ACCA - AAA

Advanced Audit and Assurance

(INT)

Study Notes
 CONTENTS
Sr # Topics Page #

01 About the Exam & How to use this notes 01

02 Re-cap of Important Terms 03

03 Impact of Corporate Governance Principles on Audit 12

04 Laws & Regulations 16

05 Money Laundering 22

06 Code of ethics for Professional Accountants 28

07 Fraud 52

08 Professional Liability 57

09 Quality Control 63

10 Obtaining & Accepting Professional Appointments 73

11 Agreeing the Terms of Engagement 78

12 The Planning Stage of Audit 81

13 Audit Evidence & Audit Procedures 104

14 Group Audit 162

15 The Review Stage of Audit 189

16 Communicating with TCWG & Key Audit Matters 199

17 Evaluation of Misstatements 204

18 Audit Opinion & Audit Report 209

19 Assurance & No-Assurance Engagements 227

20 Review Engagements 231

21 Due Diligence 236

22 Prospective Financial Information 241

23 Forensic Accounting 247

24 Audit of Performance Information in the Public Sector 256

25 Social & Environmental Issues 261

26 Impact of Big Data & Data Analytics on Audit 265

27 Professional Skepticism 270

 Syllabus Areas

A. Regulatory Environment
B. Professional & Ethical Considerations
C. Practice Management
D. Planning and conducting audit of historical financial information
E. Completion and reporting
F. Other assignments
G. Current issues and development ( ensure you check technical articles on the ACCA website before
your exam attempt)

About Advanced Audit & Assurance

The Exam

- 100 marks
- 3 hours, 15 minutes
- Two sections ( A & B)

Section A: One Case Study‐50 marks‐ Requirement from the entire syllabus.

Detailed information will be given which is likely to include:

- Extracts of financial information,
- Strategic, operational and other relevant financial information for a client business,
- Extracts from audit working papers
- Results of analytical procedures.

Includes 4 professional marks

Easiest way to get the 4 professional marks!

- Format
- Introduction and conclusion
- Headings
- Clarity of explanation

Section B: 2 compulsory 25 mark questions‐50 marks

- One question from completion, review and reporting
- The other can be from any part of the syllabus

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Using these notes

For each area of the syllabus, the notes cover:

- The key knowledge/technical areas
- The answer technique!

It is VERY important to understand that the nature of the AAA exam is such that it cannot be passed
without excessive practice so these notes HAVE to be used in combination with revision kit.

Use the LATEST revision kits from approved content providers as they update past papers to reflect
changes in accounting and auditing standards.

The past papers on the ACCA website are not updated for changes in ISAs or IFRS.

When you are attempting questions from the latest revision kits, focus on ‘knowing’ the language used
and understanding the ‘answer technique’; remember, it’s not the English language which will help you
get through the exam‐ it is the ‘audit language’!

Lastly, ensure you read the Technical articles on the ACCA website; focus on the ones that have been
published in the last 12 months from you exam attempt.

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Re‐Cap of Important Terms AAA Revision Notes

Re‐Cap of Important Terms

Terms you should be conceptually clear on!

Those charged with governance – The person(s) with responsibility for overseeing the strategic direction of the
entity and obligations related to the accountability of the entity. This includes overseeing the financial reporting
process. For some entities in some jurisdictions, those charged with governance may include management
personnel, for example, executive members of a governance board of a private or public sector entity, or an owner‐
manager.

Management – The person(s) with executive responsibility for the conduct of the entity’s operations. For some
entities in some jurisdictions, management includes some or all of those charged with governance, for example,
executive members of a governance board, or an owner‐manager.

In some cases, all of those charged with governance are involved in managing the entity, for example, a small
business where a single owner manages the entity and no one else has a governance role

Engagement partner – The partner or other person in the firm who is responsible for the audit engagement and its
performance, and for the auditor’s report that is issued on behalf of the firm, and who has the appropriate authority
from a professional, legal or regulatory body.

Engagement quality control review – A process designed to provide an objective evaluation, on or before the date
of the auditor’s report, of the significant judgments the engagement team made and the conclusions it reached in
formulating the auditor’s report.

Engagement quality control reviewer – A partner, other person in the firm, suitably qualified external person, or a
team made up of such individuals, none of whom is part of the engagement team, with sufficient and appropriate
experience and authority to objectively evaluate the significant judgments the engagement team made and the
conclusions it reached in formulating the auditor’s report.

Management’s expert – An individual or organization possessing expertise in a field other than accounting or
auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements. The
preparation of an entity’s financial statements may require expertise in a field other than accounting or auditing,
such as actuarial calculations, valuations etc. The entity may employ or engage experts in these fields to obtain the
needed expertise to prepare the financial statements. Failure to do so when such expertise is necessary increases
the risks of material misstatement.

Audit procedure: Analytical procedures: Analytical procedures consist of evaluations of financial information
through analysis of plausible relationships among both financial and non‐financial data. Analytical procedures also
encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with
other relevant information or that differ from expected values by a significant amount.

Audit procedure: Test of controls – An audit procedure designed to evaluate the operating effectiveness of controls
in preventing, or detecting and correcting, material misstatements at the assertion level

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Re‐Cap of Important Terms AAA Revision Notes

Audit procedure: Substantive procedure – An audit procedure designed to detect material misstatements at the
assertion level. Substantive procedures comprise:
(i) Tests of details (of classes of transactions, account balances, and disclosures); and
(ii) Substantive analytical procedures.

Internal control – The process designed, implemented and maintained by those charged with governance,
management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives
with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with
applicable laws and regulations. The term “controls” refers to any aspects of one or more of the components of
internal control.

Deficiency in internal control – This exists when:

(i) A control is designed, implemented or operated in such a way that it is unable to prevent, or detect and
correct, misstatements in the financial statements on a timely basis; or
(ii) A control necessary to prevent, or detect and correct, misstatements in the financial statements on a timely
basis is missing.

Test of controls‐ They are audit procedures performed to test the operating effectiveness of controls in preventing
or detecting material misstatements in the financial statements. An auditor might use inspection of documents,
observations of specific controls, re‐performance of the control, test data or other audit procedures to gather
evidence about controls.

There are many other issues that auditors struggle with when understanding and testing internal controls in audits
of all sizes, including:
• Deciding whether to test the operating effectiveness of controls;
• Determining what constitutes a deviation and the tolerable deviation rate, and then dealing with deviations;
• Revising the control risk assessment, and the effect of a revision on other audit procedures; and
• Balancing the results of controls testing with substantive procedures

Audit evidence – Information used by the auditor in arriving at the conclusions on which the auditor’s opinion is
based. Audit evidence includes both information contained in the accounting records underlying the financial
statements and other information.

Appropriateness (of audit evidence) – The measure of the quality of audit evidence; that is, its relevance and its
reliability in providing support for the conclusions on which the auditor’s opinion is based.

Sufficiency (of audit evidence) – The measure of the quantity of audit evidence. The quantity of the audit evidence
needed is affected by the auditor’s assessment of the risks of material misstatement and also by the quality of such
audit evidence.

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Re‐Cap of Important Terms AAA Revision Notes

Sources of audit evidence

Inspection Inspection involves examining records or documents, whether internal or external, in
paper form, electronic form, or other media, or a physical examination of an asset.
An example of inspection used as a test of controls is inspection of records for evidence
of authorization.
Observation Observation consists of looking at a process or procedure being performed by others,
for example, the auditor’s observation of inventory counting by the entity’s personnel,
or of the performance of control activities. Observation provides audit evidence about
the performance of a process or procedure, but is limited to the point in time at which
the observation takes place, and by the fact that the act of being observed may affect
how the process or procedure is performed
External confirmation An external confirmation represents audit evidence obtained by the auditor as a direct
written response to the auditor from a third party (the confirming party), in paper
form, or by electronic or other medium.
Inquiry Inquiry consists of seeking information of knowledgeable persons, both financial and
non‐financial, within the entity or outside the entity.
Recalculation Recalculation consists of checking the mathematical accuracy of documents or records.
Recalculation may be performed manually or electronically

Re‐performance Re‐performance involves the auditor’s independent execution of procedures or

controls that were originally performed as part of the entity’s internal control.
Analytical procedures Analytical procedures consist of evaluations of financial information through analysis
of plausible relationships among both financial and non‐financial data. Analytical
procedures also encompass such investigation as is necessary of identified fluctuations
or relationships that are inconsistent with other relevant information or that differ
from expected values by a significant amount.

Audit documentation – The record of audit procedures performed, relevant audit evidence obtained, and
conclusions the auditor reached (terms such as “working papers” or “work papers” are also sometimes used).Audit
documentation may be recorded on paper or on electronic or other media. Examples of audit documentation
include:
 Audit programs.
 Analyses.
 Issues memoranda.
 Summaries of significant matters.
 Letters of confirmation and representation.
 Checklists.
 Correspondence (including e‐mail) concerning significant matters.

Misstatement – A difference between the amount, classification, presentation, or disclosure of a reported financial
statement item and the amount, classification, presentation, or disclosure that is required for the item to be in
accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud.

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Re‐Cap of Important Terms AAA Revision Notes

Misstatements may result from:

(a) An inaccuracy in gathering or processing data from which the financial statements are prepared;

(b) An omission of an amount or disclosure, including inadequate or incomplete disclosures

(c) An incorrect accounting estimate arising from overlooking, or clear misinterpretation of, facts;

(d) Judgments of management concerning accounting estimates that the auditor considers unreasonable or the
selection and application of accounting policies that the auditor considers inappropriate.;

(e) An inappropriate classification, aggregation or disaggregation, of information; and

(f) For financial statements prepared in accordance with a fair presentation framework, the omission of a
disclosure necessary for the financial statements to achieve fair presentation beyond disclosures specifically
required by the framework.

Misstatement of a qualitative disclosure

Each individual misstatement of a qualitative disclosure is considered. This is done to evaluate its effect on the
relevant disclosure(s), as well as its overall effect on the financial statements as a whole. The determination of
whether a misstatement(s) in a qualitative disclosure is material is a matter that involves the exercise of professional
judgment.

Examples where such misstatements may be material include:

‐ Inaccurate or incomplete descriptions of information about the objectives, policies and processes for managing
capital for entities with insurance and banking activities.

‐ The omission of information about the events or circumstances that have led to an impairment loss (e.g., a
significant long‐term decline in the demand for a metal or commodity) in an entity with mining operations.

‐ The incorrect description of an accounting policy relating to a significant item in the statement of financial
position, the statement of comprehensive income, the statement of changes in equity or the statement of cash
flows.

‐ The inadequate description of the sensitivity of an exchange rate in an entity that undertakes international
trading activities.

Professional judgment – The application of relevant training, knowledge and experience, within the context
provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action
that are appropriate in the circumstances of the audit engagement.

Professional skepticism – An attitude that includes a questioning mind, being alert to conditions which may indicate
possible misstatement due to error or fraud, and a critical assessment of audit evidence. Professional skepticism
includes being alert to, for example:
• Audit evidence that contradicts other audit evidence obtained.
• Information that brings into question the reliability of documents and responses to inquiries to be used as audit
evidence.

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Re‐Cap of Important Terms AAA Revision Notes

• Conditions that may indicate possible fraud.

• Circumstances that suggest the need for audit procedures in addition to those required by the ISAs.

Reasonable assurance – In the context of an audit of financial statements, a high, but not absolute, level of
assurance.

Assertions – Representations by management, explicit or otherwise, that are embodied in the financial statements,
as used by the auditor to consider the different types of potential misstatements that may occur.

Assertions about classes of transactions and events and related disclosures for the period under audit

1. Occurrence – the transactions and events that have been recorded or disclosed, have occurred, and such
transactions and events pertain to the entity.
2. Completeness – all transactions and events that should have been recorded have been recorded and all
related disclosures that should have been included in the financial statements have been included.
3. Accuracy – amounts and other data relating to recorded transactions and events have been recorded
appropriately, and related disclosures have been appropriately measured and described.
4. Cut–off – transactions and events have been recorded in the correct accounting period.
5. Classification – transactions and events have been recorded in the proper accounts.
6. Presentation – transactions and events are appropriately aggregated or disaggregated and clearly described,
and related disclosures are relevant and understandable in the context of the requirements of the applicable
financial reporting framework.

Assertions about account balances and related disclosures at the period end

1. Existence – assets, liabilities and equity interests exist.

2. Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the obligations of
the entity
3. Completeness – all assets, liabilities and equity interests that should have been recorded have been
recorded and all related disclosures that should have been included in the financial statements have been
included.
4. Accuracy, valuation and allocation – assets, liabilities and equity interests have been included in the financial
statements at appropriate amounts and any resulting valuation or allocation adjustments have been
appropriately recorded and related disclosures have been appropriately measured and described.
5. Classification – assets, liabilities and equity interests have been recorded in the proper accounts.
6. Presentation – assets, liabilities and equity interests re appropriately aggregated or disaggregated and clearly
described, and related disclosures are relevant and understandable in the context of the requirements of the
applicable financial reporting framework

Business risk – A risk resulting from significant conditions, events, circumstances, actions or inactions that could
adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of
inappropriate objectives and strategies.

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Re‐Cap of Important Terms AAA Revision Notes

Audit sampling (sampling) – The application of audit procedures to less than 100% of items within a population of
audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a
reasonable basis on which to draw conclusions about the entire population.

Sampling risk – The risk that the auditor’s conclusion based on a sample may be different from the conclusion if the
entire population were subjected to the same audit procedure. Sampling risk can lead to two types of erroneous
conclusions:
(i) In the case of a test of controls, that controls are more effective than they actually are, or in the case of a
test of details, that a material misstatement does not exist when in fact it does. The auditor is primarily
concerned with this type of erroneous conclusion because it affects audit effectiveness and is more likely
to lead to an inappropriate audit opinion.
(ii) In the case of a test of controls, that controls are less effective than they actually are, or in the case of a test
of details, that a material misstatement exists when in fact it does not. This type of erroneous conclusion
affects audit efficiency as it would usually lead to additional work to establish that initial conclusions were
incorrect.

Non‐sampling risk – The risk that the auditor reaches an erroneous conclusion for any reason not related to sampling
risk.

Written representation – A written statement by management provided to the auditor to confirm certain matters
or to support other audit evidence.

The date of the written representations shall be as near as practicable to, but not after, the date of the auditor’s
report on the financial statements.

The written representations shall be in the form of a representation letter addressed to the auditor If the auditor
has concerns about the competence, integrity, ethical values or diligence of management, or about its commitment
to or enforcement of these, the auditor shall determine the effect that such concerns may have on the reliability of
representations (oral or written) and audit evidence in general In particular, if written representations are
inconsistent with other audit evidence, the auditor shall perform audit procedures to attempt to resolve the matter.

If management does not provide one or more of the requested written representations, the auditor shall:
(a) Discuss the matter with management;
(b) Revaluate the integrity of management and evaluate the effect that this may have on the reliability of
representations (oral or written) and audit evidence in general; and
(c) Take appropriate actions, including determining the possible effect on the opinion in the auditor’s report

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Re‐Cap of Important Terms AAA Revision Notes

Information obtained from outside of the ledger

Financial statements may contain information that is obtained from outside of the general and subsidiary
ledgers. Examples of such information may include:

‐ Information obtained from lease agreements disclosed in the financial statements, such as renewal options
or future lease payments.

‐ Information disclosed in the financial statements that is produced by an entity’s risk management system
(such as disclosures about credit risk, liquidity risk, and market risk)

‐ Fair value information produced by management’s experts and disclosed in the financial statements.

‐ Information disclosed in the financial statements that has been obtained from models, or from other
calculations used to develop estimates recognized or disclosed in the financial statements, including
information relating to the underlying data and assumptions used in those models, such as assumptions
developed internally that may affect an asset’s useful life

‐ Information disclosed in the financial statements about sensitivity analyses derived from financial models
that demonstrates that management has considered alternative assumptions.

‐ Information recognized or disclosed in the financial statements that has been obtained from an entity’s tax
returns and records

‐ Information disclosed in the financial statements that has been obtained from analyses prepared to
support management’s assessment of the entity’s ability to continue as a going concern, such as
disclosures, if any, related to events or conditions that have been identified that may cast significant doubt
on the entity’s ability to continue as a going concern.

Internal audit is defined as “An appraisal activity established within an entity as a service to the entity. Its functions
include, amongst other things, examining, evaluating and monitoring the adequacy and effectiveness of internal
control”.

Types of internal audit

There are numerous different types of audit that internal auditors can be involved in such as efficiency and
effectiveness audits. For THE ADVANCED AUDIT & ASSURANCE EXAM the two most important are compliance and
operational audits.

Compliance audits: Audit checks intended to determine whether the actions of employees are in accordance with
company policy, laws and regulations.

Operational audits: Audits of the operational processes of the organization to check not only compliance with
controls, but also the effectiveness of controls as part of the risk management process.

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Re‐Cap of Important Terms AAA Revision Notes

There are two broad categories of Computer Aided Audit Techniques:

1. Audit software; and
2. Test data.

Audit software
Audit software is used to interrogate a client's system. It can be either packaged, off‐the‐shelf software or it can be
purpose written to work on a client's system. The main advantage of these programs is that they can be used to
scrutinise large volumes of data, which it would be inefficient to do manually. The programs can then present the
results so that they can be investigated further.

Specific procedures they can perform include:

 Extracting samples according to specified criteria, such as:
o Random;
o Over a certain amount;
o Below a certain amount;
o At certain dates.
 Calculating ratios and select indicators that fail to meet certain pre‐defined criteria (i.e. benchmarking);
 Check arithmetical accuracy (for example additions);
 Preparing reports (budget vs actual);
 Stratification of data (such as invoices by customer or age);
 Produce letters to send out to customers and suppliers; and
 Tracing transactions through the computerised system.

These procedures can simplify the auditor's task by selecting samples for testing, identifying risk areas and by
performing certain substantive procedures. The software does not, however, replace the need for the auditor's own
procedures.

Test data
Test data involves the auditor submitting 'dummy' data into the client's system to ensure that the system correctly
processes it and that it prevents or detects and corrects misstatements. The objective of this is to test the operation
of application controls within the system.

To be successful test data should include both data with errors built into it and data without errors. Examples of
errors include:
 Codes that do not exist, e.g. Customer, supplier and employee;
 Transactions above pre‐determined limits, e.g. Salaries above contracted amounts, credit above limits agreed
with customer;
 Invoices with arithmetical errors; and
 Submitting data with incorrect batch control totals.

Data maybe processed during a normal operational cycle ('live' test data) or during a special run at a point in time
outside the normal operational cycle ('dead' test data). Both has their advantages and disadvantages:
 Live tests could interfere with the operation of the system or corrupt master files/standing data;
 Dead testing avoids this scenario but only gives assurance that the system works when not operating live. This
may not be reflective of the strains the system is put under in normal conditions.

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Re‐Cap of Important Terms AAA Revision Notes

Other techniques
There are other forms of CAAT that are becoming increasingly common as computer technology develops, although
the cost and sophistication involved currently limits their use to the larger accountancy firms with greater resources.

These include:
Integrated test facilities ‐ this involves the creation of dummy ledgers and records to which test data can be sent.
This enables more frequent and efficient test data procedures to be performed live and the information can simply
be ignored by the client when printing out their internal records; and

Embedded audit software ‐ this requires a purpose written audit program to be embedded into the client's
accounting system. The program will be designed to perform certain tasks (similar to audit software) with the
advantage that it can be turned on and off at the auditor's wish throughout the accounting year. This will allow the
auditor to gather information on certain transactions (perhaps material ones) for later testing and will also identify
peculiarities that require attention during the final audit.

Public oversight committee

Earlier, the accountancy profession was self‐regulated. However, due to globalisation and the failure of big
organisations such as Enron the effectiveness of self‐regulation came into doubt and a need for external regulation
emerged.

A public oversight committee is an independent body created to oversee the governance and financial reporting
of public organisations. Its main role is:
– To protect the interests of investors and the public at large.
– To give investors and others confidence that an organisation’s activities are not detrimental to the public
interest.
– To ensure that the audit report is fair and independent, providing all the essential information.
– To ensure that registered public accounting firms maintain high professional standards so as to improve the
quality of audit services offered.

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Impact of Corporate Governance Principles on Audit AAA Revision Notes

Impact of Corporate Governance Principles on Audit

Corporate governance is the system by which organisations are directed and controlled. It encompasses the
relationship between the board of directors, shareholders and other stakeholders, and the effects on corporate
strategy and performance. Corporate governance is important because it looks at how these decision makers act,
how they can or should be monitored, and how they can be held to account for their decisions and actions.

THE MAIN PRINCIPLES‐ TECHNICAL ARTICLE

LEADERSHIP: Every company should be headed by an effective board which is collectively responsible for the long‐
term success of the company, and should lead and control the company’s operations. There should be a clear division
of responsibilities at the head of the company, which will ensure a balance of power and authority, such that no one
individual has unfettered powers of decision. Non‐executive directors should constructively challenge and help
develop proposals on strategy. The board should include a balance of executive and non‐executive directors such that
no individual or small group of individuals can dominate the board’s decision taking.

EFFECTIVENESS: The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company to enable them to discharge their respective duties and responsibilities
effectively. There should be a formal, rigorous and transparent procedure for the appointment of new directors to
the board. All directors should receive induction on joining the board and should regularly update and refresh their
skills and knowledge. All directors should be submitted for re‐election at regular intervals, subject to continued
satisfactory performance.

ACCOUNTABILITY: The board should present a balanced and understandable assessment of the company’s position
and prospects. The board should maintain sound risk management and internal control systems. The board should
establish formal and transparent arrangements for considering how they should apply the corporate reporting and
risk management and internal control principles and for maintaining an appropriate relationship with the company’s
auditor.

REMUNERATION: Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality
required to run the company successfully, but a company should avoid paying more than is necessary for this purpose.
A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate
and individual performance.

RELATIONS WITH SHAREHOLDERS: There should be a dialogue with shareholders based on the mutual understanding
of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders
takes place. The board should use the Annual General Meeting to communicate with investors and to encourage their
participation.

EXTERNAL AUDITORS – GENERAL PRINCIPLES

The audit committee has specific responsibilities in respect of the external auditors, including recommending the
appointment, reappointment and removal of the external auditor, approving fees paid for audit and non‐audit
services, and agreeing on the terms of engagement with the external auditor.

One of the key issues is that the audit committee should annually assess the independence, objectivity and
effectiveness of the external audit process, considering of the ethical framework applicable in the jurisdiction in

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Impact of Corporate Governance Principles on Audit AAA Revision Notes

which the organisation is operating. The audit committee should report annually to the board on their assessment
with a recommendation on whether to propose to the shareholders that the external auditor be reappointed. The
audit committee section of the annual report should also discuss the annual assessment of the external audit process
by the audit committee and also include information on the length of tenure of the current audit firm, when a tender
was last conducted, and any contractual obligations that acted to restrict the audit committee’s choice of external
auditors.

In relation to potential threats to objectivity, the audit committee should seek reassurance that the auditors and
their staff have no financial, business, employment or family and other personal relationship with the company
which could adversely affect the auditor’s independence and objectivity. The audit committee should seek from the
audit firm, on an annual basis, information about policies and processes for maintaining independence and
monitoring compliance with relevant requirements, including current requirements regarding the rotation of audit
partners and staff.

EXTERNAL AUDITORS – THE ANNUAL AUDIT CYCLE

The audit committee should be involved at all stages of the audit, to obtain comfort that a quality audit will be
performed. The Guidance on Audit Committee specifically requires the following to take place:
At the start of each annual audit cycle, the audit committee should ensure that appropriate plans are in place for
the audit. This includes consideration of planned levels of materiality, and the proposed resources to execute the
plan, having regard also to the seniority, expertise and experience of the audit team. In practice this means that
before any audit fieldwork takes place, the audit firm should meet with the audit committee to discuss the audit
strategy and audit plan, demonstrating that auditing standards and quality control principles have been adhered to
in their development.

The audit committee should review, with the external auditors, the findings of their work. In the course of its review,
the audit committee should discuss with the external auditor major issues that arose during the course of the audit
and have subsequently been resolved and those issues that have been left unresolved; review key accounting and
audit judgements; and review levels of errors identified during the audit, obtaining explanations from management
and, where necessary, the external auditors as to why certain errors might remain unadjusted. The audit committee
should review and monitor management’s responsiveness to the external auditor’s findings and recommendations.
Thus, all key audit findings should be shared with the audit committee and discussed with them as the audit
progresses.

At the end of the annual audit cycle, the audit committee should assess the effectiveness of the audit process, by:
 Reviewing whether the auditor has met the agreed audit plan and understand the reasons for any changes,
including changes in perceived audit risks and the work undertaken by the external auditors to address those
risks
 Considering the robustness and perceptiveness of the auditors in their handling of the key accounting and audit
judgements identified and in responding to questions from the audit committee
 Obtaining feedback about the conduct of the audit from key people involved, for example the finance director
and the head of internal audit
 Reviewing and monitoring the content of the external auditor’s management letter (report to those charged
with governance), in order to assess whether it is based on a good understanding of the company’s business
and establish whether recommendations have been acted upon and, if not, the reasons why they have not
been acted upon, and
 Reporting to the board on the effectiveness of the external audit process.

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Impact of Corporate Governance Principles on Audit AAA Revision Notes

In summary, the audit committee carefully monitors the conduct of the audit, and plays an important part in ensuring
the quality and rigour of the external audit of the financial statements.

EXTERNAL AUDITORS – PROVISION OF NON‐AUDIT SERVICES

Specifically, the audit committee should develop and implement a policy on the engagement of the external auditor
to supply non‐audit services, taking into account the relevant ethical principles and requirements. The audit
committee’s objective should be to ensure that the provision of such services does not impair the external auditor’s
independence or objectivity. The audit committee should consider:
 Whether the skills and experience of the audit firm make it the most suitable supplier of the non‐audit service
 Whether there are safeguards in place to eliminate or reduce to an acceptable level any threat to objectivity
and independence in the conduct of the audit resulting from the provision of such services by the external
auditor
 The nature of the non‐audit services
 The fees incurred, or to be incurred, for non‐audit services both for individual services and in aggregate, relative
to the audit fee, and
 The criteria which govern the compensation of the individuals performing the audit.

The audit committee should set and apply a formal policy specifying the types of non‐audit service:
 For which the use of the external auditor is pre‐approved (i.e. Approval has been given in advance as a matter
of policy, rather than the specific approval of an engagement being sought before it is contracted)
 From which specific approval from the audit committee is required before they are contracted, and
 From which the external auditor is excluded.

One of the non‐audit services specifically referred to in the Guidance on Audit Committees is the provision of internal
audit by the external auditor. If the external auditor is being considered to undertake aspects of the internal audit
function, the audit committee should consider the effect this may have on the effectiveness of the company’s overall
arrangements for internal control and investor perceptions in this regard.

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Impact of Corporate Governance Principles on Audit AAA Revision Notes

Audit Committee

The role and responsibilities of the audit committee should be in writing and set out in the terms of reference.

1. Financial reporting 2. Internal controls and risk management systems

The audit committee should monitor: The audit committee should review the company’s
– The integrity of the financial statements internal financial controls, internal control and risk
of the company; and management systems
– Any formal announcements relating to
the company’s financial performance
and review of significant financial
reporting judgements contained in
them.

3. Whistle blowing 4. The internal audit process

The audit committee should review The audit committee should monitor and review the
arrangements by which staff of the company effectiveness of the company’s internal audit function.
may, in confidence, raise concerns about
possible improprieties in matters of financial
reporting or other matters.

5. Overseeing the external audit

The audit committee should make recommendations to the board in relation to the appointment,
reappointment and removal of the external auditor and approval of the remuneration and terms of
engagement of the external auditor.

The scope of the external audit should be reviewed by the audit committee with the auditor. The audit
committee should review, with the external auditors, the findings of their work.

The audit committee should also review the audit representation letters before obtaining signatures of
management and give particular consideration to matters where representation has been requested that
relate to non‐standard issues. Furthermore, the audit committee should review and monitor management’s
responsiveness to the external auditor’s findings and recommendations.

The audit committee should review and monitor the external auditor’s independence and objectivity and the
effectiveness of the audit process

The audit committee should develop and recommend to the board the company’s policy in relation to the
provision of non‐audit services by the auditor.

pg. 15
Laws & Regulations AAA Revision Notes

Laws and Regulations

ISA 250, Consideration of Laws and Regulations in an Audit of Financial Statements

An important part of an external audit is the consideration by the auditor as to whether the client has complied with
laws and regulations.

Let’s talk about THE ADVANCED AUDIT & ASSURANCE EXAM

The auditor needs to consider the requirements of ISA 250, which states that while it is management’s
responsibility to ensure that the entity’s operations are conducted in accordance with the provisions of laws and
regulation, the auditor does have some responsibility in relation to compliance with laws and regulations,
especially where a non‐compliance has an impact on the financial statements.

The auditor is required by ISA 315 Identifying and Assessing the Risks of Material Misstatement Through
Understanding the Entity and its Environment to gain an understanding of the legal and regulatory framework in
which the audited entity operates. This will help the auditor to identify non‐compliance and to assess the
implications of non‐compliance.

ISA 250 requires that when a non‐compliance is identified or suspected, the auditor shall obtain an
understanding of the nature of the act and the circumstances in which it has occurred, and further information
to evaluate the possible effect on the financial statements. Therefore procedures should be performed to obtain
evidence about any suspected non‐compliance.

ISA 250 requires suspected non‐compliance to be discussed with management and where appropriate with
those charged with governance.

The auditor needs to consider the potential implications for the financial statements. The non‐compliance could
lead to fines or penalties, which may need to be provided for in the financial statements.
Audit procedures should be performed to determine the amount, materiality and probability of payment of any
such fine or penalty imposed.

In terms of reporting non‐compliance to the relevant regulatory authorities, ISA 250 requires the auditor to
determine whether they have a responsibility to report the identified or suspected non‐compliance to parties
outside the entity. In the event that management or those charged with governance fail to make the necessary
disclosures to the regulatory authorities, the auditor should consider whether they should make the disclosure.
This will depend on matters including whether there is a legal duty to disclose or whether it is considered to be
in the public interest to do so.

pg. 16
Laws & Regulations AAA Revision Notes

An exam focussed overview

External auditor CANNOT prevent non‐ compliance

External auditor CANNOT detect ALL non‐compliance
External Auditor needs to fully understand the legal and regulatory environment of the client
Laws and regulations which have a direct effect on the F/s Laws and regulations which have an indirect
(i.e. they determine reported amounts and disclosures like effect on the F/s (
tax laws, pension laws, payroll) – provisions under which organisations are
allowed to conduct business .Non‐
compliance can result in fines, penalties
etc. which can have an impact on the F/S)

Examples
– relating to operational aspects ( health and
safety, equal opportunity, environmental
laws)
– ‐Financial sector‐highly regulated

External auditor has to :

1. Gather sufficient appropriate evidence regarding compliance
2. Identify instances of non‐compliance by:
– Enquiry of management that complying
– Enquiry of legal advisor
– Inspection of minutes of meetings
– Inspection of correspondence with regulatory. Licensing authorities
– Being alert when carrying out other audit procedures
– Get written representation that all suspected or identified non‐compliance has been disclosed to the
auditors and effects recorded in the F/S

Procedures when non‐compliance is suspected‐ these need to be tailored to the scenario given in the exam
1. Obtain an understanding of the nature of the act and the circumstances in which it has occurred
2. Evaluate effect on F/S ( financial consequences, double entries and disclosures)
3. Discuss with the management and ask them to provide sufficient information that the entity is complying
4. Perform audit procedures to determine the amount, materiality and probability of payment of any such fine
or penalty imposed.
5. Determine whether they have a responsibility to report the identified or suspected non‐compliance to parties
outside the entity.
6. If sufficient appropriate evidence regarding compliance is not obtained:
a) Consider effect on risk assessment that has been carried out
b) Consider effect on evaluation of client’s internal control system
c) Re‐consider the reliability of written representations obtained regarding laws and regulations ( there
may be further instances of non‐compliance)
d) Consider impact on audit opinion
e) Get legal advice if needed

pg. 17
Laws & Regulations AAA Revision Notes

The auditing standard that is relevant to this article is ISA 250, Consideration of Laws and Regulations in an Audit of
Financial Statements, and the objectives of the auditor according to paragraph 10 in ISA 250 are:

 To obtain sufficient appropriate audit evidence regarding compliance with the provisions of those laws and
regulations that have a direct effect on the determination of material amounts and disclosures in the financial
statements

 To perform specified audit procedures to help identify non‐compliance with other laws and regulations that
may have a material effect on the financial statements

 To respond appropriately to non‐compliance or suspected non‐compliance identified during the audit.

The standard defines an act of ‘non‐compliance’ as follows:

‘Acts of omission or commission by the entity, either intentional or unintentional, which are contrary to the prevailing
laws or regulations. Such acts include transactions entered into by, or in the name of, the entity, or on its behalf, by
those charged with governance, management or employees. Non‐compliance does not include personal misconduct
(unrelated to the business activities of the entity) by those charged with governance, management or employees of
the entity.’

pg. 18
Laws & Regulations AAA Revision Notes

This ISA distinguishes the auditor’s responsibilities in relation to compliance with two different categories of laws
and regulations as follows:

(a) The provisions of those laws and regulations generally (b) Other laws and regulations that do not
recognized to have a direct effect on the determination of have a direct effect on the determination
material amounts and disclosures in the financial of the amounts and disclosures in the
statements such as tax and pension laws and regulations. financial statements, but compliance with
which may be fundamental to the
operating aspects of the business, to an
entity’s ability to continue its business, or
to avoid material penalties (for example,
The auditor shall obtain sufficient appropriate audit evidence compliance with the terms of an
regarding compliance with the provisions of those laws and operating license, compliance with
regulations generally recognized to have a direct effect on the regulatory solvency requirements, or
determination of material amounts and disclosures in the compliance with environmental
financial statements regulations); non‐compliance with such
laws and regulations may therefore have
The auditor shall perform the following audit procedures to help a material effect on the financial
identify instances of non‐compliance with other laws and statements
regulations that may have a material effect on the financial
statements:
a. Inquiring of management and, where appropriate, those
charged with governance, as to whether the entity is in
compliance with such laws and regulations; and

b. Inspecting correspondence, if any, with the relevant

licensing or regulatory authorities.

During the audit, the auditor shall remain alert to the possibility
that other audit procedures applied may bring instances of non‐
compliance or suspected non‐compliance with laws and
regulations to the auditor’s attention.

The auditor shall request management and, where appropriate,

those charged with governance, to provide written
representations that all known instances of non‐compliance or
suspected non‐compliance with laws and regulations whose
effects should be considered when preparing financial
statements have been disclosed to the auditor.

Indications that non‐compliance may have occurred:

– Investigations by government departments or payment of fines or penalties
– Payment for unspecified services or loans to consultants, related parties, employees or government employees
– Sales commission or agent’s fees that appear excessive in relation to those ordinarily paid by the entity or in its
industry or to the services actually received

pg. 19
Laws & Regulations AAA Revision Notes

– Purchasing at prices significantly above or below market price

– Unusual payments in cash, purchases in the form of cashier’s checks payable to bearer or transfers to numbered
bank accounts
– Unusual transactions with companies registered in tax havens
– Payments for goods or services made other than to the country from which the goods or services originated
– Payments without proper exchange control documentation
– Existence of an information system which fails, whether by design or by accident, to provide an adequate audit
trail or sufficient evidence
– Un‐authorised transactions or improperly recorded transactions
– adverse media comment

Audit Procedures When Non‐Compliance Is Identified or Suspected

If the auditor becomes aware of information concerning an instance of non‐compliance or suspected non‐
compliance with laws and regulations, the auditor shall:

Procedures when non‐compliance is suspected‐ these need to be tailored to the scenario given in the AAA exam
1. Obtain an understanding of the nature of the act and the circumstances in which it has occurred
2. Evaluate effect on F/S ( financial consequences, double entries and disclosures)
3. Discuss with the management and ask them to provide sufficient information that the entity is complying
4. Perform audit procedures to determine the amount, materiality and probability of payment of any such fine or
penalty imposed.
5. Determine whether they have a responsibility to report the identified or suspected non‐compliance to parties
outside the entity.

If sufficient appropriate evidence regarding compliance is not obtained:

a) Consider effect on risk assessment that has been carried out
b) Consider effect on evaluation of client’s internal control system
c) Re‐consider the reliability of written representations obtained regarding laws and regulations ( there may be
further instances of non‐compliance)
d) Consider impact on audit opinion
e) Get legal advice if needed

Reporting of Identified or Suspected Non‐Compliance

The auditor shall communicate with those charged with governance matters involving non‐compliance with laws
and regulations that come to the auditor’s attention during the course of the audit.

If the auditor suspects that management or those charged with governance are involved in non‐compliance, the
auditor shall communicate the matter to the next higher level of authority at the entity, if it exists, such as an audit
committee or supervisory board.

Where no higher authority exists, or if the auditor believes that the communication may not be acted upon or is
unsure as to the person to whom to report, the auditor shall consider the need to obtain legal advice.

If the auditor concludes that the non‐compliance has a material effect on the financial statements, and has not been
adequately reflected in the financial statements, the auditor shall, in accordance with ISA 705, express a qualified
opinion or an adverse opinion on the financial statements

pg. 20
Laws & Regulations AAA Revision Notes

If the auditor is precluded by management or those charged with governance from obtaining sufficient appropriate
audit evidence to evaluate whether non‐compliance that may be material to the financial statements has, or is likely
to have, occurred, the auditor shall express a qualified opinion or disclaim an opinion on the financial statements on
the basis of a limitation on the scope of the audit in accordance with ISA 705.

Reporting Non‐Compliance to Regulatory and Enforcement Authorities

If the auditor has identified or suspects non‐compliance with laws and regulations, the auditor shall determine
whether the auditor has a responsibility to report the identified or suspected non‐compliance to parties outside the
entity.

Recognise when withdrawal from an engagement is necessary.

If the entity does not take the remedial action that the auditor considers necessary in the circumstances, even when
the non‐compliance is not material to the financial statements, the auditor may decide to withdraw from the
engagement. One of the reasons for such a decision by the auditor could be that the senior management is not
considering the auditor’s suggestions and therefore the auditor may have to reconsider the reliability of the
management and the representation given by management. However, before reaching this conclusion, the auditor
would ordinarily seek legal advice.

pg. 21
Money Laundering AAA Revision Notes

Money Laundering

Let’s talk THE ADVANCED AUDIT & ASSURANCE EXAM

Keep in mind the fact that questions in THE ADVANCED AUDIT & ASSURANCE EXAM will not always flag up that
candidates need to consider laws and regulations; the challenging nature of THE ADVANCED AUDIT &
ASSURANCE EXAM will mean that candidates will have to conclude for themselves that questions are testing a
specific subject area of the syllabus

ACCA’s Code of Ethics and Conduct defines ‘money laundering’ as:

‘...the process by which criminals attempt to conceal the true origin and ownership of the proceeds of their
criminal activity, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate
cover for their sources of income.’

Auditors need to be particularly careful where money laundering issues are concerned – especially for a business
that is predominantly cash‐based because the scope for money laundering in such businesses is wide. There are
usually three stages in money laundering:

 Placement – which is the introduction or ‘placement’ of illegal funds into a financial system.
 Layering – which is where the money is passed through a large number of transactions. This is done so that
it makes it difficult to trace the money to its original source.
 Integration – which is where the ‘dirty’ money becomes ‘clean’ as it passes back into a legitimate economy.

The steps can also be known by the terms, hide, move and invest.

Money laundering offences can include:

 Concealing criminal property
 Acquiring, using or possessing criminal property
 Becoming involved in arrangement which is known, or suspected, of facilitating the acquisition of criminal
property.

There are many countries in which money laundering is a criminal offence and, where an accountant or an
auditor discovers a situation which may give rise to money laundering, the accountant or auditor must report
such suspicions to a ‘money laundering reporting officer’ (MLRO) whose responsibility it is to report such
suspicions to an enforcement agency (in the UK, this enforcement agency is the National Crime Agency (NCA)).

It is an offence to fail to report suspicions of money laundering to NCA or the MLRO as soon as practicable, and
it is also an offence if the MLRO fails to pass on a report to the NCA. Where the entity is actively involved in
money laundering, the signs are likely to be similar to those where there is a risk of fraud, and can include:

 Complex corporate structure where complexity does not seem to be warranted

 Transactions not in the ordinary course of business
 Many large cash transactions when not expected

pg. 22
Money Laundering AAA Revision Notes

 Transactions where there is a lack of information or explanations, or where explanations are unsatisfactory,
or
 Transactions with little commercial logic taking place in the normal course of business.

TIPPING OFF
The term ‘tipping off’ means that the MLRO discloses something that will prejudice an investigation. It is an
offence to make the perpetrators of money laundering aware that the auditor has suspicions or knowledge
regarding their money laundering activities or that these suspicions or knowledge have been reported. It is
unnecessary for the auditor to gain all the facts, or to ascertain without a doubt, that an offence has occurred.
The auditor only needs to satisfy themselves that their suspicions are reasonable, and obtain sufficient evidence
to show the allegations are made in good faith.

Process of ML (explanation)
The basic money laundering process has three steps:

Placement: This is the introduction or placement of the illegal funds into the financial system. This is when cash
obtained through criminal activity is first placed into the financial system. Business owners who have illegally
obtained funds can use a cash‐intensive business to mix legitimate cash receipts from business activity with the
funds they wish to launder.

Examples include (amongst many possibilities):

– Making lots of small cash deposits in numerous bank accounts;
– Using a cash‐intensive business, such as a betting shop or a used car dealership, to disguise ‘dirty’ money as
legitimate revenue
– Purchasing a series of monetary instruments (cheques, currency exchange, money orders, etc.) that are then
collected and deposited into accounts at another location.

Layering: layering involves moving the money through various financial transactions to change its form and make it
difficult to locate the original source. Layering may involve:
– Several bank‐to‐bank transfers
– Wire transfers between different accounts in different names in different countries
– Making deposits and withdrawals so that the amount of money in the accounts varies continually
– Purchasing high value items such as diamonds to change the form of the money
– Making numerous purchases and sales of investments;
– Making fake sales between controlled companies (this can often be extremely subtle, e.g. through the use of
invoices that do involve a transfer of goods, but which exaggerate the price).

Layering conceals the audit trail and provides inscrutability.

Integration: the illegitimate funds re‐enter the legitimate economy in a legitimate form. At this stage, it becomes
very difficult to catch a launderer if there is no documentation during the previous stages, therefore launderers can
use the money without getting caught. The launderer might choose to invest the funds into real estate, luxury assets
or business ventures.

pg. 23
Money Laundering AAA Revision Notes

Methods of ML
Structuring deposits/smurfing: In this case, large amounts of money are broken down into smaller amounts so that
these appear less suspicious. These amounts are then deposited into one or more bank accounts. This may be done
either by several people (also called ‘smurfs’) or by a single person over a long time period. This method is also
known as smurfing.

Shell companies: These are bogus companies that exist solely for the purpose of money laundering. They accept
illegal money as "consideration" for goods or services. However, in reality neither good nor services are provided.

Overseas banks: Money laundering can be done by sending money through various bank accounts in certain offshore
locations / countries. These locations / countries allow anonymous banking for all purposes. Hong Kong, the
Bahamas, Bahrain, the Cayman Islands, Singapore and Panama have been identified as the major offshore centres
by the International Monetary Fund.

Alternative banking: Some countries have deep‐rooted, unconventional banking systems that enable undocumented
deposits, withdrawals and fund transfers to take place. Such banking systems operate outside the control of the
government and transact without leaving a paper trail, making it difficult to unearth the transaction that took place.

Contents of an anti‐ ML program

Appointment of Money The MLRO is a nominated officer who is responsible for receiving and evaluating
Laundering Reporting Officer reports of suspected money laundering from colleagues within the firm, and
(MLRO) making a decision as to whether further enquiry is required and if necessary
making reports to the appropriate external body. The MLRO should have an
appropriate level of seniority and experience and would usually be a senior
partner.

Main Responsibilities
– Consider internal reports of money laundering
– Decide if there are sufficient grounds for suspicion
– Prepare external report for appropriate authority when needed
– Advise the engagement team/individual on how to continue their work and
interact with the client to balance professional responsibilities, risk to the
business and legal responsibilities under the money laundering legislation (
need to ensure tipping off doesn’t take place)
– Train the firm’s employees in anti‐ML and reporting suspicion procedures
– Design and implement internal anti‐ML systems and procedures in the firm

External Report Contents

1. Full name of the reporting business
2. Identification information on each subject ( e.g. full name, date of birth,
nationality, occupation)
3. The role of each subject in the matter being reported ( suspect, victim )
4. Any bank account or transaction details ( for identification/reference)

pg. 24
Money Laundering AAA Revision Notes

5. Details of transactions or activities giving rise to suspicion or knowledge (

including amounts, dates, currencies, sources)
6. Information on the location of any laundered property
7. Any other relevant information ( for example persons associated with the
suspect)
Customer Identification This is often referred to as customer due diligence (CDD), or ‘know your client’
Procedures. (KYC) procedures.

The point of these procedures is to ensure that the firm has verified the identity
of clients (whether the client is an individual or an entity), and has obtained
evidence of that identity.

These procedures should be applied to new clients as well as existing ones.

This involves an understanding of:

– Who the client is and what they do (business/economic purpose)
– Who owns the entity
– Who controls the entity
– Client’s sources of funds

As part of the risk‐based approach, firms are expected to approach the CDD
process with a view to identifying situations which by their nature can present
a higher risk of ML. For example, a client which is a company which is owned by
an offshore trust may be considered to offer higher risk than an individual client
who is well known to you.

Examples of ‘high‐risk’ situations include:

‐ Where the new client has not been physically present for
identification purposes
‐ Where the new client is a ‘politically exposed person’ (pep) – a pep is
someone who is or has in the last year exercised a prominent public
function in a foreign country or an international body, or a family member
or known close associate of such a person. The purpose of making special
provision for PEPs is, quite clearly, to recognise the possibility that persons
holding political power may have or have had means of access to public
funds, and means of transporting them, that other citizens will not have,
and to ensure that accountants are doubly aware of the heightened risk
that such persons may consequently present.

Ongoing monitoring of the business relationship In keeping with the spirit of the
‘Know your Client’ concept, there is a need to monitor the transactions being
carried out by and on behalf of the client throughout the business relationship
– this is referred to as ‘ongoing monitoring’. The aim behind this is to enable the
accountant to remain aware of the scale and nature of the client’s business

pg. 25
Money Laundering AAA Revision Notes

affairs and to enable him to become aware of transactions which are so unusual,
in size or nature, that they might give him cause to suspect ML.

Methods of verification
Individuals – Name, Date of Birth, Residential Address

Corporate bodies – Full name, registered and trading addresses, date of

incorporation, registration details, names/address/DOBs of directors and main
shareholders, % shares held by each, annual accounts/annual return, details of
trading or current operations, tax registration details etc.

Trusts – Trust deed including name, date of establishment,

names/address/DOBs of the settlors, trustees and main beneficiaries, deed of
appointment, full details on the beneficial ownership, tax details or
arrangements etc.

Charities – Full name, date of establishment, charities registration number, key

personnel, tax details
Enhanced record keeping. Records must be kept of clients’ identity, the firm’s business relationship with
them, and details of transactions with the client. All records should be kept for
five years after the end of the business relationship or completion of the
transactions. Internal and external reports made in connection to money
laundering should also be securely kept for five years.
Communication and training. All relevant employees should receive training so that they are aware of the
main provisions of money laundering regulations, and so that they know how to
recognise and deal with activities which may be money laundering.

The training programme should be offered to all members of the firm with an
involvement in audit engagements. Training should also be provided on the
firm’s internal policies and procedures with relation to money laundering. In
particular all staff should be aware of appropriate lines of communication, and
who they should report suspicions of money laundering activities to. Training
should be considered for all staff, including support staff who do not carry out
an advisory role.
Internal controls, risk The firm should establish systems and controls to effectively manage the risk
assessment, management that the firm is exposed to in terms of money laundering activities. This could
and monitoring. include:
– Client screening procedures to minimise the risk of taking on a new client
with a high risk of money laundering activities
– Systems and controls to ensure that training is taken/attended and
understood by all relevant employees
– Systems that allow periodic testing that the firms’ policies and procedures
comply with legislative and regulatory requirements.

pg. 26
Money Laundering AAA Revision Notes

Include responsibilities
regarding ML in the
engagement letter

pg. 27
Code of Ethics for Professional Accountants AAA Revision Notes

Code of Ethics for Professional Accountants

Writing answers in AAA‐ Code of ethics

With regards to objectivity and independence, the general conceptual approach in the codes is as follows:
1. Identify threats to independence.
2. Evaluate the significance of the threats identified (its implication), and
3. Course of action:
 Apply safeguards, when necessary, to eliminate the threats or reduce them to an acceptable level;
 If not possible, eliminate the circumstance or relationship creating the threats or decline or terminate the
audit engagement.

A professional accountant shall comply with the following fundamental principles:

(a) Integrity – to be A professional accountant shall not knowingly be associated with reports, returns,
straightforward and communications or other information where the professional accountant believes
honest in all that the information:
professional and (a) Contains a materially false or misleading statement;
business relationships.
(b) Contains statements or information furnished recklessly; or
(c) Omits or obscures information required to be included where such omission
or obscurity would be misleading.
(b) Objectivity – to not A professional accountant may be exposed to situations that may impair
allow bias, conflict of objectivity. It is impracticable to define and prescribe all such situations. A
interest or undue professional accountant shall not perform a professional service if a circumstance
influence of others to or relationship biases or unduly influences the accountant’s professional judgment
override professional or with respect to that service.
business judgments
(c) Professional The principle of professional competence and due care imposes the following
Competence and Due obligations on all professional accountants:
Care – to maintain (a) To maintain professional knowledge and skill at the level required to ensure
professional knowledge that clients or employers receive competent professional service;
and skill at the level and
required to ensure that (b) To act diligently in accordance with applicable technical and professional
a client or employer standards when providing professional services.
receives competent
professional services Competent professional service requires the exercise of sound judgment in
based on current applying professional knowledge and skill in the performance of such service.
developments in Professional competence may be divided into two separate phases:
practice, legislation and (a) Attainment of professional competence; and
techniques and act (b) Maintenance of professional competence.
diligently and in
accordance with
applicable technical and
professional standards.

pg. 28
Code of Ethics for Professional Accountants AAA Revision Notes

(d) Confidentiality – to The principle of confidentiality imposes an obligation on all professional

respect the accountants to refrain from:
confidentiality of (a) Disclosing outside the firm or employing organization confidential
information acquired as information acquired as a result of professional and business relationships
a result of professional without proper and specific authority or unless there is a legal or professional
and business right or duty to disclose; and
relationships and, (b) Using confidential information acquired as a result of professional and
therefore, not disclose business relationships
any such information to
third parties without The following are circumstances where professional accountants are or may be
proper and specific required to disclose confidential information or when such disclosure may be
authority, unless there is appropriate:
a legal or professional (a) Disclosure is permitted by law and is authorized by the client or the employer;
right or duty to disclose, (b) Disclosure is required by law, for example:
nor use the information (i) Production of documents or other provision of evidence in the
for the personal course of legal proceedings; or
advantage of the (ii) Disclosure to the appropriate public authorities of infringements of
professional accountant the law that come to light; and by law:
or third parties. (i) To comply with the quality review of a member body or professional
body;
(ii) To respond to an inquiry or investigation by a member body or
regulatory body;
(iii) To protect the professional interests of a professional accountant in
legal proceedings; or
(iv) To comply with technical standards and ethics requirements.

In deciding whether to disclose confidential information, relevant factors to

consider include:
 Whether the interests of all parties, including third parties whose interests
may be affected, could be harmed if the client or employer consents to the
disclosure of information by the professional accountant.
 Whether all the relevant information is known and substantiated, to the
extent it is practicable; when the situation involves unsubstantiated facts,
incomplete information or unsubstantiated conclusions, professional
judgment shall be used in determining the type of disclosure to be made, if
any.
 The type of communication that is expected and to whom it is addressed.
 Whether the parties to whom the communication is addressed are
appropriate recipients.

pg. 29
Code of Ethics for Professional Accountants AAA Revision Notes

(e) Professional Behavior – The principle of professional behavior imposes an obligation on all professional
to comply with relevant accountants to comply with relevant laws and regulations and avoid any action
laws and regulations that the professional accountant knows or should know may discredit the
and avoid any action profession. This includes actions that a reasonable and informed third party,
that discredits the weighing all the specific facts and circumstances available to the professional
profession. accountant at that time, would be likely to conclude adversely affects the good
reputation of the profession.

In marketing and promoting themselves and their work, professional accountants

shall not bring the profession into disrepute. Professional accountants shall be
honest and truthful and not:
(a) Make exaggerated claims for the services they are able to offer, the
qualifications they possess, or experience they have gained; or
(b) Make disparaging references or unsubstantiated comparisons to the work of
others.

Threats
a) Self‐interest threat – the threat that a financial or other interest will inappropriately influence the professional
accountant’s judgment or behavior;
b) Self‐review threat – the threat that a professional accountant will not appropriately evaluate the results of a
previous judgment made or service performed by the professional accountant, or by another individual within
the professional accountant’s firm or employing organization, on which the accountant will rely when forming
a judgment as part of providing a current service;
c) Advocacy threat – the threat that a professional accountant will promote a client’s or employer’s position to
the point that the professional accountant’s objectivity is compromised;
d) Familiarity threat ‐ the threat that due to a long or close relationship with a client or employer, a professional
accountant will be too sympathetic to their interests or too accepting of their work; and
e) Intimidation threat – the threat that a professional accountant will be deterred from acting objectively because
of actual or perceived pressures, including attempts to exercise undue influence over the professional
accountant.

Conflicts of Interest
(Firm competes with client or firm has a joint venture with a competitor of a client or the firm has competitors as
clients)

A professional accountant in public practice shall take reasonable steps to identify circumstances that could pose
a conflict of interest. Such circumstances may create threats to compliance with the fundamental principles. For
example, a threat to objectivity may be created when a professional accountant in public practice competes
directly with a client or has a joint venture or similar arrangement with a major competitor of a client.

A threat to objectivity or confidentiality may also be created when a professional accountant in public practice
performs services for clients whose interests are in conflict or the clients are in dispute with each other in relation
to the matter or transaction in question.

pg. 30
Code of Ethics for Professional Accountants AAA Revision Notes

Application of one of the following safeguards is generally necessary:

(a) Notifying the client of the firm’s business interest or activities that may represent a conflict of interest and
obtaining their consent to act in such circumstances; or
(b) Notifying all known relevant parties that the professional accountant in public practice is acting for two or
more parties in respect of a matter where their respective interests are in conflict and obtaining their consent
to so act; or
(c) Notifying the client that the professional accountant in public practice does not act exclusively for any one
client in the provision of proposed services (for example, in a particular market sector or with respect to a
specific service) and obtaining their consent to so act.

The professional accountant shall also determine whether to apply one or more of the following additional
safeguards:
(a) The use of separate engagement teams;
(b) Procedures to prevent access to information (for example, strict physical separation of such teams,
confidential and secure data filing);
(c) Clear guidelines for members of the engagement team on issues of security and confidentiality;
(d) The use of confidentiality agreements signed by employees and partners of the firm; and
(e) Regular review of the application of safeguards by a senior individual not involved with relevant client
engagements.

Second Opinions
Situations where a professional accountant in public practice is asked to provide a second opinion on the
application of accounting, auditing, reporting or other standards or principles to specific circumstances or
transactions by or on behalf of a company or an entity that is not an existing client may create threats to
compliance with the fundamental principles.

For example, there may be a threat to professional competence and due care in circumstances where the second
opinion is not based on the same set of facts that were made available to the existing accountant or is based on
inadequate evidence. The existence and significance of any threat will depend on the circumstances of the request
and all the other available facts and assumptions relevant to the expression of a professional judgment.

When asked to provide such an opinion, a professional accountant in public practice shall evaluate the significance
of any threats and apply safeguards when necessary to eliminate them or reduce them to an acceptable level.

Examples of such safeguards include seeking client permission to contact the existing accountant, describing the
limitations surrounding any opinion in communications with the client and providing the existing accountant with
a copy of the opinion.

If the company or entity seeking the opinion will not permit communication with the existing accountant, a
professional accountant in public practice shall determine whether, taking all the circumstances into account, it
is appropriate to provide the opinion sought.

pg. 31
Code of Ethics for Professional Accountants AAA Revision Notes

Key threats and safeguards‐summary

‐ The basic ethical standards at this level are the same as those examined previously in F8; what sets apart the
level of the questions is your ability to apply those standards to more complex situations and show that you
understand both threats and safeguards.

‐ Often the marks for this area will be spread over more than one question and may be combined with
planning, professional issues or as a standalone!

Writing answers in the exam

Identify threats: Words from the case;

Principle or threat name;

Principle of threat explanation;

Comment on the significance of threat;

Safeguard.

Terms used in the code for the firm: professional accountant in public practice
QCR = Quality Control Review
Independence of mind: the state of mind that permits the provision of an opinion without being affected by
influences that compromise professional judgment, allowing an individual to act with integrity, and exercise
objectivity and professional skepticism.

Independence in appearance: the avoidance of facts and circumstances that are so significant that a reasonable and
informed third party, having knowledge of all relevant information, including any safeguards applied, would
reasonably conclude a firms, or a member of the assurance team’s, integrity, objectivity or professional skepticism
had been compromised.

Public interest entities are:

(a) All listed entities; and
(b) Any entity:
(i) Defined by regulation or legislation as a public interest entity; or
(ii) For which the audit is required by regulation or legislation to be conducted in compliance with the
same independence requirements that apply to the audit of listed entities. Such regulation may be
circulated by any relevant regulator, including an audit regulator.

pg. 32
Code of Ethics for Professional Accountants AAA Revision Notes

Actual or threatened litigation by client ‐ If the litigation involves a member of the audit team,
removing that individual from the audit team; or Having a
(self‐interest, intimidation: firm will be professional review the work performed.
worried about bad publicity, loss of client,
being proved negligent) ‐ If such safeguards do not reduce the threats to an
acceptable level, the only appropriate action is to withdraw
from, or decline, the audit engagement.
When litigation takes place, or appears likely,
between the firm or a member of the audit
team and the audit client
Gifts and hospitality ‐ Not allowed unless trivial
(self‐interest, familiarity, intimidation)
The existence and significance of any threat will depend on the
nature, value, and intent of the offer.

Where gifts or hospitality are offered that a reasonable and

informed third party, weighing all the specific facts and
circumstances, would consider trivial and inconsequential, a
professional accountant in public practice may conclude that the
offer is made in the normal course of business without the
specific intent to influence decision making or to obtain
information.
Compensation and evaluation: team ‐ Partner not allowed
member compensated for or evaluated on ‐ Other senior team member and compensation is material,
selling non‐assurance services to an audit remove
client (self‐interest) ‐ QCR

A self‐interest threat is created when a member of the audit

team is evaluated on or compensated for selling non‐assurance
services to that audit client.

The significance of the threat will depend on:

 The proportion of the individual’s compensation or
performance evaluation that is based on the sale of such
services;
 The role of the individual on the audit team; and
 Whether promotion decisions are influenced by the sale of
such services.

The significance of the threat shall be evaluated and, if the

threat is not at an acceptable level, the firm shall either revise
the compensation plan or evaluation process for that individual
or apply safeguards to eliminate the threat or reduce it to an
acceptable level.

pg. 33
Code of Ethics for Professional Accountants AAA Revision Notes

Examples of such safeguards include:

 Removing such members from the audit team; or
 Having a professional accountant review the work of the
member of the audit team.

A key audit partner shall not be evaluated on or compensated

based on that partner’s success in selling non‐assurance services
to the partner’s audit client. This is not intended to prohibit
normal profit‐sharing arrangements between partners of a firm.
Fee dependence Public interest clients:
( self interest and intimidation) If gross recurring fee from one client greater than 15% of the
firm’s revenue for two consecutive years,
‐ Tell client’s TCWG
‐ Independent QCR or external QCR before OR after issuing
2nd year’s opinion

Other clients:
‐ Reducing the dependency on the client;
‐ External quality control reviews; or
‐ Consulting a third party, such as a professional regulatory
body or a professional accountant, on key audit judgments.

Audit Clients that are Public Interest Entities (explained)

Where an audit client is a public interest entity and, for two

consecutive years, the total fees from the client and its related
entities represent more than 15% of the total fees received by
the firm expressing the opinion on the financial statements of
the client, the firm shall disclose to those charged with
governance of the audit client the fact that the total of such fees
represents more than 15% of the total fees received by the firm,
and discuss which of the safeguards below it will apply to reduce
the threat to an acceptable level, and apply the selected
safeguard:
 Prior to the issuance of the audit opinion on the second
year’s financial statements, a professional accountant, who
is not a member of the firm expressing the opinion on the
financial statements, performs an engagement quality
control review of that engagement or a professional
regulatory body performs a review of that engagement that
is equivalent to an engagement quality control review (“a
pre‐issuance review”); or

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Code of Ethics for Professional Accountants AAA Revision Notes

 After the audit opinion on the second year’s financial

statements has been issued, and before the issuance of the
audit opinion on the third year’s financial statements, a
professional accountant, who is not a member of the firm
expressing the opinion on the financial statements, or a
professional regulatory body performs a review of the
second year’s audit that is equivalent to an engagement
quality control review (“a post‐issuance review”).

When the total fees significantly exceed 15%, the firm shall
determine whether the significance of the threat is such that a
post‐issuance review issuance review is required. In such
circumstances a pre‐issuance review shall be performed.

Thereafter, when the fees continue to exceed 15% each year,

the disclosure to and discussion with those charged with
governance shall occur and one of the above safeguards shall be
applied. If the fees significantly exceed 15%, the firm shall
determine whether the significance of the threat is such that a
post‐issuance review would not reduce the threat to an
acceptable level and, therefore, a pre‐issuance review is
required. In such circumstances a pre‐issuance review shall be
performed.

