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chapter I
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Introduction
Topic List
I
Role of auditing
2
The audit process
3
Statutory audit requirement
4
Legal responsibilities
5
International standards on auditing
6
Quality control
7
Documentation
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
Role of auditing
1.1
1.2
1.3
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1.4
Definition
True: The information in the financial statements is not false and conforms to reality.
In practical terms this means that the information is presented in accordance with accounting standards
and law. The f1nancial statements have been correctly extracted from the underlying records and
those records reflect the actual transactions which took place.
Definition
Fair: The financial statements reflect the commercial substance of the company's underlying transactions
and the information is free from bias.
You will have come across examples of the application of substance over form in your financial reporting
studies e.g. the treatment of a finance lease.
The problem with making judgements such as these is that they can be called into question, particularly
where others have the benefit of hindsight. The major defence that the auditor has in this situation is to
show that the work was performed with due skill and care and that the judgements made about truth
and fairness were reasonable based on the evidence available at the time. We will look at quality control in
Section 6 of this chapter. Auditor liability is covered in Chapter I 0.
2.1
Overview
You will have covered the audit process in you earlier studies. The following diagram summarises the key
points you should be familiar with. Chapters 4 - 6 of this text cover the audit in more detail.
Point to note
BSA 200 requires that the audit should be planned and performed with an attitude of professional
scepticism.
3.1
4 Legal responsibilities
4.1
4.2
Directors' responsibilities
These duties are as follows:
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Fiduciary Duty
Directors are fiduciaries and must, therefore, display the utmost good faith towards the company in
their dealings with it or on its behalf. They must act bona fide, in what they believe to be the best
interests of the company. They must exercise their powers for the particular purpose for which they
were conferred and not for some extraneous purpose, even though they honestly believe that to be in
the best interest of the company. But the most important feature of the fiduciary nature of their duties
is that they must not fetter their discretion to exercise their powers from time to time in accordance
with the foregoing rules. Also they must not, without the consent of the company, place themselves in
a position in which there is a conflict between their duties and personal interests. Good faith must not
only be done but must manifestly be seen to be done, and the law will not allow a person acting in a
f1duciary capacity to place himself in a situation in which his judgment is likely to be biased.
Accounting records
A company is required to keep proper books of account, which are sufficient to show and explain
the company's transactions. Failure to do so may render every officer of the company liable to a fine
or imprisonment.
In addition to the statutory requirement, the directors have an overriding responsibility to ensure they
have adequate information to enable them to fulfil their duty of managing the company's business.
(c) the amount, if any, which the board recommends should be paid by way of dividend;
{d) material changes and commitments, if any, affecting the financial position of the company which
have occurred between the end to the financial year of the company of which the balance sheet
related and the date of the report:
(2) The board's report shall, so far as is material for the appreciation of the state of company's affairs
by its members, deal with any changes which have occurred during the financial year:{a) in the nature of the company's business;
(b) in the company's subsidiaries or in the nature of the business carried on by them; and
(c) generally in the classes of business in which the company has an interest.
{3) The board shall also be bound to give the fullest information and explanations in its report
aforesaid on every reservation, qualification or adverse remark contained in the auditor's report.
(4) The board's report and any addendum thereto shall be signed by its chairman if he is authorised in
that behalf by the board, and, where he is not so authorised, shall be signed by such number of
director as are required to sign the balance sheet and the profit and loss account or the income and
expenditure account of the company.
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4.3
Loans to Directors
Section I03 prohibits loans or guarantee or securities in favour of directors. This section follows section
860 of the Act of 1913 which was introduced in the company law of our country by the amending Act of
1936. A further amendment in 1938 extended the operation of the rule to loans to private companies in
which any director of the lending company was a member. Section I08 (I) (g) provides that the office of a
director shall be vacated if a director or any firm of which he is a partner or any private company of which
he is a director accepts a loan or guarantee from the company in contravention of section I03.
A private company may give or guarantee a loan if the loan is sanctioned by the board and the general
meeting and does not exceed fifty percent of the paid up value of the shares held by the director in his own
name. A contravention of section I03 may, in addition to the vacation of the office of the director, entail a
fine of five thousand taka or a simple imprisonment for six months in lieu of fine for every person who is a
party to such a contravention. Regulation 78 in the First Schedule to the Act also provides that the office of
a director shall be vacated if the director accepts a loan from the company.
4.4
Auditors' responsibilities
Under the Companies Act 1994, it is the external auditor's responsibility to form an independent
opinion on the truth and fairness of the financial statements
The auditor will also report by exception on the following. Whether:
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Proper returns, adequate for audit purposes, have been received from branches
5.1
Introduction
You will have covered the regulatory framework affecting the issue of International Standards on Auditing
(ISAs) including the role of the International Auditing and Assurance Standards Board (IAASB) in your Audit
and Assurance studies at the professional level. This section therefore provides a brief summary of the key
points.
5.2
Overview
The system in Bangladesh currently works as follows:
IAASB
Issues
BSA as used by
Bangladesh
Auditors
ICAB
Adopts
5.3
5.3.1
International Standards on Quality Control (ISQCs) (applicable to all engagements carried out
under any of the IAASB's standards)
International Audit Practice Statements (lAPS). lAPS provide interpretive guidance and practical
assistance to professional accountants in implementing ISAs and to promote good practice.
5.3.2
Authority of ISAs
ISAs are to be applied in the audit of historical financial information.
In exceptional circumstances, an auditor may judge it necessary to depart from an ISA in order to
more effectively achieve the objective of an audit. When such a situation arises, the auditor should be
prepared to justify the departure.
5.3.3
Working procedures
The working procedures of the IAASB can be summarised as follows
5.4
5.4.1
Once approved the exposure draft is distributed to member bodies of IFAC (and other international
organisations that have an interest in auditing standards) for comment
A revised exposure draft is issued after consideration of the comments received by the IAASB
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5.4.2
Identification of the broad areas by the Technical and Research Committee (TRC) for formulating the
Accounting/Auditing Standards
Constitution of the study groups by the TRC for preparing the preliminary drafts of the proposed
Accounting/ Auditing Standards
Consideration of the preliminary drafts prepared by the study groups by the TRC and revision, if any,
of the drafts on the basis of deliberations at the TRC
Consideration of the drafts Accounting/ Auditing Standards by the Councii-ICAB and if found
necessary, modification of the drafts in consultation with the TRC
The Accounting/ Auditing Standards, so finalised, are issued under the authority of the Councii-ICAB as
Bangladesh Accounting Standards (BAS), and Bangladesh Standards on Auditing (BSA)
5.5
Clarity Project
The IAASB is in the middle of a clarity project, during which they are reissuing existing ISAs, with the aim of
making the requirements within them clearer.
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5.5.1
5.5.2
Redrafted ISAs
To date the following ISAs have been reissued in the clarity form. These new standards make no significant
changes to the auditor's responsibilities but have been reworded in line with the aims of the Clarity Project.
ISA 230 (Redrafted) Audit Documentation
ISA 240 (Redrafted) The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements
ISA 250 (Redrafted) Consideration
Financial Statements
I0
6 Quality control
6.1
6.2
6.2.1
Purpose of BSQC I
The purpose of BSQC I is to ensure that firms establish a system of quality control designed to provide
it with reasonable assurance that the firm and its personnel comply with professional standards and
regulatory and legal requirements, and that reports issued by the firm or engagement partners are
appropriate in the circumstances.
6.2.2
(I)
II
Ethical requirements
Policies and procedures should be designed to provide the firm with reasonable assurance that the
firm and its personnel comply with relevant ethical requirements.
The policies and procedures should be in line with the fundamental principles, which should be
reinforced by:
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At least annually, the firm should obtain written confirmation of compliance with its policies and
procedures on independence from all firm personnel required to be independent by ethical
requirements.
(3)
(4)
Is competent to perform the engagement and has the necessary time and resources
Can comply with ethical requirements including appropriate independence from the client
Human resources
The firm's overriding desire for quality will necessitate policies and procedures on ensuring
excellence in its staff, to provide the firm with 'reasonable assurance that it has sufficient personnel
with the capabilities, competence, and commitment to ethical principles necessary to perform its
engagements in accordance with professional standards and regulatory and legal requirements, and to
enable the firm or engagement partners to issue reports that are appropriate in the circumstances'.
These will cover the following issues:
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Recruitment
Performance evaluation
Capabilities
Competence
Career development
Promotion
Compensation
The firm is responsible for the ongoing excellence of its staff, through continuing professional
development, education, work experience and coaching by more experienced staff.
The assignment of engagement teams is an important matter in ensuring the quality of an
individual assignment.
This responsibility is given to the audit engagement partner. The firm should have policies and
procedures in place to ensure that
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Key members of client staff and those charged with governance are aware of the identity of
the audit engagement partner
The engagement partner has appropriate capabilities, competence, authority and time to
perform the role
The engagement partner should ensure that he assigns staff of sufficient capabilities, competence and
time to individual assignments so that he will be able to issue an appropriate report.
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(5)
Engagement performance
The firm should take steps to ensure that engagements are performed correctly, that is, in a~cordance
with standards and guidance. Firms often produce a manual of standard engagement procedures to
give to all staff so that they know the standards they are working towards. These may be electronic.
Ensuring good engagement performance involves a number of issues:
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Direction
Supervision
Review
Consultation
Resolution of disputes
Many of these issues will be discussed in the context of an individual audit assignment (see below).
The firm should have policies and procedures to determine when a quality control reviewer will be
necessary for an engagement. This will include all audits of financial statements for listed companies.
When required, such a review must be completed before the report is signed.
The firm must also have standards as to what constitutes a suitable quality control review.
In particular the following issues must be addressed.
For listed companies in particular the review should include:
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The engagement team's evaluation of the firm's independence in relation to the specific
engagement
Significant risks identified during the engagement and the responses to those risks
Whether appropriate consultation has taken place on matters involving differences of opinion or
other difficult or contentious matters, and the conclusions arising from those consultations
The significance and disposition of corrected and uncorrected misstatements identified during the
engagement
(6)
The matters to be communicated to management and those charged with governance and, where
applicable, other parties such as regulatory bodies
Whether working papers selected for review reflect the work performed in relation to the
significant judgements and support the conclusions reached
Monitoring
The standard states that firms must have policies in place to ensure that their quality control
procedures are:
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Relevant
Adequate
Operating effectively
Complied with
In other wqrds, they must monitor their system of quality control. Monitoring activity should be
reported on to the management of the firm on an annual basis.
There are two types of monitoring activity, an ongoing evaluation of the system of quality control
and period inspection of a selection of completed engagements. An ongoing evaluation might include
such questions as, 'has it kept up to date with regulatory requirements?'
A period inspection cycle would usually fall over a period such as three years, in which time, at least
one engagement per engagement partner would be reviewed.
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Point to note
All quality control policies and procedures 'should be documented and communicated to the firm's
personnel'
6.2.3
Practical application
The ICAEW Audit and Assurance Faculty publication Quality Control in the Audit Environment: A practical guide
for frrms on implementing ISQC I recommends that firms take the following key steps to give them
confidence that they are compliant with ISQC I:
6.3
Lead from the top giving a consistent message on the importance of quality control
Focus on the right clients being matched by the right skills with emphasis on integrity and
competencies
Maintain capable and competent staff giving due attention to the firm's human resources policies and
procedures
Deliver quality audits consulting when needed and meeting requirements for engagement quality
control review
Monitor the firm's system of quality control and carry out a periodic objective inspection of a
selection of completed audit engagements
6.3.1
Direction
At the planning stage, but also during the audit, the engagement partner ensures that the members of
the engagement team are informed of:
Their responsibilities
The nature of the entity's business
Risk issues
Problems that may arise
Detailed approach to the audit engagement
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Supervision
Supervision includes:
Tracking the process of the audit engagement
Considering the capabilities of individual members of the engagement team and that they
understand their instructions
Addressing issues that arise and modifying the audit approach if appropriate
Identifying matters for consultation or consideration by more senior members of the audit
engagement.
Review
Reviewing concerns the inspection of work by engagement members by more senior members of the
same engagement. This includes ensuring that:
The work has been carried out in accordance with professional and regulatory requirements
Significant matters are given further consideration
Appropriate consultations have taken place and have been documented
Where appropriate the planned audit work is revised
The work performed supports the conclusions
The evidence obtained supports the audit opinion
The objectives of the engagement have been achieved
6.3.2
Practical application
The ICAEW Audit and Assurance Faculty publication Audit Quality identifies the following as major factors
which drive audit quality:
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Leadership
This involves:
Setting the strategies and objectives
Recognising the commonality of commercial and professional approaches
Ensuring the organisation will deliver the required quality
Setting the right tone at the top
Ensuring quality is consistently communicated
People
Audit quality is highly dependent on the quality of the people. Staff need to be both competent and
motivated. Training and development must be an integral part of professional life.
Client relationships
Managing client relationships involves:
Clearly defining the responsibilities of the auditor and management
Assessing whether the audit partner and the audit firm is objective and independent but still close
enough to have a good understanding of the business
Managing communications with the client management and audit committee so that issues are
dealt with on a regular and timely basis.
Working practices
Good working practices include:
A clear understanding of roles and responsibilities by all members of the audit team
The application of sufficient thought at each stage of the audit
Audit work should be performed with alertness of mind, professional scepticism and rigour
Completion procedures must be performed and audit conclusions carefully considered
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Internal monitoring
This essentially represents an 'internal audit' performed by staff independent of the audit team.
External monitoring
External monitoring is to be carried out through the ICAB QAD visit. Reports from the QAD visit
provide independent feedback on a firm's quality review processes and provide an opportunity to
measure them against good practice elsewhere.
Member bodies should adopt or develop quality control standards and relevant guidance that require
firms to establish quality control policies and procedures
Member bodies should develop quality review programs designed to evaluate whether firms have
established and complied with appropriate quality control policies and procedures and are complying
with those
Member bodies should require firms to make improvements in their quality control policies and
procedures where improvement is required. Corrective action should be taken where the firm fails to
comply with relevant professional standards. Educational or disciplinary measures may be necessary.
You are an audit senior working for the firm Addystone Fish. You are currently carrying out the audit of
Wicker Ltd, a manufacturer of waste paper bins. You are unhappy with Wicker's inventory valuation policy
and have raised the issue several times with the audit manager. He has dealt with the client for a number of
years and does not see what you are making a fuss about. He has refused to meet you on site to discuss
these issues.
The former engagement partner to Wicker retired two months ago. As the audit manager had dealt with Wicker
for so many years, the other partners have decided to leave the audit of Wicker largely in his hands.
Requirement
Comment on the situation outlined above.
I6
7 Documentation
7 .I
Audit documentation
Audit documentation is a key part of the overall quality control framework during the course of an audit.
All audit work must be documented: the working papers are the tangible evidence of all work done in
support of the audit opinion. BSA 230 Audit Documentation provides guidance on this issue.
In your previous studies, you have learnt the practical issues surrounding how audit papers should be
completed. The key general rule concerning what to include on a working paper to remember, is:
'What would be necessary to provide an experienced auditor, with no previous connection with the
audit, with an understanding of the nature, timing, and extent of the audit procedures performed to
comply with the ISAs and applicable legal and regulatory requirements and the results of the audit
procedures and the audit evidence obtained, and significant matters arising during the audit and the
conclusions reached thereon.'
The key reason for having audit papers therefore is that they provide evidence of work done. They may be
required in the event of litigation arising over the audit work and opinion given.
The BSA sets out certain requirements about what should be recorded, such as the identifying
characteristics of the specific items being tested.
It also sets out points an auditor should record in relation to significant matters. These include:
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How the auditor addressed information that appeared to be inconsistent with his conclusions in
relation to significant matters.
If an auditor felt it necessary to depart from customary audit work required by audit standards, he should
document why, and how the different test achieved audit objectives.
The BSA also contains details about how the audit file should be put together and actions in the event of
audit work being added after the date of the audit report (for example, if subsequent events results in
additional work being carried out}. You should be familiar with these points from your earlier studies.
7.2
R~view
We shall briefly revise here the review of working papers. Review of working papers is important, as it
allows a more senior auditor to evaluate the evidence obtained during the course of the audit for
sufficiency and reliability, so that more evidence can be obtained to support the audit opinion, if required. lt.
is an important quality control procedure.
Work performed by each assistant should be reviewed by personnel of appropriate experience to consider
whether:
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The work has been performed in accordance with the audit programme.
The work performed and the results obtained have been adequately documented.
Any significant matters have been resolved or are reflected in audit conclusions.
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The conclusions expressed are consistent with the results of the work performed and support the
audit opinion.
The results of control and substantive procedures and the conclusions drawn including the
results of consultations
The financial statements, proposed audit adjustments and the proposed auditors' report
In some cases, particularly in large complex audits, personnel not involved in the audit may be asked to
review some or all of the audit work, the auditors' report etc. This is sometimes called a peer review or
hot review.
Viewco is a manufacturer of TVs and video recorders. It carries out a full physical inventory count at its
central warehouse every year on 31 December, its financial year-end. Finished goods are normally of the
order of CU3 million, with components and work in progress normally approximately CUI million.
You are the audit senior responsible for the audit of Viewco for the year ending 31 December 20X I.
Together with a junior member of staff, you will be attending Viewco's physical inventory count.
Requirements
(a)
(b)
State, giving reasons, what information the working papers relating to this inventory count attendance
should contain.
You are the audit senior on the audit ofTrucksToGo Ltd. You are supervising the work of a relatively
inexperienced audit junior. The junior has been carrying out audit procedures on the assertions of
completeness and existence of non-current assets. According to the junior, audit work has been completed
and the memo below has been produced outlining some of the issues found during the audit.
Memo: Issues identified during audit
The directors have confirmed that there are no further non-current assets to include in the financial
statements. This representation was received in a meeting with the Finance Director and recorded on the
audit file at this time.
Part of the existence work on non-current assets included obtaining a sample of assets from the asset
register and then physically verifying those assets. Unfortunately, a significant number of assets were not
available for verification- the vehicles were in use by the company and therefore not on the premises. As
an alternative, vehicles on the premises were agreed back to the asset register.
A number of vehicles were noted on the company premises in a poor state of repair; for example, engines
missing. On enquiry, the vehicle manager confirmed that the vehicles were under repair. I am therefore
happy that the vehicles belonged to the company and no further action is necessary.
I have reached the conclusion that all non-current assets are correctly stated and valued in the financial
statements.
I8
Requirement
Explain to the junior why the evidence collected is insufficient, and detail the action necessary to complete
the audit procedures. Refer to your objectives in reviewing audit documentation as a format for your
answer.
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Summary
21
chapter 2
Ethics
Introduction
Topic List
I
Relevance of ethics
33
ETHICS
Relevance of ethics
1.1
Introduction
In general terms ethics is a set of moral principles and standards of correct behaviour. Far from
being noble ideals which have little impact on real life they are essential for any society to operate and
function effectively. Put simply, they help to differentiate between right and wrong, although their
application often involves complex issues, judgement and decisions. Whilst ethical principles can be
incorporated into law in many cases their application has to depend on the self-discipline of the individual.
This principle can be seen to apply to society as a whole, the business community and the accounting
profession.
From your knowledge brought forward from your previous studies, and any practical experience of auditing
you may have, write down as many potential ethical risk areas concerning audit as you can in the areas
below. (Some issues may be relevant in more than one column.)
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1.2
Ethics in business
Business life is a fruitful source of ethical dilemmas because its whole purpose is material gain, the making of
profit. Success in business requires a constant search for potential advantage over others and business
people are under pressure to do whatever yields such an advantage. As a result organisations have become
increasingly under pressure to act and to be seen to be acting ethically. In recent years many have
demonstrated this by publishing ethical codes, setting out their values and responsibilities towards
stakeholders.
1.3
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Clients
Lenders
Governments
Employers
Employees
Investors
The business and financial community
Others who rely on the work of the professional accountant
For the work of the accountant in practice or in business to maintain its value the accountant must be
respected and trusted. The individual professional accountant therefore has a duty and a responsibility to
maintain the reputation of the profession and the confidence of the public.
As a key aspect of reputation and professionalism is ethical behaviour the accounting profession has
developed ethical codes of conduct. These include:
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IFAC Code
ICAB Code of Conducts
They provide guidance on what constitutes ethical behaviour and also provide assistance on determining the
right course of action where problems are encountered. This not only ensures that the highest standards
36
ETHICS
are maintained but also provides protection for the professional providing a benchmark against which
any alleged failings can be measured.
1.4
List the factors which you think may have affected Betty Vinson's decision to make the fraudulent entries.
What other courses of action could she have taken?
See Answer at the end of this chapter.
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2.1
Fundamental principles
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2.2
The IFAC Code is based on the principle that integrity, objectivity and independence are subject to
various threats and that safeguards must be in place to counter these.
Self-interest threat
Self-review threat
Advocacy threat
Intimidation threat
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The IFAC Code considers that there are two general categories of safeguard:
(I}
(2}
Safeguards in the work environment may differ according to whether a professional accountant works
in public practice, in business or in insolvency.
When evaluating safeguards what a reasonable and informed third party, having knowledge of all
relevant information, including the significance of the threat and the safeguards applied, would
conclude to be unacceptable should be considered.
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ETHICS
2.3
Professional appointment
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2.4
Confidentiality
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Information received in confidence should not be disclosed except in the following circumstances:
Where disclosure is permitted by law and is
authorised by the client or the employer.
For example:
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Confidential information should not be used for personal advantage or the advantage of third parties
e.g. insider trading
Applying this guidance will involve difficult judgements, particularly in making the decision as to
whether disclosure is in the public interest. Other specific matters which may need to be
considered include:
BSA 240 The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements
(see Chapter I0)
BSA 250 Considerations
2.5
I0)
Conflicts of interest
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Conflicts of interest and confidentiality are related matters. Where a conflict of interest arises, one of
the key issues is whether it will be possible to keep information confidential.
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Where safeguards do not mitigate the risks sufficiently the professional accountant should not
accept the engagement or should cease to act for one of the parties.
You are the Engagement Partner at Stewart Brice, a firm of Chartered Accountants. The following
situations exist.
Teresa is the audit manager assigned to the audit of Recreate, a large quoted company. The audit has been
ongoing for one week. Yesterday, Teresa's husband inherited 1,000 shares in Recreate. Teresa's husband
wants to hold on to the shares as an investment.
The Stewart Brice pension scheme, which is administered by Friends Benevolent, an unconnected company,
owns shares in Tadpole Group, a listed company with a number of subsidiaries. Stewart Brice has recently
been invited to tender for the audit of one of the subsidiary companies, Kermit Co.
Stewart Brice has been the auditor of Kripps Bros, a limited liability company, for a number of years. It is a
requirement of Kripps Bros' constitution that the auditor owns a token CUI share in the company.
Requirement
Comment on the ethical and other professional issues raised by the above matters.
Identify the ethical and professional issues Stewart Brice would need to consider.
See Answer at the end of this chapter.
3.1
Where these are in conflict the public interest should take priority.
40
ETHICS
The ICAB Code sets out a framework that accountants can follow when faced with these issues, which may
be set out as framework as follows, and you may find useful when considering ethical problems in the exam.
The ICAB Code suggests that the resolution process should consider the following:
----------------------------------------------------------Relevant facts
This may involve:
Relevant parties
---------------------These include:
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Immediate superior
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consultation.
Alternative courses of action
Symbolic consequences
Where the conflict is significant and cannot be resolved the accountant would need to seek legal advice.
After exhausting all other possibilities and depending on the nature of the conflict, the individual may
conclude that withdrawal from the engagement team or resignation from the firm/employing organisation is
appropriate.
Point to note
Withdrawal/resignation would be seen very much as a last resort.
41
3.2
Exam context
Ethical issues will have been examined in the Knowledge and Application stage papers. However, at the
Advanced stage you will be faced with more complex situations. More emphasis will be placed on your
ability to use your judgement in the light of the facts provided, rather than testing your knowledge of the
ethical codes and standards in detail. In some instances the correct action may be uncertain and it will be
your ability to identify the range of possible outcomes which will be important rather than concluding
on a single course of action.
You should also be aware that the term 'ethics' will be used in a much broader sense than it has been in the
earlier Assurance and Audit and Assurance papers. It is likely to be combined with financial reporting,
business and tax issues where you may be required to assess the ethical judgements made by others
including management. You may also be asked to consider the issue from the point of view of the
accountant in practice and the accountant in business.
The following Interactive question demonstrates these points.
You are the auditor of Bellevue Ltd for the year ended 31 December 20X8. The company provides
information to the financial services sector and is run by the managing director, Toby Stobbart. It has a
venture capital investment of which part is in the form of a loan. The investment agreement details a
covenant designed to protect the loan. This states an interest cover of 2 is required as a minimum i.e. the
company must be able to cover interest and loan principal repayments with profits at least twice.
70% of the revenue of the business is subscription based and contracts are typically 3 years in duration. 30%
of the revenue is for consultancy work which is billed on completion of the work. Consultancy projects are
for a maximum of 2 months.
During the previous year the management performed a review of the subscription revenue and concluded
that 40% of this represented consultancy work and should therefore be recognised in the first year of the
contract rather than being recognised over the duration of the contract as had previously been the case.
The audit file for 20X7 indicates that this treatment had been questioned vigorously by the audit manager
but had been agreed with the audit partner, James Cowell. James Cowell subsequently left the firm abruptly.
You have received a copy of the 20X8 draft accounts which show an interest cover of 2.02 for 20X7 and
2.0 I for 20X8. You have also been told that a similar review of subscription income has been made for
20X8 with 40% being reclassified as consultancy work as in the previous year.
What are the issues that you as auditor would need to consider in this situation?
See Answer at the end of this chapter.
42
ETHICS
Summary
43
chapter 3
Governance
Introduction
Topic List
I
Associated guidance
Sarbanes-Oxley
65
GOVERNANCE
1.1
Introduction
Corporate governance potentially covers a wide range of issues and disciplines from company secretarial
and legal through business strategy, executive and non-executive management and investor relations to
accounting and information systems.
Corporate governance issues came to prominence in the business world from the late 1980s. The main
drivers associated with the increasing demand for developments in this area included the following:
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Financial reporting
Issues concerning financial reporting were raised by many investors and were the focus of much
debate and litigation. Shareholder confidence in what was being reported in many instances was
eroded. Whilst corporate governance development is not just about better financial reporting
requirements, the regulation of creative accounting practices, such as off-balance sheet financing,
has led to greater transparency and a reduction in risks faced by investors.
Corporate scandals
The early 1990s saw an increasing number of high profile corporate scandals and collapses including
Polly Peck International, BCCI, and Maxwell Communications Corporation. This prompted the
development of governance codes in the early 1990s. However, the scandals since then, including
En ron, have raised questions about further measures that may be necessary.
1.2
67
Definition
Corporate governance: The system by which organisations are directed and controlled.
An alternative definition is:
Corporate governance: The set of processes, customs, policies, laws and institutions affecting the way in
which an entity is directed, administered or controlled. Corporate governance serves the needs of
shareholders, and other stakeholders, by directing and controlling management activities towards good
business practices, objectivity and integrity in order to satisfy the objectives of the entity.
Specifies the distribution rights and responsibilities among different participants in the
corporation, such as the board, managers, shareholders and other stakeholders
Spells out the rules and procedures for making decisions on corporate affairs
1.3
Provides a framework for an organisation to pursue its strategy in an ethical and effective way and
offers safeguards against the misuse of resources, human, financial, physical or intellectual
1.3.1
1.3.2
1.3.3
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GOVERNANCE
1.3.4
Lack of supervision
Employees who are not properly supervised can create large losses for the organisation through their own
incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the employee who caused
the collapse of Barings bank was not challenged because he appeared to be successful, whereas he was using
unauthorised accounts to cover up his large trading losses. Leeson was able to do this because he was in
charge of dealing and settlement, a systems weakness or lack of segregation of key roles that was
featured in other financial frauds.
1.3.5
1.3.6
1.3.7
1.3.8
69
One view of governance is that it is based on a series of underlying concepts. These are important as
good corporate governance depends on a willingness to apply the spirit of the guidance as well as the
letter ofthe law.
2.1
Fairness
The directors' deliberations and also the systems and values that underlie the company must be balanced
by taking into account everyone who has a legitimate interest in the company, and respecting their rights
and views. In many jurisdictions, corporate governance guidelines reinforce legal protection for certain
groups, for example minority shareholders.
2.2
Openness/transparency
In the context of corporate governance, transparency means corporate disclosure to stakeholders.
Disclosure in this context obviously includes information in the financial statements, not just the numbers
and notes to the accounts but also narrative statements such as the directors' report and the operating and
financial review. It also includes all voluntary disclosure, that is disclosure above the minimum required
by law or regulation. Voluntary corporate communications include:
~
~
~
Management forecasts
Analysts' presentations
Press releases
Information placed on websites
Other reports such as stand-alone environmental or social reports.
The main reason why transparency is so important relates to the agency problem, that is the potential
conflict between owners and managers. Without effective disclosure the position could be unfairly weighted
towards managers, since they normally have far more knowledge of the company's activities and financial
situation than owners/investors. Reducing this information asymmetry requires not only effective
disclosure rules, but strong internal controls that ensure that the information that is disclosed is reliable.
2.3
Independence
Independence is an important concept in relation to directors (as well as auditors). Corporate governance
reports have increasingly stressed the importance of independent non-executive directors; directors
who are not primarily employed by the company and who have very strictly controlled other links with it.
They should be free from conflicts of interest and in a better position to promote the interests of
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GOVERNANCE
shareholders and other stakeholders. Freed from pressures that could influence their activities,
independent non-executive directors should be able to carry out effective monitoring of the company in
conjunction with independent external auditors on behalf of shareholders and other stakeholders.
2.4
Probity/honesty
Hopefully this should be the most self-evident of the principles, relating not only to telling the truth, but
also not misleading shareholders and other stakeholders by presenting information in a biased way.
2.5
Responsibility
For management to be held properly responsible, there must be a system in place that allows for
corrective action and penalising mismanagement. Responsible management should do, when
necessary, whatever it takes to set the company on the right path.
The board of directors must act responsively to, and with responsibility towards, all stakeholders of the
company. However the responsibility of directors to other stakeholders, both in terms of to whom they
are responsible and the extent of their responsibility, remains a key point of contention in corporate
governance debates.
2.6
Accountability
Corporate accountability refers to whether an organisation (and its directors) are answerable in some
way for the consequences of their actions.
The UK Combined Code emphasises that boards of directors are accountable to shareholders. (See section
3). However, the Code stresses that making the accountability work is the responsibility of both parties.
Directors, as we have seen, do so through the quality of information that they provide whereas
shareholders do so through their willingness to exercise their responsibility as owners, which means
using the available mechanisms to query and assess the actions of the board.
As with responsibility one of the biggest debates in corporate governance is the extent of management's
accountability towards other stakeholders such as the community within which the organisation
operates.
2. 7
Reputation
In the same way directors' concern for an organisation's reputation will be demonstrated by the extent to
which they fulfil the other principles of corporate governance. There are purely commercial reasons for
promoting the organisation's reputation, that the price of publicly traded shares is often dependent on
reputation and hence reputation is often a very valuable asset of the organisation.
2.8 judgement
Judgement means the board making decisions that enhance the prosperity of the organisation. This
means that board members must acquire a broad enough knowledge of the business and its
environment to be able to provide meaningful direction to it. This has implications not only for the
attention directors have to give to the organisation's affairs, but also the way the directors are recruited
and trained.
The complexities of senior management mean that the directors have to bring multiple conceptual skills
to management that aim to maximise long-term returns. This means that corporate governance can involve
balancing many competing people and resource claims against each other.
71
2.9
Integrity
The UK Combined Code provides the following definition:
Definition
Integrity: Straightforward dealing and completeness. What is required of financial reporting is that it
should be honest and that it should present a balanced picture of the state of the company's affairs. The
integrity of reports depends on the integrity of those who prepare and present them.
Integrity can be taken as meaning someone of high moral character, who sticks to principles no matter
the pressure to do otherwise. In working life this means adhering to principles of professionalism and
probity. Straightforward dealing in relationships with the different people and constituencies whom
you meet is particularly important; trust is vital in relationships and belief in the integrity of those with
whom you are dealing underpins this.
The UK Combined Code definition highlights the need for personal honesty and integrity of preparers
of accounts. This implies qualities beyond a mechanical adherence to accounting or ethical regulations or
guidelines. At times accountants will have to use judgement or face financial situations which aren't covered
by regulations or guidance, and on these occasions integrity is particularly important.
Integrity is an essential principle of the corporate governance relationship, particularly in relation to
representing shareholder interests and exercising agency. As with financial reporting guidance, ethical codes
don't cover all situations and therefore depend for their effectiveness on the qualities of the accountant. In
addition we have seen that a key aim of corporate governance is to inspire confidence in participants in the
market and this significantly depends upon a public perception of competence and integrity.
3.1
72
GOVERNANCE
exist, the Board of those companies should be constituted as may be prescribed by such primary regulators
in so far as those prescriptions are not inconsistent with the aforesaid condition.
(f) There are no significant doubts upon the issuer company's ability to continue as a going concern. If the
issuer company is not considered to be a going concern, the fact along with reasons thereof should be
disclosed.
(g) Significant deviations from last year in operating results of the issuer company should be highlighted and
reasons thereof should be explained. (h) Key operating and financial data of at least preceding three years
should be summarised.
(i) If the issuer company has not declared dividend (cash or stock) for the year, the reasons thereof should
be given.
73
(j} The number of Board meetings held during the year and attendance by each director should be
disclosed.
(k} The pattern of shareholding should be reported to disclose the aggregate number of shares (along with
name wise details where stated below) held by:(i} Parent/Subsidiary/Associated companies and other related parties (name wise details);
(ii} Directors, Chief Executive Officer, Company Secretary, Chief Financial Officer,
Head of Internal Audit and their spouses and minor children (name wise details);
(iii) Executives; and
(iv) Shareholders holding ten percent (I 0%) or more voting interest in the company (name wise details).
Explanation: For the purpose of this clause, the expression "executive" means top five salaried employees of
the company, other than the Directors, Chief Executive Officer, Company
Secretary, Chief Financial Officer and Head of Internal Audit.
3.1.2 Chief Financial Officer (CFO), Head Of Internal Audit And Company Secretary:
3.1.2.1 Appointment
The company should appoint a Chief Financial Officer (CFO), a Head of Internal Audit and a Company
Secretary. The Board of Directors should clearly define respective roles, responsibilities and duties of the
CFO, the Head of Internal Audit and the Company Secretary.
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GOVERNANCE
(ii) The Chairman of the audit committee should have a professional qualification or knowledge,
understanding and experience in accounting or finance.
3.1.3.3. Reporting of the Audit Committee
3.1.3.3.1 Reporting to the Board of Directors
(i) The Audit Committee should report on its activities to the Board of Directors.
(ii) The Audit Committee should immediately report to the Board of Directors on the following findings, if
any:(a) Report on conflicts of interests;
(b) Suspected or presumed fraud or irregularity or material defect in the internal control system;
(c) Suspected infringement of laws, including securities related laws, rules and regulations; and
(d) Any other matter which should be disclosed to the Board of Directors immediately.
3.1.3.3.2 Reporting to the Authorities
If the Audit Committee has reported to the Board of Directors about anything which has material impact
on the financial condition and results of operation and has discussed with the
Board of Directors and the management that any rectification is necessary and if the Audit Committee finds
that such rectification has been unreasonably ignored, the Audit Committee should report such finding to
the Commission, upon reporting of such matters to the Board of Directors for three times or completion
of a period of 9 (nine) months from the date of first reporting to the Board of Directors, whichever is
earlier.
3.1.3.3.3. Reporting to the Shareholders and General Investors
Report on activities carried out by the Audit Committee, including any report made to the Board of
Directors under condition 1.7.3.1 (ii) above during the year, should be signed by the Chairman of the Audit
Committee and disclosed in the annual report of the issuer company.
75
3.2
76
GOVERNANCE
Review the efficiency and effectiveness of internal audit function;
Review that findings and recommendations made by the internal auditors for removing the irregularities
detected and running the affairs of the bank are duly considered by the management.
External audit
Review the audit performance of the external auditors and their audit reports
Review that findings and recommendations made by the external auditors for removing the irregularities
detected and also running the affairs of the. bank are duly considered by the management
Make recommendations to the board regarding the appointment of the external auditors.
Compliance with existing laws and regulations
Review whether the laws and regulations framed by the regulatory authorities (central bank and other
bodies) and internal regulations approved by the board have been complied with.
Other responsibilities
Place compliance report before the board on quarterly basis regarding regularisation of the errors and
omissions fraud and forgeries and other irregularities as detected by the internal and external auditors and
inspectors of regulatory authorities/Bangladesh Bank.
Perform other oversight functions as requested by the board and evaluate the committee's own
performance on a regular basis.
3.2.2 Bangladesh Bank has also issued a guideline on the implementation of 'Money Laundering
Prevention Act 2002'.
3.2.3 Bangladesh Bank has issued guidelines for managing core risks in banking companies as
well as internal control implementation techniques for banking companies.
3.3
77
Advanc~d
C. Accountability/audit:
I Audit committee and auditors
2 Disclosure on share trading
3 Financial reporting and annual report.
D. Relations with shareholders:
I Rights of shareholders
I. The board should include a balance of executive and non-executive directors (including some
independent non-executive directors) such that no individual or small group of individuals can
dominate the board's decision taking.
A Composition of Board
B Executive and Non-executive Directors and Independent Directors
C. Independent Director
2. Chairman and Chief Executive (A2)
Board Should lay down solid foundation for oversight and management of the company through:
- Clear division of responsibilities of the Chairperson of the board and the Chief Executive;
- Recognizing and publishing respective roles of the board and management; and
- Establishing an effective ethics and compliance framework
A Chairperson and Lead Independent Director
B Role of Chairperson
C Powers, Functions & Responsibilities of BOD
D Ethics and Values
E Meetings of BOD
F The Company Secretary
G Matters to be placed before BOD
3. Members of the Board and its Committees should not be over extended. All directors should
receive induction training upon joining the board and there should be an effective orientation
program for directors to regularly update and refresh their skills and knowledge. (A3)
A Qualification and Eligibility to act as Director
B Election of directors
C Training of BOD
4. Board should establish a process of performance evaluation in the company to ensure its sustained
success. (A4)
A Evaluation of BOD as a whole and that of individual directors
B Evaluation of CEO
C Committees of the BOD
5. Levels of remuneration should be sufficient to attract, retain and motivate directors and members
of senior management of the quality required to run the company successfully, but the company
should avoid paying more than is necessary for this purpose. A reasonable proportion of executive
directors' remuneration should be structured so as to link rewards to corporate and individual
performance. (B I)
A Remuneration Committee
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GOVERNANCE
6. The board should ensure planned and progressive refreshing of the board. (B2)
A Nomination Committee
Powers, Functions and Responsibilities of Nomination Committee
7. The board should establish formal and transparent arrangements for considering how they should
apply the financial reporting and internal control principles and for maintaining an appropriate
relationship with the company's auditors. (C I)
A Audit Committee
B Internal Control and Internal Audit
C Appointment & Qualification of External Auditors
D Disclosure of interest by Auditors' holding company's shares
9. The board should present a balanced and understandable assessment of company's position and
prospects through periodic financial reporting which shall include certain other information together
with certain statements/declarations by the directors and the management of the company. (C3)
A Annual Report
B Report on Corporate Governance
I0. Board should respect the rights of shareholders and facilitate the effective exercise of those
rights. (D I)
A Relationship with Shareholder
The Corporate Governance Code is a SEC requirement for listed companies. It is recommended for other
companies. Some argue that the code should be mandatory for all companies.
Requirement
(a)
Discuss the benefits of the Code to shareholders and other interested users of financial statements.
(b)
Discuss the merits and drawbacks of having such provisions in the form of a voluntary code.
79
4.1
Scope of role
If the board is to act effectively, its role must be defined carefully. The Cad bury report suggests that the
board should have a formal schedule of matters specifically reserved to it for decision. Some would be
decisions such as mergers and takeovers that are fundamental to the business and hence should not
be taken just by executive managers. Other decisions would include acquisitions and disposals of assets
of the company or its subsidiaries that are material to the company and investments, capital projects,
bank borrowing facilities, loans and their repayment, foreign currency transactions, all above a certain size
(to be determined by the board).
Other tasks the board should perform include:
~
Overseeing strategy
Monitoring the human capital aspects of the company in regard to succession, morale, training,
remuneration etc.
Ensuring that there is effective communication of its strategic plans, both internally and externally
80
GOVERNANCE
4.2.1
Nomination committee
In order to ensure that balance of the board is maintained, the board should set up a nomination
committee, to oversee the process for board appointments and make recommendations to the board.
The Combined Code recommends that a majority of the committee members should be independent nonexecutive directors.
The nomination committee needs to consider the balance between executives and independent nonexecutives, the skills and knowledge possessed by the board, the need for continuity and succession
planning and the desirable size of the board. Recent corporate governance guidance has laid more stress on
the need to attract board members from a diversity of backgrounds.
The nomination committee should also be responsible for reviewing the time required from nonexecutive directors, as a basis for deciding whether the non-executive directors are spending enough time
on the company's activities. The nomination committee should also brief newly-appointed non-executive
directors about what is expected of them in terms of time commitments, committee service and
4.3
4.4
Performance of board
Appraisal of the board's performance is an important control over it. The Higgs report recommends that
performance of the board should be assessed once a year. Separate appraisal of the chairman and
chief executive should also be carried out, with links to the remuneration process.
4.5
4.6
Non-executive directors
Non-executive directors have no executive (managerial) responsibilities.
Non-executive directors should provide a balancing influence, and play a key role in reducing conflicts
of interest between management (including executive directors) and shareholders. They should provide
reassurance to shareholders, particularly institutional shareholders, that management is acting in the
interests of the organisation.
81
4.6.1
Companies operating in international markets could benefit from having at least one non-executive
director with international experience
Lawyers, accountants and consultants can bring skills that are useful to the board
Including individuals with charitable or public sector experience but strong commercial awareness can
increase the breadth of diversity and experience on the board
4.6.2
Strategy: non-executive directors should contribute to, and challenge the direction of, strategy.
Risk: non-executive directors should satisfy themselves that financial information is accurate and that
financial controls and systems of risk management are robust.
