P7 All notes

Regulatory Environment

International Regulatory Frameworks

The Need for Standards and Regulations

Regulation is needed to ensure that auditors are acting in the public

interest

These 'regulations' come in 4 ways

1. Ethics
2. Standards
3. Regulations
4. Statutory

The international regulatory framework for audit and assurance services encompasses:
International Federation of Accountants (IFAC) pronouncements

Corporate Governance

Audit Committees

Know the Structure, Role & Benefits / Drawbacks

Structure of the Committee

At least one member of the committee should have recent and relevant financial experience.

There should be at least 3 non executive directors. In the case of smaller companies, this may be 2.

Role of the committee

1. To improve the quality of financial reporting
2. To increase the confidence of the public in the financial statements.
3. Assist directors in meeting their responsibilities in respect of financial reporting.
4. Provide a channel to external auditors to report concerns or issues.
5. Review the companys system of internal controls.
6. Strengthen the position of internal audit by providing greater independence from management.
7. Appointment of external auditor.

Advantages of a committee
Independent Reporting
Provides internal audit with an independent reporting mechanism. Without this management may be tempted to hide
unfavourable reports.

Frees up Executive time

Leaves top executives free to manage by providing expertise on financial reporting

Corporate Governance monitored

Ensures that corporate governance requirements are brought to attention of the board

Appropriate Internal Controls

Should ensure that an appropriate system of internal control is maintained.

Better Communication

Better communication between the directors, external audit and management is facilitated.

Strengthens external audit independence

Strengthens independence of external audit as their appointment is now not made by the board.

Disadvantages of Committee
1. Executive directors may perceive it as a threat to their authority.
2. Finding non executive directors with appropriate expertise may be difficult.
3. Additional costs will be involved.
4. Too much detail may be thrust upon non executive directors.

Communication with the audit committee

Why does the external auditor speak first to the Audit Committee?
1. To ensure independence between the board and the audit firm.
The audit committee consists of independent NEDs, who can therefore take an objective view of the audit report.

2. The audit committee has more time to review the audit report and other communications (eg management letters) than the board.
The auditor should therefore benefit from their reports being reviewed carefully

3. The audit committee can ensure that any recommendations from the auditor are implemented.
The NEDs can pressurise the board to taking action on auditor recommendations

4. The audit committee also has more time to review the effectiveness and efficiency of the work of the external auditor than the
board.
The committee can therefore make recommendations on the re-appointment of the auditor, or recommend a different firm if this
is appropriate

Public Interest Oversights Board

A profession has a responsibility to the public

Public Interest Oversight Boards

1. Oversees IFAC's auditing and assurance
2. Believes standards should be high quality, clear and usable
3. Ensures auditors act independently of personal interests, and be responsive to emerging needs of standard users
4. Promote compliance with IFAC standards by the member bodies of IFAC around the world

Money Laundering
Money Laundering Basics

Examples
Cashing up
A business taking large amounts of small change each week (e.g. a convenience store) needs to deposit that money in a bank. If
its deposits vary greatly for no obvious reason this can draw suspicion; but if the transactions are regular and roughly the same
the suspicion is easily discounted. This is the basis of all money laundering, a track record of depositing clean money before
slipping through dirty money.
In the United States, for example, cash transactions and deposits of more than $10,000 must be reported by the cashier (the
bank etc) as "significant cash transactions" to the Financial Crimes Enforcement Network FinCEN, with any other suspicious
financial activity identified as "suspicious activity reports" (SARs).
In other jurisdictions suspicion-based requirements may be placed on financial services employees and firms to report suspicious

activity to the authorities.

Captive business
Another method is to start a business whose cash inflow cannot be monitored, and funnel the small change into it and pay taxes
on it. But all bank employees are trained to be constantly on the lookout for transactions that seem to be trying to get around
reporting requirements. To avoid suspicion, shell companies should deal directly with the public, perform some service (not
provide physical goods), and have a business that reasonably would accept cash as a matter of course. Dealing directly with the
public in cash gives a plausible reason for not having a record of customers.
For example, it is quite reasonable to think that a hairstylist is paid in cash and, even if she knows her customer's names, does
not know their bank details. A record of a haircut must ostensibly be accepted as prima facie evidence. Service businesses have
the advantage of the anonymity of resources but the disadvantage that they must deal in cash. A business that sells
computers has to account for the computers, whereas the hairstylist does not have to produce the cut hair, but the receipt for
the computer, even if inflated, exists that for the haircut probably does not. It is of course also possible to invent customers,
purely for the purpose of accepting money from them.

International efforts to combat money laundering

The Financial Action Task Force (FATF) is an international body, which promotes policies globally to combat money laundering and
terrorist financing. In 1990 FATF issued recommendations to combat the misuse of financial systems to launder drug money.
The recommendations include:
making money laundering a criminal offence
measures to be taken by businesses and professions to prevent money laundering, including:

customer due diligence and recordkeeping

reporting of suspicious transactions to an appropriate authority
international cooperation including extradition of suspects.
These recommendations have become the benchmark against which a countrys rules are assessed.

There are various criminal offences connected with money laundering. The UK examples are:

Possessing or concealing the proceeds of any crime

Attempting or helping to commit the above offence

Failure by a person in the regulated sector to inform the appropriate party of a suspicion that someone is money laundering

Making a disclosure which is likely to prejudice an investigation into money laundering (tipping off)
The last two offences are the ones that accountants may find themselves affected by even inadvertently, as accountants operate
in the regulated sector and are therefore required to report suspicions of money laundering

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Defences to charges of money laundering:
A report had been made to the appropriate party
There was an intention to make a report and a reasonable excuse (likely to include fear of physical violence or other menaces) for
not having done so
Acquiring or using property for adequate consideration in good faith

Money laundering is creating the appearance that money obtained from

crimes originated from a legitimate source.

In US law it is the practice of engaging in financial transactions to conceal the identity, source, or destination of illegally gained
money.
In UK law the common law definition is wider. It is taking any action with property of any form which is either wholly or in part
the proceeds of a crime that will disguise the fact that that property is the proceeds of a crime or obscure the beneficial
ownership of said property.
It basically means any financial transaction which generates an asset or a value as the result of an illegal act, which may involve
actions such as tax evasion or false accounting.
Money laundering is thus the process by which criminals attempt to conceal the true origin and ownership of the proceeds
generated by illegal means, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for
their sources of income.

The term is widely defined to include:

1. Possessing
2. Dealing with in any way
3. Concealing

.....the proceeds of any crime

International Efforts on Money Laundering

The Financial Action Task Force on Money Laundering (FATF) is an

international body which sets standards, and develops policies to combat
money laundering and terrorist financing

It currently has 35 member countries/territories and observers such as the World Bank and International Monetary Fund).
Their recommendations are endorsed by more than 180 countries and are the international anti-money laundering standard
against which national anti-money laundering systems are assessed

The recommendations cover

Policies and coordination

Money laundering and confiscation

Terrorist financing and financing of proliferation

More specifically these deal with:

1. The scope of the criminal offence of money laundering
2. Measures to prevent money laundering including:
customer due diligence (CDD) and record-keeping; and
reporting of suspicious transactions and compliance to an external financial intelligence unit (FIU);

3. Measures needed in systems for combating money laundering, including transparency of legal persons and arrangements
4. International co-operation including mutual legal assistance and extradition

Scope of Money Laundering

Principal Offences of Money Laundering..

These are the common ones under UK legislation but generally apply worldwide and hence
in the exam..
1. Not appointing a Money Laundering Reporting Officer (MLRO)
2. Not having risk management procedures and internal controls complying with anti-ML legislation
3. Not verifying identity of all new clients
4. No ongoing client due diligence
5. Failure to report a suspicion of ML
6. Tipping off
7. Tax evasion

Tipping-off
This is when an individual who is suspicious, discloses that suspicion to the suspect
In fact even non-disclosure/action maybe considered tipping off (e.g. not carrying out a client's instructions that is effectively a
money laundering operation).
If the client asks the accountant to commit a suspected ML offence, this must be reported to the appropriate authority
Also not being suspicious is not a defence if it is clear that a reasonable person should have been suspicious
The fear of tipping off should not prevent the professional accountant from discussing money laundering matters with clients on
a non-specific basis. Not doing so, when requested, may amount to tipping off.

How Accountants May Be Protected

All partners are potentially liable on a joint and several basis for breaches
of the firm's obligations

General Defences
Defences to money laundering offences include:

Reporting to the MLRO

Intending to report BUT there was a reasonable excuse for not doing so (fear of violence)

We thought the client's actions were in good faith (and it's a reasonable assumption)

How Accountants Prevent Money Laundering

Accountants have money laundering obligations..

The following will prevent their organisations being used for money laundering purposes
1. Establish a top-down anti-money laundering culture
2. Have risk management procedures & internal controls
3. Appoint a money laundering reporting officer (MLRO)
4. Have record keeping systems for all transactions
5. Keep systems for initial verification and continued monitoring of clients' identities
6. Have internal suspicion reporting procedures
7. Educate and train all staff in the main requirements of the legislation

Client Acceptance Procedures

should include

Identification procedures

Know your Client information

including...

Their expected patterns of business

Their business model
Where their funds come from

Money Laundering Reporting Officer

Basically should have a suitable level of seniority and experience

1.

If the MLRO is away then a deputy must be appointed (as reports must be made as soon as practicable)

2.

Sole practitioners do not need to appoint an MLRO

3. Responsibilities Include
Internal reports of money laundering
Deciding if sufficient grounds for suspicion
Preparing the external report to present to the appropriate authority
Key liaison individual with the authorities
Advising the engagement individual/team on how to continue their work and interact with the client
Training on ML matters
Designing anti-ML systems

Reporting Duties

Professional accountants must report money laundering to the

appropriate authority (e.g. MLRO, Police).

Some Points about Reporting

It is a criminal offence not to report

Regardless of the amount or seriousness

There is no obligation to quantify the certainty of suspicion

There is no automatic need to cease working for a particular client where a report has been filed

Doing so may even be tipping off!

An external report should be made to the authorities

It should include the following

Name of the reporting business

Identification information of each person (DOB, address etc)

Role of each person (eg Suspect)

Any references seen (eg Bank account)

Details of suspicious transaction

Location of any laundered property

Resignation
You should consider resigning where..

It is in your commercial interests to do so

It is professionally and ethically responsible to do so

Just be careful to avoid tipping off. Again, legal advice should be sought if in doubt

What are suspicious transactions?

Large cash deposits

Unexplained foreign transactions

Transactions with no business explanation

Anti-Money Laundering Programme

The MLRO is responsible for setting up the anti-money laundering

programme

The following is required

1. Dedicated Resources
An MLRO in place

The MLRO has appropriate knowledge, experience and responsibility

2. Written Policies and Procedures

The procedures should use available technology and identify risk factors - items to look for when detecting money laundering

These risk factors could include

Secrecy with a transaction

Transactions through several jurisdictions or financial institutions without any apparent purpose
Using central bank or government-owned banks as the source of funds
A rapid increase/decrease in a balance, not explained by fluctuations in the underlying market value of investments held
Frequent or excessive use of funds/wire transfers in or out of an account
Repeated deposits or withdrawals just below the monitoring and reporting threshold on or around the same day
A pattern that after a deposit or wire transfer the same (or similar) amount is wired to another financial institution
(especially one that is offshore).
A frequent clearing out of an account for purposes other than maximising the value of the funds held in the account

3. Comprehensive Coverage
All aspects of a company's business, particularly those that
have contact with customers should be covered

A comparison of the account holder's identity to the government lists of known or suspected terrorists

4. Timely Escalation and Resolution

Timely reports

Appropriate reviews of the report

Identify the outcome / resolution of matters

5. Explicit Management Support

Senior management should set the tone

Their support clearly visible to all employees

6. Sufficient Training and Education

Integral to the whole programme

Courses on how to recognise suspicious activity and what to do next

7. Regular Review of the Program

To make sure it is working as designed

Accompanied by a formal assessment / report

ACCA factsheet 145 on Money Laundering

The offences

Failing to disclose or report money laundering

Tipping off
Prejudicing an investigation

Systems and Controls

Identify complex / unusually large transactions

Prevent use of anonymity granting products
Perform customer due diligence
Appoint mlro
Customer record keeping for 5 years
ML compliance monitoring
Make employees aware of ML regulations

Risk-Based approach

Target efforts where risk is highest

Watch for unusual transactions
Keep customer due diligence up to date

Customer Due Diligence

Test riskiness of client to see amount of DD

Always at the start of a business relationship
When there's unusual transaction
When suspicious
To new and old clients on a risk sensitive basis
Identify beneficial owner
Monitor throughout relationship

Reporting

Suspicious activity reports

Have an MLRO to report to
Failure to report is an offence
When reports made, they are protected
Report as soon as possible

MLRO

Significant responsibility
Senior person
Absences covered

Learn more list

The fact sheet in full baby!

Good luck with it, and if you get to the end, give yourself a medal

Ethical Framework or Rules

Current Issue - Is an ethical framework better than rules?

Here's some reasons why a framework is good...

1. Needs auditor to consider his situation actively - not just a checklist
2. Ensures there are no loopholes by interpreting rules too narrowly
3. Every situation is different
4. A framework works better in changing environments

Laws and regulations

Responsibilities of management and auditors

Management is responsible for ensuring that the company complies with

laws and regulations

Auditors are responsible for

concluding FS free from mistatements caused by non-compliance with laws and regulations

having a general understanding of the legal and regulatory framework within which the company operates

applying professional scepticism

obtaining a general understanding of applicable laws and

regulations

understanding how the entity complies with those laws and regulations

identifying instances of non-compliance

being aware of the impact of breaches of regulations on the assertions

Responsibilities of Management (and Those Charged With Governance)

1. Prevention AND detection of fraud and error
2. Strong risk management and internal control
3. A culture of honesty and ethical behaviour
4. Compliance with applicable laws and regulations
5. Monitoring legal requirements
6. Developing, publicising and following a Code of Conduct
7. Training

Non-Compliance Discovery

There are indicators that Non-compliance may have occurred

These are
1. Government Investigations
2. Fines or penalties
3. Unspecified payments for to related parties or (government) employees
4. Excessive sales commissions
5. Purchasing at not market price
6. Unusual bank transfers
7. Payments without exchange control documentation
8. Lack of adequate audit trail

Consequences of Non-Compliance
Provision for fines, charges etc

Potential disclosures needed

Decide if so serious that true and fair view is questioned

Procedures when possible noncompliance is discovered

These are:
1. Document findings
2. Discuss with management
3. Discuss with their lawyer
4. Discuss with own lawyer
5. Consider impact on other areas of the audit

6. Consider if you can now rely on other management representations

How to Report on Non-Compliance

Auditors should tell directors of any non-compliance immediately

This should happen without delay, and make appropriate reports, as set out below:

THOSE CHARGED WITH GOVERNANCE

If the auditors suspect non-compliance with laws and regulations

Communicate to audit committee

Consider the need for legal advice

SHAREHOLDERS
Only if it causes FS to not give a true and fair view or there is a fundamental uncertainty

Report in usual way (See reporting section)

REGULATORY AUTHORITIES

REGULATORY AUTHORITIES
Auditor decides if there's a responsibility to report to parties outside the entity

When to Withdraw From the Engagement

This is a last resort

There are many factors to consider

1. Are management implicated?
2. Non-compliance affect on relationship with client
3. Legal responsibilities?
4. Any alternatives?

WHEN TO WITHDRAW
Management refuses to remedy the situation

Significant doubts about the competence or integrity of management

When withdrawing the auditor must

Discuss the reasons for WITHDRAWING with the appropriate level of management

Consider any professional or legal requirements to report his withdrawal

Professional and Ethical Considerations

Code of Ethics for Professional Accountants

Fundamental Principles

The 5 fundamental principles of the ACCA Code of Ethics must be

followed

The 5 Fundamental principles and what they mean

1. Integrity
Be straightforward and honest in all professional relationships

2. Objectivity
No bias or conflict of interest influencing your business judgements

3. Professional Competence & Due Care

Keep up your professional knowledge and skill so as to give a competent professional service, using current developments and
techniques
Act diligently and within appropriate standards when providing professional services

4. Confidentiality
Don't disclose any confidential information to third parties without proper and specific authority
You can, however, if there is a legal or professional right or duty to disclose
Obviously never use it for personal advantage of yourself or third parties

5. Professional behaviour
A professional accountant should act in a manner consistent with the good reputation of the profession
Refrain from any conduct which might bring discredit to the profession

In the exam question you may have to apply

these to a case study - groovy baby..

Threats

An auditor must be independent and be seen to be independent

Categories of Threat
Auditors need to be fully aware of situations that may damage their independence.

1. Self-interest
Here the auditor may have a financial (or other) interest in a matter.
Therefore the auditor may not act with objectivity and independence.

2. Self-review
Here the auditor reviews a judgement she has taken herself.
Or an audit firm prepared the financial statements and then acted as auditor.
This is a threat to objectivity and independence.

3. Advocacy
Here the auditor is expected to defend or justify the position of the client, and act as an advocate.
This is a threat to objectivity and independence.

4. Intimidation
Here the auditor can't act independently as she is scared due to intimidatory threats such as the threat to take away the work
unless they do as the client wishes.

5. Familiarity
Here the auditor and client have a too close relationship, for example due to a long association over many years in carrying out the
annual audit.

Examples of Threats
Financial Interest
Here look for the nature of the interest and the degree of control the accountant has over it - obviously the more control
the higher the risk.
No member of the assurance team (or immediate family) should hold a financial interest in a client.
The interest should either be disposed of, or the team member removed from the engagement.

Loans and guarantees

If the client is a bank (or similar) and the loan is on normal commercial terms then there is no threat to independence.
All other loans or guarantees are a self- interest threat and should be avoided.

Close business relationships

A material joint venture with a client is a self-interest threat, so should be avoided.
Buying things from a client is fine if on normal commercial terms and in the normal course of business.

Family and personal relationships

Think here about the seniority of the assurance staff and the closeness of the relationship.
If the family member is able to exert significant influence over the subject matter then the threat to independence can only
be avoided by removing the individual from the assurance team.

Recent employment with client

The threat can be reduced by getting an independent third party to review the audit file.
If a member thinks they might soon be employed by the client (having applied for a job there) then this should be disclosed
by the member immediately.

Serving on the board of assurance clients

Auditors should not do this.
Although if it's only routine administrative services, like a company secretary, then it may be ok.
What is vital is that they are not involved in making management decisions.

Long association of senior personnel with assurance clients

This may cause a familiarity threat.
In the exam you need to look at the nature of the role and the length of time that he has been doing it when deciding
which staff members to involve in assurance work.
An audit engagement partner and/or quality control reviewer shouldn't work on the same client for more than seven years
and should not be returned to the engagement for at least two years after being rotated off the team.

Fees
If the client fees are a large proportion of a firms total fees, there is a significant self-interest threat.
ACCA rules state that recurring fees paid by one client or a related group of clients should not exceed 15% of the income of
the audit practice (10% if the client is listed).
In larger firms an individual office may exceed these limits as long as responsibility for signing off the audit file should be
passed to a different office.
Overdue fees should be avoided as they are practically a loan.