Referral fee or commission Examples of safeguards include:

For example, where the professional  Disclosing to the client any arrangements to pay a referral
accountant in public practice does not provide fee to another professional accountant for the work
the specific service required, a fee may be referred;
received for referring a continuing client to  Disclosing to the client any arrangements to receive a
another professional accountant in public referral fee for referring the client to another professional
practice or other expert. accountant in public practice; or
 Obtaining advance agreement from the client for
A professional accountant in public practice commission arrangements in connection with the sale by a
may receive a commission from a third party third party of goods or services to the client.
(for example, a software vendor) in
connection with the sale of goods or services
to a client. Accepting such a referral fee or
commission creates a self‐interest threat to
objectivity and professional competence and
due care.

A professional accountant in public practice

may also pay a referral fee to obtain a client,
for example, where the client continues as a
client of another professional accountant in
public practice but requires specialist services

pg. 35
Code of Ethics for Professional Accountants AAA Revision Notes

not offered by the existing accountant. The

payment of such a referral fee also creates a
self‐interest threat to objectivity and
professional competence and due care.
Overdue fee: Perceived as a loan to the client ‐ QCR
(self‐interest, intimidation) ‐ At least partial recovery or recovery plan before starting
new work

THE ADVANCED AUDIT & ASSURANCE EXAM: also means your

firm’s credit control procedures are weak!

An additional professional accountant who did not take part in

the audit engagement provide advice or review the work
performed. The firm shall determine whether the overdue fees
might be regarded as being equivalent to a loan to the client and
whether, because of the significance of the overdue fees, it is
appropriate for the firm to be reappointed or continue the audit
engagement.
Contingent fee: Contingent fees are fees ‐ Not permitted for audit
calculated on a predetermined basis relating ‐ Contingent fees are widely used for certain types of non‐
to the outcome of a transaction or the result assurance engagements.
of the services performed by the firm.
Examples of safeguards include:
 An advance written agreement with the client as to the
(self‐interest, advocacy) basis of remuneration;
 Disclosure to intended users of the work performed by the
professional accountant in public practice and the basis of
remuneration;
 Quality control policies and procedures; or
 Review by an independent third party of the work
performed by the professional accountant in public
practice.
Serving as a Director or Officer of an Audit ‐ No allowed.
Client ‐ Particular reference made by the code to the role of the
Company Secretary. If allowed under local laws or
(self‐interest, self‐review) professional rules, the duties and activities shall be limited
to those of a routine and administrative nature, such as
preparing minutes and maintaining statutory returns.
Long Association of Senior Personnel The significance of the threats will depend on factors such as:
(Including Partner  How long the individual has been a member of the audit
Rotation) with an Audit Client team;
 The role of the individual on the audit team;
Familiarity and self‐interest  The structure of the firm;
 The nature of the audit engagement;
 Whether the client’s management team has changed; and

pg. 36
Code of Ethics for Professional Accountants AAA Revision Notes

 Whether the nature or complexity of the client’s accounting

and reporting issues has changed.

Examples of safeguards include:

 Rotating the senior personnel off the audit team;
 Having a professional accountant who was not a member of
the audit team review the work of the senior personnel; or
 Regular independent internal or external quality reviews of
the engagement.

Audit Clients that are Public Interest Entities

In respect of an audit of a public interest entity, an individual
shall not be a key audit partner for more than seven years.

A key audit partner may remain on the audit team for up to one
additional year in circumstances where, due to unforeseen
events, a required rotation was not possible, as might be the
case due to serious illness of the intended engagement partner

After such time, the individual shall not be a member of the

engagement team or be a key audit partner for the client for two
years.

When an audit client becomes a public interest entity, the length

of time the individual has served the audit client as a key audit
partner before the client becomes a public interest entity shall
be taken into account in determining the timing of the rotation.
Recent Service with an Audit Client If employed during the period for which the audit is being done‐
Self‐interest, self‐review or familiarity threats no safeguard possible.

If, before the period covered by the audit report, existence and
significance of any threats will depend on factors such as: The
position the individual held with the client; The length of time
since the individual left the client; and The role of the
professional on the audit team.
Safeguard: review of work done by him

Temporary Staff Assignments Such assistance may be given, but only for a short period of time
and the firm’s personnel shall not be involved in:
lending of staff by a firm to an audit client may (a) Providing non‐assurance services that would not be
create a self‐review threat permitted under this section; or
(b) Assuming management responsibilities.

pg. 37
Code of Ethics for Professional Accountants AAA Revision Notes

In all circumstances, the audit client shall be responsible for

directing and supervising the activities of the loaned staff.
Examples of such include:
 Conducting an additional review of the work performed by
the loaned staff;
 Not giving the loaned staff audit responsibility for any
function or activity that the staff performed during the
temporary staff assignment; or
‐ Not including the loaned staff as a member of the audit
team.
Employment with an audit client: the director Ex‐firm member now at the client and significant connection
or a senior member of the audit client has remains between the firm and the individual‐ no safeguard
been a member of the audit team or partner acceptable
of the firm in the past
Otherwise:
(self‐interest, familiarity, intimidation)  Modifying the audit plan;
 Assigning individuals to the audit team who have sufficient
experience in relation to the individual who has joined the
client; or
 Having a professional accountant review the work of the
former member of the audit team.

For public interest entities, a 12 month gap is required.

Considering a job offer at the client

A self‐interest threat is created when a member of the audit

team participates in the audit engagement while knowing that
the member of the audit team will, or may, join the client
sometime in the future. Firm policies and procedures shall
require members of an audit team to notify the firm when
entering employment negotiations with the client. On receiving
such notification, the significance of the threat shall be
evaluated and safeguards applied when necessary to eliminate
the threat or reduce it to an acceptable level. Examples of such
safeguards include:
‐ Removing the individual from the audit team; or
‐ A review of any significant judgments made by that
individual while on the team.
Family and personal relationship The existence and significance of any threats will depend on a
(self‐interest, familiarity, intimidation) number of factors, including the individual’s responsibilities on
the audit team, the role of the family member or other individual
within the client and the closeness of the relationship.

pg. 38
Code of Ethics for Professional Accountants AAA Revision Notes

If a director or an employee in a position to exert significant

influence over the preparation of the client’s accounting records
or the financial statements on which the firm will express an
opinion, ‐ no safeguard acceptable

Otherwise:
Removing the individual from the audit team; or Structuring the
responsibilities of the audit team so that the professional does
not deal with matters that are within the responsibility of the
immediate family member.
Business relationship Commercial relationship or common financial interest:
 Having a financial interest in a joint venture with either the
client or a controlling owner, director, officer or other
(self‐interest, intimidation due to actual or individual who performs senior managerial activities for
perceived pressure about losing the audit that client.
assignment)  Arrangements to combine one or more services or products
of the firm with one or more services or products of the
‐ Commercial relationship client and to market the package with reference to both
‐ Common financial interest parties.
 Distribution or marketing arrangements under which the
Examples: joint venture with the client or a firm distributes or markets the client’s products or services,
controlling owner/ director, formal marketing or the client distributes or markets the firm’s products or
of each other’s product, combine the services services.
of the firm with those being offered by client
and market the package If material, no safeguard acceptable.

The purchase of goods and services from an audit client by the

firm, or a member of the audit team, or a member of that
individual’s immediate family, does not generally create a threat
to independence if the transaction is in the normal course of
business and at arm’s length. However, such transactions may
be of such a nature or magnitude that they create a self‐interest
threat. The significance of any threat shall be evaluated and
safeguards applied when necessary to eliminate the threat or
reduce it to an acceptable level. Examples of such safeguards
include:
 Eliminating or reducing the magnitude of the transaction; or
 Removing the individual from the audit team.
Loans and Guarantees (team member, his If not under normal lending conditions, no safeguard acceptable
immediate family, or firm)
If under normal lending conditions‐ review by network firm
Self interest
Financial interest ( self‐interest, intimidation) Direct financial interest: has control over the investment vehicle:
Team member or immediate family, other partners or
immediate family have direct financial interest‐ no safeguard

pg. 39
Code of Ethics for Professional Accountants AAA Revision Notes

Holding a financial interest in an audit client Close family of team member‐ review of work or removal from
may create a self‐interest threat. The team:
existence and significance of any threat Team member and director of client have a financial interest in
created depends on: another company‐ review of work or removal from team
(a) The role of the person holding the
financial interest, If a firm or a partner or employee of the firm, or a member of
(b) Whether the financial interest is direct or that individual’s immediate family, receives a direct financial
indirect, and interest or a material indirect financial interest in an audit client,
(c) The materiality of the financial interest. for example, by way of an inheritance, gift or as a result of a
merger and such interest would not be permitted to be held
under this section, then:
(a) If the interest is received by the firm, the financial interest
shall be disposed of immediately, or a sufficient amount of
an indirect financial interest shall be disposed of so that the
remaining interest is no longer material;
(b) If the interest is received by a member of the audit team, or
a member of that individual’s immediate family, the
individual who received the financial interest shall
immediately dispose of the financial interest, or dispose of
a sufficient amount of an indirect financial interest so that
the remaining interest is no longer material; or
(c) If the interest is received by an individual who is not a
member of the audit team, or by an immediate family
member of the individual, the financial interest shall be
disposed of as soon as possible, or a sufficient amount of an
indirect financial interest shall be disposed of so that the
remaining interest is no longer material. Pending the
disposal of the financial interest, a determination shall be
made as to whether any safeguards are necessary.

Custody of Client Assets A professional accountant in public practice entrusted with

(Custodial services: documents, assets kept for money (or other assets) belonging to others shall therefore:
a fee) (a) Keep such assets separately from personal or firm assets;
(b) Use such assets only for the purpose for which they are
A professional accountant in public practice intended;
shall not assume custody of client monies or (c) At all times be ready to account for those assets and any
other assets unless permitted to do so by law income, dividends, or gains generated, to any persons
and, if so, in compliance with any additional entitled to such accounting; and
legal duties imposed on a professional (d) Comply with all relevant laws and regulations relevant to
accountant in public practice holding such the holding of and accounting for such assets.
assets.
As part of client and engagement acceptance procedures for
The holding of client assets creates threats to services that may involve the holding of client assets, a
compliance with the fundamental principles; professional accountant in public practice shall make
for example, there is a self‐interest threat to appropriate inquiries about the source of such assets and
professional behavior and may be a self‐ consider legal and regulatory obligations. For example, if the

pg. 40
Code of Ethics for Professional Accountants AAA Revision Notes

interest threat to objectivity arising from assets were derived from illegal activities, such as money
holding client assets. laundering, a threat to compliance with the fundamental
principles would be created. In such situations, the professional
accountant may consider seeking legal advice.

Provision of Non‐assurance Services to an Audit Client

Self‐review, self‐interest and advocacy threats.

Firms have traditionally provided to their audit clients a range of non‐assurance services that are consistent with
their skills and expertise.

Providing non‐assurance services may, however, create threats to the independence of the firm or members of
the audit team. The threats created are most often self‐review, self‐interest and advocacy threats.

New developments in business, the evolution of financial markets and changes in information technology make
it impossible to draw up an all‐inclusive list of non‐assurance services that might be provided to an audit client.

Before the firm accepts an engagement to provide a non‐assurance service to an audit client, a determination
shall be made as to whether providing such a service would create a threat to independence. In evaluating the
significance of any threat created by a particular non‐assurance service, consideration shall be given to any threat
that the audit team has reason to believe is created by providing other related non‐assurance services. If a threat
is created that cannot be reduced to an acceptable level by the application of safeguards, the non‐assurance
service shall not be provided.
a) Management responsibility involve Okay If not related to decision making ( eg routine and
leading and directing an entity, including administrative like filing returns)
making significant decisions regarding the
acquisition, deployment and control of Examples of activities that would generally be considered a
human, financial, physical and intangible management responsibility include:
resources.  Setting policies and strategic direction;
 Directing and taking responsibility for the actions of the
entity’s employees;
 Authorizing transactions;
 Deciding which recommendations of the firm or other third
parties to implement;
 Taking responsibility for the preparation and fair
presentation of the financial statements in accordance with
the applicable financial reporting framework; and
 Taking responsibility for designing, implementing and
maintaining internal control.

Activities that are routine and administrative, or involve matters

that are insignificant, generally are deemed not to be a
management responsibility.

pg. 41
Code of Ethics for Professional Accountants AAA Revision Notes

For example, executing an insignificant transaction that has

been authorized by management or monitoring the dates for
filing statutory returns and advising an audit client of those
dates is deemed not to be a management responsibility. Further,
providing advice and recommendations to assist management in
discharging its responsibilities is not assuming a management
responsibility.
b) Prepare f/s ‐ public interest: not allowed
‐ pvt: segregation of teams, QCR

Preparing Accounting Records and Financial Statements

Audit clients that are not public interest entities

The firm may provide services related to the preparation of

accounting records and financial statements to an audit client
that is not a public interest entity where the services are of a
routine or mechanical nature, so long as any self‐review threat
created is reduced to an acceptable level.

Examples of such services include:

 Providing payroll services based on client‐originated data;
 Recording transactions for which the client has determined
or approved the appropriate account classification;
 Posting transactions coded by the client to the general
ledger;
 Posting client‐approved entries to the trial balance; and
 Preparing financial statements based on information in the
trial balance.

Examples of safeguards include:

 Arranging for such services to be performed by an individual
who is not a member of the audit team; or
 If such services are performed by a member of the audit
team, using a partner or senior staff member with
appropriate expertise who is not a member of the audit
team to review the work performed

Audit clients that are public interest entities

Except in emergency situations, a firm shall not provide to an

audit client that is a public interest entity accounting and
bookkeeping services, including payroll services, or prepare
financial statements on which the firm will express an opinion or
financial information which forms the basis of the financial
statements.

pg. 42
Code of Ethics for Professional Accountants AAA Revision Notes

c) Valuation Normally not allowed it material effect on F/s.

Certain valuations do not involve a significant degree of

subjectivity. This is likely the case where the underlying
assumptions are either established by law or regulation, or are
widely accepted and when the techniques and methodologies to
be used are based on generally accepted standards or
prescribed by law or regulation. In such circumstances, the
results of a valuation performed by two or more parties are not
likely to be materially different.
d) Internal audit ‐ Public interest: no for ICS over financial reporting
‐ Pvt: segregation of teams, Board should acknowledge
responsibility for establishing and monitoring ICS

To avoid assuming a management responsibility, the firm shall

only provide internal audit services to an audit client if it is
satisfied that:
(a) The client designates an appropriate and competent
resource, preferably within senior management, to be
responsible at all times for internal audit activities and to
acknowledge responsibility for designing, implementing,
and maintaining internal control;
(b) The client’s management or those charged with governance
reviews, assesses and approves the scope, risk and
frequency of the internal audit services;
(c) The client’s management evaluates the adequacy of the
internal audit services and the findings resulting from their
performance;
(d) The client’s management evaluates and determines which
recommendations resulting from internal audit services to
implement and manages the implementation process; and
(e) The client’s management reports to those charged with
governance the significant findings and recommendations
resulting from the internal audit services.

Audit clients that are public interest entities

In the case of an audit client that is a public interest entity, a firm

shall not provide internal audit services that relate to:
(a) A significant part of the internal controls over financial
reporting;
(b) Financial accounting systems that generate information
that is, separately or in the aggregate, significant to the
client’s accounting records or financial statements on which
the firm will express an opinion; or

pg. 43
Code of Ethics for Professional Accountants AAA Revision Notes

(c) Amounts or disclosures that are, separately or in the

aggregate, material to the financial statements on which
the firm will express an opinion.
e) IT systems ‐ Public interest: no if related to financial reporting
‐ Pvt: segregation of teams, Board should acknowledge
responsibility for establishing and monitoring ICS

In the case of an audit client that is a public interest entity, a firm

shall not provide services involving the design or
implementation of IT systems that
(a) Form a significant part of the internal control over financial
reporting or
(b) Generate information that is significant to the client’s
accounting records or financial statements on which the
firm will express an opinion.

Otherwise:
(a) The client acknowledges its responsibility for establishing
and monitoring a system of internal controls;

(b) The client assigns the responsibility to make all

management decisions with respect to the design and
implementation of the hardware or software system to a
competent employee, preferably within senior
management;
(c) The client makes all management decisions with respect to
the design and implementation process;
(d) The client evaluates the adequacy and results of the design
and implementation of the system; and
(e) The client is responsible for operating the system (hardware
or software) and for the data it uses or generates.

pg. 44
Code of Ethics for Professional Accountants AAA Revision Notes

f) Recruiting services (self‐interest ‐ Public interest: not allowed for directors or senior
regarding the quality of shortlisted positions related to f/s preparation
candidates, familiarity and intimidation as ‐ Otherwise, final decision should be by the client and DO
won’t criticize the person firm has NOT negotiate on the client’s behalf
recommended)
The significance of any threat created shall be evaluated and
safeguards applied when necessary to eliminate the threat or
reduce it to an acceptable level. In all cases, the firm shall not
assume management responsibilities, including acting as a
negotiator on the client’s behalf, and the hiring decision shall be
left to the client.

The firm may generally provide such services as reviewing the

professional qualifications of a number of applicants and
providing advice on their suitability for the post. In addition, the
firm may interview candidates and advice on a candidate’s
competence for financial accounting, administrative or control
positions.

Audit clients that are public interest entities

A firm shall not provide the following recruiting services to an

audit client that is a public interest entity with respect to a
director or officer of the entity or senior management in a
position to exert significant influence over the preparation of
the client’s accounting records or the financial statements on
which the firm will express an opinion:
 Searching for or seeking out candidates for such positions;
and
 Undertaking reference checks of prospective candidates for
such positions.
g) Corporate finance services Not allowed to promote shares, deal in shares or underwrite
Providing corporate finance services such shares
as:
 Assisting an audit client in developing For other services like advice In raising finance, identifying
corporate strategies; Identifying possible targets for acquisition etc.:
possible targets for the audit client to ‐ Using professionals who are not members of the audit team
acquire; to provide the services; or
 Advising on disposal transactions; ‐ Having a professional who was not involved in providing
 Assisting finance raising transactions; the corporate finance service advise the audit team on the
and service and review the accounting treatment and any
 Providing structuring advice, financial statement treatment.

pg. 45
Code of Ethics for Professional Accountants AAA Revision Notes

h) Taxation Tax return preparation: okay if management takes responsibility

for the return Calculation for accounting entries: not allowed for
public interest entities Tax planning: okay if supported by tax
authorities/ precedent Tax disputes resolution: not
recommended if raltes to a material areas and if the subject of
dispute is a service given by the firm, otherwise, segregation of
teams, external tax professional advice should be taken
i) Litigation Support Services Litigation support services may include activities such as acting
as an expert witness, calculating estimated damages or other
amounts that might become receivable or payable as the result
of litigation or other legal dispute, and assistance with
document management and retrieval. These services may
create a self‐review or advocacy threat.

If significant, same safeguards as valuation services

Generic intimidation examples‐

‐ Being asked to reduce extent of work to reduce fee
‐ Team members feels pressured to agree with client’s judgment as client has more expertise
Advocacy examples
Legal services(eg expert witness), corporate finance work like negotiating with banks on client’s behalf, contingent
fee

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Code of Ethics for Professional Accountants AAA Revision Notes

Technical Article: EXAM Techniques

Ethical standards and their application form a major part of the Advanced Audit and Assurance syllabus and are
examined regularly. Often the marks for this area will be spread over more than one question and may be combined
with planning, professional issues or as a standalone.

The basic ethical standards at this level are the same as those examined previously in Audit and Assurance; what
sets apart the level of the questions is your ability to apply those standards to more complex situations and show
that you understand both threats and safeguards. This is an area of the exam where candidates can use good exam
technique to increase the marks attained without having to rote learn much additional information above that learnt
for previous exams.

This article will demonstrate how to maximise marks on these areas using good technique. It is, however, specific to
the context of auditing and assurance and will therefore have a different focus and application to the way ethics is
examined in other areas of the ACCA Qualification.

WHAT YOU NEED TO KNOW

The starting point for preparing for any exam is to know the underlying knowledge that is required for this part of
the syllabus. At this level the content of the guidance is what you should focus on. Marks are not awarded for
memorising or quoting standard numbers, it is the application of the content of those standards that is important.
For the Advanced Audit and Assurance exam the following standards are examinable:
 ACCA’s Code of Ethics and Conduct (2016)
 IESBA’s Code of Ethics for Professional Accountants (Revised May 2015)
 IESBA–Changes to the Code Addressing Certain Non‐Assurance Services Provisions for Audit and Assurance
Clients Ethical Considerations Relating to Audit Fee Setting in the Context of Downward Fee Pressure (January
2016)

In addition, for the UK exam candidates will be examined on the Financial Reporting Council’s Revised Ethical
Standard 2016, for the IRL exam candidates will be tested on the IAASA’s Ethical Standard for Auditors (Ireland)
2016, and SGP candidates should also refer to the ISCA Code of Professional Conduct and Ethics (Revised November
2015).

You will be familiar with ACCA’s Code of Ethics from the Audit and Assurance exam. This mirrors the IESBA’s Code of
Ethics so you will be familiar with the five basic principles of Integrity, Objectivity, Professional Competence and Due
Care, Confidentiality, and Professional Behaviour. You will also be familiar with the general areas of threat to the
fundamental principles of Self Review, Self Interest, Advocacy, Familiarity, and Intimidation.

The situations you will be appraising at this level will usually involve an assessment of those same principles within
scenarios given in the question. In addition, you may be expected to identify situations where the auditor is at risk
of assuming a management responsibility with respect to providing additional services to audit clients or appreciate
the differences between listed (or other public interest entities) and non‐listed clients when it comes to applying
these principles.

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Code of Ethics for Professional Accountants AAA Revision Notes

With regards to objectivity and independence, the general conceptual approach in the codes is as follows:
(a) Identify threats to independence
(b) Evaluate the significance of the threats identified, and
(c) Apply safeguards, when necessary, to eliminate the threats or reduce them to an acceptable level.

When the professional accountant determines that appropriate safeguards are not available or cannot be applied
to eliminate the threats or reduce them to an acceptable level, the professional accountant shall eliminate the
circumstance or relationship creating the threats or decline or terminate the audit engagement.

HOW TO APPLY THE KNOWLEDGE

When addressing ethical situations in the exam, you will usually have to demonstrate these skills:
1. That you can identify an ethical threat
2. That you understand how it arises and the implication of the threat, and
3. That you can relate the guidance to the specific scenario to determine the safeguards or course of action
required.

Each of these skills can be illustrated through the examples below (note that the answers provided here are focusing
on the ethical issues arising and do not cover the professional or other issues you might also need to discuss arising
from the scenarios). These answers are not fully comprehensive and give an example of the content which could be
produced in an exam. There are further points in each case that could be developed and additional outcomes
available within the ethical codes; however, they do represent a well‐developed answer a candidate could use to
attain the full marks available.

Example 1
The audit committee of, Mumbai Co, has asked the partner to consider whether it would be possible for the audit
team to perform a review of the company’s internal control system. A number of recent incidents have raised
concerns amongst the management team that controls have deteriorated and that this has increased the risk of
fraud, as well as inefficient commercial practices. The auditor’s report for the audit of the financial statements of
Mumbai Co for the year ended 31 March 2016 was signed a few weeks ago. Mumbai Co is a listed company.

Required:
Comment on the ethical issues raised and the actions your firm should take in response to the client’s request.
(6 marks)

In this example, we are asked to provide an additional service to an audit client – a review of systems and controls.
This is going to give rise to a self‐review threat and may possibly lead to assuming a management responsibility. This
identification is the first step to answering the question, but these points alone will not score credit in the exam until
you have developed them. In order to do this you can use the steps described to build up marks as follows. The
important phrases are in bold.

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Code of Ethics for Professional Accountants AAA Revision Notes

Demonstrating you understand the threats, how they arise and the implication

Providing a review of the company’s system and controls gives rise to a self‐review threat as these controls will
then be reviewed by the firm when determining our audit strategy. The firm may be reluctant to highlight
errors or adopt a substantive approach during the audit as this may highlight deficiencies in the firm’s work on
the additional service.
(1 mark)

The design of systems and controls is a management responsibility so a review of such may give rise to a situation
where the auditor is assuming a management responsibility by taking on the role of management.
(1 mark)

Apply the guidance to the scenario – evaluate the significance and suggest safeguards

The code states that the threat to independence of undertaking management responsibilities for an audit client
is so significant that there are no safeguards which could reduce the threat to an acceptable level.
(1 mark)

However, this answer could score three marks, it is likely that more marks are available. From an exam technique
point of view, you should be looking for additional points to make. At this stage, don’t start speculating about relative
fee size; try to focus on the information the examiner has given you. Here, the company is flagged as listed, so there
must be further development available on this area. Think about how you’ve seen management responsibility issues
overcome during your studies and past question practice. It is these points that you can use to attract further marks.

Management responsibility can be avoided if the client takes responsibility for monitoring the reports made and
taking the decisions on recommendations.
(1 mark)

However, as this client is listed, we are prohibited from undertaking internal audit services which relate to a
significant part of the controls over financial reporting. (1 mark)

Conclude

As such we must decline the additional work. (1 mark)

In other circumstances, the safeguard of using separate teams to overcome self‐review threats or considering the
competence of the firm to provide this service would attain credit; however, in this case, the client is listed so these
points are irrelevant here.

Note that, in the exam, no marks are awarded for simply listing self‐review or management responsibility as they
will need to be described before marks are awarded. As such, ensure that you take the time to explain the threats
rather than simply writing terms.

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Code of Ethics for Professional Accountants AAA Revision Notes

Example 2
Your firm’s advisory department has been carrying out a due diligence assignment on a potential acquisition target
of an audit client, Blue Co. The management team of Blue Co has also approached White & Co to ask
whether representatives of the firm would be available to attend a meeting with the company’s bankers, who they
are hoping will finance the acquisition of Red Co, to support the management team in conveying the suitability of
the acquisition of Red Co. For the meeting the bank requires the most up‐to‐date interim accounts of Red Co with
the accompanying auditor’s independent interim review report. Your firm is due to complete the interim review
shortly and the management team of Red Co has requested that the interim review is completed quickly so that it
does not hold up negotiations with the bank, stating that if it does, it may affect the outcome of the next audit
tender, which is due to take place after the completion of this year’s audit.

Required:
Comment on the ethical issues raised and recommend any actions your firm should take in response to the client’s
requests.
(8 marks)

In this example we have additional services and pressure relating to existing services to an audit client. The issues
we face are advocacy, self‐review, management responsibility and intimidation.

Demonstrating you understand the threats, how they arise and the implication

Attending a meeting with the bank would give rise to an advocacy threat as we would be perceived as promoting
the interests of our client and confirming the client’s assertions in negotiations.
(1 mark)

In addition, this may give rise to legal proximity exposing the firm to potential litigation.
(1 mark)

Attending the meeting may result in the firm being perceived to support the acquisition of Red Co. As these
are decisions which should be taken by management we could be perceived as taking on a management role.
(1 mark)

Self‐review threats may also arise when we later audit the finance and acquisition in the financial statements of the
group as we may be reluctant to highlight errors or are less sceptical about the values in the subsidiary as we have
provided the due diligence work.
(1 mark)

Further, an intimidation threat exists as the client has threatened that if the interim report is delayed it would affect
the outcome of the tender for audit in the future and there is a risk that quality is reduced in order to meet the
client’s demands.
(1 mark)

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Code of Ethics for Professional Accountants AAA Revision Notes

Apply the guidance to the scenario – evaluate the significance and suggest safeguards and conclude
here, there are different directions that the answer could take – for example, discussing in depth the exact nature
of the assignment and meeting attendance; however, it is possible to attract marks without such detail in your
answer as follows:

Assuming a management responsibility can be avoided if the directors confirm in writing that they
are responsible for any decision regarding the acquisition.
(1 mark)

The firm should decline to attend the meeting with the bank.
(1 mark)

The self‐review threat can be reduced by having an independent partner review the audit work prior to signing the
auditor’s report.
(1 mark)

The intimidation threat should be reported to those charged with governance.

(1 mark)

Note that, in this instance, a separate team for the due diligence and audit assignments was not suggested as the
scenario already told us that a different department had been carrying out the due diligence work.

The above two examples aim to cover a range of issues and illustrate how candidates can attract strong marks when
answering ethics questions. As with most areas of the Advanced Audit and Assurance exam, it is the application of
knowledge to a scenario rather than the knowledge itself that will attract marks. This means that when preparing
for this exam, a good grasp of the knowledge underpinning the syllabus is important but practising questions and
developing the skills of applying that knowledge is key to passing. Written by a member of the AAA examining team

pg. 51
Fraud AAA Revision Notes

Fraud

An exam focused overview

Types of fraud
1. Fraudulent financial reporting ( fake journal entries, manipulating estimates and judgments, omitting
transactions and events or recording them in the incorrect period, omitting or misstating F/S disclosures,
altering records and supporting documents etc.)

2. Misappropriation of assets (embezzling receipts, stealing physical assets or intellectual property, causing an
entity to pay for goods/services not received, using an entity’s assets for personal use)

Responsibilities

Management: Prevent and detect fraud through strong internal controls and a culture of honesty.

External Auditor:
1. NOT primary responsibility to detect fraud‐ needs to gain reasonable assurance that F/S are free from
material fraud. The auditor might not be able to detect fraud (and error) because evidence is persuasive
not conclusive, sophisticated accounting techniques may have been used to commit fraud, collusion may
have occurred, sampling is used so immaterial fraud may not be detected etc)

2. Professional skepticism

3. Discussion among the engagement team ( how and where F/S may be susceptible to fraud)

4. Risk assessment( auditor has to identify and assess risk of misstatement in F/S due to fraud)

5. Analytical procedures

6. Enquire of management: their assessment of risk related to fraud, their process of assessing risk, whether
they have knowledge of actual or suspected fraud

7. Enquire of Internal auditor: their assessment of risk related to fraud, whether they have knowledge of
actual or suspected fraud

8. Auditor has to design and implement appropriate responses to risky areas identified and when fraud is
identified

9. When fraud is discovered, auditor has to extend testing into other areas and consider implications for the
entire audit.

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Fraud AAA Revision Notes

Fraud: ISA 240 (Redrafted) defines fraud as: ‘An intentional act by one or more individuals among management,
those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or
illegal advantage.’

Error: is an unintentional misstatement in financial statements, including the omission of an amount or a disclosure.

Irregularity: refers to intentional misstatement or omission of events, transactions or other significant information.

Irregularity includes:
– Financial reporting which renders the financial statements misleading
– Misappropriation of assets

Hence an irregularity amounts to fraud.

Misstatement is a difference between the amounts, classification, presentation, or disclosure of a reported financial
statement item and the amount, classification, presentation, or disclosure that is required for the item to be in
accordance with the applicable financial reporting framework.
Misstatements can arise from error or fraud.

Two types of intentional misstatements are relevant to the auditor – misstatements resulting from fraudulent
financial reporting and misstatements resulting from misappropriation of assets.

Fraudulent financial reporting

Fraudulent financial reporting often involves management override of controls that otherwise may appear to be
operating effectively. Fraud can be committed by management overriding controls using such techniques as
intentionally:
• Recording fictitious journal entries, particularly close to the end of an accounting period, to manipulate
operating results or achieve other objectives.
• Inappropriately adjusting assumptions and changing judgments used to estimate account balances.
• Omitting, advancing or delaying recognition in the financial statements of events and transactions that have
occurred during the reporting period.
• Omitting, obscuring or misstating disclosures required by the applicable financial reporting framework, or
disclosures that are necessary to achieve fair presentation.
• Concealing facts that could affect the amounts recorded in the financial statements.
• Engaging in complex transactions that are structured to misrepresent the financial position or financial
performance of the entity Altering records and terms related to significant and unusual transactions

Misappropriation of assets involves the theft of an entity’s assets and is often perpetrated by employees in relatively
small and immaterial amounts. However, it can also involve management who are usually more able to disguise or
conceal misappropriations in ways that are difficult to detect. Misappropriation of assets can be accomplished in a
variety of ways including:
• Embezzling receipts (for example, misappropriating collections on accounts receivable or diverting receipts in
respect of written‐off accounts to personal bank accounts).
• Stealing physical assets or intellectual property (for example, stealing inventory for personal use or for sale,
stealing scrap for resale, colluding with a competitor by disclosing technological data in return for payment).

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Fraud AAA Revision Notes

• Causing an entity to pay for goods and services not received (for example, payments to fictitious vendors,
kickbacks paid by vendors to the entity’s purchasing agents in return for inflating prices, payments to fictitious
employees).
• Using an entity’s assets for personal use (for example, using the entity’s assets as collateral for a personal loan
or a loan to a related party).

Misappropriation of assets is often accompanied by false or misleading records or documents in order to conceal
the fact that the assets are missing or have been pledged without proper authorization.

Earnings Management
An example of fraud is management overriding controls and manipulating information i.e. ‘earnings management’.
Earnings management occurs when companies deliberately manipulate their revenues and/ or expenses in order to
inflate (or deflate) figures relating to profits and earnings per share. In other words, it is when companies use
‘creative accounting’ to construct reported figures that show the position and performance that management want
to show.

Earnings management does not always mean that the applicable financial reporting framework has not been
followed. Earnings management is often described as ‘bending the rules’. It may be that the manipulation of
published figures is the result of selecting an accounting policy which is allowed under the financial reporting
framework, but which does not reflect economic reality. For example, changing the estimated life of a non‐current
asset is allowed under financial reporting standards, but if it is done purely to manipulate the depreciation charge
(and therefore earnings), then it becomes an example of earnings management.

Responsibilities of External Auditors and Management in Relation to the Detection of Fraud

Management/TCWG
ISA 240 makes it clear that the primary responsibility for the prevention and detection of fraud rests with both those
charged with governance and management of an entity. By establishing a sound system of operational and financial
controls, management should reduce opportunities for fraud to take place, and establish a culture which should
persuade individuals not to commit fraud due to the likelihood of detection and punishment. In some jurisdictions,
codes of corporate governance require specific actions to be taken in respect of internal controls by management.

External Auditor
The external auditor may provide recommendations and advice on the improvement of internal controls, but it is
not their responsibility to put the recommendations into practice.

The auditor’s responsibility is to consider the risk of material misstatement in the financial statements due to fraud.
This means that the auditor is more focused on fraud that impacts on the accounts than on operational fraud which
may not cause a material misstatement.

A fraud with an immaterial impact may not be detected by audit procedures. Because the external auditor will use
sampling techniques based on a level of materiality, not all balances and transactions will be subject to detailed
testing, so small frauds are not likely to be detected. A similarity is that both management and the external auditor
should assess the strength of controls in place within the entity, and in doing so, evaluate the likelihood of a fraud
occurring. The auditor will perform this evaluation while planning the audit.

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Fraud AAA Revision Notes

ISA 240
1. Professional Skepticism: the auditor shall maintain professional skepticism throughout the audit, recognizing
the possibility that a material misstatement due to fraud could exist. If conditions identified during the audit
because the auditor to believe that a document may not be authentic or that terms in a document have been
modified but not disclosed to the auditor, the auditor shall investigate further.

2. Discussion among the Engagement Team: Led by the engagement partner. Particular emphasis should be
placed on how and where the entity’s financial statements may be susceptible to material misstatement due to
fraud, including how fraud might occur.

3. Risk Assessment Procedures and Related Activities (Obtain information for use in identifying the risks of
material misstatement due to fraud.)

The auditor shall make inquiries:

 Regarding management’s assessment of the risk that the financial statements may be materially misstated
due to fraud
 Regarding management’s process for identifying and responding to the risks of fraud in the entity
 to determine whether they the management/TCWG have knowledge of any actual, suspected or alleged
fraud affecting the entity

For those entities that have an internal audit function, the auditor shall make inquiries of appropriate individuals
within the function to determine whether they have knowledge of any actual, suspected or alleged fraud
affecting the entity, and to obtain its views about the risks of fraud.

The auditor shall evaluate whether unusual or unexpected relationships that have been identified in performing
analytical procedures that may indicate risks of material misstatement due to fraud.

The auditor shall consider whether other information obtained by the auditor indicates risks of material
misstatement due to fraud. The auditor shall evaluate whether the information obtained from the other risk
assessment procedures and related activities performed indicates that one or more fraud risk factors are
present.

Overall responses to address the assessed risks of material misstatement due to fraud at the financial statement
level
In determining the overall responses to address the assessed risks of material misstatement due to fraud at the
financial statement level, the auditor shall:
a) Assign engagement responsibilities to personnel based on knowledge, skill and ability. For example, assigning
additional individuals with specialised skill and knowledge, such as forensic and IT experts, or by assigning more
experienced individuals to the engagement;
b) Evaluate whether the selection and application of accounting policies by the entity may be indicative of
fraudulent financial reporting resulting from management’s effort to manage earnings. This is particularly
applicable to those accounting policies which involve subjective measurements and complex transactions, and
c) Incorporate an element of unpredictability in the selection of the nature, timing and extent of audit
procedures, such as performing audit procedures at different locations or at particular locations, unannounced.

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Fraud AAA Revision Notes

Communication of Fraud and Error

To appropriate level of management: material misstatement leading to fraud

To those charged with governance: fraud involving management or when fraud is ignored by management

To regulators: when the duty of confidentiality is overridden by law

To shareholders: when misstatements leading to fraud affect the F/S

Auditor’s Withdrawal from an Engagement

When fraud and errors are suspected or detected, the auditor may withdraw from the engagement under the
following conditions:

1. Sometimes the auditor may come across situations which will not permit the auditor to continue performing
the audit.

Examples of such situations are as follows

– The auditor has serious concerns about the integrity of the management or those charged with governance,
like an arms manufacturer supplying arms to a terrorist organisation.
– The entity does not address fraud which is not material to the financial statements, but for which the
auditor requires the management to take suitable action.

2. All entities have various complexities. Hence fraud occurs under different situations in different entities.
Therefore there are no clear guidelines of the situations in which the auditor can withdraw from the
engagement. However the auditor may decide to withdraw from the assignment when the auditor is worried
about the implications of the involvement of those charged with governance or the effect on the auditor of
continuing the association with the entity. For example, the auditor of the arms manufacturer may be worried
about being associated with the client on account of the client’s dealings.

3. The auditor will also need to consider the professional and legal responsibilities applicable in the circumstances,
including whether there is a requirement for the auditor to report to the person or persons who made the audit
appointment or, in some cases, to regulatory authorities.

If the auditor withdraws:

– Discuss with the appropriate level of management and those charged with governance the auditor’s
withdrawal from the engagement and the reasons for the withdrawal; and
– Determine whether there is a professional or legal requirement to report to the person or persons who
made the audit appointment or, in some cases, to regulatory authorities, the auditor’s withdrawal from the
engagement and the reasons for the withdrawal.

4. However, according to ISA 240, auditors of public sector entities often do not have the option of withdrawing
from the engagement due to public interest considerations.

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Professional Liability AAA Revision Notes

Professional Liability
An exam focused overview

Criminal liability for negligence: breach of trust (e.g. confidentiality), breach of contract (e.g. insufficient skills
and care, late audit report), insider dealing, failure to report money laundering, destroying documents

Specific statutory liability: arising from tax legislation, insolvency legislation etc.

Civil liability
1. An act of default

2. By a member or his employee

3. Which must lead to financial loss

4. To the client
Or

A 3rd party ( for example bank, prospective investor) to who duty of care is owed the 3rd party informed the
auditor that they will use the auditor’s report or there was proximity: i.e. the auditor should have foreseen
that F/S will be relied upon by the 3rd party

External auditor’s liability towards client External auditor’s liability towards a 3rd party

– Contract – No contract

– Duty of care owed to client – 3rd party has to prove duty of care owed to them

– 3rd party has to prove that there has been a

– Client has to prove breach of breach of duty of care
contract/breach of duty of care
– 3rd party has to prove financial loss
– Client has to prove financial loss

How can auditor restrict professional liability? LEARN

Client acceptance procedures; Performance and documentation of audit work; Quality control; External
consultations;

Issue disclaimer; Use engagement letter; Capping or setting a limit on amount of liability; Operate as an
incorporation Choosing limited liability partnership; Obtaining professional indemnity insurance

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Professional Liability AAA Revision Notes

Accountants who do not discharge their services responsibly face the following legal liabilities:
1. Criminal liability for negligence
2. Specific statutory liability
3. Civil liability for negligence

1. Criminal liability
Breach of trust: the auditor Right Accountants are the auditors of Dvyne Plc. Dvyne Plc has recently
not maintaining the tendered for a catering contract with Cat Airlines. The partner of Right
confidentiality of information informed his brother‐in‐law (who was a caterer) about the value of the
or not using client tender.
information for the benefit of
the client. This is a criminal liability involving a breach of trust since:
– Confidentiality is not maintained i.e. information about the client was
passed to the auditor’s brother‐in‐law
– Client information was not used for the benefit of the client i.e. it was
used for the benefit of the auditor’s brother‐in‐law.
Breaches of contract: An auditor is required to exercise sufficient care and skill while executing his
continuation of an audit duties. The ACCA clarifies this under Fundamental Principles in the Rules of
engagement after the term of Professional Conduct.
appointment is completed.
A company enters into a contract with its auditors. Therefore, the
appointment of an auditor by a company is governed by contract laws.
Insider trading: the auditor makes use of unpublished price sensitive information to obtain personal benefit.
Auditors generally avoid purchasing shares in the client company so that the probability of insider trading
will not occur.

Failure to report fraud or money laundering

Willful false statement

Destroying or damaging any document

2. Specific statutory liability

Liability arising from Rex is a professional accountant. On 25 April 20X8, he was appointed the
insolvency legislation liquidator of Minerex Plc, a mining company located in the UK. The tasks
which were performed for the winding up of the company included selling
off all free assets and obtaining as much dividend as possible.

The priority chain was as follows:

– secured claims
– claims with first priority (tax claims and settlement with regulators)
– claims with second priority (wage claims or settlement with employees)
– claims without priority (unsecured payables)

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Professional Liability AAA Revision Notes

The list of secured claims included Jasmine Plc (whose director is a cousin of
Rex) who is actually a supplier of the company. Lisa, an employee of the
company, was aware of the matter and sued Rex for negligence in the
administration of his duties in the capacity of liquidator.
Liability arising from statute For example, when the auditor does not disclose creative accounting
such as tax legislation. practices made by the client with the intention of paying lower taxes

Liability arising under e.g. non‐compliance with stock exchange regulations, Sarbanes‐Oxley Act
regulatory legislation provisions

Criminal offences, if proved, are punishable by payment of a penalty and / or imprisonment.

3. Civil liability
A professional accountant can face civil liabilities for negligence, when he conducts his duties negligently. The
liability of the auditor towards third parties is called a liability in tort. The term liability in tort means a third
party liability.

Liability for negligence

The ACCA Rulebook deals with liability on account of professional negligence.

The circumstances which can give rise to a liability are as follows:

– An act of default;‐‐‐‐‐by member / his or her employee / associate;‐‐‐‐‐which must lead to financial loss;
– To client or third party to whom duty of care is owed.

An act of default Professional competence and due care

means either an act or Accountants can be charged with non‐application of professional care and skills if they:
omission which occurs
due to non‐ Do not ensure that clients or employers are provided with professional services based
application of the on the latest developments in the profession, both legislative and technical.
professional care and
skills which are Do not apply the code of ethics which are laid down by the profession. Do not ensure
normally applied by that either they or their employees and professional associates are suitably trained
accountants and and supervised
auditors.
Not carry out further audit procedures on occasions when auditors suspect that there
are material misstatements in the financial statements.
by member / his or Professional accountant is expected to take responsibility for his work. In short, the
her employee / work of the accountant, if performed by his employee or his associate, needs to be
associate carried out under the supervision of the accountant. Therefore, even if the accountant
takes the assistance of either his employees or his associates, the accountant cannot be
absolved of his responsibility.
must lead to financial Professional accountants can be charged with liabilities for negligence, only if either
loss their clients or third parties suffer from financial loss on account of acts of negligence
by auditor. The financial loss suffered by a client must be a direct financial loss, i.e. not
an indirect or remote loss.

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Professional Liability AAA Revision Notes

to client or third party An act of negligence arises when a duty of care exists.
to whom duty of care
is owed For a duty of care to exist, the following factors need to be satisfied:
i. The accountant must be in a position to reasonably foresee that the
statements (or the work carried out by the accountant) would be relied upon
by the client or the third party.

ii. The accountant is sometimes informed before carrying out the work that a
third party would rely on the statements (or work) carried out by the
accountant. For example, an accountant who is asked to prepare a project
report for the purpose of getting a bank loan will be in a position to know, in
advance, that the project report will be used by the bank for the purpose of
vetting the loan application.

However, even when the accountant is not explicitly informed by the client
that a third party would rely upon the results of his work, the accountant is
expected to understand the likely parties who would rely on his work.

iii. There has to be a “relevant degree of proximity” between the parties.

Proximity means closeness. It does not mean physical nearness but rather
closeness in terms of relationship or because the parties are likely to rely on
the work of the accountant.

Jay, the auditor of Sea Shells Resorts, certifies a report solely for Prego Hotels,
which has requested and commissioned this report. In this case, Jay will only
have a duty of care towards Prego Hotels since he has ‘proximity’ with them.

However, if the auditor’s report is used by other prospective investors who

suffer economic losses, the prospective investors have no proximity with the
auditors. Therefore the auditors do not have a duty of care.

Restricting Audit Liability

All audit firms want to avoid litigation, due to the bad publicity that is likely to follow, the financial consequences,
and the potential collapse of the audit firm. There are several ways that an audit firm can reduce its exposure to
claims.

Client acceptance Firms should carefully assess the risk associated with potential audit clients.
procedures Screening procedures should be used to identify matters that create potential
exposure for the audit firm. For example, it would be unwise to take on a new
client with significant going concern problems. The issue is that a client should
only be accepted if the associated risk can be managed to an acceptably low level
given the skills and resources of the audit firm.

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Professional Liability AAA Revision Notes

Performance and Audit firms should ensure that professional standards are maintained, and that
documentation of audit International Standards on Auditing. (ISAs) are adhered to. It is crucial that full
work documentation is maintained for all aspects of the audit, including planning,
evaluation of evidence, and consideration of ethical issues. A claim of negligence
is unlikely to be successful if the audit firm has documentary evidence that ISAs
have been followed.
Quality control Firms must ensure they have implemented firm‐wide quality control procedures,
as well as procedures applicable to the individual audit engagement. Quality
control acts as an internal control for the audit firm, helping to ensure that ISAs
and internal audit methods have been followed at all times.
Firms should make use of external specialists when the need arises, for example
External consultations obtaining legal advice where appropriate, to ensure that the auditor’s actions are
acceptable within the legal and regulatory framework
Issue disclaimer In recent years it has become common in some jurisdictions for audit firms to
include a disclaimer paragraph in the audit report. This is an attempt to restrict
the duty of care of the audit firm to the shareholders of the company, thereby
attempting to restrict legal liability to that class of shareholders. Disclaimers,
however, may not always be effective.

“This report has been marked ‘CONFIDENTIAL’. It has been prepared solely for the
members of Cosby Company in accordance with the Companies Act 2006. The
audit report consists of those matters that are required to be undertaken for an
audit and to be stated in an audit report and not for any other purpose. In the
circumstances, with the full support of law, I am not held responsible for any other
party other than the company and the company members for the audit report or
for the audit opinion.”

The ACCA (according to ACCA Fact sheet 84) discourages the use of standard
disclaimers. This is because standard disclaimers amount to reducing the value of
the audit report. Furthermore, the disclaimer can be misused by auditors as a
safeguard against an improper audit
Use engagement letter The engagement letter should be used to clearly state the responsibilities of the
auditor, and of management. As it forms a contract between the audit firm and
the client, it should be updated on an annual basis, with care being taken to ensure
the client is fully aware of any changes in the scope of the audit, or the reporting
responsibilities of the audit firm.
Capping or setting a limit on The auditor’s liability can be restricted by capping or setting a limit on the amount
amount of liability of liability which can be imposed on any specific party.

This amount can be determined as a multiple of audit fees for a particular

engagement, i.e. there will be a direct relationship between the audit fees and the
amount of liability or the liability will be a proportion of the turnover of the
company.

pg. 61
Professional Liability AAA Revision Notes

Operating as incorporation In many jurisdictions, auditors are allowed to operate only as sole traders or
partners i.e. firms have joint and several liabilities. This means that a partner can
face liability on account of negligence by other partners of the firm as well as the
directors of the client company.

KPMG in the UK is an example of where auditors have chosen to become

incorporated. This means that the liability of the partners is restricted to the
assets of the incorporation.

Audit firms may form incorporations to address their liability problems.

However, forming incorporation does not overcome the problems described
above.

This is because:
– it makes the audit company fully liable for the total amount of any judgment
which exceeds the professional indemnity insurance
– it makes the audit partners and the company liable for negligent acts by any
partner of the company
– it protects the private assets of the ‘innocent’ audit partners
– partners who are ‘guilty’ of negligence owe joint and several responsibilities
– the firm can be forced into liquidation
– the firm would need to publish its financial statements and also be subjected
to audit
Choosing limited liability Under an LLP, ‘innocent’ members are not personally liable for the acts of
partnership negligence by other members. Their liability is restricted to their share in the
assets of the business. In short there is no difference between the liabilities of
members of incorporation and an LLP. The only difference between the two
entities is the taxation implications, i.e. incorporation has to pay taxes like any
other ‘company’. However an LLP does not pay tax. Only its members pay taxes
for the income earned through the LLP. Ernst & Young in the UK is an example of
an LLP.
Obtaining professional Accountants who do not discharge their services responsibly face several legal
indemnity insurance liabilities. Accountant’s face legal claims from clients and third parties due to
negligent services provided to clients.

Many countries have instituted insurance policies which cover risks associated
with professional negligence. These risks include liabilities against claims for
professional negligence or loss through fraud. The ACCA has made it mandatory
for all ACCA holders of practicing certificates to obtain a minimum level of
insurance cover.

pg. 62
Quality Control AAA Revision Notes

Quality Control

An exam focused overview

ISQC 1 (applicable for the FIRM)

- Provides guidance on the overall quality control systems that should be implemented by an audit firm.

Quality control on AN INDIVIDUAL AUDIT‐ISA 220

- Specifies the quality control procedures that should be applied by the engagement team in individual audit
assignments.

Elements of quality control

1 Leadership Audit: Engagement Partner
responsibility for
quality Firm: A senior member ( responsible for creating awareness about quality,
implemented a quality oriented culture, ensuring policies are followed, establishing
communication channels from Engagement Partner to team and vice versa)

2 Ethical Engagement Partner to ensure independence not compromised throughout the audit
requirements
3 Acceptance/ As before (CDD, ethics, conflict of interest, resources etc.)
continuance of
client
4 HR policies Audit: Engagement Partner should have skills, authority, time required for audit. He
should also ensure the team has relevant skills
Firm: Appropriate policies regarding staff recruitment, performance evaluation, skills,
promotion.

5 Engagement a) Direction
performance ‐ Set by Engagement Partner
‐ Set in the planning meeting
‐ Responsibilities assigned to team
‐ Objective of work to be done communicated
‐ Initial audit approach decided
‐ Risks
‐ Team told how to deal with problems as they arise

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Quality Control AAA Revision Notes

b) Supervision
Main responsibility: Engagement Partner

Should be continuous: The audit supervisor should keep track of the progress of
the audit engagement to ensure that the audit timetable is met and should ensure
that the audit manager and partner are kept updated of progress
‐ Ensure work according to planned approach (The competence and capabilities
of individual members of the engagement team should be considered,
including whether they have sufficient time to carry out their work, whether
they understand their instructions and whether the work is being carried out
in accordance with the planned approach to the audit.)
‐ Ensure important matters told to seniors
‐ Ensure audit approach modified if needed ( based on any significant matters
that may arise during the audit)
‐ See if consultation is needed.

c) Consultation
‐ From outside the team or outside the firm
‐ On difficult/contentious matters

d) Review
Hierarchical review (consider whether work has been performed in accordance
with professional standards and other regulatory requirements and if the work
performed supports the conclusions reached and has been properly documented.)
‐ On a timely basis throughout the audit
‐ Ensure work according to all relevant standards ( including quality standards)
‐ Check if objective of work has been achieved
‐ Ensure conclusions are supported by sufficient appropriate evidence
‐ HAS to be done by the Engagement Partner( need not review all audit
documentation, but only a ’quick look’ at the working papers could indicate
that areas of risk or critical judgement have not been reviewed in sufficient
detail.)
e) Engagement Quality Control Review (if needed)
‐ Reviewer appointed by Engagement Partner
‐ Reviewer will review significant judgments
‐ Reviewer will evaluate conclusions reached in making the audit report
‐ Reviewer will ensure consultations have been taken where needed

f) Documentation
‐ Maintain and retain all documentation ( working papers)
‐ Ensure confidentiality
6 Monitoring – The firm should ensure quality control procedures are adequate and complied
with.
– The firm should retain evidence about the relevance, adequacy and effectiveness
of quality control procedures and of the corrective actions taken.

pg. 64
Quality Control AAA Revision Notes

The firm shall establish and maintain a system of quality control that includes policies and procedures that address
each of the following elements:
(a) Leadership responsibilities for quality within the firm.
(b) Relevant ethical requirements.
(c) Acceptance and continuance of client relationships and specific engagements.
(d) Human resources.
(e) Engagement performance.
(f) Monitoring.

Documentation of the System of Quality Control: The firm shall establish policies and procedures requiring
appropriate documentation to provide evidence of the operation of each element of its system of quality control.
These should be communicated to the firm’s personnel.

Element ISQC 1 (applicable for the FIRM) Quality control on AN INDIVIDUAL AUDIT‐
Engagements provides guidance on the overall ISA 220
quality control systems that should be Specifies the quality control procedures
implemented by an audit firm. that should be applied by the engagement
team in individual audit assignments.

Leadership The standard requires that the firm implements The engagement partner shall take
Responsibilities policies such that the internal culture of the firm is responsibility for the overall quality on
for Quality one where quality is considered essential. Such a each audit engagement to which that
within the Firm culture must be inspired by the leaders of the firm, partner is assigned.
who must sell this culture in their actions and
messages.

The firm may appoint an individual or group of

individuals to oversee quality in the firm. Such
individuals must have:
– Sufficient and appropriate experience
– The ability to carry out the job
– The necessary authority to carry out the job
Relevant The firm shall establish policies and procedures Throughout the audit engagement, the
Ethical designed to provide it with reasonable assurance engagement partner shall remain alert,
Requirements that the firm: through observation and making enquiries
– Maintains independence where required by as necessary, for evidence of non‐
relevant ethical requirements. compliance with relevant ethical
– Is notified of breaches of independence requirements by members of the
requirements, and takes appropriate actions engagement team.
to resolve such situations.
The engagement partner shall:
(a) Obtain relevant information from the
firm and, where applicable, network
firms, to identify and evaluate

pg. 65
Quality Control AAA Revision Notes

circumstances and relationships that

create threats to independence
(b) Evaluate information on identified
breaches, if any, of the firm's
independence policies and procedures
to determine whether they create a
threat to independence for the audit
engagement
(c) Take appropriate action to eliminate
such threats or reduce them to an
acceptable level by applying
safeguards, or, if considered
appropriate, to withdraw from the
audit engagement, where withdrawal
is possible under applicable law and
regulation.
Acceptance Consider whether the firm: There should be full documentation, and
and (a) Is competent to perform the engagement and conclusion on, ethical and client
Continuance of has the capabilities, including time and acceptance issues in each audit
Client resources, to do so; assignment.
Relationships (b) Can comply with relevant ethical
and Specific requirements; and The engagement partner should consider
Engagements (c) Has considered the integrity of the client, and whether members of the audit team have
does not have information that would lead it complied with ethical requirements, for
to conclude that the client lacks integrity. example, whether all members of the team
are independent of the client. Additionally,
the engagement partner should conclude
whether all acceptance procedures have
been followed, for example, that the audit
firm has considered the integrity of the
principal owners and key management of
the client. Other procedures on client
acceptance should include:
– Obtaining professional clearance from
previous auditors
– Consideration of any conflict of
interest
– Money laundering (client
identification) procedures.
Human The firm should have policies and procedures on Procedures should be followed to ensure
Resources ensuring excellence in its staff, so that there is that the engagement team collectively has
'reasonable assurance that it has sufficient the skills, competence and time to perform
personnel with the capabilities, competence, and the audit engagement. The engagement
commitment to ethical principles. partner should assess that the audit team,
for example:

pg. 66
Quality Control AAA Revision Notes

These will cover the following issues: – Has the appropriate level of technical
– Recruitment knowledge
– Performance evaluation – Has experience of audit engagements
– Capabilities ‐Competence of a similar nature and complexity
– Career development – Has the ability to apply professional
– Promotion judgement
– Compensation – Understands professional standards,
– The estimation of personnel needs and regulatory and legal
requirements.
The firm is responsible for the on‐going excellence
of its staff, through continuing professional ISA 220 text: Assignment of the
development, education, work experience and engagement team
coaching by more experienced staff. This responsibility is given to the audit
engagement partner. The firm should have
policies and procedures
in place to ensure that:
– 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 is aware of
his responsibilities as engagement
partner

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
Engagement Firms often produce a manual of standard Direction
Performance engagement procedures to give to all staff so that The partner directs the audit.
they know the standards they are working towards.
These may be electronic. Procedures such as an engagement
planning meeting should be undertaken to
Ensuring good engagement performance involves a ensure that the team understands:
number of issues: – Their responsibilities
– Direction – The objectives of the work they are to
– Supervision perform
– Consultation – The nature of the client’s business
– Review – Risk related issues
– Resolution of disputes – How to deal with any problems that
may arise; and

pg. 67
Quality Control AAA Revision Notes

– The detailed approach to the

performance of the audit.

The planning meeting should be led by the

partner and should include all people
involved with the audit. There should be a
discussion of the key issues identified at
the planning stage.

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

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

Review
The review process is one of the key quality
control procedures. All work performed
must be reviewed by a more senior
member of the audit team. Reviewers
should consider for example whether:

pg. 68
Quality Control AAA Revision Notes

– Work has been performed in

accordance with professional
standards
– The objectives of the procedures
performed have been achieved
– Work supports conclusions drawn and
is appropriately documented.

The review process itself must be

evidenced.

Quality control review

The audit engagement partner is
responsible for appointing a reviewer, if
one is required. He is then responsible for
discussing significant matters arising with
the reviewer and for not issuing the audit
report until the quality control review has
been completed.

A quality control review should include:

• An evaluation of the significant
judgements made by the engagement
team
• An evaluation of the conclusions
reached in formulating the auditor's
report

A quality control review for a listed entity

will include a review of:
• Discussion of significant matters with
the engagement partner
• Review of financial statements and the
proposed report
• Review of selected audit
documentation relating to significant
audit judgements made by the audit
team and the conclusions reached
• Evaluation of the conclusions reached
in formulating the auditor's report and
consideration of whether the auditor's
report is appropriate
• The engagement team's evaluation of
the firm's independence towards the
audit

pg. 69
Quality Control AAA Revision Notes

• Whether appropriate consultations

have taken place on differences of
opinion/contentious matters and the
conclusions drawn
• Whether the audit documentation
selected for review reflects the work
performed in relation to significant
judgements/supports the conclusions
reached
• When ISA 701applies, the conclusions
reached by the engagement team in
formulating the auditor’s report
include determining:
 The key audit matters to be
included in the auditor’s report;
 The key audit matters that will not
be communicated in the auditor’s
report in accordance, if any; and
 If applicable, depending on the
facts and circumstances of the
entity and the audit, that there are
no key audit matters to
communicate in the auditor’s
report.

• In addition, the review of the

proposed auditor’s report includes
consideration of the proposed
wording to be included in the Key
Audit Matters section.

Other matters relevant to evaluating

significant judgements made by the audit
team are likely to be:
• The significant risks identified during
the engagement and the responses to
those risks (including
• assessment and response to fraud)
• Judgements made, particularly with
respect to materiality and significant
risks
• Significance and disposition of
corrected and uncorrected
misstatements identified during the
audit

pg. 70
Quality Control AAA Revision Notes

• Matters to be communicated with

management/those charged with
governance
Monitoring The standard states that firms must have policies in The audit engagement partner is required
place to ensure that their quality control to consider the results of monitoring of the
procedures are: firms (or network's) quality control systems
– Relevant and consider whether they have any
– Operating effectively impact on the specific audit he is
– Adequate conducting.
– Complied with

In other words, 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.

The people monitoring the system are required to

evaluate the effect of any deficiencies found.
These deficiencies might be one‐offs. Monitors will
be more concerned with systematic or repetitive
deficiencies that require corrective action. When
evidence is gathered that an inappropriate report
might have been issued, the audit firm may want
to take legal advice.

Corrective action
– Remedial action with an individual
– Communication of findings with the training
department
– Changes in the quality control policies and
procedures
– Disciplinary action, if necessary

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Quality Control AAA Revision Notes

Eligibility of a person to perform an engagement review.

ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information, and Other
Assurance and Related Services Engagements outlines how a firm decides on the eligibility of a person to perform
an engagement review.

Firstly, the reviewer must have a high standard of technical knowledge, encompassing a thorough understanding of
auditing and financial reporting standards, as well as any specific regulatory issues (such as stock exchange listing
rules) which may be relevant to the client.

In addition, the reviewer should be an experienced auditor, preferably with specific practical experience of auditing
companies operating in a similar industry or business sector as the client.

The reviewer should possess a level of authority within the firm. This will allow the reviewer to challenge the
decisions made by other members of the firm, including senior managers and partners. It is important that the
reviewer is not intimidated by the senior members of the audit team who could feel criticised by any negative
comments that the reviewer may have on their work and decisions. ISQC 1 recommends that a reviewer of listed
client’s audits should normally be at partner level within the firm.

Finally, the reviewer must be independent of the audit team. This allows a totally objective review to take place. The
engagement partner therefore should not be involved in deciding who should review the audit. Consultations
between the engagement partner and the reviewer can take place during the audit, but care should be taken to
preserve the reviewer’s objectivity.

pg. 72
Obtaining & Accepting Professional Appointments AAA Revision Notes

Obtaining and Accepting Professional Appointments

Change in auditor‐ reasons
1. Audit fee: perceived to be too high, not value for money, not competitive
1. 2.Size: Client’s business expands beyond auditor’s capacity, client falls below exemption limit
2. 3.Personality: client falls out with auditor
3. 4.Audit rotation: independence related reasons
4. 5.Auditor does not seek re‐election: disagreement with client, another client in competition, auditor has ethical
reasons

Advertising
Basic Guidelines
Advertising is allowed as long as the advertising does not go against any of the fundamental principles contained in
ACCA’s Code of Ethics and Conductor IFAC’s Code of Ethics for Professional Accountants.