Directors and managers: non-executive directors are responsible for determining appropriate
levels of remuneration for executives, and are key figures in the appointment and removal of senior
managers and in succession planning.
82
They may have external experience and knowledge which executive directors do not
possess. The experience they bring can be in many different fields. They may be executive directors
of other companies, and thus have experience of different ways of approaching corporate governance,
internal controls or performance assessment. They can also bring knowledge of markets within which
the company operates.
Non-executive directors can provide a wider perspective than executive directors who may be
more involved in detailed operations.
Good non-executive directors are often a comfort factor for third parties such as investors or
creditors.
The English businessman Sir John Harvey-Jones has pointed out that there are certain roles nonexecutive directors are well-suited to play. These include 'father-confessor' (being a confidant for the
chairman and other directors), 'oil-can' (intervening to make the board run more effectively) and
acting as 'high sheriff (if necessary taking steps to remove the chairman or chief executive).
The most important advantage perhaps lies in the dual nature of the non-executive director's role.
Non-executive directors are full board members who are expected to have the level of knowledge
that full board membership implies. At the same time they are meant to provide the so-called strong,
independent element on the board. This should imply that they have the knowledge and
detachment to be able to assess fairly the remuneration of executive directors when serving on the
remuneration committee, and to be able to discuss knowledgeably with auditors the affairs of the
company on the audit committee.
GOVERNANCE
4.6.3
4.6.4
In many organisations, non-executive directors may lack independence. There are in practice a
number of ways in which non-executive directors can be linked to a company, as suppliers or
customers for example. Even if there is no direct connection, potential non-executive directors are
more likely to agree to serve if they admire the company's chairman or its way of operating.
There may be a prejudice in certain companies against widening the recruitment of non-executive
directors to include people proposed other than by the board or to include stakeholder
representatives.
High-calibre non-executive directors may gravitate towards the best-run companies, rather than
companies which are more in need of input from good non-executives.
Non-executive directors may have difficulty imposing their views upon the board. It may be easy to
dismiss the views of non-executive directors as irrelevant to the company's needs. This may imply that
non-executive directors need good persuasive skills to influence other directors. Moreover, if
executive directors are determined to push through a controversial policy, it may prove difficult for
the more disparate group of non-executive directors to oppose them effectively.
Sir John Harvey-Jones has suggested that not enough emphasis is given to the role of non-executive
directors in preventing trouble, in warning early on of potential problems. But on the contrary,
when trouble does arise, non-executive directors may be expected to play a major role in rescuing the
situation, which they may not be able to do.
Perhaps the biggest problem which non-executive directors face is the limited time they can devote
to the role. If they are to contribute valuably, they are likely to have time-consuming other
commitments. In the time they have available to act as non-executive directors, they must contribute
as knowledgeable members of the full board and fulfil their legal responsibilities as directors. They
must also serve on board committees. Their responsibilities mean that their time must be managed
effectively, and they must be able to focus on areas where the value they add is greatest.
4.6.5
Non-executive directors should have no business, financial or other connection with the
company, apart from fees and shareholdings. Recent reports such as the Higgs report have widened
the scope of business connections to include anyone w.ho has been an employee or had a material
business relationship over the last few years, or served on the board for more than ten years.
They should not take part in share option schemes and their service should not be pensionable,
to maintain their independent status.
Appointments should be for a specified term and reappointment should not be automatic. The
board as a whole should decide on their nomination and selection.
83
Procedures should exist whereby non-executive directors may take independent advice, at the
company's expense if necessary.
Whenever a question scenario features non-executive directors, watch out for threats to, or questions
over, their independence.
4.6.6
Multi-tier boards
Some jurisdictions take the split between executive and other directors to its furthest extent. Institutional
arrangements in German companies are based on a two-tiered board. A supervisory board has
workers' representatives, and perhaps shareholders' representatives including banks' representatives, in
equal numbers. The board has no executive function, although it does review the company's direction and
strategy and is responsible for safeguarding stakeholders' interests. An executive board, composed
entirely of managers, will be responsible for the running of the business.
In Japan there are three different types of board of director.
~
Functional boards -made up of the main senior executives with a functional role
Monocratic boards - with few responsibilities and having a more symbolic role
Proposals to introduce two (or more) tier boards have been particularly criticised in the UK and USA as
leading to confusion and a lack of accountability. This has affected the debate on enhancing the role of nonexecutive directors, with critics claiming that moves to increase the involvement of non-executive directors
are a step on the slippery slope towards two-tier boards.
S Associated guidance
-5.1
5.1.1
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GOVERNANCE
it did emphasise the importance of companies reporting on their internal controls and risk management
procedures.
5.1.2
~
~
~
The Turnbull Report emphasises that the guidance aims to reflect sound business practice, as well as to help
companies comply with the internal control requirements of the Combined Code.
5.1.3
"-
The revised 2005 Turnbull Report clarifies that directors will be expected to apply the same standard
of care when reviewing the effectiveness of internal control as when exercising their general duties.
Management
~
~
Employees
~
5.1.4
Necessary knowledge, skills, authority etc to establish, operate and monitor the system of internal
controls.
Control environment- the tone set from the top of the organisation.
(2)
Risk assessment- process to identify major risks and assess their impact.
(3)
Information systems- include monthly reporting, comparison with budgets etc as well as nonfinancial performance indicators.
(4)
Control procedures- internal controls to overcome risk (segregation of duties, authorisation, etc)
(5)
Monitoring - procedures designed to assure the board that the system is managing risk (audit
committees, internal audit, etc.)
85
Points to note
These five headings are essentially the same as the five components of internal control identified in BSA 315
Understanding the Entity and its Environment and Assessing the Risks
of Material Misstatement
Many perceive the overall control environment as the key component of internal control. Its importance
can be seen in the following worked example.
5.1.5
Internal control
The Board has overall responsibility for the system of
internal controls, including risk management, and has
delegated certain responsibilities to the Audit Committee.
The Audit Committee has reviewed the effectiveness of
the system of internal control and ensured that any
required remedial action has or is being taken on any
identified weaknesses. The system of internal controls is
designed to manage rather than eliminate the risk of
failure to achieve the Company's business objectives
and can only provide reasonable and not absolute
assurance against material misstatement or loss. It
includes all controls including financial, operational and
compliance controls and risk management. The
processes used to assess the effectiveness of the
internal control systems are ongoing, enabling a
cumulative assessment to be made, and include the
following:
86
GOVERNANCE
Report and Financial Statements and accords with the
Turnbull guidance. The effectiveness of the process is
reviewed annually by the Audit Committee which then
reports to the Board. The process consists of:
fonnal identification by management at each level
of the Company through a self assessment
process of the key risks to achieving their business
objectives and the controls in place to manage
them. The likelihood and potential impact of each
risk is evaluated and actions necessary to mitigate
them are identified and monitored;
The Turnbull Report requires Boards to confirm in the annual report that necessary action has been, or is
being, taken to remedy any significant failings or weaknesses identified from their review of the
effectiveness of the internal control system. The Board should also include in the annual report such
information as is considered necessary to assist shareholders' understanding of the main features of the
company's risk management processes and system of internal control.
Audit committees
Audit committees of independent non-executive directors should liaise with external audit, supervise
internal audit, and review the annual accounts and internal controls.
The Cadbury committee summed up the benefits that an audit committee can bring to an organisation.
'If they operate effectively, audit committees can bring significant benefits. In particular, they have the
potential to:
5.2.2
(a)
improve the quality of financial reporting, by reviewing the financial statements on behalf of the Board;
(b)
create a climate of discipline and control which will reduce the opportunity for fraud;
(c)
enable the non-executive directors to contribute an independent judgement and play a positive role;
(d)
help the finance director, by providing a forum in which he can raise issues of concern, and which he
can use to get things done which might otherwise be difficult;
(e)
strengthen the position of the external auditor, by providing a channel of communication and forum
for issues of concern;
(f)
provide a framework within which the external auditor can assert his independence in the event of a
dispute with management;
(g)
strengthen the position of the internal audit function, by providing a greater degree of independence
from management;
(h)
Recommendations
Following the major corporate failures in the US in 2002, an independent group, chaired by Sir Robert
Smith, was set up to clarify the role and responsibilities of audit committees and to develop the existing
Combined Code guidance. The report was issued in January 2003.
The key points, which are now reflected in the Combined Code and the detailed guidance, are set out
below.
87
The committee must include at least three members, all independent non-executive directors .
.,
At least one member must have significant, recent and relevant financial experience, and all members
must be given suitable training.
To monitor the integrity of the company's financial statements, reviewing significant financial
reporting judgements .
.,
To review the company's internal financial control system and risk management systems
(unless covered by a separate risk committee or the board itself) .
.,
.,
To recommend to the board which firm should be appointed as external auditor. If the board rejects
this recommendation, the committee and the board must explain their respective positions in the
annual report.
.,
To monitor and review the independence, objectivity and effectiveness of the external auditor,
taking into account relevant UK professional and regulatory requirements .
.,
To develop and implement policy on the engagement of the external auditor to supply non-audit
services, taking into account relevant ethical guidance regarding the provision of non-audit services by
the external audit firm.
Other
.,
.,
Its activities should be reported in a separate section of the directors' report (within the annual
report) .
.,
The chairman of the committee should be present to answer questions at the AGM.
Disclosures
The disclosures in the accounts are as follows:
.,
.,
.,
.,
5.3
5.3.1
88
.,
An open, fair and rigorous appointments process designed to promote meritocracy in the
boardroom and to widen the pool of candidates .
.,
.,
The roles of chairman and chief executive to be separated (with the chief executive not progressing
to become chairman of the same company) .
.,
A new definition of 'independence', addressing both relationships that would affect a director's
objectivity and also those that could appear to do so. At least half the board would need to meet the
new test, as would all members of the audit and remuneration committees and a majority of the
nomination committee.
GOVERNANCE
~
The performance of individual directors and of the board as a whole recommended to be evaluated at
least annually.
Directors'
remuneration
Shareholders
and theAGM
Accountability
and audit
------------------
The company should set up an audit committee to liaise between the board
and the external and internal auditors;
The committee should keep under review the nature and extent of non-audit
services provided by the audit firm;
There should be written terms of reference which deal clearly with its authority
and duties.
In addition, the audit committee should review the scope and results of the audit
and its cost-effectiveness. It should report to the board on:
89
5.3.2
Clarity as to the audit committee's role, which will normally include the duty to challenge management
in respect of the financial reporting process, to monitor management's commitment to a sound
internal control environment and to appoint and fix the remuneration of the external auditors;
Frank communication between the external auditors and the committee, dealing with all significant
issues, even sensitive ones, in an open manner. This may require the bypassing of management and
direct contact with the committee, if potentially contentious situations arise;
At the completion of the audit, discussion between the external auditors and the committee about any
non-compliance with laws and regulations, the control environment, significant adjustments made, and
not made, to the financial statements and how any differences between the auditors and management
have been resolved, or not resolved.
Northwitch Ltd is a multinational energy group, quoted on the London and Dhaka Stock Exchanges.
The chief executive (and chairman), David Spence, was appointed four months before the year end for a
term of three years. He is keen to impose his views on the group and the audit. He has already made clear
that his Ipswich Town private box (CU 14,535), purchased through the company, will be made available only
to those who remain loyal to his cause.
Requirement
Outline any governance and related issues arising from David's appointment.
See Answer at the end of this chapter.
6.1
90
GOVERNANCE
6.2
OECD guidance
The Organisation for Economic Co-operation and Development (OECD) has carried out an extensive
consultation with member countries, and developed a set of principles of corporate governance that
countries and companies should work towards achieving. The OECD has stated that its interest in
corporate governance arises from its concern for global investment. Corporate governance
arrangements should be credible and should be understood across national borders. Having a common set
of accepted principles is a step towards achieving this aim.
The OECD developed its Principles of Corporate Governance in 1998 and issued a revised version in April
2004. They are non-binding principles, intended to assist governments in their efforts to evaluate and
improve the legal, institutional and regulatory framework for corporate governance in their countries.
They are also intended to provide guidance to stock exchanges, investors and companies. The focus is on
stock exchange listed companies, but many of the principles can also apply to private companies and stateowned organisations.
The OECD principles deal mainly with governance problems that result from the separation of
ownenhip and management of a company. Issues of ethical concern and environmental issues are also
relevant, although not central to the problems of governance.
6.3
OECD principles
The OECD principles are grouped into five broad areas:
(i)
(ii)
91
7 Sarbanes-Oxley
7.I
92
GOVERNANCE
~
Information asymmetry
That is the agency problem of the directors/managers knowing more than the investors. The investors
included Enron's employees. Many had their personal wealth tied up in Enron shares, which ended up
being worthless. They were actively discouraged from selling them. Many of En ron's directors,
however, sold the shares when they began to fall, potentially profiting from them. It is alleged that the
Chief Financial Officer, Andrew Fastow, concealed the gains he made from his involvement with
affiliated companies.
7.2
'-~~
Along with rules from the Securities and Exchange Commission, Sarbanes-Oxley requires companies to
increase their financial statement disclosures, to have an internal code of ethics and to impose
restrictions on share trading by, and loans to, corporate officers.
7.3
:;,w;.
"<~~-
Auditing standards
Audit firms should retain working papen for at least seven years and have quality control
standards in place such as second partner review. As part of the audit they should review internal
control systems to ensure that they reflect the transactions of the client and provide reasonable
assurance that the transactions are recorded in a manner that will permit preparation of the
financial statements in accordance with generally accepted accounting principles. They
should also review records to check whether receipts and payments are being made only in
accordance with management's authorisation.
93
Non-audit services
Auditors are expressly prohibited from carrying out a number of services including internal audit,
bookkeeping, systems design and implementation, appraisal or valuation services, actuarial services,
management functions and human resources, investment management, legal and expert services.
Provision of other non-audit services is only allowed with the prior approval of the audit
committee.
Audit committees
Audit committees should be established by all listed companies.
All members of audit committees should be independent and should therefore not accept any
consulting or advisory fee from the company or be affiliated to it. At least one member should be a
financial expert. Audit committees should be responsible for the appointment, compensation and
oversight of auditors. Audit committees should establish mechanisms for dealing with complaints
about accounting, internal controls and audit.
Corporate responsibility
The chief executive officer and chief finance officer should certify the appropriateness of the financial
statements and that those financial statements fairly present the operations and financial condition of
the issuer. If the company has to prepare a restatement of accounts due to material non-compliance
with standards, the chief finance officer and chief executive officer should forfeit their bonuses.
Whistleblowing provisions
Employees of listed companies and auditors will be granted whistleblower protection against
their employers if they disclose private employer information to parties involved in a fraud claim.
94
GOVERNANCE
7.4
7.5
7.6
Criticisms of Sarbanes-Oxley
Sarbanes-Oxley has been criticised in some quarters for not being strong enough on certain issues, for
example the selection of external auditors by the audit committee, and at the same time being over-rigid on
others. Directors may be less likely to consult lawyers in the first place if they believe that legislation could
override lawyer-client privilege.
In addition it has been alleged that a Sarbanes-Oxley compliance industry has sprung up focusing companies'
attention on complying with all aspects of the legislation, significant or much less important. This has
distracted companies from improving information flows to the market and then allowing the market to
make well-informed decisions. The Act has also done little to address the temptation provided by generous
stock options to inflate profits, other than requiring possible forfeiture if accounts are subsequently
restated.
Most significantly perhaps there is recent evidence of companies turning away from the US Stock markets
and towards other markets such as London. An article in the Financial Times suggested that this was partly
due to companies tiring of the increased compliance costs associated with Sarbanes-Oxley
implementation. In addition the nature of the regulatory regime may be an increasingly significant factor
in listing decisions.
95
8.1
Auditors' responsibilities
As we have seen in section 3, companies are required to provide a disclosure regarding compliance with
the conditions of the SEC corporate governance notification. As required under BSA 720, auditors should
review the compliance statement.
These include sections which deal with the following matters
~
In order to conduct the review the auditor will need to obtain audit evidence to support the compliance
statement. The following general procedures are those usually performed by the auditor:
8.2
Reviewing the minutes of the meetings of the board of directors, and of relevant board committees
Reviewing supporting documents prepared for the board of directors or board committees that are
relevant to those matters specified for review by the auditor
Making enquiries of certain directors (such as the chairman of the board of directors and the chairman
of relevant board committees) and the company secretary
Attending meetings of the audit committee at which the annual report and accounts, including the
statement of compliance are considered and approved for submission to the board of directors.
96
GOVERNANCE
misunderstanding on the scope of the auditors' role, the Bulletin recommends that the following wording be
used in the audit report.
'We are not required to consider whether the board's statements on internal control cover all risks
and controls, or form an opinion on the effectiveness of the company's corporate governance
procedures or its risk and control procedures.'
It is particularly important for auditors to communicate quickly to the directors any material weaknesses
they find, because of the requirements for the directors to make a statement on internal control.
The directors are required to consider the material internal control aspects of any significant problems
disclosed in the accounts. Auditors' work on this is the same as on other aspects of the statement; the
auditors are not required to consider whether the internal control processes will remedy the problem.
The auditors may report by exception if problems arise such as:
(a)
The board's summary of the process of review of internal control effectiveness does not reflect
the auditors' understanding of that process.
(b)
The processes that deal with material internal control aspects of significant problems do not
reflect the auditors' understanding of those processes.
(c)
The board has not made an appropriate disclosure if it has failed to conduct an annual review, or
the disclosure made is not consistent with the auditors' understanding.
97
Summary
98
chapter I 0
Introduction
Topic List
I
Fraud
2
Money laundering
Auditor liability
407
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Introduction
As mentioned in Chapter 3, the OECD developed a set of principles for Corporate Governance in 1998
with a revised version being issued in 2004. The ultimate aim of these principles and any corporate
governance is to minimise business risk. Fraud is a contributing factor to business risk
The recently released Global Economic Crime Survey by PwC (PricewaterhouseCoopers) illustrated that
businesses have in fact failed to tackle fraud appropriately. In the UK the average cost of fraud to a business
was 0.8m in 2005 and this has risen to 1.75m in 2007.
Whilst one would hope that businesses were trying to address and minimise fraud, it is clear that the
opposite is happening. Businesses are, in fact in many cases complacent when it comes to fraud. The PwC
survey revealed that of the companies surveyed only 17% of them believed that they would be a victim of
fraud and yet 48% of the companies had been affected. In addition, 49% of the UK cases involved an
overseas party.
With this in mind it remains clear that fraud is still a risk to business and to the auditor. Whilst management
may still have a complacent attitude towards fraud the same cannot be said for the auditor. The risk is too
high.
1.2
What is fraud?
Definition
Fraud: Fraud is an intentional act by one or more individuals among management, those charged with
governance (management fraud), employees (employee fraud) or third parties involving the use of deception
to obtain an unjust or illegal advantage. Fraud may be perpetrated by an individual, or colluded in with
people internal or external to the business.
The Fraud Act 2006 of UK came into force in january 2007. The Act defines three classes of fraud:
~
~
~
An offence has occurred in any of these classes if a person has acted dishonestly and with the intent of
making a gain for themselves or for someone else, or of inflicting a loss on someone else.
409
1.3
~
~
Such fraud may be carried out by overriding controls that would otherwise appear to be operating
effectively, for example, by recording fictitious journal entries or improperly adjusting assumptions or
estimates used in financial reporting.
You will recall in the Parmalat example in Chapter 5 that the scenario also raises the question as to
whether auditors can simply rely on bank confirmations when they relate to substantial sums of assets. Do
these confirmations constitute sufficient and appropriate audit evidence?
There is also another form of fraudulent financial reporting known as AEM (Aggressive earnings
management). It is a topical issue and, at its most aggressive, may constitute fraudulent financial reporting.
AEM is an example of creative accounting. It occurs when management alter the financial reports in
order to mislead stakeholders about the financial position or performance of the business or to influence
the outcome of contracts. It usually involves the artificial enhancement of revenue and profit. Businesses are
likely to be at risk of this when:
~
4I0
There has been an adverse market reaction and so management may want to present a healthier
picture about the company than there is
Management bonuses are tied into targets and there may be a personal conflict between what
management want for themselves and what is good for the company.
The business wants to reduce its tax liabilities and in this case profits may be deliberately reduced
The business needs to remain within certain financial parameters (limits, ratios) in order to achieve
new funding or so as not to be in breach of loan covenants. The parameters will be set to try and
protect the lender and the incentive for the business will be to remain within the limits in order to
keep the funding. Profit overstatement could be an issue as well as understatement of liabilities and
overstatement of assets.
Auditors should be on the alert for issues such as unsuitable revenue recognition, unnecessary accruals,
reduced liabilities, overstatement of provisions, reserves accounting and large numbers of immaterial
breaches of financial reporting requirements to see whether together, they constitute fraud.
1.4
Misappropriation of assets
This is the theft of the entity's assets (for example, cash, inventory). Employees may be involved in such
fraud in small and immaterial amounts, however, it can also be carried out by management for larger items
who may then conceal the misappropriation, for example by:
~
~
~
~
1.5
1.6
41 I
BSA 240.27
Members of the engagement team should discuss the susceptibility of the entity's financial statements to
material misstatements due to fraud.
You are an audit partner of Dupi Ltd. The company operates a chain of sandwich bars throughout the south
of England. The company is owned by 3 directors. At your last meeting with the client you were informed
that the company was hoping to expand and open up some shops in the north of England. The directors
had not yet formalised the strategy for the expansion or its financing.
You have received the following letter:
'I have been an employee of this company for a number of years. Unfortunately, I have come across some
information which I am not sure what to do about. There have been a number of journals relating to
revenue for which I have not been able to obtain an explanation. The effect of these journals is to increase
revenue substantially. Not sure if this is relevant to you'.
The planning meeting with the audit team for this year's audit is scheduled for next week.
Requirement
What are the issues that you would raise at the planning meeting?
See Answer at the end of this chapter.
I. 7
Obtaining an Understanding
of the Entity and its Environment and Assessing the Risk of Material Misstatement,
which will include assessing the risk of fraud. These procedures will include:
~
Inquiries of management and those charged with governance (e.g. as to whether there have been any
incidences of fraud, the nature of the fraud and the outcome)
Consideration of when fraud risk factors are present (some businesses are more susceptible to
fraudulent activity than others e.g. poor control environment, cash based business, dominant senior
management, poor staff relations, need for more finance, increased competition, poor market
performance)
Consideration of results of analytical procedures (e.g. any unusual fluctuations in business year on year
ratios and also those compared to industry norm)
In identifying the risks of fraud, the auditor is required by the BSA to carry out some specific procedures.
Requirement
Following on from Dupi Ltd (Interactive Question I), outline the information that the auditor would seek
from the client.
See Answer at the end of this chapter.
41 2
I .8
As mentioned at the beginning of this chapter BSA 240 splits fraud into two types:
~
Appendix I to BSA 240 provides further analysis of these types of fraud depending on the conditions that
exist in the client's business community:
Incentives/pressures
Opportunities
Attitudes/rationalisations
~
~
FRAUDULENT ..
FINANCIAL REPORT'ING
IJ>o
IJ>o
IJ>o
IJ>o
OpPortunitieS
Attitudes/rationalisations
Ineffective communication or
enforcement of the entity's .
values or ethical standards by
management
IJ>o Known history of violations of
secuiitles laws or other . laws and
regulations .
1J>o A practice bY. management of
. . comm!ttfng to achieve aggressive
or unrealistic forecasts
IJ>o Low morale among senior
manage111ent
.
IJ>o Relationship between
management and the current or
predecessor auditor is strained
IJ>o.
group
Complex or unstable
organisational strUcture
..... lntemal.contro.l. components
are deficient
IJ>o
Incentives/pressures
IJ>o
IJ>o
. hand or p~essed.. ..
...
lnV~ntory'kerfis
#a...
small
lri .size; en high Value, or in high
demand~ .
.over assets
41 3
BSA 240.57
When identifying and assessing the risks of material misstatement at the financial statement level, and at the
assertion level for classes of transactions, account balances and disclosures, the auditor should identify and
assess the risks of material misstatement due to fraud. Those assessed risks that could result in a material
misstatement due to fraud are significant risks and accordingly, to the extent not already done so, the
auditor should evaluate the design of the entity's related controls, including relevant control
activities, and determine whether they have been implemented.
The auditor:
~
~
~
You are an audit manager for Elle and Emm. You are carrying out the planning of the audit of Sellfones Ltd,
a high street retailer of mobile phones in Bangladesh, for the year ending 30 September 20X7. The notes
from your planning meeting with Pami Desai, the financial director, include the following:
One of Sellfones' main competitors ceased trading during the year due to the increasing pressure on
margins in the industry and competition from online retailers.
2
A new management structure has been implemented, with I0 new divisional managers appointed
during the year. The high street shops have been allocated to these managers, with approximately 20
branch managers reporting to each divisional manager. The divisional managers have been set
challenging financial targets for their areas with substantial bonuses offered to incentivise them to meet
the targets. The board of directors have also decided to cut the amount that will be paid to shop staff
as a holiday season bonus.
In response to recommendations in the prior year's Report to Management, a new inventory system
has been implemented. There were some teething problems in its first months of operation but a
report has been submitted to the board by Steven Maclennan, the chief accountant, confirming that
the problems have all been resolved and that information produced by the system will be accurate.
Pami commented that the chief accountant has had to work very long hours to deal with this new
system, often working at weekends and even refusing to take any leave until the system was running
properly.
The company is planning to raise new capital through a share issue after the year end in order to
finance expansion of the business into other countries in Europe. As a result, Pami has requested that
the auditor's report is signed off by 15 December 20X7 (6 weeks earlier than in previous years).
CUm
Revenue
Cost of sales
Gross profit
Operating expenses
Exceptional profit on
sale of properties
Profit before tax
6
414
320
215
105
(89)
CUm
280
199
Revenue
Cost of sales
Gross profit
8T
Operating expenses
(70)
30
40
-II
Several shop properties owned by the company were sold under sale and leaseback arrangements.
Requirement
(a)
Identify and explain any fraud risk factors that the audit team should consider when planning the audit
of Sellfones Ltd.
{b)
Link the fraud risk to what could go wrong in the financial statements of Sellfones
(c)
Consider the likely magnitude of any potential misstatement in the financial statements for Sellfones
for the year ended 30 September 20X7.
1.9
Requirement
Following on from Questions I and 2, outline the steps that the auditor should now integrate into the audit
procedures for Dupi Ltd.
See Answer at the end of this chapter.
1.1 0
1.1 I
Documentation
The auditor must document:
~
~
~
~
~
I .I 2
Reporting
There are various reporting requirements in BSA 240.
BSA 240.93
If the auditor has identified a fraud or has obtained information that indicates a fraud may exist, the auditor
should communicate these matters as soon as practicable to the appropriate level of management.
41 S
BSA240.95
If the auditor has identified fraud involving:
(a)
Management
(b)
(c)
Others, where the fraud results in a material misstatement in the financial statements the auditor
should communicate these matters to those charged with governance as soon as practicable.
The auditor should also make relevant parties within the entity aware of material weaknesses in the
design or implementation of controls to prevent and detect fraud which have come to the auditor's
attention, and consider whether there are any other relevant matters to bring to the attention of those
charged with governance with regard to fraud.
The auditor may have a statutory duty to report fraudulent behaviour to regulators outside the entity. If no
such legal duty arises, the auditor must consider whether to do so would breach their professional duty of
confidence. In either event, the auditor should take legal advice.
1.13
'The sub-prime lender meltdown in the US has seen Grant Thornton resign as auditor for two
troubled lenders, the companies have revealed in separate regulatory filings'.
Accredited Home Lenders Holding and Fremont General said separately that Grant Thornton had
resigned as their auditor after advising them that it needed to 'significantly expand' the scope of its audit of
their 2006 financial statements.
News of Grant Thornton's resignation came at the same time that New Century Financial, a leader in the
once-booming subprime lending industry, filed for bankruptcy.
'Akintola Williams Deloitte (AWD) is stepping down from the role after 40 years in the wake of the
accounting issues that have plagued the subsidiary'.
After conducting an impairment review at the beleaguered Nigerian arm Cadbury stated in its year-end
results that the scandal had forced the company to issue a further 15m goodwill write-down. This
followed a 23m exceptional charge in the wake of overstatements for 'current and prior years.'
Cadbury said: 'After more than 40 years of service, Akintola Williams Deloitte has resigned from its
appointment as auditors to Cadbury Nigeria (CN) by mutual agreement, effective immediately.
'Following the recent disclosure of overstatement in CN's financial position and subsequent need for
restatement, we mutually believe that it would be in the interests of shareholders and in the spirit of the
highest standards of corporate governance for AWD to stand down.'
Cad bury Nigeria were careful to rule out any suggestion that the Deloitte division was involved in the
deception that led to the overstatements:
'While, thus far, there has been no suggestion of complicity by AWD in the overstatements, AWD accepts
that best practice in corporate governance requires that Cadbury Nigeria commences its rebirth on a
completely fresh slate.'
Cadbury added: 'A new auditor will be appointed by Cadbury Nigeria as soon as practicable.'
41 6
I .14
Requiring auditors to report to boards and audit committees on the adequacy of controls to
prevent and detect fraud
Extending the auditor's responsibilities - research indicates that extra work by auditors with the
inevitable extra costs is likely to make little difference to the detection of fraud because:
1.1 5
More than half of frauds involve misstated financial reporting but do not include diversion of
funds from the company
Far more is spent on investigating and prosecuting fraud in a company than on its audit
Current developments
The IAASB have issued ISA 240 (Redrafted) The Auditor's Responsibilities Relating to Fraud in an Audit of
Financial Statements which has been redrafted in accordance with the clarity conventions (see Chapter I).
41 7
2. I
Environmental law
and regulation
An auditor must be aware of the effect that non-compliance with the laws and regulations would have on
the financial statements (e.g. asset impairment, penalties, rectification costs)
BSA 250 Consideration of Laws and Regulations in an Audit of Financial Statements provides guidance on the
auditor's responsibility to consider laws and regulations in an audit of financial statements.
BSA 250.2
When designing and performing audit procedures and in evaluating and reporting the results thereof, the
auditor should recognise that non-compliance by the entity with laws and regulations may materially affect
the financial statements.
An audit cannot detect non-compliance with all laws and regulations as not all of them impact in
the financial statements.
'Non-compliance' refers to acts of omission or commission by the entity being audited, either intentional or
unintentional, which are contrary to the prevailing laws or regulations. Such acts include transactions
4 I8
2.2
You are the auditor of a new company called Flowell Ltd. The directors are extremely knowledgeable about
the products they sell but less so about the regulatory framework for their industry especially the Health
and Safety aspects. You have been asked for advice about the types of policies arid procedures that they
could put in place to reduce the risk of non compliance.
Requirement
Provide a list of controls that the management of Flowell Ltd could put in place to minimise the risk of noncompliance. Detailed knowledge of Health and Safety Law is not required.
See Answer at the end of this chapter.
2.3
There are many laws and regulations, relating principally to the operating aspects of the entity, that
typically do not have a material effect on the financial statements.
(b)
The effectiveness of audit procedures is affected by the inherent limitations of the accounting and
internal control systems and by the use of testing.
(c)
Much of the audit evidence obtained by the auditor is persuasive rather than conclusive.
(d)
Non-compliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate
failure to record transactions, senior management override of controls or intentional
misrepresentations being made to the auditor.
BSA 250.13
In accordance with BSA 200 Objective and General Principles Governing an Audit of Financial Statements, the
auditor should plan and perform the audit with an attitude of professional scepticism recognising that the
audit may reveal conditions or events that would lead to questioning whether an entity is complying with
laws and regulations.
The auditor would only test for compliance with specific laws and regulations if engaged to do so.
41 9
BSA 250.15
In order to plan the audit, the auditor should obtain a general understanding of the legal and
regulatory framework applicable to the entity and the industry arid how the entity is complying with that
framework.
In obtaining this general understanding the auditor should obtain an understanding of the procedures
followed by the entity to ensure compliance. He should recognise that some laws and regulations may have
a fundamental effect on the operations of the entity, i.e. they may cause the entity to cease operations or
call into question the entity's continuance as a going concern. For example, non-compliance with the
requirements of the entity's licence or other title to perform its operations could have such an impact (for
example, for a bank, non-compliance with capital or investment requirements).
2.4
Following on from Question 5, you are now planning the first audit of Flowell Ltd.
Requirement
Outline the information that you are likely to require on the regulation affecting the business of Flowell and
the likely nature of the audit work that you would undertake.
See Answer at the end of the chapter.
2.5
Getfit Ltd is a chain of fitness centres with about 20 branches around the country. The head office is
located in Northumberland. The centre manager is responsible for the day-to-day running of the centre but
also has the responsibility of reporting the centre's financial results to the head office on a monthly basis.
This should be done using a standard template and the results prepared in accordance with company
policies.
In order to operate, each centre must have an operating licence from the local authority. The licences cost
CU6,000 and are valid for 5 years subject to satisfactory inspection by the local authority. At the end of the
5 year period Getfit Ltd must reapply for a new operating licence.
Each centre has the following facilities:
~
~
~
~
~
~
A licensed bar
A creche
Sun beds
A swimming pool
A sauna and steam room
A gym
Staff should receive a formal induction when they start. The programme includes health and safety issues,
life guard training, food hygiene and child care depending on which area they will be working in. There are
additional training programmes for the fitness instructors.
There has recently been some bad press in the local media about the standards of maintenance of the
equipment of some of the centres.
420
Requirement
(a)
Using the above scenario outline the possible compliance issues for the auditor
(b)
Link the issues in (a) to the potential misstatements in the financial statements for Getfit Ltd.
2.6
The potential financial consequences, such as fines, penalties, damages, threat of expropriation of
assets, enforced discontinuation of operations and litigation
Whether the potential financial consequences require disclosure
Whether the potential financial consequences are so serious as to call into question the true and fair
view (fair presentation) given by the financial statements
BSA 250.28
When the auditor believes there may be non-compliance, the auditor should document the findings and
discuss them with management.
Such discussions are subject to the laws concerning 'tipping off. If information provided by management is
not satisfactory, the auditor should consult the entity's lawyer and, if necessary, his own lawyer on the
application of the laws and regulations to the particular circumstances.
BSA 250.30/31
When adequate information about the suspected non-compliance cannot be obtained the auditor should
consider the effect of the lack of audit evidence on the auditor's report.
The auditor should consider the implications of non-compliance in relating to other aspects of the audit
particularly the reliability of management representations.
On this last point, as with fraud and error, the auditor must reassess the risk assessment and the
validity of management representations.
2. 7
Reporting of non-compliance
To management
BSA 250.32/33/34
The auditor should, as soon as practicable, either communicate with the audit committee, the board of
directors and senior management, or obtain evidence that they are appropriately informed regarding noncompliance that comes to the auditor's attention.
If, in the auditor's judgement, the non-compliance is believed to be intentional and material, the auditor
should communicate the finding without delay.
If the auditor suspects that members of senior management, including members of the board of directors,
are involved in non-compliance, the auditor should report the matter to the next higher level of authority
at the entity, if it exists, such as an audit committee or a supervisory board.
421
2.8
2. 9
2.1 I
2.1 1.1
Laws which are central to the ability of the client to conduct its business
Other laws and regulations
In practice:
422
(a)
For some business, certain laws and regulations will be central, for other businesses the same laws and
regulations will not be central.
(b)
For some businesses, laws and regulations which were not central last year may be central this year,
(for example where the maximum penalty for a first offence is a warning, but subsequent infringements
may lead to closure of the business).
You work for an audit firm which has a chemical factory as one of its clients. This factory has to produce
reports on its emissions.
This work is done in addition to the statutory audit and a separate report will be produced. The auditor
would review the company's systems for keeping emissions under control and would also review
correspondence with the environmental authority for evidence of breaches and the details of emissions
reported.
However, the auditors would not be expected to check the actual emissions. This demonstrates the
difference between checking systems of compliance and checking actual compliance. The auditor will reach
the required level of confidence by reviewing the system.
The auditor's competence in this area also needs to be considered, as the firm is unlikely to be expert in
measuring emissions. They may need to rely on the work of an expert in order to be satisfied that the
emissions are reasonable.
3 Money laundering
3.1
Introduction
Money Laundering is a form offraud. It received increased publicity after September 2001 when serious
issues were raised as to how terrorists were managing to finance their activities. It is essentially a process
where the perpetrator attempts to legitimise the proceeds of any crime (dirty money made good).
Proceeds of crime can include activities such as drug trafficking, terrorism, shoplifting, theft ,tax evasion and
other financial criminal activity. As a form of fraud, the emphasis is on concealing the illegal source of the
money which makes it difficult to detect especially given that the transactions are rarely linked to one
country.
3.2
423
Source: icWa!es.co.ul<
After lengthy investigations and a trawl of 17 bank accounts, the owners of one of Wales's most popular
Chinese restaurants were ordered to pay I.Sm after being convicted of money laundering. The lengthy
investigation into their restaurant and property interests came after they admitted money laundering at
Cardiff Crown Court in April, 2005.
They may also face further jail terms if they fail to pay the I.Sm within 12 months.
The court heard that the couple had suppressed the amount of takings at the restaurant they have run for
I0 years leading to tax evasion and non-payment of VAT.
The investigation into their finances began in April 2003 as a result of a separate - and ongoinginvestigation by the multi-agency customs, police and HMRC Asset Recovery Team.
3.2.1
Accountants' obligations
CAMLCO: All financial institutions must designate a Chief Anti-Money Laundering Compliance Officer
(CAMLCO) at their head office who has sufficient authority to implement and enforce corporate wide antimoney laundering policies, procedures and measures and who will report directly to senior management
and the board of directors. This provides evidence of senior management's commitment to efforts to
combat money laundering and, more importantly, provides added assurance that the officer will have
sufficient authority to investigate potentially suspicious activities.
424
3.3
Risk-based approach
On any assignment, the accountants should assess the risk of money laundering activities. Clearly, every
circumstance is different, but the following diagram illustrates some key risk factors.
!Secrecy]
! Excessive use J
Transactions
rooted through
several
jurisdictions
Repeated depositS or
withdrawals Just below.
the monitoring threshold
on the same day
3.4
3.5
Definition
Knowledge:
~
Actual knowledge
Deliberately deterring a person from making disclosures, the content of which one might not care to
have
Knowledge of circumstances which would indicate the facts to an honest and reasonable person
Knowledge of circumstances which would put an honest and reasonable person on inquiry and failing
to make the reasonable inquiries which such a person would have made.
425
Definition
Suspicion: Suspicion is not defined in existing legislation. Case law and other sources indicate that
suspicion is more than speculation but it falls short of proof or knowledge. Suspicion is personal and
subjective but will generally be built on some objective foundation and so there should be some degree of
consistency in how a business's CAMLCO treats possible causes of suspicion.
4 Auditor liability
,;
4.1
Legal liability
Auditor liability is a serious issue. We have already discussed the Enron scandal and how it caused the
demise of Arthur Andersen. Suing the auditor is a popular activity when things go wrong with a business. In
April 2005 Equitable Life launched a 4bn suit against their auditors claiming that they signed off its financial
statements without warning of the problems that led to its collapse. In December 2006 a major firm of
auditors were presented with a bill for 1.5m after having been found guilty by the Joint Disciplinary
Scheme for failing to perform a proper audit.
Under certain legislation, notably insolvency legislation, auditors may be found to be officers of the company
and could be charged with criminal offences or found liable for civil offences in connection with the winding
up of the company.
Auditors may also be found guilty of the offence of insider dealing, which is a criminal offence, as they are
privy to inside information.
Auditors could be found guilty of a criminal offence if they knew or suspected a person was laundering
money and they failed to report their suspicions to the proper authority.
4.2
Negligence
Negligence is a common law concept. It seeks to provide compensation to a person who has suffered
loss due to another person's wrongful neglect. To succeed in an action for negligence, an injured party must
prove three things:
426
(a)
(b)
(c)
The breach caused the injured party loss which can be measured reliably. In the case of negligence in
relation to financial advisers/auditors, this loss must be pecuniary (i.e. financial) loss.
\,_,_._
4.3
The company
Shareholders
The bank
Other lenders
Other interested third parties
A key difference between the various potential claimants is the nature of the duty of care owed to
them.
4.4
COMPANY
SHAREHOLDERS AS A BODY
SHAREHOLDER
SHAREHOLDER
The company has a contract with the audit firm. In the law of many countries, a contract for the supply of a
service such as an audit has a duty of reasonable care implied into it by statute.
In other words, whatever the express terms of any written contract between the company and the audit
firm, the law always implies a duty of care into it. Therefore, if the company (all the shareholders acting as a
body) want to bring a case for negligence, the situation would be as follows.
AUTOMATIC
Breached?
MUST BE PROVED
MUST BE PROVED
In order to prove whether a duty of care had been breached, the court has to give further consideration to
what the duty of 'reasonable' care means in practice.
4.5
427
The auditors have a responsibility to keep themselves abreast of professional developments. Auditing
Standards are likely to be taken into account when the adequacy of the work of auditors is being
considered in a court of law or in other contested situations.
When the auditors are exercising judgement they must act both honestly and carefully. Obviously, if
auditors are to be 'careful' in forming an opinion, they must give due consideration to all relevant matters.
Provided they do this and can be seen to have done so, then their opinion should be above criticism.
However if the opinion reached by the auditors is one that no reasonably competent auditor would have
been likely to reach then they would still possibly be held negligent. This is because however carefully the
auditors may appear to have approached their work, it clearly could not have been careful enough, if it
enabled them to reach a conclusion which would be generally regarded as unacceptable.
If the auditor's suspicions are aroused, they must conduct further investigations until such suspicions are
either confirmed or allayed. Over the years, there have been many occasions where the courts have had to
consider cases in which it has been held, on the facts of those cases, that the auditors ought to have been
put upon enquiry.
4.6
Third parties
The auditor only owes a duty of care to parties other than the audit client if one has been established.
Under the law of contract the principle of 'privity of contract applies', such that there is only a duty of
care to the contracted parties.
'Third parties' in this context means anyone other than the company (audit client) who wished to make
a claim for negligence. It therefore includes any individual shareholders in the company and any potential
investors. It also includes, importantly, the bank, who is very often a key financier of the company.
The key difference between third parties and the company is that third parties have no contract with
the audit firm. There is therefore no implied duty of care. The situation is therefore as follows.