Gifts and hospitality

Only accept if not significant to either party

Consider the following:

Could the value affect objectivity?

Was the hospitality when the auditors should have been working?

Were remaining members of the team properly supervised?

Ensure the member checked with more senior people in the firm to check if it was allowed - otherwise it is a
disciplinary offence also.

Actual and threatened litigation

If actual litigation then resign from the engagement.

Safeguards

Safeguarding independence is the responsibility of the audit firm & the

profession

Audit Firm Level

A culture of independence should be created, this means a rotation of the engagement partner and senior staff.
In addition, an audit firm should have the following procedures in place:

Training
To an appropriate level for the role

Quality control procedures

This ensures that independence is considered in all work performed by the audit firm.

Consultation
So issues can be discussed internally and procedures are laid out to facilitate this

Ethical Codes
of conduct

Internal Controls

The Profession
The profession should take disciplinary action as appropriate.
The profession regularly suggest new practices and procedures designed to improve auditor independence.
So things that the profession do to help safeguard against ethical threats are:

1. Regular rotation of auditors made compulsory

2. Using audit committees

3. ACCA Exams and CPD :)

4. Corporate Governance and of course auditing standards

The Individual
An individual auditor can limit ethical threats by..

Complying with CPD regulations - and staying up to date

Keeping in contactwith fellow professionals

To informally discuss issues and problems

Independent Mentor used to discuss individual threats

Confidentiality

Never disclose unless consent has been given or you're obliged to

Recognised exceptions to the duty of confidentiality

Sometimes disclosure is required and sometimes it is voluntary

Obligatory disclosure
when the auditor knows, or has reason to suspect that, a client has committed..

Treason

Terrorism

Drug trafficking

Money laundering

More exceptions
Voluntary disclosure
This is permitted in the following circumstances:

1. Protecting Member Interests

For example, defending yourself against an accusation of negligence

2. Legal Process
The courts may require documents

3. Public Interest
For example - Informing tax authorities of non-compliance by a client company with tax regulations

Resolving Ethical Issues

When the auditor is suspicious of an ethical threat, action must be taken

Follow these steps..

1. Assess the facts
2. Consider ethical Issues
3. Fundamental Principles Are they affected?
4. See what established procedures there are for dealing with it otherwise..

5. Look for alternative measures such as an external regulator, or worst case scenario, resigning!

Conceptual Framework

Works on principles, not listing every reason why auditors may not do
the right thing

The conceptual framework works like this..

1. Identify the threat that may cause a fundamental principle to be broken
2. The fundamental principle how likely is it to be broken?
3. Limit the risk if the threat is more than negligible - to an acceptable level

There are 3 types of safeguard

which can limit the risk

Profession
Training & Education Gaining experience at work, passing your exams :) & CPD on ethical matters

Legislation On things such as who is fit and proper to become an auditor

Corporate Governance regulations These often set out best practice for some ethical situations

Individual
CPD Keeping up to date with auditing standards and developments

Networks Keeping in contact with other professionals to discuss matters informally or contacting ACCA for guidance

Independent Mentor A formal relationship with another auditor to discuss ethical threats on a confidential basis

Work
Codes of Conduct created and followed by the firm with controls and procedures in place

Ethical Standards Relating to audit engagements such as discussions with audit committees and staff rotation policies

Typical threats

The auditor is tempted to gain a personal or family benefit rather than

give an appropriate service

Holding Shares in a client

Don't! Here look for the nature of the interest and the degree of control the accountant has over it - obviously the more
control the higher the risk
No member of the assurance team (or immediate family) should hold a financial interest in a client.
The interest should either be disposed of, or the team member removed from the engagement

Significant Income from client

Limit the amount 10% of total fees if listed
15% of total fees if unlisted
In larger firms an individual office may exceed these limits as long as responsibility for signing off the audit file should be
passed to a different office.
Overdue fees should be avoided as they are practically a loan

Separate business venture with client

Don't! Although buying things from a client is fine if on normal commercial terms and in the normal course of business

Giving a loan to the client

This may include unpaid audit fees

Don't

Getting a loan from a client

If the client is a bank (or similar) and the loan is on normal commercial terms then there is no threat to independence.
All other loans or guarantees are a self- interest threat and should be avoided

Lowballing
Setting a very low fee either to attract new clients or ensure further work
Safeguard
Auditors should not set fees in this way, the fee must be based on a pre-determined level of work required

Hospitality and Benefits

Any such items given to the auditor by a client could be seen to be a bribe
So do not accept

Contingent Fees
Where auditors fees are contingent on another event happening.
Audit Fees are not to be determined in this way

Accounting Services
If an auditor prepares the accounts it is 100% sure that they will be reviewing their own work. They may be tempted to hide
errors to save face.
So the Auditor must not undertake accounting services for a client, if they are a LISTED company.
No management decisions should be made in other companies and a different team should provide each service.

Professional Scepticism

A healthy scepticism is a fundamental part of any audit

We need to see more scepticism

Not a total distrust it requires an enquiring mind that is open to the possibility that something may be wrong
Is it supported by evidence
Is it consistent with what is known from elsewhere?

Are assumptions reasonable? In today's world, impairment testing is commonplace and works on assumptions
The auditor needs to not only see a record of what the assumptions are, but also challenge them and understand how they
affect the conclusions the client has come to.
Too often it seems that the auditor is looking for reasons why assumptions can be supported, without also considering facts
that might suggest they are not appropriate - too optimistic, for example.

Is there sufficient evidence? If an auditing standard requires a certain presumption - for example, of a significant risk of
fraud in the case of revenue recognition - does the auditor too easily find reasons for overriding the presumption?

Professional Scepticism and Judgement

When planning and performing an audit, the auditor should adopt an

attitude of professional scepticism

It is An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to
error or fraud, and a critical assessment of audit evidence

In other words, they must not simply believe everything management tells them

The exercise professional judgement in planning and performing an audit

The auditor will need to exercise professional judgement on both the quantity and the quality of evidence.

So he has to judge..
1. When is there sufficient evidence?
2. What is the quality of this evidence

Factors to help with the judgement are...

The seriousness of the risk

The materiality of the item

The strength of internal controls

The sampling method used (see later)

Fraud and Error

Definitions

Fraud

An intentional act....involving the use of deception to obtain an unjust or illegal advantage

Three main areas of fraud exist:

Corruption

Misappropriation of assets

Financial statement fraud

Error

An unintentional misstatement in financial statements, including the omission of an amount or a disclosure

Examples are:
A mistake in gathering data from which FS are prepared

An incorrect accounting estimate due to an oversight

A mistake in applying accounting principles

Irregularity

An intentional misstatement to mislead users

If a material error is identified, but not corrected it becomes an irregularity

Investigating Misstatements

If a misstatement is discovered, the audit impact needs to be considered

This is done by:

1. looking at the circumstances of the offence
2. Gathering information about the FS effect

2. Gathering information about the FS effect

3. If material, additional procedures should be carried out
4. Communicated to those charged with governance
Find out their action to rectify it and whether it is likely to happen again

Management and Auditor Responsibilities

Management Responsibilities

These are:
1. Safeguards created to avoid fraud and error using internal controls
2. Internal audit is responsible for monitoring and implementing these

Auditor Responsibilities

If fraud or error leads to amaterial misstatement, the auditor is responsible for detecting it

At the Planning Stage

The auditor must consider the risk of material misstatement due to fraud and error when planning and performing their audit

If fraud is discovered
Report it to the audit committee or
Highest level of management (if not involved in the fraud), or
Shareholders if the fraud is by those in senior management

Reporting Fraud and Error

Fraud and error must be reported to management or the audit

committee ASAP

What about reporting to shareholders?

By including a paragraph in the audit report

What if it's in the public interest?

Report to a 3rd party (eg. Regulator)
Especially if management involved

Audit Approach

Audit teams members should discuss the risk of fraud at planning stage

Further Procedures:
1. Ask Management what their assessment of the risk is
2. Ask Management what their processes are for identifying and dealing with these risks
3. Ask Management how they communicate this process to staff
4. Ask management if any actual or suspected fraud has occurred

Professional Liability
When are Auditors Liable to their Client?

The auditor has a contract with her client

This means that the contract can be broken by the auditor and so become liable
This begins when it can be shown that the auditor didn't use "reasonable skill and care"

How can you show "Due skill and care"?

Applying IFRS and ISA's correctly

Following ethical standards

Following engagement letter terms

Using properly trained and competent staff

Being Sued for Negligence

This means 3 tests need to be proven:

1. Duty of Care owed

This is obvious for an audit client (though not necessarily for 3rd Parties)

2. Breach of that Duty

such as..

Incorrect Opinion
ISA's not followed correctly

3. Client suffered a Financial Loss

The client wouldn't have made this loss otherwise

Client

3rd party

Duty of care exists?

Automatic

Needs proving

Breached?

Needs proving

Needs proving

Loss made?

Needs proving

Needs proving

LIMITING LIABILITY TO YOUR CLIENT

Reducing liability for statutory audit work is normally not allowable
However there are options:

Limited Liability Partnerships

A separate legal entity the LLP itself is liable to the full extent of its assets
The liability of the members will be however limited to the investment made in the LLP
Negligent Partner will still be sued personally - but non-negligent partners are protected

Limited Liability Agreements

Here companies limit auditor liability by contract - needs shareholder approval
It must be:

1. Fair and reasonable

2. For the current year only

3. Made clear as part of any tender process

When are Auditors Liable to 3rd Parties?

A duty of care must be owed to a 3rd party - and it needs proving!

Client

3rd party

Duty of care exists?

Automatic

Needs proving

Breached?

Needs proving

Needs proving

Loss made?

Needs proving

Needs proving

This involves looking at:

1. Foreseeability of damage to the 3rd party
2. A relationship of "proximity" with the 3rd party
3. It's fair, just and reasonable to impose such a duty on the accountants

Another way of looking at this is..

1. The auditor acted negligently
2. The auditor ought to have known that 3rd parties relied upon her opinion
3. The 3rd party suffered financial loss as a result

CONSEQUENCES
A shareholder stands no different from any other investing member of the public to whom the auditor owes no duty

Shareholders are seen as a class, the auditor reports to the class and not to assist individuals

The Expectation Gap

Difference between client's expectations and actual audit work

performed

What causes the 'Expectation Gap'

1. Management misunderstanding their responsibilities
2. Management misunderstanding the scope of the audit
3. Management misunderstand that it is THEIR responsibility to detect fraud
4. Management think that the auditors are liable for any errors

How is the 'Expectation Gap' narrowed?

In the Audit report
Responsibilities of management and the auditor;
Show that audits are performed on a test basis only
A statement that the opinion gives reasonable NOT absolute assurance that FS are free from material misstatement

In the Engagement letter

Responsibilities of management and the auditor
The nature, scope and purpose of an audit

There are many disclaimers protecting the auditor and reducing the amount of reliance that users can place on these reports.
However, auditors are exposed to the threat of liability from bad clients and without any protection may not accept many

engagements

Practice Management

Quality Control
Definitions for Quality Control

learn the meaning of the following terms:

1. Engagement partner
The partner responsible for the audit engagement, performance and report
Also she has the appropriate authority from a professional, legal or regulatory body

2. Engagement Quality Control Review

Provides an objective evaluation, before signing the report,
of any significant judgments & conclusions
It is for listed entity audits and any where the firm thinks such a review is required

3. Engagement Quality Control Reviewer

Someone not part of the engagement team, with experience and authority to objectively evaluate the significant judgments &
conclusions

4. Engagement team
All partners and staff performing the engagement, plus anyone engaged by to do audit work
This excludes external experts

5. Firm
A sole practitioner, partnership or corporation of professional accountants

6. Inspection
These provide evidence of compliance with the firms quality control policies

7. Listed entity
An entity whose shares (or debt) are quoted on a stock exchange

8. Monitoring

An ongoing evaluation of the firms quality control

It includes periodic inspections of a selection of completed engagements

Principles & Purpose

Firms need to be sure that the audits they perform meet quality
standards

This is to decrease the risks of:

Litigation against us for professional litigation

Incorrect Audit opinion and hence an increased investor confidence in the financial statements

There are 2 standards on Quality Control

1. At the FIRM level International Standard on Quality Control 1 (ISQC 1) Quality Control for firms that perform audits and reviews
2. At the individual AUDIT level ISA 220 Quality Control for audits of historical financial information

ISQC 1 (firm level)

ISQC 1 identifies six building blocks of a firms system of quality control:

1. Ethics
2. Client Relationships
3. Leadership
4. Human Resources
5. Engagement Performance

6. Monitoring

We will look at the above in more detail in the next section. See you there, hotpants....

Elements of a QC system

This follows on from the previous section

Firm Level Quality Control

The objective of the firm is to establish and maintain a system of quality control to provide it with reasonable assurance that:
(a) The firm and its personnel comply with professional standards and applicable legal and regulatory requirements; and
(b) Reports issued by the firm or engagement partners are appropriate in the circumstances

1. Leadership
An internal culture focused on quality is key
This means training, appraisal & mission statements.
Commercial considerations never override quality
Pay & Benefits must reflect commitment to quality.
Resources must be available to support quality

2.

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3. Human Resources
All staff to have the capabilities & competence to ensure quality.
Appraisals and development regularly

4.

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5. Engagement Issues - Planning

Discuss known risks with the client and document
Staff suitably qualified and experienced, have knowledge of the client
Contentious areas must be consulted on in a cost effective way
A timetable for suitable reviews
Ensure independence and any issues addressed
Time pressure
All audits should be planned to ensure that adequate time
can be spent to obtain sufficient appropriate audit evidence to support the audit opinion.

6. Engagement Issues - Supervision

Staff supervised and assessed to control the work flow.
Any problems tackled immediately and consultation on any deviations from the original plan.

7. Engagement Issues - Review

Review has the purpose of identifying previously unrecognised problems and examining them along with the rest of the
work carried out.
Is the amount of evidence gathered sufficient or is further work required?
Quality control can be achieved during the review stage by:
1) Learn lessons from mistakes made
2) Appraisal staff immediately after assignments to praise &/or constructively criticise

8. Monitoring
Ensure new developments in standards and regulations are implemented
Ensure CPD is kept up to date.
Any breaches to monitoring system dealt with

9. Ethical Requirements
Have procedures to comply with ethical requirements eg. independence

Emphasise through leadership, education/training, monitoring and dealing with non-compliance

Have procedures to identify independence threats eg. prompt notification by employees

Ensure that firm is notified of breaches of ethical requirements promptly

Types Of Review
Hot Reviews
A hot review is carried out before the audit report is signed.
Performed by a suitably independent reviewer such as a senior manager (not part of the management team).
Listed company engagements must have a hot review as well as those of public interest or with significant risks.
it reviews the quality of the judgements made such as:

Is the firm independent?

Are risk assessment judgements justified?

Use of work outside the audit team.

Have misstatements been correctly dealt with?

Do working papers support the conclusions reached?

Is the final engagement report justified in the circumstances?

Cold Reviews
A cold review is a review carried out after the audit report is signed.

It will be designed to identify problems in procedures and poor practice.

The cold review should make recommendations for improvements.

Engagement Performance

Direction, Supervision and Performance

Directing the engagement team means telling them about:

1. Their ethical responsibilities
Their need to plan and perform an audit with professional skepticism

2. The objectives of the work to be performed

3. The nature of the entitys business
4. Risk-related issues
5. Problems that may arise
6. The detailed approach to the performance of the engagement

Supervision includes:
Seeing if the team has enough time and competence to do their job
Also whether they understand their instructions

Addressing significant matters arising during the audit and modifying the plan appropriately

Identifying matters for consultation with experienced engagement team members

Reviews include:
Ensuring that work of less experienced team members is reviewed by more experienced ones

Ensuring that significant matters have been raised for further consideration

Appropriate consultations have happened

The work performed supports the conclusions reached and is appropriately documented

The Engagement Partners Review of Work Performed

This involves timely reviews of the following:

1. Critical areas of judgment
2. Significant risks

Engagement Quality Control Review

Note the following:

It helps to see if sufficient appropriate evidence has been obtained

It is done throughout the audit so significant matters are promptly resolved before the date of the auditors report.

Documentation of the review may be completed after the auditors report (as part of the assembly of the final audit file)

The extent of the review depends on:

1) The complexity of the audit
2) If the entity is listed and
3) The risk of an inappropriate auditors report

Assigning the Audit Team

You need to consider the team's competence and capabilities

This means looking at their:

1. Understanding of, and experience with, similar audits
2. Understanding of professional standards and regulations
3. IT expertise and any specialist accounting / auditing
4. Knowledge of the client's industry
5. Ability to apply professional judgment
6. Understanding of the firms quality control policies

Individual level of Quality Control

Individual Level Quality Control

ISA 220 Quality Control for Audits of Historical Financial Information specifies the following quality control procedures that should
be applied by the engagement team in individual audit assignments.

Client acceptance procedures

There should be full documentation, and conclusion on, ethical and client acceptance issues in each audit assignment.
The engagement partner should consider whether members of the audit team have complied with ethical requirements, for
example, whether all members of the team are independent of the client.
Additionally, the engagement partner should conclude whether all acceptance procedures have been followed, for example, that
the audit firm has considered the integrity of the principal owners and key management of the client.
Other procedures on client acceptance should include:

1. Obtaining professional clearance from previous auditors

2. Consideration of any conflict of interest
3. Money laundering (client identification) procedures.
Establish the identity of the entity and its business activity e.g. by obtaining a certificate of incorporation
If the client is an individual, obtain official documentation including a name and address, e.g. by looking at
photographic identification such as passports and driving licences
Consider whether the commercial activity makes business sense (i.e. it is not just a front for illegal activities)
Obtain evidence of the companys registered address e.g. by obtaining headed letter paper
Establish the current list of principal shareholders and directors.

Engagement team
Procedures should be followed to ensure that the engagement team collectively has the skills, competence and time to perform
the audit engagement.
The engagement partner should assess that the audit team, for example:

1. Has the appropriate level of technical knowledge

2. Has experience of audit engagements of a similar nature and complexity
3. Has the ability to apply professional judgement
4. Understands professional standards, and regulatory and legal requirements.

Direction
The engagement team should be directed by the engagement partner.
The planning meeting should be led by the partner and should include all people involved with the audit.
There should be a discussion of the key issues identified at the planning stage.
Procedures such as an engagement planning meeting should be undertaken to ensure that the team understands:

1. Their responsibilities
2. The objectives of the work they are to perform
3. The nature of the clients business
4. Risk related issues
5. How to deal with any problems that may arise; and

Supervision
Supervision should be continuous during the engagement.
Any problems that arise during the audit should be rectified as soon as possible.
Attention should be focused on ensuring that members of the audit team are carrying out their work in accordance with the
planned approach to the engagement.
Significant matters should be brought to the attention of senior members of the audit team.

Review
The review process is one of the key quality control procedures.

