assessed the control environment, the auditor will then identify and assess the control activities
carried out by management. Control activities in this context are the policies and procedures that help
ensure management's directives are carried out.
Control activities that the auditor will investigate include:
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).
Segregation Segregation of the authorisation of transactions, recording of transactions and custody

of duties of any related assets. For example, employees receiving cash should not be
responsible for recording that cash in the receivables' ledger – teeming and lading
could occur.
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.
• Application controls – over the processing of individual transactions again ensuring

the completeness and accuracy of recording.
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:
Assertion Explanation Typical control activities

Assertion Explanation Typical control activities
Occurrence Transactions and events that have • Segregation of duties

been recorded have occurred and
• Daily/monthly reconciliation of
pertain to the entity
subsidiary records with an independent
review
• Prenumbering of documents (with

completeness of numbering confirmed)
Completeness All transactions and events that • Segregation of duties

should have been recorded have been
• Prenumbering of documents (with
recorded
completeness of numbering confirmed)
• Daily/monthly reconciliation of
subsidiary records with an independent
review
Authorisation All transactions and events are • Authorisation of transactions at

properly authorised important control points
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
• Internal verification of the accuracy of

posting
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.
6.2.4 Detection risk

Detection risk is the risk that audit procedures will fail to detect material errors. Detection risk relates to C
the inability of the auditors to examine all evidence. Audit evidence is usually persuasive rather than H
conclusive so some detection risk is usually present, allowing the auditors to seek 'reasonable A
confidence'. P
T
The auditor's inherent and control risk assessments influence the nature, timing and extent of
E
substantive procedures required to reduce detection risk and thereby audit risk.
R
Interactive question 5: Audit risk [Difficulty level: Intermediate]
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.

The management structure at Forsythia is simple. Of the three non-corporate shareholders, only Mr
Rose has any involvement in management. He runs the day to day operations of the company
(marketing, sales, purchasing etc) although the company employs two landscape gardeners to actually
carry out projects. The accounts department employs a purchase clerk and a sales clerk, who deal with
all aspects of their function. The sales clerk is Mr Rose's daughter, Justine. Mr Rose authorises and
produces the payroll. The company ledgers are kept on Mr Rose's personal computer. Two weeks after
the year end, the sales ledger records were severely damaged by a virus. Justine has a single print out
of the balances as at year end, which shows the total owed by each customer.
Forsythia owns the equipment which the gardeners use and they pay them a salary and a bonus based
on performance. Mr Rose is remunerated entirely on a commission basis relating to sales and, as a
shareholder he receives dividends annually, which are substantial.
Forsythia does not carry any inventories. When materials are required for a project, they are purchased
on behalf of the client and charged directly to them. Most customers pay within the 60-day credit period,
or take up the extended credit period which Forsythia offer. However, there are a number of accounts
that appear to have been outstanding for a significant period.
Justine and her father do not appear to have a very good working relationship. She does not live at
home and her salary is not significant. However, she appears to have recently purchased a sports car,
which is not a company car.
The audit partner has recently accepted the audit of Forsythia as a new client. You have been assigned
the task of planning the first audit.
Requirement
Identify and explain the audit risks arising from the above scenario.
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 occurrence of creative accounting depends on both incentives and opportunity.
• The consequences of creative accounting depend upon a range of factors that change over time
but are specific to individual companies.
• Creative accounting can be overt (disclosed) or covert (not disclosed).
• 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)

and incentives (eg approaching the breach of a debt covenant, an impending takeover, profit-
based bonus) to do so.
Creative accounting is covered from a Financial Reporting perspective in Chapter 24.
7.2 The nature of creative accounting
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).
• Exercise of a degree of estimation, judgement or prediction by a company within reasonable

bounds (eg non-current asset lives).
• 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.
• Setting up of artificial transactions to create circumstances where material accounting

misrepresentation can take place.
• 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:
• Deferring discretionary expenditure (eg maintenance costs, R&D) 5

• Changing the timing of the sale of investments or other assets
• Delaying investment or financing decisions.

7.3 Causes of creative accounting – opportunity
The causes of creative accounting have two key elements:
(i) Opportunity
(ii) Incentives
Where these two elements both exist then the risks of creative accounting taking place are greatest.
This section looks at opportunity. The following section looks at incentives.
It is important for the auditor to be aware of the causes of creative accounting in order to highlight the
circumstances, where there is the greatest risk or incentives for creative accounting to take place.
The causes of opportunity for creative accounting include the following:
• 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.
• Inadequate corporate governance – inadequate or inappropriate controls over directors may

permit greater discretion.
• 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.
7.4 Causes of creative accounting – incentives

The following have been put forward as incentives for companies/managers engaging in creative
accounting:
• 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

incentive schemes and share option schemes that require a given EPS before they become
operative. Directors may also benefit more indirectly from creative accounting by increasing the
security of their position.
• 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.
7.5 The consequences of creative accounting

It is important for the auditor to understand the consequences of creative accounting as:
• 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.)
• It enhances the understanding of whether the practice is material ie whether it would

reasonably influence decisions made.
• It enables an understanding of the continued impact of a particular creative accounting

practice in future years' financial statements and whether the impact will be sustainable year on
year.
The consequences of creative accounting depend crucially upon whether or not it is disclosed.
Overt creative accounting refers to practices, which may change reported profits or the statement of
financial position, but that are disclosed externally to financial statements users. Examples may
C
include:
H
• Not depreciating non-current assets A
• Capitalising development costs P
• Significant provisioning T
• Changing depreciation policy E
R
Covert creative accounting refers to practices that are used to enhance profitability or asset values but
are not disclosed. Examples might be:
• The timing of revenue recognition on complex long-term transactions 5

• The treatment of overhead allocations
• Many decisions to capitalise or expense cash outlays

As a result, such covert practices are not readily identifiable by outside users, who are thus unable, in
some cases, to distinguish increases in reported earnings arising as a result of accounting manipulation,
from those arising from improvements in substantive underlying transactions. The potential
consequences of covert creative accounting (eg for share price movements) are therefore likely to be
more substantial than for overt 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:
• Income smoothing – assuming it is smoothed at a normal level of profitability it may be sustained

indefinitely
• Off balance sheet financing

Unsustainable practices 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.
7.7 Some specific consequences

Share price effects
Where creative accounting practices are disclosed then one would expect that, in a semi strong efficient
market, investors would see through the manipulation and correctly price shares, with creative
accounting having little effect. However:
• The market may not always be efficient
• Accounting-based contracts may be affected
• 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).
7.8 Red flags and detection

The best detection techniques for creative accounting are a good knowledge of financial reporting
regulations and a good understanding of the business. There may, however, be more general

techniques and indicators that can suggest that a company is engaging in creative accounting practice.
These include:
• 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.
• Accounting policies – Consider if there is the minimum disclosure required by regulation,

changes in accounting policies, examine areas of judgement and discretion. Consider risk areas of
off-balance sheet refinancing, revenue recognition, capitalisation of expenses, significant
accounting estimates.
• Changes of accounting policies and estimates – Is the nature, effect and purpose of these
changes adequately explained and disclosed?
• Management – Estimations proved unreliable in the past, minimal explanations provided.
• 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.
• Incentives – Management rewarded on reported earnings, profit-orientated culture exists, other

reporting pressures eg a takeover.
• 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.
7.9 Examples of creative accounting techniques

C
A number of examples of creative accounting have been given above and throughout these learning
H
materials in the context of their application. The following list draws some of these together and provides
A
further examples under key headings. The list is not meant to be comprehensive.
P
T
7.9.1 Timing of operating expenses E
• Under provisioning in poor years R
• Over provisioning in good years
• Manipulation of reserves
• Aggressive capitalisation of costs 5
• Optimistic asset lives

• Accelerating expenses in good years
• Increased write downs and write offs in good years

• Exceptional gains timed to off-set exceptional losses
7.9.2 Revenue recognition

• Premature recognition of revenues
• Recording out-of period revenue
• Recognition of revenue of service contracts prior to the service being performed
• Recognition of sales prior to physical movement of goods
• Front-end recognition of sales that should be spread over more than one accounting period
• Percentage of completion estimates in construction industry
• Cut-off misapplied.
7.9.3 Off-balance sheet financing

In some circumstances transactions may be structured in order to allow a particular accounting
treatment (eg making a finance lease appear to be an operating lease) rather than presenting the fairest
view. This is one of the primary reasons for the large quantity of disclosure standards (as against
measurement standards) in previous years.
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.
8.1 Revision of materiality
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

loss. The difference between a small profit and a small loss could be material to
some readers.
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
8.2 Applying materiality

The application of materiality to an audit can be summarised in three key steps:
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.
8.2.1 Preliminary judgement

Materiality considerations during audit planning are extremely important. The assessment of materiality
at this stage should be based on the most recent and reliable financial information and will help to C
determine an effective and efficient audit approach. Materiality assessment will help the auditors to: H
A
• Determine the amount of audit work necessary to facilitate audit efficiency and effectiveness
P
• Put audit risk in context T
• Decide whether to use sampling techniques E
• Determine the applicability of accounting standards which normally apply only to material items R
• Evaluate uncorrected misstatements during the audit
• Evaluate what level of error is likely to lead to a modified audit opinion
In specifying materiality, an auditor should establish a benchmark (or benchmarks) to which a 5
percentage factor is applied. Factors that may affect the identification of an appropriate benchmark
include the following:
• The elements of the financial statements

• Items on which the attention of the users tends to be focused
• The nature of the entity, where it is in its life cycle and the industry and economic environment in
which it operates
• The entity's ownership structure and the way it is financed
• The relative volatility of the benchmark
The following benchmarks are typically used:
Benchmark Threshold
Total revenue 0.5% – 1%
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:
• Whether it is a first-year engagement

• Deficiencies in controls
• Material misstatements in prior years
• Risk of fraud
• Significant management turnover
• Unusually high market pressures
• Sensitivity of covenants in loan agreements to changes in the financial statements
• Effect of changes in results on earnings trends
8.2.2 Performance materiality

The preliminary assessment of materiality as referred to above is in the context of the financial
statements as a whole but if the audit procedures are planned solely to detect individually material
misstatements this would:
• Overlook the fact that the aggregate of individually immaterial misstatements could cause the
financial statements to be materially misstated, and
• Leave no margin for possible undetected misstatements.

Further materiality levels must therefore be set before audit procedures are designed and performed.
The requirement to do so was introduced into ISA 320 as part of the IAASB's Clarity Project, and these
lower materiality levels are referred to as performance materiality. Seen as a 'working level of
materiality,' performance materiality is a concept that most experienced auditors would have applied
throughout their careers.
The auditor must set an amount or amounts at less than the materiality for the financial statements as a
whole and this is known as performance materiality. This could be set in two ways:
• 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.

The following example illustrates, in a simplistic way, the role of performance materiality in an audit.
Worked example: Performance materiality

The auditor of Company A has set materiality for the financial statements as a whole at $100,000.
During the audit, the following misstatements were identified:
1. Misclassification of abortive research and development expenses as an intangible asset of
$41,000. This is the only intangible asset on the statement of financial position.
2. Overstatement of non-current assets by $50,000 due to cut-off errors.
3. Overstatement of receivables by $29,000 representing the unpaid balance from a customer which
has been liquidated during the period.
Considering the misstatements purely individually, the auditor may ignore the misstatements above. This
would give rise to an aggregate of uncorrected misstatements of $120,000 – exceeding materiality for
the financial statements as a whole.
In addition, the uncorrected misstatement (1) could have misled the users of the financial statements,
whose attention would have been drawn to the company's new, and only, intangible assets.
The auditor would avoid the risk of giving an inappropriate audit opinion by applying performance
materiality:
1. Set a general performance materiality at $50,000 to reduce the probability that the aggregate of
uncorrected misstatements would exceed materiality for the financial statements as a whole: This
would identify misstatement (2) as requiring adjustment.
2. Set performance materiality specific to intangible assets at $40,000 to reflect the specific risks
associated with this account: This would identify misstatement (1) as requiring adjustment.
3. Now, provided management agrees to correct misstatements (1) and (2), the only adjustment
which remains uncorrected is misstatement (3). At $29,000, this is now less than 30% of materiality
for the financial statements as a whole.
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

example of how the concept of performance materiality is applied to sampling (points (b) and (c)
above).
What constitutes sufficient audit evidence, and the different audit procedures, are covered in further
detail in Chapter 6. However, you should already be familiar with these topics from your earlier studies.
8.2.3 Estimation of likely misstatements

Towards the end of the audit, the auditor will aggregate the misstatements from each account balance,
class of transaction or disclosure (including both known and likely misstatements) and compare this with
the preliminary assessment of materiality. Where additional information has come to light the preliminary
assessment of materiality may need to be revised. If this is the case, the circumstances should be
adequately documented. Comparison of the aggregated misstatements and materiality will determine
whether the financial statements require adjustment.
Like materiality for the financial statements as a whole, performance materiality is linked to audit risk.
Where the audit risk has been revised during an audit, and the materiality level for the financial
statements as a whole has been reduced, the auditor must consider whether performance materiality
also needs to be revised. This may affect the nature, timing and extent of further audit procedures.
8.3 Problems with materiality

As discussed above, materiality is a matter of judgement for the auditor. Therefore, prescriptive rules will
not always be helpful when assessing materiality. A significant risk of prescriptive rules is that a
significant matter, which falls outside the boundaries of the rules, could be overlooked, leading to a
material misstatement in the financial statements.
The percentage guidelines of assets and profits that are commonly used for materiality (eg those
referred to in Section 8.2.1) must be handled with care. The auditor must bear in mind the focus of the
company being audited.
In some companies, post tax profit is the key figure in the financial statements, as the level of dividend
is the most important factor in the accounts.
In owner managed businesses, if owners are paid a salary and are indifferent to dividends, the key
profit figure stands higher in the statement of profit or loss and other comprehensive income, say at
gross profit level. Alternatively in this situation, the auditor should consider a figure that does not
appear on the statement of profit or loss and other comprehensive income: profit before directors'
salaries and benefits.
Some companies are driven by assets rather than the need for profits. In such examples, higher
materiality might need to be applied to assets. In some companies, say charities, costs are the driving
factor, and materiality might be considered in relation to these.
While rules or guidelines are helpful to auditors when assessing materiality, they must always keep in
mind the nature of the business they are dealing with. Materiality must be tailored to the business and
the anticipated user of financial statements, or it is not truly materiality.
Interactive question 6: Materiality (1) [Difficulty level: Easy]
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.

Interactive question 7: Materiality (2) [Difficulty level: Intermediate]
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:
Profit before tax = CU10,000 × 5% = CU500

Requirement
Comment on the suitability of the planning materiality figure.
9 Responding to assessed risks
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.
9.1 Overall responses

The auditor should determine overall responses to address the risks of material misstatement at the
financial statement level. This may include:
• 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

9.2 Audit procedures responsive to risks of material misstatement at the
assertion level
The auditor is required to design and perform procedures which will address the risks identified. The ISA
emphasises the link between further audit procedures and the risk assessment process. Factors
which the auditor will consider include:
• 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.
9.3 Evaluating the sufficiency and appropriateness of audit evidence

obtained
Based on the audit procedures performed and the evidence obtained, the auditor should conclude
whether sufficient, appropriate audit evidence has been obtained to reduce to an acceptably low
level the risk of material misstatement. While this will be considered by the auditor throughout the
audit it is of particular relevance at the review stage of the audit. We will consider this in more 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.
10 Other audit methodologies
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.
10.2 Systems audit

An auditor may predominantly test controls and systems, but substantive testing can never be
eliminated entirely. It is always used in conjunction with another approach.
You should be familiar with the systems and controls approach to auditing, from your previous studies.

Management are required to institute a system of controls which is capable of fulfilling their duty of
safeguarding the assets of the shareholders.
Auditors assess the system of controls put in place by the directors and ascertain whether they believe it
is effective enough for them to be able to rely on it for the purposes of their audit.
If they believe that the system is effective, they carry out tests of controls to ensure that the control
system operates as it is supposed to. If they believe that the control system is ineffective, they assess
control risk as high and undertake higher levels of substantive testing.
The key control objectives and procedures over the main cycles of sales, purchases and wages were
studied at length in your previous studies. If you do not feel confident in what they are, you should go
back to your learning materials in these areas and revise them now.
An auditor may choose predominantly to carry out substantive tests on the transactions and balances of
the business in the relevant period, but if internal control systems are particularly weak then no amount
of substantive testing may give adequate assurance (eg if point of sales controls over cash receipts are
inadequate, then substantive testing may never detect material understatement of revenues).
Two approaches to substantive testing are:
• The transaction cycle approach

• The balance sheet approach
10.3 Transaction cycle approach

Cycle testing is in some ways closely linked to systems testing, because it is based on the same
systems.
When auditors take a cycle approach, they test the transactions which have occurred, resulting in the
entries in the statement of profit or loss and other comprehensive income (for example, sales
transactions, inventory purchases, asset purchases, wages payments, other expenses).
They would select a sample of transactions and test that each transaction was valid and complete and
processed correctly throughout the cycle. In other words, they substantiate the transactions which
appear in the financial statements.
The key business cycles are outlined below. Remember that you know what the processes should be in the
cycle (you have assessed the system and controls previously). Under this approach, you are ensuring that
individual transactions were processed correctly. Hence, the cycles outlined below should correspond to the
controls processes you are already aware of.
C
H
A
P
T
E
R

Sales cycle
Purchases cycle

The auditor should be able to find an audit trail for each transaction, for example in the purchases cycle:
• Requisition
• Invoice
• Order
• Ledger and daybook entries
• GRN
• Payment in cashbook/cheque stub
10.4 Balance sheet approach

An alternative to the cycles (or transactions) approach to auditing is to take the balance sheet approach. This
is the most common approach to the substantive part of the audit, after controls have been tested.
The statement of financial position (balance sheet) shows a snapshot of the financial position of the business
at a point in time. It follows that if it is fairly stated and the previous snapshot was fairly stated then it is
reasonable to undertake lower level testing on the transactions which connect the two snapshots, for example,
analytical procedures.
Under this approach, therefore, the auditors seek to concentrate efforts on substantiating the closing position
in the year, shown in the statement of financial position, having determined that the closing position from the
previous year (also substantiated) has been correctly transferred to be the opening position in the current
year.
You should be aware of the financial statement assertions and the substantive tests in relation to the major
items on the statement of financial position from your previous studies. We will also review these in more
detail in Chapter 6.
10.4.1 Relationship with business risk approach

The substantive element of an audit undertaken under a business risk approach is restricted due to the high
use of analytical procedures. However, the element of substantive testing which remains in a business risk
approach can be undertaken under the balance sheet approach.
In some cases, particularly small companies, the business risks may be strongly connected to the fact that
management is concentrated in one person. Another feature of small companies may be that their statement
of financial position is uncomplicated and contains one or two material items, for example, receivables or
inventory.
When this is the case, it is often more cost-effective to undertake a highly substantive balance sheet
audit than to undertake a business risk assessment, as it is relatively simple to obtain the assurance
required about the financial statements from taking that approach.
10.4.2 Limitations of the balance sheet approach

When not undertaken in conjunction with a risk based approach or systems testing, the level of detailed
testing can be high in a balance sheet approach, rendering it costly.
11 Information technology and risk assessment
Section overview
• A huge number of organisations now use computer systems to run their businesses and to process
financial information. C
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• The main risks associated with using computerised systems include infection by viruses and access by
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unauthorised users. Both these risks could potentially have a very damaging effect on the business.
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• 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.
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• 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.
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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

Electric, and rapid advances in computer technology since then are allowing companies to conduct business
globally, making them indispensable and essential to an entity's operations.
However, the increasing use of computer systems brings with it certain risks to the business which can also
have an impact on the risk of the financial statements being misstated. These risks have increased with
the development of the Internet in the last few years and with it the facility for transactions to be conducted
electronically.
11.2 Risks associated with the use of computerised systems

The two key business risks of organisations using computerised systems are:
• The system being put at risk by a virus or some other fault or breakdown which spreads across the
system
• The system being invaded by an unauthorised user who could then
– Affect the smooth operation of the system
– Obtain commercially sensitive information

Worked example: RBS
In June 2012, a computer software error at The Royal Bank of Scotland (which also owns Natwest Bank)
resulted in the bank being unable to perform its overnight transaction run which processes the day's
transactions and updates customers' accounts. As a result, millions of bank customers were unable to carry
out transactions in or out of their accounts for several days. Branches had to be opened on a Sunday for the
first time in the bank's history to try to clear the backlog and to provide advice to customers.
11.3 Systems audit

As part of any audit, auditors are required to assess the quality and effectiveness of the accounting system.
Increasingly, this necessarily includes a consideration of the computer systems in place within the
organisation.
The following are the key areas they are likely to concentrate on to establish how reliable the systems are:
• Management policy
• Segregation of duties
• Security
You should be aware that these are important control considerations in a computer environment. The details
that the auditor will consider within each area are outlined below.
Management policy
• Does management have a written statement of policy with regard to computer systems?
• Is it compatible with management policy in other areas?
• Is it adhered to?
• Is it sufficient and effective?
• Is it updated when the systems are updated?
• Does it relate to the current system?
Segregation of duties
• Is there adequate segregation of duties with regard to data input?
• Are there adequate system controls (eg passwords) to enforce segregation of duties?
Security
• Is there a security policy in place:
– Physical security (locked doors/windows)
– Access security (passwords)
– Data security (virus shields)
• Is it adhered to?
• Is it sufficient and effective?
11.4 Internal controls in a computerised environment

ISA 315 specifically requires the auditor to gain an understanding of the entity's accounting systems and
control environment as part of the risk assessment process at the planning stage of the audit. Today, almost
any accounting system and control an auditor will encounter will involve some form of IT.
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The management policies, segregation of duties and security issues established by the organisation are
examples of the internal control activities in a computerised environment. There are two categories of internal H
controls: general controls and application controls. A
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General IT controls are the policies and procedures that relate to many IT applications at the same time.
They support application controls by maintaining the overall integrity of information and security of data. T
Examples include procedure manuals, password protection and backup facilities. E
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Application controls are manual or automated procedures that typically operate at a business process level
and apply to the processing of transactions by individual applications. They are designed to ensure the
integrity of the accounting records: that transactions occurred, are authorised, and are completely and
accurately recorded and processed. Examples include edit checks of input data, and numerical sequence 5
checks with manual follow up of exception reports.
You should already be familiar with these two types of controls from your earlier studies. We will look at them
in further detail in Chapter 7.

Summary

Self-test
1 Gates Ltd
You are an audit senior at Bob & Co and have received the following email.
From Roy Bob, Audit partner
To Jackie Smith, Audit senior
Subject Gates Ltd
We are about to take on the audit of Gates Ltd, a wholly-owned subsidiary of an American parent
company.
Gates Ltd produces computer software for the military for battlefield simulations. It also produces
'off-the-shelf' software products for other customers. I am concerned about the accounting issues
related to these products. Based on the following information, would you please identify and
comment on the accounting issues.
• 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.
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The board has asked the managing directors of each subsidiary to undertake a risk assessment
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exercise, including a review of the subsidiary's procedures and internal controls. This is partly due
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to a review of the company's compliance with the provisions of the BSEC Corporate Governance
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Guidelines (Internal control: Guidance to directors) and also because Suttoner has been severely
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affected by two recent events and now wishes to manage its future risk exposure.
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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.
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(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

significantly, many supermarkets refused to purchase goods from Suttoner for several months
thereafter.
As a result of these events the company's cash flow was severely disrupted, and significant
additional borrowing was needed.
The board's view
In guiding the risk assessment exercise, the board has set clear objectives for subsidiaries to
achieve: sales growth, profit growth and effective risk management. Additionally, the board wishes
to foster integrity and competence supported by enhancing human resource development.
The board requires managing directors of each subsidiary to report to them annually on these
objectives and on internal controls. Otherwise, they have considerable autonomy on pricing, capital
expenditure, marketing and human resource management. Bangladesh and Middle East
subsidiaries, which process raw foodstuffs, are free to choose their suppliers. The other three
subsidiaries may purchase only from Bangladesh or Middle East subsidiaries.
Over a number of years each subsidiary has been managed according to the nature and
experience of its managing director, and this has resulted in different styles and levels of control
being established locally.
Email from the head of internal audit
From Ben Jones
To Joe Lyons
Subject Risk assessment exercise
Joe
As you know, we are scheduled to update our risk assessment exercise. Can you please take the
following on board for me and produce something by Wednesday afternoon?
Firstly, I need you to identify, classify and comment on the key compliance, operating and financial
risks to which the company is exposed. On the back of this, can you then draft a note for the
finance director to send to the other directors, advising them as to the extent and the likelihood of
the three most significant risks identified. For each of these, can you identify appropriate risk
management procedures.
Finally, can you draft a note in accordance with the BSEC CG Guidelines (Internal control:
Guidance to directors) which we can put in our financial statements in relation to 'Control
environment and control activities'.
Cheers
Ben
Requirement
Respond to the email from Ben Jones.

Technical reference
1 ISA 210
• Agreement of terms of audit engagements ISA 210.9
ISA 210.10, A23–.25 &

– Principal contents of the engagement letter Appendix 1
2 ISA 300
• Preliminary engagement activities ISA 300.6
• Planning activities ISA 300.7–.11
• Documentation ISA 300.12
3 ISA 315
• Risk assessment procedures ISA 315.5–.10
• Understanding the entity and its environment ISA 315.11–.24
• Assessing the risks of material misstatement ISA 315.25–.29
• Financial statement assertions ISA 315.A111
4 ISA 320
• Definition of materiality ISA 320.2
• Relationship between materiality and planning ISA 320.10–.11
5 ISA 330
• Overall responses to risk assessment ISA 330.5
– Response at assertion level ISA 330.6–.7
– Evaluation of sufficiency and appropriateness of evidence ISA 330.25
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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.

2 Suttoner Ltd
Identification and classification of risks
Compliance risks
Health and safety regulations – risk of closure of plant and/or destruction of food if contamination arises
from purchasing, processing, storing or distribution activities.
Accounting regulations – need to comply with regulations in several different countries. May need to
restate for group accounting purposes to comply with IFRS if those countries have domestic GAAP that
differ from IFRS.
Taxation – Need to comply with tax regulations, particularly in respect of transfer pricing between
divisions in different countries.
Litigation risk – arising from the possibility of food poisoning. Risks include litigation against the company
by those individuals affected and for loss of reputation by supermarkets.
Operating risks
Loss of major customers – supermarkets may regularly renegotiate contracts and, in so doing, find
alternative suppliers. The loss of one such customer this year may be part of a trend.
Power of customers to reduce price – even where contracts with supermarkets are retained the
renegotiation may be on less favourable terms, resulting in a loss of profits.
Lack of goal congruence by divisional MDs – significant autonomy at divisional level may mean
reduced co-ordination and the pursuit of conflicting goals.
Geographically dispersed supply chain – given that processing is concentrated in only two centres,
there are significant distances involved in the supply chain. This may lead to risks of failure to supply on
time and significant low temperature transport and storage costs.
Perishable nature of inventory – the deterioration of perishable food may involve several risks
including inventory valuation, costs of inventory losses and unobserved perishing, which may lead to
further food poisoning and loss of reputation.
Measuring divisional performance (arbitrary transfer prices) – there is trade between divisions
arising from the supply of distribution divisions from processing divisions. As the companies are separate
subsidiaries there are implications for attesting the profit of individual companies, given the arbitrariness
of transfer prices. Moreover, the impact of transfer prices on taxation and their acceptance under
separate tax regimes creates additional risk in respect of the taxable profit of separate subsidiaries.
Control systems – the loss of inventory was greater due to the inability to trace the contamination to
specific inventories. This deficiency in inventory control systems magnifies any effects from
contamination risks of this type.
Generalised food scares – food scares which are not specific to the company but which arise from time
to time may create a reluctance by consumers to purchase some types of the company's product
portfolio.
Financial risks
Foreign exchange risk – This includes economic, transaction, and translation risk.
• Economic risk – refers to adverse movements in the exchange rate making goods less
competitive in overseas markets or making inputs relatively more expensive.
• Transaction risk – refers to the situation where in the period between contracting and settlement
adverse movements in the exchange rate make the contract less profitable. C
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• Translation risk – refers to the risk of the consolidated statement of financial position showing the
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assets of overseas subsidiaries at a reduced value due to adverse exchange rate movements.
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Borrowing – gearing risk/liquidity – increased financial gearing due to the additional borrowing in the T
year will make future earnings more volatile.
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Going concern problems if further contamination scares occur – the loss of business due to the R
contamination of one of the company's products meant that additional borrowing was needed: this may
create questions of going concern if a further incident arises.
Control of financial resources at divisional level – the fact that divisional MDs have significant 5
autonomy has meant that different styles and methods of control have been used. This may be a cause
for concern about potential variations in control.
BRIEFING NOTES
To Finance director

Prepared by Internal auditor
Date 6 November 20X1
Subject Extent and likelihood of three key risks
Food scare
Low probability – if appropriate controls are put in place over food quality.
High impact – arising from loss of inventory, loss of reputation, possible loss of contracts/ customers,
litigation risk, closure on health grounds.
Proposed course of action – quality control procedures, contingency plans, better inventory identification
to locate and minimise infected inventory.
Loss of customer
High probability – assuming that such contracts are being renegotiated on a regular basis.
Impact depends upon whether
• Sales are concentrated with a few customers
• New customers can be generated
• The loss of customers is systematic, in which case the cumulative impact may be significant.
Proposed course of action – maintain customer relationships, compete on price and non-price issues,
develop a wider customer base.
Foreign exchange
High probability – some (and possibly significant) foreign currency movements over time are very likely.
High impact – potentially, the effects of a major currency movement may be significant, although this
would depend on the actions taken to moderate such effects. There may also be a favourable currency
impact arising from Middle Eastern currencies becoming more readily acceptable in trading.
Proposed course of action – hedge in the short term (where appropriate and where the cost of doing so
is not significant), back-to-back financing (eg borrow in UAE Dirham to finance Middle Eastern
operations), consider acceptability of Middle Eastern currencies before significant development in these
countries.
Notes to the financial statements
Control environment and control activities
The company is committed to ensuring that a proper control environment is maintained. There is a
commitment to competence and integrity, together with the communication of clear objectives to all
divisions. These are underpinned by a human resources policy that develops quality with integrity.
The organisational structure has been developed to delegate authority with accountability to ensure that
control and consistency are maintained, having regard to an acceptable level of risk. Managing directors
report on the control environment on a regular basis to the board. Moreover, the performance of each
division is reported and reviewed regularly.
This year the board has undertaken a specific review to assess key risks and to ensure that appropriate
information and monitoring is being received.


(a) The risk is the risk of changes in value of the steel inventory due to changes in the price of the
commodity. This is a financial or market risk.
(b) The auditor would need to consider the following:
• Whether the futures contracts are to be used in a fair value hedge of the steel inventory.
• Whether the required criteria have been met ie the hedging relationship has been formally
designated and the hedge is 'effective'.
• Whether adequate documentation can be produced including details of:
– Identification of the hedging instrument
– The hedged item
– Nature of the risk being hedged
– How hedge effectiveness will be calculated
• If hedge accounting is to be used the risk of incorrect accounting treatment. This risk is increased
due to the entity's lack of experience in dealing with this type of transaction.
• Whether the accounting rules of IAS 39 Financial Instruments: Recognition and Measurement
(IFRS 9) have been complied with.
The derivative should be recognised as a financial asset at fair value and any gain recognised in
profit or loss.
• The way in which fair value has been established.
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(a) Key risk (b) Controls to mitigate (c) Audit procedures
• 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.
• Excessive expenditure on • Regular reviews of benefits • Cost-benefit review.

R&D. against costs for each drug,
each R&D unit and each • Comparison to similar
period. companies.
• Review of R&D cost control and
budgetary procedures.
• Insufficient new drugs in the • Monitoring effectiveness of • Consider sustained going
pipeline to sustain profitability. R&D function. concern.
• Consideration of adequate • Review plausibility of alternative
expenditure levels. strategies.
• Consider alternative
strategies (eg increases in
generic drug production).
• Alternative uses for existing
drugs.
• Development of new drugs by • Consider effectiveness of • Review patent registration by
competitors. patent protection. other companies.
• Consider possibility of • Review projected impact on
licensing. client.
• Quantification of effects. • Consider writing off 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.

Business risks faced by KidsStuff Ltd
• Exposure to foreign exchange risk if imports are not denominated in Taka.
• One major supplier – too reliant upon one source.
• Distance from supplier makes resolving production errors more difficult.
• Children's toy market tends to be seasonal – could require significant working capital for periods of the
year.
• Strict health and safety rules over children's toys could be breached.
• May be heavily reliant upon the skills of Joseph Cooper who will now be close to retirement.
• If unable to keep up with market trends the company will not be able to continue trading.
• Penetration of the computer games market would require significant investment which may not pay off.
• The overdraft is likely to be an expensive form of financing.
• The overdraft could be withdrawn.
Effect of risks on the audit
• The going concern basis of preparation may not be appropriate due to many of the business risks, eg
reliance on overdraft.
• Payables, purchases and inventories could all be misstated if incorrect exchange rates are used.
• Exchange gains and losses may be incorrectly accounted for or miscalculated.
• The overseas supplier is likely to have a material payables balance but evidence may be difficult to
obtain.
• Importing extends delivery times and makes cut-off more difficult to administer.
• Last year's toys in inventories may well be obsolete.
• Provisions may be required for fines or legal claims re health and safety breaches.
• If the year end is pre-busy season, inventories are likely to be material.
• If the year end is post-busy season, receivables are likely to be material.
• The bank may use the accounts in determining whether or not to renew the overdraft – a duty of care
should be considered.
• Neil Cooper may bias the accounts to show an improved performance.
Further information required
• Management accounts for the year to date
• Budgeted results for the year C
• Audited financial statements for the previous year(s)
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• Correspondence from the bank regarding the overdraft
• Correspondence with the previous auditor re previous audit issues A
• Visits to client/notes to ascertain the client's systems P
• Trade journals T
• Health and safety legislation for the industry E
• Minutes of board meetings R
• Legal costs and correspondence with solicitors as evidence for litigation risk

Risks associated with accounting treatment include the following.
• Nature of the contract
This contract is essentially a number of goods and services bundled into one contract. This fact adds
complexity to the accounting treatment and therefore adds risk. Where the elements can be separated
and sold as individual items they should be recognised as if they were independent of each other. In this
case it would be possible to sell the handset, access to the network, the call minutes and the texts
individually so separate recognition would be appropriate.
• Revenue recognition policy not in accordance with principles of IFRS 15
A distinction will need to be made between the different elements of the package. Revenue from the sale
of the handset should be recognised when the risks and rewards of ownership pass to the buyer. This
will normally be at the point that the contract is signed and the customer takes receipt of the handset.
Alternatively if the handset is sent to the customer it will be at the point of delivery.
Use of the network would be treated as the rendering of a service. As the service is provided equally
over the 12 month period of the contact the revenue attached to this element should be recognised on a
straight-line basis.
The free calls and texts would also be treated as the rendering of a service. This service however will not
necessarily be received on an equal basis each month (as not all free calls/texts may be used each
month and may be carried over). The allocation should be based on the best estimate of how the free
calls and texts will be used over the life of the contract. This will involve a large amount of estimation
which increases audit risk. Where the allocation can be based on historical information eg average
usage on similar packages risk will be reduced.
• Each component of the package may be valued incorrectly
The package is effectively a bundle of goods and services with a fair value of CU500 sold at a discount
of CU140 (500-360). If there is a specific discount policy this should be applied to the individual
components. For example, the whole of the discount could relate to the handset in which case the whole
of the discount would be deducted from the fair value of the phone. If there is no specific policy an
alternative allocation method would be required, eg on a pro-rata basis. The auditor would need to
ensure that the basis used is reasonable.

Audit risks
• Inherent
– Related party transactions/group issues
– Receivables
– Fraud – possible indicators, professional scepticism
– Profit driven management
– Credit extended – accounting/law and regulations
• Control
– Lack of segregation of duties
– PC/virus
– Suspicion of fraud?
– Key man
• Detection
– First audit
– Opening balances and comparatives – audited?
Audit risks – inherent
Related parties and group issues
Forsythia is part of a complicated group structure. This raises several issues for the audit:
• There is a risk of related party transactions existing and not being properly disclosed in the financial
statements in accordance with IAS 24.
• Similarly, there is a risk that it will be difficult to ascertain the controlling party for disclosure.
• There are likely to be some group audit implications. The firm may be required to undertake procedures
in line with the group auditors' requirements if Forsythia is to be consolidated.

Receivables
Forsythia is a service provider, and it extends credit to customers. This is likely to mean that trade
receivables will be a significant audit balance. However, there is limited audit evidence concerning trade
receivables due to the effects of a computer virus. There are also indicators of a possible fraud.
Fraud?
There are various factors that may indicate a sales ledger fraud has taken/is taking place:
• Lack of segregation of duties
• Extensive credit offered
• The virus only destroyed sales ledger information – too specific?
• Poorly paid sales ledger clerk – with expensive lifestyle
• Sales ledger clerk is daughter of rich shareholder and they do not have a good relationship
None of these factors necessarily point to a fraud individually, but added together raise significant
concerns.
Profit driven management
Mr Rose is motivated for the financial statements to show a profit for two reasons:
• He receives a commission (presumably sales driven, which impacts on profit)
• He receives dividends as shareholder, which will depend on profits
There is a risk that the financial statements will be affected by management bias .
Credit extended
We should ensure that the credit extended to customers is standard business credit. There are unlikely to be
any complications, for example, interest, but if there were, we should be aware of any laws and regulations
which might become relevant, and any accounting issues which would be raised.
Audit risk – control
There are three significant control problems at Forsythia.
Segregation of duties
There appears to be a complete lack of segregation of duties on the three main ledgers. This may have led
to a fraud on the sales ledger. The fact that there is no segregation on payroll is also a concern as this is an
area where frauds are carried out.
Lack of segregation of duties can also lead to significant errors arising and not being detected by the
system. This problem means that control risk will have to be assessed as high and substantial substantive
testing be undertaken.
Personal Computer
A PC is used for the accounting system. This is likely to have poor built in controls and further exacerbate
the problems caused by the lack of segregation of duties.
The security over PCs is also often poor, as has been the case here, where a virus has destroyed evidence
about the sales ledger.
Key man
The fact that Mr Rose is dominant in management may also be a control problem as he can override any
controls that do exist. There are also risks if he were ever to be absent as most controls appear to operate
through him and there are no alternative competent senior personnel. C
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Answer to Interactive question 6 A
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Home delivery sales
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The appropriate benchmark of materiality with regard to the home delivery sales is revenue, as the home E
delivery sales form part of the total revenue of the company.
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CU0.6 million is 1.4% of the total revenue for 20X6 (see WORKING (1) below).
An item is generally considered to be material if it is in the region of 1% of revenue, so the home delivery
services are material. 5
Provision
The appropriate benchmark of materiality with regard to the provision are total assets and profit, as the
provision impacts both the statement of financial position (it is a liability) and the statement of profit or loss and
other comprehensive income (it is a charge against profit).

CU0.2 million is 0.65% of total assets in 20X6 (see WORKING (2) below). As an item is generally considered
to be material if it is in the region of 1–2% of total assets, the provision is not material to the statement of
financial position.
However, CU0.2 million is 11% of profit before tax for 20X6 (see WORKING (3) below). An item is considered
material to profit before tax if it is in the region of 5%. Therefore, the provision is material to the statement of
profit or loss and other comprehensive income.
WORKING (1) WORKING (2) WORKING (3)
0.6 million 0.2 million 0.2 million

× 100 = 1.4% × 100 = 0.65% × 100 = 11%
42.2 million 30.7 million 1.8 million

• Although the materiality calculation is based on a benchmark commonly used, ie % of PBT, in this case
the resulting figure does not seem appropriate.
• This is due to the fact that the profit figure of the business is volatile (CU300,000 in the previous year)
and does not seem to be representative of the size of the business in terms of its assets or revenue.
• In instances like this where the company is close to break even total assets or revenue may be a more
suitable basis. Alternatively if profits are to be used an average figure over a number of years would give
rise to a more appropriate materiality balance.
• Materiality as it is currently set is extremely low. The consequence of this is that it would result in
substantially increased audit procedures which would be inefficient.

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CHAPTER 6
The statutory audit: audit

evidence
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
Technical reference
The statutory audit: audit evidence 227

Introduction
• Evaluate, where appropriate, the extent to which reliance can be placed on expertise
from other parties to support audit processes
• Determine audit objectives for each financial statement assertion
• 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

1 Revision of assertions
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.
1.2 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 used by the auditor
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:
Transactions and Account balances at Presentation and

events the period end disclosure
Should it be in the Occurrence Existence Occurrence

accounts at all?
Cut-off Rights and obligations Rights and obligations
Is it included at the right Accuracy Valuation Accuracy and
amount? measurement
Are there any more? Completeness Completeness Completeness
Is it properly disclosed Classification Allocation Classification and
and presented? understandability

Interactive question 1: Financial statement assertions (1) [Difficulty level: Easy]
Requirement
Complete the table below C
(i) Identifying procedures to satisfy the four key questions H
A
(ii) Identify the financial statement assertions that these procedures will satisfy
P
T
Audit Area Key question Examples of procedures Assertions
E
Non-current assets Should it be in the Physically verify Existence R
accounts at all?
Is it included at the right Inspect invoices/contracts Rights and 6

amount? obligations
Check depreciation
Valuation
Are there any more?
Is it properly disclosed and

presented?
Receivables Should it be in the
accounts at all?
Is it included at the right
amount?
Are there any more?

presented?
Payables Should it be in the

accounts at all?
amount?
Are there any more?

presented?
Inventory Should it be in the

accounts at all?
amount?
Are there any more?

presented?

Interactive question 2: Financial statement assertions (2)
Requirement
For the points 1–3 below identify and explain the most relevant financial statement assertions. Assume
that the year end is 31 December 20X7 in each case.
(1) Fine Ltd is proposing to award share options to five directors. The proposal is to issue 100,000
options to each of the five individuals on 1 September 20X7 (the grant date) at an exercise price of
CU7 per share. The scheme participants will need to have been with the company for at least three
years before being able to exercise their options. It is believed that all the directors will satisfy this
condition. Other relevant information is as follows:
1 September 20X7 31 December 20X7
CU CU
Market price per share 7.00 8.20 (estimated)
Fair value of each option 3.00 5.70 (estimated)
(2) Wigwam Ltd has purchased goods worth CU750,000 from Teepee Ltd on an arm's length basis.
Wigwam owns 40% of the ordinary share capital in Teepee.
(3) Deakin Ltd issued 10,000 6% convertible bonds at par value of CU10 on 31 December 20X7. On
this date the market interest rate for similar debt without the option to convert was 10%. Each bond
is convertible into 4 ordinary shares on 31 December 20X9.
2 Sufficient appropriate audit evidence

Section overview
• Auditors need to obtain sufficient, appropriate audit evidence.
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.
Worked example: Mattel Inc

This is a complex case but in simple terms Mattel Inc inflated its reported earnings by using a technique
which came to be known as 'bill and hold'. This involved billing customers for future sales. Whilst the
sale was recorded immediately (with invoices often prepared without the knowledge of the customer) the
merchandise was not shipped. To support these sales Mattel produced false sales orders, invoices and
bills of lading. The bills of lading were signed by employees as both themselves and the carrying
company. They were then stamped 'bill and hold'. Problems which arose when the goods were actually
sold were dealt with by making other fraudulent entries in the books.
When Arthur Andersen audited accounts receivable they sent accounts receivable confirmations to
customers. These were returned with many substantial discrepancies due to the 'bill and hold' entries.
As part of the reconciliation process the auditors reviewed copies of bills of lading to serve as
confirmation that the goods had been shipped. However, the auditors did not question the term 'bill and
hold' even though it was clearly stamped on the documents and did not appear to notice that the same
individual had signed as both representatives of Mattel Inc and the shipping company. A number of
entries were questioned and the audit senior who reviewed the working papers noted that additional
explanations were required but no further investigation actually took place.
Source: Principles of Auditing: An Introduction to International Standards on Auditing by Rick Hayes,
Roger Dassen, Arnold Schilder, Phillip Wallage Second Edition published by Pearson Education Limited
2005

2.2 Sufficient and appropriate evidence
[P1]'Sufficiency' and 'appropriateness' are interrelated and apply to both tests of controls and
substantive procedures.
C
Sufficient evidence relates to the quantity of evidence gathered. However it is not simply a question of H
'more is better' as different sources can be more or less persuasive. Broadly speaking however it is A
possible to say that the greater the risk of misstatement, the greater the quantity of evidence required. P
However the standards are clear that if the auditor decides to perform more comprehensive testing eg T
by selecting a bigger sample the extra work must contribute to the reduction of risk. E
R
Appropriateness relates to the quality of evidence. ISA 500 amplifies this term by saying that evidence
should be:
• Relevant 6
• Reliable
Relevance deals with the logical connection with the purpose of the audit procedure and, where
appropriate, the assertion under consideration.
Reliability is influenced by the source and nature of the evidence however you should be familiar
with the following generalisations from your earlier studies:
• Audit evidence is more reliable when it is obtained from independent sources outside the entity.
• Audit evidence that is generated internally is more reliable when the related controls imposed by
the entity are effective.
• Audit evidence obtained directly by the auditor (for example, observation of the application of a
control) is more reliable than audit evidence obtained indirectly or by inference (for example,
inquiry about the application of a control).
• Documentary evidence is more reliable, whether paper, electronic or other medium (for example,
a written record of a meeting is more reliable than a subsequent oral representation of the matters
discussed).
• Original documents are more reliable than photocopies or faxes.
Interactive question 3: Audit evidence – revision [Difficulty level: Easy]
'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.

2.3 The work of a management's expert as audit evidence
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.
Worked example: Over-reliance on confirmations

One of the largest examples of over-reliance on one type of audit confirmation was the Parmalat
collapse of 2003.
Parmalat Finanziaria Spa is an Italian-based company. Its main operating subsidiary Parmalat Spa dealt
with dairy produce around the world. On 24 December 2003 Parmalat Spa filed for bankruptcy. How
could this happen to a company that employed 36,000 employees, operated in 30 countries and was
Italy's biggest food maker? The answer is simply forged documentation!
Parmalat allegedly had €3.95 billion worth of cash and marketable securities in an account at the Bank
of America but under the name of Bonlat Financing Corporation. In 2002 Grant Thornton, the auditors of
Bonlat, had requested confirmation of the balances from Bank of America. Three months later a reply
was received by post not by fax confirming the balance. It later transpired that this letter was a forgery
and Bank of America confirmed this in a press release. The Parmalat CEO left Italy on the day of this
press release. The €3.95 billion worth of cash and securities simply did not exist.
In retrospect, additional evidence rather than simply one (forged) letter should have been obtained for
the cash balance. The case shows that even external confirmations and letters from other auditors
should be treated with some scepticism where the amounts involved are very material.
Source: Principles of Auditing: An Introduction to International Standards on Auditing by Hayes, Dassen,
Schilder and Wallage second edition 2005 Pearson Education Limited

3 Sources of audit evidence
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.
3.2 Substantive procedures

ISA 330 The Auditor's Responses to Assessed Risks states that irrespective of the assessed risk of
material misstatement, the auditor shall design and perform substantive procedures for each material
class of transactions, account balance and disclosure.
There are two key types of substantive procedure:
• Substantive analytical procedures. These are generally more applicable to large volumes of
transactions that tend to be predictable over time. We will look at these in detail in Section 5.
• Tests of details. These are ordinarily more appropriate to obtain audit evidence regarding certain
assertions about account balances. We will see how these are applied to key aspects of the
financial statements as we work through the remainder of the chapter.
4 Selection of audit procedures
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 Types of procedure

Auditors obtain evidence by using one or more of the following procedures.
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.

Examples
Inquiry includes obtaining responses to formal written questions through to asking informal questions in
relation to specific audit assertions. The response to inquiries provides the auditor with information that
was not previously possessed or may corroborate information obtained from other sources. The strength
of the evidence depends on the knowledge and integrity of the source. Where the result of inquiry is
different from other evidence obtained, then reasons for that difference must be sought and the
information reconciled.
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.

4.1.3 Inspection
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

Recalculation is particularly effective when carried out using computer assisted audit techniques
(CAATs) as the computer can perform the whole of the inventory calculation (for example) in a short
time period.
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.
4.1.6 External confirmation
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.
Key characteristics of any confirmation are:

• Information is requested by the auditor
• The request and response are in writing and the response is sent direct to the auditor
• The response is from an independent third party
• The confirmation is usually required to be positive (a response is expected) rather than negative (a
non-reply is assumed to confirm information provided to the third party).
Business focus
Confirmations are normally used in the following business processes:
• Financing: agreement of bank balances, loan amounts outstanding etc (see Appendix).
• Inventory: confirmation of inventory held at third parties
• Revenue: confirmation of amounts due from debtors and payable to creditors (see Appendix).
4.1.7 Analytical procedures

We will look at these in Section 5.
4.2 Application of procedures to specific areas of the financial statements

You should be familiar with the basic principles behind the audit of key balances in the financial
statements from your Assurance studies. This section demonstrates the application of these principles,
looking in particular at non-current assets.

4.2.1 Tangible assets
The major risks of misstatement in the financial statements are due to:
• Expenses being capitalised as non-current assets (existence assertion) C
H
• Tangible assets being carried at the wrong cost or valuation (valuation assertion)
A
• Tangible assets being carried at the wrong cost or valuation due to charging inappropriate P
depreciation, or not depreciating (valuation assertion) T
• Tangible assets being carried at the wrong cost or valuation due to impairment reviews not being E
carried out appropriately (valuation assertion) R
Interactive question 4: Audit procedures revision of tangible assets

[Difficulty level: Intermediate] 6
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.
Impairment of non-current assets

An asset is impaired when its carrying amount (depreciated cost or depreciated valuation) exceeds its
recoverable amount. Management are required to determine if there is any indication that the assets
are impaired.
The auditors will consider whether there are any indicators of impairment when carrying out risk
assessment procedures. They will use the same impairment criteria laid out in ISA36 Impairment of
Assets as management do. If the auditors believe that impairment is indicated, they should request that
management show them the impairment review that has been carried out. If no impairment review has
been carried out, then the auditors should discuss the need for one with management, and if necessary,
modify their report on grounds of disagreement (not conforming with ISA36) if management refuse to
carry out an impairment review.

If an impairment review has been carried out, then the auditors should audit that impairment review.
Management will have estimated whether the recoverable amount of the asset/cash generating unit is
lower than the carrying amount.
For auditors, the key issue is that recoverable amount requires estimation. As estimation is
subjective, this makes it a risky area for auditors.
Management have to determine if recoverable amount is higher than carrying amount. It may not have
been necessary for them to estimate both fair value and value in use, because if one is higher than
carrying amount, then the asset is not impaired. If it is not possible to make a reliable estimate of net
realisable value, then it is necessary to calculate value in use. Net realisable value is only calculable if
there is an active market for the goods, and would therefore be audited in the same way as fair value.
Costs of disposal such as taxes can be recalculated by applying the appropriate tax rate to the fair value
itself. Delivery costs can be verified by comparing costs to published rates by delivery companies, for
example, on the internet.
If management have calculated the value in use of an asset or cash-generating unit, then the auditors
will have to audit that calculation. The following procedures will be relevant.
Value in use
• Obtain management's calculation of value in use.
• Reperform calculation to ensure that it is mathematically correct.
• Compare the cash flow amounts to recent budgets and projections approved by the board to
ensure that they are realistic.
• Calculate/obtain from analysts the long-term average growth rate for the products and ensure that
the growth rates assumed in the calculation of value in use do not exceed it.
• Refer to competitors' published information to compare how much similar assets are valued at by
companies trading in similar conditions.
• Compare to previous calculations of value in use to ensure that all relevant costs of maintaining the
asset have been included.
• Ensure that the cost/income from disposal of the asset at the end of its life has been included.
• Review calculation to ensure cash flows from financing activities and income tax have been
excluded.
• Compare discount rate used to published market rates to ensure that it correctly reflects the return
expected by the market.
If the asset is impaired and has been written down to recoverable amount, the auditors should review
the financial statements to ensure that the write down has been carried out correctly and that the ISA36
disclosures have been made correctly.
4.2.2 Intangible assets

Accounting guidance for intangibles is given in ISA38 Intangible Assets and IFRS 3 Business
Combinations. The types of assets you are likely to encounter under this heading include:
• Patents
• Licences
• Trademarks
• Development costs
• Goodwill
The major risks of misstatement in the financial statements are due to:
• Expenses being capitalised as non-current assets (existence assertion).
• Intangible assets being carried at the wrong cost or valuation (valuation assertion).
• Intangible assets being carried at the wrong cost or valuation due to charging inappropriate
amortisation, or not amortising (valuation assertion).
• Intangible assets being carried at the wrong cost or valuation due to impairment reviews not being
carried out appropriately (valuation assertion).

In order to address these the auditor should carry out the following procedures:
Completeness
• Prepare analysis of movements on cost and amortisation accounts. C
Rights and obligations H
A
• Obtain confirmation from a patent agent of all patents and trademarks held.
P
• Verify payment of annual renewal fees.
T
Valuation E
R
• Review specialist valuations of intangible assets, considering:
– Qualifications of valuer
– Scope of work 6
– Assumptions and methods used
• Confirm carried down balances represent continuing value, which are proper charges to future
operations.
Additions (rights and obligations, valuation and completeness)
• Inspect purchase agreements, assignments and supporting documentation for intangible assets
acquired in period.
• Confirm purchases have been authorised.
• Verify amounts capitalised of patents developed by the company with supporting costing records.
Amortisation
• Review amortisation
– Check computation
– Confirm that rates used are reasonable
Income from intangibles
• Review sales returns and statistics to verify the reasonableness of income derived from patents,
trademarks, licences etc.
• Examine audited accounts of third party sales covered by a patent, licence or trademark owned
by the company.
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.
5.1 Use of analytical procedures

Analytical procedures are used throughout the audit.
• ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and its Environment deals with their use as risk assessment procedures.
• ISA 520 Analytical Procedures requires that analytical procedures are used near the end of the
audit when forming an overall conclusion as to whether the financial statements are consistent with
the auditor's understanding of the entity.
Analytical procedures may also be used as substantive procedures.
Auditors should not normally rely on analytical procedures alone in respect of material balances but
should combine them with tests of detail.

