P7 Course notes


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 Syllabus A: REGULATORY ENVIRONMENT 3
Syllabus A1: International regulatory frameworks 3
Syllabus A2: Money laundering 8
Syllabus A3: Laws and regulations 20

Syllabus B: PROFESSIONAL AND ETHICAL CONSIDERATIONS 24

Syllabus B1: Code of Ethics for Professional Accountants 24
Syllabus B2: Fraud and error 39
Syllabus B3: Professional liability 43

Syllabus C: PRACTICE MANAGEMENT 48

Syllabus C1: Quality control 48
Syllabus C2: Advertising, publicity, obtaining professional work and fees 59
Syllabus C3: Tendering 63
Syllabus C4: Professional appointments 64

Syllabus D: AUDIT OF HISTORICAL FINANCIAL INFORMATION 69

Syllabus D1: Planning, materiality and assessing the risk of misstatement 69
Syllabus D2: Evidence 86
Syllabus D3: Evaluation and review 104
Syllabus D4: Group audits 193

Syllabus E: OTHER ASSIGNMENTS 205

Syllabus E1: Audit-related and assurance services 205
Syllabus E2: Prospective financial information 216
Syllabus E3: Forensic audits 222
Syllabus E4: Internal audit 227
Syllabus E5: Outsourcing 231
Syllabus E6: The audit of performance information (pre-determined objectives) in the public sector 238

Syllabus F: REPORTING 243

Syllabus F1: Auditor’s reports 243
Syllabus F2: Reports to those charged with governance and management 256

Syllabus G: CURRENT ISSUES AND DEVELOPMENTS 258

Syllabus G1: Professional and ethical developments 258
Syllabus G2: Transnational audits 259
Syllabus G3: The audit of social, environmental and integrated reporting 262

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Syllabus A: REGULATORY ENVIRONMENT

Syllabus A1: International regulatory frameworks

Syllabus A1a) Explain the need for laws, regulations, standards and other guidance
relating to audit, assurance and related services.

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:

1. International Federation of Accountants (IFAC) pronouncements

2. Corporate Governance

Other Boards
• IAASB (International Auditing & Assurance Standards Board)

These develop ISAs but they must be in the public interest so are overseen by.

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• PIOB (Public Interest Oversights Board)

Their role is to make sure everything is in the public interest and not just in the interest of
the auditor

• IESB (International Ethics Standards Board)


Their role is to create an ethics code of conduct for all auditors to follow

Syllabus A1b) Outline and explain the need for the legal and professional framework
including:
i) public oversight to an audit and assurance
practice
ii) the impact of corporate governance principles on audit and
assurance practice

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
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 Syllabus A1b) Outline and explain the need for the legal and professional framework
including:
iii) the role of audit committees and impact on
audit and assurance practice.

Audit Committees

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 company’s system of internal controls.

6. Strengthen the position of internal audit by providing greater independence from

management.

7. Appointment of external auditor.

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Advantages of a committee

1. Independent Reporting

Provides internal audit with an independent reporting mechanism.  Without this
management may be tempted to hide unfavourable reports.

2. Frees up Executive time


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

3. Corporate Governance monitored


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

4. Appropriate Internal Controls


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

5. Better Communication

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

6. 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.

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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 (e.g. 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

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 Syllabus A2: Money laundering

Syllabus A2a: Define ‘money laundering’ and discuss international methods for
combatting money laundering

Money Laundering Basics

Money laundering is creating the appearance that money obtained from

crimes originated from a legitimate source.

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:

• Possessing
• Dealing with in any way
• Concealing 



.....the proceeds of any crime

Money laundering usually consists of three steps

1. placement,
2. layering and
3. integration.

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1. Placement

is the depositing of funds into the financial system

To disguise criminal activity, launderers route cash through a "front" operation; that is
often, a cash based business


The entry of cash into the financial system, (placement’ stage) is where the launderer is
most vulnerable to detection. 


Because of the large amounts of cash involved it is extremely hard to place it into a bank
account legitimately

2. Layering

involves the wire transfer of funds through a series of accounts in an attempt to hide the
funds' true origins.

This often means transferring funds to countries which have strict bank-secrecy laws. 


Once deposited in a foreign bank, the funds can be moved through accounts of "shell"
corporations, which exist solely for laundering purposes. 


The high daily volume of wire transfers makes it difficult to keep track of for those
investigating it


The keeping of comprehensive transaction records by financial organisations provides a

useful audit trail and gives useful information on people and organisations involved in
laundering schemes once discovered.

3. Integration
involves the buying of legitimate goods, using the cash after the layering stage

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 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

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 Syllabus A2b: Explain the scope of criminal offences of money laundering and how
professional accountants may be protected from criminal and civil liability.

Scope 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 may be 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.

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How Accountants May Be Protected

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

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)

Syllabus A2c: Explain the need for ethical guidance in this area.

Ethical Framework or Rules

Current Issue - Is an ethical framework better than rules?

Here's some reasons why a framework is good…

• Needs auditor to consider his situation actively - not just a checklist

• Ensures there are no loopholes by interpreting rules too narrowly
• Every situation is different
• A framework works better in changing environments

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 Syllabus A2d: Describe how accountants meet their obligations to help prevent and
detect money laundering including record keeping and reporting of suspicion to the
appropriate regulatory body.

How Accountants Prevent Money Laundering

Accountants have money laundering obligations..

The following will prevent their organisations being used for money laundering
purposes:

• Establish a top-down anti-money laundering culture

• Have risk management procedures & internal controls
• Appoint a money laundering reporting officer (MLRO)
• Have record keeping systems for all transactions
• Keep systems for initial verification and continued monitoring of clients' identities
• Have internal suspicion reporting procedures
• Educate and train all staff in the main requirements of 

the legislation

Money Laundering Reporting Officer

Basically should have a suitable level of seniority and experience

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

Sole practitioners do not need to appoint an MLRO

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MLRO 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

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 Syllabus A2e: Explain the importance of customer due diligence (CDD) and recommend
the information that should be gathered as part of CDD.

Importance of Customer Due Diligence

This is vital so as you know who you are dealing with - this is more than just
getting their passports or certificates of incorporation (if they’re a company)

To know what is a suspicious transaction you must understand what their business
patterns and models are

Also know where their income should come from, so any money laundering income would
look suspicious

Client Acceptance Procedures

Identification procedures
1. Know your Client information

including... passports, driving licences, utility bills.

2. Also company registration documents


3. Their expected patterns of business

4. Their business model

5. Where their funds come from




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 Syllabus A2f: Recognise potentially suspicious transactions
and assess their impact on reporting duties.

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:

1. Name of the reporting business
2. Identification information of each person (DOB, address etc)
3. Role of each person (e.g. Suspect)
4. Any references seen (e.g.Bank account)
5. Details of suspicious transaction
6. Location of any laundered property

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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

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 Syllabus A2g: Describe, with reasons, the basic elements of an anti-money laundering
program.

Anti-Money Laundering Programme

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

programme

The following is required:

• Dedicated Resources
An MLRO in place
The MLRO has appropriate knowledge, experience and responsibility

• 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).
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• A frequent clearing out of an account for purposes other than maximising the value of the
funds held in the account

• 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

• Timely Escalation and Resolution

• Timely reports
• Appropriate reviews of the report
• Identify the outcome / resolution of matters

• Explicit Management Support

• Senior management should set the tone
• Their support clearly visible to all employees

• Sufficient Training and Education

• Integral to the whole programme
• Courses on how to recognise suspicious activity and what to do next

• Regular Review of the Program

• To make sure it is working as designed
• Accompanied by a formal assessment / report

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 Syllabus A3: Laws and regulations

Syllabus A3a: Compare and contrast the respective responsibilities of management and
auditors concerning compliance with laws and regulations in an audit of financial
statements.

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 misstatements 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


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 Syllabus A3b: Describe the auditors considerations of compliance with laws and
regulations and plan audit procedures when possible non- compliance is discovered.

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


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 Syllabus A3c:Discuss how and to whom non-compliance should be reported.

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

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 Syllabus A3d:Recognise when withdrawal from an engagement is necessary.

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

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Syllabus B: PROFESSIONAL AND
ETHICAL CONSIDERATIONS

Syllabus B1: Code of Ethics for Professional

Accountants

Syllabus B1a) Explain the fundamental principles and the conceptual framework
approach.

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


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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..

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 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

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 Syllabus B1b) Identify, evaluate and respond to threats to compliance with the
fundamental principles.

f) Consider the ethical implications of the external auditor providing non-audit services to
a client including an internal audit service.

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.

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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.


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• 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 firm’s 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?

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 • 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.

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 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

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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.