All work performed must be reviewed by a more senior member of the audit team.
Reviewers should consider for example whether:

1. Work has been performed in accordance with professional standards

2. The objectives of the procedures performed have been achieved
3. Work supports conclusions drawn and is appropriately documented.

Consultation
Finally the engagement partner should arrange consultation on difficult or contentious matters.
This is a procedure whereby the matter is discussed with a professional outside the engagement team, and sometimes outside
the audit firm.
Consultations must be documented to show:

1. The issue on which the consultation was sought; and

2. The results of the consultation.

Advertising
Acceptable Advertising

They should inform and not try to impress

Generally they should not reflect badly on the member, the ACCA or the accounting profession as a whole

Acceptable publicity includes:

Appointments and awards

Seeking employment or professional business

Professional directories

Books, article, interviews, lectures, media appearances

Training courses and seminars

Advertisements and promotional material must not:

1. Bring ACCA into disrepute
2. Discredit the services offered by others
3. Claim superiority
4. Mislead
5. Be legal, decent & truthful

Names & Descriptions

Members may be called Chartered Certified Accountants, but not

companies

The firm may describe itself as Chartered Certified Accountants if...

At least half the partners or directors are ACCA members

They control at least 51% of the voting rights

If all partners in the firm are ACCA members they may state this on their stationery
If some partners are members of another accountancy body however, this must be made clear

Use of ACCA logo

Acceptable if:
At least 1 partner is an ACCA member

The logo is separate from the firm logo

Fees

The basis of calculation (e.g. hourly) must be clearly stated

Any reference to fees must not mislead the reader about the precise range of services and time commitment that it relates to

You can compare your fee to others if..

1. It is for the same service

2. It is an objective comparison
3. It doesn't discredit the other
4. It doesn't create confusion

Percentage discounts may be offered but must not detract from the firm or the profession

Assurance Engagement Fees

Not calculated on a % or contingency basis

Due to self-interest and advocacy threats

Non-Assurance Engagement Fees

Contingent fee possible only if possible range and variability of the fee is small

Approval by the audit committee may be needed

Setting Fees
The following needs considering:

1. Level of expertise needed

2. Time needed
3. How important the work is to client
4. The risk of taking on the work & costs incurred

Low-Balling

This is setting the initial audit fee low in order to win the client

Ethical Issues:
Client needs to stay to recover the initial losses so independence is impaired

Possibly unprofessional because many smaller practices can't compete

Tendering

This is when an audit firm is approached by a prospective client to bid

for their audit

Audit Firm Considerations:

How did the client get to know about them?

Why has the firm been approached particularly?

What is the scope of the audit?

How risky is the audit to the firm?

Does the firm have the necessary resources

Tender documents contents:

1. Fee and how it has been calculated
2. An assessment of the requirements of the prospective client
3. Our approach to the requirements
4. Deadlines and information needed
5. Outline of the firm and our staff

Professional Appointments
Accepting a new engagement

Auditors should screen clients to ensure they are not high risk

The risk to the auditor is reputation risk i.e. that they will be associated with a poorly regarded client.
An auditor is required under ISA 315 to gain an understanding of their client.
Auditors should screen clients to ensure they are not high risk

Questions to ask will be:

1. Is the client involved in any fraudulent/illegal activities?
2. What is the nature of the industry in which they are involved is it depressed?
3. Has the client had a history of changing auditor regularly or had qualified audit reports in the past?
4. Do client directors understand their role and are they able to carry it out?
5. Are management trustworthy?

Other Areas to help gain an understanding are:

The market and its competition

Legislation and regulation

Regulatory framework

Ownership of the entity

Nature of products/services and markets

Location of production facilities and factories

Key customers and suppliers

Capital investment activities

Accounting policies and industry specific guidance

Financing structure

Financing structure

Significant changes in the entity on prior year

Auditors may advertise their services.

However, adverts should not bring the ACCA into disrepute, discredit the services of others, be misleading, or fall short of
regulatory or legislative requirements.

Procedures when offered a role

These include:
1. Get permission to contact the outgoing auditor
2. Contact the old auditor, asking for any reasons why we should not accept appointment
3. Check we are sufficiently Independent
4. Check we have the competence & resources to do it

Pre-Conditions for an Audit

Auditors should only accept a new audit engagement when it
has been confirmed that the preconditions for an audit are present..

Is the FR framework acceptable?

Consider the entity & the purpose of the FS

Perhaps, also, laws say which FR framework should be used

Do Management accept their responsibilities?

For preparing FS
For internal controls
For giving the auditor all relevant information they request

If the preconditions for an audit are not present..

The auditor shall not accept the proposed audit engagement

New engagement process

Tendering for audit work

Things to consider...
1. Fee
A fee will be quoted for a piece of audit work before it is carried out under a tendering process

The auditor must not lowball as we have seen above, nor may they make unrealistic claims or promises to win the
contract

2. Get Information
The potential client will inform the auditor of what is expected, the timetable, future plans of the company and any
problems with current auditor

3. Proposal
The auditor may then draw up a proposal containing:

Proposed audit fee

Nature, purpose and legal requirements of an audit.
Assessment of the requirements of the client.
How audit firm proposes to satisfy requirements
Any assumptions made.
Proposed audit methodology.
Outline of audit firm and personnel
Ability of firm to perform the audit

Pre-conditions
Is the Financial framework used acceptable? (Consider the type of business and relevant laws and the uses of the financial
statements)

Client Decision
The client will decide on the basis of clarity, relevance, professionalism, reputation, timeliness of delivery and originality
which firm will conduct the audit

Engagement letter

An engagement letter is a letter from the auditor to the client indicating

various matters concerning the engagement

The engagement letter is sent before the audit to the client confirming their acceptance of the audit

Contents
ISA 210 Terms of Engagement gives guidance as to their content, but as a rule most will include:

The Objective of the audit.

Managements responsibility for the Financial Statements.

The scope of the audit including reference to legislation and professional standards.

The form of report to be used

Use of the work of internal audit

Reference to inherent limitations of an audit

Access to information to be allowed

Deadlines and confidentiality

Expectations of management representations

Fees

Complaints procedures

Audit of Historical Financial Information

Planning, materiality and risk

Business Risk

The risk that the business won't meet its objectives

The objective is normally profit maximisation

So we are looking for problems which may impact on the business

To look for Risks..

You could use PESTEL
Business risk identification is literally putting yourself in the shoes of the management..

Political risks
e.g. The current government may be unstable and if there is a change of government, the new government may impose
restrictions.
The Company will need to assess the likelihood of such restrictions.

Economic risks

Social and taste changes

Technological changes

Environmental issues

Legal issues

Financial Statement Risk

Simply the risk that the FS are materially misstated (before any audit procedures)
The risk comes from potential errors or deliberate misstatements

Business v Financial Risk

Business risks will affect the FS if not addressed by management

Business risks can lead to errors on specific areas of the FS (eg. Technological change leading to obsolete stock)

Business risk can have a more general effect on FS (eg. Poor controls leading to errors)

Business risks can lead to going concern problems. This too would be a FS risk (wrong basis of accounting)

Materiality

ISA 320 defines information as material if its omission or misstatement

could influence the economic decisions of users taken on the basis of the
financial statements.

Material items could be large transactions or significant events.

Materiality is important to the auditor because if a material item is incorrect, the financial statements will not show a true and
fair view.

Materiality Levels
1.

The auditor will decide materiality levels and design their audit procedures to ensure that the risk of material misstatements is
reduced to an acceptable level.
Generally, materiality will be set with reference to the financial statements such as:
0.5 1% of turnover
5 10% of profits reported
1 2 % of gross assets
Judgement will be used by the auditor in charge and will depend on the type of business and the risks it faces.

2. Considerations
Quantity
The relative size of the item

Quality
This might be something that's low in value but could still affect users' decisions e.g.. Directors wages

Tolerable Error
This is when the auditor accepts the error

For example finding one error out of 100 tested, might be ignored

The tolerable level will be decided at planning stage

Performance Materiality

This is lower than normal materiality

The idea is that this will try to prevent all those small, undetected errors do not aggregate to become material

There are now 2 standards to consider..

1. ISA 320 Audit Materiality

2. ISA 450 Evaluation of Misstatements Identified During the Audit

As we know, materiality is calculated at the planning stage

But it might not stay at that amount - oh no baby
Things happen that make the auditor change the level
Such things are often immaterial in quantity but material by their nature

Example
The company you are auditing makes a $5,000 profit.
The materiality is set at $10,000
You notice that an invoice for $6,000 has been incorrectly placed into next year.
This would be material as it changes the look of the whole accounts (changing a profit into loss)

The new standard recognises that there could well be instances where certain classes of transactions, account balances or
disclosures might be affected by misstatements which are less than the materiality level for the financial statements as a
whole, but which may well influence the decisions of the user of those financial statements regardless of the fact they are
below materiality this is where performance materiality is to be applied.
Specifically, the clarified ISA 320 suggests performance materiality be applied to areas such as related party transactions
and directors remuneration.

Evaluation of Misstatements

Material Misstatements normally lead to qualifying the audit report

Misstatements aren't just monetary figures, they could also be incorrect classification or disclosures

Evaluating Misstatements
1. Get a list of misstatements found
2. Discuss these with management at the end of the audit
3. Management will normally correct these
4. Any remaining material misstatements will cause the auditor to qualify the report

Aggregation of Immaterial Errors

Immaterial errors could aggregate to become material

These will be brought to the attention of management

If management amend material errors, then the auditor will issue an unqualified audit report

If management refuse to adjust the errors then the auditor must persuade them to do so or issue a qualified audit report

All misstatements found must be communicated to those charged with governance

This is to ensure that no management bias exists in the decision taken on what constitutes an immaterial misstatement
Management must also provide written representations that all uncorrected errors are immaterial

Components of Audit Risk

Audit risk is the risk that the auditor expresses an inappropriate audit
opinion when the financial statements are materially misstated

Stated another way, this is the risk that there is a material misstatement in the financial statements, but the auditor misses it
and says that they present a true and fair view.

Formula for audit risk is:

Inherent Risk x

Inherent Risk

Control Risk x

Detection Risk

This will be considered at the planning meeting as it depends on the auditors knowledge of the business
Examples are...

A cash based business

This is often a problem as there must be very strong controls in place if a business is a cash based one.
The auditor may feel that there are insufficient controls in place to mitigate this risk which may lead to limitation of
scope.

Fast moving Industry

In fast moving industries such as IT or fashion there may be a risk that the inventory held by the business becomes
obsolete.
The auditor may take expert advice on the valuation of inventory, or they may review post year-end sales to ensure
the goods are sold for more than they are valued at in the financial statements.

Control Risk
This is the risk of material misstatement due to inadequate internal controls within the business.
The auditor will make a judgement as to the suitability and strength of internal controls we will examine how this is done at a
later stage.
Examples are...

No segregation of duties
Segregation of duties is where different tasks in a process are performed by different people e.g. an invoice is raised
by one person and the cheque is written by another and authorise by someone else.
If this control is weak or not in place, the auditor may have to increase the sample size to ensure the financial
statements present a true and fair view.

No controls over access to assets

If employees have unfettered access to the assets of the business with no restrictions, this will increase the risk of
theft or damage to those assets
If the auditor finds this to be the case, more physical checks of the existence and condition of assets will have to be
carried out.

No controls over access to IT

If a business does not use passwords and other protection to protect its computer systems this can lead to data loss
or manipulation without authorisation.
If these controls are not in place the auditor will have to understand the system to assess the ease of which it can be
manipulated and check for anomalous trends using analytical review.

Detection Risk
This is the risk that the work carried out by the auditor does not uncover a material misstatement that exists.
Detection risk can be split into sampling & non-sampling risk

Non-sampling risks
The auditor did not sufficiently investigate a significant balance

The procedures used may have been inappropriate or misinterpreted

Sampling risk
arises from the possibility that the auditors conclusion, based on a sample may be different from the conclusion
reached if the entire population were subjected to the same audit procedure.
This is another way of saying that the sample selected by the auditor was not representative of the data.
Detection risk may be increased by things such as inexperienced audit staff or tight deadlines to complete the audit.

Affecting Audit Risk

The auditor cannot affect inherent risk or control risk as these are
internal (called Entity Risk)

The auditor therefore concentrates on detection risk once they have assessed the control and inherent risk.
Consider the elements of Audit risk and how they relate in our formula:

Inherent Risk x

Control Risk x

Detection Risk

If Inherent & Control risk are judged to be high, then to minimise overall audit risk, the auditor must attempt to minimise
detection risk.
The auditor will have to increase the amount of tests or the number of samples to ensure that there is less chance of a material
misstatement being overlooked or missed.

Why Plan an Audit?

Plan the audit so that the engagement will be performed in an effective

manner

Time spent planning the audit to ensure it is carried out efficiently will reduce the time taken and thus the cost.
The planning process will also assess and thus reduce risk.
The auditor will want to ensure that the correct team is in place to conduct the audit, they are working efficiently and that work
is focused on material areas of risk and potential problem areas.

Planning Activities
Risk Assessment
We will look in detail later at risk assessment, but at this point we should be aware that the identification of risk will
determine the entire audit process.

Audit Strategy
The audit strategy sets out the scope, timing and direction of the audit.
The scope of the audit will be determined by the reporting framework applied as well as any industry specific
requirements.
The strategy decided upon will be tailored to the client and the nature of their business and their structure. The
auditor must ensure that the strategy selected is appropriate

Geography
If there are any geographical or other factors which may affect the audit, they will be considered here.

Deadlines & Timing

The timing of the audit will set out any deadlines applicable and the dates of the interim and final audit visits.
The interim audit is conducted before the final audit to evaluate controls and document the systems in place.
In addition there may be some substantive tests carried out.
The attendance at the stock count will be carried out at this time and perhaps the receivables circularisation.
The final audit will involve the bulk of the audit work and it may be possible to concentrate on the statement of
financial position figures if sufficient work has been carried out during the interim audit.

Contents of the Plan

There are several stages in the planning process:

As follows
Ensure understanding of the business

Undertake analytical review

Assess the risks involved with the business

Establish materiality levels

Establish tolerable error for material errors

Decide the audit approach

Ensure auditor independence

Decide the budget and staff requirements

Timetable the audit & set deadlines

Permanent file
The permanent file kept by the audit firm will bring forward a lot of the knowledge of the business, but this must be kept up

to date.

Current File
The current file contains the evidence and documents relevant to the current year.

The planning section of the file will cover all of the areas above, and there will be a completion section which will review the
audit.

In between there will be a sub-section for each balance sheet item (e.g. Non Current Assets) and for each income statement
item (e.g. purchases) with the work done outlined and evidence documented

Analytical Procedures in Planning

Analytical procedures consist of evaluations of financial information

through analysis of plausible relationships among both financial and nonfinancial data

At the planning stage they help you understand the business and its environment
Because you compare figures to the industry and to previous years
Any items which go against the expected relationships help you assess the risk of material misstatement

How to perform Analytical Procedures

A step by step guide

1. Predict a figure, based on a relationship

Eg. This could be gross profit as a % of revenue (based on previous years and industry averages)

2. Define what a significant difference is

We call this the threshold below which we see any difference as just a tolerable 'error'

3. Calculate the procedure and the difference to the prediction in step 1

4. Investigate the difference
Differences indicate an increased likelihood of misstatements
If caused by factors previously overlooked, look at what impact this would have on the original expectations as if this data had
been considered in the first place, and to understand any accounting or auditing ramifications of the new data

Types of analytical procedures

Trend analysis
The analysis of changes in an account over time

Ratio analysis
The comparison of relationships using financial and non- financial data

Reasonableness testing
Comparing expectations based on financial data, non-financial data, or both to actual results

Limitations when used for Planning

1. Often budgets and forecasts needed
2. If done before Y/E extrapolations used - these aren't reliable if business is seasonal
3. Many accounting adjustments missed as only done at Y/E

4. Often uses less rigorous management accounts

5. Even more difficult for smaller companies who don't have good management accounts

How to get Initial Understanding

Firstly the auditor needs to understand the entitys environment, this will
require the auditor to assess:

The following..
Industry conditions

Principle business strategies

Competitors

Laws and regulations

Technology

Stakeholders

Financing

Acquisitions and disposals

Related parties

Competence of management

Accounting policies

From a number of sources..

1. Internal to the audit firm such as last years file.
2. External sources such as credit reference agencies.
3. Information provided by the client.
4. The auditors personal experience and knowledge

ISA 315 requires a planning meeting where the members of the engagement team should discuss the susceptibility of the entitys
financial statements to material misstatements. The minutes of this meeting should be documented as evidence of its
occurrence.
Analytical procedures should be undertaken at this stage to establish an understanding of the financial statements and draw
attention to anomalies.
We will look more closely at analytical procedures later.

Evidence
The Assertions Explained

Assertions are used for transactions, balances and disclosures to see if

sufficient evidence on them has been collected

The assertions help assess risks

They help the auditor consider potential misstatements and so design audit procedures for those particular risks.

Transactions Assertions
1. Occurrence
2. Completeness
3. Accuracy
4. Cut-off
5. Classification

Y/E Balances Assertions

1. Existence
2. Rights and obligations
3. Completeness
4. Valuation and allocation

Disclosures Assertions
1. Occurrence
2. Completeness
3. Classification and understandability
4. Accuracy and valuation

Using Assertions

So the assertions need testing to see if they're true

This is done by
1. Inspection
This means a physical examination

Things to inspect include: documentation, contracts, records and minutes.

It also includes physical examination of the assets.

This enables the auditor to verify the existence (though not ownership) of them

2. Observation
This means watching others perform a procedure

Examples include observation of

Payment of wages
Inventory counts
Opening mail

It gives assurance that official procedures are followed

3. Inquiry
This means getting information from people inside or outside the entity.

It can be a formal written or an oral inquiry

4.

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5. Confirmation
This means corroborating evidence from third parties with the internal evidence

For example, confirming accounts receivables by circularising the debtors

6. Re-Performance
This can be recalculating figures or re-counting stock etc

7. Analytical Procedures
This is the analysis of ratios and trends

It includes investigating fluctuations between current and previous performance and check whether other information is
consistent with such relationship.

For example, comparing the rent charge from one period to the next and see if other evidence such as number of rental
properties corroborates the increase or decrease

Procedures for obtaining evidence

Just remember A,E,I,O and U

So here's a reminder...
1. Analytical Procedures
2. Enquiry
3. Inspection
4. Observation
5. Re-calcUlation / Re-performance

Procedure

Meaning

Control test

Substantive test

Analytical
procedure

Exploring relationships
between data

Comparing yearly gross margins

Enquiry

Getting confirmation
from a 3rd party

Replies from a debtors circular

Inspection

Examining records

Signature as evidence

Observation

Looking at a process

Watching staff complete their

attendance sheet

Recalculation

Checking mathematical
accuracy

Getting title deeds to a property

Adding individual sales in the sdb to

check the totals

Analytical procedures

Substantive procedures help detect material misstatement or fraud at

the assertion level

There are two categories of substantive procedures - analytical procedures* and tests of detail.
*Analytical procedures generally provide less reliable evidence than the tests of detail
AP's are used at different times in the audit whereas tests of detail are only applied in the substantive testing stage

Analytical procedures are compulsory at two stages of the audit under ISA 520:
1. The planning stage &

2. The review stage

Analytical procedures use calculations such as financial ratios to generate an expectation of what a figure is likely to be and then
comparing this to the actual figure in the accounts.
They can be used to highlight unusual figures in order to focus the audit on them or to establish that a trend has continued.

