ACCA Paper P7 (INT)
Advanced Audit & Assurance Class Notes June 2011
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ACCA Paper P7 (INT)
Advanced Audit & Assurance Class Notes June 2011
© The Accountancy College Ltd, January 2011 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of The Accountancy College Ltd.
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Contents PAGE INTRODUCTION TO THE PAPER
5
CHAPTER 1:
REGULATORY ENVIRONMENT
7
CHAPTER 2:
PROFESSIONAL AND ETHICAL CONSIDERATIONS
17
CHAPTER 3:
PRACTICE MANAGEMENT
27
CHAPTER 4:
ASSIGNMENTS I – THE AUDIT OF FINANCIAL STATEMENTS
35
CHAPTER 5:
ASSIGNMENTS II – GROUP AUDITS
71
CHAPTER 6:
AUDIT REPORTS AND OTHER REPORTS
77
CHAPTER 7:
ASSIGNMENTS III – OTHER ASSIGNMENTS
97
CHAPTER 8:
CURRENT ISSUES AND DEVELOPMENTS
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Introduction to the paper
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IN T R O D U C T I O N T O T H E P A P E R
AIM OF THE PAPER The aim of the paper is to apply relevant knowledge, skills and exercise professional judgement in analysing, evaluating and concluding and reporting on the assurance engagement and other audit and assurance issues in the context of best practice and current developments. In simpler terms, this means a very practical exam, in which students need to look at real situations and identify relevant issues to an auditor (or other assurance provider), and how those issues may be addressed.
OUTLINE OF THE SYLLABUS 1.
Regulatory Environment
2.
Professional and Ethical Considerations
3.
Practice Management
4.
Audits of Historical Financial Statements
5.
Other Assignments
6.
Reporting
7.
Current Issues and Developments
FORMAT OF THE EXAM PAPER The syllabus is assessed by a three hour paper-based examination, with 15 minutes of reading time. The examination consists of: ●
two compulsory questions, totalling 50-70 marks, and covering several areas of the syllabus within a single scenario, and
●
a choice of two from three questions totalling 30-50 marks, which are each likely to focus mostly on a single syllabus area.
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Chapter 1
Regulatory environment
SYLLABUS CONTENT 1.
International regulatory frameworks ●
2.
Money laundering ●
3.
Laws and regulations affecting audit and assurance, and how they are set.
What it is, and how it affects audit and assurance providers.
Laws and regulations affecting clients ●
Responsibilities regulations.
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of
auditors
should
clients
be
breaking
laws
or
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CHAPTER 1 – REGULATORY ENVIRONMENT
CHAPTER CONTENTS EXAM QUESTIONS --------------------------------------------------------- 9 INTERNATIONAL REGULATORY FRAMEWORKS----------------------- 10 REGULATORY FRAMEWORK
10
MONEY LAUNDERING AND THE AUDITOR ----------------------------- 12 AUDIT RESPONSIBILITIES
12
LAWS AND REGULATIONS AFFECTING CLIENTS --------------------- 15 RESPONSIBILITY OF THE AUDITOR
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CHAPTER 1 – REGULATORY ENVIRONMENT
EXAM QUESTIONS ●
Define “Money Laundering”, and explain the auditor’s responsibilities.
●
Comment on the need for ethical guidance for accountants on money laundering. (Pilot Paper Q5)
●
Explain the auditor’s responsibilities relating to the laws and regulations that apply to a client’s business.
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CHAPTER 1 – REGULATORY ENVIRONMENT
INTERNATIONAL REGULATORY FRAMEWORKS Regulatory framework In each country, regulation comes from a number of sources. Since this is largely a revision area from F8, and is not examined very often on P7, the Notes here are deliberately brief. Regulation is necessary in many industries, and audit/assurance is no exception. So many people rely on the information produced by organisations, and as a result those who give assurance on that information fulfil a vital role. If work was not regulated, there would be too much variety in how work was done, and a major threat to quality control.
Summary of regulators The ACCA To be an auditor, you need to be authorized in your country to audit. In the UK (and throughout Europe) this is done by requiring you to be a member of a Recognised Supervisory Body (RSB) and ACCA is one of these. The ACCA ensures auditors are suitably qualified, monitors behaviour, and quality control.
The IAASB The International Audit & Assurance Standards Board sets International Audit Standards (ISA). Many countries have either adopted these in full, or based their own national audit standards very closely on them. The IAASB is part of the International Federation of Accountants (IFAC).
The FRC The Financial Reporting Council in the UK regulates UK financial reporting, including corporate governance. Its various bodies set UK accounting standards and the UK Corporate Governance Code. Most countries have their own version of the FRC.
Public Oversight Board Given recent corporate scandals, there has been a trend for setting up independent bodies to oversee the “experts”. IFAC has an oversight board, but individual countries also have their own (in the UK, the POB). Accountants and auditors used to be self-regulating, but too many failures (e.g. Enron) have put a stop to this.
Corporate governance Corporate Governance now appears on many of the ACCA exam papers, with most of the detail on paper P1 and F8. As such, detailed questions on P7 are relatively unlikely. Chapter 1 of the P7 Study Text has a useful reminder of the main areas, which are ot repeated here as they should be revision.
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CHAPTER 1 – REGULATORY ENVIRONMENT
There is just one area that is important enough to get a brief mention in these otes:
Audit Committees Audit Committees have been a requirement for US listed companies since the 1970s, and are also part of the UK Corporate Governance Code. Audit Committees are a sub-committee of the Board of Directors, and are typically made up only of Independent Non-Executive Directors. Their main roles: ●
To oversee the company’s financial reporting, internal control systems, and risk management processes.
●
To help appoint and monitor the performance of the internal audit function.
●
To improve the independence of internal audit (e.g. by considering the benefits of outsourcing it).
●
To act as the main contact point for external auditors, to improve their independence.
●
To suggest a firm of external auditors.
●
To monitor the quality of both internal and external audit work.
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CHAPTER 1 – REGULATORY ENVIRONMENT
MONEY LAUNDERING AND THE AUDITOR Definition The process by which criminals attempt to hide the true source of their funds in an attempt to make it look like their funds have come from legitimate sources. In many countries, the definition is even broader, and possessing or transferring the proceeds of ANY crime can be money laundering. For example, breaching health and safety regulations in order to save money makes the company a money launderer – it possesses the cost savings, and these were saved by committing a crime.
Audit responsibilities In the past, it was felt that too often auditors and accountants were failing to notice (or maybe failing to look!) that their clients had unexplainable funds, or that some of their business transactions had no obvious business logic. Over the past 20 years, and particularly since 2000, there has been an international attempt to tighten laws on money laundering, and to force professionals (especially accountants) to do more. This has been lead by the Financial Action Task Force (FATF) on Money Laundering, which has around 30 of the leading Economies of the World as members. The ACCA has issued Technical Fact Sheet 94 to provide guidance to audit firms. The main obligations are: ●
To make sure you know who your client really is, and to confirm where they get their money from (“Customer Due Diligence”).
●
To report any suspicions of money laundering to the relevant authority (in the UK, the Serious Organised Crime Agency – SOCA).
●
Not to tip off a client when you have suspicions.
Any failure to do the above can result in prison – so this needs to be taken very seriously! Accountancy firms are required to have detailed procedures in place to show that they are following the rules. Poor quality policies and procedures can lead to firms being fined.
Practical things for audit firms to do ●
Appoint an MLRO (Money Laundering Reporting Officer) whose job is to make sure all other ML processes are in place in the Firm, and to decide whether suspicions raised by staff should be reported externally to SOCA. The MLRO is likely to be a partner.
●
Have Know Your Client (KYC) procedures – the better you know your client, the easier it is to spot odd transactions and behaviour.
●
Check the identity of all new clients (e.g. by checking passports of directors, Companies House searches on the company itself, its directors and who owns it).
●
Train all relevant staff in ML processes, and in how to spot suspicious transactions.
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CHAPTER 1 – REGULATORY ENVIRONMENT
Suspicious transactions ●
Transactions that pass through several companies or countries, especially when there is no obvious reason for doing so.
●
Multiple small transactions of a similar nature, rather than one large individual transaction.
●
The creation of complicated groups of companies when a simpler solution appears to exist.
●
The creation of a new company that is never actually used to trade.
Cash-based businesses have always been a favourite for money launderers, as they can pass their illegal funds through the company and claim that it is sales revenue. Because it is cash, there may be very little (if any) proof of where it came from.
Example Mr Sowerby is a very successful international drugs dealer, and he has $10million of cash that he wishes to “launder”, so that he can spend it without fear of being questioned as to where he earned it. He builds a gym, and fills it with top of the range equipment, and opens for business. He will probably have to use mostly legitimate money to do this, as attempts to pay contractors and suppliers in cash may be greeted with suspicion. Now the gym is open and has members, he adds fake members to the membership records and pays their fees in cash, using his drugs money. He may have to set up these fake members with addresses of friends, so that if anyone chose to check, they would get the answer Mr Sowerby wants! Notice that he is quite happy to lose some of his money in order to make it legitimate. Before he gets the money as business profits, it will be taxed – but it is worth it, to allow him to spend the remainder. Observations ●
Many businesses refuse to accept cash in excess of a certain limit, as they are afraid that any large cash figure accepted may have come from illegal sources.
●
Any cash based business is useful for money laundering – casinos and launderettes for example.
How could An Auditor Spot This? ●
Analytical procedures – comparing the number of members on the register with the amount who actually turn up at the gym, or considering whether the membership numbers are reasonable for the area in which the gym is located.
●
Being aware that a gym is a potential money laundering business!
Situations that could lead to money laundering offences ●
A client under a tax investigation … if problems are found, the evaded tax is the proceeds of crime.
●
Client making “facilitation payments” (i.e. bribes) to help smooth certain transactions (e.g. paying an official a fee to ensure a contract is won).
●
Having clients in political positions makes them “politically exposed persons” (PEP), who have the power to enrich themselves with public money. As such,
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CHAPTER 1 – REGULATORY ENVIRONMENT
auditors should treat such clients with extra care, ensuring they fully understand the source of all of their funds.
The need for ethical guidance Money Laundering situations may be complex, so ethical guidance would be useful in the following ways: ●
In helping to understand the heavy legal burden.
●
In providing a framework of how to address situations not covered by law or previous experience.
●
In helping to resolve conflicts between client confidentiality, and the need to report externally.
●
In helping to guide an outgoing auditor in what he can say to an incoming auditor as part of the “professional clearance” process.
●
In helping to guide auditors working in countries where there are no / limited money laundering laws.
●
In helping to understand the interaction between money laundering and the audit report, and other reports to clients and 3rd Parties.
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CHAPTER 1 – REGULATORY ENVIRONMENT
LAWS AND REGULATIONS AFFECTING CLIENTS Responsibility of the auditor Auditors cannot know and understand every law and regulation that affects every client, but they should aim to be aware of those that could materially affect the Financial Statements. By doing this, they are more likely to spot breaches, even if management do not tell them (or are themselves not aware). Where breaches are found, that the auditor considers material: ●
Report the breach to management (it is their ultimate responsibility, not the auditor’s, to ensure the company is not breaking laws).
●
If the breach involves management, report to the highest level possible (e.g. Audit Committee).
●
If the breach involves the highest level possible, may need to take legal advice and consider whether the lack of integrity necessitates resignation by the auditor
●
Consider the effect of the breach on the accuracy of the Financial Statements – it may result in a qualified audit report.
●
If laws are new, or have been announced but precise detail is yet to be agreed by government, it may be difficult to assess the effect on the company, and may affect the Going Concern assessment.
●
In some cases, a breach may have external reporting consequences.
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CHAPTER 1 – REGULATORY ENVIRONMENT
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Chapter 2
Professional and ethical considerations
SYLLABUS CONTENT 1.
Code of ethics ●
2.
Fraud and error ●
3.
Application of fundamental principles of ethics – threats and safeguards
The auditor’s responsibility for prevention, detection, investigation, and reporting of fraud
Professional liability ●
To whom auditors may be held liable, how much for, and what can be done to restrict such liability – including the “expectation gap”.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 19 HE CODE OF ETHICS --------------------------------------------------- 20 FUNDAMENTAL PRINCIPLES
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WHY A
20
OBJECTIVITY
20
CONFIDENTIALITY
21
CONFLICTS OF INTEREST
22
THE AUDITOR AND FRAUD---------------------------------------------- 23 SOME DEFINITIONS
23
AUDITOR RESPONSIBILITIES FOR FRAUD
23
FUTURE ROLE OF AUDITOR
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AUDITOR LIABILITY ---------------------------------------------------- 24
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TO WHOM ARE AUDITORS LIABLE?
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HOW LIABLE MIGHT THE AUDITOR BE?
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EXPECTATION GAP REVISITED
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
EXAM QUESTIONS ●
Identify the ethical and other professional issues relating to the above situations and state what action, if any, should be taken (Pilot Paper Q5).
●
To whom are auditors held liable for poor audit work?
●
How can an audit firm restrict their liability?
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
THE CODE OF ETHICS It is essential that accountants have the public’s trust. As such, ethical behaviour is critical to the reputation of the accountancy profession, and to the value of accountancy and audit work. IFAC have a Code of Ethics, and most accounting bodies (including ACCA) have adopted virtually all of its content. In 2009 the IFAC Code was updated – an explanation of the changes can be found in chapter 8 Current Issues.
Fundamental principles These were met at Paper F8, and so no explanations are provided – refer to Chapter 2 of the Study Text if you need a detailed reminder: ●
Integrity
●
Objectivity
●
Professional competence and due care
●
Confidentiality
●
Professional behaviour.
Why a “Conceptual Framework”, not rules? ●
Would be impossible to have rules for every situation
●
Rules prevent the use of thought
●
As professionals, we should be able to rely on accountants to use professional judgement
●
In many cases, there may not be a “right” answer
●
Depending on your morals, 2 different people may believe there are 2 very different “right” answers!
Objectivity It is essential that auditors (and anyone giving an opinion) be, and be seen to be objective.
Threats ●
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Self-Interest o
undue dependence on a single client
o
overdue fees
o
gifts and hospitality
o
loans to/from client
o
contingency fees
o
lowballing
o
owning shares in client.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
●
●
●
●
Self-Review o
other services
o
preparation of the accounting records being audited.
Intimidation o
family relationships
o
undue dependence on a single client
o
financial / business relationship with client
o
second opinion received from another firm.
Familiarity o
family relationships
o
acting for a client for several years.
Advocacy o
contingency fees
o
legal services
o
negotiating with banks, tax authorities on client’s behalf.
Safeguards ●
Rotate audit staff (especially senior audit staff).
●
Do not allow shares to be held in client companies.
●
Use separate teams for other services.
●
Remind management that they remain responsible for all company decisions.
●
If asked for a second opinion from a non-client, refuse to provide an opinion unless allowed to consult with their current auditor.
●
No contingency fees.
●
No single client to exceed a set % of the audit firm’s total revenues.
Confidentiality The general rule is simple – do not disclose client information to anybody. However, there are exceptions: ●
Where the law requires disclosure (e.g. money laundering)
●
Where the client gives permission
●
Where it is deemed to be in the “public interest”
●
Where the ACCA are investigating the auditor’s work.
Wherever there is doubt, a consultation with a lawyer would be wise. And resigning from a client does NOT mean that the auditor is now free to disclose any information that he wishes!!!
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
Conflicts of interest Conflicts of interest can be very difficult situations. The most common is between 2 clients, where what is good for one client is bad for the other. Thus the auditor cannot help one client without harming the other … an impossible situation!
Managing conflicts of interest ●
Before accepting a new client, consider the likelihood of conflicts with existing clients … it may be best to refuse.
●
Where a conflict is possible:
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o
Send separate teams of staff …
o
… from separate offices, if possible
o
different partner at the head of each team
o
a 3rd partner to oversee that the teams are kept apart
o
stricter confidentiality rules to avoid crossover of paperwork and information
o
tell both clients of the conflict, and what the firm is doing to manage it
o
consider resignation from one, or both, clients.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
THE AUDITOR AND FRAUD This is a rare subject at this high level, as it is also on the F8 exam. As such, the Notes are very brief – consult Chapter 3 of the Study Text for more detail.