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 Syllabus B1c) Discuss and evaluate the effectiveness of available safeguards.

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

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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 contact with fellow professionals
• To informally discuss issues and problems
• Independent Mentor used to discuss individual threats

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 Syllabus B1d) Recognise and advise on conflicts in the application of fundamental
principles.

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!

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 Conceptual Framework

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 safeguards

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


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 Syllabus B1e) Discuss the importance of professional scepticism in planning and
performing an audit.

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?

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 Syllabus B1g) Assess whether an engagement has been planned and performed with
an attitude of professional scepticism, and evaluate the implications.

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)

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 Syllabus B2: Fraud and error

Syllabus B2a) Define and clearly distinguish between the terms ‘error’, ‘irregularity’, ‘fraud’
and ‘misstatement’.

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

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 Syllabus B2b) Compare and contrast the respective responsibilities of management and
auditors for fraud and error.

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 a material 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

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 Syllabus B2c) Describe the matters to be considered and procedures to be carried out
to investigate actual and/or potential misstatements in a given situation.

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
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.

Syllabus B2d) Explain how, why, when and to whom fraud and error should be reported
and the circumstances in which an auditor should withdraw from an engagement.

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 (e.g. Regulator)

Especially if management involved

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 Syllabus B2e) Discuss the current and possible future role of auditors in preventing,
detecting and reporting error and fraud.

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

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 Syllabus B3: Professional liability

Syllabus B3a) Recognise circumstances in which professional accountants may have

legal liability and the criteria that need to be satisfied for legal liability to be recognised.

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

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 Syllabus B3b) Describe the factors to determine whether or not an auditor is negligent in
given situations.

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

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 Syllabus B3c) Compare and contrast liability to client with liability owed to third parties (ie
contract vs establishing a duty of care).

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

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 Syllabus B3d) Evaluate the practicability and effectiveness of ways in which liability may
be restricted including the use of liability limitation agreements

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

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 Syllabus B3e) Discuss and appraise the principal causes of audit failure and other
factors that contribute to the ‘expectation gap’ (e.g. responsibilities for fraud and error)
and recommend ways in which the expectation gap might be bridged.

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


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Syllabus C: PRACTICE MANAGEMENT

Syllabus C1: Quality control

Syllabus C1a) Explain the principles and purpose of quality control of audit and other
assurance engagements.

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


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5. Firm

A sole practitioner, partnership or corporation of professional accountants

6. Inspection 

These provide evidence of compliance with the firm’s 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 firm’s 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

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ISQC 1 (firm level)

ISQC 1 identifies six building blocks of a firm’s 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….

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 Syllabus C1b) Describe the elements of a system of quality control relevant to a given
firm.

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

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3. 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.

4. 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.

5. 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

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



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7. 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.

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 Syllabus C1c) Select and justify quality control procedures that are applicable to a given
audit engagement.

Syllabus C1d) Assess whether an engagement has been planned and performed in
accordance with professional standards and whether reports issued are appropriate in
the circumstances.

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 entity’s 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

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• Appropriate consultations have happened
• The work performed supports the conclusions reached and is appropriately documented

The Engagement Partner’s 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 auditor’s report.
• Documentation of the review may be completed after the  auditor’s 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 auditor’s 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 firm’s quality control policies

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 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)

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 • Obtain evidence of the company’s 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 client’s business
4. Risk related issues
5. How to deal with any problems that may arise; and

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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.

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 Syllabus C2: Advertising, publicity, obtaining
professional work and fees

Syllabus C2a) Recognise situations in which specified advertisements are acceptable.

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:

1. Appointments and awards
2. Seeking employment or professional business
3. Professional directories
4. Books, article, interviews, lectures, media appearances
5. 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

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 Syllabus C2b) Discuss the restrictions on practice descriptions, the use of the ACCA
logo and the names of practising firms.

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

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 Syllabus C2c) Discuss the extent to which reference to fees may be made in
promotional material.

Syllabus C2d) Outline the determinants of fee-setting and justify the bases on which fees
and commissions may and may not be charged for services.

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

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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

Syllabus C2e) Discuss the ethical and other professional problems, for example, lowballing, involved
in establishing and negotiating fees for a specified assignment.

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

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 Syllabus C3: Tendering

Syllabus C3a) Discuss the reasons why entities change their auditors/professional
accountants

Syllabus C3b) Recognise and explain the matters to be considered when a firm is invited
to submit a proposal or fee quote for an audit or other professional engagement.

Syllabus C3c) Identify the information to be included in a proposal

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

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 Syllabus C4: Professional appointments

Syllabus C4a) Explain the matters to be considered and the procedures that an audit
firm/professional accountant should carry out before accepting a specified new client/
engagement or continuing with an existing engagement, including:
. i)  client acceptance
. ii)  engagement acceptance
. iii)  establish whether the preconditions for an audit are present
. iv)  agreeing the terms of engagement. 


Syllabus C4b) Recognise the key issues that underlie the agreement of the scope and
terms of an engagement with a client.

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?

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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
• 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..

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• 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

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 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
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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

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Syllabus D: AUDIT OF HISTORICAL
FINANCIAL INFORMATION
Syllabus D1: Planning, materiality and assessing the
risk of misstatement

Syllabus D1a) Define materiality and performance materiality and demonstrate how it
should be applied in financial reporting and auditing.

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.’

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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

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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.

Syllabus D1b) Identify and explain business risks for a given assignment.
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 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..

P - 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.

E - Economic risks
S - Social and taste changes
T - Technological changes
E - Environmental issues
L - 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

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• 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)

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 Syllabus D1c) Identify and explain audit risks for a given assignment.

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    Control Risk    x    Detection Risk

Inherent 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.

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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.


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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 auditor’s 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.

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 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.

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 Syllabus D1d) Identify and explain risks of material misstatement for a given assignment.

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

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 Syllabus D1e) Discuss and demonstrate the use of analytical procedures in the
planning of an assignment.

Analytical Procedures in Planning

Analytical procedures consist of ‘evaluations of financial information through

analysis of plausible relationships among both financial and non-financial
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


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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

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 Syllabus D1f) Explain how the result of planning procedures determines the relevant
audit strategy.

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:
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

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

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.

Direction:
The direction of the audit will be determined by the identification of high risk areas and
materiality.


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.


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 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

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 Syllabus D1h) Identify additional information that may be required to assist the auditor in
obtaining an understanding of the entity

How to get Initial Understanding

Firstly the auditor needs to understand the entity’s environment, this will
require the auditor to assess:

• 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 auditor’s personal experience and knowledge

ISA 315 requires a planning meeting where ‘the members of the engagement team should
discuss the susceptibility of the entity’s 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.

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 Syllabus D1g) Explain the planning procedures specific to an initial audit engagement.

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”

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 Syllabus D2: Evidence

Syllabus D2a) Identify and describe audit procedures (including substantive procedures
and tests of control) to obtain sufficient, appropriate audit evidence from identified
sources.
D2c) Identify additional information that may be required to effectively carry out a planned
assignment
Syllabus D2d) Identify and evaluate the audit evidence expected to be available to:
i) support the financial statement assertions and accounting treatments (including fair
values)
ii) support disclosures made in the notes to the financial statements.

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

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3. Completeness
4. Valuation and allocation

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


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 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 Comparing yearly gross

between data margins

Enquiry Getting information from Replies from a debtors

3rd party circular

Inspection Examining records Signature as evidence Getting title deeds to a

property

Observation Looking at process Watching staff complete

their attendance sheet

Re-calculation Checking mathematical Adding individual sales

accuracy in the sdb to check the
totals

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.

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 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. Confirmation
This means corroborating evidence from third parties with the internal evidence
For example, confirming accounts receivables by circularising the debtors

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

6. 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

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 Syllabus D2b) Assess and describe how IT can be used to assist the auditor and
recommend the use of Computer-assisted audit techniques (CAATs) where appropriate.

Using CAATs

CAATs use a computer to assist the auditor in testing during the audit
procedures

There are 2 categories of CAAT:

1. Audit Software
2. Test Data

Audit Software

The auditor may use audit software to run the client data to check for errors

It can be an off-the-shelf software or bespoke for the client.

They can scrutinise large volumes of data, whose results  can be investigated further

The software does not, however, replace the need for the auditor's own procedures

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It can do the following:

select a sample using different sampling techniques

check calculations
automate the confirmation letter process

produce reports

follow transactions

Test Data

Another method which may be used by the auditor is the use of test data.