428
MUST BE PROVED
Breached1
MUST BE PROVED
MUST BE PROVED
Traditionally the courts have been averse to attributing a duty of care to third parties to the auditor. We
can see this by looking at some past cases that have gone to court.
A very important case is Caparo Industries pic v Dickman and Others 1990, which is described here.
:.,
In its report The Financial Aspects of Corporate Governance, the Cad bury Committee gave an opinion on the
situation as reflected in the Caparo ruling. It felt that Caparo did not lessen auditors' duty to use skill and
care because auditors are still fully liable in negligence to the companies they audit and their shareholders
collectively. Given the number of different users of accounts, it was impossible for the House of Lords to
have broadened the boundaries of the auditors' legal duty of care.
The decision in Caparo v Dickman considerably narrowed the auditors' potential liability to third parties. The
judgement appears to imply that members of various such user groups, which could include creditors,
potential investors or others, will not be able to sue the auditors for negligence by virtue of their placing
reliance on audited annual accounts.
In England a restrictive approach was now adopted to any extension of the scope of the duty of care
beyond the person directly intended by the maker of the statement to act upon it.
(b)
In deciding whether a duty of care existed in any particular case it was necessary to take all the
circumstances into account,
(c)
Notwithstanding (b), it was possible to identify certain matters which were likely to be of importance
in most cases in reaching a decision as to whether or not a duty existed.'
---~-----------
---------------
429
A case in 1997 appeared to take a slightly different line, although this case related to some management
accounts on which no written report had been issued.
All this case law raised some problems. In spite of the judgement in Caparo, the commercial reality is
that creditors and investors (especially institutional ones) do use audited accounts. The Companies Act
requires a company to file accounts with the Registrar. Why is this a statutory requirement? It is surely
because the public, including creditors and potential investors, have a need for a credible and independent
view of the company's performance and position.
It would be unjust if auditors, who have secondary responsibility for financial statements being prepared
negligently, bore the full responsibility for losses arising from such negligence just because they are insured.
It would also be unjust if the auditors could be sued by all and sundry. While the profession has generally
welcomed Caparo, two obvious problems are raised by decision.
43 0
Is a restricted view of the usefulness of audited accounts in the profession's long-term interests?
For private companies there will probably be an increase in the incidence of personal guarantees and
warranties given by the directors to banks and suppliers.
4.7
This case did however establish the principle that auditors could exclude liability to third parties. See below.
Worked example: Galoo ltd v Bright Graham Murray ( 1994) BCC 319
Galoo Ltd had incurred losses of 25 million between 1986 and 1990, and had paid a dividend of 500,000
in 1988. It sued the auditor for breach of contractual duty to exercise reasonable care and skill, maintaining
that the trading losses were attributable to the continued existence of the company, which, in turn, was due
to reliance on the allegedly negligent audit opinions. The Court of Appeal held that there was no causal
connection between the alleged negligence and the losses incurred. The financial reports may have allowed
the company to continue trading, but the company's existence was not the cause of its losses. The claim
against the auditor was struck out.
4.8
Assurance services
The audit firm might be able and prepared to offer assurances to the bank in relation to financial
statements, position, internal controls or other matters of interest to a primary lender. If this is the case,
and the service is required by the bank, the auditor should seek to create an engagement with the bank
itself.
You should bear in mind that providing assurance services to a lender could result in a conflict of interest
arising.
43 I
4. 9
4.1 0
Disclaimers
The cases above suggest that a duty of care to a third party may arise when an accountant does
not know that his work will be relied upon by a third party, but only knows that it is work of a kind
which is liable in the ordinary course of events to be relied upon by a third party.
Conversely, an accountant may sometimes be informed or be aware, before he carries out certain work,
that a third party will rely upon the results. An example is a report upon the business of a client which the
accountant has been instructed to prepare for the purpose of being shown to a potential purchaser or
potential creditor of that business. In such a case an accountant should assume that he will be held to owe
the same duty to the third party as to his client. The Bannermann case suggests this will also be
necessary for audit work.
There are areas of professional work where it is not possible for liability to be limited or excluded. There
are other areas of professional work (for example when preparing reports on a business for the purpose of
being submitted to a potential purchaser) where although such a limitation or exclusion may be included, its
effectiveness will depend on the view which a court may subsequently form of its reasonableness.
4.1 I
Litigation avoidance
The other aspect of how firms are trying to deal with litigation is what they are trying to do to avoid
litigation. This strategy has various aspects.
~
Client acceptance procedures are very important, particularly the screening of new clients and the use
of engagement letters.
Performance of audit work. Firms should make sure that all audits are carried out in accordance
Quality control. This includes not just controls over individual audits but also stricter 'whole-firm'
procedures. (See Chapter I)
Although auditors can incur civil liability under various statutes it is far more likely that they will incur
liability for negligence under the common law, as the majority of cases against auditors have been in this
area. Auditors must be fully aware of the extent of their responsibilities, together with steps they must take
to minimise the danger of professional negligence claims.
Requirements
(a)
Discuss the extent of an auditors' responsibilities to shareholders and others during the course of
their normal professional engagement.
(b)
List six steps which auditors should take to minimise the danger of claims against them for negligent
work.
43 2
4. ~ 2
Definitions
Proportionate liability: Proportionate liability would allow claims arising from successful negligence
claims to be split between the auditors and the directors of the client company, the split being determined
by a judge on the basis of where the fault was seen to lie. This would require the approval of shareholders.
Capping liability: Capping liability would set a maximum limit on the amount that the auditor would have
to pay out under any claim.
433
chapter II
Auditing in an IT
environment
Introduction
Topic List
I
Impact on controls
Electronic commerce
45 I
AUDITING IN AN IT ENVIRONMENT
(A
Section overview
~ ~
~
The main risks associated with using computerised systems include infection by viruses and access by
unauthorised users. Both these risks could potentially have a very damaging effect on the business.
This means that a number of the. cootrols which the directors are required to put into place to
safeguard the assets of the shareholders must be ihcorporated into the computer systems.
.
.
A~ditors have to assess the effectiveness of the controls in place within computer systems and cando
this by performing a systems audit as part of their initial assessment of risk during the planning stage
of the audit.
1.1
A huge number of organisations now use computer systems to run their businesses and to process
finanCial information.
I .2
The system being put at risk by a virus or some other fault or breakdown which spreads across the
system
The client is likely to have contingency plans in the event of the system being affected by the risks
outlined above. However, it is also important to know that the original system is as reliable as could be
expected, and whether it is the best system that the company could be using, at the given cost.
The company might seek such assurances from its service provider. However, the service provider has a
vested interest in the company believing that its system is reliable and the best available, because he is paid
to supply it.
This means that the directors might seek an assurance service from the auditors or another firm of
accountants, to undertake work to ascertain whether the assertions of the service provider are correct.
If a firm of accountants considers taking on such an assurance engagement, it must ensure that it has staff of
sufficient skills and experience to undertake the procedures required to ascertain whether the assurances
are correct. It must ensure that it has an IT specialist on the team.
453
I .3
Systems audit
As part of any audit, auditors are required to assess the quality and effectiveness of the accounting
system. Increasingly, this necessarily includes a consideration of the computer systems in place within the
organisation.
Auditors could accept an assurance engagement to undertake this task outside of the audit and to report
specifically on findings. The following are the key areas they are likely to concentrate on to establish how
reliable the systems are:
~
~
~
Management policy
Segregation of duties
Security
You should be aware that these are important control considerations in a computer environment. The
details that the reporting accountant will consider within each area are outlined below.
Management policy
~
~
Does management have a written statement of policy with regard to computer systems?
Is it compatible with management policy in other areas?
Is it adhered to?
Is it sufficient and effective?
Is it updated when the systems are updated?
Does it relate to the current system?
Segregation of duties
~
Security
~
I .4
Is it adhered to?
Reporting
It is vital that management receive information on the effectiveness of their controls systems and systems
reliability generally. This is because, as stated earlier, the operations of the company are likely to rely heavily
if not completely on computer systems, and if problems arise, operations could be severely affected.
Problems could arise in terms of:
~
~
Other stakeholders, such as customers and suppliers, will also be interested in the reliability of the
company's systems, as they will not want to deal with a company which makes mistakes and cannot operate
properly.
It is because of the vital importance of this area to business that management may also want to obtain
assurance concerning the information it receives on systems reliability.
454
AUDITING IN AN IT ENVIRONMENT
2 Impact on controls
Section overview
2.1
IT controls comprise general and applic:ation controls. General controls establish a framework of
overall control over the system's activities whereas application controls are specific controls over the
applications maintained by the.system.
Computer-assisted audit techniques (CMTs) can be used by the auditor to test application controls
within the client's computer systems.
Introduction
The internal control activities in a computerised environment fall within two categories: general controls
and application controls. We will discuss these in greater detail below.
2.2
General controls
The purpose of general IT controls is to establish a framework of overall control over the computer
information system's activities to provide a reasonable level of assurance that the overall objectives of
internal controls are achieved. They include controls over access security, data centre and network
operations, software acquisition, change and maintenance, and application system acquisition, development
and maintenance. They are sometimes referred to as supervisory, management or information technology
controls. General controls are considered in detail below.
Development of
computer applications
Prevention or detection
of unauthorised changes
to programs
Segregation of duties
Full records of program changes
Password protection of programs so that access is limited to computer
operations staff
Restricted access to central computer by locked doors, keypads
Maintenance of programs logs
Virus checks on software: use of anti-virus software and policy prohibiting
use of non-authorised programs or files
Back-up copies of programs being taken and stored in other locations
Control copies of programs being preserved and regularly compared with
actual programs
Stricter controls over certain programs (utility programs) by use of readonly memory
455
Testing and
documentation of
program changes
Documentation standards
Approval of changes by computer users and management
Training of staff using programs
Operation controls over programs
Controls to prevent
wrong programs or files
being used
Libraries of programs
Proper job scheduling
Controls to prevent
unauthorised
amendments to data
files
Controls to ensure
continuity of operation
The auditors will wish to test some or all of the above general controls, having considered how they affect
the computer applications significant to the audit.
General IT controls that relate to some or all applications are usually interdependent controls, i.e. their
operation is often essential to the effectiveness of application controls. As application controls may be
useless when general controls are ineffective, it will be more efficient to review the design of general IT
controls first, before reviewing the application controls.
2.3
Application controls
The purpose of application controls is to establish specific control procedures over the accounting
applications in order to provide reasonable assurance that all transactions are authorised and recorded,
and are processed completely, accurately and on a timely basis. Application controls include data capture
controls, data validation controls, processing controls, output controls and error controls. Examples of
application controls are shown in the table below.
456
AUDITING IN AN IT ENVIRONMENT
Programs to check data fields (for example value, reference number, date) on
input transactions for plausibility
Digit verification (e.g. reference numbers are as expected)
~
Controls over
processing
Authorised
One-to-one checking
Cyclical reviews of all master files and standing data
Record counts (number of documents processed) and hash totals (for
example, the total of all the payroll numbers) used when master files are
used to ensure no deletions
Controls over the deletion of accounts that have no current balance
Control over input, processing, data files and output may be carried out by IT personnel, users of the
system, a separate control group and may be programmed into application software.
2.4
45 7
Manual controls
exercised by the user
Programmed control
procedures
In the case of certain computer systems, the auditor may find that it is
not possible or, in some cases, not practical to test controls by examining
only user controls or the system's output. The auditor may consider
performing tests of control by using CMTs, such as test data,
reprocessing transaction data or, in unusual situations, examining the
coding of the application program.
-~--------- "'
----
As we have already noted, general IT controls may have a pervasive effect on the processing of transactions
in application systems. If these general controls are not effective, there may be a risk that misstatements
occur and go undetected in the application systems. Although weaknesses in general IT controls may
preclude testing certain IT application controls, it is possible that manual procedures exercised by users
may provide effective control at the application level.
3 Electronic commerce
458
AUDITING IN AN IT ENVIRONMENT
3.1
Introduction
Definitions
Internet: The Internet is a global network connecting millions of computers.
World Wide Web: The World Wide Web (www) is a system of Internet servers that supports specially
formatted documents. A group of documents accessed from the same base web site is known as a website.
Electronic data interchange: Electronic data interchange (EDI) is a form of computer to computer data
transfer. Information can be transferred in electronic form, avoiding the need for the information to be reinputted somewhere else.
Electronic mail: Electronic mail (e-mail) is a system of communicating with other connected computers
or via the Internet in written form.
Electronic commerce: Electronic commerce (e-commerce) involves individuals and companies carrying
out business transactions without paper documents, using computer and telecommunications links.
3.2
Engaging in e-commerce
The terms described above are all now commonly used in business. You are probably familiar with most, if
not all, of them.
All of them are (or can be) used in e-commerce. As this is a very fast growing area of business, it is an
important area for everyone, including accountants, today.
A business can engage in e-commerce to a large or small extent. The greater the involvement a business has
with e-commerce, the more the risk associated with it. The extent of involvement is explored in the
following table.
LOW
Transactions with existing customers. Existing customers can be given the opportunity
to track current contracts or initiate others over the website.
Access to new customers. A website can be used as a place where new customers may
initiate transactions with the company.
New business model. A website can be used to diversify into specific web-based products,
for example, items that are 'downloadable'.
HIGH
There are a variety of business risks specific to a company involved in e-commerce, which will exist to a
greater or lesser degree depending on the extent of involvement.
~
Contractual issues arising: are legally binding agreements formed over the Internet?
Loss of transaction integrity, which may be compounded by the lack of sufficient audit trail
Security risks, such as virus attacks and the risk of frauds by customers and employees
459
Improper accounting policies in respect of capitalisation of costs such as website development costs,
misunderstanding of complex contractual arrangements, title transfer risks, translation of foreign
currency, allowances for warranties and returns, and revenue recognition issues
Many of these issues have implications for the statutory audit and these are discussed in detail in the
next section.
An entity that uses e-commerce must address the business risks arising as a result by implementing
appropriate security infrastructure and related controls to ensure that the identity of customers and
suppliers can be verified, the integrity of transactions can be ensured, agreement on terms of trade can be
obtained, as well as payment from customers is obtained and privacy and information protection protocols
are established.
3.3
Internal controls can be used to mitigate many of the risks associated withe-commerce. The auditor has
to consider the control environment and control procedures in accordance with the requirements of BSA
315. There may be situations (such as the use of highly automated e-commerce systems, high transaction
volumes, lack of electronic evidence) when the auditor would have to use tests of control as well as
substantive procedures to render audit risk to an acceptably low level. In these situations, CAATs could be
used.
When auditing an entity that uses e-commerce, BAPS I013 states that the auditor must consider in
particular the issues of security, transaction integrity and process alignment.
When examining the issue of security, the auditor should consider the following:
~
~
~
~
When considering transaction integrity, the auditor must consider the completeness, accuracy, timeliness
and authorisation of the information provided for recording and processing in the financial records, by
carrying out procedures to evaluate the reliability of the systems used for capturing and processing the
information.
Process alignment is the way the IT systems used by the entity are integrated with one another to
operate effectively as one system. Many websites are not automatically integrated with the internal systems
of the entity, such as its accounting system and inventory management system, and this may affect issues
such as the completeness and accuracy of transaction processing, the timing of recognition of sales,
purchases and other transactions, and the identification and recording of disputed transactions.
460
AUDITING IN AN IT ENVIRONMENT
3.4
Web Trust and SysTrust are examples of assurance services developed in the last few years in relation to
e-commerce. The underlying principles of these two services have been combined into one common set of
principles known as Trust Services, which allow auditors to evaluate business systems and controls.
Trust Services are based on five principles:
~
~
Web assurance seeks to remove this barrier by providing assurance to the users of the service. An
assurance assignment under WebTrust would involve looking at the assertions of the company's
website in respect of the five principles outlined above, and seeking evidence as to whether what it says
about its service is true, and whether the systems in place comply with the pre-determined criteria.
The outcome of the exercise is that if the accountant has assurance that the systems comply and the
representations made about the service are fair, the website can be WebTrust accredited.
Note however, that in order to obtain the Web Trust accreditation, the organisation must meet all the
Trust Services principles and engage a practitioner who is licensed to provide the WebTrust service.
Similarly, SysTrust allows practitioners to provide assurance on a company's information system, again using
the principles described above. Briefly, such an assignment would consider the system's infrastructure,
46 I
Interactive
Inc
level; Exam
NewForm Inc (NewForm), a client of your firm, has recently established an e-commerce division within its
existing business to provide an additional outlet for its product range, which consists of up-market casual
wear for adults. An objective in introducing the new division was to have a completely paperless ordering,
payment and despatch system.
The new e-commerce system is administered centrally by NewForm and deals with customer orders and
credit card payments. Customers are able to place orders and pay for the goods on-line. Inventories for
customer orders are held remotely by Key Distributors (KD), which is a completely separate business from
NewForm. Once on-line payment by credit card is cleared by NewForm, despatch details are forwarded to
KD electronically. KD then despatches customer orders. Inventories are ordered by NewForm for delivery
direct to KD.
Requirements
(a)
In planning the audit of NewForm, identify and explain four key risks that may arise from the
development of the new e-commerce division.
(b)
Identify and explain the application controls which you think are necessary for the integrity of the
ordering and payments system.
462
AUDITING IN AN IT ENVIRONMENT
Summary
Application controls
Data capture
- Data validation
- Processing
Output
- Errors
IT controls
General controls
Access security
Data centre and network
operations
- Software acquisition, change and
maintenance
Application systems acquisition,
development and maintenance
WebTrust and
SysTrust
Assurance
Security
- Availability
- Processing integrity
Online privacy
- Confidentiality
463
chapter I I
Auditing in an IT
environment
Contents
Introduction
Topic List
Information technology and risk
2
Impact on controls
Electronic commerce
45 I
AUDITING IN AN IT ENVIRONMENT
1 n~o
I
I 1114\.
Section overview
I .I
A huge number of organisations now use computer systems to run their businesses and to process
financial information .
._
The main risks associated with using computerised systems include infection by viruses and access by
unauthorised users. Both these risks could potentially have a very damaging effect on the business.
This means that a number of the controls which the directors are required to put into place to
safeguard the assets of the shareholders must be incorporated into the computer systems .
._
Auditors have to assess the effectiveness of the controls in place within computer systems and can do
this by performing a systems audit as part of their initial assessment of risk during the planning stage
of the audit.
1.2
The system being put at risk by a virus or some other fault or breakdown which spreads across the
system
.,
The client is likely to have contingency plans in the event of the system being affected by the nsks
outlined above. However, it is also important to know that the original system is as reliable as could be
expected, and whether it is the best system that the company could be using, at the given cost.
The company might seek such assurances from its serv1ce provider. However, the service provider has a
vested interest in the company believing that its system is reliable and the best available. because he 1s paid
to supply 1t.
This means that the directors might seek an assurance service from the auditors or another firm of
accountants, to undertake work to ascertain whether the assertions of the service prov1der are correct.
If a fwm of accountants considers taking on such an assurance engagement, it must ensure that it has staff of
sufficient skills and experience to undertake the procedures required to ascertain whether the assurances
are correct. It must ensure that it has an IT specialist on the team.
45 3
chapter 12
Introduction
Topic List
I
Fair value
Financial instruments
471
Fair value
Section overview
~.
Fair Value measurements of assets, liabilities and components of equity. may arise from both the initial
recording of transactions and .later changes in value
Auditing fair value requires both the assessment of risk and evaluating the appropriateness of the fair
value
1.1
.Fair value is a key issue to investment property, pension costs, share-based payments
Introduction
Fair value is the amount for which an asset or liability could be exchanged between knowledgeable, willing
parties in an arm's length transaction.
Fair value accounting is increasingly important and affects the audit of valuation for both assets and
liabilities. Many standards now allow valuation at fair value. The following table summarises some of the
main instances which you should be familiar with from your financial reporting studies.
When accounting for a defined benefit plan the fair value of plan
assets should be established
Recoverable amount is the higher of fair value less costs to sell and
value in use
BAS 41 Agriculture
As you can see above fair value measurements of assets, liabilities and components of equity may arise from
both the initial recording of transactions and later changes in value. Changes in fair value
measurements that occur over time may be treated in different ways under different circumstances. For
example, the revaluation of an item of owner occupied property would be recorded as other
comprehensive income and taken directly to equity, whilst the annual restatement of an investment
property will be reflected in profit or loss.
473
1.2
1.2.1
1.2.2
The relevant control activities over the process e.g. controls over data and the segregation of duties
between those committing the entity to the underlying transaction and those responsible for
undertaking the valuations.
The expertise and experience of those persons determining the fair value measurements
The types and accounts or transactions requiring fair value measurements or disclosures e.g.
whether the accounts arise from routine/recurring transactions or non-routine/unusual transactions
The extent to which the entity uses the work of experts in determining fair value measurements and
disclosures
The methods used to develop and apply management assumptions and to monitor changes in those
assumptions
The integrity of change controls and security procedures for valuation models and relevant
information systems, including approval processes
Controls over the consistency, timeliness and reliability of the data used in valuation models
474
Consider management's past history of carrying out its stated intentions with respect to assets or
liabilities
Review written plans and other documentation, including where applicable, budgets minutes etc
Consider management's ability to carry out a particular course of action given the entity's
economic circumstances, including the implications of its contractual commitments.
If there are alternative allowable methods for measuring fair value, or a particular model is not prescribed
by the relevant accounting standard, the auditor should consider whether the entity's method is
consistent with other fair value measurements in the financial statements and whether it is applied
consistently.
1.2.3
The number of significant and complex assumptions associated with the process
A higher degree of subjectivity associated with the assumptions and factors used in the process
A higher degree of uncertainty associated with the future occurrence or outcome of events
underlying the assumptions used
~
~
1.2.4
The auditor should consider the effect of subsequent events on the fair value measurements and
disclosures in the financial statements
The auditor should evaluate whether the disclosures about fair values made by the entity are in
accordance with its financial reporting framework
Current developments
As we saw in Chapter 5 the IAASB has issued ISA 540 (Revised and Redrafted) Auditing Accounting Estimates,
Including Fair Value Accounting Estimates, and Related Disclosures as part of the Clarity Project (see Chapter I).
475
1.3
Application
This section looks at the audit of a number of areas where fair value is a key issue. Note that whilst the
audit of fair value is important audit procedures also need to address other aspects too, for example
completeness, ownership, disclosure and so on.
1.3.1
Investment property
Definition
Investment property: Property (land or a building- or part of a building- or both} held (by the owner
or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:
~
~
~
~
Investment property is initially measured at its cost. After recognition it is either measured at cost or fair
value.
Audit evidence
Classification as an investment
property
47 6
Valuation
Disclosure
Property A
Property B
This is held under a finance lease and is currently rented out to a nongroup company under an operating lease
Property C
This was acquired in the year at a cost of CU3m including legal fees. It
is currently vacant but a tenant is being actively sought
Property D
This has been owned by Propertyco Ltd for a number of years and is
currently rented out to a non-group company
Propertyco Ltd wishes to adopt the fair value model in accordance with BAS 40. Currently all of the above
properties are recorded in the financial statements at fair value.
Based on the information above:
(a)
Identify the audit issues which the auditor would need to consider
(b)
List the audit procedures you would perform regarding fair values
477
1.3.2
Pension costs
The treatment of a defined contribution scheme is relatively straightforward.
BAS 19 Employee Benefits requires the following.
(a)
Contributions to a defined contribution plan should be recognised as an expense in the period they
are payable (except to the extent that labour costs may be included within the cost of assets).
(b)
Any liability for unpaid contributions that are due as at the end of the period should be recognised as a
liability (accrued expense).
(c)
Any excess contributions paid should be recognised as an asset (prepaid expense), but only to the
extent that the prepayment will lead to, e.g. a reduction in future payments or a cash refund.
(d)
Disclosure is required of a description of the plan and the amount recognised as an expense in the
period.
Step 2
These future benefits should be attributed to service performed by employees in the current period, and in
prior periods. This gives a total present value of future benefit obligations arising from past and current
periods of service.
3
The fair value of any plan assets should be established.
4
The size of any actuarial gains or losses should be determined, and the amount of these that will be
recognised.
5
If the benefits payable under the plan have been improved, the extra cost arising from past service should
be determined.
6
If the benefits payable under the plan have been reduced or cancelled, the resulting gain should be
determined
You should refer to your corporate reporting text if you require further revision of the accounting
treatment of pensions.
478
Audit evidence
Scheme liabilities
Auditors must follow the principles of BSA 620 Using the Work
of an Expert to assess whether it is appropriate to rely on the
actuary's work
Items charged to
operating profit (current
service cost, past service cost,
gains and losses on
settlements and curtailments)
Auditors will not have the same expertise as actuaries and are
unlikely to be able to challenge the appropriateness and
reasonableness of the assumptions. They should nevertheless
ascertain the qualifications and experience of the actuaries. Auditors
can, also, through discussion with directors and actuaries:
~
Where the results of auditors' work are inconsistent with the directors' and actuaries', additional
procedures, such as requesting directors to obtain evidence from another actuary, may assist in resolving
the inconsistency.
479
1.3.3
Share-based payments
BFRS 2 Share-based Payments requires entities to recognise the goods or services received as a result of
share-based payment transactions.
There are three types of share-based payment transactions.
(a)
Equity-settled share-based payment transactions, in which the entity receives goods or services
in exchange for equity instruments of the entity.
(b)
Cash-settled share-based payment transactions, in which the entity receives goods or services
in exchange for amounts of cash that are based on the price (or value) of the entity's shares or other
equity instruments of the entity.
(c)
Transactions in which the entity receives or acquires goods or services and either the entity or the
supplier has a choice as to whether the entity settles the transaction in cash (or other assets) or by
issuing equity instruments.
An entity should recognise goods or services received or acquired in a share-based payment transaction
when it obtains the goods or as the services are received. They should be recognised as expenses unless
they qualify for recognition as assets. Transactions are measured at fair value.
Audit evidence
The auditor will require evidence in respect of all the components of the estimated amounts, as well as
reperforming the calculation of the expense for the current year.
Enquire of directors
---~-~-----~~---------
General
(Also see Chapter 13 of this Study Manual for audit of remuneration packages).
480
You are the auditor of Russell Ltd. The draft financial statements for the year ending 31 December 20XS
show a profit before tax of CU400,000. Russell Ltd provided four of its directors each with 3,000 share
options on I January 20XS which vest on 31 December 20X7. The fair value of the options, determined by
use of the Black-Scholes model, is as follows:
CUIO
CUll
CUIS
CUI3
The options are dependent on continued employment. All four directors are expected to remain. No entry
has been made in the financial statements of Russell Ltd in respect of the options on the basis that they do
not vest until 31 December 20X7.
Requirement
Identify the audit issues you would need to consider in respect of the share options.
See Answer at the end of this chapter.
2 Financial instruments
2.1
Introduction
In recent years there has been huge growth in the number and complexity of financial instruments available
for investment or issue by companies. This raises both accounting and auditing issues.
Definition
Financial instrument: Any contract that gives rise to a financial asset of one entity and a financial liability
or equity instrument of another entity.
This definition is very broad which means that many common balances fall within its scope including:
~
~
Cash
Trade payables and receivables
Loans payable and receivable
48 I
~
~
~
~
2.2
A financial asset
A financial liability
An equity instrument
in accordance with the substance of the contract under which it has been issued.
~
A compound instrument (e.g. a convertible bond) should be split into its component parts at the
date it is issued.
2.3
2.3.1
Audit issues
Risk
Financial instruments, particularly complex ones, increase audit risk. Factors which increase risk include
the following:
~
482
Inappropriate classification of financial instruments, particularly between debt and equity may
lead to off-balance sheet financing. This will affect gearing and therefore the risk profile of the
business. This is particularly an issue where hybrid or compound instruments have been issued where
there are both debt and equity elements.
2.3.2
Complexity of the accounting requirements of BAS 32 and 39. This increases the risk of error.
For example financial assets and liabilities must be classified as falling within one of four categories.
This categorisation determines their subsequent measurement (amortised cost or fair value). Incorrect
classification may have a significant impact on the financial statements
Determining fair values involves the use of valuation techniques including market estimates.
Judgements will need to be made to determine whether the valuation techniques and any estimates
made are reasonable. (See section I above)
Recognition of the costs associated with the instrument is not necessarily straightforward. For
example the discount on a discounted debenture should be treated as part of the overall cost of the
instrument and recognised over the life of the debenture.
Audit procedures
Although the issues and evidence sought will depend on the specific nature of the financial instrument, the
following key considerations will normally apply:
Classification
Review the terms of the financial instrument and confirm that they have been
classified in accordance with their substance. Where the company has designated
financial instruments to be treated at fair value through profit or loss there needs
to be evidence that the required conditions according to BAS 39 have been
satisfied at the date of designation. (e.g. that there is an accounting mismatch)
(see Financial and Corporate Reporting text for details of conditions for AFVTPL
designation)
Valuation:
Confirm that all financial assets and liabilities have been valued at fair value
Initial fair
value
Valuation:
Subsequent
measurement
Confirm that the amount of amortisation has been calculated using the effective
interest method.
Confirm that financial assets and liabilities at fair value through profit or loss and
available-for-sale financial assets are remeasured at fair value
Where there is an active market agree fair value to quoted market price (current
bid price)
Where there is no active market assess the valuation technique adopted by
management and any assumptions made
(For further detail regarding the audit of fair values see section I above).
483
3: Convertible debenture
On 1 January 20X8 Berriman Ltd issued a CUI 0 million debenture at par. The debenture has a nominal rate
of interest of 4% and is redeemable on I January 20Y3. On this date the holder has the option to convert
the debenture to 6 million CUI ordinary shares in Berriman Ltd. The fmancial statements currently show a
long-term liability which represents the net proceeds of the debenture. The first payment of interest on 31
December 20X8 has also been recorded.
Requirements
(i)
(ii)
2.4
Derivatives
Definition
A derivative: is a financial instrument or other contract within the scope of BAS 39 with all three of the
following characteristics:
~
Its value changes in response to the change in a specified interest rate, financial instrument price,
commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or
other variable, provided in the case of a non-financial variable that the variable is not specific to the
party to the contract (sometimes called the 'underlying')
It requires no initial net investment or an initial net investment that is smaller than would be required
for other types of contracts that would be expected to have a similar response to changes in market
factors; and
Derivatives include swaps, options, swaptions, forwards, and futures. BAS 39 requires that
derivatives be measured at fair value in the statement of financial position unless they are linked to, and
must be settled by, an investment in an unquoted equity instrument that cannot be reliably measured at fair
value. In such cases the derivative would be measured at cost instead, which, in many cases, would be close
to zero.
In general entities use derivatives to either speculate or offset risk (hedge). When changes in fair value
occur these can be recognised either in profit or loss, or in equity. As a general rule changes in fair value of
a derivative are recognised in profit or loss. However, when the derivative is used to offset risk and special
hedge accounting conditions are met, at least some changes in fair value may, optionally, be recognised as a
separate component of equity. This is hedge accounting under BAS 39.
Entities must properly identify derivatives per the criteria given in the definition above.
Derivatives are becoming a common way for companies to manage financial risk. For many entities, the use
of derivatives has reduced exposure to changes in exchange rates, interest rates and commodity prices as
well as other risks. However the inherent characteristics of derivatives may also result in increased business
risk in turn increasing audit risk and presenting new challenges to the auditor. For example values of
derivatives may be volatile. Large and sudden decreases in their value may increase the risk of a Joss arising
exceeding the amount, if any, recorded in the statement of financial position. In addition, because of the
complexity of derivative activities, management may not fully understand the risks of using derivatives.
While all financial instruments have certain risks as we have seen above, derivatives often have particular
features which leverage risk including the following:
484
Potential risks and rewards can be substantially greater than the current outlays
The value of an entity's asset or liability may exceed the amount, if any, of the derivative that is
recognised in the financial statements
BAPS I012 Auditing Derivative Financial instruments provides guidance in this area and is summarised below.
Many of the issues which it raises could equally apply to other types of financial instrument.
2.4.1
The operating characteristics and risk profile of the industry in which the entity operates
The derivative financial instruments used by the entity, and their characteristics
The entity's information system for derivatives, including services provided by a service
organisation
The method of valuation of the derivative, for example whether fair value is determined by
quoted market price, or pricing model
The requirements of the financial reporting framework for financial statement assertions related to
derivatives
485
The industry
The entity
Market risk
This relates to economic losses due to adverse changes in the fair value of the derivative
Credit risk
The risk that a customer or counterparty will not settle an obligation for full value
Settlement risk
The related risk that one side of the transaction will be settled without value being received from the
customer or counterparty
Solvency risk
The risk that the entity would not have the funds available to honour cash outflow commitments as
they fall due
Legal risk
This relates to losses resulting from a legal or regulatory action
The BAPS also emphasises the need for a strong control environment supported by clear control
objectives. Control objectives would include the following:
486
Authorised execution
Prevention or detection of
errors
Ongoing monitoring
Valuation
In addition for derivatives designed as hedges, internal controls should assure that those derivatives
meet the criteria for hedge accounting, both at the inception of the hedge, and on an ongoing basis.
Control procedures
One of the most important control procedures identified by BAPS I0 12 is the reconciliation. It identifies
the following as being particularly relevant:
~
Reconciliation of dealers' records to records used for the ongoing monitoring process and the
position and profit or loss shown in the general ledger
Reconciliation of all clearing and bank accounts and broker statements to ensure all outstanding items
are promptly identified and cleared
Tests of controls
Examples of tests of controls to consider include:
~
Reading minutes of meetings of those charged with governance for evidence that there is a periodic
review of derivative activities and hedging effectiveness
Test transactions to determine whether the entity has obtained required approvals for the
transactions and used only authorised brokers
Discuss with management whether derivatives and related transactions are being monitored and
reported on a timely basis and read any supporting documentation
Test recorded purchases of derivatives, including their classification and prices, and the entries used to
record related amounts
Test the reconciliation process. For example, organisations that have a large number of derivative
transactions may require reconciliation and review on a daily basis
Test the controls for unrecorded transactions e.g. examine third party confirmations
Test the controls over the adequate security and back-up of data to ensure adequate recovery in the
case of disaster.
487
Completeness
488
2.4.2
~
~
An understanding of the business process involved in derivatives trading is necessary in order to audit
derivatives successfully. The steps in a typical such process are:
Entering the deal in the trader's deal sheet
2
Trader types the deal into the system and sends an e-mail
Back office process the deal using market quote information from agencies
Enter details into a 'pre-programmed' Excel sheet and/or other processing package
Net off between accounts payable and accounts receivable and wire the payment as necessary
Each type of derivative will be different and non-standard derivatives will be unique. This poses challenges
for the auditor.
Generally, however, the auditor should seek to:
~
Understand the client's business in order to establish the real role played by, and the risks that
are inherent in, the derivatives activity
Identify the controls in each process in order to establish the risk passed to the client by
inadequate or missing controls; and therefore, to establish the audit risk and thus the audit work that
needs to be performed
Obviously the exact nature of what is to be done is dependent on the circumstances of the client. Ensuring
that the information has been captured completely and accurately in each case is important.
489
Solution
Capture of information: the primary source document is the trader's deal sheet. This document should
contain the date, time, the oil index, quantity traded, the position (Long or Short), nature of trade (Hedge
or Speculation) and the rationale for the trade.
Processing of information: the back office report should contain the same information as in the deal
sheet.
Confirmation of information: There should be a statement from the clearing agents (since these are
Futures) confirming the details. [Note that Swaps transactions would be confirmed differently, via
Counterparty and Broker confirmations and that Options are confirmed in the same way that futures are].
Depositing of margin money: There should be evidence that margin money had been deposited with
the exchange as required (in case the Mark to Market crosses the exchange's threshold limits).
Settlement: There will be clearing statements from clearing agents. These should be used in collaboration
with internally generated information to confirm that the appropriate settlement amounts exchanged hands.
Accounting: The deals have been accounted for correctly.
In all these processes controls will have been implemented and the auditor should identify these and assess
their utility.
4:
level: Exam
Requirement
(a)
Identify the accounting entries you would expect to see at the inception of the contract, at 31
December 20X7, and at 31 December 20X8
(b)
Identify the risks you would expect to find in this arrangement, and the audit procedures that you
would carry out
(c)
Outline the steps that you would take to ensure compliance with BFRS 7 Financial Instruments:
Disclosures
See Answer at the end of this chapter.
490
Summary
Risk
assessment
Evaluation of appropriateness
of fair value
Audit
procedures
Evaluation of whether:
Assumptions are reasonable
Appropriate modei!Jsed
- Relevant information used
Application
.Examples
Investment property
Pension costs
..,. Share based payments
Financial instruments
.Financial instruments
491
chapter 13
Introduction
Topic List
I
Risk
Assurance
Reward packages
5I I
1.1
Introduction
Small businesses can be run as a sole trade or partnership. Businesses often incorporate after they have
been running successfully as unincorporated for a few years. This could be due to legal or tax
considerations.
1.2
Legal factors
When a business is successful, a trader has the potential to lose the value of their business, should a claim
be made, and this loss can extend to their personal possessions, due to the concept of unlimited liability.
If a business is operated through a company, the concept of limited liability means that the owner is only
liable to the extent of the share capital they have invested in. For example, if a trader owns CUI 0 share
capital in his company, the maximum he can ever lose from the original investment is CUI 0, as the company
is treated as a separate legal person.
!eve!:
Requirement
For the two examples below, do you think the courts would lift the veil of incorporation, thereby making
shareholders and/or directors personally liable for the debts of the company without limit?
Scenario I Karpaul Ltd
You are in the process of the audit for 31 December 20X7 and you discover a number of large credit notes
throughout the year addressed to group companies.
The sales director has informed you that the sales invoices to which the credit notes related were
incorrect. The original invoices did not relate to goods dispatched as claimed, but were used to receive an
advance from a debt factoring company in order to relieve cash flow difficulties to pay wages. Credit notes
were then issued and the advance repaid to the debt factors with interest.
Many of the company's creditors on average are more that 90 days old when normal credit terms are 40
days. Karen, the sales director owns the company jointly with her husband Paul, the finance director.
Scenario 2 Quality Training Ltd
Sarah Smith has been a successful tutor with a market leading accountancy training company for many years.
Sarah would like to start her own business, but is aware that her employment contract contains a valid
competition clause preventing her from becoming self employed within a certain radius of her former
employer in a certain time period.
Sarah decides to resign, as her husband already has a training company called Quality Training Ltd, which is
currently dormant. Sarah will become a shareholder and employee, and all contracts with customers will be
with Quality Training Ltd, not Sarah herself.
See Answer at the end of this chapter.
S 13
1.3
Tax factors
Companies are taxed differently to sole traders.
The rate of tax historically has been lower for sole traders than companies. In 2009 the rate of tax for a
company with profits of Tk I0,000 or less was 40%. However, directors who are also shareholders can
choose creative ways to be remunerated in order to minimise their tax liability, for example drawing
dividends instead of a salary, as dividends are taxed at a lower rate of tax.
I.4
1.5
5 14
2 Risk
Section overview
2.1
In Bangladesh, all registered ioint stock companies ar!') required by law to have an audit. Many EU
countries have a small compaQy exemption from audit. The exemption is based on the turnover of
the companies. The maximum turnover of a companywhich.qualifies as exempt under EU rules is
6.5m (but additional conditions apply to total assets and the number of employees}.
Definition
Small entity: A small entity is any enterprise in which:
(a)
There is concentration of ownership and management in a small number of individuals (often a single
individual), and
(b)
(ii)
Unsophisticated record-keeping
(iii) Limited internal controls together with potential for management override of internal controls
[Difficulty level:
Context Ltd supplies contraceptives to the leisure industry, sold through vending machines in pubs and
nightclubs. Turnover has remained steady for the past five years and the statement of comprehensive
income has shown CU6m each year.
Requirement
On I july 2006 the rate of VAT for such supplies was reduced from 17.5% to 5%. Assuming that the
company will not alter the selling price to customers, would this legislation impact on whether Context Ltd
needs an audit?
See Answer at the end of this chapter.
There has long been a debate over the benefits of audit to small companies. Where small companies are
owned by the same people that manage them, there is significantly less value in an independent review of
the stewardship of the managers than where management and ownership are separate.
The case for small companies to have an audit rests on the value of the statutory audit to those who have
an interest in audited accounts, that is, the users of the accounts. The users of the accounts will have
different ideas as follows.
S IS
Shareholders
Trade creditors
Tax authorities
Employees
Management
S 16
2 Risk
Section overview
~
2.1
In Bangladesh, all registered joint stock companies are required by law to have an audit. Many EU
countries hav:e a S1'!1alf company e.xe111pti.on from audit. The exemption is based on the turnover of
the companies. The maximum turnover 'of a company which. qualifies as exempt under EU rules is
6.Sm (but additional conditions apply to total assets and the number of employees).
Definition
Small entity: A small entity is any enterprise in which:
(a)
There is concentration of ownership and management in a small number of individuals (often a single
individual), and
(b)
(ii)
Unsophisticated record-keeping
(iii) Limited internal controls together with potential for management override of internal controls
Interactive question
Context ltd
[Difficulty level:
Context Ltd supplies contraceptives to the leisure industry, sold through vending machines in pubs and
nightclubs. Turnover has remained steady for the past five years and the statement of comprehensive
income has shown CU6m each year.
Requirement
On I July 2006 the rate of VAT for such supplies was reduced from 17.5% to 5%. Assuming that the
company will not alter the selling price to customers, would this legislation impact on whether Context Ltd
needs an audit/
See Answer at the end of this chapter.
There has long been a debate over the benefits of audit to small companies. Where small companies are
owned by the same people that manage them, there is significantly less value in an independent review of
the stewardship of the managers than where management and ownership are separate.
The case for small companies to have an audit rests on the value of the statutory audit to those who have
an interest in audited accounts, that is, the users of the accounts. The users of the accounts will have
different ideas as follows.
5I5
Interactive
For each set of stakeholders, set out the arguments for and against making audits compulsory for small
companies.
Shareholders
Trade creditors
Tax authorities
Employees
Management
51 6
2.2
2.3
If the proprietor does not himself open the mail, is it opened by a person
not connected with the accounts and read by him before it is distributed
to the staff (or is mail opening double staffed)?
Receipts
Are all cheques and postal orders received by post counted by the
proprietor before they are passed to the cashier?