The financial ratios used by the auditor will fall into 3 general categories:
Profitability/Return
1. Gross Margin

2. Net Margin

3. ROCE

Liquidity/Efficiency
1. Receivables/Payables/Inventory Days

2. Current Ratio

3. Quick Ratio

Gearing
1. Financial Gearing

2. Operational Gearing

Whether or not the auditor relies on analytical procedures as substantive procedures

depends on four factors:

Suitability
Analytical procedures will not be suitable for every assertion

Reliability
The auditor may only rely on data generated from a system with strong controls

Degree of Precision
Some figures will not have a recognisable trend over time or be comparable

Acceptable Variation
Variations having an immaterial impact on the financial statements will not hold as much interest to the auditor as
those that do

Initial Engagement

Opening Balances

Get evidence that:

1. No misstatements in them
2. Prior period c/f correctly
Or restated if necessary

3. Accounting policies consistent

If not then the comparative needs restating and disclosed

Prior Period Not Audited?

Procedures:
1. Check post Y/E cash for confirming opening receivables / payables
2. Do stock count and "roll back" to opening balance
3. Get 3rd party confirmation on other assets and liabilities

Prior period - Different Auditor

Audit procedures:
1. Review their working papers - for competence and independence
2. Check FS & audit report for information relevant to opening balances
3. If previous report modified - check it has been rectified now

Audit Report Possible Effects

Can't get enough evidence about opening balances?

"Except for" or "Disclaimer"

Opening balances or disclosures incorrect

"Except for" or "Adverse"

IAS 24 Related Parties

A party is said to be related to an entity if any of the following three

situations occur:

The 3 situations are:

1. Controls / is controlled by entity
2. is under common control with entity
3. has significant influence over the entity

Types of related party

These therefore include:

1. Subsidiaries
2. Associate
3. Joint venture
4. Key management
5. Close family member of above (like my beautiful daughter pictured in her new school uniform aaahhh)
6. A post-employment benefit plan for the benefit of employees

Not necessarily related parties

Two entities with a director in common

Two joint venturers

Providers of finance

A big customer, supplier etc

Stakeholders need to know that all transactions are at arms length and if not then be fully aware.
Similarly they need to be aware of the volume of business with a related party, which though may be at arms length, should the
related party connection break then the volume of business disappear also

Disclosures
General
The name of the entitys parent and, if different, the ultimate controlling party
The nature of the related party relationship
Information about the transactions and outstanding balances necessary for an understanding of the relationship on
the financial statements

As a minimum, this includes:

Amount of outstanding balances
Bad and doubtful debt information

Key management personnel compensation should be broken down by:

short-term employee benefits

post-employment benefits

other long-term benefits

termination benefits

share-based payment

Group and Individual accounts

1. Individual accounts
Disclose related party transactions / outstanding balances of parent, venturer or investor

2. Group accounts
The intragroup transactions and balances would have been eliminated

Auditing Related Parties

Understanding RP relationships and transactions is vital

This is because:
1. Need to recognise possible fraud risk factors
2. Need to show fair presentation
3. Need to ensure RPs identified, accounted for and disclosed

Auditors need to..

Know the indicators of RP existence (not identified by managers)
e.g. complex structures

Records/documents that may indicate related parties

See the importance management place on identifying, accounting for and disclosing RPs

Understand the risk of management override of RPs controls

Review
1. P/Y working papers for names of known RPs
2. Shareholder records/share register
3. Income tax returns
4. Records of investments and senior management pension
plans

5. Internal auditors' reports

Examples include:
An unusually high turnover of senior management

The use of business intermediaries for significant transactions

Evidence of the RPs excessive participation in selecting accounting policies

Auditing IDENTIFIED Related Parties

1. Confirm terms, conditions and amounts with the RPs
2. Inspect evidence of appropriate authorisation
3. Confirm or discuss with relevant independent persons (e.g.
banks, lawyers)

4. Review RPs FS for related party disclosures made

If transactions are OUTSIDE normal course of business

Evaluate business rational

Do management explanations make sense

Accounting and disclosure is in accordance with the reporting framework

Authorisation is appropriate

What if we find an RP that management didn't tell us about?

1. Tell the engagement team
2. Get management to identify all transactions with the RP
3. Ask why management controls failed to recognise them
4. Perform appropriate substantive audit procedures
5. Reconsider risk of other RPs not told about & perform additional procedures
6. If intentional - evaluate the implications for the audit (e.g. management's integrity etc)

Tell Those charged with governance about:

Management failure to disclose information

Disagreement with management regarding RP accounting and disclosure

Non-compliance with laws and regulations

Difficulties in identifying the party that ultimately controls the entity

Effect on Auditor's Opinion

1. Disagreement if disclosures are inadequate

2. Limitation of scope if insufficient information

Limitation of Scope if...

1. Management give identifying RP low importance
2. Lack of appropriate oversight by those charged with governance
3. Intentional disregard to controls because disclosures would be sensitive
4. Poor management understanding of RP accounting and disclosures needed
5. The absence of disclosure requirements under the applicable financial reporting framework

Why Rely on Experts?

ISA 600 deals with the use of the work of an expert by the auditor

The auditor may not have the expertise to make judgements on all aspects of a clients business and may seek help in the form
of an expert.
Examples of this are specialist inventory, property valuation and complex work in progress.

Why rely on experts?

1. Auditors do not have to be experts in everything
2. Often it's effective and efficient to do so
3. They need to where they lack the skills

How much to rely on experts?

Auditor needs to make judgements on:

Their Independence, Objectivity and Competence

Enquiries:
Competence
Is a member of a recognised professional body?
How long has the expert been a member of the recognised body?
How much experience does the expert have?
Objectivity
Does the expert have any financial interest in the company?
Does the expert have any personal relationship with any director in the company?
Is the fee paid for the service reasonable and a fair, market based price?

This is based on their qualifications and their experience

If an expert in the inventory of the entity being audited is consulted on valuation of inventory, but works for a subsidiary
of the entity then the auditor may consider them to be not sufficiently independent

Before any work is performed by the expert the auditor should agree in writing:
1. Nature, scope and objectives
2. Roles and responsibilities
3. Nature of communication
4. Confidentiality of expert

After the work - Auditor ensures it is appropriate

This means considering:

Consistency with other evidence

Any significant assumptions made

The accuracy of source data

No reference in the Audit Report

The auditor should make no reference to the use of the work of others in the audit report
It is the auditors opinion in the report and the work of others is simply one type of evidence that may be used, if sufficient and
reliable, to come to that opinion

Why Rely on Internal Audit?

The external auditor must determine whether it is likely to be adequate

for the purposes of the audit:

So we look at:
Whether the internal audit staff are sufficiently independent to retain objectivity

The qualifications and technical competence of the internal audit staff

The professionalism of the staff and the standing of internal audit within the organisation

Are internal audit constrained in any way by management?

If these considerations are fulfilled the auditor may assess the reliability of the work carried out by internal audit by

ensuring:
Internal audit working papers are well documented and have been reviewed

Evidence gained by internal audit is sufficient and appropriate

Any conclusions drawn are reasonable and valid

Management have acted on recommendations made by internal audit

If all of the above is satisfied the auditor may choose to place reliance on some of the work of internal audit.

Remember that although they may use some of the work of internal audit as evidence, the responsibility for the final opinion
will always lie with the external auditor.

Auditing specific items

IFRS 8 Determining Reporting segments

IFRS 8 Determining Reporting segments

Identifying Business and Geographical Segments

An entity must look to its organisational structure and internal reporting system to identify reportable segments.
In fact, the segmentation used for internal reports for the board should be the same for external reports

Only if internal segments are not along either product/service or geographical lines is further disaggregation appropriate.

Primary and Secondary Segments

For most entities one basis of segmentation is primary and the other is secondary (with considerably less disclosure
required for secondary segments)

To decide which is primary, the entity should see whether business or geographical factors most affect the risk and returns.
This should be helped by looking at entitys internal organisational and management structure and its system of internal
financial reporting to senior management.

Which Segments Are Reportable?

Segments with a majority of external sales and for which:

1. Total revenue is 10% or more of the total revenue; or

2. Segment result, whether profit or loss, is 10% or more of the combined result of all segments in profit or the combined result of all
segments in loss, whichever is greater in absolute amount; or

3. Assets are 10% or more of the total assets of all segments.

Very small segments

Segments deemed too small for separate reporting may be combined with each other, if related, but they may not be
combined with other significant segments for which information is reported internally.
Alternatively, they may be separately reported. If neither combined nor separately reported, they must be included as an
unallocated reconciling item.

75% External revenue test

If total external revenue of all reportable segments identified is less than 75% of the total consolidated revenue, additional
segments should be identified as reportable segments until at least 75% of total revenue is included in reportable segments.

Internal based segments

Vertically integrated segments (those that earn a majority of their revenue from intersegment transactions) may be, but need not
be, reportable segments.
If not separately reported, the selling segment is combined with the buying segment.

Illustration
Product

External Revenue

Internal Revenue

Profit

Assets

Liabilities

The Nose picker

2,000

30

(100)

3,000

2,000

The Earwax extractor

3,000

20

600

8,000

3,000

Other Products

5,000

50

1,050

20,000

14,000

Which segments should be reported upon?

Lets look at the 3 reportable segment tests:
10% of combined revenue = 1,010
10% of profits = 165
10% of losses = 10
10% of assets = 3,100
So,

1. The Nose picker only passes the revenue test, it fails the profits test as a loss of 100 is less than 165 (165 is higher than 10), it fails
the assets test.
It is still a reportable segment though as only 1 test needs to be passed

2. The Earwax extractor passes all 3 tests

3. Other Products These are not separate segments and can only be added together if the nature of the products are similar, as are
their customer type and distribution method.
So ordinarily these would not be disclosed. However we need to check whether the 2 reported segments meet the 75% external
revenue test:

4. Currently only 5,000 out of 10,000 (50%).

Therefore additional operating segments (other products) may be added until the 75% threshold is reached

What Accounting Policies Should a Segment Follow?

Segment accounting policies must be the same as those used in the consolidated financial statements.
If assets used jointly by two or more segments are allocated to segments, the related revenue and expenses must also be
allocated.

Operating Segments can be aggregated together only if..

they have similar economic characteristics such as:

1. Similar product / service

2. Similar production process
3. Similar sort of customer
4. Similar distribution methods
5. Similar regulations

Inventory and construction contracts

Inventory

Value at
Lower of cost and net realisable value

Remember to take future costs away from selling price and NOT add to costs

Questions relating to the physical inventory count:

1. Are all items marked when counted?
2. Does a management carry out test checks?
3. Are stocksheets pre-numbered and prepared in ink?
4. Is a complete set of stocksheets available covering all categories of inventory?

Construction Contracts

Show % complete (in sales and cost of sales)

Calculated one of 3 ways

1. Costs to date method

Costs to date / Total costs

2. Value of work done method

Value of work done / Total Price of contract

Loss making contracts

1. Losses must be shown IMMEDIATELY by placing more costs in current year

Contracts where not sure it is going to be profitable or not

1. Make revenue just equal costs spent to date
2. Therefore show nil profit

Construction Contracts - % complete

IAS 11 defines a construction contract as:

a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or
interdependent in terms of their design, technology, and function for their ultimate purpose or use

Accounting treatment
Basically uses the accruals concept

Sales - % complete

Costs - % complete

How do you calculate % complete?

There are 2 ways - and you will be told which to use :)

Agreed value of work method

Work done so far / Contract price total

Cost Method
Costs to date / Total costs

Illustration of % complete
Contract Price

1,000

Estimated total costs

800

Costs to date

600

Agreed value of work done

700

Progress billings invoiced

600

Calculate the stage of completion using:- a. the agreed value of work method b. the cost method

Solution - agreed value of work done

700 / 1,000 = 70%
So sales would be 700
Costs would be (70% x 800) = 560

Solution - Costs method

600 / 800 = 75%
So sales would be (75% x 1000) = 750
Costs would be 600

Changes in Accounting Policy

Changes in accounting policy

Change comparatives also

Changes in accounting estimates

Just change this year and not comparatives

Deferred tax basics

The basic idea

So as we saw in the introductory section, deferred tax is all about matching. If the accounts show the income, then they must
also show any related tax. This is normally not a problem as both the accounts and taxman often charge amounts in the same
period
The problem occurs when they dont. We saw how the accounts may show income when the performance occurs, while the
taxman only taxes it (tax base) when the money is received. In this case, as financial reporters we must make sure we match the
income and related expense.
So this was a case of the accounts showing more income then the tax man in the current year (he will tax it the following year
when the money is received). So we had to bring in more tax ourselves by creating a deferred tax liability
Hopefully you can see then that the opposite also applies:

Difference

Tax effect

Deferred Tax

More expense in I/S

less tax needed

Asset

Double entry
Dr Deferred tax asset
Cr Tax (I/S)
In fact, the following table all applies:

Difference

Tax effect

Difference

More Income

More tax

Liability

Less income

Less tax

Asset

More expense

Less tax

Asset

Less expense

More tax

Liability

Remember this more income etcis from the point of view of IFRS. Ie The accounts are showing more income, as the taxman does
not tax it until next year

Principal audit procedures recoverability of deferred tax asset

1. Obtain a copy of current tax computation and deferred tax calculations and agree figures to any relevant tax correspondence
and/or underlying accounting records.

2. Develop an independent expectation of the estimate to corroborate the reasonableness of managements estimate.
3. Obtain forecasts of profitability and agree that there is sufficient forecast taxable profit available for the losses to be offset
against.

4. Evaluate the assumptions used in the forecast against business understanding. In particular consider assumptions regarding the
growth rate of taxable profit in light of the underlying detrimental trend in profit before tax.

5. Assess the time period it will take to generate sufficient profits to utilise the tax losses. If it is going to take a number of years to
generate such profits, it may be that the recognition of the asset should be restricted.

6. Using tax correspondence, verify that there is no restriction on the ability of Company to carry the losses forward and to use the
losses against future taxable profits.

Non Current Assets - Cost

This is recorded initially and then fixed

Costs to include are:

All directly attributable costs (e.g. P&P)

All future OBLIGATED costs (at Present value)

Borrowing costs (if takes a reasonable length of time to construct)

Future obligated costs

Dr Cost
Cr Liability

The liability must then be unwound

Dr Interest (I/S)
Cr Liability

Auditing PPE additions

1. A breakdown of the components of the amount capitalised costs to ensure all items are eligible for capitalisation.
2. Agreement of a sample of the capitalised costs to supporting documentation
3. A copy of the approved budget for any capital expenditure plan
4. Documentation to verify when constructed assets are complete and ready for use
5. Recalculation of the borrowing cost, depreciation charge and carrying value of the extension at the year end, and agreement of all
figures to the draft financial statements

6. Confirmation that the additions to PPE are disclosed in the required note to the financial statements

Non-current Assets - Depreciation

Quite straightforward but a reminder..

2 main methods
Straight Line
(Cost - RV) / UEL

Reducing Balance
NBV x depreciation rate

The RV and UEL should be kept up to date each year

Any changes made prospectively (i.e. no changing of comparatives)

A change in depreciation policy is actually only a change in accounting estimate not policy
So again changes only made prospectively

On a revaluation - check that all accumulated depreciation on that asset has been cleared to zero

Non-current Assets - Revaluation

Increase goes to OCI and RR

Basic double entry steps:

Dr Accumulated depreciation
Cr Revaluation Reserve

Dr Cost
Cr Revaluation reserve

An impairment downwards after a revaluation

Dr the revaluation reserve first
then
Dr the Income statement

Keep the revaluations up to date

So change only when necessary (not always every year)

Non-current Assets - Impairments

Impair if Recoverable amount is lower than carrying value

Recoverable amount

is higher of...

Value in Use
The PV of future cash flows

FV less Costs to sell

Only check for impairment when theres been an indicator

eg
Damage
Loss of key employees
MV fall
Fall in interest rates

Order for impairment

1. Goodwill
2. All other non current assets pro rata to their carrying values

Leases - Introduction

There are 2 types of lease - an Operating and a Finance lease

In simple terms, a finance lease is where the LESSEE takes the majority of the risks and rewards of the underlying asset
Therefore with a finance lease the lessee would show the asset on their SFP (and the related finance lease liability)
When classifying look for substance rather than the form

Finance Lease Indicators

The lessee gets ownership of the asset at the end of the lease term

The lessee can buy the asset at such a low price that it is reasonably certain that the option will be exercised;

The lease term is for the major part of the economic life

The PV of the lease payments is substantially the fair value of the leased asset; and

Only the lessee can use the asset as it is so specialised

Other possible finance lease indicators

If the lessee cancels the lease, he has to pay the lessors losses

The lessee gets any residual value gains/losses and

The lessee can lease for a secondary period at a cheap rent

Land & Buildings

Normally separately classified

The minimum lease payments are allocated between the land and buildings elements in proportion to their relative fair values.

Land = Operating lease (unless title passes to the lessee at the end of the lease term)

Buildings = Operating or finance lease (by applying the classification criteria in IAS 17)

The classification of leases is a key issue in corporate reporting. From a lessees point of view, classifying as a finance lease will
increase gearing and decrease ROCE (as theres more capital employed due to the finance lease liability). Interest cover will also
decrease
As the SFP shows more liability, future borrowing will be harder to come by and current loan covenants may be breached. The
level of perceived risk may increase, loan covenants may be compromised and an entitys future borrowing capacity may be
restricted.
UK studies have revealed that average operating lease commitments are over ten times that of reported finance lease
obligations.

Sale and Leaseback

If we sell an item and lease it back - have we actually sold it? Have we
got rid of the risk and rewards?

Well if we finance lease it back - it means we keep the risks and rewards - so in effect - we have NOT sold it
If we operating lease it back - we have transferred the risks and rewards so an effective sale has been made

Finance Lease Back

Do not recognise a profit or loss on the disposal and continue to recognise the asset in the statement of financial position.
Any apparent profit (FV - CV) should be deferred and amortised over the lease term.