1. Advertisements should be truthful and not make false claims. For example, it would be inappropriate to claim
that a firm could promise to offer a cheaper audit service than the competitor firm. Equally, it would be
inappropriate to make exaggerated claims regarding the experience or the qualifications possessed by the firm’s
partners and employees.

2. In addition, any advertisement should not make disparaging remarks about any other audit or accountancy firm,
for example, it would be inappropriate to state that a firm offered a higher quality service than any other
provider.

3. Any advertisements should also be in compliance with any local rules and regulations. For example, in some
jurisdictions it is prohibited for professionals such as auditors to advertise on television, and most jurisdictions
will have some kind of regulatory authority, such as the Advertising Standards Authority in the UK, which
imposes rules on advertising to ensure it is not misleading and is in good taste.

Practice Descriptions
Members:
– can use ACCA or FCCA after their names
– not permitted to add Honours/ hons after ACCA or FCCA

A firm can describe itself as:

– “chartered certified accountants” if half or more partners are members of ACCA and they have at least 51% of
voting rights
– “members of ACCA” if all the partners are members of ACCA
– “registered auditors” if it holds auditing certificate from ACCA

Firm names should not

– Hamper the reputation/dignity of accountancy profession
– Bring discredit to other accountants
– Be the same as existing firm’s name
– Be misleading

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Obtaining & Accepting Professional Appointments AAA Revision Notes

Use of the ACCA logo: The ACCA logo, also known as the ACCA mark, can be used on the letterheads, other
professional stationery or on the website of a firm which has at least one partner or director who is a member of
the ACCA.

The logo should be exactly as recommended by the ACCA in respect to its colour, size and positioning. If the firm
has a logo of its own, it should be distinguishable from the ACCA logo

Tendering

Auditors are often approached by interested clients to submit quotations for fees to conduct particular work. The
process of calling for quotations and submitting quotes is known as tendering.

Tendering is a process through which an interested party (i.e. the client) tries to obtain quotations for fees from the
provider of services (i.e. the auditor) for a particular kind of work to be done. It is customary to submit tenders in
sealed envelopes. Such sealed offers, including firm / company information, a project outline, and a price quote are
known as tenders or bids. When an invitation to submit a proposal or fee quote is received by the auditor, the auditor
must decide whether it wants to undertake that work.

Information to be considered for a proposal

Before submitting the proposal or fee quote for an audit or other professional engagement, the bidder must be
aware of certain facts regarding the prospective client in order to be able to draw up a proposal. Such information
can be obtained through discussions with the client or may have been made available by the prospective client at
the time it invited the bids.

1. What is the business of the prospective client? Is it a new business or an existing one?
The bidder must have information about the client’s business, number of branches or subsidiaries, processes
and products and internal control systems. This will help the bidder to evaluate the work involved and the
expertise required. For example, if the client has undertaken an acquisition, expert knowledge on the accounting
of acquisitions would be helpful.

Similarly, knowledge of a client’s business can help the bidder to decide whether or not it wants to take up the
engagement, as there may be some issues which the bidder does not want to be involved with.

2. What exactly does the prospective client expect the auditor to do? (statutory audit, taxation work etc)
The duties of the bidder must be clearly defined i.e. what the bidder is being hired for. Similarly, the timeline
that the auditor is required to follow must be communicated. This will help the bidder to plan his work properly
and also give an idea of the total time required to complete the assignment.

3. What are the future plans of the prospective client?

Future plans refer to the business opportunities that the client plans to take up for expansion or future growth.

This will help the bidder to assess his own future prospects by working with the prospective client. It can also
help the bidder prepare for any future challenges that he might have to face while working for the client.

pg. 74
Obtaining & Accepting Professional Appointments AAA Revision Notes

4. Why does the prospective client intend to change the existing auditor?
If the client is seeking to change his existing auditor, the bidder may be interested to know the reason for this
change.

Matters to be included in tender document

1. Brief outline of firm: This should include a short history of the firm, a description of its organisational structure,
the different services offered by the firm (such as audit, tax, corporate finance, etc.), and the locations in which
the firm operates. The document should also state whether it is a member of any international audit firm
network.

2. Specialisms of the firm: Describe the areas in which the firm has particular experience of relevance to the
prospective client.

3. Identification of the needs of the prospective client: The tender document should outline the requirements of
the client, for example that each subsidiary is required to have an individual audit on its financial statements,
and that the consolidated financial statements also need to be audited.

4. Outline of the proposed approach: This is likely to be the most detailed part of the tender document. For
example, in case of a tender for an audit, typically contained in this section would be a description of the audit
methodology used by the firm, and an outline of the audit cycle including the key deliverables at each phase of
work. For example:
– How the firm would intend to gain business understanding at group and subsidiary level.
– Methods used to assess risk and to plan the audits.
– Procedures used to assess the control environment and accounting systems.

5. Quality control: The firm should emphasize the importance of quality control and therefore should explain the
procedures that are used within the firm to monitor the quality of the services provided. This should include a
description of firm‐wide quality control policies, and the procedures applied to individual assignments. The firm
may wish to clarify its adherence to International Standards on Quality Control.

6. Communication with management: The firm should outline the various reports and other communication that
will be made to management.

7. Outline the timeframe that would be used

8. Key staff and resources.

9. Fees: The proposed fee for the audit of the group should be stated, and the calculation of the fee should be
explained.

pg. 75
Obtaining & Accepting Professional Appointments AAA Revision Notes

Accepting Engagements

Let’s talk about THE ADVANCED AUDIT & ASSURANCE EXAM

Factors to consider when accepting new client/client continuation

1. Resources (staff, time, competence of the firm including knowledge and experience of relevant industry,
regulatory and reporting requirements, Scale of engagement‐global?)
2. Commercial considerations ( level of fee, profitability of the engagement etc)
3. Know Your Client/ Customer Due diligence
4. Risk (management integrity, money laundering, listed company, weak internal control etc)
How to assess risk at this stage? Credit reference agencies, recently published F/S (solvency, adequacy of
disclosures, appropriate accounting policies), contacts, newspapers, internet, company search (annual
returns filed, SH details, PEP‐politically exposed persons?)
5. Professional liability implication (e.g. audit required by lender)
6. Miscellaneous (complaints procedure, regulation by profession)
7. Independence, conflict of interest
8. Professional etiquette letter ( clearance from outgoing auditor)
9. Pre‐ conditions of an audit

ISQC 1 sets out what a firm must consider and document in relation to accepting or continuing an engagement,
which is the integrity of the client, whether the firm is competent to do the work and whether the firm meets the
ethical requirements in relation to the work.

Ethical Procedures before accepting nomination

considerations (a) Ensure that there are no ethical issues which are a barrier to accepting nomination (
including any conflicts of interest)
(b) Ensure that the auditor is professionally qualified to act and that there are no legal or
technical barriers
(c) Ensure that the existing resources are adequate in terms of staff, expertise and time
(d) Obtain references for the directors if they are not known personally to the audit firm
(e) Consult the previous auditors to ensure that there are not any reasons behind the
vacancy which the new auditors ought to know. This is also a courtesy to the previous
auditors

Competence of the firm

Do firm personnel have knowledge of relevant industries/subject matters?
Do firm personnel have experience with relevant regulatory or reporting requirements, or
the ability to gain the necessary skills and knowledge effectively?
Does the firm have sufficient personnel with the necessary capabilities and competence?
Are experts available, if needed?
Are individuals meeting the criteria and eligibility requirements to perform the engagement
quality control review available where applicable?
Is the firm able to complete the engagement within the reporting deadline

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Obtaining & Accepting Professional Appointments AAA Revision Notes

Work Setting fees

considerations Once the total time and staff required for the assignment is ascertained, it should be easy
for the auditor to determine the approximate fees that need to be charged. However, fees
will not only be based on the time and staff required, but also on the following:
– Importance of the work to the client
– Urgency of the work
– Complexity (which relates to time)
– Need for travel (for e.g. to branch offices)
Legal a) Eligibility of an auditor
considerations b) Restriction on the number of audits: In some jurisdictions (such as in India), there is a
maximum limit to the number of audits that can be accepted by a member or audit
partner.
Other a) What is the level at which fees are generally charged for the work concerned? For
considerations example, the fees that are charged by other auditors can be determined from the
annual reports of public companies.
b) Would it be advantageous to the auditor to accept the assignment? For example,
obtaining professional work from a particular client may enhance the auditor’s image.
c) At what level of fees was the tender accepted last year?

Preconditions for an Audit

1. Determine whether the financial reporting framework to be applied in the preparation of the financial statements
is acceptable
1. Obtain the agreement of management that it acknowledges and understands its responsibility:
(i) For the preparation of the financial statements in accordance with the applicable financial reporting
framework, including where relevant their fair presentation
(ii) For such internal control as management determines is necessary to enable the preparation of financial
statements that are free from material misstatement, whether due to fraud or error; and
(iii) To provide the auditor with:
a. Access to all information of which management is aware that is relevant to the preparation of the
financial statements such as records, documentation and other matters;
b. Additional information that the auditor may request from management for the purpose of the
audit***; and
c. Unrestricted access to persons within the entity from whom the auditor determines it necessary
to obtain audit evidence

***Additional information: Additional information that the auditor may request from management for the purpose
of the audit may include when applicable, matters related to other information in accordance with ISA 720 (Revised).
When the auditor expects to obtain other information after the date of the auditor’s report, the terms of the audit
engagement may also acknowledge the auditor’s responsibilities relating to such other information including, if
applicable, the actions that may be appropriate or necessary if the auditor concludes that a material misstatement
of the other information exists in other information obtained after the date of the auditor’s report

pg. 77
Agreeing the Terms of the Engagement AAA Revision Notes

Agreeing the Terms of the Engagement

Once the accountant agrees to work for a client, he must decide the terms of engagement in writing with the client.
Such written communication is known as an ‘engagement letter’. ISA 210 Agreeing the Terms of Audit Engagements
provides guidance on agreeing terms with a client and changes in the engagement terms. It assists the accountants
in preparing audit engagement letters for accepting audit assignments, tax, accounting, or management advisory
services.

Generally, an audit engagement letter includes the following matters:

1. Objective of the audit: e.g. statutory audit or internal audit

2. Scope of the audit: Elaboration of the scope of the audit, including reference to applicable legislation,
regulations, ISAs, and ethical and other pronouncements of professional bodies to which the auditor adheres.

3. Identification of the applicable financial reporting framework: e.g. IFRS or US GAAP

4. Time schedule: estimated time required for completion of audit

5. The requirement for the auditor to communicate key audit matters in the auditor’s report in accordance with
ISA 701

6. Deliverables: The form of any other communication of results of the audit engagement.e.g. letters, certificates
or audit report.

7. The expectation that management will provide written representations

8. The basis on which fees are computed and any billing arrangements.

9. Permission to communicate with the previous accountant (by sending the etiquette letter)

10. Access to all the records, documentation and other information requested in connection with the audit, e.g.
customs documents to verify whether the goods are being held by customs

11. Management’s responsibility for establishing and maintaining effective internal controls, e.g. maintenance of
proper accounting records

12. The fact that because of the inherent limitations of an audit, together with the inherent limitations of internal
control, there is an unavoidable risk that some material misstatements may not be detected, even though the
audit is properly planned and performed in accordance with ISAs.

13. Arrangements regarding the planning and performance of the audit, including the composition of the
engagement team.

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Agreeing the Terms of the Engagement AAA Revision Notes

14. The expectation that management will provide access to all information of which management is aware that is
relevant to the preparation of the financial statements, including an expectation that management will provide
access to information relevant to disclosures.

15. The agreement of management to make available to the auditor draft financial statements including all
information relevant to their preparation, whether obtained from within or outside of the general and
subsidiary ledgers (including all information relevant to the preparation of disclosures), and the other
information,3 if any, in time to allow the auditor to complete the audit in accordance with the proposed
timetable.

16. The agreement of management to inform the auditor of facts that may affect the financial statements, of which
management may become aware during the period from the date of the auditor’s report to the date the
financial statements are issued.

17. A request for management to acknowledge receipt of the audit engagement letter and to agree to the terms of
the engagement outlined therein.

Where the auditor is replacing an existing auditor while accepting a new client, he should contact the existing
auditor and communicate his intentions for taking up the work of that client.

This must be done after taking prior permission from the client. Such communication usually takes place in the form
of an etiquette letter or professional enquiry letter. If the client does not give permission to approach the outgoing
auditor, the auditor should refuse the engagement.

An etiquette letter / professional enquiry letter enables the new auditor to communicate with the existing auditor
and know if there are any areas of concern which he must consider before accepting the new engagement.

Many times, the apparent reason for a change of auditors may not fully reflect the facts and may indicate
disagreements with the existing accountant that may influence the decision to accept the appointment.

Audit of the components in a group: If the client entity comprises various subsidiaries, divisions, units or branches,
the auditor should consider sending separate engagement letters to each such subsidiary, division, unit or branch, if
he is appointed as the auditor for the entire group. This is because the terms of the audit’s legal requirements for
appointment of auditors of different business units (i.e. subsidiaries, divisions etc.) may be different and may not
apply to the group as a whole.

It also depends upon factors such as the extent of independence of the components in a group and the degree of
ownership by the parent company.

Recurring audits: In recurring audits, the auditor should consider whether circumstances require the terms of the
engagement to be revised and whether there is a need to remind the client of the existing terms of the engagement.

Acceptance of a change in engagement: An auditor who, before the completion of the engagement, is requested to
change the engagement to one which provides a lower level of assurance, should consider the appropriateness of
doing so.

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Agreeing the Terms of the Engagement AAA Revision Notes

A request from the client for the auditor to change the engagement may come as a result of various reasons, these
are as follows:
– A change in circumstances which affect the need for the service. E.g. a listed company may decide not to
purchase a subsidiary so therefore may not require due diligence already agreed and therefore would want the
auditors to discontinue the engagement.

– A misunderstanding in relation to the nature of an audit or a related service that was originally requested.
E.g. if an auditor, who is appointed to audit the accounts of a client is held responsible by the management for
not detecting a fraud in addition to performing the audit, then the management is said to have misunderstood
the nature of a regular audit. If detection of fraud is the primary concern of the client, the client should hire the
investigative assurance services of another auditor.

– A restriction on the scope of the engagement, whether imposed by the management or caused by
circumstances. E.g. verification of physical records made difficult due to a factory closure during a workers’ long
term strike.
The auditor should carefully consider the implications of a restriction on the scope of the engagement. For
example, the auditor must evaluate the consequences of not being able to conduct the physical verification of
records due to the strike on the audit opinion.

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The Planning Stage of Audit AAA Revision Notes

The Planning Stage of Audit

Planning Audit strategy:

Summary a) Understanding the business
b) Risk assessment
c) Materiality d) Scope, Timing, Direction

To ensure adequate resources are allocated to the audit.

Audit Plan :
Detailed instruction on how to audit (audit programmes). This includes descriptions
of risk assessment procedures and further planned audit procedures.

Audit Strategy ( approach/ initial client evaluation)

a) Understanding the client

‐ Industry, regulatory and other external factors( for example financial reporting framework, laws and
regulations, stakeholders, economic conditions like volatility of exchange rates, competition, level of
technology

‐ Nature of entity and accounting policies ( legal structure, ownership and governance, main sources of
finance)

‐ Objectives…strategies…related business risks!

‐ Measurement and review of Financial performance ( measures important to the client, KPIs, budgets,
targets)

‐ Internal control (gain an understanding about the design and implementation of internal controls)

This understanding is gained through Inquiry (from management, IA, TCWG, legal advisor). Observation,
Inspection(interim F/S, policy manuals, brochures, minutes, business plans, website), Analytical Procedures

b) Risk Assessment
i)Assess risk (ISA 315) ii)Response (ISA 320) iii) Procedures iv) Evaluate
This is done through ‐ Professional skepticism ‐ICS evidence
understanding the client, ‐ More skilled staff ‐Substantive &
Analytical procedures(evaluate ‐ Consultations Review
plausible relationships between ‐ Unpredictable testing
financial and non‐financial data),
Team discussions

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The Planning Stage of Audit AAA Revision Notes

Step 1
Business risk(problems faced by the management)

Step 2
Audit risk= Risk of material misstatement in F/S and Detection risk

Inherent risk and control risk sampling risk and non sampling risk

Risk of material misstatement: This is the risk that F/S could be misstated due to incomplete/incorrect
recording of transactions/events/disclosures. This is affected by the volume of transactions, integrity of
BOD, pressures on management, use of IT, use of accounting estimates, unusual transactions, items prone
to theft etc)

If business risk is not addressed, risk of material misstatement increases!

c) Materiality ISA 320 ( affects how many items to test, what to test, sampling techniques, level of
misstatement for modified opinion)
‐ By amount ( Exam: 5% of PBT, 2 % of TA)
‐ By nature (recurring errors, non‐recurring items, items which affect statutory requirements, items
which affect debt covenants, Bank, related party transactions etc.)
‐ By impact: used when evaluating misstatements towards the end of the audit
‐ Performance materiality ( always less than the overall materiality level!)

Important: risk and materiality are inversely proportional!

d) Scope:
‐ locations/branches/offices,
‐ financial reporting framework,
‐ industry specific regulations,
‐ use/need of experts
‐ use of CAATS,
‐ reliance on Internal Auditors,
‐ use of service organisations by the client
‐ Group audit implications

Timings: deadlines/timing for

‐ reporting,
‐ Meetings with the management/ TCWG
‐ expected communication ( management letter, auditor’s report)
‐ team meetings
‐ review of audit team’s work

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The Planning Stage of Audit AAA Revision Notes

Direction:
i) Systems audit
ii) Balance sheet approach
iii) Directional testing (test debits for overstatement and credits for understatement)
iv) Transaction cycle approach (audit trail verified for substantive testing)

AAA Examples and writing technique‐ Business Risk

NO MARKS FOR COMMENTING ON MATERIALITY
Information from the case
The Group offers a luxury product aimed at an exclusive market.

Business Risk
This in itself creates a business risk, as the Group’s activities are not diversified, and any decline in demand will
immediately impact on profitability and cash flows. The demand for luxury holidays will be sensitive to economic
problems such as recession and travel to international destinations will be affected by events in the transportation
industry
Information from the case
It is questionable whether the Group has a sound policy on expansion, given the problems encountered with
recent acquisitions which have involved expanding into locations with political instability and local regulations
which seem incompatible with the Group’s operations and strategic goals. The Group would appear to have
invested $98 million, accounting for 28% of the Group’s total assets, in these unsuitable locations, and it is
doubtful whether an appropriate return on these investments will be possible.

Business Risk
There is a risk that further unsuitable investments will be made as a result of poor strategic decisions on where
to locate new hotels. The Group appears to have a strategy of fairly rapid expansion, acquiring new sites and a
hotel complex without properly investigating their appropriateness and fit with the Group’s business model.
Information from the case
Medix Co appears to rely heavily on agents to secure sales to hospitals and clinics.

Business Risks
If the agents are unsuccessful, or decide to reduce the effort they put into promoting Medix Co’s products in
preference for products from an alternative supplier, then the company will face a substantial reduction in
revenue and cash inflows.

A second risk associated with the use of agents is that there is a scope for fraud ・the agents could deliberately
overstate the value of sales in order to maximise the commission they receive. When this point is linked to the
poor internal systems and controls as indicated by Mick Evans, it is likely that such frauds would not be detecte
AAA Exam Examples and writing technique‐ RoMM
Reminder: Audit Risk = RoMM and Detection Risk
1. Words from the case
2. Comment on materiality if possible (by amount or by nature)
3. Relevant accounting standard
4. The risk! For RoMM, the impact on the F/S HAS to be mentioned ( i.e an amount over or understated, for
errors use misstatement, disclosure might be missing or inadequate, presentation incorrect)

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The Planning Stage of Audit AAA Revision Notes

Information from the case

The 50% equity shareholding is likely to give rise to a joint venture under which control of WTC is shared between
ZCG and Wolf Communications Co.

Audit Risk
IFRS 11 Joint Arrangements requires that an investor which has joint control over a joint venture should recognise
its investment using the equity method of accounting.

Audit risk arises in that despite owning 50% of the equity shares of WTC, ZCG may not actually share control with
Wolf Communications, for example, if Wolf Communications retains a right to veto decisions or if ZCG cannot
appoint an equal number of board members in order to make joint decisions with board members appointed by
Wolf Communications. If ZCG does not have joint control, then WTC should not be treated as a joint venture.
Information from the case
There is a deferred tax asset.

Audit Risk
According to IAS 12 Income Taxes, a deferred tax asset is recognized for an unused tax loss carry‐forward or
unused tax credit if, and only if, it is considered probable that there will be sufficient future taxable profit against
which the loss or credit carry‐forward can be utilised.

While it appears that some of the deferred tax asset has been utilised this year, there remains a risk that if it is no
longer recoverable, then the amount would need to be written off.
Information from the case
A comparison of the statement of profit or loss for both years shows that the profit made on the disposal of shares
in Calgary Co has been separately disclosed as part of profit in the year ending 31 July 2016.

Materiality: The profit recognised is material at 30.3% of profit before tax. Several errors seem to have been
made in accounting for the disposal and in respect of its disclosure.

Audit Risk
It is not correct that this profit on disposal is recognised in the statement of profit or loss.

According to IFRS 10 Consolidated Financial Statements, changes in a parent’s ownership interest in a subsidiary
which does not result in the parent losing control of the subsidiary are treated as equity transactions. Any
difference between the amount by which the non‐controlling interests are adjusted and the fair value of the
consideration paid or received is recognised directly in equity and attributed to the owners of the parent.

This appears to have been incorrectly accounted for as there should not be a profit on disposal within the
statement of profit or loss. Therefore profit before tax is overstated by $10 million.
Information from the case
Analytical procedures reveals that the Group’s revenue has increased by 19%, but that operating expenses have
disproportionately increased by 25.6%, resulting in the fall in operating margin from 12.1% in 2015 to 7.2% in
2016.

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The Planning Stage of Audit AAA Revision Notes

Audit Risk
This is a significant change, and while the higher costs incurred could be due to valid business reasons, the trend
could indicate operating costs are overstated or sales are understated.

There is a risk that some of the costs involved in modernising the Group’s warehousing facilities have been
incorrectly treated as revenue expenditure when this should have been capitalized.

Commonly tested risk related requirement

Requirement examples:
- Evaluate the business risks faced by…
- Identify and explain the audit risks relevant to planning the audit…
- Evaluate the risk of material misstatement to be considered in planning the audit…
- Perform preliminary analytical procedures and evaluate the audit risks which should be considered…
- Recommend any additional information that should be requested/would be relevant…

When explaining questions in the AAA Exam

Business Risks: Think of what problems it can cause for the business ( financial issues, compliance issues,
operational issues)

Risk of material misstatement in the F/S: This of how it can impact areas in the statement of P/L, SOFP, Notes to
the accounts ( Disclosures)

Detection Risks: Think of how it could affect the auditor’s work/ his ability to detect/find fraud/error

Analytical procedures at the planning stage: Advanced Audit & Assurance Exam

Ratios that HAVE to be calculated:

- Gross profit margin
- Operating profit margin
- Return on Capital Employed
- Current and quick ratios
- Inventory holding period
- Receivable collection period
- Trade payables payment period
- Gearing ratio
- Interest cover

Other than ratios…

- Compare with last year
- Calculate percentage increase/decrease
- Evaluate relationship: Tax and Profit before tax
- Evaluate relationship: changes in finance cost with changes in associated interest bearing elements
- Evaluate relationship: change in sales to change in cost of sales

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The Planning Stage of Audit AAA Revision Notes

Planning Activities: The engagement partner and other key members of the engagement team shall be involved in
planning the audit, including planning and participating in the discussion among engagement team members

Overview of approach
• Perform risk assessment procedures (ISA 315)
• Assess the risk of material misstatement (ISA 315)
• Respond to assessed risk (ISA 330)
• Perform further audit procedures (ISA 330)
• Evaluate audit evidence obtained (ISA 330)

Audit Strategy Scope Scope involves determining the characteristics of the audit
client, such as its locations, and the relevant financial
The overall audit strategy reporting framework, as these factors will help to establish
sets the scope, timing and the scale of the assignment.
direction of the audit
 The financial reporting framework on which the
financial information has been prepared
The overall audit strategy • Industry‐specific reporting requirements such as
should then lead to the reports mandated by industry regulators.
development of the audit • Whether the entity has an internal audit function and if
plan. so, whether, in which areas and to what extent, the
work of the function can be used for purposes of the
audit.
• The entity’s use of service organizations and how the
auditor may obtain evidence concerning the design or
operation of controls performed by them.
• The effect of information technology on the audit
procedures, including the availability of data and the
expected use of computer‐assisted audit techniques.

For group audits:

• The expected audit coverage, including the number and
locations of components to be included
• The nature of the control relationships between a
parent and its components that determine how the
group is to be consolidated.
• The extent to which components are audited by other
auditors.
• The reporting currency to be used, including any need
for currency translation for the financial information
audited.

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The Planning Stage of Audit AAA Revision Notes

The need for a statutory audit of standalone financial

statements in addition to an audit for consolidation
purposes.

Timing Timing refers to establishing deadlines for completion of

work and key dates for expected communications.
 The entity’s timetable for reporting, such as at interim
and final stages.
• The organization of meetings with management and
those charged with governance to discuss the nature,
timing and extent of the audit work.
• The discussion with management and those charged
with governance regarding the expected type and
timing of reports to be issued and other
communications, both written and oral, including the
auditor’s report, management letters and
communications to those charged with governance.
• The expected nature and timing of communications
among engagement team members, including the
nature and timing of team meetings and timing of the
review of work performed.

For group audits:

Communication with auditors of components regarding the
expected types and timing of reports to be issued and other
communications in connection with the audit of
components.
Direction Establishing the overall audit strategy also includes the
consideration of preliminary materiality, and initial
‐Consider the identification of high risk areas within the financial
factors that are statements. All of these matters contribute to the
significant in assessment of the nature, timing and extent of resources
directing the necessary to perform the engagement.
engagement team’s
efforts Risk assessment and materiality are explained later in the
revision notes.
‐Consider the results
of preliminary It is important to carefully consider the selection of the
engagement engagement team (including, where necessary, the
activities engagement quality control reviewer) and the assignment
of audit work to the team members, including the
‐Ascertain the assignment of appropriately experienced team members to
nature, timing and areas where there may be higher risks of material
extent of resources misstatement.
necessary to .

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The Planning Stage of Audit AAA Revision Notes

perform the
engagement.
Audit Plan The audit plan is more detailed than the audit strategy and includes a description
‐ Details about who, of the risk assessment procedures, and the further planned audit procedures
what, where, when of necessary at the assertion level for gathering evidence on the material transactions
the audit. and balances in the financial statements. The general purpose of developing the
audit plan is to design audit procedures which will reduce audit risk to an acceptably
Who is going to carry out low level.
what procedures; Where
are they going to do them; The difference between the audit strategy and the audit plan is therefore that the
When are they going to do strategy is the initial planning to ensure there will be adequate resources allocated
them; Why are they doing to the audit assignment in response to an initial evaluation of the entity’s
it‐ what risks are they characteristics, whereas the audit plan is a detailed programme of audit
trying to assess procedures.

‐ Supervision and The strategy will therefore usually be developed before the plan; however, the two
review of the audit activities should be seen as inter‐related, as changes in one may result in changes
plan is critical to the other. Both the strategy and the plan should be fully documented as this
represents the record of proper planning of the audit assignment.
‐ The plan Must be
documented

‐ Plan must be flexible

to deal with
information
discovered later

Risk assessment
The auditor needs to conduct procedures to:
a) Understand the entity
 Industry, regulatory and other external factors: This means having an understanding of the industry in
which the company operates, including the level of competition, the nature of the relationships with
suppliers and customers, and the level of technology used in the industry. The industry may have specific
laws and regulations which impact on the business. The auditor should also consider wider economic factors
such as the level and volatility of interest rates and exchange rates and their potential impact on the client.
The importance of these issues is their potential impact on the financial statements and on the planning of
the audit. For example, if a client operates in a highly regulated industry, it may be worth considering the
inclusion in the audit team of a person with specific experience or knowledge of those regulations.
Regulations include the financial reporting framework, for example, whether the company uses local or
international financial reporting standards.

 Nature of the entity and its accounting policies: This includes having an understanding of the legal structure
of the company (and group where relevant), the ownership and governance structure, and the main sources
of finance used by the company. Complex ownership structures with multiple subsidiaries and/or locations
may increase the risk of material misstatement. Understanding the nature of the company also includes an

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The Planning Stage of Audit AAA Revision Notes

understanding of the accounting policies selected and applied to the financial statements. The auditor must
consider whether the accounting policies applied are consistent with the applicable financial reporting
framework.

 Objectives and strategies and related business risks: The management of the company should define the
objectives of the business, which are the overall plans for the company. Strategies are the operational
approaches by which management intend to meet the defined objectives. For example, an objective could
be to maximize market share, and the strategy to achieve this could be to launch a new brand or product
every year. Business risks are factors which could stop the company achieving its stated objectives, for
example, launching a product for which there is limited demand. Most business risks will eventually have
financial consequences, and thus an effect on the financial statements. This is why auditors perform a
business risk assessment as part of their planning procedures.

 Measurement and review of the entity’s financial performance: Here the auditor is looking to gain an
understanding of the performance measures which management and others consider to be of importance.
Performance measures can create pressure on management to take action to improve the financial
statements through deliberate misstatement. For example, a bonus payable to the management based on
revenue growth could create pressure for revenue to be overstated. Thus the auditor must gain an
understanding of the company’s financial and non‐financial key performance indicators, targets, budgets
and segmental information.

b) Understand controls
 The auditor must gain knowledge of internal control in order to consider how different aspects of internal
control could impact on the audit. Internal control includes the control environment, the entity’s risk
assessment procedures, information systems, control activities, and the monitoring of controls. Put simply,
the evaluation of the strength or weakness of internal control is a crucial consideration in the assessment of
audit risk, and so will have a significant impact on the audit strategy. The design and implementation of
controls should be considered as part of gaining an understanding. The auditor should also understand
whether controls are manual or automated.

How can all the above understanding be gained?

Procedures used to gain understanding
Inquiries of management and A discussion with management is often the starting point in gaining
others within the company understanding. A meeting is usually held with management to talk about all
of the aspects of the company and its environment referred to in the first
part of the briefing notes. However, inquiries can also be made of others,
who may be able to provide a different perspective or provide specific
insights into certain matters. For example, internal auditors would be able
to comment specifically on internal controls.
Analytical procedures Auditors perform analytical procedures at the planning stage in order to
(Almost always financial info given identify unusual transactions or events, and to understand the main trends
in the THE ADVANCED AUDIT & reflected in the financial statements for the year. This will enable the
ASSURANCE EXAM exam‐ you auditor, for example, to see if the company has experienced a growth or
need to look at that to identify risk decline in revenue or profits in the year, which when reviewed in the context
of material misstatement in the of industry or economic trends, may indicate a risk of material
financial statements‐ do some misstatement.

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The Planning Stage of Audit AAA Revision Notes

calculations on the figures‐DO

NOT ignore the numbers in the
questions‐ these are important
AND have easy marks. Analytical
procedures at planning stage are
explained later in these revision
notes.
Observation Observation may help to support inquiries of management and others, and
could involve, for example, physical observation of the internal control
operations, and visits to premises such as factories, warehouses and head
office.
Inspection Inspection may support inquiries made of management and others. It could
include, for example, an inspection of business plans, internal control
manuals, reports made by management such as interim financial
statements, the minutes of board meetings, and reviewing the company’s
website and brochures

The auditor’s previous experience with the entity and audit procedures
Information Obtained in Prior performed in previous audits may provide the auditor with information
Periods about such matters as:
• Past misstatements and whether they were corrected on a timely basis.
• The nature of the entity and its environment, and the entity’s internal
control (including deficiencies in internal control).
• Significant changes that the entity or its operations may have
undergone since the prior financial period, which may assist the auditor
in gaining a sufficient understanding of the entity to identify and assess
risks of material misstatement.
• Those particular types of transactions and other events or account
balances (and related disclosures) where the auditor experienced
difficulty in performing the necessary audit procedures, for example
due to their complexity.

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The Planning Stage of Audit AAA Revision Notes

Dealing with Risk Questions in THE ADVANCED AUDIT & ASSURANCE EXAM

Business risk Risk of material misstatement Audit Risk

in the F/S
AR= Risk of material misstatement in the
F/S AND Detection Risk

That can damage client’s Due to Error or fraud: In you answer, include risk of material
business misstatements in the F/S AND other factors
(internal and external 1. Misapplication of a that might increase detection risk
factors). standard leading
Under/over statement of Examples of factors which might increase
Examples include: amounts detection risk:
‐ Changes in legislations - F/S Disclosures ( ‐ Time pressure
‐ Changes in technology Disclosures may have ‐ Inexperienced audit team/incorrect task
‐ Changes in economy been omitted or Level allocation to team members
‐ Competition of detail in the ‐ New audit client
‐ Employees‐ loss of key disclosure may be ‐ Newly listed/planning on getting listed
staff inadequate) soon
‐ Systems or system ‐ Intended sale of business
changes (old may not ‐ Pressure to meet targets
work)
‐ Cash flow Writing your answer in the
‐ High gearing THE ADVANCED AUDIT &
‐ Fraud ASSURANCE EXAM Exam

1. Discuss standard
Writing your answer in the incorrectly applied
THE ADVANCED AUDIT &
ASSURANCE EXAM Exam 2. The risk that this incorrect
application creates
(under/over, non‐
In the exam, fully explain Disclosure, inadequate
WHY they are a risk disclosure)

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The Planning Stage of Audit AAA Revision Notes

Relationship between business risk and risk of material misstatement in the financial statements
The business risk approach places the auditor ‘in the shoes’ of management, and therefore provides deeper insight
into the operations of the business and generates extensive business understanding.

The business risk model is not a replacement for the traditional audit risk model but rather a vehicle, or
mechanism, for the identification of audit risk, recognising that most business risks will eventually have financial
consequences and, therefore, an effect on the financial statements.

Business risk is defined in ISA 315 Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and its Environment. The definition states that business risk is a risk resulting from
significant conditions, events, circumstances, actions or inactions which could adversely affect an entity’s ability to
achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.
Risk of material misstatement is defined in ISA 200 Overall Objectives of the Independent Auditor and the Conduct
of an Audit in Accordance with ISAs as the risk that the financial statements are materially misstated prior to audit.
Risk of material misstatement comprises inherent risk and control risk.

ISA 315 states that the auditor shall perform risk assessment procedures to provide a basis for the identification and
assessment of risks of material misstatement at the financial statement and assertion levels.

Business risks can be broken down into operational risk, financial risk and compliance risk.
1. Financial risk: risk arising from the financial activities or financial consequences of an operation
2. Compliance risk: risk that arises from non‐compliance with laws and regulations
3. Operational risk: risk arising with regard to operations

Each of these components can have a direct impact on the financial statements, and therefore understanding the
components of business risk can help the auditor to identify risks of misstatement, and to design a response to that
risk.

Some business risks impact the inherent risk component of risk of material misstatement. For example, the auditor
may have identified that an audited entity has significant levels of debt with covenants attached. The business risk
is that the covenants are breached and the debt recalled. An associated inherent risk at the financial statement level
is that the financial statements could be manipulated to avoid breaching the debt covenant.

Other business risks impact on the control risk component of risk of material misstatement. For example, the auditor
may have identified that an audited entity has a business risk due to having lost key members of personnel in the
accounting department. This has a clear impact on control risk, as it means the accounting department is short of
competent staff and errors are likely to go undetected and uncorrected.

Therefore the ISAs’ approach to planning an audit is underpinned by the concept that it is essential for an auditor to
understand the business risks of an audited entity in order to effectively identify and respond to risks of material
misstatement.

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The Planning Stage of Audit AAA Revision Notes

Example
Esteem Club Plc is a hospitality service provider and runs a chain of clubs, one of which is situated in a small town
near London. The club provides restaurant services, bar services, lodging and boarding facilities, a swimming pool
and recreation facilities such as boating, billiards, tennis, cards room etc. It has recently obtained permission from
the state to sell alcohol in its club.

The business risks and related financial statements risks of this can be:

Business risks Risk of material misstatement in the financial

statements
The permission to sell alcohol in the club may be Breach of regulation may require paying a penalty.
misinterpreted as being applicable to all the facilities However, provision relating to breach of regulation may
that the dub provides, whereas the company is not be made. This means that the profit may be
actually allowed to sell alcohol only in the bar area. understated

Hence, here there is a risk that the club will face

severe penalties from the state since if it sells
alcohol in areas that it is not permitted to sell in.
In the restaurant, employees may misappropriate Fraud may remain undetected and therefore loss arising
food items and indulge in fraud. from such fraud may remain undisclosed in the financial
statements

Materiality

The concept of materiality is applied by the auditor both in planning and performing the audit, and in evaluating the
effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements
and in forming the opinion in the auditor’s report.

Determining materiality involves the exercise of professional judgment. A percentage is often applied to a chosen
benchmark as a starting point in determining materiality for the financial statements as a whole.

Performance materiality means:

– The amounts set by the auditor at less than materiality for the financial statements as a whole
– To reduce the probability that the aggregate of uncorrected/undetected misstatements exceeds materiality for
the financial statements as a whole

Performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or
levels for particular classes of transactions, account balances or disclosures.

An item might be material due to it’s:

• Nature: eg transactions related to directors, such as remuneration or contracts with the company
• Value: eg land with a value which comprised three‐quarters of the asset value of the company
• Impact: eg a proposed journal which is not material in itself could convert a profit into a loss

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In order to calculate a level of planning materiality, auditors will often take a range of values and use an
average/weighted average.
• Profit before tax: 5%
• Revenue: 0.5%
• Total assets: 1%

When assessing materiality in exam questions calculate the relevant matter as a percentage of the relevant indicator
and assess whether it falls within these ranges.

Analytical procedures and risk assessment

According to ISA 520 Analytical Procedures, analytical procedures are the evaluation of financial information through
analysis of plausible relationships between both financial and non‐financial data. Analytical procedures can involve
comparisons of financial data including trend analysis and the calculation and comparison of ratios. Analytical
procedures include comparisons of the Group’s financial information with, for example:
 Comparable information for prior periods;
 Anticipated results of the Group, such as budgets or forecasts;
 Expectations of the auditor; or
 Comparable information from competitors.

Analytical procedures performed at the planning stage help the auditor to identify and respond appropriately to risk,
and to assist the auditor in obtaining an understanding of the client

ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its
Environment requires the auditor to perform analytical procedures as part of risk assessment procedures at the
planning stage of the audit to provide a basis for the identification and assessment of risks of material misstatement
at the financial statement and assertion levels.

An example of how analytical procedures assist the auditor is that performing analytical procedures may alert the
auditor to a transaction or event of which they were previously unaware, therefore prompting the auditor to
investigate the matter, obtain understanding of the matter and plan appropriate audit procedures to obtain
sufficient appropriate audit evidence. Therefore analytical procedures are an essential part of developing the audit
strategy and audit plan.

Analytical procedures may also help the auditor to identify the existence of unusual transactions or events, such as
significant one‐off events. Unusual amounts, ratios, and trends might also indicate matters which indicate risk.
Unusual or unexpected relationships which are identified by these procedures may assist the auditor in identifying
risks of material misstatement, especially risks of material misstatement due to fraud.

Without performing analytical procedures, the auditor would be unable to identify risks of material misstatement
and respond accordingly. This would increase detection risk, making it more likely that an inappropriate audit
opinion could be issued.

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Preliminary analytical review‐ Ratios normally used by the THE ADVANCED AUDIT & ASSURANCE EXAM
examiner
Profitability
1. GP Margin = Gross profit/revenue x 100
2. Operating profit margin= operating profit/revenue x 100
3. Return on capital employed = Operating profit/capital employed x100

Liquidity
1. Current ratio = Current assets/current liabilities
2. Quick ratio = Current assets – inventory/current liabilities
3. Inventory holding period= Inventory/cost of sales x 365
4. Receivables collection period = Receivables/revenue x 365
5. Trade payables payment period = Trade payables/cost of sales x 365

Gearing
1. Gearing ratio =Long‐term liabilities/equity
2. Interest cover = Operating profit/finance costs

Additional Considerations in Initial Audit Engagements

First audit? (New client with previous audit by another firm OR New client no audit before)

In an initial audit engagement there are several factors which should be considered in addition to the planning
procedures which are carried out for every audit.
1. Performing procedures regarding the acceptance of the client relationship and the specific audit engagement;

2. Communicating with the predecessor(outgoing) auditor (with client’s permission)‐ ask for information and
working papers from previous audit ( accounting policies, risks assessed and how they were dealt with)

3. Review opening balances (Working papers from previous audit will help)‐if no previous audit, more detailed
testing will be needed. Particular care should be taken in planning the audit procedures necessary to obtain
sufficient appropriate audit evidence regarding opening balances, and procedures should be planned in
accordance with ISA 510 Initial Audit Engagements –Opening Balances. For example, procedures should be
performed to determine whether the opening balances reflect the application of appropriate accounting
policies and determining whether the prior period’s closing balances have been correctly brought forward into
the current period.

4. Consider if previous audit report was modified‐ affecting this year? Risks identified change? Previous
modifications of the opinion could be indicative of lack of trust in management

5. Consider accounting policies‐ consistent?

6. Consider matters discussed with the management at the time of appointment. For example, there may have
been discussion of significant accounting policies which may impact on the planned audit strategy.

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7. Need to develop thorough business understanding. With an initial audit engagement it is particularly important
to develop an understanding of the business, including the legal and regulatory framework applicable to the
company. This understanding must be fully documented and will help the audit team to perform effective
analytical review procedures and to develop an appropriate audit strategy. Obtaining knowledge of the business
will also help to identify whether it will be necessary to plan for the use of auditors’ experts.

8. There is risk of material misstatement in opening balances

9. Need to use experienced team to reduce detection risk

10. The firm may have quality control procedures in place for use in the case of initial engagements, for example,
the involvement of another partner or senior individual to review the overall audit strategy prior to commencing
significant audit procedures. Compliance with any such procedures should be fully documented.

Audit Procedures Responsive to the Assessed Risks of Material Misstatement at the Assertion Level

The auditor shall design and perform further audit procedures whose nature, timing and extent are based on and
are responsive to the assessed risks of material misstatement at the assertion level.

Tests of Controls
The auditor shall design and perform tests of controls to obtain sufficient appropriate audit evidence as to the
operating effectiveness of relevant controls if:
(a) The auditor’s assessment of risks of material misstatement at the assertion level includes an expectation that
the controls are operating effectively (that is, the auditor intends to rely on the operating effectiveness of
controls in determining the nature, timing and extent of substantive procedures); or
(b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at the assertion level.

Substantive Procedures
Irrespective of the assessed risks of material misstatement, the auditor shall design and perform substantive
procedures for each material class of transactions, account balance, and disclosure.

Overall responses to address the assessed risks of material misstatement at the financial statement level may
include:
• Emphasizing to the engagement team the need to maintain professional scepticism.
• Assigning more experienced staff or those with special skills or using experts.
• Providing more supervision.
• Incorporating additional elements of unpredictability in the selection of further audit procedures to be
performed.
• Making general changes to the nature, timing or extent of audit procedures, for example: performing
substantive procedures at the period end instead of at an interim date; or modifying the nature of audit
procedures to obtain more persuasive audit evidence.

When the auditor has assessed the business and audit risks relating to the entity and decided on a materiality level,
he must then decide on an approach for gathering audit evidence.

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There are various approaches that could be adopted.

(a) Systems audits
(b) Balance sheet approach
(c) Directional testing
(d) Transaction cycle approach.

Systems These focus on the strength, or otherwise, of the internal control systems. The idea is to perform
audit extensive tests of controls and reduce the level of substantive testing.

During planning, the audit firm will ascertain record and evaluate the internal controls. If they
judge control risk to be low, the controls will be tested to confirm this.

Tests of controls will test that controls are properly designed, exist and have operated throughout
the period. Deviations will be recorded and investigated regardless of the amount involved. If
results are unsatisfactory then the initial assessment of control risk is not supported. The audit
strategy will then need to be modified.
Balance This is also known as the substantive approach. This strategy would usually be adopted when
sheet control risk is high, and controls cannot be relied upon.
Approach
Ultimately the auditor's report contains an opinion on the figures in the financial statements.
Therefore, all audits will involve some substantive testing of these balances.

Substantive testing involves collecting evidence on the assertions implied in the accounts
regarding balances.
Directional This is based on the principles of double entry bookkeeping. If a trial balance is in balance, there
testing must be a debit entry for every credit entry.

If a debit entry has been overstated there should be a corresponding credit entry which is
overstated, or another debit entry which is understated. Therefore, a test for overstatement of
receivables will provide evidence concerning the overstatement of revenue.

Directional testing also refers to checking the financial statements to the underlying records.
Transaction This approach is similar in some ways to the systems audit approach as it is based on the same
cycle transaction cycles. The difference here is that we are not focusing on controls testing but
approach substantive procedures.

Under this approach transactions that have occurred during the year and result in entries to the
income statement are tested.

In practical terms a sample of transactions relating to say, sales would be selected and
substantiated to supporting documentation (order, invoice and dispatch note) to ensure the
transactions are correctly and completely recorded in the financial statements.

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Technical Article: Exam Technique

Risk is examined in several ways within the Advanced Audit and Assurance syllabus and understanding the difference
between these can be key to scoring good marks in the exam. Quite often, risk forms part of a planning question but
it is also examined with respect to financial reporting issues elsewhere in the exam.

The key to attaining good marks for risk comes from understanding the types of risk you are looking for and
explaining them in the correct context. As with many areas of the exam, good exam technique can be used to
increase the marks attained without having to rote learn much additional information. It is application and
understanding that is important at the Professional level.

This article will demonstrate how to maximise marks on these areas using effective exam technique. It is, however,
specific to the context of auditing and assurance and will therefore have a different focus and application to the way
risks are examined in other areas of the ACCA Qualification.

WHAT YOU NEED TO KNOW

The three main types of risk you might be asked to evaluate in the exam are business risk, risk of material
misstatement and audit risk. These are defined as follows:

Business risk
A risk resulting from significant conditions, events, circumstances, actions or inactions that could adversely affect an
entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and
strategies (ISA 315)

Risk of material misstatement (RoMM)

‘The risk that a material misstatement exists in figures or disclosures within the financial statements prior to
audit’ (IAASB – glossary of terms)

Audit risk
‘The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially
misstated. Audit risk is a function of material misstatement and detection risk’ (IAASB – glossary of terms)

How they interact

You should know from your study of Audit and Assurance that the audit risk model is comprised of:
Audit risk = RoMM x detection risk
For a risk of misstatement to occur there must be an inherent risk of an item being misstated and a risk that the
client’s controls did not identify and correct this misstatement. When you are asked to evaluate RoMM in an exam,
the examiner is looking for those inherent and control risks and, in many cases, these arise from underlying business
risks.

For something to be an audit risk, there must be either a RoMM or a detection risk, the risk that the auditor’s
procedures do not identify a material misstatement in the financial statements.

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HOW TO APPLY THE KNOWLEDGE

Knowing these definitions will help you to remember which type of risk is which or to categorise risks into these sub
types but it is not something you will be awarded direct credit for in an Advanced Audit and Assurance exam.

Remember that you are often being asked to prepare an answer for the attention of the audit engagement partner,
who will certainly not need these terms explained. Therefore, these definitions are so that you know what type of
risk you are looking for in a question but the marks will be awarded for your evaluation of these risks.

Let’s consider an example of information that may be provided in the exam and how your answer would differ for
each of the risk types you might be asked to evaluate. The following is an extract from the published
September/December 2015 sample questions:

Dali Co was established 20 years ago and has become known as a leading supplier of machinery used in the quarrying
industry, with its customers operating quarries which extract stone used mainly for construction.

The machines and equipment made by Dali Co are mostly made to order in the company’s three manufacturing
sites. Customers approach Dali Co to design and develop a machine or piece of equipment specific to their needs.
Where management considers that the design work will be significant, the customer is required to pay a 30%
payment in advance, which is used to fund the design work. The remaining 70% is paid on delivery of the machine
to the customer. Typically, a machine takes three months to build, and a smaller piece of equipment takes on
average six weeks. The design and manufacture of bespoke machinery involving payments in advance has increased
during the year. Dali Co also manufactures a range of generic products which are offered for sale to all customers,
including drills, conveyors and crushing equipment.

Business risk
For the purpose of the exam, these risks can usually be thought of in terms of conditions that may prevent a business
from meeting its objectives and might include risks to achieving future profits or cashflows or to business survival.
This is a simplified explanation, but will help you describe the implications of most risks you come across in the exam.
There will be some risks whose explanation is more involved and you can find examples of these in past exams.

In general, you are looking for risks in the information that the examiner has presented to you within the scenario.
You will be asked to evaluate those risks. At this level you will not be credited for defining business risk, nor will you
receive credit for describing what a client could do to mitigate those business risks.

As set out in the ISAs, the focus of business risk evaluation as part of the audit process is identifying matters that
could impact on audit planning, in particular matters that could give risk to risks of material misstatement or audit
risks.

The focus in the Advanced Audit and Assurance exam is therefore quite different from other strategic level exams
where you might be expected to consider risks from a business perspective and to describe methods the business
may use to manage those risks. If you stray into risk mitigation from a business perspective rather than an auditor’s
perspective you are wasting valuable time on making points that cannot score marks.

As such, you need to consider how to frame the information which is provided as a business risk. As a general rule,
marks for business risks will be awarded along the following lines:
 For identifying only without meaningful explanation, ½ mark

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 For a briefly explained business risk, 1 mark will be awarded, and

 Full marks will only be awarded where a well explained business risk is presented.

Marks will not be awarded for points that are purely speculative – ie not based on specific information provided in
the question scenario – nor will marks be awarded for business risks that do not impact on the audit.
Let’s now apply that logic to the example provided above:

Identification only – worth ½ mark

The company manufactures bespoke machines for clients which may take six months to complete.

In an exam, an answer that merely repeats facts from the question is unlikely to attain many marks – in a business
risk question it can score ½ mark for identification only as the implications for the company have not been
considered.

Identified and briefly explained – worth 1 mark

The company manufactures bespoke machines for clients which may take six months to complete. During this time
the company has funds tied up in work in progress.

This point cannot score full marks as there is no development of why this is a risk; how does it impact on the business
or the audit?

Identified and well explained – worth full marks

The company manufactures bespoke machines for clients which may take six months to complete. During this time
the company has funds tied up in work in progress, which could give rise to cashflow problems, especially as the
30% deposit may not cover all the upfront costs. This service has increased in the year putting further strains on
cash flow.

It is also possible that a risk can have other implications or alternative descriptions that are valid and, if the answer
was developed in one of these directions, that would still attract credit. For example, the following would also be an
appropriate way to fully explain the same risk:

Identified and well explained – worth full marks

The company manufactures bespoke machines for clients which may take six months to complete. There is a risk
that the customer cancels the order after the company has spent significant funds on the design and manufacture
of the machine. This will have put strain on the company cash flow and it is unlikely that the machine can be sold to
a different customer for the same price due to its bespoke nature. This may mean that the company makes a loss
on the sale of the inventory or cannot sell it at all.

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In an exam such as this, it’s reasonable to assume that the examiner has given you each piece of information for a
reason. It is likely to be relevant to one of the requirements and the examiner will often flag if there are areas which
you should not consider. A good technique is to try and identify risks in each paragraph – there could be more than
one but there is unlikely to be a section of text that does not flag something relevant for at least one requirement.
Another thing to watch for is describing risks that are speculative or insignificant in the context of the scenario you
are given. There will be sufficient risk areas described in the scenario to score maximum credit if they are well
described. If you find yourself hypothesising about potential issues that may affect the client, but you don’t have
enough information to know if it’s a risk or not, then you are likely to be making irrelevant or marginal points. While
it is true that valid risks – beyond those on the marking guide – can attract credit, it is much easier and less risky to
use those that are flagged by the examiner.

Risks of Material Misstatement (RoMM)

RoMM often follow from business risks and are the impact that those risks might have on the financial statements.
It can be good practice during preparation for the exam to try and think of how a business risk might affect the
financial statements every time you are analysing them. You are looking to convert that business risk into an impact
on the calculation or disclosure of items within the financial statements.

When describing RoMMs, an effective approach is to use the following steps to construct your answer
1. Calculate and conclude on the materiality of the issue where sufficient information is available – a mark will be
given for a correct and relevant calculation of materiality with an appropriate conclusion – this will only be
awarded once per issue and materiality marks may be capped in an exam question.
2. Briefly describe the relevant financial reporting requirement – note that no credit is awarded for the accounting
standard names or numbers, only the accounting treatment.
3. Relate the risk in the scenario to the accounting treatment.
4. Illustrate the impact of the risk on the financial statements

In general, there will be credit available for each of these processes and you should recall this approach every time
you tackle a question requirement on evaluating RoMM.

Let’s consider the business risk we looked at above. The issue of bespoke machinery with an upfront payment can
affect the financial statements in terms of revenue recognition, when dealing with the upfront payments, and
inventory valuation. For the purposes of the exam, these two accounting issues are likely to be assessed as two
separate RoMMs.

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Applying this to the scenario we have above, the following illustrates a possible answer that could be written under
exam conditions and would score full marks for each of the addressed risks.

Revenue recognition
The company receives a 30% deposit for the design of bespoke machinery.

Revenue should be recognised over time or at a point in time when control is passed. Such points will be determined
by the contractual terms. Payments received in advance of control passing should be recognised as deferred
income.

There is a risk that revenue might be recognised early when payment is received rather than being deferred.

This would result in an overstatement of revenue and an understatement of liabilities for deferred revenue.

Inventory valuation
The company manufactures machines over a period of up to three months. This gives rise to work in progress.

Work in progress is valued at the lower of cost and NRV where cost includes all the costs of purchase and
conversion including overheads of getting the item to its present location and condition.

There is a risk that an order for bespoke machinery is cancelled and the inventory NRV falls below the
net costs incurred.

This would result in an overstatement of inventory (or assets) in the statement of financial position and an
understatement of cost of sales, therefore an overstatement of profit.

Note that we did not have sufficient information to calculate materiality in these examples.

Audit risks
Where you are asked to evaluate audit risks in an exam, much of your answer would be the same as for a requirement
asking for risks of material misstatements as these form the major part of audit risk. The difference here is that
detection risk is now also relevant. Examples of detection risk could include a recent appointment as the auditor,
inexperience in a client’s new market or time pressure for the audit.

If the information provided in the example we have been using included the following information:

You are the audit manager of Dali Co, a new audit client of your firm. The partner has asked you to plan the audit for
31 December 2015 and has provided you with the following information after a discussion with the client.

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Then, in addition to the RoMMs we have discussed, there would be an additional audit risk.

We are newly appointed auditors of the client and, as such, do not have the same level of understanding of the
client’s business and controls as we would for an existing client. As such, we may fail to recognise certain RoMMs
or may apply inappropriate procedures due to this lack of understanding

In addition, we have not audited the opening balances, so there is a risk that the opening balances may be incorrect
or inappropriate accounting policies have been used.

There are two common errors candidates make in the exam around the issue of a new client. First, some candidates
consider that a new auditor is a business risk or gives rise to a RoMM. This is incorrect. The underlying business is
the same regardless and it is only detection risk that alters.

The second is to assume that a new manager on an assignment is the same as having a new client. The audit partner
and the knowledge of the client within the firm is unaltered, so the discussion of a new manager to the audit resulting
in a significant audit risk does not attract credit.

It is also important to note that, from an exam point of view, none of these examples require a definition to be given
of risk types nor do they require any explanation of theories as part of the answer – if the examiner asks you to
evaluate risks, then presenting your answer using the approach of a subheading for each risk and answers like those
shown in the examples above is sufficient.

CONCLUSION: This article has focused on planning type questions where there is a specific requirement to describe
one or more of business risk, RoMM and audit risk, and has laid out an effective approach for how you can tackle
these questions to maximise your marks.

Note that RoMM is also relevant for matters and evidence questions where the structure of the answer in those
questions may be broader but the basic thought process is similar. This will be addressed further in a separate article
on accounting issues for Advanced Audit and Assurance.

Written by a member of the AAA examining team

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Audit Evidence and Audit Procedures

Let’s talk THE ADVANCED AUDIT & ASSURANCE EXAM

“Matters to consider”

Answer format

Step 1: Comment on materiality

Step 2: Explain the accounting treatment from the relevant IFRS/IAS
Step 3: Use the information given to discuss issues/risks
Step 4: Write the audit procedure OR audit evidence as asked

In the THE ADVANCED AUDIT & ASSURANCE EXAM Exam, the examiner will often ask for ‘matters to consider’
for a certain scenario. This requirement is then combined with either audit evidence or audit procedures.

The following approach needs to be used for ‘matters to consider’

Think about the facts given in the case What has happened in the scenario‐ should be reflected in
the F/S on which you will provide an opinion.
What matters should we consider as an 1. Is this material?‐in relation to assets and/or profits‐
external auditor? Remember. even if it isn’t material in isolation, can be
when aggregated with other misstatements towards the
end of the audit
Think of various aspects‐ dig deep into the 2. What are the risks to the F/S because of the facts given
scenario. in the case?
3. What do the standards require?‐use IFRS knowledge
4. Have the standards been complied with?

Audit Procedures
When a question asks for audit procedures, remember that there are some useful checklists:
 What documents would be available.
 Any 3rd Parties who can provide written confirmations.
 Would a written management representation help?
 What post year‐end events may have occurred, that would help assess the year‐end accounting treatment.
 Could this have happened in previous years – if so compare.

Another way to think of the above issues is by using the AEIOU mnemonic

(Analytical procedures, Enquiry and confirmation, Inspection, Observation and Recalculation)

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Audit Work On: Inventory, Work in progress & Standard costing systems

Inventory

Audit evidence
According to ISA 501, Audit Evidence – Additional Considerations for Specific Items, when inventory is material to
the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and
condition by attending physical inventory counting, unless this is impracticable.

When attendance is impracticable, the auditor has to consider whether alternative procedures provide sufficient
and appropriate audit evidence of the existence and condition of inventory.

ISA 501 requires the auditor to review the instructions issued by the management for physical verification,
focussing particularly on the following:
a) Control activities: count and recount procedures and control over used and unused stationery that is used to
record inventory during the inventory count. The instructions should be simple and clear. They should lay down
the responsibilities of different persons and state which location will be covered by which persons.

They should also specify the procedure to be followed and the identification marks to be made.

The intention should be to count each item and count it only once.

b) Accurate identification of slow moving / damaged items, inventory owned by third party, for example, goods
received on consignment, stage of completion of WIP.

c) Arrangements regarding the movement of inventory: dispatch and receipt of inventory before and after cut‐
off date, movement of inventory between areas during the process of counting.

d) Subsequent arrangements to check the accounting of movements mentioned above.

Work in Progress‐The valuation of work in progress is likely to be complex

Audit procedures in respect of the valuation of work in progress

– Obtain a schedule of items included in work in progress at the year end, cast it and agree the total to the general
ledger and draft financial statements.
– Agree a sample of items from the schedule to the inventory count records.
– For a sample of jobs included on the schedule:
 Agree costs to supporting documentation such as supplier’s invoice and payroll records;
 For any overheads absorbed into the work in progress valuation, review the basis of the absorption and
assess its reasonableness;
 Confirm that net realisable value is greater than cost

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Standard costing systems

IAS 2, Inventories permits valuation of inventories based on standard costing when prices fluctuate.

Therefore, while auditing standard costing systems, the auditor needs to ensure that standard costing is a valid
basis for valuing inventory and that the standard cost has been reasonably calculated.

Audit procedures
a) Review the purchase invoices and price index and enquire with management, to establish whether or not the
prices have fluctuated. The source documents should also be reviewed in order to verify the standard cost
calculations.

b) Discuss with management, whether or not standard costing is a valid costing system to use for the company’s
inventory.

c) Consider if the inventory is still comparable with the previous year’s inventory due to a change in accounting
policies, with appropriate disclosures of changes in accounting policies.

d) Check the reasonableness and accuracy of the standard cost calculation sheet by:
– Tracing the costs relating to purchases with the purchase invoices, wages with the wage sheets and
personnel records and overheads with the expense invoices
– Verifying the invoices mentioned above and checking whether the calculations are reasonable
– Casting the calculation sheet
– Verifying the standard cost calculations, including arithmetical calculations with the account totals in the
income statement.

Standard cost can also be verified by using analytical procedures such as comparison with the total related expense
in the income statement. For example the proportion of total overhead expenses (in the income statement) to the
total production during the year, would be the standard overhead cost

Factors to consider before accepting standard costs as an appropriate basis for the estimation of cost:

How often are the standard costs updated? ‐‐Do significant price variances arise? ‐‐Have the standard costs been
acceptable in the past?‐‐What controls are there over the amendment of standard cost data?

Audit work on: Statements of cash flows

Statements of cash flows are accounted for under the provisions of IAS 7 Statement of cash flows. The statement of
cash flows is essentially a reconciliation exercise between items in the operating profit and the statement of financial
position (cash).

As such, the statement of cash flows is often audited by the auditor reproducing it from the audited figures in the
other financial statements. This can be done quickly and easily in the modern era by use of computer programmes.

However, if the auditor wished to audit it another way, he could check and recalculate each reconciliation with the
financial statements. This would involve checking each line of the statement by working through the client's workings

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and agreeing items to the accounting records and backing documentation (for example, tax paid to the bank
statements) and the other financial statements.

Why is the statement of cash flows relevant to the auditors?

Report on the statement of cash flows
The statement of cash flows is specified in the audit report, as a statement the auditors are reporting on.

Financial reports are obliged to include a statement of cash flows under IAS 7 in order to show a true and fair view.
The auditors must therefore assess the truth and fairness of the statement of cash flows as required by IAS 7.