Are all cheques and postal orders crossed to the company's branch of its
bankers 'Not negotiable- account payee only'.
Are cash sales and credit sale receipts over the counter controlled by
locked cash register tapes which provide a continuous record of amounts
recorded and which only the proprietor can open?
Does the proprietor reconcile the cash register totals with the cash sales
receipts daily?
Banking
Is all cash received banked intact at intervals of not more than three days?
Does the proprietor reconcile all monies received with the copy paying-in
slips at regular intervals?
517
Payments
Are cheques signed by the proprietor only after he has satisfied himself
that
Bank statements
(Cash/cheques
safeguarded against
theft and liabilities not
paid twice)
Does the proprietor review all expenses and initial the petty cash book
before reimbursing the cashier?
Are bank statements and paid cheques sent direct to the proprietor and
opened only by him?
Does the proprietor scrutinise all paid cheques to ensure that he has
signed them all before he passes them to the cashier?
Orders
~ Does
----- -------------------- -
------------~ -------~--------~~-----------
Receipt of goods
Wages
Is a separate cheque drawn for the exact amount to pay wages and tax?
Does the proprietor either prepare or examine the wages records before
signing the cheque?
Does the proprietor initial the wages records after his examination?
Does the proprietor oversee the distribution of the wages packets or does
he/she distribute them personally?
Receivables
(Credit is extended to
creditworthy
customers and debt is
chased)
5I8
Goods outwards
(Dispatches are
recorded, invoiced and
accounted for)
Are pre-numbered dispatch notes prepared for all goods leaving the
premises?
Accounted for?
Cross-referenced with invoices and credit notes?
Is the proprietor satisfied that all goods leaving the premises have been
accounted for?
Inventory
(Inventory is kept
secure and valued
properly)
Although the above types of control are desirable and feasible, they are nevertheless relatively informal.
Consequently evidence of their performance tends to be lacking and they may indeed be overridden as
there is no check on the proprietor himself.
2.4
Exam technique
In the exam, as part of a larger integrated question, you may be asked to evaluate an internal control
system. This may include asking yourself the following questions:
(a)
(b)
(c)
(d)
If you are asked about appropriate controls or weaknesses, remember the control objectives for the
accounting area. Controls should be in place to fulfil the objectives given, weaknesses will mean that the
objectives are not fulfilled.
You should use a similar thought process when deciding how to test the controls. Think of the objectives of
the system; assess how the controls given fulfil those objectives and set out tests which demonstrate
whether the controls are working. Remember that different types of test can be used to test different
controls. For example inspection can be used to test whether different documents are being compared or
documents are being properly authorised. Computation can be used to check invoices have been properly
completed or reconciliations correctly performed.
ltd
question
level:
Peter Marigold and his wife are the sole shareholders/directors of Marigold Ltd. The business company
specialises in high value contracts providing floral displays to the Royal family.
You are auditing the payroll and there are on average 75 employees. The payroll is run by Marge, the
financial accountant and reviewed each month by Peter. There are 2 other finance staff who don't have any
payroll knowledge and Peter confesses to be 'useless with figures'.
Requirements
(a)
(b)
(c)
(d)
What tests will you carry out over the existing controls?
5I9
3 Assurance
Section overview
~
3.1
'
'
An audit provides assurance to the shareholders and otherstakeholders of a company on the financial
,
statements because it is independent and impartial
of assurance
Vera decides to set up a business selling flowers. She gets up early in the morning, visits the market, and
then sets up a stall by the side of the road. For the first year, all goes well. She sells all the flowers she is
able to buy and she derives some income from the business.
However, Vera feels that she could sell more flowers if she was able to transport more to the place where
she sells them, and she also knows that there are several other roads nearby where she could sell flowers,
if she could be in two places at once. She could achieve these two things by buying a van and by employing
other people to sell flowers on the other roads.
Vera needs more money to achieve this expansion of her business. She decides to ask her rich friend Peter
to invest in the business.
Peter can see the potential of Vera's business and wants to invest, but he doesn't want to be involved in the
management of the business. He also does not want to have ultimate liability for the debts of the business if
the business fails. He therefore suggests that they set up a limited company. He will own the majority of the
shares and be entitled to dividends. Vera will be managing director and be paid a salary for her work.
At the end of the first year of trading as a limited company, Peter receives a copy of the financial
statements. Profits are lower than expected, so his dividend will not be as large as he had hoped. He knows
that Vera is paid a salary so she does not care as much as him that profits are low.
Peter is concerned by the level of profits and feels that he wants further assurance on the accounts. He
doesn't know whether they give a true reflection on the last year's trading, particularly as the profits do not
seem as high as those Vera had predicted when he agreed to invest.
Requirement
How will an audit address Peter's concerns, and what other benefits might accrue?
Solution
The assurance Peter is seeking can be given by an independent audit or review of the financial statements.
An auditor can provide the two things that Peter requires:
~
~
Other people will also view the company's accounts with interest, for example:
~
~
The various parties interested in the accounts of a company are sometimes referred to as stakeholders.
Although they will each judge the accounts by different criteria, they will all gain assurance from learning
that the accounts they are reading have been subject to an independent report.
520
3.2.4
3.2.5
3.2.6
3.2.7
The owner-manager occupies a dominant position and may be able to ensure that some transactions
are not recorded
(b)
The entity may not have internal control procedures that provides documentary evidence that all
transactions are recorded.
In these cases, the auditor will need to look for alternative courses of evidence such as external
confirmations/evidence or analytical review to find potential risk areas.
(Para 66-70 BAPS I005)
522
3.2
3.2.1
3.2.2
3.2.3
~
~
521
3.2.8
significant.
The auditor's in-depth knowledge of the smaller entity will assist in identification of related parties (for
example other entities controlled by the owner management) which will also help the auditor to assess the
risk of any transactions being unrecorded or undisclosed.
(Para 85-87 BAPS I005)
3.2.9
3.2.1 0
3.2.11
Current developments
Internationally the revised ISAs issued as part of the Clarity Project include guidance on specific points
relating to small entity audits where relevant.
3.3
Review engagements
As discussed earlier in this chapter, an audit can be used to give assurance to a variety of stakeholders on
many issues. However, an audit is an exercise designed to give a reasonable level of assurance and involves
a high degree of testing and therefore cost. In some cases, stakeholders may find that they receive sufficient
assurance about an issue from a less detailed engagement, for example, a review. A review can provide a
cost-efficient alternative to an audit where an audit is not required by law.
The objective of a review engagement is to enable an auditor to state whether, on the basis of procedures
which do not provide all the evidence that would be required in an audit, anything has come to the auditor's
523
3.4
Levels of assurance
The degree of assurance given by the impartial professional will depend on the nature of the exercise being
carried out.
'Assurance' here means the auditors' satisfaction as to the reliability of the assertion made by one party for
use by another party.
Directors prepare financial statements for the benefit of members. They assert that the financial statements
give a true and fair view. The auditors provide assurance on that assertion. To provide such assurance, the
auditors must:
~
~
~
~
~
Assess risk
Plan procedures
Conduct procedures
Assess results
Express an opinion
The degree of satisfaction achieved and, therefore, the level of assurance which may be provided, is
determined by the nature of procedures performed and their results.
An audit can be distinguished from other assurance engagements in the following ways.
(a)
Audit engagement: the auditor provides a reasonable, but not absolute, level of assurance that the
information audited is free of material misstatement. This is expressed positively in the audit report as
reasonable assurance.
(b)
Review engagement: the auditor provides a moderate level of assurance that the information
subject to review is free of material misstatement. This is expressed in the form of limited assurance.
Limited assurance may include when an auditor gives an assurance that nothing has come to his attention
which indicates that the financial statements have not been prepared according to the framework. In other
words, he gives his assurance in the absence of any evidence to the contrary.
(Also see Chapter 7 of this Study Manual).
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ob~i~.iog'Ni'ai!9~ .';.: ,
.of
4.1
524
4.2
Lending by directors
Sometimes, the best source of finance in terms of availability and cost is money lent to the company by a
director.
It is legal and acceptable for a director to lend money to a company. The loan is
likely to be unsecured.
If a director wishes to secure the loan as a fixed or floating charge on assets,
Companies House must be notified within 21 days or the loan becomes unsecured.
Secured finance takes preference on a winding up as it ranks higher than an
unsecured loan (other than the prescribed part). It is likely that a bank will not allow
a director to have a secured loan if the bank is also providing a loan or even an
overdraft.
See section 3.2.9, the director may have to agree to subordinate the loan if the
company is in difficulty.
Another point to consider is the rate of interest paid to the director by the
company. If the interest rate is considered to be anything other than commercial,
this may cause a tax problem.
If the interest rate is excessively high, the director would be considered to have
received remuneration which will have to be declared on the directors personal tax
It would be rare for a loan from a director to be interest free, as it is not
commercially sensible and not tax efficient. In this case the auditor should consider
the possibility of money laundering by the directors.
If the director lending money to a company does not work full time in the company
and has limited financial involvement, the director may request an assurance
assignment to ensure the current financial statements have been reasonably
prepared. This is likely to constitute a review of the accounts as discussed earlier in
this chapter.
. The loan between the director and the company is a related party transaction and
should be disclosed in the accounts.
A loan made by a director will also mean that wherever the loan is ranked on the
list of creditors, this director has a different entitlement to assets on a winding up to
other directors. This could affect the control of the company.
example: Assodated
Mr Joseph and Mr Mclean jointly own Silvership Entertainment Ltd and work as comedians. They each own
SO% of the shares and neither director has lent the company money.
Mr Joseph also jointly owns another company, Mickie Ltd with Mr Marshall, another comedian.
Mickie Ltd and Silvership Ltd are not associated companies for tax purposes, as they are not under the
common control of the same persons. The same persons do not control either one of them, the definition
of control being a >SO% interest.
However, if Mr joseph loans both companies money, he would be entitled to more assets on a winding up,
so would then be in control for tax purposes as his control of assets on a winding up would exceed SO%.
This would then mean that the companies would be associated due to common control by Mr Joseph, and
525
Audit of tax
If the companies were associated for tax purposes, the small and large tax limits for companies of
CU300,000 and CU 1,500,000 would need to be divided by the number of associated companies.
If Mickie Ltd and Silvership Ltd had profits of CU200,000 each, they would currently be paying tax at the
21% small companies' rate as they are below the CU300,000 limit. If these companies became associated,
the small company limit would be:
cu 300,000
- - - - = CU150,000
2 Companies
The companies would then pay tax at the full rate less marginal relief.
Although the scenario deals with tax rules, they will affect the verification of the tax charge in the accounts
so are important for audit staff.
Audit exemption
If Mickie Ltd and Silvership Ltd were previously audit exempt, it could be argued that due to their
association, they now form a group of companies. This is an example of substance over form but is also
explored in BFRS 3 Business Combinations, which states the many different ways a company can be
controlled, not restricted to shareholdings.
4.3
S Reward packages
5.1
Reward packages
Directors of small companies are normally also shareholders. One of the advantages of having a personal
company as opposed to a sole trader business is the ability to choose a more tax efficient remuneration.
526
Salary
Benefits in kind such as company car
Dividends
Shares or share options
These forms of remuneration can cause problems for the auditor, not only in terms of calculation, but also
disclosure and inherent risks.
If companies lend money to directors, this constitutes financial assistance which is generally illegal for
public companies.
Smaller companies financial assistance rules are more relaxed to enable transactions such as management
buyouts to take place.
Company law regarding directors' loans is covered in Chapter I of this Study Manual.
5.2
Worked
In July 2007, the House of Lords gave their decision on one of the most important tax cases for small
companies in the past 25 years.
In the case Jones Vs Garnett (Artie Systems), the husband earned the revenue for the company and the wife
did some administration work.
The decision was that it is allowed for a wife to receive a reasonable wage for work done and to be taxed
on that wage as normal.
A future assurance issue would be the need to verify the wife's input to the business, by focusing on how
much work the wife did for the company and whether her wages were reasonable. This could be achieved
by assessing her level of work through observation or enquiry, or inspecting timesheets, if any.
5.3
527
5.4
5.4.1
Dividends as remuneration
Legality
Historically, dividends are normally the first choice for directors to receive as remuneration due to lower
tax rates and their exemption from national insurance.
The auditor will need to ensure that any dividends paid are legal. This normally means ensuring the
company has adequate distributable profit in order to pay a dividend.
However, in order for a dividend to be legal it must be declared. Auditors need to check for evidence of
declaration, for example resolutions or minutes of meetings.
Small company directors very often do not fully understand how a company works, and continue to drawn
cash from the business as drawings after incorporation. The cash drawn may be added to a director's loan
account and a dividend may be declared, perhaps annually or even monthly to clear this balance. The
dividend is only legal if it is legally declared.
5.4.2
Reporting
Small company directors may not be aware that dividends no longer appear in the statement of
comprehensive income and that proposed dividends are not allowed to be a liability, so the auditor will
need to request adjustments to the accounts in these areas.
BAS I0 Events after the Reporting Period requires this treatment.
Another problem for auditors where dividends are paid is if the audit report is modified. When the
auditor modifies a report, there needs to be a statement in the report regarding the legality of any
dividends.
If a disagreement has led to the modification it is straightforward to decide whether any dividends are still
legal, as the disagreed figure can easily be quantified and used to assess the real distributable profits.
If a limitation on scope has taken place, for example no records for cash sales were available, the auditor is
unsure of the size of the potential error, so it is more difficult to comment on the legality of the dividend.
The auditors must therefore extrapolate the maximum possible error to comment on the dividend.
528
S.S
5.5.1
5.5.2
~
~
~
5.5.3
5.5.4
Assurance implications
Depending on the scenario, there are wide ranging and complex issues relating to the application of BFRS 2.
Firstly, the auditor will need to assess the option pricing model used and its inputs for reasonableness.
The auditor will also recalculate the fair value using the same inputs. This part of the engagement may
involve reliance on the work of an expert.
If the share-based payment scheme is a cash settled scheme or a hybrid scheme where the employee can
choose cash, the fair value needs to be updated each reporting period, so the auditor will need to perform
these checks each year. For ~quity settled schemes the fair value of the option doesn't change, it is
worked out at the grant date and remains the same.
5.5.5
5.5.6
529
Sales
Six sales staff are offered share options with a total value of CU I00,000 for each employee, dependent on
the company reaching sales growth targets in future. The options will vest if average growth is 13% or if
growth is IS% in any one year.
In year I, growth is 14% so the options do not vest. It is forecast that sales will be sufficient to meet target
next year.
The expense in the accounts is therefore spread over two years, being 6 x
cu 100,000
2 yrs
= CU300,000.
In year 2, sales are only up by I0% so the options do not vest. It is anticipated that targets will be met in
year 3.
In year 2. the total expense will be
6 x CUI 00,000 x
l{
years =CU400,000
Expense
cu
300,000
100,000
200,000
An auditor will have concerns about these figures as they have the potential to introduce volatility into the
statement of comprehensive income.
Because the target related to non-market conditions (it did not depend on the share price) if the target was
not met in year 3 and not forecast to be met in the future, the expense of CU400,000 to the end of year 2
would be credited to the statement of comprehensive income in full in year 3, which would again produce a
volatile profit result.
The final consideration is the number of employees who will receive the shares, in particular any staff
leaving would need to be estimated and not included in the expense. This estimate for future leavers is
updated each reporting period. For a small entity it will not be a huge problem as the scheme is likely to be
restricted to senior staff who would have a very low staff turnover.
530
CU4
CU3.80
25%-40%
5%
3 years
CU0.75
Requirement
Using the information provided, list the audit tests you would perform on the disclosure for Blackberry Ltd.
5.5.7
Overall expense to be recalculated using a 75p option value and 90 employees over three years (it is
unclear how many options each employee will receive). If the scheme is equity settled, i.e. will be
settled by issuing shares, the option value is calculated at the grant date and is not adjusted even if the
underlying share price moves. Cash settled schemes on the other hand are liabilities and the fair values
must be adjusted and recalculated every year.
The disclosure for volatility is incorrect, as it gives a range of volatility, only one figure is needed.
The inputs to the model need to be recalculated, probably using relevant audit software.
The share price needs to be agreed to the stock market price on the grant date.
The exercise price should be vouched to the documentation given to employees and checked against
the rules of the scheme (tax rules often allow the exercise price to be discounted from the share
price, normally a 15% discount is allowed).
Volatility represents the standard deviation of share price movements over the past three years, which
if evidence exists can be adjusted for current conditions. The auditor will carefully check the clients
calculation. If the volatility is too low, the expense will be low, thereby increasing risk. Alternatively,
volatility could be set high to attract potential investors, as large price movements mean they could
make large profits on their investments.
The risk free rate of 5% needs to be verified against an AA rated bond for three years to ensure it is
accurate.
The option life of three years must be agreed to any tax rules governing the scheme and the
documentation given to employees.
53 I
5.6
532
Summary
Risk
Incorporation
Lack of internal
controls+
management
override
]
Rewards
Choice of remuneration
- scope for management
override of controls +
creative accounting
- audit problems with
valuation of share based
payments
Financing gap
Difficult to obtain
finance - inherent risk
-liquidity issues
-funding
533
4 Global enterprises
Section overview
follo~ing risks:
Financial risks
,Political risks ..
Regulatory risks
4.1
; ,
Introduction
Large businesses are increasingly becoming global organisations. This has implications for the business itself
and the way in which the audit is conducted. In the remainder of this section we will look at a number of
key issues affecting global organisations.
4.2
4.2.1
Inherent risk
Financial risks
By its very nature a global organisation will have businesses in countries all over the world. At any point in
time these countries may be experiencing diverse economic circumstances. This may impact on key
aspects of financial management including the effects of the following:
~
~
~
Inflation
Interest rates
Exchange rates
Currency restrictions
In some instances the impact of these can be significant. For example Zimbabwe has experienced inflation in
excess of 200 million per cent in 2008.
Overseas financial risk
The financial strategy of the company may be one of overseas financing. This could be in two
situations.
570
(I)
The raising of finance overseas but remittance of funds back to Bangladesh - probably to take
advantage of more reasonable terms.
(2)
The raising of finance overseas for the purpose of providing capital for an overseas subsidiary, branch
or significant equity investment.
'--
The legal requirements for raising loan capital in the country of origin may be more complex than the
Bangladesh equivalent.
The country of origin may have strict rules on remittance of proceeds back to Bangladesh.
The company m2y have a cultural image or mission statement with which overseas financing conflicts.
The decision to finance overseas may have been made on factors that can easily be distorted in the
short term. The factors likely to have been considered would have been
The prevailing rate of exchange
The cost of financing interest or dividend payments.
Foreign exchange and interest rates are outside the control of the individual entity. Therefore, if there is an
unfavourable movement in the foreign exchange or interest rates, it could result in a significant change in
cash flow in both the short and long term.
Obtaining legal, taxation and accounting advice prior to the overseas financing commencing.
The company should hedge any overseas transactions to reduce the risk of currency and interest rate
movements significantly affecting its assets and liabilities.
The company at board level should consider the cultural and political implications of an
investment overseas.
Examination of the loan capital terms and contractual liabilities of the company.
Checking the remittance of proceeds between the country of origin and the company by reference to
bank and cash records.
Reviewing the movement of exchange and interest rates, and discussing their possible impact with the
directors.
Obtaining details of any hedging transaction and ensuring that exchange rate movements on the
finance had been offset.
Examining the financial statements to determine accurate disclosure of accounting policy and
accounting treatment conforming to Bangladesh requirements.
Evaluating whether the directors had satisfied themselves as to the company's conforming status as a
going concern.
571
4.2.2
Political risks
Political issues, particularly political unrest may also have implications for both the business and the way in
wh'1ch its results are reported. For example, restrictions imposed by foreign governments may call into
question the ability of a parent to control its subsidiary. This may raise questions about possible
impairment of the value of the parent's investment in the subsidiary and may affect the way in which the
investment is recorded in the group financial statements.
4.2.3
Regulatory risks
A global organisation will need to be equipped to deal with a range of local legislation. Key areas include:
~
~
~
~
~
Failure to comply with these may result in financial or other penalties, having to spend money and
resources in fighting litigation and loss of reputation.
In this area governance codes will be particularly important examples of best practice which should be
adopted worldwide, and organisations must consider the risks of breaching provisions relating to integrity
and objectivity, and also control over the organisation as a whole.
Audit impact
The variation in local regulation may also have an impact on the audit itself. For example some subsidiaries
may be in countries which do not have accounting and auditing standards developed to the same extent as
those in Bangladesh. As a result, the financial statements and the audit work carried out on them by local
practitioners may not conform to Bangladesh standards.
In this situation the group auditor may need to:
~
~
The increasing acceptance of international accounting and auditing standards and ongoing convergence
between these and local regulation means tbat this problem should become less significant over time.
4.3
Internal control
Many of the internal control issues stem from the inherent risks identified above. For example,
geographical, cultural and regulatory differences may result in a variety of internal control mechanisms being
adopted by the organisation. The entity will need to ensure that these mechanisms not only satisfy local
requirements but also the internal control objectives of the entity as a whole. The following specific points
should also be noted.
572
Risk management
The management of a global enterprise will need to have regard to the corporate governance
requirements (see Chapter 3) as follows:
Control environment
This sets the tone from the top of the organisation and will need
to be applicable at both a local and global level. Factors to
consider include:
~
~-
Risk assessment
Information systems
Control procedures
Monitoring
'-
4.4
4.4.1
~
~
~
~
Disadvantages
~
573
4.4.2
4.4.3
Assessment of the division manager (based on controllable profit, i.e. costs and revenues
resulting from decisions taken by the manager)
Assessment of the division (based on traceable profit, i.e. costs and revenues which relate to the
division but which are not necessarily controllable by the manager).
Both measures rely on accounting figures that (as discussed above) are subject to manipulation and
subjectivity (e.g. whether to value non current assets at historic cost, net book value, replacement cost etc).
Both measures also require a target rate of return to be defmed. An adequate target may be difficult to
calculate, although risk can be built in to the targets so that different divisions have targets specific to their
operations.
Both measures have specific problems. Rl is troublesome when comparing divisions of different sizes, as an
additional CUI of residual income ought to be easier to achieve the larger the division. ROI, as a
percentage measure, avoids this problem, but has some of its own. For example, a new project may be
acceptable to a company because its rate of return exceeds the target. However, if the division concerned
has an ongoing average ROI that exceeds that of the project, its average will be dragged down if the project
is undertaken.
4.4.4
Transfer pricing
Transfer pricing addresses the need to value the use of goods and services of one division by another. A
well thought-out system may allow accurate divisional performance measurement while ensuring that
divisions are not motivated to make decisions adverse for the company as a whole.
However, transfer pricing often proves impossible to get right and can lead to internal conflict as well as
unreliable divisional performance measures. Recharges are often uncontrollable by those managing divisions,
yet these recharges form part of the results on which they are assessed.
Transfer pricing is often used to manipulate profits for tax purposes, rather than to measure
performance. HM Revenue and Customs spend much oftheir time analysing such recharges (particularly
57 4
To
To
To
To
A company could elect to avoid setting transfer prices, allowing managers to negotiate with each other
towards a mutually agreeable figure. However, if either party (or both) can buy/sell outside of the company
as well, there is a danger that the company under-utilises its own resources, while incurring unnecessary
expense because the two parties failed to agree on a price.
Where the product or service has a readily available outside market, internal transfers are unlikely to occur
unless the transfer price is similar to the market price. The transfer price may be slightly below the market
price to recognise the reduction in risk (e.g. no cash changes hands so no risk of bad debts) and likely
savings in packing and delivery.
Another method used to set transfer prices is 'cost plus'. The transferring division should be able to
recover its variable costs and any contribution lost because it diverted resources in order to fulfil the
internal transfer. The costs involved should be standard rather than actual, otherwise inefficiencies in the
selling division will be passed on to the buying division.
Of course, the selling division will need to recover its fixed costs in the long run and may demand some
contribution from the buying department. As a result of this issue, a company's transfer pricing system may
need to be more complex, with the two divisions recording different figures for a transfer (two-part
transfer pricing) which are reconciled at a later date.
Divisional manager autonomy may have to be partially sacrificed in order to achieve the other aims of
transfer pricing. This may involve divisions being set a transfer price (or range within which the price must
be) but being required to justify any external transactions before authority is given. An alternative solution
is to remove all internal transactions from divisional performance when managers are assessed but, where a
division relies solely/mostly on internal sales, this may be impossible without relegating the division to cost
centre status.
Company C is organised into two divisions, Division A and Division B. Division A can sell its product
outside the company at CU20 per unit or transfer internally to Division B at CU20 per unit. Division B's
usual selling price for its finished product is CU70. Division A's variable costs are CUI 0 per unit and its
fixed costs are CUS per unit. Division B's variable costs are CU IS per unit and its fixed costs are CUI 0 per
unit.
If Division B received an offer from a customer of CU30 per unit for its final product, with the transfer
price of CU20 it would not accept the offer as its books would show a negative contribution per unit of (30
- 20 - IS) CUS.
However, assuming that Division A has surplus capacity, this would not be the right decision from the point
of view of Company C as a whole as contribution would be (30 - I0- IS) CUS per unit.
If Division A is already operating at full capacity then there would be a lost external sales contribution in A
of (20 - I0) CUI 0. Therefore, in this situation, the company as a whole should also reject the offer because
the deal would represent a loss in potential contribution of CUS per unit.
57 5
4.5
Compliance
A key feature of any international business strategy is that it is likely to involve compliance with overseas
accounting and auditing regulations of the host countries in which an entity does business. The most
important piece of recent legislation in this respect has been The Sarbanes-Oxley Act. This is covered in
detail in Chapter 3 of this text.
4.6
4.6.1
Transnational audits
The Forum of Firms
In response to the trend towards globalisation an international grouping, the Forum of Firms (FoF) was
founded by the following networks: BDO, Deloitte Touche Tohmatsu, Ernst & Young, Grant Thornton,
KPMG and PricewaterhouseCoopers.
Membership is open to firms and networks that have transnational audit appointments or are interested in
accepting such appointments.
These firms have a voluntary agreement to meet certain requirements that are set out in their constitution.
These relate mainly to:
~
Promoting the use of high quality audit practices worldwide, including the use of ISAs
Maintaining quality control standards in accordance with International Standards on Quality Control
issued by the IAASB, and conducting globally coordinated internal quality assurance reviews.
The IAASB has set up the Transnational Auditors Committee (TAC) to provide guidance to the
members of the FoF.
The TAC has issued the following definition of transnational audit.
Definition
Transnational audit: means an audit of financial statements which are or may be relied upon outside the
audited entity's home jurisdiction for purposes of significant lending, investment or regulatory decisions; this
will include audits of all financial statements of companies with listed equity or debt and other public
interest entities which attract particular public attention because of their size, products or services
provided.
Guidance: Other public interest entities shall include those entities in either the public or the private
sectors which have significant transactions across national borders, whether or not having either listed
equity or debt. These would include, for example, large charitable organisations or trusts, major
monopolies or duopolies, providers of financial or other borrowing facilities to commercial or private
customers, deposit-taking organisations and those holding funds belonging to third parties in connection
with investment or savings activities.
Significant transactions across national borders - shall include transactions such that there is a reasonable
expectation that the financial statements of the entity may be relied upon by a user outside the entity's
home jurisdiction for purposes of significant lending, investment or regulatory decisions. Significant in this
context does not include use of financial statements to establish normal trade terms with vendors or to
open accounts with financial institutions (i.e. accounts for purposes of collecting customer receipts or
making vendor payments). For the avoidance of doubt, an office required solely for the purpose of legal
formation and continuing legal existence in a particular jurisdiction does not constitute a significant
transaction across national borders.
In principle, the definition of transnational audit should be applied to the consolidated entity as a whole
including the individual entities comprising the consolidated entity.
57 6
4.6.2
4.6.3
These firms may as a result be in a better position than national regulators to ensure consistent
implementation of high quality auditing standards.
Membership of the Forum of Firms imposes commitments and responsibilities, namely:
~
~
~
577
5 Audit of banks
Section overview
5.1
The auditor of a bank may seek confirmation of certain balances from other. banks
Bank supervisors are concerned with maintaining the integrity of the banking system
to shareholders
Introduction
Banking is one example of a global industry which also affects all large companies. It is a regulated industry
which highlights issues faced by many large groups.
The details relating to bank auditing are complex and the key message to extract from the following is how
banking risk is managed and to determine how audits may be planned. Key sources of guidance include:
5.2
BAPS I 000
BAPS I 004
BAPS I006
~
~
The auditor will select which banks it requires confirmation from by considering matters including:
~
~
Size of balances
Volume of activity
Degree of reliance on internal controls materiality
Requesting details of balances and other information which can then be compared with the requesting
bank's records.
Control over the content and dispatch of confirmation requests is the responsibility of the auditor.
Examples of the most commonly requested information include the following:
~
~
~
~
~
~
~
~
~
~
~
578
Balances due to/from the requesting bank on current deposit, loan and other accounts
Maturity and interest terms
Unused facilities
Lines of credit/standby facilities
Any offset or other rights or encumbrances
Collateral given or received
Contingent liabilities (e.g. arising on guarantees)
Asset repurchase and resale agreements
Options outstanding at the relevant date
Forward currency, bullion, securities and other outstanding contracts
Details of securities and other items held in safe custody
5.3
Key provisions
The relationship between bank supervisors and auditors is principally defined by the use of audited financial
statements in the supervision process. The audit of financial statements reflects the risks that banks are
exposed to. This section briefly outlines the role of banking supervision, banking risks and a brief summary
of analytical review of key ratios as an example audit technique.
Banking supervision
Briefly, the basic elements of banking supervision normally feature consideration of the following:
~
~
~
~
Bank supervisors are concerned with maintaining the stability of the banking system and uses their financial
statements in making assessments of individual bank's position and performance. The external auditor is
concerned with reporting on the bank's financial statements ordinarily to the bank's shareholders. The fact
that financial statements are used in the supervision process poses the following problems:
~
Financial statements are prepared for shareholders, not for supervisory requirements
Audits are designed only to provide reasonable assurance that the financial statements taken as a
whole are free from material misstatement
The financial position of the bank may have been affected by subsequent events since the financial
statements were prepared
Assessments of internal control are with respect to assurance relating to material error and may
not be suitable for supervision purposes.
However, there are circumstances in which findings by the auditor may require urgent banking action, such
as:
~
~
~
~
Banking risks
The risks relating to a bank's business may be categorised by:
~
Country risk: e.g. imposition of exchange restrictions arising in the customer's home country
resulting in losses for the bank
Interest rate risk losses rising from adverse interest rate movements
579
Replacement risk: failure of a customer to perform the terms of a contract. The contract will need
to be replaced, potentially at a loss
Reputational risk
Transactions can often be directly initiated and completed by the customer without any intervention
by the bank
They are regulated by governmental authorities. Non-compliance with regulatory requirements could
have implications for the bank's financial statements
They are likely to be involved in complex financial instruments requiring carefully implemented control
procedures.
Point to not<O
The relevance of banking risk has been highlighted by the collapse of Lehman Brothers and the takeover of
HBOS by LloydsTSB in September 2008. Both banks were affected by their exposure to bad debts in the
mortgage sector.
Analytical procedures
From a performance management perspective, audit of banks may be conducted by review of key ratios to
highlight potential problem areas. The ratios that might be relevant under such circumstances are:
~
~
~
~
580
Summary
- Acquisitions
- Bangladesh
-Overseas
-joint Ventures
-MBOs
-Disposals
Continued
below
Issues:
Risk
- Financial
Political
- Regulatory
Internal control
Compliance
Continued
below
581
l
J.
Principal auditors
(PAs)
Other auditors
Consider
/'
Materia lity of
Determine how
portion of FS which
work of other
do not audit
auditors affects
Degree of
their audit
knowle dge of
\..
business of
~
compo nents
Acceptance
Nature of
as PAs
relation ship with
firms acti ng as other
auditors
- Ability (where
necessa ry) to
perform additional
procedu res to
enable act as
principa I auditors
PA's duty to obtain
Riskofmate rial
Info and explanation
misstate ments in FS
required by auditors
of comp onents
from overseas subs
audited by other
auditors
Responsible
for opinion
on S's FS
ISA 600
~
Bring to attention
of PAs any matters
relevant to PA's work
Direct
Communication
~
/
Reporting
responsibilities
\..
582
~
Co-operate with
and assist PAs
As Parent's
auditors duty
to report on
P's own FS
Sole responsibility
. for opinion on
group ales
Permission to """'
communicate
refused. OAs notify
PAs ~ PAs agree
action with Parent's
directors
\..
or
Refer in
auditors'
report
~
Obtain sufficient, appropriate
evidence that work of other
auditors (OAs) is adequate
~
Advise OAs of use to
be made of their work
and arrange to co-ordinate
[Inform OAs
[Advise OAs
--r
Areas for
special
consideration
Procedures
to identify
intra-entity
transactions
Audit
timetable
Independence
requirements
Discussion of
OAs' audit
procedures
Review of
summary of
"OAs' audit
procedures
(eg questionnaire
or checklist)
l
~
Accounting,
auditing and
reporting
requirements
Review of
OAs' working
papers
583
chapter 14
Introduction
Topic List
I
Business structures
Group audits
Joint audits
Global enterprises
Audit of banks
547
Business structures
Section overview
1.1
The nature of the business structure will give rise to specific risks.
Introduction
Most quoted companies and many private companies are not single companies but groups of companies.
You will be familiar with this concept from your financial reporting studies. In the preparation of group
accounts the following accounting standards in particular must be complied with:
~
~
~
~
Many of the basic principles applied in the audit of a group are much the same as the audit of a single
company, however, there are a number of significant additional considerations. One of the key issues
will be the impact of the group structure on the risk assessment, including the process by which the
existing structure has been achieved, e.g. acquisition, MBO etc and/or changes to that structure. In many
cases the risk issues will be related to the accounting treatments adopted.
1.2
1.2.1
A ccounting treatment
Markets
People
5 ystems
By considering these areas for any change it is possible to identify the key risks of any strategy.
1.2.2
Costs
The change process will incur additional costs; these will need to be financed and accounted for.
Initially, costs may outweigh revenues achieved. The company will need to ensure that it can withstand this
potential loss-making situation.
Unfamiliarity of a market can result in costs being higher than necessary due to inexperience of pricing
policies or additional costs incurred to rectify mistakes or replace wastage.
549
I .2.3
Accounting
Each type of change will result in accounting implications for the company; it may for example mean that the
company has to
1.2.4
Satisfy the requirements of BFRS 5 Non-current Assets Held for Sale and Discontinued Operations in
relation to any disposals of material business segments
Consider provisions under BAS 37 Provisions, Contingent Uabi/ities and Contingent Assets
Account for new assets and liabilities being brought into the financial statements
Account for purchase consideration, including related disclosures, whether cash, issue of shares or
other capital instrument.
Markets
Any movement into a new market has its risks. Again, inexperience of the new customers' needs or of a
new product make it easy for mistakes to be made.
1.2.5
People
People
Staff retained
Staff disposed of
I \
550
Change in working
conditions, wage rates,
overtime working, benefits
and other policies
Reorganisation of
hierarchical structure
1.2.6
Systems
All companies should have established systems and procedures; any major change undergone by the
company should cause a review of these systems to take place.
An expansion of the company into similar areas may not cause the existing system to change much beyond
an assessment of its ability to cope with an increased volume of transactions.
Movement into new areas will cause the most changes to the systems. Staff will need to be trained, or new
staff recruited. Inexperienced staff or poor quality systems will result in errors and a loss to the business.
1.3
Acquisitions
A company may choose to grow by buying another company; therefore this type of change will usually
involve the acquiring company buying an existing company. The acquiring company will obtain control of the
acquiree's assets and liabilities and be able to direct the future operations of that company.
1.3.1
Valuation of consideration
Goodwill
Date of control
Level of control
------------
Consolidation adjustments
---------~----
551
1.3.2
Joint ventures
What is a joint venture?
Two or more companies come together to carry out a project or activity. This is different from
an acquisition as two companies are not combining together in their entirety.
Joint ventures tend not to be for the long term, only being set up for the life of the specific project.
You should be familiar with the concept of a joint venture from your Financial Reporting Studies.
ventures
The Royal Bank of Edinburgh entered into several joint ventures:
(I)
'Ecost Personal Finance has made excellent progress since it was launched 18 months ago. To date, the
joint venture has acquired over 700,000 customers.
In a relatively short time, in partnership with Ecost, we have established a significant and innovative
new force in UK banking. We remain very optimistic about the prospects for Ecost Personal Finance
and our expectations remain that this business will move into profit in the near future.
(2)
We have also received an encouraging response to the Branson One Account through our joint
venture with Branson Dlrect Personal Financial Services.'
Requirement
Using the CAMPS framework (see section 1.2.1) examine the risk factors associated with the Royal Bank of
Edinburgh joint ventures.
Solution
Costs
The set up costs of the two ventures will need financing. Will this be done from the existing funds within
the companies, or will external finance be needed?
As RBE is a financial institution, is it providing the bulk of the finance with loan amount outstanding to the
other parties?
How will the infrastructure be established? Who will pay for the Web site to be constructed and
maintained. What is the split of these costs?
What is the profit forecast for the first periods? Initial expenses are likely to exceed revenues, therefore
losses may be expected in the initial periods.
Accounting
RBE is already established in this market and is therefore likely to be providing the asset base to support to
activities. How are the assets valued in the joint venture accounts?
Is there any payment to be made to RBE for the knowledge and experience that it brings to the JV?
What is the type of venture?
What is the agreement on profit sharing? The underlying elements will need to be audited and the profit
share recalculated.
552
Markets
The products are likely to be launched through the Internet; this may expand the customer base of the
companies. E-business has its own specific set of risks, these are covered in the Business Strategy section of
Business Environment.
People
It is likely that there will be a combination of staff involved from each of the parties, plus some additional
staff new to both organisations. The cultural and operational impacts (as explained in the main text) need to
be considered.
Systems
As these will effectively be new entities a complete new set of systems will need to be established. Risk will
be increased due to the unfamiliarity of the staff with these systems.
Responsibility for control. If the entity is a limited company then the directors will be responsible for
ensuring proper controls.
1.3.3
Management Buy-Outs
Whether it is a management buy-out (MBO), a management buy-in (MBI) or a combination of the two
(BIMBO), the most pressing risk is that one party is likely to have a comparative advantage on detailed
financial information. In this respect, the current management team of a business have a major advantage
over existing shareholders, interested investors/buyers and providers of finance.
For example, in an MBI where the outgoing management team own stakes in the enterprise, there is an
inherent danger of overstating the value of the organisation. In an MBO it may work both ways, with the
MBO team looking for as low a price as possible, but also needing to convince outside providers of finance
to invest.
In a BIMBO the situation becomes even more complicated, with the existing management team looking to
convince the additional management team that prospects are good in order to conclude the deal, whilst
knowing that once the deal is finalised the two groups will have to work in tandem.
In addition to the above issues, an existing management team may find its role changing from manager to
owner/manager, introducing new risks (conflict of interest, bias in preparing financial information etc).
In any buyout scenario both historical and future financial information will play a key role.
Consistency must exist between accounting treatments in both past and future data to ensure
comparability.
Historical data is likely to suffer from the problem that the audit was not designed with a business valuation
in mind. Future data presents a more obvious problem for auditors and accountants, in that there is full
knowledge of the reasons for preparation and, as such, liability for error and omission is clearer. The level
of assurance, and therefore the level of detail of the assurance work, will necessarily be greater than for a
statutory audit.
As a result of these issues, the external parties in a buyout situation are likely to take independent
assurance advice, rather than reliance being placed on the work of the company's usual auditors or
accountants. Whilst any deal remains incomplete, privacy is likely to ensure that external parties have to
rely on complete and accurate information being presented. The due diligence exercise (see Section 4
below) provides a detailed verification, normally after the deal is complete, that the information relied upon
was correct.
The greater the level of assurance that can be achieved, the easier it is likely to be to raise finance,
whatever the source. The cost of finance may also be reduced if the assurance achieved is considered
reliable. For this reason, many organisations will pay relatively high professional fees to the largest and most
renowned firms of accountants and advisors.
Whilst the initial investment in fees is high, the returns (greater probability of finance and at a lower cost)
can easily make the decision valid.
55 3
1.3.4
Obsolete inventory
Disposal of investment
Obsolete inventory
Inventory which is no longer required will need to be written down. When carrying out the inventory
count, the auditor will need to ensure that all inventory relating to the discontinued activity is identified.
The following procedures should take place.
~
Investigation offuture costs relating to any modifications needed for the inventory.
Review of after date sales to assess likelihood of sale and sale proceeds.
Net realisable value of non current assets (review of post year end sales invoices/review of trade
magazines).
Write down of non current assets to recoverable amount, surplus property to the market value.
Impairment reviews will need to be performed. This is likely to consider the remaining assets as
one cash generating unit; lack of future revenue from this unit is likely to result in the assets being
valued at their net realisable value (i.e. fair value less costs to sell) rather than their value in use.
Disposal of investments
Disposal of a subsidiary, or other investment, will need to be accounted for in the group and parent
company financial statements.
The auditor will need to ascertain the date of disposal, through inspection of sale agreements, to identify
the correct period of allocation to the accounts.
554
Parent company- The auditor will need to compare the sale proceeds (inspection of sale
agreements/bank receipts) with the carrying amount of the investment in the statement of financial
position to ensure that the correct profit or loss on disposal is accounted for.
Group accounts- The auditor would need to ensure that the investment is not included in the yearend statement of financial position (unless some share holding remains). Amounts in the income
statement should be pro-rated for the number of months held.
2 Group audits
Section overview
2.1
The principal auditor has sole responsibility for the audit opinion in the group financial statements
The other auditors should cooperate with the principal auditors. In some cases this will be a legal
duty
The princip;~.l auditor will need to assess the extent to which the work of the other auditors can be
relied on
Where a group includes a foreign subsidiary compliance with. relevant accounting standards will need
to be considered
Risk assessment
The audit of groups presents a number of additional audit risks from those for a single undertaking.
These can include:
~
~
~
~
2.2
Risk assessment
Accounting treatment
in group accounts
Subsidiaries'
financial statements
555
2.2.1
Anticipated changes
Materiality
Misclassification of investments
(subsidiary v associate v financial asset)
Acquisition
If the group audit includes a newly acquired subsidiary or a subsidiary which is disposed of compliance
with BFRS 3 will be relevant. The auditor will need to consider the following issues in particular:
Level of control
control achieved.