This is really putting a dummy transaction through the system to ensure that controls are
working and that calculations are performed correctly

Examples of errors

Codes don't actually exist, e.g. customer, supplier and employee;

Transactions above pre-set limits, e.g. credit limits

Invoices with arithmetical errors

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Auditing around the computer

Meaning the auditor does not audit how the computer works, but rather checks that the
inputs generate the expected outputs from the system

This increases audit risk as the auditor cannot tell with certainty whether the
internal processes of the system are working correctly

It is very difficult to determine why errors occurred


Also fixing them may need an external expert

Advantages & Disadvantages of CAATs

• Advantages

1. Independently access computer data

2. Test the reliability of client software
3. Increase the accuracy of audit tests
4. Perform audit tests more efficiently

• Disadvantages

1. CAATs can be expensive and time consuming to set up

2. Client permission and cooperation may be difficult to obtain
3. Potential incompatibility with the client's computer system
4. The audit team may not have sufficient IT skills
5. Data may be corrupted or lost during the application of CAATs

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 Syllabus D2e) Apply analytical procedures to financial and non-financial data.

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.

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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

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 Syllabus D2f) Explain the specific audit problems and procedures concerning related
parties and related party transactions.

Syllabus D2g) Recognise circumstances that may indicate the existence of unidentified
related parties and select appropriate audit procedures.

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
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

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Stakeholders need to know that all transactions are at arm´s 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 arm´s length, should the related party connection break then the volume
of business disappear also.

Disclosures

• General
The name of the entity’s 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 intra- group transactions and balances would have been eliminated.


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 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


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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


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 Syllabus D2h) Evaluate the use of written representations from management to support
other audit evidence

Definition

It’s is a (written) statement by management provided to the auditor to confirm certain

matters or to support other audit evidence

Purpose
It’s purpose is:

To obtain representations that management have prepared the FS, including;

◦ in accordance with an applicable financial reporting framework;
◦ providing the auditor with all relevant information and access to records;
◦ recording all transactions and reflecting them in the financial statements.

To support other audit evidence relevant to the financial statements if determined

necessary by the auditor or required by ISA's.

This is when other evidence is not available e.g..

• plans or intentions that may affect the carrying value of assets or liabilities;
• confirmation of directors’ judgements / estimates
• compliance issues

How are written representations obtained?

As the audit progresses, the audit team will assemble a list of those items about which it is
appropriate to seek management representations.

During completion the auditors will write to the client confirming these issues

The client must formally document, and sign, a response and send it to the auditor.

In what form are they?

A letter from the client to the auditors responding to the necessary points. (It is common for
the auditor to draft the letter for the client, who simply reproduces it on their own letter-
headed paper, approves it and signs it).

Or even, minutes of a meeting where representations were made orally, which can be
signed by management.

Quality and reliability?

They are internal sources of evidence, and therefore subject to bias, and potentially
unreliable

ISA 580 also clearly states that written representations should only be sought to support
other audit evidence. They do not, on their own, constitute sufficient evidence.
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Before they can be used the auditor must consider their reliability in terms of:
• inconsistencies with other forms of evidence; and
• concerns about the competence, integrity, ethical values or diligence of
management;

If they’re inconsistent then perform further procedures.

If worries about integrity etc then consider withdrawal, or if not permitted, consider the
impact on the audit report. (likely a disclaimer of opinion)

If management refuses to provide written representations - then again a probable

disclaimer or withdrawal

Additional matters requiring written representation

• directors have assessed the risk of fraud and consider it to be low;

• directors are not aware of any actual, or suspected, instances of fraud;
• all related parties have been identified and transactions with them disclosed
• directors consider the aggregate of all uncorrected misstatements to be
immaterial;
• the directors have considered all subsequent events
• the directors have considered all possible events, matters and contingencies
in performing their going concern review.


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 Syllabus D2i) Recognise when it is justifiable to place reliance on the work of an expert
(e.g. a surveyor employed by the audit client).

Why Rely on Experts?

ISA 620 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

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• 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

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 Syllabus D2j) Assess the appropriateness and sufficiency of the work of internal auditors
and the extent to which reliance can be placed on it.

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.

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 Syllabus D3: Evaluation and review

Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:
. i)  inventory

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 stock-sheets pre-numbered and prepared in ink?
4. Is a complete set of stock-sheets available covering all categories of inventory?

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

iv)  changes in accounting policy

Changes in Accounting Policy

Changes in accounting policy

Change comparatives also

Changes in accounting estimates

Just change this year and not comparatives

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:
. v)  taxation (including deferred tax)

Deferred tax basics

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 don’t.

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)

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In fact, the following table all applies:

Difference Tax effect Deferred Tax

More income More tax Liability

Less income Less tax Asset

More expense Less tax Asset

Less expense More tax Liability

Remember this more income etc is from the point of view of IFRS.
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 management’s 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.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

. vi)  segmental reporting

IFRS for SME - Introduction

The principal aim when developing accounting standards for small-to medium-sized
enterprises (SMEs) is to provide a framework that generates relevant, reliable and useful
information, which should provide a high-quality and understandable set of accounting
standards suitable for SMEs. 

The only real users of accounts for SMEs are:

1) Shareholders
2) Management
3) Possibly government
 
IFRS for SMEs is a self-contained standard, incorporating accounting principles based on
existing IFRS, which have been simplified to suit SMEs.

If a topic is not covered in the standard there is no mandatory default to full IFRS.

Topics not really required for SMEs are excluded and so the standard does not address
the following topics:

• Earnings per share 

• Interim financial reporting 
• Segment reporting 
• Insurance (because entities that issue insurance contracts are not eligible to use the
standard) 
• Assets held for sale.

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Good news! The standards are relatively short and get the preparers to think. IFRS for
SMEs therefore contains concepts and pervasive principles, any further disclosures may
be needed to give a true and fair view. It will be updated once every 2 or 3 years only.
 

What is an SME?
There is no universally agreed definition of an SME. As there are differences between
firms, sectors, or countries at different levels of development.

Most definitions based on size use measures such as number of employees, balance
sheet total, or annual turnover. However, none of these measures apply well across
national borders. 

Ultimately, the decision regarding who uses IFRS for SMEs stays with national regulatory
authorities and standard-setters. These bodies will often specify more detailed eligibility
criteria. If an entity opts to use IFRS for SMEs, it must follow the standard in its entirety – it
cannot cherry pick between the requirements of IFRS for SMEs and the full set.
 
Different users entirely 
IFRS users are the capital markets. So, quoted companies and not SMEs. 

The vast majority of the world's companies are small and privately owned, and it could be
argued that full International Financial Reporting Standards are not relevant to their needs
or to their users.

It is often thought that small business managers perceive the cost of compliance with
accounting standards to be greater than their benefit.

Because of this, the IFRS for SMEs makes numerous simplifications to the recognition,
measurement and disclosure requirements in full IFRS.

Examples of these simplifications are:

Goodwill and other indefinite-life intangibles are amortised over their useful lives, but if
useful life cannot be reliably estimated, then 10 years. 

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 A simplified calculation is allowed if measurement of defined benefit pension plan
obligations (under the projected unit credit method) involve undue cost or effort. 

The cost model is permitted for investments in associates and joint ventures.

Differing approaches

Some argue having 2 sets of rules may mean 2 true and fair views 

Local GAAP for SME?

An alternative could have been for GAAP for SMEs to have been developed on a national
basis, with IFRS focusing on accounting for listed company activities.

Then though, SMEs may not have been consistent and may have lacked comparability
across national boundaries.

Also, if an SME wished to later list its shares on a capital market, the transition to IFRS
could be harder. 
 

List SME exemptions in the full IFRS?

Under another approach, the exemptions given to smaller entities would have been
prescribed in the mainstream accounting standard.

For example, an appendix could have been included within the standard, detailing those
exemptions given to smaller enterprises. 

Separate SME standard for each IFRS?

Yet another approach would have been to introduce a separate standard comprising all the
issues addressed in IFRS that were relevant to SMEs. 
 


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As it stands now

User friendly
The standard has been organised by topic with the intention of being user-friendlier for
preparers and users of SME financial statements

The standard also contains simplified language and explanations of the standards.

Easier transition to full IFRS

It is based on recognised concepts and pervasive principles and it allows easier transition
to full IFRS if the SME later becomes a public listed entity.

In deciding on the modifications to make to IFRS, the needs of the users have been taken
into account, as well as the costs and other burdens imposed upon SMEs by the IFRS. 
 
Cost Benefit
Relaxation of some of the measurement and recognition criteria in IFRS had to be made in
order to achieve the reduction in these costs and burdens. 

Stewardship not so important

Small companies pursue different strategies, and their goals are more likely to be survival
and stability rather than growth and profit maximisation.

The stewardship function is often absent in small companies, with the accounts playing an
agency role between the owner-manager and the bank.