However, ISA330 para A43 points out the combination will depend on the circumstances, and that the
auditor may determine:
• That performing only analytical procedures will be sufficient to reduce audit risk to an acceptably
low level. For example, where the auditor's assessment of risk is supported by audit evidence from
tests of controls.
5.2 Practical techniques

Ratio analysis is one of the key techniques which the auditor will use when performing analytical
procedures. You have looked at the relevant ratios in detail in your Assurance studies. A brief summary
is provided below.
5.2.1 Ratio analysis

When carrying out analytical procedures, auditors should remember that every industry is different and
each company within an industry differs in certain aspects.
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.
5.2.2 Other techniques

Other analytical techniques include:
(a) Simple comparisons
A simple year on year comparison could provide very persuasive evidence that an expense such
as rent is correctly stated, providing that the auditor has sufficient knowledge of the business, for
example knowing that the same premises have been leased year on year and that there has been
no rent review.
(b) Examining related accounts
Examining related accounts in conjunction with each other could provide evidence that a balance is
fairly stated. Often revenue and expense accounts are related to asset and liability accounts and
comparisons should be made to ensure relationships are reasonable.

(c) Reasonableness tests
These involve calculating the expected value of an item and comparing it with its actual value, for
example, for straight-line depreciation.
C
(Cost + Additions – Disposals) × Depreciation % = Recognised in profit or loss H
This may include the comparison of non-financial as well as financial information. A
P
For example, in making an estimate of employee costs, probably for one specific department, such
T
as manufacturing, the auditor might use information about the number of employees in the
department, as well as rates of pay increases. E
R
(d) Trend analysis
This is a sophisticated statistical technique that can be used to compare this period with the
previous period. Information technology can be used in trend analysis, to enable auditors to see 6
trends graphically with relative ease and speed.
Methods of trend analysis include:
• Scattergraphs
• Bar graphs
• Pie charts
• Any other visual representations
• Time series analysis
• Statistical regression
Time series analysis involves techniques such as eliminating seasonal fluctuations from sets of
figures, so that underlying trends can be analysed. This is illustrated below.
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
5.3 Analytical procedures as risk assessment procedures

ISA315(6) requires that risk assessment procedures include analytical procedures.
Analytical procedures are usually carried out at the planning stage of the audit because:
• It is a tool which assists in the identification of risk
• The result helps the auditor to plan the audit approach
The benefits of adopting this technique are that:
• It helps to focus on the key priorities as it is a 'top down' procedure
• It is an efficient procedure, due to its focus on key priorities

5.3.1 Technique
Although ISA 520 deals with analytical procedures in the context of substantive procedures the same
basic techniques would be applied when using analytical procedures as risk assessment procedures.
The key stages in the process are as follows:
• Interpretation
• Investigation
• Corroboration
When potential problem areas have been identified one of the key questions to ask is 'why'?
The statement of profit or loss and other comprehensive income
To apply this in more detail think about the client's statement of profit or loss and other comprehensive
income.
The key question must be:
Why did the client make more (or less) money this year?
Profit before tax
Revenue Margin Overheads
Volume Selling Costs Product Fixed Variable

price mix
More customers Different products Strategic decisions

Different customers Different suppliers Market forces
More spend per customer Different markets One offs
New outlets One offs Fraud & Error
One offs Fraud & Error
Fraud & Error
Changes in revenue must depend on changes in:

• Volumes; or
• Prices;
or perhaps a combination of the two.
Changes in margins must have something to do with changes in:
• Selling prices;
• Cost prices;
• Product mix.
Changes in overheads will need to be identified line by line, but you might like to consider the different
impacts of changes in:
• Fixed; and
• Variable overheads.
The boxes at the bottom of the diagram give some suggestions for the reasons why. The suggestions
are not intended to be exhaustive, but they should give you a good basis for an answer to an analytical
procedures type question.
A similar approach needs to be taken both to statement of financial position areas and those efficiency
ratios which link statement of financial position figures to the performance ratios.

5.3.2 Financial and non-financial factors
ISA 520 stresses the need to consider the use of non-financial information eg employee numbers,
available selling space etc. Non-financial performance indicators can be found within the financial
statements. In particular, an operating and financial review, or possibly the chairman's statement C
may serve as useful indicators as they attempt to comment on both the past and the future of the H
company. Care must be taken however, in assessing the reliability of this information as indicators may A
have been selected to ensure a positive message is conveyed. P
T
E
Interactive question 5: Analytical procedures (1) [Difficulty level: Easy]
R
You are planning the audit of Darwin Ltd for the year ended 31 December 20X7. You are currently
engaged in the interim audit during November 20X7. The company manufactures and distributes light
fittings for both internal and external use. Approximately 40% of revenue is generated from overseas
6
customers.
You have been provided with the following operating information.
10 months to 31 10 months to 31 Year to 31 December
October 20X7 October 20X6 20X6
CU'000 CU'000 CU'000
Revenue 27,187 23,516 27,068
Cost of sales 16,040 14,966 17,175
Gross profit 11,147 8,550 9,893
Operating expenses 5,437 4,938 5,678
Operating profit 5,710 3,612 4,215
Gross profit margin 41% 36% 37%
Operating profit margin 21% 15% 16%
Inventories 5,160 4,320 4,080
Requirement
Based on the operating information identify and explain the potential audit risks.
Interactive question 6: Analytical procedures (2) [Difficulty level: Intermediate]

Libby Ltd is a ladies fashion retailer operating a chain of shops in the South East of England from a head
office in Guildford. Your firm has been the auditor of Libby Ltd for some years.
During the current year one shop was closed and the product range of the remaining eight shops was
extended to include accessories and footwear.
The company has a computerised accounting system and the audit manager is keen to ensure that the
audit is as efficient as possible.
As senior in charge of the audit you are currently planning the audit procedures for trade payables and
you have obtained draft financial statements from the client.

Extracts from the draft financial statements:
Year ended 31 March
Statement of profit or loss and other Draft 20X7 Actual 20X6
comprehensive income
CU'000 CU'000
Revenue 8,173 5,650
Gross profit 1,717 1,352
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.
5.4 Analytical procedures as substantive procedures

5.4.1 Factors to consider
There are a number of factors which the auditors should consider when deciding whether to use
analytical procedures as substantive procedures. You will have covered these in your Assurance
studies. A brief reminder is given below.
Factors to consider Example
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.

Factors which should also be considered when determining the reliance that the auditors should place
on the results of substantive analytical procedures are:
Reliability factors Example

C
Other audit procedures directed Other procedures auditors undertake in reviewing the H
towards the same financial statements collectability of receivables, such as the review of subsequent A
assertions cash receipts, may confirm or dispel questions arising from the P
application of analytical procedures to a schedule of T
customers' accounts which lists for how long monies have E
been owed. R
The accuracy with which the expected Auditors normally expect greater consistency in comparing the
results of analytical procedures can be relationship of gross profit to sales from one period to another
predicted than in comparing expenditure which may or may not be made 6
within a period, such as research or advertising.
The frequency with which a A pattern repeated monthly as opposed to annually.
relationship is observed
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

amount of difference considered acceptable without investigation decreases. If the difference between
the two figures exceeds this materiality threshold then further investigation will be required in an attempt
to explain the difference. If the difference is below the materiality threshold then no further investigation
will be necessary.
The actual salary expense in the statement of profit or loss and other comprehensive income can be
found. Assuming that salary cost does not involve overtime, then the estimated amount and the actual
should be relatively close – materiality is likely to be set at say 10% difference between the two figures.
Obtain possible reasons for variances
The auditor attempts to identify reasons for the difference between the expected figure and the actual
figure in the financial statements. The level of investigation depends to some extent on the accuracy of
the auditor's expected figure. If the expected figure is precise, then more investigation will be expected.
Conversely, if the expected figure has larger element of imprecision, then it is less likely that any
difference is due to misstatement and therefore less investigation work will be performed. (The auditor
should have assessed whether expectations were capable of sufficiently precise measurement before
adopting analytical procedures).
Corroboration of any difference will normally start by obtaining written representations from
management. However, these representations should be treated with scepticism due to the inherent
problem of reliability of this source of evidence. Evidence from other sources will be required to ensure
written representations are accurate.
If the expected and actual salary expenses are more than 10% different, then further work is needed to
determine why this is the case. Initial discussions with management may highlight areas where costs
will be different, eg expansion in the last month of the year may skew the average number of managers
to a larger number than expected. Or a salary increase late in the year may also inflate expectations of
average salary. These written representations will be checked back in detail to the salary records.
Evaluate impact of any unresolved differences
Finally, the auditor will evaluate the impact of any unresolved differences on audit procedures and the
financial statements. A large difference may mean that additional substantive procedures are required
on the account balance to determine its accuracy. Any small remaining difference may be ignored as
immaterial.
Hopefully, differences in expected and actual salaries will be resolved and any remaining residual
difference will be immaterial. However, where differences remain, additional substantive testing of the
salaries figure will be required.
5.5 Analytical procedures at the completion stage

ISA 520 states that analytical procedures performed when forming an overall conclusion are intended to
corroborate conclusions formed during the audit. This assists the auditor in forming his opinion. The
steps for carrying out analytical procedures at the completion stage of the audit may be very similar to
those used as part of the risk assessment process at the planning stage. However they are applied in a
different way:
• Interpretation
The individual carrying out the analytical procedures, reads through the financial statements and
interprets them, considering the absolute figures themselves and the relevant ratios.
• Investigation
When analytical procedures are used as risk assessment procedures or as a substantive
procedure the aim is to identify potential problems. The problems are then investigated during
fieldwork by making inquiries and gathering audit evidence.
Considerations when carrying out such procedures may include:
• Whether the financial statements adequately reflect the information and explanations previously
obtained and conclusions previously reached.
• Whether the procedures reveal any new factors which may affect presentation or disclosures in the

• Whether the procedures produce results which are consistent with the auditor's knowledge of the
entity's business.
• The potential impact of uncorrected misstatements identified during the course of the audit.
C
If analytical procedures identify a previously unrecognised risk of material misstatement, then the auditor H
should reassess risk and modify the audit plan and perform further procedures as required. A
From a practical point of view it is worth remembering the following: P
T
• For the smaller client the working papers supporting the final analytical procedures may well simply
E
be an update of the work done at the planning stage.
R
• For the larger client the review becomes much more of a specific exercise.
• The financial statements used for the analytical procedures need to incorporate any adjustments
made as a result of the audit. 6
5.6 Analytical procedures and other engagements

In this section we have been looking at the role of analytical procedures in the audit process. However, the
skills and techniques involved may be applied to other aspects of the professional accountants' work.
Interactive question 7: Analytical procedures (3) [Difficulty level: Exam standard]

Harrison Ltd is a small jewellers based in Hatton Garden in Dhaka. Over the years it has built up an
impressive client portfolio, and boasts names from high society as regular customers.
Harrison Ltd now needs to restructure its long-term and short-term financing in order to facilitate future
growth, and has provided your firm with the following data to make an assessment of its liquidity. The
firm is also looking to re-evaluate its performance measures and is seeking advice on what might be the
most appropriate non-financial performance measures.
The following is an extract from the financial information provided by Harrison Ltd for the year ended 30
September 20X4.
Revenue CU2.0m
Purchases CU1.2m
Cost of sales CU1.5m
CU
Non-current assets 550,000
Inventory 300,000
Receivables 150,000
Cash 100,000
Payables (100,000)
1,000,000
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.

6 Audit of accounting estimates
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.
6.1 Audit procedures

Auditors must gain an understanding of the procedures and methods used by management to make
accounting estimates to gain evidence of whether estimates are reasonable given the circumstances
and appropriately disclosed if necessary. It will also aid the auditors' planning of their own procedures.
This ISA says that the auditor should adopt the following approaches:
• The auditor shall obtain an understanding of the following as part of the process of understanding
the business:

– The requirements of the applicable financial reporting framework
– The means by which the management identifies transactions, events and conditions that may
give rise to the accounting estimates
C
– How management makes the accounting estimate
H
• The auditor shall review the outcome of accounting estimates included in the prior period
A
financial statements. (The purpose of this is to assess the risks of misstatement in the current
P
period estimates, not to question the judgments made in prior periods.)
T
• The auditor shall evaluate the degree of estimation uncertainty associated with the accounting E
estimate and assess whether this gives rise to significant risks. R
• Based on the assessed risks the auditor will determine whether the financial reporting framework
has been properly applied and whether methods for making estimates are appropriate and have
been applied consistently. 6
• The auditor will also:
– Determine whether events occurring up to the date of the audit report provide evidence
regarding the accounting estimate.
– Test how management made the accounting estimate (including evaluation of measurement
method and assumptions).
– Test the operating effectiveness of controls together with appropriate substantive procedures.
– Develop a point estimate (the single most plausible value based on the available information)
or a range (a range of values that are all plausible in the light of the available information)
derived from audit evidence to evaluate the management's point estimate.
• The auditor shall consider whether specialist skills or knowledge are required in order to obtain
sufficient appropriate audit evidence.
• For accounting estimates which give rise to significant risks the auditor should also evaluate
the following:
– Whether management has considered alternative assumptions or outcomes
– Whether the significant assumptions used are reasonable
– Management intent to carry out specific courses of action and its ability to do so, where these
affect the accounting estimate
– Management's decision to recognise, or to not recognise, the accounting estimate
– The selected measurement basis.
• The possibility of management bias must be considered by the auditor
• Written representations will be obtained from management as to whether management believes
that significant assumptions used in making accounting estimates are reasonable.
6.2 Evaluation of results of audit procedures

ISA 540 (18) states that 'The auditor shall evaluate, based on the audit evidence, whether the
accounting estimates in the financial statements are either reasonable in the context of the applicable
financial reporting framework, or are misstated.'
Misstatements in this context would be:
• The difference between management's point estimate and the auditor's point estimate based on
audit evidence, or
• The difference between management's point estimate and a range of values that the auditor has
established based on the audit evidence.
The auditor shall also consider whether the disclosures relating to accounting estimates are adequate
and in accordance with the applicable financial reporting framework.

7 Initial audit engagements – opening balances
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.
7.1 Opening balances

Opening balances are those account balances which exist at the beginning of the period. Opening
balances are based upon the closing balances of the prior period and reflect the effects of:
• Transactions and events of prior periods
• Accounting policies applied to the prior period
ISA 510 Initial Audit Engagements – Opening Balances provides guidance on opening balances:
• When the financial statements of an entity are audited for the first time
• When the financial statements for the prior period were audited by a predecessor auditor
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

7.2.1 Specific audit procedures
For current assets and liabilities some audit evidence may be obtained as part of the current period's
audit procedures. For example, the collection (payment) of opening accounts receivable (accounts
payable) during the current period will provide some audit evidence of their existence, rights and C
obligations, completeness and valuation at the beginning of the period. H
A
In the case of inventories, however, the current period's audit procedures on the closing inventory
P
balance provide little audit evidence regarding inventory on hand at the beginning of the period.
T
Therefore, additional procedures may be necessary, such as: E
• 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.
7.2.2 Consistency of accounting policies

The auditor shall obtain sufficient appropriate audit evidence about whether the accounting policies
reflected in the opening balances have been consistently applied in the current period's financial
statements, and whether changes in the accounting policies have been appropriately properly accounted
for and adequately presented and disclosed in accordance with the applicable financial reporting
framework.
7.2.3 Prior period balances audited by a predecessor auditor

When the prior period's financial statements were audited by a predecessor auditor, the current auditor
must read the most recent financial statements and predecessor auditor's report for information relevant
to opening balances. The current auditor may be able to obtain sufficient appropriate evidence regarding
opening balances by performing this review depending on the professional competence and
independence of the predecessor auditor. Relevant ethical and professional requirements guide the
current auditor's communications with the predecessor auditor.
If there was a modification to the opinion, the auditor must evaluate the effect of the matter giving rise to
the modification in assessing the risks of material misstatement in the current period's financial
statements.
7.3 Audit conclusion and reporting

'If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances,
the auditor shall express a qualified opinion or disclaim an opinion on the financial statements, as
appropriate.
'If the auditor concludes that the opening balances contain a misstatement that materially affects the
current period's financial statements, and the effect of the misstatement is not appropriately accounted
for or not adequately presented or disclosed, the auditor shall express a qualified opinion or an adverse
opinion, as appropriate.'
Note: the Appendix to the ISA gives illustrations of auditors' reports with modified opinions relating to
opening balances.
If the auditor concludes that:
(a) The current period's accounting policies are not consistently applied in relation to opening balances
in accordance with the applicable financial reporting framework; or
(b) A change in accounting policies is not appropriately accounted for or not adequately presented or
disclosed in accordance with the applicable financial reporting framework,

the auditor shall express a qualified opinion or an adverse opinion as appropriate.
If the prior period auditor's report was modified, the auditor should consider the effect on the current
period's financial statements. For example, if there was a scope limitation in the prior period, but the
matter giving rise to the scope limitation has been resolved in the current period, the auditor may not
need to modify the current period's audit opinion.
The ISA finishes:
'If the predecessor auditor's opinion regarding the prior period's financial statements included a
modification to the auditor's opinion that remains relevant and material to the current period's financial
statements, the auditor shall modify the auditor's opinion on the current period's financial statements.'
8 Using the work of others
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.
8.1 Using the work of experts: revision

Professional audit staff are highly trained and educated, but their experience and training is limited to
accountancy and audit matters. In certain situations it will therefore be necessary to employ someone
else with different expert knowledge to gain sufficient, appropriate audit evidence. ISA 620 Using the
Work of an Auditor's Expert covers this area and this standard was covered at Professional Level. The
key points are covered below.
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.

• The nature and significance of the matter, including its complexity.
• The risks of material misstatement.
• The auditor's knowledge of and experience with the work of experts in relation to such matters and
C
the availability of alternative sources of audit evidence.
H
A
8.1.1 Competence, capabilities and objectivity of the auditor's expert
P
When planning to use the work of an auditor's expert the auditors shall assess the professional T
competence [including professional qualifications, experience and resources] of the expert. The auditor E
shall evaluate the objectivity of the expert. R
This will involve considering:
• The expert's professional certification, or licensing by, or membership of, an appropriate
professional body and the technical performance standards and other requirements, such as 6
ethical standards of that body.
• The relevance of the expert's competence to the matter for which that expert's work will be used,
including any areas of speciality within that expert's field.
• The expert's competence with respect to relevant accounting and auditing requirements, such
as assumptions and methods required by the applicable financial reporting framework.
In considering the objectivity of the expert, the auditor should consider circumstances such as self-
interest threats, advocacy threats, familiarity threat, self-review threats and intimidation threats as well
as the safeguards that may have been put in place to eliminate or reduce these.
8.1.2 Obtaining an understanding of the field of expertise of the auditor's expert

The auditor needs to have a sufficient understanding in order to be able to:
• Determine the nature, scope and objectives of the expert's work for the auditor's purposes, and
• Evaluate the adequacy of that work for the auditor's purposes.
8.1.3 Agreement with the auditor's expert

Written instructions usually cover the expert's terms of reference and such instructions may cover such
matters as follows.
• The nature, scope and objectives of the expert's work.
• The respective roles and responsibilities of the auditor and the expert.
• The nature, timing and extent of communication between the auditor and the expert, including the
form of any report to be provided by the expert.
• The need for the expert to observe confidentiality requirements.
8.1.4 Evaluating the adequacy of the auditor's expert's work

The auditors shall assess the adequacy of the expert's work for audit purposes.
Auditors should assess whether the substance of the expert's findings is properly reflected in the
financial statements or supports the financial statement assertions. It will also require consideration of:
• The relevance and reasonableness of the expert's findings or conclusions, and their consistency
with other audit evidence.
• The relevance and reasonableness of any significant assumptions and methods used.
• The relevance, completeness and accuracy of any source data used.
The auditors do not have the expertise to judge the assumptions and methods used; these are the
responsibility of the expert. However, the auditors should seek to obtain an understanding of these
assumptions, to consider their reasonableness based on other audit evidence, knowledge of the
business and so on.
If the results of the expert's work are not adequate for the auditor's purposes, the auditor shall:
• Agree with the expert on the nature and extent of further work to be performed by the expert, or

• Perform additional audit procedures appropriate to the circumstances.
8.1.5 Reference to the auditor's expert in the audit report

When issuing an unmodified audit opinion, the auditor should not refer to the work of the expert unless
required by law or regulation to do so.
Such a reference may be misunderstood and interpreted as a qualification of the audit opinion or a
division of responsibility, neither of which is appropriate.
If the auditors issue a modified audit opinion, then they may refer to the work of the expert if such a
reference is relevant to an understanding of the modification. The auditor must also indicate in the report
that the reference does not reduce the auditor's responsibility for the opinion. In such cases, auditors
may need to obtain permission in advance from the expert. If such permission is not given, then the
auditors may have to seek legal advice.
Interactive question 8: Using an expert – revision [Difficulty level: Easy]

(a) As auditor to an oil exploration company, you have ascertained that the useful life of each drilling
platform is assessed annually on factors such as weather conditions and the period over which it is
estimated that oil will be extracted. You are auditing the useful lives of the platforms.
(b) Piles of copper and brass, that can be distinguished with a simple acid test, have been mixed up.
You are attending the inventory count.
Requirement
Explain whether it is necessary to use the work of an auditor's expert in these situations. Where
relevant, you should describe alternative procedures.
8.2 Using the work of internal auditors

Using the work of internal auditors is covered at Professional level in the Audit and Assurance paper.
However a summary of the key points is set out below along with recent developments to the auditing
standard providing guidance on this area, ISA 610 Using the Work of Internal Auditors.
8.2.1 Assessment of internal audit

First, the external auditors will determine whether and to what extent to use the work of internal auditors
for the purposes of the audit.
Evaluation of internal audit
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
8.2.2 The effect on external audit procedures

The external auditor then must determine the effect of the work of the internal auditors on the nature,
timing or extent of the external auditor's procedures. The factors to consider are:

• The nature and scope of the internal audit work
• The assessed risks of material misstatement; and
• The degree of subjectivity involved in the evaluation of the audit evidence.
C
8.2.3 Evaluating specific internal auditing work H
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.
8.2.4 Direct assistance

In addition to using specific work done by an internal audit function, the external auditor may obtain
direct assistance from individuals from the internal audit department. Where this is the case, the external
auditor:
• Obtains written confirmation from those individuals and as an authorised member of the entity that
they will follow instruction from the external audit team and that they will keep specific matters
confidential.
• Confirms with the head of internal audit or those charged with governance the role those individuals
will play and the responsibility of the external auditor for quality control and the audit opinion.
• Supervises, reviews and evaluates the work performed.
• Ensures that such individuals are only involved in work where self-review or judgement is not an
important part of the procedure.
• Agrees the approach with those charged with governance.
8.2.5 Recent developments

The IAASB have issued a revised version of ISA 610 Using the Work of Internal Auditors. The IAASB's
objective in revising the ISA is to better reflect the developments in the internal auditing environment and
national auditing practices and enhance the performance of the external auditors by:

(a) Enabling them to better consider and leverage, as appropriate, the knowledge and findings of an
entity's internal audit function in making risk assessments in the external audit, and
(b) Strengthening the framework for the evaluation and, where appropriate, use of the work of internal
auditors in obtaining audit evidence.
The key changes made are as follows:
• Clearer emphasis that the external auditor's responsibility for the audit is not diminished by the
decision to use the work of the internal auditor.
• Clarification of the circumstances where the use of the internal auditor will be prohibited.
• Strengthening of the decision making framework to safeguard against undue use of internal audit
work (external auditor must make all significant judgements and must perform more procedures
directly where the risk of misstatement is higher).
• Introduction of the requirement for reperformance of some of the internal auditor's work.
In June 2013 the FRC issued ISA 610 (Revised). This adopts the provisions of the revised IAASB
standard. However, it also goes one step further by prohibiting the use of 'direct assistance' internal
audit staff on the external audit team. The aim of this prohibition is to enhance the principle of auditor
independence and promote greater confidence in the integrity of the audit for investors.
As a result of the revision of ISA 610 changes have also been made to ISA 315 Identifying and
Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment to
explain how the internal audit function and its findings can inform the external auditor's risk assessment.
ISA 315 (Revised) and ISA 610 (Revised) are not examinable in detail but you should have an
awareness of the key issues.
8.3 Service organisations
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.
9 Working in an audit team
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:

C
Engagement H
partner A
P
T
Audit manager E
R
Supervisors/ audit seniors

6
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.

• The work performed supports the conclusions reached and is appropriately documented.
• The evidence obtained is sufficient and appropriate to support the auditor's report.
• The objectives of the engagement procedures have been achieved.
Before the auditor's report is issued, the engagement partner must be sure that sufficient and
appropriate audit evidence has been obtained to support the audit opinion. The audit engagement
partner need not review all audit documentation, but may do so. He must review critical areas of
judgement, significant risks and other important matters.
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.

10.2 Engaging in e-commerce
As e-commerce is a very fast growing area of business, it is an important area for audit. For example, a
recent trend is towards cloud-based services. This can be a particularly good option for smaller
C
businesses to handle orders and process payments. There is no upfront investment and well-established
providers offer services at competitive prices. Obvious advantages include the 'anywhere access,' but H
issues of security and the stability of providers must be considered. Auditors must have an A
understanding of these kinds of developments and the impact that they will have on the business and P
the audit. T
E
A business can engage in e-commerce to a large or small extent. The greater the involvement a
business has with e-commerce, the more the risk associated with it. The extent of involvement is R
explored in the following table.
Involvement in e-commerce Risk 6
Information provision: A website can be used as a marketing device, to provide LOW

information to potential customers, and to enable them to request further information
through an email link.
Transactions with existing customers. Existing customers can be given the opportunity to
track current contracts or initiate others over the website.
Access to new customers. A website can be used as a place where new customers may
initiate transactions with the company.
New business model. A website can be used to diversify into specific web-based products,
for example, data for download. HIGH
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

10.3 Considerations for auditors
With the withdrawal by IAASB of IAPS 1013 Electronic Commerce – Effect on the Audit of Financial
Statements, there is currently no specific guidance on the special considerations for auditors who are
undertaking audits of companies that use e-commerce. The logic is that given the prevalence of e-
commerce, this should no longer be viewed as a separate specialist audit area, but one to which the
principles of any statutory audit should extend.
However, the following practical points are still relevant.
First, the auditor needs to consider whether the staff assigned to the audit have appropriate IT and
Internet business knowledge to carry out the audit. The auditor must also ensure that he/she has
sufficient knowledge of the client's business in accordance with ISA 315 Identifying and Assessing the
Risks of Material Misstatement through Understanding the Entity and Its Environment. In particular, the
auditor must consider the following:
• The entity's business activities and industry
• The entity's e-commerce strategy
• The extent of the entity's e-commerce activities
• The entity's outsourcing arrangements
Internal controls can be used to mitigate many of the risks associated with e-commerce. The auditor
has to consider the control environment and control procedures in accordance with the requirements of
ISA 315. There may be situations (such as the use of highly automated e-commerce systems, high
transaction volumes, lack of electronic evidence) when the auditor would have to use tests of control as
well as substantive procedures to render audit risk to an acceptably low level. In these situations,
CAATs could be used. (Internal controls and CAATs will be covered in further detail in Chapter 7.)
When auditing an entity that uses e-commerce, the auditor must consider in particular the issues of
security, transaction integrity and process alignment.
Security
The auditor should consider the following:
• The use of firewalls and virus protection software
• The effective use of encryption
• Controls over the development and implementation of systems used to support e-commerce
activities
• Whether security controls already in place are as effective as new technologies become available
• Whether the control environment supports the control procedures implemented
Transaction integrity
The auditor must consider the completeness, accuracy, timeliness and authorisation of the information
provided for recording and processing in the financial records, by carrying out procedures to evaluate
the reliability of the systems used for capturing and processing the information.
Process alignment
This is the way the IT systems used by the entity are integrated with one another to operate effectively
as one system. Many websites are not automatically integrated with the internal systems of the entity,
such as its accounting system and inventory management system, and this may affect issues such as
the completeness and accuracy of transaction processing, the timing of recognition of sales, purchases
and other transactions, and the identification and recording of disputed transactions.
11 Professional scepticism in the audit fieldwork stage
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.

The ongoing global financial crisis has increased the risk of misstatements. The risks centre particularly
around judgemental areas where there may be no clear 'right answer,' where the exercise of
professional scepticism is more important than ever.
The areas of particular risk today include: C
H
• Fraud: Consideration should be given to fraud at audit engagement team meetings. Fraud must be
A
considered, regardless of how well the auditor knows the client.
P
• Going concern: Smaller entities often lack detailed management information (for example, profit T
forecasts), so the auditor needs to consider a broader range of audit evidence. The client's specific E
circumstances and the challenges the business faces must be documented, along with the R
conclusions reached.
• Asset impairment: The financial crisis has affected basic assumptions – for example, the
expected future cash flows from long-term non-financial assets such as goodwill, plant and 6
equipment and intangible assets. Where the audit client has non-financial assets located in, or
related to, struggling economies, the value of such assets should be actively challenged. Where
assets have been impaired, management's assumptions behind the impairment calculation also
need to be scrutinised.
• Valuation of receivables and revenue recognition: Besides the likely impact of fraud on revenue
recognition, the liquidity problems faced by companies and governmental organisations mean that
bad debt allowances must be considered. Revenue should be recognised only when it is probable
that future economic benefits will flow to the entity.
The ICAEW Audit and Assurance Faculty released a video in 2011 on professional scepticism and other
key audit issues (www.icaew.com/en/technical/audit-and-assurance/professional-scepticism, accessed
on 25 July 2013). The video usefully mentioned some questions which auditors should bear in mind as
they perform audit fieldwork:
• Does the reporting reflect the substance of what has happened?
• Does it make sense?
• Are we focussing on the things that are there but missing the things that are not there – but should
be?
• Are there limitations on the scope of our procedures?
• Are the management's assumptions and forecasts appropriate?
• Are the assumptions still appropriate given the changing economy?
• What evidence is there besides what management has provided to us?
• Is the evidence contradictory?
In recent years, audit inspections have regularly pointed to the lack of scepticism in the performance of
audits. Two key points emerge from these audit inspection reports:
• Understanding the assumptions made is not enough: Simply finding out what the client has
done is not the same as auditing it. The auditor must challenge the assumptions and understand
how they affect the client's conclusions.
• The exercise of professional scepticism must be documented: Often, judgements were made
demonstrating appropriate scepticism – perhaps resulting from long conversations with the client –
but only the conclusion is documented, with little evidence of the process.
The process of documenting audit evidence and counter-evidence in itself can often help to identify
things that don't make sense.
The following example is adapted from the transcript of the ICAEW Audit and Assurance faculty's video
on professional scepticism. It illustrates in a helpful way what is meant by documenting the exercise of
professional scepticism.

Worked example: Documenting professional scepticism
Ben is an audit senior. In the process of auditing the client's calculation for the impairment of accounts
receivable, he identified that the discount rate used seemed out of line. He consulted Sophie, the audit
manager, and she agreed that the discount rate appears inappropriate.
Ben then asked the client to explain how the discount rate had been calculated. In the course of the
client's explanation, it became clear that the discount rate had been based on an incorrect assumption.
After two hours of discussions, the client understood the error and agreed to revise the impairment
calculation and adjust the financial statements accordingly.
Ben audited the revised impairment calculation and put it on the audit file. However, simply documenting
the revised calculation would give no indication of the audit work that had been carried out earlier, nor
would it show that professional scepticism had been exercised.
In order for the documentation to be complete, Ben should include a file note to explain:
• What issues were discussed with the client
• What the client said
• What evidence was offered
• What questions he then asked
• What further information was provided
• How he verified the information, and
• The final conclusion.
11.1 Discussion among the engagement team

ISA 240 specifically requires the audit engagement team to have discussions around the susceptibility of
the financial statements to fraud. Such a discussion should focus on how, and where, material
misstatements due to fraud may occur.
Such discussions will facilitate:
• The sharing of insight by the more experienced members of the audit team into how to identify
fraud risks.
• The consideration of an appropriate response to fraud risks, including determining who will conduct
certain audit procedures.
• The sharing of results from audit procedures with the rest of the audit team, and determining how
any allegations of fraud that come to the auditor's attention will be dealt with.
It is the audit engagement's partner's responsibility to decide which of the matters discussed are to be
communicated to those team members who are not involved in the discussion.

Appendix
C
H
This Appendix covers a number of topics which have been dealt with in detail in your earlier studies. A
A
brief reminder of the key points is provided below.
P
T
1 External confirmations E
R
1.1 Introduction
You have covered the basic audit of receivables and cash and bank in your Assurance studies. This
appendix revisits this topic in the context of ISA 505 External Confirmations. The standard sets out 6
guidance on how a confirmation should be carried out, and although it does not give a list of examples,
the principles could be applied to confirmations such as:
• Bank balances and other information from bankers
• Accounts receivable balances
• Inventories held by third parties
• Property deeds held by lawyers
• Loans from lenders
• Accounts payable balances
High profile financial failures such as Barings and Parmalat in Europe heightened awareness of the use
and reliability of external confirmations as audit evidence. Accordingly, some regulatory authorities in
major jurisdictions around the world called for more rigorous requirements pertaining to the use of
confirmations.
The major issue to be dealt with in the revision of this standard during the Clarity Project was to seek a
solution that achieved a balance between the conflicting circumstances in which regulators and others
have been demanding increasing prescription in the use of confirmations, and the anecdotal evidence
from practitioners that responses to confirmation requests may be unreliable or unobtainable.
ISA 505 refers to the guidance on evidence from ISA 500 Audit Evidence, and the specific requirement,
now in ISA 330 The Auditor's Responses to Assessed Risks, to consider, for each material class of
transactions, account balance and disclosure, whether external confirmation procedures are to be
performed as substantive procedures.
1.2 Requirements of ISA 505

1.2.1 Procedures
The auditor maintains control over the confirmation requests including:
• Determining the information to be requested
• Selecting the confirming party
• Designing the confirmation requests, including ensuring that they are correctly addressed and
contain return information for replies to be sent directly to the auditor
• Sending the requests (and second requests, if needed)
1.2.2 Management refusal

If management refuses to allow a confirmation request to be sent, the auditor shall:
• Inquire as to the reason, and seek evidence as to their validity. (The risk here is that management
may claim that the confirmation may cause problems in the context of disputes or litigation, but the
auditor must remain sceptical and consider the possibility that this may be an attempt to deny
access to evidence that might indicate the existence of fraud.)
• Evaluate the implications of refusal on the risk assessment
• Perform alternative procedures

1.2.3 Results
There is always a risk that responses may be intercepted, altered or be in some other way fraudulent.
The auditor must be alert to any factors that suggest there is any doubt about the reliability of the
responses, such as:
• It was received by the auditor indirectly (for example, was received by the client entity and passed
on to the auditor), or
• Appeared not to come from the originally intended confirming party.
In the case of non-responses, the auditor must obtain alternative evidence, the form and nature of which
will be affected by the account and the assertion in question.
1.2.4 Evaluating the evidence

The auditor must evaluate whether the confirmation results provide relevant and reliable audit evidence
or whether further audit evidence is necessary.
1.3 Confirmation of accounts receivable

1.3.1 Objectives of confirmation
ISA 505 is relevant to confirmation of accounts receivable. This section recaps the practical application
of the standard. The verification of trade accounts receivable by direct communication is a normal
means of providing audit evidence to satisfy the objective of checking whether customers exist and owe
bona fide amounts to the company (existence and rights and obligations).
Confirmation will produce a written statement from each respondent that the amount owed at the date of
the confirmation is correct. This is, prima facie, reliable audit evidence, being from an independent
source and in 'documentary' form. The confirmation of accounts receivable on a test basis should not be
regarded as replacing other normal audit checks, such as the testing in depth of sales transactions, but
the results may influence the scope of such tests.
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.
1.3.3 Client's mandate

Confirmation is essentially an act of the client, who alone can authorise third parties to divulge
information to the auditors.
The ISA outlines what the auditors' response should be when management refuse permission for the
auditors to contact third parties for evidence.
The auditor must:
• Inquire as to management's reasons and seek supporting evidence
• Evaluate the implications on the auditor's assessment of the risks of material misstatement
including fraud
• Perform alternative audit procedures
• Consider the implications for the audit opinion

1.3.4 Positive v negative confirmation
When confirmation is undertaken the method of requesting information from the customer may be either
'positive' or 'negative'.
C
• Under the positive method the customer is requested to confirm the accuracy of the balance H
shown or state in what respect he is in disagreement. A
• Under the negative method the customer is requested to reply if the amount stated is disputed. P
T
The positive method is generally preferable as it is designed to encourage definite replies from those
E
contacted.
R
The negative method may be used if the client has good internal control, with a large number of small
accounts. In some circumstances, say where there is a small number of large accounts and a large
number of small accounts, a combination of both methods, as noted above, may be appropriate.
6
1.3.5 Sample selection

Auditors will normally only contact a sample of receivables balances. If this sample is to yield a
meaningful result it must be based upon a complete list of all debtors. In addition, when constructing the
sample, the following classes of account should receive special attention:
• Old unpaid accounts
• Accounts written off during the period under review
• Accounts with credit balances
• Accounts settled by round sum payments
Similarly, the following should not be overlooked:
• Accounts with nil balances
• Accounts which have been paid by the date of the examination
1.3.6 Follow up procedures

Auditors must follow up customer disagreements and failure by customers to respond.
Auditors will have to carry out further work in relation to those debtors who:
• Disagree with the balance stated (positive and negative confirmation)
• Do not respond (positive confirmation only)
In the case of disagreements, the customer response should have identified specific amounts which are
disputed.
Reasons for disagreements
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.

When the positive request method is used the auditors must follow up by all practicable means those
debtors who fail to respond. Second requests should be sent out in the event of no reply being
received within two or three weeks and if necessary this may be followed by telephoning the customer,
with the client's permission.
After two, or even three, attempts to obtain confirmation, a list of the outstanding items will normally be
passed to a responsible company official, preferably independent of the sales accounting department,
who will arrange for them to be investigated.
1.3.7 Additional procedures where confirmation is carried out before year-end

The auditors will need to carry out the following procedures where their confirmation is carried out before
the year-end.
• Review and reconcile entries on the sales ledger control account for the intervening period.
• Verify sales entries from the control account by checking sales day book entries, copy sales
invoices and despatch notes.
• Check that appropriate credit entries have been made for goods returned notes and other evidence
of returns/allowances to the sales ledger control account.
• Select a sample from the cash received records and ensure that receipts have been credited to the
control account.
• Review the list of balances at the confirmation date and year end and investigate any unexpected
movements or lack of them (it may be prudent to send further confirmation requests at the year end
to material debtors where review results are unsatisfactory).
• Carry out analytical procedures, comparing receivables' ratios at the confirmation date and
year-end.
1.3.8 Evaluation and conclusions

All confirmations, regardless of timing, must be properly recorded and evaluated. All balance
disagreements and non-replies must be followed up and their effect on total receivables evaluated.
Differences arising that merely represent invoices or cash in transit (normal timing differences)
generally do not require adjustment, but disputed amounts, and errors by the client, may indicate that
further substantive work is necessary to determine whether material adjustments are required.
1.4 Bank reports for audit purposes

1.4.1 Planning
The auditors should decide from which bank or banks to request confirmation, having regard to the risks
in relation to relevant financial statement assertions including bank related information to be disclosed in
notes.
The auditor may be able to identify what banking relationships are in place by reviewing annual facilities
letters from the entity's banks. If no such letters are available, the auditor will ask the entity's
management to provide the information.
Given the importance of cash to an entity's business and its susceptibility to fraud, the auditor will
usually conclude that in the absence of a bank report it will not be possible to obtain sufficient
appropriate audit evidence from other sources.
In planning the submission of the request, the auditor will:
• Determine the date by which the bank report is needed.
• Determine whether confirmation is needed of additional information such as trade finance
transactions and balances.
• Check that the bank has been given valid authority to disclose information to the auditor.

1.4.2 Preparation and despatch of requests and receipt of replies
Control over the content and despatch of confirmation requests is the responsibility of the auditors.
However, banks require the explicit written authority of their customers to disclose information
requested. Where possible this should take the form of an ongoing authority. Auditors need to satisfy C
themselves that an authority is in place and up to date. Replies should be returned directly to the H
auditors and to facilitate such a reply, a pre-addressed envelope should be enclosed with the request. A
P
1.4.3 Content of confirmation requests T
E
The form and content of a confirmation request letter will depend on the purpose for which it is required
and on local practices. R
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.

2.1 Nature of sampling
The audit involves a search for evidence, and sampling is, in part, a method of assessing the quantity
and quality of that evidence. In so doing, an assessment needs to be made of an acceptable level of
sampling risk ie the risk that the sample will be unrepresentative of the population.
Sampling can be used to extract evidence for 'tests of details' or for 'tests of controls'.
The stages of sampling involve:
(1) Sample design and selection
(2) Testing
(3) Evaluation
Most research suggests, however, that the proportion of evidence that is derived from sampling,
particularly in respect of tests of details, has declined in recent years in favour of other sources of
evidence. Typically, a small sample of items may be taken by many audit firms for tests of details, where
there are no special circumstances – although the precise number of items tested tends to vary
significantly.
2.2 Sample design

Is it necessary? – While auditing standards require some substantive testing they do not require tests of
detail, as analytical procedures alone may be sufficient in some circumstances.
Sample objectives – It is initially necessary to determine the purpose of the sample. This is likely to be
different according to whether the sample is for tests of control or for tests of detail. Even in the latter
case, objectives of assessing completeness, accuracy or validity will influence sample objectives.
Population – The selection of an appropriate population from which to sample is important. Consider the
following.
• Is the population homogeneous? For example, if larger purchases are subject to more internal
controls than smaller purchases, then all purchase transactions are not subject to the same risk
and may need to be stratified into different samples.
• What is the level of risk expected in the population?
• If testing for understatement (completeness/omission) then it is important to sample from the
population making up the initial record then tracing to the final record.
• If testing for overstatement (completeness/accuracy/validity) then it is important to select the
sample from the population making up the final record then tracing to the initial record.
• Directional testing would not test all items for both over and understatement. Populations which
consist of debits would only be tested for overstatement and credits only tested for understatement.
Given the duality of double entry, this means that any one transaction is tested for misstatement.
2.3 Types of sampling

ISA 530 permits either of the two basic methods of sampling, which are
• Statistical sampling
• Judgement sampling
All types of sampling require the exercise of judgement. However judgement sampling is so called as the
sample size and selection are based upon the auditor's professional judgement rather than any
statistical basis.
The advantages of statistical sampling include the following.
• Provides unbiased sample selection.
• Sample sizes can be based upon probability theory and can more easily be justified in court.
• Provides greater consistency of judgement between different auditors in similar circumstances.
• Evaluation of results can more validly be extrapolated into the population.
Disadvantages include the following.
• Excessive sample sizes can arise.

• Significant judgement in assessing the level of assurance required from sampling (relative to other
evidence) is still needed, such that its statistical validity is questionable.
Statistical sampling is now less widely used than was once the case.
C
Methods of sampling include the following. H
Random sampling – Each item in the population has an equal chance of selection. A
th P
Systematic/Interval sampling – Takes a random start and selects every n item thereafter (ie at a
T
constant interval). It is valid if errors are randomly distributed. The interval may be numerical (eg order
numbers) or by value – monetary unit sampling (ie every nth CU of purchases). E
R
Block/cluster sampling – The selection of a group of transactions occurring together (eg a test of all
sales in the month of June). This is unlikely to be representative of the population, which damages its
statistical validity. It is, however, normally quicker to extract the data.
6
Haphazard selection – Items are selected without following a structured technique. Care must be taken
with respect to sample selection bias and completeness of population. It may be appropriate where
client records are poorly kept. Haphazard selection is not appropriate when using statistical sampling.
2.4 Sample size

Auditors need to acquire sufficient evidence and this means that determining sample size is important.
Too few items incur undue sampling risk and too many items incur unnecessary costs.
Factors affecting sample size with respect to tests of detail include the following.
• Level of assurance required from sampling – If other sources of evidence are available and indicate
low inherent and control risk then sampling may be reduced.
• Tolerable misstatement or tolerable deviation rate – When testing substantively, this is the
maximum error the auditor is willing to accept in the sample – which is based on the performance
materiality level, but could be set lower for a specific assertion. When tests of controls are being
carried out, this is the number of deviations in the sample the auditor is willing to accept without
changing the initial assessment of control risk.
• Expected misstatement or expected deviation rate – This is the expected level of error and
deviation in the sample.
• Variability of the population – This is not relevant to sampling for tests of control but increased
variability will increase sample sizes for substantive tests.
• The size of the population – Other than for very small populations, the size of the population has a
minimal effect on sample sizes.
Appendix 1 and 2 to ISA 530 contain useful summaries of the factors influencing sample sizes.
2.5 Sample evaluation

For tests of details the auditor is required to project misstatements found.
The misstatements and deviations discovered in the sample need to be extrapolated into the population
in order to draw conclusions about whether the population is materially misstated. (In order to do this
appropriately it is important that the sample was representative of the population from which it was
selected.) Where the estimated misstatement exceeds the tolerable misstatement then additional
evidence may be needed.
Consider also the following.
• While management may adjust for misstatements actually discovered, consideration needs to be
given to misstatements in un-sampled items and whether any global adjustment is appropriate.
• There may be patterns or trends in the misstatements discovered.
• There may be a pattern from previous years, which would add additional insight into the extent of
the misstatement in the population.
• Size and incidence of misstatements discovered eg a few large misstatements or many small
misstatements.

• Nature of the misstatements. Are they factual or are they perceived errors of judgement/opinion?
• Whether they are fraudulent.
• Whether a misstatement relates to the statement of financial position or to the statement of profit or
loss and other comprehensive income.
For tests of controls an unexpectedly high sample deviation rate may lead to an increase in the
assessed risk of material misstatement unless further audit evidence substantiating the initial
assessment is obtained.
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)
3.1 Tests designed to discover errors

These tests will start with sampling the final accounting records in which the transactions are recorded
and check from the entries to supporting documents or other evidence. Such tests should primarily
detect any over-statement but also note any under-statement through causes other than omission.
3.2 Tests designed to discover omissions

These tests must start from outside the accounting records and then check to those records.
Understatements through omission will never be revealed by starting with the initial recording of a
transaction (eg an order form) and traced through the various documents and accounts into the financial
statements. There would clearly be no chance of selecting items that have been omitted if sampling was
taken from the final accounts.
For most systems auditors would include tests designed to discover both errors and omissions. The type
of test, and direction of the test, should be recognised before selecting the test sample. If the sample
which tested the accuracy and validity of the sales ledger were chosen from a file of sales invoices then
it would not necessarily substantiate the fact that there were no errors in the sales ledger. The approach
known as 'directional testing' applies this testing discipline.
3.3 Directional testing and double entry

The concept of directional testing derives from the principle of double-entry bookkeeping, in that for
every debit there is a corresponding credit (assuming that the double entry is complete and that the
accounting records balance). Therefore, any misstatement of a debit entry will result in either a
corresponding misstatement of a credit entry or a misstatement in the opposite direction, of another
debit entry.
By designing audit tests carefully the auditors are able to use this principle in drawing audit conclusions,
not only about the debit or credit entries that they have directly tested, but also about the corresponding
credit or debit entries that are necessary to balance the books. Tests are therefore designed in the
following way.
Test item Example

Test debit items (expenditure or If a non-current asset entry in the nominal ledger of CU1,000 is
assets) for overstatement by selecting selected, it would be overstated if it should have been recorded
debit entries recorded in the nominal at anything less than CU1,000 or if the company did not own it,
ledger and checking value, existence or indeed if it did not exist (eg it had been sold or the amount of
and ownership CU1,000 in fact represented a revenue expense).

Test item Example
Test credit items (income or liabilities) Select a goods despatched note and check that the resultant
for understatement by selecting items sale has been recorded in the nominal ledger sales account. C
from appropriate sources independent Sales would be understated if the nominal ledger did not reflect
H
of the nominal ledger and ensuring the transaction at all (completeness) or reflected it at less than
A
that they result in the correct nominal full value (say if goods valued at CU1,000 were recorded in the
ledger entry sales account at CU900, there would be an understatement of P
CU100). T
E
In a ledger account for (say) an asset, the balance would be a debit, but there may be both debit and R
credit entries in the account. In using directional testing on this asset account balance, the debit entries
would be tested for overstatement and the credit entries for understatement. The reason is that the
understatement of a credit entry would lead to the overstatement of the asset's debit balance on the
6
account, the verification of which is the primary purpose of the test.
The matrix set out below demonstrates how directional testing is applied to give assurance on all
account areas in the financial statements.
Primary test also gives comfort on
Type of account Purpose of primary test Assets Liabilities Income Expenses
Assets Overstatement (O) U O O U

Liabilities Understatement (U) U O O U
Income Understatement (U) U O O U
Expense Overstatement (O) U O O U
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

Self-test [PS2]
1 Strombolix Ltd
Strombolix Ltd (Strombolix) is a listed company which manufactures and retails paints and other C
decorating products. You are the senior in charge of the audit of Strombolix for the year ending 30 H
June 20X2, which is currently in progress.
A
Background information provided P
The company owns a large factory manufacturing paints. These paints are sold retail through T
Strombolix's six superstores and they are also sold wholesale to other DIY retailers. In addition, the E
six superstores sell a range of other products from different suppliers. The superstores are each R
separate divisions, but there are no subsidiaries.
On 23 July 20X2 a bid was announced by Simban Ltd (Simban) to acquire the entire ordinary share
capital of Strombolix. The directors of Strombolix are contesting the bid and are anxious to publish 6
the financial statements to indicate that the company is more profitable than indicated by the
Simban offer.
As a result of the bid your audit partner has sent you the following memorandum.
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.

Requirement
Draft the notes required by Charles Church's memorandum.
2 AB Milton Ltd
You are the senior in charge of the audit of AB Milton Ltd for the year ended 31 May 20X1. Details
of AB Milton Ltd and certain other companies are given below.
AB Milton Ltd
A building company formed by Alexander Milton and his brother, Brian.
AB Milton Ltd has issued share capital of 500 ordinary CU1 shares, owned as shown below.
Alexander Milton 210 42% Founder and director
Brian Milton 110 22% Founder and director
Catherine Milton (Brian's wife) 100 20% Company secretary
Diane Hardy 20 4%
Edward Murray 60 12% Director
Edward Murray is a local business man and a close friend of both Alexander and Brian Milton. He
gave the brothers advice when they set up the company and remains involved through his position
on the board of directors. His own company, Murray Design Ltd, supplies AB Milton Ltd with
stationery and publicity materials.
Diane Hardy is Alexander Milton's ex-wife. She was given her shares as part of the divorce
settlement and has no active involvement in the management of the company. Alexander's
girlfriend, Fiona Dyson, is the company's solicitor. She is responsible for drawing up and reviewing
all key building and other contracts, and frequently attends board meetings so that she can explain
the terms of a particular contract to the directors. Her personal involvement with Alexander started
in May 20X1 and, since that time, she has spent increasing amounts of time at the company's
premises.
Cuts and Curls Ltd
A poodle parlour, of which 50% of the issued shares are owned by Diane Hardy and 50% by Gillian
Milton, who is Alexander and Diane's daughter.
Cuts and Curls operates from premises owned by AB Milton Ltd for which it pays rent at the normal
market rate.
Campbell Milton Roofing Ltd
A roofing company owned 60% by AB Milton Ltd and 40% by Ian Campbell, the managing director.
Campbell Milton Roofing Ltd carries out regular work for AB Milton Ltd and also does roofing work
for local customers. Alexander Milton is a director of Campbell Milton Roofing Ltd and Catherine
Milton is the company secretary. All legal work is performed by Fiona Dyson.
Requirements
(a) Based on the information given above, identify the potential related party transactions you
expect to encounter during the audit of AB Milton Ltd and summarise, giving your reasons,
what disclosure, if any, will be required in the full statutory accounts.
(b) Prepare notes for a training session for junior staff on how to identify related party
transactions. Your notes should include:
(i) A list of possible features which could lead you to investigate a particular transaction to
determine whether it is in fact a related party transaction, and
(ii) A summary of the general audit procedures you would perform to ensure that all material
related party transactions have been identified.

3 TrueBlue Ltd
You are planning the audit of TrueBlue Ltd, a company that has experienced a downturn in trading
over recent years. The finance director has provided you with the following information for you to
review before a planning meeting with him. C
H
Statement of profit or loss and other comprehensive income extracts:
A
20X7 20X6 20X5 P
CU CU CU T
Revenue 18,944,487 20,588,370 24,536,570 E
Cost of sales 14,587,254 14,413,543 17,176,922
R
Gross profit 4,357,233 6,174,827 7,359,648
Advertising and marketing 554,288 206,688 207,377
Legal costs 14,888 2,889 34,668
Electricity 199,488 204,844 206,488 6
Travel costs 65,833 30,892 53,588
Audit fee 21,000 21,000 20,488
Statement of financial position extracts:
20X7 20X6 20X5
CU CU CU
Trade receivables 3,477,481 3,553,609 4,089,783
Trade payables 1,056,090 1,027,380 1,164,843
Cost of sales analysis:
20X7 20X6 20X5
CU CU CU
Purchases 9,183,388 9,246,420 10,483,588
Other direct costs 6,419,410 6,894,300 7,087,148
Inventory movement (1,015,544) (1,727,177) (393,814)
Requirements
(a) Outline the areas of the financial statements you would discuss with the finance director at
your planning meeting as a result of the analytical procedures that you perform on these
figures, giving your reasons and also set out any further information you would request.
(b) Explain whether your approach would be different if you had received a tip off that the finance
director has been carrying out a fraud on receipts from receivables, and if it would be different,
outline how it would be different.
(c) Describe how you approach the audit of receivables as a result of the tip off about the finance
director.
4 Tofalco Ltd
You are an audit senior in the process of carrying out the final audit for the year ended 30
September 20X0 for Tofalco Ltd, a construction company with business activities across the Asia.

The following message is left on your answer machine by Paul Sykes, Head of Audit:
Good morning Jeremy,

Paul Sykes here. Hope all is well with you.
I have left a memo in your mailbox with the items outstanding on the year end audit of our client Tofalco
Ltd.
Please prepare a memo showing the appropriate financial reporting treatment for each item in the
financial statements for the year ended 30 September 20X0 and the audit procedures required to gain
assurance in each area.
I am concerned as the directors appear to be unwilling to provide full details of their related parties'
remuneration and seem to be denying access to the company board minutes. They are also refusing to
recognise the obligations required under ISA37 with respect to environmental costs. Please give me
your opinion on the effects of these non-compliance issues on audit risk and on the form of the audit
report to be issued.
Tofalco Ltd have also asked that we advise them on the way they should work with Investo Ltd, a
company to which they plan to outsource their investment activities. Tofalco Ltd wishes to agree on
terms of co-operation that minimise risks of financial loss, fraud and error. Is there any impact on our
audit going forward?
Finally, can you prepare a list of the ethical issues you foresee on this assignment. They would be
helpful to have to hand.
Call me if you have any queries.
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.