Accounting treatment
The accounting entries are:

1. Step 1
Derecognise the carrying amount of the asset now sold Cr Asset
Recognise the sales proceeds Dr Cash
Calculate the profit on sale (proceeds less carrying amount) Cr Deferred Income

2. Step 2
Recognise the finance lease asset Dr Asset and the associated liability Cr Finance lease liability at the lower of FV and PV of
MLP as usual

3. Step 3
Amortise the profit on sale as income over the lease term Dr. Deferred Income Cr. Income statement

Operating Lease Back

A normal sale
If its a normal profit then theres no problem - just show it in the income statement. Then show the operating lease
rentals and thats it.
A normal sale is where the sale price = Fair Value

Not normal sales - Selling Price less than Fair Value

If Operating lease rentals < market rate
So we simply take the loss and instead of hitting the income statement with it immediately, we hold it in the SFP and
take it to the income statement over the length of the operating lease.
This should have the effect of making the lease rentals in the income statement show at the true market rate

Not normal sales - Selling Price greater than Fair Value

Again you must ask yourself why did we receive more? If theres no reason then be happy and show the whole profit in the
income statement immediately.
If Operating lease rentals > market rate
So here we do not take the profit to the income statement immediately but take the extra above FV and take it to the SFP
and hold it there.
We then take it to the income statement over the length of the lease. This should have the effect of reducing the future
operating lease rentals to the market rate

Audit procedures - for the Exam

1. Classification of the lease - is it FL or OL?
2. State a correct accounting entry.
3. Is the effect of the error material to FS?
4. An adjustment should be made and, if not, the audit firm should consider the implication for the auditors opinion
5. In future accounting periods, depreciation should be calculated based on the NEW carrying value of the asset allocated over the
remaining life and the deferred income should be amortised over the same period.

Audit Evidence
A copy of the lease, signed by the lessor

A copy of insurance documents where appropriate

Physical inspection of the property complex

Confirmation of the fair value of the property complex, possibly using an auditors expert.

Agreement of the cash proceeds to bank statement and cash book.

A schedule showing the adjustment required in the financial statements.

Minutes of a discussion with management regarding the accounting treatment and including an auditors request to amend
the financial statements.

Revenue recognition

WHEN do we actually show this revenue in the accounts?

2 tests need to be passed

1. It is probable that future economic benefits will flow to the entity
2. These benefits can be measured reliably

Sale of Goods
In addition to 1 and 2 above, revenue from sale of goods can only be recognised when the majority of the risks and rewards have
been transferred and you have no more managerial control.
You need to pass 4 tests to recognise revenue from the sale of goods:

1. Probable Future Benefits

2. These can be reliably measured
3. (Majority of) Risks and rewards transferred
4. No managerial control

Breaking Down a transaction

For example, when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is
deferred and recognised as revenue over the period during which the service is performed.

Aggregating separate transactions

For example, an entity may sell goods and, at the same time, enter into a separate agreement to repurchase the goods at a later
date, thus negating the substantive effect of the transaction; in such a case, the two transactions are dealt with together.

Sale of Services
These are recognised as the service completes and again only when the revenue is probable and reliably measurable:

So the revenue from a service is recognised when:

1. Percentage Complete
2. Probable Economic Benefits
3. Reliable Measure of Economic Benefits

Interest, Royalties, and Dividends

For interest, royalties and dividends, provided that it is probable that the economic benefits will flow to the enterprise and the
amount of revenue can be measured reliably, revenue should be recognised as follows:

Interest
Use the effective interest method as set out in IAS 39

Royalties
On an accruals basis in accordance with the substance of the relevant agreement

Dividends
When the shareholders right to receive payment is established

Auditing Revenue
Auditing Consignment Stock - Procedures
Revenue may only be recognised when risks and rewards of the goods has been transferred and no more managerial control

Inspect sales contracts and confirm terms

Review the terms to see if client retains risk exposure and managerial involvement with the goods

Send a direct circularisation to selected external vendors for inventory balances at the year end

Enquire as to the % of goods usually returned

Results of auditors test counts of inventory at a selection of vendors premises to ensure the existence of goods held on
consignment

Fair Value Audit

Government Grants - audit

There re 2 types - Revenue and Capital

The debit is always cash so we only have to know where we put the credit..
Revenue Grant
Cr I/S (other income or reduce expense)
Capital Grant
Cr Cost of asset
or
Cr Deferred Income

Revenue Grant
For I/S items such as wages etc

Dr Cash Cr Other income (or expense)

Capital Grant

For NCA such as machines and buildings

1. Option 1
Dr Cash Cr Cost of asset
This will have the effect of reducing depreciation on the income statement and the asset on the SFP

2. Option 2
Dr Cash Cr Deferred Income
This will have the effect of keeping full depreciation on the income statement and the full asset and liability on the SFP
Then...
Dr Deferred Income Cr Income statement (over life of asset)
This will have the effect of reducing the liability and the expense on the income statement

An Example
Option 1
Asset $100 with 10yrs estimated useful life
Received grant of $50
Accounting for a grant received:
DR Cash $50
CR Asset $50
At the Y/E
Depreciation charge:
DR Depreciation expense (I/S) (100-50)/10yrs = $5
CR Accumulate depreciation $5

Option 2
Asset $100 with 10yrs estimated useful life
Received grant of $50
Accounting for a grant received:
DR Cash $50
CR Deferred income $50
At the Y/E
Depreciation charge:
DR Depreciation expense (I/S) 100/10yrs = $10
CR Accumulate depreciation $10
Release of deferred income:

DR Deferred income 50/10yrs =$5

CR I/S $5

Government grants can only be recognised when it is probable that all terms will be reached

What isn't a government grant?

1. Government advice
2. Preferred government supplier
3. Tax breaks from the government

Pensions Introduction

Objective of IAS 19

Companies give their employees benefits - the most obvious being wages but there are, of course, other things they may offer
such as pensions
IAS 19 says that the benefit should be shown when earned rather than when paid
Employee benefits include paid holiday, sick leave and free or subsidised goods given to employees

Short-term Employee Benefits

As we mentioned above, any benefits payable within a year after the work is done, (such as wages, paid vacation and sick leave,
bonuses etc) should be recognised when the work is done not when paid for

Profit-sharing and Bonus Payments

Recognise when there is an obligation to make such payments and a reliable estimate of the expected cost can be made

Illustration
Grazydays PLC give their employees 6 weeks of paid holiday each year, and because theyre groovy employers, any holiday not
taken can be carried forward to the next year.

Accounting Treatment
Any untaken holiday entitlement should be recognised as a liability in the current year even though it wouldnt be taken
until the next year

Types of Post-employment Benefit Plans

There are two types:

1. Defined Contribution plan

In this one the company just promises to pay fixed contributions into a pension fund for the employee and has no further
obligations
The contribution payable is recognised in the income statement for that period
If contributions are not payable until after a year they must be discounted

2. Defined Benefit plan

This is a post-employment benefit that gives the company an obligation to pay a defined pension to its employees who have left

The SFP Figure

The present value of the obligation less FV of assets (in the pension fund)

Defined Benefit Scheme - Terms

Defined Benefit Scheme - Terms

Defined benefit plan

As we said in the intro - this is A post-employment benefit that creates a constructive obligation to the enterprises employees

The SFP shows the pension fund as it stands at the year end in terms of the present value of the obligation less FV of
assets
Lets dig a little deeper to make some sense out of this.

The idea is that the company puts money into the fund, the fund spends that money on assets.
The assets make an EXPECTED return. The company hopes this return will pay off the employees future pensions when
they leave the company.

Of course, the fund will not always exactly match the pension liability. Therefore there will either be a surplus or deficit on
the SFP

Lets look at some terms before we put it all together:

1. Actuarial gains/losses
These occur due to differences between previous estimates and what actually occurred
These are recognised in the OCI

2. Past service cost

Dr Income statement
Cr Pension Liability
This is a change in the pension plan resulting in a higher pension obligation for employee service in prior periods.
They should be recognised immediately if already vested or not

3. Plan curtailments or settlements

Curtailments are reductions in benefits or the number of employees covered by the pension
Any gain/loss is recognised when the curtailment occurs.

4. Current service cost

Increase in pension liability due to benefits earned by employee service in the period
Dr Income statement
Cr Pension Liability

5. Interest cost
The unwinding on the discount of the pension liability
Dr Interest
Cr Pension Liability

6. Expected return on plan assets

This is the Interest, dividends and other revenue from the pension assets and is now to be based on the return from AA-rated
corporate bonds
This means companies cannot set expected returns according to the assets actually held by the plan; it could encourage them to
invest in more secure vehicles than is currently the case, seeing as the potential higher return will no longer be reflected in the
accounts.
The reason behind this is to improve transparency and consistency
Dr Pension Asset
Cr Interest received
The Interest cost and EROA are netted off against each other. They use the same discount rate.
So if a fund has more assets than liabilities (a surplus) - it will have net interest received
If a fund has more liabilities than assets (a deficit) - it will have net interest paid

7. Contributions to Pension fund

This is simply the money that the company puts in to the fund - so the fund can buy assets to generate an expected return
Dr Pension Asset
Cr Cash

8. Benefits paid
These are the actual pensions paid out to former employees.
Paying the pensions means we reduce the liability, but we use the pension fund to do it, so we reduce the pension asset also
Dr Pension Liability
Cr Pension Asset

Other Long-term Benefits (eg Profit shares, bonuses)

A simplified application of the model described above for other long-term employee benefits:
All past service cost is recognised immediately

Termination Benefits (eg. Redundancy)

Amount payable only recognised when committed to either:

1. Terminating the employment of employees before the normal retirement date; or

2. Providing benefits in order to encourage voluntary redundancy.
Demonstrably committed means a detailed formal plan without realistic possibility of withdrawal.
Discount down if payable in more than a year

Equity Compensation Benefits

No recognition for stock options issued to employees as compensation.
Nor does it require disclosure of the fair values of stock options or other share-based payment

IAS 19 Asset Ceiling

This stops gains being shown just because Past service costs (unvested) have been deferred.
It may be that there are net assets but not all can be recovered through refunds / contributing less in the future.
In such cases, deferral of past service cost may not result in a refund to the entity or a reduction in future contributions to the
pension fund, so a gain is prohibited in these circumstances.
So, any asset recognised in the balance sheet should be the lower of:

the net total calculated; and

the net total of:

(i) past service costs not recognised as an expense; and
(ii) the present value of any economic benefits available in the form of refunds from the plan or reductions in future
contributions to the plan.
An asset may arise where a defined benefit plan has been overfunded or in certain cases where actuarial gains are
recognised

Provisions

A provision is a liability of uncertain timing or amount

All this means is that it is not a creditor, as you know exactly how much that is and when it is to be paid
However it is still a potential liability
To create a provision though
Dr Expense
Cr Provision
the potential liability must be probable

In fact 3 tests need to be passed..

1. Is there a present obligation (legal or constructive) as a result of a past event
2. Is it probable that an outflow of resources embodying economic benefits will be required to settle the obligation
3. Can a reliable estimate can be made of the amount of the obligation

Measurement of a Provision

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present
obligation at the end of the reporting period.

Provisions for one-off events

Eg. restructuring, environmental clean-up, settlement of a lawsuit
Measured at the most likely amount

Large populations of events

Eg. warranties, customer refunds
Measured at a probability-weighted expected value

A company sells goods with a warranty for the cost of repairs required in the first 2 months after purchase.
Past experience suggests:
88% of the goods sold will have no defects
7% will have minor defects
5% will have major defects
If minor defects were detected in all products sold, the cost of repairs will be $24,000;
If major defects were detected in all products sold, the cost would be $200,000.
What amount of provision should be made?
(88% x 0) + (7% x 24,000) + (5% x 200,000) = $11,680

Contingent Assets

Here, it is not a potential liability, but a potential asset

The principle of PRUDENCE is important here, it must be harder to show a potential asset in your accounts than it is a potential
liability
This is achieved by changing the probability test
For a potential (contingent) asset - it needs to be virtually certain (rather than just probable)

Probability test for Contingent Liabilities

Remote chance of paying out - Do nothing

Possible chance of paying out - Disclosure

Probable chance of paying out - Create a provision

Probability test for Contingent Assets

Remote chance of receiving - Do nothing

Possible chance of receiving - Do nothing

Probable chance of receiving - Disclosure

Virtually certain of receiving - create an asset in the accounts

IAS 24 Related Parties

A party is said to be related to an entity if any of the following three

situations occur:

The 3 situations are:

1. Controls / is controlled by entity
2. is under common control with entity
3. has significant influence over the entity

Types of related party

These therefore include:

1. Subsidiaries
2. Associate
3. Joint venture
4. Key management
5. Close family member of above (like my beautiful daughter pictured in her new school uniform aaahhh)
6. A post-employment benefit plan for the benefit of employees

Not necessarily related parties

Two entities with a director in common

Two joint venturers

Providers of finance

A big customer, supplier etc

Stakeholders need to know that all transactions are at arms length and if not then be fully aware.
Similarly they need to be aware of the volume of business with a related party, which though may be at arms length, should the
related party connection break then the volume of business disappear also

Disclosures
General
The name of the entitys parent and, if different, the ultimate controlling party
The nature of the related party relationship
Information about the transactions and outstanding balances necessary for an understanding of the relationship on
the financial statements

As a minimum, this includes:

Amount of outstanding balances
Bad and doubtful debt information

Key management personnel compensation should be broken down by:

short-term employee benefits

post-employment benefits

other long-term benefits

termination benefits

share-based payment

Group and Individual accounts

1. Individual accounts
Disclose related party transactions / outstanding balances of parent, venturer or investor

2. Group accounts
The intragroup transactions and balances would have been eliminated

IAS 33 EPS Introduction

EPS is a much used PERFORMANCE appraisal measure

It is calculated as:
PAT - Preference dividends / Number of shares
It is not only an important measure in its own right but also as a component in the price earnings (P/E) ratio (see below)

Diluted EPS
This is saying that the basic EPS might get worse due to things that are ALREADY in issue such as:

Convertible Loan
This will mean more shares when converted

Share options
This will mean more shares wen exercised

Who has to report an EPS?

PLCs

Group accounts where the parent has shares similarly traded/being issued

EPS to be presented in the income statement

Share Based Payments - Introduction

There are 3 types of Share based payment..

These are..
1. Equity-settled share-based payment
This is where the company pays shares in return for goods and/or services received

Dr Expense
Cr Equity

2. Cash-settled share-based payment

This is where cash is paid in return for goods and services received, HOWEVER..the actual cash amount though is based on the
share price
These are also called SARs (Share Appreciation Rights)

Dr Expense
Cr Liability

3. Transactions with a choice of settlement

A choice of cash or shares paid in return for goods and services received

depends on choice made

Vesting period
Often share based payments are not immediate but payable in say 3 years. The expense is spread over these 3 years and this is
called the vesting period

How much to recognise?

So we have decided that share based payments (either shares or cash based on share price) should go into the accounts
(Dr expense Cr Equity or Liability)
We now have to look at the value to put on these

Option 1: Direct method

Use the FV of the goods or services received

Option 2: Indirect method

Use the FV of the shares issued by the company
Equity settled - Use FV of shares @ grant date
Cash settled - Update FV of shares each year
IFRS 2 suggests you choose option 1 - the FV of the goods/services.
However, if the FV of these cannot be reliably measured then you should go for option 2 - FV of shares issued.
Strangely enough, option 2 is the most common. This is because share based payments are often associated with paying
employees.
You cannot put a value on the work done by employees - except for the value of what you pay them ie. Option 2

Equity Settled
An entity grants 100 share options on its $1 shares to each of its 500 employees on 1 January Year 1. Each grant is conditional
upon the employee working for the entity over the next three years. The fair value of each share option as at 1 January Year 1 is
$10
On the basis of a weighted average probability, the entity estimates on 1 January that 100 employees will leave during the threeyear period and therefore forfeit their rights to share options.
The following actually occurs:
20 employees leave during Year 1 and the estimate of total employee departures over the three-year period is revised to 70
employees
25 employees leave during Year 2 and the estimate of total employee departures over the three-year period is revised to 60
employees
10 employees leave during Year 3

Solution
Step 1: Decide if this is a cash or equity settled SBP - share options are equity settled (so Dr Expense Cr Equity)

Step 2: Decide whether to value directly or indirectly - these are for employees so indirectly
Step 3: Calculate how many employees (and their share options each) are expected to be issued at the end of the vesting period
Year 1 430 Employees expected to be left at end (500-70) x 100 (share options each) x $10 (FV @ GRANT date) x 1/3 (time through
vesting period) = 143,300
Year 2 440 x 100 x $10 x 2/3 - 143,300 = 150,000
Year 3 445 x 100 x $10 x 3/3 - 293,300 = 151,700
So you can see that the costs and so the entries into the accounts would be:
Year 1: Dr Expense 143,300 Cr Equity 143,300
Year 2: Dr Expense 150,000 Cr Equity 150,000
Year 3: Dr Expense 151,700 Cr Equity 151,700
Notice that if you add these up it comes to 445,000. This is exactly our final liability (445 x 100 x $10 x 3/3) - its just weve spread
it over the 3 years vesting period

Cash settled illustration

Same question with additional information of share price at the end of each year:
Year 1 10
Year 2 12
Year 3 14
Solution
As this is cash settled then the double entry becomes Dr Expense Cr Liability and we do not keep the value of the option @ grant
date but change it as we pass through the vesting period
1 430 x 100 x 10 x 1/3 = 143,300
2 440 x 100 x 12 x 2/3 - 143,300 = 208,700
3 445 x 100 x 14 x 3/3 - 623,000 x 3/3 - 352,000 = 271,000
So you can see that the costs and so the entries into the accounts would be:
Year 1: Dr Expense 143,300 Cr Liability 143,300
Year 2: Dr Expense 208,700 Cr Liability 208,700
Year 3: Dr Expense 271,000 Cr Liability 271,000
Notice that if you add these up it comes to 623,000. This is exactly our final liability (445 x 100 x $14 x 3/3) - its just weve spread
it over the 3 years vesting period

Auditing SBP

Principal audit procedures measurement of share-based payment

expense

Those are:
1. Obtain management calculation of the expense and agree the following from the calculation to the contractual terms of the
scheme:
Number of employees and executives granted options
Number of options granted per employee
The official grant date of the share options
Vesting period for the scheme
Required performance conditions attached to the options.

2. Recalculate the expense and check that the fair value has been correctly spread over the stated vesting period.
3. Agree fair value of share options to specialists report and calculation, and evaluate whether the specialist report is a reliable
source of evidence.

4. Agree that the fair value calculated is at the grant date.

5. Obtain and review a forecast of staffing levels or employee turnover rates for the duration of the vesting period, and scrutinise
the assumptions used to predict level of staff turnover.

6. Obtain written representation from management confirming that the assumptions used in measuring the expense are reasonable.

If no market value available for FV

Then we need to audit the model used as follows:

Review assumptions used, and inputs into the the model (eg.option pricing model) used by management to estimate the fair
value of the share options at the grant date

Consider the appropriateness of the model

Consider using an expert to provide evidence as to the validity of the fair value used

Check the sensitivity of the calculations to a change in the assumptions used in the valuation

What is an intangible asset

What is an Intangible asset?

Well, according to IAS 38, its an identifiable non-monetary asset without physical substance, such as a licence, patent or
trademark.

Whooah there partner, whats identifiable mean??

Well it just means the asset is one of 2 things:

1. It is SEPARABLE, meaning it can be sold or rented to another party on its own (rather than as part of a business) or
2. It arises from contractual or other legal rights.

It is the lack of identifiability which prevents internally generated goodwill being recognised . It is not separable and does not
arise from contractual or other legal rights.

