01 technical
behavioural
aspects
A budget can be defined as a ‘quantified plan relating to a given
period’. Although budgets are often stated in terms of money, they
need not be and can relate to other variables.
A budget can be defined as a
‘quantified plan relating to a given
period’. Although budgets are often
stated in terms of money, they
need not be, and can also relate to
quantities made and sold, numbers of
employees to be recruited, or weights
of material to be consumed.
Quantification is important because
it adds precision and clarity to a
plan. However, it can cause problems
as budgets inevitably end up being
human obligations and we worry about
how the budget was determined,
if it is fair, what happens if we fail,
are there political dimensions to it,
should we ‘cheat’, or will account be
taken of factors outside our control?
Perhaps most importantly, how
are we to reconcile the pressure to
achieve short-term budgets (usually
carefully monitored) with ambitions for
long‑term improved performance which
may not be successfully captured by
financial statements?
relevant to acca qualification paper f5
Budgets should not be conjured
up out of thin air. Without getting
too far into the details of long-term
strategic planning, organisations will
have ambitions which should take into
account the wider environment (for
example, what is happening in the
economy), their markets (for example,
what their competitors are doing),
and their products (perhaps a certain
product is old and its sales declining).
This information, often speculative,
should allow an organisation to plot
its long-term future and then it can
dissect this long-term objective into
detailed, shorter-term plans. These
plans are usually communicated
through budgets: what volume of sales
do we hope for, what will power costs
be, how many employees will we need,
what corporation tax will be levied by
the government?
This article looks at three aspects of
budgeting, though there is considerable
cross-over between them:
¤ the purposes of a budgets, including
motivation and evaluation
¤ budgets as objectives
¤ how to set a budget.
THE PURPOSE OF A BUDGET
Budgets can accomplish the following:
Forecasting
Inevitably, if an organisation is going
to draft a budget which will be of
any use whatsoever, it will have to
make forecasts. These forecasts will
not always be correct, but at least
the organisation has had to look
ahead. It won’t see every danger or
opportunity, but looking ahead must
be better than moving forward with
eyes closed.
Forecasts are often based on the
results of previous periods, updated for
known changes. Statistical methods are
sometimes used to forecast seasonal
effects. Occasionally, specialist
data might be purchased to help
organisations take economic effects
into account as economies improve
or deteriorate.
Organisations need to beware of
forecasts becoming self-fulfilling
prophecies. For example, if a downturn
is anticipated, and because of that
production budgets are cut thus
reducing employees’ ability to sell, then
there will be a downturn in sales. We
will discuss later the difficult issue of
budgets which motivate as opposed to
a budget which we hope to achieve.