The machinery held by Tofalco at the year end has a total carrying amount of CU25 million and it is
estimated that the present value of the cost to dispose of these machines will be some CU2.5 million.
One of Tofalco's biggest customers, Stirly Ltd, is refusing to pay a sum of CU4 million. No provision has C
been created by the company and the reasons are unclear as to why Stirly Ltd is holding back payment,
H
with management being vague in their explanations and appearing to be denying access to the
A
company board minutes.
P
Assets held for sale T
On 1 January 20X0, Tofalco Ltd committed to selling an owner-occupied building which had a carrying E
amount of CU2.16 million at that date. The building was available for immediate sale from that date but R
the company continued to occupy and use the building until 1 February when the carrying amount was
approximately CU2.1 million. The recoverable amount is estimated at CU1.7 million. The building has
yet to be sold by 30 September 20X0. 6
Issue of convertible loan stock
On 1 March 20X0, Tofalco Ltd issued CU18 million of convertible loan stock, which is either redeemable
in three years' time for CU20 million, or convertible into 500,000 ordinary CU1 shares.
The present values of the cash flows, discounted at the interest rate on a debt instrument with similar
terms except that there is no conversion option, are as follows.
cu
£
Present value of principal 15,902,000
Present value of interest 960,000
16,862,000
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.

Technical reference
1 ISA 210
• Terms of audit engagements ISA 210
2 ISA 402
• Definition ISA 402.8
• Understanding the entity ISA 402.9–.14
• Audit procedures for obtaining audit evidence ISA 402.15–.16
• Reference in audit reports ISA 402.20–.22
3 ISA 315
• List of audit assertions ISA 315.A111
4 ISA 500
• Sufficient and appropriate audit evidence ISA 500.A1–.A6
• Audit procedures for obtaining audit evidence ISA 500.A10–.A25
• Evidence from information produced by a management's expert ISA 500.A34–.A48
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
• External confirmation procedures ISA 505.7–.16
7 ISA 510
• Need to obtain audit evidence ISA 510.3
• Audit procedures ISA 510.5–.9
• Audit conclusions and reporting ISA 510.10–.13
8 ISA 520
• Use of analytical procedures as substantive procedures ISA 520.5, A4–.A10
• Analytical procedures when forming an overall conclusion ISA 520.6, A17–A19
9 ISA 530
• Definitions ISA 530.5
• Design of the sample ISA 530.A4–.A9
ISA 530.A10–.A13, ,
• Sample size
Appendix 2
• Evaluation of sample results ISA 530.A21–.A23

10 ISA 540
• Examples of accounting estimates ISA 540.A6
C
H
• Substantive procedures ISA 540.15–.17 A
• Evaluation of results of audit procedures ISA 540.18 P

T
11 ISA 550 E
R
• Definitions ISA 550.10
• Risk assessment procedures ISA 550.11–17

6
• Audit procedures ISA 550.20–.24
• Written representations and reporting ISA 550.26–.27
12 ISA 610 Using the work of internal audit

• Reliance on internal audit ISA 610.8–.10
• Evaluating work of internal audit ISA 610.11–.12
13 ISA 620
• 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
• Agreeing the scope of the auditor's expert's work ISA 620.11
• Evaluating the work of the auditor's expert ISA 620.12–.13
• Reference in audit report ISA 620.14–.15

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.

• Review correspondence with the company's solicitors.
• Establish whether Strombolix made the paint itself or whether it was purchased from a
supplier, in which case there may be a corresponding claim by Strombolix.
C
• Speak to the company's production/technical director to establish the nature of the H
problem and whether any other paints may be affected. A
• Attempt to estimate the non-material costs which customers may incur in replacing the P
faulty paint. T
E
• Review returns inwards and customer compliant files from retail customers in respect of
R
the faulty paint.
• Review the latest situation with respect to litigation on a continuing basis up to the time of
audit completion. 6
Questions for finance director
• Does the company accept that it was at fault with respect to this paint?
• What attempts have been made to evaluate liability?
• What is the current status of any litigation against the company?
(2) Inventories
Issues arising
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 company also intends to take credit for a proportion of a quantity bonus payable
by the supplier in respect of this product.
There are two key audit issues.
• There has been a systems error which appears to have gone undetected and unreported
for some time. This raises concerns about the operation of the accounting and internal
control systems more generally.
• The extent of the substantive errors needs to be established and adjusted.
Systems errors – inventories
• Establish why the special offer was not programmed into the IT system.
• Establish whether any other such programming omissions occurred.
• Investigate why the error was not reported back to programmers from store managers
who were instructing sales staff to read only two of the three items.
• Consider the level of understanding of store managers of the IT system, and whether this
may have contributed to other similar errors.
• Establish how the error was ultimately detected, and thus what other controls had failed
to detect the problem prior to its discovery.
Substantive errors – inventories
Misstatement relating to special offer
• If the third item in each transaction was unrecorded, the IT records will overstate
inventory. If 20,000 units have been recorded (if they have all been sold through the
special 3-for-2 offer) 10,000 have been unrecorded. This will mean reducing inventories
in the IT records by a maximum of CU50,000.
• Adjustment will need to be made for any similar errors discovered by the above systems
review.

Taking credit for bonus
• Strombolix appears to be intending to take credit for part of the supplier's bonus in its
draft financial statements. The bonus is, however, effectively a contingent asset under
ISA37, as the payment is dependent upon making total sales of 40,000 units, including
some in the future. If this is only probable, disclosure can be made, but a pro rata amount
cannot be included in the statement of profit or loss and other comprehensive income in
the year to 30 June 20X2.
• If, on the basis of post year end evidence prior to audit completion, it is virtually certain
that sales of 40,000 units of the product will be made, and that settlement will be made
by the supplier, then a pro rata recognition is appropriate. However, as the sales appear
to be made on the total level of sales made by the supplier to Strombolix (ie including the
'free' goods and perhaps any goods still in inventories), then the credit would be a
maximum of CU67,500 (ie (30,000 ÷ 40,000) × CU90,000) if all sales were through the
special offer.
• In the absence of near certainty over attaining the bonus, there is an inventory valuation
problem. If the bonus is not paid, the NRV of any inventories remaining is less than its
cost. For example, a batch of three units would be valued in inventories at CU15 (3 ×
CU5), whereas its NRV is only CU12 (2 × CU6). In this case, consideration should be
given to writing down each inventory item to CU4 (ie CU12 ÷ 3).
Audit procedures
• Obtain explanations for the systems error.
• Review the company's internal control procedures with respect to the inclusion in the IT
system of non-standard sales arrangements.
• Obtain explanations for the non-reporting of the error by store managers.
• Review the scope for similar errors in the system in respect of both detection and
reporting.
• Consider whether (and if not, why not) the physical inventory count detected the IT error.
• Evaluate the number of sales of the product made through the '3-for-2' special offer, as
opposed to single purchases.
• Review post year end sales to assess the probability of achieving the bonus payment
from the supplier.
• Consider the adequacy of the inventory provision in the light of the results of the above.
• How did the systems error occur in respect of the special '3-for-2' offer?
• Why did it go undetected?
• What is the justification for taking credit for part of the bonus from the supplier when the
target has not been achieved at the year end?
(3) Capitalisation of interest
Issues arising
The company had a new superstore constructed during the year, and it borrowed to finance
this project. The interest on the borrowing was all capitalised.
ISA23 Borrowing Costs requires borrowing costs that are directly attributable to the
acquisition, construction or production of a qualifying asset to be capitalised as part of the cost
of the asset. It defines a qualifying asset as one that takes a substantial period of time to get
ready for its intended use or sale (ISA23 para 5). The treatment adopted by the company
therefore appears to comply with the ISAproviding that the borrowing costs are 'directly
attributable' to construction ie they would have been avoided if expenditure on the construction
of the asset had not been incurred.

The finance costs on the relevant borrowings become part of the overall asset and are
therefore recognised in profit or loss as the asset is depreciated over its useful life, rather than
as incurred.
Capitalisation should cease when substantially all the activities necessary to get the asset C
ready for its intended use or sale are complete (ISA23 para 22). It is the availability for use H
which is important, not when it is actually brought into use. An asset is normally ready for its A
intended use or sale when its physical construction is complete. P
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
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%
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).

• Confirm that the policy on interest capitalisation is consistent with that previously adopted
when building other stores.
• Why was there a delay between the purchase of land and the commencement of
preparation for planning permission?
• Does he accept that the revised calculation (above) is consistent with ISA23?
General concerns arising from the takeover bid
The takeover bid is an inherent risk in the context of this audit, particularly as the directors are
attempting to defend the bid. In this case they will be attempting to show the company in the
best possible light. This may involve disclosing the highest possible profit in the financial
statements.
This policy would be consistent with the audit issues discovered, in that there does not appear
to be any provision in respect of receivables or inventory in audit issues (1) and (2). Similarly,
the amount of interest capitalised in (3) appears to present an over-optimistic figure for profit.
Consideration will thus need to be given to the extent of reliance that can be placed on
management assurances and managerial control in this audit, even if they have proved
reliable in the past.
Moreover, if the financial statements are misstated there is a possibility of litigation against our
firm for third party negligence if Simban suffers a loss or if it relies on the financial statements
– and we know it is relying on the financial statements for the purpose of the takeover. To
some extent a report of due diligence prior to takeover may mitigate some of this risk, but this
cannot be relied upon entirely.
Consider the impact of time pressure being placed on the audit.
Reconsider materiality levels and the risk assessment in the audit plan in the light of the
takeover bid.
2 AB Milton Ltd
(a) Person/entity Related party Why Transaction

Alexander Milton  Director
Brian Milton  Director No
transactions
mentioned
Brian's wife  Wife of director
Edward Murray  Director Purchases of
stationery
Murray Design  Entity controlled by a
Director
Diane Hardy X No longer close family
and does not have control
or significant influence
Fiona Dyson  Presumed close family Contracts drawn
and shadow director
Cuts & Curls ? (see below) Rental agreement
Campbell Milton  Sub of AB Milton Work done for AB
Roofing (see below)
Ian Campbell /X Could be considered key
management of group
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.

Disclosure
The related party relationship between AB Milton and Campbell Milton Roofing must be
disclosed as it is a relationship between a parent and a subsidiary. This disclosure must be
provided irrespective of whether a transaction takes place. C
H
For other related party relationships disclosure is only required where a transaction has taken
A
place. In this case that would apply to the transactions with Edward Murray, Fiona Dyson and
P
potentially Cuts & Curls. Disclosure is required of the nature of the related party relationship
as well as information about the transaction and any outstanding balances necessary for T
users to understand the potential effect of the relationship. Disclosure should include as a E
minimum: R
• A description of the relationship

• A description of the transaction and the amounts included 6
• 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.

• Scrutiny of cash book/cheque stubs for payments made to directors or officers of
the company (probably more realistic for smaller entities).
• Review of Board minutes for evidence of approval of related party transactions
(directors are under a fiduciary duty not to make secret profits).
• Written representations from directors to give exhaustive list of all actual/potential
related parties (that is, allow us to make the materiality assessment, not them).
• Review of accounting rewards for large transactions, especially near the year-end
and with non-established customers/suppliers.
• Identification of any persons holding > 20% of the shares in the entity by reference
to the shareholders' register.
3 TrueBlue Ltd
(a) Discussion with the finance director
Revenue and marketing expense
The trend of falling revenue has continued in 20X7 from previous years. The problem seems
worse in view of the fact that 20X7 saw a substantial increase in advertising and marketing
expenditure, without which the fall would presumably have been greater. It is important to
investigate this situation and the action taken in relation to it, because the company could be
facing significant going concern problems if its products are no longer required by the market.
However, the revenue fall in 20X7 from 20X6 is not as significant as from 20X5, and it is
possible that the sales trend in 20X6 and the beginning of 20X7 has been reversed and the
company might be beginning to perform well again.
Additional information required:
• Does the additional marketing spend relate to 20X7 or was it to encourage sales in the
future?
• Were there any sales forecasts produced in connection with the marketing spend?
• Can you provide details of sales month by month to show the revenue pattern throughout
the year, particularly in relation to the marketing spend?
• Does management have other plans/intentions with regard to boosting revenue,
particularly if the additional marketing spend in 20X7 has not produced the expected
results?
Gross profit percentage
The gross profit percentage was stable in 20X6 and 20X5 at 30% but it has dropped in 20X7
to 23%. This implies either that there is a mistake in the figures (for example, an expense may
have been analysed incorrectly; there may have been an error in final inventory counting or
valuation; or some sales may not have been included correctly in revenue hence it has fallen),
or that there has been a change in the cost structure or sales mix resulting in this fall.
With revenue falling, if sales are also becoming less profitable, the problem outlined above
might be intensified. Alternatively, a new sales mix may be the directors' approach to solving
revenue fall and in the long term, increased sales at a lower margin might be the new situation
for the company.
Additional information required:
• The reason for the fall in GP%
• Analysis of sales by month and product
• Further analysis of cost of sales figures
Receivables
The trade receivables balance has fallen over the three years, which is in line with the fall in
revenue. However, it has not fallen at the same rate, which is shown by the fact that the
receivables days calculation shows that debts are not taking six more days to collect that they
were in 20X5. The significant change occurred in 20X7 with the day calculation falling from 63
to 67 days in 20X7 as opposed to 61 to 63 in 20X6.
The increase could be caused by any of the following factors:

• The marketing event has caused a change in sales patterns/debt collection later in the
year (this would be revealed by analysing detailed sales information outlined above).
• Problems with credit control/the company has uncollectible debts on the ledger that
should realistically be written off. C
H
• It is possible that a receivables ledger fraud is being carried out. A
Credit control problems would constitute a control deficiency that the auditors should note and P
respond to with regard to their audit. They should assess whether the problems with control T
extend further than the credit control department as widespread control issues could E
significantly affect risk assessment. R
If there is a large amount of old debt on the ledger, a truer picture would be presented if it
were written off. Similarly, a fraud being carried out on the ledger would affect the true and fair
view. Four days represents 1% of the year, and therefore 1% of revenue (taken on an average 6
basis) and it is therefore a material issue.
Further information required:
• Aged analysis of the receivables ledger to identify whether any significant aged debts
exist which require writing off.
• Remittance advices from customers to assess payment patterns.
Inventory, cash and liquidity
The inventory movement assessment in the cost of sales analysis shows that inventory levels
at the company have risen consistently at the company over the last three years so that the
inventory balance is now CU3 million higher than at the start of 20X5. Direct production and
purchase costs have remained stable over those years suggesting that operation levels have
not changed to reflect the situation in the market and the falling sales position. This is likely to
have had a devastating impact on the cash position of the company. The statement of
financial position will show a significantly illiquid position with an inventory pile and a decrease
in receivables conversion rate. If it also shows a significant cash deficit then there are
immediate concerns about whether the company can continue to finance operations.
Further information required:
• Production levels in 20X7 and management's future intentions concerning production
• Bank statements and statements of cash flows and projections
• Inventory sheets from 20X7 count
• Inventory valuation sheets from 20X7
Other expense items
The other expense items provided in this analysis are immaterial in relation to revenue and
therefore the auditor would not focus on them at the planning meeting.
WORKINGS
Gross profit margin:
20X7
4,357,233
= 23%
18,944,487
20X6
6,174,827
= 30%
20,588,370
20X5
7,359,648
= 30%
24,536,570
Receivables days
20X7

3,477,481
× 365 = 67
18,944,487
20X6
3,553,609
× 365 = 63
20,588,370
20X5
4,089,783
× 365 = 61
24,536,570
Payables days
20X7
1,056,090
× 365 = 42
9,183,388
20X6
1,027,380
× 365 = 41
9,246,420
20X5
1,164,843
× 365 = 41
10,483,588
(b) If fraud is suspected
The auditor is required to approach his task with an attitude of professional scepticism.
Therefore, in theory, the auditor should not approach the task differently if fraud has been
suggested than he would have before. The questions arising from the analytical procedures
would be the same, and the auditor would still seek to corroborate the answers and then
assess whether he is satisfied with the corroborated answers. Given that the auditor is
required to be aware that fraud is a possibility whether he has been tipped off or not, the
corroboration of the finance director's answers should have been thorough and based on
sources other than the finance director (such as third party invoices or the opinions/experience
of other sources in the company) anyway.
If the auditor has been given a tip off that fraud exists, he should pass on that information to
the appropriate level of management. In this case, this would be the audit committee, as the
tip off concerns the finance director.
(c) Approach to the audit of receivables
There is a good source of third party evidence in relation to the receivables balance, that is,
the customers. Usually trade receivables is audited by means of direct confirmation. It is likely
that the receivables balance at TrueBlue has been audited by a receivables confirmation in
previous years and, if there is a fraud being carried out on this balance, then it has not been
uncovered by the audit procedures. It is possible that the audit procedures have become
repetitive, that the same (largest) customers have been selected to test year on year and that
the finance director has been able to carry out a small scale fraud on smaller balances less
likely to be tested, or that the fraud has only been carried out in the current year.
The auditors should carry out a receivables confirmation in this year as it is the best source of
audit evidence. They should increase the sample size to reflect the risk associated with the
balance and extend testing to a larger number of customers than has previously been the case.
In addition, the auditors should carry out some transaction testing on sales receipts in the
year, tracing the transactions through the system and trying to match receipts with invoices on
the sales ledger.
If a fraud has been carried out in this area it casts significant doubt on the controls in this area
and the auditors should consider whether controls throughout the accounting function might
also not be operating effectively and what impact that has on the rest of the audit.

4 Tofalco Ltd
Memorandum
To: Paul Sykes C
From: Jeremy Wiquad H
A
Re: Tofalco Ltd
P
Date: 6 November 20X0 T
The memo below covers the financial reporting and auditing issues raised per your request. E
R
Financial reporting treatment and audit procedures required
• Construction contracts
6
– Given that the outcome cannot be foreseen reliably, no profit should be recognised in the
current year. Instead, CU400m should be recognised within cost of sales and, assuming
that these costs are recoverable, the same amount within revenues (therefore showing
no profit and no loss). The value of the work done in the statement of financial position
will therefore be the CU400m.
Audit procedures to gain assurance include:
– Reviewing the contract to confirm the duration and sales value of the contract.
– Reviewing the surveyor's report to confirm the value of the work performed to date.
– Examining internal cost reports and confirming items on a sample basis to invoices.
– Obtaining a written representation from management with regards to the outcome of the
contract.
• Provisions – An environmental provision for the CU2.5 million present value of the cost of
disposing of the machines is required per ISA37 and should be presented within non-current
liabilities. This cost should also be included as part of the cost of the asset. In subsequent
years the liability will increase due to the unwinding of the discount and a corresponding
finance expense will be shown within profit or loss.
– Review the law with regards to the environmental provision and the underlying
documentation relating to the CU2.5 million estimate provided.
– Assess whether the discount rate used to calculate the present value of the disposal
costs is appropriate.
– Discuss with management if there are other areas/machines that require equivalent
'environmentally friendly' costs and that these have been provided for. Include the
completeness of these provisions in the company management representation letter.
• Receivables - Per ISA39, receivables are a financial asset and it appears that an impairment
of receivables (the specific debt of Stirly Ltd) may be needed.
– Attempt to review board minutes and the correspondence file for any discussion of this
issue.
– Review subsequent events for payment of the amount due.
• Assets held for sale – According to IFRS 5, assets are classified as 'held for sale' when,
amongst other criteria, management are committed to the sale and the asset is available for
immediate sale. The situation is not entirely clear, but the criteria are probably not fully met
until February 20X0, when the recoverable amount is CU1.7 million. Therefore an impairment
adjustment of CU0.4 million is required on the transfer of the asset to the held for sale
category. The fact that the building had not been sold by September is not necessarily a
concern as 12 months have yet to elapse. This will be a matter for review however next year.

– Review management documentation (eg correspondence with estate agent or minutes)
which confirms management commitment to sell.
– Check the building is available for sale and not being used internally by the company.
– Check the selling price is close to the market value of the buildings in the immediate
area.
– Check the building is advertised for sale and for immediate transfer.
• The issue of convertible loan stock constitutes a compound financial instrument which
needs to be split between its liability and equity components for presentation in the statement
of financial position:
CU
Face value of convertible bonds 18,000,000
PVs of future cash flows of equivalent bonds with no conversion option 16,862,000 Liability
Equity (warrants) (difference between the above) 1,138,000 Equity
– Review the convertible bond certificate for the face value, interest and conversion terms.
– Recalculate the present value of the cash flows relating to the equivalent bond without
conversion options.
• Related parties – As per ISA24, given the materiality of the transactions involved, all details
of the relationship between Tofalco Ltd and Sandstone Ltd need to be disclosed along with the
particulars of the transactions within the notes to the financial statements.
– Obtain a written representation from management that all related parties have been
disclosed.
– Review invoice file to ensure that all transactions with Sandstone Ltd have been
disclosed.
Effects of non-compliance on the audit risk and form of the audit report
• Refusal to provide full details constitutes a limitation on the scope of the audit as we are
unable to obtain sufficient appropriate evidence. If the effect is deemed material, an 'except
for' opinion is given. If the effect is deemed 'pervasive', then a disclaimer is made to the effect
that 'We [the auditors] are unable to form an opinion…'
• Failure to disclose full remuneration constitutes disagreement on a legal issue (we conclude
that the financial statements are not free from material misstatement) and materiality by size is
not a factor in this area. As the matter is material irrespective of the sums involved, then an
'except for' opinion will be given.
• Refusal to recognise obligations under ISA37 constitutes disagreement. In the event that
these costs are material, an 'except for' opinion is required. In the event they are deemed
pervasive, then an adverse opinion is required stating that the financial statements 'do not give
a true and fair view'.
Terms of reference of working relationship with Investo Ltd
Terms need to cover key investment risks (eg Tofalco must set guidelines and approve investment
policy).
Internal controls with regards to the operation of the relationship (eg weekly statements sent to
company reconciled with third party information – eg contract notes, share certificates, stock
exchange confirmation).
Value for money – fee comparability and return.

Impact on future audits
• 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
• Management integrity appears to be questionable in this assignment. Management will need

to understand the importance of their behaviour and its implications on the audit and the
relationship with the auditor.
• 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.


Non-current assets Should it be in the Physically verify Existence

accounts at all?
Inspect title deeds/invoice/vehicle Rights and
registration documents obligations
Board minutes and other
authority thresholds
Is it included at the Inspect invoices/contracts Rights and
right amount? obligations
Check depreciation
Valuation
Are there any more? Review other accounts for items Completeness
which should be capitalised
Check assets physically verified
are included in the financial
statements
Is it properly disclosed Companies Act checklist Classification and
Allocation
Receivables Should it be in the Circularisation Existence
accounts at all?
After date cash Valuation
Inspect invoices Rights and
obligations
Is it included at the Inspect ageing analysis Valuation
right amount?
After date cash
Are there any more? Conclusion derived from sales Completeness
completeness testing
Cutoff work
Allocation
Payables Should it be in the Suppliers' statement Existence
accounts at all? reconciliation
Valuation
Conclusion derived from
Rights and
purchases testing
obligations
Is it included at the Suppliers' statement Existence
right amount? reconciliation
Valuation
Rights and
obligations
Cutoff
Are there any more? Unpaid invoices review Completeness

Review payments after year end Cutoff

to check for omitted liabilities C
Cutoff work H
A
Review for obvious omissions of
P
accruals
T
Review payables at last year end E
to check for omissions this year R
Review knowledge of major
suppliers to check for omissions
6
Allocation
Inventory Should it be in the Attend inventory check – test Existence
accounts at all? from records to test counts
Rights and
Cutoff work obligations
Consider inventory held for third Cutoff
parties or on consignment
Is it included at the Inspect invoices and other Valuation

right amount? costing evidence
Review for slow moving or
obsolete items
Evidence of slow moving or
damaged items from inventory
check
Are there any more? Attend inventory check – test Completeness
from test counts to records
Cutoff work
Consider other locations,
inventory held by third parties on
consignment
Allocation

(1) The relevant financial statement assertions would be as follows:
• Completeness
There is a risk that all share based payments may not have been recognised in the financial
statements as the provision of the benefit to the employee may not arise until some point in
the future. For example, in this case the options cannot be exercised until the directors have
been with the company for three years. In accordance with IFRS 2 the service acquired in a
share based payment should be recognised as received.
• Accuracy
The remuneration expense should reflect the fact that the service received in exchange for the
share-based payment will be received over a period of time ie 3 years (see calculation below).
It also needs to be estimated how many of the five directors will remain with the company and
hence how many of the options are likely to vest.
• Valuation
Equity should be increased by the fair value of the options at the grant date (see calculation
below).
Remuneration expense this year and equity recognised in respect of the options will be:
(5 × 100,000) × CU3 / 3 years × 4/12 = CU166,667
(2) The relevant financial statement assertions relate to disclosure as follows:
• Classification
Whether the transaction is a related party transaction. 40% would appear to indicate the ability
of Wigwam Ltd to exert significant influence assuming no other entity has control.
• Completeness
Whether there are any other related party transactions between these two parties and/or
whether there are any additional related party relationships.
• Accuracy
If the disclosure states that the transaction is on an arm's length basis this must be
substantiated.
(3) The relevant financial statement assertions are:
• Classification
Whether a bond should be classified as debt or equity. In this case it is a compound
instrument. The liability and equity component will be shown separately.
• Valuation
The liability component should be computed as the present value of the maximum potential
cash flows discounted @ 10% as follows:
Year Cash flow DF @ 10% Net present
value
1 6,000 0.909 5,454
2 106,000 0.826 87,556
Liability 93,010
The residual amount is the equity component (100,000 – 93,010) = CU6,990.

Appropriate – Relevance
The relevance of audit evidence should be considered in relation to the overall audit objective of forming C
an opinion and reporting on the financial statements. The evidence should allow the auditor to conclude H
on the following: A
P
• Statement of financial position items (Existence, rights and obligations, completeness, valuation
and allocation). T
E
• Statement of profit or loss items (Occurrence, completeness, accuracy, cut-off and classification). R
(a) The representations by management in respect of the completeness of sales are relevant to the
first of the objectives when gathering evidence on revenue items. Depending on the system
operated by the client and the controls over cash sales there may be no other evidence as to the 6
completeness of sales.
(b) The flowcharts prepared by the internal audit department will not be directly relevant to the auditor's
opinion on individual figures in the financial statements, but rather when the auditor is following the
requirement in ISA 315 to obtain an understanding of the entity's information system of recording
and processing transactions. The auditor will wish to assess the adequacy of the system as a basis
for the preparation of financial statements so the flowcharts will be relevant only if they are
sufficiently detailed to allow the auditor to carry out this assessment. The auditor would also wish to
make an initial assessment of internal controls at this stage so the flowcharts will be more relevant
if control procedures are specifically identified.
(c) Year-end suppliers' statements provide evidence relevant to the auditor's conclusions on:
• The completeness of payables, as omissions from the purchase ledger listing would be
identified by comparing statements received to that listing.
• The existence of payables recorded in the purchase ledger.
• The fact that the liabilities are properly those of the entity (for example, the statements are not
addressed to, say, the managing director in his own name).
• The valuation of payables at the year end with respect to cut-off of invoices and credit notes,
and discounts or allowances.
(d) The physical inspection of a non-current asset is clearly relevant to the auditor's opinion as to the
existence of the asset, and to some extent the completeness of recording of assets, that is, the
auditor can check that all the assets inspected have been recorded. In certain circumstances
evidence relevant to valuation might be obtained, for example, where a client has written down a
building due to impairment in value and the auditor sees it standing unused and derelict.
(e) The comparison of revenue and expenditure items with prior periods will provide evidence as to:
• Completeness of recording, as omissions can be identified and investigated.
• Valuation, in cases where the auditor has appropriate information on which to base
expectations, for example, if the number of workers has doubled during the year and a set
percentage wage increase had been effected in the year.
• Disclosure, as the comparison should highlight any inconsistencies of classification and
treatment from year to year.
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-

generated evidence, the auditor should ensure that these representations are included in the letter
of representation so that there is at least some documentary evidence to support any conclusions.
(b) The assessment of how reliable the flowcharts are would depend on the auditor's overall
assessment of the internal audit department. The factors to be considered would include its degree
of independence, the scope of its work, whether due professional care had been exercised, the
technical competence and level of resource available to the internal audit department. This
assessment should be documented by the external auditor if he is to make use of the flowcharts in
his audit planning and design of tests.
(c) Suppliers' statements would generally be seen as reliable evidence, being documentary and from
sources external to the entity. If the auditor had doubts as to the reliability of this evidence, it could
be improved by the auditor originating similar evidence by means of a payables' circularisation
rather than relying on suppliers' statements received by the client.
(d) Physical inspection of a non-current asset is a clear example of auditor-originated evidence, so
would usually be considered more reliable than that generated by others.
(e) Analysis such as this comparison of revenue and expenditure items with the prior periods would
again be termed auditor-generated evidence, and would be considered more reliable than evidence
generated by others. Ultimately the reliability of such audit evidence depends on the reliability of
the underlying data; this should be checked by tests of controls or substantive procedures.
Sufficiency
The auditor needs to obtain sufficient relevant and reliable evidence to form a reasonable basis for his
opinion on the financial statements. His judgements will be influenced by factors such as:
• His knowledge of the business and its environment
• The risk of misstatement
• The persuasiveness of the evidence
(a) To decide if the representations were sufficient with regard to concluding on the completeness of
sales the auditor would consider:
• The nature of the business and the inherent risk of unrecorded cash sales
• The materiality of the item; in this case it would appear that cash sales are material
• Any possible management bias
• The persuasiveness of the evidence in the light of other related audit work, for example,
testing of cash receipts.
If the auditor believes there is still a risk of material understatement of sales in the light of the
above, he should seek further evidence.
(b) Client-prepared flowcharts are not sufficient as a basis for the auditor's evaluation of the system.
To confirm that the system does operate in the manner described, the auditor should perform 'walk
through' checks, tracing a small number of transactions through the system. There is, however, no
need for the auditor to prepare his own flowcharts if he is satisfied that those produced by internal
audit are accurate.
(c) The auditor's decision as to whether the suppliers' statements were sufficient evidence would
depend on his assessment of materiality and the risk of misstatement. Its persuasiveness would be
assessed in conjunction with the results of other audit procedures, for example, substantive testing
of purchases, returns, and cash payments, and compliance testing of the purchases system.
(d) Inspection of a non-current asset would be sufficient evidence as to the existence of the asset
(provided it was carried out at or close to the end of the reporting period). Before concluding on the
non-current asset figure in the accounts, the auditor would have to consider the results of his work
on other aspects such as the ownership and valuation of the asset.

(e) In addition to the general considerations such as risk and materiality, the results of a 'comparison'
alone would not give very persuasive evidence. It would have to be followed by a detailed
investigation of variances (or lack of variances where they were expected). The results should be
compared to the auditor's expectations based on his knowledge of the business, and explanations C
given by management should be verified. The persuasiveness of the evidence should be
H
considered in the light of other relevant testing, for example, tests of controls in payments systems,
A
or substantive testing of expense invoices.
P
Answer to Interactive question 4 T
(a) Factors to consider E

R
Materiality
Property, plant and equipment (PPE) is likely to constitute a material proportion of the assets in the
statement of financial position of a manufacturing company. In addition, the depreciation charge 6
may be material to profit.
Depreciation of plant and machinery is charged to cost of sales, and therefore has a direct impact
on the gross profit margin of the business.
Inherent risk
Although PPE is generally regarded as having low inherent risk, the following factors may increase
the level of risk for Xantippe Ltd.
• Additions to plant may be misclassified as repairs and recognised in profit or loss.
• Repairs expenditure may be capitalised in error.
• Depreciation has a direct impact on profit and can potentially be manipulated by changing the
expected useful lives of assets.
Control risk
To determine the degree of reliance that can be placed on internal controls, the following will need
to be examined.
• Authorisation of expenditure on new PPE.
• Client procedures for periodic review of renewals/repairs accounts.
• Client reconciliations between the PPE register and nominal ledger account balances.
If reliance can be placed on the above controls, assurance will be obtained that PPE additions are
• Valid business items.
• Capital expenditure has been included in PPE.
• Revenue expenditure written off PPE has been accurately recorded.
Strong controls, as confirmed by tests of controls, will enable the level of substantive procedures to
be reduced.
(b) Audit procedures
Freehold property
• Agree opening balances to prior year working papers/financial statements.
• Inspect the title deeds to the property (or obtain assurance that they are held by the bank) in
order to confirm continuing ownership.
• Enquire whether any valuations have been carried out in the year.
• If any valuation shows a fall in value, propose adjustment (if material).
• Inspect the property to confirm (existence) that no provision for fall in value is necessary.
• Confirm from the bank letter (and discussions with management) any charges on the property.
• Confirm all charges are properly disclosed in a note to the financial statements.
• Discuss with directors the reasonableness of their estimate of the useful life of the freehold
buildings.
• Reperform the calculation of depreciation, ensuring that the freehold land is not depreciated.

Plant and machinery and motor vehicles
• Confirm opening balances to prior year financial statements.
• Obtain a list of additions in the year which reconciles with the total in the financial statements.
• For a sample of additions – trace to purchase invoices to confirm ownership – review board
minutes/capital expenditure requisition for authorisation.
• Review the list of additions to ensure that all items are of a capital nature.
• For a sample of assets on the register, physically inspect to confirm existence.
• Inspect invoices for motor vehicle additions to confirm that capital cost includes VAT but
excludes road tax.
• If motor vehicle additions involved a trade-in/part-exchange, discuss financial statement
adjustments required with directors (since no disposals accounted for).
• Inspect vehicle registration documents to confirm ownership.
• Compare the depreciation charge (as a percentage of cost) on a category by category basis
with that in the prior year to assess reasonableness.
• Reperform depreciation calculations for a sample of assets on the register.
• Obtain a list of disposals in the year which reconciles with the total in the financial statements.
• For a sample of disposals – trace sales proceeds to sales invoice and cash book – reperform
calculation of profit on disposal and trace to statement of profit or loss and other
comprehensive income.
• Review repairs and renewals accounts to ensure that no items of a capital nature have been
written off.

Audit risks
• Revenue has increased by 15.6% as compared to 10 months to October 20X6. There is a risk that
revenue is overstated. Investigations would be required as to why this increase has taken place.
For example, it could be the result of a change in revenue recognition policy. Revenue may also
have been affected by the translation of foreign currency sales which make up a significant
proportion of total revenue. It may also be that sales prices have increased and the price lists
should be reviewed for changes including the dates when changes were made. This includes both
official prices and discounting policy. It may also be that sales volumes or sales mix has changed.
This should be reviewed against budgeted production.
• Gross profit margin has increased. This is because cost of sales has increased by only 7.2%
compared to an increase in revenue of 15.6%. This may indicate that the increase in revenue was
largely as a result of selling price increases (which would not be reflected in increased costs) rather
than volume increases (which would have been reflected in increased cost of sales). This
proposition would be true for a retail company but, as Darwin is a manufacturing company, there
may be an alternative explanation. This is that cost of sales consists of both variable costs (eg raw
materials) and fixed costs (manufacturing overheads such as factory rent). If sales volumes have
increased significantly between 20X6 and 20X7 then, if fixed costs are significant, one would not
expect costs of sales to vary proportionately with sales revenue, but would increase by a smaller
percentage. The manufacturing cost structures would therefore need to be reviewed to formulate
an expectation of the relationship between cost of sales and revenue when volumes increase.
There is also a risk that revenue may be overstated due to accounting errors. For example, items in
transit to overseas customers being included in both revenue and in year-end inventories. This
would be consistent with the increase in inventory balance. Alternatively, it could be the result of
understatement of purchases.
• Changes in pricing strategy, sales mix or productivity would also have to be considered.
• Operating profit has increased and may be overstated. This could indicate understatement of
operating expenses for example through inadequate accrual for such expenses.

• Increasing inventory values
Assuming 360 days in a full year then inventory days have increased significantly:
10 months to 31 Oct 20X6 4,320/14,966 × 300 days = 87 days C
10 months to 31 Oct 20X7 5,160/16,040 × 300 days = 97 days H
A
• Inventory may therefore be overstated. This could be as a result of errors in the quantity of
inventory held or errors/changes in the way the inventory has been valued. P
T
• The business appears to be seasonal. In the 10 months to 31 Oct 20X6 the average monthly sales E
were CU2,352,000. In the two months to 31 December 20X6 average monthly sales were only
R
CU1,776,000. The period to sell the inventory at 31 Oct 20X7 is therefore likely to be longer than
would be implied by the average sales for the 10 month period, as two months of low sales are
forthcoming if the pattern of 20X6 is to be repeated. This would imply inventory days of more than
97 days and thus impairment should be considered. 6

(a)
Observations Impact on audit of trade payables

• Gross profit margin has fallen from 24% • Business strategy and performance must be
last year to 21% this year. discussed with the directors.
The lower margin could arise from genuine
business factors including some relating to
payables such as
– New suppliers charging higher prices
– Increases in the cost of raw materials
used by suppliers.
These factors would have to be confirmed
during the audit of payables.
• Cost of sales has increased by 50% • Where the decline in margin cannot be
while revenue has increased by 45%. adequately explained by business factors,
accounting errors must be considered. These
could include
– An inaccurate cut-off on goods received
which misstates purchases and trade
payables
– Misclassification between purchases
and other expenses.
Potential errors would increase the level of
work required on payables.
• Trade payables have increased by 38%, • The scope of circularisation and/or supplier
which is less than the increase in cost of statement reconciliation work may have to be
sales. extended if there is an increased number of
suppliers, and these have not been recorded.

• The trade payables payment period has • Information on payment terms with new
been reduced slightly from 61 days last suppliers (eg for footwear) must be obtained
year to 56 days this year. to establish expectations.
• There is a risk of unrecorded liabilities (eg

due to omission of goods received not
invoiced or inaccurate cut-off in the purchase
ledger).
• Review of subsequent cash payments to

payables should cover the two months after
the year end.
• 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.
(b) Use of audit software

(i) Reperformance of calculations
• 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 check arithmetic accuracy of individual suppliers' accounts.

(ii) Analytical procedures
• To calculate the payment period by supplier.
• 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 purchase records, a sample of suppliers for circularisation or review of

supplier statement reconciliations.
• To produce a printout of the major trade payables at the year end.
• To produce an exception report of debit balances on the payables ledger.
• 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).
• To identify unusual standing data (eg accounts for inactive suppliers).

(iv) Selection of representative samples for tests of controls
• Of purchases – to test whether they are properly authorised and matched to goods
received notes.
• Of payments – to test whether they are authorised.

(v) Payables circularisation
• To print requests for statements, monitor replies and produce second requests.
(vi) Cut-off
• To identify goods received documentation unmatched on file, for verification of

inventory/payables cut-off.
• To select post year end payments for verification of cash/payables cut-off.

(vii) Disclosure
• To extract total debits to the purchases accounts and total credits in individual suppliers' C
accounts for comparison and reconciliation.
H
• To search 'other payables' for A
– Individually significant balances P

T
– Names of trade payables. E
R
(a) Gearing ratios 6
Debt
Gearing =
Debt + Equit y
(i) Book values
250,000 + 150,000
= 40%
400,000 + 600,000
(ii) Market values
CU
Equity (V e ) 1,000,000 × 125p 1,250,000
Preference (V p ) 250,000 × 65p 162,500
Loan stock (V d ) 150,000 × 85% 127,500
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.
(b) Working capital ratios
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.

300,000
Inventory days = × 365 = 73 days
1,500,000
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.
(c) Non-financial measures

These include the following.
• Daily number of items sold
• Repeat business/customers
• Customer satisfaction
• Time taken for 'made to order' items
• Number of repairs/faulty items sold
These types of measures are important for Harrison Ltd as the volume of trade will be relatively
small on a daily basis. Each extra sale will generate extra profit, and hence keeping customers
happy and satisfied will improve the overall performance of the shop.

(a) Platforms
It is not necessary to use an auditor's expert to audit the useful lives of the platforms as there are
many other available sources of evidence. Relevant procedures include:
• Obtaining weather reports to see whether management's determination of useful lives is
consistent with them.
• Comparing budgeted oil against actual oil extracted (if the budget was optimistic, so might the
useful life be).
• Review published industry comparators (such as Shell and BP). If the useful lives of their
platforms as published in financial statements is significantly different, discuss with
management why that might be.
• Consider whether management's determination of useful lives in the past has been proved
accurate.
(b) It is not necessary to use an auditor's expert, as the question states that a 'simple' test is available.
The auditors should confirm that the company will be making use of this test during the inventory
count to separate the inventory. The auditor should reperform the test on a sample of brass and
copper as counted to ensure it has been separated correctly.

C
H
A
P
T
E
R
CHAPTER 7
7
The statutory audit:

evaluating and testing internal
controls
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
Technical reference
The statutory audit: evaluating and testing internal controls 305

Introduction
• 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
• Evaluate controls relating to information technology and e-commerce
• Explain and appraise the entity's system for monitoring and modifying internal control
systems

1 Introduction
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
2 Respective responsibilities of those charged with

governance and auditors
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.
2.1 Responsibilities of those charged with governance

As you no doubt already know, the responsibility for the design, implementation and maintenance of an
effective system of internal control, one that is capable of preventing, or detecting and correcting, errors
in the financial records, lies with those charged with governance (TCWG).
Let's revise some key definitions.
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.)

Error: An unintentional misstatement in financial statements, including the omission of an amount or a
disclosure.
Internal control: A process designed and effected by those charged with governance, management,
and other personnel to provide reasonable assurance about the achievement of the entity's objectives
with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance
with applicable laws and regulations. It follows that internal control is designed and implemented to
address identified business risks that threaten the achievement of any of these objectives.
2.2 Auditor's responsibilities

As we also outlined in your earlier studies, the auditor is required to:
(a) Assess the system of internal controls to determine whether they are capable of preventing or
detecting and correcting errors (ISA 315)
(b) Test the internal controls if required (ISA 330), and
(c) Report deficiencies in internal control to TCWG where they have been identified (ISA 265).
As part of assessing the system of internal controls as part of audit risk assessment, the auditor must:
(a) Obtain an understanding of controls relevant to the audit
(b) Evaluate the design of those controls and
(c) Determine whether they have been implemented
The auditor must then test controls if:
• The auditor intends to rely on the operating effectiveness of those controls, or
• Substantive procedures alone cannot provide sufficient appropriate audit evidence
Finally, the auditor must determine whether the audit work has identified any deficiencies in internal
control, and where these deficiencies are significant, communicate the significant deficiencies to TCWG
in writing on a timely basis.
In the following sections, we will look at each of these stages in further detail.
Effective internal controls form a crucial part of good corporate governance. For a more detailed
discussion on the importance of internal controls, and the auditor's role in relation to internal controls,
please refer back to Chapter 4.
3 Evaluating and testing internal controls
Section overview
• Sources of audit evidence include tests of controls.
3.1 Evaluation of internal controls for audit purposes: revision

Understanding an entity's internal control assists the auditor in identifying types of potential
misstatements and factors that affect the risks of material misstatement, and in designing the nature,
timing and extent of further audit procedures.
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

• The significance of the related risk
• The size of the entity
• The nature of the entity's business, including its organisation and ownership characteristics
• The diversity and complexity of the entity's operations
• Applicable legal and regulatory requirements
• The circumstances and the applicable component of internal control
• The nature and complexity of the system of internal control, including the use of service
organisations (see Section 4)
• Whether, and how, a control prevents, or detects and corrects, material misstatement.
C
Step 2 H
While gaining an understanding of internal controls, the auditor must evaluate the design of the relevant A
controls, and determine whether the controls are properly implemented. P
T
Evaluating the design of a control involves considering whether the control, individually or in
combination with other controls, is capable of effectively preventing, or detecting and correcting, material E
misstatements. R
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.

ISA 315 divides internal control into five elements. We summarise the main points below:
Elements of internal control
The control • Communication and enforcement of integrity and ethical values

environment • Commitment to competence
• Participation by TCWG
• Management's philosophy and operating style
• Organisational structure
• Assignment of authority and responsibility
• Human resource policies and practices
The entity's risk The entity's process for:
assessment process
• Identifying business risks relevant to financial reporting objectives
• Estimating the significance of the risks
• Assessing the likelihood of their occurrence
• Deciding upon actions to address those risks
The information • The classes of transactions that are significant to the financial statements
system relevant to
financial reporting • The procedures (both IT and manual) by which significant transactions are
initiated, recorded, processed, corrected, transferred to the general ledger
and reported in the financial statements
• The related accounting records, supporting information, and specific
accounts in the financial statements, in respect of initiating, recording,
processing and reporting transactions
• How the information system captures events and conditions, other than
transactions, that are significant to the financial statements
• The financial reporting process used to prepare the entity's financial
statements, including significant accounting estimates and disclosures
• Controls surrounding journal entries, including non-standard journal
entries used to record non-recurring, unusual transactions or adjustments
• How the entity communicates financial reporting roles and responsibilities
and significant matters relating to financial reporting
Control activities • Authorisation
• Performance reviews
• Information processing
• Physical controls
• Segregation of duties
Monitoring of controls Process to assess the effectiveness of internal control performance over time,
and to take necessary remedial actions.
• The sources of the information related to the entity's monitoring activities;
and
• The basis upon which management considers the information to be
sufficiently reliable for the purpose.
May include making enquiries of the internal audit function
3.2 Tests of controls: revision

You will have covered tests of controls in your earlier studies. The following section provides a
summary of the key points.

Testing of controls means obtaining sufficient appropriate audit evidence about the operating
effectiveness of the controls in preventing or detecting and correcting material misstatements.
Evidence will be required to show that:
• Controls were applied at relevant times during the year, and
• That those controls were applied consistently (eg because controls were performed by different
people or in different locations).
Tests of control may include the following.
(a) Inspection of documents supporting controls or events to gain audit evidence that internal
controls have operated properly, eg verifying that a transaction has been authorised.
(b) Inquiries about internal controls which leave no audit trail, eg determining who actually performs
each function not merely who is supposed to perform it. C
H
(c) Reperformance of control procedures, eg reconciliation of bank accounts, to ensure they were
A
correctly performed by the entity.
P
(d) Examination of evidence of management views, eg minutes of management meetings. T
(e) Testing of internal controls operating on computerised systems or over the overall information E
technology function, eg access controls. R
(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.
3.2.1 Relationship between tests of controls and risk assessment procedures

Testing of controls should not be confused with risk assessment procedures which were performed
earlier in the audit to assess the design and implementation of controls. However, in some situations
risk assessment procedures may provide persuasive evidence on the operation of controls. For
example, management review of budgets and investigation of variances on a regular basis, is indicative
that controls over sales and purchases are operating effectively.
3.2.2 Conclude on the achieved level of control risk

When control testing is complete, residual audit risk to be obtained from substantive testing must be
determined. The auditor will use:
• The achieved level of control risk, and
• The assessed level of inherent risk
to determine the remaining detection risk. This detection risk is then used to decide the nature and
timing of the remaining substantive testing.

4 Service organisations
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
4.1 Requirements of the user auditor
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.

• Determine whether this gives sufficient understanding of the effect of the service organisation on
the user entity's internal control to provide a basis for the identification and assessment of risks of
material misstatement.
If not then the auditor shall do one or more of the following:
• Obtain a report from the service organisation's auditors (there are two different types of report, see
Section 4.2 below)
• Contact the service organisation, through the user entity
• Visit the service organisation and perform procedures that will provide information about the
relevant controls, or
• Use another auditor to perform procedures that will provide information about the relevant controls.
C
H
4.2 Using reports from service auditors
A
P
Definitions T
Type 1 report E
R
A report that comprises:
(i) A description, prepared by management of the service organisation, of the service organisation's
system, control objectives and related controls that have been designed and implemented as at a 7
specified date; and
(ii) A report by the service auditor with the objective of conveying reasonable assurance that includes
the service auditor's opinion on the description of the service organisation's system, control
objectives and related controls and the suitability of the design of the controls to achieve the
specified control objectives.
Type 2 report
A report that comprises:
(i) A description, as in a Type 1 report of the system and controls, their design and implementation as
at a specified date or throughout a specified period and, in some cases, their operating
effectiveness throughout a specified period.
(ii) A report by the service auditor with the objective of conveying reasonable assurance that includes:
(a) The service auditor's opinion on the description of the service organisation's system, control
objectives and related controls, the suitability of the design of the controls to achieve the
specified control objectives, and the operating effectiveness of the controls; and
(b) A description of the service auditor's tests of the controls and the results thereof.
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.

While a Type 1 report may be useful to a user auditor in gaining the required understanding of the
accounting and internal control systems, an auditor would not use such reports as a basis for reducing
the assessment of control risk.
But a Type 2 report may provide such a basis since tests of control have been performed. If this type of
report may be used as evidence to support a lower control risk assessment, a user auditor would have
to consider whether the controls tested by the service organisation auditor are relevant to the user's
transactions (significant assertions in the client's financial statements) and whether the service
organisation auditor's tests of controls and the results are adequate.
4.3 Responding to the risks of material misstatement

The user auditor shall:
• Determine whether sufficient appropriate audit evidence concerning the relevant assertions is
available from records held at the user entity and, if not,
• Perform further procedures (or use another auditor to perform those procedures at the service
organisation on the user auditor's behalf).
4.3.1 Tests of controls

This evidence can be obtained by one or more of the following procedures:
• Obtaining a Type 2 report, if available
• Performing tests of controls at the service organisation, or
• Using another auditor to perform tests of controls at the service organisation.
4.3.2 Substantive procedures

The following procedures may be considered by the auditor:
• Inspecting documents and records held by the user entity.
• Inspecting documents and records held by the service organisation (access to records held by the
service organisation may be established as part of the contractual arrangement between the user
entity and the service organisation).
• Obtaining confirmation of balances and transactions from the service organisation where the user
entity maintains independent records of balances and transactions.
• Performing analytical procedures on the records maintained by the user entity or on the reports
received from the service organisation.
• Where a significant proportion of the audit evidence is located at the service organisation,
substantive procedures may need to be performed at the service organisation by the user auditor
or by another auditor on behalf of the user auditor.
4.4 Reporting by the user auditor

4.4.1 Modified opinions
If the user auditor is unable to obtain sufficient appropriate evidence a modified audit opinion may be
required. This could be the case when:
• The user auditor is unable to obtain a sufficient understanding of the services provided by the
service organisation and does not have a basis for assessing the risks of material misstatement
• The user auditor's risk assessment includes an expectation that the controls at the service
organisation are operating effectively and the user auditor is unable to obtain sufficient appropriate
evidence about the operating effectiveness of these controls, or
• Sufficient appropriate evidence is only available from records held at the service organisation, and
the user auditor is unable to obtain direct access to these records.

4.4.2 Reference to the work of service auditors
The user auditor shall not refer to the work of a service auditor in the user auditor's report containing
an unmodified opinion unless required by law or regulation to do so. (If such a reference is required,
the user auditor's report must indicate that this does not diminish the user auditor's responsibility for the
audit opinion.)
If reference to the work of a service auditor is relevant to an understanding of a modification to the
user auditor's opinion, the user auditor's report must indicate that this does not diminish the user
auditor's responsibility for the audit opinion.
5 Internal controls in an IT environment

C
Section overview H
A
• IT controls comprise general and application controls. General controls establish a framework of
overall control over the system's activities whereas application controls are specific controls over P
the applications maintained by the system. T
E
• Computer-assisted audit techniques (CAATs) can be used by the auditor to test application R
controls within the client's computer systems.
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.
5.2 General controls

The purpose of general IT controls is to establish a framework of overall control over the computer
information system's activities to provide a reasonable level of assurance that the overall objectives of
internal controls are achieved. They include controls over access security, data centre and network
operations, software acquisition, change and maintenance, and application system acquisition,
development and maintenance. They are sometimes referred to as supervisory, management or
information technology controls. General controls are considered in detail below.
General controls
Development of computer Standards over systems design, programming and documentation

applications
Full testing procedures using test data
Approval by computer users and management
Segregation of duties so that those responsible for design are not
responsible for testing
Installation procedures so that data is not corrupted in transition
Training of staff in new procedures and availability of adequate
documentation

General controls
Prevention or detection of Segregation of duties

unauthorised changes to
Full records of program changes
programs
Password protection of programs so that access is limited to computer
operations staff
Restricted access to central computer by locked doors, keypads
Maintenance of program logs
Virus checks on software: use of anti-virus software and policy prohibiting
use of non-authorised programs or files
Back-up copies of programs being taken and stored in other locations
Control copies of programs being preserved and regularly compared with
actual programs
Stricter controls over certain programs (utility programs) by use of read-
only memory
Testing and Complete testing procedures
documentation of
Documentation standards
program changes
Approval of changes by computer users and management
Training of staff using programs
Controls to prevent wrong Operation controls over programs
programs or files being
Libraries of programs
used
Proper job scheduling
Controls to prevent Physical security over remote terminals
unauthorised
Limited access to authorised personnel only
amendments to data files
Firewalls
User identification controls such as passwords
Encryption of data
Controls to ensure Storing extra copies of programs and data files off-site
continuity of operation
Protection of equipment against fire and other hazards
Back-up power sources
Emergency procedures
Disaster recovery procedures eg availability of back-up computer
facilities
Maintenance agreements and insurance
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.

5.3 Application controls
The purpose of application controls is to establish specific control procedures over the accounting
applications in order to provide reasonable assurance that all transactions are authorised and
recorded, and are processed completely, accurately and on a timely basis. Application controls include
data capture controls, data validation controls, processing controls, output controls and error controls.
Examples of application controls are shown in the table below.
Application controls
Controls over input: Manual or programmed agreement of control totals

completeness Document counts
One-for-one checking of processed output to source documents
Programmed matching of input to an expected input control file C
Procedures over resubmission of rejected items H
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.
5.4 The use of CAATs

Computer-assisted audit techniques (CAATs) can assist the auditor in testing application controls. As
you will know from your earlier audit studies, there are generally two types of CAATs: audit software
and test data.
Audit software includes generalised audit software and custom audit software. Generalised audit
software includes programs that allow the auditor to carry out tests on computer files and databases. An
example of a generalised audit software program is ACL.
Generalised audit software allows auditors to perform a number of functions such as database access,
sample selection, arithmetic functions, statistical analyses and report generation.