Access to capital
Where financial statements are prepared using the standard, the basis of presentation
note and the auditor's report will refer to compliance with IFRS for SMEs.

This reference may improve SME's access to capital.

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In the absence of specific guidance on a particular subject, an SME may, but is not
required to, consider the requirements and guidance in full IFRS dealing with similar
issues.

The IASB has produced full implementation guidance for SMEs.

IFRS for SMEs is a response to international demand from developed and emerging
economies for a rigorous and common set of accounting standards for smaller and
medium-sized enterprises that is much easier to use than the full set of IFRS.  

It should provide improved comparability for users of accounts while enhancing the overall
confidence in the accounts of SMEs, and reduce the significant costs involved in
maintaining standards on a national basis.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

vii)  non-current assets

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


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 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

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 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)

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xv)  impairment

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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:
. viii)  fair value

Fair Value Audit


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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

ix)  leases

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 lessor’s 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

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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)


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 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:

Step 1

• De-recognise 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

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

Step 3

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

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Operating Lease Back

• A normal sale

If it’s a ‘normal’ profit then there’s no problem - just show it in the income statement.
Then show the operating lease rentals and that’s 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 auditor’s 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.


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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 auditor’s 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 auditor’s request to amend the financial statements.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

x)  revenue from contracts with customers

Revenue Recognition - IFRS 15 - introduction

Revenue Recognition - IFRS 15

When & how much to Recognise Revenue?

Here you need to go through the 5 step process…

1. Identify the contract(s) with a customer

2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognise revenue when (or as) the entity satisfies a performance obligation

Before we do that though, let’s get some key definitions out of the way..

Key definitions

• Contract

An agreement between two or more parties that creates enforceable rights and
obligations.

• Income

Increases in economic benefits during the accounting period in the form of increasing
assets or decreasing liabilities

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• Performance obligation

A promise in a contract to transfer to the customer either:

- a good or service that is distinct; or 

- a series of distinct goods or services that are substantially the same and that have the
same pattern of transfer to the customer.

• Revenue

Income arising in the course of an entity’s ordinary activities.

• Transaction price

The amount of consideration to which an entity expects to be entitled in exchange for
transferring promised goods or services to a customer.

Revenue Recognition - IFRS 15 - 5 steps

Revenue Recognition - IFRS 15 - 5 steps

Ok let’s now get into a bit more detail…

Step 1: Identify the contract(s) with a customer

• The contract must be approved by all involved
• Everyone’s rights can be identified
• It must have commercial substance
• The consideration will probably be paid

Step 2: Identify the separate performance obligations in the contract

This will be goods or services promised to the customer
These goods / services need to be distinct and create a separately identifiable obligation

• Distinct means:

The customer can benefit from the goods/service on its own AND

The promise to give the goods/services is separately identifiable (from other promises)
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• Separately identifiable means:

No significant integrating of the goods/service with others promised in the contract 

The goods/service doesn’t significantly modify another good or service promised in the
contract. 

The goods/service is not highly related/dependent on other goods or services promised
in the contract.

Step 3: Determine the transaction price

How much the entity expects, considering past customary business practices

• Variable Consideration

If the price may vary (eg. possible refunds, rebates, discounts, bonuses, contingent
consideration etc) - then estimate the amount expected

• However variable consideration is only included if it’s highly probable there won’t need to
be a significant revenue reversal in the future (when the uncertainty has been
subsequently resolved)

• However, for royalties from licensing intellectual property - recognise only when the
usage occurs

Step 4: Allocate the transaction price to the separate performance obligations

If there’s multiple performance obligations, split the transaction price by using

their  standalone selling prices. (Estimate if not readily available)

• How to estimate a selling Price


- Adjusted market assessment approach 

- Expected cost plus a margin approach 

- Residual approach (only permissible in limited circumstances).

• If paid in advance, discount down if it’s significant (>12m)

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Step 5: Recognise revenue when (or as) the entity satisfies a performance
obligation
Revenue is recognised as control is passed, over time or at a point in time.

• What is Control

It’s the ability to direct the use of and get almost all of the benefits from the asset. 

This includes the ability to prevent others from directing the use of and obtaining the
benefits from the asset.

• Benefits could be:


- Direct or indirect cash flows that may be obtained directly or indirectly

- Using the asset to enhance the value of other assets; 

- Pledging the asset to secure a loan

- Holding the asset.

• So remember we recognise revenue as asset control is passed (obligations satisfied) to

the customer



This could be over time or at a specific point in time.

Examples (of factors to consider) of a specific point in time:

1. The entity now has a present right to receive payment for the asset;
2. The customer has legal title to the asset;
3. The entity has transferred physical possession of the asset;
4. The customer has the significant risks and rewards related to the ownership of the
asset; and
5. The customer has accepted the asset.

Contract costs - that the entity can get back from the customer

These must be recognised as an asset (unless the subsequent amortisation would be less
12m), but must be directly related to the contract (e.g. ‘success fees’ paid to agents).

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Examples would be direct labour, materials, and the allocation of overheads  - this asset is
then amortised

Revenues - Presentation in financial statements

Presentation in financial statements

Show in the SFP as a contract liability, asset, or a receivable, depending on when paid and
performed
i.e.. Paid upfront but not yet performed would be a contract liability

Performed but not paid would be a contract receivable or asset

1. A contract asset if the payment is conditional (on something other than time)
2. A receivable if the payment is unconditional

Contract assets and receivables shall be accounted for in accordance with IFRS 9.

Disclosures

All qualitative and quantitative information about:

• its contracts with customers;
• the significant judgments in applying the guidance to those contracts; and
• any assets recognised from the costs to fulfil a contract with a customer.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xi)  employee benefits

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
they’re 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 wouldn’t be taken until the next year

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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

Defined Benefit Scheme - Terms

Let’s look at some terms:

• Actuarial gains/losses

These occur due to differences between previous estimates and what actually occurred

These are recognised in the OCI

• 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

• 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.

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• Current service cost

Increase in pension liability due to benefits earned by employee service in the period

Dr Income statement

Cr Pension Liability

• Interest cost

The unwinding on the discount of the pension liability

Dr Interest

Cr Pension Liability

• 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

• 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

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• 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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xii)  government grants

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


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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


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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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xiii)  related parties

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

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Stakeholders need to know that all transactions are at arm´s 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 arm´s length, should the related party connection break then the volume
of business disappear also.

Disclosures

• General
The name of the entity’s 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 intra-group transactions and balances would have been eliminated.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xiv)  earnings per share

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
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• Share options


This will mean more shares when 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.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

. xvi)  provisions, contingent liabilities and 


contingent assets

Provisions

A provision is a liability of uncertain timing or amount

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

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

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• Large populations of events
E.g. 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

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• 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

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 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

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 Auditing Warranty Provisions

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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:
xvii)  intangible assets

What is an intangible asset

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

The three critical attributes of an intangible asset are:

1. Identifiability
2. Control (power to obtain benefits from the asset)
3. Future economic benefits

Whooah there partner, what´s 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 doesn’t have to be separable AND arise from a legal right, just one or the
other is enough).


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 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

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.

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• 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)

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 Some typical examples

Circumstance Provide?

Warranties/guarantees  Accrue a provision (past event was the sale of

defective goods) 

Customer refunds Accrue if the established policy is to give refunds 

Onerous (loss-making) contract  Accrue a provision 

Land contamination  Accrue a provision if the company's policy is to

clean up even if there is no legal requirement to do
so 

Future operating losses  No provision (no present obligation) 

Firm offers staff training  No provision (there is no obligation to provide the

training) 

Major overhaul or repairs  No provision (no obligation) 

Restructuring by sale of an operation/line of Accrue a provision only after a binding sale

business  agreement 

Restructuring by closure of business locations or Accrue a provision only after a detailed formal plan
reorganisation  is adopted and announced publicly. A Board
decision is not enough 

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

. xviii)  financial instruments

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)

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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

Audit procedures on short-term investments

1. Agree the FV of the shares held as investments to stock market share price
2. Confirm the original cost of the investment to cash book and bank statements
3. Discuss the accounting treatment with management and confirm that an adjustment will
be made to recognise the shares at fair value
4. Review the notes to the financial statements to ensure that disclosure is sufficient to
comply with the requirements of IFRS 9
5. Enquire with the treasury management as to whether there have been any disposals of
the original shares held
6. Review board minutes to confirm the authorisation and approval of the amount
invested
7. For any investments from which dividends have been received, confirm the number of
shares held to supporting documentation such as dividend received certificates

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 Impairment of Financial Instruments

Impairment of Financial Instruments

Expected Credit Loss model

This applies to:

1. Amortised cost items

2. FVTOCI items

How it works
• Significant increase in credit risk occurred? Show lifetime expected losses
• No significant increase in credit risk? Show 12-month expected losses only

How do you calculate the Expected Credit Loss?