Analytical review
The information in the statement of cash flows will be used by the auditors as part of their analytical review of the
accounts, for example, by adding further information on liquidity. This will be particularly helpful when comparing
the statement to previous periods.

Going concern
The statement of cash flows may indicate going concern problems due to liquidity failings, overtrading and over
gearing. However, the statement is an historical document, prepared well after the year‐end, and is therefore
unlikely to be the first indicator of such difficulties.

Audit evidence
The auditors will obtain very little direct audit evidence from the statement of cash flows. It has been prepared by
the company (not the auditors or an independent third party) from records which are under scrutiny by the auditors
in any case. Thus the auditors will already have most of this information, although in a different format.

However, the statement of cash flows should provide additional evidence for figures in the accounts, for example,
the purchase or sale of tangible non‐current assets. Consistency of evidence will be important and complementary
evidence is always welcome.

The statements of cash flows can be audited in two ways:

a) By reconciling each item with the financial statements. This includes:

– Tracing the items to the source documents (e.g. tracing the loan document and bank statement to the entry
on the SOCF relating to repayment of loans).

– Recalculating each reconciliation e.g. recalculating the interest paid on loans with the loan document).

– Agreeing the prior year items in the SOCF (of the current period) with the corresponding amounts in then
audited SOCF of the earlier period.

– Agreeing schedules of cash receipts (prepared based on the analysis of cash book receipts) to the
receivables ledger control account.

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– Agreeing schedules of cash payments to suppliers and employees (prepared based on the analysis of cash
book payments) to the payables ledger and payroll control accounts (respectively).

– Analytical procedures such as various liquidity ratios and gearing ratios, comparison of trade receivable
(and payable) days (i.e. average credit periods given to customers and received from suppliers) with prior
years, are performed on the current period and also on the previous period. This will enable assessment of
the ratios with reference to previous years as well as with the industry.

b) By drawing up a statement of cash flow from the audited financial statements. The use of computers has made
this task very quick and easy.

Audit work: Changes in accounting policy

According to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, due to its materiality, the error
must be adjusted for retrospectively by amending comparatives and restating retained earnings at the beginning of
the earliest period presented.

The effect of a change in accounting estimates should be accounted for prospectively, and included in profit or loss
from the date of the change in estimate. In other words, it is only current and future periods which are affected by
the change in estimate.

In addition, IAS 8 requires a note to the financial statements to disclose the nature and amount of a change in an
accounting estimate that has an effect in the current period or is expected to have an effect in future periods.

The effect of a change in accounting policy is treated as a retrospective adjustment to the opening balance of each
affected component of equity as if the accounting policy had always applied.

IAS 8 Accounting policies, changes in accounting estimates and errors states that changes in accounting policies are
rare, and only allowed if required by statute or if the change results in more reliable and relevant information.

Take care not to confuse a change in accounting policy with a change in accounting estimate. A change in policy is
rare and per IAS 8 should be accounted for retrospectively, but a change in estimate (such as the method for
calculating depreciation) is accounted for going forward (prospectively).

An example of a change in accounting estimate is a change to an entity’s depreciation policy. In this case, the entity’s
accounting policy is to depreciate non‐current assets, and the ‘depreciation policy’(which would include e.g. reducing
balance or straight line depreciation, estimates of useful lives, etc.) is merely the policy chosen by management in
order to estimate how much depreciation should be charged.

Changes in accounting policy will be rare and should be made only if:
(a) The change is required by an IFRS; or

(b) The change will result in a more appropriate presentation of events or transactions in the financial statements
of the entity, providing more reliable and relevant information.

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The standard highlights two types of event which do not constitute changes in accounting policy.
(a) Adopting an accounting policy for a new type of transaction or event not dealt with previously by the entity.
(b) Adopting a new accounting policy for a transaction or event which has not occurred in the past or which was
not material.

Audit work: Taxation

IAS 12 Income Taxes requires deferred tax to be recognised in respect of taxable temporary differences which arise
between the carrying amount and tax base of assets and liabilities, including the differences which arise on the
revaluation of non‐current assets, regardless of whether the assets are likely to be disposed of in the foreseeable
future. There is no profit impact, however, as the deferred tax would be recognised in equity.

IAS 12 states that a deferred tax asset can only be recognised where the recoverability of the asset can be
demonstrated.

Unutilised tax losses can be carried forward for offset against future taxable profits, so the client must demonstrate,
using budgets and forecasts, that future tax profits will be available for the losses to be fully utilised

Examiner feedback: Students should remember there will be 3 types of adjustments (current tax , under/over
provision tax provision from previous year, deferred tax)
1. Verify that current tax expenses are properly calculated.
2. Review the provision to make sure that it is in accordance with IAS 12.
3. Check the accounting for and disclosures related to current tax expenses, asset, and liability.
4. Carry out a numerical reconciliation between tax expense and accounting profit multiplied by the applicable tax
rate.
5. Check the arithmetical accuracy of the deferred tax calculations. This would include checking the opening
balances of the deferred tax account against the previous year’s financial statements.
6. Obtain schedule of temporary differences : agree to tax computation and accounting records. Match the figures
used to calculate the temporary differences to those on the financial statements. For example, trace the
schedule of carrying amount (i.e. cost or revalued amounts net of accumulated depreciation) of non‐current
assets to the general account balances and agree these to tax computations and the asset register.
7. Ensure the rate applied is in accordance with IAS 12 (substantially enacted)
8. Enquire with management and verify that the tax computations include all differences which need to be
adjusted. Obtain a written representation..
9. Ensure that all necessary disclosures have been made‐ Disclosure: items on which deferred tax has been
calculated, the change in liability (reconciliation of opening and closing balance) and major components of
income tax expense.
10. If a tax software is used, perform TOCs.
11. Review any correspondence with the tax authorities.

Principal audit procedures – recoverability of deferred tax asset

– Obtain a copy of current tax computation and deferred tax calculations and agree figures to any relevant tax
correspondence and/or underlying accounting records.
– Develop an independent expectation of the estimate to corroborate the reasonableness of management’s
estimate.

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– Obtain forecasts of profitability and agree that there is sufficient forecast taxable profit available for the losses
to be offset against. Evaluate the assumptions used in the forecast against business understanding.
– Assess the time period it will take to generate sufficient profits to utilise the tax losses. If it is going to take a
number of years to generate such profits, it may be that the recognition of the asset should be restricted.
– Using tax correspondence, verify that there is no restriction on the ability of the client to carry the losses forward
and to use the losses against future taxable profits.

Audit work: Segmental Reporting

IFRS 8 Operating Segments requires listed companies to disclose in a note to the financial statements the
performance of the company disaggregated over its operating or geographical segments, as the information is
viewed by management.
a) The identification of the operating segments and the amounts related to prior period that are included in
segment information must agree with the segment information included in the financial statements of the
earlier year.

b) The totals of the segment information disclosure must be cast.

c) The turnover and operating profit totals must be agreed with the amounts shown on the face of the income
statement.

d) The segment results (i.e. segment revenue less segment expense) must be agreed with the internal MIS reports
of the entity.

e) The appropriateness of the geographic segments identified for the primary reporting format must be confirmed.
For this:
– The auditor must review the MIS information of the entity to ascertain whether it indicates that the chief
operating decision maker (like the board) of the entity reviews the performance of the operating segments
and also takes decisions relating to allocation of resources based on this information. The auditor will
confirm that operating results include segment information.
– The entity must have a system of recording segment information in its accounting systems e.g. cost centre
wise information. This will provide assurance that discrete financial information relating to operating
segments is available.
– The numerical thresholds must be recalculated.
– The auditor would also discuss the basis of allocation with the entity. Furthermore on a sample basis the
information must be verified with source data such as segment revenue with invoices.
– The auditor would also look at segments which were slightly too small and double check to see if they need
to be included.

f) Revenue expenses that arise at the enterprise level on behalf of segments (e.g. head office costs) which are not
directly attributable to a segment need to be allocated between the different segments on a reasonable basis.
However, the IFRS has not explained how this is to be done. Furthermore the basis for allocation which is chosen
can have a material effect on the segment result. Therefore the auditor needs to review the basis on which such
expenses are attributed to segments and confirm that it is reasonable (i.e. whether it is in agreement with prior
year basis).

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The auditor shall obtain sufficient IFRS 8 Operating segments

appropriate audit evidence regarding the An operating segment is a component of an entity:
presentation and disclosure of segment 1. That engages in business activities from which it may earn
information in accordance with the revenues and incur expenses (including revenues and
applicable financial reporting framework by: expenses relating to transactions with other components of
(a) Obtaining an understanding of the the same entity); Whose operating results are reviewed
methods used by management in regularly by the entity's chief operating decision maker to
determining segment information make decisions about resources to be allocated to the
(b) Performing analytical procedures or segment and assess its performance; and
other audit procedures appropriate in 2. For which discrete financial information is available.
the circumstances.
IFRS 8 requires an entity to report financial and descriptive
Depending on the circumstances, example information about its reportable segments.
of matters that may be relevant when
obtaining an understanding of the methods Reportable segments are operating segments or aggregations of
used by management in determining operating segments that meet specified criteria:
segment information and whether such 1. Its reported revenue, from both external customers and
methods are likely to result in disclosure in intersegment sales or transfers, is 10% or more of the
accordance with the applicable financial combined revenue, internal and external, of all operating
reporting framework include: segments; or
• Sales, transfers and charges between 2. The absolute measure of its reported profit or loss is 10% or
segments, and elimination of inter‐ more of the greater, in absolute amount, of
segment amounts. (i) the combined reported profit of all operating segments
• Comparisons with budgets and other that did not report a loss and
expected results, for example, (ii) the combined reported loss of all operating segments
operating profits as a percentage of that reported a loss; or
sales. 3. Its assets are 10% or more of the combined assets of all
• The allocation of assets and costs operating segments.
among segments.
• • Consistency with prior periods, and If the total external revenue reported by operating segments
the adequacy of the disclosures with constitutes less than 75% of the entity's revenue, additional
respect to inconsistencies. operating segments must be identified as reportable segments
(even if they do not meet the quantitative thresholds set out
above) until at least 75%of the entity's revenue is included in
reportable segments.

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Audit work: Property, Plant & Equipment

The key risk in relation to initial recognition is of costs being incorrectly recognised as assets, when they should in
fact have been expensed to the income statement.

Non‐current assets will be carried at cost or valuation (if an item has been revalued).

For assets that are measured at cost, the auditor would have to verify the cost from the asset’s purchase invoice.

Valuation may be straightforward to audit – it can be verified to the valuation certificate.

Assets revalued by a value: The auditor would need the certificate from the valuer as proof to verify the value of
the asset. However before accepting the work of an expert, the auditor must evaluate the experts’ work
(independence, objectivity, scope of work, assumptions used) and confirm the reasonableness of the valuation.
Additionally, the auditor would have to check that the valued amount does not deviate too far from its fair value.

The carrying value of non‐current assets is therefore depreciated cost, or depreciated valuation.

Once a company has revalued assets, it is required to continue revaluing them regularly so that the valuation is not
materially different from the fair value at period end. The auditors should therefore check that valuation is
comparable to market value. They would do this by comparing the existing valuation to current market values (for
example, in an estate agent’s window).

Assets are depreciated, so their carrying value will not be original cost or valuation.

Depreciation can be verified by re performing the depreciation calculations.

Often a ‘proof‐in‐total’ check will be sufficient, where auditors calculate the relevant depreciation percentage on
the whole class of assets to see if it is comparable to the depreciation charged for that class of assets in the year.

The depreciation rate is determined by reference to the useful life of the asset. This is determined by management
based on expectations of how long the asset is expected to be in use in the business. The auditors will audit this by
scrutinising those expectations and verifying them where possible – for example, to the minutes of the meeting
where management decided to buy the asset, to capital replacement budgets, to past practice in the business.

Risks where revaluation has taken place:

IAS 16 Property, Plant and Equipment requires all assets in the same class to be revalued.

There is also a risk that depreciation has not been recalculated on the new, higher value of the properties, leading to
overstatement of non‐current assets and understatement of operating expenses.

IAS 16 also requires a significant level of disclosure in relation to a policy of revaluation, so there is a risk that the
necessary disclosures are incomplete

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Assets purchased during the year should be correctly classified under their own account headings. In the case of
additions and disposals to the assets made during the year the auditor should inspect ledger accounts to ensure that
the additions and disposals are not recorded as purchases and sales revenue.

Appropriate Cut off: This means that transactions and events have been recorded in the correct accounting period.
In this case, when auditing non‐current assets, the auditor has to ensure that all additions and disposals to the non‐
current assets account that have occurred during the year are recorded and that no transactions occurring in prior
years have been recorded in the current year’s accounts

Rights and obligations: This means that the entity has the right to use and dispose of the asset. Any liability arising
from the asset has to be paid by the entity. Only when the rights of ownership are in the hands of the entity can it
record the asset in its accounts. For property purchased during the year, the auditor would have to look at any legal
documentation that would indicate ownership of the asset e.g. title deed documents.

Existence: By existence, it means that the non‐current asset does really exist at the end of the reporting period. The
auditor would have to visit the site of the assets and physically verify that the asset exists as at the end of the
reporting period. If the auditor is not able to physically verify the assets the auditor can make a surprise physical
check of significant assets. Furthermore the auditor will confirm whether physical verification of non‐current assets
was carried out by the entity. Existence will ensure that the items exist, but will not confirm the valuation. Hence
valuation methods need to be used to confirm the valuation e.g. looking at the purchase invoices and confirming
the original cost and then estimating depreciation based on past experience with the entity etc.

Audit work: Property, Plant & Equipment

Fair Value: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date

Fair value accounting is increasingly important and affects the audit of valuation for both assets and liabilities. In
May 2011 the IASB issued IFRS 13 Fair value measurement, as a result of a joint project with the US FASB. Examples
of accounting treatments where fair values are relevant include financial instruments, employee benefits and share‐
based payments.

IFRS 13 uses a 'fair value hierarchy', which categorises inputs into three levels:
 Level 1 inputs: quoted prices in active markets for identical assets or liabilities that the entity can access at the
measurement date
 Level 2 inputs: inputs other than quoted market prices included within Level 1 that are observable for the asset
or liability, either directly or indirectly
 Level 3 inputs: unobservable inputs for the asset or liability

Exam focus point

Fair value is a very topical area at the moment, and is therefore likely to be tested, eg as part of a requirement to
discuss the difficulties involved in auditing fair value estimates.

For auditors, the determination of fair value will generally be more difficult than determining historical cost. It will
be more difficult to establish whether fair value is reasonable for complex assets and liabilities than for more

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straightforward assets or liabilities which have a market and therefore a market value. For example, for an apartment
held as an investment property, a fair value might be relatively easy to estimate, as there may be a large and active
market for similar properties that can be used as a guide to the value of the property in question. If, on the other
hand, an entity has a large pension scheme, for which the fair value of the assets depends on actuarial assumptions
about the future, then the fair value will be extremely difficult to measure, and the auditor will have to be very
careful about the assumptions made in arriving at a valuation.

Generally speaking, balances held at fair value carry the following risks.

Component of Risk
audit risk
Inherent risk Estimates are inherently imprecise, and involve judgements, eg about market conditions,
timing of cash flows, or the intentions of the entity.
Estimation models are often complex, eg discounted cash flows, or actuarial calculations.
There is a risk of the model being misapplied.
Assumptions often have to be made when estimating fair values, eg discount factors.
However, obtaining a fair value for some assets will be straight forward, eg assets that are
regularly traded on a stock exchange.
Control risk Fair value assessment is likely to take place once a year, outside of normal internal control
systems. Therefore it may not be monitored as stringently as more routine transactions and
balances. Alternatively, management may take extra care over a fair value assessment
because it is a material amount, in which case control risk is low.
Detection risk The auditor minimises detection risk through understanding the entity and its environment
at the planning stage, determining whether and where fair values are present, and what the
level of risk associated with them is.

Risk procedures: fair value

The auditor is required to assess the entity’s process for determining accounting estimates including fair value
measurements and disclosures and the related control activities and to assess the arising risks of material
misstatement.

Management’s processes for determining fair values will vary considerably from organisation to organisation. Some
companies will habitually value items at historical cost where possible, and may have very poor processes for
determining fair value if required. Others may have complex systems for determining fair value if they have a large
number of assets and liabilities which they account for at fair value, particularly where a high degree of estimation
is involved in determining the fair value.

Once the auditors have assessed the risks associated with determining fair value, they should determine further
procedures to address those risks.

Audit procedures: fair value

Audit procedures will depend heavily on the complexity of the fair value measurement. Where the fair value equates
to market value, the auditor should be able to verify this with reference to the market, for example, published price
quotations for marketable securities, or by using the work of an expert, for example, an estate agent in the case of
land and buildings.

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However, in some cases, there may be a great deal of estimation and management assumption related to a fair
value. Where this is the case, the auditor needs to consider matters such as the intent and ability of management to
carry out certain actions stated in the assumptions. This includes:
• Considering management’s past history of carrying out its stated intentions with respect to assets or liabilities
• Reviewing written plans and other documentation, including, where applicable, budgets, minutes etc
• Considering management’s stated reasons for choosing a particular course of action
• Considering management’s ability to carry out a particular course of action given the entity’s economic
circumstances, including the implications of its contractual commitments

The auditor should consider the following when considering fair value measurements:
• The length of time any assumptions cover (the longer, the more subjective the value is)
• The number of assumptions made in relation to the item
• The degree of subjectivity in the process
• The degree of uncertainty associated with the outcome of events
• Any lack of objective data
• The timings of any valuations used
• The reliability of third party evidence
The impact of subsequent events on the fair value measurement

Where a fair value measurement is based on assumptions reflecting management’s intent and ability to carry out
certain actions, then the auditor should obtain written representations from management that these assumptions
are reasonable and achievable.

Fair values – acquisition of new subsidiaries

When a parent company acquires a new subsidiary, it will pay the fair value of the acquired company as a whole.
This is because the previous owners tend to be unwilling to sell their company for less than its fair value. In order to
bring in a fair estimate of the initial value of goodwill, IFRS 3, Business Combinations requires that the individual net
assets of the acquired company be valued at their fair value at the date of the acquisition. Often, the acquirer will
have investigated their assessment of value of material assets, liabilities and contingent liabilities of the target
company as part of a pre‐acquisition due diligence investigation. In these circumstances, the values ascribed to
individual assets and liabilities in this due diligence will be an appropriate value to use for the initial recognition of
each asset and liability. This means that fair value often becomes fair value through the eyes of the acquirer. This is
not always the most appropriate valuation basis, however, since the value given by the acquirer may include some
degree of the acquirer’s intentions. For example, it is common for a new acquirer to plan to restructure an acquired
business shortly after the acquisition. This might include an intention to pay off any litigation in progress at the date
of acquisition in order to fee management time for integration of the subsidiary into its new group. This could result
in incorrect recognition of provisions that are higher than the true value of the obligation.

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Audit Work On: Employee Benefits

Scheme assets (including – Obtain direct confirmations of scheme assets from the investment professional
quoted and unquoted in charge of the plan assets.
securities, debt – Obtain reconciliations from the company’s management of the valuation as at
instruments, properties) the scheme year end date with the entity’s reporting date.
– Consider requiring scheme auditors to perform procedures
Scheme liabilities Work done by the actuary can be relied upon after evaluating his work in accordance
with the provisions of ISA 620 Using the Work of an Auditor’s Expert. Auditors must
assess whether it is appropriate to rely on the actuary's work

Specific matters would include

– The source data used
– The assumptions and methods used
– The results of actuaries' work in the light of auditors' knowledge of the business
and results of other audit procedures

Actuarial source data is likely to include:

– Scheme member data (for example, classes of member and contribution details)
– Scheme asset information (for example, values and income and expenditure
items)
Actuarial assumptions – Discuss with the actuaries the basis used to calculate assumptions and review
( for example retirement whether or not the assumptions appear to be reasonable based on their
ages, mortality rates, knowledge of the entity’s financial information.
employee – Compare the assumptions used in the current year with those used in the
turnover/termination previous years, for consistency.
rate, changes in salary – Obtain written representations from the entity’s management regarding the
and benefits, funds’ appropriateness of the assumptions in relation to their knowledge of business.
assets performance) – Auditors should determine whether the assumptions used by the entity are
Remember that it is similar to the assumptions used by other entities in the industry.
unlikely that auditors – Evaluate the reasonableness of assumptions by using your knowledge of the
will have the same level business and results of other audit procedures
of expertise as the
actuary!
– Recalculate actuarial gain/loss

Ensure Accounting treatment in accordance with the provisions of IAS 19:

– The auditors should confirm that the accounting treatment of the various aspects of the plan is recorded in
the financial statements in accordance with the provisions of IAS 19.
– Furthermore the auditor must trace some of the items recorded in the financial statements with the source
documents. For example interest cost with the loan documents, bank statements; current service costs with
payroll records, personnel records, etc.
– Defined benefit: be alert! Scheme valuation date may be different from the reporting date. In this case, a
reconciliation will be requested from the directors.

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Audit work: Government Grants

A government grant is recognised only when there is reasonable assurance that (a) the entity will comply with any
conditions attached to the grant and (b) the grant will be received

Risks
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that a grant is
recognised as income over the period necessary to match the grant received with the related costs for which they
are intended to compensate. This means that the amount received should not be recognised as income on receipt,
but the income deferred and released to profit over the estimated useful life of the assets to which it relates.

The risk is that the grant has been recognised on an inappropriate basis leading to over or understated profit for the
year.

The part of the grant not recognised in profit should be recognised in the statement of financial position.

IAS 20 allows classification as deferred income, or alternatively the amount can be netted against the assets to which
the grant relates. There is therefore also a risk that the amount is recognised elsewhere in the statement of financial
position, leading to incorrect presentation and disclosure.

If the terms of the grant have been breached, the grant or an element of it may need to be repaid. There is therefore
a risk that if there is any breach, the associated provision for repayment is not recognised, understating liabilities.

Revenue Grant‐A grant receivable as compensation for costs, either: Already incurred or For immediate financial
support, with no future related costs.

Recognise as income in the period in which it is receivable.

It may be presented in one of two ways:
 Separately as ‘other income’
 Deducted from the related expense.

Grants where related costs have already been incurred offer no difficulties to account for or to audit. To audit them,
the auditor should:
• Obtain documentation relating to the grant and confirm that it should be classified as revenue
• The value may be agreed to the documentation (for example, a letter outlining the details of the grant, or a copy
of an application form sent by the client)
• The receipt of the grant can be agreed to bank statements

A grant relating to assets may be presented in one of two ways:

 as deferred income, or
 by deducting the grant from the asset's carrying amount.

The grant is recognised as income over the period necessary to match it with the related costs, for which it is intended
to compensate on a systematic basis and should not be credited directly to equity.

If a grant becomes repayable, it should be treated as a change in estimate.

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Capital grants can be more difficult to audit

Audit procedures:
• Consider whether the basis of accounting is comparable to the previous year.
• Discuss the basis of accounting with the directors to ensure that the policy used is the best one
• Ensure that any changes in accounting policy are disclosed.

Under IAS 20, the grant should be presented on the statement of financial position either as deferred income, or by
deducting the grant in arriving at the asset’s carrying value.

Audit procedures in respect of the recognition and measurement of the government grant
– Obtain the documentation relating to the grant to confirm the amount, the date the cash was received, and the
terms on which the grant was awarded.
– Review the documentation for any conditions attached to the grant
– Discuss with management the method of recognition of the amount received, in particular how much of the
grant has been recognised in profit and the treatment of the amount deferred in the statement of financial
position.
– Confirm that the grant criteria have been complied with ( scenario specific information needs to be
incorporated)
– Using the draft financial statements, confirm the accounting treatment outlined by discussion with management
has been applied and recalculate the amounts recognised. {Recalculate ‘release’ to match with costs (revenue
grant) or depreciation (capital grant)}
– Confirm the cash received to bank statement and cash book
– Review Disclosures for adequacy and completeness:
Disclosure
• Accounting policy note.
• Nature and extent of government grants and other forms of assistance received.
• Unfulfilled conditions and other contingencies attached to recognised government assistance.

Non‐monetary grants, such as land or other resources, are usually accounted for at fair value.

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Audit work: Related parties

Examples of related parties: subsidiaries, JV, shareholder with significant influence, directors, other senior
management like CFO

Indicators: loans (with no interest, low interest, no specific repayment terms), non‐monetary exchange of property,
sale of real estate at a market value , loan from a stockholder to hide liquidity problems

Related party – A party that is either:

(i) A related party as defined in the applicable financial reporting framework; or

(iii) Where the applicable financial reporting framework establishes minimal or no related party requirements:
a. A person or other entity that has control or significant influence, directly or indirectly through one or
more intermediaries, over the reporting entity;
b. Another entity over which the reporting entity has control or significant influence, directly or indirectly
through one or more intermediaries; or
c. Another entity that is under common control with the reporting entity through having:
i. Common controlling ownership;
ii. Owners who are close family members; or
iii. Common key management.

ISA 550 Related Parties requires that the auditor evaluates whether identified related party relationships and
transactions have been appropriately accounted for and disclosed in accordance with the applicable financial
reporting framework.

Why are related parties difficult to identify

Related parties and related party transactions can be difficult to identify.

1. Management may be unaware of the existence of all related party relationships and transactions, resulting in
them not being revealed to the auditor on enquiry. Auditors of smaller companies can often find it difficult to
identify related parties because management does not understand the disclosure requirements or the
significance of the disclosures required.
2. It can also be difficult to decide if a related party relationship exists, as some of the definitions in IAS 24 Related
Party Disclosures are subjective, also resulting in non‐disclosure to the auditor of potential related parties and
transactions.
3. Management of larger companies may have a better understanding of recording and disclosing related party
transactions. However auditors of the larger companies have to deal with larger more complex transactions that
can be more difficult to understand and follow.
4. There could also be a deliberate attempt by management to conceal related party relationships or transactions.
Knowledge of related party relationships is largely confined to management, and in the absence of alternative
procedures other than management enquiry, the auditor could not know of the existence of some related party
relationships, especially the family members of key management personnel. ISA 550 Related Parties identifies
that related party relationships may represent a greater opportunity for collusion, concealment or manipulation
by management.

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5. The accounting system may not be set up to identify related party transactions. For example, cash payments
made to a related party may not be separately identified from payments to trade suppliers within the ledgers.
6. Finally, some related party transactions occur at minimal value, and sometimes at nil value. This makes the
transaction almost impossible for the auditor to detect, other than relying on management to disclose the
transaction on enquiry.

Procedures helpful in identifying related parties

• Enquire of management and the directors as to whether transactions have taken place with related parties that
are required to be disclosed by the disclosure requirements that are applicable to the entity
• Review prior year working papers for names of known related parties
• Review minutes of meetings of shareholders and directors and other relevant statutory records such as the
register of directors' interests
• Review accounting records for large or unusual transactions or balances, in particular transactions recognised
at or near the end of the financial period
• Review confirmations of loans receivable and payable and confirmations from banks. Such a review may
indicate the relationship, if any, of guarantors to the entity
• Review investment transactions, for example purchase or sale of an interest in a joint venture or other entity
• Enquire as to the names of all pension and other trusts established for the benefit of employees and the names
of their management and trustees
• Enquire as to the affiliation of directors and officers with other entities
• Review the register of interests in shares to determine the names of principal shareholders
• Enquire of other auditors currently involved in the audit, or predecessor auditors, as to their knowledge of
additional related parties
• Review the entity's tax returns, returns made under statute and other information supplied to regulatory
agencies for evidence of the existence of related parties
• Review invoices and correspondence from lawyers for indications of the existence of related parties or related
party transactions

Circumstances which indicate the existence of a related party

The following are the circumstances that indicate the existence of a related party.
1. Economic substance of the transaction differs from form: In situations where the substance and economic
reality of a transaction is different from the legal form, the possibility of a related party exists and it becomes
necessary to assess the transaction on its substance and economic reality.
2. No logical business reason: The auditor can identify the transaction where there is no logical business reason
to effect the particular transaction.
3. Not adhering to the set methods of processing transactions: Transactions that are not processed in the routine
manner may be on account of related party transactions.
4. Terms of trade different from normal: If the terms of trade are different and not according to routine business
transactions, there can be a related party transaction.
5. High volume with one customer / supplier: An extraordinary high volume of sales or purchases with one
customer or vendor is also a risky area as this can be construed as a related party transaction.
6. Unrecorded transaction: If there are any unrecorded transactions, the auditor can assess whether there is a
genuine error or whether the mistake had been made on purpose.
7. Transactions not having adequate evidence: An auditor always asks for the audit evidence which is sufficient
and reasonable to cover the risk. If any particular transaction is effected without adequate documentary

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evidence, there is a probability of the transaction being a related party transaction e.g. absence of documentary
evidence to support an investment made in the shares of a company.
8. Unusual transactions entered at the start and end of year

Audit work
ISA 550 requires that where a significant related party transaction outside of the entity’s normal course of business
is identified, the auditor shall:
1. Inspect the underlying contracts or agreements, if any, and evaluate whether:
a) The business rationale (or lack thereof) of the transactions suggests that they may have been entered into
to engage in fraudulent financial reporting or to conceal misappropriation of assets;
b) The terms of the transactions are consistent with management’s explanations; and
c) The transactions have been appropriately accounted for and disclosed in accordance with the applicable
financial reporting framework.
2. The auditor shall also obtain audit evidence that the transactions have been appropriately authorised and
approved.
3. IAS 24 states that a related party transaction should be disclosed if it is material In relation to a material related
party transaction, IAS 24 requires disclosure of the nature of the related party relationship along with
information about the transaction itself, such as the amount of the transaction, any relevant terms and
conditions, and any balances outstanding.
4. The auditor needs to get a written representation from management stating that management has disclosed to
the auditor the identity of the entity’s related parties and all the related party relationships and transactions of
which they are aware, and that management has appropriately accounted for and disclosed such relationships
and transactions in accordance with the requirements of IAS 24.
5. Auditor shall inquire of management:
– The identity of related parties including changes from prior period
– The nature of the relationships between the entity and its related parties
– Whether any transactions occurred between the parties, and if so, what
– What controls the entity has to identify, account for and disclose related party relationships and
transactions
– What controls the entity has to authorise and approve significant transactions and arrangements with
related parties
– What controls the entity has to authorise and approve significant transactions and arrangements outside
the normal course of business
6. Perform procedures specific to the transaction given in the question

IAS 24
Related party: a person or entity that is either
(a) A person or a close member of that person’s family is related to a reporting entity if that person:
(i) has control or joint control over the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting
entity.
b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which means that each parent,
subsidiary and fellow subsidiary is related to the others).

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(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a
member of a group of which the other entity is a member).
(iii) Both entities are joint ventures of the same third party.
(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.
(v) The entity is a post‐employment benefit plan for the benefit of employees of either the reporting
entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the
sponsoring employers are also related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).

Related party transactions are a transfer of resources or obligations between related parties, regardless of
whether a price is charged.

Audit work: Earnings per share

Audit issues
The size of the figure is unlikely to be material in itself, but it is a key investor figure. As it will be of interest to all
the investors who read it, it is material by its nature.

When considering earnings per share, the auditor must consider two issues:
• Whether it has been disclosed on a comparable basis to the prior year, and whether any changes in accounting
policy have been disclosed, and
• Whether it has been calculated correctly

A key audit risk is that the entity fails to meet IAS 33’s disclosure requirements. These are:
(a) The amounts used as the numerators in calculating basic and diluted EPS, and a reconciliation of those amounts
to the net profit or loss for the period
(b) The weighted average number of ordinary shares used as the denominator in calculating basic and diluted EPS,
and a reconciliation of these denominators to each other.

IAS 33 requires EPS to be calculated based on the profit or loss for the year attributable to ordinary shareholders as
presented in the statement of profit or loss, EPS based on an alternative profit figure is only allowed to be disclosed
in the notes to the financial statements as an additional figure, and should not be disclosed on the face of the
financial statements.

The denominator used in the EPS calculation should be based on the weighted average number of shares which were
in issue during the financial year.

Audit procedures on earnings per share

– Review board minutes to confirm the authorisation of the issue of share capital, the number of shares and the
price at which they were issued.
– Inspect any other supporting documentation for the share issue, such as a share issue prospectus or
documentation submitted to the relevant regulatory body.
– Confirm that the share issue complies with the company’s legal documentation (e.g. the memorandum and
articles of association).
– Recalculate the weighted average number of shares for the year.

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– Recalculate EPS using the profit as disclosed in the statement of profit or loss and the weighted average number
of shares.
– Discuss with management the existence of any factors which may impact on the calculation and disclosure of a
diluted EPS figure, for example, convertible bonds.
– Read the notes to the financial statements in respect of EPS to confirm that disclosure is complete and accurate
and complies with IAS 33.

Audit work on: Impairment

When auditing an entity’s non‐current assets, the auditor would, use the same criteria as set out by the management
in accordance with IAS 36 Impairment of Assets, check for indicators that may suggest a possibility for impairment
on assets.

IAS 36 specifies the following indicators of possible impairment

External sources of information regarding possible impairment:

– Market value declines significantly;
– Negative changes in technology, markets, economy, or legal environment;
– Increases in market interest rates that are likely to affect the discount rate using to calculate value
– in use;
– Company stock price is below book value.

Internal sources of information regarding possible impairment:

– Obsolescence or physical damage;
– Significant changes with an adverse effect on use, eg asset will become idle, is part of a restructuring, or is held
for disposal;
– Internal evidence shows worse economic performance of the asset than was expected..

The auditors will consider whether there are any indicators of impairment when carrying out risk assessment
procedures. They will use the same impairment criteria laid out in IAS 36 as management do.

If there is an indication of impairment on an asset, the auditors should request the management for a copy of the
impairment review. If the management has carried out an impairment review, that impairment review should be
audited.

If the management has not conducted an impairment review, then the auditors should propose an impairment
review and qualify their report depending on whether or not the management agrees to carry out the impairment
review.

The matters to be audited would be:

Verify the Carrying Value (the amount at which an asset is recognised in the balance sheet after deducting
accumulated depreciation and accumulated impairment losses)

Recoverable amount: this depends on the fair value, cost to sell and value in use.

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Fair value and cost to sell: both are subject to estimations. Therefore they need to be reviewed carefully. The risk
assessment procedures to assess the risks of material misstatement in relation to accounting estimates and fair
values would have to be carried out. Additionally while reviewing cost to sell the items which can be included and
excluded must be in accordance with the provisions of IAS 36.

Cost to sell should be checked for arithmetical accuracy. Furthermore, cost of delivery can be verified from the rates
published by delivery companies. Cost to sell includes transaction taxes. These can be recalculated by applying the
applicable tax rate to the fair value. Stamp duty can be recalculated based on the regulatory requirements.

Value in use
If the management has used the asset’s value in use, the auditor must conduct the following audit procedures.
1. Physically inspect the asset; this provides evidence of existence and condition of asset as on the reporting date.
2. Obtain the document containing value in use (along with the working papers) from the entity.
3. Trace the projected cash flows in the workings with budgets and projections, to ensure that they are approved
by the board and are reasonable (e.g. asset days available and average daily utilisation per asset).
4. 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
5. Check the arithmetical accuracy of the document.
6. Cash flows need to be discounted to present values. Confirm that the present values used for discounting should
be in accordance with the published market rates expected by the market.
7. Recalculate on a sample basis, the makeup of the cash flows included in the forecast..
8. Compare to previous calculations of value in use to ensure that all relevant costs of maintaining the asset have
been included
9. Ensure that the cost/income from disposal of the asset at the end of its life has been included
10. Review calculation to ensure cash flows from financing activities and income tax have been excluded
11. Written representation: regarding expected future performance and that the management’s assumptions are
reasonable.

Ensure Disclosure requirements have been met.

– Impairment losses recognised in profit or loss , impairment losses reversed in profit or loss
– Impairment losses on revalued assets recognised in other comprehensive income , impairment losses on
revalued assets reversed in other comprehensive income
– The valuation techniques used to measure fair value less costs of disposal and the key assumptions used in the
measurement of fair value measurements
– Discount rate used for value in use

Audit procedures – impairment of goodwill

The auditor should perform the following procedures:
– The assumptions used in the impairment test should be confirmed as agreeing with the auditor’s understanding
of the business based on the current year’s risk assessment procedures, e.g. assess the reasonableness of
assumptions on cash flow projections.
– Confirm that the impairment review includes the goodwill relating to all business combinations.
– Consider the impact of the auditor’s assessment of going concern on the impairment review, e.g. the impact on
the assumption relating to growth rates which have been used as part of the impairment calculations.
– Obtain an understanding of the controls over the management’s process of performing the impairment test
including tests of the operating effectiveness of any controls in place, for example, over the review and approval

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of assumptions or inputs by appropriate levels of management and, where appropriate, those charged with
governance.
– Confirm whether management has performed the impairment test or has used an expert.

– The methodology applied to the impairment review should be checked by the auditor, with inputs to
calculations, e.g. discount rates, agreed to auditor‐obtained information.
– Develop an independent estimate of the impairment loss and compare it to that prepared by management.
– Confirm that the impairment calculations exclude cash flows relating to tax and finance items.
– Perform sensitivity analysis to consider whether, and if so how, management has considered alternative
assumptions and the impact of any alternative assumptions on the impairment calculations.
– Check the arithmetic accuracy of the calculations used in the impairment calculations

Audit work: provisions, contingent liabilities, contingent assets

According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised where
there is a present obligation as a result of a past event, a probable outflow of economic benefit and a reliable
estimate can be made.

Contingent Assets should not be recognised until such time as the inflow of economic benefits is virtually certain. If
the inflow of benefits is probable rather than virtually certain, then the matter should only be disclosed in a note to
the financial statements.

ISA 540 directs the auditor’s work from a starting point of uncertainty rather than the materiality of the draft
figure in the financial statements. The greater the estimation uncertainty, rather than the size of the draft figure,
the greater the amount of evidence that the auditor will need to obtain.
– The schedule forming part of the financial statements relating to provisions and contingent assets and liabilities
should be obtained from the client. The schedule must include opening balances, movements during the current
period and the closing balances. The amounts relating to opening balances should be agreed with the previous
period’s financial statements.
– Considering the nature of the entity’s business the auditor must consider whether appropriate provisions are
made. For example the auditor of a mining company would verify whether provisions for site restoration are
made on mines.

Obtain an understanding When performing risk assessment procedures, the auditor shall obtain an
understanding of the following:
1. The requirements of the applicable financial reporting framework relevant to
accounting estimates, including related disclosures.
2. How management identifies those transactions, events and conditions that may
give rise to the need for accounting estimates to be recognized or disclosed in
the financial statements.
3. How management makes the accounting estimates, and an understanding of
the data on which they are based, including:
 The method, including where applicable the model, used in making the
accounting estimate;
 Relevant controls;

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Whether management has used an expert;

The assumptions underlying the accounting estimates;
Whether there has been or ought to have been a change from the prior
period in the methods for making the accounting estimates, and if so, why;
and
 Whether and, if so, how management has assessed the effect of estimation
uncertainty(The susceptibility of an accounting estimate and related
disclosures to an inherent lack of precision in its measurement.)
Review and test the (a) Evaluation of the data and consideration of the assumptions on which the
process used by estimate is based
management to develop (b) Testing of the calculations involved in the estimate
the estimate; (c) Comparison, where possible, of estimates made for prior periods with actual
results of those periods
(d) Consideration of management’s approval process.
Use an independent The auditor may make or obtain an independent estimate and compare it with the
estimate, either made or accounting estimate prepared by management.
obtained by the auditor,
for comparison with that When using an independent estimate the auditor would ordinarily evaluate the data,
prepared by consider the assumptions and perform audit procedures on the calculation
management; procedures used in its development.

It may also be appropriate to compare independent estimates made for prior periods
with actual results of those periods.

Review subsequent Transactions and events which occur after period end, but prior to completion of the
events which provide audit, may provide audit evidence regarding an accounting estimate made by
audit evidence of the management. The auditor's review of such transactions and events may reduce, or
reasonableness of the even remove, the need for the auditor to review and perform audit procedures on
estimate made. the process used to develop the accounting estimate or to use an independent
estimate in assessing the reasonableness of the accounting estimate.
The auditor shall obtain sufficient appropriate audit evidence about whether the disclosures in the financial
statements related to accounting estimates are in accordance with the requirements of the applicable financial
reporting framework.

Provisions: nature of obligation, timing of outflow, any uncertainty regarding amount or time, any assumptions
about future events, numerical reconciliation of opening and closing balances
The auditor shall review the judgments and decisions made by management in the making of accounting
estimates to identify whether there are indicators of possible management bias.
The auditor shall obtain written representations from management and, where appropriate, those charged with
governance whether they believe significant assumptions used in making accounting estimates are reasonable
Consider the need for 3rd party confirmation or inspection of client’s correspondence with 3rd parties.

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Management Bias
“Management bias” according to ISA 540 Auditing accounting estimates is a lack of neutrality by management in the
preparation of financial information. In theory, management should be unbiased or neutral when preparing financial
information because the information itself needs to be unbiased so users can rely on it. However, management may
find it difficult to take an objective view simply because they normally have an inherent interest in that information.
For example, bonus payments may vary as a direct result of reported profit or share price change resulting from
publication of financial information

THE ADVANCED AUDIT & ASSURANCE EXAM‐ extracted from past exams‐ examples given below.

Contingencies arising as a result of litigation. Litigation and legal claims against the entity may have a material
effect on the financial statements. Due to this, the auditor should carry out appropriate audit procedures to
identify litigation legal claims against the client.

Audit procedures
These procedures would include enquiring from management, reviewing board meetings and legal expense
accounts, among other tasks.

If the audit procedures indicate the existence other material litigation or claims the auditor should seek direct
confirmation (from the client’s external legal counsel) on the litigation matter. This will enable the auditor to
obtain sufficient appropriate evidence relating to:
– Identification of potentially material litigation
– Claims
– Management’s estimates of the financial implications, including costs and whether they are reasonable.

This communication after the client’s management provides the auditor with a letter requesting its legal counsel
to directly communicate with its auditors.

If it is perceived that the external legal counsel would not respond to a general letter of enquiry, a letter of
specific inquiry would have to be sent. This letter would include:
– A list of legal claims against the company,
– The management’s assessment of the outcome (if available) of each of the identified litigation and claims
and its estimate of the financial implications, including costs involved,
– A request to the lawyers to confirm or disaffirm the reasonableness of the management’s assessment of
the outcome of the claims brought up against the company. Furthermore a request for further information,
if the list is considered by the entity’s external legal counsels to be incomplete or incorrect.

Written representations from the management must include completeness of all the potential litigation and
claims being disclosed to the auditors.

Refusal by the management to provide the auditor with permission to communicate with the legal counsel
would result in a modified opinion in the audit report.

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Decommissioning provision
According to IAS 16 Property, Plant and Equipment, the cost of an asset should include the estimated costs of
dismantling and removing the asset (also known as decommissioning costs) if there is an obligation to incur the
cost at the end of the life of the asset.

According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should only be recognised
if there is a present obligation as a result of a past event, giving rise to a probable outflow of economic benefit.

The measurement of the provision is inherently subjective and complex, as it involves estimations of the expected
decommissioning cost, the estimated life of the power stations, and the application of an appropriate discount
factor to calculate the present value of the expected costs. There is risk that inappropriate assumptions have been
used in determining these estimates.

Important risky area: The auditor should consider whether it seems reasonable that in the scenario, the value of
the provision is reducing over the period of time. It would normally be expected to see the value of the provision
increase over time, as the provision is unwound each year to increase its present value. The fact that the provision
has decreased in value could indicate that management has changed one or more of the assumptions used in the
measurement of the provision (e.g. using a higher interest rate to calculate the present value of the provision),
the reasons for which would need to be investigated.

It should be considered whether sufficient disclosure has been made in the notes to the financial statements. IAS
37 requires that the notes should contain narrative information including a brief description of the nature of the
obligation and the expected timing of any outflows of economic benefits, and an indication of the uncertainties
about the amount or timing of those outflows. In addition, the notes should disclose the major assumptions made
concerning future events. The notes should also contain numerical disclosures, namely a reconciliation of the
opening and closing provision, analysing the movement in the year.

Audit evidence
– A review of any agreement for confirmation that there is an obligation to decommission.
– A copy of management’s calculations used to measure the provision, and confirmation that the calculation is
based on assumptions in line with our understanding of the entity, and which are consistent with other audit
evidence obtained (e.g. that the remaining life of the assets is 20 years, that the discount rate used to
determine the present value of the provision is appropriate).
– A review of documentation used to support management’s assumptions
– A discussion with management as to whether there has been, or ought to have been, a change from the prior
year in the methods for making the estimates or assumptions used in the measurement of the provision.
– An assessment of the controls in place over the estimate of the provision (e.g. are there controls to ensure
that the circumstances giving rise to the provision, and the assumptions used in calculations are periodically
reviewed, and whether there is review and approval of the calculations).
– A written representation from management indicating that management consider that significant
assumptions used in making the accounting estimate are reasonable.
– A review of the notes to the draft financial statements to confirm sufficiency of narrative and numerical
disclosures

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Restructuring provisions: A restructuring provision shall include only the direct expenditures arising from the
restructuring.
Restructuring provisions were used by some companies to manipulate their results; therefore IAS 37 specifically
lays down the accounting requirements in this area.
A restructuring is a programme that is planned and controlled by management, and materially changes either:
a) The scope of a business undertaken by an entity; or
b) The manner in which that business is conducted.

The following are examples of events that may fall under the definition of restructuring, as specified in the IAS:
a) Sale or termination of a line of business
b) The closure of business locations in a country or region or the relocation of business activities from one
country or region to another
c) Changes in management structure, for example, eliminating a layer of management
d) Fundamental reorganizations that have a material effect on the nature and focus of the entity’s operations

An entity is required to recognise the constructive obligations for restructuring if the following conditions are
satisfied:
a) A formal plan exists
b) A valid expectation that it will carry out the restructuring exists

Onerous contracts
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract
exceed the economic benefit expected to be received under the contract.

The liabilities derived from onerous contracts have to be provided for as onerous contracts fulfill all the three
conditions of the recognition criteria.

Audit work: Intangible assets

IAS 38 Intangible assets

An intangible asset is an identifiable non‐monetary asset without physical substance. It may be held for using in the
production and supply of goods or services, or for rental to others, or for administrative purposes. The asset must
be:
– Controlled by the entity as a result of events in the past, and
– Something from which the entity expects future economic benefits to flow.

Examples of items that might be considered as intangible assets include computer software, patents, copyrights,
motion picture films, customer lists, franchises and fishing rights. An item should not be recognised as an intangible
asset, however, unless it fully meets the definition in the standard.

Internally generated goodwill may not be recognised as an asset.

IAS 38 Intangible Assets states that an intangible asset with a finite useful life is amortised, and an intangible asset
with an indefinite useful life is not.

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An intangible asset with an indefinite useful life shall not be amortised BUT has to be tested for impairment annually,
and whenever there is an indication that the intangible asset may be impaired

Audit work – development costs

Research costs must be expensed and strict criteria must be applied to development expenditure to determine
whether it should be capitalised and recognised as an intangible asset.
For example, the ability of the development costs to generate economic benefit should be demonstrated, along with
the existence of resources to complete the development.

When an intangible asset has a finite useful life, it should be amortised systematically over that life.

For a development asset, the amortisation should correspond with the pattern of economic benefits generated from
the sale of associated goods. There is a risk that the amortisation period has not been appropriately assessed.
– Check project reports (from the management as well as experts) to ensure that the expenditure relating to the
research and development project can be separately identified and feasible to be completed.
– Confirm that all the conditions relating to development cost are completed before the development expenses
are capitalised. For this confirm:
o The technical feasibility and viability by verifying reports from technical experts, results of test runs, etc.
o The market research documents, budgets, forecasts to conclude whether the entity believes that a market
for the internally developed asset exists.
o That the various significant expenses are supported with valid invoices in order to confirm that expenditure
that would be incurred from developing the asset and can be reliably measured.
o View the budgeted revenues and costs and calculations for future cash flows to ensure that resources
required to fulfil the budgets actually exist.
– Check the appropriateness of amortisation i.e. the asset should be amortised over its useful life. Therefore the
auditor should verify the expert’s report relating to useful life of the development costs.
– The auditor should also verify the accounting entries to confirm that the financial statements are correctly
drawn up.
– Review adequacy and completeness of the Disclosure (useful life or amortisation rate, amortisation method,
accumulated amortisation and impairment losses, basis for determining that an intangible has an indefinite life,
intangible assets carried at revalued amounts , the amount of research and development expenditure
recognised as an expense in the current period)
– Ensure Initial measurement: at cost. Measurement subsequent to acquisition: cost model and revaluation
models allowed.

Audit work: Brands

The key accounting issue with regard to brands is whether the asset is internally generated or not.

Remember, IAS 38 forbids the capitalisation of internally generated brands.

If a brand has been purchased separately (that is, not as part of goodwill) then auditors should test the value of the
brand according to the sales documentation.

Procedures on an acquired brand

– Review board minutes for evidence of discussion of the purchase of the acquired brand, and for its approval.
– Agree the cost to the company’s cash book and bank statement.

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– Obtain the purchase agreement and confirm the rights of client in respect of the brand.
– Discuss with management the estimated useful life of the brand and obtain an understanding of how the useful
life has been determined.
– If the useful life is a period stipulated in the purchase document, confirm to the terms of the agreement.
– If the useful life is based on the life expectancy of the product, obtain an understanding of the basis for this, for
example, by reviewing a cash flow forecast of sales of the product.
– Obtain any market research or customer satisfaction surveys to confirm the existence of a revenue stream.
– Consider whether there are any indicators of potential impairment at the yearend by obtaining pre year‐end
sales information and reviewing terms of contracts to supply the products to pharmacies.
– Recalculate the amortisation expense for the year and agree the charge to the financial statements, and confirm
adequacy of disclosure in the notes to the financial statements.

Basic audit Work on Goodwill‐ to be discussed in detail later

1. Verifying the amount of goodwill calculated by matching the purchase consideration to the acquisition
agreement.
2. Confirming that the fair value of the assets are acquired by conducting audit procedures, relating to fair values.
3. Recalculating the amount of goodwill and agreeing it with the amount recognised in the financial statements.
4. Ensuring that the goodwill calculation does not include internally generated goodwill.
5. Ensuring that goodwill is not amortised as it is not permitted by IFRS 3.
6. Reviewing the calculations relating to impairment of goodwill for accuracy and reasonableness.
7. Goodwill impairment test
8. If useful life is judged to be indefinite, ensure impairment review has been carried out

Audit work: Financial Instruments

When auditing financial instruments, the auditors will have to ensure that recognition and valuation is in accordance
with IFRS 9 Financial instruments.

Financial assets
Initial recognition of a financial asset is at the fair value of the consideration. Subsequent to this initial recognition,
IFRS 9 requires that financial assets are classified as measured at either:
• Amortised cost, or
• Fair value

The IFRS 9 classification is made on the basis of both:

(a) The entity's business model for managing the financial assets, and
(b) The contractual cash flow characteristics of the financial asset.

An application of these rules means that equity investments may not be classified as measured at amortised cost
and must be measured at fair value. This is because contractual cash flows on specified dates are not a characteristic
of equity instruments. In addition, all derivatives are measured at fair value.

A debt instrument may be classified as measured at either amortised cost or fair value depending on whether it
meets the criteria above.

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Financial liabilities
As with financial assets, a financial liability is initially measured at the fair value of the consideration received.
Subsequent to this, IFRS 9 requires that financial assets are classified as measured at either:
(a) Fair value through profit or loss, or
(b) Amortised cost under the effective interest rate method

A financial liability is classified at fair value through profit or loss if:

(a) It is held for trading, or
(b) Upon initial recognition it is designated at fair value through profit or loss.

Derivatives are always measured at fair value through profit or loss.

IFRS 7 Financial instruments: disclosure

The principles in IFRS 7 complement the principles for recognising, measuring and presenting financial assets and
financial liabilities in IAS 32 Financial instruments: Presentation IAS 39 Financial instruments:

Recognition and measurement, and IFRS 9 Financial instruments.

IFRS 7 requires entities to make extensive disclosures in relation to financial instruments, which we will recap briefly
here. The standard requires qualitative and quantitative disclosures about exposure to risks arising from financial
instruments and specifies minimum disclosures about credit risk, liquidity risk and market risk.

Two types of disclosure need to be made: about the significance of the financial instruments, and about the nature
and extent of risks arising from the financial instruments.

IFRS 7 requires disclosures about the significance of financial instruments to be made in relation to the SOFP and
the SOCI. For example, entities must disclose the carrying amounts included within each IAS 39/IFRS 9 category on
the SOFP, and the reason for any reclassification between these categories. The SOCI must then disclose the net
gain/loss that is attributable to each of these categories.

Regarding the nature and extent of risks, IFRS 7 requires disclosures in respect of credit risk, currency risk, interest
rate risk, liquidity risk, loans payable, market risk, other price risks, and instruments that are past due.

Compound financial instruments: Convertible debt is a commonly‐examined example here, where the debt and
equity elements of the instrument need to be presented separately in the financial statements. Accounting in this
area requires a level of judgement, which can be risky from an auditor’s point of view. For example, judgement is
required when calculating the present value of debt repayments (e.g. in selecting an appropriate discount rate).

Audit Risk
Classification: inaccurate classification of financial instruments can cause material misstatements in the financial
statements as they will reflect incorrect gearing ratios and hence the risk profile of the entity.

Therefore the auditor will:

– Understand the classification by making enquiries with the management.
– Read the terms of contracts related to the financial instruments to determine the substance of the transaction.

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Challenging to audit because:

Financial instruments, particularly complex ones, increase audit risk. Factors which increase audit risk include the
following:
(a) Lack of management understanding of financial instruments and therefore inadequate management control.
(b) 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 with both debt and equity elements.
(c) The use of 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.
(d) 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

Classification Review the terms of the financial instrument and confirm that they have been classified in
accordance with their substance.

Enquire of management as to their intention ie to sell in the short term or hold to maturity.
Corroborate any statements by a review of events after the reporting period, forecast and
projections.
Existence For listed shares the auditor can check the company exists by reviewing stock exchange
listings.
Unlisted companies can be verified by simple enquiries a the Companies Registry.
Valuation: initial fair Confirm that all financial assets and liabilities have been valued at fair value where this is
value required by IFRS 9.
Agree fair value to transaction price (the cost of shares can be verified by checking the
purchase documentation).
Where part of the consideration has been given for something other than the financial
instrument, assess valuation technique adopted, eg discounting of future cash flows.
Valuation: • Verify the subsequent classification of financial instruments by enquiry of
Subsequent management, as to the business model according to which the instruments are being
Measurement held (ie whether they are being held for trading or to maturity). This information
should be corroborated by a review of events after the reporting period and of
forecasts and projections.
• Confirm that all financial assets that are equity or are derivatives are held at fair value.
• Check calculation of amortised cost complies with IFRS 9:
• The initial amount recognised for the financial asset
• Less any repayments of the principal sum
• Plus any amortization
– Confirm that the amount of amortisation has been calculated using the effective
interest method.
– Confirm that financial assets and liabilities at fair are remeasured to fair value at
the end of the reporting period in accordance with IFRS 13.

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– 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.
Ownership Ownership of shares in another company should be checked to the share certificate.
The share certificate may be kept in a bank or at a brokers, in which case the auditor should
confirm with these parties that the share certificate exists.
Presentation and Check that disclosures comply with IFRS 7. This includes eg qualitative disclosures about
disclosure exposure to risk and risk management, and quantitative disclosures of summary data
about exposures.

Audit procedures on the portfolio of short‐term investments

– Agree the fair value of the shares held as investments to stock market share price listings
– Confirm the original cost of the investment to cash book and bank statements.
– Review the notes to the financial statements to ensure that disclosure is sufficient to comply with the
requirements of IFRS 9.
– Enquire with the treasury management function as to whether there have been any disposals of the original
shares held and reinvestment of proceeds into the portfolio.
– Review board minutes to confirm the authorisation and approval of the amount invested.
– For any investments from which dividends have been received, confirm the number of shares held to supporting
documentation such as dividend received certificates or vouchers.

Loan

Evidence
– Re‐performance of management’s calculation of the finance charge in relation to the loan,
– Agreement of the loan receipt and interest payment to bank statement and cash book.
– Review of board minutes for approval of the loan to be taken out.
– A copy of the loan agreement, reviewed to confirm terms including the maturity date, any premium to be paid
on maturity and annual interest payments.
– A copy of the note to the financial statements which discusses the loan to ensure all requirements of IFRSs 7
and 13 have been met.

Extracted from past exam answers:

Commonly tested in THE ADVANCED AUDIT & ASSURANCE EXAM‐ Risks related to companies which have foreign
exchange transactions:

“The company may have entered into hedging arrangements as a way to reduce exposure to foreign exchange
fluctuations. There is a risk that hedging arrangements are not identified and accounted for as derivatives according
to IFRS 9 Financial Instruments which could mean incomplete recognition of derivative financial assets or liabilities
and associated gains or losses.”

“This is a complex accounting issue, and there are numerous audit risks arising.

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There is a risk that not all forward exchange contracts are identified, leading to incomplete recording of the balances
involved. There is also a risk in determining the fair value of the derivative at the year end, as this can be judgemental
and requires specialist knowledge. There is also a risk that hedge accounting rules have not been properly applied,
or that inadequate disclosure of relevant risks is made in the notes to the financial statements.”

“IFRS 9 requires that financial assets to be classified and then measured subsequent to initial recognition at either
amortised cost or at fair value through profit or loss. Speculative investments in equity shares should be measured
at fair value through profit or loss because the assets are not being held to collect contractual cash flows.”

Audit work: Investment properties

A key factor to consider when auditing investment properties is whether one exists according to the criteria of IAS
40 Investment property.

Investment property is 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:
• Use in the production or supply of goods or services or for administrative purposes, or
• Sale in the ordinary course of business

Recognition
Investment property should be recognised as an asset when it is probable that the future economic benefits that are
associated with the property will flow to the entity, and the cost of the property can be reliably measured.

Procedures

Initial measurement: Investment property is initially measured at cost, including transaction costs.

Review breakup of cost and ensure Cost does not include start‐up costs, abnormal waste, or initial operating
losses incurred before the investment property achieves the planned level of occupancy.
Subsequent measurement: can choose between the fair value and the cost model. Ensure the accounting policy
choice must be applied to all investment property.
Fair value model
– Investment properties are measured at fair value, which is the price that would be received to sell the
investment property in an orderly transaction between market participants at the measurement date
– The auditor should be able to verify this by reference to a valuer's certificate as professional valuation is
encouraged under the IAS.
– Gains or losses arising from changes in the fair value of investment property must be included in profit or
loss for the period in which it arises

Cost model
– Investment property is measured in accordance with requirements set out for that model in IAS 16….cost
less accumulated depreciation and less accumulated impairment losses

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Carry out the normal property procedures Existence, rights and obligation, valuation documents
Disclosure: The auditor should review the disclosures made in the financial statements in relation to investment
properties to ensure that they have been made appropriately, in accordance with IAS 40.
– Whether the fair value or the cost model is used
– The methods and significant assumptions applied in determining the fair value of investment property
– The extent to which the fair value of investment property is based on a valuation by a qualified
independent valuer; if there has been no such valuation, that fact must be disclosed

Audit Work On: Share‐Based Payment

Ascertain the major terms of the – Obtain the details of the share‐based payment plan to ascertain the
plan from the contractual major terms of the plan including:
documentation  The grant date and vesting date
 The number of executives and senior managers awarded options
 The number of share options awarded to each individual
 The required conditions attached to the options
 The fair value of the share options at the grant date.

– Scrutinise the conditions attached to the options to confirm any market

conditions and non‐market conditions according to IFRS 2.
Fair value of instruments 1. For equity‐settled schemes check that fair value is estimated at grant
date. The grant date fair value is recognised over the vesting period.
2. For cash‐settled schemes check that the fair value is recalculated at the
year end and at the date ofsettlement
3. Review the assumptions used, and inputs into the option pricing model
used by management to estimate the fair value of the share options at
the grant date.
4. Consider the appropriateness of the model used to generate a fair value
for the share options.
5. Consider the use of an expert possessing specialist skills in share option
pricing, such as a chartered financial analyst, to provide evidence as to
the validity of the fair value of share options used in the calculations.
6. Consider whether assumptions used appear reasonable. For example,
Obtain and review a forecast of staffing levels or employee turnover
rates relevant to executives and senior managers over the vesting period
and consider whether assumptions used appear reasonable.
7. Check the sensitivity of the calculations to a change in the assumptions
used in the valuation.

Risks can be discussed relating to the use of option pricing models .In
determining the expense to be recognised, client needs to use a valuation
method for estimating the fair value of the share options at the grant date.
Various models can be used, but all are based on inputs such as share price,
exercise price, rate of return and estimated dividend yield. The risk is that

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inappropriate assumptions have been input to the valuation model, resulting

in an unrealistic estimate of the fair value of share options at the grant date.
Further, there is a risk that the wrong valuation model has been used.

Written representations Obtain written representations from management confirming their view
that:
– The assumptions used in measuring the expense are reasonable, and
– There are no share‐based payment schemes in existence that have not
been disclosed to the auditors.

Extracted from past exams

Equity‐settled share‐based payment plans are complicated to value and account for, and are inherently risky. IFRS 2
Share‐based Payment requires that an expense should be recognised over the vesting period, calculated based on
the fair value of the share options at the grant date. Market conditions are not relevant to determining whether an
expense is recognised or the amount of it.

Market conditions should be taken into account when determining the fair value of the share options at the grant
date and are not to be taken into account for the purpose of estimating the number of equity instruments that will
vest. This means where the market condition has not been met, an expense should be recognised irrespective of
whether that condition is satisfied, and an expense continues to be recognised over the remainder of the vesting
period.

IFRS 2 also requires extensive disclosures including the effect of share‐based payment transactions on the entity’s
profit or loss for the period and on its financial position.

The share‐based payment plan should also have a deferred tax consequence – a deferred tax asset arises due to the
deductible temporary difference arising from the accounting treatment. There is a risk that assets are incomplete if
this is not recognised in the statement of financial position.