Review consolidation schedules to ensure amounts
have been time apportioned if appropriate.
556
Valuation of consideration
Planning issues
Audit deadline
Type and quality of audit papers
Review of audit
2.2.2
Disposal
Where the group includes a subsidiary which has been disposed of during the year the following issues will
be relevant:
~
Assessment of the remaining stake to determine the appropriate accounting treatment post
disposal
Whether the profit or loss on disposal has been calculated in accordance with BFRS
Whether amounts have been appropriately time apportioned e.g. income and expense items
55 7
2.2.3
Consolidation adjustments
Inter-company guarantees
Any inter-company guarantees (e.g. as surety for
external loans) should be ascertained and
consideration given to whether disclosure as a
contingent liability is required.
558
'.
.....__
2.2.4
Materiality
Where a subsidiary is immaterial it can normally be ignored. However care should be taken with respect to
the following.
~
2.2.5
Subsidiaries with a small asset base may engage in transactions of significant value and which may be
relevant to understanding the group.
2.3
Plan work to deal with different accounting frameworks or policies applied throughout the group
Deal with differences in auditing standards
Integrate the group audit process effectively with local statutory audit requirements.
2.3.1
The duty of the principal auditors is to report on the group accounts, which includes balances and
transactions of all the components of the group.
Principal auditors have sole responsibility for this opinion even where the group financial statements
include amounts derived from accounts which have not been audited by them. As a result, they cannot
discharge their responsibility to report on the group financial statements by an unquestioning acceptance of
component companies' financial statements, whether audited or not.
SS9
2.3.2
The right to require from auditors of subsidiaries also incorporated in Great Britain the information
and explanations they require.
The right to require the parent company to take all reasonable steps to obtain reasonable information
and explanations from foreign subsidiaries
Point to note
The principal auditors also have all the statutory rights and powers in respect of their audit of the parent
company that you should be familiar with from your earlier studies (for example right of access at all times
to the parent company's books, accounts and vouchers).
2.3.3
The materiality of the portion of the financial statements which they do not audit
(b)
(c)
The risk of material misstatements in the fmancial statements of the components audited by other
auditors
(d)
The performance of additional procedures as set out in the BSA regarding the components
audited by the other auditor resulting in the principal auditor having significant participation in such an
audit
(e)
The nature of the principal auditor's relationship with the firm acting as other auditor.
Point to note
In addition to these points, the prospective principal auditor should also consider the general points relating
to acceptance of appointment which you have covered in your earlier studies.
2.3.4
The principal auditor should perform procedures to obtain sufficient appropriate audit evidence that the
work of the other auditor is adequate for the principal auditor's purposes.
BSA 600 states that the principal auditors should advise the other auditors of:
(a)
The independence requirements of both the entity and component. The principal auditors should
obtain written representations on compliance.
(b)
The use to be made of the other auditors' work and report. The principal auditors should make
sufficient arrangements for the co-ordination of efforts at the planning stages of the audit. The
principal auditors should inform the other auditors about the following matters.
~
~
560
(c)
These procedures may be considered unnecessary if evidence has already been obtained of quality
control over the other auditors' work, for example, through inter-firm reviews within affiliated firms.
The principal auditor should also consider the significant findings of the other auditor.
This consideration may involve:
~
~
~
Discussions with the other auditors and with the management of the component
Review of copies of reports to directors or management issued by the other auditors
Supplementary tests, performed by the principal auditors or by the other auditors.
Under the revised BSA the principal auditor is required to document any review that it undertakes, for the
purposes of the group audit, of the audit work conducted by other auditors.
2.3.5
561
2.3.6
Reporting considerations
As we have said in section 2.3.1 above, the principal auditor has sole responsibility for the audit opinion
on the group financial statements. This includes responsibility for those elements of the group financial
statements which have been audited by the other auditors.
When the principal auditor concludes that the work of the other auditor cannot be used and the principal
auditor has not been able to perform sufficient additional procedures regarding the financial information of
the component audited by the other auditor, the principal auditor should express a qualified opinion or
disclaimer of opinion because there is a limitation in the scope of the audit.
If the other auditors issue a modified report, the principal auditors should consider whether the nature and
significance of the qualification means that the principal auditors' report also needs to be modified.
Division of responsibility
BSA 600 states that the above procedures are always desirable. Nevertheless, in some countries the
principal auditors can base their opinion solely on the other auditor's audit report.
When the principal auditor does so, the principal auditor's report should state this fact clearly and should
indicate the magnitude of the portion of the financial statements audited by the other auditor. In these
circumstances the procedures of the principal auditors will be confined to considering the competence of
the other auditors, and communicating with the other auditors at the planning stage. The fact that the
principal auditor has sole responsibility for the group audit opinion means that this would not apply and any
reference to the other auditors in the group audit report could be misunderstood.
Interactive
I: Other auditors
[Difficulty: Exam
You are the main auditor of Mouldings Holdings, a listed company, which has subsidiaries in Bangladesh and
overseas, many of which are audited by other firms. All subsidiaries are involved in the manufacture or
distribution of plastic goods and have accounting periods coterminous with that of the parent company.
Requirement
(a)
State why you would wish to review the work of the auditors of the subsidiaries not audited by you
(b)
Describe the key audit procedures you would carry out in performing such a review.
2.4
Consolidation adjustments are a major source of journal entries therefore procedures relating to the
detection of fraud may be relevant
Risks may arise from incomplete information to support adjustments between accounting frameworks
An important part of the work on the consolidation will be checking the consolidation adjustments.
Consolidation adjustments generally fall into two categories:
~
~
The audit steps involved in the consolidation process may be summarised as follows:
562
Compare the audited accounts of each subsidiary/associate to the consolidation schedules to ensure figures
have been transposed correctly.
Review the adjustments made on consolidation to ensure they are appropriate and comparable with the
previous year. This will involve:
~
Recording the dates and costs of acquisitions of subsidiaries and the assets acquired
Adjust the individual subsidiary financial statements for differences in accounting policies compared to
the parent. This may include compliance with the accounting regulations of a different jurisdiction (e.g.
where the individual subsidiary is UK GAAP compliant and the group reports under BFRS)
3
For business combinations determine:
~
If acquisition accounting has been used, that the fair value or acquired assets and liabilities is
reasonable (to ascertainable market value by use of an expert)
Goodwill has been calculated correctly and if amortised, period of amortisation is reasonable
4
For disposals:
Agree the date used as the date for disposal to sales documentation
~
Review management accounts to ascertain whether the results of the investment have been included
up to the date of disposal, and whether figures used are reasonable
Step 5
Consider whether previous treatment of existing subsidiaries or associates is still correct
(consider level of influence, degree of support)
6
Verify the arithmetical accuracy of the consolidation workings by recalculating them
7
Review the consolidated accounts for compliance with the legislation, accounting standards and other
relevant regulations. Care will need to be taken where:
~
Accounting policies of group members differ because foreign subsidiaries operate under different rules,
especially those located in developing countries
~
~
~
~
Treatment of associates
Treatment of goodwill and intangible assets
Foreign currency translation
Taxation and deferred tax
Treatment of loss-making subsidiaries
Treatment of restrictions on distribution of profits of a subsidiary
Share options
563
Review the consolidated accounts to confirm that they give a true and fair view in the circumstances
(including subsequent event reviews from all subsidiaries updated to date of audit report on consolidated
accounts)
level;
Your firm is the auditor of Varma Industries, a limited company, which has a number of subsidiaries in your
country (and no overseas subsidiaries), some of which are audited by other firms of professional
accountants. You have been asked to consider the work which should be carried out to ensure that intragroup transactions and balances are correctly treated in the group accounts.
Requirement
(a)
Describe the audit work you would perform to check that intra-group balances agree, and to state
why intra-group balances should agree, and the consequences of them not agreeing.
(b)
Describe the audit work you would perform to verify that intra-group profit in inventory has been
correctly accounted for in the group accounts.
2.5
Overseas subsidiaries
The inclusion of one or more foreign subsidiaries within a group introduces additional risks including the
following:
~
Possible difficulty in the parent being able to exercise control, for example due to political instability
There may be threats to going concern due to economic and/or political instability
Audit procedures
These would include the following:
~
Check that the balances of the subsidiary have been appropriately translated to the group reporting
currency:
Assets and liabilities at the closing rate at the end of the reporting period
Income and expenditure at the rate ruling at the transaction date. An average would be a
suitable alternative provided there have been no significant fluctuations.
564
Confirm consistency of treatment of the translation of equity (Closing rate or historic rate)
Check that the consolidation process has been performed correctly e.g. elimination of intra-group
balances
If the foreign operation is operating in a hyperinflationary economy confirm that the fmancial
statements have been adjusted under BAS 29 Financial Reporting in Hyperinflationary Economies before
they are translated and consolidated.
Saturn Ltd trades in Bangladesh preparing accounts to 31 March annually. Several years ago Saturn Ltd
acquired 80% ofthe issued ordinary share capital of Venus Inc which trades in Zorgistan. This country is
experiencing hyperinflation and severe political instability as a result. The local currency is the zorg but
Venus Inc has adopted the US$ as its functional currency. The presentation currency of the group is Taka.
Venus Ltd is audited by a reputable local firm of auditors.
Requirement
Identify the issues the auditor would need to consider in respect of the audit of the Saturn group financial
statements for the year ended 31 March 20X7.
See Answer at the end of this chapter.
2.6
Related parties
Remember that when auditing a consolidation, the relevant related parties are those related to the
consolidated group. Transactions with consolidated subsidiaries need not be disclosed, as they are
incorporated in the financial statements.
The principal auditors are often requested to carry out the consolidation work even where the accounts of the
subsidiaries have been prepared by the client. In these circumstances the auditors are of course acting as
accountants and auditors and care must be taken to ensure that the audit function is carried out and evidenced.
Management representations
BSA 580 Management Representations makes the following comments about obtaining representations in a
group situation.
(a)
When the auditors have responsibility for reporting on group financial statements, where appropriate
they should obtain written confirmation of representations relating to specific matters regarding
both the group financial statements and the financial statements of the parent undertaking.
(b)
How they obtain these representations depends on the group's methods of delegation of management
control and authority.
S6S
2.7
Get organised
Discussing the other auditor with colleagues from their own firm
For other auditors based overseas consider whether they have enough
knowledge and experience of ISAs
566
Business risks
Understand internal
control across the group
Known factors affecting the group that may provide the incentive or
pressure for group or component management or others to commit
fraud or indicate a culture or environment that enables those people to
rationalise committing fraud
Plan early any specialist involvement, for example the use of a tax expert to
deal with international issues or a valuation expert for share options
2.8
2.8.1
2.8.2
Objective
The stated objective of the ISA is to enable auditors to determine whether they can accept an
engagement as group auditor, to communicate clearly with component auditors about the scope and
timing of their work and obtain sufficient appropriate evidence to reduce the audit risk for the group
financial statements to an acceptably low level. This will be achieved by:
~
~
~
56 7
2.8.3
Significant components
The ISA distinguishes between significant components and other components which are not
individually significant to the group financial statements.
Definition
Component. An entity or business activity for which group or component management prepares financial
information that should be included in the group financial statements.
Significant component. A component identified by the group engagement team (i) that is of individual
financial significance to the group, or (ii) that, due to its specific nature or circumstances, is likely to include
significant risks of material misstatement of the group financial statements.
The group auditor should be involved in the assessment of risk in relation to significant components.
If a component is financially significant to the group financial statements then the group auditor will require the
other auditors to carry out a full audit of that component, based on the materiality level the other auditors
have calculated for that component.
If a component is otherwise significant because it is likely to include significant risks of material
misstatement due to its nature or circumstances, the group auditors will require one of the following:
~
~
~
Components not subject to these requirements will be subject to analytical review at a group level.
If audit work on:
~
~
~
Significant components
Group wide controls and the consolidation process
Analytical procedures performed at group level
does not give the group auditor sufficient appropriate audit evidence about the group financial statements,
the group auditor would request one of the three procedures outlined above (a full audit, an audit of
;specified account balances or specified audit procedures) or a review of other individually insignificant
components of group fmancial statements.
2.8.4
Consolidation
The group auditor will:
2.8.5
Design and perform further audit procedures on the consolidation process to respond to the
assessed risks of material misstatement
Subsequent events
The group auditor will perform, or require the other auditors to perform, audit procedures designed to
identify subsequent events that may require adjustment to or disclosure in the financial statements of
significant components.
568
3 Joint audits
Section overview
3.1
Both parties to a joint audit are responsible for the audit opinion
Both parties will have to assess the extent to which the other party can be relied on
Definition
joint audit: One where two or more auditors are responsible for an audit engagement and jointly produce
an audit report to the client.
Two or more firms of accountants could act as joint auditors for a number of reasons.
(a)
Takeover. The holding company may insist that their auditors act jointly with those of the new
subsidiary.
(b)
Locational problems. A company operating from widely dispersed locations may find it convenient
to have joint auditors.
(c)
Political problems. Overseas subsidiaries may need to employ local auditors to satisfy the Jaws of
the country in which they operate. It is sometimes found that these local auditors act jointly with
those of the holding company.
(d)
Companies preferring to use local accountants, while at the same time enjoying the wider range of
services provided by a large national firm.
3.3
569
chapter IS
Insolvency
Contents
Introduction
Topic List
I
Insolvency
Insolvency legislation
599
INSOLVENCY
Insolvency
Section overview
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1.1
A company is insolvent when it cannot pay its debts as they fall due
1.2
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1.3
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Auditor
Provider of assurance services
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2.1
2.1 .I
Going concern
In planning and performing audit procedures and in evaluating the results management's use of the going
concern assumption must be challenged. This is the case in all audits performed in accordance wrth BSAs.
Clearly this is judgemental and relates to a particular point in time, about the future outcome of events or
conditions which are inherently uncertain. Guidance for the auditor is provided in BSA 570 Going Concern.
This was covered in detail in Chapter 6 in the context of the audit process. The key points from this BSA to
remember are as follows:
Uncertainty increases with the length of time forecasts are made or over which judgements extend
Any judgement about the future is based on information available at the time which the judgement is
made
The more complex the organisation, the more variables that management are required to make a
judgement about.
The BSA also provides examples of events or conditions, which may give rise to business risks, that
individually or collectively may cast doubt about the going concern assumption. These are categorised as
follows:
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Financial factors
Operating factors
Other factors
Audit procedures
The following procedures might be employed when problem areas are identified including the following:
2.1.2
Review management's plans for future actions based on its going concern assessment
Gather sufficient appropriate evidence to confirm or dispel whether or not a material uncertainty
exists through carrying out audit procedures considered necessary, including considering the effect of
any plans of management and other mitigating factors
Seek written representations from management regarding its plans for future action
Accounting issues
Accounting treatments will be affected by the viability or otherwise of the business and the auditor will
need to take these into account. In particular the following issues will need to be addressed:
Provisions
One of the key aspects of corporate distress is the need to make provisions under BAS 37 Provisions,
Contingent Liabilities and Contingent Assets (e.g. for onerous contracts). The nature of such provisions makes
them extremely difficult to audit as the likelihood of economic benefits being transferred (and to an
the value of these benefits) will probably vary directly with the probability of insolvency occurring.
ext~nt
Impairment of assets
The auditor will need to consider the impact of going concern issues on the valuation of assets and in
particular whether factors indicate that assets have been impaired in accordance with BAS 36 Impairment
Assets. BAS 36 specifically includes the following as an external factor which should be considered when
assessing indications of impairment:
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602
of
Significant changes with an adverse effect on the entity have taken place during the period, or will take
place in the near future, in the technological, market, economic or legal environment in which the
entity operates or in the market to which the asset is dedicated.
INSOLVENCY
2.1.3
Reliance on an expert
In assessing going concern, auditors may need to place reliance on the work of an industry, or perhaps legal,
expert. The detail of BSA 620 Using the Work of an Expert was covered in Chapter 5. The relevance of this
issue here is in respect of asset valuations and the interpretation of legal documents.
2.2
2.2.1
Other assurance
Prospective financial information
In the context of insolvency the professional accountant may be asked to evaluate prospective financial
information. This topic is covered in detail in Chapter 7 of this text.
Gunthorpe Plumbing Supplies ('Gunthorpe') is a wholly owned subsidiary of Lucknow Builders Merchants
('Lucknow') and has been trading at a loss for a number of years. The recent bleak economic climate has led
the directors of Lucknow to decide to put Gunthorpe into liquidation and make all the employees
redundant, including its three directors.
The three directors of Gunthorpe have decided to form a new company, Gunthorpe Plumbing Supplies
(200 I) ('Gunthorpe (200 I)'), and use their redundancy pay and personal savings to purchase all the shares in
the company.
The board of directors of Lucknow have agreed to sell the following assets and liabilities of Gunthorpe to
the new company.
(a)
All the non-current assets except for one warehouse (see below)
(b)
(c)
The price for the non-current assets has been agreed and the value of the trading inventories, receivables
and payables, will be confirmed at the date of transfer by an independent valuer.
The directors of Gunthorpe (200 I) propose to obtain additional finance in the form of a long term loan
from a merchant bank and working capital will be financed by a bank overdraft from their existing bankers.
The directors have asked you to assist-them in preparing a profit forecast and cash flow forecast for
submission to the two banks. They have provided you with copies of the detailed accounts of Gunthorpe
for the past five years, and they point out the following changes which, in their opinion, will enable the new
company to trade at a profit.
(a)
The substantial management charge imposed by Lucknow will disappear. However, additional costs will
have to be incurred for services which were provided by the parent company, such as maintaining the
accounting records and servicing the company's vehicles
(b)
(c)
Only one of the company's two premises is being taken over- the premises which are not being taken
over will be sold by Lucknow on the open market.
The directors have provided you with the following brief details of Gunthorpe's trade. It currently has a
revenue of about CUI million and is a wholesaler of plumbing equipment (copper pipes, pipe connections,
water taps etc) which are sold mainly on credit to plumbers and builders. Trade discount is given to larger
customers. There are some cash sales to smaller customers, but these represent no more than I0% of total
sales.
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Requirements
Describe the work you would perform to:
(a)
Verify that the value of items included in the profit forecast are reasonable
(b)
Verify that the value of items included in the cash flow forecast are reasonable.
2.2.2
Internal audit
The provision of an internal audit service could lead to the risk of insolvency being highlighted. Internal
audit is covered in Chapter 5 and Chapter 9 of this text.
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3.1
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Directors' responsibilities
Directors are responsible for safeguarding company assets. The directors can appoint a liquidator on
behalf of the shareholders, although it is usually the members themselves, the creditors or the Court who
will do this.
When a company is insolvent, steps should be taken by the directors to ensure that creditors are
protected.
An insolvency practitioner/receiver will be appointed to repay creditors, and they will assess the
reasons for the insolvency.
3.2
Directors' liability
If the directors knowingly enter into transactions when a company is insolvent, this could be classed as
wrongful trading.
This is one of the few situations where directors can be disqualified and sued personally for the
company's liabilities, the other situations involve fraud and money laundering.
Directors may also incur personal liability if the liquidator can establish that antecedent transactions
have occurred. These are transactions at an undervalue and preferential transactions, i.e. those that are
intended to prefer the interests of one creditor over the others.
These were covered in the Law study text at Knowledge level, but for the sake of completeness we
reproduce the material here.
604
The Court may, by order, nullify the transfer of any property of the debtor, whether made by the
debtor himself or by his legal representative or his heirs or administrator of other authorised
person within fifteen years immediately preceding the date of the order of adjudication, if the
INSOLVENCY
Court is satisfied that the transfer was made to defeat any debt owned by the debtor. but the
nullification shall not be applicable to the following transfers, namely:a.
b.
c.
2)
Where an order under subsection (I) is made nullifying a transfer, the property shall form part of
Estate and shall stand vested in the Receiver or as the case may be in the court and accordingly
possession thereof shall be taken over immediately.
3.3
Auditors' responsibilities
If a company becomes insolvent, there is a strong possibility that shareholders will suffer losses.
In this case, shareholders and creditors might look towards the auditors, and consider them to be
responsible for alerting them to potential going concern issues at the earliest opportunity.
This is another example of the expectation gap. It cannot be said that the auditors are completely free
from responsibility as it depends on the circumstances behind the insolvency. The extent of the auditor's
liability is covered in the next section.
As we have seen in section 2, as part of every audit, the auditor must review whether the company is a
going concern, normally meaning its survival in the foreseeable future of one year beyond the approval of
the accounts.
3.4
Auditors' liability
The reason for the insolvency must be ascertained in order to decide whether the auditor can face any
liability.
It might be the case that if the auditors should have identified going concern problems at the time of the
audit, the auditors might be accused of professional negligence.
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Following the collapse of Enron, the audit firm of En ron, Arthur Andersen, collapsed. Senior management of
En ron have been since imprisoned for fraud. Allegations of fraud have also extended to the bankers of the
company, and many connected people were given long prison sentences.
4 Insolvency legislation
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Section ~verview
4.1
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Introduction
A company in difficulty or in crisis (an insolvent company) basically has a choice of two alternatives:
(I)
(2)
To carry on with the business, using statutory methods to help remedy the situation
To stop
A company which is heading towards insolvency can often be saved, using a variety of legal protections
from creditors until the problem is sorted out. The directors of a company can get into a lot of trouble if
they carry on trading through a company in serious financial difficulties, and their actions result in
creditors being defrauded.
However, alternative I does not have to mean carrying on as if everything is normal. It can mean seeking
help from the court or a qualified insolvency practitioner to put a plan together to save the
company and get it out of its poor financial position.
Unfortunately, many companies cannot be saved, and the members and directors are forced to take
alternative 2, to stop operating the business through the company. Liquidation, sometimes called 'winding
up', is when a company is formally dissolved and ceases to exist.
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INSOLVENCY
4.2
Liquidation
Definition
Liquidation means that the company must be dissolved and its affairs 'wound up', or brought to an end.
The assets are realised, debts are paid out of the proceeds, and any surplus amounts are returned to
members. Liquidation leads on to dissolution of the company. It is sometimes referred to as winding up.
4.2.1
The directors
The creditors
The members
The directors are best placed to know the financial position and difficulty that the company is in. The
creditors may become aware that the company is in financial difficulty when their invoices do not get paid
on a timely basis, or at all.
The members are likely to be the last people to know that the company is in financial difficulty, as they
rely on the directors to tell them. In public companies, there is a rule that the directors must call a general
meeting of members if the net assets of the company fall to half or less of the amount of its called-up share
capital. There is no such rule for private companies.
4.3
4.4
4.5
All company documents (e.g. invoices, letters, emails) and the website must state the company is in
liquidation
Voluntary liquidation
A winding up is voluntary where the decision to wind up is taken by the company members, although if
the company is insolvent, the creditors will be heavily involved in the proceedings.
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4.5.1
A members' voluntary winding up, where the company is solvent and the members merely
decide to 'kill it off'
A creditors' voluntary winding up, where the company is insolvent and the members resolve to
wind up in consultation with creditors
The effect of the voluntary winding up being a creditors' one is that the creditors have a decisive
influence on the conduct of the liquidation.
4.5.2
4.5.3
4.6
Compulsory liquidation
A creditor may apply to the court to wind up the company, primarily if the company is unable to pay its
debts. There are statutory tests to prove that a company is unable to pay its debts.
4.6.1
4.6.2
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INSOLVENCY
it is the liquidator's duty to continue it with a view only to realisation, for instance by sale as a going
concern.
Within 21 days of the making of the order for winding up (or of the appointment of a provisional liquidator)
a statement of affairs must be delivered to the liquidator (official receiver) verified by one or more
directors and by the secretary (and possibly by other persons). The statement shows the assets and
liabilities of the company and includes a list of creditors with particulars of any security.
The liquidator may require that any officers or employees concerned in the recent management of the
company shall join in submitting the statement of affairs.
4.6.3
4. 7
(a)
The official receiver may require the public examination in open court of those believed to be
implicated (a much-feared sanction).
(b)
The official receiver may apply to the court for public examination where half the creditors or threequarters of the shareholders (in value in either case) so request.
Chapter I I in the US
In the United States, the most common procedure for an ailing company is Chapter I I Bankruptcy, similar
to administration in the UK. This gives the company an opportunity to reorganise and emerge from
bankruptcy. Management are able to stay in charge while negotiating an outcome with creditors. At the
time of writing the fall out from the sub-prime lending problem in the US is causing a number of financial
services companies in the US to file under Chapter II, the most notable being Lehman Brothers Bank.
4.8
At the time of distribution of the Estate I prior to the payment of dividends to creditors, there shall be
paid first the administrative expenses including the necessary expenses incurred by the Receiver and
thereafter the Receiver's fee under section 66( I). or, as the case may be, section 74 (3) and then the
other dividends shall, subject to sub-section (2), be paid in the following order of priority:a.
All taxes and other debts of a like nature due to the Government;
b.
All wages or salaries, not exceeding Tk2,000 due to any clerk, servant, labourer, or workmen
in respect of services rendered to the debtor during the period of 6 months immediately
before the date of filing the Plaint;
c.
d.
e.
2)
Where the Estate, after paying the debts specified in clauses (a) and (b) of sub-section (I), is not
sufficient to pay all bank-debts in full and at least 50% of all unsecured claims, the priority given to
bank-debts shall abate to the extent so far as may be necessary to ensure that the payments to be
made in respect of unsecured claim is at least of 50% of the bank debts.
3)
The debts or claims of each class specified in sub-section (I) shall rank equally between themselves,
and shall be paid in full, unless the Estate is insufficient to meet them, and if the Estate's is sufficient,
they shall abate in equal proportions between themselves.
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If after the retention of the sums necessary for the administration expense and the Receiver's fee, all
the debts and claims specified in subsection (I) shall be paid forthwith in consideration of the
sufficiency of the Estate.
5)
Where the debtor is a partnership firm, the partnership property shall be applicable in the first
instance in payment of the debts of the firm and if the Estate derived from such property is not
sufficient for such payment, the personal property of each partner shall be applicable in payment of his
debts and liabilities in relation to the firm.
6)
Where, after application of the personal property or, as the case may be, of the partnership property
in pursuance of sub-section (i), there remains a surplus, it shall be dealt with as part of the partnership
property and shall be divisible among the partners in proportion to the rights and interests of each
partner in the partnership.
7)
Subject to the foregoing provisions of this section, all debts entered in the schedule shall be paid
rateably according to the amounts of such debts respectively and without any preference.
8)
Where there is any surplus after payment of all expenses, fees, debts and claims, it shall be applied in
payment of interest, calculating from the date on which the debtor is adjudged bankrupt, at a rate of
not exceeding six per cent per annum on all debts include in the schedule.
Subject to the approval of the Court and the provision of section 64(3) (b), the Receiver shall be
entitled to take from the sale proceeds of the assets realised out of the Estate a fee ofa.
an amount not exceeding I0% of the first Tk I0, I0,000 or part thereof;
b.
5% of the amount in excess of Tk I0, I0,000 but not exceeding Tk2,00,00,000; and
c.
2)
A Receiver shall also be entitled to the reimbursement of all expenses actually incurred by him in
realizing and distributing the assets of the Estate or any part thereof, including the expense for giving
reward under section 71 (4).
Where the Receiver, pursuant to section 55, sells a property for the benefit of the secured creditor or
jointly for the benefit of the secured creditor and the Estate, he shall ordinarily be entitled to a fee, subject
to the approval of the Court and the provisions of sections 54(3) (b), of not more than 4% of the value of
such property sold, and the remaining portion of the sale proceeds, after deducting the amount spent on
the expense of the sale, shall be included in the Estate.
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INSOLVENCY
Summary
Order of Payment
Liquidation fees
All taxes, other dues to
Government
All wages or salaries, not
exceeding Tk2,000
All bank debts
All unsecured claims
Any subordinated claims
Shareholders
Directors Responsibility
- Wrongful trading: knowingly
entering into transactions when
company is insolvent
- Can be personally liable
Role of Auditor
- Difficult to give
assurance on prospective
financial information
Consider ethical position
when accepting
Preferences
-Treating creditors unfairly
Auditor Responsibility
Consider going concern basis
-Use financial and operating
indicators as required
Consider disclosure of material
uncertainty about going concern
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chapter 4
Introduction
Topic List
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Process of planning
5
6
Analytical procedures
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9
Materiality
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Creative accounting
III
1.1
Overview
Whilst there may be variations between specific procedures adopted by individual firms the modern audit
process is a well-defined methodology designed to enable the auditor to obtain sufficient, appropriate
evidence.
This process can be summarised in a number of key stages:
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In this chapter we will consider stages 1-4. In Chapter 5 we will consider stage 5, and in Chapter 6, stages 6
and 7. However it is important not to view the audit as a series of discrete stages and individual pieces of
audit work. For example, it can be argued that all audit procedures which provide evidence are risk
assessment procedures whether they are conducted during planning, control evaluation, substantive testing
or completion. The modern audit process will adopt a strategy where complimentary evidence is acquired
and evaluated from a range of sources. The process is repeated until the auditor has obtained sufficient,
appropriate audit evidence which is adequate to form an opinion.
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2 Process of planning
2.1
Introduction
Auditors are required to plan their work to ensure that attention is paid to the correct areas of the audit,
and the work is carried out in an effective manner.
In order to produce this plan the auditor must:
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Understand the business, its control environment, its control procedures and its accounting system
Determine materiality
Develop an audit strategy setting out in general terms how the audit is to be carried out and the type
of approach to be adopted.
Produce an audit plan which details specific procedures to be carried out to implement the strategy
taking into account all the evidence and information collected to date.
You have already covered planning and risk assessment issues in your earlier studies and the relevant BSAs
which include:
of Audit Engagements
BSA 300 Planning an Audit of Financial Statements
BSA 315 Obtaining an understanding of the Entity and Its Environment and Assessing the Risks of Material
BSA 21 0 Terms
Misstatement
BSA 320 Audit Materiality
BSA 330 The Auditor's Procedures in Response to Assessed Risks
A number of issues are developed in the remainder of this chapter, however it is assumed that you are
already familiar with the basic requirements of the above BSAs. A summary of these and other related BSAs
can be found in the technical reference section at the end of the chapter for revision purposes.
3.1
Procedures
BSA 315 states that 'the auditor should obtain an understanding of the entity and its environment, including
its internal control, sufficient to identify and assess the risks of material misstatement of the financial
statements whether due to fraud or error, and sufficient to design and perform further audit procedures'.
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Classes of transactions
Occurrence; Completeness;
Accuracy; Cut-off; Classification
i.
Identify risk of material
misstatement at the financial
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statement and assertion levels
Account balances
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I;xistence; Rights and obligations;
Completeness; Valuation and
allocation
i.
Determine Whether any risks. are
so
significant that they require
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special audit COfiSideratlon
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The auditors must use a combination of the top three techniques, and must engage in the discussion for
every audit. The auditor may use his prior period knowledge, but must carry out procedures to ensure that
there have not been changes in the year meaning that it is no longer valid.
The BSA sets out a number of areas of the entity and its environment that the auditor should gain an
understanding of. These are summarised as follows:
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The purpose of obtaining the understanding is to assess the risks of material misstatement in the
financial statements for the current audit. The BSA says that 'the auditor should identify and assess the risks
of material misstatement at the financial statement level, and at the assertion level for classes of
transactions, account balances and disclosures'. It requires the auditor to take the following steps:
Step I
Identify risks throughout the process of obtaining an understanding of the entity
I IS
Step 2
Relate the risks to what can go wrong at the assertion level
Step 3
Consider whether the risks are of a magnitude that could result in a material misstatement
Step 4
Consider the likelihood of the risks causing a material misstatement
Notice therefore that the stages of the planning process often take place simultaneously rather being
performed in sequence. For example, as the auditor learns more about the business certain risks will come
to light as a result. So the auditor is both gaining an understanding of the business and identifying risk by
adopting the same procedures. We will look at risk specifically in sections 4 and 5 of this chapter.
Inventory
If certain items of the inventory are obsolescent due to the fact that it has been produced in excess of the
customer's requirement and there is no other available market for the inventory, then there is a risk that
inventory as a whole in the financial statements will not be carried at the appropriate value. Given that
inventory is likely to be a material balance in the statement of financial position of a manufacturing company,
and the value could be up to I0% of the total value, this has the capacity to be a material misstatement.
The factors that will contribute to the likelihood of these risks causing a misstatement are matters such as:
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Whether management regularly review inventory levels and scrap items that are obsolescent
Whether such items are identified and scrapped at the inventory count
Whether such items can be put back into production and changed so that they are saleable
losing custom
The long term risk of losing custom is a risk that in the future the company will not be able to operate (a
going concern risk). It could have an impact on the financial statements, if sales were attributed to them
that they dispute, revenue and receivables could be overstated, that is, not carried at the correct value.
However, it appears less likely that this would be a material problem in either area, as the problem is likely
to be restricted to a few number of customers, and only a few number of sales to those customers.
Again, review of the company's controls over the recording of sales and the debt collection procedures of
the company would indicate how likely these risks to the financial statements are to materialise.
Some risks identified may be significant risks (indicated by the following factors), in which case they
present special audit considerations for the auditors.
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Risk of fraud
Its relationship with recent developments
The d~gree of subjectivity in the financial information
Routine, non-complex transactions are less likely to give rise to significant risk than unusual transactions or
matters of director judgement because the latter are likely to have more management intervention,
complex accounting principles or calculations, greater manual intervention or there is a lower opportunity
for control procedures to be followed.
When auditors identify a significant risk, if they have not done so already, they should evaluate the design
and implementation of the entity's controls in that area.
3.2
3.2.1
Industry
The type of entity being audited will also have a significant impact on the audit plan. For example:
Little or no inventory
Payment by commission
An understanding and appreciation of these differences will assist the auditor in identifying risk areas and in
developing an appropriate audit approach.
From the auditor's point-of-view, the different entities will result in a different audit approach for each
entity. For example, the lack of inventory in service industries will obviously mean h~ss time will be devoted
to that area. Conversely, the use of complicated costing systems will require use of specialist computerauditors to identify, record and test various computerised systems.
3.2.2
Business processes
From the comments above, it is also possible to identify the different business processes that the auditor
will need to focus on. The five main processes are summarised in the diagram below.
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Financing
Obtaining capital by borrowing
or third parti~s i~vesting in the
company
Purchasing
Acquiring goods to support
prod!Jcti~n and sales.of
company's own products
Revenue
Generating revenue through .
sales of goods and obtaining
cash from debtors
Inventory management
Process of accu111ulating and
illocating costs to Inventory
and work-in~progress
An understanding of each process focuses the auditor's attention on specific parts of the business.
Financing
Verification of new share issues I confirming current account and loan balances
and where necessary bank support for the business.
Purchasing
Human resources
Inventory
management
Revenue
The actual audit approach will depend partly on the audit methodology used which we will look at later in
this chapter.
4.1
Business risk
Business risk is the risk arising to entities that they will not achieve their objectives. It includes risks at all
levels of the business.
Business risks can be classified into 3 categories:
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Financial risks
Operating risks
Compliance risks
Definitions
Financial Risks- are those risks arising from the company's financial activities (e.g. investment risks) or
the financial consequences of operations (e.g.-receivables risks).
Examples: going concern, market risk, overtrading, credit risk, interest rate risk, currency risk, cost of
capital, treasury risks.
Operating Risks -are those risks arising from the operations of the business.
Examples: loss of orders; loss of key personnel; physical damage to assets; poor brand management;
technological change; stock-outs; business processes unaligned to objectives.
Compliance Risks- are those risks arising from non-compliance with: laws, regulations, policies
procedures and contracts.
Examples: breach of company law, non compliance with accounting standards; listing rules; taxation; health
and safety; environmental regulations; litigation risk against client.
Business risk may be caused by many factors, or combination of factors including the following:
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Complex environment
Dynamic environment
Competitors' actions
Inappropriate strategic decision making
Operating gearing
Financial gearing
Lack of diversification
Susceptibility to currency fluctuations
Inadequate actual or contingent financial resources
Dependence on one or few customers
Regulatory change or violation
Adequacy and reliability of suppliers
Over-trading
Developing inappropriate technology
Macro-economic instability
Poor management
Clearly different risks will impact upon businesses in different ways. Moreover, even within one company,
different stakeholders may be affected differently. For example:
4.2
One company may not be diversified but shareholders, who hold diversified portfolios, my be- they
would therefore view risk differently from other stakeholders
Directors who determine business strategy may take decisions more in line with their own risk
preferences, rather than those of other stakeholders to whom they are accountable
Identify significant risks which could prevent the business achieving its objectives
Provide a framework to ensure that the business can meet its objectives
Review the objectives and framework regularly to ensure that objectives are met
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4.2.1
Risk profiling
One means of assessing business risk is to consider two particular aspects:
(I)
Consequences- the consequences to the organisation if a particular event or scenario takes place
(2)
Low
High
Impact
Low
Consider ac:tion
. (cost/beciefit)
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Periodic review .
This method of risk assessment can be used by both the business and the auditor alike.
4.2.2
Risk responses
The following are some examples of strategies which a company may adopt in respect of risk management.
4.3
4.3.1
Accept the risk- If the likelihood and impact of a risk are within tolerable boundaries then the risk
may be accepted without any mitigation procedures. Alternatively, a higher level of risk may be
tolerated if it is associated with a higher level of return.
Transfer the risk to a third party- For example, altering contractual terms to shift the
consequences of failure. Alternatively, the risk of holding high levels of inventory can be transferred to
suppliers by adopting a just-in-time strategy. Frequently however, this merely changes the form of the
risk rather than removing it altogether as there is now a risk that supplies will not arrive on time.
Eliminate the risk- For example, foreign currency risks can often be eliminated by hedging, but
there is an associated cost. Alternatively, it may involve adopting an exit strategy.
Sharing the risk with another party- Examples include a joint venture, joint and several liability,
franchising, licensing.
Insure against risk- Many types of adverse events can be insured against.
What factors lead to the problems which may cause material misstatements?
What can the audit contribute to the business pursuing its goals?
The business risk audit approach tries to mirror the risk management steps that have been taken by the
directors. In this way, the auditor will seek to establish that the financial statement objectives have been
met, through an investigation into whether all the other business objectives have been met by the directors.
The application of the business risk model (BRM) is therefore related to the client's:
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Objectives
Business strategy
Risk management procedures
Industry environment
Economic environment
This approach to the audit has been called a 'top-down' approach, because it starts with the business and
its objectives and works back down to the financial statements, rather than working up from the financial
statements which has historically been the approach to audit involving detailed tests of transactions and
balances. The BRM therefore looks at the 'big risks' that may significantly threaten the valuation, profitability
or even the going concern of the business. Those who support this approach argue that the key audit risks
are more likely to relate to the failure of the company's strategy than the misstatement of a transaction.
The BRM does not, however, seek to replace the more traditional audit risk model (see section 5). Rather,
it seeks to expand it by taking a different perspective of risk. Instead of viewing risk from the perspective of
the financial statements, it views it from the client's penpective in terms of its objectives and business
environment. In this way the context and underlying economic events which financial statements record are
taken into account.
In particular, the BRM focuses on a company's critical business processes, which are those processes that
are key to the way a business operates and determines its success. (For example the process of
development of new vehicles may be key to the success of a car manufacturer). We looked at business
processes in section 3.2.2. Supporters of the BRM argue that it is only by understanding how the entity
conducts its business and the underlying strategy that one can understand the risks associated with
how those activities are recorded in the financial statements.
A key element in the application of the BRM is that, having identified relevant business risks, they need to
be specifically linked to control risks and ultimately to the risk of financial reporting misstatement.
The following table demonstrates the way in which business risks can have implications for the financial
statements and therefore the audit.
Receivables recoverability
Going concern
Receivables valuation
Going concern
Litigation - provisions and contingencies
Inventories - net realisable value
Anywhere
I 21
State what category of business risk each of the risks in the above table falls under.
On I january 20X8 a steel production company has significant steel inventories with a total value of
CU20 million.
To protect the inventory from changes in value, the entity enters into a futures contract on a commodities
exchange to fix the selling price in 18 months' time. This is the first time that the entity has entered into
this type of transaction.
Requirements
(i)
(ii)
4.3.2
Application
There is no auditing standard covering the BRM, so its application may vary significantly from audit firm to
audit firm. The following are, however, some common themes relevant to its application
Identifying business risks
The techniques and models used by the auditor to identify key business risks are likely to parallel those
used by management. These models are included in the brought forward material from Professional Stage
Business Management and may briefly be summarised as set out below.
~
Porter's five forces model - Examines the forces affecting an industry's competitive environment
(customers, suppliers, competitors, new entrants, substitutes).
Porter's value chain- Relates a company's resource profile to its strategic performance in obtaining
competitive advantage.
PEST (or PESTEL) analysis- Considers the impact of external forces upon the company. (PEST is
Political, Economic, Social, Technological. PESTEL adds Environmental and Legal.)
SWOT analysis - Considers the internal and external factors affecting the position of the business
(strengths, weaknesses, opportunities, threats}.
I 22
,__
The system of monitoring is likely to vary from company to company depending upon the risk management
procedures in place and the nature and scale of the risks being faced. Typical risk monitoring procedures
may, however, included.
~
~
~
~
A key point is that controls for mitigating risk should be embedded into the processes and culture
which are used to achieve an organisation's objectives. A series of occasional or one-off exercises are
unlikely to be effective. As such it should be a part of normal and regular internal reporting procedures.
Tests of controls
As the auditor pays greater attention to the high level controls used by
directors to manage business risks, controls testing will be focused on items
such as the control environment and corporate governance than the detailed
procedural controls tested under traditional approaches.
Analytical
procedures
Detailed testing
The combination of the above two factors, particularly the higher use of
analytical procedures will result in a lower requirement for detailed testing,
substantive testing will not be eliminated completely.
You are using the business risk model in the statutory audit of a major international pharmaceutical
company.
You are told that the key determinant of profitability is the development of new types of drug, which are
superior to those of competitors. This is achieved by significant investment in R&D. You are also informed,
however, that such drugs may take as many as I0 years before gaining regulatory approval for use. One
major R&D project is a joint venture with another pharmaceutical company.
Requirements
Outline
(a)
(b)
(c)
I 23
4.3.3
4.3.4
Audit effectiveness and efficiency- Understanding of the business and its environment enables
identification of the key risks facing the client at the planning stage such that auditing procedures can
be designed as an appropriate response.