The advantages of generalised audit software include the fact that it is easy to use, limited IT
programming skills are needed, the time required to develop the application is relatively short, and entire
populations can be examined, thus negating the need for sampling. However, the drawbacks of using
this type of CAAT are that it involves auditing after the client has processed the data rather than while
the data is being processed, and it is limited to procedures that can be performed on data that is
available electronically.
Custom audit software is normally written by auditors for specific audit tasks. It is normally used in
situations where the client's computer system is not compatible with the auditor's generalised audit
software or where the auditor wants to do some testing that might not be possible with the generalised
audit software. However, this type of CAAT can be expensive and time-consuming to develop and
may require a lot of modification if the client changes its accounting application programs.
Test data is used to test the application controls in the client's computer programs. Test data is first
created for processing and it includes both valid and invalid data which is processed on the client's
computer and application programs. The invalid data should therefore be highlighted as errors. Test data
allows the auditor to check data validation controls and error detection routines, processing logic
controls, arithmetic calculations and the inclusion of transactions in records and files.
The main benefit of test data is that it provides direct evidence on the effectiveness of controls in the
client's application programs. However, its drawbacks include the fact that it is very time-consuming to
create the test data, the auditor cannot be certain that all relevant controls are tested and the auditor
must make sure that all valid test data is removed from the client's systems.
In the table below, we briefly examine ways of testing application controls, including the use of CAATs to
do so.
Testing of application controls
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.
Interactive question 1: NewForm Ltd [Difficulty level: Exam standard]

NewForm Ltd (NewForm), a client of your firm, has recently established an e-commerce division within
its existing business to provide an additional outlet for its product range, which consists of upmarket
casual wear for adults. An objective in introducing the new division was to have a completely paperless
ordering, payment and despatch system.
The new e-commerce system is administered centrally by NewForm and deals with customer orders and
credit card payments. Customers are able to place orders and pay for the goods online. Inventories for
customer orders are held remotely by Key Distributors (KD), which is a completely separate business
from NewForm. Once online payment by credit card is cleared by NewForm, despatch details are
forwarded to KD electronically. KD then despatches customer orders. Inventories are ordered by
NewForm for delivery direct to KD.
Requirements
(a) In planning the audit of NewForm, identify and explain four key risks that may arise from the
development of the new e-commerce division.

(b) Identify and explain the application controls which you think are necessary for the integrity of the
ordering and payments system.
6 Communicating and reporting on internal control
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

Self-test
1 Dodgy Burgers Ltd
The board of directors of your client, Dodgy Burgers Ltd, which runs a chain of 30 burger
restaurants across the country, have just completed a review of the structure of the business and
relevant controls which are in place within the business. This review was completed in the year
ended 31 March 20X8.
A partner of your firm asked for a copy of the report that the directors completed to assist in the
identification of controls that the directors had implemented to mitigate business risk. The partner
would like to use this as a basis for testing and placing reliance on these controls to reduce the
amount of audit work undertaken for the audit for the year ended 31 March 20X8.
Listed below are some extracts from the report.
C
Health and Safety issues H
This was a key business risk that we identified during our initial strategic review of the company. A
P
The company has had problems in this area in the past, with staff selling burgers before these had
been completely cooked through. T
E
It was felt necessary to ensure that good controls were in place to provide an early warning system R
of any breaches of the Health and Safety regulations required by our type of business.
The following systems have now been introduced.
(1) The new internal audit department set up in September 20X7 will make spot checks on the 7
various shops to ensure that the new Health and Safety policies are being followed. Reports of
these visits will be sent to the board within two weeks of the visit. The internal audit
department plans to visit all the branches within one year.
(2) All staff will receive Health and Safety training, particularly on the areas of food handling,
storage, preparation, cooking and hygiene. This will be implemented immediately and by the
end of 20X8 we will have trained all staff.
Competition
Our main competitor, Chip Butty, has begun buying properties and setting up shops in the vicinity
of our existing branches within the large city centres. This has been a recurrent theme through
20X8 so far and we expect this to continue into 20X9. We have identified this as a threat to our
sales income and consider that action is required.
To counteract the potential loss in sales we have embarked on three new marketing initiatives.
(1) Advertising on all major local television networks, comparing our burgers to the inferior Chip
Butty products.
(2) Promoting our new toys, sold in conjunction with Dotty Films, which are free with all kiddy
packs.
(3) Employing a part-time member of staff to visit the competition's premises and reporting on any
new initiatives Chip Butty embarks upon.
Branch cash controls
As our business is primarily cash based, we were concerned over the potential for theft of cash
takings.
We have decided to implement a new policy in this area to monitor the takings from each branch
more closely.
All tills in every branch will include a standard float of CU150. At the end of each day the takings
will be counted and bagged from each till leaving the CU150 float. A printout from the till will be
made detailing the daily takings. The physical cash will need to be reconciled to the till balance.
Cash will then be banked and the reconciliation emailed to head office.
Discount prices will be set in the till to ensure that no meals can be sold at below the discounted
price.

Increased turnaround in branches
We have identified a capacity problem in our branches, given the limited seating area at each of the
branches during peak times.
Following a cost benefit review of the branches it was decided not to increase these areas as we
feel that it would not be cost effective, due to the huge increase in rates that would be incurred, the
building costs and lost time due to renovation.
The board is prepared to accept the risk that some customers may be lost during peak times, but
may in the future consider some form of takeaway discount at peak times.
Environmental policy
We felt it was necessary to reassure the public that as a company our policies are 'environmentally
friendly' as this was key to a consumer business such as ours. The increased cost of the packaging
products has been passed on in full via a small price increase, as we have been able to negotiate
an excellent package with our suppliers and the waste contractors.
We have therefore introduced the following.
(1) In all our branches recycled packaging, which has been clearly labelled to show that it is made
from paper used from managed forests.
(2) Waste separation at branches, which is collected on a daily basis by an external contractor
who pays us CU30 for each ton of paper and plastic collected.
Requirements
(a) Identify the business risks set out in the board report and state the risk category (ie financial,
operational or compliance). For each risk identified state the strategy management have
adopted to deal with the risk.
(b) For each of the risks identified set out the audit procedures that would need to be completed
before reliance could be placed on the controls in place.
2 Happy Flights Ltd

Happy Flights Ltd (HF) is a low-cost airline that was established fifteen years ago and has since
grown rapidly. You are a senior on the audit of HF for its year ended 30 June 20X6.
As part of the audit planning procedures the assignment manager, Geraint Johns, visited the
finance director of HF, Rory Hiller, and identified a number of risk areas (Exhibit 1).
Geraint rang you immediately after the meeting:
'I have just been to visit Happy Flights and there are a number of issues that have arisen. The
audit team needs to discuss these matters at a planning meeting so we can determine our
approach. I would like you to prepare a memorandum for the meeting which explains in detail
the key audit risks arising from these matters. I would also like you to identify the audit
procedures that we will need to carry out in respect of each of these risks. If there are any
financial reporting issues on these matters could you also explain these as part of the
memorandum.'
Exhibit 1
Plane crash
You will be aware that on 20 June 20X6 one of the HF planes crashed with a loss of 56 lives and a
further 121 injuries. The cause of the crash has not yet been established. Indeed, it is unclear
whether HF is to blame. Some legal claims have begun to arrive at HF headquarters but it is still
early in the investigation process. Final settlement, if applicable, may take some years.
Operating issues
HF has suffered declining profits in recent years and recorded an operating loss for the first time in
the year to 30 June 20X5. As a consequence, there have been continuing cash flow problems
which have been partially alleviated by special measures adopted this year including:
• Significant discounts for bookings made, and paid for in full, at least six months before travel.
• Extension of operating leases on existing aircraft, rather than leasing new aircraft (all planes
are leased).
• Significant new fixed-term borrowings.

Database system
A new database system for bookings was introduced in January 20X4. IT consultants in our firm
helped with the installation alongside the hardware providers and other IT consultants. The purpose
of the new system was to allow data on HF's flight availability to be accessed by travel agents and
other flight booking agencies around the world. Agencies can all make bookings on the same
system.
The database system is used not just for bookings, but also as part of the receivables accounting
system for agents to collect money from customers and pay to HF after deducting their
commission. The data collected then feeds into the financial statements.
Unfortunately, since installation, the following problems have been discovered, either in the
database system, or relating to operatives using the system:
• It is Happy Flights' policy to overbook its flights by 5% of seat capacity. However, there have been C
a number of instances where overbookings have far exceeded 5% due to processing delays. H
• The system has crashed on a number of occasions causing delays in processing and loss of A
data. P
T
• A computer virus penetrated the system, although it did not cause any damage and was
quickly removed. E
R
• Cash received in advance has been recorded as revenue at the date of receipt by HF.
Requirement
Prepare the memorandum requested by the assignment manager. 7

Technical reference
1 ISA 315
• Understanding the entity and its environment ISA 315.11–.24
• Assessing the risks of material misstatement ISA 315.25–.29
• Financial statement assertions ISA 315.A111
2 ISA 330
• Overall responses to risk assessment ISA 330.5
– Response at assertion level ISA 330.6–.7
– Evaluation of sufficiency and appropriateness of evidence ISA 330.25

1 Dodgy Burgers Ltd
(b) Audit procedures to be completed in

(a) Business risk and Management strategy
order to place reliance on the
category to combat risk
controls in place
Health and safety

• Partially cooked • Management has • Obtain a copy of the Health and Safety
burgers have been set up a Health and policy and review to ensure that the C
sold. Safety training policies are adequate. File on the H
programme. permanent audit file for future reference. A
• This constitutes an
P
operational risk • Hold discussions with the branch
T
(failure to comply will managers on a sample basis to ensure
E
result in the company that the policy has been implemented if
being shut down) and staff do not reach the required standard. R
compliance risk
(breach of Health and • Review the training course to establish
what procedures are being taught to the
Safety regulations). 7
staff, and what follow up has been
implemented if staff do not reach the
required standard.
• Internal audit spot • Assess the internal audit department

checks on Health staff to ensure they have the
and Safety are to be appropriate authority, and are
carried out at the technically competent to complete the
branches. review.
• Discuss with the internal audit
department how the branches have
been selected for sampling.
• Review copies of the internal audit
reports to identify
– The issues found
– How they have been resolved
– What follow up work was required
– How this was monitored
• Discuss with the directors how many
visits have been completed in the year
and whether they received all the copies
of the reports.
• Review correspondence files and
external Health and Safety visits during
the period before the internal audit
department was set up.
• Provided that the internal visits are
effective audit procedures can be
limited to the period before the internal
audit department was set up, as this is
likely to be the higher audit risk area.

controls in place
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.

controls in place
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.

2 Happy Flights Ltd
Memorandum
To: Geraint Johns (Assignment Manager)
From: A Senior
Date: 24 July 20X6
Subject: Happy Flights – audit risks
(1) Plane crash
Financial reporting issues
The plane crash occurred in the year to 30 June 20X6, thus potentially gives rise to a liability
that might need to be recognised in the current period. This might include:
• Civil litigation by those passengers injured and the relations of those killed.
• Criminal penalties against HF and/or its directors.
• If health and safety regulations have been breached then further penalties and
constraints may apply.
• Liability for employees killed and injured.
Any litigation may be in several jurisdictions according to the location of the crash and the
nationality of the passengers, thus the issues may be complex and take some time to resolve.
While such liabilities may ultimately be substantial they may also turn out to be small if the
fault lies with airport authorities or other causes. It seems likely that these issues will be
unresolved when the financial statements are authorised for issue thus it is unclear whether a
contingency or a provision would arise. If there is significant uncertainty, or if there is a low
probability of a claim, this might indicate a contingency, but more information would be needed
to draw a firmer conclusion (see below).
Audit risks
A key audit risk is the lack of information on which to base a judgement in respect of the
following:
• Whether any liability is probable or only possible.
• The amount and timing of such a liability is unlikely to be known at the date of audit
completion.
According to IAS 37 where the amount of an obligation cannot be measured with sufficient
reliability then it should be disclosed as a contingent liability. In this case it would not be
recognised in the financial statements. If the information available is still fundamentally unclear
at the date the financial statements are authorised for issue, then this may be the most
appropriate treatment.
If the company is insured then recovery of any insurance should be regarded as a separate
matter from the provision/contingency question.
Going concern – notwithstanding the treatment of the provision/contingency then going
concern is likely to be an issue. Given that the company is already struggling financially, any
claim may prove to be a significant additional factor in assessing going concern. However,
insurance recovery may be considered in making any such assessment.
There may, however, be other more immediate going concern issues arising from the crash
other than the settlement of litigation.
These include:
• Reduction in passenger numbers as the reputation for safety may have diminished.
• Grounding of aircraft by health and safety regulators perhaps resulting in loss of
revenues, cancellations and delays.
• Reconsideration of leasing older planes resulting in additional costs.

Audit procedures
• Review claims against HF received by audit completion.
• Review correspondence with HF's legal advisers and consider taking independent legal
advice regarding the amount and probability of any claim against HF.
• Review any announcements by investigation teams and any correspondence with HF
regarding causes of the crash and the extent HF was to blame up to the date of audit
completion (eg 'black box' flight recorder evidence).
• Consider the possibility of counter claims by HF against others responsible for the crash
by considering legal advice.
• Review any correspondence with Health and Safety Executive regarding grounding of
planes or possible causes of the crash. C
• Review flight bookings since crash for evidence of a decline in reputation and fall in future H
sales. A
P
• Assess impact on budgeted cash flows to consider impact on going concern.
T
(2) Operating issues E
R
• The decline in operating profits is further evidence of going concern problems.
• If the operating leases have been extended then consideration needs to be given as to 7
whether the new leases are finance leases if the residual value at the end of the lease on
an old plane is small.
Audit risks
The key audit risk is going concern. If there is adequate disclosure in the financial statements
by the directors regarding the uncertainties about going concern then an unmodified audit
opinion with an emphasis of matter paragraph is likely to be sufficient. If the directors do not
disclose going concern uncertainties appropriately, however, it may be necessary to modify
the audit opinion.
The receipt of cash from customers in advance is likely to cause concern if the company does
have going concern issues as this may amount to fraudulent trading if the customers, as
unsecured creditors, are unable to recover their payment.
The additional borrowing also increases financial risk and makes profit more sensitive to
changes in the level of operating activity.
Audit procedures
As already noted, cash flow forecasts will need to be reviewed up to the date of audit
completion to assess the future viability of the company. This should include:
• Examine overdraft and other lending facilities (eg for 'headroom' against existing
liabilities, for interest rates and for capital repayment dates). Build a picture of future
financial commitments.
• Identify the level of advanced payments and discuss with the directors the issue of
continuing the policy of advanced payments and the implications for fraudulent trading.
• Examine budgets and cash flow projections as part of going concern. Review to assess
future expected changes in liquidity.
• Examine lease contracts to assess the lease renewals position in order to ascertain
future levels of commitment.
(3) Database system
Audit risks
General systems issues
As our firm helped to install the new system, there is an ethical risk of self-interest and self-
review from criticising a system that has failings. The ethics partner should be consulted and

there may need to be separation of staffing from the team that installed the system and the
audit team. However:
• Any fault in the database system may arise from the hardware suppliers or the other
consultants. In terms of the engagement risk, establishing the nature of the faults and the
responsibilities of our IT team in the installation may be appropriate.
• Some of the problems appear to be with the people operating the systems rather than the
system itself. These are employees rather than staff of the accounting firm so this effect
also needs to be assessed.
There appear to be two control risks in the IT system:
• The maintenance and control of the database itself and the information contained therein.
• The on-line processing of transactions.
Separate controls are needed over each of these aspects.
Specific issues
Excess bookings – risks include
• A system error appears to have arisen as the system should not accept unintentional
double bookings. The level of confidence in the system is thus reduced, thereby
increasing our assessment of control risk.
• Revenue may have been double counted if two bookings have been taken.
System crashing – risks include
• Loss of data is a major problem as it not only affects operating capability but also
reduces confidence in IT controls over financial statement assertions as the database
feeds into the financial statements.
• There may be a risk of corruption of data as well as loss of data. This may have been a
cause of the above double bookings.
Computer virus – risks include
• Loss of future data if it reoccurs.
• Corruption of data.
• Loss of confidentiality of information.
• Risk of fraud from 'hacking' into system to create false bookings or false payments.
Advanced payments recognised as revenue
• If payments are recognised as revenue on receipt, then revenue is overstated if
payments occur in one financial year and the flight occurs in the next financial year. The
risk is that all such payments recognised in advance have not been identified.
The key financial reporting issue is the inappropriate recognition of revenue for advanced
payments by customers. While this can be corrected in the draft financial statements in the
current year, it may have also have occurred in the previous year. If material, this should be
recognised as a prior period error. Retained earnings brought forward should be adjusted and
the relevant revenue should be correctly recognised in the current year with comparatives
adjusted.
Audit procedures
The control risk relating to the IT system needs to be established. If reliance cannot be placed
on the IT system it may not be possible to test income for understatement due to lack of
relevant, reliable audit evidence. This may lead to a modified audit opinion on the basis of
insufficient evidence (limitation of scope).
Regarding on-line processing, tests of controls with respect to the following may be relevant:
• Access controls, passwords (eg review logs of access and user authorisation).
• Programming (review programming faults discovered, actions taken to amend faults, re-
occurrence of same faults).

• Firewall (consider response to virus and why firewall failed to detect it; procedures for
updating firewalls; best practice review).
• Use of CAATs to interrogate the system's ability to detect and prevent errors and fraud.
Regarding database itself:
• Review procedures manuals for database management system (DBMS). This is the
software that creates, operates and maintains the database.
• Review data independence procedures (the data should be independent of the
application such that the structure of the data can be changed independently of the
application).
• Consider the wider database control environment. This includes the general controls and
who has access to change particular aspects of the database. C
• General controls might include: a standard approach for development and maintenance H
of application programs; access rights; data resource management; data security and A
data recovery. P
T
E
R


(a) Key risks from the development of the e-commerce division
There are a number of concerns that an auditor of NewForm should address in relation to its new
e-commerce division. However, the general rule is that the scale of risk that is related to e-
commerce is directly proportional to the number of users and the value of their transactions, which
is critical to NewForm's proposal. The key areas are likely to be as follows.
• Consider what security issues have been addressed by the company. For example, there may
be difficulties with ensuring the integrity of the payments system.
• Consider what additional inventory control measures have been implemented. Inventories are
presumably fairly high value, and hence will be material to NewForm's activities. What
measures have been implemented to track customer orders? What procedures have been put
in place to deal with returned goods in relation to checking claims relating to returned goods
and authorisation/processing of refunds? This may be a particular difficulty, given the remote
nature of the shipment of goods.
• Assess if NewForm has the technical skills to develop and support a new e-commerce division
of the type proposed.
• Evaluate if consideration has been given to ensuring the continuity of operations, given the
increasing reliance of the business on technology. Specific issues include the following.
– Lack of resources may undermine effective contingency plans; this may force a business
to accept a higher tolerance of errors in the system, thus leading to a deeper inherent risk
within the organisation.
– Inadequate controls surrounding the interaction of e-commerce applications with other
business critical applications.
– Undermining of otherwise effective controls, eg from inadequate recognition and use of
controls, combined with inadequate monitoring of control compliance.
• Inventories are held remotely, and thus control over a significant asset is exercised largely by
a third party.
• Online ordering creates problems of security and data protection.
• Lack of audit trail in a paperless system.
• Dependence on a sole distributor.
(b) Application controls
A number of application controls may be relevant, for example the following.
• Pre-processing authorisation
– Customer password systems
– Credit payment authorisation
– Customer account balance limit tests.
• Validation tests
– Consistency with previous orders in terms of value.

CHAPTER 8
The statutory audit: finalisation, C

H
A
review and reporting P
T
E
R
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
Technical reference
Statutory audit: finalisation, review and reporting 333

Introduction
• Review the appropriateness of the going concern assumption
• Review events after the reporting period
• 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)

1 Review and audit completion
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:
• Consider governance issues

• Review the financial statements
• Perform completion procedures
• Report to the board
• Prepare the auditor’s report
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.
1.2 Governance issues

1.2.1 Quality control
We have looked at the importance of quality control in Chapter 1 of this Study Manual. Quality control is
an important consideration throughout the audit. In particular, for the audit of listed entities, ISA 220
Quality Control for an Audit of Financial Statements states that the auditor’s report should not be issued
until the completion of the engagement quality control review. This includes ensuring that:
• 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

• The work performed supports the conclusions
• The evidence obtained supports the audit opinion
• The objectives of the audit have been achieved
• The audit report is appropriate in the circumstances
In addition, under Sarbanes-Oxley, a concurring or second partner review should be performed by

another partner not associated with the audit or by an independent reviewer (see Chapter 4 for more
details of the Sarbanes-Oxley Act).
1.2.2 Governance evidence

Important governance evidence will be obtained from the following sources:
• Written representation letters from management (see later in this Chapter)

• Information about contingent liabilities and commitments (Chapter 13)
• Information about related parties (Chapter 9)
1.3 Financial statement review

1.3.1 Introduction
Once the bulk of the substantive procedures have been carried out, the auditors will have a draft set of
financial statements which should be supported by appropriate and sufficient audit evidence. At the
beginning of the end of the audit process, it is usual for the auditors to undertake an overall review of
the financial statements. This review, in conjunction with the conclusions drawn from the other audit
evidence obtained, gives the auditors a reasonable basis for their opinion on the financial statements.
It should be carried out by a senior member of the audit team, with appropriate skills and experience.
1.3.2 Compliance with accounting regulations

The auditors should consider whether:
(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.
When examining the accounting policies, auditors should consider:
• Policies commonly adopted in particular industries
• Policies for which there is substantial authoritative support
• 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.
1.3.3 Review for consistency and reasonableness

The auditors should consider whether the financial statements are consistent with their knowledge of the
entity's business and with the results of other audit procedures, and the manner of disclosure is fair. The
principal considerations are as follows.
(a) Whether the financial statements adequately reflect the information and explanations previously
obtained and conclusions previously reached during the course of the audit.

(b) Whether it reveals any new factors which may affect the presentation of, or disclosure in, the
(c) Whether analytical procedures applied when completing the audit, such as comparing the
information in the financial statements with other pertinent data, produce results which assist in
arriving at the overall conclusion as to whether the financial statements as a whole are consistent
with their knowledge of the entity's business.
(d) Whether the presentation adopted in the financial statements may have been unduly influenced by
the directors' desire to present matters in a favourable or unfavourable light.
(e) The potential impact on the financial statements of the aggregate of uncorrected misstatements
(including those arising from bias in making accounting estimates) identified during the course of
the audit.
1.3.4 Analytical procedures

In Chapter 6, we discussed how analytical procedures are used as part of the overall review
procedures at the end of an audit. The procedures may be similar to those performed at the planning
stage as risk assessment procedures, but at the end of the audit, the purpose of the procedures is to
corroborate the conclusions drawn during detailed testing.
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

cumulative position is zero. This also applies to the adjustment to last year’s accrued expenses
(adjustment (d)). Cumulative misstatements may also be shown, which have increased from year to
year, for example adjustments (a) and (f). It is normal to show both the statement of financial position
and the effect on profit or loss, as in the example given here. This may also be extended to the entire
statement of profit or loss and other comprehensive income.
1.3.6 Evaluating the effect of misstatements

ISA 450 Evaluation of Misstatements Identified During the Audit states that the objective of the auditor is
to evaluate:
(a) The effect of identified misstatements on the audit, and

(b) The effect of uncorrected misstatements, if any, on the financial statements.
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.
The aggregate of uncorrected misstatements comprises:
(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
(b) Their best estimate of other misstatements which cannot be quantified specifically.
ISA 450 distinguishes between:
• Factual misstatements – about which there is no doubt.
• Judgmental misstatements – differences arising from judgments of management concerning

estimates that the auditor considers unreasonable, or the use of accounting policies that the auditor
considers inappropriate.
• Projected misstatements – the auditor’s best estimate of misstatements in populations, involving

the projection of misstatements identified in samples to entire populations.
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:
• Performing additional audit procedures or

• By requesting management to adjust the financial statements for identified misstatements
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.

2.1 Events after the reporting period
In accordance with ISA 560 Subsequent Events, subsequent events include:
• 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.
2.2 Events occurring up to the date of the auditor's report

The auditor must perform procedures designed to obtain sufficient appropriate audit evidence that all
events up to the date of the auditor's report that may require adjustment of, or disclosure in, the
financial statements have been 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
Inquiries of Status of items involving subjective judgement/accounted for using A

management preliminary data P
T
New commitments, borrowings or guarantees
E
Sales or destruction of assets R
Issues of shares/debentures or changes in business structure
Developments involving risk areas, provisions and contingencies
Unusual accounting adjustments 8
Major events (eg going concern problems) affecting appropriateness of

accounting policies for estimates
Other procedures Consider procedures of management for identifying subsequent events
Read minutes of general board/committee meetings
Review latest accounting records and financial information
Reviews and updates of these procedures may be required, depending on the length of the time
between the procedures and the signing of the auditor’s report and the susceptibility of the items to
change over time.
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
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:

• Discuss the matter with the management
• Consider whether the financial statements need amendment, and if so
• Inquire how management intends to address the matter in the financial statements
When the financial statements are amended, the auditors shall:
• Extend the procedures discussed above to the date of their new report
• Carry out any other appropriate procedures
• 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.
(a) Carry out the audit procedures necessary in the circumstances
(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
(c) Issue a new report on the revised financial statements
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,

the auditor may wish to take advice on whether it might be possible to withdraw their report. In either
case, other possible courses of action include those charged with governance or the auditors making a
statement at the AGM.
Interactive question 1: Subsequent events [Difficulty level: Intermediate]
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
• Financial risk is indicated by the following circumstances:

C
– Financial indications H
– Operating indications A
– Other indications P
T
3.1 Reporting consequences E
R
Under the 'going concern assumption,' an entity is ordinarily viewed as continuing in business for the
foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking
protection from creditors pursuant to laws or regulations. Accordingly, assets and liabilities are recorded
on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal 8
course of business.
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.

3.2 Financial risk
The possibility of a business not being a going concern is one of the financial risks to which a business
is exposed. Financial risks are those risks arising from the financial activities of the company, for
example:
• 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
• Net liabilities or net current liability position
• Fixed-term borrowings approaching maturity without realistic prospects of renewal or

repayment, or excessive reliance on short-term borrowings
• Indications of withdrawal of financial support by creditors
• Negative operating cash flows indicated by historical or prospective financial statements
• Adverse key financial ratios
• Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
• Arrears or discontinuance of dividends
• Inability to pay creditors on due dates
• Inability to comply with terms of loan agreements
• Change from credit to cash-on-delivery transactions with suppliers
• Inability to obtain financing for essential new product development or other essential
investments
(b) Operating
• Management intentions to liquidate the entity or to cease operations

• Loss of key management without replacement
• Loss of a major market, key customer, franchises, licence, or principal supplier
• Labour difficulties
• Shortages of important supplies
• Emergence of a highly successful competitor
(c) Other
• Non-compliance with capital or other statutory requirements
• Pending legal or regulatory proceedings against the entity that may, if successful, result in
claims that could not be met
• Changes in legislation or government policy
• Uninsured or underinsured catastrophes when they occur

The significance of such indications can often be mitigated by other factors.
(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.
3.3 ISA 570 Going Concern

You should also be familiar with the following key points from ISA 570:
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
– to determine the implications for the auditor’s report.
• 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:
– The process management used

– The assumptions on which management's assessment is based
– Management's plans for future action
• 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

date of approval of the financial statements and not disclosed that fact the auditor shall disclose it
in the audit report.
• 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.
Additional audit procedures
• 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:
• Evaluate the reliability of the underlying data, and
• 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
– Inquire of the entity's lawyer regarding litigation and claims
– Confirm the existence, legality and enforceability of arrangements to provide or maintain

financial support with related and third parties
– Assess the financial ability of such parties to provide additional funds
– Evaluate the entity's plans to deal with unfulfilled customer orders
– 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
– Confirm the existence, terms, and adequacy of borrowing facilities
– Obtain and review reports of regulatory actions
– Determine the adequacy of support for any planned disposals of assets

• Based on the audit evidence obtained, the auditor shall determine if, in the auditor’s judgement, a
material uncertainty exists related to events or conditions that alone or in aggregate, may cast
significant doubt on the entity's ability to continue as a going concern. The auditor must document
the extent of his or her concern (if any) about the entity's ability to continue as a going concern.
Auditor conclusions and reporting
Use of going concern assumption appropriate but a material uncertainty exists
• The auditor shall determine whether the financial statements:
– 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.
Use of going concern assumption is inappropriate

8
• If the going concern basis has been used but in the auditor’s judgement this is not appropriate, the
auditor shall express an adverse opinion.
3.4 Going concern issues during the current economic conditions

In December 2008, Bulletin 2008/10 Going Concern Issues During the Current Economic Conditions
was published. This bulletin aims to provide extra guidance on how to apply ISA 570 in the specific
circumstances of the credit crunch.
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

confirmations to the directors that facilities will continue to be available. Auditors must consider whether
or not the lack of a confirmation reflects the existence of a material matter regarding going concern
(which should be emphasised in the auditor’s report).
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.
If the auditor considers that alternative strategies
• 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).
Interactive question 2: Going concern [Difficulty level: Intermediate]
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

Long-term liabilities
Bank loan 750 1,000
Lease obligations 473 –
1,223 1,000
Net assets 3,607 3,793
You have been informed by the managing director that the fall in revenue is due to:
(1) The loss, in July, of a long-standing customer to a competitor, and

(2) A decline in trade in the repair of commercial vehicles.
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
See Answer at the end of this chapter. H

A
P
T
4 Comparatives[AGU1] E
R
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.
4.1 ISA 710 Comparative Information

ISA 710 Comparative Information – Corresponding Figures and Comparative Financial Statements
establishes standards and provides guidance on the auditor’s responsibilities regarding comparatives.
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 corresponding figures, the auditor’s report only refers to the financial statements of the
current period.
• 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.
4.2 Audit procedures

The auditor must obtain sufficient appropriate audit evidence that the comparative information meets the
requirements of the applicable financial reporting framework.
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.
When the financial statements of the prior period:
• Have been audited by other auditors, or

• Were not audited
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

effects of the unresolved matter on the comparability of the current period’s figures and the
corresponding figures.
• 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.
4.4 Incoming auditors: additional requirements

When the prior period financial statements were audited by other auditors, in some countries the
incoming auditors can refer to the predecessor auditor’s report on the corresponding figures in the
incoming auditor's report for the current period.
When the auditor decides to refer to another auditor, the incoming auditor's report should indicate:
(a) That the financial statements of the prior period were audited by the predecessor auditor;
(b) The type of opinion expressed by the predecessor auditor and, if the opinion was modified, the
reasons therefore; and
(c) The date of that report.
In Bangladesh, the existing auditor does not make reference to another auditor in his report.
The situation is slightly different if the prior period financial statements were not audited. C
When the prior period financial statements are not audited, the incoming auditor must state in the H
auditor's report that the corresponding figures are unaudited. A
P
The inclusion of such a statement does not, however, relieve the auditors of the requirement to perform
T
appropriate procedures regarding opening balances of the current period. If there is insufficient evidence
about corresponding figures or inadequate disclosures, the auditor should consider the implications E
for his report. R
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.
• Where there is doubt as to the reliability of written representations or if management refuse to

provide representations, the auditor will need to re-assess the level of assurance obtained from
this source of evidence.
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
• Respond appropriately to the representations or if representations are not provided

5.2 Management from whom written representations are requested
'The auditor shall request written representations from management with appropriate responsibilities for
the financial statements and knowledge of the matters concerned.'
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.
5.3 Written representations

5.3.1 Management's responsibilities
ISA 580 specifies a number of general representations which management must provide.
These are as follows:
• 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
5.3.2 Other written representations

Other written representations may be required regarding specific issues. These may be required due to
the provisions of other ISAs (a list is given in Appendix 1 of ISA 580) or to support other audit evidence.
In particular, written representations may be sought where sufficient appropriate evidence cannot be
obtained independently. This might be the case where an assertion is affected by judgement or
management intent. For example, management intent would be an important factor in the valuation
basis used to value investments.
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.
• Whether the selection and application of accounting policies are appropriate

• Whether the following have been recognised, measured and presented (where relevant)
– 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

5.3.3 Threshold amount
The ISA allows for the possibility that the auditor may agree a 'threshold amount' above which matters
cannot be regarded as clearly trivial.
5.4 Date of written representations

'The date of the written representations shall be as near as practicable to, but not after, the date of the
auditor's report on the financial statements. The written representations shall be for all the financial
statements and periods referred to in the auditor's report.'
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.
5.5 Form of written representations

'The written representation shall be in the form of a representation letter addressed to the auditor. If law
or regulation requires management to make written public statements about its responsibilities and the
auditor determines that such statements provide some or all of the representations required by
paragraphs 10 or 11 (covered in paragraph 5.3.1 above), the relevant matters covered by such
statements need not be included in the representation letter.'
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.
5.7 Written representations not provided

ISA 580 requires the following procedures to be followed where written representations are not provided.
• Discuss the matter with management

• Re-evaluate the integrity of management and evaluate the effect that this may have on the
reliability of representations (oral and written) and evidence in general
• Take appropriate actions including determining the possible effect on the audit opinion
Where management does not provide representations about management's responsibilities
regarding the preparation and presentation of financial statements and information provided to the
auditor, the audit opinion will be a disclaimer.
Interactive question 3: Written representations [Difficulty level: Intermediate]
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

evidence for the revaluation, and a survey of business property values in the area does not show
any increase.
(c) The directors confirm that the company owns 75% of the newly formed company, Subsidiary Ltd, at
the year end.
(d) The directors confirmed that the 500 gallons of oil in Warehouse B belong to Leaf Oil Ltd.
Requirement
Comment on whether you would expect to see these matters referred to in the written representation
letter.
6 The auditor’s report
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.
6.1 The standard report

The auditor’s report which you are familiar with is the standard auditor’s report. This is governed in
Bangladesh by legislation and the principles contained within ISA 700 (Revised October 2012) The
Auditor’s Report on Financial Statements. Details on contents and different types of audit opinions are
covered in Application Level Audit and Assurance.
6.2 Current issues

6.2.1 The act of communication
In essence, the auditor’s job is straightforward. They carry out tests and inquiries and evaluate evidence
received with the purpose of drawing an audit opinion. They then communicate that opinion, in the form
of an audit report, as we have been discussing. This can cause problems.
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.

Communicating the audit opinion in a way that people can understand it is a challenge. ISA 700
(Revised June 2013) goes some way to addressing those challenges. (see section 6.1.3 above).
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.
This issue may cause misunderstanding: C

• Language barriers may cause additional understandability problems H
• It may not be clear which financial information an auditor’s report refers to A
P
• The auditor’s report may be subject to malicious tampering by hackers or personnel
T
If an auditor’s report is published electronically, auditors lose control of the physical positioning of the E
report, that is, what it is published with. This might significantly impact on understandability and also R
perceived responsibility.
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
– 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:

– Icons or watermarks
– Colour borders
– Labels/banners such as ‘annual report’ or ‘audited financial statements’
The auditors may reserve the right to decline the report being so published, if they do not like the
presentation of the report and the associated financial statements that the directors propose.
Interactive question 4: Forming an audit opinion [Difficulty level: Exam standard]

You are an audit senior. You are nearing the end of the audit of Russell Ltd for the year ended 30 June
20X7. The financial statements show a profit before tax of CU14 million (20X6: CU6 million) and a
statement of financial position total of CU46 million (20X6: CU30 million). The following points have
arisen on the audit:
(1) Russell Ltd owns a number of its retail premises, which it revalues annually. This year several of its
shops did rise sharply in value due to inflated property prices in their locality. Russell Ltd also
capitalises refits of its shops. Four shops were refitted in the year. The total increase in assets due
to refits and revaluations is CU20 million. Russell Ltd does not revalue its factory premises, which
are recognised in the statement of financial position at CU250,000.
(2) Russell Ltd makes approximately 20% of its sales via an internet site from which it sells the
products of Cairns Ltd. Russell Ltd earns commission of 15% on these sales. Customers place
their order on the internet site and pay for goods by providing their credit card details. Once Russell
Ltd has received authorisation from the credit card company the order is passed to Cairns Ltd. The
product is then shipped directly to the customer and all product returns, and credit card related
issues are dealt with by Cairns Ltd. The total product sales achieved through the internet site and
despatched to customers in the year were CU6,000,000. This amount has been recognised as
revenue for the year ended 30 June 20X7.
Requirement
Comment on the matters you will consider in relation to the implications of the above points on the
auditor’s report of Russell Ltd.
6.3 The Auditor's Responsibilities Relating to Other Information in

Documents Containing Audited Financial Statements
6.3.1 What other information?
ISA 720 (Revised October 2012) Section A – The Auditor’s Responsibilities Relating to Other
Information in Documents Containing Audited Financial Statements establishes standards and provides
guidance on the auditor’s consideration of other information, on which the auditors have no obligation
to report, in documents containing audited financial statements. It was revised in October 2012 to give
effect to changes made in corporate governance (see Chapter 4).
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.

Definitions
Other information: is financial and non-financial information (other than the audited financial statements
and the auditor’s report) which is included, either by law, regulation or custom, in a document containing
audited financial statements and the auditor’s report thereon.
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
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.
Examples of other information are:
• A report by management or those charged with governance on operations

• Financial summaries or highlights C
• Employment data H
A
• Planned capital expenditures
P
• Financial ratios
T
• Name of officers and directors
E
• Selected quarterly data R
Further examples relevant are a directors’ report required by statute (dealt with specifically in Section B
of ISA 720), statements relating to corporate governance, a chairman’s statement and a voluntary
Operating and Financial Review. 8
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.
6.3.2 Access to other information

Timely access to other information will be required. The auditors therefore must make arrangements
with the client to obtain such information prior to the date of their report.
6.3.3 Material inconsistencies

If, on reading the other information, the auditor identifies a material inconsistency, the auditor must
determine whether the audited financial statements or the other information needs to be amended. The
auditor should seek to resolve the matter through discussion with those charged with governance.

If an amendment is necessary in the audited financial statements and the entity refuses to make the
amendment, the auditor should express a qualified or adverse opinion.
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
(b) Withhold the auditor’s report; or
(c) Withdraw from the engagement.
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.
7 Other reporting responsibilities
Section overview
• Auditors may have to report on entire special purpose financial statements or simply one element
of those financial statements.
• Auditors may have to report on summary financial statements.
7.1 Special Considerations – Audits of Financial Statements Prepared in

Accordance with Special Purpose Frameworks
7.1.1 Introduction
ISA 800 Special Considerations – Audits of Financial Statements Prepared in Accordance with Special
Purpose Frameworks has been adopted in Bangladesh.
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.
7.1.3 General considerations

• Before undertaking a special purpose audit engagement, the auditor should ensure there is
agreement with the client as to the exact nature of the engagement and the form and content of
the report to be issued
• 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.
7.1.4 Special purpose frameworks

In the context of the ISA, special purpose frameworks refer to accounts which are prepared in situations
other than within a Companies Act statutory audit. Specific examples of special purpose frameworks
given in the ISA include:
• 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 established by a regulator to meet that regulator’s
requirements
• 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
• The auditor may express an unmodified opinion on an element

of the financial statements if:
– Not prohibited by law
– The opinion is published separately, and
– The specific element does not form a major portion of the
entity’s complete set of financial statements
7.1.6 Engagements to Report on Summary Financial Statements
ISA 810 Engagements to Report on Summary Financial Statements has been adopted in Bangladesh.
The key point which this ISA makes is that the auditor should not express an opinion on the
summarised financial statements unless they have expressed an audit opinion on the financial
statements from which they have been derived.

Reporting considerations
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.

However, a revalued asset will have depreciation charged on its historical cost and the increase in the
value in the asset. The Companies Act allows the depreciation provision on the valuation increase to be
treated also as a realised profit.
Effectively there is a cancelling out, and at the end only depreciation that relates to historical cost
will affect dividends.
Worked example: distributable profit

Suppose that an asset purchased for CU20,000 has a 10 year life and nil residual value. Provision is
made for depreciation on a straight line basis. This means the annual depreciation charge of CU2,000
must be deducted in reckoning the company's realised profit less realised loss.
Suppose now that after five years the asset is revalued to CU50,000 and in consequence the annual
depreciation charge is raised to CU10,000 (over each of the five remaining years of the asset's life).
The effect is that CU8,000 of this amount may be reclassified as a realised profit for each remaining year
of the asset’s life. The net effect is that realised profits are reduced by only CU2,000 in respect of
depreciation, as before.
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
(b) Capital redemption reserve 8
(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.
Worked example: dividends

Suppose that a public company has an issued share capital (fully paid) of CU800,000 and CU200,000
on share premium account. If its net assets are less than CU1 million, it may not pay a dividend. If,
however, its net assets are CU1,250,000, it may pay a dividend, but only of such amount as will leave
net assets of CU1 million or more - its maximum permissible dividend is therefore CU250,000.
The dividend rules apply to every form of distribution of assets except the following:
• The issue of bonus shares whether fully or partly paid

• The redemption or purchase of the company's shares out of capital or profits
• A reduction of share capital
• A distribution of assets to members in a winding up
7.2.2 Relevant accounts

Whether a company has profits from which to pay a dividend is determined by reference to its 'relevant
accounts', which are generally the last annual accounts to be prepared.

If the auditors have modified their report on the accounts, they must also state in writing whether, in their
opinion, the subject matter of the modification is material in determining whether the dividend may be
paid. This statement must have been circulated to the members (for a private company) or considered at
a general meeting (for a public company).
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]

Self-test
1 Branch Ltd
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:
'Earnings per share
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.
Financial performance statement
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
We recommend that an unmodified auditor’s report be issued.'
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
Prepare the briefing note as requested. (20 marks)

Exhibit 1
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
Audit file notes
(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.

(3) I have gathered together some data relating to SAH prior to performing analytical procedures,
but have yet to get around to doing it. The relevant data is
Year end May 20X1 20X2 20X3

Revenue (CU000) 500 1,140 990
Gross profit margins (%) 22 19 17
Profit/(loss) retained in the year (CU000) 2 45 (42)
I understand eSAH’s provisional revenue to the year end 31 May 20X3 to be about
CU500,000, and gross profitability was at 10%. Inventory has remained constant during the
year ended 31 May 20X3 in SAH.
(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.
(i) Net current assets to remain positive.
(ii) Overdraft balances to be no more than CU150,000 at all times.
(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.

Technical reference
ISA 260
• Auditor’s objective ISA 260.9
• Who auditor should communicate to ISA 260.11-.13
• Matters to be communicated to those charged with governance ISA 260.14-.17
• Timing of communications ISA 260.21
• Form of communications ISA 260.19-.20
ISA 265
• Identifying significant deficiencies ISA 265.A5-.A7
• Written communication ISA 265.11
ISA 450
• Evaluating the effects of misstatements ISA 450.10-.11
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
• Audit procedures for obtaining audit evidence ISA 560.7 - .9
• 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
• Auditor’s responsibility ISA 570.6 - .7
• Auditor’s objectives ISA 570.9
• Indicators of going concern problems ISA 570.A2
• Audit procedures ISA 570.16, A15
• Evaluating management assessment of going concern ISA 570.12 - .14
• Audit procedures – period beyond management’s assessment ISA 570.15
• Audit conclusions and reporting ISA 570.17 - .22
ISA 580
• Acknowledgement of management responsibility ISA 580.10-.12
• Representations by management as audit evidence ISA 580.13
• Documentation of representations ISA 580.15

• Elements of a representation letter ISA 580 Appendix 2
• Actions if management refuse to provide written representations ISA 580.19
ISA 700
• Elements of a standard audit report ISA 700.12-.26
ISA 705
• Circumstances when modifications are required ISA 705.6
• Types of modification ISA 705.7-10, A1
ISA 706
• Emphasis of matter paragraphs ISA 706.6-.7
• Other matter paragraphs ISA 706.8
ISA 710
• Reporting responsibilities ISA 710.3
• Overview of audit procedures ISA 710.7-.9
• Corresponding figures – reporting ISA 710.10 - .14
• Comparative financial statements – reporting ISA 710.15 - .16
ISA 720
• Action on identifying a material inconsistency ISA 720.8-.10
• Action on identifying a material misstatement of fact ISA 720.14-.16
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
• Reports on summary financial statements ISA 810.14-.15 &

Appendix

1 Branch Ltd
Earnings per share
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.
Exercise of share options

C
The fact that the director has exercised his share options after the year end does not require H
disclosure in the financial statements. However, it is likely that he has exercised them as part of a A
new share issue by the company and if so, the share issue would be a non-adjusting event after P
the reporting period that would require disclosure in the financial statements. We should check if T
this is the case and, if so, whether it has been disclosed. Non-disclosure would be further grounds E
for modification. R
Financial performance statement
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.
Corporate governance statement
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
– materially inconsistent with the information in the audited financial statements or

– is apparently incorrect based on, or materially inconsistent with, the knowledge acquired by
the auditor in the course of the audit or that is otherwise misleading.
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
BRIEFING NOTES TO MANAGER
To Audit Manager
From Audit Senior
Date July 20X3
Client SafeAsHouses (hereafter SAH) and eSAH
Subject Major issues arising in audit work performed to date
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.
Incorrect financial statements
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.
Net current assets
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.

(1) The treatment of the payment on account of CU120,000 is incorrect and does not accord with
prudent revenue recognition rules. The payment should not have been taken to revenue, but
credited to an account in short-term payables. This adjustment will reduce net current assets
to (CU203,000).
(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
(c) Its ability to use or sell the intangible asset.
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.

Receivable and payable days
I have calculated these on a consolidated basis. The relevant figures are
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.
• Look to correspondence with financiers to ascertain evidence of refinancing or of a relaxation

of the covenants.


Implications
(1) Accounting treatment
• 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.

(a)
Circumstances Why cause for concern?

Fall in gross profit % achieved Whilst the fall in absolute revenue has been explained the fall
in gross profit margin is more serious.
This will continue to be a problem as expenses seem
constant and interest costs are growing.
This will make a future return to profitability difficult.
Losses CU249,000 Such levels of losses by comparison to 20X4 profits will make
negotiations with bank difficult, especially with the loss of a
major customer.
Increased receivables balance and Worsening debt collection is bad news when the company is
increased ageing making losses and has a deteriorating liquidity position.
20X4 74.8 days The increase in average debt collection period may be due to
an irrecoverable receivable on the account of the major

Circumstances Why cause for concern?
20X5 96.7 days customer lost in the year.
An irrecoverable receivable write-off would cause much
increased losses.
Worsening liquidity ratio This is a significant fall which will worsen further if an
20X4 1.03 allowance for irrecoverable receivables is required.
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.
• Obtain his opinion about future contracts in a written representation letter.
• 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.
• Obtain cash flow and profit forecasts:
– Discuss assumptions with the directors

– Perform sensitivity analysis flexing the key assumptions ie interest rates, date of payment
of payables and receipts from customers
• Check all commitments have been cleared in accordance with legal agreements
– 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.

(a) I would expect to see this referred to in a written representation letter. Appendix 1 to ISA 580 cross
refers to the requirement in ISA 560 Subsequent Events that management should inform auditors
of relevant subsequent events.
(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.

(1) Non-current assets
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.
(i) Revaluation policy C

H
Per IAS 16, non-current assets may be held at cost or valuation. Where a company applies a A
revaluation policy, IAS 16 requires that all revaluations are made with sufficient regularity that P
the carrying amount does not vary materially from that which would be determined if fair value T
were used. Russell Ltd revalues annually, so meets the latter requirement.
E
Russell Ltd revalues property and IAS 16 requires that all items in the same class of assets be R
revalued, so the question arises as to whether it should also revalue the factory. This might
have a material effect on the statement of financial position.
8
IAS 16 states that a ‘class’ of property, plant and equipment is a grouping of assets of a
similar nature and use in an entity’s operations. Although the IAS implies that buildings
comprise one class, in this case the nature and use of the two kinds of building are quite
distinct. Therefore creating two classes (retail premises and manufacturing premises) would
appear reasonable.
(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.

(2) Revenue recognition
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.
In accordance with IFRS 15 commission received by a party acting as an agent should be

recognised as earned. As Russell Ltd has no further obligations once the initial transaction has
been undertaken the commission should be recognised at this time. Commission of approximately
CU900,000 should be recognised (CU6,000,000 x 15%). An additional adjustment may be required
in respect of sales made not despatched. The CU6,000,000 trading revenue should be eliminated
with any associated costs of sale and inventory. These amounts are likely to be material to the
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.

CHAPTER 9
Reporting financial
performance
C
H
A
Introduction P
Topic List T
1 IAS 1 Presentation of Financial Statements E
2 IFRS 8 Operating Segments R
3 IFRS 5 Non-current Assets Held for Sale and Discontinued Operations

4 IAS 24 Related Party Disclosures
9
5 IFRS 1 First Time Adoption of International Financial Reporting Standards
6 IAS 34 Interim Financial Reporting
7 Audit focus - General issues with reporting performance
8 Audit focus – Specific issues
Technical reference
Reporting financial performance 375

Introduction
• Appraise the significance of inconsistencies and omissions in reported information in

evaluating performance
• Compare the performance and position of different entities allowing for inconsistencies in
the recognition and measurement criteria in the financial statement information provided
• Make adjustments to reported earnings in order to determine underlying earnings and

compare the performance of an entity over time
• 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
Specific syllabus references for this chapter are: 2(a), 2(b), 2(c), 2(d), 14(f)

1 IAS 1 Presentation of Financial Statements
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.
1.1 Main features

Titles of financial statements
The three main financial statements under IAS 1 are:
• Statement of financial position

• Statement of profit or loss and other comprehensive income
• Statement of cash flows
You may still see the old names (balance sheet, etc), as these new titles are not mandatory.
Reporting owner changes in equity and comprehensive income

IAS 1 classifies changes in equity in a period as either:
• Owner changes in equity, or
• Non-owner changes in equity.
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.
Non-owner changes in equity (known as 'comprehensive income') include:
1 The profit or loss for the period

2 Income or expenditure recognised directly in equity (known as 'other comprehensive income'). C
These are presented in the statement of profit or loss and other comprehensive income. H
A
Summary
P
IAS 1 T
E
Profit or loss for period Statement of profit or loss and other
R
Non-owner transactions recognised directly in equity comprehensive income
Owner transactions Statement of changes in equity

Presentation of comparatives 9
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:
• Retrospectively applies an accounting policy

• Retrospectively restates items in the financial statements, or
• Reclassifies items in the financial statements.
In effect this will result in the presentation of three statements of financial position when there is a prior
period adjustment.
1.2 Statement of financial position

Note that reserves other than share capital and retained earnings may be grouped as 'other components
of equity'.

Statement of financial position as at 31 December 20X7
31 Dec 20X7 31 Dec 20X6
$m $m
ASSETS
Non-current assets
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investments in associates X X
Available-for-sale financial assets X X
X X
Current assets
Inventories X X
Trade receivables X X
Other current assets X X
Cash and cash equivalents X X
X X
Total assets X X
EQUITY AND LIABILITIES
Equity attributable to owners of the parent
Share capital X X
Retained earnings X X
Other components of equity X X
X X
Non-controlling interests X X
Total equity X X
Long-term borrowings X X
Deferred tax X X
Long-term provisions X X
Total non-current liabilities X X
Current liabilities
Trade and other payables X X
Short-term borrowings X X
Current portion of long-term borrowings X X
Current tax payable X X
Short-term provisions X X
Total current liabilities X X
Total liabilities X X
Total equity and liabilities X X
1.3 Statement of profit or loss and other comprehensive income
The statement of profit or loss and other comprehensive income presents the total comprehensive
income of an entity for a period.
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:
• Changes in the revaluation surplus.
• Remeasurements (actuarial gains and losses on defined benefit plans recognised in accordance
with IAS 19 Employee Benefits (revised 2011)) (Chapter 18).

• Gains and losses arising from translating the financial statements of a foreign operation (Chapter
21).
• Gains and losses on remeasuring available-for-sale financial assets (Chapter 16).
• The effective portion of gains and losses on hedging instruments in a cash flow hedge (Chapter
17).
1.3.1 2011 Revision of IAS 1

In June 2011, the IASB published an amendment to IAS 1 called Presentation of items of other
comprehensive income, changing the presentation of items contained in Other Comprehensive Income
(OCI) and their classification within OCI.
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
IAS 1 allows comprehensive income to be presented in two ways:
1 A single statement of profit or loss and other comprehensive income, or 9
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:
Statement of profit or loss and other comprehensive income

for the year ended 31 December 20X7
20X7 20X6
$m $m
Revenue X X
Cost of sales (X) (X)
Gross profit X X

20X7 20X6
$m $m
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Loss for the year from discontinued operations (X)
PROFIT FOR THE YEAR X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Investment in equity instruments (available-for-sale financial
assets) (X) X
Actuarial gains (losses) on defined benefit pension plans (X) X
Share of gain (loss) on property revaluation of associates X (X)
Income tax relating to items that will not be reclassified X (X)
(X) X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Cash flow hedges (X) (X)
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax (X) X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X
Profit attributable to:
Owners of the parent X X
X X
Total comprehensive income attributable to:
Owners of the parent X X
X X
Earnings per share ($)

Basic and diluted X X
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:

• In profit or loss, or
• In other comprehensive income
1.4 Statement of changes in equity

All changes in equity arising from transactions with owners in their capacity as owners are shown in the
statement of changes in equity.
Non-owner transactions are not permitted to be shown in the statement of changes in equity other than
in aggregate.
Statement of changes in equity for the year ended 31 December 20X7

Available
Translation -for-sale Non-
Share Retained of foreign financial Cash flow Revaluation controlling Total
capital earnings operations assets hedges surplus Total interest equity
Balance at CU'00 CU'000 CU'000 CU'000 CU'000 CU'000 CU'00 CU'000 CU'000
0 0
1 Jan 20X7 X X (X) X X – X X X
Changes in
accounting
policy – X – – – – X – X
Restated
balance X X (X) X X – X X X
Changes
in equity
during 20X7
Issue of share
capital X – – – – – X – X
Dividends – (X) – – – – (X) (X) (X)
Total
comprehensive
income for the
year – X X X X X X X X
Transfer to
retained
C
earnings – X – – – (X) – – –
H
Balance at
31 Dec 20X7 X X X X X X X X X A
P
A comparative statement for the prior period is also required.
T
Here is an example of a statement of changes in equity with some real figures in, to give you a better E
idea of what it looks like: R
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

2 IFRS 8 Operating Segments
An important aspect of reporting financial performance is segment reporting. This is covered by IFRS 8
Operating Segments.
Section overview
IFRS 8 is a disclosure standard.
• Segment reporting is necessary for a better understanding and assessment of:
– Past performance
– Risks and returns
– Informed judgements
• IFRS 8 adopts the managerial approach to identifying segments.
• 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.
• The entity's past performance will be better understood

• The entity's risks and returns may be better assessed
• More informed judgements may be made about the entity as a whole
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.
2.2 Objective and scope

An entity must disclose information to enable users of its financial statements to evaluate the nature and
financial effects of the business activities in which it engages and the economic environments in which it
operates.
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.)
2.3 Definition of operating segment

Definition
Operating segment: This is a component of an entity:
(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
(c) For which discrete financial information is available.