Use:
1. a probability-weighted outcome
2. the time value of money
3. the best available forward-looking information.

Notice the use of forward-looking info - this means judgement is needed - so it will be
difficult to compare companies

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Stage 1 - Assets with no significant increase in credit risk

For these assets:

1. 12-month expected credit losses (‘ECL’) are recognised and
2. Interest revenue is calculated on the gross carrying amount of the asset (that is,
without deduction for credit allowance)

12-month ECL are based on the asset’s entire credit loss but weighted by the probability
that the loss will occur within 12 months of the Y/E

Stage 2 - Assets with a significant increase in credit risk (but no evidence of

impairment)

For these assets:

1. Lifetime ECL are recognised
2. Interest revenue is still calculated on the gross carrying amount of the asset.

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Lifetime ECL come from all possible default events over its expected life
Expected credit losses are the weighted average credit losses with the probability of
default (‘PD’) as the weight.

Stage 3 - Assets with evidence of impairment

For these assets:

1. Lifetime ECL are recognised and
2. Interest revenue is calculated on the net carrying amount (that is, net of credit
allowance

In subsequent reporting periods, if the credit quality improves so there’s no longer a

significant increase in credit risk since initial recognition, then the entity reverts to
recognising a 12-month ECL allowance

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Where does the impairment go?
The changes in the loss allowance balance are recognised in profit or loss as an
impairment gain or loss

So what do all these new rules on impairment mean?

Impairments are now recorded BEFORE any actual impairment (except for FVTPL items)
due to the 12-month ECL allowance for all assets

The ECL model is more forward looking when calculating ECLs

Entities with shorter term and higher quality financial instruments are likely to be less
significantly affected.

Higher volatility in the ECL amounts charged to profit or loss, increasing as economic
conditions are forecast to deteriorate, meaning more judgement required

For companies, the ECL model will most likely not cause a major increase in allowances
for short-term trade receivables because of their short term nature.

The provision matrix should help measure the loss allowance for short-term trade
receivables.

Collective Basis
If the asset is small it’s just not practical to see if there’s been a significant increase in
credit risk


So, you can assess ECLs on a collective basis, to approximate the result of using
comprehensive credit risk information that incorporates forward-looking information at an
individual instrument level

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Simplified Approach
This means no tracking changes in credit risk!


Instead just recognise a loss allowance based on lifetime ECLs at each reporting date,
right from origination.


The simplified approach is for trade receivables, contract assets with no significant
financing component, or for contracts with a maturity of one year or less

12-month expected credit losses

These are a portion of the lifetime ECLs that are possible within 12 months

The portion is weighted by the probability of a default occurring

It is not the predicted (probable) defaults in the next 12 months. For instance, the
probability of default might be only 25%, in which case, this should be used to calculate
12-month ECLs, even though it is not probable that the asset will default.

Also, the 12-month expected losses are not the cash shortfalls that are predicted over only
the next 12 months. For a defaulting asset, the lifetime ECLs will normally be significantly
greater than just the cash flows that were contractually due in the next 12 months.

Lifetime expected credit losses

These are from all possible default events over the expected life
Estimate them based on the present value of all cash shortfalls

So, basically, it’s the difference between:

• The contractual cash flows And
• The cash flows now expected to receive

As PV is used, even late (but the same) cashflows create an ECL

For a financial guarantee contract, the ECLs would be the PV of what it expects to pay as
guarantor less any amounts from the holder


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 Financial liabilities - Categories

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

Right-y-o, we’ve 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.
*A quaint old English saying - meaning you're an idiot :p

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...

1. Fair Value Through Profit and Loss (FVTPL)


This includes financial liabilities incurred for trading purposes and also derivatives.

2. Amortised Cost

If financial liabilities are not measured at FVTPL, 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

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So - the question is - how do you measure the FV of a loan??
Well again the answer is simple - and you’ve 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 (effective rate) then this is no
problem and you don’t really have to follow those 2 steps as you will just come back to the
capital amount…let 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 (10%) IS THE SAME AS
THE MARKET RATE (10%) 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 you’re 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)
e.g. 4% 1,000 payable loan - with a 10% premium on redemption.

This means that the EFFECTIVE interest rate (the rate we actually pay) is more than 4% -
because we haven’t 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 - let’s say 8%.

The crucial point here is that you presume the effective rate (e.g. 8%) is the same as the
market rate (8%) so the initial FV is still 1,000.


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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

e.g. 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 (the rate you actually pay) is let’s say
7% (will be given in the exam).

The crucial point here is that the discount is paid immediately. So, although you presume
that the effective rate (7%) 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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xix)  investment properties

Investment property

So here we are dealing with a situation where a company owns a building (or
land) but doesn’t 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 useless (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

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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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

. xx)  share-based payment transactions

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.


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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 i.e. 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 three-year period and therefore forfeit their rights to share
options.

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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) - it’s just we’ve spread it over the 3 years vesting period.

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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) - it’s just we’ve spread it over the 3 years vesting period.

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 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 specialist’s 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


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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xxi)  business combinations

Syllabus D4e) Recognise the audit problems and describe audit procedures specific to
a business combination, including goodwill, accounting policies, inter-company trading,
the classification of investments, equity accounting for associates, changes in group
structure, and accounting for a foreign subsidiary.[

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

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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

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 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. Recalculation 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


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 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.

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Here you will need to do the following calculation:

FV of consideration (for the extra % bought) x

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 is 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.

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 Syllabus C2b) Apply and discuss the treatment of non-current assets held for sale.

Assets Held for Sale

How do we deal with items in our accounts which we are no longer going to
use, instead we are going to sell them

So, think about this for a moment.. Why does this matter to users?
Well, the accounts show the business performance and position, and you expect to see
assets in there that they actually are looking to continue using.

Therefore their values do not have to be shown at their market value necessarily (as your
intention is not to sell them)

Here, though, everything changes… we are going to sell them.

So maybe market value is a better value to use, but they haven’t been sold yet, so
showing them at MV might still not be appropriate as this value has not yet been achieved
So these are the issues that IFRS 5 tried, in part, to deal with and came up with the
following solution..

Accounting Treatment

1. Step 1 - Calculate the Carrying Amount...


Bring everything up to date when we decide to sell

This means:

- charge the depreciation as we would normally up to that date or

- revalue it at that date (if following the revaluation policy)

2. Step 2 - Calculate FV - CTS


Now we can get on with putting the new value on the asset to be sold..

Measure it at Fair Value less costs to sell (FV-cts). 

This is because, if you think about it, this is the what the company will receive.

HOWEVER, the company hasn’t actually made this sale yet and so to revalue it now to
this amount would be showing a profit that has not yet happened

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3. Step 3 - Value the Assets held for sale 

IFRS 5 says the new value should actually be…

...The lower of carrying amount (step 1) and FV-CTS (step 2)

4. Step 4 - Check for an Impairment 


Revaluing to this amount might mean an impairment (revaluation downwards) is
needed. 

This must be recognised in profit or loss, even for assets previously carried at revalued
amounts.

Also, any assets under the revaluation policy will have been revalued to FV under step 1
Then in step 2, it will be revalued downwards to FV-cts.
Therefore, 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.

When is an asset recognised as 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

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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.

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.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

. xxii)  assets held for sale and discontinued 

operations

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 client’s depreciation calculations, to confirm no depreciation once reclassified
as held for sale

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xxiii)  events after the end of the reporting 

period

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 the situation at the SFP date was. 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…


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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.

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xxiv) the effects of foreign exchange rates

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
e.g. Dealing with foreign transactions

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

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 Syllabus D3a) Evaluate the matters (e.g. materiality, risk, relevant accounting standards,
audit evidence) relating to:

xxv) borrowing costs

Borrowing Costs

Borrowing Costs

Let’s 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.

So instead of taking interest to the I/S as an expense you add it to the cost of the asset.
(in other words - you capitalise it)

There are 2 scenarios here to worry about:

1. You use current borrowings to pay for the asset
2. You get a specific loan for the asset

1) Use current borrowings

This is looking at the scenario where we use funds we have already borrowed from
different sources.

So, if the funds are borrowed generally – we need to calculate the weighted average cost
of all the loans we have generally.

(I know you're thinking - how the cowing'eck do I work out the weighted average of
borrowings... aaarrgghh!).

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Well relax my little monkey armpit - here's how you do it:
1. Calculate the total amount of borrowings
2. Calculate the interest payable on these in total
3. Weighted average  of borrowing costs = Divide the interest by the borrowing - et voila!
4. We then take this weighted average of borrowing costs and multiply it by any
expenditure on the asset. 