Added value client service- Viewing risk from the perspective of the client's business can place
the auditor in a good position to "add value" to the entity's risk management procedures and assist in
the development of a business strategy in a changing environment.
Corporate governance- By focusing on wider issues of governance, rather than merely internal
financial controls, the BRM emphasises a broader understanding of the relationships between
stakeholders, the relative risks that they incur and the role of financial information in facilitating such
relationships.
Engagement risk- Engagement risk is the risk to the audit firm arising from a particular audit
engagement (e.g. litigation risk, reputation effect). It is argued that adoption of the BRM better enables
audit firms to assess and control engagement risk by enhancing an understanding of the factors that
are most likely to give rise to such risks.
Assurance assignments- The BRM lends itself to many assurance assignments where
methodologies may be enhanced by its application.
Turnbull report- Listed companies are required to report upon their risk management procedures.
The adoption of the BRM will enable a greater understanding by the auditor of such procedures and
he would thus be better placed to review their application.
Risk can seldom be eliminated completely and additional risk may be desirable from the client's
perspective if it is accompanied by an improved return.
Business risks may be unforeseen, and indeed unforeseeable, thus other tools are also necessary to
assess risk
Certain key risks to companies and auditors may fall largely outside the BRM. An example might be
creative accounting, which can have significant consequences but can at best only be partially
understood and detected by the BRM.
If too many "added value" strategic services are carried out for a client an auditor's independence may
be threatened.
In applying the business risk model, it has been found that it is frequently difficult to quantify how
financial statement assertions are affected by the business risks that have been identified. As a
consequence, the identification of business risks does not always clearly assess risks that may directly
affect the audit opinion.
KidsStuff Ltd imports children's toys from a supplier in the Far East into its warehouse in Liverpool and
distributes them to retailers throughout the UK. The company was set up by Joseph Cooper 40 years ago
and is managed by Joseph and his two sons. The company had experienced reasonable growth until the last
five years, but recent performance has been poor and the company now relies on a substantial overdraft.
124
Joseph feels that the decline is due in part to the competitiveness of the market and the trend towards
computer games. KidsStuff Ltd does not have a strong market presence in this area but this is currently
being addressed by Joseph's son, Neil, who is confident that performance has improved.
You have received the following e-mail from the engagement partner.
From
Allan Partner
To
Audrey Senior
5.1
Audit risk
Definition
Audit risk: is the risk that auditors may give an inappropriate opinion on the financial statements. Audit
risk has two key components; risk of material misstatement in financial statements (financial statement risk)
and the risk of the auditor not detecting the material misstatements in financial statements (detection risk).
Financial statement risk breaks down into inherent risk and control risk.
Inherent risk: is the susceptibility of an account balance or class of transactions to material misstatement,
either individually or when aggregated with misstatements in other balances or classes, irrespective of
related internal controls.
125
Could be material, either individually or when aggregated with misstatements in other balances or
classes, and
Would not be prevented, or detected and corrected on a timely basis, by the accounting and internal
control systems.
Detection risk: is the risk that the auditor's procedures do not detect a misstatement that exists in an
assertion that could be material, individually or when aggregated with other misstatements.
Point to note
The terms 'inherent risk', 'control risk' and 'detection risk' are key to understanding the audit risk model.
5.2
= IR X CR X DR
Inherent risk and control risk are assessed, either separately or in combination. This will involve an
assessment of business risk and the risk of material misstatement (due to fraud or error)
Detection risk is then set at an appropriate level by 'solving' the audit risk equation.
Very low
High
Low
Low
High
Low
High
Moderate
Low
Moderate
Moderate
High
This model will then assist in the determination of the extent and type of procedures to be performed. For
example, the higher the assessment of inherent and control risk, the lower the assessment of detection risk
resulting in more evidence being obtained from the performance of substantive procedures.
Point to note
126
One of the criticisms of the ARM is the 'compensatory' approach it takes. In the table above, high
inherent and control risk is compensated for by low detection risk. Arguments have been put forward
(for example in the KPMG publication 'The 21" Century Public Company Audit') that evidence should
be complementary rather than compensatory.
Inherent risk and control risk are either 'high' or 'low' in the above table. This 'all or nothing'
approach is adopted by some audit firms. Thus, for instance, where there is a significant risk event
with respect to an audit area, then the inherent risk would always be deemed to be high. Other audit
firms may see risk as a spectrum with, for instance, an intermediate rating of 'moderate risk' where
there would be some reliance gained from inherent assurance, despite there being some measure of
risk observed.
5.2.1
,.
'r
"
'
'
materfai misstatementS
. in the fi~an~iatst.aten.1eriU
EValuate'tlle"ehtlty's fesf)()ns~s t6
assertion
and ct8tennrni;
(Source: Auditing and Assurance Services International Edition. Aasmund Eilifsen, William F. Messier jr,
Steven M. Glover, Douglas F. Prawitt)
Point to note
Notice the relationship between business risk (which we looked at in detail above) and audit risk.
Business risk includes all risks facing the business. In other words, inherent audit risk may include
business risks.
In response to business risk, the directors institute a system of controls. These will include controls to mitigate
against the financial aspect of the business risk. These are the controls that audit control risk incorporates.
Therefore, although audit risk is very financial statements focused, business risk does form part of the
inherent risk associated with the financial statements, (i.e. is part of financial statement risk) not least,
because if the risks materialise, the going concern basis of the financial statements could be affected. The
following illustrates the link between business risk and financial statement risk:
5.2.2
Inherent risk
As we saw in section 5.1 financial statement risk is made up of:
~
~
Inherent risk
Control risk
127
Inherent risk is the risk that items will be misstated due to characteristics of those items, such as the fact
they are estimates or that they are important items in the accounts. The auditors must use their
professional judgement and the understanding of the entity they have gained to assess inherent risk. If no
such information or knowledge is available then the inherent risk is high.
management
----
-------------
Nature of business
Industry factors
Information technology
------------------------
Complex accounts
Unusual transactions
(computers)
------------------- -------------------
Strength of individual departments (sales, purchases,
cash etc)
Accounting system may have problems coping
Transactions for large amounts, with unusual names,
not settled promptly (particularly important if they
occur at period-end)
Transactions that do not go through the system, that
relate to specific clients or processed by certain
individuals
Staff
I 28
5.2.3
Control risk
Control risk is the risk that client controls fail to detect material misstatements. A preliminary
assessment of control risk at the planning stage of the audit is required to determine the level of
controls and substantive testing to be carried out.
In this respect, a key initial audit question is "how does management control the business?" An understanding of
this issue is a key element in an initial assessment of control risk.
Substantive and reliance strategies
For an ongoing client, the auditor will already have significant information on file regarding the control
systems at the audit client. The audit strategy will therefore focus on updating this control information.
For a new client, a judgement on audit strategy will normally be deferred until after a more detailed
understanding of internal control is obtained. For the new client, the auditor will obtain information on
the control systems and then perform an initial testing of those controls to determine whether or not
they are working correctly. Where these risk assessment procedures indicate that controls are not working
correctly, then it is unlikely that the auditor will place reliance on those controls, as CR will be set to
maximum. Substantive procedures will be used instead. However, if the risk assessment procedures
indicate that controls are working correctly, then some reliance will be placed on internal controls. CR
may be set only as either 'high' or 'low' in an all or nothing approach, as previously noted. Alternatively
there may be a possibility of setting control risk to an intermediate amount(s) within some firms' audit
methodologies.
So, providing an initial determination of the nature, timing and extent of audit procedures, two possible
audit strategies are normally identified:
~
Substantive strategy- focusing on substantive testing, (i.e. tests of details and analytical procedures);
and
Reliance strategy -focusing on tests of controls and reliance from inherent assurance.
129
Points to note
I.
There will not be one strategy for the entire audit. Each business process or specific audit assertion
will be allocated its own strategy. Similarly, each audit assertion may be allocated a different "mix" of
reliance and substantive strategy.
2.
Auditing Standards do require some substantive testing for each material class of transactions, account
balances and disclosure, so the audit strategy for any one assertion will never be completely a reliance strategy.
3.
It is possible, however (but unusual) that substantive testing may comprise entirely of analytical
procedures, without any tests of details being carried out.
An entity uses electronic data interchange to initiate orders; there will be no paper
documentation to verify.
An entity provides electronic services to its customers e.g. an Internet Service Provider or telephone
company. No physical goods are produced with all information being collected and billing carried out
electronically.
The test is for understatement
Whichever strategy is chosen, the auditor will document the reasons for choosing that strategy and then
perform detailed auditing procedures in accordance with that strategy.
Control environment
Within an entity, the control system works within the control environment. A poor control
environment implies that the control system itself will also be poor, because the entity does not place
sufficient emphasis on having a good control environment.
So, the control environment sets the philosophy of an entity effectively influencing the "control
consciousness" of directors and employees.
Factors affecting the control environment include:
130
Communication and
enforcement of integrity
and ethical values
Commitment to
competence
Each job should have a job description showing the standards expected in
that job. Employees should then be hired with the competences to carry
out the job without compromising on the quality of work produced.
Involvement of those
charged with governance
Management philosophy
Reporting hierarchy
HR policies and
procedures
From a review of these factors, the auditor will form an opinion on the effectiveness of the control
environment. The auditor will also consider the means by which the entity monitors controls e.g. by the
internal audit department (see Chapter 9). This then in turn affects the opinion on how well the internal
control systems will be implemented and operated.
Control risk will also increase where specific events occur within an organisation. Events that tend to
increase control risk include:
-,
The case
Xerox was, and still is, a significant supplier of office equipment, based mainly in the USA. In the 1990s, the
company found its main USA sales base declining due to foreign competition. However, there was a
management incentive scheme in place that would provide $35million in bonuses if the share price
increased to more than $60. Rather than lose this source of income, various managers in Xerox decided to
artificially increase r~venue.
In the main scheme (there was a smaller scheme involving movements in reserves not reported here), short
term rental contracts were re-classified as long term leases. Under accounting regulations, short term
rentals could only be counted as revenue in the year that they were earned (and many short term rentals
went on for many years) whereas long-term leases could be counted wholly as revenue in the year the lease
was taken out. The re-classification therefore meant that revenue from future rental periods was
recognised much earlier, increasing revenue, profit and also the share price. The managers were therefore
not creating fictitious income (as in some fraudulent cases) but simply recognising future income earlier.
The share price of Xerox did reach $60 share in 1999, enabling managers to claim the bonuses. However,
the scheme was detected by the Securities and Exchange Commission and investigated in 2002. The result
was a fine on Xerox of $1 0 million with the six executives involved in the case also paying fines in total of
$22 million.
It was argued by the SEC that "the numbers have gotten so large that it's akin to auditors driving past Mt Everest
and saying they never saw it". The auditors had recognised that the revenue recognition policy was "halfbaked revenue recognition", but the senior partner on the audit was replaced when he started to raise
concerns. The auditors were also investigated by the SEC.
Implications
The Xerox case identifies weaknesses in the control environment as well as the ethical values of the
executives carrying out the scheme. Remember that a good control environment needs senior management
13 I
Control activities
Having assessed the control environment, the auditor will then identify and assess the control activities
carried out by management. Control activities in this context are the policies and procedures that help
Physical
controls
Controls to ensure the security of assets including data files and computer programs
(e.g. not simply tangible assets such as company motor vehicles).
Segregation
of duties
Performance
reviews
Reviews to check the performance of individuals are carried out on a regular basis. The
review includes comparing actual performance against agreed standards and budgets
and accounting/obtaining reasons for any variances.
Information
processing
controls
These are controls to check the completeness, accuracy and authorisation of the
processing of transactions. Two types of controls are generally recognised:
~
~-
I 32
Occurrence
Completeness
Segregation of duties
Segregation of duties
---~~-~----------,,--~--
Authorisation
\
Accuracy
~--
Cut-off
Classification
Authorisation of transactions at
important control points
~--~
,:
_,~
Monitoring controls
The auditor should also assess the means by which management monitors internal control over financial
reporting. In many entities internal auditors fulfil this function. You have studied BSA 61 0 Considering the
Work of Internal Audit in your earlier studies. A brief revision of BSA 610 can be found in Chapter 9.
5.2.4
Detection risk
Detection risk is the risk that audit procedures will fail to detect material errors. Detection risk relates to
the inability of the auditors to examine all evidence. Audit evidence is usually persuasive rather than
conclusive so some detection risk is usually present, allowing the auditors to seek 'reasonable confidence'.
The auditor's inherent and control risk assessments influence the nature, timing and extent of
substantive procedures required to reduce detection risk and thereby audit risk.
133
,,
Forsythia is a small limited company offering garden landscaping services. It is partly owned by three
business associates, Mr Rose, Mr White and Mr Grass, who each hold I0% of the shares. The major
shareholder is the parent company, Poppy Ltd. This company owns shares in 20 different companies, which
operate in a variety of industries. One of them is a garden centre, and Forsythia regularly trades with it.
Poppy Ltd is in turn wholly owned by a parent, White Holdings Ltd.
The management structure at Forsythia is simple. Of the three non-corporate shareholders, only Mr Rose
has any involvement in management. He runs the day to day operations of the company (marketing, sales,
purchasing etc) although the company employs two landscape gardeners to actually carry out projects. The
accounts department employs a purchase clerk and a sales clerk, who deal with all aspects of their function.
The sales clerk is Mr Rose's daughter, Justine. Mr Rose authorises and produces the payroll. The company
ledgers are kept on Mr Rose's personal computer. Two weeks after the year end, the sales ledger records
were severely damaged by a virus. Justine has a single print out of the balances as at year end, which shows
the total owed by each customer.
Forsythia owns the equipment which the gardeners use and they pay them a salary and a bonus based on
performance. Mr Rose is remunerated entirely on a commission basis relating to sales and, as a shareholder
he receives dividends annually, which are substantial.
Forsythia does not carry any inventories. When materials are required for a project, they are purchased on
behalf of the client and charged directly to them. Most customers pay within the 60 day credit period, or
take up the extended credit period which Forsythia offer. However, there are a number of accounts that
appear to have been outstanding for a significant period.
Justine and her father do not appear to have a very good working relationship. She does not live at home
and her salary is not significant. However, she appears to have recently purchased a sports car, which is not
a company car.
The audit partner has recently accepted the audit of Forsythia as a new client. You have been assigned the
task of planning the first audit.
Requirement
Identify and explain the audit risks arising from the above scenario.
6 Creative accounting
134
6.1
Introduction
One of the factors affecting the overall level of financial statement risk is the potential for creative
accounting.
Directors have choices and they may exercise those choices to recognise values that do not reflect
economic reality. A prime example is the choice of the cost model when an asset's fair value is significantly
higher than cost. (note: if an asset's fair value and value in use were lower than cost, then an impairment
would be required under BAS 36 and directors would not have the discretion to disclose at cost}.
Directors are more likely to make use of their discretion to mislead financial statement users if they have
the opportunity (e.g. imprecise accounting regulations, weak auditors) and incentives (e.g. approaching
the breach of a debt covenant, an impending take-over, profit-based bonus) to do so.
This well-documented practice is a potential problem for auditors in assessing the underlying performance
and position of a company and recent evidence suggest that it is one of the major issues facing financial
reporting.
Accounting measures involve a degree of subjectivity, choice and judgement and it would be wrong to
describe all such activity as creative accounting. Moreover, creative accounting normally falls within
permitted regulation and is not therefore illegal. It is thus ofte'l a question of fine judgement as to when
creative accounting is of such an extent that it becomes misleading.
The spectrum of creative accounting practices may include the following (commencing with the most
legitimate}:
~
Exercise of normal accounting policy choice within the rules permitted by regulation(e.g. FIFO or
average cost for inventory valuation).
Judgement concerning the nature or classification of a cost (e.g. expensing or capitalising costs).
Systematic selection of legitimate policy choices and estimations to alter the perception of the
position or performance of the business in a uniform direction.
Systematic selection of policy choice and estimations that fall on the margin of permitted
regulation (or are not subject to regulation) in order to alter materially the perception of the
performance or position of the business.
Fraudulent activities.
It can thus be a matter of fine judgement for an auditor as to where within this spectrum creative
accounting becomes unacceptable.
Companies may also seek to manipulate the perception of their performance and position by altering
underlying transactions, rather than just the way they are recorded. Accounting regulation seeks to limit the
effects of this behaviour in a number of ways as previously discussed. Nevertheless, while it may seek to
report faithfully transactions that actually take place, it cannot regulate for transactions which do not take
135
6.3
Opportunity
Incentives
Where these two elements both exist then the risks of creative accounting taking place are
greatest. This section looks at opportunity. The following section looks at incentives.
It is important for the auditor to be aware of the causes of creative accounting in order to highlight the
circumstances, where there is the greatest risk or incentives for creative accounting to take place.
The causes of opportunity for creative accounting include the following:
~
Subjectivity- areas of subjectivity lend themselves to a greater degree of choice, judgement and
uncertainty.
Complexity- complex industries and transactions are difficult to regulate precisely and give more
scope for manipulation.
Insufficiently independent auditors- auditors may come under increased managerial pressure to
approve creative accounting practices.
6.4
Imprecise regulations -where regulations are imprecise or inadequate, companies have greater
scope to exercise discretion, and auditors have a poor benchmark to challenge the selected accounting
procedures.
Inadequate sources of information- where reliable sources of audit evidence exist (e.g. to
challenge management estimations) the scope for effeetive manipulation is more limited.
Inadequate penalties- where creative accounting is discovered to have misled users, the penalties
for the company, and for the directors, are regarded by some as inadequate to provide sufficient
disincentives.
Income smoothing- companies normally prefer to show a steady trend of growth in profits, rather
than volatility with significant rises and falls. Income smoothing techniques (e.g. declaring higher
provisions or deferring income recognition in good years) contribute to reducing volatility in reported
earnings.
Achieving forecasts- where forecasts of future profits have been made, reported earnings may be
manipulated to tie in with these forecasts.
I 36
Profit enhancement- this is where current year earnings are boosted to enhance the short-term
perception of performance.
Maintain or boost share price- where markets can be made to believe that increased earnings
represents improved underlying commercial performance, then share price may rise, or at least be
higher than it would be in the absence of creative accounting.
Accounting based contracts- where accounting based contracts exist (e.g. loan covenants, profit
related pay) then any accounting policy that falls within the terms of the contract may significantly
impact upon the consequences of that contract. For example, the breach of a gearing based debt
covenant may be avoided by the use of off-balance sheet financing.
Incentives for directors- there may be personal incentives for directors to enhance profit in order
to enhance their remuneration. Examples might include: bonuses based upon EPS, or share incentive
schemes and share option schemes that require a given EPS before they become operative. Directors
may also benefit more indirectly from creative accounting by increasing the security of their position.
Taxation- where accounting practices coincide with taxation regulations there may be an incentive
to reduce profit in order to reduce taxation. In these circumstances, however, it may necessary to
convince not only the auditor, but also NBR..
Regulated industries -where an industry is currently, or potentially, regulated then there may an
incentive to engage in creative accounting to reduce profit in order to influence the decisions of the
regulator. This may include utilities where regulators may curtail prices if it is perceived that excessive
profits are being earned. It may also be relevant to avoid a reference to the Competition Commission.
Internal accounting- a company as a whole may have reason to move profits from division to
division (or subsidiary to subsidiary) in order to affect tax calculations or justify the closure/expansion
of a particular department.
losses - companies making losses may be under greater pressure to enhance reported performance.
Commercial pressures- where companies have particular commercial pressures to enhance the
perception of the company there is increased risk of creative accounting. For example, a take-over bid,
or the raising of new finance.
Thus, a range of stakeholders may have incentives to engage in creative accounting. In particular, however,
an appropriate degree of professional scepticism should be applied where benefits arise for directors, as
they are also the group responsible for implementing creative accounting practices.
6.5
It enables an understanding of the motivations and reasons for the company's directors to
engage in the practice. (For instance, the existence and nature of debt covenant that mat be affected
by creative accounting)
It enhances the understanding of whether the practice is material i.e. whether it would
reasonably influence the decisions.
The consequences of creative accounting depend crucially upon whether or not it is disclosed.
Overt creative accounting refers to practices, which may change reported profits or the statement of
financial position, but that are disclosed externally to financial statements users. Examples may include:
~
~
~
Covert creative accounting refers to practices that are used to enhance profitability or asset values but
are not disclosed. Examples might be:
~
~
~
13 7
As a result, such covert practices are not readily identifiable by outside users, who are thus unable, in some
cases, to distinguish increases in reported earnings arising as a result of accounting manipulation, from those
arising from improvements in substantive underlying transactions. The potential consequences of covert
creative accounting (e.g. for share prices movements) are therefore likely to be more substantial than for
overt creative accounting.
6.6
Sustainability
Some creative accounting practices are sustainable in the long term while others may only serve to enhance
the current year's profit, but only with the effect that future profits are correspondingly reduced.
Sustainable practices may include:
~
Off-balance-sheet financing
6. 7
Capitalisation of expenses -if, for instance, annual development costs are inappropriately
capitalised and amortised over ten years then, after that period, assuming constant expenditure, the
profit will be equivalent for either write off or amortisation policies (though not the statement of
financial position) as there will be I 0 amounts of I0% amortisation recognised in profit or loss.
Revenue recognition- bringing forward the recognition of revenues may initially enhance profit,
but at the cost of reducing future profits.
Complex series of transactions may mean that markets may fail to appreciate fully the impact of
creative accounting
Covert creative accounting is likely to include all the above effects but in addition, even where the market is
semi strong efficient, it cannot always 'see through' the creative accounting and shares could be mispriced.
This may result in shareholders suffering an undue loss.
Recent revelations regarding creative accounting have resulted in significant falls in the share prices of the
companies concerned providing evidence of previous mispricing. However, shares prices also fell in other
companies, as markets generally placed less trust on reported earnings and the perceived auditors as being
unable to prevent creative accounting.
Accounting based contracts
Whether creative accounting is covert or overt, it can affect the application of accounting based contracts,
so long as the selected accounting treatment falls within the terms of that contract. Typically, a restrictive
covenant on gearing, or interest cover, may be avoided by enhancing equity or earnings. This may benefit
one stakeholder (e.g. shareholders) but disadvantage another (e.g. debtholders).
I38
6.8
Cash flows - Operating cash flows are systematically out of line with reported operating profits over
time.
Reported income and taxable income- Is financial reporting income significantly out of line with
taxable income with inadequate explanation or disclosure?
Acquisitions- Where a significant number of acquisitions have taken place there is increased scope
for many creative accounting practices.
Financial statement trends - Indicators include: unusual trends, comparing revenue and EPS
growth, atypical year end transactions, flipping between conservatism and aggressive accounting from
year to year, level of provisions compared to profit indicating smoothing, EPS trend, timing of
recognition of exceptional items.
Ratios- Ageing analyses revealing old inventories or receivables, declining gross profit margins but
increased net profit margins, inventories/receivables increasing more than sales, gearing changes.
Accounting policies -Consider if there is the minimum disclosure required by regulation, changes
in accounting policies, examine areas of judgement and discretion. Consider risk areas of off-balance
sheet refinancing, revenue recognition, capitalisation of expenses, significant accounting estimates.
Changes of accounting policies and estimates- Is the nature, effect and purpose of these .
changes adequately explained and disclosed?
- "" i~
profit warnings, inadequate or late profit warnings leading to 'surprises', interim financial statements
out of line with year end financial statements.
~
Audit qualifications- Are they unexpected and are any auditors adjustments specified in the audit
report significant?
Related Party Transactions- Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not suggested that
the above practices necessarily mean there is creative accounting, but where a number of these factors
exist simultaneously, then the auditor should be put 'on enquiry' to make further investigations.
6.9
6.9.1
~
~
~
~
139
6.9.2
Revenue recognition
~
~
~
~
~
~
~
6.9.3
Off-balance-sheet financing
In some circumstances transactions may be structured in order to allow a particular accounting treatment
(e.g. making a finance lease appear to be an operating lease) rather than presenting the fairest view. This is
one of the primary reasons for the large quantity of disclosure standards (as against valuation standards) in
previous years.
140
6.1 I
.,...,
7 Analytical procedures
7 .I
Review
Assurance engagements
Prospective financial information
In terms of its use during the audit the auditor must comply with BSA 520 Analytical Procedures. As you
should be aware from your earlier studies this states that analytical procedures are used as follows:
~
As risk assessment procedures to obtain an understanding of the entity and its environment
As substantive procedures
At or near the end of the audit when forming an overall conclusion as to whether the financial
statements as a whole are consistent with the auditor's understanding of the entity.
Point to note
BSA 520 requires the use of analytical procedures for the first and third purposes listed above. They may
also be used as substantive procedures and are commonly used in practice in this way.
We will look at analytical procedures in more detail in Chapter 5, as although the aim of the procedures is
different at each of the three key stages of the audit there are many common features in their application.
141
8 Materiality
8.1
Revision of materiality
Definition
Materiality: 'Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements. Materiality depends on the size of the item or error
judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a
threshold or cut-off point rather than being a primary qualitative characteristic which information must have
if it is to be useful.' (BSA 320)
Materiality criteria
An item might be material due to its
Nature
Given the definition of materiality that an item would affect the readers of the
financial statements, some items might by their nature affect readers. Examples
include transactions related to directors, such as remuneration or contracts with
the company.
Value
Some items will be significant in the financial statements by virtue of their size, for
example, if the company had bought a piece of land with a value which comprised
three-quarters of the asset value of the company, that would be material. That is why
materiality is often expressed in terms of percentages (of assets, of profits).
Impact
Although there are general guidelines on how materiality might be calculated in practice, the calculation
involves the application of judgement. It should also be reassessed throughout the course of the audit as
more information becomes available.
142
Step 2
Step 3
Steps I and 2 would normally be performed as part of the planning process. Step 3 is normally performed
as part of the review stage of the audit when the auditor evaluates the audit evidence.
\.
8.2.1
Preliminary judgement
Materiality considerations during audit planning are extremely important. The assessment of materiality
at this stage should be based on the most recent and reliable financial information and will help to
determine an effective and efficient audit approach. Materiality assessment will help the auditors to:
~
Determine the amount of audit work necessary to facilitate audit efficiency and effectiveness
Put audit risk in context
In specifying materiality, an auditor should establish a base (or bases) to which a percentage factor is
applied. The following bases are typically used:
Total revenue
Gross profit
Profit before tax
5.0%
Total assets
0.5%
Equity
1.0%
The resulting balance would then be adjusted for any relevant qualitative factors including:
~
~
~
~
~
~
~
~
143
8.2.2
Tolerable misstatement
Determining the tolerable misstatement involves the allocation of planning materiality to:
~
An account balance or
Class of transaction
As with overall materiality both quantitative and qualitative factors will be taken into accourtt.
Quantitative benchmarks include:
~
~
Point to note
These approaches result in a combined tolerable misstatement greater than the overall planning materiality
set. However, it would be inefficient for the auditor to simply allocate the planning materiality
proportionately to each account balance as this would lead to low tolerable misstatement levels which in
turn would result in more extensive testing.
Qualitative factors would also be taken into account. These include:
~
~
~
8.2.3
8.3
144
You are the manager responsible for the audit of Albreda Ltd. The draft consolidated financial statements
for the year ended 30 September 20X6 show revenue of CU42.2 million (20X5 CU41.8 million), profit
before taxation of CU 1.8 million (20X5 CU2.2 million) and total assets of CU30.7 million (20X5 CU23.4
million). In September 20X6, the management board announced plans to cease offering 'home delivery'
services from the end of the month. These sales amounted to CU0.6 million for the year to 30 September 20X6
(2005 CU0.8 million). A provision of CU0.2 million has been made at 30 September 20X6 for the compensation of
redundant employees (mainly delivery van drivers).
Requirement
Comment upon the materiality of these two issues.
See Answer at the end of this chapter.
You are the auditor of Oscar Ltd and are in the process of planning the audit for the year ended 31
December 20X8. In the past the audit of this company has been straightforward. The following information
is available:
20XB
CU'OOO
1,800
2,010
10
Total assets
Total revenue
Profit before tax
20X7
CU'OOO
1,750
1,900
300
tax
Requirement
Comment on the suitability of the planning materiality figure.
See Answer at the end of this chapter.
8.4
8.4.1
Current developments
Audit materiality
Internationally, there is currently an exposure draft of BSA 320 (Revised and Redrafted) Materiality in Planning
and Performing an Audit in issue. The key issues in relation to this exposure draft are:
(a)
Definition of materiality. The ED makes clear that the definition of materiality used by the auditors
should be the same as the definition in the applicable reporting framework. (For example, the
definition in current BSA 320 is the same as in BAS 1.)
(b)
Users. The ED indicates that it is reasonable for the auditor to assume that users:
~
Have a reasonable knowledge of the business and economic activities and accounting and a
willingness to study the information in the financial statements with reasonable diligence
Understand that financial statements are prepared and audited to levels of materiality
Recognise the uncertainties inherent in the measurement of amounts based on the use of
estimates, judgment and the consideration of future events
Make reasonable economic decisions on the basis of the information in the financial statements
145
8.4.2
(c)
Materiality and audit risk. The link between materiality and audit risk is emphasised.
(d)
Percentage benchmarks. The ED provides more guidance on the use of percentage benchmarks
for calculating materiality.
(b)
Considerations. In the light of identified misstatements the auditor should consider whether the
overall audit strategy and plan need to be revised.
(c)
(d)
Evaluation. The ED sets out that establishing a materiality level does not mean some matters should
be ignored in overall review. Materiality levels used in planning and performing the audit are
reassessed based on the actual financial results
:;l,f}"lif,~~~~~~~~;r~r
As a result of the auditor's risk assessment and assessment of materiality an audit strategy will be
developed in response. BSA 330 makes the following points in this context which you should be familiar
with.
9 .I
Overall responses
The auditor should determine overall responses to address the risks of material misstatement at the
financial statement level. This may include:
~
Emphasising to the audit team the need to maintain professional scepticism in gathering and
evaluating audit evidence
Assigning more experienced staff, those with special skills or using experts
The auditor may also make general changes to the nature, timing or extent of audit procedures, for
example, by performing substantive procedures at the period end instead of at an interim date. These
decisions will take into account the auditor's assessment and understanding of the control environment.
146
The nature of the specific controls used by the entity and in particular whether they are manual or
automated
Whether the auditor expects to obtain audit evidence to determine if the entity's controls are
effective in preventing, or detecting and correcting, material misstatements.
The auditor will then determine the nature, timing and extent of further audit procedures. We will
look at this aspect of the audit in detail in Chapter 5.
9.3
9.4
Documentation
The BSA emphasises the need to document the link between the audit procedures and the assessed risks.
These matters should be recorded in accordance with BSA 230 Audit Documentation with which you should
be familiar from your earlier studies.
I0.1
Introduction
In this chapter we have looked in detail at the business risk model and the audit risk model. However there
are a number of other audit approaches which may be adopted.
I0.2
'--
Systems audit
An auditor may predominantly test controls and systems, but substantive testing can never be eliminated
entirely. It is always used in conjunction with another approach.
You should be familiar with the systems and controls approach to auditing, from your previous studies.
Management are required to institute a system of controls which is capable of fulfilling their duty of
147
I0.3
Sales cycle
~Take
omern~
Receive
payment
Document
order
Make
order
148
Purchases cycle
~
Raise
'"""'''"0~ .
/
Supplier will
extend credit in
Send
Purchasmg
department
pl:~toffi
rnl"
Rec/lvz
eany on
production
Raise goods
received note
\
Record and
account for invoice
Accounts /
~partment
match
"
GRN to invoice
The auditor should be able to find an audit trail for each transaction, for example in the purchases cycle:
~
Requisition
Invoice
Order
Ledger and daybook entries
GRN
~
~
I0.4
149
10.4.1
I 0.4.2
I SO
Summary
Financial. :rtsk .
operating nsk
Compliance risk
IS I
chapter 5
Audit evidence
Introduction
Topic list
I
Risk and assertions
2
Sufficient appropriate audit evidence
3
Sources of audit confidence
4
Audit procedures
Analytical procedures
5
6
Provisions and contingencies
7
Audit of accounting estimates
8
Related parties
9
Management representations
I0
Opening balances
II
Service organisations
Appendix I
Appendix 2
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
179
AUDIT EVIDENCE
1.1
~'
~~-
'
',
'
'
'/
Introduction
As we have seen audit work is about reducing risk- the risk that the financial statements will include
material misstatements. At the most basic level, the financial statements simply consist of information
about the:
~
~
~
~
Revenues
Costs
Assets
Liabilities and
Capital
of the entity. These items will have certain attributes if they are included correctly in the financial
statements. These attributes are referred to as financial statement assertions.
1.2
For example, if the statement of financial position includes a figure for freehold land and buildings the
directors are asserting that:
It is either owned by the company outright or else the company has suitable rights over it
There are no other items, of a similar nature, which ought to be included but which have been
omitted
It is disclosed in the financial statements in a way which is not misleading and is in accordance with the
relevant 'reporting framework' e.g. international accounting standards
BSA 500 Audit Evidence states that 'the auditor should use assertions for classes of transactions, account
balances, and presentation and disclosures in sufficient detail to form the basis for the assessment of
risks of material misstatement and the design and performance of further audit procedures'. It gives
examples of assertions in these areas. Depending on the nature of the balance, certain assertions will be
more relevant than others.
18 I
Assertions about
classes of
transactions and
events for the
period under audit
Occurrence: transactions and events that have been recorded have occurred and
pertain to the entity.
Completeness: all transactions and events that should have been recorded have
been recorded.
Accuracy: amounts and other data relating to recorded transactions and events
have been recorded appropriately.
Cut-off: transactions and events have been recorded in the correct accounting
period.
Classification: transactions and events have been recorded in the proper accounts.
Assertions about
account balances
at the period end
Assertions about
presentation and
disclosure
Occurrence and rights and obligations: disclosed events, transactions and other
matters have occurred and pertain to the entity.
Completeness: all disclosures that should have been included in the financial
statements have been included.
Classification and understandability: financial information is appropriately
presented and described, and disclosures are clearly expressed.
Accuracy and valuation: financial and other information are disclosed fairly and at
appropriate amounts.
1.2.1
A summary
We have seen that there are 13 assertions applying in different ways to different items in the financial
statements.
You can summarise them in the following four questions:
~
~
~
~
The following table shows how the assertions fit with these questions:
Should it be in the
accounts at all?
Occurrence
Existence
Occurrence
Cut-off
Accuracy
Valuation
Accuracy and
measurement
Completeness
Completeness
-------------Allocation
Completeness
---~
----~
Is it properly disclosed
and presented?
182
Classification
---~"---~---~,----~-
Classification and
understandability
AUDIT EVIDENCE
Requirement
Complete the table below
(i)
(ii)
Identify the financial statement assertions that these tests will satisfy
assets
accounts at all?
Is it included at the right
amount?
i Inspect invoices/contracts
Check depreciation
Valuation
Valuation
Receivables
Should it be in the
Inventory
Is it included at the right
amount?
, Are there any more?
Is it properly disclosed and
presented?
183
Requirement
For the points 1-3 below identify and explain the most relevant financial statement assertions. Assume that
the year end is 31 December 20X7 in each case.
(I)
Fine Ltd is proposing to award share options to 5 directors. The proposal is to issue I00,000 options
to each of the 5 individuals on I September 20X7 (the grant date} at an exercise price of CU7 per
share. The scheme participants will need to have been with the company for at least three years
before being able to exercise their options. It is believed that all the directors will satisfy this
condition. Other relevant information is as follows:
I September 20X7
31 December 20X7
cu
cu
7.00
8.20 (estimated)
3.00
5.70 (estimated)
(2)
Wigwam Ltd has purchased goods worth CU750,000 from Teepee Ltd on an arm's length basis.
Wigwam owns 40% of the ordinary share capital in Teepee.
(3)
Deakin Ltd issued I0,000 6% convertible bonds at par value of CUI 0 on I January 20X7. On this date
the market interest rate for similar debt without the option to convert was I0%. Each bond is
convertible into 4 ordinary shares on 31 December 20X9.
2.1
Importance
BSA 500 states that the auditor should obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion.
The importance of obtaining sufficient, appropriate audit evidence can be demonstrated in the Arthur
Andersen audit of Mattei Inc.
184
__
AUDIT EVIDENCE
that the goods had been shipped. However, the auditors did not question the term 'bill and hold' even
though it was clearly stamped on the documents and did not appear to notice that the same individual had
signed as both representatives of Mattei Inc and the shipping company. A number of entries were
questioned and the audit senior who reviewed the working papers noted that additional explanations were
required but no further investigation actually took place.
Source: Principles of Auditing: An Introduction to International Standards on Auditing by Rick Hayes, Roger Dassen,
Arnold Schilder, Phillip Wallage Second Edition published by Pearson Education Umited 2005
2.2
Relevant
Reliable
Audit evidence is more reliable when it is obtained from independent sources outside the entity
Audit evidence that is generated internally is more reliable when the related controls imposed by the
entity are effective
Audit evidence obtained directly by the auditor (for example, observation of the application of a
control) is more reliable than audit evidence obtained indirectly or by inference (for example,
inquiry about the application of a control)
Documentary evidence is more reliable, whether paper, electronic or other medium (for
example a written record of a meeting is more reliable than a subsequent oral representation of the
matters discussed)
Original documents are more reliable than photocopies or faxes.
'The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions
on which to base the audit opinion.'
(BSA 500.2)
Discuss the extent to which each of the following sources of audit evidence is sufficient and appropriate.
(a)
Oral representation by management in respect of the completeness of sales where the majority of
transactions are conducted on a cash basis
(b)
Flowcharts of the accounting and control system prepared by a company's internal audit department
(c)
185
(e)
Comparison of revenue and expenditure items for the current period with corresponding information
for earlier periods.
2.3
Triangulation
Forming an audit opinion is a question of using professional judgement at all times and judgements have
to be made about the nature, the quality and the mix of evidence gathered. It is also essential that individual
items of evidence are not simply viewed in isolation but instead support other evidence and are supported
by other evidence. This approach views evidence from different sources as predominantly complementary,
rather than compensatory. This strategy of acquiring and evaluating complementary evidence from a
range of sources is referred to as triangulation in The 2/'1 Century Public Company Audit: Conceptual
Bements of KPMG's Global Audit Methodology. This approach is an application of the general principle that
evidence obtained from different sources, that presents a consistent picture, is mutually strengthening and
gives greater reliance than merely increasing the amount of evidence from a single source. The consequence
of over-reliance on one specific type and source of evidence can be seen in the case of the collapse of
Parmalat.
186
AUDIT EVIDENCE
< ; . . .
3.1
That those controls were applied consistently (e.g. because controls were performed by different
people or in different locations).
Inspection of documents supporting controls or events to gain audit evidence that internal controls
have operated properly, e.g. verifying that a transaction has been authorised
(b)
Inquiries about internal controls which leave no audit trail, e.g. determining who actually performs
each function not merely who is supposed to perform it
(c)
Reperformance of control procedures, e.g. reconciliation of bank accounts, to ensure they were
correctly performed by the entity
(d)
(e)
Testing of internal controls operating on computerised systems or over the overall information
technology function, e.g. access controls
(f)
Observation of controls to consider the manner in which the control is being operated
~
~
Tests of controls are distinguished from substantive tests which are designed to detect material
misstatements in the financial statements.
Deviations in the operation of controls {caused by change of staff etc) may increase control risk and tests of
control may need to be modified to confirm effective operation during and after any change.
Audit procedures will include the test of control and then other procedures (e.g. substantive and/or
analytical procedures) to confirm the operating effectiveness of that control. Overall, audit procedures may
be limited where automated processing is involved as control errors are less likely e.g. computers tend to
make less mistakes than humans after a given procedure has been correctly programmed).
The use of computer assisted audit techniques (CAATs} is referred to in Chapter I I of this Study Manual.
3.1.1
187
3.1.2
to determine the remaining detection risk. This detection risk is then used to decide the nature and
timing of the remaining substantive testing.
3.2
Substantive procedures
BSA 330 The Auditor's Procedures in Response to Assessed Risks states that irrespective of the assessed risk of
material misstatement, the auditor should design and perform substantive procedures for each material
class of transactions, account balance and disclosure.
There are two key types of substantive procedure:
~
Substantive analytical procedures. These are generally more applicable to large volumes of
transactions that tend to be predictable over time. We will look at these in detail in section 5.
Tests of details. These are ordinarily more appropriate to obtain audit evidence regarding certain
assertions about account balances. We will see how these are applied to key aspects of the financial
statements as we work through the remainder of the chapter.
4 Audit procedures
The procedures used are selected according to the nature of the balance being audited and the assertion
being considered.
4.1
Types of procedure
Auditors obtain evidence by using one or more of the following procedures.
4.1.1
Inquiry
Definition
Inquiry: means gathering information from knowledgeable persons both within and external to the entity
being audited.
188
AUDIT EVIDENCE
Examples
Inquiry includes obtaining responses to formal written questions through to asking informal questions in
relation to specific audit assertions. The response to inquiries provides the auditor with information that
was not previously possessed or may corroborate information obtained from other sources. The strength
of the evidence depends on the knowledge and integrity of the source. Where the result of inquiry is
different from other evidence obtained, then reasons for that difference must be sought and the
information reconciled.
Business focus
Common uses of inquiry are:
~
Management representations -where management have information not available from any other
source
Asking employees about the internal control systems and effectiveness of the controls they are
operating
Remember it is not normally sufficient to accept inquiry evidence by itself- some corroboration will be
sought. The USA court case of Escott et al. v Bar Chris Corporation ( 1968) ruled that the auditor was
negligent in not following up answers to management inquiries. The judge indicated that the auditor was too
easily satisfied with glib answers and that these should have been checked with additional investigation.
4.1.2
Observation
Definition
Observation: involves looking at a procedure or process being performed by others.
Examples
Observation is not normally a procedure to be relied on by itself. For example, the auditor may observe a
non-current asset, such as a motor vehicle. However, this will only proof the vehicle exists; other
assertions such as rights and obligations will rely on other evidence such as invoices and valuation possibly
on the use of specialist valuers or documentation.