Some Definitions Fraud is defined as the use of deception to gain an unfair advantage. Misstatement in the FS could be caused by fraud (assets may be overstated if they have in fact been stolen, or FS info may be deliberately misstated to paint a particular picture of the company to allow fraudsters to gain through bonuses, higher share price, or simply keeping their jobs). An Error is an unintentional misstatement. As well as mistakes in the FS (deliberate or otherwise), there could be other Irregularities (e.g. missing information).
Auditor responsibilities for fraud A company’s Board of Directors has the primary legal responsibility for the prevention and detection of fraud. However, the audit process is naturally suited to finding fraud, and fraud is highly likely to affect the truth and fairness of the Financial Statements, so the auditor has significant responsibility. A key concept here is scepticism. Auditors should not accept any information presented to them unless there is sufficient supporting evidence. The auditor is responsible for planning their work in such a way as to maximise the likelihood of identifying all material misstatements, whether fraud or error. The engagement team should discuss fraud during planning, risks should be assessed, and the audit process adapted as necessary. This requires a deep understanding of the client, to understand the motivations and opportunities that might exist. The auditor may also have to report externally when a fraud is suspected, and will eed to consider whether to continue to act for a client where fraud is suspected/proved.
Future role of auditor For many years, an expectation gap has existed and it is clear that the public believes/expects auditors to be far more active in detection of fraud (and possibly in prevention as well). In recent years, the redrafting of ISA 240 has made clear that the auditor’s role is no longer “watchdog” and is much more “bloodhound”. In the next few years, auditors may be expected to report on a company’s internal controls (as they already do in the US under SOX), and other increases in duties relating to fraud at clients are highly likely.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
AUDITOR LIABILITY To whom are auditors liable? Shareholders as a body The auditor is effectively employed by the company (the shareholders as a body) to perform a service for a fee. If the service is poorly/negligently performed, it is highly likely that the shareholders have a claim against the auditor for any losses they have suffered. This is true of all assignments, not just audits.
Third parties To be liable to a 3rd Party, the following conditions must exist: ●
There was a duty of care at the time the audit opinion was given o
Auditor knew, when giving the opinion, the 3rd Party would rely on the audit opinion
o
Reliance on the audit opinion was a reasonable action.
●
The audit work was negligent.
●
Losses have been suffered as a result of this negligence.
The auditor can issue a disclaimer to cancel a duty of care to 3rd Parties. There are a number of legal cases that have helped to clarify the current position, but no detailed knowledge of cases is expected.
How liable might the auditor be? In general, if an auditor has been negligent and people have lost out as a result, it would seem right that the auditor should compensate the losses. However, the quantity of compensation has long been a point of debate. The main issue is that when people lose money it is usually due to some mismanagement of the company, fraud, or accounting errors – all of which are primarily the responsibility of the directors. If the auditor fails to spot the problem, then there is likely to be some fault in the audit work, but the auditor is ot the only one to blame so should not be required to pay all the compensation! In addition, if auditors are required to pay massive compensation claims, there is a danger that no audit firm is willing to accept high-risk clients. Possible Solutions In some countries, including the UK, there are legal ways in which liability can be restricted: ●
Put a disclaimer to all 3rd Parties in the Audit Report (in the UK, most firms did this as a result of the 2001 Bannerman case – whether the disclaimer stands up in law is yet to be tested).
●
Become an LLP. This removes the unlimited liability of being a standard partnership, as only those partners directly found to be negligent could be found guilty.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
●
Become a limited company. This removes liability, but has massive tax and reporting consequences.
●
Government-set liability cap. audit firm could be sued for.
●
Proportionate liability would allow compensation to be split in the proportion of wrongdoing.
●
Allow audit firms to agree a system with each client’s shareholders. If both parties agree, any restriction would be allowed (a government could decide to overturn any “Limited Liability Agreement” which it felt was unfair).
There would be a maximum amount that an
Expectation gap revisited As noted above (see Fraud section), there is an expectation gap between what the public thinks auditors do (or should do), and what the audit profession actually does. During the recent Banking Crisis, many in auditing have said that “the audit profession had a good crisis” – meaning that audits had been done properly and there was no suggestion (yet!) that auditors had been negligent or unprofessional. However, others have said that if auditing cannot forewarn that major international banks are too optimistic in their asset valuation and risk management, then there is something wrong with auditing and it needs to be changed. Any extra responsibilities for auditors would cause liability issues – every job an auditor does creates a risk of another legal case – and audit firms are unlikely to accept more responsibilities without the liability implications also being discussed and an acceptable conclusion being reached.
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C H A P T E R 2 – P R O F E S S IO N A L A N D E T H IC A L C O N S ID E R A T I O N S
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Chapter 3
Practice management
SYLLABUS CONTENT 1.
Quality control ●
2.
Advertising, fees, obtaining professional work, tendering ●
3.
How audit firms control the quality of their work, both overall and on individual assignments.
Professional issues involved in trying to win new business.
Professional appointments ●
Matters involved in agreeing a new assignment with a client.
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CHAPTER 3 – PRACTICE MANAGEMENT
CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 29 QUALITY CONTROL ------------------------------------------------------ 30 ADVERTISING, FEES, AND TENDERING ------------------------------- 31 ADVERTISING AND PUBLICITY
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FEES
31
TENDERING FOR WORK
32
PROFESSIONAL APPOINTMENTS--------------------------------------- 33
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CHAPTER 3 – PRACTICE MANAGEMENT
EXAM QUESTIONS ●
For the above scenario, outline the quality control issues and how they might be resolved.
●
For the above scenarios, explain the professional issues raised by the planned publicity, advertising and fee proposals.
●
Suggest the factors a firm should consider when tendering for work.
●
Suggest the factors a firm should consider when deciding whether to accept a ew assignment.
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CHAPTER 3 – PRACTICE MANAGEMENT
QUALITY CONTROL Given the importance of the work done by accountants and auditors, and the reputation damage to both the firm and the profession when that work is of poor quality, it is clear that quality control is extremely important.
Quality control within the firm At the overall level of the Firm, several things can be done: ●
Appoint a Quality Control Partner, to ensure quality is considered at the highest level.
●
Have documented processes for staff to follow.
●
Ensure staff are trained in these processes.
●
Have strict recruitment policies.
●
Ensure appraisal processes recognise quality (and the lack of it).
●
Ensure overall Environment is one where quality is rewarded, and poor quality is punished.
●
Careful selection of assignment teams, based on skills, experience, overall workload etc.
●
Cold Review process where a selection of completed assignments are checked to help future work be done better.
Quality control on each assignment ●
All work is suitably: o
Directed
o
Supervised
o
Reviewed.
●
Suitable consultation with others, where matters are unclear.
●
Hot Review (before the work is finished) of any assignment where the risk of mistakes is higher.
●
Careful thought about which member of the team should perform and review each task, and the best time for that task to be performed.
●
All work to be suitably planned and documented.
●
Careful procedures on acceptance / continuance of client relationships.
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CHAPTER 3 – PRACTICE MANAGEMENT
ADVERTISING, FEES, AND TENDERING Advertising and publicity All businesses need to consider how they will attract clients. However, advertising and publicity are by their nature in the public eye, so care must be taken not to do anything that could be considered “unprofessional”, as this may damage the reputation of the firm, or the profession as a whole. The general principles are as follows:
Clarity and accuracy There should be no comments that could be misleading, or that are simply not true
No unsubstantiated claims Statements such as “we are the best auditors in London” cannot be included … unless the firm were voted “Best Auditors in London” at some awards ceremony … but the advertisement would need to make reference to this fact.
No adverse comments about fellow professionals Comments such as “we are so much better than KPME” are not acceptable.
General professionalism Adverts should avoid doing anything that might damage the reputation of the profession – a naked parade through the streets handing out leaflets would be inappropriate, for example!
Use of the ACCA name and logo It should be clear that the firm is registered with the ACCA, but is a separate organisation.
Fees Generally speaking, fees should be charged which reflect the work done. Most firms operate a system of charge-out rates for each member of staff, so that the bill is simply hours worked multiplied by the relevant rates. However, there are some issues:
Contingency Fees We met these when studying ethics – they are banned!
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CHAPTER 3 – PRACTICE MANAGEMENT
Lowballing This is the process of offering a very low fee in order to win business, in the hope of making the money back with increased fees in the future, or by selling additional services at a premium. In most countries, lowballing is not banned. However, some countries have tried to stop it happening, by insisting that audit fees are at least a minimum % of the client’s sales revenue. The ACCA position is that lowballing is acceptable (although it is preferable NOT to do it), as long as: ●
Quality of work is not affected
●
The client is told that the fee is lower than standard.
Tendering for work Exercise A company has grown rapidly and finds itself needing to appoint an external audit firm for the first time. Your Firm has been invited to tender. What content should go into your Firm’s presentation?
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CHAPTER 3 – PRACTICE MANAGEMENT
PROFESSIONAL APPOINTMENTS Why companies change auditors There are many reasons: ●
Disagreement over the audit fee
●
Audit firm considered too small (e.g. client has grown rapidly)
●
Personality conflict
●
Independence reasons
●
Conflict of interest
●
Audit firm chooses not to seek re-election.
Issues when considering a client Other than those already considered in earlier sections of the Notes – ethics, money laundering etc.: ●
Does firm have the time to do the audit and meet client deadlines
●
Does firm have the staff and resources
●
Professional clearance – any issues raised by the outgoing auditors
●
Ensure that outgoing firm correctly removed / resigning
●
Assess integrity of the client and its directors
●
Assess risk of the client.
It may be possible to obtain some audit paperwork from the outgoing auditor. There are legal issues involved, although in the UK there are moves to make it easier for the incoming firm to get such information from the outgoing firm. The auditor must also ensure that “the necessary preconditions for an audit” are in place – an audit cannot take place unless the company can confirm that their financial statements follow an accepted system of financial reporting (if no standards have been followed, there would be nothing for the auditors to check against), and management must confirm they understand their own responsibilities in allowing the auditors to carry out the audit process. This last point leads us neatly to ...
Engagement letter Once all issues have been dealt with, the audit firm sends an engagement letter (a contract) to the client, and both parties sign it. More details about engagement letters can be found in Chapter 5 of the study text – but this should be revision from paper F8 (2.6), and is rarely examined at this higher level.
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CHAPTER 3 – PRACTICE MANAGEMENT
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Chapter 4
Assignments I – the audit of financial statements
SYLLABUS CONTENT 1.
Planning ●
2.
Evidence gathering ●
3.
Assessment of risk, materiality, and other matters in the planning process.
The use of various audit techniques to get evidence about the truth and fairness of all items in the Financial Statements (note – any area covered in P2 (3.6) Corporate Reporting is examinable here).
Completion phase ●
The assessment of going concern, corresponding figures, other information, subsequent events and other completion phase audit activities.
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CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 38 AUDIT PLANNING ------------------------------------------------------- 39 RISK BASED APPROACHES TO AUDITING
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RISK QUESTIONS IN THE EXAM ---------------------------------------- 42 EVIDENCE GATHERING-------------------------------------------------- 44 RELIANCE ON EXPERTS
45
PRESENTATION OF FINANCIAL STATEMENTS
45
INVENTORIES
46
CASHFLOW STATEMENTS
46
CHANGE IN POLICIES, ESTIMATES ETC.
47
EVENTS AFTER THE REPORTING PERIOD
47
LONG TERM CONTRACTS
47
PROVISIONS AND CONTINGENCIES
48
GOODWILL
49
RESEARCH AND DEVELOPMENT COSTS
50
OTHER INTANGIBLE ASSETS
50
ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS
51
IMPAIRMENT
52
GOVERNMENT GRANTS
53
INVESTMENT PROPERTIES
54
LEASES
55
RELATED PARTY TRANSACTIONS
56
SEGMENTAL REPORTING
57
SUBSTANCE OVER FORM
58
TANGIBLE NON-CURRENT ASSETS
58
BORROWING COSTS
59
DEFERRED TAX
60
EARNINGS PER SHARE
60
SHARE-BASED PAYMENTS
61
FAIR VALUE AND ESTIMATES
61
EMPLOYEE BENEFITS
62
FOREIGN EXCHANGE TRANSACTIONS
64
FINANCIAL INSTRUMENTS
64
THE COMPLETION PHASE ----------------------------------------------- 66
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MANAGEMENT REPRESENTATIONS
66
SUBSEQUENT EVENTS REVIEW
67
OTHER INFORMATION
68
OPENING BALANCES AND COMPARATIVES
69
FINAL ANALYTICAL PROCEDURES
70
OTHER COMPLETION ISSUES
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C H A P T E R 4 – A S S I G N M E N T S I: T H E A U D I T O F F IN A N C I A L S T A T E M E N T S
EXAM QUESTIONS ●
Identify the business risks associated with the above company, and how these might best be managed.
●
Identify the business risks associated with the above company, and how these might relate to financial statement risk.
●
Identify the financial statement risks associated with the above company.
●
Identify the audit risks associated with the above company, and how the auditor may seek to address them.
●
Suggest the audit procedures that may be carried out (or the audit evidence that may be collected) for the following areas of the Financial Statements.
●
Discuss the extent to which analytical procedures could be used during substantive testing for the above client.
●
Explain the importance of subsequent events to the audit.
●
Explain the auditor’s responsibilities towards corresponding figures.
●
Explain the auditor’s responsibilities towards the going concern assessment.
●
Explain the auditor’s responsibilities towards Other Information.
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AUDIT PLANNING Risk based approaches to auditing The audit risk approach You should be familiar with the audit risk model from earlier studies on F8 (2.6), but here is some brief revision:
Audit Risk = Inherent Risk x Control Risk x Detection Risk Audit Risk is the risk of giving the wrong audit opinion … primarily, the risk that there are material mistakes in the Financial Statements and the auditor fails to detect them during substantive testing. The risk of material mistakes in the Financial Statements is called Financial Statement Risk, and is made up of 2 elements: ●
Inherent Risk – the risk of material mistakes occurring due to the nature of the company and its business transactions.
●
Control Risk – the risk that the inherent risks are not prevented or detected by the company’s Control Systems.
Auditors assess Financial Statement Risk by: ●
Assessing Inherent Risk.
●
Assessing Control Risk o
Do the controls look good in theory
o
Are they actually operating properly (Control Tests).
If Financial Statement Risk is HIGH then the auditor needs to keep Detection Risk LOW, by increasing the quantity of substantive tests, sending a more experienced audit team etc.
Problems with the audit risk approach A number of academics and leading audit firms were concerned that there were weaknesses with the audit risk approach: ●
●
Either lots of detailed substantive tests got done, or a combination of detailed control tests and substantive tests got done … but whichever approach was taken, there was a heavy focus on detail. o
This could result in missing bigger issues – major fraud, or problems with going concern
o
Detailed tests are likely to be done by relatively junior staff … meaning:
Even less chance of big issues being spotted, due to a lack of experience
Difficult to give clients “added value”.
The approach was time consuming, and was not making the best use of advances in IT.
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Business risk / top-down approach The business risk / top-down approach starts by considering risks to the business itself – this is necessarily going to focus on high-level issues likely to concern investors. Once business risks are identified: ●
The auditor can consider how these business risks are likely to create financial statement risks
●
Audit work can then be directed at these financial statement risks
●
The auditor can add value to the client by suggesting how business risks could be managed.
The approach requires more time to be spent understanding the client so planning time is likely to increase compared with the audit risk approach. However, this creates efficiency later in the audit: ●
When assessing control systems, the knowledge of the client allows more time to be spent on the control environment, rather than extensive testing of detailed control procedures
●
When performing substantive tests, the knowledge of the client allows more focus on analytical procedures, rather than substantive tests of detail (Enquiry, Inspection, Observation, Recalculation).
Both of these issues are likely to save time … and both require the use of more experienced, senior members of the audit team. The involvement of more senior staff should solve the other problems of the audit risk approach – an inability to add value, and an inability to spot bigger issues with the client.
Some audit strategy issues There are a number of choices for the auditor that can make a big difference to audit efficiency:
1.
Audit Plan v Audit Strategy? The audit strategy sets the overall scope, timing and direction of the audit. It will include the decision on how much to rely on the company’s internal controls (see below). The audit plan is the more detailed process which sets out the work to be done in order to achieve the chosen strategy. Audit plans will include materiality assessment, preliminary analytical procedures, detailed risk assessment and audit procedures planned in response to the assessed risks.