The amount capitalised should not exceed total borrowing costs incurred in the period.

Illustration

5% Overdraft 1,000
8% Loan 3,000
10% Loan 2,000

We buy an asset with a cost of 5,000 and it takes one year to build - how much interest
goes to the cost of the asset?

Solution
Calculate the WA cost of the borrowings:

1. Total Borrowing = (1,000+3,000+2,000) = 6,000

2. Interest payable = (50+240+200) = 490
3. 490/6,000 = 8.17%
4. So the total interest to be added to the asset is 8.17% x 5,000 = 408

2) Get a specific loan

Ok well you would think this is easy - just the interest paid, surely?! But it’s not quite that
easy…

It is the actual borrowing costs less investment income on any temporary investment
of the funds

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So what does this mean exactly?

Well imagine you need 10,000 to build something over 3 years. You borrow 10,000 at the
start but don’t need it all straight away.

So the bit you don’t need you leave in the bank to gain interest
So, the amount you could capitalise would be the interest paid on the 10,000 less the
interest received on the amount not used and left in the bank (or reinvested elsewhere)

Steps:

1. Calculate the interest paid on the specific loan

2. Calculate any interest received on loans proceeds not used
3. Add the net of these 2 to 'cost of the asset'

Illustration

Buy asset for 2,000 - takes 2 years to build.

Get a 2,000 10% loan.
We reinvest any money not used in an 8% deposit account.
In year 1 we spend 1,200.

How much interest is added to the cost of the asset?

1. Interest Paid = 2,000 x 10% = 200

2. Interest received = ((2,000-1,200) x 8%) = 64
3. Dr  PPE Cost (200-64) = 136

Cr  Interest Accrual

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.


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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 can’t be anything that is available for use when you buy it.

It has to take quite a while to build (PPE, Investment Properties, Inventories and
Intangibles).

You don’t 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 e.g. Plans drawn up, getting planning etc. So
just having an asset for development without anything happening is not enough to
qualify for capitalisation

Are borrowing costs just interest?

It’s actually any costs that an entity incurs in connection with the borrowing of funds.
So it includes:

• Interest expense calculated using the effective interest method.

• Finance charges in respect of finance leases

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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, e.g. Bank holidays etc.

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

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 Syllabus D3b) Explain the use of analytical procedures in evaluation and 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

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

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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.

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 Syllabus D3c) Explain how the auditor’s responsibilities for corresponding figures,
comparative financial statements, and ‘other information’, are discharged.

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

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Other Information

The other information in the accounts such as the Directors report, the Chairman’s 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

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 Syllabus D3d) Apply the further considerations and audit procedures relevant to initial
engagements.

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 client’s 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

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 Syllabus D3f) Specify audit procedures designed to identify subsequent events that
may require adjustment to, or disclosure in, the financial statements of a given entity.

Auditor responsibility for Subsequent Events

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 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

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 Syllabus D3g) Identify and explain indicators that the going concern basis may be in
doubt and recognise mitigating factors.

Going Concern Review & Indicators

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

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 Syllabus D3h) Recommend audit procedures, or evaluate the evidence that might be
expected to be available and assess the appropriateness of the going concern basis in
given situations.

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.

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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

Assess if can carry on for foreseeable future

Management Responsibility
At least 12 months

Decide if management are right to use going

concern status
Auditor Responsibility
Should uncertainties be disclosed

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 Syllabus D3i) Assess the adequacy of disclosures in financial statements relating to
going concern and explain the implications for the auditor’s report with regard to the
going concern basis.

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

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 Syllabus D4: Group audits

Syllabus D4a) Recognise the specific matters to be considered before accepting

appointment as group auditor to a group in a given situation

Syllabus D4b) Explain the responsibilities of the component auditor before accepting
appointment, and the procedures to be performed in a group situation.

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

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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


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 Syllabus D4c) Identify and explain the matters specific to planning an audit of group
financial statements including assessment of group and component materiality, the
impact of non-coterminous year ends within a group, and changes in group structure.

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

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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 liabilities 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

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, liabilities, 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

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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 Liabilities 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


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 D4d) Justify the situations where a joint audit would be appropriate.

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. 


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 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 firm’s method to use, for example, to calculate
materiality, sample sizes  etc 

One firm’s 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.

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 Syllabus D4g) Identify and describe the matters to be considered and the procedures to
be performed at the planning stage, when a group auditor considers the use of the work
of component auditors.

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

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 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 group’s 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

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 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)

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 Syllabus D4i) Explain the implications for the auditor’s report on the financial statements
of an entity where the opinion on a component is modified in a given situation.

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

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 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

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Syllabus E: OTHER ASSIGNMENTS

Syllabus E1: Audit-related and assurance services

Syllabus E1a) Describe the nature of audit-related services, the circumstances in which
they might be required and the comparative levels of assurance provided by professional
accountants and distinguish between:

i) audit-related services and an audit of historical financial statements

ii) an attestation engagement and a direct engagement.

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)

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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

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 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.

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 • 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 client’s 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

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 Syllabus E1b) Plan review engagements, for example


. ii)  a ‘due diligence’ assignment (when 


acquiring a company, business or other assets).

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.

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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 personnel’s 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.

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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

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 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

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 Syllabus E1b) Plan review engagements, for example


i)  a 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


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 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

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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

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 Syllabus E2: Prospective financial information

Syllabus E2a) Define ‘prospective financial information’ (PFI) and distinguish between a
‘forecast’, a ‘projection’, a ‘hypothetical illustration’ and a ‘target’.

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

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 Syllabus E2b)  Explain the principles of useful PFI.

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


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 Syllabus E2c) Identify and describe the matters to be considered before accepting a
specified engagement to report on PFI.

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

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 Syllabus E2d) Discuss the level of assurance that the auditor may provide and explain
the other factors to be considered in determining the nature, timing and extent of
examination procedures.

. Syllabus E2e) Describe examination procedures to verify forecasts and

projections.

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

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 Syllabus E2f) Compare the content of a report on an examination of PFI with reports
made in providing audit-related services.

Syllabus F3a) Analyse the form and content of the professional accountant’s report for
an assurance engagement as compared with an auditor’s report.

Syllabus F3b) Discuss the content of a report on examination of prospective financial

information.

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 management’s 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

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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


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 Syllabus E3: Forensic audits

Syllabus E3a) Define the terms ‘forensic accounting’, ‘forensic investigation’ and
‘forensic audit’.

Syllabus E3d) Plan a forensic audit engagement.

Syllabus E3e) Select investigative procedures and evaluate evidence appropriate to

determining the loss in a given situation.

Forensic Definitions

Forensic Accounting

Forensic accounting uses accounting, auditing, and investigative skills to examine a

company’s 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
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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)

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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

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 Syllabus E3b) Describe the major applications of forensic auditing (e.g. fraud,
negligence, insurance claims) and analyse the role of the forensic auditor as an expert
witness.

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

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 Syllabus E3c) Apply the fundamental ethical principles to professional accountants
engaged in forensic audit assignments.

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

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 Syllabus E4: Internal audit

Syllabus E4a) Evaluate the potential impact of an internal audit department on the
planning and performance of the external audit.

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

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Reporting
• Internal Audit
Determined by the nature of the assignment

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

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• Audit Work

Auditing their own work (Self review threat)


Action

Chief internal auditor doesn’t 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

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 Syllabus E4b) Explain the benefits and potential drawbacks of outsourcing internal audit.

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.

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 Syllabus E5: Outsourcing

Syllabus E5a)Explain the different approaches to ‘outsourcing’ and compare with

‘insourcing’.

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

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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 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

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 Syllabus E5b) Discuss and conclude on the advantages and disadvantages of
outsourcing finance and accounting functions.

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.

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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

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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

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 Syllabus E5c) Recognise and evaluate the impact of outsourced functions on the
conduct of an audit.

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

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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

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Syllabus E6: The audit of performance information (pre-
determined objectives) in the public sector

Syllabus E6a) Describe the audit of performance information (pre-determined objectives)

and differentiate from performance auditing.

Audit of performance information

The audit of Performance information isn’t:

An audit of performance - ie. Are the operations effective and offering value for money

The audit of Performance Information is:

The audit of the information about the achievement of a Public sector organisation’s
objectives

So we are looking at information about things like waiting lists in hospitals, league tables
for schools, better staff morale etc

So the key thing is the term information which should be:

• Relevant
• Reliable
• Timely
• Accurate
• Understandable
• Neutral
• Verifiable

So as auditors we provide assurance about the quality of the information the organisation
gives about their objectives

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 Syllabus E6b)  Plan the audit of performance information (pre-determined objectives),
and describe examination procedures to be used in the audit of this type of information.