Examples
Employees can never be recognised as an asset; they are not under the control of the employer, are not separable and do
not arise from legal rights

A taxi licence can be an intangible asset as they are controlled, can be sold/exchanged/transferred and arise from a legal
right
(The intangible doesnt have to be separable AND arise from a legal right, just one or the other is enough)

Auditing Intangible Assets

Audit procedures & Evidence needed as follows

Basic procedures are:

1. Inspect legal documents, confirming the length / type / cost of asset
2. Agree cash paid to the bank statement and the cash book
3. Inspect minutes of a discussion with management regarding amortisation / non-amortisation and recalculate where necessary
4. Look at forecast sales records to determine the future economic benefit to be derived

Auditing Goodwill

Learn the 3 components of goodwill

FV of Consideration
If it's cash easy - use the figure given

If it's future payment - discount this figure down

If it's a contingent item (dependent on something happening) - use the FV of that item

NCI

One of two choices

Proportionate value of FV of S's NA

FV of S as a whole

This means goodwill share is only given to NCI in the FV method

FV of NA acquired
Include intangibles and contingent liabilities that are not on S's accounts normally

If the values are provisional - there is 1 year from date of acquisition to change this figure

Audit evidence
1. Agreement of the monetary value and payment dates of the consideration per the client schedule to legal documentation signed
by vendor and acquirer.

2. Inspect the bank statement and cash book whether the payment was paid.
3. If payment occurs after year end confirm that a current liability is recognised on the individual company and consolidated
statement of financial position (balance sheet).

4. Board minutes approving the payment.

5. Recomputation of discounting calculations applied to deferred and contingent consideration.
6. Agreement that the discount rate used is pre-tax, and reflects current market assessment of the time value of money
7. Agree % of ownership, e.g. using Companies House search/register of significant shareholdings
8. Obtain due diligence report and agree net assets valuation if appropriate

Step Acquisitions

Step Acquisitions

When Control is achieved is the key date..

Consolidation only occurs when control is eventually achieved

When Control is achieved this occurs:

Remeasure all previous holdings to FV

Any gain or loss to income statement

Illustration
P acquired 10% of S in year 1 for 100
P acquired a further 60% of S in year 2 for 800. At this date, the original 10% now has a FV of 140
How would this be accounted for?
The key date of when controlled is achieved is year 2. At this date we must:

Revalue the original 10% from 100 to 140

The 40 gain goes to the income statement (and retained earnings)

Also we would now start consolidating S (as we now control it). The Consideration figure in the goodwill working would now
be 940 (140 + 800)

Further acquisition after control is achieved

If there are further acquisitions after control - this is deemed to be a purchase from the other owners (NCI) - so no profit is
calculated. Simply
Here you will need to do the following calculation:

FV of consideration (for the extra % bought)

Decrease in NCI

(x)

Difference - goes to Equity of the Parent

x/(x)

Illustration
H acquired 60% S for 100 in year 4 when the FV of its NA was 90. Proportionate NCI method used.
2 years later its NA are 150 and H acquires another 20% for 80
Calculate decrease in NCI and movement in parents equity for the latest acquisition

FV of consideration

80

Decrease in NCI

(30)

Difference - goes to Equity of the Parent

50

NCI

@ Acquisition

36 (40% x 90)

Post acquisition

24 (40% x (150-90))

Impairment

(0)

TOTAL AT DATE OF DISPOSAL

60

SO NCI was 60 (representing 40%). Now, by acquiring a further 20% from the NCI, this means NCI will go from 40% to 20%. It has
halved.
So NCI has gone down by 30.

Group accounting audit

Always think of the basics

Acquisition in year
I/S pro rate inclusion of sub

Calculate GW

Pro rata NCI in the year

Think about component auditors

Materiality will now increase

Ensure sub uses same accounting policies and same year end as parent

Analytical procedures may be enough for the audit of this acquisition (if its in the same industry as us)

New related party transactions (with the sub)

Further acquisition?
e.g. from 60% to 80%

Any "profit" goes to equity NOT I/S

Partial Disposal
eg. 80% to 60%

Any profit goes to equity NOT I/S

Full Disposal
eg 60% to 30%

Any profit goes to I/S

The sub is taken out completely from group accounts (NA, GW, NCI)

Is replaced by an associate at FV

Investment property

So here we are dealing with a situation where a company owns a

building (or land) but doesnt use it . Instead it is just an investment for
them

It stands alone and makes the company some cash:

1. From Rental Income
- no surprise here - throw it in the income statement. No problemo

2. From Capital appreciation

- As the asset is not used, but rather held for investment purposes, then historic cost becomes particularly unuseful (you could
argue).
Much better is a market based fair value. So each property is revalued and the difference is added to the asset and the other side
goes to the income statement

What if the property is ours but only under an Operating Lease?

This is fine but the property must be measured using the FV model (see later)
IAS 40 lists the following as examples of investment property:

Land held for long-term capital appreciation rather than short-term sale

Land held for a currently undetermined future use

A building owned by the entity (or held under a finance lease) and leased to a third party under an operating lease

A building which is vacant but is held to be leased out under an operating lease

Property being constructed or developed for future use as an investment property

The following are NOT investment property

Property intended for sale in the ordinary course of business (IAS 2)

Property being constructed or developed on behalf of third parties (IAS 11)

Owner-occupied property (IAS 16)

Property leased to another entity under a finance lease (IAS 17)

An investment property should be recognised when:

It is probable that the future economic benefits will flow; and

The cost of the investment property can be measured reliably.

Initially measured at cost .

This includes:

Purchase price

Directly attributable costs, for example transaction costs (professional fees, property transfer taxes)

This does not include Start up costs

Financial liabilities - Categories

There's only 2 categories, FVTPL and Amortised cost.. Yay!

Right-y-o, weve looked at recognising (bring into the accounts for those of you who are a sandwich short of a picnic*) - now we
want to look at HOW MUCH to bring the liabilities in at.
We already dealt with this on a tricky convertible loan.
Trust me this section is much easier. Basically there are 2 categories of Financial Liability...

2 Categories
1. Fair Value Through Profit and Loss
This includes financial liabilities incurred for trading purposes and also derivatives

2. Amortised Cost
If financial liabilities are not measured at FVTPL (see below), they are measured at amortised cost

The good news is that whatever the category the financial liability falls into - we always recognise it at Fair Value INITIALLY.
It is how we treat them afterwards where the category matters (and remember here we are just dealing with the initial
measurement)

Accounting Treatment of Financial Liabilities

(Overview)
Initially

At Year-End

Any gain/loss

FVTPL

Fair Value

Fair Value

Income Statement

Amortised Cost

Fair Value

Amortised Cost

So - the question is - how do you measure the FV

of a loan??
Well again the answer is simple - and youve done it already with compound instruments. All you do is those 2 steps:

STEP 1:

Take all your actual future cash payments

STEP 2:

DIscount them down at the market rate

If the market rate is the same as the rate you actually pay then this is no problem and you dont really have to follow those 2
steps as you will just come back to the capital amountlet me explain

10% 1,000 Payable Loan 3 years

Capital 1,000 x 0.751 751
Interest 100 x 2.486 249
Total
1,000

So the conclusion is - WHERE THE EFFECTIVE RATE YOU PAY IS THE SAME AS THE MARKET RATE THEN THE FV IS THE PRINCIPAL so no need to do the 2 steps.
Always presume the market rate is the same as the effective rate youre paying unless told otherwise by El Examinero.

Possible Naughty Bits

Premium on redemption
This is just another way of paying interest. Except you pay it at the end (on redemption)

eg 4% 1,000 payable loan - with a 10% premium on redemption.

This means that the EFFECTIVE interest rate is more than 4% - because we havent yet taken into account the extra 100 (10% x
1,000) payable at the end. So the examiner will tell you what the effective rate actually is - lets say 8% (not enough info in the
question to calculate this)
The crucial point here is that you presume the effective rate is the same as the market rate so the initial FV is still 1,000

Discount on Issue
Exactly the same as above - it is just another way of paying interest - except this time you pay it at the start
eg 4% 1,000 payable loan with a 5% discount on issue
So again the interest rate is not 4%, because it ignores the extra interest you pay at the beginning of 50 (5% x 1,000). So the
effective rate is lets say 7% (again we cannot calculate this and will just be given in the exam)
The crucial point here is that the discount is paid immediately. So, although you presume that the effective rate is the same as
the market rate (7% say), the INITIAL FV of the loan was 1,000 but is immediately reduced by the 50 discount - so is actually 950
NB You still pay interest of 4% x 1,000 not 4% x 950
*A quaint old English saying - meaning youre an idiot :p

Financial assets - Accounting Treatment

So we have these 3 categories..

Category

Initial Measurement

Year-end Measurement

Difference goes where?

FVTPL

FV

FV

Profit and Loss

FVTOCI

FV

FV

OCI

Amortised Cost

FV

Amortised Cost

Initially both are measured at FV

Now let's look at what happens at the year-end..

FVTPL accounting treatment

1. Revalue to FV
2. Difference to I/S

FVTOCI accounting treatment

1. Revalue to FV
2. Difference to OCI

Amortised cost accounting treatment

1. Re-calculate using the amortised cost table
(see below)

Amortised Cost Table

8% 100 receivable loan (effective rate 10% due to a premium on redemption)

Opening Balance

Interest (effective rate)

(CashReceived)

Closing balance

100

10

(8)

102

Assets Held for Sale

Key Issues

When is an asset held for sale?

Management is committed to a plan to sell

The asset is available for immediate sale

An active programme to locate a buyer is initiated

The sale is highly probable, within 12 months of classification as held for sale

The asset is being actively marketed for sale at a sales price reasonable in relation to its fair value

Abandoned Assets
The assets need to be disposed of through sale. Therefore, operations that are expected to be wound down or abandoned would
not meet the definition. Therefore assets to be abandoned would still be depreciated.

Measurement
Immediately before the initial classification
The carrying amount of the asset will be measured in accordance with applicable IFRSs. Generally, bring depreciation up to date

(if cost model followed) or revalue (if revaluation policy followed).

After classification as held for sale

Measured at the lower of carrying amount and fair value less costs to sell

An Impairment?
Any impairment loss must be recognised in profit or loss, even for assets previously carried at revalued amounts.
Revalued assets will need to deduct costs to sell from their fair value and this will result in an immediate charge to profit or
loss.

Subsequent increase in Fair Value?

This basically happens at the year end if the asset still has not been sold
A gain is recognised in the p&l up to the amount of all previous impairment losses.

Non-depreciation
Non-current assets or disposal groups that are classified as held for sale shall not be depreciated

Balance sheet presentation

Presented separately on the face of the balance sheet in current assets

Subsidiaries Held for Disposal

IFRS 5 applies to accounting for an investment in a subsidiary held only with a view to its subsequent disposal in the near
future.

Subsidiaries already consolidated now held for sale

The parent must continue to consolidate such a subsidiary until it is actually disposed of. It is not excluded from
consolidation and is reported as an asset held for sale under IFRS 5.
So subsidiaries held for sale are accounted for initially and subsequently at FV-CTS of all the net assets not just the amount
to be disposed of

Auditing Held for Sale

Audit procedures & Evidence needed as follows

Procedures Include:
1. Inspect board minute at which the disposal of the properties was agreed by management
2. Ensure active programme to locate a buyer, for example, instructions given to real estate agency
3. Inspect any minutes of meetings held with prospective purchasers of any of the properties, or copies of correspondence
with them

4. Written representation from management on the opinion that the assets will be sold within a year
5. Subsequent events review, including a review of post year-end board minutes and a review of significant cash transactions, to
confirm if any properties are sold in the period after the year end

6. Review clients depreciation calculations, to confirm no depreciation once reclassified as held for sale

IAS 10 Events After The Reporting Period

Events can be adjusting or non-adjusting

If the event gives us more information about the condition at the year end then we adjust
If not then we don't

When is the "After the Reporting date" period?

It is anytime between period end and the date the accounts are authorised for issue

Ok and why is it important?

Well it may well be that many of the figures in the accounts are estimates at the period end
However, what if we get more information about these estimates etc afterwards, but before the accounts are authorised and
published.. should we change the accounts or not?
The most important thing to remember is that the accounts are prepared to the SFP date. Not afterwards.
So we are trying to show what was the situation at the SFP date. However, it may be that more information ABOUT the
conditions at the SFP date have come about afterwards and so we should adjust the accounts.
Sometimes we do not adjust though

Adjusting Events
The event (which occurred after the SFP date) provides evidence of conditions that existed at the period end
Examples are..

1. Debtor goes bad 5 days after SFP date

(This is evidence that debtor was bad at SFP date also)

2. Stock is sold at a loss 2 weeks after SFP date

3. Property gets impaired 3 weeks after SFP date
(This implies that the property was impaired at the SFP date also)

Non-Adjusting Events - these are disclosed only

These are events (after the SFP date) that occurred which do not give evidence of conditions at the year end, rather they are

indicative of conditions AFTER the SFP date

1. Stock is sold at a loss because they were damaged post year end
(This is evidence that they were fine at the year end - so no adjustment)

2. Property impaired due to a fall in market values generally post year end
(This is evidence that the property value was fine at the year end - so no adjustment required)

Non-adjusting event which affects Going Concern

Adjust the accounts to a break up basis regardless if the event was a non-adjusting event

Foreign exchange effects

Understand these from a single and group company viewpoint

Group Companies
e.g. Foreign subsidiary

1. Retranslate SFP at year end rate

2. Retranslate I/S at average or actual rate
3. Difference goes to reserves NOT I/S

Single company
eg Dealing with foreign transactions

1. Difference between buying and paying rate

1. Difference between buying and paying rate

2. Difference between selling and receiving rate
3. Retranslate all foreign monetary balances (cash, loans, debtors etc) at year end rate
4. Difference goes to I/S

Borrowing Costs Part 1

Borrowing Costs Part 1

Lets say you need to get a loan to construct the asset of your dreams - well the interest on the loan then is a directly
attributable cost.
Remember that directly attributable costs get added to the cost of an asset per IAS 16 - so does iAS 23 agree and add interest to
the cost of the asset?

Well this is what it says:

Where the loan is specifically for building a substantial asset, the interest is to be added to the cost of the asset (as opposed
to going to the income statement as an expense as normal)
This means the cost of an asset includes ALL costs to get it ready for use or sale

Basic Idea
Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset form part of the
cost of that asset.
Other borrowing costs are recognised as an expense.

So what is a Qualifying asset?

It is one which needs a substantial amount of time to get ready for use or sale.
This means it cant be anything that is available for use when you buy it.
It has to take quite a while to build do could be PPE, Investment Properties, Inventories and Intangibles

You dont have to add the interest to the cost of the following assets:
1. Assets measured at fair value,
2. Inventories that are manufactured or produced in large quantities on a repetitive basis even if they take a substantial period of
time to get ready for use or sale.

When should we start adding the interest to the cost of the asset?
Capitalisation starts when all three of the following conditions are met:

1. Expenditure begins for the asset

2. Borrowing costs begin on the loan
3. Activities begin on building the asset eg. Plans drawn up, getting planning etc
So just having an asset for development without anything happening is not enough to qualify for capitalisation

When will capitalisation stop?

Well, when virtually all the activities work is complete. This means up to the point when just the finalising touches are left
NB

Stop capitalising when AVAILABLE for use. This tends to be when the construction is finished

If the asset is completed in parts then the interest capitalisation is stopped on the completion of each part.

If the part can only be sold when all the other parts have been completed, then stop capitalising when the last part is
completed.

What about if the activities stop temporarily?

Well you should stop capitalising when activities stop for an extended period
During this time borrowing costs go to the profit or loss.
Be careful though - If the temporary delay is a necessary part of the construction process then you can still capitalise, eg. Bank
holidays etc

Auditing Provisions

Audit procedures & Evidence needed as follows

Procedures would include:

Obtain written evidence from legal advisors that in their opinion amounts are probable to be paid, and the basis of that
opinion

Review the claim itself to confirm the amount

Inspect the board minutes for evidence of discussion of the claim, to obtain an understanding as to the reason for the claim
and whether it has been disputed

Auditing Insurance claims (Contingent Assets)

Obtain a copy of the insurance claim made and confirm the amount claimed

Enquire as to the basis of the amount claimed

Review any supporting documentation such as management accounts showing lost income for the period of halted
production

Scrutinise the terms of the insurance policy, to determine whether covered

Seek permission to contact the insurance provider to enquire as to the status of the claim, and attempt to receive written
confirmation of the likelihood of any payment being made

Review correspondence between the client and the insurance provider, looking for confirmation of any amounts to be paid

Contact client lawyers to enquire if there have been any legal repercussions arising from the insurance claim, e.g., the
insurance company disputing the claim

Auditing Warranty Provisions

ISA 540 Audit of Accounting Estimates requires that auditors should

obtain sufficient audit evidence as to whether an accounting estimate is
reasonable and that disclosure is appropriate.

Audit procedures
1. Review and test the process used by management to develop the estimate
2. Review contracts or orders for the terms of the warranty to gain an understanding of the obligation
3. Review correspondence with customers during the year to gain an understanding of claims already in progress at the
year end

4. Perform analytical procedures to compare the level of warranty provision year on year, and compare actual to budgeted
provisions.

5. Re-calculate the warranty provision

6. Agree the percentage applied in the calculation to the stated accounting policy of the Client
7. Review board minutes for discussion of on-going warranty claims, and for approval of the amount provided

Development cost

Research and Development Definitions

Research
Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and
understanding.

An example of research could be a company in the pharmaceuticals industry undertaking activities or tests aimed at
obtaining new knowledge to develop a new vaccine.
The company is researching the unknown, and therefore, at this early stage, no future economic benefit can be expected to
flow to the entity.

Development
Development is the application of research findings or other knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes, systems, or services, before the start of commercial production or
use.

An example of development is a car manufacturer undertaking the design, construction, and testing of a pre-production
model.

Accounting Treatment of Research and Development

1. Research costs
IAS 38 states that all expenditure incurred at the research stage should be written off to the income statement as an expense
when incurred, and will never be capitalised as an intangible asset.

2. Development costs
Should be capitalised as an intangible assets if meet the following criteria.
Dr Intangible non-current assets (SOFP)
Cr Bank/Payables

Under IAS 38, an intangible asset must demonstrate all of the following criteria:
P robable future economic benefits

I ntention to complete and use or sell the asset

R esources (technical, financial and other resources) are adequate and available to complete and use the asset

A bility to use or sell the asset

T echnical feasibility of completing the intangible asset (so that it will be available for use or sale)

E xpenditure can be measured reliably

Audit procedures:
1. Are the development costs material?
2. Evaluate whether the development costs meet the recognition criteria (PIRATE)

Review
Analytical procedures at review stage

These are compulsory at review and at planning stage

Analytical procedures are also an effective tool for gathering evidence throughout the audit.
By using expectations, and comparing to actuals, they highlight unexpected movements
These can then be focussed on during the audit

These can then be focussed on during the audit

The financial ratios fall into 3 general categories:

1. Profitability
Gross margin
Net margin
ROCE

2. Liquidity
Receivables/Payables/Inventory Days
Current ratio
Quick ratio

3. Gearing
Financial gearing
Operational gearing

Whether or not the auditor relies on analytical procedures as substantive procedures

depends on 4 factors:
1. Suitability:
Analytical procedures will not be suitable for every assertion

2. Reliability:
The auditor may only rely on data generated from a system with strong controls

3. Degree of Precision:
Some figures will not have a recognisable trend over time or be comparable.

4. Acceptable Variation:
Variations having an immaterial impact on the financial statements will not hold as much interest to the auditor as those
that do.