The term 'chief operating decision maker' identifies a function, not necessarily a manager with a specific
title. That function is to allocate resources and to assess the performance of the entity's operating
segments.
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:
• The nature of the products or services

• The nature of the production process
• The type or class of customer for their products or services
• The methods used to distribute their products or provide their services, and
• If applicable, the nature of the regulatory environment
2.5 Determining reportable segments

An operating segment is reportable where:
1 It meets the definition of an operating segment, and
2 Any of the following size criteria are met:
(a) Segment revenue ≥ 10% of total (internal and external) revenue, or
(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
(c) Segment assets ≥ 10% of total assets.
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).
2.5.1 Aggregating segments

Two or more operating segments below the thresholds may be aggregated to produce a reportable
segment if the segments have similar economic characteristics, and the segments are similar in a C
majority of the aggregation criteria above. H
A
2.5.2 Non-reportable segments
P
Operating segments that do not meet any of the quantitative thresholds may be reported separately if T
management believes that information about the segment would be useful to users of the financial E
statements. R
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:
• Factors used to identify the entity's reportable segments

• Types of products and services from which each reportable segment derives its revenues
• For each reportable segment:
– Operating segment profit or loss

– Segment assets
– Segment liabilities
– Certain income and expense items

A reconciliation of each of the above material items to the entity's reported figures is required.
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.
2.6.2 Entity wide disclosures

The following disclosures are required for the whole entity:
• External revenue by each product and service (if reported basis is not products and services)
• Geographical information:
Notes:
(1) External revenue is allocated based on the customer's location.
(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).

2.6.3 Disclosure example from IFRS 8
The following example is adapted from the IFRS 8 Implementation Guidance, which emphasises that
this is for illustrative purposes only and that the information must be presented in the most
understandable manner in the specific circumstances.
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.
Car Motor All

parts vessel Software Electronics Finance other Totals
$ $ $ $ $ $ $
Revenues from external
customers 3,000 5,000 9,500 12,000 5,000 1,000 35,500
Intersegment revenues – – 3,000 1,500 – – 4,500
Interest revenue 450 800 1,000 1,500 – – 3,750
Interest expense 350 600 700 1,100 – – 2,750
Net interest revenue – – – – 1,000 – 1,000
Depreciation and 200 100 50 1,500 1,100 – 2,950
amortisation
Reportable segment profit 200 70 900 2,300 500 100 4,070
Other material non-cash items:
Impairment of assets – 200 – – – – 200
Reportable segment assets 2,000 5,000 3,000 12,000 57,000 2,000 81,000
Expenditure for reportable
segment non-current assets 300 700 500 800 600 – 2,900
Reportable segment liabilities 1,050 3,000 1,800 8,000 30,000 – 43,850
• 'All other' segment results are attributable to four operating segments of the company which do not
meet the quantitative thresholds. Those segments include a small property business, an electronics
equipment rental business, a software consulting practice and a warehouse leasing operation.
None of those segments has ever met any of the quantitative thresholds for determining reportable
segments. C
H
• The finance segment derives a majority of its revenue from interest. Management primarily relies
on net interest revenue, not the gross revenue and expense amounts, in managing that segment. A
Therefore, as permitted by IFRS 8, only the net amount is disclosed. P
T
E
R

2.6.4 Suggested pro forma
Information about profit or loss, assets and liabilities
Segment Segment Segment All other Inter Entity
A B C segments segment total
Revenue – external customers X X X X – X
Revenue – inter segment X X X X (X) –
X X X X (X) X
Interest revenue X X X X (X) X
Interest expense (X) (X) (X) (X) X (X)
Depreciation and
amortisation (X) (X) (X) (X) – (X)
Other material non-cash
items X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Material income/expense
(IAS 1) X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Share of profit of
associate/JVs X X X X – X
Segment profit before tax X X X X (X) X
Income tax expense (X) (X) (X) (X) – (X)
Unallocated items X/(X)
Profit for the period X
Segment assets X X X X (X) X
Investments in
associate/JVs X X X X – X
Unallocated assets X
Entity's assets X
Expenditures for reportable

assets X X X X (X) X
Segment liabilities X X X X (X) X
Unallocated liabilities X
Entity's liabilities X
Information about geographical areas
Country of Foreign
domicile countries Total
Revenue – external customers X X X
Non-current assets X X X
Interactive question 1: Segments [Difficulty level: Intermediate]
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.
Operating segment information as at 31 December 20X5

Revenue Segment Segment Segment
External Internal Total profit/(loss) assets liabilities
CUm CUm CUm CUm CUm CUm
Chemicals: Europe 14 7 21 1 31 14
Rest of world 56 3 59 13 778 34
Pharmaceuticals wholesale 59 8 67 9 104 35
Pharmaceuticals retail 22 0 22 (2) 30 12
Cosmetics 12 3 15 2 18 10
Hair care 11 1 12 4 21 8
Body care 18 24 42 (6) 54 19
192 46 238 21 336 132

Requirement
Which of the operating segments of Endeavour constitute a 'reportable' operating segment under IFRS 8
Operating Segments for the year ending 31 December 20X5?
3 IFRS 5 Non-current Assets Held for Sale and

Discontinued Operations
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)
• Assets arising from employee benefits (IAS 19)

9
• Financial assets (IAS 39)
• 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)
• Insurance contracts (IFRS 4)
3.1 Classification of assets held for sale

A non-current asset (or disposal group) should be classified as held for sale if its carrying amount will
be recovered principally through a sale transaction rather than through continuing use. A number
of detailed criteria must be met:
(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).

For the sale to be highly probable, the following must apply.
(i) Management must be committed to a plan to sell the asset.
(ii) There must be an active programme to locate a buyer.
(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.
Subsidiaries acquired exclusively with a view to resale
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).
Interactive question 2: Available-for-sale [Difficulty level: Exam standard]
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
How should the manufacturing facility be accounted for as at 31 December 20X3?
3.2 Measurement of assets held for sale

A non-current asset (or disposal group) that is held for sale should be measured at the lower of its
carrying amount and fair value less costs to sell (net realisable value).
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.

3.3 Presenting discontinued operations
Definitions
Discontinued operation: a component of an entity that has either been disposed of, or is classified as
held for sale, and:
(a) Represents a separate major line of business or geographical area of operations
(b) Is part of a single co-ordinated plan to dispose of a separate major line of business or geographical
area of operations, or
(c) Is a subsidiary acquired exclusively with a view to resale.
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:
(a) The post-tax profit or loss of discontinued operations and
(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.
(b) The related income tax expense.
(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.
Interactive question 3: Closure [Difficulty level: Intermediate]
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?

3.4 Presentation of a non-current asset or disposal group classified as

held for sale
Non-current assets and disposal groups classified as held for sale should be presented separately
from other assets in the statement of financial position. The liabilities of a disposal group should be
presented separately from other liabilities in the statement of financial position.
(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.
3.5 IFRS 5 and impairment

There are particular rules on impairment in the context of IFRS 5. These are covered in Chapter 12,
Section 1.4 of this study manual.
3.6 Additional disclosures

In the period in which a non-current asset (or disposal group) has been either classified as held for sale
or sold the following should be disclosed.
(a) A description of the non-current asset (or disposal group).
(b) A description of the facts and circumstances of the disposal.
(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.
4 IAS 24 Related Party Disclosures
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.
4.1 Overview of material from earlier studies

Scope
IAS 24 requires disclosure of related party transactions, and outstanding balances, in the separate
financial statements of:
• A parent
• A venturer or
• An investor
What constitutes a related party?
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:
(i) Has control or joint control over the reporting entity;
(ii) Has significant influence over the reporting entity; or

(iii) Is a member of the key management personnel of the reporting entity or of a parent of the
reporting entity.
(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.
(vi) The entity is controlled or jointly controlled by a person identified in (a).
(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
(i) Providers of finance

(ii) Trade unions
(iii) Public utilities
(iv) Government departments and agencies C
H
(d) Any single customer, supplier, franchisor, distributor, or general agent with whom the entity
A
transacts a significant amount of business, simply by virtue of the resulting economic dependence.
P
What constitutes a related party transaction? T
E
Definition
R
Related party transaction: A transfer of resources, services or obligations between related parties,
regardless of whether a price is charged.
9
What must be disclosed?
• A related party relationship between parent and subsidiaries.
• 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).
– The amount of the transactions.
– The amount of any balance outstanding at the year-end.

– The terms and conditions attaching to any outstanding balance (for example, whether security
or guarantees have been provided and what form the payment will take).
– 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).)
Interactive question 4: Related party transactions [Difficulty level: Intermediate]
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?
4.2 Application of substance over form

Under IAS 24 attention should be directed to the substance of the relationship rather than focusing on
its legal form. For example, the following are not related parties:
• 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.
Worked example: Related parties

The following examples illustrate the application of the definition of a related party to practical situations:
(a) Person A owns 30% of Entity B and Entity C owns 40% of Entity B
Entity B is the reporting entity:
Person A is a related party under definition (a)(ii) and Entity C is a related party under
definition (b)(ii)
Entity C is the reporting entity:
Entity B is a related party under definition (b)(ii)
(b) Person A and Entity B have joint control over Entity C

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)
(c) Person A is a non-executive director of Entity B
Person A falls within the definition of Entity B's key management personnel and is a related
party under definition (a)(iii)
(d) Person A owns 70% of Entity B and is a director of Entity C
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)
Entity B is a related party under definition (b)(vi)
5 IFRS 1 First-time Adoption of International Financial

Reporting Standards
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.
5.1 General principles

An entity applies IFRS 1 in its first IFRS financial statements.
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.

5.2 Opening IFRS statement of financial position
An entity prepares and presents an opening IFRS statement of financial position at the date of
transition to IFRS as a starting point for IFRS accounting.
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).
Illustration: Opening IFRS SOFP

Comparative year 1st year of adoption
1.1.20X8 31.12.20X8 31.12.20X9
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).
5.4 Transition process

(a) Accounting policies
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.
(b) Derecognition of assets and liabilities
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.
(c) Recognition of new assets and liabilities
New assets and liabilities may need to be recognised.
Eg deferred tax balances and certain provisions such as environmental and decommissioning
costs.
(d) Reclassification of assets and liabilities
Eg compound financial instruments need to be split into their liability and equity components.
(e) Measurement
Value at which asset or liability is measured may differ under IFRS.
Eg discounting of deferred tax assets/liabilities not allowed under IFRS.

5.5 Main exemptions from applying IFRS in the opening IFRS statement of
financial position
(a) Property, plant and equipment, investment properties and intangible assets
• Fair value/previous GAAP revaluation may be used as a substitute for cost at date of transition
to IFRSs.
(b) Business combinations
For business combinations prior to the date of transition to IFRSs:
• The same classification (acquisition or uniting of interests) is retained as under previous

GAAP.
• 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.
(c) Employee benefits
• Unrecognised actuarial gains and losses can be deemed zero at the date of transition to
IFRSs. IAS 19 is applied from then on.
(d) Cumulative translation differences on foreign operations
• Translation differences (which must be disclosed in a separate translation reserve under

IFRS) may be deemed zero at the date of transition to IFRS. IAS 21 is applied from then on.
(e) Adoption of IFRS by subsidiaries, associates and joint ventures
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.
5.6 Organisational and procedural changes

The technical changes involved in adopting a new body of standards will provide a challenge to
company management and their advisers. These are some of the key issues:
(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

participants can personally account for what they are doing as well as flag up any problems as
early as possible. Project drift should be avoided.
(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.
Interactive question 5: IFRS 1 [Difficulty level: Intermediate]
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
Advise the directors of Europa on the following.
(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.
6 IAS 34 Interim Financial Reporting
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

production.
The following definitions are used in IAS 34.
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.
6.1 Scope of IAS 34

IAS 34 does not make the preparation of interim financial reports mandatory, taking the view that this is
a matter for governments, securities regulators, stock exchanges or professional accountancy bodies to
decide within each country. The IASB does, however, strongly recommend to governments, and
regulators, that interim financial reporting should be a requirement for companies whose equity or debt
securities are publicly traded.
IAS 34 encourages publicly traded entities:
• 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.
6.2 Minimum components

IAS 34 specifies the minimum component elements of an interim financial report as follows:
• Condensed statement of financial position

C
• Condensed statement of profit or loss and other comprehensive income, presented either as a
H
single condensed statement or a statement of profit or loss and a statement showing other
A
P
• Condensed statement of changes in equity T
E
• Condensed statement of cash flows
R
• Selected note disclosures
IAS 34 applies where an entity is required to or chooses to publish an interim financial report in
accordance with International Financial Reporting Standards (IFRSs). 9
An interim report complying with IFRSs may be:
• 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.
6.3 Form and content

Where full financial statements are given as interim financial statements, IAS 1 should be used as a
guide, otherwise IAS 34 specifies minimum contents.
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 previous financial year, thus providing a summary of the economic resources of the entity and its
financial structure.
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.
6.3.1 Selected explanatory notes

IAS 34 states that relatively minor changes from the most recent annual financial statements need not
be included in an interim report. However, the notes to an interim report should include the following
(unless the information is contained elsewhere in the report).
• 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.

Worked example: Disclosure
Requirement
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
• Reversal of any provisions for the costs of restructuring
• Acquisitions and disposals of items of property, plant and equipment
• Commitments for the purchase of property, plant and equipment
• Litigation settlements
• Corrections of fundamental errors in previously reported financial data
• Any debt default or any breach of a debt covenant that has not been corrected subsequently
• Related party transactions
6.4 Periods covered

The Standard requires that interim financial reports should provide financial information for the following
periods or as at the following dates.
• 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.
6.6 Recognition and measurement principles

A large part of IAS 34 deals with recognition and measurement principles, and guidelines as to their
practical application. The guiding principle is that an entity should use the same recognition and
measurement principles in its interim statements as it does in its annual financial statements.
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.

Applying this principle of recognition and measurement may result, in a subsequent interim period or at
the year-end, in a remeasurement of amounts that were reported in a financial statement for a previous
interim period. The nature and amount of any significant remeasurements should be disclosed.
Revenues received occasionally, seasonally or cyclically

Revenue that is received as an occasional item, or within a seasonal or cyclical pattern, should not be
anticipated or deferred in interim financial statements, if it would be inappropriate to anticipate or defer
the revenue for the annual financial statements. In other words, the principles of revenue recognition
should be applied consistently to the interim reports and year-end reports.
Costs incurred unevenly during the financial year

These should only be anticipated or deferred (ie treated as accruals or prepayments) if it would be
appropriate to anticipate or defer the expense in the annual financial statements. For example, it would
be appropriate to anticipate a cost for property rental where the rental is paid in arrears, but it would be
inappropriate to anticipate part of the cost of a major advertising campaign later in the year, for which no
expenses have yet been incurred.
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.
Payroll taxes or insurance contributions paid by employers

In some countries these are assessed on an annual basis, but paid at an uneven rate during the course
of the year, with a large proportion of the taxes being paid in the early part of the year, and a much
smaller proportion paid later on in the year. In this situation, it would be appropriate to use an estimated
average annual tax rate for the year in an interim statement, not the actual tax paid. This treatment is
appropriate because it reflects the fact that the taxes are assessed on an annual basis, even though the
payment pattern is uneven.
Cost of a planned major periodic maintenance or overhaul

The cost of such an event later in the year must not be anticipated in an interim financial statement
unless there is a legal or constructive obligation to carry out this work. The fact that a maintenance or
overhaul is planned and is carried out annually is not of itself sufficient to justify anticipating the cost in
an interim financial report.
Other planned but irregularly-occurring costs

Similarly, these costs such as charitable donations or employee training costs, should not be accrued in
an interim report. These costs, even if they occur regularly and are planned, are nevertheless
discretionary.
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.
Worked example: Bonus

An entity's accounting year ends on 31 December each year and it is currently preparing interim
financial statements for the half year to 30 June 20X4. It has a contractual agreement with its staff that it
will pay them an annual bonus equal to 10% of their annual salary if the full year's output exceeds one
million units. Budgeted output is 1.4 million units and the entity has achieved budgeted output during the
first six months of the year. Annual salaries are estimated to be CU100 million, with the cost in the first
half year to 30 June being CU45 million.
Requirement
How should the bonus be reflected in the interim financial statements?

Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the year is in
line with budgeted figures, which exceed the required level of output. So a bonus of CU4.5 million should
be recognised in the interim financial statements at 30 June 20X4.
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.
Non-monetary intangible assets

The entity might incur expenses during an interim period on items that might or will generate non-
monetary intangible assets. IAS 38 Intangible Assets requires that costs to generate non-monetary
intangible assets (eg development expenses) should be recognised as an expense when incurred
unless the costs form part of an identifiable intangible asset. Costs that were initially recognised as an
expense cannot subsequently be treated instead as part of the cost of an intangible asset. IAS 34 states
that interim financial statements should adopt the same approach. This means that it would be
inappropriate in an interim financial statement to 'defer' a cost in the expectation that it will eventually be
part of a non-monetary intangible asset that has not yet been recognised: such costs should be treated
as an expense in the interim statement.
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.
Foreign currency translation gains and losses

These should be calculated by the same principles as at the financial year end, in accordance with IAS
21.
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.
Worked example: Taxation charge

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim financial
statements for the half year to 30 June 20X4. Its profit before tax for the six month period to 30 June

20X4 is CU6 million. The business is seasonal and the profit before tax for the six months to 31
December 20X4 is almost certain to be CU10 million. Income tax is calculated as 25% of reported
annual profit before tax if it does not exceed CU10 million. If annual profit before tax exceeds CU10
million the tax rate on the whole amount is 30%.
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.
Interactive question 6: Interim financial statements [Difficulty level: Intermediate]
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.
Worked example: Inventory valuations

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim financial
statements for the half year to 30 June 20X4. The price of its products tends to vary. At 30 June 20X4, it
has inventories of 100,000 units, at a cost per unit of CU1.40. The net realisable value of the inventories
is CU1.20 per unit at 30 June 20X4. The expected net realisable value of the inventories at 31
December 20X4 is CU1.55 per unit.
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:
100,000 × CU1.20 = CU120,000
6.7 Use of estimates

Although accounting information must be reliable and free from material error, it may be necessary to
sacrifice some accuracy and reliability for the sake of timeliness and cost-benefits. This is particularly the
case with interim financial reporting, where there will be much less time to produce reports than at the
financial year end. The standard therefore recognises that estimates will have to be used to a greater
extent in interim reporting, to assess values or even some costs, than in year-end reporting.

An appendix to IAS 34 gives some examples of the use of estimates.
• 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.
• Intercompany reconciliations. Intercompany balances that are reconciled at a detailed level at

the year end may be reconciled at a less detailed level at the interim reporting date.
• 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.
6.9 IFRS 13 amendments

IFRS 13 Fair Value Measurement amended IAS 34, requiring interim reports to make the disclosures
required by paragraphs 91–93(h), 94–96, 98 and 99 of IFRS 13 Fair Value Measurement and
paragraphs 25, 26 and 28–30 of IFRS 7 Financial Instruments: Disclosures.
7 Audit focus: General issues with reporting performance
Section overview
• The auditor must consider the risk of fraud in general, and the risk of creative accounting in

particular, when auditing financial performance.
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.
8 Audit focus: Specific issues
Section overview
• This section looks at some of the audit issues related to certain financial reporting treatments
covered earlier in this chapter.
8.1 Presentation and disclosure of segment information

ISA 501 Specific considerations for selected items governs the auditor's approach to auditing segment
information.
Auditors are required to obtain sufficient appropriate audit evidence regarding the presentation and
disclosure of segment information by:
(a) Obtaining an understanding of the methods used by management in determining segment

information, and:
(i) Evaluating whether such methods are likely to result in disclosure in accordance with the
applicable financial reporting framework, and
(ii) Where appropriate, testing the application of such methods; 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:
• Sales, transfers and charges between segments, elimination of inter-segment amounts.
• Comparisons with budgets and other expected results, for example, operating profits as a
percentage of sales.
• Allocations of assets and costs.
• Consistency with prior periods, and the adequacy of the disclosures with respect to inconsistencies.

It is important to stress that auditors only have a responsibility in relation to the financial
statements taken as a whole. Auditors are not required to express an opinion on the segment
information presented on a standalone basis.
8.2 Held for sale assets

As we have seen above, IFRS 5 Non-current Assets Held for Sale and Discontinued Operations requires
that assets which meet the criteria 'held for sale' are shown at the lower of carrying amount and fair
value less costs to sell, that held for sale assets are classified separately on the statement of
financial position and the results of discontinued operations are presented separately on the statement
of profit or loss and other comprehensive income.
Audit procedures to ensure assets meet the criteria include:
• Inquiries/written representations from management concerning intentions

• Reviewing minutes of management for evidence of firm plan to sell
• Ascertaining whether appropriate estate agent appointed (by reviewing contract between the
parties)
• Reviewing sale particulars
• Comparison of sale price per sale particulars to fair value
• Asking estate agent of likelihood of completion within a year
Interactive question 7: Audit procedures – held for sale assets

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
8.3 Related parties

Related parties are often involved in cases of fraudulent financial reporting, as highlighted in many
major corporate scandals. Transactions with related parties provide scope for distorting financial
information in financial statements and hiding the economic substance of transactions or fraud in
companies.
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.

• It provides a definition of a related party, which is to be used as a minimum level for audit purposes
where the applicable financial reporting framework establishes minimal or no related party
requirements.
8.4 Related parties: key issues

Readers of financial statements normally assume that transactions reflected in financial statements are
made with independent parties unless told otherwise.
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.
8.5 The audit of related parties

8.5.1 Scope
ISA 550 provides guidance on the auditor's responsibilities, and audit procedures regarding related
parties and transactions with such parties.
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:
(a) A related party as defined in the applicable financial reporting framework; or
(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:
• Common controlling ownership;

• Owners who are close family members; or
• Common key management.
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:

• Management may be unaware of the existence of all related party relationships.
• 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.
• Failure to comply with IAS 24
• There may be a misstatement in the financial statements – transactions may be on a non-arm's

length basis and thus may result in assets, liabilities, profit or loss being overstated or
understated.
• 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 the company has no systematic system for detecting RPTs.
• Where RPTs are not with a party that the auditor could reasonably expect to know is a related
party.
• RPTs from an earlier period have remained as an unsettled balance.
• Management have concealed, or failed to disclose fully, related parties or transactions with such
parties.
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The term 'arm's length' continues to be used in the context of IAS 24 even though it has been removed A
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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
The auditor needs to perform the following procedures:
• The engagement team shall discuss the risks of fraud-related misstatements.
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.

Where controls are ineffective or non-existent, the auditor may be unable to obtain sufficient,
appropriate audit evidence and will need to consider the impact of this on the audit opinion.
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.
8.5.5 Responses to the risks of material misstatement

In accordance with ISA 330, the auditor must design and perform further audit procedures to obtain
sufficient appropriate evidence about the assessed risks of material misstatement. These may
include:
• Confirming or discussing the transactions with intermediaries eg banks, lawyers or agents.

• Confirming the purposes, specific terms or amounts of the transaction with the related party.
• Reading the financial statements of the related party for evidence of the transaction in the related
party's accounting records.
Where the risk of misstatement may be due to fraud additional procedures may apply:
• 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
Identification of previously unidentified or undisclosed related parties or significant related party

transactions
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:
• Inspect the underlying contracts and agreements and evaluate whether:
(a) The business rationale or lack of suggests fraud

(b) The terms are consistent with the management's explanations
(c) The transaction has been appropriately accounted for and disclosed
• Obtain audit evidence that transactions have been appropriately authorised and approved.

Management assertions
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:
• Considering the appropriateness of management's process for supporting the assertion.
• 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.
8.5.6 Evaluation of accounting and disclosure

The auditor is required to evaluate whether related parties and related party transactions have been
properly accounted for and disclosed and do not prevent the financial statements from achieving fair
presentation.
8.5.7 Written representations

The auditor is required to obtain written representations from management and, where appropriate,
those charged with governance that all related parties and related party transactions have been
disclosed to the auditor and that these have been appropriately accounted for and disclosed.
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.
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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
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• 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.
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• Design procedures to respond to risks identified.
• Perform completion procedures.
8.7 First time adoption of IFRS

Companies adopting IFRS for the first time are required to produce comparative financial statements,
restating prior period figures in accordance with IFRS.
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.
8.7.1 Scope of the audit

Comparative financial statements refers to a full set of financial statements for the prior period,
included in the current period's annual report. This differs from corresponding figures, where prior
period figures are set out next to current period figures in a set of financial statements for comparison.

While the auditor does not express an opinion on corresponding figures, where comparative financial
statements are issued, the auditor is required to express an opinion on both the restated prior
period and the current period.
8.7.2 Audit procedures

ISA 710 requires the auditor to evaluate:
(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.
8.7.3 Audit reporting

ISA 710 states that 'the auditor's opinion shall refer to each period for which the financial statements are
presented.
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
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Self-test
IAS 1 Presentation of Financial Statements
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:
Buildings 5% per annum straight line.
Plant and equipment 25% per annum reducing balance.
Depreciation of buildings is considered an administrative cost while depreciation of plant and

equipment should be treated as a cost of sale.
(ii) On 31 March 20X3 the land was revalued to $24,000,000.
(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.

(v) The 7% loan notes are 10-year loans due for repayment by 31 March 20X7. Interest on these
loan notes needs to be accrued for the six months to 31 March 20X3.
(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.
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
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
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Non-current Assets Held for Sale and Discontinued Operations. At that date the asset's carrying
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amount was CU19,500, its fair value was estimated at CU26,500 and the costs to sell at CU1,950.
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The asset was sold on 18 October 20X6 for CU26,000. P
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Requirement
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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
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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?

5 Ndombe
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.
Asset values and dates are as follows:

Polishing Other assets
machine
CU CU
Cost at 1 January 20X5 400,000 1,500,000
Accumulated depreciation to 31 December 20X6 (160,000) (600,000)
Carrying amount on 31 December 20X6 240,000 900,000
Useful life 5 years 5 years
Fair value less costs to sell 31 December 20X6 210,000 970,000
Fair value less costs to sell 31 December 20X7 190,000 880,000
Value in use at 31 December 20X7 170,000 810,000
Requirement
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?
IAS 24 Related Party Disclosures
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.

(a) The Nereidum Company, one of whose non-executive directors is an executive director of
Phlegra CU300,000.
(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?
IAS 34 Interim Financial Reporting
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
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follows:
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'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.
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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

The Marmoset Company offers the service of transport consultations. Its accounting year ends on
31 December each year and it is currently preparing half-yearly interim financial statements for the
six months to 30 June 20X7.
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?

Technical reference
• Applies to all general purpose financial statements
• Links back to much in the IASB Framework
• Presentation and disclosure rules apply only to material items IAS 1.31 and IAS 1.7
IAS 1.54, 56, 60, 66,

• Statement of financial position
69, 79
IFRS 8 Operating Segments
• 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.
• Geographical disclosures of external revenue and non-current assets are

also required.
Discontinued operations
• Definition IFRS 5.31–32
• Disclosures on the face of the statement of profit or loss and other IFRS 5.33(a)
comprehensive income:
– A single amount comprising the total of:
– The post-tax profit or loss of discontinued operations, and C

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– The post-tax gain or loss recognised on related assets A
• Disclosures on the face or in the notes IFRS 5.33(b) (c) P
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– An analysis of the single amount on the face E
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• Comparative figures must be restated IFRS 5.34
• Narrative disclosures are also required IFRS 5.41

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• Definition of a related party and related party transaction IAS 24.9
• Exclusions from definition of related party IAS 24.11
• Disclosures IAS 24.12,16,17,18
IFRS 1 First Time Adoption of International Financial Reporting Standards
• Opening IFRS SOFP IFRS 1.6
• Accounting policies IFRS 1.7–12
• Estimates IFRS 1.23-33
• Transition process IFRS 1 App C,D
• Exemptions IFRS 1.20–33

• Disclosure
IAS 34 Interim Financial Reporting
• Minimum components of an interim financial report IAS 34.8
• Form and content of interim financial statements IAS 34.9–11
• Selected explanatory notes IAS 34.16
• Disclosure of compliance with IFRSs IAS 34.19
• Periods for which interim financial statements are required to be presented IAS 34.20
• Materiality IAS 34.23
Disclosure in annual financial statements
• If an estimate of an amount reported in an interim period is changed IAS 34.26

significantly during the final interim period of the financial year but a separate
financial report is not published for that final interim period, the nature and
amount of that change in estimate shall be disclosed in a note to the annual
financial statements for that financial year.
Recognition and measurement
• 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 received seasonally, cyclically, or occasionally
• 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 incurred unevenly during the 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.
• Applying the recognition and measurement principles IAS 34.40
• Use of estimates IAS 34.41
• Restatement of previously reported interim periods IAS 34.43
ISA 501
• Audit of segment information ISA 501.13

ISA 550
• Definition of related parties ISA 550.10
• Auditor's responsibilities in relation to related parties ISA 550.3–7
• Audit procedures in respect of related parties ISA 550.11–28
ISA 710
• Audit procedures in respect of comparative financial statements ISA 710.7–9
• Audit reporting in respect of comparative financial statements ISA 710.10–19
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1 AZ
AZ
Statement of profit or loss and other comprehensive income
for the year ended 31 March 20X3
$'000
Revenue 124,900
Cost of sales (W1) (94,200)
Gross profit 30,700
Distribution costs (W1) (9,060)
Administrative expenses (W1) (17,535)
Other expenses (W1) (121)
Finance income 1,200
Finance costs (18,250 × 7%) (1,278)
Profit before tax 3,906
Income tax expense (976)
PROFIT FOR THE YEAR 2,930
Other comprehensive income:
Gain on land revaluation 4,000
TOTAL COMPREHENSIVE INCOME FOR THE YEAR 6,930
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
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

AZ
Statement of changes in equity for the year ended 31 March 20X3
Share Share Retained Revaluation Total
capital premium earnings surplus
$'000 $'000 $'000 $'000 $'000
Balance at 1 April 20X2 20,000 430 28,077 3,125 51,632
Issue of share capital 2,000 400 2,400
Dividends (1,000) (1,000)
Total comprehensive income for the 2,930 4,000 6,930
year
Balance at 31 March 20X3 22,000 830 30,007 7,125 59,962
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.
No depreciation is charged on these assets in 20X7 (IFRS 5.25).
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.
This gives a total value of CU1,040,000 at 31 December 20X7.

6 Sapajou
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.
So neither Nereidum nor Chub is a related party of Phlegra.
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
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
Six months ending 30 June 20X7 CU20,000 profit decrease

Six months ending 31 December 20X7 CU16,000 profit increase
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.


IFRS 8 Operating Segments states that an operating segment is separately reportable if it has been
identified as a separate operating segment meeting the operating segment definition, and:
(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
Chemicals * 33.6% 48.3% 32.4%
Pharmaceuticals 28.2% 31.0% 31.0%

wholesale
Pharmaceuticals retail 9.2% 6.9% 8.9%
Cosmetics 6.3% 6.9% 5.4%
Hair care 5.0% 13.8% 6.3%
Body care 17.6% 20.7% 16.1%
* 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.

Hair care
The Hair care segment is separately reported due to its profitability being greater than 10% of total
segments in profit.
Body care
All size criteria are met.
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).

The facility will not be transferred until the backlog of orders is completed; this demonstrates that the
facility is not available for immediate sale in its present condition. The facility cannot be classified as
'held for sale' at 31 December 20X3. It must be treated in the same way as other items of property, plant
and equipment: it should continue to be depreciated and should not be separately disclosed.

Because the steel works is being closed, rather than sold, it cannot be classified as 'held for sale'. In
addition, the steel works is not a discontinued operation. Although at 31 December 20X3 the group was
firmly committed to the closure, this has not yet taken place and therefore the steel works must be
included in continuing operations. Information about the planned closure could be disclosed in the notes
to the financial statements.

In its financial statements S must disclose all benefits provided in exchange for services rendered to S
(but not those rendered to P), whether they are provided by S, by P, or on behalf of S (as are the
pension benefits and the share options). All the amounts listed should be disclosed by S, with the
exception of the CU20,000 payable in respect of services rendered to P.

(a) Europa's first IFRS financial statements will be for the year ended 31 December 20X8. IFRS 1
requires that at least one year's comparative figures are presented and therefore the date of
transition to IFRSs is the beginning of business on 1 January 20X7 (or close of business on 31
December 20X6).
Therefore the procedure for adopting IFRSs is:
(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.

The company will almost certainly need to change some of its accounting policies and to
adjust some of the amounts that it reported previously at the same dates using previous
GAAP. It should recognise these adjustments directly in retained earnings (ie in equity).
(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).
The process will be affected by the following:
(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.
(ii) Court case
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

previous GAAP. Europa does not recognise a provision at 31 December 20X7 and accounts
for the payment in the year ended 31 December 20X8.
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.

30% × CU4 million = CU1.2 million
The tax rate for the entire year is applied to the profits for the interim period.

Production machinery
(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.
(b) Audit procedures would be as follows:
• Discuss with management intentions to run down production and the time scales involved.
• Review minutes of management/board meetings to confirm management's intentions.
• 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).
(b) Audit procedures would be as follows:
• 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.

CHAPTER 10
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
P
Answers to Interactive questions T
E
R
10
Reporting revenue 431

Introduction
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
example identifying an appropriate mix of tests of controls, analytical procedures and tests
of details
Specific syllabus references for this chapter are: 1(e), 2(a), 2(b), 2(d), 14(c), 14(d), 14(f)

1 Revenue recognition
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.
1.1 Measurement of revenue

The amount of revenue is usually decided by the agreement of the buyer and seller. Revenue is
measured as the fair value of the consideration received.
1.2 Sale of goods

Revenue from the sale of goods should only be recognised when:
• 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
• The amount of revenue can be measured reliably
• It is probable that the economic benefits associated with the transaction will flow to the entity
• The costs incurred in respect of the transaction can be measured reliably

If significant risks and rewards remain with the seller the transaction is not a sale and revenue cannot be
recognised.
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:
• The amount of revenue can be measured reliably
• 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.

1.3 Disclosure
• Accounting policies
• Amount of each significant category of revenue recognised during the period

• Amount of revenue from exchanges of goods or services included in each significant category of revenue
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.
Interactive question 1: Recognition [Difficulty level: Intermediate]
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.
Interactive question 2: More revenue recognition [Difficulty level: Intermediate]
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.
1.4 IFRIC 12 Service concession arrangements
1.4.1 What is a service concession arrangement?
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.

1.4.2 The two types of arrangement
IFRIC 12 draws a distinction between two types of service concession arrangement.
(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.
1.4.3 Accounting – Financial asset model

The operator recognises a financial asset to the extent that it has an unconditional contractual right to
receive cash or another financial asset from or at the direction of the grantor for the construction
services. The operator has an unconditional right to receive cash if the grantor contractually guarantees
to pay the operator
(a) Specified or determinable amounts or
(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.
The operator measures the financial asset at fair value.
1.4.4 Accounting – Intangible asset model

The operator recognises an intangible asset to the extent that it receives a right (a licence) to charge
users of the public service. A right to charge users of the public service is not an unconditional right to
receive cash because the amounts are contingent on the extent that the public uses the service.
The operator measures the intangible asset at fair value.
1.4.5 Operating revenue

The operator of a service concession arrangement recognises and measures revenue in accordance
with IFRS 15 for the services it performs.
1.5 Customer loyalty programmes

The issue
IFRS 15 addresses accounting by entities that grant loyalty award credits (such as ‘points’ or travel
miles) to customers who buy other goods or services. Specifically, it explains how such entities should
account for their obligations to provide free or discounted goods or services (‘awards’) to customers who C
redeem award credits. H
A
Key provisions
P
(a) An entity that grants loyalty award credits shall allocate some of the proceeds of the initial sale to T
the award credits as a liability (its obligation to provide the awards). In effect, the award is E
accounted for as a separate component of the sale transaction. R
(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.

(d) If at any time the expected costs of meeting the obligation exceed the consideration received, the
entity has an onerous contract for which IAS 37 would require recognition of a liability.
(e) If IFRS 15 causes an entity to change its accounting policy for customer loyalty awards, IAS 8
applies.
Illustration: Customer loyalty programmes

During July and August 20X8 Sagefoot introduced a customer loyalty programme on a trial basis.
Customers were granted points when they spent a certain amount in the company’s stores. Once a
customer has collected a certain number of points, these can be exchanged for further goods, provided
that this is done before 31 December 20X8. The scheme did not appear to increase revenue
significantly, and so it was discontinued after the end of August 20X8. During the period covered by the
scheme, customers were granted 650,000 points. Each point has a fair value of CU20 and at 30
September 20X8 125,000 points had been redeemed. Management has no previous experience of
customer loyalty schemes of this type. Through research it has established that where retailers operate
ongoing loyalty schemes, approximately 20% of points are never redeemed.
What is the correct treatment for the customer loyalty programme?
Solution
The total fair value of the points issued is CU13,000,000 (650,000 × CU20) and the best estimate would
appear to be that 520,000 (80% × 650,000) of these will be redeemed.
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.
1.6 Principal or agent?

Previously IAS 18 covered the accounting treatment for amounts collected by an agent on behalf of a
principal, which is: recognise only the commission as revenue (not the amounts collected on behalf of
the principal). However, it did not give guidance on determining whether an entity is acting as agent or
principal.
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
(d) The entity bearing the customer’s credit risk.
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.
Illustration: Principal or agent?

During July and August 20X8 Sagefoot introduced a customer loyalty programme on a trial basis.

Williams Co operates in the telecommunications industry. The company sells handsets to dealers for
CU150 and invoices the dealers for those handsets. The dealer can return the handset up to a service
contract being signed by a customer. When the customer signs a service contract, the customer
receives the handset free of charge. Williams allows the dealer a commission of CU280 on the
connection of a customer and the transaction with the dealer is settled net by a payment of CU130 by
Williams to the dealer being the cost of the handset to the dealer (CU150) deducted from the
commission (CU280). The handset cannot be sold separately by the dealer and the service contract
lasts for a 12 month period. Dealers do not sell prepaid phones, and Williams receives monthly revenue
from the service contract.
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
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immediately.
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2.1 Context
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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:
• When should the profit be recognised? 10
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

experience are essential in this assessment process. The timing of the recognition of claims, variations
and penalties under the contract can also affect revenue and profit significantly.
The negotiation period for contracts can be substantial, starting with an open tender period followed by
the selection of a preferred bidder with whom final negotiations are concluded. The costs involved in
these negotiations can be significant and their treatment can have an immediate impact on earnings.
The timing of contract receipts is critical to the funding of working capital. There is also the problem that
the timing of cash receipts and the recognition of revenue may be different.
2.2 What is a construction contract?

Definition
A construction contract is a contract specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in terms of their design, technology
and function or their ultimate purpose or use.
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.
2.3 Combining and segmenting construction contracts

Generally IFRS 15 requires individual construction contracts to be treated separately. However there are
some exceptions, when the substance of the arrangements is that several contracts are really one, or
one contract is really several.
2.3.1 Combining contracts

A number of small contracts should be combined into a single larger one if the individual contracts:
• Have been negotiated as one

• Are closely interrelated with an overall profit margin
• Are performed at the same time or consecutively.
2.3.2 Segmenting contracts

If one contract covers a number of individual assets which have been separately tendered for and
negotiated, it will be necessary to treat each asset as a separate contract.
2.4 Recognition of contract revenue and contract costs

The objective of IFRS 15 is to recognise contract revenue and costs in each accounting period
according to the stage of completion of the contract.
Contract revenue and contract costs should only be recognised in profit or loss when the outcome of the
contract can be estimated reliably.
2.4.1 Contract revenue

Contract revenue is the total amount of consideration receivable under a contract.
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:
• It is probable that they will result in revenue; and

• The amount can be measured reliably.

2.4.2 Contract costs
Contract costs comprise:
• Those directly related to the specific contract

• An allocation of costs incurred in contract activity in general.
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.
Interactive question 3: Contract costs [Difficulty level: Easy]
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?
Fill in the proforma below. C

CU H
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Costs
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WORKINGS T
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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.

Point to note:
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:
(a) Output methods; and

(b) Input methods.
• Output methods recognize revenue on the basis of direct measurements of the value to the
customer of the goods or services transferred to date relative to the remaining goods or services
promised under the contract. Output methods include methods such as
- Surveys of performance completed to date
- Appraisals of results achieved, milestones reached, time elapsed and units produced
or units delivered.
• Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a
performance, such as
- Resources consumed, labour hours expended, costs incurred, time elapsed or
machine hour used relative to the total expected inputs to the satisfaction of that
performance obligation.
- If the entity’s efforts or inputs are expended evenly throughout the performance period,
it may be appropriate for the entity to recognize revenue on a straight line basis.
Points to note:
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.
2.5 Estimate of contract outcome is reliable

Contract revenue and costs should only be recognised where the outcome of the contract can be
measured reliably.
The criteria to be met for reliability depend upon the type of contract.
The outcome of a fixed price contract can be estimated reliably if:
• Total contract revenue can be measured reliably

• It is probable that the economic benefits associated with the contract will be received by the entity
• Contract costs to complete can be measured reliably
• The stage of completion can be measured reliably, and
• Contract costs to date can be identified and measured reliably.
The outcome of a cost plus contract can be estimated reliably if:
• 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.
Worked example: Cost plus

The following information relates to a cost-plus contract won recently by a business with a 30 June year
end. The profit as a percentage of costs has been agreed at 20%.
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.

What amounts should be recognised as revenue, costs and profit for each of the two financial years?
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.
Interactive question 4: Fixed price contract [Difficulty level: Easy]
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.
2.6 Estimate of contract outcome is not reliable

Where the outcome of the contract cannot be estimated reliably:
• Contract costs should be recognised immediately and
• Contract revenue should only be recognised to the extent that it is probable that the costs are
recoverable from the customer.
The effect of this is that:
• 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
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2.7 Expected losses P
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When the process of estimating the outcome of a contract results in an overall loss being forecast, the
loss should be recognised immediately. E
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Point to note:
Such a loss should be recognised even if work on the contract has not yet commenced.
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Worked example: Expected loss
The following details relate to one of an entity’s construction contracts:
CU'000
Estimated contract revenue 400

Contract costs incurred to date 240
Estimated costs to complete 200
How should any expected loss be dealt with?
Solution
On the basis of the estimated costs to complete, the contract will be loss-making:
CU400,000 – (240,000 + 200,000) = CU40,000 loss
This should be recognised in profit or loss immediately.
The revenue should be recognised according to the stage of completion, so:

cu£400,000 × 240,000
= CU218,000
(240,000 + 200,000)
Cost of sales comes out as the balancing figure

CU'000
Revenue (400 × 240/440) 218
Cost of sales (bal fig) (258)
Contract loss ( 40)
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.
2.8 Judgements required

As noted, accounting for construction contracts requires estimates to be made of how the contracts are
likely to turn out once they have been completed. It is very important that consistent approaches are
taken to matters such as:
• 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 estimation of the stage of completion of each 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.
2.9 Relevance of information for users

The timing of cash receipts and the recognition of revenue may be different. IFRS 15 requires
disclosures to be made of information which is essential as a means of assessing construction contracts
in progress and the likely nature of future cash flows. The required disclosures are:
• The contract revenue recognised in the period.

• The methods used to determine that revenue and the stage of completion of contracts in progress.
• 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.
3 Criticisms and current developments
Section overview
• IAS 18 Revenue and IAS 11 Construction Contracts have both been criticised, and changes are
made through IFRS 15 .
3.1 Criticisms of existing standards

Note. You will not be tested in detail on the material in this Section, but you need to be aware of the
issues involved.
Under current US GAAP there are more than 100 revenue recognition standards, dealing with specific
industries but these are sometimes inconsistent with each other. This has led to contracts with similar
economic effects being treated differently in different industries. In addition, the amounts
recognised under current standards may not faithfully represent the nature of the transactions.
IAS 18 Revenue has been criticised for being vague and this has led to inconsistency in how it has
been applied by different entities. IAS 11 Construction Contracts has also been criticised, and there is
sometimes uncertainty about which standard to apply.
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Specifically, the weaknesses of those standards are as follows.
H
(a) Timing of revenue recognition A
Many companies remain uncertain about when they should recognise revenue because there is a P
lack of clear and comprehensive guidance in IAS 18 and IAS 11. This is particularly the case for T
combined packages of goods and services because goods are sold at a point in time whereas E
services may be provided over time. This means that the revenue recognised may not represent R
fairly the pattern of transfer to the customer of the goods and services.
(b) Distinguishing between goods and services
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IAS 18 does not clearly distinguish between goods and services, so some companies may not be
entirely sure whether to account for some transactions under IAS 18 or IAS 11. The standards
are very different. Even though construction contracts are effectively the ‘sale of goods’, IAS 11
uses the ‘stage of completion’ method, under which, contract revenue and costs are recognised
as revenue and expenses in profit or loss in the period in which the work is performed and losses

recognised immediately when foreseen. IAS 18, in contrast, requires revenue from sale of goods
to be recognised only when the risks and rewards of ownership are transferred to the customer.
The revenue reported could vary considerably depending on which standard is applied.
(c) Conflict with the IASB Conceptual Framework
Under the Conceptual Framework, income is recognised when an increase in future economic
benefits related to an increase in an asset or a decrease of a liability has arisen that can be
measured reliably. This means, in effect, that recognition of income occurs simultaneously with
the recognition of increases in assets or decreases in liabilities (for example, the net increase in
assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver
of a debt payable). It is not clear how this applies in the case of construction contracts.
(d) Variable consideration
Some contracts will have variable terms for the consideration paid to a company by its
customer. However, IAS 18 and IAS 11 do not include comprehensive guidance for measuring
how much revenue should be recognised in such cases.
(e) Multi-element arrangements
Some transactions, often called multi-element arrangements, involve the delivery of more than
one good or service. IAS does not give sufficient guidance on dealing with such
transactions. IAS 18 states that in certain circumstances the revenue recognition criteria must be
applied to the separately identifiable components of a transaction. However, it does not explain
the circumstances when a transaction can be broken down into separate components or the basis
for identifying those components. Sometimes all the revenue in a multi-element arrangement is
recognised on delivery of the first item. Alternatively, and inconsistently, sometimes recognition is
delayed until delivery of the final item.
Under the IFRS 15, Revenue from contracts with customers, distinct performance obligations
have been accounted for separately. Goods or services are distinct if they are sold separately by
the company, or if they provide separate benefits to the company’s customer.
(f) Disclosures
Disclosures in current standards on revenue recognition are seen as inadequate when compared
to disclosures in other standards.
3.2 Background to the ED

The IASB and US Financial Accounting Standards Board (FASB) are undertaking a joint project to
develop a new revenue recognition standard. The ED was issued in June 2010, following a 2008
Discussion Paper and re-exposed with some modifications in November 2011.
3.3 IFRS 15 Revenue from contracts with customers approach

• Step 1. Identify the contract with the customer. Identifying a contract is usually straightforward,
as there will be a written agreement or an alternative according to normal business practice. The
entity would normally treat each contract separately, but there are cases where they might combine
them. The key point is price interdependence. Usually a company would apply the proposals to a
single contract. However, in some cases the company would account for two or more contracts
together if the prices of those contracts are interdependent. Conversely, a company would segment
a single contract and account for it as two or more contracts if some goods or services are priced
independently of other goods and services.
• Step 2. Identify the separate performance obligations. The key point is distinct goods or services.
A contract includes promises to provide goods or services to a customer. Those promises are called
performance obligations. A company would account for a performance obligation separately only if
the promised good or service is distinct. A good or service is distinct if it is sold separately or if it could
be sold separately because it has a distinct function and a distinct profit margin.
• Step 3. Determine the transaction price. The key proposal is a probability weighted expected
amount. The transaction price is the amount of consideration a company expects to be entitled to
from the customer in exchange for transferring goods or services. The transaction price would
reflect the company’s probability-weighted estimate of variable consideration (including reasonable
estimates of contingent amounts) in addition to the effects of the customer’s credit risk and the time
value of money (if material).

• Step 4. Allocate the transaction price to the performance obligations. The key proposal is
relative selling price allocation. A company would allocate the transaction price to all separate
performance obligations in proportion to the stand-alone selling price of the good or service
underlying each performance obligation. If the good or service is not sold separately, the company
would estimate its stand-alone selling price.
• Step 5. Recognise revenue when a performance obligation is satisfied. A company would
recognise revenue when it satisfies a performance obligation by transferring the promised good or
service to the customer. The good or service is transferred when the customer obtains control of
the promised good or service. An indicator of this is when the customer has the risks and rewards
of ownership.
The amount of revenue recognised is the amount allocated to that performance obligation in Step 4.
3.4 Additional guidance

IFRS 15 gives guidance on cost:
A company would recognise the costs of obtaining a contract (eg selling and marketing costs) as
expenses when incurred. If the costs incurred in fulfilling a contract are not eligible for recognition as an
asset in accordance with other standards (eg inventory), the company would recognise an asset only if
those costs:
(a) Relate directly to a contract
(b) Relate to future performance under the contract and
(c) Are expected to be recovered.
The proposed standard would also contain enhanced disclosure requirements to help users of financial
statements better understand the amount, timing and uncertainty of revenue and cash flows from
contracts with customers. Those proposals would require a company to disclose qualitative and
quantitative information about:
(a) its contracts with customers, including a maturity analysis for contracts extending beyond one year
(b) the significant judgments, and changes in judgments, made in applying the proposed standard to
those contracts.
3.5 Key effects of the new standard IFRS 15

(a) Revenue would be recognised only in the transfer of goods or services to a customer. This
proposal would affect some long-term contracts currently accounted for using a percentage of
completion method when the customer does not receive goods or services continuously (eg some
construction and some software development contracts). Under the proposal, a company would
apply the percentage of completion method of revenue recognition only if the company transfers
services to the customer throughout the contract – ie if the customer owns the work in progress as
it is built or developed.
(b) Separate performance obligations would be recognised for distinct goods or services. This
proposal could result in some revenue being attributed to goods or services that are now
considered incidental to the contract – for instance, to mobile phones that are provided free of
charge with airtime contracts and to some post-delivery services, such as maintenance and
installation. C
(c) Probability weighted estimates would be required of the consideration to be received. This H
could result in a company recognising some revenue on the transfer of a good or service, even if A
the consideration amount is contingent on a future event – for example, an agent that provides P
brokerage services in one period in exchange for an amount of consideration to be determined in T
future periods, depending on the customer’s behaviour.
E
(d) A customer’s credit risk would be reflected in the measurement of revenue. This could result R
in a company recognising some revenue when it transfers a good or service to a customer even if
there is uncertainty about the collectability of the consideration, rather than deferring revenue
recognition until the consideration is collected.
10
(e) The transaction price will be allocated in proportion to the stand-alone selling price. This will
affect some existing practices, particularly in the software sector, that currently result in the deferral
of revenue if a company does not have objective evidence of the selling price of a good or service
to be provided.

(f) Contract acquisition costs are to be expensed. This proposal would affect companies that
currently capitalise such costs – for example, commissions and other directly incremental costs –
and amortise them over the contract period.
Interactive question 5: Revenue recognition [Difficulty level: Exam standard]
(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.
A discount rate of 4% should be used in any calculations.
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.
4.1 Audit procedures for construction contracts

The following procedures will be relevant:
• 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)
• Agree total revenue to sales contract
• Obtain details of costs incurred and agree to supporting documentation
• 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)

• Where the stage of completion is based on costs incurred to date, assess whether they fairly
represent the stage of completion (ie they do not represent inefficiencies)
• 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)
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Interactive question 6: Construction contracts [Difficulty level: Intermediate]
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.
The contract price is made up as follows:

CU'000
Contract price 600
Incentive payment if completed on time 40
640
Total contract costs at the end of 20X6 were estimated to be CU470,000. At the end of 20X7 this
estimate has increased to CU570,000 due to extra costs incurred to rectify a number of construction
faults.
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
For the year ended 31 December 20X7:
(a) Identify the audit issues you would need to consider

(b) List the audit procedures you would perform

Summary
IFRS 15
IFRS 15
Revenue from
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Self-test
IFRS 15 Revenue from Contracts with Customers
1 Laka
On 30 June 20X7 the Laka Company sells kitchen appliances for CU4,400, on the basis that a 20%
deposit is paid on the same date and the balance in a single payment after 24 months’ free credit.
Currently the yield on high quality corporate bonds is 6.5% and the rate for an issuer with a credit
rating similar to that of the borrower is 8.0% per annum.
Requirement
What is the total amount of income to be recognised under IFRS 15 Revenue from Contracts with
Customers , by Laka in its statement of profit or loss and other comprehensive income for the year
ended 31 December 20X7?
2 Renpet
The Renpet Company operates a franchise system whereby, at the commencement of a franchise,
a franchisee signs two contracts each with a separate fee. The financial terms of the two contracts
are as follows:
(1) The CU36,000 fee receivable at the time the first contract is signed covers Renpet’s initial set-
up costs and the provision to the franchisee of certain equipment with a fair value of
CU19,000. 40% of the equipment is delivered to the franchisee when the contract is signed,
the remainder 8 months later and title passes on delivery.
(2) The CU9,000 fee receivable at the time the second contract is signed is the first annual fee
and covers the provision of continuing support services. This fee is set at the cost of these
services to Renpet. The fair value of the services is CU12,000, which reflects a reasonable
profit.
Requirement
According to IFRS 15 Revenue from Contracts with Customers , what revenues should Renpet
recognise in its financial statements for the year ended 31 December 20X7 in respect of the
CU45,000 receivable for a franchise commencing on 1 September 20X7?
3 Baros
Under a single four-month contract with one of its customers, the Baros Company is obliged to
produce a package of six advertisements for television and to purchase airtime for their broadcast.
Under the contract Baros will receive the CU5.4 million fair value for the production of all six
advertisements (on which it expects to incur CU4.32 million costs), and a 10% commission on the
CU40,000 airtime cost of each broadcast. Each advertisement is to be broadcast 30 times.
Baros’s financial year end fell half way through the four-month contract period, at which point
production of four advertisements was complete and work on the other two had not started. By the
year end, booking had been made for two of the advertisements to be broadcast 30 times each. 15
of these broadcasts for each of the two advertisements had been transmitted by the year end.
Requirement
According to IFRS 15 Revenue from Contracts with Customers , what revenue should Baros
recognise in its financial statements for its year just ended?
4 Health club
The terms for taking up membership of a health club included the requirement to pay a one-off non-
returnable membership fee of CU3,000. In exchange, the club offers new members the right over
the first 6 months of their membership to buy equipment with a list price of CU1,200 at a discount of
20%.
On 1 October 20X7, 100 new members joined on these terms. Recent experience is that 40% of
new members take advantage of the offer of discounted equipment, making their CU1,200 of
equipment purchases evenly over the relevant period.