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Audit work: Assets Held For Sale and discontinued operations

Key points to remember for THE ADVANCED AUDIT & ASSURANCE EXAM
1. Assets can only be classified as held for sale if the conditions referred to in IFRS 5 Non‐current Assets Held for
Sale and Discontinued Operations are met. The conditions include the following:
a) Management is committed to a plan to sell the asset or disposal group;
b) The asset must be available for immediate sale in its present location and condition
c) An active programme to locate a buyer and complete the plan must have been initiated.
d) The sale is highly probable, within 12 months of classification as held for sale
e) The asset is being actively marketed for sale at a sales price reasonable in relation to its fair value;
f) Actions required to complete the plan indicate that it is unlikely that the plan will be significantly changed
or withdrawn.

2. IFRS 5 requires that at classification as held for sale, assets are measured at the lower of carrying value and fair
value less costs to sell.

3. The assets should not be depreciated after being classified as held for sale

4. It is required by IFRS 5 Non‐Current Assets Held for Sale and Discontinued Operations that the assets and
liabilities of disposal groups should not be offset and must be presented separately within total assets and total
liabilities

Audit work
1. Discuss with the management about the existence of assets held for sale.

2. Confirm that the assets meet the definition of assets held for sale:
 Written representations from the management regarding its intention to sell
 Discuss with management the availability of asset for sale
 Written representation from management on the opinion that the assets will be sold
 Assess management commitment, for example A copy of the board minutes at which the disposal was
agreed by management.
 Evaluate and assess practical steps being taken to sell the asset eg appropriate agents appointed
 Determine when the sale is expected to take place by assessing progress to date
 Determine and assess the basis on which the sale price has been set
 Discuss with management any significant changes to the plans

3. Confirm that the asset has been valued as held for sale in accordance with IFRS 5 and assess how fair value has
been determined. {Confirm assets measured at lower of: Carrying value and FV‐ costs to sell (any impairment
loss to P & L)}
4. A copy of the client’s depreciation calculations, to confirm that depreciation was not charged subsequent to the
reclassification of the assets as held for sale.
5. Confirm separate disclosure in accordance with IFRS 5 {to include a description of the non‐current assets
classified as held for sale, a description of the facts and circumstances of the sale and its expected timing,
and a quantification of the impairment loss and where in the statement of profit or loss and other
comprehensive income it is recognised}

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6. Subsequent events review, including a review of post year‐end board minutes and a review of significant cash
transactions, to confirm if any non‐current assets are sold in the period after the year end.
7. Details of any impairment review conducted by management on the non‐current assets
8. Ensure accurate presentation: must be presented separately on the face of the statement of financial position

Discontinued operations
To require separate classification in the statement of comprehensive income, discontinued operations must be:
• A component (i.e. separately identifiable)
• Which represents a separate major line of business/geographical area
• In part of a single co‐ordinated plan to dispose of a separate major line of business/geographical area
• Or is a subsidiary acquired exclusively with a view to resale

Discontinued operations and operations held for sale must be disclosed separately in the statement of financial
position at the lower of their carrying value less costs to sell.

An entity should present and disclose information that enables users of the financial statements to evaluate the
financial effects of discontinued operations and disposals of non‐current assets or disposal groups.

This allows users to distinguish between operations which will continue in the future and those which will not and
makes it more possible to predict future results.

An entity should disclose a single amount in the statement of comprehensive income comprising the total of:
(a) The post‐tax profit or loss of discontinued operations and
(b) The post‐tax gain or loss recognised on the measurement to fair value less costs to sell or on the disposal of
the assets or disposal group(s) constituting the discontinued operation.

An entity should also disclose an analysis of this single amount into:

(a) The revenue, expenses and pre‐tax profit or loss of discontinued operations
(b) The related income tax expense
(c) The gain or loss recognised on the measurement to fair value less costs to sell or on the disposal
(a) of the assets of the discontinued operation
(d) The related income tax expense

This may be presented either in the statement of comprehensive income or in the notes. If it is presented in the
statement of comprehensive income it should be presented in a section identified as relating to discontinued
operations, i.e. separately from continuing operations. This analysis is not required where the discontinued
operation is a newly acquired subsidiary that has been classified as held for sale.

An entity should disclose the net cash flows attributable to the operating, investing and financing activities of
discontinued operations. These disclosures may be presented either on the face of the statement of cash flows or in
the notes.

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Audit procedures
1. Discuss with the management the existence of discontinued operations.
2. Review minutes of meetings/make enquiries of management to ascertain management's intentions
3. Obtaining accounting records for component to ensure it is separately identifiable. Review company
documentation (such as annual report) to ensure it is separately identifiable
4. The auditor must go through the entity’s accounting records and other company documentation (e.g. MIS
records, production records of the current year and previous year) to confirm that the discontinued operations
represent a major line of the entity’s business or is a subsidiary acquired with a view to resell). This will ensure
that the assets meet the definition of discontinued operations.
5. Carry out the audit procedures to assess the reasonableness of the fair vales and cost to sell.
6. Compare the opening balance of the carrying value of the asset from the previous year’s financial statements.
Recalculate the depreciation for the current year (up to the date of classification as discontinued operations).
7. To audit whether the disclosures have been made correctly, the auditor should undertake the following
procedures:
a) Obtain a copy of the client's workings to disclose the discontinued operations.
b) Review the workings to ensure that the figures are reasonable and agree to the financial statements.
c) Trace a sample of items disclosed as discontinuing items to backing documentation (invoices) to ensure that
they do relate to discontinued operations.

Remember, the results of discontinued operations should be presented separately in the statement of
comprehensive income for the entire period, and not just the results since the operation became discontinued.
Comparative figures should also be re‐stated

Audit work on: the effects of foreign exchange rates

Individual company
For an individual company conducting trade in foreign currencies, there are two separate accounting issues:
conversion and translation.

Conversion is uncontroversial, and relates to an entity conducting transactions in a foreign currency, and which
incurs exchange gains/losses in relation to these transactions.

According to IAS 21 The Effects of Changes in Foreign Exchange Rates, foreign currency transactions should be
initially recognised having been translated using the spot rate, or an average rate may be used if exchange rates do
not fluctuate significantly.

The rule is simple: the gain or loss on conversion is recognised directly in profit and loss in the period in which it
occurs. The principal risk here is of the wrong exchange rate being used, resulting in misstatement of the gain/loss
in the financial statements.

Translation is more complex. Translation is required at the end of an accounting period when a company still holds
assets or liabilities in its statement of financial position which were obtained or incurred in a foreign currency. IAS
21 distinguishes between monetary items and non‐monetary items. The basic rule is that monetary items (eg cash,
receivables) should be retranslated using the rate rule at the end of each accounting period. Non‐monetary items
such as inventory are left at the amount recognised at the date of the transaction.

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The risk is that the yearend retranslation does not take place, or that an inappropriate exchange rate is used for the
retranslation

Audit procedures here would therefore include:

• Check that monetary items included in the statement of financial position at the yearend are translated at the
closing rate of exchange.
• Check that non‐monetary items are translated at the historical rate of exchange.
• Check that items are included in the statement of comprehensive income at the historical rate of exchange.

Groups
It is also possible that a parent company may have overseas subsidiaries. It must translate the financial statements
of those operations in to its own reporting currency before they can be consolidated in to group accounts. There are
two methods of achieving this. The method used depends on whether the foreign operation has the same functional
currency as the parent.

Same functional currency as the reporting entity

In this situation the foreign operation normally carries on its business as though it were an extension of the reporting
entity's operations.

We can summarise the treatment as follows:

Income statement: Translate using actual rates. An average for a period may be used but not where there is a
significant fluctuation and the average is therefore unreliable.

Non‐monetary items: Translate using an historic rate at the date of purchase (or revaluation to fair value, or
reduction to realisable/recoverable amount). This includes inventories and long‐term assets (and their depreciation).

Monetary items: Translate at the closing rate

Exchange differences: Report as part of profit for the year

Different functional currency from the reporting entity

In this situation although the reporting entity may be able to exercise control, the foreign operation normally
operates in a semi‐autonomous way. It accumulates cash and other monetary items, generates income and incurs
expenses, and may also arrange borrowings, all in its own local currency.

We can summarise the treatment as follows:

Assets and liabilities: Translate at the closing rate at the period end. (The balancing figure on the translated
statement of financial position represents the reporting entity's net investment in the foreign operation.

Income statement: Translate items at the rate ruling at the date of the transaction (an average rate will usually be
used for practical purposes)

Exchange differences: Taken to equity‐ IAS 21 states that exchange gains and losses arising as a result of the
restranslation of the subsidiary’s balances are recognised in other comprehensive income. The risk is incorrect
classification, for example, the gain or loss could be recognised incorrectly as part of profit for the year

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Audit Work On: Foreign Exchange Rates

– Discuss with management and verify the appropriateness of the functional currency used while recording
transactions and preparing financial statements.
– Verify for the samples selected whether the transactions are recorded correctly using appropriate exchange
rates.
– Discuss with management about foreign operations of the company and obtain a list of all branches, subsidiaries
and associates situated in foreign countries along with their domestic currencies.
– Determine whether the hedging provisions are sufficient and appropriate for foreign exchange risks.
– Verify whether the account balances have been properly classified into monetary and non‐monetary items.
– For a few transactions selected on a random basis, verify that the effect of the foreign exchange rate has been
correctly taken in financial statements in accordance with IAS 21.
– Perform audit trail for a few transactions or carry out a walk through analysis to verify the efficiency of the
accounting system from the inception to presentation of foreign exchange transactions

Audit work: Borrowing costs

According to IAS 23 Borrowing Costs, borrowing costs that are directly attributable to the acquisition, construction
or production of a qualifying asset should be capitalised as part of the cost of that asset.

The borrowing costs should be capitalised only during the period of construction, with capitalisation ceasing when
substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete

Audit work
1. Review an original copy of the loan agreement, confirming the amount borrowed, the date of the cash receipt,
the interest rate and whether the loan is secured on any assets.
2. Confirm: only directly attributable costs capitalized: ask for the breakdown and review supporting documents
3. Confirm: Capitalized only during construction‐ cease when suspended or completed; THEN depreciate.
4. Interest can be verified by performing analytical reviews as the relationship of various loans and the interest
amounts is predictable.
5. Recalculate and agree the following figures to the draft financial statements.
– The borrowing cost (Amount= borrowing cost less temp investment income OR if generally obtained loan,
weighted average of borrowing costs applicable to borrowing outstanding)
– Depreciation charge
– Carrying value of the asset at the year end,
6. Agree figures in respect of interest payments made to statements from lender and/or bank statements
7. Ensure the adequacy and completeness of disclosures (Amount of borrowing costs capitalized during the
period; Capitalisation rate used to determine borrowing costs eligible for capitalisation.)

IAS 23 Borrowing costs

• Borrowing costs. Interest and other costs incurred by an entity in connection with the borrowing of funds.
• A qualifying asset is an asset that takes a substantial period of time to get ready for its intended use or sale.
That could be property, plant, and equipment and investment property during the construction period,
intangible assets during the development period, or "made‐to‐order" inventories.

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Accounting treatment
• Borrowing costs should be capitalized as part of the cost of the asset if they are directly attributable to
acquisition/construction/production. Other borrowing costs must be expensed.
• Borrowing costs eligible for capitalization are those that would have been avoided otherwise. Use
judgement where a range of debt instruments is held for general finance.
• Amount of borrowing costs available for capitalization is actual borrowing costs incurred less any
investment income from temporary investment of those borrowings.
• For borrowings obtained generally, apply the capitalisation rate to the expenditure on the asset (weighted
average borrowing costs). It must not exceed actual borrowing costs.
• Capitalisation is suspended if active development is interrupted for extended periods. (Temporary delays or
technical/administrative work will not cause suspension.)
• Capitalisation ceases (normally) when physical construction of the asset is completed, capitalisation should
cease when each stage or part is completed.
• Where the carrying amount of the asset falls below cost, it must be written down/off.

Audit work: Using the work of others

Using the work of an auditor’s expert

Auditor’s expert – An individual or organization possessing expertise in a field other than accounting or auditing,
whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit
evidence.

Management’s expert – An individual or organization possessing expertise in a field other than accounting or
auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements.

Reliance on an expert might be necessary in the following situations:

(a) Valuation of certain types of asset, e.g. land and buildings, precious stones
(b) Determination of quantities or physical condition of assets
(c) Actuarial valuations on pensions or insurance liabilities
(d) Measurement of work completed and to be completed on contracts in process
(e) Legal opinions re interpretations of agreements and regulations, or the outcome of litigation.

Contract with the auditor’s expert

The following matters need to be agreed in writing:
– The nature, scope and objectives of that expert’s work,
– The respective roles and responsibilities of the auditor and that expert,
– The nature, timing and extent of communication between the auditor and that expert, including the form of any
report to be provided by that expert,
– The need for the auditor’s expert to observe confidentiality requirements.

Written instructions should have been provided by the auditor to the expert prior to them carrying out the work.
The instructions should include matters such as the scope of the work, the applicable financial reporting framework
and any specific matters to be addressed. As a first step, the auditor should consider if these instructions have been
followed by the expert.

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ISA 620 Using the Work of an Auditor’s Expert contains requirements relating to the objectivity and capabilities of
the auditor’s expert, the scope and objectives of their work, and assessing their work.

1. Objectivity: The auditor shall evaluate whether the auditor’s expert has the necessary objectivity and that
this should include inquiry regarding interests and relationships which may create a threat to the expert’s
objectivity. The audit firm will need to ensure that the expert has no connection to the client, for example,
that they are not a related party of the company or any person in a position of influence over the financial
statements. If the expert’s objectivity is threatened, less reliance can be placed on their work.
2. Competence: ISA 620 also requires the competence of the expert to be considered; this should include
considering the expert’s membership of appropriate professional bodies. Any doubts over the competence
of the expert will reduce the reliability of audit evidence obtained.
3. Scope of work: ISA 620 requires the auditor to agree the scope of work with the expert. This may include
agreement of the objectives of the work, how the expert’s work will be used by the auditor and the
methodology and key assumptions to be used. In assessing the work performed by the expert, the auditor
should confirm that the scope of the work is as agreed at the start of the engagement. If the expert has
deviated from the agreed scope of work, it is likely to be less relevant and reliable.
4. Relevance of conclusions: ISA 620 a) Review the auditor’s expert’s working papers and reports to
states that the auditor shall evaluate ensure that:
the relevance and adequacy of the – The work meets the objectives of the audit
expert’s findings or conclusions. This – The evidence contained in the report is consistent with
will involve consideration of the other evidence obtained by the auditor
source data which was used, the – The work is based on the correct period and takes into
appropriateness of assumptions and account events after the reporting date where necessary.
the reasons for any changes in b) Evaluate the appropriateness of models used by the expert
methodology or assumptions. The c) Compare the findings of the expert with results produced by
conclusion should be consistent with management, eg compare the fair values determined by the
other relevant audit findings and with expert with those determined by management.
the auditor’s general understanding d) Re‐perform any calculations contained in the expert’s working
of the business. Any inconsistencies papers, eg recalculate movements in fair value on the
should be investigated as they may derivatives.
indicate evidence which is not e) Evaluate the assumptions used by the expert, including:
reliable. – Whether the assumptions are consistent with the
requirements of the relevant financial reporting framework
– If the assumptions are consistent with the auditor’s
knowledge and understanding of the client’s operations
and environment.
– Verify the origin of source data used in the expert’s work,
eg agree figures used in calculations to the general ledger
and documentation maintained by the client.

Relying on Internal Auditor’s work

Internal audit function – A function of an entity that performs assurance and consulting activities designed to
evaluate and improve the effectiveness of the entity’s governance, risk management and internal control
processes.

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Direct assistance – The use of internal auditors to perform audit procedures under the direction, supervision and
review of the external auditor.

According to ISA 610 Using the Work of Internal Auditors, the external auditor may decide to use the work of the
audit client’s internal audit function to modify the nature or timing, or reduce the extent, of audit procedures to be
performed directly by the external auditor.

Note that in some jurisdictions the external auditor may be prohibited, or restricted to some extent, by law or
regulation from using the work of the internal audit function.

The firm should consider whether it is prohibited by the law or regulations from relying on the work of internal audit
department or using the internal auditors to provide direct assistance.

The firm must evaluate the internal audit department to determine whether its work is suitable by evaluating:
1. The extent to which the internal audit function’s organisational status and relevant policies and procedures
support the objectivity of the internal auditors.
2. The level of competence of the internal audit function.
3. Whether the internal audit function applies a systematic and disciplined approach, including quality control.

One of the key issues to be evaluated is objectivity – the internal audit department should be unbiased in their work
and be able to report their findings without being subject to the influence of others. The internal audit department
should report directly to the audit committee or to those charged with governance in order to maintain their
independence.

The Factors that may affect the external auditor’s determination include whether the internal audit function is
adequately and appropriately resourced relative to the size of the entity and the nature of its operations. whether
there are established policies for hiring, training and assigning internal auditors to internal audit engagements and
whether the internal auditors have adequate technical training and proficiency in auditing.

In order to determine whether the internal audit department works in a systematic and disciplined way, the firm
should consider matters including the nature of documentation which is produced by the department and whether
effective quality control procedures are in place such as direction, supervision and review of work carried out.

Determining Whether, in Which Areas, and to What Extent Internal Auditors Can Be Used to Provide Direct
Assistance

If the firm wants to use the internal audit function to provide direct assistance, then the firm should:
– obtain written agreement from an authorised representative of the entity that the internal auditors will be
allowed to follow the external auditor’s instructions, and that the entity will not intervene in the work the
internal auditor performs for the external auditor; and
– obtain written agreement from the internal auditors that they will keep confidential specific matters as
instructed by the external auditor and inform the external auditor of any threat to their objectivity.

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If these confirmations cannot be obtained, then the internal auditors should not be used to provide direct assistance.

The external auditor shall not use internal auditors to provide direct assistance to perform procedures that:
(a) Involve making significant judgments in the audit;
(b) Relate to higher assessed risks of material misstatement where the judgment required in performing the
relevant audit procedures orevaluating the audit evidence gathered is more than limited

The external auditor shall direct, supervise and review the work performed by internal auditors on the engagement.

Relying on the work of service organisations

Outsourcing
Outsourcing is when certain functions within a business are contracted out to third parties known as service
organisations.

In sourcing: In sourcing is when an organization decides to retain a centralised department for the key function, but
brings experts in from an external market on a short‐term basis to account for 'peak' and 'trough' periods.

It is a business decision that is often made to maintain control of certain critical production or competencies.

In sourcing is therefore a business practice in which work that would otherwise have been contracted out is
performed in house.

Impact of outsourced functions on External Audit

Key terms
Service auditor – An auditor who, at the request of the service organization, provides an assurance report on the
controls of a service organization.

Service organization – A third‐party organization (or segment of a third‐party organization) that provides services to
user entities that are part of those entities’ information systems relevant to financial reporting. User auditor – An
auditor who audits and reports on the financial statements of a user entity. User entity – An entity that uses a service
organization and whose financial statements are being audited.

Service organisations usually operate in one of two ways:

1. The service organisation fully maintains the outsourced function, dealing with all aspects of the function
including establishing accounting records, maintaining those records and initiating transactions relevant to the
function. Here the reporting entity may hold no internal records at all in relation to the function other than
those provided from the service organisation.
2. The service organisation executes transactions only at the request of the entity, or acts as a custodian of assets.
Here the reporting entity will maintain internal records relating to the outsourced function.

It is increasingly common for functions such as data processing, payroll, and internal audit to be outsourced. ISA 402
Audit Considerations Relating to Entities Using Service Organisations contains guidance for auditors on how
outsourcing should be considered during the audit process.

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The matters to be considered in planning the audit approach of the outsourced function are:
– Materiality of the outsourced area
– Accessibility: the auditors do not necessarily have the right of access to books and records held at the service
organisation.
– Control risk: Extent of controls operated by service organisation; Extent of quality assurance within the service
organisation (e.g. internal audit); Degree of monitoring by client (e.g. monthly review of records maintained by
the service organisation)
– Experience of errors within the outsourced area since outsourcing commenced.
– Existence of independent records relating to the outsourced area (independent back up records maintained by
the client)’
– Compliance with the relevant laws and regulations by the service organisation

Outsourcing does have an impact on audit planning. ISA 402 Audit Considerations Relating to an Entity Using a
Service Organisation requires the auditor to obtain an understanding of how the audited entity (also known as the
user entity) uses the services of a service organisation in the user entity’s operations, including the following matters:
1. The nature of the services provided by the service organisation and the significance of those services to the
audited entity, including the effect on internal control;
2. The nature and materiality of the transactions processed or accounts or financial reporting processes affected
by the service organisation;
3. The degree of interaction between the activities of the service organisation and those of the audited entity;
4. The nature of the relationship between the audited entity and the service organisation, including the relevant
contractual terms.

The reasons for the auditor being required to understand these matters is so that any risk of material misstatement
created by the use of the service organisation can be identified and an appropriate response planned.

The auditor is also required under ISA 402 to evaluate the design and implementation of relevant controls at the
audited entity which relate to the services provided by the service organisation, including those which are applied
to the transactions processed by the service organisation. This is to obtain understanding of the control risk
associated with the outsourced function, for example, whether the transactions and information provided by the
service organisation is monitored and whether checks are performed prior to inclusion in the financial statements.

Information should be available from the audited entity to enable the understanding outlined above to be obtained,
for example, through reports received from the service organisation, technical manuals and the contract between
the audited entity and the service organisation.

The auditor may decide that further work is necessary in order to evaluate the risk of material misstatement
associated with the outsourcing arrangement’s impact on the financial statements. It is common for a report on the
description and design of controls at a service organisation to be obtained.

A type 1 report focuses on the description and design of controls, whereas a type 2 report also covers the operating
effectiveness of the controls. This type of report can provide some assurance over the controls which should have
operated at the service organisation.

Alternatively, the auditor may decide to contact the service organisation to request specific information, to visit the
service organisation and perform procedures, probably tests on controls, or to use another auditor to perform such

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procedures. All of these methods of evaluating the service organisation’s controls require permission from the client
and can be time consuming to perform.

The purpose of obtaining the understanding above is to help the auditor to determine the level of competence of
the service organisation, and whether it is independent of the audited entity. This will then impact on the risk of
material misstatement assessed for the outsourced function.

Audit work: Other Information in documents containing Audited Financial Statements

Other information – Financial or non‐financial information (other than financial statements and the auditor’s
report) included in an entity’s annual report/Integrated report

Misstatement of the other information – A misstatement of the other information exists when the other
information is incorrectly stated or otherwise misleading.

Obtaining the Other The auditor shall:

Information
a) Determine, through discussion with management, which document(s)
comprises the annual report, and the entity’s planned manner and timing
of the issuance of such document(s);

b) Make appropriate arrangements with management to obtain in a timely

manner and, if possible, prior to the date of the auditor’s report, the final
version of the document(s) comprising the annual report; and

c) When some or all of the document(s) determined in (a) will not be

available until after the date of the auditor’s report, request management
to provide a written representation that the final version of the
document(s) will be provided to the auditor when available, and prior to
its issuance by the entity, such that the auditor can complete the
procedures required by this ISA.
Reading and Considering the The auditor shall read the other information and, in doing so shall:
Other Information (a) Consider whether there is a material inconsistency between the other
information and the financial statements.
(b) Consider whether there is a material inconsistency between the other
information and the auditor’s knowledge obtained in the audit, in the
context of audit evidence obtained and conclusions reached in the audit.

Responding When a Material If the auditor identifies that a material inconsistency appears to exist (or
Inconsistency Appears to Exist becomes aware that the other information appears to be materially
or Other misstated), the auditor shall discuss the matter with management and, if
Information Appears to Be necessary, perform other procedures to conclude whether:
Materially Misstated (a) A material misstatement of the other information exists;
(b) A material misstatement of the financial statements exists; or
(c) The auditor’s understanding of the entity and its environment needs to be
updated.

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If the auditor concludes that a material misstatement of the other information

exists, the auditor shall request management to correct the other information.
If management:
(a) Agrees to make the correction, the auditor shall determine that the
correction has been made; or

(b) Refuses to make the correction, the auditor shall communicate the matter
with those charged with governance and request that the correction be
made.

Reporting
The auditor’s report shall include a separate section with a heading “Other Information” when, at the date of the
auditor’s report:
(a) For an audit of financial statements of a listed entity, the auditor has obtained, or expects to obtain, the other
information; or
(b) For an audit of financial statements of an entity other than a listed entity, the auditor has obtained some or all
of the other information.

When the auditor’s report is required to include an Other Information section, this section shall include:

(a) A statement that management is responsible for the other information;

(b) An identification of:
 Other information, if any, obtained by the auditor prior to the date of the auditor’s report; and
 For an audit of financial statements of a listed entity, other information, if any, expected to be obtained
after the date of the auditor’s report;

(c) A statement that the auditor’s opinion does not cover the other information and, accordingly, that the auditor
does not express (or will not express) an audit opinion or any form of assurance conclusion thereon;
(d) A description of the auditor’s responsibilities relating to reading, considering and reporting on other information
as required by this ISA; and
(e) When other information has been obtained prior to the date of the auditor’s report, either:
(i) A statement that the auditor has nothing to report; or
(ii) If the auditor has concluded that there is an uncorrected material misstatement of the other
information, a statement that describes the uncorrected material misstatement of the other
information.

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Audit work: Opening balances in initial audit engagements

Initial audit engagement – An engagement in which either:

(iii) The financial statements for the prior period were not audited; or
(iv) The financial statements for the prior period were audited by a predecessor auditor.

Opening balances – Those account balances that exist at the beginning of the period. Opening balances are based
upon the closing balances of the prior period and reflect the effects of transactions and events of prior periods and
accounting policies applied in the prior period. Opening balances also include matters requiring disclosure that
existed at the beginning of the period, such as contingencies and commitments.

ISA 510 Initial Audit Engagements – Opening Balances requires certain audit procedures to be carried out in an initial
engagement where the prior year financial statements were not audited.

1. It is required that the auditor shall read the most recent financial statements for information relevant to
opening balances, including disclosures.

2. Then the auditor shall obtain sufficient appropriate evidence about whether the opening balances contain
misstatements that materially affect the current year’s financial statements.
– This evidence is obtained by firstly determining whether the prior period’s closing balances have been
correctly brought forward.
– The auditor shall also determine whether the opening balances reflect the application of appropriate
accounting policies.

3. Depending on the nature The auditor needs to consider performing one or more of the following:
of the opening balances, – Where the prior year financial statements were audited, reviewing the
specific audit procedures predecessor auditor’s working papers to obtain evidence regarding the
are performed to gain opening balances;
specific evidence on those – Evaluating whether audit procedures performed in the current period
opening balances. provide evidence relevant to the opening balances(***)
Additional procedures
would be required if it ***For current assets and liabilities, some audit evidence about opening
appears that the opening balances may be obtained as part of the current period’s audit procedures. For
balances contain example, the collection (payment) of opening accounts receivable (accounts
misstatements that could payable) during the current period will provide some audit evidence of their
materially affect the existence, rights and obligations, completeness and valuation at the beginning
current period’s financial of the period. In the case of inventories, however, the current period’s audit
statements. procedures on the closing inventory balance provide little audit evidence
regarding inventory on hand at the beginning of the period. Therefore,
additional audit procedures may be necessary, and one or more of the following
may provide sufficient appropriate audit evidence:
• Observing a current physical inventory count and reconciling it to the
opening inventory quantities.
• Performing audit procedures on the valuation of the opening inventory
items.

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For non‐current assets and liabilities, such as property, plant and equipment,
investments and long‐term debt, some audit evidence may be obtained by
examining the accounting records and other information underlying the opening
balances. In certain cases, the auditor may be able to obtain some audit
evidence regarding opening balances through confirmation with third parties,
for example, for long‐term debt and investments. In other cases, the auditor
may need to carry out additional audit procedures.
4. Finally, the auditor shall obtain sufficient appropriate evidence about whether the accounting policies
reflected in the opening balances have been consistently applied in the current period’s financial statements,
and that any changes in accounting policies have been accounted for and disclosed in accordance with IAS 8
Accounting Policies, Changes in Accounting

When the financial statements include comparative financial information, the requirements and guidance in ISA 710
(comparative information) also apply.

If material misstatements found in opening balances

If the auditor obtains audit evidence that the opening balances contain misstatements that could materially affect
the current period’s financial statements, the auditor shall perform such additional audit procedures as are
appropriate in the circumstances to determine the effect on the current period’s financial statements.

The auditor shall communicate the misstatements with the appropriate level of management and those charged
with governance.

Impact on audit report

 If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances, the
auditor shall express a qualified opinion or disclaim an opinion on the financial statements.
 If the auditor concludes that the opening balances contain a misstatement that materially affects the current
period’s financial statements, and the effect of the misstatement is not appropriately accounted for or not
adequately presented or disclosed, the auditor shall express a qualified opinion or an adverse opinion.
 If the predecessor auditor’s opinion regarding the prior period’s financial statements included a modification to
the auditor’s opinion that remains relevant and material to the current period’s financial statements, the auditor
shall modify the auditor’s opinion on the current period’s financial statements.

Audit work on: Corresponding figures and comparatives

Corresponding figures – Comparative information where amounts and other disclosures for the prior period are
included as an integral part of the current period financial statements, and are intended to be read only in relation
to the amounts and other disclosures relating to the current period (referred to as “current period figures”). The
level of detail presented in the corresponding amounts and disclosures is dictated primarily by its relevance to the
current period figures.

Comparative financial statements – Comparative information where amounts and other disclosures for the prior
period are included for comparison with the financial statements of the current period but, if audited, are referred
to in the auditor’s opinion. The level of information included in those comparative financial statements is comparable
with that of the financial statements of the current period

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Audit procedures
The auditor shall determine whether the financial statements include the comparative information required by the
applicable financial reporting framework and whether such information is appropriately classified.

The auditor shall evaluate whether the comparative information agrees with the amounts and other disclosures
presented in the prior period or, when appropriate, have been restated

The auditor shall evaluate whether the accounting policies reflected in the comparative information are consistent
with those applied in the current period or, if there have been changes in accounting policies, whether those changes
have been properly accounted for and adequately presented and disclosed.

If the auditor becomes aware of a possible material misstatement in the comparative information while performing
the current period audit, the auditor shall perform such additional audit procedures as are necessary in the
circumstances to obtain sufficient appropriate audit evidence to determine whether a material misstatement exists.

If the prior period financial statements are amended, the auditor shall determine that the comparative information
agrees with the amended financial statements.

The auditor shall request written representations for all periods referred to in the auditor’s opinion. The auditor
shall also obtain a specific written representation regarding any restatement made to correct a material
misstatement in prior period financial statements that affect the comparative information.

Audit Reporting

Corresponding Figures

If the auditor’s report on the prior period, as previously issued, included a qualified opinion, a disclaimer of opinion,
or an adverse opinion and the matter which gave rise to the modification is unresolved, the auditor shall modify the
auditor’s opinion on the current period’s financial statements.

In the Basis for Modification paragraph in the auditor’s report, the auditor shall either:
(a) Refer to both the current period’s figures and the corresponding figures in the description of the matter giving
rise to the modification when the effects or possible effects of the matter on the current period’s figures are
material; or
(b) In other cases, explain that the audit opinion has been modified because of the effects or possible effects of the
unresolved matter on the comparability of the current period’s figures and the corresponding figures.

If the auditor obtains audit evidence that a material misstatement exists in the prior period financial statements on
which an unmodified opinion has been previously issued, and the corresponding figures have not been properly
restated or appropriate disclosures have not been made, the auditor shall express a qualified opinion or an adverse
opinion in the auditor’s report on the current period financial statements, modified with respect to the
corresponding figures included therein.

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Prior Period Financial Statements Audited by a Predecessor Auditor

If the financial statements of the prior period were audited by a predecessor auditor and the auditor is not prohibited
by law or regulation from referring to the predecessor auditor’s report on the corresponding figures and decides to
do so, the auditor shall state in an Other Matter paragraph in the auditor’s report:
(a) That the financial statements of the prior period were audited by the predecessor auditor;

(b) The type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons
therefore; and

(c) The date of that report.

Prior Period Financial Statements Not Audited

If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph in the
auditor’s report that the corresponding figures are unaudited. Such a statement does not, however, relieve the
auditor of the requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain
misstatements that materially affect the current period’s financial statements.

Comparative Financial Statements

When comparative financial statements are presented, the auditor’s opinion shall refer to each period for which
financial statements are presented and on which an audit opinion is expressed.

When reporting on prior period financial statements in connection with the current period’s audit, if the auditor’s
opinion on such prior period financial statements differs from the opinion the auditor previously expressed, the
auditor shall disclose the substantive reasons for the different opinion in an Other Matter paragraph in accordance
with ISA 706.

Prior Period Financial Statements Audited by a Predecessor Auditor

If the financial statements of the prior period were audited by a predecessor auditor, in addition to expressing an
opinion on the current period’s financial statements, the auditor shall state in an Other Matter paragraph:
(a) that the financial statements of the prior period were audited by a predecessor auditor;
(b) the type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons
therefore; and
(c) the date of that report, unless the predecessor auditor’s report on the prior period’s financial statements is
reissued with the financial statements.

If the auditor concludes that a material misstatement exists that affects the prior period financial statements on
which the predecessor auditor had previously reported without modification, the auditor shall communicate the
misstatement with the appropriate level of management and, unless all of those charged with governance are
involved in managing the entity,those charged with governance and request that the predecessor auditor be
informed. If the prior period financial statements are amended, and the predecessor auditor agrees to issue a new
auditor’s report on the amended financial statements of the prior period, the auditor shall report only on the current
period.

Prior Period Financial Statements Not Audited

If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph that
the comparative financial statements are unaudited. Such a statement does not, however, relieve the auditor of the

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requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements
that materially affect the current period’s financial statements.

Audit work on: Revenue from contracts with customers

Performance obligations satisfied at a point in time

‐ Substantive procedures: revenue recognized to relevant documents like work certificates, contracts etc.
‐ Analytical procedures: Match with prior years and budgets, other related figures such as inventory and
receivables, similar industry information
‐ Analytical procedures based on operational factors: for example, total rental income from a building predicted
by considering the number of apartments, rental rates and vacancy rates etc.

Performance obligations satisfied over time

‐ Copy of revenue calculation: Recalculate assets/liabilities recognized
‐ Basis of revenue calculation: compare to last year
‐ Method of measuring progress for performance obligations: review to ensure reasonable and appropriate in
line with IFRS 15
‐ Verify figures in calculation‐ for example, total contract price to original contract. Revenue can be compared
with performance completed to date. Receivables can me matched to sales invoices. Performance completed
to date matched with input methods such as certification of work completed, cost of work completed etc.

Audit work on: Lease

Classification and rights and obligations

‐ Copy of lease agreement: review to ensure lease terms has been determined correctly in line with IFRS 16
Valuation
‐ Client’s workings of lease liability: Recalculate. Also recalculate interest and ensure implicit interest accounted
for in accordance with IFRS 16.
‐ New assets matched to lease agreements
‐ Lease payments matched to bank statements

One of the trickiest parts of IFRS 16 is determining whether or not the contract is a lease at all. Leases may be found
in many contracts that until recently were not treated as leases, so there is a risk regarding the completeness of
leasing transactions – have any been missed out?

The definition of a lease refers to the 'right to control the use' of an asset. Determining whether there is control
involves judgment, which introduces an element of risk for the auditor. Likewise the assessment of lease term which
requires judgment where there are options for either extension or termination.

IFRS 16 requires lease and non‐lease components to be separated from one another. For example, a lease might be
for just one part of a building, in which case it is necessary to allocate the consideration between the part that is
leased and the part that is not leased. Again, this requires judgment and is therefore risky.

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Many entities will not want to recognise assets and liabilities for lease transactions, so auditors need to be alert to
the risk of distortion in relation to any of these areas of judgment.

The auditor needs to be alert to the possibility of sale and leaseback transactions. If there is a sale and leaseback,
then you need to check that gains are treated in line with IFRS 16, along with any prepayments or additional
financing.

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Technical Article: Exam Techniques

In the Advanced Audit and Assurance exam you will be required to discuss accounting issues in many contexts. It
could be that during planning you are asked identify areas of audit risk or risk of material misstatement arising from
accounting issues. You may be expected to discuss accounting issues and their treatment in a completion question,
where the appropriateness of a treatment is considered, or areas of risk exist. Accounting issues could arise in
reporting questions where there may be an impact on the auditor’s report and the type of opinion which will be
given. This list is not exhaustive but illustrates how important it is to have a good understanding of the accounting
and financial reporting issues covered in all of the financial reporting areas of the qualification. In addition you will
be required to recommend audit procedures or explain the evidence you would expect to see in the audit file in
order to conclude on the appropriateness of these treatments and amounts.

As such, bringing forward a sound knowledge of financial reporting is crucial when preparing for the Advanced Audit
and Assurance exam. Some of those areas may be relatively straight forward, for example the valuation of inventory
at the lower of cost and net realisable value while others can be more involved or complex such as financial
instruments, revenue recognition or pensions.

The purpose of this article is to utilise past questions from the Advanced Audit and Assurance exam to illustrate how
accounting issues could be examined and to recap the accounting treatment on some of the areas candidates
typically find difficult in this exam.

EXAMPLE 1 – IMPAIRMENT
It is rare to see an Advanced Audit and Assurance exam which does not cover impairment and the requirements of
IAS 36 Impairment of Assets. This is a crucial standard which you need to understand as impairment considerations
apply to so many assets within a set of financial statements.

A summary of the key financial reporting principles from IAS 36 is provided below:
 An asset is impaired if its carrying amount is higher than recoverable amount.
 The recoverable amount of an asset is the higher of its value in use (the present value of future cash flows
deriving from the asset – or group of assets) and its fair value less disposal costs (the price which would be
received in an orderly transaction between market participants – eg what you could sell it for).
 Where an asset is impaired it should be written down to its recoverable amount and generally that loss would
be taken to the statement of profit or loss for the year.
 An impairment review is required for assets where there is an indicator of impairment such as a change in
technology, increase in interest rates or possible obsolescence.
 There is also a specific rule to perform annual impairment reviews on intangible assets with indefinite lives,
intangible assets not yet available for use and purchased goodwill (remember that internally generated
goodwill isn’t recognised).
 Where an asset cannot be assessed for its recoverable amount individually it can be assessed as part of a cash
generating unit. Where this is done the impairment is written off against the assets of the cash generating unit
by allocating first against goodwill then against the other assets on a prorated basis but no asset should be
reduced below the higher of its fair value less costs of disposal or value in use

IAS 36 paragraph 36.2 lists the assets which fall outside the scope of the standard including inventories, deferred tax
assets, financial assets and non‐current assets held for sale.

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RECENT EXAMPLE – SAMPLE MARCH/JUNE 17, QUESTION 4

This is an example from a matters and evidence style question. These questions are typically set at the completion
stage of an audit. Materiality, accounting treatment and risks are typical areas which would count as matters to be
considered. In these questions the auditor’s report implication is only relevant if you are asked specifically to
consider this area.

You are the manager responsible for the audit of Osier Co, a jewellery manufacturer and retailer. The final audit for
the year ended 31 March 2017 is nearing completion and you are reviewing the audit working papers. The draft
financial statements recognise total assets of $1,919 million (2016 – $1,889 million), revenue of $1,052 million
(2016 – $997 million) and profit before tax of $107 million (2016 – $110 million).

At the yearend management performed an impairment review on its retail outlets, which are a cash generating unit
for the purpose of conducting an impairment review. While internet sales grew rapidly during the year, sales from
retail outlets declined, prompting the review. At 31 March 2017 the carrying amount of the assets directly
attributable to the retail outlets totalled $137 million, this includes both tangible assets and goodwill. During the
year management received a number of offers from parties interested in purchasing the retail outlets for an average
of $125 million. They also estimated the disposal costs to be $1∙5 million, based upon their experience of corporate
acquisitions and disposals. Management estimated the value in use to be $128 million. This was based upon the
historic cash flows attributable to retail outlets inflated at a general rate of 1% per annum. This, they argued, reflects
the poor performance of the retail outlets. Consequently the retail outlets were impaired by $9 million to restate
them to their estimated recoverable amount of $128 million. The impairment was allocated against the tangible
assets of the outlets on a pro rata basis, based upon the original carrying amount of each asset in the unit.
(7 marks)

In this question you can open with the materiality of the impairment. The impairment loss of $9m represents 0.47%
of total assets and 8.41% of profit before tax and is material to the statement of profit or loss
(1 mark for an appropriate calculation and conclusion).

You should then state the underlying rule that an indicator of impairment triggers an impairment review and define
impairment and recoverable amount.
(1 mark)

Most of the credit will be available for determining and explaining the risks arising and applying the accounting
treatment to the information you have available.

We’re told that

 Carrying value is $137m
 Net realisable value is $125m ‐ £1.5m = $123.5m (you will generally receive ½ mark for calculating this figure)
 Value in use is estimated at $128m
 Recoverable amount is therefore $128m based on management’s calculations
 Impairment write off was based on value in use and has been pro‐rated against assets based on the original
carrying value of the assets in each unit.

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As auditors we need to look for risks in the process and treatment. Based on the information you can conclude that
the carrying value is relatively low risk – we audited last year’s figures and it’s not an inherently risky area in general
so in the absence of other information to the contrary you need to focus on the more risky areas.

The net realisable value carries some risk – external offers though are a good source of evidence and while not set
in stone there have been several parties interested so it’s likely that the company would be able to sell the retail
outlets for that price.

So what are the key risk areas and the matters which should be considered?

Risk 1 – Management has estimated the costs of sale. An estimation is inherently risky as it is not certain. It’s also
been estimated by management who could be biased.

Risk 2 – The value in use is the major source of risk. The calculation is complex and judgemental and so is inherently
risky. It has been calculated by management who may be biased to keep the impairment loss as low as possible. The
calculation was based on historic cash flows with 1% annual growth which appears unrealistic given that retail sales
have fallen not grown at 1%.

If the forecast used is overly optimistic then the impairment write off is insufficient and therefore assets are
overstated and profit is overstated (as expenses are understated).

Risk 3 – The treatment of the impairment write off may be incorrect as goodwill should be reduced before reducing
the assets on a prorate basis and it should be ensured that no individual asset is reduced to below its own
recoverable amount.

The matters part of this question as illustrated within the boxes above and answer points which focussed on these
risk areas would attract maximum credit for that part of the question.

As this was a matters and evidence question remember that you also need to go on to explain evidence you would
expect to find on the audit file. The requirement is for the evidence to be explained in these questions so listing
sources of evidence is not sufficient. Your answer points must also explain what they are providing evidence of in
order to attract high marks. If you write out evidence as a list of described procedures then this will be acceptable
and well described, relevant procedures will generally receive a mark each.

EXAMPLE 2 – INTANGIBLES
Intangible assets are non‐monetary assets without physical substance such as patents, trademarks, customer lists,
quotas, brands, franchise agreements etc.
A summary of the key financial reporting principles from IAS 38 Intangible Assets is provided below:
 Intangible assets must be
– identifiable (capable of being separated and sold/transferred and arise from contractual or other legal
rights)
– controlled
– provide future economic benefits
 In order to be recognised as an asset there must be a probable future economic benefit arising from the asset
and the cost must be capable of reliable measurement. If this is not possible then expenditure on the asset

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Audit Evidence & Audit Procedures AAA Revision Notes

must be recognised as an expense. This is why internally generated brands and customer lists are not allowed
to be recognised but purchased ones can be (including those purchased as part of the acquisition of another
company)
 Subsequent treatment of intangible assets will be either on a historical cost basis or under a fair value model
if it is possible that fair value can be determined by reference to an active market (eg production quotas, taxi
licences).

Exam focus

By definition brands are unique and therefore it would not be possible to compare to an active market hence the
fair value model does not apply and they cannot be revalued upwards.

 Intangible assets will either have a finite life (a limited period of benefit to the company over which the asset
will be amortised with the amortisation expense being charged to profit and loss) or an indefinite life (where
no foreseeable limit to the period of economic benefits exist – hence no amortisation is charged)
 Where an asset is deemed to have an indefinite life it is not amortised but the useful life should be reviewed
every reporting period to determine whether events continue to support an indefinite life and additionally, the
asset should be assessed for impairment each reporting period.
 All intangible assets are subject to an impairment review where there is an indicator of impairment.

RECENT EXAMPLE – SAMPLE MARCH/JUNE, QUESTION 1

This is an extract from a planning question which asked candidates to evaluate risks of material misstatement arising
from a scenario where the Group holds several purchased brand names for products.

Acquired brand names are held at cost and not amortised on the grounds that the assets have an indefinite life.
Annual impairment reviews are conducted on all brand names. In December 2016, the Chico brand name was
determined to be impaired by $30 million due to allegations made in the press and by customers that some
ingredients used in the Chico perfume range can cause skin irritations and more serious health problems. The Chico
products have been withdrawn from sale.

When answering a requirement to evaluate risks from a scenario relating to specific accounting issues you should
start by calculating the materiality of the issue‐ in this question, total assets were $358 million and PBT
$28million. The impairment of the Chico brand is 8.4% of total assets and more than 100% of PBT and is therefore
material to both the statement of financial position and the profit and loss for the year.

(1 mark for an appropriate calculation and conclusion).

You should then state the underlying accounting rule

(1 mark).

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Audit Evidence & Audit Procedures AAA Revision Notes

Acquired brand names should be capitalised and amortised over their useful life. Where this is indefinite, no
amortisation is required, however an annual review of the appropriateness of the assumption of indefinite life
should be performed and an annual impairment test is also required.

How this should be written up in a risk question has been illustrated in the article in this series.

Here, the company has decided to hold brands at cost as they deem them to have an indefinite life – this is an
acceptable treatment under IAS 38 however the important part of the standard which we need to consider is that
this should only be done if there is no foreseeable limit to the periods of benefit. There’s also a requirement that
this assumption should be reviewed annually and additionally an impairment review performed. The scenario tells
us that an impairment review has been performed but not that a review of the indefinite life has occurred hence
there is a risk that this may not have been done.

That decision to hold the brands with an indefinite life is a judgement call on behalf of management – judgements
are subjective and therefore are a source of inherent risk. Quite often the justification for such a decision would be
linked back to expenditure on the brand and marketing efforts along with market research. These costs cannot be
capitalised but do provide evidence to support an indefinite life.

Similarly, impairment reviews for a brand would be looking at value in use based on the discounted value of future
expected cash flows which is complex and judgemental.

In the exam you need to communicate these risk areas arising above‐ an example of a description for each that
would be sufficient in an exam is shown below:

Risk 1 – Management’s judgement that the brands have an indefinite life may be incorrect

Risk 2 – Management may not have reviewed the useful life of the brands in the reporting period to ensure that
the assumption of indefinite life is still correct

Risk 3 – The impairment review may not be accurate as the assumptions used by management may not be
appropriate as the calculation is complex and judgemental. (IAS 36)

The scenario goes on to describe the impairment of the Chico brand after allegations made about the products. The
products have been withdrawn from sale. This brings in the impairment consideration in more detail. Here there has
been a specific indicator of impairment for both the brand and inventory relating to Chico and therefore poses more
risks.

Risk 4 – The impairment of the Chico Brand may not be sufficient (we can’t tell if it has been fully written down IAS
36)

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Audit Evidence & Audit Procedures AAA Revision Notes

Risk 5 – The inventory relating to Chico products may need to be written off if its net realisable value is below cost
(IAS 2 Inventories)

Risk 6 – Other brands and inventory may be affected by the negative publicity regarding Chico and may also need
to be written down (IAS 36)

Exam focus
No credit is awarded for the name or number of auditing and financial reporting standards.

You should avoid describing audit approach or evidence/procedures unless you have been asked to do this in
the requirement.

Written by a member of the AAA examining team

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Group Audit AAA Revision Notes

Group Audit

Let’s talk THE ADVANCED AUDIT & ASSURANCE EXAM

The group engagement team shall determine the type of work to be performed on the financial information of
components in response to assessed risks

The ISA distinguishes between significant components and components that are not significant

Components that are not significant: Group engagement team shall perform analytical procedures at group
level

Significant components
‐ If a component is financially significant, perform a full audit based on the component materiality
level
‐ If the component is otherwise significant due to its nature or circumstances, one of the following is required:
 A full audit using component materiality
 An audit of specified account balance related to identified significant risks
 Specified audit procedures relating to identified significant risks

Key terms
a) Component –An entity or business activity for which group or component management prepares financial
information that should be included in the group financial statements. ( subsidiaries, associates, joint ventures
etc)

b) Component auditor – An auditor who, at the request of the group engagement team, performs work on financial
information related to a component for the group audit.

c) Component management –Management responsible for the preparation of the financial information of a
component.

d) Component materiality – The materiality for a component determined by the group engagement team.

e) Group –All the components whose financial information is included in the group financial statements. A group
always has more than one component.

f) Group audit – The audit of group financial statements.

g) Group audit opinion – The audit opinion on the group financial statements.

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Group Audit AAA Revision Notes

h) Group engagement partner – The partner The group engagement partner is responsible for the direction,
in the firm who is responsible for the group supervision and performance of the group audit engagement
audit engagement and its performance, and whether the auditor’s report that is issued is appropriate.
and for the auditor’s report on the group
financial statements that is issued on As a result, the auditor’s report on the group financial
behalf of the firm. statements shall not refer to a component auditor, unless
required by law or regulation to include such reference.

i) Group engagement team – Partners, including the group engagement partner, and staff who establish the
overall group audit strategy, communicate with component auditors, perform work on the consolidation
process, and evaluate the conclusions drawn from the audit evidence as the basis for forming an opinion on the
group financial statements.

j) Group financial statements – Financial statements that include the financial information of more than one
component.

k) Group management – Management responsible for the preparation of the group financial statements.

l) Group‐wide controls – Controls designed, implemented and maintained by group management over group
financial reporting.

Group‐wide controls may include a combination of the following:

• Regular meetings between group and component management to discuss business developments and to
review performance.
• Monitoring of components’ operations and their financial results, including regular reporting routines,
which enables group management to monitor components’ performance against budgets, and to take
appropriate action.
• Group management’s risk assessment process, that is, the process for identifying, analyzing and managing
business risks, including the risk of fraud, that may result in material misstatement of the group financial
statements.
• Monitoring, controlling, reconciling, and eliminating intra‐group transactions and unrealized profits, and
intra‐group account balances at group level.
• A process for monitoring the timeliness and assessing the accuracy and completeness of financial
information received from components.
• A central IT system controlled by the same general IT controls for all or part of the group.
• Control activities within an IT system that is common for all or some components.
• Monitoring of controls, including activities of the internal audit function and self‐assessment programs.
• Consistent policies and procedures, including a group financial reporting procedures manual.
• Group‐wide programs, such as codes of conduct and fraud prevention programs.

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m) Significant component – A component As the individual financial significance of a component increases,

identified by the group engagement team the risks of material misstatement of the group financial
(i) That is of individual financial statements ordinarily increase. The group engagement team may
significance to the group, or apply a percentage to a chosen benchmark as an aid to identify
(ii) That, due to its specific nature or components that are of individual financial significance.
circumstances, is likely to include Identifying a benchmark and determining a percentage to be
significant risks of material applied to it involve the exercise of professional judgment.
misstatement of the group Depending on the nature and circumstances of the group,
financial statements. appropriate benchmarks might include group assets, liabilities,
cash flows, profit or turnover. For example, the group
engagement team may consider that components exceeding 15%
of the chosen benchmark are significant components. A higher or
lower percentage may, however, be deemed appropriate in the
circumstances.

The group engagement team may also identify a component as

likely to include significant risks of material misstatement of the
group financial statements due to its specific nature or
circumstances (that is, risks that require special audit
consideration. For example, a component could be responsible
for foreign exchange trading and thus expose the group to a
significant risk of material misstatement, even though the
component is not otherwise of individual financial significance to
the group.

If a component is financially significant to the group financial statements then the group engagement team
or a component auditor will perform a full audit based on the component materiality level.

The group auditor should be involved in the assessment of risk in relation to significant components. If the
component is otherwise significant due to its nature or circumstances, the group auditors will require one of the
following:
 Full audit using component materiality
 An audit of specified account balances related to identified significant risks
 Specified audit procedures relating to identified significant risks

Components that are not ‘significant components’ will be subject to analytical procedures at a group level –
a full audit is not required.

The diagram shows how the significance of the component affects the group engagement team’s determination
of the type of work to be performed on the financial information of the component.

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Group Audit AAA Revision Notes

Responsibility
The group engagement partner is responsible for the direction, supervision and performance of the group audit
engagement in compliance with professional standards and applicable legal and regulatory requirements, and
whether the auditor’s report that is issued is appropriate in the circumstances. As a result, the auditor’s report on
the group financial statements shall not refer to a component auditor, unless required by law or regulation to include
such reference.

The group engagement partner shall agree on the terms of the group audit engagement.

The group engagement team shall establish an overall group audit strategy and shall develop a group audit plan
which shall then be reviewed by the group engagement partner.

Acceptance and Continuance

Determine whether sufficient appropriate  Obtain an understanding of the group, its components, and
audit evidence can reasonably be expected to their environments that is sufficient to identify components
be obtained in relation to the consolidation that are likely to be significant components.
process and the financial information of the
components on which to base the group audit  Where component auditors will perform work on the
opinion. financial information of such components, the group
engagement partner shall evaluate whether the group
engagement team will be able to be involved in the work of
those component auditors to the extent necessary to obtain
sufficient appropriate audit evidence.

Terms of Engagement

The group engagement partner shall agree on the terms of the group audit engagement in accordance with ISA 210.
Additional matters may be included in the terms of a group audit engagement, such as the fact that:
- The communication between the group engagement team and the component auditors should be unrestricted.
- Important communications between the component auditors, those charged with governance of the
component, and component management, including communications on significant deficiencies in internal
control, should be communicated as well to the group engagement team;
- Important communications between regulatory authorities and components related to financial reporting
matters should be communicated to the group engagement team; and
- To the extent the group engagement team considers necessary, it should be permitted:
 Access to component information, those charged with governance of components, component
management, and the component auditors (including relevant audit documentation sought by the group
engagement team); and
 To perform work or request a component auditor to perform work on the financial information of the
components.

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Group Audit AAA Revision Notes

Overall Audit Strategy and Audit Plan

The group engagement team shall establish an overall group audit strategy and shall develop a group audit plan in
accordance with ISA 300.

The group engagement partner shall review the overall group audit strategy and group audit plan.

Understanding the Group, Its Components, and Their Environments

The auditor is required to identify and assess the risks of material misstatement through obtaining an understanding
of the entity and its environment.

The group engagement team shall:

Enhance its understanding of the group, its (the industry, regulatory, and other external factors that affect
components, and their environments, the entity, including the applicable financial reporting
including group‐wide controls, obtained framework; the nature of the entity; objectives and strategies
during the acceptance or continuance stage and related business risks; and measurement and review of the
entity’s financial Performance)

Obtain an understanding of the consolidation Group management ordinarily issues instructions to

process, including the instructions issued by components. Such instructions specify the requirements for
group management to components financial information of the components to be included in the
group financial statements and often include financial reporting
procedures manuals and a reporting package. A reporting
package ordinarily consists of standard formats for providing
financial information for incorporation in the group financial
statements. Reporting packages generally do not, however, take
the form of complete financial statements prepared and
presented in accordance with the applicable financial reporting
framework.

The instructions ordinarily cover:

- The accounting policies to be applied;
- Statutory and other disclosure requirements applicable to
the group financial statements, including:
o The identification and reporting of segments;
o Related party relationships and transactions;
o Intra‐group transactions and unrealized profits;
o Intra‐group account balances; and
o A reporting timetable.

‐ Obtain an understanding that is sufficient Information used to identify the risks of material misstatement
to assess the risks of material of the group financial statements due to fraud may include the
misstatement of the group financial following:
statements, whether due to fraud or • Group management’s assessment of the risks that the
error. group financial statements may be materially misstated as
a result of fraud.

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Group Audit AAA Revision Notes

• Group management’s process for identifying and

responding to the risks of fraud in the group, Whether there
are particular components for which a risk of fraud is likely.

The key members of the engagement team are required to

discuss the susceptibility of an entity to material misstatement
of the financial statements due to fraud or error, specifically
emphasizing the risks due to fraud. In a group audit, these
discussions may also include the component auditors.

Understanding the Component Auditor

If the group engagement team plans to request a component auditor to perform work on the financial information
of a component, the group engagement team shall obtain an understanding of the following:
‐ Whether the component auditor understands and will comply with the ethical requirements that are relevant
to the group audit and, in particular, is independent.
‐ The component auditor’s professional competence.
‐ Whether the group engagement team will be able to be involved in the work of the component auditor to the
extent necessary to obtain sufficient appropriate audit evidence.
‐ Whether the component auditor operates in a regulatory environment that actively oversees auditors.

If a component auditor does not meet the independence requirements that are relevant to the group audit, or the
group engagement team has serious concerns about the other matters ,the group engagement.

Team shall obtain sufficient appropriate audit evidence relating to the financial information of the component
without requesting that component auditor to perform work on the financial information of that component.

Materiality
The group engagement team shall determine the following:
(a) Materiality for the group financial statements as a whole when establishing the overall group audit strategy.

(b) If, in the specific circumstances of the group, there are particular classes of transactions, account balances or
disclosures in the group financial statements for which misstatements of lesser amounts than materiality for
the group financial statements as a whole could reasonably be expected to influence the economic decisions
of users taken on the basis of the group financial statements, the materiality level or levels to be applied to
those particular classes of transactions, account balances or disclosures.
(c) Component materiality for those Component materiality shall be lower than materiality for the
components where component auditors group financial statements as a whole.
will perform an audit or a review for
purposes of the group audit. Different component materiality may be established for
different components.

Component materiality is used by the component auditor to

evaluate whether uncorrected detected misstatements are
material, individually or in the aggregate.

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Group Audit AAA Revision Notes

Where component auditors will perform an audit for purposes of the group audit, the group engagement team shall
evaluate the appropriateness of performance materiality determined at the component level.

Responding to Assessed Risks

The auditor is required to design and implement appropriate responses to address the assessed risks of material
misstatement of the financial statements.

The group engagement team shall determine the type of work to be performed by the group engagement team, or
the component auditors on its behalf, on the financial information of the components.

The group engagement team shall also determine the nature, timing and extent of its involvement in the work of
the component auditors.

If the nature, timing and extent of the work to be performed on the consolidation process or the financial
information of the components are based on an expectation that group‐wide controls are operating effectively, or
if substantive procedures alone cannot provide sufficient appropriate audit evidence at the assertion level, the group
engagement team shall test, or request a component auditor to test, the operating effectiveness of those controls.

Determining the Type of Work to Be Performed on the Financial Information of Components

Significant Components: For a component that is significant due to its individual financial significance to the group,
the group engagement team, or a component auditor on its behalf, shall perform an audit of the financial
information of the component using component materiality.

For a component that is significant because it is likely to include significant risks of material misstatement of the
group financial statements due to its specific nature or circumstances, the group engagement team, or a component
auditor on its behalf, shall perform one or more of the following:
a) An audit of the financial information of the component using component materiality.
b) An audit of one or more account balances, classes of transactions or disclosures relating to the likely significant
risks of material misstatement of the group financial statements.
c) Specified audit procedures relating to the likely significant risks of material misstatement of the group financial
statements.

Components that Are Not Significant Components

For components that are not significant components, the group engagement team shall perform analytical
procedures at group level.

If the group engagement team does not consider that sufficient appropriate audit evidence on which to base the
group audit opinion will be obtained from:
a) The work performed on the financial information of significant components;
b) the work performed on group‐wide controls and the consolidation process; and
c) The analytical procedures performed at group level, the group engagement team shall select components that
are not significant components and shall perform, or request a component auditor to perform
• An audit of the financial information of the component using component materiality.
• An audit of one or more account balances, classes of transactions or disclosures.
• A review of the financial information of the component using component materiality.
• Specified procedures.

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Group Audit AAA Revision Notes

The group engagement team shall vary the selection of components over a period of time.

Involvement in the Work Performed by Component Auditors

Significant Components—Risk Assessment
If a component auditor performs an audit of the financial information of a significant component, the group
engagement team shall be involved in the component auditor’s risk assessment to identify significant risks of
material misstatement of the group financial statements.

It shall include:
a) Discussing with the component auditor or component management those of the component’s business
activities that are significant to the group;
b) Discussing with the component auditor the susceptibility of the component to material misstatement of the
financial information due to fraud or error; and
c) Reviewing the component auditor’s documentation of identified significant risks of material misstatement of
the group financial statements. Such documentation may take the form of a memorandum that reflects the
component auditor’s conclusion with regard to the identified significant risks.

Identified Significant Risks of Material Misstatement of the Group Financial

Statements—Further Audit Procedures
If significant risks of material misstatement of the group financial statements have been identified in a component
on which a component auditor performs the work, the group engagement team shall evaluate the appropriateness
of the further audit procedures to be performed to respond to the identified significant risks of material
misstatement of the group financial statements. Based on its understanding of the component auditor, the group
engagement team shall determine whether it is necessary to be involved in the further audit procedures.

Consolidation Process
The group engagement team obtains an understanding of group‐wide controls and the consolidation process,
including the instructions issued by group management to components.

The group engagement team, or component auditor at the request of the group engagement team, tests the
operating effectiveness of group‐wide controls.

The group engagement team shall design and perform further audit procedures on the consolidation process to
respond to the assessed risks of material misstatement of the group financial statements arising from the
consolidation process. This shall include evaluating whether all components have been included in the group
financial statements.

The group engagement team shall evaluate the appropriateness, completeness and accuracy of consolidation
adjustments and reclassifications, and shall evaluate whether any fraud risk factors or indicators of possible
management bias exist. If the financial information of a component has not been prepared in accordance with the
same accounting policies applied to the group financial statements, the group engagement team shall evaluate
whether the financial information of that component has been appropriately adjusted for purposes of preparing and
presenting the group financial statements.

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Group Audit AAA Revision Notes

If the group financial statements include the financial statements of a component with a financial reporting period‐
end that differs from that of the group, the group engagement team shall evaluate whether appropriate adjustments
have been made to those financial statements in accordance with the applicable financial reporting framework.