2.
Rely on Controls, or do a Full Substantive audit? If controls are weak, there is no choice – a full substantive audit is the only option. However, if controls appear strong, there is a choice:
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●
Spend time testing controls, in the hope that substantive tests can then be reduced
●
Invest no time testing controls, and just do a full substantive audit anyway.
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C H A P T E R 4 – A S S I G N M E N T S I: T H E A U D I T O F F IN A N C I A L S T A T E M E N T S
Whichever approach is expected to get the required amount of audit evidence the quickest, is the approach that will be selected.
3.
How much can we use Analytical Procedures? Analytical Procedures are one of the most efficient forms of substantive audit test – so in most cases, the more they can be used, the better! However, it is generally easier to use analytical procedures when:
4.
●
The client is NOT new
●
There are no major changes in the client’s business since last year
●
There are other companies similar to the client, for comparison purposes
●
The company is well controlled, meaning detailed statistics can be trusted
●
There are lots of estimates in the Financial Statements, as there may ot be much other evidence available!
Materiality Reminders from F8As learned on F8, materiality is a measurement of the potential importance of an error or omission to those reading the financial statements. Remember that items may be material due to their relative size, or due to their nature. Materiality is initially set at the Planning stage, and this may require the use of estimated/budgeted/prior year figures. As the audit progresses, materiality may need to be reassessed (e.g. as draft figures are altered due to errors being discovered). Remember that all small errors are noted, and then added up at the end of the audit to see if the cumulative effect is itself material. For some areas of the financial statements, the auditor may decide that a specific (usually smaller) materiality level should be set. Also, auditors may allocate smaller materiality figures to each area of the financial statements, knowing that errors in each section might sum up to an error which is material at the overall FS level. Such smaller/specific materiality figures are called Performance Materiality.
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C H A P T E R 4 – A S S I G N M E N T S I: T H E A U D I T O F F IN A N C I A L S T A T E M E N T S
RISK QUESTIONS IN THE EXAM These are on virtually every high level audit exam paper that the ACCA has ever sat, and P7 students can expect to see at least one question, almost certainly compulsory, on every P7 exam paper. The questions need thought, and a lot of practice, because: ●
There are different types of risk that can be examined, but the scenarios often look very similar … so it would be easy to answer with the wrong type of risk and score zero.
●
The questions tend to be fairly repetitive, so practice should ensure that you are very well prepared for whatever company the examiner gives you on exam day!
Audit risk questions The exam technique is the same as for the lower level audit paper F8 (2.6) … but the scenario is likely to have some more complicated things in it. The key is to remember you are looking for audit risks – so explanations need to be relevant to the auditor.
Example LNA is a company that sells laptop computers to shops throughout the UK. Just over a year ago, LNA paid $1million for a 5-year exclusive right to sell the EK69 model in the UK market. Sales of the EK69 were excellent for the first few months, but sales have been falling in the last 2 months, partly because of repeated technical faults with the most recent batch sold. What are the audit risks? ●
The 5-year right is an intangible asset which should have been capitalised on purchase. It should be amortised over its 5 year life, and probably therefore has a carrying value of $0.8m at present.
●
The fall in sales represents evidence that the value of the right may have been impaired.
●
In fact, with the speed of technical change in computers, it seems unlikely that sales of any laptop would stay high for 5 years.
●
Therefore, there is a risk that the right is overvalued on the Balance Sheet.
●
Any inventory of the EK69 may also be overstated, as technical faults may bring NRV below cost.
●
If this product is very important to LNA, or if the reputation damage from the faults is high, the company’s going concern status could be in doubt. There may be a lack of disclosure of these doubts in the Notes to the Financial Statements.
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Tips for Audit Risk questions ●
If an audit risk question goes on to ask what audit work you would do for “X”, then “X” must surely be an audit risk – so put it in your answer to the audit risk bit of the question!
●
Most audit risk answers are full of inherent risks, with very few control or detection risks.
Financial statement risk questions Remember, Financial Statement Risk is inherent risk and control risk – so it is simply audit risk without considering detection risk issues. So if a question asks for financial statement risks, you simply need to identify why their FS could be materially wrong. Questions in recent years have been very repetitive, with common issues being: ●
Inaccurately estimated provisions
●
Impaired assets (especially intangibles)
●
Failure to disclose going concern risks
●
Preparation of the FS on a going concern basis when the company does not appear to be a going concern
●
Overvalued inventory.
Business risk questions Business Risks are risks to the business! In other words, they are risks to the future success of the company, so it is the company, rather than the company’s financial statements, that needs to be focussed on. You need to know very little to answer business risk questions. There are hundreds of different types of business risks – just use the information in the question.
Business risk and financial statement risk Sometimes questions combine business risk and financial statement risk, requiring you to: ●
Identify the business risks
●
Explain how these link to financial statement risks.
The easiest way to understand the differences between the question types is with an example:
Example PGC is a company that buys and sells in a number of different countries around the world. What are the audit risks? What are the business risks? How could these business risks link to financial statement risks?
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EVIDENCE GATHERING On the P7 exam students can expect to be required to suggest audit procedures for specific matters raised in a company scenario. Whereas on F8 this audit work is likely to involve relatively simple areas of accounting (inventory valuation, depreciation, bad debts etc.), on P7 the questions could involve audit work on virtually any area of the Financial Statements. Strictly speaking, any accounting standard on the P2 syllabus could be examined on the P7 exam paper. However, because some students are still attempting P7 before P2 due to the transition to the new ACCA syllabus, it is likely that the majority of standards that arise on P7 will continue to be F7 rather than P2. This section of the syllabus requires 2 things: ●
A thorough knowledge of the accounting standards, so that accounting issues can be identified from a scenario in the exam
●
The ability to suggest audit procedures to address those accounting issues.
As such, this section of the Notes takes you through all of the relevant accounting areas, highlighting the main points of each standard and the most likely audit work.
Question technique Accounting Matters If a question asks for Matters, the main issues are: ●
What is the correct accounting treatment in this situation?
●
Is the company’s accounting treatment correct or not?
●
How material are the mistakes they are making?
Evidence / Procedures When a question asks for audit procedures, remember that there are some useful checklists: ●
What documents would be available.
●
Any 3rd Parties who can provide written confirmations.
●
Would a written management representation help.
●
What post year-end events may have occurred, that would help assess the year-end accounting treatment.
●
Could this have happened in previous years – if so compare.
Another way to think of the above issues is by using the AEIOU mnemonic (Analytical procedures, Enquiry and confirmation, Inspection, Observation and RecalcUlation)
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Reliance on experts As well as using external confirmations as a form of evidence (e.g. from the client’s bank, suppliers, customers etc.), auditors may sometimes need to seek help from other experts (i.e. not accountants/auditors). The increase in the use of the fair value concept is one major reason for the increased desire to seek external help on an audit. The use of such experts creates risks, and these need to be addressed: ●
if the expert comes from outside the audit firm, they will not be subject to the audit firm’s quality control procedures
●
if they do not understand the context of an audit, their expert advice may lack usefulness (and may in fact result in the wrong audit opinion)
As such, auditor’s experts must be carefully selected, and their competence, objectivity etc. must be without question. They must understand the audit, and the auditor must understand how the expert does their work (to ensure it is relevant to the audit process, proper quality control etc.) Where a client supplies their own expert, they can never be deemed to be objective. Also, the auditor must not refer to the reliance on an expert in the audit report – this might suggest the auditor is not wholly responsible for the audit opinion, which of course they are. If the laws of their country force a reference to the expert to be made, the auditor must add a note to the audit report making clear that they retain full responsibility for the audit opinion (this is the same situation in a Group audit where there are Component Auditors). External auditors may wish to place reliance on the client’s internal audit provider, as they may have done work that is very relevant to the external auditor. Similar issues as explained above will need to be considered before any reliance can be placed.
Presentation of financial statements This standard has all the basic accounting concepts in it. Nothing major for the P7 exam, but INT students should note that: ●
The Balance Sheet is now the Statement of Financial Position
●
The Income Statement is now the Statement of Comprehensive Income
Items that would previously have moved through Reserves (e.g. a revaluation surplus) will now be reported at the bottom of the S of CI.
Accounting issues Companies will typically prepare Financial Statements under the Going Concern concept. If the company has going concern doubts, these should be disclosed in the Financial Statements. If the company is not considered a going concern, its Financial Statements should be presented under an alternative basis.
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Audit work Auditors should assess the going concern status of clients by: ●
Reviewing the latest trading results of management accounts after the year end.
the
company,
●
Assessing the cash the company has (e.g. by agreeing bank statements, loan agreements etc.) and the cash the company could generate: o
Assets that could be sold
o
Assets that could be used as security for a loan
o
Receivables that could be collected (or sold to a factor).
by
inspecting
●
Assessing the state of the industry.
●
Obtaining a written representation from the Board that the company is a going concern.
●
Assessing company forecasts for reasonableness.
Inventories Accounting issues Should be valued at the lower of cost or net realisable value (NRV). Not much for P7 students here, as most of the IAS 2 issues were examined under Paper F8. However: ●
All methods of inventory valuation that are likely to produce a reasonable valuation are allowed (note – LIFO is banned!).
●
If inventory is purchased on credit, but there is an interest charge for the delayed payment, the interest charge is NOT part of cost.
Audit work Cost should be agreed to: ●
Invoices (if purchased)
●
Materials requisitions / timesheets / personnel records if manufactured
●
If manufactured, overhead absorption method would need to be reassessed for reasonableness.
NRV should be agreed to: ●
Post year-end selling prices / invoices.
Stocktake attendance should ensure that the quantities are correct.
Cashflow statements Very little here for the P7 exam. Various Notes can be presented in different ways, and if a new method is chosen in one year, the prior year presentation would need to be changed as well.
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Change in policies, estimates etc. Prior period adjustments Where: ●
an accounting policy is changed in the current year
●
an error is discovered in a prior year
the prior year figures should be restated. Watch dates in questions carefully …….
Audit work ●
Agree events to whatever documentation exists.
●
Inspect Financial Statements to verify disclosure of PPA.
Events after the reporting period Accounting issues Events that occur after the year-end are usually relevant to the next year’s Financial Statements. However, some post year-end events can be important: ●
Adjusting Events are those that provide new information about the company’s position at the year end.
●
Non-Adjusting Events may be disclosable if they are important enough to matter to shareholders.
●
Any event becomes adjusting if it affects going concern.
Audit work This will depend entirely on the issue in the question – but since such events can be audited right up to the date the audit report is signed, investigation of all post yearend evidence is vital.
Long term contracts Accounting issues If a contract‘s outcome can be reliably estimated, a share of profits should be recognised at the year end, depending on the % completed. The main accounting issues are: ●
Whether the method of measuring completeness of the contract is reasonable.
●
Whether all costs and revenues are included in the correct contract.
●
Whether on loss making contracts, the full loss has been accounted for.
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C H A P T E R 4 – A S S I G N M E N T S I: T H E A U D I T O F F IN A N C I A L S T A T E M E N T S
Audit work To assess whether a contract is profitable: ●
Assess future contract estimates for reasonableness
●
Agree contract income back to the contract document itself.
To assess loss-making contracts: ●
Investigate all transfers of costs and revenues between contracts to ensure correct.
Provisions and contingencies This has been one of the most examined accounting areas on the exam in recent years. There are several examples, and being estimates they are naturally harder to audit than areas of fact.
Accounting issues Provisions are required where: ●
There is an obligation existing at the year end (either legal or constructive)
●
A future payment (or other transfer of economic benefits) is probable
●
The amount can be estimated
If all these conditions are in place, a liability is recorded on the Balance Sheet (Statement of Financial Position). The other half of the entry (the debit) usually goes to expenses, thus reducing profit for the year. However, this is not always the case. Where the existence of a year-end obligation and future payment is possible rather than probable, then no liability is recorded. Instead, the situation is disclosed in a Note to the Financial Statements – this is called a contingent liability. If there is a probable inflow which can be reliably estimated, then we have a contingent asset. Despite this inflow being probable, it is NOT recorded as an asset. Prudence dictates that the matter is simply disclosed in a Note. Provisions and contingencies can arise for many reasons: ●
Legal cases that the company might lose.
●
Laws or regulations that have been broken.
●
Breaches of contract with staff / suppliers etc.
●
Products sold under warranty.
●
Decommissioning obligations.
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Audit work Audit work will depend on the situation, but there are some procedures that will be useful in many of the above situations: ●
Where the provision is likely to have also been made in prior years, compare prior year provision to actual events to see how accurate last year’s estimate was. If last year was accurate and the same method of estimation is used this year, some assurance is gained that this year’s figure is reasonable.
●
For anything legal, obtain written confirmation of the situation from the company’s lawyers.
●
For anything contractual, inspect a copy of the contract / agreement.
●
Correspondence with the other parties involved should be inspected.
●
If the provision involves a calculation, it should be re-performed (with any assumptions assessed for reasonableness).
Goodwill Accounting issues Goodwill is the difference between the fair value of the consideration paid, less the fair value of the net assets acquired. It is most likely to be seen on the exam where there has been an acquisition. Goodwill represents an intangible asset. However, unlike most other intangibles, it is not amortised. should be assessed for impairment on at least an annual basis.
Instead, goodwill
Any fall in performance of an acquired business below the expectation at the date it was acquired would suggest that the business may have been bought at too high a price. The first asset whose value should be reduced is goodwill.
Audit work Since goodwill is the fair value of consideration less the fair value of net assets purchased, audit work should include: ●
At the date of purchase, agreeing consideration to purchase contract
●
Where any consideration is deferred, assessing any discount rate used for reasonableness
●
Where there is contingent consideration, assessing the likelihood that such consideration will be paid
●
Verifying any valuation work done on the net assets acquired.
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Research and development costs Accounting issues The costs incurred in developing new products may be an intangible asset, if there is reliable evidence that the new products will generate future economic benefits. To generate benefits, the new products: ●
●
Need to be completed o
Which requires the company to have the resources to invest
o
Which requires no legal barriers to completing the products
o
Which requires the company to intend to finish the development, and ot divert resources to other projects
o
Which requires the new product to be technically feasible.
Needs to sell enough to exceed the development costs.
Audit work ●
Inspect project development.
budgets to assess
the
finance needed
to
finish
the
●
Inspect bank letter, loan facilities etc. to assess company’s available finance.
●
Inspect Board Minutes to assess company’s intention to complete the project.
●
Observe testing of prototype to help assess technical feasibility of the new product (may need a technical expert to assist).
●
Obtain written confirmation from company’s lawyers that there are no known legal issues in completing the development.
●
Obtain written management representation to confirm management intentions to complete the development.
●
Inspect results of company’s market research to assess future sales of the product.
●
If any orders / deposits already received, inspect order forms to confirm.
●
Analyse the costs which have been capitalised to confirm they belong to this project.
Other intangible assets Accounting issues Any purchased intangibles – rights, licences, brands etc. – should normally be capitalised as intangible assets and amortised over their expected useful lives. Typically, useful lives are assumed to be a maximum of 20 years. It is allowable to amortise over a period of more than 20 years, or even not to amortise at all … but only if annual impairment reviews are carried out instead. The main accounting issue with intangibles in exam questions tends to be impairment.
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Audit work ●
Agree cost of intangible to purchase documentation
●
Analyse trend of income generated by the intangible (both in the past, and future forecasts) to assess impairment
●
Compare accounting treatment with previous examples in this company, and with similar examples in the industry.
Assets held for sale and discontinued operations Accounting issues Assets held for Sale Where a company has: ●
Decided to sell an asset
●
Made the asset ready for sale by the year-end
●
Is actively trying to sell the asset at the year-end, and expects a sale within 12 months.
Then the asset is deemed to be “held for sale”. It should: ●
No longer be depreciated
●
Be shown separately on the face of the Statement of Position
●
Be valued at the lower of book value (i.e. depreciated cost) or NRV.
Of course, an asset held for sale could include a subsidiary company, or an entire division of a business. This brings us on to discontinued operations.
Discontinued Operations A discontinued operation is a subsidiary, division, or other clearly separate part of a business that: ●
Has been permanently closed, or has been sold, during the accounting year, or
●
Is “held for sale” (see above Notes) at the year-end.