Requirement
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:

CU'000
Vehicles (lorries) 240
Intangible assets (licences) 60
Trade receivables 20
Cash 100
Trade payables (40)
380
Unfortunately, three of the lorries were stolen on 1 February 20X7. The lorries were not insured,
because the road haulage company manager had failed to complete the paperwork in time. The
lorries had a net book value of CU60,000, and we estimate that CU60,000 was also their fair value
less costs to sell.
I believe that, as a result of the theft of the uninsured lorries, the value in use of the cash
generating unit has fallen. We should recognise an impairment loss of CU90,000, inclusive of the
loss of the stolen lorries.
We have another problem with this business. A competitor has started operating, covering similar
routes and customers. Our revenue will be reduced by one quarter, which will in turn reduce the fair
value less costs to sell and the value in use of our haulage business to CU310,000 and CU300,000
respectively. Part of this decline is attributable to the competitor’s actions causing the net selling
value of the licences to fall to CU50,000. There has been no change in the fair value less costs to
sell of the other assets, which is the same as on the date of acquisition.
The company will continue to rent out the lorries for the foreseeable future.
How should we show this impairment in the financial statements?
Fall in value of machines
The goods produced by some of our machines have been sold below their cost. This has affected
the value of the machines in question, which has suffered an impairment. The carrying amount of
the machines at depreciated historical cost is CU580,000 and their fair value less costs to sell is
estimated to be CU240,000. We anticipate that cash inflows from the machines will be CU200,000
per annum for the next three years. The annual market discount rate, as you know, is 10%.
How should we determine the impairment in value of the machines in the financial statements and
how should this be recognised?
Own brand
This year, Eco-Ergonom has been developing a new product, the Envirotop. Envirotop is a new
range of environmentally friendly kitchen products and an ergonomic kitchen design service. The
expenditure in the year to 31 December 20X7 was as follows:
Period from Expenditure type CUm
1 Jan 20X7 – 31 March 20X7 Research on size of potential market 6
1 April 20X7 – 30 June 20X7 Prototype kitchen equipment and product 8
design
1 July 20X7 – 31 August 20X7 Wage costs in refinement of products 4
1 September 20X7 – 30 November Development work undertaken to finalise 10
20X7 design of kitchen equipment
1 December 20X7 – 31 December Production and launch of equipment and 12
20X7 products
40
Currently an intangible asset of CU40 million is shown in the financial statements for the year
ended 31 December 20X7.
Included in the costs of the production and launch of the products are the cost of upgrading the
existing machinery (CU6 million), market research costs (CU4 million) and staff training costs (CU2
million).
Please explain the correct treatment of all these costs.

Purchase of Homecare
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
Prepare the memorandum asked for by the Finance Director.
IFRS 15 Revenue from contracts with customers
7 Henley Co
Henley Co is an entity that engages in large-scale construction projects. It is summarising costs

incurred in its years ended 31 December 20X4 and 31 December 20X5 in respect of a major
building construction contract for Astronaut 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.
• 32 manual workers were employed at a cost of CU800,000. 20 of these 32 were engaged on

the Astronaut contract.
• 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.
• CU120,000 was spent on hire of machinery for the Astronaut contract.

10
• Henley Co spent CU60,000 on public liability insurance. Henley’s accounting policy is to
apportion this to individual contracts as 10% of depreciation.
• 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.

Requirement
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.
At 31 December 20X7 amounts relating to the contract were as follows.
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:
(i) contract costs incurred as a proportion of total estimated contract costs
(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.

During 20X9 the project was completed. In the year Prideaux incurred construction costs of
CU15.5 million and the customer accepted invoices totalling another CU19 million. By 31
December 20X9 the customer had settled all these invoices.
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

Technical reference
• Revenue recognised when: IFRS 15 Objective
– Probable that future economic benefits will flow to the entity and
– These benefits can be measured reliably

• Apply principle of substance over form
IFRS 15
• Revenue defined as gross inflows that result in increase in equity
– Sales taxes (eg VAT) and amounts collected by agent on behalf of IFRS 15
principal are excluded
IFRS 15
• Measured as fair value of consideration – discounted where appropriate
IFRS 15
• Recognition of sale of goods: when buyer has obtained significant
risks/rewards of ownership
IFRS 15
• Recognition of rendering of services: can take account of stage of
completion, if over a long period:
IFRS 15
– Include pro rata costs and consider costs to complete
– If overall outcome cannot be estimated reliably, revenue limited to IFRS 15
costs recoverable from customer
IFRS 15
• Practical considerations, including ‘free’ servicing, where revenue
deferred to cover both cost and reasonable profit
• Definitions of construction IFRS 15
• Combining and segmenting contracts
– Standard usually applied to separate contracts IFRS 15

– Segmenting construction contracts IFRS 15
– Combining construction contracts IFRS 15
• Contract revenue IFRS 15
• Contract costs IFRS 15
• Recognition of contract revenue and expenses
– When outcome estimated reliably recognise by reference to stage IFRS 15

of completion
– Fixed price contract IFRS 15
– Cost plus contract IFRS 15
– Stage of completion IFRS 15
– Methods of determining stage of completion IFRS 15
– When outcome cannot be estimated reliably IFRS 15
• Recognition of expected losses IFRS 15
• 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
IFRS 15 sets out guidance in relation to franchise fees.
Of the CU36,000 first contract fee:
• CU19,000 relates to equipment
– 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.
• CU17,000 is an initial set up fee
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
– The remaining CU14,000 of the initial fee is recorded as revenue

C
Of the CU9,000 second contract fee PLUS the CU3,000 of the initial set up fee allocated as above: H
A
• CU12,000 × 4m/12m = CU4,000 relates to this financial year and is recorded as revenue P
• The remaining CU8,000 is deferred until the following financial year. T
Therefore revenue recognised is CU7,600 + CU14,000 + CU4,000 = CU25,600. E

R
3 Baros
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.

• Production commissions are recognised by reference to the stage of completion of the project.
The best measure of the stage of completion is the physical quantity of advertisements
produced. Therefore CU5.4 million × 4/6 = revenue of CU3.6 million.
Total revenue is CU3.6 million + CU120,000 = CU3,720,000.
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.
The amount to be deferred is calculated as:
The number of × Proportion who × Amount of the × Remaining

new members take advantage benefit period over
of offer which offer can
be exercised
100 × 40% × (CU1,200 × × 3m/6m

20%)
= CU4,800
Therefore revenue recognised = CU300,000 - CU4,800 = CU295,200
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
To: Deborah Carroll, Finance Director

From: Financial Controller
Date: 15 March 20X8

Subject: Accounting treatment of non-current assets
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).
Fall in value of machines
An impairment review will be carried out because of the losses and the haulage business problems.
For the productive machinery

CU
Carrying amount 580,000
Fair value less costs to sell 240,000
Value in use (200,000 × 3, discounted at 10%) 497,200
An impairment loss of CU82,800 (580,000 – 497,200) will be recognised in profit or loss.
Development of new product
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
Development expenditure is capitalised when an entity demonstrates all the following. A

P
(a) The technical feasibility of completing the project T
E
(b) Its intention to complete the asset and use or sell it
R
(c) Its ability to use or sell the asset
(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.

Assuming that all these criteria are met, the cost of the development should comprise all directly
attributable costs necessary to create the asset and to make it capable of operating in the manner
intended by management. Directly attributable costs do not include selling or administrative costs,
or training costs or market research. The cost of upgrading existing machinery can be recognised
as property, plant and equipment. Therefore the expenditure on the project should be treated as
follows:
Recognised in statement of financial
position
Expense Intangible Property,
(income assets plant and
statement) equipment
CUm CUm CUm
Research 6
Prototype design 8
Wage costs 4
Development work 10
Upgrading machinery 6
Market research 4
Training 2
12 22 6
Eco-Ergonom should recognise CU22 million as an intangible asset.
Purchase of Homecare
IFRS 3 Business Combinations states that the cost of a business combination is the aggregate of
the fair values of the consideration given. Fair value is measured at the date of exchange. Where
any of the consideration is deferred, the amount should be discounted to its present value. Where
there may be an adjustment to the final cost of the combination contingent on one or more future
events, the amount of the adjustment is included in the cost of the combination at the acquisition
date only if the fair value of the contingent consideration can be measured reliably.
The purchase consideration consists of CU20 million paid on the acquisition date plus a further
CU5 million payable on 31 December 20X8 including CU3 million payable only if profits exceed
forecasts. At the acquisition date it appeared that profit forecasts would not be met. However,
under IFRS 3, contingent consideration must be recognised and measured at fair value at the
acquisition date. Therefore the cost of combination at 1 January 20X7 is CU24.49 million
(CU20m + (CU5m × 0.898)).
A further issue concerns the valuation and treatment of the 'Homecare' brand name. The brand
name is an internally generated intangible asset of Homecare, and therefore it will not be
recognised in the statement of financial position of Homecare. However, IFRS 3 requires intangible
assets of an acquiree to be recognised if they meet the identifiability criteria in IAS 38 Intangible
Assets and their fair value can be measured reliably. For an intangible asset to be identifiable the
asset must be separable or it must arise from contractual or other legal rights. It appears that these
criteria have been met (a brand is separable) and the brand has also been valued at CU4 million
for the purpose of the sale to Eco-Ergonom. Therefore the 'Homecare' brand will be separately
recognised in the consolidated statement of financial position.
7 Henley Co
Recoverable
Amount incurred from on Astronaut
1 Jan 20X5 to 31 Dec 20X5 on: Total contract Basis
CU'000 CU'000
Preparation and negotiation
(from 1 August 20X4) 170 46.36 3/11 months
Supervision 300 56.25 3/8 × 6/12
Manual labour 800 250 20/32 × 6/12
Design department 100 25 1/4
R&D 50 0 None
General management 400 0 None
Casual labour 1,200 1,200 All

Depreciation 600 90 6/12 × 30%
Moving machinery 80 80 All
Equipment hire 120 120 All
Liability insurance 60 9 10% × depreciation
Materials 3,200 2,600 600 in normal inventory
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.
Statement of profit or loss
Contract costs Work certified

CU’000 CU’000
Revenue 14,000 14,700
Cost of sales (12,000) (12,000)
Profit 2,000 2,700
Statement of financial position
Contract costs Work certified

CU’000 CU’000
Gross amount due from customers
Costs incurred 12,000 12,000
Recognised profits 2,000 2,700
14,000 14,700
Progress billings (13,000) (13,000)
1,000 1,700
Trade receivables 1,500 1,500

An alternative presentation of profit and cost of sales under the work certified basis would be to
calculate cost of sales as a proportion of total expected costs, rather than actual costs incurred to
date: C
H
Work certified
A
CU’000
Statement of profit or loss P
Revenue 14,700 T
Cost of sales (18m × 0.7) (12,600) E
Profit 2,100 R

Gross amount due from customers
Costs incurred 12,000 10
Recognised profits 2,100
14,100
Progress billings (13,000)
1,100

(b) The contract costs method assumes that the same profit margin is earned on all parts of a construction
contract. The certified sales method can, and in this instance does, take account of the margin on certain
parts of a contract being higher than on others, perhaps because the customer places a higher value on
those parts.
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
Statement of profit or loss for year to 31 December

20X6 20X7 20X8 20X9
Note 1 Note 2 Note 3 Note 4
CU’000 CU’000 CU’000 CU’000
Revenue 2,900 13,350 10,417 19,333
Cost of sales (2,900) (10,100) (15,667) (14,833)
Gross profit – 3,250 (5,250) 4,500
Operating expenses (800) – – –
Net profit/(loss) (800) 3,250 (5,250) 4,500
Statement of financial position at 31 December

20X6 20X7 20X8 20X9
CU’000 CU’000 CU’000 CU’000
Costs incurred to date 2,900 13,000 28,000 43,500
Recognised profits less losses – 3,250 (2,000) 2,500
Recognised cumulative revenue 2,900 16,250 26,000 46,000
Less: progress billings (2,000) (11,000) (27,000) (46,000)
Gross amount due from 900 5,250 –
customers
Gross amount due to customers 1,000
Trade receivables:
Progress billings 2,000 11,000 27,000 46,000
Amounts received (1,500) (8,000) (25,000) (46,000)
500 3,000 2,000 –
Notes
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)


(a) A sale must never be recognised before the goods have even been ordered by a customer. There
is no certainty about the value of the sale, nor when it will take place, even if it is virtually certain
that goods will be sold.
(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 director wishes to recognise the sale as early as possible. However, following IFRS 15 Revenue
from Contracts with Customers , he cannot recognise revenue from this sale because the risks and
rewards of ownership of the caravan have not been transferred. This happens on the date of delivery,
which is 1 August 20X7. Accordingly, no revenue can be recognised in the current period.
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 journal entries would be as follows:
DEBIT Cash CU3,000

C
CREDIT Deferred income CU3,000
H
Being deposit received in advance of the sale being recognised. A
P
On 1 August 20X7, when the sale is recognised, this deferred income account will be cleared. In T
addition:
E
The revenue from the sale of the caravan will be recognised. Of this, CU12,000 is receivable in two R
years’ time, which, with a 10% discount rate, is: CU12,000/ 1.12 = CU9,917. CU15,000 is receivable on 1
August 20X7.
10
The service plan is not really ‘free’ – nothing is. It is merely a deduction from the cost of the caravan.
The CU1,500 must be recognised separately. It is deferred income and will be recognised over the three
year period.
The sales revenue recognised in respect of the caravan will be a balancing figure.

The journal entries are as follows
DEBIT Deferred income CU3,000

DEBIT Cash (1st instalment) CU15,000
DEBIT Receivable (balance discounted) CU9,917
CREDIT Deferred income (service plan monies

received in advance) CU1,500
CREDIT Sales (balancing figure) CU26,417
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.

Costs CU2,476,000
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 procedure is to identify the costs incurred, to calculate the profit and to insert revenue as the
balancing figure.
The amounts relating to this contract which should be recognised in profit or loss for each of the three
financial years are:
Stage of completion Revenue Cost of sales Profit

CU'000 CU'000 CU'000
20X5 100/400 = In 20X5 125 100 25
25%
20X6 300/420 = Cumulative to end-
71% 20X6, then 20X5 (57 – 25)
amounts deducted 232 (bal fig) (300 – 100) 200 32
20X7 100% Cumulative to end-
20X7, then
cumulative previous (90 – 57)
amounts deducted 143 (bal fig) (410 – 300) 110 33
Total 500 410 90

(a) Credit risk and time value of money
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

different times. In such cases a discount rate could usefully be applied. This should reflect the
timing of receipt and the credit risk – in effect it is treating the receipt as a financing transaction.
The use of discount rates involves judgement, and could be viewed as subjective. The proposed
standard would take account of the time value of money.
(b) (i) Credit risk
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.
Taking account of credit risk under IFRS 15
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.
(ii) Time value of money
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:
DEBIT Cash CU3m

CREDIT Deferred income CU3m
Then on delivery in a year’s time, revenue is recognised:
DEBIT Deferred income CU3m

CREDIT Sales revenue CU3m
Taking account of the time value of money C

H
While the CU2m deferred receipt would be treated the same way under the proposed A
standard, that of CU3m payment in advance would differ in having to recognise an interest P
expense on what is effectively a financing transaction. Petra would recognise a contract
T
liability of CU3m:
E
DEBIT Cash CU3m R
CREDIT Contract liability CU3m
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:
DEBIT Interest expense CU120,000

CREDIT Contract liability CU120,000

On transfer of the product to the customer, Petra would recognise revenue of CU3.12m:
DEBIT Contract liability CU3.12m

CREDIT Sales revenue CU3.12m

(a) Issues
• 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.

CHAPTER 11
Earnings per share
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
Technical reference
467
Introduction
• Explain and appraise accounting standards that relate to reporting performance: in respect
of […] EPS
of details
Specific syllabus references for this chapter are: 2(b), 2(d), 14(c), 14(d), 14(f)

1 EPS: overview of material covered in earlier studies C
H
A
Section overview
P
• This section reviews the material on basic and diluted earnings per share covered at Professional T
level. E
R
Scope
• IAS 33 applies to entities whose ordinary shares are publicly traded or are in the process of being
issued in public markets. 11
Basic earnings per share

• Basic EPS is calculated as:
Profit / (loss) attributable to ordinary equity holders of the parent

Weighted average number of ordinary shares outstanding during the period
• 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:
Redeemable No adjustment is required as these shares are classified as liabilities

preference shares and the finance charge relating to them will already have been charged
to profit or loss as part of finance charges.
Irredeemable These shares are classified as equity and the dividend relating to them
preference shares is disclosed in the statement of changes in equity. This dividend must
be deducted from profit for the year to arrive at profit attributable to the
ordinary shareholders.
• The weighted average number of shares should be adjusted for changes in the number of
shares without a corresponding change in resources, for example a bonus issue, by assuming that
the new number of shares had always been in issue.
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.
Diluted earnings per share

• A diluted EPS figure should also be reported by an entity. A dilution is a reduction in the EPS figure
(or increase in a loss per share) that will result from the issue of more equity shares on the
conversion of convertible instruments already issued.
• 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.
Earnings per share 469

• Treasury shares are accounted for as a deduction from shareholders' funds. Since such shares are
no longer available in the market, they are excluded from the weighted average number of ordinary
shares for the purpose of calculating EPS.
Interactive question 1: Adjustment for preference shares [Difficulty level: Easy]
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?
2 Basic EPS: weighted average number of shares
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.
2.1 Calculation of the weighted average number of shares

The use of the weighted average number of ordinary shares outstanding during the period reflects the
possibility that the amount of shareholders' capital varied during the period.
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.
2.2 Time weights determination

Shares are usually included in the weighted average number of shares from the date consideration is
receivable (which is generally the date of their issue), for example:
• Ordinary shares issued in exchange for cash are included when cash is receivable.
• Ordinary shares issued on the voluntary reinvestment of dividends on ordinary or preference

shares are included when dividends are reinvested.
• 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.

• Contingently issuable shares are included in the calculation of basic earnings per share only from
the date when all necessary conditions for their issue are satisfied. Shares that are issuable solely C
after the passage of time are not contingently issuable shares, because the passage of time is a H
certainty.
A
• Outstanding ordinary shares that are contingently returnable (ie subject to recall) are excluded from P
the calculation of basic earnings per share until the date the shares are no longer subject to recall. T
E
Worked example: Weighted average number of ordinary shares R
The following information is provided for an entity.

Shares Treasury Shares
11
issued shares outstanding
1 January 20X1 Balance at beginning of year 2,000 300 1,700
31 May 20X1 Issue of new shares for cash 800 – 2,500
1 December 20X1 Purchase of treasury shares for cash – 250 2,250
31 December 20X1 Balance at year-end 2,800 550 2,250
Requirement
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
2.3 Partly paid shares

Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic earnings
per share as a fraction of an ordinary share to the extent that they were entitled to participate in
dividends during the period relative to a fully paid ordinary share.
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.
Worked example: Partly paid shares

At 1 January 20X5 an entity had 900 ordinary shares in issue. It issued 600 new shares at 1 September
20X5, at a subscription price of CU4 per share. At the date of issue each shareholder paid CU2. The
balance of CU2 per share will be paid during 20X6. Each part-paid share will be entitled to dividends in
proportion to the percentage of the issue price paid up on the share. The entity has a year end of 31
December.

Requirement
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:
• Bonus issues (capitalisation issues)

• Share consolidation
2.4.1 Bonus issue

In a bonus or capitalisation issue, or a share split, ordinary shares are issued to existing shareholders for
no additional consideration. Therefore, the number of ordinary shares outstanding is increased without a
corresponding increase in resources.
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.
Bonus issue after the reporting date
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.

Worked example: Bonus issue
C
The following information is given for an entity. H
Profit attributable to ordinary equity holders for y/e 30 September 20X6 CU300 A
Profit attributable to ordinary equity holders for y/e 30 September 20X7 CU900 P
Ordinary shares outstanding until 30 September 20X7 200 T
Bonus issue 1 October 20X7 two ordinary shares for each ordinary share E
outstanding at 30 September 20X7 R
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:
Additional shares issued 200 × 2 = 400
Basic earnings per share 20X7

cu£900
=cu
£1.50
(200 + 400)
Basic earnings per share 20X6
cu£300
cu£0.50
=
(200 + 400)
2.4.2 Share consolidation

A consolidation of ordinary shares generally reduces the number of ordinary shares outstanding without
a corresponding reduction in resources.
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.
Worked example: Share consolidation

At the start of its financial year ended 31 December 20X5, an entity had 10 million ordinary shares in
issue. On 30 April 20X5 it issued three million shares in consideration for the acquisition of a majority
holding in another entity. On 31 August 20X5 it went through a share reconstruction by consolidating the
shares in issue, on the basis of one new share for two old shares.
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).

The calculation of the weighted number of shares in issue is as follows:
Adjusted
Number Weighting number
At 1 January 20X5 10,000,000
Effect of consolidation is to halve the number of shares (since
one new share was issued for every two old shares held) (5,000,000)
5,000,000 12/12 5,000,000
30 April 20X5 issue 3,000,000

Effect of consolidation is to halve the number of shares (1,500,000)
1,500,000 8/12 1,000,000
Weighted average shares in issue 6,000,000
Worked example: Special dividend and share consolidation

A company has issued 20,000 shares with a nominal value of 20p each. At the beginning of 20X7 it
considers whether to launch a share repurchase of 2,000 shares at the current market price of CU2 per
share, or pay a special dividend of 20p per share to be followed by a share consolidation of nine new
shares for 10 old shares. The profit after tax for 20X6 and 20X7 is expected to be CU4,000 for each
year. Interest rates stand at 5% and the company tax rate is 20%.
Requirement
Calculate the basic EPS for the two alternatives.
Solution
(a) Share repurchase at fair value
20X7 20X6
CU CU
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
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)

2.5 Rights issue
C
A rights issue is an issue of shares for cash to the existing ordinary equity holders in proportion to their
H
current shareholdings, at a discount to the current market price.
A
Because the issue price is below the market price, a rights issue is in effect a combination of an issue at P
fair value and a bonus issue. T
E
In order to calculate the weighted average number of shares when there has been a rights issue, an
adjustment factor is required: R
Pre-rights issue price of shares

Adjustment factor =
Theoretical ex-rights price (TERP) 11
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.
Worked example: Rights issue

The following information is provided for an entity which is making a rights issue.
20X4 20X5 20X6

Profit attributable to ordinary equity holders of the parent entity CU1,100 CU1,500 CU1,800
Shares outstanding before rights issue: 500 shares
Rights issue: One new share for each five outstanding shares (100 new shares total)
Exercise price: CU5.00
Date of rights issue: 1 January 20X5
Last date to exercise rights: 1 March 20X5
Market price of one ordinary share immediately before exercise on 1 March 20X5: CU11.00
Reporting date 31 December
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)

Calculation of adjustment factor
Fair value per share before exercise of rights cu£11

Adjustment factor = = = 1.10
Theoretical ex-rights value per share cu£10
Calculation of basic earnings per share
20X4
20X4 basic EPS as originally cu£1,100

reported: = CU2.20
500 shares
20X4 basic EPS restated for cu£1,100
rights issue in 20X5 accounts: =
(500 shares) × (adjustment factor) CU2.00
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
Weighted average number of shares:
1 January – 28 February 500 × 11/10 × 2/12 92

Rights issue 100
1 March – 31 December 600 × 10/12 500
592
cu£1,500
Basic EPS including effects of rights issue: = CU2.53
592 shares
20X6
cu£1,800
Basic EPS: = CU3.00
600 shares
Worked example: Cash and rights issue

An entity had 14 million ordinary shares in issue on 1 January 20X4 and 20X5. In its financial year
ended 31 December 20X5 it issued further shares, as follows:
• 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:

Computation of theoretical ex-rights price (TERP):
No. Price Total C
Pre-rights issue 6 CU20 CU120 H
holding A
Rights share 1 CU15 CU15 P
7 CU135 T
Therefore TERP = CU135/7 = CU19.29 E

R
The adjustment factor is therefore CU20/CU19.29
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
20X5 earnings per share:
CU17m / 18,794,453 shares = CU0.90
20X4 restatement – original EPS: CU14m ÷ 14m shares = CU1.00
CU1.00 × 19.29/20.00 = CU0.96
3 Basic EPS: profits attributable to ordinary equity holders
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.
This is done in two steps:
• 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.
3.1 Adjusting earnings for the impact of preference shares

Where an entity has preference shares in issue depending on their terms these will be classified as
either:
• Financial liabilities or
• Equity under IAS 32

Preference shares classified as equity
Any dividends and other appropriations (for example, amortised premium or discount) is debited directly
to equity, in the statement of changes in equity. Therefore an adjustment is required to deduct these
amounts from the profit for the period in order to derive the profit attributable to ordinary shareholders
(equity holders).
Preference shares classified as liabilities

Any dividends or other appropriations are treated as finance costs in arriving at profit for the period and
no adjustment is required.
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.
Cumulative preference shares

Where preference shares are cumulative, the dividends for the period need to be taken into account
irrespective of whether these have been declared or not.
Non-cumulative preference shares

For non-cumulative preference dividends only the amount of dividend declared for the period should be
deducted in arriving at profit or loss attributed to ordinary equity holders.
Interactive question 2: Redeemable preference shares [Difficulty level: Intermediate]
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
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?
3.1.1 Other adjustments in respect of preference shares

Increasing rate preference shares
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.
In addition, there may be other elements amortised such as transaction costs.
All these elements should be deducted in arriving at the earnings attributed to ordinary equity holders.

Worked example: Increasing rate preference shares
C
Entity D issued non-convertible, non-redeemable class A cumulative preference shares of CU100 par H
value on 1 January 20X1. The class A preference shares are entitled to a cumulative annual dividend of
A
CU7 per share starting in 20X4.
P
At the time of issue, the market rate dividend yield on the class A preference shares was 7 per cent a T
year. Thus, Entity D could have expected to receive proceeds of approximately CU100 per class A E
preference share if the dividend rate of CU7 per share had been in effect at the date of issue. R
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.
Carrying amount of class A Imputed Carrying amount of class A Dividend

Year preference shares 1 January dividend preference shares paid
31 December
CU CU CU CU
20X1 81.63 5.71 87.34 –
20X2 87.34 6.12 93.46 –
20X3 93.46 6.54 100.00 –
Thereafter: 100.00 7.00 107.00 (7.00)
Convertible preference shares
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.
Deduction = Fair value of ordinary shares – Fair value of ordinary shares

issued / consideration paid issuable under original terms
Worked example: Cumulative convertible preference shares

An entity issued CU100,000 2% cumulative convertible preference shares in 20X4 and the shares were
due to be converted in the current year, 20X6.
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?

Solution
The excess of the fair value of additional ordinary shares issued on conversion of the convertible
preference shares over fair values of the ordinary shares to which they would have been entitled under
the original conversion terms is deducted from profit as it is an additional return to the convertible
preference shareholders.
CU
Profits attributable to the ordinary equity holders 150,000
Fair value of additional ordinary shares
issued on conversion of convertible preference shares (300)
149,700
There is no adjustment in respect of the preference shares as no dividend accrual was made in respect
of the year. The payment of the previous year's cumulative dividend is ignored for EPS purposes as it
will have been adjusted for in the prior year.
Repurchase of preference shares
• 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.
Worked example: Repurchase of preference shares

An entity has issued CU100,000 8% non-redeemable non-cumulative preference shares. Half way
through the year, the entity repurchased half of the preference shares at a discount of CU1,000. No
dividends were paid on these shares in respect of the amounts repurchased or outstanding at the end of
the year.
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.

3.2 Participating securities and two-class ordinary shares
C
The equity of some entities includes:
H
• Instruments that participate in dividends with ordinary shares according to a predetermined formula A
(for example, two for one) with an upper limit on the extent of participation (for example, up to, but P
not beyond, a specified amount per share), or T
E
• A class of ordinary shares with a different dividend rate from that of another class of ordinary
R
shares.
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.
To calculate basic earnings per share:
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.
Worked example: Participating equity instruments

The following information is provided for an entity.
Profit attributable to equity holders of the parent entity CU100,000

Ordinary shares outstanding 10,000
Non-convertible preference shares 6,000
Non-cumulative annual dividend on preference shares
(before any dividend is paid on ordinary shares) CU5.50 per share
After ordinary shares have been paid at a dividend of CU2.10 per share, the preference shares
participate in any additional dividends on a 20:80 ratio with ordinary shares.
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
Calculate the earnings attributable to ordinary shares.
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:
(A × 10,000) + (B × 6,000) = CU46,000

As B's entitlement is one quarter that of A's, we can eliminate B from the equation as follows:
(A × 10,000) + (1/4 × A × 6,000) = CU46,000
10,000A + 1,500A = CU46,000
11,500A = CU46,000
A = CU46,000/11,500
A = CU4.00
Therefore B = CU1.00
Basic per share amounts

per preference
share per ordinary share
Distributed earnings CU5.50 CU2.10
Undistributed earnings CU1.00 CU4.00
Totals CU6.50 CU6.10
4 Diluted earnings per share
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.
4.1 Potential ordinary shares

Potential ordinary shares are financial instruments or other contracts that may entitle their holders to
ordinary shares. Potential ordinary shares are:
• 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.

4.2 Dilutive and antidilutive potential ordinary shares
C
Potential ordinary shares are dilutive when their conversion to ordinary shares would decrease earnings H
per share or increase loss per share from continuing operations. A
Potential ordinary shares are antidilutive when their conversion to ordinary shares would increase P
earnings per share or decrease loss per share from continuing operations. Antidilution is therefore the T
situation where the 'diluted' EPS is greater than the basic EPS (or where there is a lower loss per share). E
IAS 33 defines antidilution as follows. R
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.
Determining whether potential ordinary shares are dilutive or antidilutive
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.
A separate EPS calculation is performed for each potential share issue.
• 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.
4.3 Computation of diluted earnings

For the purpose of calculating diluted earnings per share, the profit or loss attributable to ordinary equity
holders of the parent entity should be adjusted for the after-tax effect of:
• 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.
4.4 Calculation of the number of shares

In the calculation of diluted earnings per share, the number of ordinary shares in the denominator is the
weighted average number of ordinary shares calculated for the basic earnings per share plus the
weighted average number of ordinary shares that would be issued on the conversion of all the dilutive
potential ordinary shares into ordinary shares. That is:

Number of shares in diluted = Number of shares in basic + Dilutive potential ordinary
earnings per share earnings per share shares
• 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.
5 Diluted EPS: convertible instruments
Section overview
• This section deals with the impact of convertible instruments on the diluted earnings per share.
5.1 Convertible instruments

Convertible instruments, such as convertible loan stock or convertible preference shares impact both the
profit or loss attributed to ordinary equity holders, and the number of ordinary shares, on conversion.
Where this has a dilutive effect, the instrument should be taken into account when calculating DEPS.
Indicators that convertible instruments are antidilutive
Convertible preference shares are antidilutive whenever the amount of the dividend on such shares
declared in, or accumulated for, the current period per ordinary share obtainable on conversion exceeds
basic earnings per share.
Similarly, convertible debt is antidilutive whenever its interest (net of tax and other changes in income or
expense) per ordinary share obtainable on conversion exceeds basic earnings per share.
Worked example: Convertible loan stock 1

On 1 January 20X5 entity A had in issue:
• 24 million ordinary shares of CU1 nominal value each.
• 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.

Solution
C
Basic EPS
H
CU15m / 24m shares = CU0.63 A
P
Diluted EPS
T
To calculate the diluted earnings per share we need to consider the impact on both earnings and E
number of shares. R
Impact on earnings: On conversion, after tax earnings attributed to ordinary shareholders should
be increased by the reduction in the interest charge payable to loan holders.
Taking tax into account, the interest saved will be: 11
CU7m × 0.1 × (1 – 0.2) = CU0.56m
Therefore diluted earnings = CU15m + CU0.56m = CU15.56m
Impact on number of On conversion the number of ordinary shares will increase by CU8m/2 = 4
shares: million shares, raising the number of ordinary shares after conversion to 28
million ordinary shares.
Therefore DEPS = CU15.56m/28 million shares = CU0.56
Interactive question 3: Test of dilution [Difficulty level: Intermediate]

The issued share capital of Entity A at 31 December 20X5 was 2,000,000 ordinary shares of CU1 each.
On 1 January 20X6, Entity A issued CU1,500,000 of 7% convertible loan stock for cash at par. (Ignore
the requirement to split the value of a compound financial instrument.) Each CU100 nominal of the loan
stock may be converted into 140 ordinary shares at any time after 1 January 20X9.
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
Test whether the potential shares are dilutive.
Worked example: Convertible loan stock 2

On 1 January 20X5 Entity A had in issue:
• 20 million ordinary shares
• 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
• CU12.6 million of 9% convertible loan stock, convertible at any time from 1 January 20X9. The
The entity reported profit attributable to the ordinary equity holders of CU4 million for its year ended
31 December 20X5.
Requirement
Ignoring taxes, calculate the diluted earnings per share.

Solution
The incremental earnings per share for each type of potential ordinary shares is shown below.
Increase in Earnings per

earnings Increase in additional
(interest saved) number of share
CU shares CU
CU11 million of 6.5% convertible loan stock
CU10m × 9% convertible loan stock 900,000
1 ordinary share for CU2 nominal of loan stock 5,500,000 0.16
CU9 million of 6.75% convertible loan stock
CU8m × 8% convertible loan stock 640,000
CU12.6 million of 9% convertible loan stock
CU12m × 12% convertible loan stock 1,440,000
The earnings per share can be calculated adjusting both the earnings and the number of shares for each
type of potential shares, and the results are shown below. Each issue of potential ordinary shares is
added to the calculation at a time, taking the most dilutive factor first.
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.
5.2 Testing for dilution

In some cases some convertible preference shares are redeemed or converted in a period, and others
remain outstanding.
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.
6 Diluted EPS: options
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.
6.1 Options, warrants and their equivalents

Options and warrants are dilutive when they would result in the issue of ordinary shares for less than the
average market price of ordinary shares during the period (ie when they are 'in the money').

To calculate DEPS where there are options or warrants, the potential ordinary shares at less than
average market price are treated as consisting of two elements: C
H
• A contract to issue some shares at average market price. These shares are assumed to be fairly
priced and to be neither dilutive nor antidilutive. They are ignored in the calculation of diluted A
earnings per share. P
T
• A contract to issue the remaining ordinary shares for no consideration These shares are dilutive E
and are added to the number of ordinary shares outstanding in the calculation of diluted earnings R
per share.
Average market price of ordinary shares

11
• Theoretically every market transaction for an entity's ordinary shares could be included in the
determination of the average market price. It is however adequate to use a simple average of
weekly or monthly prices.
• 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.
Interactive question 4: Diluted earnings per share [Difficulty level: Intermediate]
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.
6.2 Employee share options

The most common type of option that leads to earnings dilution is an employee share option granted by
a company to its employees.
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.

Worked example: Vested options
The profit attributable to the ordinary equity holders of an entity for the year ended 31 December 20X5
was CU30 million and the weighted average number of its ordinary shares in issue was 60 million. Its
basic earnings per share was CU0.50.
In addition, there was a weighted average of five million shares under options which had vested (ie were
able to be exercised). The exercise price for the options was CU21 and the average market price per
share over the year was CU30.
Requirement
Calculate the diluted EPS.
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.
Worked example: Unvested options

Assume the same information as in above example, except that:
• The options have not yet vested; and
• 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.
7 Diluted EPS: contingently issuable shares
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.
7.1 Contingently issuable shares

The consideration for acquisitions of other entities may partly be in the form of shares which will only be
issued if certain targets are met in the future. The additional consideration is contingent consideration
and the additional shares are described as contingently issuable.
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).

Worked example: Contingently issuable shares
C
The profit attributable to the ordinary equity holders of an entity for the year ended 31 December 20X5 H
was CU20 million and the weighted average number of its ordinary shares in issue was 16 million. Basic
A
earnings per share was therefore CU1.25.
P
Under an agreement relating to a business combination, two million additional shares were to be issued T
if the share price on 30 June 20X6 was CU8 or above. On 31 December 20X5 the share price was CU9. E
Assuming the end of the reporting period was the end of the contingency period, the condition would R
have been met.
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:
Diluted earnings per share = CU20m / (16m + 2m) = CU1.11
7.2 Conditions for issue

Contingently issuable shares are included within the calculation of DEPS where
• The shares have not yet been issued

• The relevant performance criteria have been met
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.
Market price of shares
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.
Future earnings and market price of shares
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).

In this case, the contingently issuable ordinary shares are included in the calculation of diluted earnings
per share according to the status at the end of the reporting period.
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.
Worked example: Cumulative targets

A manufacturer has in issue 3,000,000 ordinary shares at 1 January 20X7. It agreed to issue 500,000
shares to its staff if factory output averages 100,000 units per annum over the period from 1 January
20X7 to 31 December 20X9. The shares are to be issued on 1 January 20Y0.
Results for the three periods are:
Units produced Profits

20X7 120,000 CU780,000
20X8 99,000 CU655,000
20X9 105,000 CU745,000
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:
Basic EPS Diluted EPS

20X7 cu£780,000 CU0.26 Not relevant
=
3,000,000 shares
20X8 cu£655,000 CU0.22 Not relevant
=
3,000,000 shares
20X9
cu£745,000 CU0.25 cu£745,000 CU0.21
= =
3,000,000 shares 3,500,000 shares
7.3 Issue of contingently issuable shares

Where contingently issuable shares are issued at the end of a contingency period, they must be
included within the calculation of basic EPS. Any outstanding contingently issuable shares are included
in DEPS as discussed above.
Worked example: Contingently issuable shares

The profit attributable to the ordinary equity holders of an entity for the year ended 31 December 20X5
was CU200 million and the number of its ordinary shares in issue at 1 January 20X5 was 80 million.
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.
There were no other issues of ordinary shares.
Requirement
Determine the basic and diluted EPS.

Solution
C
Basic earnings per share
H
The 24 million additional shares are weighted by the period they have been in issue: A
Adjusted P
Issued Weighting number T
1 January 20X5 – 28 February 80,000,000 2/12 13,333,333 E
Issued 28 February 12,000,000 R
1 March – 30 Sept 92,000,000 7/12 53,666,667
Issued 30 September 12,000,000
30 September – 31 December 104,000,000 3/12 26,000,000 11
Basic earnings per share = CU200m/93m = CU2.15
As the 24 million additional shares do not result in any additional resources for the entity, the diluted
calculation assumes all the new shares were issued at the start of the year (see section 2.4).
Diluted earnings per share = CU200m / (80m +12m + 12m) = CU1.92
8 Retrospective adjustments and presentation and

disclosure
Section overview
• This section deals with retrospective adjustments to EPS and the provisions of IAS 33 concerning
presentation and disclosure.
8.1 Retrospective adjustment

Bonus issues, share splits and share consolidations
If the number of ordinary or potential ordinary shares outstanding increases as a result of a

capitalisation, bonus issue or share split, or decreases as a result of a share consolidation, the
calculation of basic and diluted earnings per share for all periods presented must be adjusted
retrospectively.
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.
Prior period adjustments and errors
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.

• Earnings per share is presented for every period for which a statement of comprehensive income is
presented.
• If diluted earnings per share is reported for at least one period, it shall be reported for all periods
presented, even if it equals basic earnings per share.
• If basic and diluted earnings per share are equal, dual presentation can be accomplished in one
line on the statement of comprehensive income.
• An entity that reports a discontinued operation shall disclose the basic and diluted amounts per
share for the discontinued operation either on the face of the statement of comprehensive income
or in the notes.
• An entity shall present basic and diluted earnings per share, even if the amounts are negative (ie a
loss per share).
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.
Examples of transactions referred in the paragraph above include:
• An issue of shares for cash
• An issue of shares when the proceeds are used to repay debt or preference shares outstanding at
the reporting date
• The redemption of ordinary shares outstanding
• The conversion or exercise of potential ordinary shares outstanding at the reporting date into
ordinary shares
• An issue of options, warrants, or convertible instruments
• 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).

Additional EPS
C
If an entity discloses, in addition to basic and diluted earnings per share, amounts per share using a
H
reported component of profit other than one required by IAS 33, such amounts shall be calculated using
A
the weighted average number of ordinary shares determined in accordance with this Standard.
P
Basic and diluted amounts per share relating to such a component shall be disclosed with equal T
prominence and presented in the notes. E
R
An entity shall indicate the basis on which the numerator(s) is (are) determined, including whether
amounts per share are before tax or after tax.
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.
Worked example: Allied Irish Bank Ltd

In addition to the required EPS under IAS 33 Allied Irish Bank Ltd reports an adjusted EPS measure
excluding hedge volatility, profit on disposal of property and business and construction contract income.
A comment to the disclosure states that the adjusted measure is presented to help better understand
underlying business performance.
Allied Irish Bank Ltd 31 December 2006
Extract from Notes to the accounts:

Profit attributable Earnings per share
2006 2005 2006 2005
19 Adjusted earnings per share €m €m € €
(a) Basic earnings per share
As reported (note 18(a)) 2,147 1,305 246.8 151.0
Adjustments:
Construction contract income (82) (38) (9.4) (4.4)
Hedge volatility 4 (6) 0.5 (0.7)
Profit on disposal of property (290) – (33.4) –
Profit on disposal of business (189) – (21.7) –
1,590 1,261 182.8 145.9
Although not required under IFRS, adjusted earnings per share is presented to help understand the
underlying performance of the Group. The adjustments in 2006 and 2005 are items that management
believe do not reflect the underlying business performance. The adjustment in respect of profit on sale of
property relates only to the profit on sale of properties that are subject to sale and leaseback
arrangements (note 12). The adjustments listed above are shown net of taxation.

Summary
IAS 33

Self-test
C
IAS 33 Earnings per Share H
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
On 1 July 20X7 Puffbird made a three for one bonus issue. R
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
The Urtica Company is listed on a recognised stock exchange.
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.
Statement of comprehensive income CU'000


Ordinary shares of CU1 8,400
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.
Statement of comprehensive income

Profit after tax CU
Continuing operations 1,600,000
Discontinued operations (400,000)
Total attributable to ordinary equity holders 1,200,000

Ordinary shares of CU1 9,600,000
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.

CU
Equity component 100,000
Liability component 1,100,000
1,200,000
The effective interest rate on the liability component is 10%. The bonds are convertible on specified
dates in the future at the rate of one ordinary share for every CU2 bond.
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.
(1) A one for five bonus issue on 1 May 20X7

(2) A two for five rights issue on 1 September 20X7 at CU0.45 when the market price was
CU1.50.
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?

8 Citric
C
The following information relates to The Citric Company for the year ended 31 December 20X7.
H
Statement of comprehensive income A
Profit after tax CU100,000 P
T
E
Ordinary shares of CU1 1,000,000
R
There are warrants outstanding in respect of 1.7 million new shares in Citric at a subscription price
of CU18.00. Citric's share price was CU22.00 on 1 January 20X7, CU24.00 on 30 June 20X7,
CU30.00 on 31 December 20X7 and averaged CU25.00 over the year. 11
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)

Technical reference
IAS 33 Earnings per Share
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
Dilutive potential ordinary shares
• 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.
Options, warrants and their equivalents IAS 33.45
Convertible instruments IAS 33.49
Contingently issuable shares IAS 33.52
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.
Presentation IAS 33.66
Disclosure IAS 33.70

Answers to Self-test C
H
A
P
IAS 33 Earnings per Share T
E
1 Puffbird
R
23.75 pence
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
Therefore revised EPS = 95p × ¼ = 23.75p
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
Tax (75,000)
Preference dividend (CU500,000 × 6%) (30,000)
Profit attributable to ordinary equity holders 195,000
Therefore BEPS = CU195,000/5,000,000 shares = 3.9p
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
Number of equity shares for basic EPS 8,400,000

Number of dilutive shares under option 800,000
Adjusted number of shares 9,200,000
DEPS (CU5,400,000/9,200,000 shares) 58.7p
According to IAS 33.46, the proceeds of the options should be calculated using the average market
price during the year. The difference between the number of ordinary shares issued and the
number that would have been issued at the average market price are the 'free' shares that create
the dilutive effect.

4 Whiting
12.6 pence
Basic EPS cu£1,600,000 16.7 p

Based on continuing operations =
9,600,000
Incremental EPS Increment to profits after conversion of bonds:

CU1,100,000 x 10% x (1-20%) = CU88,000
Increase to number of shares:
CU1,200,000/CU2 = 600,000
cu£88,000
Therefore: = 14.7 p
600,000
Diluted EPS cu+ 88,000)

£(1,200,000
= 12.6 p
9,600,000 + 600,000 shares
The shares issuable on conversion of the bonds are potentially dilutive, but IAS 33.41 only requires
them to be taken into account if they dilute the basic EPS figure based upon continuing operations.
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:
TERP: 2 shares @ CU2.00 = CU4.00

1 share @ CU1.40 = CU1.40
3 CU5.40 therefore CU5.40/3 = CU1.80
Market value of share cu£2.00
Adjustment factor: =
TERP cu£1.80
1 Jan X7 – 31 March X7 × 3/12 666,667
2,400,000 × 2.00
1.80
Rights issue 1,200,000
1 April X7 – 31 Dec X7 3,600,000 × 9/12 2,700,000
3,366,667
Basic EPS
cu£3,000,000
= 89.1p
3,366,667 shares
6 Sakho
(a) False
(b) True
Number of shares post issue 6

Bonus fraction = =
Number of shares pre issue 5
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

The basic EPS for the prior year is multiplied by the inverse of the rights factor and the bonus
factor, so 1.20 / 1.50 × 5/6 = 2/3. C
H
7 Sardine
A
35.9 pence P
T
Issue price of preference shares = CU300,000 / 1.082 = CU257,202
E
Profit attributable to ordinary equity holders = CU200,000 – (8% × CU257,202) = CU179,424 R
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
(a) Shares issued at average market price (1,700,000 × CU18)/CU251,224,000
Shares issued at nil consideration (1,700,000 – 1,224,000) 476,000
(b) Incremental profits (CU1,750,000 × 7% × (1 – 25%)) CU91,875
Increase in number of shares (CU2,000,000/CU5 × 2) 800,000
Therefore incremental EPS (CU91,875 / 800,000 shares) 11.5p
(c) Profits Number of shares EPS

Basic EPS CU100,000 1,000,000 10p
Add in options CU100,000 1,476,000 6.78p
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.


No, the 4% preference shares are classed as liabilities under IAS 32. The dividend has been charged to
profits as part of the finance cost and no adjustment is necessary.

CU1.75
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.

Basic EPS
20X6
Trading results CU
Profit before interest and tax 1,050,000
Interest on 7% convertible loan stock (105,000)
Taxation (283,500)
Number of shares outstanding 2,000,000
Basic EPS (CU661,500 / 2,000,000 shares) CU0.33
Testing for dilutive impact
Increase in earnings = interest saved (CU1,500,000 × 7% × (1-30%)) CU73,500

Increase in number of shares (CU1,500,000/CU100 × 140) 2,100,000
EPS (CU73,500 / 2,100,000) 3.5p
This is less than basic EPS and therefore the convertible loan stock is dilutive.

20X7
Trading results CU
Number of shares outstanding 3,000,000
Basic EPS CU0.30
Number of shares under option
Issued at full market price (600,000 x 50p)/CU1.50 200,000
Issued at nil consideration 600,000 – 200,000 400,000
Total number of shares under option 600,000
Number of equity shares for basic EPS 3,000,000
Number of dilutive shares under option 400,000
Adjusted number of shares 3,400,000
Diluted EPS (CU900,000 / 3,400,000) CU0.26

CHAPTER 12
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
Technical reference
503
Introduction
• 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
of details
Specific syllabus references for this chapter are: 3(a), 3(b), 14(c), 14(d), 14(f)

1 Review of material from earlier studies
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.
• Future economic benefit

• Control
• The transaction to acquire control has already taken place
1.1 Property, plant and equipment

• Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction.
• 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.
Reporting of assets 505

Accounting treatment
• As with all assets, recognition depends on two criteria
– 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).
• Once recognised as an asset, items should initially be measured at cost
• Cost is the purchase price, less trade discount/rebate plus
– 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.
• Measurement subsequent to initial recognition
– 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.)

C
H
A
P
T
E
R
12
Interactive question 1: Revaluations [Difficulty level: Intermediate]
(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
(a) Account for the revaluation in the current year

(b) Account for the decrease in value
(c) Account for the revaluation and state the treatment for depreciation from 20X8 onwards

1.2 Inventories
Valuation
Lower of:
• Cost
• Net realisable value
Each item / group / category considered separately
Allowable costs
Allowable costs
include:
• Cost of purchase
exclude:
• Cost of storage
• Cost of selling
Determining cost
• FIFO
• Weighted average cost
Net realisable value

• Estimated cost of completion
• Estimated costs necessary to make the sale (eg marketing, selling and distribution)
Interactive question 2: Attributable cost [Difficulty level: Intermediate]
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.
Budgeted cost information for the most recent month is as follows.

Total Product 1 Product 2
CU CU CU
Direct cost 300,000 140,000 160,000
Indirect production overheads
Identifiable 82,000 37,000 45,000
Other 50,000
432,000
Budgeted output – units 690 900
The entity has a policy which allocates indirect costs which are not specifically identifiable to an
individual product by reference to relative selling prices. This results in 60% being allocated to Product 1
and 40% to Product 2.
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
Calculate the cost attributable to Products 1 and 2.

Interactive question 3: Reclassification of asset [Difficulty level: Intermediate]
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.

C
H
A
1.3 IAS 38 Intangible Assets P
T
• An intangible asset is an identifiable non-monetary asset without physical substance, such
E
as a licence, patent or trademark.
R
• An intangible asset is identifiable if it is separable (ie it can be sold, transferred, exchanged,
licensed or rented to another party on its own rather than as part of a business) or it arises from
contractual or other legal rights. 12
• 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.
• Internally generated goodwill should not be recognised.
• 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
• On disposal of an intangible asset the gain or loss is recognised in profit or loss.
Interactive question 4: Intangible assets [Difficulty level: Easy]
Requirements
(a) Give some common examples of intangible assets.

(b) Can employees be recognised as intangible assets?
1.4 IAS 36 Impairment of Assets

Scope
IAS 36 applies to impairment of all assets other than:
• 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
IAS 36 most commonly applies to:
• Property, plant and equipment accounted for in accordance with IAS 16 Property, Plant and
Equipment
• Intangible assets accounted for in accordance with IAS 38 Intangible Assets
• 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
Fair value less Value in use

costs to sell
Fair value less costs to sell

Fair value less costs to sell is the price that would be received to sell the asset in an orderly
transaction between market participants at the measurement date (IFRS 13 definition of fair value, see
Chapter 2, Section 4), less the direct incremental costs attributable to the disposal of the asset.
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.
The cash flows should include:
• Projections of cash inflows from continuing use of the asset

• Projections of cash outflows necessarily incurred to generate the cash inflows from continuing use
of the asset
• 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
They should exclude:
• 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
CU'000 CU'000 CU'000 CU'000 CU'000
Future cash flows 230 211 157 104 233
(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.
Note: PV factors at 15% are as follows.
Year PV factor @15%

1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718
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.

External
• Significant decline in market value of the asset below that expected due to normal passage of time
or normal use
• Significant changes with an adverse effect on the entity in the
– Technological or market environment

– Economic or legal environment
• Increased market interest rates or other market rates of return affecting discount rates and thus
reducing value in use
• Carrying amount of net assets of the entity exceeds market capitalisation
Internal
• Evidence of obsolescence or physical damage

• Significant changes with an adverse effect on the entity*:
– The asset becomes idle

– Plans to discontinue/ restructure the operation to which the asset belongs
– Plans to dispose of an asset before the previously expected date
– Reassessing an asset's useful life as finite rather than indefinite
• 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
Cash-generating units (CGUs)

Where it is not possible to estimate the recoverable amount of an individual asset, the entity estimates
the recoverable amount of the cash-generating unit to which it belongs.
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.
Interactive question 6: Cash-generating units [Difficulty level: Intermediate]
Requirement
Discuss whether the following items would be cash-generating units in their own right, or part of a larger
cash-generating unit.
(a) A pizza oven in a pizza restaurant.
(b) A branch of a pizza restaurant in Warsaw.
(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.

(e) The internal large telephone network of a country's railway system, although its use is currently not
permitted to anybody other than railway workers.
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.
Allocation of impairment losses in a CGU 12
General rule
The impairment should be allocated in the following order:
• Goodwill allocated to the CGU

• Other assets on a pro-rata basis based on carrying value
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.
Allocation of loss with unallocated corporate assets or goodwill
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 of individual CGUs
• 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 of group of CGUs
• 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
After the impairment review

The depreciation/ amortisation should be adjusted in future periods to allocate the asset's revised
carrying amount less its residual value on a systematic basis over its remaining useful life.
Treatment of the non-controlling interest element of goodwill

The revision to IFRS 3 allows two methods of initially valuing the non-controlling (minority) interest in an
entity:
• As a share of the net assets of the entity at the acquisition date, or

• At fair value.

The non-controlling interest is then taken into account in the goodwill calculation per the revised
standard:
Purchase consideration X
Non-controlling interest X
X
Total fair value of net assets of acquiree (X)
Goodwill X
This means that the resulting goodwill will represent
• 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.
Interactive question 7: Allocation of impairment loss [Difficulty level: Exam standard]
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
Show the allocation of the impairment losses:
(a) If the recoverable amount was CU510m at 31.12.20X1

(b) If the recoverable amount was CU570m at 31.12.20X1
Reversal of past impairments

A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the carrying
amounts of those assets.
However, the carrying amount of an asset is not increased above the lower of:
• Its recoverable amount (if determinable); and

• Its depreciated carrying amount had no impairment loss originally been recognised.
Any amounts left unallocated are allocated to the other assets (except goodwill) pro-rata.

The reversal is recognised in profit or loss, except where reversing a loss recognised on assets carried
at revalued amounts, which are treated in accordance with the applicable IFRS.
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
Once recognised, impairment losses on goodwill are not reversed.
Impairment and IFRS 5

IFRS 5 is covered in detail in Chapter 9. Regarding impairment, note the following:
• 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).
2 IAS 40 Investment Property
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.
• The cost of the investment property can be measured reliably.