Performance objectives 12, 13 and 14 are relevant to this exam
of budgeting
Planning
Once forecasts are completed,
planning can be carried out. For
example, if the forecast suggests a
dramatic increase in demand, then
new production facilities might have to
be planned. However, it is important
to be aware at the planning stage that
the forecasts might not be correct, or
even if they were correct at the time
they were made, things can change.
Detailed planning might even require
the forecasting stage to be revisited
to check estimates or to try to gather
more evidence for estimates. Even
if forecasting does not have to be
reviewed, planning should, as far
as possible, remain flexible, just in
case the forecast isn’t fulfilled. So,
perhaps instead of acquiring new
production facilities, it might be
better to hire or subcontract initially
to see if the forecast is right. If it is,
then the organisation can go ahead
and buy production facilities for the
following period.
The planning of cash flows is
particularly important. Cash flow
forecasts are routinely produced but
the organisation which believes them
unconditionally will have a short life.
Plan for possible shortfalls; build in
flexibility; have short term financing
facilities planned and on call should
things not turn out as well as expected.
student accountant issue 09/2010
Studying Paper F5?
Coordination
In many ways, coordination is an aspect
of planning (making sure the company
delivers what it has budgeted to sell),
but it is worthy of a separate mention.
What this heading really highlights is
that there has to be a match between
the organisation’s structure and
ambition and the requirements for
its success.
In some businesses it is important
to meet well-understood customer
demands quickly and reliably, and in
this context, strict budget targets and
measurement can be vital to success.
Other businesses might find that
flexibility, adaptability and technical
innovation are more important. If you
don’t know what customers require,
then setting targets through budgets
is less applicable – and might even be
counter-productive because it can limit
responses: it’s not in the budget, so we
can’t do it.
A budget is a succinct and precise way of
communicating targets to departments and
employees – or at least some aspects of what
should be achieved. The problem is not what
is specified in the budget, it’s what’s not
specified. It is important for budgets
to communicate requirements as
comprehensively as possible.
02
Communication
A budget is a succinct and precise way of
communicating targets to departments
and employees – or at least some
aspects of what should be achieved.
The problem is not what is specified
in the budget, it’s what’s not specified.
The budget might state explicitly that
2,000 units should be made in a period,
but implicit in the target is that the
units should be of a certain quality.
The budget might be explicit about
the labour rate per hour to be paid,
but might not specify the skills that
employees should have. Unfortunately,
but inevitably, employees will take most
notice of explicit requirements and are
liable to downgrade other important but
unspecified factors. Of course, a lot will
depend on how the budgets are imposed
and how results are interpreted, but it is
important for budgets to communicate
requirements as comprehensively
as possible.
03 technical
Authorisation
A budget can be an authorisation
to spend, and can, therefore, be a
powerful way of delegating power
within an organisation. For example,
once you give a department a capital
expenditure budget you then let that
department get on with it, buying
new equipment as it sees fit. The only
alternative is to have the departmental
head keep coming back for permission
for bits and pieces of expenditure. Of
course, before the budget is ‘given’ to
the department, that department needs
to make a case for the expenditure. It
will put forward arguments as to why
it needs certain capital expenditure
(as will other departments), and the
budget committee that oversees the
budgeting process will have coordinated
matters as best it can. So the budget
represents pre-authorised expenditure
and combines delegation to spend
with restraints as to the maximum that
should be spent.
Motivation
A budget represents a target, and
aiming towards a target can be a
powerful motivator. However, whether
the target will actually cause employees
to do better is thought to depend on
how difficult the target is perceived
to be. Employees have different
perceptions of targets, but generally it
is thought that:
A budget represents a target, and aiming
towards a target can be a powerful
motivator. whether the target will cause
employees to do better is thought to depend
on how difficult the target is perceived to be.
¤ if targets are very low, actual
performance can be pulled down
from where it might naturally
have been
¤ if targets are habitually very high,
then employees might give up and,
again, performance can be reduced
– if you know that no matter how
hard you try you will fail to meet the
target, it’s easy to conclude that you
might as well not try at all.
So, the aim is to set budgets which
are perceived as being possible, but
which entice employees to try harder
than they otherwise might have done.
Of course, two employees can look
at the same budget and have quite
different impressions about how
difficult it is, but we are unlikely to
develop individual budgets tailored to
individual psychologies. The concept
of a ‘motivating budget’, however, is a
powerful one, although the budget which
is best for motivating might not represent
the results which are actually expected.
Managers can, and perhaps should, build
in a margin for noble failure.
The relationship between budget
difficulty and actual performance is
typically represented in Figure 1 on
page 4, which shows the following:
¤ When the budget is very easy, actual
performance is low. It has been
pulled down by the low demands
made of  employees.
¤ When the budget is very difficult,
actual performance is low. Why try
when you are doomed to failure?
¤ When a budget is set at the level of
the expectations (the best estimate
of what performance will actually
be), employees are likely to perform
as expected.
¤ If a more difficult aspirational budget
is set, employees will try harder, and
if the budget is judged just right then
their actual performance will be at its
maximum, though often falling short
of the budget.
The last situation can give rise to
what’s known as the ‘bottom drawer
phenomenon’. Managers issue a
public, motivational budget, but then
have a secret budget (‘kept in the
bottom drawer’) which more accurately
reflects what they think will actually
happen. One is forced to wonder
what happens to motivation when
the existence of the hitherto secret
budget becomes known. What baroque
dance of bluff and counter bluff
will occur?
Evaluation
Once budgets have been set as
performance targets, inevitably
performance will be evaluated. This
can be simply a comparison of
actual with budgeted performance or
alternatively can be a more elaborate
comparison of actual performance
with flexed budget performance, as
is found in variance analysis and
operating statements.
The evaluation stage is often one of
the most contentious as it is here that
performance is likely to be criticised
and employees will be sensitive. There
are many potential difficulties:
 student accountant issue 09/2010
04

¤ The budget might simply have been FIGURE 1: THE RELATIONSHIP BETWEEN BUDGET DIFFICULTY AND
wrong, unachievable from the outset. ACTUAL PERFORMANCE
¤ The budget might have
become unachievable as the Performance Budgeted performance
period progresses.
¤ Departments’ performances could
interfere with each other’s.
¤ Elements of the budget could be
incompatible so meeting one target
means missing another.
¤ Although the right decision was
made for long-term profitability,
this had an adverse effect on the
short‑term budget. Expectations Motivational
budget budget
Hopwood1 identified three distinct
ways of using budget information when
evaluating performance:
1 Budget constrained style. Here,
an employee’s performance is
primarily judged on their ability to
continuously meet their budgets on
a short-term basis. This criterion
is held to be more important than
all other desirable outcomes. So,
for example, over-spending to get
a machine repaired quickly so that
an important order is shipped
would be criticised because the
repair budget was exceeded.
Not surprisingly, this approach leads
to very poor manager–subordinate
relationships and also encourages
the manipulation and misreporting
of  information.