If it qualifies as discontinued, the results of this part of the business should be disclosed separately from the rest of the business in the Income Statement. If the segment remains “held for sale” at the year-end, it should be treated on the Balance Sheet as any other “held for sale” asset, as explained above.
Audit work For assets / operations that have been disposed of: ●
Agree proceeds to sales documentation and bank statements
●
Recalculate any gain or loss on disposal and ensure separately disclosed in Income Statement
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●
If asset had previously been revalued, ensure any balance on revaluation reserve has been transferred to income reserves (Equity), not included in the year’s profit
●
Verify date on sales documentation to prove asset was sold before year end.
For assets / operations “held for sale”: ●
Inspect Board Minutes to confirm intention to sell
●
Inspect correspondence with agent to confirm company is actively trying to sell the asset
●
If company has documentation
●
Obtain management representation to confirm Board’s intention to sell
●
Inspect correspondence regarding the sale
●
If company has made any announcements regarding the plan to sell, inspect copies and agree date before year end
●
Assess asset / operation for impairment, as a plan to sell often indicates asset / operation is not performing as well as company would like.
advertised
the
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If a company is planning to close down an operation, it is NOT a discontinued operation unless it was closed before the year end. As a separate issue, closing down (or announcing plans to close down) an operation: ●
Strongly suggests the operation is impaired … so if it still to be closed at the year end, it should be assessed for impairment
●
Is likely to result in obligations being created (e.g. redundancy and other closure costs).
Impairment Accounting issues Assets are at risk of overstatement if their recoverable value is less than their carrying value. This risk attaches itself to all assets, both current and non-current, and therefore impairment can arise in many exam scenarios. As well as basic situations such as inventory sold shortly after the year-end at below cost, or receivables which go bad after the year-end, impairment could be suggested by under-performing divisions or subsidiaries (resulting in all/any of the assets of that part of the business – the cash generating unit – being overstated). When companies choose to shut down part of their business, the most obvious accounting standard to consider is Discontinued Operations. However, you should also ask yourself why they are considering closing it down – does this not suggest a problem with this part of the business, and hence impairment? Typically impairment losses will go straight to the Income Statement, and hence there is a natural risk that the directors do not want to recognise this – meaning they may hide evidence from auditors.
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Audit work ●
Compare the results of each part of a business with budgets/forecasts, to establish if the segment is under-performing.
●
Assess the present value of future cashflows associated with the asset that might be impaired (e.g. projected sales revenue for a brand) and compare with carrying value.
●
Monitor events after the year-end (e.g. sale of an asset below carrying value) for evidence of overvalued year-end assets.
●
Inspect Board Minutes for evidence of discussions of known problems with individual assets or parts of the business.
Government grants Accounting issues Government Grants (or grants from any other source) are typically received by a company to assist with the purchase of an asset, or to help towards the expenses of some activity that the government wishes to support or encourage. For example, to encourage companies to be more environmentally friendly, government might offer to reimburse them for 50% of the cost of investing energy-saving machinery. Or to encourage investment in poorer parts of country, there may be grants receivable for every new job created, in the form assistance with paying salaries.
a in a of
Typically, the grant is given for very specific purposes and there will be terms and conditions. If these are breached, the grant is likely to become repayable. ●
If the grant is to help pay expenses (a revenue grant), the grant should be matched against those expenses in the Income Statement / Profit and Loss Account.
●
If it is to help pay future expenses, the grant should be credited to Deferred Income on the Balance Sheet and then gradually released as the related expenses are paid by the company.
●
If the grant is to help pay for an asset (capital grant), the grant should again be credited to Deferred Income and then released as the related asset is depreciated, so that again the grant is matched against the related expense (the depreciation) in the Income Statement / Profit and Loss Account.
●
For a capital grant, it might be allowable to net the grant off the cost of the asset, thus automatically ensuring the grant is set off against depreciation charges. However, in many countries this is not an allowable solution, as it results in “netting off” assets and liabilities (therefore it is banned in the UK, for example).
●
Should the term of the grant be broken, the rules of provisions and contingencies apply – so if repayment is probable a provision would be eeded. If repayment is possible rather than probable, a contingent liability would need to be disclosed in the Notes to the Financial Statements.
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Audit work ●
Inspect the grant agreement, in order to check: o
What the grant is helping to pay for
o
The total amount of the grant (may be future amounts receivable)
o
the conditions under which it would have to be repaid.
●
Inspect cashbook and bank statements to verify receipt of the grant.
●
Inspect Board Minutes to assess whether company has done anything (or is about to do anything) that might make the grant repayable.
●
Recalculate any release of deferred grant income to ensure it matches with the related expenditure.
Investment properties Accounting issues Sometimes companies buy / lease properties not for their own use, but for their investment potential – to rent out, possibly with a view to selling the building for a profit at some point in the future. These properties are not being used by the company as part of normal operations to generate operating profit – they are more like an investment in shares, where the rental income replaces the dividends. ●
Investment properties are originally recorded at cost.
●
Given their nature they are likely to be subject to regular revaluation. It is however possible to leave them at cost and depreciate them like any other asset.
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If being revalued (i.e. held at “fair value”), they should not be depreciated, but they could be impaired just like any other asset (e.g. if the rental market is weak for a long period of time, the value of the property may be affected).
●
All gains and losses on revaluation or impairment of investment properties go to the Income Statement (note the difference from other asset revaluations, where a surplus would usually go to reserves (equity), not profit).
●
A building owned by one group company and leased to another could be an investment property in the separate company FS, but from the group perspective it is owner occupied so is not an investment property in the consolidated FS.
●
A building that is part owner-occupied and part leased out can be treated as two separate assets (i.e. the leased out part can be a separate “investment property”, the occupied part a separate “property”).
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There are lots of disclosure requirements (e.g. who did the revaluations, whether any leased assets are being treated as investment properties etc.).
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Audit work ●
●
Remember that investment properties are properties! As such, normal audit work for properties applies: o
Inspect property to confirm existence (and that company is not owneroccupying)
o
Inspect title deeds and land registry records to confirm ownership
o
Inspect copy of latest valuation document
o
Assess independence, qualifications, experience of the valuer
o
Inspect FS to ensure all necessary disclosures are included.
Ensure gains and losses on revaluation have gone to the Income Statement.
Leases Accounting issues There are 2 types of lease – operating leases and finance leases. ●
Operating leases are treated as rentals. any others.
Lease payments are expenses like
●
Companies must disclose commitments made under operating leases.
●
Finance leases are leases where the rights and obligations of ownership have been transferred to the company using the asset (lessee). Since in substance the asset is “owned”, it is treated as a non-current asset on the balance sheet and depreciated over the life of the lease.
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With finance leases, the “cost” of the asset is the present value of the minimum guaranteed lease payments, the other side of which is treated as a liability.
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As with other assets, if the fair value of the asset is lower than the carrying value, then fair value must be used (i.e. the asset has been impaired).
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Lease payments will be split between a reduction in the liability, and a finance charge (just as a loan repayment is partly repaying a loan, and partly interest).
●
The liability must be split between current liabilities and non-current liabilities.
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With both operating leases and finance leases, lease commitments must be disclosed between <1 year, 2-5 years, and >5 years.
Sale and Leaseback ●
Where an asset is sold and then leased back to the company, the accounting treatment depends on the nature of the lease in the leaseback.
●
If the leaseback is an operating lease, then in substance the asset has been sold – so a gain or loss on disposal will occur in the normal way. If the gain or loss is not on normal commercial terms (because it is tied in to higher or lower lease payments in the lease agreement), then things change:
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●
o
If there is a loss on disposal, but it is compensated for by lower lease payments in the future, then the loss is deferred and amortised to match the lower lease payments.
o
If there is a gain on disposal, it is deferred and amortised over the life of the lease.
If the leaseback is a finance lease, then in substance no asset disposal has occurred and the asset should remain on the balance sheet. Any excess of proceeds over the asset’s carrying value is deferred and amortised over the lease term.
Audit work The main piece of audit evidence is the lease agreement, as this will allow the auditor to: o
Agree the length of the lease
o
Agree the lease payments
o
Assess how much of the rights and obligations of ownership have been transferred.
●
For operating leases, any prepayment or accrual should be recalculated.
●
For finance leases, the present value of minimum lease payments should be recalculated and the discount rate agreed as appropriate.
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Disclosures of future lease payments should be verified as accurate.
Related party transactions Accounting issues Related Party Transactions are a disclosure issue, but may also be an indication of fraud. Any material transactions between companies and related parties must be disclosed in the Notes to the Financial Statements. Parties are related if one has the ability to control the other party or exercise significant influence over its operating or financial decisions.
Audit work The auditor has two main problems: o
Knowing who are related parties of the client
o
Being able to spot transactions that have the appearance that suggests they might be with related parties.
To try to identify who the related parties are:
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o
Inspect shareholder register
o
Inspect Board Minutes for evidence of directors raising related party issues
o
Inspect prior year related party disclosures
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To identify potential related party transactions, bear in mind that if two parties in a transaction are connected, this may result in the transaction not being on commercial terms, so look out for transactions that are: o
At a price other than market price
o
At an odd time
o
Between 2 companies who have no obvious reason to do business
o
Lacking in overall business logic!
It is difficult to ensure that all RPTs heavily on the Board to tell them about the above audit work, auditors representation to confirm that the disclosed.
have been disclosed, as the auditors rely related party relationships, so in addition to will typically obtain a management Board believe that all RPTs have been
Segmental reporting Accounting issues This area typically applies only to listed companies. Companies must present an analysis of revenue, profit, and assets between major operating segments. A segment is defined as a part of the business to which separate revenues and costs can be attributed, and which is treated as a separate segment when making decisions within the business. Segmental information must be disclosed for all segments that represent at least 10% of the assets, or revenues, or profits, or losses of the company. If all such segments total less than 75% of the company, additional segments must be reported (even if <10%) until the 75% threshold is reached. Consistency of segment analysis is required year on year – any change in how segments are split this year would require a restatement of the prior year analysis.
Audit work ●
Ensure segmental analysis adds up and agrees to the totals reported in the Financial Statements.
●
Compare figures with prior year to ensure consistency of presentation.
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Where a change in segments this year, ensure prior year figures altered and agree “new” figures back to prior year accounting records.
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Agree this year’s analysis back to internal management accounts.
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Substance over form Accounting issues In general, the substance of transactions should be recorded, even where this is different to the legal form of the transaction. Sometimes transactions appear to be one thing, when in fact they are something else (either deliberately, or because of the nature of the transaction). For example:
Consignment Stock Sometimes, companies sell products on consignment. The customer takes delivery of the goods and pays for them at a future date, but may be allowed (or forced) to return them before the payment date arrives. Whilst the products are with the customer, they may or may not have full control of the products – for example, the original manufacturer may still be able to control the final selling price that the customer uses to sell the product on. If company X appears to have bought something, and has taken delivery, it may in substance have purchased the item. However, if X can send the item back, or if X can be forced to send the item back, then the rights and obligations of ownership may not yet have been significantly transferred.
Audit work Auditors will need to examine the agreements involved in any transactions to assess the true substance. With consignment stock, the auditors will need to assess: o
Whether the purchaser has the right to return the goods
o
Whether the seller can enforce return of the goods
o
Whether the seller has full control of the goods (e.g. setting the selling price).
Tangible non-current assets Accounting issues ●
Typically assets are recorded at cost and then depreciated over their useful economic lives.
●
Assets may be revalued. If so, all assets in a class should be revalued together. Any surplus should be taken to a separate revaluation reserve.
●
On disposal, a gain or loss is calculated as the difference between the carrying value and the proceeds.
●
When a revalued asset is sold, any balance on the revaluation reserve should be transferred to profit reserves (equity), not reported in the year’s profit.
●
Where an asset has a significant element that is replaced every few years, this element may need to be treated as a separate asset in itself, with its own useful life. Therefore, an industrial burner (“furnace”) that needs its lining
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replaced every 5 years is likely to treat the lining as a separate asset, as the burner itself is likely to have a significantly longer life. ●
A change in the ability of a company to use an asset may suggest it has been impaired. Where this is the case, the company should perform an impairment review – assessing the present value of the net cashflows associated with asset in order to assess whether these are less than the current balance sheet carrying value.
Audit work ●
Assets should be inspected to verify their existence, and that they are in use.
●
Ownership documents (title deeds, vehicle registration documents) should be inspected.
●
For new assets, purchase documents (e.g. invoices) should be inspected to check price and date.
●
Depreciation policies should be compared with prior year and those of similar companies to assess if appropriate.
●
Depreciation policies should also be compared with any company replacement policies, and with the recent trend in gains and losses on the sale of assets.
●
Depreciation calculations should be re-performed and compared with prior year.
●
Revaluations should be checked to valuation reports, and the valuer assessed for independence, qualifications and experience.
Borrowing costs Accounting issues The costs of borrowing (typically interest) that relate to the construction of specific assets (or the preparation of purchased assets for use) should be capitalised as part of the cost of the asset. It is also possible to allocate a share of general borrowings, as long as they were used for a specific asset. The amount of capitalised interest must be disclosed in the Notes to the Financial Statements.
Audit work ●
Use analytical review on borrowing costs (as the interest should be a predictable percentage of borrowings).
●
Agree interest payments to bank statements and cash book.
●
Agree interest payments to loan documentation.
●
Assess whether loan is directly attributable to the asset concerned
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Deferred tax Accounting issues Deferred Tax is the tax on temporary (in UK, timing) differences. A temporary difference is where the carrying amount of an asset or liability on the balance sheet is different to the amount used for tax purposes. Deferred tax must be assessed where this difference will result in an increase or decrease in tax in the future when the temporary difference reverses. The most common example of deferred tax is on tangible assets where the depreciation is disallowed for tax purposes, and the government instead uses its own method (capital allowances) for spreading the tax deductibility of the cost of the asset. If the asset’s capital allowances are awarded faster than depreciation is charged, the company will get larger tax deductions in early years of the asset’s life – but this will reverse in later years or when the asset is disposed of. In calculating deferred tax, the current tax rate is typically used, unless a new tax rate has been significantly enacted by government by the year end.
Audit work Deferred Tax does not get examined much, as the main audit issue is to identify temporary differences and recalculate the deferred tax. Typically, the tax software used to calculate the company’s corporation (business) tax will be useful evidence, as it should automatically calculate any deferred tax issues.
Earnings per share Accounting issues ●
Listed companies must, on the face of the Income Statement present: o
Basic EPS
o
Diluted EPS.
●
Diluted EPS is EPS after taking account of anything that could convert into ordinary shares (e.g. convertible debt, convertible preference shares, share options).
●
In doing the calculations, weighted average number of shares should be used.
●
It will sometimes be necessary (e.g. with a bonus issue) to recalculate the prior year EPS based on the new number of shares, in order for it to be comparable with the current year figures.
Audit work ●
Recalculate basic EPS and diluted EPS.
●
Ensure any necessary restatements of prior year EPS have been done, and suitably disclosed.
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Share-based payments Accounting issues Sometimes companies pay for things by issuing their own shares, rather than with cash. This creates a problem – since issuing more shares is the company’s own internal decision, and no cash changes hands, what are the accounting entries? There is a link to goodwill here – a company might issue new shares as part of the cost of an acquisition – and the new shares issued would be valued at fair value (along with other consideration) as part of the goodwill rules. As a general rule: ●
Shares used to make payments should be valued at fair value.
●
If employees are granted share options, the fair value should be calculated at the date of GRANT, using an appropriate model (e.g. Black Scholes).
●
The fair value needs to take account of the likelihood of the options being execised/vested, and that will depend on whether the employees meet the associated performance targets, and whether they are still employed at the date of vesting – all of these uncertainties will need to be taken into account.
Audit work ●
For share options, review management assumptions over likelihood of vesting.
●
Ensure fair value model used complies with IFRS 2.
●
Where shares issued to pay for other things, ensure value of shares links to fair value of what they paid for.