Comparatives

Comparatives must be presented in accordance with the applicable

financial reporting framework

Audit work on comparatives is far less than current year figures.

Basically just ensure:
1) They agree with the previous period
2) Accounting policies are consistent applied in the two periods

What if a material misstatement is found in the comparative?

Perform appropriate additional procedures

Comparatives and the Audit Report

The audit opinion should not normally refer to the corresponding figures

Unless the following apply:

Qualified opinion last time remains unresolved - Modify this year's report

Misstatement in comparative found but not restated - Adverse opinion on comparative

Prior period financial statements were audited by another auditor - use "other matter" paragraph to explain this

Prior period financial statements were not audited - use "other matter" paragraph to explain this

Comparative Issue Resolved

"Other matter" paragraph if material to this year

Comparative Issue NOT Resolved

Modify Report

Other Information
The other information in the accounts such as the Directors report, the Chairmans report and the employees report are not
covered by the audit.
However, the auditor must review such information and highlight any material inconsistency with the audited financial
statements or material misstatements of fact.

Material inconsistency
If FS are wrong - and management refuse to amend - qualify the audit report due to disagreement
If OTHER INFO is wrong - and management refuse to amend - an EOM paragraph only is needed

Misstatement of fact
If management refuse to amend then an EOM paragraph is needed

FS problem not resolved

"Except for" paragraph or "Adverse" opinion

Other information NOT corrected

"Other matter" paragraph or seek legal advice

Initial Engagements

This is when an Auditor takes on a new engagement

Things to Consider:
1. Previous audit qualified?
If so, ensure that the matter was resolved

2. Any audit adjustments in previous year?

Ensure made in the clients accounting system as well as the final accounts

3. Were the accounts audited last year?

Carry out some work to ensure happy with the opening position

By consulting with management and reviewing the systems in place the auditor may not have to carry out substantive
procedures, but if these are unsatisfactory then substantive procedures may be required

Auditor responsibility for Subsequent Events

Purpose of a Subsequent Events Review

Auditors are responsible for their audit work from Y/E to issuing of FS

This duty is both Active and Passive

And ranges from

Active Duty
Between the Y/E and signing the FS

To search for all material events

Passive Duty
Between the signing and issue date

To act if they become aware of anything that may affect their audit opinion

Subsequent events are events which occur after the balance sheet date

The auditor must perform a subsequent events review

This involves:

Review post Y/E management accounts, budgets and cash flow forecast

Review of post Y/E board minutes

Review how management assess subsequent events and ask if any have been found

Obtain a management representation letter confirming this

Check post Y/E cash received to ensure:

1) Receivables are received and
2) NRV of inventory is as expected

Going Concern Disclosures and Reporting

Going Concern Disclosures

If GC is appropriate
No need to mention GC in their report

If GC not appropriate
Qualify the audit report

(unless management agree to alter the financial statements )

Insufficient Disclosure
Qualify the audit report

(unless management agree to alter the disclosures)

If NOT on Going Concern basis

Always refer to it in their report in an emphasis of matter paragraph

Going Concern Responsibilities

FS are prepared on a going concern basis unless inappropriate to do so

Going concern is defined under IAS 1 as the assumption that the company will continue in operational existence for the
foreseeable future

Some Key Issues:

1. Foreseeable Future
This isn't defined :(

but is generally accepted to be at least one year into the future

and further if specific business reasons make it appropriate

2. Use of Judgement
GC involves the use of judgement on the basis of the information available at the time

3. Break up basis
This is when GC basis is not appropriate

This values assets at their sale value and inventory at NRV

Director's Responsibility
They must assess going concern

They should use a suitable basis on which to base the going concern

They should use information on sources of finance, future profitability and repayment of debt

If the directors have any material uncertainties as to the going concern of the business they must disclose them in the financial
statements.

Auditors Responsibility
They must assess the appropriateness of the going concern assumption

If there are going concern issues, the auditor must ensure that sufficient disclosures are made

Management Responsibility

Assess if can carry on for foreseeable future

At least 12 months

Auditor Responsibility

Going Concern Review & Indicators

Decide if management are right to use going concern status

Should uncertainties be disclosed

Going concern is vital as the FS must show a true and fair view

The auditor will undertake a number of procedures in the going concern review:
Look at the economic conditions of the industry at that time

Contact providers of finance to check they're happy to continue

Assess management intentions for the future

Review post Y/E cash flow statements, management accounts and budgets

Review management assumptions - are they reasonable

Conduct analytical review of the FS to check for worsening performance

Review correspondence with solicitors to ensure no likely actions or cases

Review correspondence with banks to provide evidence of continued good relations

Indicators of Going Concern

Technology changes in the industry

Suppliers unwilling to provide credit terms

Banks withdrawing loan facilities

Management plans for risky diversification

Cash-flow problems post year end or large cash outflows

Deterioration in key ratios

Loss of Key staff

Legal action against the company

Late payment of staff salaries, PAYE payments, VAT or supplier invoices

Sales of major assets without prior warning

Loss of key customer or supplier

Group Audits
Should we accept the job?

Group accounts are audited by a principal auditor with subsidiaries being

audited by other auditors

What are "Components"?

Subsidiaries

Associates

So what are the problems?

Principle auditor may rely on the work of component auditors

Complex groups mean a complex audit

Consolidation adjustments must comply with the specific accounting standards applicable

So what are the considerations before accepting a role as principal auditor

Materiality of the portion to be audited

Degree of Knowledge of the components

Risk of material misstatement of the components

Any additional procedures required on components

Relationship with other auditors

The principal auditor will have to gather sufficient, appropriate evidence to form an opinion on the consolidated financial
statements.
In complex groups, perhaps having up to 50 subsidiaries, this is no easy task

Planning a group audit

Think materiality, non-coterminous year, and changes in structure etc

Here's a nice little proforma to use in the exam

1. Group structure
The group structure must be ascertained to identify the entities that should be consolidated

2. Materiality assessment
If an acquisition in year - Preliminary materiality will be much higher than in the prior year

The materiality of each subsidiary should be assessed (in terms of the group)
This will help decide:
Which to visit &
Which to do just analytical procedures on

3. Goodwill
Audit any goodwill arising on acquisitions

Audit any impairment test at the balance sheet date

4. Goodwill - Consideration
Any shares issued - use their MV
Any amounts in the future - Use the PV
Check discount rate and recalculate the PV
Any contingent consideration - Use the FV
Check assumptions used and discount rate for this

5. Goodwill - FV of NA acquired
Check FV is used not book value
Check the FV of these items are correct (independently valued, work of others etc)

6. Groups - General
SFP - Ensure assets and liabs of Parent and subs added together but Associate not (separate line)

I/S - Ensure any mid year acquisitions and disposals are accounted for pro-rata

7. Additions in year
Step Acquisition - check the first acquisition has been revalued

Further Acquisition
Ensure that the difference between amount paid and the NCI decrease goes only to reserves and not I/S

Goodwill
See above

8. Disposals
Partial disposal
Ensure that the difference between amount received and the NCI increase goes only to reserves and not I/S

Full disposal
Ensure all assets, liabs, goodwill and NCI relating to the sub have been removed and any profit on disposal is shown in
the I/S

9. Group Transactions & Balances

A list of all the companies in the group included in group audit instructions
(to ensure that intra-group transactions and balances are eliminated) on consolidation

10. Analytical procedures

Acquiring subs with similar activities may extend the scope of analytical procedures available.
This could have the effect of increasing audit efficiency

11. Other auditors

(See separate section)

12. Accounting policies

Material accounting policies should comply with the rest of the group.
So a group accounting policy for adjustment on
consolidation may be needed

13. Timetable
Key dates should be planned for:

Agreement of inter-company balances and transactions

Submission of proforma statements to Parent
Completion of the consolidation package
Tax review of group accounts
Subsequent events review
Completion of audit fieldwork by other auditors
Final clearance on accounts of subsidiaries
Parent's final clearance of consolidated financial statements

14. Foreign Subs

SFP Ensure assets and Liabs are translated at the year end closing rate

I/S Ensure the transactions are translated at the average or actual rate

Goodwill Ensure it is retranslated at the year end

Forex differences Ensure these go a translation reserve and not the Income statement

15. Associates
Check accounted for correctly using the equity method
Cost + Post acquisition reserves on the SFP
Share of PAT on the I/S

The work of component auditors

The principal auditor should evaluate the component auditor, if going to

rely on his work

She will look at..

1. Their competence, qualifications and experience
2. The procedures carried out to obtain sufficient, appropriate evidence that the work of the other auditor is adequate
3. The findings of the other auditor
4. The strategy of the other auditor

The principal auditor should also..

Perform risk assessment on components

Evaluate business risk of components

Evaluate susceptibility of other auditors to error

Attend the closing meetings of component audit

Review of component files

Evaluate whether further substantive testing should be performed at a component level

Support letters

When the parent undertaking (or a fellow subsidiary) is able and willing
to provide support

Group accounts are prepared on a going concern basis when a group, as a single entity, is considered to be a going concern
So often the parent might have to guarantee this for other subs..
Many banks routinely require a letter of reassurance from a parent company stating that the parent would financially or
otherwise support a subsidiary with cashflow or other operational problems

As audit evidence:
1. Formal confirmation is a comfort letter confirming the parent s intention to keep the subsidiary in operational existence
2. This letter of support should normally be approved by a board minute of the parent company
3. The ability of the parent to support the company should also be confirmed, for example, by examining the groups cash flow
forecast

4. The period of support may be limited (eg one year)

Sufficient other evidence concerning the appropriateness of the going concern assumption must therefore be obtained where a
later repayment of material debts is foreseen

5. The fact of support and the period to which it is restricted should be noted in the Sub's FS

Horizontal groups

Horizontal groups of entities under common control increase audit risk as

fraud is often hidden via complex group structures

Auditors need to understand and confirm the economic purpose of entities within business empires

Difficulties faced by auditors include:

1. failing to detect related party transactions and control relationships;
2. not understanding the substance of transactions with entities under common control
3. excessively creative tax planning
4. the implications of transfer pricing (eg failure to identify profits unrealised at the business empire level)
5. a lack of access to relevant confidential information held by others
6. relying on representations made in good faith by those whom the auditors believe manage the company when control rests
elsewhere

Audit work is inevitably increased if an auditor is put upon inquiry to investigate dubious transactions and arrangements.
However, the complexity of business empires across multiple jurisdictions with different auditors may deter auditors from liaising
with other auditors (especially where legal or professional confidentiality considerations prevent this)

Joint Audits

Where more than one firm is appointed and are both responsible for the
opinion

There are several advantages and disadvantages in a joint audit being performed
Advantages
Efficiency
The subs auditor will have a good understanding of the business / controls etc so working together will help the
principal auditor catch up quicker
This is a key issue, as the principal auditor needs a thorough understanding of the subsidiary also for risk assessment
Resources
A joint audit allows sufficient resources to be allocated to the subs audit, assuring the quality of the opinion given
Quality
Both auditors can discuss contentious issues together
Often a fresh pair of eyes helps.
It should be easier to challenge management and therefore ensure that the auditors position is taken seriously

Disadvantages
More expensive for the client
From a cost/benefit point of view there is clearly no point in paying twice for one opinion to be provided.
Despite the audit workload being shared, both firms will have a high cost for being involved in the audit in terms of
senior manager and partner time
Different audit approaches
Problems could arise in deciding which firms method to use, for example, to calculate materiality, sample sizes etc
One firms methods may dominate, eliminating the benefit of a joint audit being conducted
Working Together
There may be problems for the two audit firms to work together harmoniously
Joint Liability
Both firms are jointly liable
They could, however, blame each other, making the litigation process more complex
However, it could be argued that joint liability is not necessarily a drawback, as the firms should both be covered by
professional indemnity insurance.

Modified Audit Reports

So what if the subsidiary report is qualified - is the group too??

It basically depends if the group auditor thinks it is material or not

If so - then the group accounts are qualified too
If not - then no effect

Examples:
Group auditor can't get full access to sub
Disclaimer of Opinion in component
Except for paragraph in group

Subs inventory is incorrectly valued

It is material to the group also

Qualified "except for" in component

Qualified "except for" in group

Going concern doubts over the sub

It is material to the group also

Emphasis of matter paragraph in component

Emphasis of matter paragraph in group

Going concern doubts over the sub

It is NOT material to the group though

Emphasis of matter paragraph in component

No modification in group

Auditing Goodwill

Audit procedures & Evidence needed as follows:

Basic procedures include:

1. Obtain the legal purchase agreement and confirm the date of the acquisition
2. Inspect the purchase agreement, confirm the consideration paid, and details of any contingent consideration, including its amount,
date potentially payable, and the factors on which payment depends

3. Confirm % owned through a review of shareholder register, and by agreement to legal documentation
4. Agree any cash paid to cash book and bank statements
5. Review the board minutes for discussion regarding the purchase
6. Obtain the due diligence report prepared by the external provider and confirm the estimated fair value of net assets at acquisition
7. Recalculate goodwill

Other Assignments

Audit-related services
Levels of Assurance

Reasonable Assurance is where there is sufficient evidence that the

subject matter agrees to certain criteria.

It is a high level of assurance

It is Positive Assurance (This means that in their opinion the subject has been prepared in accordance with the criteria required)

An example is the external audit

Limited Assurance is where there's sufficient evidence that the subject

matter is plausible in the circumstances

It is a moderate level of assurance

It is a Negative Assurance (This means that in their opinion there is nothing to suggest that the subject has not been prepared

in line with the relevant criteria)

An example is a review engagement

Here, the auditor reviews the financial statements using less evidence than required by an audit
It is not an audit.
The report will not be to the shareholders but to the body that commissioned the review e.g. Bank, Directors.

Remember!
A Review Engagement gives Negative Assurance

An Audit Report gives Positive Assurance

Absolute assurance will never be provided by an assurance engagement

whether audit or review

Non-Audit Engagements

There are three main types of non-audit engagements

They are more likely to arise with small companies, and only a general awareness is needed

They are...
1. Review Engagements
Offer limited assurance

Used by smaller companies who do not require an audit but may want to apply for finance

The assurance given is negative assurance

Involves a lot less work than an audit

Agree the terms with the client and send an engagement letter

Look at the systems in place and how judgements made by management affect the items under review

Assess materiality & procedures to be used

Analytical Review (year on year figures) + forecasts as well as establish relationships between balances

Assess the entities accounting practices and how information is recorded during the review and examine minutes of
important meetings to establish any facts which may affect the financial statements.

2. Agreed Upon Procedures

In certain situations the auditor may not be asked to express an opinion, but merely to present the results of a set of procedures

The client draws their own conclusions from the data presented by the auditor.

Eg. A report for a bank as to the validity of the receivables balance

The report will only be for the client

The engagement letter shows the purpose & procedures to be applied and the form of any report.

It should also make clear that neither an audit, nor a review is being carried out and that the report should not be

It should also make clear that neither an audit, nor a review is being carried out and that the report should not be
distributed

3. Compilation Engagements
This is where the accountant is asked to compile financial information for presentation to the client

An example is the compilation of FS from a clients books and records

No opinion is issued

Eg.
On the basis of information provided by management we have compiled, in accordance with the International Standard on
Related Services (or refer to relevant national standards or practices) applicable to compilation agreements, the balance
sheet of Jamima Ltd at 31 March 20XX and statements of income and cash-flows for the year ended then.
Management is responsible for these financial statements.
We have not audited or reviewed them and accordingly express no opinion thereon.
ACCOUNTANT Date
Address

Due Diligence

There is little specific guidance on due diligence reviews, despite this

being an increasingly common form of assurance

Normally someone buying a company wants info about the target organisation.
So, the assurance provider tries to verify any management representations and offer practical recommendations regarding the

acquisition process

Scope of a due diligence assignment compared to an audit

Fact finding from a WIDER range of sources
Such as..

Several years prior financial statements

Management accounts

Profit and cash flow forecasts

Any business plans recently prepared

Discussions with management, employees and third parties

Purpose of a Due diligence review

1. Information Gathering
about a target company so the buyer knows everything
Essentially the aim is to uncover any skeletons in the closet before a decision regarding the acquisition is made.

2. Verification of specific management reps

3. Identification of assets and liabilities
Especially internally generated intangibles such as customer databases and brand names (these won't show on the SFP)

4. Operational issues
Risk can come from issues such as high staff turnover, or suppliers contract terms

5. Acquisition planning
Look for commercial effects of the acquisition. Eg. synergies & economies of scale
Also acquisition expenses to pay such as redundancies and change management

6. Management involvement
Reduces time spent by the directors on fact finding, leaving more time to focus on strategic matters to do with the acquisition and
on running the existing group.

7. Credibility
An external investigation is independent & impartial view, enhancing the credibility of the amount paid for the investment.

NO aim to provide assurance that financial data is free from material misstatement
No detailed audit procedures will be performed unless there are specific issues which cause concern
More AP used
More forward looking
No detailed tests of control

Information requested for Due diligence review

1. Directors, and any other key management personnels contracts of employment
these will be needed to see if there are any contractual settlement terms if the contract of employment is terminated after the
acquisition.

2. An organisational structure should be obtained

- to identify the members of management and key personnel and their roles

3. Details of any legal arrangement, such as a lease.

4. Prior-year audited financial statements, and management accounts for this financial year
- FS will also provide useful information regarding contingent liabilities, the liquidity position of the company, accounting policies,
and the value of assets.