Easy budget Budget difficulty Very difficult budget

05 technical
The balanced scorecard approach of Kaplan and Norton, and the
building block approach of Fitzgerald and Norton can be a great help
in ensuring that objectives (or targets), or budgets are set for a very
wide range of factors, both financial and non-financial.
2 The profit conscious style. Here,
employees are primarily judged
on their ability to increase the
long-term effectiveness of their
departments. Budgets are not
ignored, but they are regarded more
as guidelines than strict targets
and are interpreted flexibly. In the
above example, the employee would
be more likely to be praised for
getting the machine repaired as that
enabled the organisation to meet
customer requirements.
3 Non-accounting style. Here,
budgetary information does not
play a big part in evaluation. It’s
almost impossible to envisage
any organisation which is not now
subject to financial and therefore
budgetary restraints, but from
time to time there are elements of
an organisations where money is
relatively unimportant. An example
might be the budget required by an
airline company to meet health and
safety requirements, because the
consequences of not doing so would
be disastrous.
BUDGETS AS OBJECTIVES
Budgets can obviously be used for
setting organisational, departmental
or individual objectives (or targets).
It is often said that, to be successful,
objectives should be SMART:
¤ Specific or stated. There’s no point
in simply telling a department to
be ‘better’. No one quite knows
what is meant by ‘better’, so it is
essential to be very specific about
what is required, in terms such as
units sold, travelling expenses, or
development costs.
¤ Measurable. To be unequivocally
communicated and later evaluated,
measurement is essential and this
usually means trying to derive
a quantitative measurement.
Accountancy deals with quantitative
measures but that does not mean
that accountancy holds all the secrets
to successful operations. Quality
of output is very important, and is
relatively easy to quantify, but routine
accountancy documents, such as
monthly management accounts, do
not usually report quality.
¤ Agreed/accepted/achievable. This
desirable attribute of objectives
relates to motivational budgets and
budget acceptance. Suffice to say
that if an objective is not agreed
or accepted, or not thought to
be achievable, it is unlikely to be
very effective.
¤ Relevant. Objectives must be seen as
being relevant to the organisation’s
purpose, whether that is to make
profits, or for a not-for-profit
purpose such as curing the sick or
educating children. If objectives
seem to have no connection with
the higher purpose, then employees
begin to feel that objectives are set
purely as exercises of managerial
power (‘I will give you this objective,
not because it is useful or necessary,
but because it allows me to impose
my will’).
¤ Time limited. Fairly obviously, if a
time limit is not defined, objectives
are unlikely to be effective.
The SMART approach to
objectives and budgets may seem
uncontroversial, but there are several
important behavioural aspects to take
into consideration.
First, more than one objective
is needed. As mentioned under
‘Communication’, above, employees
know that whatever is set as an
objective will be measured and will
be used for performance evaluation.
Naturally, that is what they will
therefore concentrate on, unfortunately
often to the exclusion of other
important aspects of performance.
It is vital, therefore, to try to set
objectives for all important measures
of performance.
Second, not all aspects of desirable
performance are easy to measure, but
that doesn’t mean you shouldn’t try
and that you shouldn’t set objectives.
Remember, most accountancy
measures are of no interest whatsoever
to consumers. Consumers do not
care much how much it costs to make
something, or how long production
takes, or the cost of the machine on
which the manufacturing was done.
Consumers care about quality, reliable
delivery, innovation, style, and how
the price of the item and its features
compares with competing products.
If consumers don’t like what they
see they won’t buy, and conventional
accountancy will give no clues about
why the organisation performs poorly.
Third, short-term budget pressures
(measured meticulously) can muscle
in on longer-term important aspects of
performance (poorly measured).
The balanced scorecard approach of
Kaplan and Norton, and the building
block approach of Fitzgerald and
Norton can be a great help in ensuring
that objectives (or targets), or budgets
are set for a very wide range of factors,
both financial and non-financial.