Fair value and estimates Accounting issues Fair value is a concept which is found in many accounting areas – Property, Plant and Equipment can be recorded at fair value, it can affect share-based payments, and it is a major issue when valuing financial instruments, for example. Fair value means the value that would be involved in an arm’s length transaction between two willing and knowledgeable parties. Fair value can cause problems for auditors, because sometimes the reliability of the valuation can be questionable. If the asset is in a market which is relatively inactive, there will be no obvious “going rate” to use as evidence. If the asset is relatively unique or company-specific, or is highly complex (e.g. derivatives) it may also make it very difficult to value. Even where there is an active market, values can sometimes be highly volatile. As with all other estimates, fair values can be subjective, complicated, and subject to manipulation.
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Audit work ●
Understand how management have made their estimates and the models used.
●
Assess the amount of uncertainty inherent in the estimate and use this to assess the risk of misstatement.
●
Monitor events after the year-end, as these often give further evidence of the accuracy of a year-end estimate.
●
Assess company controls over the estimation process, especially where it is complex.
●
Compare methods used for estimates with prior years to ensure consistency (assuming consistency is justified).
●
Compare prior year estimates with actual results, to assess management’s record on accurate estimating (and to test the validity of the models they use).
●
Consider the use of an outside auditor’s expert to assess the estimate and the assumptions on which it is based.
●
Obtain written representations from management that they believe the assumptions behind their estimates to be reasonable.
●
Where valuations are contingent on a business plan being followed, monitor the progress of the plan and ensure it is on track and finance is available to complete it.
Employee benefits Accounting issues The main issue here is pension costs, where a company pays into a fund to pay employees a pension after they retire. The basic concept is straightforward – it is matching. If by working as an employee this year I have earned another year of pension benefits, these should be recognised as a cost now, to match against the company profits that my employment has helped to generate. For defined contribution schemes, the company agrees to pay money into a pension scheme now, but there is no guarantee of what it will be worth to the employee in the future. These are easy to account for, as this year’s contributions are the payment for the employee, so are recognised as incurred. The complex issue is the defined benefit scheme. In this case, it is the benefit in the future which is promised – and contributions are made in order to try to ensure that these benefits can be paid by the pension scheme. If the promised future benefit is based on unknown information – for example, it will depend on how long the employee works for, what his salary is in future years at the company, and how long he lives after retirement (and is therefore drawing his pension). As such, by working one more year, we know an employee has created a pension cost to the company – but we have to estimate what this cost might be. Bear in mind it is not just the problem of knowing how much pension will be paid to the current employees as a result of their employee service this year – the assets
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of the scheme (from the funds invested) will also grow (or maybe shrink) based on investment performance – yet another unknown. And the value of a pension scheme may change simply because the actuary has changed their assumptions on all of these variables (actuarial gains and losses). With companies required to recognise an asset (if the Scheme is in surplus – it has more assets than it needs to meet estimated future liabilities) or a liability (if the Scheme is in deficit), with any year-on-year movement having to be recognised somewhere as a gain or loss, pension scheme accounting is both complex and controversial. Pension Schemes are typically valued by actuaries, and auditors will necessarily have to rely partly on the actuarial valuation for the purposes of recording the Scheme surplus or deficit in the Statement of Financial Position, as well as the pension scheme expense in the Income Statement. To make matters even more confusing, some of the changes in Scheme value may ot get recognised this year (e.g. actuarial gains and losses). And if the Scheme is in surplus and you think you have an asset, bear in mind that an asset cannot be carried at more than its recoverable value to the company. A Scheme in surplus is an asset to the extent that the surplus will result in reduced company contributions to the Scheme in the future (in effect they have prepaid future employee pension benefits) or possibly even a refund from the Scheme.
Audit work ●
If the Scheme valuation was not at the date of the accounting year end, reconcile the value between the two dates.
●
Use analytical procedures on Scheme costs (for example, an ageing workforce may be on higher average salaries and nearer retirement, which may suggest a higher liability to the company – or strong Stock Market performance may indicate that Scheme assets should have grown faster than predicted, leading to a Surplus).
●
Agree the valuation to the most recent actuarial valuation.
●
Assess the reliability, experience, qualifications, experience and independence of the actuary.
●
Review the audit report on the Pension Scheme itself.
●
Compare actuary’s assumptions with other audit evidence (e.g. staff turnover assumptions with personnel records).
●
Confirm the Scheme’s assets exist by inspecting a list of assets from the Scheme’s investment manager.
●
Recalculate the pension expense recorded in the Income Statement.
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Foreign exchange transactions Accounting issues Exchange gains and losses on transactions during the year should be recognised in the Income Statement. At the year-end, any balances in foreign currency should be retranslated (if “monetary” items) with gains and losses recognised in the Income Statement. In a group audit, there may be a foreign subsidiary whose financial statements are in a different currency to the consolidated financial statements. These financial statements will require translation before consolidation. This is more complex than individual transactions and balances issues described in the preceding paragraph. The Income Statement will be retranslated at average rate, as this should be a reasonable estimate of the actual exchange rates behind the individual transactions during the year. The Statement of Financial Position will be retranslated at closing rate. Exchange differences on the subsidiary are taken to Equity. Note also that where the foreign subsidiary is in a country with hyper (very high) inflation, the financial statements may have to be restated in terms of the value of money at the year end.
Audit work ●
Check the exchange rates used for all retranslation against published rates.
●
Ensure exchange differences have been recognised in the correct place (Income Statement or Equity as appropriate).
Financial Instruments Accounting issues Financial Instruments range from the fairly simple (cash, trade receivables, trade payables) to the far more complicated (derivatives, hedge accounting). Whilst auditors are expected to know the accounting issues, on P7 it is unlikely that any question would go into as much depth as on P2. Key Issues: ●
Financial Instruments comprise Financial Assets, Financial Liabilities.
●
Financial Assets include cash, receivables, investments in shares (equity) and investment in debt.
●
Financial Liabilities include overdrafts, payables, loans etc.
●
For Financial Assets:
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o
Investments in Shares usually held at “Fair Value Through Profit or Loss” (FVTPL)
o
If not held for trading, can elect to take changes in FV through Other Comprehensive Income (OCI) instead of profit or loss
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C H A P T E R 4 – A S S I G N M E N T S I: T H E A U D I T O F F IN A N C I A L S T A T E M E N T S
o
Investments in Debt also usually held at FVTPL, unless:
●
Held for long term, to receive fixed repayments, can hold at Amortised Cost instead.
For Financial Liabilities: o
Usually held at Amortised Cost, unless:
Held for trading, in which case FVTPL
Company can choose FVTPL, if the business manages the Financial Liability at FV for internal purposes.
●
Financial Liabilities are removed from the financial statements only when paid off.
●
Financial Assets may get derecognised on a risks and rewards basis (e.g. debts have been factored).
There are a lot of disclosures required about Financial Instruments. The above is aimed to be a quick summary of some very complex accounting standards – made more complex by the gradual replacement of IAS 39 by IFRS 9. It should be more than enough for P7 purposes.
Audit work For Instruments held at fair value: ●
Assess valuation model used for consistency and reasonableness.
●
Ensure disclosures are accurate in terms of sensitivity of valuation to prove volatility, assumptions used etc.
●
Where fair value based on external valuation (e.g. Stock Market, expert), confirm year end value.
●
Consider use of suitable experts where necessary, especially with complex financial instruments.
●
Obtain contracts to ensure terms of all financial instruments are fully understood, properly accounted for, and transparently disclosed.
●
Where investments are managed by a 3rd party, obtain direct confirmation of holdings and reconcile to client’s own records.
Also, auditors should consider the potential for fraud, especially with more complex instruments, and should assess the client’s controls over creating, recording, and settling contracts – the better the controls, the more likely the transactions are honest and fairly recorded. Note – audit work on “basic” areas such as trade receivables, payables and bank balances have not been included, as these are assumed knowledge from F8 (and are simple).
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THE COMPLETION PHASE Management representations For some matters, the auditor may need confirmations from management to support other evidence. This will be particularly important where: ●
There is not much other evidence.
●
The matter is one where the opinion of management / directors is important.
●
The facts are only known by management.
For all such matters, the auditor will create a list of confirmations and put them into a form of a letter. This letter is passed to the client, who (hopefully!!) signs the list and passes it back to the auditor – it is called the Management Letter of Representation. Typical matters included in the Letter are: ●
Confirmation that the Board believes the company to be a going concern.
●
Confirmation that all contingent liabilities have been disclosed in the Financial Statements.
●
Confirmation that management have fulfilled their responsibilities to prepare accurate financial statements and that all evidence has been made available to the auditors.
●
Confirmation that the Board believe that any estimates in the Financial Statements are accurate (e.g. that inventory will be sold for more than cost).
It must be understood that written representations from management are NEVER enough evidence on their own (unlike External Confirmations from independent 3rd Party experts, which could be sufficient on their own). Written management representations collaborate other evidence collected – in many ways, they are obtained to ensure that answers from management are not “at odds” with the other evidence collected.
What if the Board refuses to sign the Letter? If the Board refuses to sign the Letter, and there are no changes to the wording that will make them change their minds, then the auditor should question management integrity / whether the audit can be satisfactorily completed. This may make it impossible for an opinion to be given on the truth and fairness of some figures (or maybe all figures) in the Financial Statements. As we will see in the next Chapter, this will result in the audit opinion having a Limitation of Scope qualification (and may also lead to resignation).
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Subsequent events review Between the client’s year-end, and the date the Financial Statements are signed by the Board, events may occur that have an impact on the accuracy of the Financial Statements. All events in this period are known as Post Balance Sheet Events (PBSEs), and they are either: ●
Non-adjusting
●
Non-Adjusting, but requiring a disclosure note (because they are important enough that the shareholders should be told)
●
Adjusting
It should also be remembered that any event that occurs in this period that has an impact on the company’s going concern status may lead to disclosures of going concern threats, or a restatement of the Financial Statements under the break-up basis.
Example Your client, Squirrel, has a year-end of 31 December 2008. The audit is currently taking place, and the Financial Statements are due to be signed by the Board in one week’s time. The following events have occurred: ●
On 18 January 2009, Squirrel received a letter from a major customer telling them that the customer had gone bust and would not be paying the amount they had owed since October 2008.
●
On 15 February 2009, Squirrel’s head office was totally destroyed by a fire. This caused Squirrel to shut down operations for a few weeks. An insurance payout has just been received and rebuilding is in progress.
●
On 24 February 2009, a significant quantity of inventory had to be destroyed because changes in the law made on 17 February 2009 made the products illegal.
How should these matters be dealt with?
Active and passive duty Until the audit report is signed, the auditor has an active duty to keep checking the Financial Statements – analysing, enquiring, inspecting (AEIOU!!!) etc. Once the audit report has been signed, audit work stops … but the auditor still has a passive duty that lasts until the Financial Statements are approved by the shareholders at the AGM.
Example Squirrel (see previous example) had its Financial Statements signed by the Board on 14 March 2009, and the audit report was signed the same day, stating that the auditors believed the Financial Statements gave a true and fair view. The AGM is due to take place on 19 April 2009. Today’s date is 29 March 2009, and you have just been told that a balance in the Financial Statements is materially wrong – evidence that you should have seen during the audit was not made available to you. www.studyinteractive.org
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What do you do next? Well, you have a problem! The client has an audit report, signed by you, stating that the Financial Statements are free from material error, but you now know this is not the case. You have a responsibility to make sure that the shareholders are not misled. Possible Solutions 1.
2.
If Squirrel’s directors refuse to put the mistake right, and refuse to allow you to change your audit report, then you will probably: ●
Attend the AGM and tell the shareholders that the Financial Statements are wrong
●
Obtain legal advice
●
Consider resignation
●
If the company is listed, and there has already been a preliminary announcement of their results, a statement to the Stock Exchange that you are withdrawing your audit opinion may be needed.
If the directors agree to change the mistake, and reissue the Financial Statements: ●
Do additional audit work to verify that the change has been made correctly.
●
Make sure they have not changed anything else as well!!!
●
Audit all events affecting the company between 14 March and 29 March – there may have been additional adjusting (or disclosable) PBSEs.
●
Issue a new audit report on or after the date that the reissued Financial Statements appear.
Other information Over the past few years, the quantity of “other information” being issued to shareholders with the audited Financial Statements has grown. The majority of this information is not audited, and this can lead to problems: ●
Something in the “other information” may be different to what is said in the Financial Statements.
●
Something in the “other information” may be inaccurate, or misleading to shareholders.
Because this other information is not subject to audit, any issues are very unlikely to affect the audit opinion. But if other information may confuse or mislead the shareholders, auditors have a professional responsibility to try to do something about it. Where the problem relates to something in the Financial Statements, the audit report will require an “Emphasis of Matter” paragraph to be added. If the problem is unrelated to the Financial Statements, there will still be an additional paragraph in the audit report – but now it is called “Other Matter”.
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Example Luvumore is a listed company, and each year it produces an Annual Report to accompany the audited Financial Statements. In this year’s Annual Report, the Chairman’s Statement includes the following comments: ●
“The company has grown rapidly over the past 12 months, opening new outlets in seven European countries.”
●
“The company’s profitability has improved over the past year.”
As a result of your audit work, which is almost complete, you are aware that no ew outlets have been opened (although some are due to be opened in a few weeks’ time). The Financial Statements show profits to have fallen since last year, and your audit work suggests the Financial Statements are true and fair. What should the auditor do in these circumstances? The Financial Statements do not appear to be affected by these issues – there is no evidence of any errors. However, both of these statements are untrue, and the comment about profitability may lead shareholders to believe that the Income Statement is incorrect – even though your audit opinion says it is ok! As such, the auditor needs to do the following: ●
Read all Other Information (unaudited documents attached to the audited Financial Statements) before the audit is completed.
●
Request changes to any information that is incorrect or misleading.
●
If the Board refuses to make changes to the Other Information that the auditor requests, the auditor has a professional responsibility to let the shareholders know there is a problem, which could be done by: o
Adding a paragraph to the end of the Audit Report (known as an “Other Matter”– explained further in the next Chapter)
o
Attending the AGM and reporting the problem to the shareholders (having taken legal advice first).
Opening balances and comparatives The auditor’s job is to give an opinion on the current year figures in the Financial Statements. However: ●
Last year’s figures will also be included in this year’s Financial Statements as comparatives – so if the auditor is aware of errors with last year’s figures, the shareholders should be told.
●
Last year’s figures are the opening balances for this year – so any problems with last year’s figures may mean that this year’s figures are also materially misstated.
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You should be aware that there are several possible problems with last year’s figures: ●
Last year’s auditors may have disagreed with some of last year’s figures.
●
Last year’s auditors may have been unable to form an opinion on some of last year’s figures.
●
Last year’s figures may have been audited by another firm of auditors.
●
Last year’s figures may not have been audited at all!
Audit Work It is standard practice to check that this year’s brought forward balances agree to last year’s closing balances. However, if there are any issues with last year’s figures, it may be necessary to do additional audit work on them (the evidence should still exist, as companies are required to keep accounting records for some years) so that the true situation can be reported to shareholders. If last year’s figures are known to be wrong, and the Directors will not put through a Prior Period Adjustment, then this year’s audit report may need to report last year’s mistake to the shareholders.
Final analytical procedures Before the audit report is signed, it is sensible to do some final analysis of the Financial Statements (e.g. ratio analysis) – just to make sure that the auditor is confident in the audit opinion. There are 2 main reasons for this final analysis: ●
The Financial Statements may have been adjusted during the audit as mistakes were found, so the final figures may never have been analysed or been subject to ratio analysis.
●
The auditor will have learned more about the company during the audit, so is in a better position at the end of the audit to analyse the figures and understand trends in ratios.
Other completion issues Before the audit report is signed, the auditor needs to know that the work is finished and that all necessary issues have been dealt with. The easiest way to do this is to use a series of checklists: ●
The audit plan should be reviewed, to verify that all issues raised have been resolved.
●
An Accounting Standards Checklist will be completed, forcing the auditor to consider every possible accounting issue that could affect the client’s Financial Statements.
Additional checklists may be necessary (e.g. Company Law) to make sure that any other issues have been fully considered.
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Chapter 5
Assignments II – group audits
SYLLABUS CONTENT 1.
The additional issues for group audits ●
How the audit of a group can differ from that of a single company, especially in the year when a subsidiary is acquired, and when the Group Auditor does not audit every “component” in the Group.
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CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 73 ISSUES ARISING WITH GROUP AUDITS ------------------------------ 74
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COMPONENT AUDITORS
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PRACTICAL ISSUES WITH GROUP AUDITS
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EXAM QUESTIONS ●
What effect will the acquisition of company X have on the audit of company Y?