Subsequent Events
The group engagement team or the component auditors shall perform procedures designed to identify events at
those components that occur between the dates of the financial information of the components and the date of the
auditor’s report on the group financial statements, and that may require adjustment to or disclosure in the group
financial statements. The group engagement team shall request the component auditors to notify the group
engagement team if they become aware of subsequent events that may require an adjustment to or disclosure in
the group financial statements.
Communication with the Component Auditor

From group engagement team to component auditor

The group engagement team shall communicate its requirements to the component auditor on a timely basis. This
communication shall set out the work to be performed, the use to be made of that work, and the form and content
of the component auditor’s communication with the group engagement team. It shall also include the following:
‐ A request that the component auditor confirms that the component auditor will cooperate with the group
engagement team.
‐ The ethical requirements that are relevant to the group audit and, in particular, the independence
requirements.
‐ Component materiality (and, if applicable, the materiality level or levels for particular classes of transactions,
account balances or disclosures) and the threshold above which misstatements cannot be regarded as clearly
trivial to the group financial statements.
‐ Identified significant risks of material misstatement of the group financial statements, due to fraud or error. The
group engagement team shall request the component auditor to communicate on a timely basis any other
identified significant risks of material misstatement of the group financial statements, due to fraud or error, in
the component, and the component auditor’s responses to such risks.
‐ A list of related parties prepared by group management. The group engagement team shall request the
component auditor to communicate on a timely basis related parties not previously identified by group
management or the group engagement team. The group engagement team shall determine whether to identify
such additional related parties to other component auditors.

From component auditor to group engagement team

The group engagement team shall request the component auditor to communicate matters relevant to the group
engagement team’s conclusion with regard to the group audit. Such communication shall include:
‐ Whether the component auditor has complied with ethical requirements that are relevant to the group audit,
including independence and professional competence;
‐ Whether the component auditor has complied with the group engagement team’s requirements;
‐ Identification of the financial information of the component on which the component auditor is reporting;
‐ Information on instances of non‐compliance with laws or regulations that could give rise to a material
misstatement of the group financial statements;
‐ A list of uncorrected misstatements of the financial information of the component
‐ Indicators of possible management bias;
‐ Description of any identified significant deficiencies in internal control at the component level;

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Group Audit AAA Revision Notes

‐ Other significant matters that the component auditor communicated or expects to communicate to those
charged with governance of the component, including fraud or suspected fraud involving component
management, employees who have significant roles in internal control at the component level or others where
the fraud resulted in a material misstatement of the financial information of the component;
‐ The component auditor’s overall findings, conclusions or opinion.

Evaluating the Sufficiency and Appropriateness of Audit Evidence Obtained

Evaluating the Component Auditor’s Communication and Adequacy of their Work

The group engagement team shall evaluate the component auditor’s communication. The group engagement team
shall:
‐ Discuss significant matters arising from that evaluation with the component auditor, component management
or group management, as appropriate; and
‐ Determine whether it is necessary to review other relevant parts of the component auditor’s audit
documentation.

If the group engagement team concludes that the work of the component auditor is insufficient, the group
engagement team shall determine what additional procedures are to be performed, and whether they are to be
performed by the component auditor or by the group engagement team.

Sufficiency and Appropriateness of Audit Evidence

The group engagement team shall evaluate whether sufficient appropriate audit evidence has been obtained from
the audit procedures performed on the consolidation process and the work performed by the group engagement
team and the component auditors on the financial information of the components, on which to base the group audit
opinion.

The group engagement partner shall evaluate the effect on the group audit opinion of any uncorrected
misstatements (either identified by the group engagement team or communicated by component auditors) and any
instances where there has been an inability to obtain sufficient appropriate audit evidence.

Communication with Group Management and Those Charged with Governance of the Group

Communication with Group Management

The group engagement team shall determine which identified deficiencies in internal control to communicate to
those charged with governance and group management in accordance with ISA 265. In making this determination,
the group engagement team shall consider:
‐ Deficiencies in group‐wide internal control that the group engagement team has identified;
‐ Deficiencies in internal control that the group engagement team has identified in internal controls at
components; and
‐ Deficiencies in internal control that component auditors have brought to the attention of the group engagement
team.

If fraud has been identified by the group engagement team or brought to its attention by a component auditor or
information indicates that a fraud may exist, the group engagement team shall communicate this on a timely basis
to the appropriate level of group management in order to inform those with primary responsibility for the prevention
and detection of fraud of matters relevant to their responsibilities.

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Group Audit AAA Revision Notes

Examples of Conditions or Events that May Indicate Risks of Material Misstatement of the Group Financial
Statements
The examples provided cover a broad range of conditions or events; however, not all conditions or events are
relevant to every group audit engagement and the list of examples is not necessarily complete.
• A complex group structure, especially where there are frequent acquisitions, disposals or reorganizations.
• Poor corporate governance structures, including decision‐making processes that are not transparent.
• Non‐existent or ineffective group‐wide controls, including inadequate group management information on
monitoring of components’ operations and their results.
• Components operating in foreign jurisdictions that may be exposed to factors such as unusual government
intervention in areas such as trade and fiscal policy, and restrictions on currency and dividend movements; and
fluctuations in exchange rates.
• Business activities of components that involve high risk, such as long‐term contracts or trading in innovative or
complex financial instruments.
• Uncertainties regarding which components’ financial information require incorporation in the group financial
statements in accordance with the applicable financial reporting framework, for example, whether any special‐
purpose entities or non‐trading entities exist and require incorporation.
• Unusual related party relationships and transactions.
• Prior occurrences of intra‐group account balances that did not balance or reconcile on consolidation.
• The existence of complex transactions that are accounted for in more than one component.
• Components’ application of accounting policies that differ from those applied to the group financial statements.
• Components with different financial year‐ends, which may be utilized to manipulate the timing of transactions.
• Prior occurrences of unauthorized or incomplete consolidation adjustments.
• Aggressive tax planning within the group, or large cash transactions with entities in tax havens.
• Frequent changes of auditors engaged to audit the financial statements of components.

Extracted from past exams

Overall risks
On consolidation, the intercompany receivables and payables balances should be eliminated, leaving only
balances between the Group and external parties recognised at Group level.

If the intercompany transaction included a profit element, then the inventory needs to be reduced in value by an
adjustment for unrealised profit.

There is a risk that intra‐group sales, purchases, payables and receivables are not eliminated, leading to
overstated revenue, cost of sales, payables and receivables in the Group financial statements.

There is also a risk that intercompany transactions are not identified in either/both companies’ accounting
systems.

intra‐group transactions are by definition related party transactions according to IAS 24

Related Party Disclosures,

No disclosure of the transactions is required in the Group financial statements in respect of intra‐group
transactions because they are eliminated on consolidation. However, both the individual financial statements of

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Group Audit AAA Revision Notes

the Group company supplying the parent and the financial statements of the parent company must contain notes
disclosing details of the intra‐group transactions. There is a risk that this disclosure is not provided.

In addition, inventory may be supplied including a profit margin or mark up, in which case a provision for
unrealised profit should be recognised in the Group financial statements. If this is not accounted for, Group
inventory will be overstated, and operating profit will be overstated.

Other risks
Mid‐year acquisition
Subsidiary was acquired part way through the accounting period. Its results should be consolidated into the group
statement of comprehensive income from the date that control passed to the parent. The risk is that results have
been consolidated from the wrong point in time.

The company’s functional and presentational currency is local, and different to the rest of the group. Prior to
consolidation, the financial statements must be retranslated, using the rules in IAS 21 The Effects of Changes in
Foreign Exchange Rates. The assets and liabilities should be retranslated using the closing exchange rate, income
and expenses at the average exchange rate, and exchange gains or losses on the retranslation should be
recognised in group equity. This is a complex procedure, therefore inherently risky, and the determination of the
average rate for the year can be subjective.

Adjustments necessary to bring in line with group accounting policies

Subsidiary does not use the same financial reporting framework as the rest of the group. The company’s financial
statements must be adjusted to align them with group accounting policies. This will require considerable expertise
and the risk of errors is high.

Goodwill Risks
The various components of goodwill have specific risks attached. For the consideration, the contingent element
of the consideration is inherently risky, as its measurement involves a judgement as to the probability of the
amount being paid.

IFRS 3 (Revised) Business Combinations requires that contingent consideration is recognised at fair value at the
time of the business combination, meaning that the probability of payment should be used in measuring the
amount of consideration that is recognised at acquisition. This part of the consideration could therefore be
overstated, if the assessment of probability of payment is incorrect.

Another risk is that the contingent consideration does not appear to have been discounted to present value as
required by IFRS 3, again indicating that it is overstated.

The other component of the goodwill calculation is the value of identifiable assets acquired, which IFRS 3 requires
to be measured at fair value at the date of acquisition. This again is inherently risky, as estimating fair value can
involve uncertainty. Possibly the risk is reduced somewhat as the fair values have been determined by an external
firm.

Goodwill should be tested for impairment annually according to IAS 36 Impairment of Assets, and a test should
be performed in the year of acquisition, regardless of whether indicators of impairment exist. There is therefore
a risk that goodwill may be overstated if management has not conducted an impairment test at the year end.

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Risks of material misstatement arise because the various components of goodwill each have specific risks
attached, for example:
– Not all assets and liabilities may have been identified, for example, contingent liabilities and contingent assets
may be omitted
– Fair value is subjective and based on assumptions which may not be valid.
– There is also a risk that the cost of investment is not stated correctly, for example, that any contingent
consideration has not been included in the calculation.

Subsequent measurement of goodwill

According to IFRS 3 Business Combinations, goodwill should be subject to an impairment review on an annual
basis. The risk is that a review has not taken place, and so goodwill is overstated and Group operating expenses
understated if impairment losses have not been recognised

Disclosure
Extensive disclosures are required by IFRS 3 to be included in the notes to the Group financial statements, for
example, to include the acquisition date, reason for the acquisition and a description of the factors which make
up the goodwill acquired. The risk is that disclosures are incomplete or not understandable

Goodwill Evidence
The goodwill should be recognised as an intangible asset and measured according to IAS 38 Intangible Assets and
IFRS 3 Business Combinations.
– The purchase consideration should reflect the fair value of total consideration paid and payable, and there is
a risk that the amount shown in the calculation is not complete, for example, if any deferred or contingent
consideration has not been included.
– The non‐controlling interest has been measured at fair value. This is permitted by IFRS 3, and the decision to
measure at fair value can be made on an investment by investment basis. The important issue is the basis for
measurement of fair value. If the client is a listed company, then the market value of its shares at the date of
acquisition can be used and this is a reliable measurement. If the client is not listed, then management should
have used estimation techniques according to the fair value hierarchy of inputs contained in IFRS 13 Fair
Value Measurement. This would introduce subjectivity into the measurement of non‐controlling interest and
goodwill and the method of determining fair value must be clearly understood by the auditor.
– The net assets acquired should be all identifiable assets and liabilities at the date of acquisition. Some form
of due diligence investigation should have been performed, and one of the objectives of this would be to
determine the existence of assets and liabilities, even those not recognised in the individual financial
statements. There is a risk that not all acquired assets and liabilities have been identified, or that they have
not been appropriately measured at fair value, which would lead to over or understatement of goodwill and
incomplete recording of assets and liabilities in the consolidated financial statements.
– IAS 38 requires that goodwill is tested annually for impairment regardless of whether indicators of potential
impairment exist.

Evidence
– Agreement of the purchase consideration to the legal documentation pertaining to the acquisition, and a
review of the documents to ensure that the figures included in the goodwill calculation are complete.
– Agreement of the purchase consideration to the bank statement and cash book of the acquiring company

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– Review of board minutes for discussions relating to the acquisition, and for the relevant minute of board
approval.
– A review of the purchase documentation and a register of significant shareholders of to confirm the 20% non‐
controlling interest.
– If the subsidiary’s shares are not listed, a discussion with management as to how the fair value of the non‐
controlling interest has been determined and evaluation of the appropriateness of the method used.
– If the subsidiary’s shares are listed, confirmation that the fair value of the non‐controlling interest has been
calculated based on an externally available share price at the date of acquisition.
– A copy of any due diligence report relevant to the acquisition, reviewed for confirmation of acquired assets
and liabilities and their fair values.
– An evaluation of the methods used to determine the fair value of acquired assets, including the property,
and liabilities to confirm compliance with IFRS 3 and IFRS 13.

Goodwill impairment
– Look for indicators of goodwill impairment for example one of the subsidiaries has suffered a 25% reduction
in revenue
– In another question, A trading division relating to one‐third of a subsidiary’s net assets is held for sale at the
year end. Any goodwill relating to this trading division should be reclassified out of goodwill and into the
disposal group of assets held for sale. It may be a subjective and complex process to determine how much of
the subsidiary’s goodwill should be allocated to the trading division which is held for sale. It may be that no
goodwill is attached to this trading division, but this should be confirmed through further audit procedures.

Procedures on goodwill initially recognised with contingent considertion (can’t include impairment procedures
then!)
– Obtain the legal purchase agreement and confirm the date of the acquisition as being the date that control
of Subsidiary passed to parent
– From the legal purchase agreement, confirm the consideration paid, and the details of the contingent
consideration, including its amount, date potentially payable, and the factors on which payment depends.
– Agree the cash payment to cash book and bank statements.
– Review the board minutes for discussion regarding, and approval of the purchase
– Obtain the due diligence report prepared by the external provider and confirm the estimated fair value of
net assets at acquisition.
– Ask management to recalculate the contingent consideration on a discounted basis, and confirm goodwill is
recognised on this basis in the consolidated financial statements.

Cost of investment
According to the schedule provided by the client, the cost of investment comprises three elements. One matter
to consider is whether the cost of investment is complete.

It appears that no legal or professional fees have been included in the cost of investment (unless included within
the heading ‘cash consideration’). Directly attributable costs should be included per IFRS 3 Business Combinations,
and there is a risk that these costs may be expensed in error, leading to understatement of the investment.

The cash consideration of $2∙5 million is the least problematical component. The only matter to consider is
whether the cash has actually been paid. Given that subsidiary was acquired in the last month of the financial

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year it is possible that the amount had not been paid before the year end, in which case the amount should be
recognised as a current liability on the statement of financial position (balance sheet). However, this seems
unlikely given that normally control of an acquired company only passes to the acquirer on cash payment.

IFRS 3 states that the cost of investment should be recognised at fair value, which means that deferred
consideration should be discounted to present value at the date of acquisition. If the consideration payable at the
yearend has not been discounted, the cost of investment, and the corresponding liability, will be overstated.

Contingent consideration should be accrued if it is probable to be paid. Here the amount is payable if revenue
growth targets are achieved over the next four years. The auditor must therefore assess the probability of the
targets being achieved, using forecasts and projections of revenue. Such information is inherently subjective, and
could have been manipulated in order to secure the deal and maximise consideration. Here it will be crucial to be
sceptical when reviewing the forecasts, and the assumptions underlying the data.

Audit evidence
– Agreement of the monetary value and payment dates of the consideration per the client schedule to legal
documentation signed by vendor and acquirer.
– Agreement of $2∙5 million paid to the bank statement and cash book prior to year end. If payment occurs
after yearend confirm that a current liability is recognised on the individual company and consolidated
statement of financial position (balance sheet).
– Board minutes approving the payment.
– Recomputation of discounting calculations applied to deferred and contingent consideration.
– Agreement that the discount rate used is pre‐tax, and reflects current market assessment of the time value
of money (e.g. by comparison to weighted average cost of capital).
– Revenue and profit projections checked for arithmetic accuracy.
– A review of assumptions used in the projections, and agreement that the assumptions are comparable with
the auditor’s understanding of the business.

Disposal of a subsidiary disposed off at a profit during the year

Derecognition of assets and liabilities
On disposal, all of its assets and liabilities which had been recognised in the Group financial statements should
have been derecognised at their carrying value, including any goodwill in respect of the company.

There is therefore a risk that not all assets, liabilities and goodwill have been derecognised leading to
overstatement of those balances and an incorrect profit on disposal being calculated and included in Group profit
for the year.

Profit consolidated prior to disposal

There is a risk that the disposed subsidiary’s income for the year has been incorrectly consolidated. It should have
been included in Group profit up to the date that control passed and any profit included after that point would
mean overstatement of Group profit for the year.

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Calculation of profit on disposal

There is a risk that the profit on disposal has not been accurately calculated, e.g. that the proceeds received have
not been measured at fair value as required by IFRS 10 Consolidated Financial Statements, or that elements of
the calculation are missing.

Classification and disclosure of profit on disposal

IAS 1 Presentation of Financial Statements requires separate disclosure on the face of the financial statements of
material items to enhance the understanding of performance during the year.

The risk is that the profit is not separately disclosed, e.g. is netted from operating expenses, leading to material
misstatement.

Extensive disclosure requirements exist in relation to subsidiaries disposed of, e.g. IAS 7 Statement of Cash Flows
requires a note which analyses the assets and liabilities of the subsidiary at the date of disposal. There is a risk
that not all necessary notes to the financial statements are provided.

Treatment of the disposal in parent company individual financial statements

The parent company’s financial statements should derecognise the original cost of investment and recognise a
profit on disposal based on the difference between the proceeds and the cost of investment. Risk arises if the
investment has not been derecognised or the profit has been incorrectly calculated.

Tax on disposal
There should be an accrual in both the parent company and the Group financial statements for the tax due on the
disposal. This should be calculated based on the profit recognised in the parent company. There is a risk that the
tax is not accrued for, leading to overstated profit and understated liabilities. There is also a risk that the tax
calculation is not accurate.

Procedures to be performed on the disposal of a subsidiary

– Obtain the statement of financial position of the disposed off subsidiary to confirm the value of assets and
liabilities which have been derecognised from the Group.
– Review prior year Group financial statements and audit working papers to confirm the amount of goodwill
that exists in respect of the disposed off subsidiary and trace to confirm it is derecognised from the Group on
disposal.
– Confirm that the Group is no longer listed as a shareholder of the disposed off subsidiary.
– Obtain legal documentation in relation to the disposal to confirm the date of the disposal and confirm that
disposed off subsidiary’s profit has been consolidated up to this date only.
– Perform substantive analytical procedures to gain assurance that the amount of profit consolidated appears
reasonable and in line with expectations based on prior year profit.
– Re‐perform management’s calculation of profit on disposal in the Group financial statements.
– Agree the proceeds received to legal documentation, and to cash book/bank statements.
– Confirm that the above proceeds is the fair value of proceeds on disposal and that no deferred or contingent
consideration is receivable in the future.

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– Review the Group statement of profit or loss and other comprehensive income to confirm that the profit on
disposal is correctly disclosed as part of profit for the year (not in other comprehensive income) on a separate
line.
– Using a disclosure checklist, confirm that all necessary information has been provided in the notes to the
Group financial statements.
– Obtain management’s estimate of the tax due on disposal, re‐perform the calculation and confirm the
amount is properly accrued at parent company and at Group level.
– Review any correspondence with tax authorities regarding the tax due.
– Possibly the tax will be paid in the subsequent events period, in which case the payment can be agreed to
cash book and bank statement.

Parent company’s individual F/S

– Obtain the parent company’s statement of financial position to confirm that the cost of investment is
derecognised.
– Using prior year financial statements and audit working papers, agree the cost of investment derecognised
to prior year’s figure.
– Re‐perform the calculation of profit on disposal in the parent company’s financial statements.
– Reconcile the profit on disposal recognised in the parent company’s financial statements to the profit
recognised in the Group financial statements.

Associates
Associates are accounted for under IAS 28 Investments in Associates and Joint Ventures, which states that an
entity with joint control of, or significant influence over, an investee shall account for its investment in an
associate or a joint venture using the equity method. If it cannot demonstrate the ability to exercise significant
influence, then the investments should be treated as trade investments, and would not be consolidated

Risk arises in relation to any possible impairment of the investment, which may cause it to be overstated in both
the individual financial statements of the client, and the Group financial statements.

There is also a disclosure issue, as the Group’s share of post‐investment profit of the associate should be
recognised in profit, and IAS 1 Presentation of Financial Statements requires that the profit or loss section of the
statement of profit or loss shall include as a line item the share of the profit or loss of associates accounted for
using the equity method.

According to IAS 28, if an entity holds, directly or indirectly, 20% or more of the voting power of the investee, it is
presumed that the entity has significant influence, unless it can be clearly demonstrated that this is not the case.
If the holding does not give rise to significant influence, for example, if the shares do not convey voting rights, it
should be classified as an investment rather than an associate.

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Co‐terminous year ends

It is possible that all of the entities within a group will not have co‐terminous reporting periods. In this case, ISA
600.37 requires the group auditor to evaluate whether appropriate adjustments have been made to the financial
statements that are not co‐terminous, in accordance with the relevant financial reporting framework. In the case of
IFRSs, IFRS 10 requires that the difference between period‐end dates of the parent and a subsidiary is no more than
three months. Adjustments must be made for any significant events which occur between the date of the
subsidiary’s and the parent’s financial statements.

‘Support letters’

Tutorial note: Although there are different types and uses of such letters (eg for registering a prospectus), the only
reference to them in the THE ADVANCED AUDIT & ASSURANCE EXAM Syllabus and Study Guide is in the context of
group audits.

Consolidated financial statements are prepared on a going concern basis when a group, as a single entity, is
considered to be a going concern. However, the going concern basis may only be appropriate for certain separate
legal entities (e.g. subsidiaries) because the parent undertaking (or a fellow subsidiary) is able and willing to provide
support. Many banks routinely require a letter of reassurance from a parent company stating that the parent would
financially or otherwise support a subsidiary with cash flow or other operational problems.

As audit evidence:
• Formal confirmation of the support will be sought in the form of a letter of support or ‘comfort letter’ confirming
the parent company’s intention to keep the subsidiary in operational existence (or otherwise meet its
obligations as they fall due).

• The letter of support should normally be approved by a board minute of the parent company (or by an individual
with authority granted by a board minute).

• The ability of the parent to support the company should also be confirmed, for example, by examining the
group’s cash flow forecast.

• The period of support may be limited (eg to one year from the date of the letter or until the date of disposal of
the subsidiary). Sufficient other evidence concerning the appropriateness of the going concern assumption must
therefore be obtained where a later repayment of material debts is foreseen.

• The fact of support and the period to which it is restricted should be noted in the financial statements of the
subsidiary.

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Transnational audit

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

Examples: Private company in UK raising debt finance in Canada; International charity taking donations through
various national branches and making grants around the world; Project financial statements for the construction of
an electrical generation facility in Nigeria using funds loaned by World Bank

Risk associated with transnational audits

1. Application of auditing standards: Although many countries of the world have adopted International Standards
on Auditing (ISAs), not all have done so, choosing instead to use locally developed auditing regulations. In
addition, some countries use modified versions of ISAs. This means that in a transnational audit, some
components of the group financial statements will have been audited using a different auditing framework,
resulting in inconsistent audit processes within the group, and potentially reducing the quality of the audit as a
whole.

2. Regulation and oversight of auditors: Similar to the previous comments on the use of ISAs, across the world
there are many different ways in which the activities of auditors are regulated and monitored. In some countries
the audit profession is self‐regulatory, whereas in other countries a more legislative approach is used. This also
can impact on the quality of audit work in a transnational situation.

3. Financial reporting framework: Some countries use International Financial Reporting Standards, whereas some
use locally developed accounting standards. Within a transnational group it is likely that adjustments,
reconciliations or restatements may be required in order to comply with the requirements of the jurisdictions
relevant to the group financial statements (i.e. the jurisdiction of the parent company in most cases). Such
reconciliations can be complex and require a high level of technical expertise of the preparer and the auditor.

4. Corporate governance requirements and consequent control risk: In some countries there are very prescriptive
corporate governance requirements, which the auditor must consider as part of the audit process. In this case
the auditor may need to carry out extra work over and above local requirements in order to ensure group wide
compliance with the requirements of the jurisdictions relevant to the financial statements. However, in some
countries there is very little corporate governance regulation at all and controls are likely to be weaker than in
other components of the group. Control risk is therefore likely to differ between the various subsidiaries making
up the group.

JOINT AUDIT
A joint audit is when two or more audit firms are jointly responsible for giving the audit opinion. This is very common
in a group situation where the principal auditor is appointed jointly with the auditor of a subsidiary to provide a joint
opinion on the subsidiary’s financial statements.

Advantages
It can be beneficial in terms of audit efficiency for a joint audit to be conducted, especially in the case of a new
subsidiary. A joint audit will allow sufficient resources to be allocated to the audit, assuring the quality of the opinion
provided.

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If there is a tight deadline, as is common with the audit of subsidiaries, which should be completed before the group
audit commences, then having access to two firms’ resources should enable the audit to be completed in good time.
The audit should also benefit from an improvement in quality. The two audit firms may have different points of view,
and would be able to discuss contentious issues throughout the audit process. Joint audits increase competition in
the profession. In particular, joint audits have been proposed as a way for ‘mid tier’ audit firms to break into the
market of auditing large companies and groups, which at the moment is monopolized by the ‘Big 4’.

Disadvantages
For the client, it is likely to be more expensive to engage two audit firms than to have the audit opinion provided by
one firm.

From a cost/benefit point of view there is clearly no point in paying twice for one opinion to be provided. Despite
the audit workload being shared, both firms will have a high cost for being involved in the audit in terms of senior
manager and partner time.

These costs will be passed on to the client within the audit fee. The two audit firms may use very different audit
approaches and terminology. This could make it difficult for the audit firms to work closely together, negating some
of the efficiency and cost benefits discussed above. Problems could arise in deciding which firm’s method to use, for
example, to calculate materiality, design and pick samples for audit procedures, or evaluate controls within the
accounting system. It may be impossible to reconcile two different methods and one firm’s methods may end up
dominating the audit process, which then eliminates the benefit of a joint audit being conducted. It could be time
consuming to develop a ‘joint’ audit approach, based on elements of each of the two firms’ methodologies, time
which obviously would not have been spent if a single firm was providing the audit.

Potentially, problems could arise in terms of liability. In the event of litigation, because both firms have provided the
audit opinion, it follows that the firms would be jointly liable. The firms could blame each other for any negligence
which was discovered, making the litigation process more complex than if a single audit firm had provided the
opinion. However, it could be argued that joint liability is not necessarily a drawback, as the firms should both be
covered by professional indemnity insurance.

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Very Important Technical Article: GROUP AUDIT

Group auditing often necessitates that the group auditor places considerable reliance on other audit firms. However,
ISA 600 doesn’t allow the group auditor to wholly outsource responsibility for parts of the audit to another auditor.

To begin at the beginning: acceptance of the assignment

ISA 600 requires the group engagement partner each year formally to assess whether it is appropriate to act as group
auditor. If at any point the group engagement partner concludes that they lack the professional skills necessary to
form a group audit opinion, they should resign. ISA 600 requires that the group engagement partner resign
immediately if there is any significant restriction placed by the parent company management on information made
available from within the group (or disclaim opinion if resignation is not legally possible).

ISA 600 (revised and redrafted) extends this responsibility to require that the auditor relying on the third party’s
work has obtained their own understanding of the specialist area in question, or business of each subsidiary or
associate(referred to as ‘components’ in ISA 600, with that company’s auditor referred to as the ‘component
auditor’). The group auditor must form their own concurring opinion on any judgmental areas. This does not
require having the same depth of knowledge as the expert/other auditor, but they would need to be able to review
the third party’s files and have sufficient independent knowledge to understand the work done, the reason for the
work and the conclusions from that evidence.

Group audit opinion

The parent company of a group will normally publish its financial statements as an individual company and the group
financial statements in the same document, so, the audit opinion will normally be expressed on ‘the financial
statements of the company and of the group as at...’ Although presented asone opinion, it logically contains two
separate opinions; one on the entity financial statements of the parent itself and another on the financial statements
of the group. ISA prohibits the group auditor from making any reference to the work of any other experts or auditors,
as doing so would diminish the credibility of the audit opinion and allow the group auditor to ‘pass the buck’ for
responsibility for part of the audit. You should be prepared to explain this point in the exam. This is an example of
where ISA differs from US audit standards, where reference to other auditors conducting some of the work on
components is permissible.

Planning work required

Groups often have a number of subsidiaries that are either dormant or immaterial. At a minimum, the group
engagement team must develop an understanding of each component of the group and review the financial
statements of each subsidiary. Where a component is judged to be material or a significant contributor of inherent
risk at the group level, further work will be required to be satisfied that the financial statements of each component,
in order to be satisfied that the component is unlikely to introduce errors that could be material at the group level.

This work might include:

 Discussing with the component auditor, and/or the management of the component, the business activities that
are significant to the group
 Reviewing the more significant parts of the component auditor’s working papers
 Discussing with the component auditor the susceptibility of the company’s financial statements to material error
or deliberate misstatement
 Reviewing the component auditor’s documentation of identified significant risks, and the conclusions reached
on these risks

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 Observing final clearance meetings between the component auditor and the management of the company.

The group auditor as the repository of information

The group engagement team’s role brings information flowing to them that is useful to disseminate around the
group. This includes materiality (see below)and matters such as related party relationships, which may be unknown
at the component level, because two subsidiaries may be unaware of each other’s existence. The group auditor asks
each component auditor for known related party relationships and then communicates a collated list of all related
party relationships to each component auditor.

Materiality
At the planning stage, the group engagement partner must determine several figures for materiality for each
component part of the group (ISA 600:21).

Group Parent Each component

Financial statements materiality Group auditor Group auditor Component auditor

Materiality for the consolidation Group auditor Group auditor Group auditor
package as a whole
Level of reduced materiality for Group auditor Group auditor Group auditor
sensitive figures
Performance materiality Group auditor Group auditor Group auditor

Performance materiality is the figure below that any errors in the financial statements may be considered trivial. The
component auditor will be required to communicate to the group auditor a summary of all unadjusted errors in the
consolidation package.

It is common in larger group audits for the financial statements to be prepared using a consolidation package of
information that is sent to the parent company by each component company. This will omit many of the disclosures
that will be in the eventual entity financial statements. The component auditor may, therefore, be required to issue
a special audit opinion on the truth and fairness of the consolidation package. This opinion is likely to be addressed
to the directors of the component company, or may be addressed to the group auditor directly. In order to minimise
the risk of several accidental or deliberate errors in the financial statements together exceeding group materiality,
component materiality figures will normally be significantly lower than the group materiality figure, even for the
largest component companies.

Example 1
Imagine that financial statements materiality is taken to be 10% of profit or loss for each entity within a group and
performance materiality is set at 0.5%of profit. Imagine that a group has a parent company and two components,
one of which is profit making and one of which is loss making:

$'000s Parent Subsidiary 1 Subsidiary 2 Group

Profit 2,000 12,000 (8,000) 6,000
Component materiality @ 10% 200 1,200 800 600
Performance materiality @ 0.5% 10 60 40 30

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If subsidiary 1 were audited by another firm using the same materiality calculation method as the parent, an
unadjusted error of $10m would correctly result in issuance of an unmodified audit opinion on the financial
statements of that individual company.

However, the effect of losses elsewhere in the group would mean that although this error would not be material at
the component level, it would be material at the group level. Since it is only likely to be the parent auditor who has
this overview of the group, the group engagement team must communicate materiality figures to component
auditors in advance of audit work commencing.

In this example, the maximum component materiality figure that the group auditor could communicate to the
component auditors would be 600, but it would be wise to select a lower figure than this, in order to reduce to a
tolerable level the risk of errors in both component companies together exceeding 600.In the exam, if you are given
extracts from draft financial statements, it’s often a good start to recommend and briefly explain a figure for
materiality.

Communication between auditors

ISA 600 in its revised form contains extensive new requirements on the communication between parent and
component auditor. In addition to practical matters such as materiality, the required format of the consolidation
package, deadlines and contact details, the group auditor must communicate a number of matters at the planning
to the component auditor, including:
 Related party relationships known anywhere around the group
 Identified significant risks, whether due to error or fraud
 Methodology to be used for impairment testing of goodwill. Audit of estimates is subjective and so it’s essential
that the group auditor’s preferred method is used throughout the group. Be prepared to explain this in Paper
THE ADVANCED AUDIT & ASSURANCE EXAM.

Matters that the component auditor must communicate to the group auditor will include: any known related party
relationships and related party transactions
 Any indications of management bias
 Any significant risks to the truth and fairness of the component financial statements, work done on these risks
and the conclusions reached
 All intra‐group transactions, period end balances and allowances forum realised profit
 Any observed non‐trivial failure to observe relevant laws and regulations
 All observed control weaknesses, flagging significant weaknesses separately
 Any known events after the reporting date.

Audit of the consolidation process

Once the group engagement partner is satisfied that the individual financial statements within the group are free
from material misstatement, attention can now shift to audit of the consolidation process good news for exam
purposes is that this stage of the audit is very similar regardless of the specific company, so good marks can be
obtained largely by memorising the risks and responses below.
Principal risks arising in the consolidation process include errors or omissions arising during:
 Transcription of figures from individual financial statements to consolidation workings
 Classification of components (e.g. Associate, subsidiary)
 Cancellation of intra‐group trading, cancellation of intra‐group balance sand allowance for unrealised profit on
intra‐group transfers

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 Recognition of impairment of purchased positive goodwill

 Determination of fair values being used on acquisition
 Arithmetical inaccuracy in the consolidation process
 Identification and disclosure of related party relationships and transactions
 Foreign currency translation from functional currency of components to reporting currency of the group.

The most reliable evidence on completeness and accuracy of consolidation adjustments in a large group is likely to
be determining whether the client’s accounting systems adequately flags transactions with fellow group companies.
The process is still likely to be highly substantive in nature and will probably include these tests of detail:
 line‐by‐line agreement of all items from audited component financial statements (or consolidation packages
submitted to head office) to the consolidation schedules
 detailed discussion with management on the reason for classification of each component
 sample testing of known intra‐group transactions to ensure that they have been eliminated in the client’s
consolidation
 recalculation of all significant workings, such as goodwill, non‐controlling interests and foreign currency
translation.

Principal audit procedures that are performed on the consolidation process.

ISA 600 firstly requires that the auditor shall obtain an understanding of the group‐wide controls and the
consolidation process. This includes an evaluation of instructions given by group management to components of the
group. The operating effectiveness of controls over the consolidation process will be tested.

The audit procedures will mainly focus on adjustments made on consolidation. For example, significant adjustments
such as goodwill calculations and impairments are recalculated, underlying assumptions checked for validity, and
the authorisation of the adjustment should be checked. Adjustments should be agreed to underlying documentation,
and where relevant, to prior year audited financial statements or audit working papers.

The elimination of inter‐company transactions is usually a key feature of the consolidation process. Reconciliations
of intercompany balances should be arithmetically checked, and unrealised profits should be recalculated for
accuracy.

Figures included in the consolidation schedules should be agreed back to audited financial statements of all
components. Disclosures made in the notes to the group financial statements should also be agreed back to the
individual component’s financial statements where relevant, for example disclosures on related parties.

Audit procedures will be needed to verify that subsidiary balances have been included where relevant at fair value
in the consolidated financial statements. For example, properties may be held at cost in the individual financial
statements of the component, but should be consolidated at fair value. The auditor may consider the need to engage
an expert to provide evidence on fair values, especially if the amounts involved are material. The audit of fair values
is crucial as it forms the basis of the goodwill calculation.

The accounting policies of all components of the group should be checked for consistency, as additional adjustments
may be necessary to bring the components into line with group accounting policies.

The deferred tax consequences of consolidation and fair value adjustments should be reviewed for completeness,
and calculations re‐performed for accuracy.

pg. 186
Group Audit AAA Revision Notes

Where the group has investments in non‐controlling interests, additional procedures will be necessary to check the
validity of treating the investments as associates and/or joint ventures, such as verification of the percentage
shareholding by a review of purchase documentation or obtaining copies of the register of significant investors from
the investee companies. The consolidation schedule should be arithmetically checked by casting and cross‐casting.

Final review of financial statements

The group audit opinion may be signed on some date on or after the audit opinions on material components are
signed. Once the component auditor has issued their opinion, their responsibility for reporting on the impact on
events after the reporting date is greatly diminished, yet there may be material events that could be material in the
group financial statements. The group engagement team will normally agree in advance with the auditor of
significant components that an update on events is given by the component auditor to the group engagement
partner immediately before the group audit opinion is signed. It is the responsibility of the group engagement team
to ensure that material events are reported.

Reporting to management and the board

In addition to the usual requirements for reporting to those charged with governance (the ‘management letter’), ISA
600:49 requires the group engagement partner also to report to management on any concerns that they had about
possible fraud anywhere in the group, any restrictions on information made available by component management
and any concerns that they had about the quality of work performed by any component auditor.

In addition to the audit report to shareholders, the group auditor is required by ISA 600 to report on a group‐wide
basis to group management and separately to those charged with governance at a group level, such as the audit
committee of the board. This split communication echoes the requirements of ISA 260Communication with Those
Charged with Governance to produce different letters to different levels of management.
The report to management will include details of all observed instances of non‐trivial fraud and all non‐trivial
deficiencies in internal controls around the group.

The report to those charged with governance, most probably the audit committee, will include:
 An overview of the audit approach insofar as it affects component auditors
 Any doubts that the group auditor may have about the quality of work performed by the component auditor,
giving the group auditor a potentially awkward need to publicly question the skills of a fellow professional.
 Any limitations on audit scope anywhere within the group
 Any suspected fraud where management is suspected of involvement.

Summary
ISA 600 represents a significant extension of the responsibilities of both group auditor and component auditor
compared with the previous ISA. It is likely to be a controversial standard in practice, and it is therefore likely to be
in many Paper THE ADVANCED AUDIT & ASSURANCE EXAM exams.Understanding and memorising the key points of
the standard is a very good use of study time when preparing for the Paper THE ADVANCED AUDIT & ASSURANCE
EXAM exam. The table below outlines come of the other audit risks that may be present with an overseas subsidiary,
along with some possible audit procedures to mitigate those risks

pg. 187
Group Audit AAA Revision Notes

Audit risk Procedures

Potential misstatement due to the effects of high • Confirm that financial statements have been correctly
inflation. IAS 29 requires financial statements to be restated
restated in terms of measuring units current at the • Check that disclosures have been made in line with IAS
end of the reporting period, and a gain or loss on 29
the net monetary position included within net
income
Subsidiary may have been audited by component Need to consider the extent to which their work can be relied
auditors. upon, as per ISA 600

Different accounting framework may have been Confirm the accounting framework used, and that accounting
used by subsidiary policies are consistent with the rest of the group

Possible difficulty in the parent being able to Need to consider whether there is still control, and whether
exercise control, eg due to political instability, or it is correct to produce group accounts per IFRS 3
laws and regulations
Currency restrictions limiting payment of profits to • Need to consider whether there is still control
the parent • Need to consider impact on parent's status as a going
concern

End of technical article

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The Review Stage of Audit – Key Points AAA Revision Notes

The Review Stage of Audit‐ Key Points

Before the audit report is signed, the auditor needs to know that the work is finished and that all necessary issues
have been dealt with. The easiest way to do this is to use a series of checklists:
 The audit plan should be reviewed, to verify that all issues raised have been resolved.
 An Accounting Standards Checklist will be completed, forcing the auditor to consider every possible accounting
issue that could affect the client’s Financial Statements.
 Additional checklists may be necessary (e.g. Company Law) to make sure that any other issues have been fully
considered

All audit work should be subject to review. This is a basic quality control requirement of ISA 220, Quality Control for
an Audit of Financial Statements, and serves to ensure that sufficient appropriate audit evidence has been obtained
in respect of transactions and balances included in the financial statements.

In performing a file review, the reviewer should consider the sufficiency of evidence obtained and may need to
propose further audit procedures if evidence is found to be insufficient or contradictory. ISA 230, Audit
Documentation requires that documentation of the review process includes who reviewed the audit work completed
and the date and extent of such review.

Typically, the auditor will present the client with a list of misstatements (often referred to as the ‘audit error
schedule’), quantifying the amount of each misstatement, and proposing the necessary adjustment to the financial
statements. The proposed adjustment may be in the form of a journal entry, an amendment to the presentation of
the financial statements, or a correction to a disclosure note. When management makes the necessary adjustments
to the financial statements, the auditor should confirm that the adjustments have been made correctly.

Final analytical procedures

Before the audit report is signed, it is sensible to do some final analysis of the Financial Statements (e.g. ratio
analysis) – just to make sure that the auditor is confident in the audit opinion.

There are 2 main reasons for this final analysis:

– The Financial Statements may have been adjusted during the audit as mistakes were found, so the final figures
may never have been analyzed or been subject to ratio analysis.
– The auditor will have learned more about the company during the audit, so is in a better position at the end of
the audit to analyze the figures and understand trends in ratios.

One of the objectives of the auditor in complying with ISA 520 (analytical procedures) is to design and perform
analytical procedures near the end of the audit that assist in forming an overall conclusion as to whether the financial
statements are consistent with the auditor’s understanding of the entity.

The analytical procedures performed at this stage of the audit are not different to those performed at the planning
stage – the auditor will perform ratio analysis, comparisons with prior period financial statements and other
techniques to confirm that trends are as expected, and to highlight unusual transactions and balances that may
indicate a risk of misstatement.

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The Review Stage of Audit – Key Points AAA Revision Notes

The key issue is that, near the end of the audit, the auditor should have sufficient audit evidence to explain the issues
highlighted by analytical procedures, and should therefore be able to conclude as to the overall reasonableness of
the financial statements.

When the analytical procedures performed near the end of the audit reveal further previously un‐recognized risk of
material misstatement, the auditor is required to revise the previously assessed risk of material misstatement and
modify the planned audit procedures accordingly. This means potentially performing further audit procedures in
relation to matters that are identified as high risk.

As well as reviewing the main elements of the financial statements, the auditor must at this stage carefully review
the notes to the financial statements for completeness and compliance with the applicable financial reporting
framework. In many situations, this will be the first opportunity for the auditor to review this information, as clients
often prepare the notes to the financial statements towards the end of the audit process.

At this stage, the auditor should also read the other information to be issued with the financial statements for
consistency with the financial statements.

This is important as inconsistencies may have implications for the auditor’s report. Specific items of other
information are subject to specific regulation in some jurisdictions – for example, in the UK and Ireland the auditor’s
report must state whether the Directors’ Report is consistent with the financial statements.

Overall Review of evidence obtained

An overall review includes the following:

1. Review of financial – Any irregularity in compliance with the applicable laws and regulations
statements, – ISA 520 Analytical Procedures requires the application of analytical procedures, at
analytical the overall review stage to conclude whether the financial statements as a whole
procedures are consistent with the auditors’ knowledge of the business

2. Sufficiency and The review ensures that:

appropriateness of – The financial statements have been prepared using acceptable accounting policies
audit evidence and are applied consistently and are appropriate for the entity’s business
– The information included in the financial statements and the results of operations
are compatible with the auditor’s knowledge of the entity’s business
– Adequate disclosures are made wherever appropriate
– The financial statements comply with all statutory and other requirements
relevant to the entity’s business
– The conclusions drawn on the basis of the audit procedures carried

pg. 190
The Review Stage of Audit – Key Points AAA Revision Notes

pg. 191
The Review Stage of Audit – Key Points AAA Revision Notes

Going Concern Review

Going concern basis of accounting

Under the going concern basis of accounting, the financial statements are prepared on the assumption that the
entity is a going concern and will continue its operations for the foreseeable future. General purpose financial
statements are prepared using the going concern basis of accounting, unless management either intends to liquidate
the entity or to cease operations, or has no realistic alternative but to do so.

When the use of the going concern basis of accounting is appropriate, assets and liabilities are recorded on the basis
that the entity will be able to realize its assets and discharge its liabilities in the normal course of business.

Management’s Responsibilities
Management should assess going concern in order to decide on the most appropriate basis for the preparation of
the financial statements.

IAS 1 Presentation of Financial Statements (revised) requires that where there is significant doubt over an entity’s
ability to continue as a going concern, the uncertainties should be disclosed in a note to the financial statements.

Where the directors intend to cease trading, or have no realistic alternative but to do so, the financial statements
should be prepared on a ‘break up’ basis.
Thus the main focus of the management’s assessment of going concern is to ensure that relevant disclosures are
made where necessary, and that the correct basis of preparation is used.

Auditor’s Responsibilities
The auditor’s responsibility is to consider the appropriateness of the management’s use of the going concern
assumption in the preparation of the financial statements and to consider whether there are material uncertainties
about the entity’s ability to continue as a going concern that need to be disclosed in a note.

The auditor should also consider the length of the time period that management have looked at in their assessment
of going concern.

The auditor will therefore need to come to an opinion as to the going concern status of an entity but the focus of
the auditor’s evaluation of going concern is to see whether they agree with the assessment made by the
management ( whether they agree with the basis of preparation of the financial statements, or the inclusion in a
note to the financial statements, as required by IAS 1, of any material uncertainty).

Indicators of going concern problems

Events or Conditions That May Cast Significant Doubt on the Entity’s Ability to Continue as a Going Concern
Financial
• Net liability or net current liability position.
• Fixed‐term borrowings approaching maturity without realistic prospects of renewal or repayment; or excessive
reliance on short‐term borrowings to finance long‐term assets.
• Indications of withdrawal of financial support by creditors
• Negative operating cash flows indicated by historical or prospective financial statements.
• Adverse key financial ratios.

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The Review Stage of Audit – Key Points AAA Revision Notes

• Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
• Arrears or discontinuance of dividends.
• Inability to pay creditors on due dates.
• Inability to comply with the terms of loan agreements.
• Change from credit to cash‐on‐delivery transactions with suppliers.
• Inability to obtain financing for essential new product development or other essential investments.

Operating
• Management intentions to liquidate the entity or to cease operations.
• Loss of key management without replacement.
• Loss of a major market, key customer(s), franchise, license, or principal supplier(s).
• Labor difficulties.
• Shortages of important supplies.
• Emergence of a highly successful competitor.

Other
• Non‐compliance with capital or other statutory or regulatory requirements, such as solvency or liquidity
requirements for financial institutions.
• Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that the entity
is unlikely to be able to satisfy.
• Changes in law or regulation or government policy expected to adversely affect the entity.
• Uninsured or underinsured catastrophes when they occur

Any mitigating factors?

The significance of such events or conditions often can be mitigated by other factors.

For example, the effect of an entity being unable to make its normal debt repayments may be counter‐balanced by
management’s plans to maintain adequate cash flows by alternative means, such as by disposing of assets,
rescheduling loan repayments, or obtaining additional capital.

Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable alternative source of supply.

These risk assessment procedures are likely to be an important issue and have an impact on planning the audit.
These procedures allow for more timely discussions with management, including a discussion of management’s
plans and resolution of any identified going concern issues.

Auditor’s procedures
When going concern problems are discovered, the auditor is required by IAS 570 to carry out additional procedures.

If events or conditions have been identified that may cast significant doubt on the entity’s ability to continue as a
going concern, the auditor shall obtain sufficient appropriate audit evidence to determine whether or not a material
uncertainty exists related to events or conditions that may cast significant doubt on the entity’s ability to continue
as a going concern through performing additional audit procedures, including consideration of mitigating factors.

pg. 193
The Review Stage of Audit – Key Points AAA Revision Notes

These procedures shall include:

Where management has not yet ‐ Analyzing and discussing cash flow, profit and other relevant forecasts
performed an assessment of the with management.
entity’s ability to continue as a ‐ Analyzing and discussing the entity’s latest available interim financial
going concern, requesting statements.
management to make its
‐ Reading the terms of debentures and loan agreements and determining
assessment.
whether any have been breached.
‐ Reading minutes of the meetings of shareholders, those charged with
Their assessment is then
governance and relevant committees for reference to financing
evaluated.
difficulties.
‐ Inquiring of the entity’s legal counsel regarding the existence of litigation
and claims and the reasonableness of management’s assessments of their
outcome and the estimate of their financial implications.
‐ Confirming the existence, legality and enforceability of arrangements to
provide or maintain financial support with related and third parties and
assessing the financial ability of such parties to provide additional funds.
‐ Evaluating the entity’s plans to deal with unfilled customer orders.
‐ Performing audit procedures regarding subsequent events to identify
those that either mitigate or otherwise affect the entity’s ability to
continue as a going concern.
‐ Confirming the existence, terms and adequacy of borrowing facilities.
‐ Obtaining and reviewing reports of regulatory actions.
‐ Determining the adequacy of support for any planned disposals of assets
‐ Analyzing and discussing cash flow, profit and other relevant forecasts
Evaluating Management’s Plans Evaluating management’s plans for future actions may include inquiries of
for Future Actions management as to its plans for future action, including, for example, its plans
to liquidate assets, borrow money or restructure debt, reduce or delay
expenditures, or increase capital.

In addition to the procedures above, the auditor may compare:

‐ The prospective financial information for recent prior periods with
historical results; and
‐ The prospective financial information for the current period with results
achieved to date. Where management’s assumptions include continued
support by third parties, whether through the subordination of loans,
commitments to maintain or provide additional funding, or guarantees,
and such support is important to an entity’s ability to continue as a going
concern, the auditor may need to consider requesting written
confirmation (including of terms and conditions) from those third parties
and to obtain evidence of their ability to provide such support.

pg. 194
The Review Stage of Audit – Key Points AAA Revision Notes

Written Representations The auditor may consider it appropriate to obtain specific written
representations in support of audit evidence obtained regarding
management’s plans for future actions in relation to its going concern
assessment and the feasibility of those plans.

Impact on opinion and audit report

Matters relating to going concern may be determined to be key audit matters, and a material uncertainty related
to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern is,
by its nature, a key audit matter.

Auditor’s conclusions
Use of going concern basis of accounting is Use of Going Concern Basis of Accounting Is Inappropriate
appropriate When the use of the going concern basis of accounting is not
But a material uncertainty exists relating to appropriate in the circumstances, management may be
events or conditions that may cast significant required, or may elect, to prepare the financial statements on
doubt on the entity’s ability to continue as a another basis (e.g., liquidation basis). The auditor may be able
going concern. to perform an audit of those financial statements provided that
the auditor determines that the other basis of accounting is
In auditor’s judgment, appropriate disclosure of acceptable in the circumstances.
the nature and implications of the uncertainty
is necessary.

If adequate disclosure If adequate disclosure The financial The auditor may be able to express
about the material about the material statements have been an unmodified opinion on
uncertainty is made in uncertainty is not prepared using the those financial statements, provided
the financial made in the financial going concern basis of there is adequate disclosure therein
statements, the statements, the accounting but, in the about the basis of accounting on
auditor shall express auditor shall: auditor’s judgment, which the financial statements are
an unmodified opinion Express a modified management’s use of prepared, but may consider it
and the auditor’s opinion ( Qualified or the going appropriate or necessary to include
report shall include a Adverse as concern basis of an Emphasis of Matter
separate section under appropriate) accounting in the paragraph
the heading “Material preparation of the
Uncertainty In the Basis for financial statements is
Related to Going Opinion section of the inappropriate, the
Concern” report, state that a auditor shall express
(a) Draw attention to material uncertainty an adverse opinion
the note in the exists that may cast
financial doubt on entity’s

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The Review Stage of Audit – Key Points AAA Revision Notes

statements that ability to continue as

discloses the a going concern and
matters that F/ S do NOT
(b) State that these adequately disclose
events or this matter
conditions
indicate that a
material
uncertainty exists
that may cast
significant doubt
on the entity’s
ability to continue
as a going concern
and that the
auditor’s opinion
is not modified in
respect of the
matter.

Example
Material Uncertainty
Related to Going
Concern
We draw attention to
Note 6 in the financial
statements, which
indicates that the
Company
incurred a net loss of
ZZZ during the year
ended December 31,
20X1 and, as of that
date, the Company’s
current liabilities
exceeded its total
assets by YYY. As
stated in Note 6, these
events or conditions,
along with other
matters as set forth in
Note 6, indicate that a
material uncertainty
exists that may cast
significant doubt on
the Company’s ability

pg. 196
The Review Stage of Audit – Key Points AAA Revision Notes

to continue as a going
concern. Our opinion is
not modified in
respect of this matter.

Subsequent Events Review

Subsequent events are defined as those events occurring between the date of the financial statements and the date
of the auditor’s report, and also facts discovered after the date of the auditor’s report.

Auditor’s responsibilities in relation to subsequent events.

Events occurring up to the date of the auditor’s report.

The auditor has an active duty to perform audit procedures designed to identify, and to obtain sufficient appropriate
evidence of all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the
financial statements.

These procedures should be performed as close as possible to the date of the auditor’s report, and in addition,
representations would be sought on the date that the report was signed.

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The Review Stage of Audit – Key Points AAA Revision Notes

Procedures would include:

– Obtaining an understanding of any procedures management has established to ensure that subsequent events
are identified.
– Inquiring of management and, where appropriate, those charged with governance as to whether any
subsequent events have occurred which might affect the financial statements.
– Reading minutes, if any, of the meetings of the entity’s owners, management and those charged with
governance that have been held after the date of the financial statements and inquiring about matters discussed
at any such meetings for which minutes are not yet available.
– Reading the entity’s latest subsequent interim financial statements, if any
– The auditor shall request management and, where appropriate, those charged with governance, to provide a
written representation that all events occurring subsequent to the date of the financial statements and for
which the applicable financial reporting framework requires adjustment or disclosure have been adjusted or
disclosed.

Where a material subsequent event is discovered, the auditor should consider whether management have properly
accounted for and disclosed the event in the financial statements in accordance with IAS 10 Events after the
Reporting Period.

Facts discovered after the date of the auditor’s report but before the date the financial statements are issued.
The auditor does not have any responsibility to perform audit procedures or make any enquiry regarding the
financial statements or subsequent events after the date of the auditor’s report.

In this period, it is the responsibility of management to inform the auditor of facts which may affect the financial
statements. When the auditor becomes aware of a fact which may materially affect the financial statements, the
matter should be discussed with management.

If the financial statements are appropriately amended then a new audit report should be issued, and procedures
relating to subsequent events should be extended to the date of the new audit report.

If management do not amend the financial statements to reflect the subsequent event, in circumstances where the
auditor believes they should be amended, a qualified or adverse opinion of disagreement should be issued.

Facts discovered after the financial statements have been issued.

After the financial statements have been issued, the auditor has no obligation to perform any audit procedures
regarding such financial statements. However, if, after the financial statements have been issued, a fact becomes
known to the auditor that, had it been known to the auditor at the date of the auditor’s report, may have caused
the auditor to amend the auditor’s report, the auditor shall:
(b) Discuss the matter with management and, where appropriate, those charged with governance;
(c) Determine whether the financial statements need amendment; and, if so,
(d) Inquire how management intends to address the matter in the financial statements.

If management amends the financial statements, the auditor shall:

(a) Carry out the audit procedures necessary in the circumstances on the amendment.
(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.

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Communicating with Those Charged with Governance AAA Revision Notes

Communicating with Those Charged with Governance

Matters to Be Communicated –ISA 260 and 265

Auditor’s responsibilities in relating to F/S ‐ Forming and expressing an opinion on the F/S ( in accordance
with ISAs)
‐ Auditor’s responsibility to determine and communicate KAM
‐ This does not relieve the management and TCWG of their
responsibilities re F/S
Planned scope and timing of audit ‐ Significant risks identified by the auditor and how auditor plans
to address them
‐ Auditor’s approach to internal control relevant to audit
‐ Application of concept of materiality
‐ Use of auditor’s expert (if needed)
‐ If applicable, discussion about planned use of internal auditor’s
work
‐ Discussions about entity’s objectives, strategies, related
business risks
Significant findings from the audit ‐ Auditor’s views about accounting policies, accounting
estimated, F/S disclosures
‐ Significant difficulties encountered during the audit (delays in
receiving information, unavailability of info etc.)
‐ Significant matters that were discussed with the management
‐ Written representations that the auditor is requesting
‐ Circumstances that affect form and content of auditors report
(for example modified opinion, KAM, EOMP etc.)
‐ Any other significant matter
Auditor independence (listed companies) ‐ Auditor has complied with relevant ethical requirements
‐ All relationships that may have an impact on independence (
including total fee charged during the period for audit and non‐
audit services)
‐ Safeguards that have been applied to eliminate or reduce these
threats

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Communicating with Those Charged with Governance AAA Revision Notes

Key Audit Matters

Key audit matters: Those matters that, in the auditor’s professional judgment, were of most significance in the audit
of the financial statements of the current period. Key audit matters are selected from matters communicated with
those charged with governance.

Objectives: The objectives of the auditor are to determine key audit matters and, having formed an opinion on the
financial statements, communicate those matters by describing them in the auditor’s report.

Determining KAM
The auditor shall determine, from the matters communicated with those charged with governance, those matters
that required significant auditor attention in performing the audit. In making this determination, the auditor shall
take into account the following:
1. Areas of higher assessed risk of material misstatement, or significant risks identified in accordance with ISA 315
(Revised).
2. Significant auditor judgments relating to areas in the financial statements that involved significant management
judgment, including accounting estimates that have been identified as having high estimation uncertainty.
3. The effect on the audit of significant events or transactions that occurred during the period.
4. Other considerations

Areas of higher assessed ISA 260 (Revised) requires the auditor to communicate with those charged with
risk of material governance about the significant risks identified by the auditor.
misstatement, or
significant risks identified The auditor may also communicate with those charged with governance about how
in accordance with ISA 315 the auditor plans to address areas of higher assessed risks of material misstatement.
(Revised).
ISA 315 (Revised) explains that the auditor’s assessment of the risks of material
misstatement at the assertion level may change during the course of the audit as
additional audit evidence is obtained. Revision to the auditor’s risk assessment and
re‐evaluation of the planned audit procedures with respect to a particular area of
the financial statements (i.e., a significant change in the audit approach, for
example, if the auditor’s risk assessment was based on an expectation that certain
controls were operating effectively and the auditor has obtained audit evidence that
they were not operating effectively throughout the audit period, particularly in an
area with higher assessed risk of material misstatement) may result in an area being
determined as one requiring significant auditor attention.
Significant auditor ISA 260 (Revised) requires the auditor to communicate with those charged with
judgments relating to governance the auditor’s views about significant qualitative aspects of the entity’s
areas in the financial accounting practices, including accounting policies, accounting estimates and
statements that involved financial statement disclosures.
significant management
judgment, including In many cases, this relates to critical accounting estimates and related disclosures,
accounting estimates that which are likely to be areas of significant auditor attention, and also may be
have been identified as identified as significant risks.

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Communicating with Those Charged with Governance AAA Revision Notes

having high estimation

uncertainty.

The effect on the audit of Events or transactions that had a significant effect on the financial statements or the
significant events or audit may be areas of significant auditor attention and may be identified as
transactions that occurred significant risks.
during the period.
For example, the auditor may have had extensive discussions with management and
those charged with governance at various stages throughout the audit about the
effect on the financial statements of significant transactions with related parties or
significant transactions that are outside the normal course of business for the entity
or that otherwise appear to be unusual.

Management may have made difficult or complex judgments in relation to

recognition, measurement, presentation or disclosure of such transactions, which
may have had a significant effect on the auditor’s overall strategy.

Significant economic, accounting, regulatory, industry, or other developments that

affected management’s assumptions or judgments may also affect the auditor’s
overall approach to the audit and result in a matter requiring significant auditor
attention.
Other considerations Other considerations that may be relevant to determining the relative significance
of a matter communicated with those charged with governance and whether such
a matter is a key audit matter include:
• The importance of the matter to intended users’ understanding of the financial
statements as a whole, in particular, its materiality to the financial statements.
• The nature of the underlying accounting policy relating to the matter or the
complexity or subjectivity involved in management’s selection of an appropriate
policy compared to other entities within its industry.
• The nature and materiality, quantitatively or qualitatively, of corrected and
accumulated uncorrected misstatements due to fraud or error related to the
matter, if any.
• The nature and extent of audit effort needed to address the matter, including:
 The extent of specialized skill or knowledge needed to apply audit
procedures to address the matter or evaluate the results of those
procedures, if any.
 The nature of consultations outside the engagement team regarding the
matter.
• The nature and severity of difficulties in applying audit procedures, evaluating
the results of those procedures, and obtaining relevant and reliable evidence
on which to base the auditor’s opinion, in particular as the auditor’s judgments
become more subjective.
• The severity of any control deficiencies identified relevant to the matter.
• Whether the matter involved a number of separate, but related, auditing
considerations. For example, long‐term contracts may involve significant

pg. 201
Communicating with Those Charged with Governance AAA Revision Notes

auditor attention with respect to revenue recognition, litigation or other

contingencies, and may have an effect on other accounting estimates.

Communicating Key Audit Matters

The auditor shall describe each key audit matter, using an appropriate subheading, in a separate section of the
auditor’s report under the heading “Key Audit Matters,”

The introductory language in this section of the auditor’s report shall state that:
(a) Key audit matters are those matters that, in the auditor’s professional judgment, were of most significance in
the audit of the financial statements [of the current period]; and
(b) These matters were addressed in the context of the audit of the financial statements as a whole, and in forming
the auditor’s opinion thereon, and the auditor does not provide a separate opinion on these matters.

Key Audit Matters Not a Substitute for Expressing a Modified Opinion

The auditor shall not communicate a matter in the Key Audit Matters section of the auditor’s report when the auditor
would be required to modify the opinion in accordance with ISA 705 (Revised) as a result of the matter.

Descriptions of Individual Key Audit Matters

The description of each key audit matter in the Key Audit Matters section of the auditor’s report shall include a
reference to the related disclosure(s),

If any, in the financial statements and shall address:

‐ Why the matter was considered to be one of most significance in the audit and therefore determined to be a
key audit matter; and
‐ How the matter was addressed in the audit.

Interaction between Descriptions of Key Audit Matters and Other Elements Required to Be Included in the Auditor’s
Report
A matter giving rise to a modified opinion in accordance with ISA 705 (Revised), or a material uncertainty related to
events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern in
accordance with ISA 570 (Revised), are by their nature key audit matters.

However, in such circumstances, these matters shall not be described in the Key Audit Matters section of the
auditor’s report. Rather, the auditor shall:
(a) Report on these matter(s) in accordance with the applicable ISA(s);
and
(b) Include a reference to the Basis for Qualified (Adverse) Opinion or the Material Uncertainty Related to Going
Concern section(s) in the Key Audit Matters section.