Plan the audit of performance information

How is such an Information Audit planned?

Step 1: Understand the information in the first place

Ask how it was collected and aggregated?

What systems (and controls) are used in the above

We can do this by discussions with management and then we can document these
processes and systems

Step 2: Inspect the Original Documents

Step 3: Analytical Procedures (comparisons and trends)
Step 4: Get written representations on the accuracy and completeness of the information
Step 5: Re-work some of the calculations
Step 6: Reporting

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 Syllabus E6c)  Discuss the audit criteria of reported performance information, namely
compliance with reporting requirements, usefulness, measurability and reliability. 


Syllabus E6d)  Discuss the form and content of a report on the audit of performance
information


Syllabus E6e)  Discuss the content of an audit conclusion on an integrated report of

performance against pre-determined objectives

Reporting

Contents of a report:

1. Title, addressee
2. Introductory Paragraph (what PI is being reported on)
3. Scope of our work
4. Criteria we used to judge it
5. Management Responsibilities
6. Our Responsibilities (we didn't prepare)
7. Inherent limitations of the Report
8. Summary and Conclusion

Criteria

So we must understand the criteria that is being used. This criteria we will refer to in the
report - e.g.. Waiting list times, feedback of customers etc

Inherent Limitations

Remember how difficult it is to define some of the objectives, and how difficult it can be to
collect the information

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Where is the information used

e.g. In websites, annual reports

We then provide assurance on this information in our report

An example of a public Sector body - a University

Performance information should be relevant to users, e.g. students will be interested in the
quality of the teaching provided and the likelihood of securing employment on completion
of the university course.

Other interested parties will include the government body which provides funding to the
University, regulatory bodies which oversee higher education and any organisations which
support the University’s work, for example, graduate employers. 


So, performance measures such as the graduation rate and employability rate will be
relevant as this will provide information on the success of students in completing their
degree programmes and subsequently obtaining a job.

Students will be interested in the proportion of graduates who achieve a distinction as this
may lead to better job prospects and a better return on the investment (of time and money)
in their education.

Finally, students will find the performance measure on course satisfaction relevant
because it indicates that the majority of students rated the quality of the course as high, an
important factor in deciding whether to enrol onto a degree programme.

Stakeholders other than current and potential students may find other performance
information more relevant to them, for example, potential graduate employers may be
interested in the amount of work experience which is provided on the University’s degree
programme. 


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The performance measures are most relevant where they can be compared to the
measures of other universities.

In terms of measurability, as with many key performance indicators, it is sometimes difficult

to precisely define or measure the performance information. Some of the measures are
quite subjective, for example, the rating which a student gives to a course is down to
personal opinion and it is difficult to substantiate, for example, the difference between a
course rating of excellent and very good.

Similarly, defining ‘graduate level employment’ could be subjective. Some measures will be
easier to quantify, for example, the degree completion percentage, which will be based on
fact rather than opinion. 


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 Syllabus F: REPORTING

Syllabus F1: Auditor’s reports

Syllabus F1a) Determine the form and content of an unmodified audit report and assess
the appropriateness of the contents of an unmodified audit report.

Syllabus F1b) Critically appraise the form and content of an auditor’s report in a given
situation.

Syllabus F1c) Recognise and evaluate the factors to be taken into account when
forming an audit opinion in a given situation and justify audit opinions that are consistent
with the results of audit procedures.

Structure of an Unmodified Audit Report

ISA 700 sets out the elements of an audit report:

The headings are as follows..

1. Title
Clearly indicates that it is the report of an independent auditor

2. Addressee
Addressed appropriately based on the circumstances of the engagement

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 3. Auditor’s Opinion
The first section of the auditor’s report shall include the auditor’s opinion, and shall
have the heading “Opinion.”

If unmodified:
In our opinion, the accompanying financial statements give a true and fair view of [...] in
accordance with [the applicable financial reporting framework].

4. Basis for Opinion

Directly following the Opinion section, with the heading “Basis for Opinion”, that:

States that the audit was conducted in accordance with ISAs

Refers to the section of the auditor’s report that describes the auditor’s responsibilities
Includes a statement that the auditor is independent of the entity
Identifies the IESBA Code
States audit evidence is sufficient and appropriate to provide a basis for the auditor’s
opinion

5. Going Concern
Where applicable, the auditor shall report in accordance with ISA 570

6. Key Audit Matters

Communicate key audit matters in the auditor’s report

7. Responsibilities of Management for the Financial Statements.

In some jurisdictions, the appropriate reference may be to those charged with

governance.

This shall describe management’s responsibility for: (Ref: Para. A40–A43)

Preparing the financial statements / internal controls to prevent MM due to fraud or

error; and
Assessing the entity’s ability to continue as a going concern

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 8. Auditor’s Responsibilities for the Audit of the Financial Statements

This states that the objectives of the auditor are:

To obtain reasonable assurance that FS are free from material misstatement

To state that reasonable assurance is a high level of assurance, but is not a guarantee
that an audit conducted in accordance with ISAs will always detect a material
misstatement when it exists; and

To state that the auditor exercises professional judgment and maintains professional
skepticism throughout the audit

To state that the risk of not detecting a material misstatement resulting from fraud is
higher than for one resulting from error, as fraud may involve collusion, forgery,
intentional omissions, misrepresentations, or the override of internal control.

To obtain an understanding of internal control

To evaluate the appropriateness of accounting policies

To conclude on the appropriateness of management’s use of the going concern basis

To evaluate the overall presentation, structure and content of the financial statements,
including the disclosures, and whether the financial statements represent the
underlying transactions and events in a manner that achieves fair presentation.

Example:

Auditor’s Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial
statements as a whole are free from material misstatement, whether due to fraud or
error, and to issue an auditor’s report that includes our opinion. Reasonable assurance

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 is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists.
Misstatements can arise from fraud or error and are considered material if, individually
or in the aggregate, they could reasonably be expected to influence the economic
decisions of users taken on the basis of these financial statements.

A further description of our responsibilities for the audit of the financial statements is
located at [Organisation’s] website at: [website address]. This description forms part of
our auditor’s report.

9. Other Reporting Responsibilities

Heading titled “Report on Other Legal and Regulatory Requirements” or otherwise as
appropriate to the content of the section

10. Name of the Engagement Partner

The name of the engagement partner shall be included in the auditor’s report for audits
of complete sets of general purpose financial statements of listed entities unless, in
rare circumstances, such disclosure is reasonably expected to lead to a significant
personal security threat

Why?
ISQC 1 requires it plus naming the engagement partner in the auditor’s report is
intended to provide further transparency to the users of the auditor’s report

11. Signature of the Auditor

The auditor’s report shall be signed

12. Auditor’s Address

The auditor’s report shall name the location in the jurisdiction where the auditor
practices.

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 13. Date of the Auditor’s Report
The auditor’s report shall be dated no earlier than the date on which the auditor has
obtained sufficient appropriate audit evidence on which to base the auditor’s opinion on
the financial statements

Why?
The date of the auditor’s report informs the user the auditor has considered the effect
of events and transactions of which the auditor became aware and that occurred up to
that date. Identifies the report as an ‘Independent Auditors Report’

The key things to note about the above are:

A Key audit matters section in the report


A key matter is the most significant matters that came up in the AUDITORS judgement -
NOT those likely to be most important to users

This is because the auditor would otherwise have to:

1) Determine what is important to a user

2) Possibly include 'original information' in the audit report (which may blur the roles of
management, those charged with governance and the auditor). 


These key matters would be selected from the matters the auditor sends to those charged
with governance

Independence

An explicit statement about the auditor’s independence and other relevant ethical
requirements

Engagement partner

Explicitly state the name of the engagement partner

Prominence of opinion

Placed at the beginning of the report

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Ordering 

A preferred (not mandatory) ordering of the items in the report

Going concern 

Explicitly reported on, including the appropriateness of management's use of the going
concern basis and any material uncertainties identified
Auditor responsibilities 

Some responsibilities could be moved to an appendix, or referenced to a website of an
appropriate authority

ISSUES TO THINK ABOUT

Key audit matters disclosure

1. Possibly unnecessary where such matters are already in the Annual Report by those
charged with Governance

2. Whats the difference between an Emphasis of Matter and a Key Audit Matter?

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 auditor’s report is intended solely for the use of the company’s
member, and that no responsibility is accepted or assumed to third parties.

1. Advantages:

– Potential to limit liability exposure

– Clarifies extent of auditor’s responsibility

– Reduces expectation gap

– Manages audit firm’s risk exposure

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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

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 Syllabus F1d) Assess whether or not a proposed audit opinion is appropriate. 