Looking at the balanced scorecard in
more detail, this approach considers a
hierarchy of performance perspectives,
as shown in Figure 2.
FIGURE 2: THE BALANCED
SCORECARD – THE HIERARCHY OF
PERFORMANCE PERSPECTIVES
Financial perspective
Customer perspective
Internal business perspective
Innovation and learning perspective
Ultimately, businesses must perform
well financially and there should be
budgets and objectives set for measures
such as return on capital employed,
profit, growth, gross profit percentages
and so on. This is the financial
perspective. However, successful financial
performance depends on pleasing
customers and we should take care that
budgets and objectives take account of
factors such as customer satisfaction,
repeat business, or market growth. This
is the customer perspective. To do this,
the organisation needs to ask:
¤ Why do customers like us?
Presumably because we are good at
what we do, in terms of adequate stock-
holding, quality, efficient production,
flexible responses to customer
requests. Budgets should be set for
these because they are important. This
is the internal business perspective.
student accountant issue 09/2010
¤ Finally, we ask, how can we keep
up with competitors and customer
demands? Only through continual
innovation, improvement and
learning. This is the innovation and
learning perspective.
So the organisation’s financial success
(easily and frequently measured by
budgets) ultimately depends on more
nebulous matters such as innovation,
quality, style, and flexibility. Therefore,
it is essential that budgets are set for
these as well, otherwise they will be
ignored as employees strive to meet the
often more superficial and short-term
conventional budget elements.
HOW TO SET A BUDGET
Broadly, when setting a budget, there
are two choices:
¤ top down imposition
¤ bottom up participation.
Organisations should look for the most
effective way of setting their budgets:
¤ How do they get employees to
pay heed to a budget and to take
it seriously?
¤ How can they get accurate budgets?
¤ How can they motivate employees to
try hard?
In management theory, participation
in decision making, such as in budget
setting, is usually seen as bringing
advantages to organisations. It allows
information to be gathered from
many sources, thereby increasing the
chance that all pertinent factors have
been considered. Participation usually
increases motivation and commitment as
it is very difficult subsequently to ignore
the decisions or targets which one has
helped develop.
06
However, the demand and expectation
for participation and consultation
may sometimes have more to do with
the polemics of modern management
than practical management,
because participation:
¤ is time-consuming
¤ requires appropriate knowledge, skill
and expectations
¤ may involve selfish motives (for
example, building slack into
timescales and targets).
Participation undoubtedly has it uses,
but it is not a cure for all organisational
problems. One only has to think of the
difficult budgetary decisions that have
had to be made by many organisations
during the current recession, where
cut backs, redundancies and restraint
have had to be imposed as a matter of
survival. As a result, there has recently
been a swing back to more authoritative
approaches to budget setting and
performance evaluation. It is important to
realise that the budget setting approach
adopted for one department, for one set
of employees, or for one economic or
competitive environment, is unlikely to
be universally acceptable and managers
must be prepared to vary their approach
to match the situation. This can be
regarded as a contingency (or ‘best‑fit’)
approach to budgeting where there is no
single correct method. It depends on the
manager, the subordinates, the task and
the environment.
Ken Garrett is a freelance writer
and lecturer
REFERENCE
1 Hopwood A G, An Accounting System
and Managerial Behaviour, Saxon
House, 1973.
01 technical

a matter of
relevant to acca qualification papers F8 and p7

It is one of the most fundamental When an auditor is able to satisfactorily

concepts in auditing; auditors are paid
to offer an opinion. It is what they do;
it’s their ‘raison d’être.’ Why then,
if the audit opinion is so significant,
are audit examiners continually
underwhelmed by candidates’
appreciation of this topic?
This article, which is relevant to
Paper F8 and P7, revisits the basic
principles of forming an audit opinion
and looks at how this knowledge should
be applied by considering a past
Paper P7 exam question.
The basics
When an auditor is able to satisfactorily
conclude that the financial statements
are free from material misstatement
they express an unmodified opinion.
The complete form and content of
the unmodified opinion are presented
in ISA 700, Forming an Opinion and
Reporting on Financial Statements.
However, auditors typically use one of
two well-known phrases to reflect their
conclusion, either:
¤ ‘The financial statements present
fairly, in all material respects...’ or
¤ ‘The financial statements give a true
and fair view of…’
conclude that the financial statements are
free from material misstatement they express
an unmodified opinion.
Modifications to the opinion
There are two circumstances when the
auditor may choose not to issue an
unmodified opinion:
¤ When the financial statements are not
free from material misstatement or
¤ When they have been unable to obtain
sufficient appropriate evidence.
In these circumstances the auditor
has to issue a modified version of
their opinion. There are three types of
modification. Their use depends upon
the nature and severity of the matter
under consideration.
They are:
¤ the qualified opinion
¤ the adverse opinion
¤ the disclaimer of opinion.
Guidance as to the usage of the three
forms of modification is provided by
ISA 705, Modifications to the Opinion in
the Independent Auditor’s Report. This
has been summarised in Table 1.
Pervasiveness is a matter that
confuses many candidates as, once
again, it is a matter that requires
professional judgment. In this case
the judgment is whether the matter is
isolated to specific components of the
financial statements, or whether the
matter pervades many elements of the
financial statements, rendering them
unreliable as a whole.
The bottom line is that if the auditor
believes that the financial statements
may be relied upon in some part
for decision making then the matter
is material and not pervasive. If,
however, they believe the financial
statements should not be relied upon at
all for making decisions then the matter
is pervasive.