2.2 Initial measurement and further aspects of recognition
An investment property should initially be measured at its cost, including transaction costs.
Further aspects of recognition

Transaction costs Expenses that are directly attributable to the investment property, for example
professional fees and property transfer taxes. Cost does not include activities
that, while related to the investment property, are not directly attributable to it.
For example, start up costs, abnormal amounts of wasted resources in
constructing the property, relocation costs, losses incurred before full occupancy
and the normal servicing of the property are not directly attributable.
Self-constructed Property being self-constructed or under development for future use as an
investment investment property qualifies itself as an investment property.
properties
Leases A property interest held under a lease and classified as an investment
property shall be accounted for as if it were a finance lease. The asset is
recognised at the lower of the fair value of the property and the present
value of the minimum lease payments. An equivalent amount is recognised
as a liability.
Entity occupies part If the two portions can be sold separately or leased separately under a
of property and finance lease, each is accounted for as appropriate. If not, entire property is
leases out balance an investment property only if insignificant portion is owner occupied.
Entity supplies An investment property only if the services are insignificant to the
services to the arrangement as a whole.
lessee of the
property
Property leased to An investment property in entity's own accounts but owner occupied from
and occupied by group perspective.
parent, subsidiary or
other group company
Interactive question 8: Identification of investment property [Difficulty level: Intermediate]
(a) An entity has a factory that has been shut down due to chemical contamination, worker unrest and
strike. The entity plans to sell this factory.
(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?

2.3 Measurement subsequent to initial recognition
Following initial measurement, investment properties are held either:
• At cost less accumulated depreciation (the cost model), or

• Measured at fair value (the fair value model).
Cost model
Where the cost model is adopted, the property should be accounted for in accordance with IAS 16
Property, Plant and Equipment.
Fair value model

• After initial recognition, an entity that chooses the fair value model should measure all of its C
investment property at fair value, except in the extremely rare cases where this cannot be
H
measured reliably. In such cases it should apply the IAS 16 cost model.
A
• A gain or loss arising from a change in the fair value of an investment property should be P
recognised in net profit or loss for the period in which it arises. T
E
• The fair value of investment property should reflect market conditions at the reporting date.
R
• A change in use of an investment property may lead to a change in classification.
Whatever policy the entity chooses should be applied to all of its investment property.
12
Interactive question 9: Estimating fair value [Difficulty level: Intermediate]
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.

Interactive question 10: Disposal of investment property [Difficulty level: Easy]
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.
2.5 Transfers following a change in use

A change in use may lead to recognition or de-recognition of an investment property. The following is a
summary of such instances.
Evidence of change in use Accounting treatment

Commencement of owner • Owner occupied property recognised under IAS 16.
occupation • If fair value model was used, treat fair value as deemed cost.
Commencement of development • Reclassify as inventory under IAS 2.
with a view to sale • If fair value model was used, treat fair value as deemed cost.
Development with view to • Continue to hold as an investment property.
continue letting
End of owner occupation with • Transfer to investment properties under IAS 40.
view to let to third parties
• If fair value model to be used, revalue at date of change and
recognise difference as revaluation under IAS 16.
Property held as inventory now • Transfer to investment properties under IAS 40.
let to a third party
• If fair value model to be used, revalue at date of change and
recognise difference in profit or loss.
Commencement of operating • Transfer from property, plant and equipment to investment
lease to another party property under IAS 40.
Interactive question 11: Change of use [Difficulty level: Intermediate]
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.
The fair value of the head office was as follows.
At 31 December 20X5 CU6 million

At 31 December 20Y0 CU7.5 million
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.

2.6 Summary of disclosure requirements
An entity shall disclose
• Whether it has followed the fair value model or cost model

• Whether property interests held as operating leases are included in investment property
• Criteria for classification as investment property
• Assumptions in determining fair value
• Use of independent professional valuer (encouraged but not required)
• Rental income and expenses
• Any restrictions or obligations
Fair value model – additional disclosures C

An entity that adopts this must also disclose a reconciliation of the carrying amount of the investment H
property at the beginning and end of the period. A
P
Cost model – additional disclosures T
These relate mainly to the depreciation method, rates and useful lives used as well as a reconciliation of E
the carrying amount at the beginning and end of the period. In addition, an entity which adopts the cost R
model must disclose the fair value of the investment property.
Interactive question 12: Installation of new equipment 1 [Difficulty level: Intermediate]

12
An entity owns the freehold of an office building which was acquired on 31 December 20X0 for CU17
million, CU2 million of which was attributable to the land. The freehold is an investment property
measured under the cost model with the building's useful life estimated at 30 years. The building was
fully equipped with an air-conditioning system. No separate value was placed on the air conditioning unit
as this was not something that was required by accounting standards at the time of acquisition.
On 31 December 20X5 the entity replaced the air-conditioning system for CU1.2 million, which has an
estimated useful life of 10 years. As no more reliable information was available, it used this cost as an
indication of the cost of the old system.
Requirement
How should the replacement of the air-conditioning be accounted for?
Interactive question 13: Installation of new equipment 2 [Difficulty level: Intermediate]
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?

Interactive question 14: Replacement property [Difficulty level: Intermediate]
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
How should the entity recognise these transactions?
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.
Biological transformation: A biological transformation comprises the processes of growth,

degeneration, production and procreation that cause qualitative or quantitative changes in a biological
asset.
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.
Biological asset: A biological asset is a living plant or animal.
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,

milk the agricultural produce and cheese the product that is processed after the point of harvest. Another
example is wine: vines are the biological asset, grapes the agricultural produce and wine the end
product.
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.
Common characteristics of agricultural activities
• 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.
Food products raw materials

The entity owns farmland on which it grows annual crops of corn for sale to food manufacturers. The
growing process is aided by the careful application of a range of nutrients, while additives are
administered to the underlying land immediately after harvesting has ended. This is an agricultural
activity; the corn growing each year is the biological transformation; growth is encouraged by
management's activities and the change is monitored, to identify the time at which harvest should
commence.
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.
Interactive question 15: Classification [Difficulty level: Easy]
Into which category would the following items be classified according to IAS 41 Agriculture?
(a) Wool
(b) Vines
(c) Sugar
3.2 Recognition and measurement

3.2.1 Recognition criteria
A biological asset or agricultural produce should only be recognised when:

• The entity controls the asset as a result of past events, for example the acquisition of dairy cattle.
The past event is the purchase, and control is obtained as the entity is now the legal owner
• 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
• Fair value, or cost, of the asset can be measured reliably.
3.2.2 Measurement of biological assets

A biological asset should initially be measured at its fair value less estimated costs to sell, such as
duty and commission to brokers or dealers.
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
• Sector-based benchmarks, for example the value of meat per kilogram.
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.
3.2.3 Measurement of agricultural produce

Agricultural produce should be measured at its fair value, less estimated costs to sell at the point of
harvest. Subsequent measurement is by reference to IAS 2. It will always be possible to fair value the
agricultural produce since, by its very nature, there must be a market for it.
Interactive question 16: Costs to sell [Difficulty level: Easy]
Which of the following expenses would be classified as costs to sell when valuing biological assets and
agricultural produce?
(a) Commission to brokers

(b) Transfer taxes and duties
(c) Transport costs
(d) Advertising costs

Worked example: Fair value
An entity rears animals to be sold in a local market. The market is 50km away, and transport to market
costs CU1 per animal. At the measurement date the open market value is CU60. The auctioneers
charge a sales commission of 2% of market value and there is a government levy, based on market
value, of 1% on purchases and 3% on sales.
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.
Land is dealt with under IAS 16 or IAS 40.

3.3 Gains and losses
Gains or losses arising on the initial recognition at fair value of a biological asset and agricultural
produce should be reported directly in profit or loss for the period to which they relate, for example a
gain may arise on the birth of a calf. Subsequent changes in the fair value will also be reported directly in
profit or loss.
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.
Worked example: Changes in fair value

A herd of five four-year old animals was held on 1 January 20X3. On 1 July 20X3 a 4.5-year old animal
was purchased. The fair values less estimated costs to sell were as follows.
4 year-old animal at 1 January 20X3 CU200

4.5 year-old animal at 1 July 20X3 CU212
5 year-old animal at 31 December 20X3 CU230
Requirement
Show the reconciliation of the changes in fair value.

Solution
The movement in the fair value less estimated costs to sell of the herd can be reconciled as follows.
CU
At 1 January 20X3 (5 × CU200) 1,000
Purchased 212
Change in fair value (the balancing figure) 168
At 31 December 20X3 (6 × CU230) 1,380
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.
4 IFRS 6 Exploration for and Evaluation of Mineral

Resources
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.
4.2 Measurement at recognition

At recognition, exploration and evaluation assets must be measured at cost.
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.
4.3 Measurement after recognition

Entities must apply either the cost model or the revaluation model in IAS 16.

4.4 Changes in accounting policies
These may be made if the change makes the financial statements more relevant to users. IAS 8 criteria
need to be applied.
4.5 Classification and reclassification

Exploration and evaluation assets are classified as tangible or intangible according to the nature of
the assets acquired. The classification must be applied consistently. They should no longer be classified
as such when the technical feasibility and commercial viability of extracting a mineral resource are
demonstrable.
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
– Exploration rights have expired
– 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
In such circumstances, impairment is undertaken in accordance with IAS 36.
4.7 Presentation and disclosure

Exploration and evaluation assets are recorded as tangible or intangible assets, as appropriate. Once
benefits are demonstrable, assets dealt with under IFRS 6 are superseded by other appropriate
standards and are reclassified accordingly.
Disclosure relates to:
• A description of the accounting policies applied
• 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.

Interim guidance has been issued in phase one of the project in the form of IFRS 4; it is a stepping stone
to the second phase of the project. IFRS 4 largely focuses on improving the disclosure requirements in
relation to insurance contracts; however, it also includes a number of limited improvements to existing
accounting requirements.
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.
5.2 What is an insurance contract?

Definition
Insurance contracts: are contracts between two parties, where one party, the insurer, agrees to
compensate the other party, the policyholder, if it is adversely affected by an uncertain future event.
An uncertain future event exists where at least one of the following is uncertain at the inception of an
insurance contract:
• The occurrence of an insured event

• The timing of the event; or
• The level of compensation that will be paid by the insurer if the event occurs (IFRS 4 Appendix B).
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.
Examples of insurance contracts
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;
• Disability and medical cover;
• Credit insurance, covering the policyholder for non-recoverable receivables; and
• Travel cover to provide against any loss suffered whilst travelling.
Examples of an insurer taking on insurance risk are:
• 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.

• A gas boiler repair service available from a supplier who, for the payment of a fixed fee, will fix the
malfunctioning boiler. This is an insurance contract as it is a payment-in-kind contract, with the
uncertain event being whether the boiler will break down and the policyholder will be adversely
affected.
Examples which are not insurance contracts
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;
• Contingent consideration that has arisen as a result of a business combination; and 12
• Insurance contracts that the entity holds as policyholder.
5.3 Recognition and measurement

IFRS 4 exempts an insurer temporarily (during phase one of the IASB's insurance project) from the need
to consider the IASB Framework in selecting accounting policies for insurance contracts where there is
no specific accounting requirement set out in another international Standard (IFRS 4.13, through its
reference to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors). However, IFRS 4
expressly:
• 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.
Liability adequacy test

An insurer recognises its insurance liabilities at each reporting date based on the current estimate of
future contractual cash flows, and related items such as handling costs, arising under the insurance
contracts.
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.

The liability adequacy test considers all contractual cash flows under current insurance contracts, and
related costs, such as claims handling costs. Where there are embedded options or guarantees within a
contract, any cash flows arising should also be included in the assessment. Where an entity has
deferred acquisition costs and related intangible assets such as those arising from an insurance based
business combination these should be deducted from the insurance liabilities.
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.
Worked example: Liability adequacy test

An insurance entity writes one-year policies for one of its classes of general insurance business and is
carrying the following amounts for that class in its draft statement of financial position at 31 December
20X5.
Liabilities CUm
Provision for claims – discounted value of likely claims for insured

losses occurring up to 31 December 20X5 75
Liability for unearned premiums – proportion of premiums for policies

already written which relates to cover in 20X6 30
Assets
Deferred acquisition costs – proportion of commission and other

business acquisition costs for policies already written which relate
to the unearned premiums 10
The effect of reinsurance is immaterial.
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.

5.4 Disclosures
IFRS 4 sets out an overriding requirement that the information to be disclosed in the financial statements
of an insurer 'identifies and explains amounts arising from insurance contracts'.
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
• The audit of investment properties should focus on: R
(a) Whether the property has been correctly classified;
(b) Whether the valuation is materially correct (either under the cost model or the FV model), and 12
(c) Whether the disclosure complies with IAS 40/IFRS 13.
6.1 General approach to auditing assets

You should be familiar with the auditing of tangible and intangible assets from the Certificate level
Assurance paper. If you do not feel confident in this area, we would recommend that you revise this
area.
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.
6.2 Auditing investment properties

Definition
Investment property: Property (land or a building – or part of a building – or both) held (by the owner or
by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
• Use in the production or supply of goods or services or for administrative purposes; or

• Sale in the ordinary course of business.
The following would be non-investment properties:
• Property held for sale in the ordinary course of business

• Property being constructed or developed on behalf of third parties
• Owner occupied property
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.

Audit evidence
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
• 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:
Property A This is used as the company head office

Property B This is held under a finance lease and is currently rented out to a non-
group company under an operating lease
Property C This was acquired in the year at a cost of CU3m including legal fees. It
is currently vacant but a tenant is being actively sought
Property D This has been owned by Propertyco Ltd for a number of years and is
currently rented out to a non-group company
Propertyco Ltd uses the fair value model in accordance with IAS 40. Currently all of the above properties
are recorded in the financial statements at fair value.
Requirements
Based on the information above:

(a) Identify the audit issues which the auditor would need to consider
(b) List the audit procedures you would perform regarding fair values
C
H
A
P
T
E
R
12

Summary

C
H
A
P
T
E
R
12

C
H
A
P
T
E
R
12
IAS 39

Self-test
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:
Number of motors held in inventory at 31 December 4,000 motors

Expected sales in the four months to 30 April 20X8 1,600 motors
Net selling price per motor sold to Bushbaby CU50
Net selling price per motor unsold at 30 April 20X8 CU10
Cost per motor CU25
Requirement
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?

IAS 16 Property, Plant and Equipment
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:
Component Useful life Cost

CU'000
Pump 5 years 110
Filter 4 years 240
Engines 15 years 450
Under the terms of the 15-year licence agreement for the use of the machinery, the engines (but
not the other components) were to be dismantled at the end of the licence period. The machinery
contained three engines, and dismantling costs for all three engines were initially estimated at a
total cost of CU480,000 (ie CU160,000 per engine) payable in 15 years' time. Oruatua's discount
rate appropriate to the risk specific to this liability is 7% per annum.
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.
(a) The carrying amount of the machinery at 31 December 20X6

(b) The profit/loss on the disposal of the faulty engine
(c) The carrying amount of the machinery at 31 December 20X7

IAS 36 Impairment of 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.

Requirement
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
Determine the following amounts in respect of Acetone's consolidated financial statements at

31 December 20X7 according to IAS 36 Impairment of Assets.
(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
IAS 38 Intangible Assets
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:
Remaining period over which Value in active

Copyright cost at publication is expected to market at 31
Publication name 1 January 20X7 generate cash flows at 1 December 20X7
January 20X7
Dominoes CU900,000 6 years CU700,000
Billiards CU1,200,000 16 years CU1,150,000
Skittles CU1,700,000 8 years Unknown
Darts CU1,400,000 Indefinite CU2,100,000
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?

10 Lewis
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.
The cost of these assets can be measured reliably.
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
The following issues have arisen within a diversified group of businesses.
(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.

During 20X4 Piperazine incurred CU70,000 on the process of preparing an application for licences
for 15 taxis to operate in a holiday resort where, in order to prevent excessive traffic pollution, the
licensing authority only allowed a small number of taxis to operate. The outcome of its application
was uncertain up to 30 November 20X4 when the local authority accepted its application. In
December 20X4 Piperazine incurred a total cost of CU9,000 in registering its licences. The licences
were for a period of nine years from 1 January 20X5. The licences are freely transferable and an
active market in them exists. The fair value of the licences at 31 December 20X4 was CU9,450 per
taxi and Piperazine carried them at fair value in its statement of financial position at 31 December
20X4.
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
IAS 40 Investment Property
14 Which of the following properties fall under the definition of investment property and therefore 12
within the scope of IAS 40 Investment Property?
(a) Property occupied by an employee paying market rent

(b) A building owned by an entity and leased out under an operating lease
(c) Property being constructed on behalf of third parties
(d) Land held for long-term capital appreciation
15 Boron
The Boron Company is an investment property company. On 31 December 20X6 it purchased a

retirement home as an investment at a cost of CU600,000. Legal costs associated with the
acquisition of this property were a further CU50,000.
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
The Acimovic Company is an investment property company. It acquired an industrial investment

property on 31 December 20X6 from The Tyrant Company, a finance house, on a long lease which
is a finance lease in accordance with IAS 17 Leases. The following information is available.
At 31 December 20X6 20X7

CU CU
Present value of minimum payments under the lease 740,000 720,000
Fair value of the property interest 840,000 875,000
Fair value of the property 790,000 890,000
The property has a useful life of 40 years from 31 December 20X6.
Requirement

What amount should appear in the statement of profit or loss and other comprehensive income of
Acimovic in the year ending 31 December 20X7 in respect of the property under IAS 40 Investment
Property?
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 following market data is available in respect of the sheep.

Type of animal At 30 June 20X7 At 31 December 20X7
Fair value per animal Fair value per animal
CU CU
Newborn 22 23
6 months old 25 26
The animal fair values are based upon transactions prices in the local markets. Auctioneers'
commission is 1.5% of the transaction price and the government sales levy is 0.5% of that price.
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?

IFRS 4 Insurance Contracts
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
Explain how these contracts should be accounted for.
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?
IFRS 6 Exploration for and Evaluation of Mineral Resources
25 Give examples of circumstances that would trigger a need to test an evaluation and exploration
asset for impairment.

Technical reference
• Recognition IAS 16.7

• Initial costs IAS 16.11
• Subsequent costs IAS 16.12
• Measurement at recognition IAS 16.15
• Measurement after recognition IAS 16.29
C
• Derecognition IAS 16.67–72
H
• Disclosure IAS 16.73–79
A
IAS 38 Intangible Assets P
T
• Scope IAS 38.2 E
• Definitions IAS 38.8 R
• Intangible assets IAS 38.9–10
• Identifiability IAS 38.11–12
12
• Control IAS 38.13
• Future economic benefits IAS 38.17
• Recognition and measurement IAS 38.18–67
• Recognition of an expense IAS 38.68
• Measurement after recognition IAS 38.72
• Cost model IAS 38.74
• Revaluation model IAS 38.75–87
• Useful life IAS 38.88–96
• Intangible assets with finite useful lives IAS 38.97–106
• Intangible assets with indefinite useful lives IAS 38.107–110
• Recoverability of the carrying amount – impairment losses IAS 38.111
• Retirements and disposals IAS 38.112
• Disclosure IAS 38.118
IAS 2 Inventories
• Measurement and disclosure but not recognition IAS 2.1
• Measured at lower of cost and net realisable value IAS 2.9
• 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
– fixed costs included by reference to normal levels of activity IAS 2.13
• Cost formula: FIFO or Weighted average IAS 2.25
• NRV includes costs to complete and selling costs IAS 2.6
• Disclosures include accounting policies, carrying amounts and amounts IAS 2.36–38
recognised as an expense

1 Indications
• At each reporting date assess whether indication of impairment: IAS 36.9
– If so, estimate recoverable amount (RA)

– RA is higher of fair value less costs to sell and value in use (present IAS 36.6
value of future cash flows in use and on disposal)
– Review both external and internal information for evidence of IAS 36.12
impairment
• Impairment loss where carrying amount exceeds RA IAS 36.59
2 Fair value less costs to sell
• 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
• Examples of disposal costs IAS 36.28
3 Value in use
• Calculation involves the estimation of future cash flows as follows: IAS 36.39
– Cash flows from continuing use

– Cash flows necessarily incurred to generate cash inflows from
continuing use
– Net cash flows receivable/payable on disposal
• These should reflect the current condition of the asset IAS 36.44
• The discount rate should reflect:
– The time value of money IAS 36.55

– Risks specific to the asset for which the future cash flow estimates
have not been adjusted.
4 Cash-generating units
• Estimate recoverable amount of CGU if not possible to assess for an IAS 36.66
individual asset
• Identification of an asset's CGU involves judgement IAS 36.68
• Goodwill should be allocated to each of the acquirer's CGUs that are IAS 36.80
expected to benefit
• Goodwill that cannot be allocated to a CGU on a non-arbitrary basis is IAS 36.81

allocated to the group of CGUs to which it relates
• Annual impairment review required for any CGU which includes goodwill IAS 36.90
• Corporate assets should be allocated on a reasonable and consistent IAS 36.102

basis
5 Impairment losses
• 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
• An impairment loss for a CGU should be allocated: IAS 36.104
– To goodwill then
– To all other assets on a pro-rata basis

• When a CGU is a non-wholly owned subsidiary AND non-controlling IAS 36 (Appendix C)
interest is measured at acquisition date at share of net assets, notionally
gross up goodwill for that part attributable to the non-controlling interest
6 Reversals
• An impairment loss recognised for goodwill should not be reversed IAS 36.124
7 Disclosures
• All impairments IAS 36.126

• For a material impairment on an individual asset IAS 36.130
• For a material impairment on a CGU IAS 36.130
1 IAS 40 Investment Property C

Definition of investment property IAS 40.5 H
A
Definition of fair value IFRS 13.9 P
Property held by lessee under operating lease may be investment IAS 40.6 T
property E
R
IAS 40.33-35, IAS
Fair value model
40.38
Cost model IAS 40.56 12
Scope IAS 41.1
Agricultural activity IAS 41.5, 8

– Biological assets
– Agricultural produce at the point of harvest
– Government grants
Recognition and measurement IAS 41.10, 12-13
Gains and losses IAS 41.26, 28
Government grants IAS 41.34–35
IAS 41.40, 41, 46-50,
Disclosure
54–57
3 IFRS 6 Exploration For and Evaluation of Mineral Resources
Scope IFRS 6.3–5
Measurement at recognition IFRS 6.8–11
Measurement after recognition IFRS 6.12
Changes in accounting policies IFRS 6.13
Impairment IFRS 6.18
Objective IFRS 4.1
Scope IFRS 4.2–6
Embedded derivatives IFRS 4.7–9
Liability adequacy test IFRS 4.15

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).

(b) The loss on disposal is (per IAS 16.71) the difference between the carrying amount of an
individual engine at 1 January 20X7 of CU194,118 (CU623,952 / 3 × 14/15)) and the scrap
sale proceeds of CU40,000, to give a loss of CU154,118.
(c) The replacement engine is capitalised at cost of CU226,170 (CU168,000 + CU150,000 x

0.3878), and then depreciated over the remaining length of the licence of 14 years. The
carrying amount of the asset at 31 December 20X7 is therefore CU756,521 (CU110,000 × 3/5)
+ (CU240,000 × 2/4) + (CU623,952 × 2/3 × 13/15) + (CU226,170 × 13/14).
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
amount is recognised through profit or loss. Thus: P

T
• The carrying amount at 31 December 20X2 is 45/50 × CU5.0m = CU4.5m. E
R
• The revaluation reserve created is CU3.5m (ie CU8.0m – CU4.5m)
• The carrying amount at 31 December 20X7 is 40/45 × CU8.0m = CU7.1m

12
• The recoverable amount at 31 December 20X7 is CU2.9m.
• The total impairment charge is CU4.2m (ie CU7.1m – CU2.9m).
• 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.
Thus revenues are 4,000 × CU1,500 = CU6,000,000
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:
Carrying amount under original conditions = CU10m × 16/20 years = CU8.0m.
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

CU600,000 – (80% × CU400,000) 280,000
Notional goodwill (CU280,000 × 20/80) 70,000
750,000
(b) The impairment loss is the total CU750,000 less the recoverable amount of CU520,000 =
CU230,000. Under IAS 36.104 this is firstly allocated against the CU350,000 goodwill. (As the
impairment loss is less than the goodwill, none is allocated against identifiable net assets.) As
only the goodwill relating to Acetone is recognised, only its 80% share of the impairment loss
is recognised:

CU
Carrying value of goodwill 280,000
Impairment (80% × 230,000) (184,000)
Revised carrying amount of goodwill 96,000
(c) CU
Carrying amount of Maclulich's net assets 700,000
Recognised goodwill 205,000
Notional goodwill (15/85 × CU205,000) 36,176
941,176
Recoverable amount (660,000)
Impairment loss 281,176
C
Allocated to: H
Recognised and notional goodwill 241,176 A
Other net assets 40,000 P
T
Therefore the non-controlling interest is (CU700,000 – CU40,000) × 15% = CU99,000.
E
IAS 38 Intangible Assets R
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.
The total charge is CU672,500.
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).

11 Diversified group
(a) Not an intangible

(b) An intangible
(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).
IAS 40 Investment Property
14 (b) and (d) fall under the definition of investment property
(b) A building owned by an entity and leased out under an operating lease
(d) Land held for long-term capital appreciation
IAS 40.8 and 9 give examples of types of investment property.

15 Boron
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.
So the change in fair value is CU700,000 – (CU600,000 + CU50,000) = CU50,000.
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.
Thus CU1,250,000 – (CU80,000 × 4/10) + CU140,000 = CU1,358,000
18 Ramshead
(a) CU250,000 gain

(b) CU575,000 gain
(c) CU540,000 decrease
(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

sales proceeds of CU3.535m less CU3.5m = CU35,000. This is a reduction of CU540,000 on
the cost model gain.
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)).
Total gain is CU8,892.
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).
The statement of financial position carrying amount per sheep is:

CU
Fair value 90.00
Costs to sell (CU90 × 5%) + CU2.00 (6.50)
Value per sheep 83.50
For the flock of 400 sheep, the amount is CU33,400.
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
There is, therefore, a gain on the flock of 500 sheep of CU5,700.
22 Monkey
(a) CU86,000 loss on initial recognition

(b) CU686,000 gain on subsequent measurement

(a)
CU'000
Cost of herd 1,800
Recognised at FV – costs to sell (CU1.8m – fees (CU1.8m × 2%) – Gvnmt fee (1,714)
CU50,000)
Initial loss on recognition 86
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
IFRS 4 Insurance Contracts
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
The entity is permitted to continue with both policies.
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.
IFRS 6 Exploration for and Evaluation of Mineral Resources
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.


(a) The double entry is:
Dr Asset value (statement of financial position) CU7,000

Cr Profit or loss CU2,000
Cr Revaluation surplus (other comprehensive income) CU5,000
The case is similar for a decrease in value on revaluation. Any decrease should be recognised as
an expense, except where it offsets a previous increase taken as a revaluation surplus in other
comprehensive income. Any decrease greater than the previous upwards increase in value must
be recorded as an expense in profit or loss.
(b) The double entry is:
Dr Revaluation surplus (other comprehensive income) CU5,000

Dr Profit or loss CU2,000
Cr Asset value (statement of financial position) CU7,000
There is a further complication when a revalued asset is being depreciated. An upward
revaluation means that the depreciation charge will increase. Normally, a revaluation surplus is only
realised when the asset is sold, but when it is being depreciated, part of that surplus is being
realised as the asset is used. The amount of the surplus realised is the difference between
depreciation charged on the revalued amount and the (lower) depreciation which would have been
charged on the asset's original cost. This amount can be transferred to retained (ie realised)
earnings but not through profit or loss.
(c) On 1 January 20X8 the carrying value of the asset is CU10,000 – (2 × CU10,000 ÷ 5) = CU6,000.
For the revaluation:
Dr Asset value (statement of financial position) CU6,000

Cr Revaluation surplus (other comprehensive income) CU6,000
The depreciation for the next three years will be CU12,000 ÷ 3 = CU4,000 compared to
depreciation on cost of CU10,000 ÷ 5 = CU2,000. Each year the extra CU2,000 is treated as
realised and transferred to retained earnings:
Dr Revaluation surplus CU2,000

Cr Retained earnings CU2,000
This is a movement within reserves, not an item in profit or loss.

The total cost attributable to Product 1 is calculated as:
CU140,000 + CU37,000 + (60% × CU50,000) = CU207,000
The cost per unit therefore being CU207,000 / 690 = CU300 each.
The total cost attributable to Product 2 is:
CU160,000 + CU45,000 + (40% × CU50,000) = CU225,000
The cost per unit therefore being CU225,000 / 900 = CU250 each.
The allocation of the cost for Product 2 is therefore:
CU250 × 675 = CU168,750 as inventories

CU250 × 225 = CU56,250 as an expense
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.

CU
Cost (being lower than NRV) 36,000
Depreciation (CU36,000/3 years) (12,000)
24,000
(a) Common examples of intangible assets are:
• 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.

12
The fair value less costs to sell of the plant is below its carrying value so it may be impaired. It is now
necessary to find the value in use in order to determine whether an impairment has occurred and to
quantify any impairment loss.
Year Discounted future

Future cash flows PV factor at 15% cash flows
CU'000 CU'000
1 230 0.86957 200
2 211 0.75614 160
3 157 0.65752 103
4 104 0.57175 59
5 233 0.49718 116
638
To calculate the impairment loss, compare the carrying value of CU749,000 with the higher of value in
use (CU638,000) and fair value less costs to sell (CU550,000). The impairment loss is therefore
CU749,000 – CU638,000 = CU111,000.

The key issue is whether the cash-generating unit produces cash flows which are independent of other
assets or not.
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:
(b) A branch of a pizza restaurant in Warsaw
(d) A commuter monorail
(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).

(a) (b)
CUm CUm
Recognised goodwill 90 90
Notional goodwill (CU90m × 40/60) 60 60
Carrying amount of net assets 550 550
700 700
Recoverable amount 510 570
Impairment loss 190 130
Allocation of impairment loss:
CUm CUm
Recognised goodwill cognised goodwill 90 90
Notional goodwill 60 40
Other assets pro rata 40 –
190 130
Carrying value after impairment:
CUm CUm
Goodwill (90 – (150 × 60%))/(90 – (130 × 60%)) – 12
Other net assets (550 – 40) 510 550
510 562

(a) The factory is not an investment property. It should be classified as property held for sale and
accounted for under IFRS 5.
(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.

(1) The CU5 million value could be used as a basis of fair value, because the price was agreed
between market participants.
(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.

The cost model CUm
(a) Net proceeds 6.00
Carrying amount CU5,500,000 × 47/50 (5.17)
Profit on sale 0.83
The fair value model CUm

(b) Net proceeds 6.0
Fair value (6.2)
Loss on sale (0.2)
Answer to Interactive question 11 C
H
The changes of use will be reflected in the financial statements based on whether the entity uses the
A
cost model or the fair value model for investment properties as follows.
P
The cost model for investment properties T
E
At 31 December 20X5, the building has a carrying amount of:
R
CU5.5m × 45/50 years = CU4.95 million in accordance with IAS 16.
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.
At 31 December 20Y0, the building has a carrying amount of:
CU4.95m × 40/45 years = CU4.4 million in accordance with IAS 40.
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.
The fair value model for investment properties
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.

(1) CU1 million is derecognised being the depreciated cost of the replaced system:
CU1.2 million × (25/30 years)
(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

The carrying amount of the failed system should be derecognised:
Carrying amount is CU100,000 (CU400,000 less six years' depreciation at 12.5%)
and the replacement system should be recognised:
Total carrying amount of the office building is CU3,500,000
(CU3m – CU100,000 + CU600,000)

The entity recognises these transactions and events as follows.
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
The insurance proceeds of CU3.9 million are recognised in profit or loss.
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.

(a) Wool: Agricultural produce
(b) Vines: Biological assets
(c) Sugar: Products that are the result of processing after harvest

(a) Commission to brokers
(b) Transfer taxes and duties
Commissions to brokers and transfer taxes and duties are recognised costs to sell in the Standard.

(a) Audit issues
(i) Classification as an investment property
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
• Review any documentation to support assumptions
• Agree level of disclosure is in accordance with IAS 40/IFRS 13

562
CHAPTER 13
C
Reporting of non-financial liabilities H
A
P
T
E
R
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
Technical reference
Reporting of non-financial liabilities 563

Introduction
• 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
of details
Specific syllabus references for this chapter are: 1(e), 3(a), 3(b) 14(c), 14(d), 14(f)

1 IAS 10 Events After the Reporting Period
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.
1.1 Overview of earlier studies

Events after the reporting period are split into adjusting and non-adjusting events.
Adjusting events after the reporting period
Adjusting events are events that provide evidence of conditions that existed at the reporting date, and
the financial statements should be adjusted to reflect them. Examples include:
• Settlement of a court case that confirms that the entity had an obligation at the reporting date
• Evidence that an asset was impaired at the reporting date eg:
– Bankruptcy of a customer
– Selling prices achieved for inventory
C
• Determination of profit-sharing or bonus payments relating to the year H
• Finalisation of prices for assets sold or purchased before year end A
P
• The discovery of fraud or errors (where material) that show that the financial statements are T
misstated
E
• An adjustment to the disclosed earnings per share for transactions such as bonus issues, share R
splits or share consolidations where the number of shares altered without an increase in resources.
The additional shares are thus treated as having been in issue for the whole period.
Non-adjusting events after the reporting period 13
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.

Going concern basis
• Financial statements are prepared on the 'going-concern' basis. Where an entity goes into
liquidation after the reporting date, it is no longer considered to be a going concern and the
financial statements should not be prepared on this basis.
• Where the going-concern basis is clearly not appropriate, a basis other than the going concern
basis should be adopted, for example the 'break-up basis'. The break-up basis measures the
assets at their recoverable amount in a non trading environment, and a provision is recognised for
future costs that will be incurred to 'break-up' the business.
• Where the financial statements are not prepared on a going-concern basis, this should be fully
disclosed, along with the actual basis of preparation used.
• Management is required to make an explicit assessment of the entity's ability to continue as a going
concern by considering a number of financial, operating and other indicators. Indicative of inability
to continue as a going concern would be major restructuring of debt, adverse key financial ratios,
substantial sale of non-current assets not intended to be replaced, loss of key staff or major
markets.
The period of review
• The cut-off date for the consideration of events after the reporting period is the date on which the
financial statements are authorised for issue. Events that occur after the reporting date but before
the financial statements are authorised for issue need to be considered, regardless of what
financial information has been made publicly available during this period.
• Normally the financial statements are authorised by the directors before being issued to the
shareholders for approval; the authorisation date is the date these are authorised for issue to the
shareholders, and not the date they are approved by the shareholders.
• Where a supervisory board is made up wholly of non-executive directors, the financial statements
will first be authorised by the executive directors for issue to that supervisory board for its approval.
The relevant cut-off date for the review of events that have occurred after the reporting date is the
date on which the financial statements are authorised for issue to the supervisory board.
• The date on which the financial statements were authorised for issue should be disclosed, since
events occurring after that date will not be reflected in the financial statements.
Treatment of errors
• Errors identified before the authorisation date will be adjusted in the current financial statements.
Those identified after the financial statements have been published, should be dealt with in a
subsequent period under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
IAS 8 requires an error relating to a prior period to be treated as an adjustment to the comparative
information presented in the subsequent financial statements.
• If a significant event occurs after the authorisation of the financial statements but before the annual
report is published, the entity is not required to apply the requirements of IAS 10. However, if the
event was so material that it affects the entity's business and operations in the future, the entity
may wish to discuss the event in the narrative section at the front of the Annual Review but outside
of the financial statements themselves.
Equity dividends
• These should only be recognised as a liability where they have been declared before the reporting
date, as this is the date on which the entity has an obligation. Where equity dividends are declared
after the reporting date, this fact should be disclosed but no liability recognised at the reporting
date.
Further points to note
Information on customers and suppliers
• Information after the reporting date on either a customer or supplier may not only affect amounts
that have been recorded in the financial statements but also impact on the future trading of the
entity.
• This should be assessed and disclosure made if the liquidation of a major customer or supplier is
likely to influence the economic decisions of users of the financial statements.

• Significant customer and supplier relationships are fundamental where an entity relies on one major
supplier. An example of a significant supplier/customer relationship is Intel Corporation and Dell
Inc, where until recently Dell computers have used only Intel microprocessors. Dell relies almost
totally on the ongoing supplier/customer relationship with Intel, and the success of Intel is vitally
important to the future trade of Dell itself.
Contingent liabilities
Evidence may come to light regarding a contingent liability or provision that an entity was unaware of at
the reporting date. The distinction between a contingent liability and a provision is discussed in IAS 37
Provisions, Contingent Liabilities and Contingent Assets. An example of an unknown provision is where,
because of a major fault with goods which were purchased before the reporting date, an electrical retail
chain has had the goods returned after the reporting date. The fault may raise safety issues and the
retailer may have to recall all such items sold within a period of time in order to repair the fault. In such
circumstances, a provision should be recognised for the repair of all items that have been sold prior to
the reporting date. The entity may not have been aware of the problem at the reporting date, but as it
existed at that date, a provision should be recognised in light of the new information.
Interactive question 1: Various events [Difficulty level: Easy]

The Roach Company is completing the preparation of its draft financial statements for the year ended
31 May 20X6.
On 24 July 20X6, an equity dividend of CU200,000 was declared and a contractual profit share payment
of CU35,000 was made, both based on the profits for the year to 31 May 20X6.
C
On 20 June 20X6, a customer went into liquidation having owed the company CU31,000 for the past six
H
months. No provision had been made against this debt.
A
On 17 July 20X6, a manufacturing plant was destroyed by fire resulting in a financial loss of CU200,000. P
Requirement T
E
According to IAS 10 Events After the Reporting Period, which amounts should be recognised in Roach's
R
financial statements for the year to 31 May 20X6 to reflect adjusting events after the reporting period?
13
Interactive question 2: Significant events [Difficulty level: Easy]

An entity's draft financial statements for the year ended 31 December 20X3 were completed on 30 May
20X4, approved by the finance director on 7 June 20X4, authorised for issue on 20 June 20X4 and
approved by the shareholders on 5 July 20X4.
The following events occurred after the reporting date (assume all amounts are significant to the entity):
(1) Notification on 18 Feb 20X4 that a customer owing CU100,000 as at 31 December 20X3 has gone
into liquidation. The financial statements already include a specific provision of CU20,000 for this
customer and the entity does not make general provisions.
(2) A rights issue on 6 April 20X4 to raise CU1,500,000 for an acquisition.
(3) Confirmation on 28 May 20X4 from the entity's insurer that they will pay CU500,000 for inventories
that were destroyed in a fire on 24 December 20X3. The entity had claimed CU650,000 and
included this as a receivable in the financial statements.
Requirement
How should the entity treat these events in its financial statements?

Interactive question 3: Dividends proposed and declared [Difficulty level: Easy]
The recent financial calendar of an entity with a 31 December year end, has included the following:
Authorised by directors Approved in annual
for issue general meeting
Financial statements for 20X2 28 February 20X3 3 May 20X3
Financial statements for 20X3 28 February 20X4 4 May 20X4
Dividends on ordinary Proposed by Declared by Approved in annual general

shares directors directors meeting
20X2 final 28 Feb 20X3 no yes
20X3 interim 31 Aug 20X3 yes no
20X3 final 28 Feb 20X4 no yes
Requirement
How will the dividends be dealt with in the entity's financial statements?
2 IAS 37 Provisions, Contingent Liabilities and Contingent

Assets
Section overview
• The following is a summary of the material covered in earlier studies.
2.1 Overview of 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.

Contingent liability
• A contingent liability arises where a past event may lead to an entity having a liability in the future
but the financial impact of the event will only be confirmed by the outcome of some future event not
wholly within the entity's control.
• A contingent liability should be disclosed in the financial statements unless the possible outflow of
resources is thought to be remote.
Contingent asset
• A contingent asset is a potential asset that arises from past events but whose existence can only
be confirmed by the outcome of future events not wholly within an entity's control.
• A contingent asset should be disclosed in the financial statements only when the expected inflow of
economic benefits is probable.
Reimbursement
• An entity may be entitled to reimbursement from a third party for all or part of the expenditure
required to settle a provision. In these circumstances, an entity generally retains the contractual
obligation to settle the expenditure. A provision and reimbursement are therefore recognised
separately in the statement of financial position. A reimbursement should be recognised only when
it is virtually certain that an amount will be received.
Recognition and disclosure
• A full reconciliation of movements in provisions should be presented in the financial statements.
C
Detailed narrative explanations should also be provided in relation to provisions, contingent
liabilities and contingent assets. The narrative should include an estimate of the financial amount in H
relation to contingent liabilities and assets as well as indications of uncertainties. A
P
• The required disclosures have already been covered at Professional level. In particular, in relation
T
to discounting, any increase in the value of the discounted amount arising from the passage of time
E
or the effect of any change in the discount rate need to be disclosed.
R
Disclosure let out
• IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions, contingent
liabilities and contingent assets if they would be expected to be seriously prejudicial to the 13
position of the entity in dispute with other parties. However, this should only be employed in
extremely rare cases. Details of the general nature of the provision/contingency must still be
provided, together with an explanation of why it has not been disclosed.
Discounting to present value
• Where the time value of money is material, the amount of provision should be the present value of
the expenditures required to settle the obligation. The main types of provision where the impact of
discounting may be significant are those relating to decommissioning and other environmental
restoration liabilities. For most other provisions, no discounting will be required as the cash flows
are not sufficiently far into the future.
• The discount rate to be used should reflect current market assessments of the time value of money
and the risks specific to the liability (ie it would be a risk adjusted rate). In practice it may be more
appropriate to use a risk-free rate and adjust the cash flows for risk. For further guidance on the
risk-free rate you may refer to your Business Analysis Study Manual. Whichever method is
adopted, it is important not to double count risk.
Unwinding the discount
• Where discounting is used, the carrying amount of the provision increases each period to reflect
the passage of time and this is recognised as a finance cost in profit or loss.
Interactive question 4: Constructive obligation [Difficulty level: Intermediate]

On 25 September 20X7, further to a decision made earlier in the year by the Board of directors,
Industrial Ltd announced publicly a decision to reduce the level of harmful emissions from its
manufacturing plants.

The directors had reached their decision to proceed with the project after appraising the investment
using discounted cash flow techniques and an annual discount rate of 8%.
The directors estimated that the future cash payments required to meet their stated objective would be:
• CU20 million on 30 September 20X8
• CU25 million on 30 September 20X9
• CU30 million on 30 September 20Y0
No contracts were entered into until after the start of the new accounting year on 1 October 20X7,
however the entity has a reputation of fulfilling its financial commitments after it has publicly announced
them. Industrial included a provision for the expected costs of its proposal in its financial statements for
the year ended 30 September 20X7. The actual expenditure in September 20X8 was CU20 million as
expected.
The average remaining useful lives of the factories on 30 September 20X7 (the reporting date) was 30
years and depreciation is computed on a straight-line basis and charged to cost of sales.
Requirements
(a) Compute the appropriate provision in the statements of financial position in respect of the proposed
expenditure at 30 September 20X7 and 30 September 20X8, and explain why the directors
decided to recognise the provision.
(b) Compute the two components of the charge to profit in respect of the proposal for the year ended
30 September 20X8. You should explain how each component arises and identify where in the
statement of profit or loss and other comprehensive income each component is reported.
Interactive question 5: Unwinding the discount [Difficulty level: Intermediate]

A company has a present obligation at 31 December 20X0, which it expects to settle in four years' time
for CU200,000. It calculates that the present value of the obligation is CU136,603, discounted at 10%.
The unwinding of the discount in 20X1, 20X2, 20X3 and 20X4 is shown in the table below.
Provision
Cr
Cr Unwinding Cr
Balance discount Balance
b/f @10% c/f
1 Jan 31 Dec 31 Dec
CU CU CU
20X1 136,603 13,660 150,263
20X2 150,263 15,026 165,289
20X3 165,289 16,529 181,818
20X4 181,818 18,182 200,000
Requirement
What are the accounting entries for the above for 20X1?

Interactive question 6: Restructuring [Difficulty level: Intermediate]
(a) An entity has a 31 December year end. The directors approved a major restructuring programme
on 1 December 20X5 and announced the details on the entity's intranet and to the media on 2
December 20X5. The programme involves two stages.
Stage 1 Closure of three production lines during 20X6, the redundancy of 3,000 employees on
31 March 20X6, and the transfer during 20X6 of 500 employees to continuing parts of the
business. All associated costs would be settled during 20X6.
Stage 2 Probable closure of four more production lines during 20X7, with probable redundancies of
3,500 employees during 20X7. Other staff will be transferred to continuing businesses. All
associated costs would be settled during 20X7. Assume that the details of stage 2 were
formally confirmed on 1 November 20X6.
(b) The entity had some years ago signed a 'take or pay' contract with a supplier, in order to ensure the
reliable supply each year of 100,000 tonnes of critical raw materials to each of the seven
production lines affected by the restructuring programme. Under the contract, the entity must pay
for the 700,000 tonnes each year, even if it decides not to take delivery. This contract falls due for
renewal on 1 January 20X8.
Requirement
How should these matters be recognised in the statement of profit or loss and other comprehensive
income?
C
H
A
Interactive question 7: Obligation to dismantle [Difficulty level: Intermediate]
P
A company is awarded a contract to build and operate a nuclear power station on 1 January 20X1. The T
power station comes into operation on 31 December 20X3 and the operating licence is for 30 years from E
that date. R
The construction cost of the power station was CU450m. Part of the agreement for the contract was that
in addition to building and operating the power station, the company is obliged to dismantle it at the end
of its 30-year life and make the site safe for alternative use. At 31 December 20X3, the estimated cost of 13
the obligation was CU50m.
An appropriate discount rate reflecting market assessments of the time value of money and risks specific
to the power station is 8%.
Requirement
Explain the treatment of the cost of the power station and obligation to dismantle it as at 31 December
20X3 and for the year ended 31 December 20X4.
Work to the nearest CU0.1m.
3 Current issues
Section overview
• This section covers proposed changes to IAS 37.
3.1 Proposed amendments to IAS 37

An Exposure Draft issued in June 2005 proposed amendments to IAS 37. These were supplemented
by a further Exposure Draft in January 2010. A full replacement of IAS 37 is expected.

(a) The Standard would be re-named 'Liabilities' and be extended to include all liabilities not covered
by other Standards.
(b) The terms contingent liability and contingent asset would be removed, and unconditional and
conditional obligations introduced.
(c) Expected values would be used.
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.
3.2 Scope and terminology

IAS 37 defines a provision as a liability of uncertain timing or amount. The ED does not use the
term provision, but proposes the use of the term 'liability' as defined above. This includes items
previously described as provisions, but also all other liabilities not covered by other Accounting
Standards.
3.3 Contingent liabilities

3.3.1 IAS 37 treatment
IAS 37 defines a contingent liability as a possible obligation or a present obligation that is not
recognised. A contingent liability could be a present obligation that is not recognised either because it is
not probable that an outflow of resources will be required to settle the obligation or because the amount
of the obligation cannot be measured with sufficient reliability. The Standard does not permit contingent
liabilities to be recognised but requires them to be disclosed, unless the possibility of any outflow of
economic resources in settlement of the contingent liability is remote.
3.3.2 The proposals

The ED proposes changing the treatment as follows:
• The term 'contingent liability' will be eliminated
• The term 'contingency' will be used to refer to uncertainty about the amount that will be required
to settle a liability rather than uncertainty about whether a liability exists. The 2010 Exposure Draft
clarified that liabilities will be (initially and subsequently) measured at the amount an entity would
rationally pay to be relieved of the present obligation
• The ED specifies that a liability for which the settlement amount is contingent on one or more
uncertain future events is recognised independently of the probability that the uncertain future
event(s) will occur (or fail to occur)
The purpose of these amendments is twofold:
• To clarify that only present obligations (rather than possible obligations) of an entity give rise to
liabilities and that liabilities arise from unconditional obligations
• To require uncertainty about future events that affect the amount that will be required to settle a
liability to be reflected in the measurement of the liability
3.4 Contingent assets

IAS 37 defines a contingent asset as a possible asset. It does not permit contingent assets to be
recognised, but requires them to be disclosed if an inflow of economic benefits is probable.

3.4.2 The proposals
The ED proposes changing the treatment as follows:
• The term 'contingent asset' would be eliminated.
• The term 'contingency' would be used to refer to uncertainty about the amount of the future
economic benefits embodied in an asset, rather than uncertainty about whether an asset exists.
The purpose of this amendment is to clarify that only resources currently controlled by the entity as a
result of a past transaction or event (rather than possible assets) give rise to assets, and that assets
arise from unconditional rights.
3.5 Constructive obligations

IAS 37 defines a constructive obligation as an obligation that derives from an entity's actions when the
entity has (a) indicated to other parties that it will accept particular responsibilities and (b) as a result has
created a valid expectation on the part of those other parties that it will discharge those responsibilities.
3.5.2 The ED proposals

• The definition of a constructive obligation will be amended to clarify that the actions of an entity
must result in other parties having a valid expectation that they can reasonably rely on the entity
to discharge its responsibilities.
C
• Additional guidance will be provided to help determine whether an entity has incurred a H
constructive obligation. A
P
3.6 Probability recognition criterion T
E
The ED proposes omitting the probability recognition criterion (currently in IAS 37) from the
R
Standard because, in all cases, an unconditional obligation satisfies the criterion. Therefore, items that
satisfy the definition of a liability are recognised unless they cannot be measured reliably.
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.
Worked example: Product warranty

In the case of a product warranty, the question is not whether it is probable that the entity will be
required to repair or replace the product. Rather, the question is whether the entity's unconditional
obligation to provide warranty coverage for the duration of the warranty (ie to stand ready to honour
warranty claims) will probably result in an outflow of economic benefits.
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.

For future services (eg decommissioning), outflows are based on contractor prices. The exception is for
onerous contracts, where the amount to be used is the amount the entity, rather than the contractor,
would pay.
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.
3.9 Onerous contracts

The ED provides additional recognition guidance relating to onerous contracts. The amount to be used is
the amount the entity, rather than the contractor, would pay.
3.10 Restructuring provisions

IAS 37 states that an entity that (a) has a detailed formal plan for restructuring and (b) has raised a valid
expectation in those affected that it will carry out the restructuring has a constructive obligation.
Therefore, it recognises a liability for the direct expenditures arising from the restructuring.
3.10.2 The ED proposals

The ED proposes the following changes.
• The application guidance will be revised to specify that a liability for a cost associated with a
restructuring is recognised only when the definition of a liability has been satisfied for that
cost. Accordingly, a cost associated with a restructuring is recognised as a liability on the same
basis as if that cost arose independently of a restructuring.
• More specific guidance will be given for costs associated with a restructuring.
3.11 Example of change from IAS 37

An entity is being sued for damages of CU15 million. Legal proceedings have started, but the entity
disputes liability. The entity estimates that it has a 20 per cent chance of losing the case. Under IAS 37,
the entity would disclose a contingent liability of CU15 million in the notes to the accounts. Under the
new proposals, the entity has an unconditional obligation to stand ready to pay the damages if awarded.
In this case, it would recognise a liability of CU3 million.
Worked example: Present obligation

Shortly before 31 December 20X0, a patient dies in a hospital as a result of a mistake made during an
operation. The hospital is aware that a mistake occurred. In these circumstances, the hospital's past
experiences and lawyer's advice indicate that it is highly likely that the patient's relatives will start legal
proceedings and, if the matter comes to court, that the hospital will be found guilty of negligence.
At the time that the financial statements are authorised for issue in early 20X1, the hospital has not
received notice of legal proceedings against it.
Explain the accounting treatment required, in terms of recognition or otherwise and measurement.
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.

4 Audit focus
Section overview
• Auditors will carry out specific procedures on provisions and contingencies.
4.1 Auditing provisions and contingencies

Much of the audit work here is focused on ensuring that the recognition and treatment of these items is
in accordance with IAS 37, which we looked at in sections 2 and 3 of this chapter.
The audit procedures that should be carried out on provisions and contingent assets and liabilities are as
follows.
• Obtain details of all provisions which have been included in the accounts and all contingencies
that have been disclosed
• Obtain a detailed analysis of all provisions showing opening balances, movements and closing
balances
• Determine for each material provision whether the company has a present obligation as a result
of past events by:
C
– Review of correspondence relating to the item H
– Discussion with the directors, have they created a valid expectation in other parties that they A
will discharge the obligation? P
• Determine for each material provision whether it is probable that a transfer of economic T
benefits will be required to settle the obligation by: E
R
– Checking whether any payments have been made after the end of the reporting period in
respect of the item
– Review of correspondence with solicitors, banks, customers, insurance company and
suppliers both pre and post year end 13
– Sending a letter to the solicitor to obtain their views (where relevant)

– Discussing the position of similar past provisions with the directors. Were these provisions
eventually settled?
– Considering the likelihood of reimbursement
• Recalculate all provisions made
• Compare the amount provided with any post-year end payments and with any amount paid in the
past for similar items
• In the event that it is not possible to estimate the amount of the provision, check that this
contingent liability is disclosed in the accounts
• Consider the nature of the client's business. Would you expect to see any other provisions, for
example, warranties?
• Consider whether disclosures of provisions, contingent liabilities and contingent assets are
correct and sufficient
4.2 Procedures regarding litigation and claims

4.2.1 Introduction
ISA 501 Audit Evidence – Specific Considerations for Selected Items provides guidance on procedures
regarding litigation and claims.
A summary of the procedures regarding litigation and claims is provided below.

4.2.2 Litigation and claims
Litigation and claims involving the entity may have a material effect on the financial statements, and so
will require adjustment to or disclosure in those financial statements.
The auditor shall design and perform procedures in order to identify any litigation and claims involving
the entity which may give rise to a risk of material misstatement.
Such procedures would include the following:
• Make appropriate inquiries of management and those charged with governance including
obtaining representations
• Review board minutes and correspondence with the entity's lawyers
• Examine legal expense account
• Use any information obtained regarding the entity's business including information obtained from
discussions with any in-house legal department
When litigation or claims have been identified or when the auditor believes they may exist, the auditor
must seek direct communication with the entity's lawyers.
This will help to obtain sufficient appropriate audit evidence as to whether potential material litigation
and claims are known and management's estimates of the financial implications, including costs, are
reliable.
Form of the letter of enquiry
The letter, which should be prepared by management and sent by the auditor, should request the lawyer
to communicate directly with the auditor.
If it is thought unlikely that the lawyer will respond to a general enquiry, the letter should specify the
following.
(a) A list of litigation and claims
(b) Management's assessment of the outcome of the litigation or claim and its estimate of the financial
implications, including costs involved
(c) A request that the lawyer confirm the reasonableness of management's assessments and provide
the auditor with further information if the list is considered by the lawyer to be incomplete or
incorrect
The auditors must consider these matters up to the date of their report and so a further, updating letter
may be necessary.
A meeting between the auditors and the lawyer may be required, for example where a complex matter
arises, or where there is a disagreement between management and the lawyer. Such meetings should
take place only with the permission of management, and preferably with a management representative
present.
If management refuses to give the auditor permission to communicate with the entity's lawyers or if the
lawyer refuses to respond as required and the auditor can find no alternative sufficient evidence, this
would mean that the auditor is unable to obtain sufficient appropriate evidence and should ordinarily lead
to a qualified opinion or a disclaimer of opinion.