Business focus
Observation is commonly used in the business processes of inventory management. After inventory has
been purchased, an organisation holds raw materials, work-in-progress and finished goods in its warehouses
and factories. Observation is used to determine that the inventory exists, it is valued correctly (looking for
old and slow moving inventory) and that inventory is complete in the organisation's books. Note the link to
audit assertions here.
Additionally, the auditor will be observing the internal control systems over inventory, particularly in
respect to perpetual inventory checking and any specific procedures for year-end inventory counting. You
should be familiar with the audit procedures in respect of attendance at an inventory count from your
assurance studies.
Observation may also be used in the human resource business process. The auditor will observe employees
operating specific controls with the internal control system to determine the effectiveness of application of
those controls, as well as the ability of the employee to operate the control. However, the act of observing
the employee limits the effectiveness of the evidence obtained; many employees will amend their work
practices when they identify the auditor observing them.
189
4.1.3
Inspection
Definition
Inspection: means the examination of records, documents or tangible assets.
Examples
By carrying out inspection procedures, the auditor is substantiating information that is, or should be, in the
financial statements. For example, inspection of a bank statement confirms the bank balance for the bank
reconciliation which in turn confirms the cash book figure for the financial statements.
Business focus
Inspection assists with the audit of most business processes. For example:
~
Financing: inspection of loan agreements to confirm the term and repayment details (part of the
completeness of disclosure in the financial statements)
Purchasing: Inspection of purchase orders to ensure that the order is valid and belongs to the
company (occurrence assertion amongst others)
Human resources: Inspection of pay and overtime schedules as part of wages audit
Inventory management: Inspection of the work-in-progress ledger confirming cost allocation to specific
items of work-in-progress (valuation assertion)
Revenue: Inspection of sales invoices to ensure that the correct customer has been invoiced with the
correct amount of sales (completeness and accuracy assertions)
Inspection of assets that are recorded in the accounting records confirms existence, gives evidence of
valuation, but does not confirm rights and obligations
Confirmation that assets seen are recorded in accounting records gives evidence of completeness
Confirmation to documentation of items recorded in accounting records confirms that an asset exists or a
transaction occurred. Confirmation that items recorded in supporting documentation are recorded in
accounting records tests completeness
Cut-off can be verified by inspecting the reverse population, that is, checking transactions recorded after
the end of the reporting period to supporting documentation to confirm that they occurred after the end
of the reporting period
Inspection also provides evidence of valuation/measurement, rights and obligations and the nature of
items (presentation and disclosure). It can also be used to compare documents (and hence test
consistency of audit evidence) and confirm authorisation
4.1.4
Recalculation
Definition
Recalculation: means checking the arithmetical accuracy of source documents and accounting records.
Examples
Recalculation obviously relates to financial information. It is deemed to be a reliable source of audit
evidence because it is carried out by the auditor.
190
AUDIT EVIDENCE
Business focus
Recalculation relates to most business processes. For example:
~
~
~
Recalculation is particularly effective when carried out using computer assisted audit techniques
(CAATs) as the computer can perform the whole of the inventory calculation (for example) in a short time
period.
4.1.5
Confirmation
Definition
Confirmation: is the response to an inquiry from a third party to corroborate information in the
accounting records of an audit client.
Examples
A typical example of confirmation evidence is obtaining a response from a debtors' circularisation (see
below for revision on this area). The evidence obtained is highly persuasive as it comes from an
independent external source.
The request and response is in writing and is sent direct to the auditor
Business focus
Confirmations are normally used in the following business processes:
~
~
4.1.6
Financing: agreement of bank balances, loan amounts outstanding etc (see Appendix).
Inventory: confirmation of inventory held at third parties
Revenue: confirmation of amounts due from debtors and payable to creditors (see Appendix).
Analytical procedures
We will look at these in section 5.
I9I
4.2.1
Tangible assets
The major risks of misstatement in the financial statements are due to:
~
Tangible assets being carried at the wrong cost or valuation (valuation assertion)
Tangible assets being carried at the wrong cost or valuation due to charging inappropriate
depreciation, or not depreciating (valuation assertion)
Tangible assets being carried at the wrong cost or valuation due to impairment reviews not being
carried out appropriately (valuation assertion)
At
I january
20X6
Cost
Freehold property
Plant and machinery
Motor vehicles
cu
80,000
438,000
40,500
558,500
At
I january
20X6
Depreciation
Freehold property
Plant and machinery
Motor vehicles
cu
8,000
139,500
20,000
167,500
Additions
Disposals
62,000
13,000
75,000
(10,000)
cu
Charge
for
year
cu
1,600
47,000
10,200
58,800
cu
(10,000)
20X6
cu
80,000
490,000
53,500
623,500
At
31 December
Disposals
cu
(3,000)
(3,000)
20X6
cu
9,600
183,500
30,200
223,300
Requirements
(a)
Explain the factors that should be considered in determining an approach to the audit of property,
plant and equipment of Xantippe Ltd.
(b)
State the procedures you would perform in order to reach a conclusion on property, plant and
equipment in the financial statements of Xantippe Ltd for the year ended 31 December 20X6
192
AUDIT EVIDENCE
If an impairment review has been carried out, then the auditors should audit that impairment review.
Management will have estimated whether the recoverable amount of the asset/cash generating unit is lower
than the carrying amount.
For auditors, the key issue is that recoverable amount requires estimation. As estimation is
subjective, this makes it a risky area for auditors.
Management have to determine if recoverable amount is higher than carrying amount. It may not have been
necessary for them to estimate both fair value and value in use, because if one is higher than carrying
amount, then the asset is not impaired. If it is not possible to make a reliable estimate of net realisable
value, then it is necessary to calculate value in use. Net realisable value is only calculable if there is a
active market for the goods, and would therefore be audited in the same way as fair value (the audit of
fair values is dealt with in detail in Chapter 12). Costs to sell such as taxes can be recalculated by applying
the appropriate tax rate to the fair value itself. Delivery costs can be verified by comparing costs to
published rates by delivery companies, for example, on the internet.
If management have calculated the value in use of an asset or cash-generating unit, then the auditors will
have to audit that calculation. The following procedures will be relevant.
Value in use
~
Calculate/obtain from analysts the long term average growth rate for the products and ensure that the
growth rates assumed in the calculation of value in use do not exceed it
Refer to competitors' published information to compare how much similar assets are valued at by
companies trading in similar conditions
Compare to previous calculations of value in use to ensure that all relevant costs of maintaining the
asset have been included
Ensure that the cost/income from disposal of the asset at the end of its life has been included
Review calculation to ensure cash flows from financing activities and income tax have been excluded
Compare discount rate used to published market rates to ensure that it correctly reflects the return
expected by the market
If the asset is impaired and has been written down to recoverable amount, the auditors should review the
financial statements to ensure that the write down has been carried out correctly and that the BAS 36
disclosures have been made correctly.
The asset must be available for immediate sale in the present condition
(b)
193
~
~
CU 180,000 relates to a piece of land which was classified as held for sale on I October. (You should
assume that the BFRS 5 criteria are satisfied.) On this date the land's fair value was estimated to be
CU21 0,000 with costs to advertise the asset as being available for sale estimated at CU6,000. The
CU 180,000 represents the carrying value of the land on the basis that it is lower than fair value less
costs to sell. Robinson Ltd has adopted a revaluation policy for land.
Requirement
For each of the above assets:
(I)
(2)
State the audit procedures which would be performed to address this issue
4.2.2
Intangible assets
Accounting guidance for intangibles is given in BAS 38 Intangible Assets and BFRS 3 Business Combinations.
The types of assets you are likely to encounter under this heading include:
~
~
~
~
~
Patents
Licences
Trademarks
Development costs
Goodwill
The major risks of misstatement in the financial statements are due to:
~
Intangible assets being carried at the wrong cost or valuation (valuation assertion)
Intangible assets being carried at the wrong cost or valuation due to charging inappropriate
depreciation, or not depreciating (valuation assertion)
Intangible assets being carried at the wrong cost or valuation due to impairment reviews not being
carried out appropriately (valuation assertion)
In order to address these the auditor should carry out the following procedures:
194
"--
AUDIT EVIDENCE
Completeness
~
Valuation
~
Confirm carried down balances represent continuing value, which are proper charges to future
operations
\ ..
Inspect purchase agreements, assignments and supporting documentation for intangible assets acquired
in period
Verify amounts capitalised of patents developed by the company with supporting costing records
Amortisation
~
Review amortisation
Check computation
Confirm that rates used are reasonable
Review sales returns and statistics to verify the reasonableness of income derived from patents,
trademarks, licences etc
'
Examine audited accounts of third party sales covered by a patent, licence or trademark owned
by
the company
5 Analytical procedures
ri~:~,l~1t~~t~"';i1;''~~~~~;1f2:
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5.1
As risk assessment procedures to obtain an understanding of the entity and its environment
At or near the end of the audit when forming an overall conclusion as to whether the financial
statements as a whole are consistent with the auditor's understanding of the entity
I 95
5.2
Practical techniques
Ratio analysis is one of the key techniques which the auditor will use when performing analytical
procedures. You have looked at the relevant ratios in detail in your Assurance studies. A brief summary is
provided below.
5.2.1
Ratio analysis
When carrying out analytical procedures, auditors should remember that every industry is different and
each company within an industry differs in certain aspects.
Important
accounting ratios
I
I
Gross profit margins, in total and by product, area and months/quarter (if
possible)
Receivables ratio (average collection period)
Inventory turnover ratio (inventory divided into cost of sales)
Current ratio (current assets to current liabilities)
1
I
Return on capital employed (profit before tax to total assets less current
jl
I
liabilities)
~--------------------~-------------------------------------------------------~
I Related items
Payables and purchases
/
Inventory and cost of sales
Non current assets and depreciation, repairs and maintenance expense
Intangible assets and amortisation
Loans and interest expense
Investments and investment income
Receivables and bad debt expense
Receivables and sales
Ratios mean very little when used in isolation. They should be calculated for previous periods and for
comparable companies. The permanent file should contain a section with summarised accounts and the
chosen ratios for prior years.
In addition to looking at the more usual ratios the auditors should consider examining other ratios that
may be relevant to the particular client's business, such as revenue per passenger mile for an airline
operator client, or fees per partner for a professional office.
5.2.2
Other techniques
Other analytical techniques include:
(a)
Simple comparisons
A simple year on year comparison could provide very persuasive evidence that an expense such as
rent is correctly stated, providing that the auditor has sufficient knowledge of the business, for
example knowing that the same premises have been leased year on year and that there has been no
rent review.
196
AUDIT EVIDENCE
(b)
(c)
Reasonableness tests
These involve calculating expected value of an item and comparing it with its actual value, for
example, for straight-line depreciation.
(Cost+ Additions- Disposals) x Depreciation%= Recognised in profit or loss
This may include the comparison of non-financial as well as financial information.
For example, in making an estimate of employee costs, probably for one specific department, such as
manufacturing, the auditor might use information about the number of employees in the department,
as well as rates of pay increases.
(d)
Trend analysis
This is a sophisticated statistical technique that can be used to compare this period with the previous
period. Information technology can be used in trend analysis, to enable auditors to see trends
graphically with relative ease and speed.
Methods of trend analysis include:
Scattergraphs
Bar graphs
Pie charts
Any other visual representations
Time series analysis
Statistical regression
Time series analysis involves techniques such as eliminating seasonal fluctuations from sets of figures,
so that underlying trends can be analysed. This is illustrated below.
Example
Sales
Months
June
December
June
Line (I) in the diagram shows the actual sales made by a business. There is a clear seasonal fluctuation
before Christmas. Line (2) shows a level of sales with 'expected seasonal fluctuations' having been stripped
out.
197
5.3
5.3.1
Technique
Although we are specifically considering analytical procedures as risk assessment procedures the basic
techniques adopted throughout the audit are very similar. The key stages in the process are as follows:
~
~
~
Interpretation
Investigation
Corroboration
When potential problem areas have been identified one of the key questions to ask is 'why'?
The statement of comprehensive income
To apply this in more detail think about the client's statement of comprehensive income.
The key question must be:
Why did the client make more (or less) money this year?
Profit before tax
Overheads
More customers
Different customers
More spend per customer
New outlets
One offs
Fraud & Error
~
~
~
198
Different products
Different suppliers
Different markets
One offs
Fraud & Error
Changes in revenue;
Changes in margins;
Changes in overheads.
Strategic decisions
Market forces
One offs
Fraud & Error
AUDIT EVIDENCE
Changes in revenue must depend on changes in:
~
~
Volumes; or
Prices;
Selling prices;
Cost prices;
Product mix.
Changes in overheads will need to be identified line by line, but you might like to consider the different
impacts of changes in:
~
Fixed; and
Variable overheads.
The boxes at the bottom of the diagram give some suggestions for the reasons why. The suggestions are
not intended to be exhaustive, but they should give you a good basis for an answer to an analytical review
type question.
A similar approach needs to be taken both to statement of financial position areas and those efficiency
ratios which link statement of financial position figures to the performance ratios.
5.3.2
You are planning the audit of Darwin Ltd for the year ended 31 December 20X7. You are currently
engaged in the interim audit during November 20X7. The company manufactures and distributes light
fittings for both internal and external use. Approximately 40% of revenue is generated from overseas
customers.
You have been provided with the following operating information
I 0 months to 31 October
20X7
I 0 months to 31 October
20X6
Year to 31 December
20X6
27,187
16,040
11,147
5,437
5,709
41%
21%
5,160
23,516
14,966
8,550
4,938
3,612
36%
15%
4,320
27,Q68
17,175
9,892
5,678
4,214
37%
16%
4,080
cuooo
Revenue
Cost of sales
Gross profit
Operating expenses
Operating profit
Gross profit margin
Operating profit margin
Inventories
cuooo
cuooo
Requirement
Based on the operating information identify and explain the potential audit risks.
I 99
Libby Ltd is a ladies fashion retailer operating a chain of shops in the South East of England from a head
office in Guildford. Your firm has been the auditor of Libby Ltd for some years.
During the current year one shop was closed and the product range of the remaining eight shops was
extended to include accessories and footwear.
The company has a computerised accounting system and the audit manager is keen to ensure that the audit
is as efficient as possible.
As senior in charge of the audit you are currently planning the audit work for trade payables and you have
obtained draft financial statements from the client.
Extracts from the draft financial statements:
Year ended 31 March
Draft 20X7
Aaua/20X6
Revenue
Gross profit
8,173
1,717
5,650
1,352
Draft
cuooo
cuooo
Aaual
cuooo
cuooo
2,799
1,746
991
514
2,616
1,127
718
460
Requirements
(a)
State what observations you can draw from the extracts from the draft financial statements and how
they may affect your audit of trade payables.
(b)
Indicate how audit software could be used in the audit of trade payables to achieve a more efficient
audit.
Factors to consider
There are a number of factors which the auditors should consider when deciding whether to use analytical
procedures as substantive procedures. You will have covered these in your Assurance studies. A brief
reminder of those identified by BSA 520 is given below.
200
AUDIT EVIDENCE
previous audits
Factors which should also be considered when determining the reliance that the auditors should place on
the results of substantive analytical procedures are:
Reliance on the results of analytical procedures depends on the auditor's assessment of the risk that the
procedures may identify relationships (between data) do exist, whereas a material misstatement exists (that
is, the relationships, in fact, do not exist). It depends also on the results of investigations that auditors have
made if substantive analytical procedures have highlighted significant fluctuations or unexpected
relationships.
20 I
5.4.2
Thirdly, obtain possible reasons for variance between expected value and recorded amount
Fourthly, evaluate impact of any unresolved differences between the expected and recorded
amounts on the audit and financial statements.
202
AUDIT EVIDENCE
Evaluate impact of any unresolved differences
Finally, the auditor will evaluate the impact of any unresolved differences on audit work and the financial
statements. A large difference may mean that additional substantive testing is required on the account
balance to determine its accuracy. Any small remaining difference may be ignored as immaterial.
Hopefully, differences in expected and actual salaries will be resolved and any remaining residual difference
will be immaterial. However, where differences remain, additional substantive testing of the salaries figure
will be required.
5.5
Interpretation
The individual carrying out the analytical procedures, reads through the financial statements and
interprets them, considering the absolute figures themselves and the relevant ratios.
Investigation
When analytical procedures are used as risk assessment procedures or as a substantive procedure the
aim is to identify potential problems. The problems are then investigated during fieldwork by making
enquiries and gathering audit evidence.
At the completion stage the reviewer will expect to find the answers to the issues raised by the
review on the audit file.
Corroboration
Should those answers not be on the file, then further work will need to be performed.
5.6
For the smaller client the working papers supporting the final analytical procedures may well simply be
an update of the work done at the planning stage
For the larger client the review becomes much more of a specific exercise
The financial statements used for the analytical procedures need to incorporate any adjustments made
as a result of the audit
Any problems identified by the procedures that indicate that the financial statements should be
amended need to be actioned.
Harrison Ltd is a small jewellers based in Hatton Garden in London. Over the years it has built up an
impressive client portfolio, and boasts names from high society as regular customers.
Harrison Ltd now needs to restructure its long-term and short-term financing in order to facilitate future
growth, and has provided your firm with the following data to make an assessment of its liquidity. The firm
is also looking to re-evaluate its performance measures and is seeking advice on what might be the most
appropriate non-financial performance measures.
The following is an extract from the financial information provided by Harrison Ltd for the year ended 30
September 20X4.
203
CU2.0m
CUI.2m
CUI.5m
cu
Non-current assets
Inventory
Receivables
Cash
Payables
550,000
300,000
150,000
100,000
(100,000)
1,000,000
250,000
350,000
250,000
150,000
1,000,000
cu
The ordinary shares are currently quoted at 125p each, the loan stock is trading at CUSS per CUI 00
nominal, and the preference shares at 65p each.
Requirement
Advise the company.
6.1
Audit procedures
You should be familiar with the definitions of a provision and a contingent liability and contingent asset from
BAS 37 Provisions, Contingent Liabilities and Contingent Assets. As you will see below much of the audit work is
focused on ensuring that the recognition and treatment of these items is in accordance with financial
reporting standards.
The audit tests that should be carried out on provisions and contingent assets and liabilities are as follows.
~
Obtain details of all provisions which have been included in the accounts and all contingencies
that have been disclosed
Obtain a detailed analysis of all provisions showing opening balances, movements and closing
balances
Determine for each material provision whether the company has a present obligation as a
result of past events by:
Review of correspondence relating to the item
Discussion with the directors, have they created a valid expectation in other parties that they
will discharge the obligation?
204
AUDIT EVIDENCE
~
Determine for each material provision whether it is probable that a transfer of economic
benefits will be required to settle the obligation by:
Checking whether any payments have been made after the end of the reporting period in
respect of the item
Review of correspondence with solicitors, banks, customers, insurance company and suppliers
both pre and post year end
Sending a letter to the solicitor to obtain their views (where relevant)
Discussing the position of similar past provisions with the directors. Were these provisions
eventually settled1
Considering the likelihood of reimbursement
Compare the amount provided with any post year end payments and with any amount paid in the
past for similar items
In the event that it is not possible to estimate the amount of the provision, check that this
contingent liability is disclosed in the accounts
Consider the nature of the client's business. Would you expect to see any other provisions, for
example, warranties1
Consider whether disclosures of provisions, contingent liabilities and contingent assets are
correct and sufficient
6.2
6.2.1
Attendance at an inventory count has been covered in detail in Assurance. A summary of the procedures
regarding litigation and claims is provided below.
6.2.2
Use any information obtained regarding the entity's business including information obtained from
discussions with any in-house legal department
When litigation or claims have been identified or when the auditor believes they may exist, the auditor
should seek direct communication with the entity's lawyers.
This will help to obtain sufficient appropriate audit evidence as to whether potential material litigation
and claims are known and management's estimates of the financial implications, including costs, are reliable.
205
(b)
Management's assessment ofthe outcome of the litigation or claim and its estimate of the financial
implications, including costs involved
(c)
A request that the lawyer confirm the reasonableness of management's assessments and provide the
auditor with further information if the list is considered by the lawyer to be incomplete or incorrect
The auditors must consider these matters up to the date of their report and so a further, updating
letter may be necessary.
A meeting between the auditors and the lawyer may be required, for example where a complex matter
arises, or where there is a disagreement between management and the lawyer. Such meetings should take
place only with the permission of management, and preferably with a management representative present.
If management refuses to give the auditor permission to communicate with the entity's lawyers, this would
be a scope limitation and should ordinarily lead to a qualified opinion or a disclaimer of opinion.
If the lawyer refuses to respond as required and the auditor can find no alternative sufficient evidence, a
In February 20X7 the directors of Newthorpe Engineering Ltd suspended the managing director. At a
disciplinary hearing held by the company on 17 March 20X7 the managing director was dismissed for gross
misconduct, and it was decided the managing director's salary should stop from that date and no
redundancy or compensation payments should be made.
The managing director has claimed unfair dismissal and is taking legal action against the company to obtain
compensation for loss of his employment. The managing director says he has a service contract with the
company which would entitle him to two years' salary at the date of dismissal.
The financial statements for the year ended 30 April 20X7 record the resignation of the director. However,
they do not mention his dismissal and no provis'1on for any damages has been included in the financial
statements.
Requirements
(a)
State how contingent liabilities should be disclosed in financial statements according to BAS 37
Provisions, Contingent Uabilities and Contingent Assets.
(b)
Describe the audit work you will carry out to determine whether the company will have to pay
damages to the director for unfair dismissal, and the amount of damages and costs which should be
included in the financial statements.
Note. Assume the amounts you are auditing are material.
206
--
AUDIT EVIDENCE
BSA 540 Audit of Accounting Estimates provides guidance on the audit of accounting estimates contained in
financial statements and requires auditors to obtain sufficient, appropriate audit evidence regarding
accounting estimates.
Definition
An accounting estimate: is an approximation of the amount of an item in the absence of a precise means
of measurement.
Depreciation and amortisation to allocate the cost of non-current assets over their estimated useful
lives
Accrued revenue
Deferred tax
Directors and management are responsible for making accounting estimates included in the financial
statements. These estimates are often made in conditions of uncertainty regarding the outcome of events
and involve the use of judgement. The risk of a material misstatement therefore increases when
accounting estimates are involved.
Audit evidence supporting accounting estimates is generally less than conclusive and so auditors need
to exercise greater judgement than in other areas of an audit.
Accounting estimates may be produced as part of the routine operations of the accounting system, or may
be a non-routine procedure at the period-end. Where, as is frequently the case, a formula based on past
experience is used to calculate the estimate, it should be reviewed regularly by management (e.g. actual vs.
estimate in prior periods).
If there is no objective data to assess the item, or if it is surrounded by uncertainty, the auditors should
consider the implications for their report.
7 .I
Audit procedures
Auditors should gain an understanding of the procedures and methods used by management to make
accounting estimates to gain evidence of whether estimates are reasonable given the circumstances and
appropriately disclosed if necessary. It will also aid the auditors' planning of their own procedures.
207
7.1.1
(a)
Review and test the process used by management or the directors to develop the estimate
(b)
Use an independent estimate for comparison with that prepared by management or the
directors or
(c)
Seek appropriate evidence from outside client (for example, industry sales projections to confirm
internal estimates of future sales orders)
Check whether data is appropriately analysed and projected (for example, age analysis of debtors)
Compare previous estimates with actual results, aiming to obtain evidence about
General reliability of the client's estimating procedures
Whether adjustments to estimating formulae will be required
Whether differences between previous estimates and actual figures ought to be disclosed
7.1.2
7.1.3
208
AUDIT EVIDENCE
7.2
7.3
7.3.1
Deferred tax
Accounting treatment: reminder
Deferred tax is the tax attributable to temporary differences. Where a company has a tax reduction
in the current period, by accelerated capital allowances for example, a provision for the tax charge is
made in the statement of financial position.
The provision is made is because over the course of the asset's life, the tax allowances will reduce until the
depreciation charged in the accounts is higher than the allowances. This will result in taxable profit being
higher than reported profit and the company will be 'suffering higher tax' in this period.
As part of the planning process, if the client receives tax services from the firm, the auditor should
consult the tax department as to the company's future tax plans, to ascertain whether they expect a
deferred tax liability to arise. This will assist any analytical review they carry out on the deferred tax
provision.
7.3.2
Audit procedures
The following procedures will be relevant:
Obtain a copy of the deferred tax workings and the corporation tax computation
Check the arithmetical accuracy of the deferred tax working
Agree the figures used to calculate timing differences to those on the tax computation and the
financial statements
Consider the assumptions made in the light of your knowledge of the business and any other evidence
gathered during the course of the audit to ensure reasonableness
Agree the opening position on the deferred tax account to the prior year financial statements
Review the basis of the provision to ensure:
It is line with accounting practice under BAS 12/ncome Taxes
It is suitably comparable to practice in previous years
Any changes in accounting policy have been disclosed
209
7.4.2
Recognise contract revenue as revenue in the accounting period in which the work is performed.
Recognise contract costs as an expense in the accounting period in which the work to which they
relate is performed.
Any expected excess of total contract costs over total contract revenue should be recognised as an
expense immediately.
Any costs incurred which relate to future activity should be recognised as an asset if it is probable
that they will be recovered (often called contract work in progress, that is, amounts due from the
customer).
Where amounts have been recognised as contract revenue, but their collectability from the
customer becomes doubtful, such amounts should be recognised as an expense, not a deduction from
revenue.
Audit procedures
The following procedures will be relevant:
~
Determine whether the outcome of the contract can be measured reliably, in particular the
assessment of the directors that payment will be received under the contract
Where this is not the case confirm that revenue is recognised only to the extent that costs are
recoverable
Check the calculation of the overall expected outcome for the project i.e. profitable/loss making
Review the calculation of costs to complete and assess the validity of any assumptions made by
management. Where possible compare the overall expected profitability with other similar projects.
Assess the basis on which profit is recognised e.g. stage of completion method. Establish the way
in which the stage of completion has been measured e.g. by surveyor and determine whether it
appears reasonable
Where the stage of completion is based on costs incurred to date assess whether they fairly
represent the stage of completion (i.e. they do not represent inefficiencies)
Confirm that any costs accounted for as contract work in progress are recoverable under the
contract
Assess the likelihood of recovery of revenue recognised but not yet received (may represent a bad
debt)
Construction Ltd has entered into a fixed price contract to construct an office block. Construction
commenced on I September 20X6 and is expected to take 36 months. You are auditing the financial
statements for the year ended 31 December 20X7.
The contract price is made up as follows:
cuooo
Contract price
Incentive payment if completed on time
600
__1Q
640
Total contract costs at the end of 20X6 were estimated to be CU470,000. At the end of 20X7 this estimate
has increased to CU570,000 due to extra costs incurred to rectify a number of construction faults.
21 0
AUDIT EVIDENCE
At the end of 20X6 the contract was assessed as being 30% complete and at the end of 20X7 60%
complete. Draft financial statements show that the following amounts have been recognised:
lOX?
Revenue
Profit
20X6
cuooo
cuooo
192
192
51
42
Requirement
For the year ended 31 December 20X7:
(I)
(2)
-~-
7 .S
Current developments
The IMSB has issued ISA 540 (Revised and Redrafted) Auditing Accounting Estimates, Including Fair Value
Accounting Estimates, and Related Disclosures as part of the Clarity Project (see Chapter I). This standard
combines two former standards, still in use in Bangladesh, BSA 540 Audit of Accounting Estimates and BSA
545 Auditing Fair Value Measurements and Disclosures (see Chapter 12) as similar issues and risks arise in both
cases. Its specific requirements stress:
~
Focus must be on figures with a high level of estimation uncertainty as well as estimates with a high
risk of material misstatement, and
If management has not considered a range of outcomes the auditors should consider whether to
calculate their own reasonable range of outcomes
The auditor shall obtain an understanding of the following as part of the process of understanding the
business:
The requirements of the applicable financial reporting framework.
The means by which the management identifies transactions, events and conditions that may give
rise to the accounting estimates.
How management makes the accounting estimate.
This means that the auditor must have a sound knowledge of the accounting requirements relevant to
the entity and when fair value is allowed, for example, BAS 16 allows fair value provided 'it can be
measured reliably'.
The auditor should evaluate the degree of estimation uncertainty associated with the accounting
estimate and assess whether this gives rise to significant risks.
Based on the assessed risks the auditor will determine whether the financial reporting framework has
been properly applied and whether methods for making estimates are appropriate and have been
applied consistently.
21 I
For accounting estimates which give rise to significant risks the auditor should also evaluate the
following:
How management has considered alternative assumptions or outcomes
Whether the significant assumptions used are reasonable
Management intent to carry out specific courses of action and its ability to do so, where these
affect the accounting estimate
Management's decision to recognise, or to not recognise the accounting estimate
The selected measurement basis
Written representations will be obtained from management as to whether management believes that
significant assumptions used in making accounting estimates are reasonable.
8 Related parties
8.1
Introduction
The need for enhanced reporting on related party transactions was highlighted by many DTI investigations
into company failures. Transactions with related parties may have been concealed from auditors or
inaccurate information given. Hence the financial statements and audit report may have failed to disclose
relevant information. Thus, in line with the continued importance of reporting all information to
stakeholders, BAS 24 Related Pany Disclosures and BSA 550 Related Parties were developed.
8.2
Key issues
Readers of financial statements normally assume that transactions reflected in financial statements are made
with independent parties unless told otherwise.
Readers will also normally assume that a company is owned by a number of shareholders and is not
subject to control or significant influence by any one person or company unless told otherwise, e.g.
through disclosure of identity of parent company and significant shareholdings disclosure.
Where a company does business with "related parties", for instance with shareholders or directors, these
assumptions may not be valid.
21 2
AUDIT EVIDENCE
8.3
8.3.1
8.3.2
Responsibilities
Management is responsible for the identification of related parties and the disclosure of transactions with
such parties. Management should set up appropriate internal controls to ensure that related parties are
identified and disclosed along with any related party transactions.
The auditor needs to obtain appropriate audit evidence regarding the assertions by management in respect
of related parties. This involves an understanding of the entity and its environment to identify events,
transactions and practices with respect to related parties.
8.3.3
' ---
Risks
The following audit risks may arise from a failure to discover a related party.
~
There may be a misstatement in the financial statements - transactions may be on a non-arm's length
basis and thus may result in assets, liabilities, profit or loss being overstated or understated.
The reliance on a source of audit evidence may be misjudged. An auditor may rely on what is
perceived to be third party evidence when in fact it is from a related party. More generally, reliance on
management assurances may be affected if the auditor were made aware of non-disclosure of a related
party.
The motivations of related parties may be outside normal business motivations and thus may be
misunderstood by the auditor if there is non-disclosure. In the extreme this may amount to fraud.
The risk of failure to detect a related party transaction (RPT) may depend upon the following.
~
Whether there has been no charge made for a RPT (i.e. a zero cost transaction)
Where disclosure would be sensitive for directors or have adverse consequences for the company
Where RPTs are not with a party that the auditor could reasonably expect to know is a related party
RPTs from an earlier period have remained as an unsettled balance
8.3.4
Management have concealed, or failed to disclose fully, related parties or transactions with such
parties
Audit testing
The planning stage
In planning the audit the auditor needs to consider the risk of undisclosed related party transactions.
This is a difficult area because BAS 24 does not have consideration for materiality. Thus, even small RPTs
should be disclosed by a company. Indeed, related party relationships where there is control (e.g. a
subsidiary) need to be disclosed even where there are no transactions with this party.
21 3
-------- ------
Steps
Related parties
Practical procedures
Obtain directors'
representations
Consider implications for report
where
insufficient evidence
inadequate disclosure
21 4
AUDIT EVIDENCE
Point to note
The law regarding transactions with directors was covered in Chapter I of this Study Manual.
8.4
Current developments
In july 2008 the IAASB issued ISA 550 (Revised and Redrafted) Related Parties as part of its Clarity Project
The overall aim of the revised ISA is to enhance the auditor's consideration of related parties and related
party transactions establishing an approach that requires the auditor to assess the risks of misstatement and
design audit tests to address these. In particular the ISA includes the following:
~
Clearer responsibilities for the auditor with a distinction being made between circumstances where
the accounting framework includes disclosure and other reporting requirements for related parties
and circumstances where either there are no such requirements or they are inadequate
Clearer distinction between the work performed by the auditor to identify the risks of material
misstatement from related party transactions and the procedures taken to address those risks
It provides a definition of a related party which is to be used as a minimum level for audit purposes
where the applicable financial reporting framework establishes minimal or no related party
requirements
Definition
Related party: A party that is either:
(a)
(b)
Where the applicable financial reporting framework establishes minimal or no related party
requirements:
(i)
A person or other entity that has control or significant influence, directly or indirectly through
one or more intermediaries, over the reporting entity
(ii)
Another entity over which the reporting entity has control or significant influence, directly or
indirectly through one or more intermediaries; or
(iii) Another entity that is under common control with the reporting entity through having:
~
However, entities that are under common control by a state (i.e. a national, regional or local
government) are not considered related unless they engage in significant transactions or share
resources to a significant extent with one another.
2I5
9 Management representations
9 .I
Representations
The auditors receive many representations during the audit, both unsolicited and in response to specific
questions. Some of these representations may be critical to obtaining sufficient appropriate audit evidence.
Representations may also be required for general matters, e.g. full availability of accounting records.
BSA 580 Management Representations covers this area.
The auditor should obtain appropriate representations from management. Written confirmation of
appropriate representations from management, should be obtained before the audit report is issued.
Definition
Management: comprises officers and those who also perform senior managerial functions.
Relevant minutes of meetings of the board of directors or similar body, or by attending such a
meeting
9.3
(a)
It acknowledges its responsibility for the design and implementation of internal control to prevent and
detect error; and
(b)
It believes the effects of those uncorrected financial statement misstatements aggregated by the
auditor are immaterial, both individually and in the aggregate, to the financial statements taken as a
whole. A summary of such items should be included in or attached to the written representation.
216
AUDIT EVIDENCE
The auditor should obtain written representations from management on matters material to the
financial statements when other sufficient appropriate audit evidence cannot be reasonably
expected to exist.
Written confirmation of oral representations avoids confusion and disagreement. Such matters should
be discussed with those responsible for giving the written confirmation, to ensure that they understand
what they are confirming. Written confirmations are normally required of appropriately senior
management. Only matters which are material to the financial statements should be included.
When the auditors receive such representations they should:
~
Seek corroborative audit evidence from sources inside or outside the entity
Evaluate whether the representations made by management appear reasonable and are consistent
with other audit evidence obtained, including other representations
Consider whether the individuals making the representations can be expected to be wellinformed on the particular matters
Knowledge of the facts is confined to management, for example, the facts are a matter of
management intention.
The matter is principally one of judgement or opinion, for example, the trading position of a
particular customer.
There may be occasions when the representations received do not agree with other audit evidence obtained.
If a representation by management is contradicted by other audit evidence, the auditor should investigate
the circumstances and, when necessary, consider whether it casts doubt on the reliability of other
representations made by management.
Investigations of such situations will normally begin with further enquires of management; the
representations may have been misunderstood or, alternatively, the other evidence misinterpreted. If
explanations are insufficient or unforthcoming, then further audit procedures may be required.
9.4
A letter from the auditors outlining the auditors' understanding of management's representations, duly
acknowledged and confirmed by management
Relevant minutes of meetings of the board of directors or similar body or a signed copy of the financial
statements
Point to note
A signed copy of the financial statements for a company may be sufficient evidence of the directors'
acknowledgement of their collective responsibility for the preparation of the financial statements where it
incorporates a statement to that effect. A signed copy of the financial statements, however, is not, by itself,
sufficient appropriate evidence to confirm other representations given to the auditor as it does not,
ordinarily, clearly identify and explain the specific separate representations.
21 7
9.5
The letter will usually be dated on the day the financial statements are approved, but if there is any
significant delay between the representation letter and the date of the auditors' report, then the auditors
should consider the need to obtain further representations.
A management representation letter is usually signed by the members of management who have primary
responsibility for the entity and its fmancial aspects (that is, the senior executive officer and the senior
financial officer) based on the best of their knowledge and belief.
9.6
9. 7
9.8
Current developments
In April 2008 the IAASB issued ISA 580 (Revised and Redrafted) Written Representations as part of its Clarity
Project. The main points to note are as follows:
~
The auditor is required to determine the relevant parties from whom representations should be
sought (individuals other than management/those charged with governance may have specialised
knowledge)
Written representations can be general (i.e. about the premises on which the audit is based) and
specific. The content of the general representations in relation to the financial statements and internal
control is specified by the ISA and includes the following:
Management has fulfilled its responsibility for the preparation of the financial statements
Management has provided the auditor with all relevant information
All transactions have been recorded and reflected in the financial statements
218
The auditor may decide that it may be more effective if written representations were limited to
matters above threshold limits
AUDIT EVIDENCE
There have been no events subsequent to the period end requiring adjustment in the financial
statements.
(b)
The company has revalued 2 properties in the year. The directors believe that the property market is
going to boom next year, so have decided to revalue the other 2 properties then.
(c)
The directors confirm that the company owns 75% of the newly formed company, Subsidiary Ltd, at
the year end.
(d)
The directors confirmed that the 500 gallons of oil in Warehouse B belong to Flower Oil Co.
Requirement
Comment on whether you would expect to see these matters referred to in the management
representation letter.
I 0 Opening balances
I0.1
Audit procedures
Opening balances are those account balances which exist at the beginning of the period. Opening
balances are based upon the closing balances of the prior period and reflect the effects of:
~
~
BSA 51 0 Initial Engagements - Opening Balances and Continuing Engagements - Opening Balances provides
guidance on opening balances:
~
~
I0.2
When the financial statements of an entity are audited for the first time
When the financial statements for the prior period were audited by another auditor
Initial engagements
For initial audit engagements, the auditor should obtain sufficient appropriate audit evidence that:
(a)
the opening balances do not contain misstatements that materially affect the current
the prior period's closing balances have been correctly brought forward to the current
period or, when appropriate, have been restated; and
219
appropriate accounting policies are consistently applied or changes in accounting policies have
been properly accounted for and adequately disclosed.
In addition, the auditor should carry out the above on continuing engagements. Appropriate and sufficient
audit evidence is required on opening balances and this depends on matters such as the following.
~
Whether the prior period's financial statements were audited and, if so, whether the auditors'
report was modified
The nature of the accounts and the risk of their misstatement in the current period's financial
statements
The materiality of the opening balances relative to the current period's financial statements
The auditor must consider whether opening balances reflect the application of appropriate
accounting policies and that those policies are consistently applied in the current period's financial
statements. When there are any changes in the accounting policies or application thereof, the auditor
should consider whether they are appropriate and properly accounted for and adequately disclosed.
I 0.3
I 0.4
Observing a current physical inventory count and reconciling it back to the opening inventory
quantities
220
AUDIT EVIDENCE
For non-current assets and liabilities, the audit will ordinarily examine the records underlying the
opening balances. In certain cases, the auditor may be able to obtain confirmation of opening balances with
third parties, for example, for long-term debt and investments. In other cases, the auditor may need to
carry out additional audit procedures.
I 0.5
A qualified opinion;
(b)
A disclaimer of opinion; or
(c)
In those jurisdictions where it is permitted, an opinion which is qualified or disclaimed regarding the
results of operations and unqualified regarding financial position.
If the opening balances contain misstatements which could materially affect the current period's financial
statements, the auditor should inform management, and any predecessor auditor.
If the effect of the misstatement is not properly accounted for and adequately disclosed, the auditor should
express a qualified opinion or an adverse opinion, as appropriate.
The report will also be modified if accounting policies are not consistently applied.
If the current period's accounting policies have not been consistently applied in relation to the opening
balances and if the change has not been properly accounted for and adequately disclosed, the auditor should
express a qualified opinion or an adverse opinion as appropriate.
If the prior period auditor's report was modified, the auditor should consider the effect on the current
period's financial statements. For example, if there was a scope limitation, such as one due to the
inability to determine opening inventory in the prior period, the auditor may not need to qualify or disclaim
the current period's audit opinion. The BSA finishes by stating that if a modification regarding the prior
period's financial statements remains relevant and material to the current period's financial statements, the
auditor should modify the current auditor's report accordingly.
Note: If the prior period was not audited there may also need to be a limitation of scope qualification with
respect to comparative figures.
II
Service organisations
Definition
A service organisation is an organisation that provides services to another organisation.
BSA 402 Audit Considerations Relating to Entities Using Service Organisations provides guidance to auditors
whose client uses such an organisation. It describes the auditor reports from the service organisation's
auditors which the client's auditors may obtain. It states that 'the auditor should consider how an entity's
221
I I .I
When the services provided by the service organisation are limited to recording and processing
client transactions and the client retains authorisation and maintenance of accountability, the client
may be able to implement effective policies and procedures within its organisation.
(b)
When the service organisation executes the client's transactions and maintains accountability,
the client may deem it necessary to rely on policies and procedures at the service organisation.
The BSA states, 'the auditor should determine the significance of service organisation activities to the client
and the relevance to the audit'.
The BSA lists the following activities as relevant activities (this is not an exhaustive list):
~
~
~
~
The BSA requires the auditor to understand the terms of the agreement between the service organisation
and the user entity. The following should be obtained and documented:
(a)
The contractual terms which apply to relevant activities undertaken by service organisations
(b)
The way that the user entity monitors those activities so as to ensure that it meets its fiduciary and
other legal responsibilities
222
Whether the terms contain an adequate specification of the information to be provided to the user
entity and responsibilities for initiating transactions relating to the activity undertaken by the service
organisation.
The way that accounting records relating to relevant activities are maintained
Whether the user entity has a right to access accounting records prepared by the service organisation
concerning the activities undertaken, and relevant underlying information held by it, and the conditions
in which such access may be sought.
Whether the terms take proper account of any applicable requirements of regulatory bodies
concerning the form of records to be maintained, or access to them.
The way in which the user entity monitors performance of relevant activities and the extent to which
its monitoring process relies on controls operated by the service organisation.
Whether the service organisation has agreed to indemnify the user entity in the event of a
performance failure.
Whether the contractual terms permit the user entity auditors access to sources of audit evidence
including accounting records of the user entity and the information necessary for the conduct of the
audit.
~UDIT
EVIDENCE
The terms of contract and relationship between the client and the service organisation.
The extent to which the client's accounting and internal control systems interact with the
systems at the service organisation.
The entity's internal controls relevant to the service organisation activities include:
~
The service organisation's capability and financial strength, including the possible effect of the
failure of the service organisation on the client.