●
What are the issues that arise when the Group Auditor has to work with Component Auditors?
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ISSUES ARISING WITH GROUP AUDITS Component auditors When auditing a group, the group auditor may find that some subsidiaries are audited by other audit firms, known as “component auditors”. The group auditor must consider: ●
The materiality of those elements audited by others.
●
Whether the work of the other firm can be relied upon.
●
How many additional procedures may be required (e.g. reviewing the plan and the work of the other firm).
●
Whether the other firm is performing audit work in the same way as the principal auditor (e.g. if an overseas firm, may be following different audit standards, or be subject to different (or no!) audit regulations).
Typically, the principal auditor retains sole legal responsibility for the opinion on the consolidated financial statements, and in most countries is not allowed to even mention that other auditors were involved in auditing part of the group (although this is allowed to be mentioned in the audit report in some countries, notably USA).
Joint audits In some situations, especially within a group, two audit firms may jointly provide an audit opinion. There are several advantages and disadvantages:
Advantages ●
The group auditor can play a part in the audit of subsidiaries audited by another firm.
●
This is particularly helpful when a new subsidiary has recently been acquired, as the current auditors will have useful existing knowledge. A joint audit in year 1 may then be followed by the group auditor taking over as sole auditor in year 2.
●
The resources (staff and expertise) of 2 audit firms are available.
●
It may improve quality control of the audit process, as each firm effectively acts as a quality check on the other.
●
Being directly involved in the audit of all components of a group may speed up the audit of the consolidation process for the group auditor.
●
Joint audits may be the only way to ensure that firms outside the Big 4 retain an involvement in the audit of large companies. Historically, medium sized firms of auditors found they would lose a major client because it had been taken over by another company, and the auditors of the acquiring company had been appointed auditor of the new subsidiary. Note – another current audit issue is the belief that there is a lack of competition in the audit industry, with only 4 big firms dominating the market. Anything that helps firms outside the Big 4 to have a bigger involvement in audits, especially of larger companies, is likely to be seen as helping competition. There is more on this topic later in this chapter.
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Disadvantages ●
Potential for arguments if the 2 firms of auditors disagree.
●
Trying to combine 2 different audit approaches may be difficult.
●
Trying to combine 2 different cultures may be difficult (a problem when 2 companies come together for any reason, not just for joint audits!).
●
There will be increased time (and cost) at the planning stage as a joint audit approach needs to be developed.
●
The overall cost is bound to increase. Both firms are required to have enough evidence and client understanding to be able to give an opinion.
Practical issues with group audits Comfort Letters Where a subsidiary is financed entirely by another company in a group, the auditor may feel that the only way to assess the going concern status of the subsidiary is to receive some form of confirmation from the other company that is providing the support. A Letter of Support / Comfort Letter may be requested from the company providing the finance. It will say something like “We confirm that it is our intention to continue financing the company for at least 1 year from the date of this letter.”
Different Year Ends and Accounting Policies Where a group company does not share the same year end as the parent company, it may need to produce a second set of Financial Statements (or make adjustments to its existing Financial Statements) before they can be consolidated. Where a group company has different accounting policies, the figures would need to be adjusted to the group’s policies before consolidation.
Materiality A subsidiary may be totally immaterial to the group as a whole, especially if it was acquired shortly before the year end (as it will have only a minor effect on the company in that accounting year).
Knowledge of Client A new subsidiary will need to have its inherent risks and control systems assessed. An auditor cannot simply agree to audit a new subsidiary, or continue to audit a group, without first ensuring that the new subsidiary does not undermine the auditor’s overall understanding.
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Accounting Issues ●
Goodwill arising will need to be audited, especially in the year of acquisition, checking the consideration paid (including any contingent consideration) and the fair values of the net assets acquired.
●
All intracompany transactions and balances will need to be removed in the consolidation process.
●
Any new investment must be checked to ensure it is treated properly (e.g. is it a trade investment, an associate, a subsidiary, a joint venture etc.).
●
There may be intercompany guarantees within the group. If one company has guaranteed the loans of another company, and these loans are in danger of not being repaid, the guarantor will need to account for a contingent liability or provision as appropriate.
Practical / Logistical Issues A detailed timetable will need to be created, to ensure that the auditors of each part of the group know their responsibilities and deadlines. Typically a consolidation pack is sent to each audit team to try to ensure that each audit generates information for the consolidation in a similar form.
Consolidation Process – Audit Work ●
Agree the consolidation schedule figures to the financial statements of each group company.
●
Cast and cross-cast the schedule.
●
Recalculate all consolidation adjustments (e.g. intracompany) and important figures (e.g. goodwill, pre-acquisition reserves).
●
Agree brought forward consolidation schedule.
●
Reconcile opening and closing group reserves.
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schedule
figures
to
prior
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Chapter 6
Audit reports and other reports
SYLLABUS CONTENT 1.
The audit report ●
2.
Reporting to management ●
3.
Explaining how different issues can affect the form of audit report.
The Management Letter.
Assurance reports other than audit ●
How non-audit assurance reports differ from audit reports.
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CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 79 AUDIT REPORT CONTENTS --------------------------------------------- 80 STANDARDISED AUDIT REPORTS
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AUDIT REPORTS – POSSIBILITIES ------------------------------------ 81 UNMODIFIED REPORT
81
MODIFIED REPORTS
81
REPORTING TO THOSE CHARGED WITH GOVERNANCE -------------- 84 OTHER REPORTS --------------------------------------------------------- 85 APPENDIX – AUDIT REPORTS ------------------------------------------ 86
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EXAM QUESTIONS ●
For the above matters, describe the possible effects on the audit report.
●
Critically evaluate the draft audit report, suggesting alternative presentations.
●
Explain the content of reports to “those charged with governance”.
●
Discuss the likely differences between audit reports and the reports issued on other assignments.
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AUDIT REPORT CONTENTS The Audit Report is based on a standard layout, set out in Audit Standards. In different countries the precise layout will change, as the audit report is governed ot just by audit standards, but also by what individual governments require. The standard layout is: ●
Title
●
Addressee
●
Introduction
●
Respective Responsibilities of Directors and Auditors
●
Basis of Opinion
●
Opinion
●
Signature and Date.
The Opinion section may have additional opinions in it, due to national requirements.
Standardised audit reports The Audit Standard provides a standard layout for an audit report. Individual countries have tailored the standard for their own purposes, but it remains the case that in individual countries, all audit reports look similar. This can have advantages and disadvantages:
Advantages ●
Comparability between companies.
●
It guarantees a minimum level of content.
Disadvantages ●
It guarantees no more than the minimum level of content!
●
In being standardised, the language may be seen as overly technical.
●
It may restrict an auditor’s ability to say what they really wish to say.
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AUDIT REPORTS – POSSIBILITIES There are several different possible forms of audit report, depending on the situation. For this exam, there are 6 forms that you need to understand. The different outcomes are in groups, as follows:
Unmodified report This is the standard report that is the outcome for the vast majority of companies. In this situation: ●
The auditors believe the Financial Statements are true and fair
●
The auditors believe the Financial Statements were properly prepared
●
There is nothing else the auditors wish to report.
Modified reports There are 5 modifications to know: 1.
A qualification due to a material misstatement (disagreement) in the Financial Statements.
2.
A qualification due to a lack of sufficient appropriate evidence (limitation of scope) during the audit.
3.
An adverse opinion – where the auditors disagree with the truth and fairness of the Financial Statements overall.
4.
A disclaimer of opinion, where a limitation is so large that the auditors are unable to give an opinion at all.
5.
An Emphasis of Matter or Other Matter, where there is nothing wrong with the Financial Statements, and no limitation on the scope of the audit work … but there is something important that the auditors wish to draw to the shareholders’ attention.
1.
Qualification due to material misstatement
When there is a single material mistake in the Financial Statements (or a small umber of individual mistakes), the overall Financial Statements remain true and fair. The auditor reports that, Except for the effect of the error(s), the Financial Statements give a true and fair view. There are many examples that would lead to this opinion, for example: ●
Failure to provide for a material doubtful debt
●
Material error in the calculation of depreciation
●
The treatment of a material expense as an asset.
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2.
Qualification due to a lack of sufficient evidence
With this “limitation of scope”, the auditor was unable to fully carry out his work due to a lack of the usual evidence. Whilst he is happy that the overall Financial Statements show a true and fair view, he has concerns about possible material errors with a particular balance (or balances). The auditor reports that, Except for any adjustments that might have been necessary, had the auditor seen the evidence, the Financial Statements give a true and fair view. Examples include: ●
The auditor was unable to attend the year-end stocktake (e.g. due to being appointed auditor after the year end).
●
There are lots of cash transactions (where there is not a lot of documentary evidence).
3.
Adverse opinion
This is a form of misstatement that is so strong, it affects the opinion of the Financial Statements as a whole (pervasive). The most common form of this in the exam is a disagreement that the company is a going concern. As such, the auditor is disagreeing with the entire basis of preparation of the Financial Statements, which is likely to result in disagreement with many of the figures in the Financial Statements. The auditor reports that the Financial Statements do not give a true and fair view.
4.
Disclaimer of opinion
This is a lack of evidence that is so strong, the auditor feels unable to report on the overall truth and fairness of the Financial Statements. Imagine turning up to an audit client to be told that all of the accounting records were lost the previous day in a fire, and that there are no back-ups. Without any evidence, the auditor is unable to do an audit, so cannot give an opinion. The auditor reports that “we do not provide an opinion”, or similar wording.
5.
Emphasis of matter / other matter
Sometimes the auditor is happy that the Financial Statements are true and fair, and that all evidence has been received. However, there remains something that the auditor wishes to (or is forced by law to) draw to the attention of those reading the Financial Statements: ●
There is a very important Disclosure Note which the shareholders must ensure they have read (typically involving going concern threats). In this case, an Emphasis of Matter paragraph is required in the audit report, directly under the Opinion section.
●
There is a mistake / inconsistency in the unaudited documents attached to the Financial Statements (“Other Information”), and this mistake / inconsistency conflicts with the correct information in the FS. In this case, the
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required paragraph is called an “Other Matter”, but also appears under the Opinion section. Other Matter paragraphs can be used for many other issues, for example where a country’s laws require auditors to report on other matters that are not related to the financial statements. For example, in the UK auditors must report on the consistency of the Directors Report with the audited Financial Statements.
Example Suggest the most likely forms of audit report in the following situations: (a)
Ryako, a listed company, with Profit Before Tax of $24.7 million, received a letter on 7th January 2009 indicating that Kud, one of its customers, had gone out of business, and that no money was expected to be recovered. At its year-end on 31st December 2008, Ryako was owed $1.1 million by Kud. Ryako also had inventory to the value of $0.7 million (at cost) which was purchased specifically to supply Kud – the inventory would need to be altered at a cost of $0.4 million in order to sell it to any other customer.
(b)
Lenaku, a private company with a year-end of 31st January 2009, gets 65% of its sales revenue and profits from Aikido, its biggest customer. Lenaku has an annual contract to supply Aikido, and this contract is due to expire on 15th May 2009, three weeks after the audit is due to be completed. The relationship between Lenaku and Aikido has been strained recently, and there is some doubt over whether the contract will be renewed. Lenaku would probably survive if the contract is not renewed, and Aikido has indicated that it probably will renew the deal, but it is looking at other suppliers. Lenaku has fully disclosed the situation in a Note to the Financial Statements.
(c)
Edgar is a company that organizes specialist events in pubs and clubs around the country. The main service supplied is “And Ye Love Karaoke!”, where a DJ runs a karaoke night. Guests can have their performance made into a professional music video, and their vocal performances made into a CD. The nights are very popular, and cash revenues on each night usually exceed $3,000. No documentary evidence exists for the sales revenue – whatever cash the DJ takes is paid into a company bank account the next day.
(d)
Nosirem sells equipment to schools for sports halls. In recent months it has lost a number of contracts and has failed to attract new customers. Projections suggest that unless there is a major change in events, the company will run out of cash within 3 months. At present, no finance provider has indicated a willingness to provide new finance to the company. The directors have presented the Financial Statements under the going concern basis.
(e)
Aberdeen is a company that manufactures cots, high chairs, playpens, and other baby-related furniture. You have just arrived to carry out the annual audit, but the client has told you that the accounting records have been wiped out by a computer virus. Even worse, the automatic computer back-up process, which was understood to be running on a weekly basis, has not in fact backed up any data for the past 9 months.
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REPORTING TO THOSE CHARGED WITH GOVERNANCE For many years, auditors have presented clients with a “Management Letter” at the end of an audit, highlighting internal control weaknesses (now called “significant deficiencies”), consequences of these, and giving recommendations to improve. This remains in place, so the issues learned on paper F8 are still relevant at P7. Effective “management letters” should be: ●
Clearly explained.
●
Sent in a timely fashion.
●
Discussed with all relevant parties (“those charged with governance”, such as an Audit Committee, as well as non-board management as necessary).
●
Accompanied by a covering letter explaining the purpose of the communication, that it is purely for the client’s use, should not be relied upon by 3rd parties etc.
As well as controls issues, there are numerous other issues which auditors are now expected to discuss formally (usually in writing) with “those charged with governance” – usually the Audit Committee. These matters may be combined with the Management Letter (above), but are now covered by their own separate audit standard: ●
The new focus is on encouraging 2-way communication, as a better audit is likely to occur with a stronger communication relationship with the client.
●
It has largely been forced on the audit profession by the growth in importance of corporate governance, and the ever-increasing role of audit committees.
Matters likely to be communicated include: ●
Confirmation of the auditor’s responsibilities, to back up the same information presented in the Engagement Letter and audit report.
●
Details of the timing of the audit process, significant findings, difficulties experienced during the audit (e.g. an imposed limitation of scope).
●
Discussion of the management representations requested.
●
Ethical issues identified and the safeguards put in place.
●
Issues with accounting policies in use by company, estimation techniques.
●
A list of all errors notified to management which remain uncorrected.
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OTHER REPORTS When other assignments are carried out, a report is likely to be produced for the client. These reports are likely to have many similarities to an audit report, but some differences are likely. Differences are likely to include: ●
The addressee is less likely to be the shareholders – this will depend on the ature of the assignment and will usually be at the agreement of the client.
●
The form of assurance may be “positive” like an audit opinion, but may take a different form. For example, it may be “negative assurance”, where the wording says “no errors have been found” instead of “there are no errors”.
●
It may be possible to include a liability disclaimer, subject to agreement with a client.
●
The firm is likely to emphasise the fact that an audit has NOT been carried out, as many reading a report issued by an audit firm may jump to the wrong conclusion based on familiarity with the firm’s name.
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APPENDIX – AUDIT REPORTS Example 1 – Standard Unmodified Report
INDEPENDENT AUDITOR’S REPORT TO THE MEMBERS OF BRITISH AIRWAYS PLC We have audited the financial statements of British Airways Plc for the year ended March 31, 2010 which comprise the Group consolidated income statement, the Group statement of other comprehensive income, the Group and Parent Company balance sheets, the Group and Parent Company cash flow statements, the Group and Parent Company statement of changes in equity and the related notes 1 to 38. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standards (IFRS) as adopted by the European Union and, as regards the Parent Company financial statements, as applied in accordance with the provisions of the Companies Act 2006. This report is made solely to the Company's members, as a body, in accordance with Chapter 3 of Part 16 of the Companies Act 2006. Our audit work has been undertaken so that we might state to the Company's members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Company and the Company's members as a body, for our audit work, for this report, or for the opinions we have formed. Respective Responsibilities of Directors and auditors As explained more fully in the Directors’ responsibility statements, the Directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view. Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). These standards require us to comply with the Auditing Practices Board’s (APB’s) Ethical Standards for Auditors. Scope of the audit of the financial statements An audit involves obtaining evidence about the amounts and disclosures in the financial statements sufficient to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. This includes an assessment of: whether the accounting policies are appropriate to the Group’s and the Parent Company’s circumstances and have been consistently applied and adequately disclosed; the reasonableness of the significant accounting estimates made by the Directors; and the overall presentation of the financial statements.