Interactive question 8: Contingencies [Difficulty level: Intermediate]
In February 20X7 the directors of Newthorpe Engineering Ltd suspended the managing director. At a
disciplinary hearing held by the company on 17 March 20X7 the managing director was dismissed for
gross misconduct, and it was decided the managing director's salary should stop from that date and no
redundancy or compensation payments should be made.
The managing director has claimed unfair dismissal and is taking legal action against the company to
obtain compensation for loss of his employment. The managing director says he has a service contract
with the company which would entitle him to two years' salary at the date of dismissal.
The financial statements for the year ended 30 April 20X7 record the resignation of the director.
However, they do not mention his dismissal and no provision for any damages has been included in the
Requirements
(a) State how contingent liabilities should be disclosed in financial statements according to IAS 37
Provisions, Contingent Liabilities and Contingent Assets.
(b) Describe the audit procedures you will carry out to determine whether the company will have to pay
damages to the director for unfair dismissal, and the amount of damages and costs which should
be included in the financial statements.
Note. Assume the amounts you are auditing are material.
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

Self-test
IAS 10 Events After the Reporting Period
1 ABC International
ABC International Inc is a company that deals extensively with overseas entities and its financial
statements include a substantial number of foreign currency transactions. The entity also holds a
portfolio of investment properties.
Requirement
Discuss the treatment of the following events after the reporting date.
(a) Between the reporting date of 31 December 20X6 and the authorisation date of 20 March
20X7, there were significant fluctuations in foreign exchange rates that were outside those
normally expected.
(b) The entity obtained independent valuations of its investment properties at the reporting date
based on current prices for similar properties. On 15 March 20X7, market conditions which
included an unexpected rise in interest rates and the expectation of further rises resulted in a
fall in the market value of the investment properties.
(c) A competitor introduced an improved product on 1 February 20X7 that caused a significant
price reduction in the entity's own products.
2 Saimaa
The Saimaa Company operates in the banking industry. It is attempting to sell one of its major C
administrative office buildings and relocate its employees. H
Saimaa has found a potential buyer, The Nipigon Company, which operates a chain of retail stores. A
Nipigon would like to convert the building into a new retail store but would require planning P
permission for this change of use. Nipigon may, however, still consider purchasing the building and T
using it for its own administrative offices if planning permission is declined. It is estimated that there E
is approximately a 50% probability of planning permission being granted. R
A contract for sale of the building is to be drawn up in November 20X7 and two alternatives are
available:
Contract 1 This sale contract would be made conditional on planning permission being granted. 13
Thus the contract would be void if planning permission is not granted but it would
otherwise be binding.
Contract 2 This contract would be unconditional and binding, except that the price would vary
according to whether or not planning permission is granted.
The financial statements of Saimaa for the year to 31 December 20X7 are authorised for issue on
28 March 20X8. A decision on planning permission will be made in February 20X8.
Requirement
With respect to the financial statements of Saimaa for the year to 31 December 20X7, and
according to IAS 10 Events After the Reporting Period, indicate whether the granting of planning
permission on each of the contracts is an adjusting event.
3 Quokka
The Quokka Company manufactures balers for agricultural use. The selling price per baler, net of
selling expenses, at 31 December 20X7 is CU38,000. Due to increasing competition, however,
Quokka decides to reduce the selling price by CU5,000 on 3 January 20X8.
On 4 January 20X8 a health and safety report was delivered to Quokka by the government,
showing that some of its balers were toppling over on moderate gradients. CU9,000 per baler
would need to be incurred by Quokka to correct the fault. No further sales could be made without
the correction. Quokka had been unaware of any problem or health and safety investigation until
the report was delivered.
The financial statements of Quokka for the year to 31 December 20X7 are to be authorised for
issue on 23 March 20X8.

The cost of manufacture for each baler was CU36,000 and there were 80 balers in inventory at 31
December 20X7.
Requirement
After adjustment (if any) for the above events, what should be the carrying amount of the inventory
in the financial statements of Quokka at 31 December 20X7, in accordance with IAS 10 Events
After the Reporting Period, and IAS 2 Inventories?
4 Labeatis
The financial statements of the Labeatis Company for the year to 31 December 20X7 were
approved and issued with the authority of the board of directors on 6 March 20X8. The financial
statements were not, however, presented to the shareholders' meeting until 27 March 20X8.
The following events took place:
Event 1 On 18 February 20X8 the government announced a retrospective increase in the tax rate
applicable to Labeatis's year ending 31 December 20X7.
Event 2 On 19 March 20X8 a fraud was discovered which had had a material effect on the
financial statements of Labeatis for the year ending 31 December 20X7.
Requirement
State which event (if any) is an adjusting event according to IAS 10 Events After the Reporting
Period.
5 Scioto
The Scioto Company's financial statements for the year ended 30 April 20X7 were approved by its
finance director on 7 July 20X7 and a public announcement of its profits for the year was made on
10 July 20X7.
The board of directors authorised the financial statements for issue on 15 July 20X7 and they were
approved by the shareholders on 20 July 20X7.
Requirement
Under IAS 10 Events After the Reporting Period, after which date should consideration no longer
be given as to whether the financial statements to 30 April 20X7 need to reflect adjusting and non-
adjusting events?
IAS 37 Provisions, Contingent Liabilities and Contingent Assets
6 Fushia
The Fushia Company sells electrical goods covered by one-year warranty for any defects.
Of sales of CU60 million for the year, the company estimates that 3% will have major defects, 6%
will have minor defects and 91% will have no defects.
The cost of repairs would be CU5 million if all the products sold had major defects and CU3 million
if all had minor defects.
Requirement
What amount should Fushia provide as a warranty provision?
7 Wilcox
The Wilcox Company has been lead mining in Valovia for many years. To clean the lead, Wilcox
uses toxic chemicals which are then deposited back into the mines. Historically there has not been
any legislation requiring environmental damage to be cleaned up. The company has a policy of
only observing its environmental responsibilities when legally obliged.
In December 20X7, the government of Valovia introduced legislation on a retrospective basis,
forcing mining companies to rectify environmental damage that they have caused.
Wilcox estimates that the damage already caused will cost CU27 million to rectify, but the work
would not be paid for until December 20X9. It also estimates that damage caused by its operations
each year for the remaining four years of the mines' lifespan will be CU3 million, payable at the end
of the relevant year.

17% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
Requirement
To the nearest CU1 million, what provision should be shown in the statement of financial position of
Wilcox at 31 December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent
Assets?
8 Yau Enterprise
The Yau Enterprise Company signed a non-cancellable lease for a property, Hyde Court, on 1
January 20X4. The lease was for a period of 10 years, at an annual rental of CU480,000 payable in
arrears.
On 31 December 20X7, Yau Enterprise vacated Hyde Court to move to larger premises. Yau
Enterprise has the choice of signing a contract to sub-lease Hyde Court at an annual rental of
CU120,000 for the remaining six years of the lease, payable in arrears, or immediately to pay
compensation of CU2.2 million to Hyde Court's landlord.
5% is the pre-tax rate that reflects the time value of money and the risk specific to these liabilities.
The cumulative present value of CU1 for 6 years at an interest rate of 5% is CU5.076.
Requirement
What provision should appear in the statement of financial position of Yau Enterprise at 31
December 20X7 under IAS 37 Provisions, Contingent Liabilities and Contingent Assets?
9 Noble
C
The Noble Company operates a fleet of commercial aircraft. On 1 April 20X7 a new law was
H
introduced requiring all operators to use aircraft fitted with fuel-efficient engines only.
A
At 31 December 20X7 Noble had not fitted any fuel-efficient engines and the total cost of fitting P
them throughout the fleet was estimated at CU4.2 million.
T
Under the terms of the legislation, the company is liable for a fine of CU1 million for non- E
compliance with legislation for any calendar year, or part of a year, in which the law has been R
broken. The government rigorously prosecutes all violations of the new law.
The effect of the time value of money is immaterial.
13
Requirement
State the provision required in Noble's financial statements for the year ended 31 December 20X7
under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
10 Noname
The Noname Company decided to carry out a fundamental restructuring of its papermaking division
which operates in Hyberia. The effect was that most activities carried out in this location would
cease with a number of employees being made redundant, whereas other activities and employees
would relocate to Sidonia where there was unused capacity. Negotiations with landlords and
employee representatives were concluded on 30 December 20X7 and a formal announcement was
made to all employees on 31 December 20X7.

The restructuring budget approved by the board of directors in November 20X7 included the
following amounts:
CU
Payments to employees:
Termination payments to those taking voluntary redundancy 90,000
Termination payments to those being made compulsorily redundant 180,000
One-off payments to employees agreeing to move to Sidonia 37,000
Employment cost for closing down activities in Hyberia in preparation 50,000
for the move to Sidonia
Lease costs:
5 years remaining of a lease which can immediately be sublet for 45,000 per annum
CU70,000 per annum
7 years remaining of a lease which can immediately be sublet for 90,000 per annum
CU35,000 per annum
Cost of moving plant and equipment from Hyberia to Sidonia 26,000
Impairment losses on non-current assets under IAS 36 Impairment of 110,000
Assets
Trading transactions in Hyberia up to date of closure, other than those
itemised above:
Revenue 850,000
Expenses 1,150,000
None of these amounts has yet been recognised in Noname's financial statements. The effect of
the time value of money is immaterial.
Requirement
Determine the amounts to be included in the financial statements for the Noname Company for the
year ending 31 December 20X7 according to IAS 37 Provisions, Contingent Liabilities and
Contingent Assets.

Technical reference
IAS 10 Events after the Reporting Period
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
4 Going concern basis

• Financial statements are not to be prepared on going concern basis if IAS 10.14
management intends to liquidate entity or cease trading
• If going concern assumption no longer appropriate, disclosures required in IAS 10.16
accordance with IAS 1
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
• Scope IAS 37.1
• Definitions IAS 37.10
• Recognition of provisions IAS 37.14–15

• Contingent liabilities IAS 37.27
• Contingent assets IAS 37.31
• Measurement best estimate IAS 37.36
• Risks and uncertainties IAS 37.42
• Present value IAS 37.45–47
• Future events IAS 37.48
• Onerous contracts IAS 37.66
IAS 37.70–72
• Restructuring
IAS 37.78–80
ISA 501
• Audit procedures in respect of litigation and claims ISA 501.9–12

IAS 10 Events After the Reporting Period

1 ABC International
(a) Details of the abnormal fluctuations in exchange rates should be disclosed as a non-adjusting
event after the reporting period.
(b) The decline in the value of investment properties is a non-adjusting event as it does not reflect the
state of the market at the reporting date. The valuation should reflect the state of the market at the
reporting date and should not be affected by hindsight or events at a later date.
(c) The improved product issued by the competitor is likely to have been developed over a period of
time. The value of inventories should be reviewed and adjusted to their net realisable value where
appropriate. Non-current assets may need to be reviewed for possible impairment. This is an
adjusting event as it reflects increased competitive conditions which existed at the reporting date
even if the entity was not fully aware of them.
2 Saimaa
Contract 1 is a non-adjusting event. Contract 2 is an adjusting event.
Under IAS 10.3, events after the reporting period are those which occur after the reporting period but
before the financial statements are authorised for issue. The planning permission decision is such an
event, because it is to be made before the financial statements are to be authorised for issue on 28
C
March 20X8. Adjusting events are those providing evidence of conditions that existed at the reporting
date and non-adjusting events are those indicative of conditions that arose after that date. H
A
Under Contract 1, the uncertainty surrounding the contract at the reporting date would be such that no
sale could be recognised as at that date. So there is no transaction for which the planning permission P
decision could provide evidence and there would not be an adjusting event. T
E
Under Contract 2, there would be an unconditional sale recognised at the reporting date, with only the
consideration needing to be confirmed after the reporting date. According to IAS 10.9(c) the planning R
permission decision would provide additional evidence of the proceeds and would be an adjusting event.
3 Quokka
13
CU1,920,000
IAS 2.9 states that inventories should be stated at the lower of cost and NRV, and under IAS 10.9(b)(ii)
the sale of inventories after the reporting date may give evidence of NRV at the reporting date.
The 3 January price reduction is a response to competitive conditions which would have existed at the
reporting date. So even though it comes after the year end, it is an adjusting event. Similarly, the safety
report received after the year end relates to conditions at the year end (as the balers in inventories were
defective at this date) and is an adjusting event.
The carrying amount is 80 balers at the lower of cost (CU36,000) and NRV CU(38,000 – 5,000 – 9,000).
So 80 × CU24,000 = CU1,920,000
4 Labeatis
Event 1 is a non-adjusting event. Event 2 happened after the statements were authorised, so does not
constitute an event after the reporting period.
Applying IAS 10.3, events after the reporting period are those which occur after the 31 December 20X7
reporting date but before the financial statements are authorised for issue on 6 March 20X8.
Event 1 occurs before the 6 March 20X8 but is a non-adjusting event, because in accordance with IAS
10.22(h) this change was not enacted before the reporting date. This is the case even though the
announcement has retrospective effect on the financial statements still being prepared.
Event 2, the discovery of fraud, would have been an adjusting event per IAS 10.9(e), had it occurred
prior to the date of authorisation for issue. As it was not discovered until 19 March 20X8, it is not even an
event after the reporting period, let alone an adjusting event.
5 Scioto
15 July is the correct answer.

IAS 10.7 states that the authorisation date is the date on which the financial statements are authorised
for issue, even if this is after a public announcement of profit. IAS 10.5 confirms that it is not the date on
which the shareholders approve the financial statements.
6 Fushia
CU330,000
Provision must be made for estimated future claims by customers for goods already sold.
The expected value (CU5 million × 3%) + (CU3 million × 6%) is the best estimate of this amount
(IAS 37.39).
7 Wilcox
CU20 million
At the year end a legal obligation exists – through the retrospective legislation – as a result of a past
event (the environmental damage caused in the past) (IAS 37.14). The company should therefore create
a provision for the damage that has already been caused.
It should not now set up a provision for the future damage, because that will be caused by a future event
(the company could close down the mines and therefore not cause further damage to the environment).
Because the effect of discounting at 17% over two years is material, the cost should be discounted to
present value (IAS 37.45).
2
So, the provision is CU27m / 1.17 = CU20m (to the nearest CUm)
8 Yau Enterprise
CU1,827,360
The signing of the lease is a past event that creates a legal obligation to pay for the property under the
terms of the contract and is an obligating event (IAS 37.14). The company should therefore create a
provision for the onerous contract that arises on leaving the premises (IAS 37.66). This is calculated as
the excess of unavoidable costs of the contract over the economic benefits to be received from it. The
unavoidable cost is the lower of the cost of fulfilling the contract and the penalty that arises from failing to
fulfil it (IAS 37.68).
The effect of the time value of money over six years is material, so the provision should be discounted to
its present value (IAS 37.45).
The present value of the sub-lease arrangement is CU1,827,360 ((CU480,000 – CU120,000) × 5.076).
As this is less than the CU2.2m compensation payable, it should be used to measure the provision.
9 Noble
No provision is required for the fitting of the engines. This is because the present obligation as a result of
the past event required by IAS 37.14 does not exist. The company can choose not to fit the engines and
then not to operate the aircraft.
A provision of CU1.0 million is, however required in relation to the fines, because at the reporting date
there is a present obligation in respect of a past event (the non-compliance with legislation).
10 Noname
The total amount recognised in profit or loss is the CU385,000 lease provision for the onerous lease +
the CU270,000 restructuring provision + the CU110,000 impairment losses = CU765,000
The five-year lease is not an onerous contract in terms of IAS 37.10 because the premises can be sublet
at profit. The seven-year lease is an onerous contract and under IAS 37.66 the provision should be
measured at (CU90,000 – 35,000) × 7 years = CU385,000.
Under IAS 37.80 all the payments to employees should be included in the restructuring provision, with
the exception of the employment costs of CU50,000 in preparation for the move to Sidonia and
CU37,000 payable to those moving to Sidonia – this relates to the ongoing activities of the business, so
is disallowed by IAS 37.80(b). For the same reason the costs of moving plant and equipment is
disallowed. Impairment losses reduce the carrying amount of the relevant assets rather than increasing
the restructuring provision and revenue less expenses are trading losses which are disallowed by IAS
37.63. So provision, excluding the onerous lease is CU90,000 + 180,000 = CU270,000.


The CU35,000 profit share payment and the CU31,000 bad debt expense are adjusting events and
should be recognised in the financial statements.
See IAS 10.9, 10.12 and 10.22.

(1) This is an adjusting event as it provides more up-to-date information about a provision that was
recognised at the reporting date. The CU100,000 receivable should be written off.
(2) This is a disclosable non-adjusting event. The rights issue occurred after the reporting date, but is
considered to be of significant importance and should be disclosed in the financial statements.
(3) This is an adjusting event since it is in relation to an asset that was recognised at the reporting
date. The receivable should be reduced to CU500,000.

These dividends will be dealt with in the entity's financial statements for 20X2, 20X3 and 20X4 as C
follows: H
Financial statements for: 20X2 20X3 20X4 A

20X2 final dividend disclosed in the charged to statement of – P
notes changes in equity T
E
20X3 interim dividend – charged to statement of – R
changes in equity
20X3 final dividend – disclosed in the notes charged to statement

of changes in equity 13

(a) Provision at 30 September 20X7
CU'000
Expenditure on:
30 September 20X8 20,000 × 0.926 18,520
30 September 20X9 25,000 × 0.857 21,425
30 September 20Y0 30,000 × 0.794 23,820
63,765
Provision at 30 September 20X8
CU'000
Expenditure on:
30 September 20X9 25,000 × 0.926 23,150
30 September 20Y0 30,000 × 0.857 25,710
48,860
A provision should be recognised where
1 There is a present obligation as a result of a past event, and
2 There is a probable outflow of economic benefits, and
3 The amount can be measured reliably.
2 and 3 are clearly met, as Industrial will incur expenditure and the detailed estimates of the
amounts have been prepared.

By announcing the plan to reduce emissions publicly, Industrial has created a constructive
obligation to carry out the project. Therefore, although there is no legal obligation, Industrial should
record a provision for the estimated (and discounted) costs of the project.
(b) The charge to profit or loss for the year ended 30 September 20X8 consists of:
(i) Depreciation (CU63,765,000 ÷ 30) CU 2,125,500

This is reported in cost of sales.
The provision of CU63,765,000 also represents an asset as it gives rise to future economic
benefits (it enhances the performance of the factories). This is capitalised and depreciated
over 30 years (the average useful life of the factories).
(ii) Unwinding of the discount (see working) CU 5,095,000

This is reported as a finance cost.
WORKING
CU'000
Provision at 1 October 20X7 63,765
Expenditure on 30 September 20X8 (20,000)
Unwinding of discount (balancing figure) 5,095
Provision at 30 September 20X8 48,860
The accounting entry to record the unwinding of the discount in 20X1 will be:
Dr Finance costs CU13,660
Cr Provisions CU13,660

(a) Detailed information was made available about who would be affected by Stage 1 and when the
various steps in the first stage of the closure programme would take place.
The announcement about Stage 2 was more of an overview. It was not until 1 November 20X6 that
information was announced in respect of Stage 2 in as much detail as that provided in December
20X5 about Stage 1. There is a constructive obligation in respect of Stage 1 on 2 December 20X5,
no such obligation in respect of Stage 2 is made until 1 November 20X6. Although the
announcement is made as a single restructuring programme, there will be two entirely separate
restructuring provisions.
The costs of this major programme will be recognised in profit or loss for the years ending 31
December 20X5 – 20X7 as follows:
Reason Stage 1 Stage 2
Termination payments to those taking voluntary Restructuring 20X5 20X6
redundancy provision
Termination payments to those being made Restructuring 20X5 20X6
compulsorily redundant provision
Employment costs during closing down activities Restructuring 20X5 20X6
and selling off inventory provision
One-off payments to employees agreeing to Continuing 20X6 20X7
move to continuing parts of the business activities
Cost of moving plant and equipment to continuing Continuing 20X6 20X7
parts of the business activities
Cost of moving saleable inventory to continuing Continuing 20X6 20X7
parts of the business activities
Impairment losses on non-current assets See Note 20X5 & 20X5 to
20X6 20X7
Losses on disposal of non-current assets Year when loss 20X6 20X7

Reason Stage 1 Stage 2
on disposal
incurred
Revenue less expenses up to date of closure, Year when 20X6 20X7
other than itemised expenses operating losses
incurred
Note:
The announcement of a restructuring programme is an indicator of impairment under IAS 36, so an
impairment test should be carried out at the time of the first announcement for all relevant non-
current assets. Despite Stage 2 only being 'probable', its assets should still be tested for
impairment in 20X5.
(b) A provision should be recognised in respect of all contracts when they become onerous, regardless
of whether this is associated with a restructuring programme. If the entity's production lines were
loss-making before the restructuring announcement, then this contract may already have been
classified as onerous.
If it had not already been identified as being onerous, then at a minimum, a provision should be
made for the 300,000 tonnes per annum for the three Stage 1 production lines, for the period from
when they cannot take any further supplies through to the end of the contract on 31 December
20X7.
A provision should be made for the remaining 400,000 tonnes per annum for the four Stage 2
production lines for the period from when they cannot take any further supplies through to the end
C
of the contract on 31 December 20X7.
H
Note: This answer includes a comprehensive list of issues to be considered under restructuring A
programmes, included for learning purposes. P
T
Answer to Interactive question 7 E
R
At 31 December 20X3
The discounted amount of the provision would be included in the initial measurement of the cost of the
power station as at 31 December 20X3: 13
CUm
Cost 450.0
Provision (CU50m × 1/1.08 )
30
5.0
455.0
Year ended 31 December 20X4
The power plant would be depreciated over its 30-year life resulting in a charge of CU455.0m/30 =
CU15.2m to profit or loss and a carrying amount of CU455m – CU15.2m = CU439.8m.
The provision would begin to be compounded resulting in an interest charge of CU5.0 × 8% = CU0.4m
and an outstanding provision of CU5.0 + CU0.4 = CU5.4m in the statement of financial position.
Any change in the expected present value of the provision would be made as an adjustment to the
provision and to the asset value (affecting future depreciation charges).

(a) IAS 37 states that a provision should be recognised in the accounts if:
• An entity has a present obligation (legal or constructive) as a result of a past event
• A transfer of economic benefits will probably be required to settle the obligation
• A reliable estimate can be made of the amount of the obligation.
Under IAS 37 contingent liabilities should not be recognised. They should however be disclosed
unless the prospect of settlement is remote. The entity should disclose:
• The nature of the liability
• An estimate of its financial effect
• The uncertainties relating to any possible payments

• The likelihood of any re-imbursement
(b) The following procedures should be carried out to determine whether the company will have to pay
damages and the amount to be included in the financial statements.
(i) Review the director's service contract and ascertain the maximum amount to which he
would be entitled and the provisions in the service contract that would prevent him making a
claim, in particular those relating to grounds for justifiable dismissal.
(ii) Review the results of the disciplinary hearing. Consider whether the company has acted in
accordance with employment legislation and its internal rules, the evidence presented by
the company and the defence made by the director.
(iii) Review correspondence relating to the case and determine whether the company has
acknowledged any liability to the director that would mean that an amount for compensation
should be accrued in accordance with IAS 37.
(iv) Review correspondence with the company's solicitors and obtain legal advice, either from
the company's solicitors or another firm, about the likelihood of the claim succeeding.
(v) Review correspondence and contact the company's solicitors about the likely costs of the
case.
(vi) Consider the likelihood of costs and compensation being re-imbursed by reviewing the
company's insurance arrangements and contacting the insurance company.
(vii) Consider the amounts that should be accrued and the disclosures that should be made in
the accounts. Legal costs should be accrued, but compensation payments should only be
accrued if the company has admitted liability or legal advice indicates that the company's
chances of success are very poor. However, the claim should be disclosed unless legal advice
indicates that the director's chance of success appears to be remote.

CHAPTER 14
Leases, government grants

and borrowing costs
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
Technical reference
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
of details
Specific syllabus references for this chapter are: 1(e), 4(a), 4(b), 4(d), 14(c), 14(d), 14(f)
IFRS 16, Leases

IFRS 16 Leases will replace IAS 17 Leases and will start to apply on all the financial years starting after
1st January, 2019.

1 Overview of material covered in earlier studies
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'.
1.1 Lessee accounting

Lessee accounting
Finance lease Operating lease
• A lease that transfers substantially all the • A lease other than a finance lease
risks and rewards incidental to
ownership of an asset to the lessee. Title
may or may not eventually be transferred
• Capitalise asset and recognise liability at • Rentals are charged to profit or loss on a
fair value of leased property or, if lower, straight-line basis over the lease term
present value of minimum lease payments unless another systematic basis is
representative of the user's benefit
• Add initial direct costs (incremental costs • Incentives to sign operating leases (and
directly attributable to negotiating and initial reverse premiums or rent-free
arranging a lease) to amount recognised as periods) are spread over the life of the
an asset operating lease reducing the overall
payments on the lease charged to profit or
loss (SIC-15)
C
(see also section 2)
H
• Depreciate asset over the shorter of the A
useful life and the lease term including P
any secondary period (useful life if T
reasonable certainty the lessee will obtain E
ownership)
R
• Apply finance charge so as to give a constant
rate on the outstanding liability (using the
interest rate implicit in the lease) 14
• Rental payments are split between the
finance charge element and the repayment of
capital
1.2 Finance lease classification
IAS 17 identifies five situations which would normally lead to a lease being classified as a finance lease.
• 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
eases, government grants and borrowing costs 593

• The leased asset is so specialised that it could only be used by the lessee without major
modifications being made
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.
1.3 Summary of disclosures

1.3.1 Leased assets
• For each class of asset, the net carrying amount at the reporting date
1.3.2 Finance lease liabilities

• Give maturity analysis
– Not later than one year

– Later than one year and not later than five years
– Later than five years
• Reconciliation of minimum lease payments and present value
– Within one year

– Less: future finance charges
– Present value of finance lease liabilities
• Present value of finance lease liabilities
– Within one year

1.3.3 Operating leases

Disclose the future minimum lease payments under non-cancellable operating leases analysed as
follows.
• Operating lease payments
– Within one year

Interactive question 1: Lessee [Difficulty level: Intermediate]
A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are to pay:
• A non-refundable deposit of CU5,800 on inception.

• Six annual instalments of CU16,000 payable in arrears.
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.

As part of the lease agreement the company guaranteed to the lessor that the asset could be sold for
CU8,000 at the end of the lease term. It also incurred CU2,000 of costs in setting up the lease
agreement.
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:
(i) For CU10,000

(ii) For only CU6,000
1.4 Lessor accounting

Lessor accounting
Finance lease Operating lease
Substance
• Risks and rewards with the lessee (or • Risks and rewards with the lessor
other third parties)
• Recognise a receivable equal to 'net • Asset retained in the books of the lessor and is
investment in the lease'. This is the depreciated over its useful life
gross investment (minimum lease
payments plus any unguaranteed residual
value (see below) accruing to the lessor)
discounted at the interest rate implicit in
the lease
C
• Initial direct costs incurred by the lessor • Rentals are credited to profit or loss on a
H
are not added separately to the net straight line basis over the lease term unless
investment as they are already included in another systematic basis is more representative A
the discounted figures since they are P
included in the calculation of the interest T
rate implicit in the lease (reducing the E
return) R
• Finance income is recognised reflecting
constant periodic rate of return on the
lessor's net investment outstanding 14
1.4.1 Unguaranteed residual value

The unguaranteed residual value is that portion of the residual value of the leased asset which is not
assured or is guaranteed solely by a party related to 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:

Present value of Present value of Fair value of
minimum lease + unguaranteed = leased asset
payments residual amount
accruing to lessor
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.
Interactive question 2: Unguaranteed residual value [Difficulty level: Exam standard]
A company leased an asset to another company on 1 January 20X1 on the following terms.
Lease term 4 years

Inception of lease 1.1.X1
Annual instalments in advance CU22,000
Residual value of asset as guaranteed by lessee CU10,000
Expected residual value at end of lease CU12,000
Fair value of the asset CU82,966
Initial direct costs incurred by the lessor CU700
Interest rate implicit in the lease 11%
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)
1.4.2 Finance income

A lessor should recognise finance income based on the pattern which reflects a constant periodic rate of
return on the net investment recognised. A systematic and rational basis for allocation should be
applied. Use of the actuarial method for determining finance costs will generally be appropriate as this
reflects accurately the constant rate of return on the net investment. IAS 17 does not state that the use
of approximations is allowed by a lessor in the way it is to a lessee, and therefore such approximations
are not appropriate.
1.4.3 Non-current assets held for sale

An asset which is provided by a lessor under a finance lease arrangement but is classified as held for
sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations should
be treated in accordance with IFRS 5 rather than IAS 17.
Interactive question 3: Lessor [Difficulty level: Intermediate]
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.

The annual rental is CU400,000 payable in advance and the interest rate implicit in the lease has been
calculated as 8.3%.
Requirement
How should the transaction be recognised on 1 January 20X5 and in the year ending 31 December
20X5?
1.5 Manufacturer or dealer lessors

Context
• Special consideration is needed in the case of:
– Manufacturers, who lease out assets they have made

– Dealers, who acquire assets to lease to third parties
• 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.
• Manufacturers and dealers offering finance leases should recognise separately
– A normal selling profit as if from an outright sale, based on the normal selling price adjusted
for normal volume or trade discounts
– Finance income over the lease term
• 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.
Interactive question 4: Dealer lessor [Difficulty level: Exam standard]
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:

Year Cash flow Discount factor at 8% Present value
CU CU
20X5 8,750 1.000 8,750
20X6 8,750 1 8,102
= 0.926
(1.08)
20X7 8,750 1 7,499
= 0.857
(1.08) 2
24,351
Requirement
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'.
1.6 Sale and leaseback transactions

Entities sometimes enter into sale and leaseback transactions. These involve the original owner of
the asset selling it, typically to a finance house or bank, and immediately leasing it back, thereby
raising cash and retaining the use of the asset.
• 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.
1.7 Sale and leaseback as a finance lease

This transaction is essentially a financing arrangement. The seller (who is subsequently the lessee) does
not dispose of the risks and rewards of ownership (because the leaseback is through a finance lease)
and no profit should be recognised immediately on disposal.
The accounting entries are:
• Derecognise the carrying amount of the asset now sold
• Recognise the sales proceeds
• Calculate the profit on sale and recognise it as deferred income
• 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)
• Recognise the profit on sale as income over the lease term
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.

The lease includes a clause transferring title back to the entity at the end of the lease; the lease is
recognised as a single finance lease comprising both land and building elements. The annual rental is
CU400,000 payable in advance and the interest rate implicit in the lease has been calculated as 8.3%.
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.
1.8 Sale and leaseback as an operating lease

Some businesses arrange sales and operating leasebacks to give them the capital to build a
replacement asset while occupying the original one for a short period of time. For example, a football
club might sell its stadium, and then lease it back for a year, while using the sale proceeds to fund the
construction of a new stadium.
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.
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

Sale price below fair value

Profit No profit Recognise profit No profit (Note 1)
immediately
Loss not Recognise loss Recognise loss Note 1
compensated immediately immediately
immediately for by
future lease rentals
below market rate
Loss compensated for Defer and amortise Defer and amortise Note 1
by future lease rentals loss loss
below market rate
Sale price above fair value

Profit Defer and amortise Defer and amortise Defer and amortise
profit (sale price less fair profit (Note 2)
value)
Recognise
immediately (fair value
less carrying amount)
Loss No loss No loss Note 1
Note 1
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.
2 Evaluating the Substance of Transactions Involving the

Legal Form of a Lease – SIC 27 and Operating Lease
Incentives – SIC 15
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.
2.1 Lease and leaseback arrangements (SIC 27)

SIC 27 – Evaluating the Substance of Transactions Involving the Legal Form of a Lease relates to the
situation where an entity may enter into a series of structured transactions (an arrangement) with an
unrelated party (an investor) that involves the legal form of a lease.
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.

In these circumstances, if the two leases are similar, then the economic substance is unchanged and the
entity should continue to recognise the leased asset as previously. Thus, the general rule is that
accounting treatment should reflect the economic substance of the arrangement.
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.
2.2 Operating lease incentives (SIC 15)

In negotiating a new or renewed operating lease, the lessor may provide incentives for the lessee to
enter into the agreement. Examples of such incentives are:
• An up-front cash payment to the lessee

• The reimbursement of costs of the lessee
• Initial rent-free or reduced rent periods
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.
Interactive question 6: Operating lease incentive [Difficulty level: Intermediate]
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
3 Determining Whether an Arrangement Contains a Lease –

14
IFRIC 4
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:

• Outsourcing arrangements (eg the outsourcing of the data processing functions of an entity).
• 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
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
• The arrangement conveys a right to use the asset.
Fulfilment of the arrangement is dependent on the use of a specific asset
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.
Arrangement conveys a right to use the asset
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.

Worked example: Arrangement that contains a lease
An entity (the supplier) enters into an arrangement to supply electricity for the building for a new airport.
To be able to fulfil this obligation, the supplier builds a power station next to the new airport site.
The supplier has no access to any other electricity generating stations and maintains ownership and
control of the power station.
The contractual agreement provides for the following. C

H
• The power generating station is specifically identified in the agreement. The supplier has the right A
to provide electricity from other sources although doing so is not feasible. P
T
• The supplier has the right to provide electricity to other customers. However, this is not
economically feasible as the power station is designed to meet only the purchaser's needs. E
R
• The purchaser pays a fixed capacity charge and a variable charge based on electricity power
taken. The variable charge is based on normal energy costs.
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.

4 Current developments
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.

(e) Rentals during renewal periods would be included as part of the lease liability on the basis of
the longest possible lease term that is more likely to occur than not.
(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.
Reaction to the August 2010 Exposure Draft

Many respondents commented that the proposed approach was overly complex, expensive, and in
some cases, inconsistent with the economics of the underlying transactions. In response, the IASB
made a number of significant changes to their original proposals for lessee accounting.
• 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.
• Arrangements with bargain purchase options or ownership transfer would be considered

leases, not purchases.
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.
Interactive question 8: Leasing proposals 2 [Difficulty level: Exam standard]
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%.

On 1 May 20X4, Sutton has also entered into a short operating lease agreement to lease another
building. The lease will last for three years and is currently CU5 million per annum. However an inflation
adjustment will be made at the conclusion of leasing years 1 and 2. Currently inflation is 4% per annum.
The following discount factors are relevant (8%).
Single cash flow Annuity

Year 1 0.926 0.926
Year 2 0.857 1.783
Year 3 0.794 2.577
Year 4 0.735 3.312
Year 5 0.681 3.993
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 replaces the following standards and interpretations:

• IAS 17 Leases
• IFRIC 4 Determining whether an Arrangement contains a Lease
• SIC-15 Operating Leases - Incentives
• SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease
IFRS 16 vs IAS 17
Operating lease accounting treatment
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.

Potential impacts:
• 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
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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.
Measuring PV and rate
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 – Measures the lease liabilities at the PV of the lease payments that are not paid at the date
discounted using the implicit rate if known, otherwise, the incremental borrowing rate. There is no
reference to the fair value and the measurement does not relate to the minimal lease payments. Instead,
the lease payments that are not paid.
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.
5 IAS 20 Accounting for Government Grants and

Disclosure of Government Assistance
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.
Government grants: Assistance by government in the form of transfers of resources to an entity in

return for past or future compliance with certain conditions relating to the operating activities of the
entity. They exclude those forms of government assistance which cannot reasonably have a value

placed upon them and transactions with government which cannot be distinguished from the normal
trading transactions of the entity.
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.
• 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.
• Use a systematic basis of matching over the relevant periods.
• 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
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• Grants related to income may be presented in the statement of profit or loss and other
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comprehensive income (in profit or loss) either as a separate credit or deducted from the related
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expense.
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• Repayment of government grants should be accounted for as a revision of an accounting estimate. R
Disclosure
• Accounting policy note 14

• Nature and extent of government grants and other forms of assistance received
• Unfulfilled conditions and other contingencies attached to recognised government assistance
Interactive question 9: Government grants [Difficulty level: Intermediate]
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
What are the arguments in support of each method?

6 IAS 23 Borrowing Costs
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
• 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

Interactive question 10: Borrowing costs 1 [Difficulty level: Exam standard]
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.
Interactive question 11: Borrowing costs 2 [Difficulty level: Exam standard]
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
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7 Statements of cash flows 14
Section overview
• This section briefly revises single company statements of cash flows. Consolidated statements of
cash flows are revised in Chapter 20.
7.1 Basic statements of cash flows – revision

• A statement of cash flows prepared in accordance with IAS 7 provides information about the
historical changes in an entity's cash and cash equivalents. This information is presented in a
statement that classifies cash flows between operating activities, investing activities and financing
activities.
• 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.

• 'Operating activities' are the principal revenue-generating activities of an entity, together with any
other activities which are not identified as being investing or financing in nature.
• 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)
– Whether the lease/depreciation/finance expense charged to profit or loss, and amounts

recognised in the statement of financial position (in the case of finance leases) are in line
with accounting standards and based on reasonable assumptions
– Whether the disclosure is in line with applicable accounting standards
8.1 Auditing leases

In auditing leases recognised at fair value, the auditor must evaluate whether the fair value is
appropriate. We will cover the auditing of fair value in further detail in the Audit Focus section in Chapter
17.
The table below summarises the areas of audit focus when auditing leases, and provides some
examples of audit evidence required.

Issue Evidence
Ascertaining that the Obtain schedules of finance leases and operating leases, including any leases
leases recorded in the that existed at the end of the prior period, and any new leases.
financial statements are Determine that any leased property is still in use.
complete
Obtain assurance about the completeness of the schedule by making
enquiries of informed management, and consider any evidence of additional
leases by examining other documents such as board meeting minutes,
significant contracts and property additions.
The classification of the Review lease agreements for indicators that the risks and rewards of
leases reflects the ownership have been transferred to the entity, such as:
substance of the – Responsibility for repairs and maintenance
transaction
– Transfer of legal title at the end of the lease term
– The lease is for most of the assets' useful life
– The present value of the minimum lease payments is substantially all

of the assets' fair value
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
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Issue Evidence
Ascertaining that the Recalculate the finance charges charged against profit and loss.
finance leases have Agree interest rates used in calculations to lease agreements.
been correctly recorded
in the statements of Agree the calculation of the leased assets' fair value to external evidence,
financial position and such as market prices or surveyors' reports.
profit or loss Recalculate the depreciation charges applied to non-current assets.
Review the assumptions made in respect of the useful life of each finance
lease asset, and agree the useful life/lease term to the depreciation
workings to ensure that the assets are depreciated over an appropriate
period.
Review rentals paid during the year to verify that rental payments are split
between the finance charge element and the repayment of capital in
accordance with IAS 17.
Ascertaining that the Review the disclosures in the financial statements to determine whether the
lease liability has been disclosures are consistent and complete.
disclosed in the financial
statements in
accordance with IFRS.

Summary
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Self-test
IAS 17 Leases
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.
Other details are as follows.

Machine X Machine Y Machine Z
CU CU CU
Fair value 280,000 265,000 300,000
Residual value at 31 December 20Y0 1,000 100,000 3,000
All the machines are to be returned to the lessor at the end of the lease period. The useful life of
Machine Y is six years. The useful life of the other machines is 3 years.
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?

4 Szczytno
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.
Other information available is as follows.
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.
(a) The profit on sale recognised in the year
(b) Excluding any profit on sale, the total effect on profit or loss for the year of the building
element of the lease
(c) The total liability to the financial institution at 31 December 20X7
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.
Bodgit's incremental borrowing rate is 12%.

14
Requirement
Explain the accounting implications of the sale and leaseback arrangement.

Technical reference
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:
– Ownership passing at end of term IAS 17.10–11

– Bargain purchase option
– Lease term the major part of asset's life
– Very substantial charges for early cancellation
– Peppercorn rent in secondary period
– PV of minimum lease payments substantially all of asset's fair value. IAS 17.10(d)
• Otherwise, an operating lease IAS 17.4
• Classify at inception IAS 17.13
• 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
– Measured at inception of lease IAS 17.4

– Recognised at commencement of lease term IAS 17.4
• 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
• Consider whether IAS 36 impairment procedures needed IAS 17.30
• Debit lease payments to liability, without separating into capital and interest
• Charge lease interest to profit or loss and credit lease liability
• Charge interest so as to produce constant periodic rate of charge on reducing IAS 17.25
liability – approximations allowed
• Disclosures:
– Show carrying value of each class of leased assets IAS 17.31
– 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)
– Other IAS 16 disclosures re leased PPE assets IAS 17.32

3 Operating lease
• 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:
– Lease payments charged as expense in the period IAS 17.35(c)
– In a 'commitment' note, show analysis of amounts payable in 1, 2 to 5 and IAS 17.35(a)

over five years, even though not recognised in statement of financial
position
– General description of significant leasing arrangements IAS 17.35(d)
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
• Recognition of finance income should be based on a pattern reflecting a IAS 17.39

constant periodic rate of return on the lessor's net investment
• Finance income should be allocated on a systematic and rational basis IAS 17.40
• Special rules for manufacturer/dealer lessors IAS 17.42
• Disclosures IAS 17.47
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
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• 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
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• Disclosures IAS 17.56
5 Sale and finance leaseback

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• Recognise excess sale proceeds as deferred income and amortise over the IAS 17.59-60
lease term
• Alternative: treat as a secured loan
6 Sale and operating leaseback
• Treatment depends on relationship between sale price and fair value: IAS 17.61
– Sale price at fair value

– Sale price below fair value
– Sale price above fair value
• If the fair value at the time of the sale and leaseback is less than the carrying IAS 17.63
amount of the asset, the loss (carrying amount minus fair value) is recognised
immediately

• Lease and leaseback arrangements SIC 15 & 27
IAS 20 Accounting for Government Grants and Disclosure of Government

Assistance
1 Treatment
• Should only be recognised if reasonable assurance that: IAS 20 (7)
– Entity will comply with conditions

– Grant will be received
• 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 should not be accounted for on a cash basis IAS 20 (16)
• Grants in recognition of specific expenses are recognised as income in same IAS 20 (17)
period as expense
• Grants related to depreciable assets usually recognised in proportion to IAS 20 (17)

depreciation
• Grants related to non-depreciable assets requiring fulfilment of certain IAS 20 (18)

obligations should be recognised as income over periods which bear the cost of
meeting obligations
• 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)
2 Presentation of grants related to assets
• Can be presented in the statement of financial position by: IAS 20 (24)
– Setting up the grant as deferred income or

– Netting it off against the carrying amount of the asset
3 Presentation of grants related to income IAS 20 (29)
• Either:
– Recognised in profit or loss as income separately or under a general

heading or
– Deducted in arriving at the amount of the related expense recognised in
profit or loss
4 Repayment of government grants
• Accounted for as a revision to an accounting estimate IAS 20 (32)
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
– Transactions with government which cannot be distinguished from the

normal trading transactions of the entity

6 Disclosures
• Required disclosures IAS 20 (39)
IAS 23 Borrowing Costs
• Core principle IAS 23 (1 and 8)
• Qualifying asset IAS 23 (5 and 7)
• Directly attributable borrowing costs IAS 23 (10–11)
• Eligible borrowing costs IAS 23 (12–15)
• Excess of carrying amount over recoverable amount of asset IAS 23 (16)
• Commencement of capitalisation IAS 23 (17–19)
• Suspension of capitalisation IAS 23 (20–21)
• Cessation of capitalisation IAS 23 (22–25)
• Disclosure IAS 23 (26)
IAS 7 Statement of Cash Flows
• Objective of the statement of cash flows
– 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
• Presentation of a statement of cash flows Appendix A
– 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
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received in cash from investments (ie dividends and interest)
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• Financing activities include: IAS 7.17
– Cash proceeds from issuing shares

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– Cash proceeds from issuing debentures, loans, notes, bonds, mortgages and
other short or long-term borrowings
– Cash repayments of amounts borrowed
– Dividends paid to shareholders / the non-controlling interest
– Principal repayments of amounts borrowed under finance leases
• Cash flows from operating activities
– There are two methods of presentation allowed:
• Direct method IAS 7.19
• Indirect method IAS 7.20

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:
Cash flows(CU) 10% discount PV(CU)

factor
100,000 1.0 100,000
100,000 1/1.1 90,909
100,000 1/(1.1 × 1.1) 82,645
273,554
For Machine Z, this is increased by the CU50,000 premium to CU323,554.
As Machine Z has a lower fair value, it should be recognised at fair value.
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

(a) The leaseback of the land element results in an operating lease because land normally has an
infinite life (IAS 17.14). The leaseback of the building element results in a finance lease
because in leasing it back for 35 of its 36 years Szczytno has access to substantially all the
risks and rewards of ownership (IAS 17.4). The sale and leaseback is at fair value, because
the sales proceeds are substantially equal to the sum of the fair values of the 35-year interest.
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).
Land profit: proceeds CU90,000 – carrying amount (CU436,000-CU366,000) = CU20,000

Building profit: proceeds CU607,000 – carrying amount CU366,000 = CU241,000
Profit on sale recognised in year: CU
Full land profit 20,000
Proportion of building profit (CU241,000/35 years) 6,886
26,886
(b) The annual rental is allocated between the two elements in proportion to the relative fair
values of the leasehold interest (IAS 17.16), so the amount allocated to the building element
is:
CU43,600 × 607,000 / (607,000 + 90,000) = CU37,970
The present value over 35 years is CU37,970 × 15.368 = CU583,523.
This amount is recognised as a non-current asset and a liability.
The 20X7 depreciation charge on the asset is CU583,523 / 35 = CU16,672,
while since the lease payments are in advance, the finance charge is CU(583,523 – 37,970) ×
6% = CU32,733.
The total effect on profit or loss is CU16,672 + CU32,733 = CU49,405.
(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 key factors which indicate this are as follows.
• 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.
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

being 1/5 × CU750,000 = CU150,000 and the building being the remaining CU600,000) and their
carrying value.
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.
Sale and leaseback as an operating lease
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.
Sale and leaseback as a finance lease
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.


(a) Financial statement extracts
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
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):
Dr Profit or loss CU2,000

Make guaranteed payment to lessor and derecognise the asset and lease liability:
Dr Finance lease liability CU8,000

Cr Cash CU2,000

(a) Unguaranteed residual value and net investment in the lease at 1 January 20X1
Date Gross Discount Net

investment factor investment
(11%)
CU CU
1.1.X1 Instalment 22,000 1 22,000
1.1.X2 Instalment 22,000 0.901 19,822
1.1.X3 Instalment 22,000 0.812 17,864
1.1.X4 Instalment 22,000 0.731 16,082
31.12.X4 Guaranteed residual value 10,000 0.659 6,590
Lessee's
Minimum lease payments 98,000 82,358
liability
31.12.X4 Unguaranteed residual value 2,000 0.659 1,318
Lessor's
Investment in the lease 100,000 83,676
asset
Note: The net investment in the lease is equal to the fair value of the asset of CU82,966 plus the
lessor's costs of CU700. In this instance there is a rounding difference of CU10.
(b) Financial statement extracts
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 31 DECEMBER 20X1

(EXTRACT)
CU
Finance income (Working) 6,784
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X1 (EXTRACT)
CU
Non-current assets
Net investment in finance lease (Working) 46,460
Current assets
Net investment in finance lease (Working) (68,460 – 46,460) 22,000
WORKING
Net investment in finance lease
Interest
Instalments in income at
Bal b/f advance c/f 11% Bal c/f 31 Dec
CU CU CU CU CU
20X1 83,676 (22,000) 61,676 6,784 68,460
20X2 68,460 (22,000) 46,460
The transaction will be recognised by the entity as follows.
1 January 20X5 Derecognise CU5 million investment property asset

Recognise CU5 million finance lease receivable
Recognise CU400,000 cash received as a reduction in the receivable
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.
31 December 20X5 Increase the receivable by CU381,800 (8.3% × (CU5,000,000 – CU400,000))

Recognise finance income of CU381,800 in profit or loss

Statement of comprehensive income
CU
Revenue (lower of FV CU26,250 and PV of MLPs CU24,351) 24,351
Cost of sales (lower of cost and CV – PV of unguaranteed residual value) (21,000)
Profit 3,351
Finance income: (Working) 1,248
Receivable (Working) 16,849
WORKING
Instalments in Interest Bal c/f
Bal b/f advance c/f income at 8% 31 Dec
CU CU CU CU CU
20X5 24,351 (8,750) 15,601 1,248 16,849
On 1 January 20X5, the transaction will be recorded by the entity as follows:
• Recognise cash proceeds received of CU5,000,000
• Derecognise the asset of CU3,500,000
• Recognise deferred income of CU1,500,000 and release the profit over the lease term (CU37,500
per annum)
• Recognise the building at CU5,000,000
• Recognise a finance lease liability at CU5,000,000
• Recognise CU400,000 cash paid
For the year ended 31 December 20X5, the entity will recognise:
• Income of CU37,500 out of the deferred profit, being CU1.5m/40 years

• Depreciation of CU125,000 (CU5m/40 years)
C
• Finance charge of CU381,800 being 8.3% of (CU5m – CU0.4m)
H
Answer to Interactive question 6 A
P
The amount lost as a result of agreeing to the rent-free period is treated as a reduction in the net T
consideration receivable by the lessor, which has the effect of spreading it over the lease term. The total E
consideration receivable over the 21-year lease is:
R
19.5 years × 4 quarterly payments × CU30,000 = CU2,340,000.
This results in an annual income of CU2,340,000 / 21 years = CU111,429. 14

At 31 December 20X5, no cash will have been received from the lessee, so the lessor recognises a
receivable CU111,429 – the first year's rent.

Sutton's lease and Framework definitions
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.

(c) The control results from past events, that is the signing of the lease contract.
(d) Future economic benefits are expected to flow to Sutton during the lease term.
In conclusion, the leased plant meets the Framework's definition of an asset.
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:
(a) There is a present obligation to pay rentals.
(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.
In conclusion, the leased plant meets the Framework's definition of a liability.

(a) Sale and leaseback
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:
Sale of building on 1 May 20X4
DEBIT Cash CU150m
CREDIT Office building CU120m
CREDIT Deferred income (SOFP) CU30m
Being recognition of the gain on the sale of the building.
The gain is released over the five year lease period
DEBIT Deferred income (SOFP) CU30m ÷ 5 CU6m
CREDIT Deferred income (P/L) CU6m
Being release of gain on sale of building.
DEBIT Operating lease asset CU63.89m
CREDIT Obligation to pay rentals CU63.89m
Being recognition of the leaseback at net present value of lease payments using 8% discount
factor (CU16m × 3.993)
First year of leaseback to 30 April 20X5
DEBIT Lease obligation: rentals CU16m
CREDIT Cash CU16m
Being recognition of payment of rentals.
DEBIT Finance cost CU5.11
CREDIT Lease obligation CU5.11
Being recognition of interest expense (CU63.89m × 8%)

DEBIT Depreciation expense CU12.78m
CREDIT Operating lease asset CU12.78m
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.
(b) Inflation adjustment
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.
Sutton would recognise operating rentals as follows:
Year 1
CU5 million
Year 2
CU5 million plus (CU5m × 4%) = CU5.2m
Year 3
CU5.2 million plus (CU5.2m × 4%) = CU5.408m

IAS 20 gives the following arguments in support of each method.
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.

Asset X Asset Y
CU'000 CU'000
Borrowing costs
CU5.0m/CU10m × 10% 500 1,000
Less investment income
To 30 June 20X8 CU2.5m/CU5.0m × 8% × 6/12 (100) (200)
400 800
CU'000 CU'000
Cost of assets
Expenditure incurred 5,000 10,000
Borrowing costs 400 800
5,400 10,800
120 80
Capitalisation rate = weighted average rate = (10% × ) + (9.5% × ) = 9.8%
120 + 80 120 + 80
Borrowing costs = (CU30m × 9.8%) + (CU20m × 9.8% × 3/12)

= CU3.43m

The amounts appearing in the statement of cash flows for operating and financing activities include:
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

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3468corporate Reporting Volume - 1

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Corporate reporting

First Edition: 2018

© The Institute of Chartered Accountants in England and Wales

Principles and Regulations in Corporate Reporting and Auditing

Ethics and Governance

The Modern Audit Process

Assets and Liabilities

2.2 Specification grid

Learning objectives Tick off

• Appraise and explain the role and context of auditing

1.2 How this Study Manual is structured

1.2.2 Ethics and governance

1.2.3 The modern audit process

1.2.4 Financial reporting chapters

1.2.5 Financial analysis chapters

1.2.6 Assurance and other related services

2 The importance of corporate reporting

2.1 What is corporate reporting?

2.1.3 Management accounting

Interactive question 1: Management decisions [Difficulty level: Easy]

2.3 Financial statements

2.4 Requirement to produce financial statements

2.5 Financial reporting standards

2.7 Judgements and financial statements

2.8 Users of financial statements

2.9 Objective of financial statements

2.10 Accountability of management

2.11 Financial position, performance and changes in financial position

2.11.1 Financial position

2.11.2 Financial performance

2.11.3 Changes in financial position

3 The role and context of modern auditing H

3.1 Purpose of the audit

3.2 Part of the economic infrastructure

3.3 The expectation gap

3.4 The audit opinion

3.5 The audit process

3.6 Statutory audit requirement

4 Legal responsibilities of directors and auditors

4.2 Directors' responsibilities

(a) the state of the company's affairs;

(a) in the nature of the company's business;

4.2.2 The Directors’ Report to Shareholders in accordance with BSEC notification

(i) Industry outlook and possible future developments in the industry.

103. Loan of Director— H

4.4 Auditors' responsibilities

(e) whether personal expenses have been charged to revenue account;

(4) The auditors’ report shall also state-

5.1 Interaction between FRC and IAASB Standards

5.2 International Auditing and Assurance Standards Board

5.3 Clarity Project

6 Audit quality control

6.1 Principles and purpose

6.2 Quality control at a firm level

6.2.1 Objective of ISQC 1

6.2.2 Elements of a system of Quality Control

6.3 Quality control on an individual audit

6.3.1 Policies and procedures

6.4 Assuring the Quality of Professional Services

Interactive question 2: Addystone Fish [Difficulty level: Intermediate]

6.5 Audit documentation

Interactive question 3: Documentation (revision) [Difficulty level: Intermediate]