Form and Content of the Key Audit Matters Section in Other Circumstances
If the auditor determines, depending on the facts and circumstances of the entity and the audit, that there are no
key audit matters to communicate, the auditor shall include a statement to this effect in a separate section of the
auditor’s report under the heading “Key Audit Matters.”

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Communicating with Those Charged with Governance AAA Revision Notes

Communication with Those Charged with Governance

The auditor shall communicate with those charged with governance:

(a) Those matters the auditor has determined to be the key audit matters;
Or
(b) If applicable, depending on the facts and circumstances of the entity and the audit, the auditor’s determination
that there are no key audit matters to communicate in the auditor’s report.

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Evaluation of Misstatements AAA Revision Notes

Evaluation of Misstatements
During the completion stage of the audit, the effect of uncorrected misstatements must be evaluated by the auditor,
as required by ISA 450 Evaluation of Misstatements Identified during the Audit. In the event that management refuses
to correct some or all of the misstatements communicated by the auditor, ISA 450 requires that the auditor shall
obtain an understanding of management’s reasons for not making the corrections and shall take that understanding
into account when evaluating whether the financial statements as a whole are free from material misstatement.
Therefore a discussion with management is essential in helping the auditor to form an audit opinion.

ISA 450 also requires that the auditor shall communicate with those charged with governance about uncorrected
misstatements and the effect that they, individually or in aggregate, may have on the opinion in the auditor’s report.

Each of the matters included in the schedule of uncorrected misstatements will be discussed below and the impact
on the audit report considered individually and in aggregate.

Important terms regarding misstatements

To assist the auditor in evaluating the effect of misstatements accumulated during the audit and in communicating
misstatements to management and those charged with governance, it may be useful to distinguish between factual
misstatements, judgmental misstatements and projected misstatements.
 Factual misstatements are misstatements about which there is no doubt.
 Judgmental misstatements are differences arising from the judgments of management concerning accounting
estimates that the auditor considers unreasonable, or the selection or application of accounting policies that
the auditor considers inappropriate.
 Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the
projection of misstatements identified in audit samples to the entire populations from which the samples were
drawn.

Misstatement which might be material by nature

The circumstances related to some misstatements may cause the auditor to evaluate them as material, individually
or when considered together with other misstatements accumulated during the audit, even if they are lower than
affect the evaluation include the extent to which the misstatement:
• Affects compliance with regulatory requirements;
• Affects compliance with debt covenants or other contractual requirements;
• Relates to the incorrect selection or application of an accounting policy that has an immaterial effect on the
current period’s financial statements but is likely to have a material effect on future periods’ financial
statements;
• Masks a change in earnings or other trends, especially in the context of general economic and industry
conditions;
• Affects ratios used to evaluate the entity’s financial position, results of operations or cash flows;
 Has the effect of increasing management compensation, for example, by ensuring that the requirements for the
award of bonuses or other incentives are satisfied;
• Relates to items involving particular parties (for example, whether external parties to the transaction are related
to members of the entity’s management);

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Evaluation of Misstatements AAA Revision Notes

Auditor’s work
– The auditor shall communicate on a timely basis all misstatements accumulated during the audit with the
appropriate level of management, unless prohibited by law or regulation. The auditor shall request management
to correct those misstatements.
– If management refuses to correct some or all of the misstatements communicated by the auditor, the auditor
shall obtain an understanding of management’s reasons for not making the corrections and shall take that
understanding into account when evaluating whether the financial statements as a whole are free from material
misstatement
– Prior to evaluating the effect of uncorrected misstatements, the auditor shall reassess materiality determined
in accordance with ISA 320 to confirm whether it remains appropriate in the context of the entity’s actual
financial results.
– The auditor shall determine whether uncorrected misstatements are material, individually or in aggregate. In
making this determination, the auditor shall consider:
(a) The size and nature of the misstatements)
(b) The effect of uncorrected misstatements related to prior periods

The auditor shall communicate with those charged with governance uncorrected misstatements and the effect that
they, individually or in aggregate, may have on the opinion in the auditor’s report, unless prohibited by law or
regulation.

The auditor shall request a written representation from management and, where appropriate, those charged with
governance whether they believe the effects of uncorrected misstatements are immaterial, individually and in
aggregate, to the financial statements as a whole. A summary of such items shall be included in or attached to the
written representation.

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Evaluation of Misstatements AAA Revision Notes

Technical Article: Evaluation of Misstatements

The completion stage of the audit is when the auditor reviews the work performed and considers the implications
for the auditor’s report. A crucial part of this review is the evaluation of misstatements found during the audit. This
article describes and discusses the requirements of ISA 450, Evaluation of Misstatements Identified during the
Audit and provides some examples of the application of the ISA in the context of the Advanced Audit and Assurance
exam.

ISA 450 – OBJECTIVES AND DEFINITIONS

According to ISA 450, the objectives of the auditor are to evaluate:
 The effect of identified misstatements on the audit, and
 The effect of uncorrected misstatements, if any, on the financial statements

A misstatement occurs when something has not been treated correctly in the financial statements, meaning that
the applicable financial reporting framework, namely IFRS, has not been properly applied. Examples of
misstatement, which can arise due to error or fraud, could include:
 An incorrect amount has been recognised – for example, an asset is not valued in accordance with the relevant
IFRS requirement.
 An item is classified incorrectly – for example, finance cost is included within cost of sales in the statement of
profit or loss.
 Presentation is not appropriate – for example, the results of discontinued operations are not separately
presented.
 Disclosure is not correct or misleading disclosure has been included as a result of management bias – for
example, a contingent liability disclosure is missing or inadequately described in the notes to the financial
statements.

SPECIFIC REQUIREMENTS AND APPLICATION OF ISA 450

ISA 450 requires that ‘the auditor shall accumulate misstatements identified during the audit, other than those that
are clearly trivial’.

The auditor should set a monetary benchmark below which misstatements are considered to be clearly trivial and
would not need to be accumulated because the auditor expects that the accumulation of such amounts clearly would
not have a material effect on the financial statements. The application notes to ISA 450 make it clear that ‘clearly
trivial’ is not another expression for ‘not material.’ The auditor will need to use judgement to decide whether matters
are clearly trivial, and this may be affected by a range of issues including but not limited to the monetary size of the
matter, for example, the level of audit risk being applied in the situation.

ISA 450 also requires that ‘The auditor shall communicate on a timely basis all misstatements accumulated during
the audit with the appropriate level of management, unless prohibited by law or regulation. The auditor shall request
management to correct those misstatements.’

Simply put, this means that the auditor keeps a note of all misstatements (other than those which are clearly trivial),
raises them with management and asks for the misstatements to be corrected in the financial statements.

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Evaluation of Misstatements AAA Revision Notes

It is useful, when evaluating misstatements and in making requests to management for misstatements to be
corrected, to consider and apply the framework as laid out in ISA 450, which categorises misstatements as follows:
 Factual misstatements are misstatements about which there is no doubt. An example would be a clear breach
of an IFRS requirement meaning that the financial statements are incorrect, for instance if a necessary
disclosure is missing – for example, non‐disclosure of EPS for a listed company.
 Judgmental misstatements are differences arising from the judgments of management concerning accounting
estimates that the auditor considers unreasonable, or the selection or application of accounting policies that
the auditor considers inappropriate. There are of course many examples of using judgement in financial
reporting, for instance, when determining the fair value of non‐current assets, the level of disclosure necessary
in relation to a contingent liability, or the recoverability of receivables.
 Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the
projection of misstatements identified in audit samples to the entire populations from which the samples were
drawn.

For the auditor it is important to distinguish between these types of misstatements in order to properly discuss them
with management, and ask for the necessary corrections, where relevant, to be made. For example, with a factual
misstatement, there is little room for negotiation with management, as the item has simply been treated incorrectly
in the financial statements. With judgemental misstatement there is likely to be more discussion with management.
The auditor will need to present their conclusion based on robust audit evidence, in order to explain the
misstatement which has been uncovered, and justify a recommended correction of the misstatement.

With projected misstatements, because these are based on extrapolations of audit evidence, it is normally not
appropriate for management to be asked to correct the misstatement. Instead, a projected misstatement should be
evaluated to consider whether further audit testing is appropriate.

CORRECTION OF MISSTATEMENTS
Management is expected to correct the misstatements which are brought to their attention by the auditor. If
management refuses to correct some or all of the misstatements, ISA 450 requires the auditor to obtain an
understanding of management’s reasons for not making the corrections, and to take that understanding into account
when evaluating whether the financial statements as a whole are free from material misstatement.

EVALUATING THE EFFECT OF UNCORRECTED MISSTATEMENTS

The auditor is required to determine whether uncorrected misstatements are material, individually or in aggregate.
At this point the auditor should also reassess materiality to confirm whether it remains appropriate in the context
of the entity’s actual financial results. This is to ensure that the materiality is based on up to date financial
information, bearing in mind that when materiality is initially determined at the planning stage of the audit, it is
based on projected or draft financial statements. By the time the auditor is evaluating uncorrected misstatements
at the completion stage of the audit, there may have been many changes made to the financial statements, so
ensuring the materiality level remains appropriate is very important.

Some misstatements may be evaluated as material, individually or when considered together with other
misstatements accumulated during the audit, even if they are lower than materiality for the financial statements as
a whole. Examples include, but are not restricted to the following:
 Misstatements which affect compliance with regulatory requirements
 Misstatements which impact on debt covenants or other financing or contractual arrangements
 Misstatements which obscure a change in earnings or other trends

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Evaluation of Misstatements AAA Revision Notes

 Misstatements which affect ratios used to evaluate the entity’s financial position, results of operations or cash
flows
 Misstatements which increase management compensation
 Misstatements which relate to misapplication of an accounting policy where the impact is immaterial in the
context of the current period financial statements, but may become material in future periods

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE

ISA 450 requires the auditor to communicate uncorrected misstatements to those charged with governance and the
effect that they, individually or in aggregate, will have on the opinion in the auditor’s report. The auditor’s
communication shall identify material uncorrected misstatements individually and the communication should
request that uncorrected misstatements be corrected. The auditor may discuss with those charged with governance
the reasons for, and the implications of, a failure to correct misstatements, and possible implications in relation to
future financial statements. Perhaps the key issue here is that that auditor should discuss the potential implications
for the auditor’s report, which is likely to contain a modified opinion, if material misstatements are not corrected as
requested by the auditor.

In addition the auditor is required to request a written representation from management and, where appropriate,
those charged with governance with regard to whether they believe the effects of uncorrected misstatements are
immaterial, individually and in aggregate, to the financial statements as a whole.

DOCUMENTATION
Finally, ISA 450 requires certain documentation in relation to misstatements:
 The amount below which misstatements would be regarded as clearly trivial
 All misstatements accumulated during the audit and whether they have been corrected, and
 The auditor’s conclusion as to whether uncorrected misstatements are material, individually or in aggregate,
and the basis for that conclusion.

This is an important part of the audit working papers, as it shows the rationale for the auditor’s opinion in relation
to material misstatements.

CONCLUSION
Candidates preparing for the Advanced Audit and Assurance exam should ensure that they are familiar with the
requirements of ISA 450 as ultimately in forming an opinion on the financial statements the auditor must conclude
on whether reasonable assurance has been obtained that the financial statements as a whole are free from material
misstatements and this conclusion takes into account the auditor’s evaluation of uncorrected misstatements.

Written by a member of the AAA examining team

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Audit Opinion & Audit Report AAA Revision Notes

Audit Opinion & Audit Report

Exam Technique

Questions in AAA will often ask students to evaluate, as part of the final review, the matters the auditor would
consider and audit evidence he would obtain to confirm if sufficient and appropriate evidence has been obtained
with regards to the scenario given.

As before, Matters would include a discussion on:

‐ Materiality
‐ Risk
‐ Relevant accounting standards

And THEN write further audit procedures that the auditor would perform at this stage to gather sufficient
appropriate evidence regarding that matter.

The requirement may then go on to ask for the impact on the audit opinion AND the audit report if these issues are
not resolved.

Remember, Opinion would either be unmodified or modified (qualified OR adverse OR disclaimer). There is no other
types of opinion!

Impact on report means the student is expected to consider any additional paragraphs that may be needed AND
changes to the audit report due to the unresolved issues above.

An exam focused overview

Misstatements in the F/S

1. Communicate to management and ask them to adjust

2. If they refuse , obtain an understanding of reasons for their refusal to adjust
3. Communicate to TCWG
4. If still uncorrected, opinion might be affected of they are material ( can be material individually or in
aggregate)
5. For listed client, QCR before issuing the audit report
a) The reviewer will review the F/S, the proposed audit report and the working papers
b) He will ensure adequate documentation for any judgments made by the auditor in making the opinion
c) He will ensure adequate communication has been done with TCWG

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Audit Opinion & Audit Report AAA Revision Notes

An exam focused overview

Audit Opinion

Unmodified opinion
Auditor concludes that the financial statements are prepared, in all material respects, in accordance with the
applicable financial reporting framework.

Modified opinion ( Qualified; Adverse; Disclaimer)

- Qualified ( When an uncorrected misstatement or inability to get SAE is material)
- Adverse ( When an uncorrected misstatement is material and pervasive)
- Disclaimer ( When an inability to get SAE is material and pervasive)

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Audit Opinion & Audit Report AAA Revision Notes

An exam focused overview

Emphasis of matter paragraph (EOMP)

A paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the
financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’
understanding of the financial statements.

Circumstances where EOMP may be necessary

- An uncertainty relating to the future outcome of exceptional litigation or regulatory action. Contingent
liability disclosure
- To highlight a correctly given disclosure regarding the fact that the F/S have been made on an alternate (break
up basis)
- Early application (where permitted) of a new accounting standard that has a material effect on the financial
statements.

Other Matter Paragraph(OMP)

A paragraph included in the auditor’s report that refers to a matter other than those presented or disclosed in
the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the
auditor’s responsibilities or the auditor’s report

Examples of circumstances in which an Other Matter Paragraph may be necessary

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Audit Opinion & Audit Report AAA Revision Notes

Prior Period Financial Statements Audited by a Predecessor Auditor

Prior Period Financial Statements Not Audited

Auditor’s report on F/S prepared in accordance with a fair presentation framework

1. Title
2. Addressee
3. Opinion
4. Basis for opinion
5. Key Audit Matters
6. Other information in the document containing the F/S
7. Responsibilities of management & TCWG
8. Auditor’s responsibilities for audit of F/S
9. Report on other legal and regulatory requirements
10. Engagement partner’s name
11. Signatures
12. Auditor’s address
13. Date

Impact of various issues on the audit report

1. Title
2. Addressee
3. Opinion: If modified, heading changes to name of modified opinion, wording of opinion changes
4. Basis for opinion:If modified, heading changes to Basis for Qualified/Adverse/Disclaimer; need to explain
nature, amount, impact of issue and the relevant accounting standard
5. If needed, Material uncertainty re. going concern paragraph will be placed here.
6. Key Audit Matters
7. If needed, EOMP can be placed either here or before KAM
8. If needed, OMP will be placed here
9. Other information in the document containing the F/S: any uncorrected inconsistencies in other information
will be explained here. This paragraph will then be moved from here to underneath the Basis for opinion
paragraph.
10. Responsibilities of management & TCWG
11. Auditor’s responsibilities for audit of F/S
12. Report on other legal and regulatory requirements
13. Engagement partner’s name
14. Signatures
15. Auditor’s address
16. Date

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Audit Opinion & Audit Report AAA Revision Notes

Questions in AAA where you are asked to critically evaluate the extract of an audit report.
1. Is the type of opinion correct?
2. Opinion and Basis for opinion para headings correct?
3. Placement of Opinion and Basis for opinion correct?
4. Basis for opinion ( All FOUR of these mentioned?Nature, amount, impact, ifrs)
5. Additional Paras: needed? If yes, placement correct?
6. KAM: ( Do matters identified as KAM actually fulfill the criteria of being called KAM? Introduction proper i.e. to
explain the concept of KAM etc.? Significance of issues identified as KAM and how these affected auditors’
efforts explained? How each KAM was addressed in the audit explained? Placement of the paragraph correct?)
7. Unprofessional wording?

Applied to a past exam question

M/J 2018 Blackmore
1. Is the type of opinion correct? Yes. Qualified, Except for is correct as material ( 13% of loss, 2% of Total Assets)
2. Opinion and Basis for opinion para headings correct? NO! Heading of opinion paragraph should be ‘Qualified
Opinion’. Instead of ‘Customer Liquidation’, the heading should be ‘Basis of Qualified Opinion)
3. Placement of Opinion and Basis for opinion correct? NO. Opinion para comes BEFORE basis for opinion para.
4. Basis for opinion ( All FOUR of these mentioned?Nature, amount, impact, ifrs) IFRS name not mentioned.
5. Additional Paras: needed? If yes, placement correct? EOMP not needed. Should have the Material Uncertainty
re. Going Concern Para instead
6. KAM: ( Do matters identified as KAM actually fulfill the criteria of being called KAM? Yes as judgment and high
risk. Introduction proper i.e. to explain the concept of KAM etc.? Not done! Significance of issues identified as
KAM and how these affected auditors’ efforts explained? Not done! How each KAM was addressed in the audit
explained? Not done! Placement of the paragraph correct? No. Cannot come above the opinion paragraph)
7. Unprofessional wording? Yes. Why is the finance director’s name being used? Why is his inexperience
mentioned?

Questions on audit reports in Paper THE ADVANCED AUDIT & ASSURANCE EXAM 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

Form of opinion
Unmodified opinion The auditor shall express an unmodified opinion when the auditor concludes that
the financial statements are prepared, in all material respects, in accordance with
the applicable financial reporting framework.
Modified opinion If the auditor:
(a) concludes that, based on the audit evidence obtained, the financial statements
as a whole are not free from material misstatement; or
(b) is unable to obtain sufficient appropriate audit evidence to conclude that the
financial statements as a whole are free from material misstatement, the
auditor shall modify the opinion in the auditor’s report in accordance with ISA
705 (Revised).

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Audit Opinion & Audit Report AAA Revision Notes

Key terms

Inability to obtain appropriate and sufficient evidence:

The auditor cannot obtain sufficient appropriate audit evidence on which to base the opinion. The auditor’s
inability to obtain sufficient appropriate audit evidence is also referred to as a limitation on the scope of the audit
and could arise from:
 Circumstances beyond the entity’s control (e.g. accounting records destroyed)
 Circumstances relating to the nature or timing of the auditor’s work (e.g. the timing of the auditor’s appointment
prevents the observation of the physical inventory count).
 Limitations imposed by management (e.g. management prevents the auditor from requesting external
confirmation of specific account balances).

Pervasiveness
Pervasive – A term used, in the context of misstatements, to describe the effects on the financial statements of
misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due
to an inability to obtain sufficient appropriate audit evidence. Pervasive effects on the financial statements are those
that, in the auditor’s judgment:
(i) Are not confined to specific elements, accounts or items of the financial statements;
(ii) If so confined, represent or could represent a substantial proportion of the financial statements; or
(iii) In relation to disclosures, are fundamental to users’ understanding of the financial statements.

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.

Material misstatement of the financial statements

They may arise in relation to:
– The appropriateness of the selected accounting policies. For example, the valuation of inventories at cost
instead of the lower of cost or net realisable value as prescribed by IAS 2, Inventories.
– The application of the selected accounting policies. For example, the valuation of non‐current assets is done
using the cost model for one financial year, and in the next year the same assets are valued using the revaluation
model. Furthermore, during the third year, the cost model is adopted to value the same non‐current assets.
– The appropriateness or adequacy of disclosures in the financial statements. For example the financial
statements of a manufacturing company prepared under IFRS, do not include all of the disclosures relating to
revenue recognition and non‐current assets

The auditor shall form an opinion on whether the financial statements are prepared, in all material respects, in
accordance with the applicable financial reporting framework In particular, the auditor shall evaluate whether, in
view of the requirements of the applicable financial reporting framework:
a) The financial statements adequately disclose the significant accounting policies selected and applied;

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Audit Opinion & Audit Report AAA Revision Notes

b) The accounting policies selected and applied are consistent with the applicable financial reporting framework
and are appropriate;
c) The accounting estimates made by management are reasonable;
d) The information presented in the financial statements is relevant, reliable, comparable, and understandable;
e) The financial statements provide adequate disclosures to enable the intended users to understand the effect
of material transactions and events on the information conveyed in the financial statements; and
f) The terminology used in the financial statements, including the title of each financial statement, is appropriate.

The auditor shall express an unmodified opinion when the auditor concludes that the financial statements are
prepared, in all material respects, in accordance with the applicable financial reporting framework.

Unmodified opinion – The opinion expressed by the auditor when the auditor concludes that the financial
statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.
If the auditor:
(a) Concludes that, based on the audit evidence obtained, the financial statements as a whole are not free from
material misstatement; or
(b) Is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole
are free from material misstatement, the auditor shall modify the opinion in the auditor’s report in accordance
with ISA 705.

Types of Modified Opinions

There are three types of modified opinions, namely, a qualified opinion, an adverse opinion, and a disclaimer of
opinion.

The decision regarding which type of modified opinion is appropriate depends upon:
(a) The nature of the matter giving rise to the modification, that is, whether the financial statements are materially
misstated or, in the case of an inability to obtain sufficient appropriate audit evidence, may be materially
misstated; and
(b) The auditor’s judgment about the pervasiveness of the effects or possible effects of the matter on the financial
statements.

Determining the Type of Modification to the Auditor’s Opinion

Form and Content of the Auditor’s Report When

the Opinion Is Modified
Qualified The auditor shall express a qualified opinion the auditor shall use the heading “Qualified
Opinion when: Opinion,”
(a) The auditor, having obtained sufficient
appropriate audit evidence, concludes the auditor shall state in the opinion paragraph
that misstatements, individually or in the that, in the auditor’s opinion, except for the effects
aggregate, are material, but not of the matter(s) described in the Basis for Qualified
pervasive, to the financial statements; or Opinion paragraph:
(b) The auditor is unable to obtain sufficient (a) The financial statements present fairly, in all
appropriate audit evidence on which to material respects (or give a true and fair view)
base the opinion, but the auditor in accordance with the applicable financial
concludes that the possible effects on the reporting framework when reporting in

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Audit Opinion & Audit Report AAA Revision Notes

financial statements of undetected accordance with a fair presentation

misstatements, if any, could be material framework; or
but not pervasive. (b) The financial statements have been prepared,
in all material respects, in accordance with the
applicable financial reporting framework
when reporting in accordance with a
compliance framework.

When the modification arises from an inability to

obtain sufficient appropriate audit evidence, the
auditor shall use the corresponding phrase “except
for the possible effects of the matter(s) ...” for the
modified opinion.

Adverse The auditor shall express an adverse opinion the auditor shall state in the opinion paragraph
Opinion when the auditor, having obtained sufficient that, in the auditor’s opinion, because of the
appropriate audit evidence, concludes that significance of the matter(s) described in the Basis
misstatements, individually or in the for Adverse Opinion paragraph:
aggregate, are both material and pervasive to (a) The financial statements do not present fairly
the financial statements. (or give a true and fair view) in accordance
with the applicable financial reporting
framework when reporting in accordance with
a fair presentation framework; or
(b) The financial statements have not been
prepared, in all material respects, in
accordance with the applicable financial
reporting framework when reporting in
accordance with a compliance framework.
Disclaimer The auditor shall disclaim an opinion when the When the auditor disclaims an opinion due to an
of Opinion auditor is unable to obtain sufficient inability to obtain sufficient appropriate audit
appropriate audit evidence on which to base evidence, the auditor shall state in the opinion
the opinion, and the auditor concludes that paragraph that:
the possible effects on the financial (a) Because of the significance of the matter(s)
statements of undetected misstatements, if described in the Basis for Disclaimer of
any, could be both material and pervasive. Opinion paragraph, the auditor has not been
able to obtain sufficient appropriate audit
The auditor shall disclaim an opinion when, in evidence to provide a basis for an audit
extremely rare circumstances involving opinion; and, accordingly.
multiple uncertainties, the auditor concludes (b) The auditor does not express an opinion on
that, notwithstanding having obtained the financial statements.
sufficient appropriate audit evidence
regarding each of the individual uncertainties,
it is not possible to form an opinion on the
financial statements due to the potential
interaction of the uncertainties and their

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Audit Opinion & Audit Report AAA Revision Notes

possible cumulative effect on the financial

statements.

Basis for Opinion

When the auditor modifies the opinion on the financial statements, the auditor shall, in addition to the specific
elements required by ISA 700 (Revised):
1. Amend the heading “Basis for Opinion” to “Basis for Qualified Opinion,” “Basis for Adverse Opinion,” or
“Basis for Disclaimer of Opinion,” as appropriate; and

2. Within this section, include a description of the matter giving rise to the modification.

If there is a material misstatement of the financial statements that relates to specific amounts in the financial
statements (including quantitative disclosures), the auditor shall include in the Basis for Opinion section a description
and quantification of the financial effects of the misstatement, unless impracticable.

If it is not practicable to quantify the financial effects, the auditor shall so state in this section.

If there is a material misstatement of the financial statements that relates to qualitative disclosures, the auditor shall
include in the Basis for Opinion section an explanation of how the disclosures are misstated.

If there is a material misstatement of the financial statements that relates to the non‐disclosure of information
required to be disclosed, the auditor shall:
‐ Discuss the non‐disclosure with those charged with governance
‐ Describe in the Basis for Opinion section the nature of the omitted information; and
‐ Include the omitted disclosures, provided it is practicable to do so and the auditor has obtained sufficient
appropriate audit evidence about the omitted information.

If the modification results from an inability to obtain sufficient appropriate audit evidence, the auditor shall
include in the Basis for Opinion section the reasons for that inability.

When the auditor expresses a qualified or adverse opinion, the auditor shall amend the statement about whether
the audit evidence obtained is sufficient and appropriate to provide a basis for the auditor’s opinion to include the
word “qualified” or “adverse”, as appropriate.

When the auditor disclaims an opinion on the financial statements, the auditor’s report shall not include these
elements:
‐ A reference to the section of the auditor’s report where the auditor’s responsibilities are described; and
‐ A statement about whether the audit evidence obtained is sufficient and appropriate to provide a basis for the
auditor’s opinion.

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Audit Opinion & Audit Report AAA Revision Notes

Even if the auditor has expressed an adverse opinion or disclaimed an opinion on the financial statements, the
auditor shall describe in the Basis for Opinion section the reasons for any other matters of which the auditor is aware
that would have required a modification to the opinion, and the effects thereof.

ISA 700: FORMING AN OPINION AND REPORTING ON FINANCIAL STATEMENTS

The auditor shall evaluate whether the financial In particular, the auditor shall evaluate whether, in view of
statements are prepared, in all material respects, the requirements of the applicable financial reporting
in accordance with the requirements of the framework:
applicable financial reporting framework. This (a) The financial statements adequately disclose the
evaluation shall include consideration of the significant accounting policies selected and applied;
qualitative aspects of the entity’s accounting (b) The accounting policies selected and applied are
practices, including indicators of possible bias in consistent with the applicable financial reporting
management’s judgments. framework and are appropriate;
(c) The accounting estimates made by management are
reasonable;
(d) The information presented in the financial statements
is relevant, reliable, comparable, and understandable;
(e) The financial statements provide adequate disclosures
to enable the intended users to understand the effect
of material transactions and events on the information
conveyed in the financial statements; and (Ref: Para.
A4)
(f) The terminology used in the financial statements,
including the title of each financial statement, is
appropriate.
The auditor’s evaluation as to whether the financial statements achieve fair presentation shall include
consideration of:
(a) The overall presentation, structure and content of the financial statements; and
(a) Whether the financial statements, including the related notes, represent the underlying transactions and
events in a manner that achieves fair presentation.

Auditor’s report

Title The auditor’s report shall have a title that clearly indicates that it is the report of an
independent auditor
Addressee The auditor’s report shall be addressed, as appropriate, based on the circumstances
of the engagement.
Auditor’s opinion Heading “Opinion.”

The Opinion section of the auditor’s report shall also:

(a) Identify the entity whose financial statements have been audited;
(b) State that the financial statements have been audited;
(c) Identify the title of each statement comprising the financial statements;

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Audit Opinion & Audit Report AAA Revision Notes

(d) Refer to the notes, including the summary of significant accounting policies; and
(e) Specify the date of, or period covered by, each financial statement comprising
the financial statements.

Wording
In our opinion, the accompanying financial statements present fairly, in all material
respects, […] in accordance with [the applicable
financial reporting framework]
or
In our opinion, the accompanying financial statements give a true and fair view of
[…] in accordance with [the applicable financial reporting framework]
Basis for opinion The auditor’s report shall include a section, directly following the Opinion section,
with the heading “Basis for Opinion”, that:
1. States that the audit was conducted in accordance with International Standards
on Auditing;
2. Refers to the section of the auditor’s report that describes the auditor’s
responsibilities under the ISAs;
3. Includes a statement that the auditor is independent of the entity in
accordance with the relevant ethical requirements relating to the audit, and has
fulfilled the auditor’s other ethical responsibilities in accordance with these
requirements. The statement shall identify the jurisdiction of origin of the
relevant ethical requirements or refer to the International Ethics Standards
Board for Accountants’ Code of Ethics for Professional Accountants (IESBA
Code); and
4. States whether the auditor believes that the audit evidence the auditor has
obtained is sufficient and appropriate to provide a basis for the auditor’s
opinion.
Going Concern Where applicable, the auditor shall report in accordance with ISA 570 (Revised)
Key Audit Matters For audits of complete sets of general purpose financial statements of listed entities,
the auditor shall communicate key audit matters in the auditor’s report in
accordance with ISA 701.

“Key audit matters are those matters that, in our professional judgment, were of
most significance in our audit of the financial statements of the current period. These
matters were addressed in the context of our audit of the financial statements as a
whole, and in forming our opinion thereon, and we do not provide a separate opinion
on these matters.”

[Description of each key audit matter in accordance with ISA 701.]

Other information Where applicable, the auditor shall report in accordance with ISA 720.
“Responsibilities of This section of the auditor’s report shall describe management’s responsibility for:
Management/TCWG for - Preparing the financial statements in accordance with the applicable financial
the Financial Statements.” reporting framework, and for such internal control as management determines
is necessary to enable the preparation of financial statements that are free from
material misstatement, whether due to fraud or error;

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Audit Opinion & Audit Report AAA Revision Notes

- Assessing the entity’s ability to continue as a going concern and whether the
use of the going concern basis of accounting is appropriate as well as disclosing,
if applicable, matters relating to going concern. The explanation of
management’s responsibility for this assessment shall include a description of
when the use of the going concern basis of accounting is appropriate.
Auditor’s responsibilities This section of the auditor’s report shall:
for the audit of F/S (a) State that the objectives of the auditor are to:
 Obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error;
The description of the and
auditor’s responsibilities  Issue an auditor’s report that includes the auditor’s opinion.
for the audit of the
financial statements shall (b) State that reasonable assurance is a high level of assurance, but is not a
be included: guarantee that an audit conducted in accordance with ISAs will always detect a
(a) Within the body of the material misstatement when it exists; and
auditor’s report;
(b) Within an appendix to (c) State that misstatements can arise from fraud or error, and provide a definition
the auditor’s report, or description of materiality in accordance with the applicable financial
in which case the reporting framework.
auditor’s report shall
include a reference to (d) State that, as part of an audit in accordance with ISAs, the auditor exercises
the location of the professional judgment and maintains professional skepticism throughout the
appendix; or audit; and
(c) By a specific reference
within the auditor’s (e) Describe an audit by stating that the auditor’s responsibilities are:
report to the location  To identify and assess the risks of material misstatement of the financial
of such a description statements, whether due to fraud or error;
on a website of an  To design and perform audit procedures responsive to those risks;
appropriate authority,  and to obtain audit evidence that is sufficient and appropriate to provide a
where law, regulation basis for the auditor’s opinion.
or national auditing  To obtain an understanding of internal control relevant to the audit in
standards expressly order to design audit procedures that are appropriate in the circumstances,
permit the auditor to but not for the purpose of expressing an opinion on the effectiveness of
do so the entity’s internal control.
 To evaluate the appropriateness of accounting policies used and the
reasonableness of accounting estimates and related disclosures made by
management.
 To conclude on the appropriateness of management’s use of the going
concern basis of accounting and, based on the audit evidence obtained,
whether a material uncertainty exists related to events or conditions that
may cast significant doubt on the entity’s ability to continue as a going
concern. If the auditor concludes that a material uncertainty exists, the
auditor is required to draw attention in the auditor’s report to the related
disclosures in the financial statements or, if such disclosures are
inadequate, to modify the opinion. The auditor’s conclusions are based on
the audit evidence obtained p to the date of the auditor’s report. However,

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Audit Opinion & Audit Report AAA Revision Notes

future events or conditions may cause an entity to cease to continue as a

going concern.
 To evaluate the overall presentation, structure and content of the financial
statements, including the disclosures.

The Auditor’s Responsibilities for the Audit of the Financial Statements section of
the auditor’s report also shall:
- State that the auditor communicates with those charged with governance
regarding, among other matters, the planned scope and timing of the audit and
significant audit findings, including any significant deficiencies in internal
control that the auditor identifies during the audit;
- For audits of financial statements of listed entities, state that the auditor
provides those charged with governance with a statement that the auditor has
complied with relevant ethical requirements regarding independence and
communicate with them all relationships and other matters that may
reasonably be thought to bear on the auditor’s independence, and where
applicable, related safeguards; and
- State that, from the matters communicated with those charged with
governance, the auditor determines those matters that were of most
significance in the audit of the financial statements of the current period and
are therefore the key audit matters.
“Report on Other Legal In some jurisdictions, the auditor may have additional responsibilities to report on
and Regulatory other matters that are supplementary to the auditor’s responsibilities under the
Requirements” ISAs

For example, the auditor may be asked to report certain matters if they come to the
auditor’s attention during the course of the audit of the financial statements.

Alternatively, the auditor may be asked to perform and report on additional

specified procedures, or to express an opinion on specific matters, such as the
adequacy of accounting books and records, internal control over financial reporting
or other information.

Auditing standards in the specific jurisdiction often provide guidance on the

auditor’s responsibilities with respect to specific additional reporting
responsibilities in that jurisdiction
Name of the Engagement
Partner
Signature of the auditor
Auditor’s address
Date of the auditor’s
report

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Audit Opinion & Audit Report AAA Revision Notes

ISA 706: EMPHASIS OF MATTER PARAGRAPHS AND OTHER MATTER PARAGRAPHS IN THE INDEPENDENT
AUDITOR’S REPORT

Emphasis of Matter paragraph :A paragraph included in the auditor’s report that refers to a matter appropriately
presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is
fundamental to users’ understanding of the financial statements.

Emphasis of Matter Paragraphs in the Auditor’s Report

If the auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial
statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of
the financial statements, the auditor shall include an Emphasis of Matter paragraph in the auditor’s report provided:
‐ The auditor would not be required to modify the opinion in accordance with ISA 705 (Revised) as a result of the
matter; and
‐ When ISA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the
auditor’s report. (When ISA 701 applies, the use of Emphasis of Matter paragraphs is not a substitute for a
description of individual key audit matters.)

There may be a matter that is not determined to be a key audit matter in accordance with ISA 701 (i.e., because it
did not require significant auditor attention), but which, in the auditor’s judgment, is fundamental to users’
understanding of the financial statements (e.g., a subsequent event). If the auditor considers it necessary to draw
users’ attention to such a matter, the matter is included in an Emphasis of Matter paragraph in the auditor’s report
in accordance with this ISA.

When the auditor includes an Emphasis of Matter paragraph in the auditor’s report, the auditor shall:

(a) Include the paragraph within a separate section of the auditor’s report with an appropriate heading that
includes the term “Emphasis of Matter”;

(b) Include in the paragraph a clear reference to the matter being emphasized and to where relevant disclosures
that fully describe the matter can be found in the financial statements. The paragraph shall refer only to
information presented or disclosed in the financial statements; and

(c) Indicate that the auditor’s opinion is not modified in respect of the matter emphasized.

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Audit Opinion & Audit Report AAA Revision Notes

Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter
paragraph are
1. An uncertainty relating to the future outcome of exceptional litigation or regulatory action.
2. A significant subsequent event that occurs between the date of the financial statements and the date of the
auditor’s report.
3. Early application (where permitted) of a new accounting standard that has a material effect on the financial
statements.
4. A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.
5. When a financial reporting framework prescribed by law or regulation would be unacceptable but for the
fact that it is prescribed by law or regulation.
6. When facts become known to the auditor after the date of the auditor’s report and the auditor provides a
new or amended auditor’s report (i.e., subsequent events)

Other Matter paragraph – A paragraph included in the auditor’s report that refers to a matter other than those
presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to users’ understanding
of the audit, the auditor’s responsibilities or the auditor’s report.

Other Matter Paragraphs in the Auditor’s Report

If the auditor considers it necessary to communicate a matter other than those that are presented or disclosed in
the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s
responsibilities or the auditor’s report, the auditor shall include an Other Matter paragraph in the auditor’s report,
provided:

(a) This is not prohibited by law or regulation; and

(b) When ISA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the
auditor’s report.

When the auditor includes an Other Matter paragraph in the auditor’s report, the auditor shall include the paragraph
within a separate section with the heading “Other Matter,” or other appropriate heading.

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Audit Opinion & Audit Report AAA Revision Notes

Circumstances in Which an Other Matter Paragraph May Be Necessary

1. Relevant to Users’ Understanding of the Audit: In the rare circumstance where the auditor is unable to
withdraw from an engagement even though the possible effect of an inability to obtain sufficient appropriate
audit evidence due to a limitation on the scope of the audit imposed by management is pervasive,the auditor
may consider it necessary to include an Other Matter paragraph in the auditor’s report to explain why it is
not possible for the auditor to withdraw from the engagement.

2. Relevant to Users’ Understanding of the Auditor’s Responsibilities or the Auditor’s Report: Law, regulation
or generally accepted practice in a jurisdiction may require or permit the auditor to elaborate on matters that
provide further explanation of the auditor’s responsibilities in the audit of the financial statements or of the
auditor’s report thereon.

3. Reporting on more than one set of financial statements: An entity may prepare one set of financial
statements in accordance with a general purpose framework (e.g., the national framework) and another set
of financial statements in accordance with another general purpose framework (e.g., International Financial
Reporting Standards), and engage the auditor to report on both sets of financial statements. If the auditor
has determined that the frameworks are acceptable in the respective circumstances, the auditor may include
an Other Matter paragraph in the auditor’s report, referring to the fact that another set of financial
statements has been prepared by the same entity in accordance with another general purpose framework
and that the auditor has issued a report on those financial statements.

4. Prior Period Financial Statements Audited by a Predecessor Auditor . If the financial statements of the prior
period were audited by a predecessor auditor and the auditor is not prohibited by law or regulation from
referring to the predecessor auditor’s report on the corresponding figures and decides to do so, the auditor
shall state in an Other Matter paragraph in the auditor’s report:
a. That the financial statements of the prior period were audited by the predecessor auditor;
b. The type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons
therefore; and
c. The date of that report.

5. Prior Period Financial Statements Not Audited : If the prior period financial statements were not audited, the
auditor shall state in an Other Matter paragraph in the auditor’s report that the corresponding figures are
unaudited. Such a statement does not, however, relieve the auditor of the requirement to obtain sufficient
appropriate audit evidence that the opening balances do not contain misstatements that materially affect
the current period’s financial statements

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Audit Opinion & Audit Report AAA Revision Notes

Placement of EOMP and OMP

The placement of an Emphasis of Matter paragraph or Other Matter paragraph in the auditor’s report depends on
the nature of the information to be communicated, and the auditor’s judgment as to the relative significance of such
information to intended users compared to other elements required to be reported
EOMP:
1. immediately following the Basis of Opinion section to provide appropriate context to the auditor’s opinion :
When the Emphasis of Matter paragraph relates to the applicable financial reporting framework,
2. May be presented either directly before or after the Key Audit Matters section, based on the auditor’s judgment
as to the relative significance of the information included in the Emphasis of Matter paragraph. The auditor
may also add further context to the heading “Emphasis of Matter”, such as “Emphasis of Matter – Subsequent
Event”, to differentiate the Emphasis of Matter paragraph from the individual matters described in the Key Audit
Matters section

Other Matter Paragraphs

• When a Key Audit Matters section is presented in the auditor’s report and an Other Matter paragraph is also
considered necessary, the auditor may add further context to the heading “Other Matter”, such as “Other
Matter – Scope of the Audit”, to differentiate the Other Matter paragraph from the individual matters described
in the Key Audit Matters section.
• When an Other Matter paragraph is included to draw users’ attention to a matter relating to Other Reporting
Responsibilities addressed in the auditor’s report, the paragraph may be included in the Report on Other Legal
and Regulatory Requirements section.
• When relevant to all the auditor’s responsibilities or users’ understanding of the auditor’s report, the Other
Matter paragraph may be included as a separate section following the Report on the Audit of the Financial
Statements and the Report on Other Legal and Regulatory Requirements.

Quality control procedures prior to issuing the audit report

ISA 220 Quality Control for an Audit of Financial Statements and ISQC 1 Quality Control for Firms that Perform Audits
and Reviews of Historical Financial Information, and Other Assurance and Related Services Agreements require that
an engagement quality control reviewer shall be appointed for audits of financial statements of listed entities.

The audit engagement partner then discusses significant matters arising during the audit engagement with the
engagement quality control reviewer.

The engagement quality control reviewer must review the financial statements and the proposed auditor’s report,
in particular focusing on the conclusions reached in formulating the auditor’s report and consideration of whether
the proposed auditor’s opinion is appropriate.

The audit documentation will be carefully reviewed, and the reviewer is likely to consider whether procedures
performed in relation to risky balances were appropriate.

Any modification to the auditor’s report will be scrutinised, and the firm must be sure of any decision to modify the
report, and the type of modification made.

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Audit Opinion & Audit Report AAA Revision Notes

The engagement quality control reviewer should ensure that there is adequate documentation regarding the
judgements used in forming the final audit opinion, and that all necessary matters have been brought to the
attention of those charged with governance.

The auditor’s report must not be signed and dated until the completion of the engagement quality control review.

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Assurance & No‐Assurance Engagements AAA Revision Notes

Assurance & No‐Assurance Engagements

Elements of an assurance engagement:

The definition of an assurance engagement is set out below but you should be familiar with it from your earlier
auditing studies.

An assurance engagement is one where a professional accountant evaluates or measures a subject matter that is
the responsibility of another party against suitable criteria, and expresses an opinion which provides the intended
user with a level of assurance about the subject matter.

Assurance engagement―An engagement in which a practitioner aims to obtain sufficient appropriate

evidence in order to express a conclusion designed to enhance the degree of confidence of the intended
users other than the responsible party about the subject matter information (that is, the outcome of the
measurement or evaluation of an underlying subject matter against criteria).

Each assurance engagement is classified on two dimensions:

Audit‐related services and an audit of historical financial statements

Dimension 1 Dimension 2
Either a reasonable assurance Either an attestation engagement or a direct engagement
engagement or a limited assurance
engagement:
Reasonable assurance: An Assurance Attestation engagement
engagement in which the Practioner Attestation engagement is an engagement in which a practitioner is
reduces engagement risk to an appointed to issue a written communication to convey a conclusion
acceptably low level in the about the dependability of the assertion from the accountant who
circumstances of the engagement as performs the attestation engagement.
the basis for the practitioner’s
conclusion. The practitioner’s It involves the following:
conclusion is expressed in a form that – Examining, reviewing and performing agreed‐upon procedures
conveys the practitioner’s opinion on on the subject matter of an assertion
the outcome of the measurement – Issuing a written communication which expresses a conclusion
or evaluation of the underlying about the reliability of written assertions prepared by a separate
subject matter against criteria. party

Examples of attestation engagements

Limited assurance engagement: An – Verifying compliance with applicable laws and regulations.
assurance engagement in which the – Verifying internal control over financial reporting.
practitioner reduces engagement risk – Verifying accounting for reporting on grants and contracts.
to a level that is acceptable in the – IT / system audit.
circumstances of the engagement but – Examining financial forecasts and projections.
where that risk is greater than for a

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Assurance & No‐Assurance Engagements AAA Revision Notes

reasonable assurance engagement as In all cases, the practitioner is attesting that something is correct or
the basis for expressing a conclusion fairly stated, from the work they have carried out.
in a form that conveys whether,
based on the procedures performed Direct reporting engagement
and evidence obtained, a matter(s)
has come to the practitioner’s A direct reporting engagement involves the following:
attention to cause the practitioner – An independent examination of financial information or other
to believe the subject matter information that has been prepared for use by another party
information is materially misstated. – Engaging party may or may not make a written assertion or a
The nature, timing and extent of set of assertions (e.g. the engaging party may not state that the
procedures performed in a limited financial statements follow IAS. However, the examining party
assurance engagement is limited will still need to state which standards have been used)
compared with that necessary in a – Expressing an opinion in accordance with the agreed terms of
reasonable assurance engagement but the engagement
is planned to obtain a level of
assurance that is, in the In a direct reporting engagement, the accountant is engaged to make
practitioner’s professional judgment, enquiries into the accounts, organisation or activities of an entity.
meaningful. To be meaningful, the
level of assurance obtained by the The following table summarises the differences between an
practitioner is likely to enhance the attestation engagement and a direct reporting engagement:
intended users’ confidence about
the subject matter information to a Attestation Direct reporting
degree that is clearly more than Assurance is provided on the Assurance is provided
inconsequential. written assertion, or set of irrespective of whether the
assertions, made by one party, written assertion, or set of
responsible for a matter of assertions, is made.
accountability, to another
party.
An audit of historical financial A direct reporting engagement
statements is an example of an is a kind of review engagement
attestation engagement where where opinion is provided but
management makes an not always on the assertions
assertion e.g. the financial made by the engaging party.
statements give a true and fair Due diligence review is an
view and are free of material example of a direct reporting
misstatements. engagement.
The assurance engagement risk The assurance engagement risk
is reduced to an acceptably low is reduced to a moderate level.
level.
Comparatively extensive audit Comparatively limited audit
procedures are performed. procedures are performed.
Audit procedures generally Procedures generally comprise
comprise inspection, enquiry and analytical
observation, confirmation, procedures.
recalculation, re performance,

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Assurance & No‐Assurance Engagements AAA Revision Notes

analytical procedures and

enquiry.

“Reasonable assurance” is “Limited assurance” is

provided. provided.
The opinion is expressed The opinion is expressed
positively such as “in our negatively such as “nothing has
opinion subject matter come to our attention that
conforms in all material causes us to believe that
respects to criteria.” subject matter does not
conform in all material respects
to criteria.”

The following table summarises the difference between the two types of services:
Audit of historical financial statements Audit related services
Audit provides reasonable assurance Review: offers limited but negative assurance.
Agreed‐upon procedures: no assurance, only factual
findings.
Compilation: no assurance.

The auditor decides the scope of the work to be carried Review: reviewer decides the scope of audit.
out in an audit. Agreed‐upon procedures: client entity decides the
scope
Compilation: client entity decides the scope of work.

In many countries, an audit is required by law (for large These services are not required by law.
and public companies).

Audit risk i.e. risk of mistakes, omissions or incorrect Risk of mistakes, omissions etc. is greater in review and
disclosures is lower in audit as compared to other other services than in audit, as generally less work is
engagements. carried out or concentrated on certain areas.

Cost is higher than cost of review and other services. Cost is significantly less than cost of audit.

Agreed‐upon procedures

Agreed‐upon procedures assignment. In an engagement to perform agreed‐upon procedures, an auditor is

engaged to carry out those procedures of an audit nature to which the auditor and the entity and any appropriate
third parties have agreed and to report on factual findings. The recipients of the report must form their own
conclusions from the report by the auditor. The report is restricted to those parties that have agreed to the
procedures to be performed since others, unaware of the reasons for the procedures, may misinterpret the results.
Agreed upon procedures assignments are discussed in ISRS 4400 Engagements to perform agreed‐upon
procedures regarding financial information.

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Assurance & No‐Assurance Engagements AAA Revision Notes

In an ‘agreed‐upon procedures’ engagement, the auditor is engaged to perform certain procedures which have
been agreed between the auditor, the entity and any other interested third party e.g. fraud investigations, verifying
accounts payables, verifying accounts receivables and verifying non‐financial data, such as waiting times in hospitals.
The procedures applied in an agreed‐upon procedures engagement may include the following:
– enquiry and analysis
– recomputation, comparison and other clerical accuracy checks
– observation
– inspection
– obtaining confirmations

In an agreed upon procedure engagement, auditor does not express his opinion; instead he gives only the factual
findings.

Agreed upon procedures engagements are required in the following circumstances for example:
– investigating fraud or irregularity
– verifying insurance claims
– reporting on non‐financial data e.g. number of units sold

Compilation engagements‐ Compilation does not provide assurance; it only gives compiled information.

A compilation of financial statements is an accounting service:

– In which an accountant prepares or assists in preparing financial statements;
– Without expressing any assurance that the statements are accurate and complete.

In other words, it is an engagement which requires more accounting expertise than auditing expertise and involves
collecting, classifying and summarising financial information. Data is presented in a manageable and understandable
form without a requirement to test the assertions underlying that information.

Examples
– Preparing financial statements
– Calculating taxable income

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Review Engagements AAA Revision Notes

Review Engagements

Many clients (for whom audit is not compulsory) require some assurance on their financial statements. However,
they do not want to incur the heavy cost of audit. For these clients, a review engagement may be the appropriate
service to provide this assurance. This is because review provides limited assurance that the financial statements are
reasonable and one can believe in them.

Generally, when a client approaches a bank for a loan, the bank asks for a review report.

THE ADVANCED AUDIT & ASSURANCE EXAM Specific

The objective of a review engagement is to enable the auditor to obtain moderate assurance as to whether the
financial statements have been prepared in accordance with an identified financial reporting framework. This is
defined in ISRE 2400

Engagements to Review Financial Statements.

In order to obtain this assurance, it is necessary to gather evidence using analytical procedures and enquiries with
management. Detailed substantive procedures will not be performed unless the auditor has reason to believe
that the information may be materially misstated.

The auditor should approach the engagement with a high degree of professional scepticism, looking for
circumstances that may cause the financial statements to be misstated.

As a result of procedures performed, the auditor’s objective is to provide a clear written expression of negative
assurance on the financial statements. In a review engagement the auditor would state that ‘we are not aware of
any material modifications that should be made to the financial statements….’
This is normally referred to as an opinion of ‘negative assurance’.

Negative assurance means that the auditor has performed limited procedures and has concluded that the
financial statements appear reasonable. The user of the financial statements gains some comfort that the figures
have been subject to review, but only a moderate level of assurance is provided. The user may need to carry out
additional procedures of their own if they want to rely on the financial statements.

In comparison, in an audit, a high level of assurance is provided. The auditors provide an opinion of positive, but
not absolute assurance. The user is assured that the figures are free from material misstatement and that the
auditor has based the opinion on detailed procedures.

The objective of a review engagement is to enable a practitioner 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 practitioner’s attention
that causes the practitioner to believe that the financial statements are not prepared, in all material respects, in
accordance with an applicable financial reporting framework

The assurance provided in review engagements is limited and negative i.e. the practitioners (those carrying out
review engagements) are required to state in their report whether anything has come to their attention that causes

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Review Engagements AAA Revision Notes

them to believe that the financial statements are not prepared, in all material respects, in accordance with an
identified financial reporting framework.

Negative assurance concentrates on the fact that the practitioner is stating that from the limited work he has carried
out, everything looks reasonable and plausible. There is no detailed testing, hence using the phrase,‘ nothing comes
to our attention to believe that the accounts do not give a true and fair view’.

The procedures to be performed in a review engagement will vary depending on the specific requirements of the
engagement. They are generally based on:
– gaining an understanding of the client’s activities, including knowledge of the accounting practices of the
industry or area in which the client operates
– enquiry into the entity’s accounting principles and practices, the entity’s procedure from recording of
transactions and events to preparing the financial statements and all material assertions in the financial
statements
– analytical review The whole premise behind a review is that the auditor does not do the detailed testing to
gain positive assurance that the figures are true and fair. He is just looking to ensure that they are plausible
and reasonable under the circumstances.

ISRE (International Standard on Review Engagements) 2400 Engagements to review financial statements contains
guidance on review engagements.

ISRE 2400.7
For the purpose of expressing negative assurance in the review report, the practitioner should obtain sufficient
appropriate evidence primarily through inquiry and analytical procedures to be able to draw conclusions.

ISRE 2400.8
The procedures required to conduct a review of financial statements should be determined by the practitioner
having regard to the requirements of this ISRE, relevant professional bodies, legislation, regulation and, where
appropriate, the terms of the review engagement and reporting requirements.

Many of the requirements of the ISRE are similar to the requirements of an audit.

Planning
Obtain knowledge of the business
Same materiality requirements
Using the work of others

Evidence
Document all important matters
Apply judgement in determining nature, timing and extent of procedures
Enquire about subsequent events
Extend procedures if material misstatements are suspected

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Review Engagements AAA Revision Notes

Review of Interim Financial Information Performed by the Independent Auditor

of the Entity

This subject is covered by ISRE 2410 Review of interim financial information performed by the independent auditor
of the entity.

Interim financial information is financial information that is prepared and presented in accordance with an
applicable financial reporting framework and comprises either a complete or a condensed set of financial statements
for a period that is shorter than the entity’s financial year.

In many countries, listed companies are required to publish quarterly or half‐yearly interim financial information
which has been reviewed by a professional accountant. In order to comply with this, companies may appoint
professional accountants (who may or may not be the company’s auditors) to review the interim financial
information.

The review of interim financial information enables the accountant to express a conclusion on whether, based on
the review, anything has come to his attention that causes him to believe that the interim financial information has
not been prepared, in all material respects, in accordance with an applicable financial reporting framework.

If, during the review, the accountant comes across matters that require modification in order for the information to
be presented in conformity with the international financial reporting framework, he should communicate with the
engaging party about the modifications required.

THE ADVANCED AUDIT & ASSURANCE EXAM Specific

The auditor should perform analytical procedures in order to discover unusual trends and relationships, or
individual figures in the interim financial information, which may indicate a material misstatement.

Procedures should include the following:

– Comparing the interim financial information with anticipated results, budgets and targets as set by the
management of the company.
– Comparing the interim financial information with:
 Comparable information for the immediately preceding interim period,
 The corresponding interim period in the previous year, and
 The most recent audited financial statements.

– Comparing ratios and indicators for the current interim period with those of entities in the same industry.

– Considering relationships among financial and non‐financial information. The auditor also may wish to
consider information developed and used by the entity, for example, information in monthly financial reports
provided to the senior management or press releases issued by the company relevant to the interim financial
information.

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Review Engagements AAA Revision Notes

– Comparing recorded amounts or ratios developed from recorded amounts, to expectations developed by the
auditor. The auditor develops such expectations by identifying and using plausible relationships that are
reasonably expected to exist based on the accountant’s understanding of the entity and the industry in which
the entity operates.
– Comparing disaggregated data, for example, comparing revenue reported by month and by product line or
operating segment during the current interim period with that of comparable prior periods.

The auditor should obtain an understanding of the entity and its environment as it relates to both the interim review
and final audit.

The key elements of the review will be:

Enquiries of accounting and finance staff

Analytical procedures
Ordinarily procedures would include:
– Reading the minutes of meetings of shareholders, those charged with governance and other appropriate
committees
– Considering the effect of matters giving rise to a modification of the audit or review report, accounting
adjustments or unadjusted misstatements from previous audits
– If relevant, communicating with other auditors auditing different components of the business
– Analytical procedures designed to identify relationships and unusual items that may reflect a material
misstatement
– Reading the interim financial information and considering whether anything has come to the auditors' attention
indicating that it is not prepared in accordance with the applicable financial reporting framework
– Agreeing the interim financial information to the underlying accounting records

Auditors should make enquiries of members of management responsible for financial and accounting matters about:
– Whether the interim financial information has been prepared and presented in accordance with the applicable
financial reporting framework
– Whether there have been changes in accounting policies
– Whether new transactions have required changes in accounting principle
– Whether there are any known uncorrected misstatements
– Whether there have been unusual or complex situations, such as disposal of a business segment
– Significant assumptions relevant to fair values
– Whether related party transactions have been accounted for and disclosed correctly
– Significant changes in commitments and contractual obligations
– Significant changes in contingent liabilities including litigation or claims
– Compliance with debt covenants
– Matters about which questions have arisen in the course of applying the review procedures
– Significant transactions occurring in the last days of the interim period or the first days of the next
– Knowledge or suspicion of any fraud
– Knowledge of any allegations of fraud Knowledge of any actual or possible non‐compliance with laws and
regulations that could have a material effect on the interim financial information
– Whether all events up to the date of the review report that might result in adjustment in the interim financial
information have been identified

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Review Engagements AAA Revision Notes

– Whether management has changed its assessment of the entity being a going concern

The auditor should evaluate discovered misstatements individually and in aggregate to see if they are material.

The auditor should obtain written representations from management that it acknowledges its responsibility for the
design and implementation of internal control, that the interim financial information is prepared and presented in
accordance with the applicable financial reporting framework and that the effect of uncorrected misstatements are
immaterial (a summary of these should be attached to the representations). The auditor should also obtain
representations that all significant facts relating to frauds or non‐compliance with law and regulations has been
disclosed to the auditor and that all significant subsequent events have been disclosed to the auditor.

The auditor should read the other information accompanying the interim financial information to ensure that it is
not inconsistent with it.

If the auditors believe a matter should be adjusted in the financial information, they should inform management as
soon as possible. If management does not respond within a reasonable time, then the auditors should inform those
charged with governance. If they do not respond, then the auditor should consider whether to modify the report or
to withdraw from the engagement and the final audit if necessary. If the auditors uncover fraud or non‐compliance
with laws and regulations, they should communicate that promptly with the appropriate level of management. The
auditors should communicate matters of interest arising to those charged with governance.

pg. 235
Due Diligence Review AAA Revision Notes

Due Diligence Review

Due diligence reviews are a specific type of review engagement. A typical due diligence engagement is where an
advisor (often an audit firm) is engaged by one company planning to take over another to perform an assessment of
the material risks associated with the transaction (including validating the assumptions underlying the purchase), to
ensure that the acquirer has all the necessary facts and that the perceived business opportunities are in fact real.
This is important when determining purchase price.

Similarly, due diligence can also be requested by sellers.

An accountant may be asked to perform a due diligence review of the company, unit or other assets, as the case
may be acquired in mergers and acquisitions. The accountant is supposed to identify risks such as the risk of non‐
disclosure of any relevant information and non‐disclosure of any liability. The accountant can review target
companies and comment on whether it is worth investing into these companies.

– Financial due diligence (a review of the financial position and obligations of a target to identify such matters as
covenants and contingent obligations)
– Operational and IT due diligence (extent of operational and IT risks, including quality of systems, associated with
a target business)
– People due diligence (key staff positions under the new structure, contract termination costs and cost of
integration)
– Regulatory due diligence (review of the target's level of compliance with relevant regulation)
– Environmental due diligence (environmental, health and safety and social issues in a target)

Matters to be considered before accepting a due diligence assignment

1. Competency of firm: the audit firm should have the experience and skill to perform the review
2. Independence issues: as required in any assurance assignment, the accountant should be independent of both
the parties
3. Sufficiency of resources: whether the firm has adequate manpower to perform the engagement
4. Degree of confidentiality: who the assignment will be performed for and who will see the results
5. Scope of work: what areas are to be concentrated on
6. Purpose of the acquisition e.g. whether the acquiring company is interested in acquiring the company (i.e. the
share capital) or its trading assets. This is because the auditor will accordingly concentrate his work on that
particular area, if any.
7. Planning due diligence assignments. In due diligence assignments, the scope of the work should be written
down in the engagement letter and agreed to by both the accountant and the client. The engagement letter
should also include the following:
– scope of work
– a clear demarcation of the responsibilities of the management and the accountant
– a clarification of interim report requirements
– confidentiality

Apart from the usual considerations of the audit / review plan, a due diligence plan should include preparing a list
of required information and the people to be interviewed

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Due Diligence Review AAA Revision Notes

In due diligence, the accountant analyses the information supplied by the target company and interviews a member
of the management of the target company. In order to do this more effectively, the required information and
interviewees should be identified well in advance and included in the plan. The target company needs to be informed
well in advance about the required information and the interviewees required so that the company can make these
resources available.

In a review engagement, the auditor will rely more heavily on procedures such as enquiry and analytical review
than on more detailed substantive testing.

A typical due diligence review could include enquiries into:

– Structure, including how the target is owned and constituted and what changes will be necessary
– Financial health, based on a detailed examination of past financial statements and an analysis of the existing
asset base
– Credibility of the owners, directors and senior managers, including validation of the career histories of all the
main players in the business
– Future potential, reflected in the strengths of its products or services and the probability of earnings growth
over the medium to long term
– Assessment of the risk to the acquiring business, in terms of their markets, strategy and likely future events
– The business plan, in terms of how realistic it is, how solid the assumptions used are and how well it conveys
the potential

Extracted from past exams

Need of due diligence/ Purpose of a ‘due diligence’ review

1. Before purchasing a company, it is crucial that the purchaser undertake a comprehensive survey of the
business in order to avoid any operational or financial surprises post‐acquisition. Due diligence can simply be
seen as ‘fact finding’, and as a way to minimise the risk of making a bad investment

2. Investigative due diligence is the process by which information is gathered about a target company, for the
purpose of ensuring that the acquirer has full knowledge of the operations, financial performance and
position, legal and tax situation, as well as general commercial background. Essentially the aim is to uncover
any ‘skeletons in the closet’ and therefore to reveal any potential problem areas before a decision regarding
the acquisition is made.

3. Verification of specific management representations: the vendor may make representations to the potential
acquirer which it is essential to verify.

4. Identification of assets and liabilities: From an accounting perspective it is crucial that all of the assets of the
target company are identified. This is important because internally generated intangibles such as customer
databases, trade dress, and brand names are unlikely to be recognised in the individual company statement
of financial position (balance sheet), but should be identified and valued for the purpose of calculating
goodwill on acquisition. As these assets are, by definition, without physical substance, only a detailed due
diligence investigation will uncover them. As well as being important for the goodwill calculation, it is crucial

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Due Diligence Review AAA Revision Notes

to identify these assets as they represent ‘hidden wealth’ within the target company, and should be taken
into account when negotiating the acquisition price.