Table 1: guidance as to the usage of the three forms of opinion modification

Auditor’s Judgment about the Pervasiveness of the Matter

Nature of the matter Material but NOT Pervasive Material AND Pervasive
Financial statements are Qualified opinion Adverse opinion
materially misstated (‘...except for...’) (‘...do not present fairly...’)

Unable to obtain sufficient appropriate Qualified opinion Disclaimer of opinion
audit evidence (‘...except for...’) (‘...we do not express an opinion...’)

Performance objectives 17 and 18 are relevant to these exams
opinion?
Emphasis of Matter
Emphasis of matter (EOM) is rarely
dealt with satisfactorily in the exam.
This is mainly because candidates
believe that EOM is linked somehow to
modifications of the opinion. This is not
the case: EOM and modified opinions
are totally separate matters.
The purpose of an EOM paragraph is
to draw the users attention to a matter
already disclosed in the financial
statements because the auditor
believes it is fundamental to their
understanding. It is a way of saying to
the users: ‘you know that note in the
financial statements, the one about
the uncertainty surrounding the legal
dispute? Well us auditors think it’s
really important, so make sure you’ve
read it!’.
The usage of EOM paragraphs is
described in ISA 706, Emphasis of
Matter Paragraphs and Other Matter
Paragraphs in the Independent Auditor’s
Report. This identifies three examples
of circumstances when the usage of
EOM is appropriate:
¤ when there is uncertainty about
exceptional future events
¤ early adoption of new accounting
standards and
¤ when a major catastrophe
has had a major effect on the
financial position.
Of course, in all of these examples
the auditor can only refer back to
disclosures already made in the
financial statements. If the directors
haven’t disclosed a matter as required
by financial reporting standards,
then the auditor may conclude
that the financial statements are
materially misstated and modify the
opinion instead.
student accountant issue 09/2010
Studying Paper F8 or P7?
Other Matters
‘Other matter’ paragraphs are used
to refer to matters that have not been
disclosed in the financial statements
that the auditor believes are significant
to user understanding. One usage of
these paragraphs is where the auditor
concludes that there is a material
inconsistency between the audited
financial statements and the other
(unaudited) information contained
within the annual report and accounts,
as required by ISA 720, The Auditor’s
Responsibilities Relating to Other
Information in Documents Containing
Audited Financial Statements.
Application to exam questions
Now that we have recapped the basic
principles of audit opinions let us
consider how these may be applied to
an exam scenario.
Questions on audit reports in Paper
P7 typically fall into two distinct types:
critical appraisal of an audit report that
has already been written; or explanation
of how matters will affect an audit
opinion. In both cases the principles
affecting the choice of audit opinion are
the same.
The purpose of an EOM paragraph is to draw
the users attention to a matter already
disclosed in the financial statements because
the auditor believes it is fundamental to
their understanding.
02
If you face a question of this nature
simplify your task by asking the
following questions:
¤ Is there a misstatement in the
financial statements (ie a fraud
or error)?
¤ Has the auditor gathered sufficient
appropriate evidence?
¤ Is/could the matter be material?
¤ Does the matter pervade the
financial statements?
¤ Does the scenario refer to a
disclosure made in the financial
statements concerning an uncertain
future event?
Based on this approach you should be
able to pinpoint exactly what form of
opinion is appropriate and whether an
EOM paragraph is necessary.
As an example, Question 5 in the
June 2009 Paper P7 exam asked
candidates to ‘critically appraise the
proposed audit report of Pluto Co
for the year ended 31 March 2009’.
Relevant extracts from the audit report
are given in Illustration 1. The full
text may be downloaded from the
ACCA website.
Please note that the extract is
from the International version of the
syllabus and refers to International
Accounting Standards.
03 technical