5. The most recent management accounts for the current year should be analysed.
6. Forecasts and budgets for future periods

Key performance indicators

Key performance indicators

Many companies now publish some key performance indicators (KPIs) in the FS
The increased tendency to disclose such data is often in response to shareholder expectations

Types
1. Financial
such as ratios based on the financial statements

2. Non-financial
such as targets on social and environmental matters

The Assurance approach

1. Definition
2. Calculation method
3. Reporting Purpose
4. Evidence available

Problems for the Assurance Provider

Getting precise definitions of KPI targets

Poor KPI data capturing systems

Manipulation of results / spin

However, an assurance report provided on the KPIs should add credibility to the published data if sufficient evidence is available

Review of Interim Financial Information

Review of Interim Financial Information

Some companies are required to report interim results after six months of
their financial year

This will usually be an income statement and certain balance sheet items

Level of Assurance Given:

Negative

The objective is to see if anything has come to the auditor's attention that suggests that the information is not in accordance
with an identified financial reporting framework
The auditor:
1) Makes inquiries
2) Performs analytical and other review procedures

The review will NOT include:

Tests of accounting records through inspection, observation or confirmation

Obtaining corroborative evidence in response to enquiries

Other typical audit tests (e.g. test of controls)

Planning an Interim Review

1. Create an Engagement Letter

Objective and scope of the review

Management's responsibility for:

1) Internal Controls
2) Making records available
3) Written representations

Level of Assurance (Negative)

Style of Report

2. Understanding the Entity

As the review will be carried out by the auditor, this means updating the understanding from the year-end audit and the last
interim review

Identify potential material misstatement

Identify their likelihood

Select the inquiries, analytical and other review procedures

3. Procedures:
Read minutes

Consider effect of any past report modifications

In group audits, communicate with component auditors

4. Inquire about..
Changes in accounting policy

Any relevant unusual circumstances

Assumptions relating to FV valuations

Related Party Transactions

Contingent liability details

Fraud / Non-compliance events

5. Analytical procedures including..

Actual interim to expected and prior interim results

Actual interim to budget and actual financial results

Comparison to similar company's interim results

Compare key items (e.g. revenue, expenses) by month, by product line, by source of revenue, by location

6. Going Concern
Management assessment of GC changed?

Any significant factors since Y/E to affect GC?

Discuss with management if GC doubts

Consider adequacy of GC disclosures

Prospective Financial Information

This is financial information based about possible future events and

actions

PFI work is highly subjective in its nature, and its preparation requires the exercise of considerable judgement

Before accepting a PFI engagement:

1. Agree terms
2. Get knowledge of the business
3. Clarify the time period it relates to

Get written management reps on..

1. Its intended use
2. The completeness of their significant assumptions
3. Their acceptance of their responsibility for the PFI

Assurance given
Given the subjective and speculative nature of the PFI, an opinion cannot be given on whether the results shown in the report
will be achieved, so only negative assurance can be given

Negative

Assurance Services
Prospective Financial Information
Definition of PFI

Prospective financial information is future information

It covers:
1. Forecasts up to one year ahead
2. Projections up to five years ahead

Forecasts

are based on expected future events

Projections
are based on hypothetical assumptions

A Hypothetical Illustration
is based on assumptions about uncertain future events and undecided management actions

Targets
are based on assumptions about future performance

Accepting a PFI engagement

There are matters to consider before accepting an engagement

These are:
1. Who will use the information?

Internal or External?
If it's 3rd parties for investment decisions - more risky for the auditor

2. What assumptions have been made?

Best-estimates and assumptions may have little basis and will lead to higher risk

3. What elements are included in the information?

The auditor must understand the information

4. How long is the period covered?

Short term forecasts are more reliable than long term

5. Will the information be for general or limited distribution

Procedures and Assurance on PFI

The assurance given is limited and negative usually

So they will state that nothing has come to their attention to suggest the assumptions are not a reasonable basis for the
forecast

Examination Procedures

Verifying PFI will be based around analytical procedures and assessing the validity of the assumptions

Possible procedures:
1. Assess management assumptions
2. Is it prepared on a consistent basis with historical financial statements, using appropriate accounting policies
3. Are calculations correct?
4. Is information properly prepared on the basis of the assumptions
5. Agree the cash figure to bank statement or bank reconciliation

The procedures are often restricted to enquiry and analytical review

PFI Report

A PFI report will include:

The following:
1. Title, date & address
2. Reference to standards or laws
3. Basis of opinion
An opinion as to whether the PFI is properly prepared on the basis of the assumptions and is presented in accordance with the
relevant financial reporting framework.

4. Identification of the PFI contents

5. Statement of managements responsibility for preparation of the PFI
6. Reference to the purpose and distribution of the report
The PFI is based on hypothetical assumptions, the events and figures contained in the PFI may not necessarily occur as expected.

7. Expression of assurance (negative)

8. Appropriate caveats (on achievability of results)
9. Accountants name etc

Such a report would:

State if anything has come to the auditor's attention to believe that the assumptions do not provide a reasonable basis for
the PFI

Give opinion that it's prepared on the basis of the assumptions and is presented in accordance with the relevant financial
reporting framework

State that actual results are likely to be different from the PFI & and the variation could be material

in the case of a projection, state that there are hypothetical assumptions about future events and management's actions
that are not necessarily expected to occur

Forensic audits
Forensic Definitions
Forensic Accounting
Forensic accounting uses accounting, auditing, and investigative skills to examine a companys financial statements.

A financial investigation where the evidence may be use in court generally

Covers..
Forensic Investigations &
Forensic Auditing

Forensic Investigations
A forensic investigation is a process whereby a forensic accountant carries out procedures to gather evidence, which could
ultimately be used in legal proceedings or to settle disputes.

Eg. fraud or money laundering cases

Forensic Auditing
Forensic auditing uses audit procedures within a forensic investigation to find facts and gather evidence, usually focused on the
quantification of a financial loss.

Objectives of a Forensic Investigation

1. Decide if a fraud has actually taken place
2. Discover the perpetrator(s) of the fraud, and ultimately to assist in their prosecution
3. Quantify the financial loss
4. Produce evidence which is sufficient and relevant enough to be used to assist legal proceedings

Steps in investigating a suspected fraud

1. Determine the type of fraud
2. Consider how the fraud could have taken place
Eg. Usually by circumventing internal controls

3. Gather evidence
- Determine the identity of the perpetrator(s) and
- The monetary value of the fraud.

Gathering evidence includes:

The motive for the fraud,
The ability of the alleged fraudster to conduct the fraud, and
Any attempt made by the alleged to conceal the crime.
- An examination of accounting records and other documentation,
- The use of computer-assisted auditing techniques (CAATs),
- Interviewing employees of the company, and
- Discussions with management.
Evidence must be sufficient and relevant.

4. An interview with the suspect(s)

5. Produce a report for the management
- summarising all findings
- concluding on the identity of the fraudster(s) and
- the amount of financial loss suffered.
This report is also likely to be presented as part of evidence during court proceedings.

6. An advice can be provided to management

Application of Forensic Auditing

Different practical contexts could appear in the exam

Such as:
Insurance claims
Possibly to quantify losses

Fraud
Such as tax evasion - where we trace funds etc

Professional negligence
To quantify damages

The auditor may assist in legal proceedings as an expert witness.

To be an expert witness, the auditor must be suitably qualified and experienced

Forensic auditing and Ethics

Forensic auditors are often in contact with criminals..

This can create an ethical threat - lets see this in light of the fundamental principles

Threats:
Advocacy threat
Try not to feel pressured into promoting the interests of the client

Self Review
Ensure that they possess the specialist knowledge and skills to undertake the work required

Confidentiality
but reveal all relevant information required to the court

In order to maintain the reputation of the profession, the auditor should be sure to act in a professional manner at all times

Internal Audit Service

Internal v External Audit

Let's look at the difference in roles between internal and external audit

Objective & Planning

Internal Audit
Dictated by management - planning follows this
However, good corporate governance would allow IA a degree of independence over objectives

External Audit
Ensure accounts free from material misstatement and prepared in line with reporting framework.
Planned in accordance with ISAs
Work planned by themselves

Evidence
Internal Audit
The amount / type gathered would depend upon the objective set
Eg It may just be a check that assets exist, with no concern over their value

External Audit
Governed by IAS 330 - gather evidence to address misstatement risk
The risk would have been analysed during planning and in the light of subsequent evidence

Reporting
Internal Audit
Determined by the nature of the assignment

External Audit
Determined by statute & ISAs 700/5/6
Communicate to stakeholders

Scope and limitations of Internal Audit

The scope is to give assurances on...

Items such as
1. Effectiveness of systems
2. Effectiveness of Internal Controls
3. Whether manuals are followed
4. Whether internally produced info is reliable
5. Compliance with OECD

Oooh nice... What about limitations though?

Reporting System
Reporting to the Finance Director - who is responsible for some of the info being reported on!

Action
Report to Audit Committee instead

Scope of Work
Could be decided by executive directors and thus influenced away from their particular areas (the cheeky monkeys)

Action
Scope decided by chief internal auditor or audit committee

Audit Work
Auditing their own work (Self review threat)

Action
Chief internal auditor doesnt establish any controls herself
(see how modern metrosexual I am... ;)

Lengths of Service
Too long in IA and there may well be a familiarity threat

Action
Rotation of work into different areas
So being an IA is basically just a crazy, roller-coaster of a life..

Appointment of Chief Internal Auditor

Don't let the CEO do it....!

Action

Appointed by the whole of the board or Audit committee

Outsourcing internal audit

A firm may decide to outsource its internal audit function as this may
seem like better value for money

Advantages of Outsourcing
1. The provider will have specialist staff.
2. Cost of employing and training full time staff is avoided.
3. Outsourcing provides an immediate internal audit department.
4. The time scale is flexible with the contract lasting just for the appropriate time.
5. Independence may be improved.
6. Audit methodology and technologies will be up to date.

Disadvantages
If Internal and External audit are provided by the same firm (prohibited under ethics rules in UK) then there may be a
conflict of interest.

Independence may not be ensured by outsourcing due to threat of management not renewing the contract.

The cost of outsourcing may be so high as to encourage the firm not to have an internal audit function at all.

Lack of understanding of firms culture, objectives and attitudes.

The standard of service provided cannot be controlled.

Blurring of the distinction between internal and external audit function.

Minimising/Managing risks of Outsourcing

1. Setting and reviewing performance measures
2. Quality reviews and working paper reviews
3. Clear agreement on scope, responsibilities and reporting procedures
4. Ensure external audit and internal audit are two separate functions.

Outsourcing
Outsourcing v Insourcing

The use of external suppliers for finished products &services

Outsourcing
is when an external specialist organisation (also known as a service organisation) is used to carry out functions which would
normally be performed within the entity.

Service organisations usually operate in one of two ways:

1. The service organisation fully maintains the outsourced function (keeps accounting records and internal records)
2. The service organisation executes transactions only at the request of the entity, or acts as a custodian of assets.
Here the reporting entity will maintain internal records relating to the outsourced function.

Insourcing is making the finished products & services yourself

When to outsource
Low strategic importance processes

Eg. Payroll

When to insource
High strategic importance process

Eg. Where value is added

The current economic environment presents an excellent opportunity to further utilise outsourcing as a way to reduce their
manufacturing and design costs, there are challenges and difficulties that come with this kind of change.
The most successful situations are those where the customer understands that outsourcing is as much a cultural change as a
strategic one for their organization
The bottom line is that even in the best of economic times, the decision to outsource should be made based on a careful
cost/benefit analysis. It is not a quick, short-term solution

Should a Process be bought?

Should we outsource?

The idea is here that some processes may be best not performed in house but rather bought in from outside ie Outsourced
Let's think of aCOWtancy.com

Should I outsource the materials writing and videos?

I'm HOPING you're screaming "Nooooooooo!!!!"

The reason being that the whole competitive advantage of aCOWtancy.com is the simplicity of the materials, videos
(amongst a million other things :P)

In all seriousness - this is one process I wouldn't outsource - because the suppliers competences don't match my needs

However, what about the design of the site?

Well I personally think design is of enormous strategic importance (like the materials and videos etc).
However, here I do outsource some. Why?

Well here my strength is in teaching accountancy and not in the design and usability of websites.

I know a fair bit about these topics and i study them daily but it is sooooo important to me that I want to be the best in the
world at it.

So i outsource it to people who I believe are the best in the world.. Naomi, Dan, Miki... take a bow

Some processes are more suited too to outsourcing than others eg Standardised processes (you're not losing a competitve
advantage then)
Never forget though also the external v internal costs of processing.
Is it cheaper or more expensive to have the process outsourced

Business Process Outsourcing

Under the right circumstances outsourcing can certainly provide significant opportunities for savings, though it is no panacea.
Sony announced plans recently to close 10 percent of its plants worldwide and shift more manufacturing to outsourcing
Different companies will have different expectations for their outsourcing partners.
A niche business to business producers core competencies are very different than those of a provider that's set up to produce
large volumes of a consumer-oriented product
The current economic environment presents an excellent opportunity to further utilise outsourcing as a way to reduce their
manufacturing and design costs, there are challenges and difficulties that come with this kind of change.
The most successful situations are those where the customer understands that outsourcing is as much a cultural change as a
strategic one for their organisation
The bottom line is that even in the best of economic times, the decision to outsource should be made based on a careful
cost/benefit analysis.
It is not a quick, short-term solution

Advantages of BPO
1. Cost savings
2. Improved customer care
3. Allows management to focus on core competencies

Problems of BPO
1. More outsourcing suppliers leads to fragmentation and a less cohesive business

2. Security problems
3. Managing of the outsourcers
4. Performance measuring problems

Auditing an outsourced function

The auditor has no direct contractual relationship with the service

organisation

Planning
1. Potential problems with access and confidentiality
Although the service organisation should co-operate with us as it is in their interests

2. Obtain an understanding of the nature and significance of the services provided by the service organisation

Service limited to recording and processing?

Client does all the authorising

Client uses own control policies and procedures

Service provider is accountable

Client relies on their control policies

Audit risk is now higher - new procedures required

Things to Consider
1. Nature of services provided and relationship between client and service organisation
Regulations involved?

2. Contractual terms
Oral or legal contract?

3. Material financial statements assertions affected ?

4. Extent to which client's accounting and internal control systems interact with service organisations
5. Client's internal controls (to ensure completeness, accuracy, validity). Are they the same as if processing were done "in house"?
6. Service organisation's capability and financial standing. Consider the effect of business failure on the client entity
7. Information available in user and technical manuals
8. Existence of third party reports about the operation and effectiveness of the service organisation's accounting and control
systems.

Evidence when client can't get sufficient evidence

Use the service organisations auditor's reports - on their controls

Contact or visit the service organisation (via the user entity) to obtain specific information

Engage the services of another auditor

Reports

Auditor Reports
Structure of an Unmodified Audit Report

ISA 700 sets out the elements of an audit report:

The headings are as follows..

1. Title
Identifies the report as an Independent Auditors Report

2. Addressee
The shareholders i.e. for whom the report is produced.

3. Statement of responsibilities of Management

Management have prepared financial statements in accordance with GAAP and representing a true and fair view.

Application of accounting policies and estimates as well as responsibilities for systems and controls

4. Statement of responsibilities of Auditor

The audit was planned and assessed the risk of material misstatement considering internal controls and obtaining
sufficient appropriate evidence

That the auditor will express an opinion

5. Scope Paragraph
Standards under which the audit was conducted, the processes and the test basis as well as the appropriateness of
policies and disclosures

6. Opinion
Do the statements present a true and fair view? Are they prepared according to applicable GAAP and legislation?

7. Auditors signature
Auditor or firm is registered and authorised to conduct the audit.

8. Date of the Report

Signed after approved by directors on the same day.

9. Auditors address

Liability disclaimer paragraph

It is not a requirement of auditing standards but it has become increasingly common for audit firms to include a disclaimer
paragraph within the audit report.
It states the fact that the auditors report is intended solely for the use of the companys member, and that no responsibility is
accepted or assumed to third parties.

1. Advantages:
Potential to limit liability exposure
Clarifies extent of auditors responsibility
Reduces expectation gap
Manages audit firms risk exposure

2. Disadvantages:
Each legal case assessed individually no evidence that a disclaimer would offer protection in all cases
May lead to reduction in audit quality

Audit Opinion

Modified Audit Reports

If the auditor disagrees with some aspect of the financial statements or is unable to state that they provide a true and fair view,
then a modified audit report will be issued

There are two types of modified audit report:

1. An unqualified audit report with an emphasis of matter paragraph
2. A qualified audit report

Emphasis of matter
If the auditor wishes to draw attention to a particular matter, but agrees with the financial statements an emphasis of
matter paragraph will be included in the audit report.

The matter referred to will be fully disclosed in the accounts and the auditor is simply drawing the users attention to it.

The paragraph will make it clear that the opinion is not qualified and will be given a separate heading after the opinion
paragraph.

Qualified Reports
There are two reasons that an auditor may qualify an audit report:

1. Disagreement
2. Insufficient Evidence

Disagreement
A qualified report for the reason of disagreement will be issued if the auditor disagrees with the application of accounting
policies, the policies used, treatment of a particular item or the adequacy of disclosures

The disagreement can be either:

Material or
Material & Pervasive

A material disagreement - "Except for" Paragraph

This will mean that the auditor agrees with the rest of the financial statements, but disagrees with that particular
element of them.
Except for paragraph
In this situation the auditor will qualify the audit with an except for paragraph i.e. In our opinion, except for the
effect on the financial statements of the matter referred to in the preceding paragraph, the financial statements give
a true and fair view,

Material and Pervasive - Adverse Opinion

A disagreement which is material and pervasive is of such significance that the financial statements do not give a
true and fair view.
Adverse opinion
In such a situation an adverse opinion is issued i.e. the financial statements do not give a true and fair view.

Insufficient Evidence
If the auditor is unable to form an opinion, then the report will be qualified for Insufficient Evidence
Insufficient Evidence will be due to being unable to obtain sufficient evidence which should have been available.

The insufficient evidence can be either:

Material or
Material & Pervasive

Material - "Except for" paragraph

A material insufficient evidence will mean that the auditor agrees with the rest of the financial statements, but is
unable to agree with that particular element of them
Except for Paragraph
In this situation the auditor will qualify the audit with an except for paragraph i.e. In our opinion, except for the
matter referred to in the preceding paragraph, the financial statements give a true and fair view

Material & Pervasive - Disclaimer of opinion

Insufficient evidence which is material and pervasive is of such significance that auditor is unable to state whether
the financial statements give a true and fair view
Disclaimer of Opinion
In such a situation a disclaimer of opinion is issued i.e. the auditors do not express an opinion on the financial
statements

EOM and Other Matter Compared

There are 2 types of modified but not qualified reports..

Emphasis of Matter
This refers specifically to matters in the FS
Other Matters
This refers to anything else the auditor may wish to bring to the users attenion

Emphasis of matter

Other matter

What is it?

Draws attention to fundamental issue in the fs

Draws attention to another issue users need

to know about

Where does
it go?

After the opinion paragraph

After the opinion paragraph & eom paragraph

Headed
how?

Emphasis of matter

Other matter

Key points?

Highlights the matter in the FS by reference to its

page or note number

The effect on the auditor's responsibilities

Effect on
opinion?

None

None

Example

Uncertainty regarding a contingent liability

Auditor wishes to resign but legally cannot

Management Reports
Management Letters

The aim of the letter to management is to ensure the audit runs

smoothly and to highlight weaknesses and problems

Matters which should be included are:

1. Weaknesses in internal controls

2. Failures by staff to adhere to proper procedures
3. Any efficiencies which could be made
4. Any other specific issues

Often times the auditor does not sufficiently communicate these matters and such problems include:
No outline of weaknesses in internal controls or assessment of potential effects

No assessment of the cost of implementation of recommendations

Lack of recognition of clients experience in running their own business

Rubbing management up the wrong way with wide ranging suggestions.

The report to management takes the form of either a formal report or a letter

Communication with those charged with governance

Communicate matters of audit importance

Management letter - see above

Specific internal control issues