Syllabus F1e) Advise on the actions which may be taken by the auditor in the event that
a modified audit report is issued.

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
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• 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


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• 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

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 Syllabus F1f) Recognise when the use of an emphasis of matter paragraph, other
matter paragraph and KAM disclosure would be appropriate.

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 attention

Emphasis of matter Other matter

What is it? Draws attention to fundamental Draws attention to another issue

issue in the fs 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 The effect on the auditor's
reference to its page or note responsibilities
number

Effect on opinion? None None

Example Uncertainty regarding a Auditor wishes to resign but

contingent liability legally cannot

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 Syllabus F1g) Discuss the courses of action available to an auditor if a material
inconsistency or material misstatement exists in relation to other information such as
contained in the integrated report

What is different in today’s financial reporting

environment?
Well, annual reports now have way more narrative info - with things such as:

The entity’s business model

Risks they face and
Uncertainties

And users like it - as it helps them understand the more complex areas in the financial statements

There’s more documents other than the annual report such as management reports, or
statements on corporate governance / internal control and risk assessment

Sp the IAASB wanted:

• Greater consistency regarding auditors’ consideration of other information;
• Enhanced responsibilities regarding other information; and
• Auditors to state their responsibilities (re other info) in their reports

What are the main changes in relation to the scope and

auditor’s work effort?
The scope of other information

Other information is anything in the annual report (except for the FS and auditors report)

The auditor’s work effort with respect to other information

The auditor must read the other information and see if:

There’s a material inconsistency between the other information and the FS; and
There’s a material inconsistency between the other information and the auditor’s knowledge

The auditor must also remain alert for indications that the other information appears to be
materially misstated, regardless if obtained prior to or after the date of the auditor’s report

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What will be communicated in the auditor’s report about
other information?
The auditor’s report will always include a separate Other Information section

It will include:

A statement that management is responsible for the other information.

1. Identification of the other information obtained
2. A statement that the auditor’s opinion does not cover the other information
3. A description of the auditor’s responsibilities relating to reading, considering and reporting on
other information
4. When other information has been obtained prior to the date of the auditor’s report, either :
A statement that the auditor has nothing to report; or
A statement that describes the uncorrected material misstatement

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Syllabus F2: Reports to those charged with governance
and management

Syllabus F2a) Critically assess the quality of a report to those charged with governance
and management.

. Syllabus F2b) Advise on the content of reports to those charged with

governance and management in a given situation.

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

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Communicate matters of audit importance
Management letter - see above
Specific internal control issues

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Syllabus G: CURRENT ISSUES AND
DEVELOPMENTS

Syllabus G1: Professional and ethical developments

Syllabus G1a) Discuss emerging ethical issues and evaluate the potential impact on the
profession, firms and auditors.
Syllabus G1b) Discuss the content and impact of exposure drafts, consultations and
other pronouncements issued by IFAC and its supporting bodies (including IAASB,
IESBA and TAC)

Ethical framework and a rulebook

Using a Rulebook gives the following advantages:

Certainty - a rule is a rule

Clarity - Rules can be detailed and strict in their interpretation

However these very advantages are weaknesses too (and conversely advantages of using
a framework instead)

Such weaknesses are:

Rules cannot possibly cover all situations

Rules can be interpreted too narrowly - and miss the spirit of the rule in the first place

Rules will struggle to be applied across different national borders


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 Syllabus G2: Transnational audits

Syllabus G2a) Define ‘transnational audits’ and explain the role of the Transnational Audit
Committee (TAC) of IFAC.

Transnational audits

Definition: A transnational audit means an audit of financial statements which are relied
upon outside the audited entity’s home jurisdiction for the purpose of significant lending,
investment or regulatory decisions.

So if a company is listed on the stock exchange of several countries, and is planning to

raise more finance, this means it is subject to the regulations of all stock exchanges on
which it is listed, and so is bound by listing rules outside of its home jurisdiction

The Forum of Firms (FOF, Forum) is an independent association of international

networks of firms that perform transnational audits.

The objective of the Forum is to promote consistent and high-quality standards of financial
reporting and auditing practices worldwide—bringing together firms that perform
transnational audits and involving them more closely with IFAC’s activities in audit and
other assurance-related areas.

Members of the FoF must demonstrate their commitment to adhere to and promote the
consistent application of high-quality audit practices worldwide, as detailed in the FOF
Constitution

Transnational Auditors Committee

The IFAC Transnational Auditors Committee (TAC) serves as the official link between IFAC
and the Forum of Firms. It is broadly responsible for implementing and advancing the
FoF’s objectives and operations, and plays a major role in encouraging members of the
FoF to conduct high-quality international audits by requiring the commitment to comply
with certain international standards as a condition of membership.

The TAC also supports audit quality by:

◦ Identifying audit practice issues and making recommendations to the
appropriate standard-setting boards to review these issues as needed;
◦ Providing a forum to discuss best practices in areas including quality control,
auditing, independence, and training and continuing professional development;
◦ Facilitating interaction among transnational firms, international regulators,
and financial institutions with regard to audit quality, systems of quality control, and
transparency of international networks; and
◦ Identifying qualified candidates to serve on the international standard-setting
boards.

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 Syllabus G2b) Discuss how transnational audits may differ from other audits of historical
financial information (e.g. in terms of applicable financial reporting and auditing
standards, listing requirements and corporate governance requirements).

Transnational audit and audit risk

Application of auditing standards

Although many countries of the world have adopted International Standards on Auditing
(ISAs), not all have done so, choosing instead to use locally developed auditing
regulations.

In addition, some countries use modified versions of ISAs.

This means that in a transnational audit, some components of the group financial
statements will have been audited using a different auditing framework, resulting in
inconsistent audit processes within the group, and potentially reducing the quality of the
audit as a whole.

Regulation and oversight of auditors

Across the world there are many different ways in which the activities of auditors are
regulated and monitored. In some countries the audit profession is self-regulatory,
whereas in other countries a more legislative approach is used.

This also can impact on the quality of audit work in a transnational situation.

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Financial reporting framework

Some countries use IFRS, whereas some use locally developed accounting standards.

Within a transnational group it is likely that adjustments, reconciliations or restatements

may be required in order to comply with the requirements of the jurisdictions relevant to
the group financial statements (i.e. the jurisdiction of the parent company in most cases).

Such reconciliations can be complex and require a high level of technical expertise of the
preparer and the auditor

Corporate governance requirements and consequent control risk

In some countries there are very prescriptive corporate governance requirements, which
the auditor must consider as part of the audit process.

In this case the auditor may need to carry out extra work over and above local
requirements in order to ensure group wide compliance with the requirements of the
jurisdictions relevant to the financial statements.

However, in some countries there is very little corporate governance regulation at all and
controls are likely to be weaker than in other components of the group.

Control risk is therefore likely to differ between the various subsidiaries making up the
group


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 Syllabus G3: The audit of social, environmental and
integrated reporting

Syllabus G3a) Plan an engagement to provide assurance on integrated reporting

(performance measures and sustainability indicators).

Syllabus G3g) .Discuss the form and content of an independent verification statement
of an integrated report

Purpose and content of an integrated report

To explain to providers of financial capital how an organisation creates value

over time

The ‘building blocks’ of an integrated report are:

Guiding principles

These underpin the integrated report

They guide the content of the report and how it is presented

Content elements

These are the key categories of information 

They are a series of questions rather than a prescriptive list

Guiding Principles
1. Are you showing an insight into the future strategy..?
2. Are you showing a holistic picture of the the organisation's ability to create value over
time?

Look at the combination, inter-relatedness and dependencies between the factors that
affect this
3. Are you showing the quality of your stakeholder relationships?

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4. Are you disclosing information about matters that materially affect your ability to create
value over the short, medium and long term?
5. Are you being concise? 

Not being burdened by less relevant information
6. Are you showing Reliability, completeness, consistency and comparability when
showing your own ability to create value.

Content Elements
1. Organisational overview and external environment

What does the organisation do and what are the circumstances under which it
operates?
2. Governance

How does an organisation’s governance structure support its ability to create value in
the short, medium and long term?
3. Business model 

What is the organisation’s business model?
4. Risks and opportunities 

What are the specific risk and opportunities that affect the organisation’s ability to
create value over the short, medium and long term, and how is the organisation dealing
with them?
5. Strategy and resource allocation

Where does the organisation want to go and how does it intend to get there?
6. Performance

To what extent has the organisation achieved its strategic objectives for the period and
what are its outcomes in terms of effects on the capitals?
7. Outlook

What challenges and uncertainties is the organisation likely to encounter in pursuing its
strategy, and what are the potential implications for its business model and future
performance?

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