This is largely irrelevant to our
understanding of the audit opinion;
however, the question does deal
with matters where the financial
reporting requirements across different
accounting regimes are broadly similar.
The company in the question is a
listed company.
Illustration 1 (when this question
was written, isa 701 was examinable and
disagreement with management was a
reason for qualifying a report)
Adverse opinion arising from
disagreement about application of IAS 37
The directors have not recognised a
provision in relation to redundancy
costs… and so the recognition criteria
of IAS 37 have not been met. We
disagree with the directors as we feel
that an estimate can be made… We feel
that this is a material misstatement as
the profit for the year is overstated.
In our opinion, the financial
statements do not show a true and fair
view of the financial position of the
company as of 31 March 2009...
Emphasis of matter paragraph
The directors have decided not to
disclose the Earnings per share for
2009… Our opinion is not qualified in
respect of this matter.
Response – redundancy provision
We are not going to consider the whole
wording, merely the choice of opinion.
A more complete response is given
in the model answer, which can be
accessed via the ACCA website.
The first question to ask is whether
there is a misstatement. The answer
to this is clearly ‘yes’ as the report
concludes that the directors have
failed to make a provision when they
should have. This contravenes the
relevant accounting framework (IAS 37,
Provisions, Contingent Liabilities and
Contingent Assets). The report also
clearly states that this is considered to
be material to the financial statements.
Next we have to consider whether
the auditor has been able to gather
sufficient appropriate evidence. Once
again the answer is ‘yes;’ the auditor
has been able to reach a considered
conclusion on the matter.
At this point we have established
that there is a material misstatement.
Therefore, we will have to modify
our opinion. However, the final version
of the modification depends upon
whether the matter is pervasive
or not.
There is no indication in the audit
report that the auditor considers
the matter pervasive. It should also
be considered that redundancy
provisions will only affect two
areas of the financial statements:
current liabilities and wages/salary
costs. Does misstatement here
render the remainder of the financial
statements unreliable? This is an
unlikely conclusion.
It therefore appears unlikely that
an adverse opinion is necessary
in the circumstances. A qualified
(‘except for’) opinion would appear
more appropriate.
Earnings per share (EPS)
The second issue is that of the EOM
paragraph. Ask the question referred
to earlier: does the scenario refer to
a disclosure made in the financial
statements concerning an uncertain
future event? Clearly the answer is
no. Therefore an EOM paragraph is
not appropriate.
If this is the case how should the
matter be dealt with? Well, go through
the same questions again. First, is
there a misstatement?

Audit reports are a fundamental part of the auditing process and

are therefore significant for audit students at all levels. This will
continue to be a regular exam topic. If you do struggle with these
questions it is NOT a good strategy to suggest every possible form of
opinion hoping that one of them will be correct.