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Opinion on financial statements In our opinion: • The financial statements give a true and fair view of the state of the Group’s and of the Parent Company’s affairs as at 31 March 2010 and of the Group’s loss for the year then ended; • The Group financial statements have been properly prepared in accordance with IFRS as adopted by the European Union; • and the Parent Company financial statements have been properly prepared in accordance with IFRS as adopted by the European Union and as applied in accordance with the provisions of the Companies Act 2006; and • The financial statements have been prepared in accordance with the requirements of the Companies Act 2006 and, as regards the Group financial statements, Article 4 of IAS Regulation. Opinion on other matters prescribed by the Companies Act 2006 In our opinion: • The part of the Directors’ remuneration report to be audited has been properly prepared in accordance with the Companies Act 2006; and • The information given in the Directors’ report for the financial year for which the financial statements are prepared is consistent with the financial statements. Matters on which we are required to report by exception We have nothing to report in respect of the following: Under the Companies Act 2006 we are required to report to you if, in our opinion: • Adequate accounting records have not been kept by the Parent Company, or returns adequate for our audit have not been received from branches not visited by us; or • The Parent Company financial statements and the part of the Directors; remuneration report to be audited are not in agreement with the accounting records and returns; or • Certain disclosures of Directors’ remuneration specified by law are not made; or • We have not received all the information and explanations we require for our audit. Under the Listing Rules we are required to review: • The Directors’ statement, in relation to going concern; and • The part of the corporate governance statement relating to the Company’s compliance with the nine provisions of the June 2008 Combined Code specified for our review. Ernst & Young LLP Richard Wilson (Senior statutory auditor) For and on behalf of Ernst & young LLP, Statutory auditor London 20 May 2010
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Example 2 – Qualification “Except for” Material Misstatement
INDEPENDENT AUDITORS' REPORT TO THE PRINCIPALS OF LA VINGTAINE DE LA VILLE DE ST HELIER FOR 2009 We have audited the financial statements on pages 2 to 4, which have been prepared under the accounting policies set out on page 4. This report is made solely to the Vingtaine's principals, as a body. Our audit work has been undertaken so that we may state to the principals those matters we are required to state to them in an auditor's report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Vingtaine and the principals as a body, for our audit work, for this report, or for the opinions we have formed. Respective responsibilities of Procureurs and auditors: The Procureurs are responsible for the preparation of financial statements which show the general balances of the Vingtaine and its revenue and expenditure for each financial year. The Procureurs are also responsible for keeping proper accounting records and for safeguarding the assets of the Vingtaine and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). We report to you our opinion as to whether the financial statements give a true and fair view. We also report to you if, in our opinion, the Procureurs have not kept proper accounting records or if we have not received all the information and explanations we require for our audit. Basis of Opinion: We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the Procureurs in the preparation of the financial statements, and of whether the accounting policies are appropriate to the Vingtaine's circumstances, consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also
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evaluated the overall adequacy of the presentation of information in the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion. Basis for Qualified Opinion Included within the fixed assets are investment properties with a carrying value of £24,152 which have not been revalued. This treatment is not consistent with Statement of Standard Accounting Practice No 19 - Accounting for Investment Properties, which requires that investment properties are carried at their open market value. It has not been practicable to quantify the effect that any such revaluation would have on the related revaluation reserve. Qualified Opinion Except for this failure to revalue investment properties, in our opinion the financial statements give a true and fair view of the state of the Vingtaine's affairs at 31 December 2009 and of its revenue and expenditure for the year then ended. ALEX PICOT Chartered Accountants 21 June 2010
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Example 3 – Qualification “Except for” Unable to Obtain Sufficient Appropriate Evidence
Independent Auditors’ Report to the Trustees of The Neuroblastoma Society We have audited the financial statements of The Neuroblastoma Society for the year ended 31 December 2003, which comprise the Statement of Financial Activities, the Balance Sheet and related notes. These financial statements have been prepared under the historical cost convention and the accounting policies set out therein. This report is made solely to the charity’s trustees, as a body. Our audit work has been undertaken so that we might state to the charity’s trustees those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the charity and the charity’s trustees as a body, for our audit work, for this report, or for the opinions we have formed. Respective responsibilities of trustees and auditors The Trustees’ responsibilities for preparing the Trustees’ Report and the financial statements in accordance with applicable law and United Kingdom Accounting Standards are set out in the Statement of Trustees’ Responsibilities. We have been appointed auditors under section 43 of the Charities Act 1993 and report in accordance with regulations made under section 44 of that Act. Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and United Kingdom Auditing Standards. We report to you our opinion as to whether the financial statements give a true and fair view and are properly prepared in accordance with the Charities Act 1993. We also report to you if, in our opinion, the Trustees’ Report is not consistent with the financial statements; if the charity has not kept proper accounting records, or if we have not received all the information and explanations we require for our audit. We are not required to consider whether the statement in the Trustees’ Report concerning the major risks to which the charity is exposed covers all existing risks and controls, or to form an opinion on the effectiveness of the charity’s risk management and control procedures. We read other information in the Trustees’ Report and consider whether it is consistent with the audited financial statements. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any other information.
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Basis of opinion We conduct our audit in accordance with United Kingdom Auditing Standards issued by the Auditing Practices Board. An audit includes an examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the Trustees in the preparation of the financial statements, and of whether the accounting policies adopted are appropriate to the charity’s circumstances, consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluate the overall adequacy of the presentation of information in the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion. Basis for Qualified Opinion The charity derives a substantial proportion of its income from voluntary donations, which cannot be fully controlled until they are entered in the accounting records, and are therefore not susceptible to independent audit verification. Qualified Opinion Except for any adjustments that might have been found to be necessary had we been able to obtain sufficient evidence concerning the completeness of voluntary donations, included in these financial statements at £116,816, in our opinion, the financial statements give a true and fair view of the state of the charity’s affairs as at 31 December 2003 and of its incoming resources and applications of resources in the year then ended and have been properly prepared in accordance with the Charities Act 1993. Report on Other Legal and Regulatory Requirements In respect alone of the limitation on our work relating to voluntary donations: (a) we have not obtained all the information and explanations that we considered necessary for the purpose of our audit; and (b) we were unable to determine whether proper accounting records have been maintained. KNB CHARTERED ACCOUNTANTS Registered Auditors Liverpool 1st March 2004
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Example 4 – Modified Report due to Emphasis of Matter
INDEPENDENT AUDITOR’S REPORT TO THE MEMBERS OF BRITISH POLYTHENE INDUSTRIES PLC We have audited the group and parent company financial statements (the “financial statements”) of British Polythene Industries PLC for the year ended 31 December 2005 which comprise the group income statement, the group and parent company balance sheets, the group cash flow statement, the group statement of recognised income and expense and the related notes. These financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the Directors’ Remuneration Report that is described as having been audited. This report is made solely to the company’s members, as a body, in accordance with section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s members as a body, for our audit work, for this report, or for the opinions we have formed. RESPECTIVE RESPONSIBILITIES OF DIRECTORS AND AUDITORS The directors’ responsibilities for preparing the directors’ report and the group financial statements in accordance with applicable law and International Financial Reporting Standards (IFRSs) as adopted by the EU, and for preparing the parent company financial statements and the Directors’ Remuneration Report in accordance with applicable law and UK Accounting Standards (UK Generally Accepted Accounting Practice) are set out in the Statement of Directors’ Responsibilities on page 35. Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). We report to you our opinion as to whether the financial statements give a true and fair view and whether the financial statements and the part of the Directors’ Remuneration Report to be audited have been properly prepared in accordance with the Companies Act 1985 and whether, in addition, the group financial statements have been properly prepared in accordance with Article 4 of the IAS Regulation. We also report to you if, in our opinion, the directors’ report is not consistent with the financial statements, if the company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed. We review whether the Corporate Governance Statement reflects the company’s compliance with the nine provisions of the 2003 FRC Combined Code specified for our
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review by the Listing Rules of the Financial Services Authority, and we report if it does not. 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 group’s corporate governance procedures or its risk and control procedures. We read the other information, including the directors’ report, contained in the annual report and consider whether it is consistent with the audited group financial statements. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the group financial statements. Our responsibilities do not extend to any other information. BASIS OF AUDIT OPINION We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the group’s and company’s circumstances, consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements and the part of the Directors’ Remuneration Report to be audited are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the financial statements and the part of the Directors’ Remuneration Report to be audited. Uncertainty relating to European Commission Inquiry. In forming our opinion, we have considered the adequacy of the disclosures made in note 29 to the financial statements concerning the uncertainty over the amount of any financial penalties that may result from the Competition Directorate of the European Commission inquiry into alleged infringement of European Competition Law. In view of the significance of this uncertainty, we consider that it should be drawn to your attention but our opinion is not qualified in this respect. OPINION In our opinion: • The group financial statements give a true and fair view, in accordance with IFRSs as adopted by the EU, of the state of the group’s affairs as at 31 December 2005 and of its profit for the year then ended; • The group financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation;
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• The parent company financial statements give a true and fair view, in accordance with UK Generally Accepted Accounting Practice, of the state of the parent company’s affairs as at 31 December 2005; • The parent company financial statements have been properly prepared in accordance with the Companies Act 1985; and • The parts of the directors’ Remuneration Report to be audited have been properly prepared in accordance with the Companies Act 1985. KPMG Audit Plc Chartered Accountants Registered Auditor 191 West George Street Glasgow G2 2LJ 6 March 2006
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Example 5 – Adverse Opinion (relevant sections only)
The accounts in respect of the year ended 31 December 2003 were qualified by the auditors and the following was included in the audit report: Basis for Adverse Opinion As fully explained in note 1 no adjustments have been made in respect of the company no longer being considered as a going concern. In our opinion provision for these adjustments should be made. In addition as the company is the parent company of a plc group it is required under s229(1) Companies Act 1985 to prepare consolidated group accounts as at the year end. Due to a lack of accounting records in respect of the company’s subsidiary undertakings, which have gone into Administrative Receivership during September 2003, group accounts have not been prepared as required by s229(1) Companies Act 1985. Adverse Opinion In view of the effect of the above points in our opinion the financial statements do not give a true and fair view of the company and the group’s affairs as at 31 December 2003 and of the loss of the company and the group for the year then ended, and have not been prepared in accordance with the Companies Act 1985.”
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Example 6 – Disclaimer of Opinion
Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on conducting the audit in accordance with Singapore Standards on Auditing. Because of the matters described in the Basis for Disclaimer of Opinion paragraph, however, we were not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Basis for Disclaimer of Opinion We were not appointed as auditors of the company until after December 31, 20X1 and thus did not observe the counting of physical inventories at the beginning and end of the year. We were unable to satisfy ourselves by alternative means concerning the inventory quantities held at December 31, 20X0 and 20X1 which are stated in the balance sheet at xxx and xxx, respectively. In addition, the introduction of a new computerized accounts receivable system in September 20X1 resulted in numerous errors in accounts receivable. As of the date of our audit report, the directors were still in the process of rectifying the system deficiencies and correcting the errors. We were unable to confirm or verify by alternative means accounts receivable included in the balance sheet at a total amount of xxx as at December 31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the income statement, statement of changes in equity and cash flow statement. Disclaimer of Opinion Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements.
Note to Students – small changes have been made to the wording of the actual audit reports issued in the Notes, in order to reflect changes in the relevant audit standard ISA 705 Modifications to the Opinion in the Independent Auditor’s Report.
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Chapter 7
Assignments III – other assignments
SYLLABUS CONTENT 1.
Audit-related services ●
2.
Assurance services ●
3.
How forensic work takes place, and detailed procedures that may be used.
Internal audit ●
5.
What types exist, and the issues involved in assurance work that is NOT an audit.
Forensic audits ●
4.
What they are, and why the external auditor tends to be asked to do them.
The work of internal auditors.
Outsourced services ●
Different services that companies may outsource, the costs and benefits, and the effect on the audit process.
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CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------- 99 FACTORS TO CONSIDER BEFORE ACCEPTING APPOINTMENT ----- 100 FACTORS BEFORE ACCEPTING ANY ASSIGNMENT
100
ADDITIONAL ISSUES IF NOT AN AUDIT
100
DIFFERENT LEVELS OF ASSURANCE ---------------------------------- 102 REVIEW ASSIGNMENTS
102
AGREED-UPON PROCEDURES
103
AGREED-UPON PROCEDURES
103
TYPES OF ASSIGNMENT ------------------------------------------------ 104
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REVIEW OF BUSINESS PLANS / FORECASTS
104
DUE DILIGENCE REVIEW
105
OTHER ASSIGNMENTS
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EXAM QUESTIONS ●
Explain the factors engagement.
●
Describe the different levels of assurance (from reasonable, to zero) associated with audits, review assignments, agreed-upon procedures etc.
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Describe the types of report that will arise with these different assignments.
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Describe the procedures that an accountant might carry out for different types of assignment.
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that
should
be
considered
before
accepting
the
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FACTORS TO APPOINTMENT
CONSIDER
BEFORE
ACCEPTING
As with a statutory audit, an accountant cannot simply say yes to every request from companies to perform work. Most of the issues that would be considered before accepting an audit assignment are also relevant to other types of assignment, but if the assignment is NOT a statutory audit additional matters need to be considered.
Factors before accepting any assignment ●
competence of accountant to perform the work
●
whether fees can be agreed
●
time available / client deadlines
●
staff and other resources available
●
integrity of client’s management / client reputation
●
level of risk associated with the work
●
financial health of client
●
if an opinion is to be given, whether the accountant is independent
●
conflicts of interest with existing clients
●
whether other work may be available from this client
●
reason why they are asking us / why changing advisor.
Additional issues if not an audit There are several considerations that can be ignored with a statutory audit, because the matters are dealt with by the law or audit standards. But for non-audit work, especially if it involves assurance (i.e. an opinion will be given), these additional issues must be considered and agreed with the client: ●
who will the report be addressed to
●
who else will read it (and potentially rely on it)
●
can a liability disclaimer be included
●
how detailed does the client want our work to be
●
what evidence will be made available
●
what format of report would they like
●
how much assurance do they want us to provide
●
why is this assignment being done
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if we are to check something, against what criteria / standards are we to check
●
is there any professional guidance available for this type of assignment
●
who is responsible for the matter we are checking and reporting on.
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With a statutory audit, these issues would all be known – the level of assurance must be “reasonable”, the audit report format is laid down within standards, all evidence must be made available etc. For each additional assignment, a separate engagement letter should be produced.
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DIFFERENT LEVELS OF ASSURANCE A statutory audit of the annual published financial statements of a company provides a relatively high level of assurance (“reasonable assurance”). Detailed audit procedures are carried out to enable the auditors to express a positive opinion stating whether in their opinion the financial statements do, or do not, give a true and fair view. For non-audit assignments where an opinion is required, the level of assurance can vary a great deal.
Review assignments A “review” assignment is a less detailed form of checking – so it shares many features of the audit process. Typically the review is less detailed than a full audit because the client does not want such detailed work carried out, or because there is a tight deadline for the work to be finished.
Review – typical procedures With a statutory audit, typical procedures are AEIOU – analytical procedures, enquiry and confirmation, inspection, observation, and recalculation. With a review assignment, most of the work is less detailed and concentrates only on: ●
analytical procedures
●
enquiries and confirmation (typically of management, rather than 3rd parties).
The review report Because less detailed work is carried out, it is not possible to provide a high level of assurance like an audit. A typical review report will include: ●
an introduction explaining what has been reviewed
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an explanation that the work carried out was less detailed than an audit
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a clear statement that an audit has not been done
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an opinion using negative assurance – “nothing has come to our attention that causes us to believe that the accompanying information does not give a true and fair view”.
Examples of review assignments Popular examples for the exam are: ●
reviewing prospective financial information (e.g. a business plan)
●
a due diligence review (e.g. when a company is looking to takeover another company).
Listed companies producing half-year financial statements (“Interim financial statements”) often choose to have these figures “reviewed” by their auditors.
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Details on the procedures undertaken for the more popular exam examples follow later in this chapter.
Agreed-upon procedures Agreed-upon procedures are, as their name suggests, procedures carried out by accountants at their client’s request! They require the accountant to present factual findings, rather than an opinion on some matter, and as such no assurance is being provided. Examples can include: ●
a fraud investigation
●
compilation (e.g. putting together a set of financial statements from a trial balance).