Information about the service organisation such as that reflected in user and technical manuals.
Information available on general controls and computer systems controls relevant to the client's
applications.
If this leads the auditor to decide that the control risk assessment will not be affected by controls at the
service organisation, further consideration of this BSA is unnecessary. However, if he concludes that risk is
affected, further audit procedures should be carried out.
The client auditor should also consider the existence of third-party reports from service organisation
auditors, internal auditors, or regulatory agencies as a means of providing information about the accounting
and internal control systems of the service organisation and about its operation and effectiveness.
The BSA states that 'if the client auditor concludes that the activities of the service organisation are
significant to the entity and relevant to the audit, the auditor should obtain a sufficient understanding of the
entity and its environment, including its internal control, to identify and assess the risks of material
misstatement and design further audit procedures in response to the assessed risk.'
If information is insufficient, the client auditor should consider asking the service organisation to have its
auditor perform such procedures as to supply the necessary information, or the need to visit the service
organisation to obtain the information. A client auditor wishing to visit a service organisation may advise the
client to request the service organisation to give the client auditor access to the necessary information.
I 1.2
Assess whether sufficient appropriate audit evidence concerning the relevant financial statement
assessment is available from records held at the user entity; and if not
(b)
Determine effective procedures to obtain evidence necessary for the audit, either by direct access to
records kept by service organisations or through information obtained from the service organisations
or their auditors'
Obtaining representations to confirm balances and transactions from the service organisation
Performing analytical review on the records maintained by the user entity, or the returns received
from the service organisation
Requesting specified procedures re-performed by the service organisation and the user entity's
internal audit department
Reviewing information from the service organisation or its auditors concerning the design and
operation of its control systems
223
I I .3
(b)
Re.port on suitability of design and operating effectiveness. This will contain the same as a
report on design, plus an opinion by the service organisation auditor that the accounting and internal
control systems are operating effectively based on the results from the tests of control.
While reports on design may be useful to a client auditor in gaining the required understanding of the
accounting and internal control systems, an auditor would not use such reports as a basis for reducing the
assessment of control risk.
By contrast a report on operating effectiveness may provide such a basis since tests of control have been
performed. If this type of report may be used as evidence to support a lower control risk assessment, a
client auditor would have to consider whether the controls tested by the service organisation auditor are
relevant to the client's transactions (significant assertions in the client's financial statements) and whether
the service organisation auditor's tests of controls and the results are adequate.
The auditor of a service organisation may be engaged to perform substantive procedures that are of use
to a client auditor. Such engagements may involve the performance of procedures agreed upon by the client
and its auditor and by the service organisation and its auditor.
224
chapter 6
Audit completion
and reporting
rev1ew
Introduction
Topic list
I
Subsequent events
Going concern
Comparatives
Internal reporting
Appendix
Summary and Self-test
Technical reference
Answers to Self-test
Answers to Interactive questions
269
1.1
Introduction
Auditing initially may be carried out in components, with opinions being formed on elements of the financial
statements in isolation. However, it is essential that auditors step back from the detail and assess the
financial statements as a whole, based on knowledge accumulated during the audit process. In particular the
following procedures will need to be performed at the review and completion stage of the audit
~
~
~
~
~
Review and reporting issues have been covered in the Assurance and Audit and Assurance Study Manuals at
the Professional level. Therefore you should be familiar with the following BSAs which are relevant to this
stage of the audit:
BSA 260 Communication
1.2
1.2.1
Governance issues
Quality control
We have looked at the importance of quality control in Chapter I of this Study Manual. However, quality
control is an important consideration throughout the audit and not just in the initial acceptance of a client
and planning of the engagement. In particular for the audit of listed entities BSA 220 Quality Control for Audits
of Historical Financial Information states that the auditor's report should not be issued until the completion of
the engagement quality control review. This includes ensuring that:
~
~
~
~
~
~
~
The work has been carried out in accordance with professional and regulatory requirements
Significant matters are given further consideration
Appropriate consultations have taken place and been documented
Where appropriate the planned work is revised
The work performed supports the conclusions
The evidence obtained supports the audit opinion
The objectives of the audit have been achieved
271
1.2.2
Governance evidence
Important governance evidence will be obtained from the following sources:
~
~
~
1.3
1.3.1
1.3.2
(b)
The accounting policies employed are in accordance with accounting standards, properly disclosed,
consistently applied and appropriate to the entity.
An important consideration in assessing the presentation of the financial statements is the adequacy of
disclosure. In addition to the basic Companies Act requirements and compliance with accounting standards
the entity may also need to satisfy the requirements of the Sarbanes-Oxley.
When examining the accounting policies, auditors should consider:
~
Whether any departures from applicable accounting standards are necessary for the financial
statements to give a true and fair view
Whether the financial statements reflect the substance of the underlying transactions and not merely
their form
When compliance with local/national statutory requirements and accounting standards is considered, the
auditors may find it useful to use a checklist.
272
1.3.3
"--
1.3.4
(a)
Whether the financial statements adequately reflect the information and explanations previously
obtained and conclusions previously reached during the course of the audit.
(b)
Whether it reveals any new factors which may affect the presentation of, or disclosure in, the
financial statements.
(c)
Whether analytical procedures applied when completing the audit, such as comparing the information
in the financial statements with other pertinent data, produce results which assist in arriving at the
overall conclusion as to whether the financial statements as a whole are consistent with their
knowledge of the entity's business.
(d)
Whether the presentation adopted in the financial statements may have been unduly influenced by
the directors' desire to present matters in a favourable or unfavourable light.
(e)
The potential impact on the financial statements of the aggregate of uncorrected misstatements
(including those arising from bias in making accounting estimates) identified during the course of the
audit.
Analytical procedures
In Chapter 5 we have discussed how analytical review procedures are used as part of the overall
review procedures at the end of an audit. Remember the areas that the analytical review at the final stage
must cover.
~
~
~
~
~
~
~
~
~
As at other stages, significant fluctuations and unexpected relationships must be investigated and
documented.
1.3.5
'--
Summarising errors
During the course of the audit, errors will be discovered which may be material or immaterial to the
financial statements. It is very likely that the client will adjust the financial statements to take account of
these during the course of the audit. At the end of the audit, however, some errors may still be outstanding
and the auditors will summarise these unadjusted errors. An example is provided below.
273
[Q]
(current period)
Dr
Cr
(a) ABC Ltd debt unprovided
(b) Opening/ closing inventory
under-valued*
(c) Closing inventory undervalued
(d) Opening unaccrued expenses
Telephone*
Electricity*
(e) Closing unaccrued expenses
Telephone
Electricity
(f) Obsolete inventory write off
Total
*Cancelling items
cu
cu
10,470
Statement of
financial position
(current period)
Dr
Cr
cu
21,540
427
1,128
2,528
36,093
21,540
14,553
cu
10,470
Income
Statement
(prior period)
Cr
Dr
cu
4,523
21,540
21,540
34,105
34,105
453
905
453
905
35,463
35,463
453
905
34,105
453
905
34,105
cu
Statement of
financial position
(prior period)
Cr
Dr
cu
4,523
21,540
453
905
453
905
427
1,128
2,528
36,093
21,540
cu
\',___
3,211
9,092
21,540
21,540
3,211
9,092
14,553
The summary of errors will not only list errors from the current year (adjustments (c) and (e)), but also
those in the previous year(s). This will allow errors to be highlighted which are reversals of errors in the
previous year. For example in this instance last year's closing inventory was undervalued by CU21,540
(adjustment (b)). Inventory in the prior year statement of financial position should be increased (DR) and
profits increased (CR). At the start of the current accounting period the closing inventory adjustment is
reversed out so that the net effect on the cumulative position is zero. This also applies to the adjustment to
last year's accrued expenses (adjustment (d)).Cumulative errors may also be shown, which have increased
from year to year for example adjustments (a) and (f). It is normal to show both the statement of financial
position and the income statement effect, as in the example given here. This may also be extended to the
entire statement of comprehensive income.
1.3.6
material.
The aggregate of uncorrected misstatements comprises:
(a)
Specific misstatements identified by the auditors, including the net effect of uncorrected
misstatements identified during the audit of the previous period if they affect the current period's
financial statements
(b)
Their best estimate of other misstatements which cannot be quantified specifically (i.e. projected
errors)
If the auditors consider that the aggregate of misstatements may be material, they must consider reducing
audit risk by extending audit procedures or requesting management to adjust the financial statements
(which management may wish to do anyway).
27 4
The schedule will be used by the audit manager and partner to decide whether the client should be
requested to make adjustments to the financial statements to correct the errors.
2 Subsequent events
2.1
Events occurring between the period end and the date of the auditor's report
Facts discovered after the date of the auditor's report
BAS I0 Events after the Reporting Period deals with the treatment in financial statement of events, favourable
and unfavourable, occurring after the period end. It identifies two types of event:
~
~
Those that provide further evidence of conditions that existed at the period end
Those that are indicative of conditions that arose subsequent to the period end
The extent of the auditor's responsibility for subsequent events depends on when the event is identified.
2.2
Enquiries of
management
275
Other procedures
Reviews and updates of these procedures may be required, depending on the length of the time between
the procedures and the signing of the auditor's report and the susceptibility of the items to change over
time.
When the auditor becomes aware of events which materially affect the financial statements, the auditor
should consider whether such events are properly accounted for and adequately disclosed in the
financial statements.
2.3
Facts discovered after the date of the auditor's report but before
the financial statements are issued
The financial statements are the management's responsibility. They should therefore inform the
auditors of any material subsequent events between the date of the auditor's report and the date
the financial statements are issued. The auditors do not have any obligation to perform procedures,
or make enquires regarding the financial statements after the date of their report.
When, after the date of the auditor's report but before the financial statements are issued, the auditor
becomes aware of a fact which may materially affect the financial statements, the auditor should:
~
~
Extend the procedures discussed above to the date of their new report
Carry out any other appropriate procedures
Issue a new audit report dated the day it is signed.
The situation may arise where the statements are not amended but the auditors feel that they should be.
If the auditor's report has not been released to the entity, the auditor should express a qualified
opinion or an adverse opinion.
If the auditor's report has already been issued to the entity then the auditor should notify those who
are ultimately responsible for the entity (the management or possibly a holding company in a group), not to
issue the financial statements or auditor's reports to third parties. If they have already been so issued, the
auditor must take steps to prevent the reliance on the auditor's report. The action taken will depend
on the auditor's legal rights and obligations and the advice of the auditor's lawyer.
2.4
27 6
'-..-
(b)
Review the steps taken by management to ensure that anyone in receipt of the previously issued
financial statements together with the auditor's report thereon is informed of the situation
(c)
The new auditor's report should include an emphasis of a matter paragraph referring to a note to the
financial statements that more extensively discusses the reason for the revision of the previously issued
financial statements and to the earlier report issued by the auditor.
In our opinion, the revised financial statements give a true and fair view (or 'present fairly, in all material
respects'), as at the date the original financial statements were approved, of the financial position of the
company as of December 31, 20X I , and of the results of its operations and its cash flows for the year then
ended in accordance with [relevant national legislation].
In our opinion the original financial statements for the year to December 31, 20X I, failed to comply with
[relevant national standards or legislation].
Date
AUDITOR
Address
Where local regulations allow the auditor to restrict the audit procedures on the financial statements to
the effects of the subsequent event which caused the revision, the new auditor's report should contain a
statement to that effect.
Where the management does not revise the financial statements but the auditors feel they should be
revised, or if the management does not intend to take steps to ensure anyone in receipt of the previously
issued financial statements is informed of the situation, then the auditors should consider steps to take, on a
timely basis, to prevent reliance on their report. The actions taken will depend on the auditor's legal rights
and obligations (for example, to contact the shareholders directly) and legal advice received.
You are the auditor of Extraction Ltd, an oil company. You have recently concluded the audit for the year
ended 31 December 20X7 and the audit report was signed on 28 March 20X8. The financial statements
were also authorised for issue on this date. On the I" of April you are informed that the company has
identified a major oil leak which has caused significant environmental damage.
Requirement
Identify and explain the implications of the information regarding the oil spill.
See Answer at the end of this chapter.
277
3 Going concern
3.1
Reporting consequences
Under the 'going concern assumption' an entity is ordinarily viewed as continuing in business for the
foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking
protection from creditors pursuant to laws or regulations. Accordingly assets and liabilities are recorded on
the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course
of business.
If however, management determines that it intends to or has no realistic alternative but to liquidate the
entity or cease trading then the financial statements should not be prepared on the going concern
basis. This is specified by BAS I0 Events After the Reporting Period. The entity should instead adopt a basis of
preparation that is considered more appropriate in the circumstances, although no specific guidance is
provided in BAS I0. In practice the most obvious method is break-up value. Specific accounting
consequences will include the need to consider:
~
~
Impairment of assets
Recognition of provisions e.g. for onerous contracts
Disclosure of the change of basis of preparation should be provided in accordance with BAS I Preparation
of Financial Statements. In addition the directors of listed companies must report specifically on the going
concern status of the company under the Combined Code and further commentary will be included within
the Operating and Financial Review.
3.2
Financial risk
The possibility of a business not being a going concern is one of the financial risks to which a business is
exposed. Financial risks are those risks arising from the financial activities of the company, for example:
~
~
Raising capital
The capital structure
Financial consequences of an operation e.g. operating in an overseas environment
As a consequence of the original capital structure or subsequent operation, there may be a risk due to a
shortage of finance or an inability to manage finance in accordance with a company's day-to-day
requirements.
BSA 570 identifies the presence of financial risk in the following circumstances
(a)
278
Financial indications
~
Major debt repayment falling due where refinancing is necessary to the entity's continued
existence
(b)
Substantial operating losses or significant deterioration in the value of assets used to generate
cash flows
Major losses or cash flow problems which have arisen since the end of the reporting period
Inability to obtain financing for essential new product development or other essential investments
Operating indications
Loss of key management without replacement
~
(c)
Fundamental changes in the market or technology to which the entity is unable to adapt
adequately
Other indications
~
Pending legal proceedings against the entity that may, if successful, result in judgements that could
not be met
Issues which involve a range of possible outcomes so wide that an unfavourable result could
affect the appropriateness of the going concern basis
3.3
(a)
The effect of an entity being unable to make its normal debt repayments may be counterbalanced by
management's plans to maintain adequate cash flows by alternative means, such as by disposal of
assets, rescheduling of loan repayments, or obtaining additional capital.
(b)
The loss of a principal supplier may be mitigated by the availability of a suitable alternative source of
supply.
Auditor response
A substantive approach could be adopted in which case the following work may be appropriate:
~
279
Confirmation in the form of management representations would be sought as to the going concern
status of the company. The directors' plans for resolving any matters giving rise to the going concern
issue would be discussed and analysed
Budget or forecast information would be obtained and tested for reasonableness of assumptions and
accuracy of calculations
Alternatively, a business risk audit approach could be adopted. In approaching business and financial
risks emphasis is placed on understanding the going concern risk to which the entity is subject to in its
environment, operation and control processes. We have considered the business risk audit approach in
detail in Chapter 4 of this text.
(Going concern is also relevant in the context of insolvency which is covered in Chapter 15 of this text.)
3.4
Management's responsibility
~
BSA 570 states that when preparing accounts, management should make an explicit assessment of
the entity's ability to continue as a going concern. Most accounting frameworks require management
to do so.
When management are making the assessment, the following factors should be considered.
The degree of uncertainty about the events or conditions being assessed increases significantly
the further into the future the assessment is made.
Judgements are made on the basis of the information available at the time.
Judgements are affected by the size and complexity of the entity, the nature and condition of
the business and the degree to which it is affected by external factors.
Auditor's responsibilities
~
When planning and performing audit procedures and in evaluating the results thereof, the auditor
should consider the appropriateness of management's use of the going concern assumption in the
preparation of the financial statements. The auditor should consider any relevant disclosures in
financial statements.
280
In obtaining an understanding of the entity, the auditor should consider whether there are events or
conditions and related business risks which may cast significant doubt on the entity's ability to continue
as a going concern.
The auditor should remain alert for evidence of events or conditions and related business risks which
may cast doubt on the entity's ability to continue as a going concern throughout the audit. If such
events or conditions are identified, the auditor should consider whether they affect the auditor's
assessments of the components of audit risk
Management may already have made a preliminary assessment of going concern. If so, the auditors
would review potential problems management had identified, and management's plans to resolve them.
Alternatively auditors may identify problems as a result of discussions with management.
..___
The auditor should evaluate management's assessment of the entity's ability to continue as a going
concern. The auditors should consider:
The process management used
The assumptions on which management's assessment is based
Management's plans for future action
If management's assessment covers a period of less than twelve months from the end of the
reporting period, the auditor should ask management to extend its assessment period to twelve
months from the end of the reporting period.
The auditor will examine the borrowing facilities available to the company. They will confirm the
existence and terms of bank facilities and make an assessment of the bankers' intentions towards the
company.
Management should not need to make a detailed assessment, and auditors carry out detailed
procedures, if the entity has a history of profitable operations and ready access to financial
resources.
The auditor should inquire of management as to its knowledge of events or conditions and related
business risks beyond the period of assessment used by management that may cast significant doubt on
the entity's ability to continue as a going concern.
When questions arise on the appropriateness of the going concern assumption, some of the normal
audit procedures carried out by the auditors may take on an additional significance. Auditors may
also have to carry out additional procedures or to update information obtained earlier. The BSA
lists various procedures which the auditors should carry out in this context.
Analyse and discuss cash flow, profit and other relevant forecasts with management
Analyse and discuss the entity's latest available interim financial statements
Review the terms of debentures and loan agreements and determine whether they have
been breached
Read minutes of the meetings of shareholders, the board of directors and important
committees for reference to financing difficulties
Enquire of the entity's lawyer regarding litigation and claims
Confirm the existence, legality and enforceability of arrangements to provide or maintain
financial support with related and third parties
Assess the financial ability of such parties to provide additional funds
Consider the entity's position concerning unfulfilled customer orders
Review events after the period end for items affecting the entity's ability to continue as a
going concern
Based on the audit evidence obtained, the auditor should determine if, in the auditor's judgement, a
material uncertainty exists related to events or conditions that alone or in aggregate, may cast
significant doubt on the entity's ability to continue as a going concern. The auditor should document
the extent of the auditor's concern (if any) about the entity's ability to continue as a going concern.
28 I
If adequate disclosure is made in the financial statements, the auditor should express an unqualified
opinion but modify the auditor's report by adding an emphasis of a matter paragraph that highlights the
existence of a material uncertainty relating to an event or condition that may cast significant doubt on
the entity's ability to continue as a going concern and draws attention to the note in the financial
statements that discloses the matters.
._
The auditors may express a disclaimer of opinion if for example there are multiple material
uncertainties .
._
If adequate disclosure is not made in the financial statements, the auditor should express a qualified or
adverse opinion, as appropriate. The report should include explicit reference to the fact that there is a
material uncertainty which may cast significant doubt about the company's ability to continue as a
going concern .
._
If management is unwilling to make or extend its assessment when requested to do so by the auditor,
the auditor should consider the need to modify the auditor's report as a result of the limitation on the
scope of the auditor's work.
You are the senior on the audit of Truckers ltd whose principal activities are road transport and
warehousing services, and the repair of commercial vehicles. You have been provided with the draft
accounts for the year ended 3 I October 20XS
Draft lOXS
Summary income statement
Revenue
Cost of sales
Gross profit
Administrative expenses
Interest payable and similar charges
Net (loss) profit
Summary statement of financial position
Non-current assets
Current assets
Inventory (parts and consumables)
Receivables
Current liabilities
Bank loan
Overdraft
Trade payables
lease obligations
Other payables
long-term liabilities
Bank loan
lease obligations
Net assets
cuooo
10,971
(I 0,203)
768
(782)
(235)
(249)
11,560
(I 0,474)
1,086
(779)
(185)
122
5,178
4,670
95
2,975
3,070
61
2,369
2,430
250
1,245
1,513
207
203
3,481
750
473
1,223
3,544
You have been informed by the managing director that the fall in revenue is due to:
282
(I)
(2)
Aauai20X4
CU'OOO
913
1,245
149
2,307
1,000
1,000
3,793
Due to the reduction in the repairs business, the company has decided to close the workshop and sell the
equipment and spares inventory. No entries resulting from this decision are reflected in the draft accounts.
During the year, the company replaced a number of vehicles funding them by a combination of leasing and
an increased overdraft facility. The facility is to be reviewed in january 20X6 after the audited accounts are
available.
The draft accounts show a loss for 20X5 but the forecasts indicate a return to profitability in 20X6 as the
managing director is optimistic about generating additional turnover from new contracts.
Requirements
(a)
State the circumstances particular to Truckers Ltd which may indicate that the company is not a going
concern. Explain why these circumstances given cause for concern.
(b)
Describe the audit work to be performed in respect of going concern at Truckers Ltd.
4 Comparatives
4.1
BSA 71 0 Comparatives
BSA 710 establishes standards and provides guidance on the auditor's responsibilities regarding
comparatives.
Comparatives are presented differently under different countries' financial reporting frameworks. Generally
comparatives can be defined as corresponding amounts and other disclosures for the preceding
financial reporting period(s), presented for comparative purposes. Because of these variations in countries'
approach to comparatives, the BSA refers to the following frameworks and methods of presentation.
Corresponding figures are amounts and other disclosures for the preceding period included as part of
the current period financial statements, which are intended to be read in relation to the amounts and other
disclosures relating to the current period (referred to as 'current period figures'). These corresponding
figures are not presented as complete financial statements capable of standing alone, but are an integral part
of the current period financial statements intended to be read only in relationship to the current period
figures.
Comparative financial statements are amounts and other disclosures of the preceding period included
for comparison with the financial statements of the current period, but do not form part of the current
period financial statements.
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For corresponding figures, the auditor's report only refers to the financial statements of the
current period.
For comparative financial statements, the auditor's report refers to each period that financial
statements are presented.
BSA 71 0 provides guidance on the auditor's responsibilities for comparatives and for reporting on them
under the two frameworks in separate sections. We will consider the guidance on corresponding figures
as this is the approach usually adopted in Bangladesh.
4.2
Corresponding figures
The auditor should obtain sufficient appropriate audit evidence that the corresponding figures meet the
requirements of the applicable financial reporting framework.
Audit procedures performed on the corresponding figures are usually limited to checking that the
corresponding figures have been correctly reported and are appropriately classified. Auditors must assess
whether:
~
Accounting policies used for the corresponding figures are consistent with those of the current
period or whether appropriate adjustments and/or disclosures have been made.
Corresponding figures agree with the amounts and other disclosures presented in the prior
period or whether appropriate adjustments and/or disclosures have been made.
In Bangladesh, the auditors should obtain sufficient appropriate audit evidence that:
(a)
The accounting policies used for the corresponding amounts are consistent with those of the
current period and appropriate adjustments and disclosures have been made where this is not the
case.
(b)
The corresponding amounts agree with the amounts and disclosures presented in the preceding
period and are free from errors in the context of the financial statements of the current
period, and
(c)
Where corresponding amounts have been adjusted as required by relevant legislation and accounting
standards, appropriate disclosures have been made.
the incoming auditors assess whether the corresponding figures meet the conditions specified above and
also follow the guidance in BSA 51 0 Initial Engagements - Opening Balances and Continuing Engagements Opening Balances. This was considered in Chapter 5.
If the auditors become aware of a possible material misstatement in the corresponding figures when
performing the current period audit, then they must perform any necessary additional procedures.
4.3
Reporting
When the comparatives are presented as corresponding figures, the auditor should issue an audit report in
which the comparatives are not specifically identified because the auditor's opinion is on the current
period financial statements as a whole, including the corresponding figures.
The auditor's report will only make any specific reference to corresponding figures in the circumstances
described below.
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When the auditor's report on the prior period, as previously issued, included a qualified opinion,
disclaimer of opinion, or adverse opinion and the matter which gave rise to the modification is:
(a)
Unresolved, and results in a modification of the auditor's report regarding the current period
figures, the auditor's report should also be modified regarding the corresponding figures; or
(b)
Unresolved, but does not result in a modification of the auditor's report regarding the current
period figures, the auditor's report should be modified regarding the corresponding figures
If a modified report was issued, but the matter which gave rise to it is resolved and properly dealt with
in the financial statements, the current report will not usually refer to the previous modification. If the
matter is material to the current period, however, the auditors may include an emphasis of
matter paragraph to deal with it.
In performing the audit of the current period financial statements, the auditors, in certain unusual
circumstances, may become aware of a material misstatement that affects the prior period
financial statements on which an unmodified report has been previously issued.
In such circumstances, the auditor should consider the guidance in BSA 560 and:
(a)
If the prior period financial statements have been revised and reissued with a new auditor's
report, the auditor should be satisfied that the corresponding figures agree with the revised
financial statements; or
(b)
If the prior period financial statements have not been revised and reissued, and the
corresponding figures have not been properly restated and/or appropriate disclosures have not
been made, the auditor should issue a modified report on the current period financial statement
modified with respect to the corresponding figures included therein.
In these circumstances, if the prior period financial statements have not been revised and an auditor's
report has not been reissued, but the corresponding figures have been properly restated and/or
appropriate disclosures have been made in the current period financial statements, the auditors may include
an emphasis of matter paragraph describing the circumstances and referencing to the appropriate
disclosures.
4.4
That the financial statements of the prior period were audited by another auditor;
(b)
The type of report issued by the predecessor auditor and, if the report was modified, the reasons
therefore; and
(c)
In Bangladesh, the existing auditor does not make reference to another auditor in his report.
The situation is slightly different if the prior period financial statements were not audited.
When the prior period financial statements are not audited, the incoming auditor should state in the
auditor's report that the corresponding figures are unaudited.
The inclusion of such a statement does not, however, relieve the auditors of the requirement to perform
appropriate procedures regarding opening balances of the current period. Clear disclosure in the financial
statements that the corresponding figures are unaudited is encouraged. If there is insufficient evidence
about corresponding figures or inadequate disclosures, the auditor should consider the implications for
his report.
In situations where the incoming a(Jditor identifies that the corresponding figures are materially misstated,
the auditor should request management to revise the corresponding figures or if management refuses to do
so, appropriately modify the report.
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5 Internal reporting
5.1
5.1.1
Definition
Governance: is the term used to describe the role of persons entrusted with the supervision, control and
direction of the entity. Those charged with governance ordinarily are accountable for ensuring that the
entity achieves its objectives, financial reporting and reporting to interested parties. Those charged with
governance include management only when it performs such functions.
The auditor should communicate audit matters of governance interest arising from the audit of financial
statements with those charged with governance of an entity. The scope of the BSA is limited to matters
that come to the auditor's attention as a result of the audit; the auditors are not required to design
procedures to identify matters of governance interest.
The auditor should determine the relevant persons who are charged with governance and with whom audit
matters of governance interest are communicated.
The auditors may communicate with the whole board, the supervisory board or the audit committee
depending on the governance structure of the organisation. To avoid misunderstandings, the engagement
letter should explain that auditors will only communicate matters that come to their attention as a result of
the performance of the audit. It should state that the auditors are not required to design procedures for
the purpose of identifying matters of governance interest.
The letter may also:
Describe the form which any communications on governance matters will take
Identify the relevant persons with whom such communications will be made
Identify any specific matters of governance interest which it has agreed are to be communicated
286
Relationships that may bear on the firm's independence and the integrity and objectives of the audit
engagement partner and audit staff
The general approach or overall scope of the audit, including limitations or additional requirements
The potential effect on the financial statements of any significant risks and exposures, for example
pending litigation, that are required to be disclosed in the accounts
Other significant matters such as material weaknesses in internal control, questions regarding
management integrity, and fraud involving management
Other matters
The auditor should communicate to those charged with governance an outline of the nature and scope,
including, where relevant, any limitations thereon, of the work the auditor proposes to undertake and the
form of the reports the auditor expects to make including the following:
(a)
The auditor's views about the qualitative aspects of the entity's accounting practices and financial
reporting
(b)
The final draft of the representation letter that the auditor is requesting management and those
charged with governance to sign. The communication should specifically refer to any matters where
management is reluctant to make the representations requested by the auditor
(c)
Uncorrected misstatements
(d)
(e)
(f)
Matters specifically required by other BSAs to be communicated to those charged with governance,
and
(g)
Written representation should be sought from those charged with governance that explains their reasons
for not correcting misstatements brought to their attention by the auditor.
Requirement
In each of the cases listed below identify to whom the auditor would initially report:
(I)
The auditor has obtained evidence that the operations manager has committed a fraud against the
company
(2)
The auditor has obtained evidence that the finance director has committed a fraud against the
company
(3)
5.1.2
Current developments
The IAASB has issued ISA 260 (Revised and Redrafted) Communication with Those Charged with Governance as
part of the Clarity Project. This has not resulted in any changes in substance.
5.1.3
Reporting to management
Auditors may also issue a report on control weaknesses to management. These reports were a key element
in your earlier studies in auditing.
287
It should not include language that conflicts with the opinion expressed in the audit report.
It should state that the accounting and internal control system were considered only to the
extent necessary to determine the auditing procedures to report on the financial statements
and not to determine the adequacy of internal control for management purposes or to provide
assurances on the accounting and internal control systems.
It will state that it discusses only weaknesses in internal control which have come to the
auditor's attention as a result of the audit and that other weaknesses in internal control may exist.
It should also include a statement that the communication is provided for use only by
management (or another specific named party).
The auditors will usually ascertain the actions taken, including the reasons for those suggestions
rejected
The auditors may encourage management to respond to the auditor's comments in which case any
response can be included in the report
6.1
6.1.1
288
',
6.2
6.2.1
(b)
Qualified opinion
Disclaimer of opinion
Adverse opinion
289
6.2.2
Definition
An uncertainty: is a matter whose outcome depends on future actions or events not under the direct
control of the entity but that may affect the financial statements.
Examples of emphasis of matter paragraphs are contained in the Appendix to this chapter. See
Illustrations I and 2.
6.2.3
(b) There is a disagreement with management regarding the acceptability of the accounting policies
selected, the method of their application or the adequacy of financial statement disclosures.
There are different types and degrees of modified opinion.
~
~
The following table summarises the different types of qualified opinion, and we will look at the detail of each
ofthese in turn:
Disagreement
Limitation in scope
Disclaimer of opinion
Adverse opinion
----------------
The BSA describes these different modified opinions and the circumstances leading to them as follows.
~
290
A qualified opinion should be expressed when the auditor concludes that an unqualified opinion
cannot be expressed but that the effect of any disagreement with management, or limitation on scope
is not so material and pervasive as to require an adverse opinion or a disclaimer of opinion. A qualified
opinion should be expressed as being 'except for the effects of the matter to which the qualification
relates'.
~
A disclaimer of opinion should be expressed when the possible effect of a limitation on scope is so
material and pervasive that the auditor has not been able to obtain sufficient, appropriate audit
evidence and accordingly is unable to express an opinion on the financial statements.
An adverse opinion should be expressed when the effect of a disagreement is so material and
pervasive to the financial statements that the auditor concludes that a qualification of the report is not
adequate to disclose the misleading or incomplete nature of the financial statements.'
Limitation on scope
There are two circumstances identified by the standard where there might be a limitation on scope.
(I)
A limitation on the scope of the auditor's work may sometimes be imposed by the entity (for
example, when the terms of the engagement specify that the auditor will not carry out an audit
procedure that the auditor believes is necessary).
However, when the limitation in the terms of a proposed engagement is such that the auditor believes
the need to express a disclaimer of opinion exists; the auditor would usually not accept such a limited
audit engagement, unless required by statute. Also, a statutory auditor would not accept such an audit
engagement when the limitation infringes on the auditor's statutory duties.
(2)
A scope limitation may be imposed by circumstances (for example, when the timing of the
auditor's appointment is such that the auditor is unable to observe the counting of physical inventory).
It may also arise when, in the opinion of the auditor, the entity's accounting records are inadequate or
when the auditor is unable to carry out an audit procedure believed to be desirable. In these
circumstances, the auditor would attempt to carry out reasonable alternative procedures to obtain
sufficient, appropriate audit evidence to support an unqualified opinion.
Where there is a limitation on the scope of the auditor's work that requires expression of a qualified
opinion or a disclaimer of opinion, the auditor's report should describe the limitation and indicate the
possible adjustments to the financial statements that might have been determined to be necessary had the
limitation not existed.
See Appendix Illustrations 3 and 5.
Disagreement
The auditor may disagree with management about matters such as the acceptability of accounting policies
selected, the method of their application, or the adequacy of disclosures in the financial statements. The
BSA states that if such disagreements are material to the financial statements, the auditor should express a
qualified or an adverse opinion.
See Appendix Illustrations 4 and 6.
6.3
6.3.1
Current issues
The act of communication
In essence, the auditor's job is straightforward. They carry out tests and enquiries and evaluate evidence
received with the purpose of drawing an audit opinion. They then communicate that opinion, in the form
of an audit report, as we have been discussing. This can cause problems.
The communication problem is caused by a number of different problems that can be identified under three
headings, although some of the problems are broadly linked between categories. The three problematic
areas are:
~
~
Understandability
Responsibility
Availability
291
6.3.2
Understandability
Although the essence of the auditor's role is simple, in practice it is surrounded by auditing standards and
guidance as it is a technical art. It also involves relevant language, or 'jargon' that non-auditors may not
understand.
Communicating the audit opinion in a way that people can understand it is a challenge. In the Audit and
Assurance faculty document, Audit Quality Fundamentals- Auditor Reporting the following suggestions are
made that would improve readability:
~
The current audit report could be re-arranged so that the most relevant information i.e. the opinion is
shown first
The opinion should be expanded to include a positive statement that adequate accounting records
have been kept by the company and that there are no matters within the annual accounts to which the
auditors wish to draw attention by way of emphasis
Standardised information e.g. the inherent limitations and the scope of the audit could be shown
elsewhere in the report or as an appendix to the main report. Alternatively they could be placed on a
website or in a place that is publicly accessible and cross-referenced in the audit report
6.3.3
Responsibility
Connected with the problem of what the audit is and what the audit opinion means is a problem of what
the auditors are responsible for. As far as the law is concerned, auditors have a restricted number of
duties. Professional standards and other bodies, such as the Financial Services Authority, put other
duties on auditors.
Users of financial statements, and the public, may not have a very clear perception of what the auditors are
responsible for and what the audit opinion relates to, or what context it is in.
The issue of auditor's liability ties in here. Audit reports are addressed to shareholders, to whom
auditors have their primary and legal responsibility. However, audited accounts are used by significantly
more people than that. Should this fact be addressed in the audit report1
6.3.4
Availability
The availability of audit reports has been increased by the trend to publish financial statements on
companies' websites. Auditors should consider the risks of this.
The fact that a significant number of people use audited accounts has just been mentioned. Audit reports
are publicly available, as they are often held on public record. This fact alone may add to any perception
that exists that auditors address their report to more than just shareholders.
The problem of availability is exacerbated by the fact that many companies publish their financial
statements on their website. This means that millions of people around the world have access to the
audit report.
This issue may add significant misunderstandings.
~
~
~
If an audit report is published electronically, auditors lose control of the physical positioning of the
report, that is, what it is published with. This might significantly impact on understandability and also
perceived responsibility.
When financial information is available electronically, auditors must ensure that their report is not
misrepresented.
292
The auditors should ensure that their report is worded so that it is appropriate for inclusion on a
website. This will include reference to specific financial statements rather than the use of page
numbers, for example.
'
Where the auditor's report is to be published electronically, the auditors should carry out a series of
checks:
They should review the process for deriving the electronic information from the hard copy
financial statements
They should check that the electronic copy is identical to the hard copy
They should check that the presentation has not been distorted (i.e. that certain items have
not been given greater emphasis in the new presentation)
As the directors are responsible for controls in their business, they are responsible for ensuring
that the report is not tampered with once it is on the website.
You are an audit senior. You are nearing the end of the audit of Russell Ltd for the year ended 30 June
2007. The financial statements show a profit before tax of CU 14 million (2006: CU6 million) and a
statement of financial position total of CU46 million (2006: CU30 million). The following points have arisen
on the audit:
(I)
Russell Ltd owns a number of its retail premises, which it revalues annually. This year several of its
shops did rise sharply in value due to inflated property prices in their locality. Russell Ltd also
capitalises refits of its shops. Four shops were refitted in the year. The total increase in assets due to
refits and revaluations is CU20 million. Russell Ltd does not revalue its factory premises, which are
recognised in the statement of financial position at CU250,000.
(2)
Russell Ltd makes approximately 20% of its sales via an internet site from which it sells the products of
Cairns Ltd. Russell Ltd earns commission of 15% on these sales. Customers place their order on the
internet site and pay for goods by providing their credit card details. Once Russell Ltd has received
authorisation from the credit card company the order is passed to Cairns Ltd. The product is then
shipped directly to the customer and all product returns, and credit card related issues are dealt with
by Cairns Ltd. The total product sales achieved through the internet site and despatched to customers
in the year were CU6,000,000. This amount has been recognised as revenue for the year ended 30
June 2007.
Requirement
Comment on the matters you will consider in relation to the implications of the above points on the audit
report of Russell Ltd.
See Answer at the end of this chapter.
293
6.4
6.4.1
Material inconsistency between the financial statements and the directors' report
In our opinion, the information given in the seventh paragraph of the Business Review in the directors'
report is not consistent with the financial statements. That paragraph states without amplification that "the
company's trading for the period resulted in a I 0% increase in profit over the previous period's profit". The
income statement, however, shows that the company's profit for the period included a profit of CUZ which
did not arise from trading but arose from the disposal of assets of a discontinued operation. Without this
profit on the disposal of assets, the company would have reported a profit for the year of CUY,
representing a reduction in profit of 25% over the previous period's profit on a like for like basis. Except for
this matter, in our opinion the information given in the directors' report is consistent with the financial
statements.
6.4.2
Definition
Other information: is financial and non-financial information other than the audited financial statements
and the auditor's report, which an entity may include in its annual report, either by custom or statute.
A material inconsistency: exists when other information contradicts information contained in the
audited financial statements. A material inconsistency may raise doubt about the audit conclusions drawn
from audit evidence previously obtained and, possibly, about the basis for the auditor's opinion on the
financial statements.
Auditors have no responsibility to report that other information is properly stated because an audit is only
an expression of opinion on the truth and fairness of the financial statements. However, they may be
engaged separately, or required by statute, to report on elements of other information. In any case,
the auditors should give consideration to other information as inconsistencies with the audited financial
statements may undermine their report.
Some countries require the auditors to apply specific procedures to certain other information, for example,
required supplementary data and interim financial information. If such other information is omitted or
contains deficiencies, the auditors may be required to refer to the matter in their report.
When there is an obligation to report specifically on other information, the auditor's responsibilities are
determined by the nature of the engagement and by local legislation and professional standards.
When such responsibilities involve the review of other information, the auditors will need to follow the
guidance on review engagements in the appropriate BSAs.
6.4.3
6.4.4
Material inconsistencies
If, on reading the other information, the auditor identifies a material inconsistency, the auditor should
determine whether the audited financial statements or the other information needs to be amended .. The
auditor should seek to resolve the matter through discussion with those charged with governance.
If an amendment is necessary in the audited financial statements and the entity refuses to make the
amendment, the auditor should express a qualified or adverse opinion.
If an amendment is necessary in the other information and the entity refuses to make the amendment,
the auditor should consider including in the auditor's report an emphasis of matter paragraph
describing the material inconsistency or taking other actions.
The actions taken by the auditors will depend on the individual circumstances and the auditors may
consider taking legal advice.
6.4.5
295
Notifying those ultimately responsible for the overall direction of the entity
Obtaining legal advice.
7.I
7.1.1
7 .1.2
Overview
The BSA aims to address special considerations that are relevant to:
~
A complete set of financial statements prepared in accordance with another comprehensive basis
of accounting
The aim of the BSA is simply to identify additional audit requirements relating to these areas. To be clear,
all other BSAs still apply to the audit engagement.
7.1.3
7.1.4
General considerations
~
Before undertaking a special purpose audit engagement, the auditor should ensure there is agreement
with the client as to the exact nature of the engagement and the form and content of the
report to be issued
To avoid the possibility of the auditor's report being used for purposes for which it was not intended,
the auditor may wish to indicate in the report the purpose for which it is prepared and any
restrictions on its distribution and use.
296
Tax basis of accounting for a set of financial statements that accompany an entity's tax return
Cash receipts and payments basis of accounting for cash flow information that an entity may be
requested to prepare for creditors
The audit report in these circumstances should include a statement that indicates the basis of accounting
used or should refer to the note to the financial statements giving that information. The opinion should
state whether the financial statements are prepared, in all material respects, in accordance with the
identified basis of accounting.
7.1.5
7.1.6
7.1.7
7.2
Introduction
The IAASB have issued International Auditing Practice Statement (lAPS) I 014 to provide guidance when the
auditor expresses an opinion on financial statements that are asserted by management to be prepared:
~
In accordance with a national financial reporting framework with disclosure of the extent of
compliance with IFRSs.
The BAPS will be used in Bangladesh where the audit client prepares financial statements in
accordance with IFRSs, which are BFRS in Bangladesh.
7.2.2
297
7.2.3
The financial statements indicate that they have been prepared in accordance with BFRSs but then go
on to specify certain material departures. For example, a note describing the accounting polices used
states that the financial statements are prepared in accordance with BFRSs except for the nondisclosure of sales for geographical segments.
The financial statements identify specific BFRS requirements that the entity uses to prepare the
financial statements, but these do not include all the requirements that are applicable to an entity fully
complying with BFRSs.
The financial statements indicate partial compliance with BFRSs without reference to specific
departures. For example, a note describing the accounting policies used states that the financial
statements are "based on" or "comply with the significant requirements of' or "are in compliance with
the accounting requirements of' BFRSs.
Note that BAPS I0 14 also explains that if the auditor's report contains any qualifying or limiting language
when describing the financial reporting framework, it does not meet the requirement BSA 700. This
is because the auditor's report does not clearly indicate the financial reporting framework used to prepare
the financial statements. For example, an opinion paragraph that indicates "the financial statements give a
true and fair view and are in substantial compliance with International Financial Reporting Standards" does
not meet the requirements of BSA 700 as the term "substantial compliance" cannot be quantified - the
reporting framework is therefore not transparent.
298