The directors have failed to disclose
the EPS for the year. This contravenes
IAS 33, Earnings per Share (and in
the UK, FRS 22, Earnings per share),
which requires the basic and diluted
EPS to be disclosed in the financial
statements of all listed companies.
There is, therefore, a misstatement in
the financial statements.
Next we consider whether the matter
is material. The clarified ISA 320,
Materiality in Planning and Performing an
Audit requires the auditor to consider
the informational requirements of
the users. EPS is a vital investor
analysis tool and can therefore be
considered material by nature. For
listed companies, it is a requirement of
financial reporting standards that EPS
is disclosed with prominence in the
financial statements. There is therefore
a material misstatement in the
financial statements.
Finally the auditor should consider
whether the matter is pervasive to
the financial statements. The lack of
disclosure of the EPS ratio is unlikely
to render other elements of the
financial statements unreliable; it is an
isolated error.
In this instance a qualified opinion
should be given on the basis of
a material misstatement of the
financial statements.
Application to the Paper F8 Exam
The concepts considered above are
equally as relevant to the Paper F8
exam. However, the wording of the
questions to date has been slightly
different from the Paper P7 exam. So
far candidates have been provided
with short scenarios and asked to
either state or explain the effects
of the matters on the audit report.
student accountant issue 09/2010
04
The approach discussed above
may be applied in the same way to
these questions.
The matters considered so far (in
the December 2007 and December
2009 exams) include: a failure to
depreciate non-current/fixed assets,
an auditor not being able to attend the
year-end inventory/stock count, and a
failure to disclose a contingent liability
in the financial statements.
Candidates should also prepare for
questions requiring them to define
or explain the terms referred to above.
This style of requirement is
illustrated in Question 2 from the June
2009 exam paper.
Concluding thoughts
Audit reports are a fundamental part of
the auditing process and are therefore
significant for audit students at all
levels. This will continue to be a regular
exam topic.
If you do struggle with these
questions it is NOT a good strategy
to suggest every possible form of
opinion hoping that one of them will
be correct.
Auditing requires critical
appraisal, the use of professional
judgement and the ability to offer a
reasoned opinion.
By asking yourself a series of
simplified questions you will go
through a critical thought process
that allows you to come to your own
conclusion and, more importantly, offer
your own opinion.
This will undoubtedly allow you to
present an answer that stands out from
the others.
Simon Finley is an audit
subject specialist at Kaplan Publishing
01 technical
changes to the
study guide part 1 relevant to acca qualification paper P1
June 2011 sees a number of new
additions to the Paper P1 Study
Guide. I will explain these changes
in two consecutive articles. In this
issue, I discuss the dynamic nature
of risk, management responses
to changing risk assessments,
risk appetite, and the concepts of
business and financial risk. In the
next issue of Student Accountant, I
conclude my discussion of the Study
Guide changes.
In seeking to maintain the currency
and relevance of the P1 Study Guide, I
have made a few changes which come
into effect from the June 2011 exam
onwards. All are in the risk sections of
the syllabus and reflect some of the
latest thinking in risk management as
well as some issues that have arisen as
a result of recent events in business.
In this article I discuss each of the
changes I have made.
I am also introducing the possibility
of bringing in some simple arithmetic
calculations into Paper P1 exam
papers (again, from June 2011
onwards). This is to enable some
aspects of risk to be examined that
cannot be examined in a solely
narrative-based answer. This is a
change to the advice I gave when
the Paper P1 Study Guide was first
introduced. Students should not
expect complicated calculations but
should be prepared to manipulate
numerical data and accordingly, a
calculator may be helpful in future
Paper P1 exams.
figure 1: the nature of risk assessment
Static
Increasing environmental
change and turbulence
New C1(c): Explain the dynamic nature of
risk assessment
This entry into the Study Guide was
added to emphasise the fact that
risks are not static: they change over
time and between situations. One
of the key features of any business
environment is that the things that
affect an organisation, either internal or
external factors, are very changeable. In
some situations, environmental factors
change relatively little, but in other
environments, risk factors can change a
great deal. These are sometimes called
‘turbulent’ environments, shown in
Figure 1.
As with environmental analyses
in strategic analysis, it is important
to recognise that the extent of
environmental change can be
understood as a continuum (see
Figure 1 above). Continua of any type
describe two extremes and a variable
state between the two extremes.
At the left extreme is the situation
in which nothing in the internal or
external environment of an organisation
ever changes.
Dynamic
This means that no risks ever
change from year to year – no new
risks materialise and no existing ones
disappear or weaken. Of course this
is only a theoretical situation and
doesn’t exist in practice. It’s the same
at the other extreme – a situation in
which the environment changes so
frequently that all risks are changing
all the time. Again, this situation
doesn’t exist in reality, but situations
close to it do exist. It is also the case
that the risks that an organisation
faces can change with changes in
the internal activities as well as with
external environmental changes. New
product launches, changes in financial
structure, changes in markets served,
etc, can also change the risks faced by
an organisation.
What matters is to appreciate that
organisations differ in how exposed they
are to changes in internal and external
risks. Some are very changeable,
perhaps in industries that are subject to
a wide range of local and international
influences (perhaps shipping,
telecommunication and technology)