With such procedures, the accountant is likely to produce a report making it clear that no audit or checking has been carried out. For example, when compiling financial statements from a trial balance, there is a risk that the reader believes that the accountant has checked the accuracy of the figures. Therefore it must be made clear that the figures were produced by the client and have not been checked at all – just presented in the form of financial statements.
Audit Related Services Audit-related services are, as the name suggests, services which would normally be carried out by a company’s external auditor (i.e in addition to the actual audit process). Given the external auditor’s client knowledge, it often makes sense for them to be asked to perform these additional services, without any other firms ever being considered. Examples would include: ●
due diligence on a potential acquisition
●
auditing the company’s Pension Scheme financial statements
●
“reviewing” the company’s 6-monthly (“Interim”) financial statements
Sometimes the auditors may be required/asked to give an opinion on things the company’s management have asserted – this is an attestation assignment. Sometimes an external party may want the auditor to report on a matter of their choice, without the client’s management ever having made any stated assertions – this is a direct reporting engagement. Auditors could, in theory, be asked to do anything – so some audit-related services will involve assurance (i.e. an opinion), whilst others may not.
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TYPES OF ASSURANCE ASSIGNMENT Review of business plans / forecasts If a company has produced prospective (i.e. future) financial information, they may wish to have it checked by independent accountants, especially if these forecasts are to be shown to others (e.g. the bank).
Procedures Remember, being a review, the main procedures will be analytical and enquiry. Typical procedures may include: ●
enquiry of management as to the assumptions in the estimates
●
a review of the reasonableness of these assumptions
●
a comparison of forecasts with the most recent actual figures
●
a comparison of forecasts with industry expectations
●
a comparison of the accounting policies used in the forecasts with those used currently
●
ratio analysis to ensure figures are internally consistent
●
enquiry of management as to any planned policy changes in the future (e.g. a decision to give extended credit to customers to try to boost sales should be reflected in higher debtor days, more bad debts etc.)
●
enquiry of management as to any changes in laws likely to affect the company during the forecast period
●
analysis of the figures to ensure easy-to-forget items have not been omitted – a profit forecast should include depreciation, bad debts, settlement discounts, loan interest, tax etc.
It may be possible to do more specific work on some items in the forecasts: ●
payroll costs may already be agreed with staff
●
the cost of new assets may have been agreed, and contracts signed / quotes obtained
●
sales early in the forecast period may already have been fixed (e.g. orders received, deposits taken, contracts signed)
●
depreciation on assets that already exist, interest on current loans is already fixed.
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Due diligence review Where a company is taking over another, it will want assurance about various matters before the deal is completed. If you were buying a house, you would employ a solicitor to check various matters before completing the purchase – whether the seller actually owns the house, whether there are any legal issues affecting the house, plans to build a motorway right outside the front gate etc.! Likewise, a company acquiring another company will employ lawyers, accountants etc. to check various matters.
Procedures Typical procedures may include: ●
verifying the existence of the assets the target company claims to have
●
verifying the ownership of these assets
●
reviewing company forecasts for reasonableness
●
analytical procedures on the target’s management accounts since the last year-end (as these results have not been audited)
●
checking contracts with key employees, customers, suppliers etc. as any of these may be due to finish, or there may be terms in the agreements relevant to a takeover (e.g. an employee may have the right to resign without notice if the ownership of the company changes)
●
checking employee contracts as some may be entitled to a payout on a change of ownership
●
likewise, checking lease agreements for similar clauses
●
assessing whether the change in ownership would create tax liabilities, or cause loans to be repaid.
Other assignments The following assignments are either examined a lot less than those above, or have been covered elsewhere in the course notes.
Business risk management A question might ask you to identify business risks for a company, and suggest how these risks could be managed. This is a popular exam question, but was covered in chapter 4 of the notes.
E-commerce Being a specialist area requiring IT skills, it is unlikely that any detailed questions could appear on the exam. However, students should be aware that when companies buy/sell via their websites (or similar methods), they may wish to have these processes checked so that assurance can be given (e.g. next time you buy something on the internet, ote the “badge” of assurance to tell you that the site is safe).
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Typical problems in e-commerce include: ●
virus infection of data
●
loss of data
●
lack of knowledge of identity of customer
●
breach of Data Protection Act
●
hacking
●
knowing which laws apply given the web is “world-wide”.
Forensic work This may appear more often on the exam in the future, as it has been added to the syllabus with the change in the ACCA exam structure from December 2007. Students should note that it appeared both on the pilot paper and the first sitting of P7 in December 2007. Forensic accounting refers to accountancy work that results from actual or expected legal cases likely to be heard in a court of law. The work may be done to help provide evidence to help the resolution of a court case, or to help settle a dispute. Forensic auditing more specifically refers to the gathering, analysis and reporting on data (i.e. an audit) in situations that have legal consequences. As with all audits, a pre-agreed context / set of criteria will be set against which the auditor will report. If the forensic auditor finds fraudulent transactions, a wider forensic investigation will then try to discover how the transactions were able to be created. Typically, forensic work will: ●
require the auditor / accountant to appear in court to explain their work and findings
●
require absolute objectivity, with no threats whatsoever
●
involve zero materiality (i.e. be very detailed)
●
create confidentiality issues (as disclosure during the court case may be required)
●
have reputation implications for the firm of accountants, especially in a high profile case.
Students should remember that a forensic audit is still an audit! Therefore, much of the work is similar to a standard audit, subject to the features listed above.
Social and environmental audits Over the past 20 years, there has been a rapid growth in companies: ●
accepting that they have some responsibility for the social and environmental impacts of their operations
●
reporting social and environmental performance, both using narrative and data.
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As such, a company may make statements in their Annual Report (e.g. that their operations are based on sustainability) and provide performance data that shareholders and other stakeholders may want someone to check, and issue an opinion on. Whilst this “audit” work is not the same as an audit of financial information, and is likely to be carried out by specialists, many accountancy firms provide such services. Procedures may include: ●
advising the company on the key performance indicators (“metrics”) to present
●
checking these statistics using available evidence and typical audit procedures
●
reading board minutes to verify stated policies are true
●
assessing whether related costs (e.g. clean-up, alteration of an asset to make it more environmentally sound, development of “greener” products) are expense or asset in nature
●
assessing environmental provisions and contingencies for accuracy
●
assessing whether new environmental regulations (or social expectations) mean that some assets have been impaired
●
assessing the impact of social and environmental matters on the future viability of the company.
Internal audit As noted earlier in these Notes (see Reliance on Experts in chapter 4), external auditors may choose to rely on the work of a client’s internal auditors, to the extent that it is relevant to the audit of the financial statements, has been done objectively, competently etc. Outsourcing Where a client has outsourced its internal audit function, or parts of its accounting function, potential exam questions arise: ●
●
●
the pros and cons of outsourcing o
benefits of outside expertise
o
allows management to focus on core strategy
o
improved independence
o
cost implications
o
but may lose control
o
harder to monitor external provider
o
external provider slower response time.
impact of an outsourced service on the external auditor o
needs to assess work of the external service provider
o
may have difficulty gaining access to records.
hard to assess controls at the external provider.
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Chapter 8
Current issues and developments
SYLLABUS CONTENT 1.
Ethics and professional Issues ●
2.
Information Technology ●
3.
The specific issues involved in transnational audits compared with ormal audits
Social and Environmental Assurance ●
5.
Specific issues created by developments in IT
Transnational Audits ●
4.
Emerging issues in ethics, including the new IFAC Code which is adopted from January 2011
This current issue is covered within chapter 7
Other Current Issues, including new ISAs ●
This could include virtually anything!
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CHAPTER CONTENTS EXAM QUESTIONS ------------------------------------------------------ 111 ETHICAL AND PROFESSIONAL ISSUES ------------------------------- 112 INFORMATION TECHNOLOGY ----------------------------------------- 113 OTHER CURRENT ISSUES ---------------------------------------------- 114
110
LIABILITY LIMITATION FOR AUDITORS
114
LACK OF COMPETITION IN THE AUDIT INDUSTRY
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CHAPTER 8 – CURRENT ISSUES AND DEVELOPMENTS
EXAM QUESTIONS ●
A discussion question on any current issue could arise, and is likely to be within one of the compulsory case study questions.
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ETHICAL AND PROFESSIONAL ISSUES In 2009, the IFAC Code of Ethics for Professional Accountants was updated, and it comes into force from January 2011 (with transitional periods for some areas of change). The basics of ethics have not changed, but there have been some changes in detail which are worth noting involving Independence being strengthened: ●
Tougher rules on listed companies now apply to all “Public Interest Entities” (PIE), meaning tougher independence rules for additional companies going forward.
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There is a new concept of “Key Audit Partner” (KAP), to whom tougher rules apply. KAPs will include the Engagement Partner, any Engagement Quality Control Review partner, as well as other key decision-making partners.
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External auditors cannot also provide internal audit, most tax services, material valuation services, IT services, or recruiting services to their PIE clients.
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When a KAP (e.g. engagement partner, or the firm’s Senior Partner) moves to a client to take up a job, there must be a gap of at least 1 full year’s audit before the audit firm can consider itself independent.
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All KAPs must be rotated off an audit client at least every 7 years, and there is a mandatory 2-year “cooling-off” period before they may return.
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Where a PIE audit client represents >15% of the firm’s total fees for two years running, the second year’s audit must be subjected to a Hot or Cold Review.
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INFORMATION TECHNOLOGY The last 20 years have seen a major change for auditors, with the increased use of computers, the Internet etc. both by clients and by their auditors. This has created a number of new issues, many of which can emerge very quickly: ●
Many audit firms record their work online (e.g. by using their own private Intranet). This allows for work to be reviewed by managers/partners online as the audit progresses, rather than waiting for completed paper-based audit files to be presented at the end of the audit process. However, it also raises the risk of data loss, corruption, or security breaches.
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Audit firms may get some external confirmations using electronic means. They could receive bank confirmations by email, or be required to request them from a web portal set up by the bank, or through a 3rd party hired by the bank. All of these increase the risk of fraud, as the communication may have been tampered with, and the auditor cannot know who sent it at the other end.
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Most companies now upload their financial statements onto their websites, including the audit report. In effect, this means that “Other Information” includes every page on the website – not only are there too many pages to read, any of them could change within seconds of the auditor reading them, making it pointless for the auditor to be expected to read them.
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And don’t forget Computer-Assisted Audit Techniques (CAATs) from Paper F8. Audit software and Test Data can bring efficiencies to the audit process, especially where there are large volumes of transactions to audit
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In some countries (including UK and Singapore), companies may submit their financial statements to regulators (e.g. Companies House) using Extensible Business Reporting Language (XBRL). This is computer language and errors would not be visible to someone who does not understand it well enough to “read”. At present there are no rules requiring auditors to check XBRL data, but firms may be asked to check the data (or the system producing it) as an other service, and an assurance standard may be needed in the near future.
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Many companies are finding their systems being hacked into, which could result in accounting information being lost or changed.
Auditors need to be aware of all of the above issues in order to understand the increased risk of misstatements in the financial statements.
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OTHER CURRENT ISSUES Liability limitation for auditors This topic was covered earlier in the course notes in Chapter 2. A question may ask for the advantages and disadvantages of allowing audit firms to limit their liability (as many countries, including the UK, are now allowing them to do).
Advantages ●
Protects auditors from frivolous claims.
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Fairer – means that investors would need to press claims on other guilty parties (e.g. the company directors).
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Those put off joining the audit industry by the risk of losing a large legal case will be attracted back to the profession.
Disadvantages ●
May reduce the incentive o do a high quality audit.
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If shareholders refuse to accept a liability limitation clause in the engagement letter, the company may find it hard to appoint an audit firm.
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Audit firms may collude to ensure maximum liability caps are kept low.
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Investors who suffer losses due to the fault of others may find it harder to recoup their losses.
Lack of competition in the audit industry Since the late 1980s, a series of mergers (and the loss of Andersens after Enron) has resulted in the audit and accountancy industry being dominated by a small umber of massive international firms (PwC, KPMG, Deloitte, Ernst & Young being the main ones in the UK). Outside of these major firms, the next largest (“mid-tier firms”) are much smaller. Understandably, many believe that this “quadropoly” has resulted in higher costs, and lower quality.
Advantages ●
Potential economies of scale.
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They are large enough to have the resources to invest in researching improved methods for the future.
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Can compete with other industries (e.g. investment banks) for the best graduates and other talent.
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Can provide a varied career for staff.
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Big enough not to be intimidated by multinational clients.
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Big enough to have the resources to service multinational clients.
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Disadvantages ●
Increased cost and lower quality?
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With ethical considerations, companies may have very little choice when replacing their auditors (potentially no choice, unless they are willing to look outside the Big 4).
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Other firms will gradually lose the skills associated with auditing the biggest companies, meaning that the situation is likely to get even worse.
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One more major legal case could cause another big firm to collapse … and thus even more concentration of power in the industry.
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The big firms are so powerful they are likely to have too much influence in the setting of new standards for the profession.
Solutions? Whilst many agree that there is some sort of problem, solving it is far from easy. Possible solutions could include: ●
Insisting on joint audits that involve at least 1 firm from outside the Big 4.
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Governments awarding government contracts only to non-Big 4 firms.
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An enforced break-up of the Big 4 firms.
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Promoting mergers amongst the mid-tier firms.
All of these require governments to “interfere” in the accountancy industry to some extent, and in many countries such interference is not seen as a positive step.
Current IAASB projects and guidance The IAASB is always working on a number of projects designed to improve audit and assurance standards. At present, such projects include: ●
AUDIT REPORTS – an ongoing debate over the use of standardised formats, and whether a different approach might be needed in the future.
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REVIEW AND COMPILATION – an attempt to update standards covering review and compilation engagements, with a hope that companies that are exempt from a full audit could find some real value in hiring professional accountants to do a lesser form of audit (a review), or at least to produce their published accounts for them (a compilation).
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EXTERNAL CONFIRMATIONS – there are concerns that confirmations are too easily taken as sufficient audit evidence, on the basis that they are from 3rd parties and therefore reliable evidence. However: o
Fraud is a risk, especially in a financial downturn, as the audit client may have told the 3rd party confirming the information what to say. All confirmations should be checked against other available evidence.
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The confirmation may not be reliable, for example if the person returning the confirmation is not the person with the necessary information, or does not understand the nature of the request.
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As noted above in “Information technology”, many external confirmations are now done electronically, leading to risks of interception and alteration.
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o
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Many confirmations contain disclaimers. If these are standard (e.g. not to be used by anyone other than the auditor), they are probably not a problem. However, if the disclaimer states that the information provided is “a matter of opinion only and should not be relied on”, it questions the reliability of the confirmation!
SME AUDITS – The accounts of Small and Medium Sized Entities (SMEs) can follow the IFRS for SMEs, rather than full IFRS. Does this mean that the audits of these companies could follow a smaller version of ISAs? The Clarity Project has taken this into account, with new ISAs having provisions that take note of SME audits. ALL audits must follow all ISAs (on every audit, some ISAs will be irrelevant of course – if the client does not use service organisations, then ISA 402 does not apply to the audit, for example), but the new ISAs are designed for SME audits as well as large companies and transnational audits.
The above is not a complete list, as the list of projects is updated regularly. After the extensive work done in The Clarity Project, completed in 2009, there are not many standards being looked at for updates at present. Any of the ISAs that received material updates during The Clarity Project are potential exam questions for the near future – so make sure you are happy with the issues surrounding related parties, estimates and fair value, materiality, reliance on the work of component auditors in a group audit, communicating with those charged with governance etc.
Other topical IAASB pronouncements The recent global economic problems have resulted in some additional IAASB guidance for auditors, in particular: ●
Guidance on assessing Fair Values in a market where such values may be changing reapidly and unpredictably.
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Guidance on assessing Going Concern when many normal assumptions about a company’s ability to continue trading, collect its debts, negotiate new finance etc. are no longer valid.
Important note to finish There is no fixed list of current issues, and naturally such issues are constantly changing. To attempt to produce a fuller list would make this section of the Notes appear far more important to the syllabus than it actually is. Your examiner expects you to read the business press, accountancy publications, be aware of which audit standards are being discussed (e.g. by reading the IFAC website as necessary), and most importantly to read Student Accountant for relevant articles.
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