paper p1
for june 2011
while others are subject to fewer and
less changeable risks. In other words,
they occupy different positions along
the static‑dynamic continuum.
The result of this is that the
assessment of any given risk can
change and, thereby, the strategy for
managing that risk.
The probability or impact of a risk
can change over time and this change
can move a risk on the likelihood/
impact map which is often used in risk
assessment (see Figure 2).
Suppose, for example, Risk A has a
high potential impact and is assessed as
having a 60% likelihood of materialising
in a given period of time. Then a change
in the environment or in the company’s
internal controls occurs which makes
the likelihood much less, say down
to 25%. The risk would then move on
the graph, as shown on Figure 2, from
position A to A’.
Similarly, suppose a risk is very
unlikely but with a high potential
figure 2: risk assessment probability
High
Likelihood
(probability)
B’
Low
Low Consequences (impact/hazard)
student accountant issue 09/2010
Studying Paper P1?
Performance objectives 1, 2 and 3 are relevant to this exam
impact (position B). A change in the
environment might decrease the
potential impact of the risk, moving it
on the map to position B’. In both cases,
the risks have moved, as a result of the
environmental change, to a new area
of the map. In both cases, the strategy
adopted for managing the risk will be
likely to change.
New C1 (d): Explain the importance and
nature of management responses to
changing risk assessments
Following on from the discussion
above about changing risks, it follows
that management must tailor its
risk management to match the
nature of the risk threat. In terms
of policy, those organisations in
more changeable (or more dynamic)
environments must make a greater
investment in risk management
strategies in order to manage the
range and changeability of those
risks. It follows that an organisation’s
A seeking. Rather than doing this for
A’
B This range of possible attitudes
High
02
risk management must match the
complexity of its risks. To fail to do
this would be an incongruity between
risk and response which could, in
turn, be a failure in the strategy of
the organisation. Some of the themes
relevant to this entry are touched on
in the other additions to the Study
Guide which I have described in the
remainder of this article and in the
follow-on article in the next issue
of  Student Accountant.
New C1 (e): Explain risk appetite and how
this affects risk policy (2)
This addition to the Study Guide
introduces the notion of risk appetite
which, as its name suggests, is a
measure of the general attitude to
accepting risk. Some individuals live
their lives in a very careful way, seeking
to avoid risks and withdrawing from
situations in which a risk might be
experienced. Other people, conversely,
positively seek out and thrive on
risk. They might enjoy gambling,
parachuting, scuba diving and similar
activities with very high potential
hazards/impacts.
In the same way, some organisations
are risk averse while others are risk
the ‘thrill’ of it, however, risk-seeking
organisations generally seek risk in
the belief that higher risk is often
associated with higher returns.
to risk can be represented on a
continuum (see Figure 3 on page 3).
03 technical
figure 3: risk attitude continuum
Risk averse
More likely to refuse and
avoid risk
As with any other continuum, the
two ends represent to two possible
extremes while ‘real life’ takes place
at various points along the continuum
between the two extremes.
At the left-hand extreme is the
situation of an organisation that
always accepts risk and is actively
risk seeking. At the other extreme are
organisations (also mainly hypothetical
rather than real) that never accept
any risks and manage the strategy to
always avoid situations in which risk
may occur.
Risk appetite has an important
influence on the risk controls that the
organisation is likely to have in place.
Organisations that actively seek to
avoid risks, perhaps found more in the
public sector, charitable sector and in
some ‘process’-oriented companies,
do not need the elaborate and costly
systems that a risk seeking company
might have. Organisations such as
those trading in financial derivatives,
volatile share funds and venture
capital companies will typically have
complex systems in place to monitor
and manage risk. In such companies,
the management of risk is likely to
be a strategic core competence of
the business.
Risk seeking
More likely to
accept risk
New C2 (c): Describe and evaluate the
nature and importance of business and
financial risks
In the original Study Guide for Paper
P1, I listed a range of common risks
encountered by organisations in
section C2b. This list was far from
comprehensive but did serve to
illustrate some of the specific risks that
are commonly faced. In adding this
new entry to the Study Guide, I want to
clarify the fact that there are other risks
that can affect organisations.
Business risks are strategic risks
that threaten the health and survival of
a whole business. A number of factors
can increase business risk and one of
the purposes of the annual audit is to
review the factors that might increase
business risk such as the presence
of any operational, financial or
compliance failures that might affect
the business as a ‘going concern’.
Business risk varies greatly between
companies and sometimes over time,
and is generally thought to be greatest
for young businesses or those in
cyclical industries such as tourism.
The banking crisis in 2008 and 2009
taught us, however, that business risk
can also apply to much older and more
established companies.
A typical way of considering business
risk is to examine the probability
of a period of poor earnings and
possible failure, and also to consider
the potential impact of that failure.
This brings us back to the notion of
stakeholders because the issue is
‘impact upon whom?’
The stakeholders most affected by
business risk depend on the situation.
If the business fails altogether, the
employees will be greatly affected but
the shareholder loss will depend on
the individual exposure (the proportion
of a portfolio invested in the failing
company). If the business experiences
a period of poor performance, the
shareholders may be more adversely
affected than the employees.
One of the major causes of business
risk is financial risk. Large variability
in cash flow and liquidity introduces
instability to the financial health of the
business. While these can be caused
by trading fluctuations, the financial
structure of a business can also be a
strong contributory factor. High gearing,
for example, can place pressure on
cash flow because of the need to
service debt in a way that would not
be necessary with a higher proportion
of equity capital. So while debt can be
a favourable means of financing when
interest rates are low or when equity
capital is difficult to raise, it increases
financial risk because of the increased
likelihood of strained cash flow and
defaulting on debt repayment.
Financial risks are typically of most
concern to lenders and those that
depend upon a company’s cash flow
such as suppliers who rely on prompt
payment of payables.
David Campbell is examiner for Paper P1