5. Contingent liabilities must also be identified, as the acquirer will need to understand the likelihood of the
liability crystallising, and the potential financial consequence.
.
6. Operational issues: One of the key benefits of due diligence is to discover problems or risks within the entity.
These risks may not necessarily arise in the context of a contingent liability, but could instead be operational
issues such as high staff turnover, or the need to renegotiate contract terms with suppliers or customers. The
directors of the acquiring company will need to carefully consider whether such matters constitute deal
breakers, in which case the investment would be considered too risky and so would not go ahead.
Alternatively, the risks uncovered could be useful in negotiation to reduce the consideration paid, or the
target company could be asked to provide assurance that these problems will be resolved pre acquisition.

7. Acquisition planning: The due diligence investigation will also assess the commercial benefits, and potential
drawbacks, of the acquisition. On the positive side, it will highlight matters such as expected operational
synergies to be created post acquisition, and potential economies of scale to be exploited. On the downside
there will be acquisition expenses to pay, costs in terms of reorganisation and possible redundancies, as well
as the important but hard to quantify issue of change management. The due diligence provider may be able
to offer recommendations as to the best way to integrate the new company into the group.

8. Management involvement: Due diligence investigations can be performed internally, by the directors of the
acquiring company. However, this can be time consuming, and the directors may lack sufficient specialist
knowledge to perform the investigation. Therefore one of the purposes of an externally provided due
diligence service is to reduce time spent by the directors on fact finding, leaving more time to focus on
strategic matters to do with the acquisition and on running the existing group.

9. Credibility: An external investigation will also provide an independent, impartial view on the situation,
enhancing the credibility of the investment decision, and the amount paid for the investment.

Scope of a due diligence assignment compared to an audit

When conducting a due diligence assignment, the scope is focused, as discussed above, primarily on fact finding.
This means that although the most recent set of financial statements will form a crucial source of information,
the investigation will draw on a much wider range of sources of information, including:
– Several years prior financial statements
– Management accounts
– Profit and cash flow forecasts
– Any business plans recently prepared
– Discussions with management, employees and third parties.

The aim of due diligence, in contrast to an audit, is NOT to provide assurance that financial data is free from
material misstatement, but rather to provide the acquirer with a set of information that has been reviewed.
Consequently no detailed audit procedures will be performed unless there are specific issues which either cause
concern, or have been specifically selected for further verification.

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Due Diligence Review AAA Revision Notes

For example, the acquirer may specifically request that the due diligence exercise provides an estimate of the
valuation of acquired intangible assets, as discussed above.

The type of work performed will therefore be quite different, as a due diligence investigation will primarily use
analytical procedures as a means of gathering information. Very few, if any substantive procedures would be
carried out, unless they had been specifically requested by the client.

Due diligence is much more ‘forward looking’ than an audit. Much of the time during a due diligence investigation
will be spent assessing forecasts and predictions. In comparison audit procedures only tend to cover future events
if they are directly relevant to the yearend financial statements, for example, contingencies, or going concern
problems.

In contrast to an audit, when it is essential to evaluate systems and controls, the due diligence investigation will
not conduct detailed testing of the accounting and internal control systems, unless specifically requested to do
so.

Difference between due diligence and audit

Requirements
Year end audits are legally required for all limited companies exceeding the minimum audit thresholds. They are
also subject to strict regulations in the guise of International Standards of Auditing.

Due diligence is initiated at the request of directors and subject to fewer prescribed rules. An outline of the
processes that should be followed can be found in: ISRE 2400 Engagements to Review Financial Statements; ISRS
4400 Engagements to Perform Agreed upon Procedures Regarding Financial Information; ISAE 3400 The
Examination of Prospective Financial Information; and ISAE 100 Assurance Engagements.

Audience
An audit opinion is offered to the shareholders of the business subject to audit.
In contrast, the reports from due diligence engagements are provided to the directors of the company.

Form of Assurance
The opinion offered on an audit is one of reasonable assurance. This means that sufficient, appropriate evidence
has been gathered to support an opinion as to whether the accounts are free from material misstatement.

Absolute assurance cannot be given for reasons such as: the use of accounting estimates; the nature of fraud (i.e.
it is hidden); and the necessary use of audit sampling.

As the timescale for a due diligence review is often relatively short but wide in scope clients may not always
request the expression of an opinion. However the accountant will be engaged to report upon certain criteria
requested specifically by the client. If sought, the assurance offered would be limited assurance.

Wording of Opinion
In an audit report a positive statement of opinion is offered as to whether the accounts are – or are not – a true
and fair representation of the position and performance of the business under scrutiny.

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Due Diligence Review AAA Revision Notes

In a limited assurance report a negative statement of opinion is given. This indicates whether anything has come
to light during the review to indicate a departure from the criteria initially agreed with the client.

Evidence
During an audit evidence is usually gathered using a mixture of analytical review, enquiry, inspection of
documentation, observation of procedures, and recompilations of certain balances.

During due diligence evidence is restricted, at least initially, to analytical review and enquiry. Further
corroborative evidence might be sought if any material concerns were identified.

Due diligence conclusion

Due diligence is a specific example of a direct reporting assurance engagement. The form of the report issued in this
type of engagement is covered by ISAE 3000 Assurance Engagements other than Audits or Reviews of Historical
Financial Information, and ISRE 2400 Engagements to Review Historical Financial Statements also contains relevant
guidance.

The main difference between a review report and an audit report is the level of assurance that is given. In a review
report a conclusion is expressed in a negative form. The conclusion would start with the wording ‘based on our
review, nothing has come to our attention...’

This type of conclusion is used because the nature of a due diligence review is that only limited assurance has been
obtained over the subject matter. The procedures used in a review engagement are mainly enquiry and analytical
review which can only provide limited assurance.

In comparison, in an audit of historical information, the auditor will use a wide variety of procedures to obtain
evidence to give reasonable assurance that the financial statements are free from material misstatement. This
means that an opinion expressed in a positive form can be given.

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Prospective Financial Information AAA Revision Notes

Prospective Financial Information

Basic Understanding

Forecasts: A financial forecast consists of prospective financial statements that present, to the best of the
responsible party's knowledge and belief, an entity's expected financial position, results of operations, and cash
flows.

Projections: A financial projection consists of prospective financial statements that present, given one or more
hypothetical assumptions, an entity's expected financial position, results of operations, and cash flows. A financial
projection is sometimes prepared to present one or more hypothetical courses of action for evaluation, as in
response to a “what if?” scenario.

The key difference between a forecast and a projection is the nature of the assumptions. In a forecast, the
assumptions represent the company's expectations of actual future events. A projection is used when the
assumptions desired are not those believed to be most likely (essentially, the "what if?"scenario).

Definitions
Prospective financial information (PFI):‘financial information based on assumptions about events that may occur in
the future and possible actions by an entity.’

‘Assumptions about future events’ can be in the form of a forecast or a projection, or a combination of both.
Assumptions for a probable future event are highly subjective in nature and can vary from situation to situation.

‘A forecast means PFI prepared on the basis of assumptions as to future events which the management expects to
take place and the actions the management expects to take as of the date the information is prepared (best‐estimate
assumptions).’

A projection means prospective financial information prepared on the basis of:

o Hypothetical assumptions about future events and management actions which are not necessarily expected,
e.g. entities in a start‐up phase or considering a major change in the nature of operations or
o A mixture of best‐estimate and hypothetical assumptions.

A forecast is usually made for a period of no more than one year. Unlike a forecast, a projection is made generally
for a period of more than one year. Usually, it is made for the period ranging from two to twenty years.
There are two other terms commonly associated with PFI:

Hypothetical illustration. PFI based on assumptions about uncertain future events and management actions which
have not yet been decided on.

Target. PFI based on assumptions about the future performance of the entity.

Listed companies should have procedures that allow them to generate reliable PFI, compare it to market
expectations, publish it when necessary and subsequently report actual performance against it.

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Prospective Financial Information AAA Revision Notes

Prospective financial information can include financial statements or one or more elements of financial statements
and may be prepared:
(a) As an internal management tool, for example, to assist in evaluating a possible capital investment; or
(b) For distribution to third parties in, for example:
(i) A prospectus to provide potential investors with information about future expectations.
(ii) An annual report to provide information to shareholders, regulatory bodies and other interested
parties.
(iii) A document for the information of lenders which may include, for example, cash flow forecasts.

Matters to consider before accepting the assignment

– The exact components of the prospective financial information
– The form of the assurance report that is required – in an assurance engagement the nature and wording of the
expected opinion should be discussed.
– The intended recipient of the report
– Limiting liability (if applicable)
– Deadlines
– Availability of evidence
– Professional regulation – firm should discuss the kind of procedures that will be undertaken, and confirm that
they will be complying with relevant professional guidance, for example: ISAE 3000 Assurance Engagements
other than Audits or Reviews of Historical Financial Information and ISAE 3400 The Examination of Prospective
Financial Information
– Engagement administration: fee, personnel to be assigned to the assignment, complaints procedure

Matters to consider and include in the term of engagement for prospective financial information
Management’s responsibilities The terms of the engagement should set out management’s responsibilities for
the preparation of the business plan and forecast financial statements, including
all assumptions used, and for providing the auditor with all relevant information
and source data used in developing the assumptions. This is to clarify the roles
and reduce the scope for any misunderstanding.

The intended use of the report This will establish the potential liability to third parties, and help to determine the
, for example, is it intended for need and extent of any liability disclaimer that may be considered necessary.
internal or external use?

The elements to be included in The extent of the review should be agreed. For example, determine whether they
the review and report are being asked to report just on the forecast financial statements. This will help
to determine the scope of the work involved and its complexity.

The period covered by the This should be confirmed when agreeing the terms of the engagement, as
forecasts assumptions become more speculative as the length of the period covered
increases, making it more difficult to substantiate the acceptability of the figures,
and increasing the risk of the engagement.

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Prospective Financial Information AAA Revision Notes

The nature of the assumptions It is crucial to determine the nature of assumptions, especially whether the
used assumptions are based on best estimates or are hypothetical. This is important
because ISAE 3400 The Examination of Prospective Financial Information states
that the auditor should not accept, or should withdraw from, an engagement
when the assumptions are clearly unrealistic or when the auditor believes that the
prospective financial information will be inappropriate for its intended use.

The planned contents of the The engagement letter should confirm the planned elements of the report to be
assurance report issued, to avoid any misunderstanding with management. In particular, it clarify
that their report will contain a statement of negative assurance as to whether the
assumptions provide a reasonable basis for the prospective financial information,
and an opinion as to whether the prospective financial information is properly
prepared on the basis of the assumptions and is presented in accordance with the
relevant financial reporting framework

Level of assurance provided

Prospective financial information is difficult to give assurance about because it is highly subjective and this makes it
a difficult area to examine and report on. Hence the level of assurance provided is negative, as opposed to external
audits, which examine historical financial information, and where the assurance provided is reasonable.

Guidance on reporting on it is given in ISAE 3400 the examination of prospective financial information.
The ISAE suggests that the auditor express an opinion including:
– A statement of negative assurance as to whether the assumptions provide a reasonable basis for the
prospective financial information.
– An opinion as to whether the prospective financial information is properly prepared on the basis of the
assumptions and the relevant reporting framework.
– Appropriate caveats as to the achievability of the forecasts.

Due to the nature of PFI, the audit firm will be unable to conclude on whether the results forecast will be achieved.
Also there may be insufficient evidence available to conclude that the assumptions are free from material
misstatement. Therefore, the audit firm can generally only provide a limited level of assurance.

The audit firm will normally provide negative assurance. This means they will state that "nothing has come to their
attention" which causes them to believe that the assumptions are not a reasonable basis for the forecast.

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Prospective Financial Information AAA Revision Notes

Examination procedures

General:
– The auditor should obtain sufficient appropriate evidence as to whether management's assumptions on which
the PFI is based are not unreasonable.
– The auditor should obtain a sufficient knowledge of the business to be able to evaluate whether the assumptions
are justified.
– The auditor should review whether information is properly prepared on the basis of the assumptions.
– The auditor should review whether the information is properly presented and all material assumptions are
adequately disclosed.
– The auditor should review whether the PFI is prepared on a consistent basis with historical financial statements,
using appropriate accounting policies. The historical information will be used as a yardstick to assess the
assumptions underlying the information.
– Obtain backing schedules for the information, cast and ensure they are numerically accurate. Re‐perform
calculations to confirm the arithmetic accuracy of the forecast financial statements.
– Obtain management representation with regard to the completeness and accuracy of information and
assumptions used. Also this should contain a statement that it is management's responsibility to produce the
information.
– Identify and document internal controls over the process. Consider the role played by the internal audit
department.
– Consider the accuracy of forecasts prepared in prior periods by comparison with actual results and discuss with
management the reasons for any significant variances.
– Perform analytical procedures to assess the reasonableness of the forecast financial statements. For example,
finance charges should increase in line with the additional finance being sought.
– Consider the reasonableness of forecast trends in the light of auditor’s knowledge of business and the current
and forecast economic situation and any other relevant external factors.
– Whether the forecast under review is based on forecasts regularly prepared for the purpose of management or
whether it has been separately and specially prepared for the immediate purpose
– Whether the forecast under review represents the management's best estimate of results which they
reasonably believe can and will be achieved rather than targets which the management have set as desirable
– The extent to which profits are derived from activities having a proven and consistent trend and those of a more
irregular, volatile or unproven nature
– How the forecast takes account of any material extraordinary items and prior year adjustments, their nature,
and how they are presented
– Whether adequate provision is made for foreseeable losses and contingencies and how the forecast takes
account of factors which may cause it to be subject to a high degree of risk, or which may invalidate the
assumptions

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Prospective Financial Information AAA Revision Notes

Specific Matters

The following list of procedures may also be relevant when assessing prospective financial information. The auditor
should undertake the review procedures discussed above in addition to these.

Profit forecasts
**Verify projected income figures to suitable evidence. This may involve:
– Comparison of the basis of projected income to similar existing projects in the firm
– Review of current market prices for that product or service

**Verify projected expenditure figures to suitable evidence. There is likely to be more evidence available about
expenditure in the form of:
– Quotations or estimates provided to the firm
– Current bills for things such as services which can be used to reliably estimate
– Market rate prices, for example, for advertising
– Interest rate assumptions can be compared to the bank's current rates
– Costs such as depreciation should correspond with relevant capital expenditure projections

Capital expenditure
The auditor should check the capital expenditure for reasonableness. For example, if the projection relates to buying
land and developing it, it should include a sum for land.

**Projected costs should be verified to estimates and quotations where possible

**The projections can be reviewed for reasonableness, including a comparison with prevailing market rates where
such information is available (such as for property)

Cash forecasts
**The auditors should review cash forecasts to ensure the timings involved are reasonable.

**The auditor should check the cash forecast for consistency with any profit forecasts (income/expenditure should
be the same, just at different times)

Report on Examination of Prospective Financial Information

The assurance report should make it clear that management is responsible for the PFI and also the assumptions on
which it is based. Given the subjective and speculative nature of the PFI, an opinion cannot be given on whether the
results shown in the report will be achieved, so only negative assurance can be given.

Contents
1. Title and Addressee
2. Identification of the prospective financial information
3. A reference to the ISAE or relevant national standards
4. A statement that management is responsible for the prospective financial information including the
assumptions on which it is based

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Prospective Financial Information AAA Revision Notes

5. When applicable, a reference to the purpose and/or restricted distribution of the prospective financial
information
6. A statement of negative assurance as to whether the assumptions provide a reasonable basis for the
prospective financial information
7. An opinion as to whether the prospective financial information is properly prepared on the basis of the
assumptions and is presented in accordance with the relevant financial reporting framework
8. Appropriate warnings concerning the achievability of the results indicated by the prospective financial
information
9. Date of the report which should be the date procedures have been completed
10. Auditor’s address and Signature.

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Forensic Accounting AAA Revision Notes

Forensic Accounting
Forensic accounting is the term used to describe the type of engagement. It is the whole process of carrying out a
forensic investigation, including preparing an expert’s report or witness statement, and potentially acting as an
expert witness in legal proceedings.

Forensic investigation is a part of a forensic accounting engagement. Forensic investigation is the process of
gathering evidence so that the expert’s report or witness statement can be prepared. It includes forensic auditing,
but incorporates a much broader range of investigative techniques, such as interviewing witnesses and suspects,
imaging or recovering computer files including emails, physical searches of premises etc.

Forensic auditing is the application of traditional auditing procedures and techniques in order to gather evidence as
part of the forensic investigation.

Objectives of a forensic investigation

– The first objective is to decide if a deliberate fraud has actually taken place.
– Secondly, the investigation will aim to discover the perpetrator(s) of the fraud, and ultimately to assist in their
prosecution. The investigation will gather evidence, which may include an interview with the suspected
fraudster, which can then be used in criminal procedures against the individual(s) concerned.
– Thirdly, the investigation should quantify the financial loss

TYPES OF INVESTIGATION
The forensic accountant could be asked to investigate many different types of fraud. It is useful to categorise these
types into three groups to provide an overview of the wide range of investigations that could be carried out. The
three categories of frauds are corruption, asset misappropriation and financial statement fraud.

Corruption

There are three types of corruption fraud: conflicts of interest, bribery, and extortion. Research shows that
corruption is involved in around one third of all frauds.
 In a conflict of interest fraud, the fraudster exerts their influence to achieve a personal gain which detrimentally
affects the company. The fraudster may not benefit financially, but rather receives an undisclosed personal
benefit as a result of the situation. For example, a manager may approve the expenses of an employee who is
also a personal friend in order to maintain that friendship, even if the expenses are inaccurate.
 Bribery is when money (or something else of value) is offered in order to influence a situation.
 Extortion is the opposite of bribery, and happens when money is demanded (rather than offered) in order to
secure a particular outcome.

Asset misappropriation
By far the most common frauds are those involving asset misappropriation, and there are many different types of
fraud which fall into this category. The common feature is the theft of cash or other assets from the company, for
example:
 Cash theft – the stealing of physical cash, for example petty cash, from the premises of a company.

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Forensic Accounting AAA Revision Notes

 Fraudulent disbursements – company funds being used to make fraudulent payments. Common examples
include billing schemes, where payments are made to a fictitious supplier, and payroll schemes, where
payments are made to fictitious employees (often known as ‘ghost employees’).
 Inventory frauds – the theft of inventory from the company.
 Misuse of assets – employees using company assets for their own personal interest.

Financial statement fraud

This is also known as fraudulent financial reporting, and is a type of fraud that causes a material misstatement in the
financial statements. It can include deliberate falsification of accounting records; omission of transactions, balances
or disclosures from the financial statements; or the misapplication of financial reporting standards. This is often
carried out with the intention of presenting the financial statements with a particular bias, for example concealing
liabilities in order to improve any analysis of liquidity and gearing.

Forensic accounting engagements are agreed‐upon procedures engagements, not assurance engagements. The
forensic accountant will not provide an assurance opinion – that is the role of the auditor when reviewing the
amount of loss included in the financial statements.

This will normally involve determining an appropriate value or quantifying a loss as discussed above; this is quite
distinct from an assurance engagement in which the engagement team would review an amount determined by
the client.

As an agreed‐upon procedures engagement, the forensic accountant will normally prepare a report for the client
that sets out their findings, based on the scope agreed in the engagement letter. This report may be addressed
to management, often in the case of a fraud, or to the insurer.

It may be that a witness statement/report for submission to the court/arbitrator is required in addition to or
instead of a report to the client.

Stages Involved

Accepting the The forensic accountant must initially consider whether their firm has the necessary skills and
investigation experience to accept the work. Forensic investigations are specialist in nature, and the work
requires detailed knowledge of fraud investigation techniques and the legal framework.
Investigators must also have received training in interview and interrogation techniques, and
in how to maintain the safe custody of evidence gathered.

Additional considerations include whether or not the investigation is being requested by an

audit client. If it is, this poses extra ethical questions, as the investigating firm would be
potentially exposed to self‐review, advocacy and management threats to objectivity. Unless
robust safeguards are put in place, the firm should not provide audit and forensic investigation
services to the same client.

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Forensic Accounting AAA Revision Notes

Commercial considerations are also important, and a high fee level should be negotiated to
compensate for the specialist nature of the work, and the likely involvement of senior and
experienced members of the firm in the investigation.
Planning the Planning will commence with a meeting with the client in which the engagement team will
investigation develop an understanding of the issue/events (the fraud, theft etc) and actions taken by the
client since it occurred.

A key part of planning is to confirm exactly what format the output is required in, and exactly
what matters are required to be covered within it.

At this stage any key documentation will be obtained and scrutinised – for example, the
insurance policy, the partnership agreement, the evidence that led to the discovery of the
fraud, etc.

The team will agree with the client, what access to other information or personnel will be
required and this will be arranged.

Based on the above, the team will design procedures that enable them to meet the
requirements of the client, as agreed. This may or may not include test of controls, depending
on the circumstances. There would be no need to tests control when valuing a business for a
matrimonial dispute. However, testing controls will be key to determining how a fraud took
place.

The investigating team must carefully consider what they have been asked to achieve and plan
their work accordingly. The objectives of the investigation could include:
– Identifying the type of fraud, its duration, and how it was committed
– Identifying the parties involved in the fraud
– Quantifying the financial loss suffered due to the fraud
– Gathering evidence to be used in court proceedings
– Providing recommendations to avoid the recurrence of the fraud

The investigators should also consider the best way to gather evidence – the use of computer
assisted audit techniques, for example, is very common in fraud investigations.
Gathering Forensic engagements will include a detailed and wholesale review of all documentation and
evidence electronic evidence available. The opinion given by the expert accountant must be reasoned,
and backed up by evidence. Their opinion cannot be objective if only based on what they are
told; they must corroborate that information.

To be awarded marks in the exam, your procedures cannot be vague. They must be specific
enough that the engagement team could actually follow your instructions.

For example, it would not be sufficient to write 'interview the suspect'. You must suggest
questions that should be asked of the suspect in interview, depending on the circumstances in
the scenario. For example, the suspect could be asked to explain their job role and what access
that gives them to systems, cash, inventory etc.

pg. 249
Forensic Accounting AAA Revision Notes

This also applies when recommending enquires of or discussions with management – it must
be clear in your answer what it is the engagement team should ask of them, eg have they
informed the police, has the suspect been suspended, have they informed the insurer etc.

Equally it is not sufficient to suggest the use of computer assisted auditing techniques (CAATs).
You must specify how the CAATs could be used. For example, data matching bank accounts
used for paying suppliers with bank accounts for paying employees, exception reports
identifying employees who are not taking holiday, etc.

In order to design appropriate procedures you must identify the type of forensic accounting
engagement, and the specific type of fraud, insurance or negligence claim. For example,
quantifying the theft of goods will be very different from quantifying a loss from payroll or
‘ghost employee’ fraud or loss of profits following a business interruption (as discussed above).

In order to gather detailed evidence, the investigator must understand the specific type of fraud
that has been carried out, and how the fraud has been committed. The evidence should be
sufficient to ultimately prove the identity of the fraudster(s), the mechanics of the fraud
scheme, and the amount of financial loss suffered. It is important that the investigating team
is skilled in collecting evidence that can be used in a court case, and in keeping a clear chain of
custody until the evidence is presented in court.

If any evidence is inconclusive or there are gaps in the chain of custody, then the evidence may
be challenged in court, or even become inadmissible. Investigators must be alert to documents
being falsified, damaged or destroyed by the suspect(s).

Evidence can be gathered using various techniques, such as:

 Testing controls to gather evidence which identifies the weaknesses, which allowed the
fraud to be perpetrated
 Using analytical procedures to compare trends over time or to provide comparatives
between different segments of the business
 Applying computer assisted audit techniques, for example to identify the timing and
location of relevant details being altered in the computer system
 Discussions and interviews with employees
 Substantive techniques such as reconciliations, cash counts and reviews of documentation

The ultimate goal of the forensic investigation team is to obtain a confession by the fraudster,
if a fraud did actually occur. For this reason, the investigators are likely to avoid deliberately
confronting the alleged fraudster(s) until they have gathered sufficient evidence to extract a
confession. The interview with the suspect is a crucial part of evidence gathered during the
investigation.

With reference to court proceedings (see below) evidence may also be gathered to support
other issues which would be relevant in the event of a court case. Such issues could include:
 The suspect’s motive and opportunity to commit fraud
 Whether the fraud involved collusion between several suspects

pg. 250
Forensic Accounting AAA Revision Notes

 Any physical evidence at the scene of the crime or contained in documents

 Comments made by the suspect during interviews and/or at the time of arrest
 Attempts to destroy evidence.

Audit procedures examples‐to be read NOT learnt!

The specific procedures which would be performed as part of a forensic audit will depend on
the specific nature of the investigation. However, using a fraud investigation as an example,
the following would normally apply.
 Develop a profile of the entity under investigation including its personnel
 Identify weaknesses in internal control procedures and basic record keeping, e.g. banker
conciliations not performed
 Perform trend analysis and analytical procedures to identify significant transactions and
significant variations from the norm
 Identify changes in patterns of purchases/sales, particularly where a limited number of
suppliers/customers are involved
 Identify significant variations in consumption of raw materials and consumables,
particularly where consumption appears excessive
 Identify unusual accounts and account balances, e.g. closing credit balances on debit
accounts and vice versa
 Review accounting records for unusual transactions and entries, e.g. large numbers of
accounting entries between accounts, transactions not executed at normal commercial
rates
 Review transaction documentation (e.g. invoices) for discrepancies and inconsistencies
 Once identified trace the individual responsible for fraudulent transactions
 Obtain information regarding all responsibilities of the individual involved
 Inspect and review all other transactions conducted by the individual of a similar nature
 Consider all other aspects of the business which the individual is involved with and
perform further analytical procedures targeting these areas to identify any additional
discrepancies

Reporting The client will expect a report containing the findings of the investigation, including a summary
of evidence and a conclusion as to the amount of loss suffered as a result of the fraud. The
report will also discuss how the fraudster set up the fraud scheme, and which controls, if any,
were circumvented. It is also likely that the investigative team will recommend improvements
to controls within the organization to prevent any similar frauds occurring in the future

Court The investigation is likely to lead to legal proceedings against the suspect, and members of the
proceedings investigative team will probably be involved in any resultant court case. The evidence gathered
during the investigation will be presented at court, and team members may be called to court
to describe the evidence they have gathered and to explain how the suspect was identified. It
is imperative that the members of the investigative team called to court can present their
evidence clearly and professionally, as they may have to simplify complex accounting issues so
that non‐accountants involved in the court case can understand the evidence and its
implications.

pg. 251
Forensic Accounting AAA Revision Notes

THE ROLE OF AN EXPERT WITNESS

An expert witness is quite different to any other witness in court proceedings. Most witnesses
are 'witnesses of fact', ie they can only provide evidence on what they saw, did or heard. Most
importantly, they cannot give their opinion on any of the matters about which they give
evidence. By contrast, an expert witness is specifically called to give their opinion on a
particular matter.

An accountant can be called to give evidence as a professional witness, ie a witness of fact, or

an expert witness. In order to give evidence as an expert witness they must be just that, an
expert. They must be able to demonstrate a level of expertise that means their opinion is
valuable to the court. This means not only expertise in accountancy, but also expertise in the
particular area of accountancy that they are giving evidence on.

A witness will provide a written report/statement to the court, and may also be required to
attend court to give live evidence, in person, and be cross‐examined by the ‘other side’.

However, not all forensic engagements will require evidence to be submitted to a court. Often,
the engagement will simply require a report for the client’s own purposes or sometimes a
report for use by the insurer.

Either way, a key skill necessary in being a successful forensic accountant is the ability to
explain complex accounting concepts in simple terms to someone who is not themselves an
accountant, whether that be as an expert witness explaining matters to the judge or jury, or
when explaining matters to the client. Forensic accounting integrates investigative,
accountancy, and communication skills.

Following are some of the main duties of the forensic accountant as an expert witness:
1. To exercise reasonable skill and care in helping the court on matters within their expertise
2. To comply with any relevant code of ethics, Civil Procedure Rules and court orders
3. To provide assistance so as to enable the court to deal with cases in accordance with the
overriding objective. However, such overriding duty does not mean that experts should
act as mediators between the parties or intrude upon the role of the court in deciding
facts.
4. To provide an independent opinion that is free from any litigation pressures. The forensic
accountant should neither engage in the role of an advocate nor promote the viewpoint
of the party by whom he is paid.

If any matters fall outside the purview of an expert’s expertise, he should disclose such matters
without delay and refrain from providing an opinion in relation to such matters.

pg. 252
Forensic Accounting AAA Revision Notes

How is a forensic investigation different from an audit?

Whilst many of the techniques used in a forensic investigation will be similar to those used in an audit the different
objectives and risks involved will require some differences in approach.

Materiality In many investigations there will be no materiality threshold.

Timing Clearly less predictable than audit

Timing of procedures needs to be unpredictable

Documentation Needs to be reviewed more critically than on an audit

The example in this section shows what an experienced fraud investigator might identify in
a fraudulent invoice.

Interviews It may be appropriate to interview a suspected fraudster in the hope of obtaining an

admission but this entails some problems:
 Challenging and requires a high skill level
 Legal issues including the risk of being sued for defamation

Computer‐aided Data mining is a key part of many investigation processes. It allows the accountant to access
techniques and analyse thousands or millions of transactions that have passed through an accounting
system, and identify, say. Unusual trends far more quickly than by traditional documentary
analysis.100% of an entity's transactions can be checked for characteristics such as date.
Time, amount, approval, payee etc. If possible, data should be gathered prior to the initial
field visit to reduce the risk of the data being compromised.

Application of ethical principles to a fraud investigation

IFAC’s Code of Ethics for Professional Accountants applies to all ACCA members involved in professional assignments,
including forensic investigations. There are specific considerations in the application of each of the principles in
providing such a service.

Integrity
The forensic investigator is likely to deal frequently with individuals who lack integrity, are dishonest, and attempt
to conceal the true facts from the investigator. It is imperative that the investigator recognises this, and acts with
impeccable integrity throughout the whole investigation.

Objectivity
As in an audit engagement, the investigator’s objectivity must be beyond question. The report that is the outcome
of the forensic investigation must be perceived as independent, as it forms part of the legal evidence presented at
court. The investigator must adhere to the concept that the overriding objective of court proceedings is to deal with
cases fairly and justly.
Any real or perceived threats to objectivity could undermine the credibility of the evidence provided by the
investigator.

This issue poses a particular problem where an audit client requests its auditors to conduct a forensic investigation.
In this situation, the audit firm would be exposed to threats to objectivity in terms of advocacy, management
involvement and self‐review.

pg. 253
Forensic Accounting AAA Revision Notes

The advocacy threat arises because the audit firm may feel pressured into promoting the interests and point of view
of their client, which would breach the overriding issue of objectivity in court proceedings. Secondly, the
investigators could be perceived to be involved in management decisions regarding the implications of the fraud,
especially where the investigator acts as an expert witness. It is however the self‐review threat that would be the
most significant threat to objectivity. The self‐review threat arises because the investigation is likely to involve the
estimation of an amount (i.e. the loss), which could be material to the financial statements.

For the reasons outlined above, The Code states that the firm should evaluate threats and put appropriate safeguards
in place, and if safeguards cannot reduce the threats to an acceptable level, then the firm cannot provide both the
audit service and the forensic investigation.

Professional competence and due care

Forensic investigations will involve very specialist skills, which accountants are unlikely to possess without extensive
training.

Such skills would include:

– Detailed knowledge of the relevant legal framework surrounding fraud,
– An understanding of how to gather specialist evidence,
– Skills in the safe custody of evidence, including maintaining a clear ‘chain’ of evidence, and
– Strong personal skills in, for example, interview techniques, presentation of material at court, and tactful dealing
with difficult and stressful situations.

It is therefore essential that forensic work is only ever undertaken by highly skilled individuals, under the direction
and supervision of an experienced fraud investigator. Any doubt over the competence of the investigation team
could severely undermine the credibility of the evidence presented at court.

Confidentiality
Normally accountants should not disclose information without the explicit consent of their client. However, during
legal proceedings arising from a fraud investigation, the court will require the investigator to reveal information
discovered during the investigation. There is an overriding requirement for the investigator to disclose all of the
information deemed necessary by the court.

Outside of the court, the investigator must ensure faultless confidentiality, especially because much of the
information they have access to will be highly sensitive.

Professional behaviour
Fraud investigations can become a matter of public interest, and much media attention is often focused on the work
of the forensic investigator. A highly professional attitude must be displayed at all times, in order to avoid damage
to the reputation of the firm, and of the profession. Any lapse in professional behaviour could also undermine the
integrity of the forensic evidence, and of the credibility of the investigator, especially when acting in the capacity of
expert witness.

During legal proceedings, the forensic investigator may be involved in discussions with both sides in the court case,
and here it is essential that a courteous and considerate attitude is presented to all parties.

pg. 254
Forensic Accounting AAA Revision Notes

Forensic audit and accounting is a rapidly‐growing area. The major accountancy firms all offer forensic services, as
do a number of specialist companies. The demand for these services arises partly from the increased expectation of
corporate governance codes for:
 Company directors to take seriously their responsibilities for the prevention and detection of fraud, and also
from
 Governments concerned about risks arising from criminal funding of terrorist groups.

pg. 255
Audit of Performance Information AAA Revision Notes

Audit of Performance Information in the Public Sector

‐ Performance measures should be:
 Measurable
 Should have a good system to generate performance info ( completeness and accuracy of data ensured)
 Consistency in how information captured
 Consistency in how information reported
 Measures should be clearly defined
 Some measures might be more subjective if cannot measure precisely (for e.g. customer satisfaction)

 Relevant
 Should address a valid concern
 Specific info needs of stakeholders

 Comparable (with other similar origanisations)

 Reliable
 Sample or 100%?
 Source and how info was generated‐ Internal control over this procedure

AAA‐ the thought process

The auditor is still looking to ultimately report on the validity of the information included regarding the entity’s
performance.
Step 1: List of performance measures
Step 2: Are the measures comparable, relevant, reliable, and measureable?
Step 3: Evaluate internal control over capturing and reporting this performance information
Step 4: Verify the measure

Reporting
- No specific format or wording.
- Generally, the auditor will provide a conclusion on whether the public sector entity has achieved its objectives
as shown by the reported performance information and concludes on the information itself.
- The auditor will agree the type of conclusion with the public sector organisation and usually its regulating body.

Often the performance information will be provided as part of the public sector organisation’s integrated report, in
which case the auditor’s conclusion will be included within the integrated report.

pg. 256
Audit of Performance Information AAA Revision Notes

Technical Article: Performance Information in the Public Sector

The syllabus and study guide for THE ADVANCED AUDIT & ASSURANCE EXAM (INT), Advanced Audit and
Assurance (and SGP adapted paper) includes a section entitled ‘The audit of performance information (pre‐
determined objectives) in the public sector’. This article is intended to provide insight into this syllabus area and
explain some of the issues of which candidates should be aware when studying this aspect of the syllabus.

BACKGROUND
While the specifics will vary from country to country, in general public sector organisations are funded wholly or
partly by the government, and in turn by the tax payers in a particular jurisdiction. Public sector organisations may
include hospitals and other health care facilities such as ambulance services, schools and universities, the police
force and organisations responsible for public transport and the road network. In some cases, such as the UK
university sector, organisations do charge for services provided but still rely on government funding to support their
activities.

The government as well as other stakeholders will pay close attention to the performance of these organisations to
evaluate whether public funds are being used appropriately. The organisations should aim to demonstrate that
public monies allocated to them are being used effectively, that specific targets are being met, and that appropriate
decisions are being made in respect of long term planning. Essentially the management and those charged with
governance of a public sector organisation need to show that the organisation is meeting its objectives and
performing its role in society, and performance information is likely to be required in order for this to be
demonstrated. If a public sector organisation is not performing well then its funding may be cut and its management
may be replaced; in extreme situations the organisation may even be shut down.

This is supported by guidance issued by the public sector board of IFAC which notes that the primary function of
governments and most public sector entities is to provide services to constituents. Consequently, their financial
results need to be assessed in the context of the achievement of service delivery objectives. Reporting non‐financial
as well as financial information about service delivery activities, achievements and/or outcomes during the reporting
period is necessary for a government or other public sector entity to discharge its obligation to be accountable.

An example of how this is implemented is given below, taken from the UK’s National Health Service (NHS) website:

In the NHS, performance monitoring should:

 help to define performance targets/goals across the key aspects of service delivery, including management of
resources (personnel, infrastructure), customer service and financial viability
 provide a comprehensive picture of the organisation's progress towards achieving its performance targets/goals
 provide an early indication of emerging issues/cost pressures that may require remedial action
 indicate where there is potential to improve the cost effectiveness of services through comparison with other
organisations

Source: www.institute.nhs.uk/quality_and_service_improvement_tools/

pg. 257
Audit of Performance Information AAA Revision Notes

MEASURING PERFORMANCE INFORMATION

Candidates will be familiar with the concept of Key Performance Indicators (KPIs) which are widely used by private
sector organisations in relation to non‐financial information such as social and environmental reporting; there have
been several examination requirements in past THE ADVANCED AUDIT & ASSURANCE EXAM exams focusing on this
syllabus area. In the public sector the same principles apply in that target KPIs will be established as a performance
objective and the organisation’s performance against the target KPIs will be measured.

Performance measures should be measurable and relevant if they are to be effective. Measurability means trying to
ensure that there is consistency in how performance information is captured and reported. The measures should be
clearly defined and unambiguous, but measurability is sometimes difficult where the subject matter of the
performance information is subjective in nature. For example for an ambulance service it would be quite easy to
measure the average time taken for an ambulance to respond to an emergency as this is quantifiable, but more
difficult to measure the patient’s satisfaction with the service provided as this is based on the patient’s opinion.
An issue linked to measurability is the existence of data to generate the performance information. Much of the work
involved in setting up a good system for reporting on performance information is focussed on ensuring the
completeness and accuracy of supporting information and that the information is sufficiently robust to withstand
scrutiny.

Relevance means that the performance information addresses a valid concern and public sector organisations should
consider the specific needs of their stakeholders in developing relevant performance measures. Continuing to using
the UK’s NHS as an example, identified stakeholders who regularly review the NHS performance information include:
 The government department responsible for health services
 Medical staff
 NHS management team and non‐executive committee members
 Patients
 Private companies who supply to the NHS
 Academics and students researching the NHS

The NHS therefore has to produce a range of performance measures relevant to the needs of this wide range of
stakeholders. Different stakeholders have different needs, for example patients may focus on the effectiveness of a
certain medical procedure, whereas management may focus on the cost of providing that procedure. Therefore a
very wide range of performance information may be required yet it would be pointless to set targets and produce
performance information on an issue which is not relevant to any stakeholder.

THE AUDIT OF PERFORMANCE INFORMATION

It is worth reiterating the difference between the audit of performance information and performance auditing as
both are likely to occur in the public sector. Candidates are reminded that the audit of performance information is
concerned with the audit of reported performance information against predetermined objectives. The auditor’s role
here is usually to report on the credibility, usefulness and accuracy of the reported performance. Performance
auditing is related to the evaluation of how the public sector body is utilising resources and often focuses on
determining how the public sector body is achieving economy, efficiency and effectiveness, sometimes referred to
as value for money auditing. It is the former that is the focus of this area of the THE ADVANCED AUDIT & ASSURANCE
EXAM syllabus.

pg. 258
Audit of Performance Information AAA Revision Notes

In some jurisdictions it is part of the audit requirement for public sector organisations that the auditor should report
on performance information. In jurisdictions where this is not a requirement, the auditor may be asked to perform
a separate engagement to the financial statement audit, the objective of which is to report specifically on the
performance information. In either case, the auditor will need to plan procedures in much the same way as in a
conventional audit scenario. Candidates are therefore encouraged to apply their existing knowledge of audit
planning (risk assessment) and evidence gathering techniques to this type of information. The auditor is still looking
to ultimately report on the validity of the information included in this respect. The auditor may find the principles of
ISAE 3000 Assurance Engagements other than Audits or Reviews of Historical Financial Information provide a useful
framework for planning and performing the work on performance information.

As with any engagement to provide assurance, this would likely start with an understanding of the entity to ensure
knowledge of the predetermined performance measures, an evaluation of the systems and controls used to derive
and capture the performance information and also performing substantive procedures on the reported measures.
The auditor will also need to understand the rationale behind the measures that are being reported on, considering
the relevance and suitability of them in terms of the objectives of the public sector organisation in order to help
assess the usefulness of the information being provided.

Audit procedures may include:

 Tests of controls on the systems used to generate performance information
 Performing analytical review to evaluate trends and gauge the consistency of the information
 Discussion with management and other relevant individuals, for example those responsible for the reporting
process
 Review of minutes of meetings where performance information has been discussed
 Confirmation of performance information to source documentation; this may be performed on a sample basis
 Recalculation of quantitative performance information measures

Of course, the procedures must be specifically tailored to the performance information subject to the audit. Further
as in any audit, the working papers must contain a summary of findings and clear conclusions on the procedures that
have been performed.

Important characteristics of useful performance information

‐ Relevant to the needs of stakeholders

‐ Comparable to measures of other similar organisations
‐ Measurable: some measure may be more subjective than others. Being subjective means they cannot be
measured precisely and involve judgment.
‐ Reliable: the quality of information needs to be considered (this includes the source of information, internal
control over the process of generating information etc.)

pg. 259
Audit of Performance Information AAA Revision Notes

REPORTING ON PERFORMANCE INFORMATION

There is no specific format or wording that is prescribed by international regulations for reporting on public sector
performance information, though in some jurisdictions the national regulators may issue country‐specific
requirements.

Generally, the auditor will provide a conclusion on whether the public sector entity has achieved its objectives as
shown by the reported performance information and concludes on the information itself. This conclusion may be in
the form of a reasonable assurance conclusion – ie an opinion is expressed, or may be in the form of a negative
assurance conclusion – ie no opinion is expressed. Essentially, in the absence of any jurisdiction specific
requirements, the auditor will agree the type of conclusion with the public sector organisation and usually its
regulating body.

Often the performance information will be provided as part of the public sector organisation’s integrated report, in
which case the auditor’s conclusion will be included within the integrated report.

CONCLUSION
The audit of performance information in public sector organisations can be approached in a similar way to the audit
of KPIs in private sector organisations, and conventional audit techniques can be employed, though they will need
to be tailored to the specific measures that are subject to audit. In approaching scenarios based on this syllabus area,
candidates are encouraged to apply their understanding of audit techniques to the specific information in the
question and to avoid vague and unfocussed remarks.
Written by a member of the THE ADVANCED AUDIT & ASSURANCE EXAM examining team

pg. 260
Social & Environmental Issues AAA Revision Notes

Social and Environmental Issues

BASIC OVERVIEW
Over the past 20 years, there has been a rapid growth in companies:
– Accepting that they have some responsibility for the social and environmental impacts of their operations
– Reporting social and environmental performance, both using narrative and data.

As such, a company may make statements in their Annual Report (e.g. that their operations are based on
sustainability) and provide performance data that shareholders and other stakeholders may want someone to
check, and issue an opinion on. Whilst this “audit” work is not the same as an audit of financial information, and
is likely to be carried out by specialists, many accountancy firms provide such services.

Procedures may include:

– Advising the company on the key performance indicators (“metrics”) to present
– Checking these statistics using available evidence and typical audit procedures
– Reading board minutes to verify stated policies are true
– Assessing whether related costs (e.g. clean‐up, alteration of an asset to make it more environmentally sound,
development of “greener” products) are expense or asset in nature
– Assessing environmental provisions and contingencies for accuracy
– Assessing whether new environmental regulations (or social expectations) mean that some assets have been
impaired
– Assessing the impact of social and environmental matters on the future viability of the company.

IMPORTANT TERMS:

ENVIRONMENTAL AUDIT: WHAT?

An environmental audit, and the production of an environmental report, enables an organization to demonstrate its
responsiveness to all the sources of concern outlined above. Except in some highly regulated situations (such as
water), the production of an environmental audit is voluntary. The production of such a report, however, ensures
that an organization has systems in place for the collection of data that can also be used in its environmental
reporting.

An environmental audit typically contains three elements:

1. Agreed metrics (what should be measured and how),
2. Performance measured against those metrics, and
3. Reporting on the levels of compliance or variance.

The problem, however, and the subject of most debate, is what to measure and how to measure it. As an
environmental audit isn’t compulsory, there are no mandatory audit standards and no compulsory auditable
activities. So an organization can engage with a social and environmental audit at any level it chooses (excepting
those in regulated industries for which it is mandatory). Frameworks do exist, such as the data‐gathering tools for
the Global Reporting Initiative (GRI), AA1000, and the ISO 14000 collection of standards, but essentially there is no
underpinning compulsion to any of it.

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Social & Environmental Issues AAA Revision Notes

In practice, the metrics used in an environmental audit tend to be context specific and somewhat contested. Typical
measures, however, include measures of emissions (e.g. pollution, waste and greenhouse gases) and consumption
(e.g. of energy, water, non‐renewable feed stocks).

Together, these comprise the organization’s environmental footprint. Some organizations have a very large
footprint, producing substantial emissions and consuming high levels of energy and feed stocks, while others have
a lower footprint. One of the assumptions of environmental management is that the reduction of footprint is
desirable, or possibly of ‘unit footprint’: the footprint attributable to each unit of output. If a target is set for each of
these then clearly a variance can be calculated against the target. Some organizations report this data – others do
not. It is this ability to pick and choose that makes voluntary adoption so controversial in some circles.

A recent trend, however, is to adopt a more quantitative approach to the social and environmental audit. The data
gathered from the audit enables metrics to be reported against target or trend (or both). It is generally agreed that
this level of detail in the report helps readers better understand the environmental performance of organizations.

An environmental management system (EMS) is a system for managing an organization’s overall risk associated
with its environment, encompassing the organizational elements, the planning and the resources involved in
developing, implementing and maintaining the organization’s policy in this area.

Environmental Issues and External Auditors

Environmental issues cannot be ignored by external auditors. Potential impacts on the financial statements may
arise from:
(a) The application of environmental laws and regulations;
(b) The operation of processes that may cause pollution or the use of hazardous substances;
(c) The holding of an interest in land and buildings that have been contaminated by previous occupants; or
(d) Dependence on a major customer segment whose business is threatened by environmental pressures.

Substantive procedures‐DETAILS
The auditor may perform substantive testing to obtain evidence in relation to environmental matters. Below are
some suggested procedures from IAPS 1010 the Consideration of environmental matters in the audit of financial
statements. It is not intended that all of the procedures will be appropriate in any particular case. In many cases, the
auditor may judge it unnecessary to perform any of these procedures.

General: Documentary review

1. Consider minutes from meetings of directors, audit committees, or any other subcommittees of the board
specifically responsible for environmental matters.
2. Consider publicly available information regarding any existing or possible future environmental matters.
3. Where relevant, consider:
(a) Reports by environmental experts about the entity, such as site assessments, due diligence investigations
or environmental impact studies;
(b) Internal audit reports and other internal reports dealing with environmental matters;
(c) Reports issued by, and correspondence with, regulatory and enforcement agencies;
(d) Publicly available registers or plans for the restoration of soil contamination;
(e) Environmental performance reports issued by the entity; and
(f) Correspondence with the entity's lawyers.

pg. 262
Social & Environmental Issues AAA Revision Notes

4. Obtain written representations from management that it has considered the effects of environmental matters
on the financial statements, and that it:
(a) Is not aware of any material liabilities or contingencies arising from environmental matters, including those
resulting from illegal or possibly illegal acts;
(b) Is not aware of environmental matters that may result in a material impairment of assets; or
(c) If aware of such matters, has disclosed to the auditor all related facts.

Assets: Asset impairment

Enquire about any planned changes in capital assets, for example, in response to changes in environmental
legislation or changes in business strategy and their impact on the valuation of those assets or the company as
a whole.

For any asset impairments related to environmental matters that existed in previous periods, consider whether
the assumptions underlying a write‐down or related carrying values continue to be appropriate.

Liabilities, provisions and contingencies: Completeness

Enquire about policies and procedures operated to identify liabilities, provisions or contingencies arising from
environmental matters.

Enquire about events or conditions that may give rise to liabilities, provisions or contingencies arising from
environmental matters, for example
‐ Penalties or possible penalties arising from breaches of environmental laws and regulations; or
‐ Claims or possible claims for environmental damage.

For property abandoned, purchased, or closed during the period, enquire about requirements or intentions for
site clean‐up and restoration.

For property sold during the period and in prior periods, enquire about any liabilities relating to environmental
matters retained by contract or by law.

Accounting estimates
For liabilities, provisions, or contingencies related to environmental matters, consider whether the assumptions
underlying the estimates continue to be appropriate.

Disclosure: Review the adequacy of any disclosure of the effects of environmental matters on the financial
statements.

Measuring and reporting on social and environmental performance

Many companies attempt to measure social and environmental performance by setting targets or key performance
indicators (KPIs), and then evaluating whether they have been met. The results are often published to enable a
comparison to be made year on year or between companies. But it can be difficult to measure social and
environmental performance for a number of reasons.

First, targets and KPIs are not always precisely defined. For example, Osprey Co may state a target of reducing
environmental damage caused by its operations, but this is very vague. It is difficult to measure and compare

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Social & Environmental Issues AAA Revision Notes

performance unless a target or KPI is made more specific, for example, a target of reducing electricity consumption
by 5% per annum.

Second, targets and KPIs may be difficult or impossible to quantify, with Osprey Co’s planned KPI on employee
satisfaction being a good example. This is a very subjective matter, and while there are methods that can be used to
gauge the levels of employee satisfaction, whether this can result in a meaningful statistic is questionable.

Third, systems and controls are often not established well enough to allow accurate measurement, and the
measurement of socio‐environmental matters may not be based on reliable evidence. In Osprey Co’s case, it may
not be possible to quantify how much toxic chemical has been leaked from the factory.

Finally, it is hard to compare these targets and KPIs between companies, as they are not strictly defined, so each
company will set its own target. It will also be difficult to make year on year comparisons for the same company, as
targets may change in response to business activities. For example, if Osprey Co were to expand its operating, its
energy and water use would increase, making its performance on environmental matters look worse. Users would
need to understand the context in order to properly appraise why a target had not been met.

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Impact of Big Data & Data Analytics AAA Revision Notes

Impact of Big Data and Data Analytics on Audit

Big data‐ a simple explanation
Big data refers to our ability to collect and analyze the vast amounts of data we are now generating in the world.
Take this business example: Wal‐Mart is able to take data from your past buying patterns, their internal stock
information, your mobile phone location data, social media as well as external weather information and analyze all
of this in seconds so it can send you a voucher for a BBQ cleaner to your phone – but only if you own a barbeque,
the weather is nice and you currently are within a 3 miles radius of a Wal‐Mart store that has the BBQ cleaner in
stock. That's scary stuff, but one step at a time, let's first look at why we have so much more data than ever before.
In the world of ‘Big Data’ we talk about the 4 Vs that characterize big data:
Volume – the vast amounts of data generated every second

Velocity – the speed at which new data is generated and moves around (credit card fraud detection is good example
where millions of transactions are checked for unusual patterns in almost real time)

Variety – the increasingly different types of data (from financial data to social media feeds, from photos to sensor
data, from video capture to voice recordings)

Veracity – the messiness of the data (just think of Twitter posts with hash tags, abbreviations, typos and colloquial
speech)

Use of data analytics in external audit

Use and challenges

Data analytics (DA) is the process of examining data sets in order to draw conclusions about the information they
contain, increasingly with the aid of specialized systems and software.

With the increasing volume of data in business today, data analytics can be used as an audit technique to better
understand and analyze large volumes of data. Equipped with a more in‐depth knowledge of the entity’s business,
the auditor is able to focus on items of greater audit interest.

The International Auditing and Assurance Standards Board (IAASB) is currently evaluating whether and to what
extent data analytics should be integrated into the ISAs

Data analytics enhances audit quality because the population tested is larger with the objective that 100 % of the
data is screened. As a result, auditors can generally derive a combination of quality and value from its use

Data analytics provide an opportunity to maximize the effectiveness of the human element.

For example, technology solutions can reduce the amount of time dedicated to manual analysis, allowing more time
to be spent by the auditor on the more judgmental aspects of an analysis.

Data analytics increases the automation in the audit process which allows the auditor to increase his focus on the
more fundamental audit procedures and the more complex and risky areas of audit.

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Impact of Big Data & Data Analytics AAA Revision Notes

The application of professional skepticism and professional judgment is improved when the auditor has a robust
understanding of the entity and its increasingly complex and high‐volume data environment.

This enhances the quality of the auditor’s risk assessment and response.

Data analytics presents an opportunity for more valuable and informed engagement and dialogue with those charged
with governance within the audited entity.

While the benefits are clear, data analytics also means new challenges.

The analytic techniques should be embedded in the audit approach but testing large populations often generates a
high number of exceptions. What is the audit conclusion in case of numerous exceptions?

Also the “acquisition” of data can take significant time for the audit team. The information delivered by the client
should be in a format that can be used by the auditor and this is not always obvious. The fragmentation of the ERP
systems market is also a hurdle: the format of information can be different from system to system.

At different stages of audit

Data analytics can be applied throughout the phases of the audit, including:
• Plan the audit.
• Perform tests of operating effectiveness of control.
• Perform substantive procedures.
• Evaluate results.

Data analytics can either be exploratory (plan the audit) or used to perform further audit procedures (i.e., tests of
controls and substantive procedures).

Exploratory data analysis (EDA) is an approach to analyzing data sets to summarize their main characteristics, often
with visual methods. The auditor does a first and general analysis of the information of the data in order to get
preliminary insights about the data. It can be used in the planning phase and during the risk analysis. It starts with
looking at the data and asking questions such as:
• What does the data indicate?
• Does the data suggest something might have gone wrong?
• Where do the risks appear to be?
• Are there potential fraud indicators?
• What assertions should we focus on?
• What models and approaches appear to be optimal for analytical procedures?

Exploratory data analytics are generally used when performing risk assessment procedures, including:
• Understanding the entity and its environment.
• Identifying and assessing the risks of material misstatement.
• Designing further audit procedures that are tailored to the risks identified.

Population analysis can also be performed through data analytics. It can help the auditor design tailored audit
procedures by providing general information about a population (e.g., total distribution of debits/credits, amounts,
volume, and timing of transactions) based on common fields in the general ledger

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Impact of Big Data & Data Analytics AAA Revision Notes

Depending on types of statistics, this insight can be used for enhanced risk assessment. It can also be used prior to
the performance of the further audit procedures when we have obtained the population and want to enhance the
auditor’s understanding of the population

Implementation of audit approach

When using data analytics to perform audit procedures, the techniques are more structured than exploratory data
analytics and tend to be more mathematical and analytical (e.g., regression analysis).

Using data analytics to perform audit procedures can provide the auditor with sufficient appropriate audit evidence
regarding the assessed risks. The following types of procedures could be supported by data analytics:
• Tests of controls.
• Tests of details.
• Substantive analytical procedures.

TOCs
Inspection or re‐performance of controls — Data analytics may be used to test the operating effectiveness of
controls through inspection of the data for evidence of the control operating as designed. In some circumstances,
data analytics can also re‐perform the control activity itself.

Test of details
Recalculations — Data analytics can be used to perform a recalculation of an entire population as opposed to only
a sample of items.

Reconciliations and Roll forwards — Data analytics can be used to compare and agree information from multiple
sets of data, or to roll forward data from one period to the next

Substantive analytical procedures

Regression Analysis — Data analytics can be used to analyze the relationships between variables in the data to
identify differences between recorded amounts and our established expectations that may warrant further
investigation

Other areas
Automation of Manual Procedures — Data analytics may be used to perform time‐consuming and often tedious
manual audit procedures.

Journal Entry Testing to Address the Risk of Management Override of Controls — Data analytics are often used for
testing journal entries to address the risk of management override of controls through the use of an electronic
approach.

Evaluation of misstatements
An audit allows the auditor to express an opinion about whether the financial statements are free of material
misstatement. Because the auditor must limit overall audit risk to a low level, reasonable assurance must be at a
high level. Stated in mathematical terms, if audit risk is 5 percent, then the level of assurance is 95 percent. When
analyzing exceptions and misstatements, the auditor should always keep in mind that the main objective should be
to provide reasonable assurance. However, data analytics will not lead to providing an absolute assurance.

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Impact of Big Data & Data Analytics AAA Revision Notes

Deviations identified through data analytics should be analyzed, sorted and clustered. Part of the deviations can
often be justified. For example, when a system is configured to prevent pricing changes, a manual price change is a
deviation. However, if the change has been duly approved, there is no issue from an audit point of view.

And what if data analytics identifies misstatements? Regardless of the audit technique employed to identify
misstatements, once the auditor has established that a misstatement exists, he should investigate the nature and
cause of any misstatements identified and evaluate their possible effect on the purpose of the audit procedure and
on other areas of the audit.

When the auditor performs a data analytics as a test of details to test 100 percent of the population, he typically
would not identify a projected misstatement because he has not performed an audit sample. Audit sampling
procedures are used to draw inferences about the entire population based on the results of testing a sample of
selected items from the population. This involves projecting factual misstatements identified in the sampled items
to the remainder of the population (projected misstatement). However, when using data analytics as a test of
details, there may be circumstances in which the auditor identifies a large number of exceptions such that it is not
practical to investigate them all individually. If he samples the exceptions and identifies a factual misstatement in
his sample, and the nature and cause of the misstatement is specific to the exception population, it is appropriate
to project the identified misstatement to the population of exceptions, resulting in a projected misstatement.

For example use of data analytics as a test of details to perform a 100 percent match of recorded invoices to a
standard price listing. In this example, the invoice prices are automatically generated at the time an invoice is created
based on the standard price listing; however, there are circumstances in which deviations from the standard price
listing may be approved and manually overridden. The results of the data analytic identified a number of exceptions
indicating manual overrides from the standard pricing had been applied to invoices. In order to assess whether these
manual overrides are properly approved, the auditor selects a sample of the exceptions to test. Upon investigation
of the sample of exceptions he determines that a portion of them were not properly approved and therefore
represent factual misstatements in the population. It would then be appropriate to extrapolate the identified factual
misstatement over the remaining population of exceptions to determine the corresponding projected misstatement
within the population

Commonly performed data analytics routines

• Comparing the last time an item was bought with the last time it was sold, for cost/NRV purposes.
• Inventory ageing and how many days inventory is in stock by item.
• Receivables and payables ageing and the reduction in overdue debt over time by customer.
• Analyses of revenue trends split by product or region.
• Analyses of gross margins and sales, highlighting items with negative margins.
• Matches of orders to cash and purchases to payments.
• ‘Can do did do testing’ of user codes to test whether segregation of duties is appropriate, and whether any
inappropriate combinations of users have been involved in processing transactions.
• Detailed recalculations of depreciation on fixed assets by item, either using approximations (such as assuming
sales and purchases are mid‐month) or using the entire data set and exact dates.
• Analyses of capital expenditure v repairs and maintenance.
• Three‐way matches between purchase/sales orders, goods received/despatched documentation and invoices.

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Impact of Big Data & Data Analytics AAA Revision Notes

Test of controls using data analytics

Examples include the following tests of controls:

• Analysis of all paid invoices of the fiscal year: approval present? Timely? Correct person?
• Analysis of credit limits by customers: any exceeded?
• Analysis of access rights of users and possible changes throughout the fiscal year

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Professional Skepticism AAA Revision Notes

Professional Skepticism
In recent years regulatory bodies including the International Auditing and Assurance Standards Board (IAASB) and
the UK Financial Reporting Council (FRC) have issued documents highlighting the importance of professional
scepticism in an audit of financial statements. The objective of this article is to explain the importance of professional
scepticism as an essential part of the auditor’s mindset, and to consider the reasons why approaching an audit with
an attitude of professional scepticism is becoming increasingly important.

WHAT IS PROFESSIONAL SCEPTICISM?‐TECHNICAL ARTICLE

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

ISA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International
Standards on Auditing, contains more guidance on how and why the auditor should act with an attitude of
professional scepticism. ISA 200 contains a specific requirement in relation to professional scepticism:

The auditor shall plan and perform an audit with professional skepticism recognising that circumstances may exist
that cause the financial statements to be materially misstated.

This overall objective is the fundamental driver for the relevant learning outcomes within the Paper THE ADVANCED
AUDIT & ASSURANCE EXAM syllabus, namely:
 To discuss the importance of professional scepticism in planning and performing an audit (B1e), and
 To assess whether an engagement has been planned and performed with an attitude of professional
scepticism, and evaluate the implications .

The application paragraphs of ISA 200 contain more guidance on what is meant by applying professional scepticism
when conducting an audit:

Professional scepticism includes being alert to, for example:

 Audit evidence that contradicts other audit evidence obtained.
 Information that brings into question the reliability of documents and responses to inquiries to be used as audit
evidence.
 Conditions that may indicate possible fraud.
 Circumstances that suggest the need for audit procedures in addition to those required by the ISAs. (ISA 200
A.18).

Essentially, ISA 200 requires the use of professional scepticism as a means of enhancing the auditor’s ability to
identify risks of material misstatement and to respond to the risks identified. Professional scepticism is closely
related to fundamental ethical considerations of auditor objectivity and independence. Professional scepticism is
also linked to the application of professional judgment by the auditor. An audit performed without an attitude of
professional scepticism is not likely to be a high quality audit. At its core the application of professional scepticism
should help to ensure that the auditor does not neglect unusual circumstances, oversimplify the results from audit
procedures or adopt inappropriate assumptions when determining the audit response required to address identified
risks, all of which should improve audit quality.

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Professional Skepticism AAA Revision Notes

HOW DOES THE AUDITOR APPLY PROFESSIONAL SCEPTICISM?

The auditor is likely to apply professional scepticism at various stages from client acceptance and at various points
during the audit process, and some typical examples are given below:
 When assessing engagement acceptance – at this stage the auditor should consider whether the management
of the intended audit client acts with integrity and whether there are any matters that may impact on the auditor
being able to act with professional scepticism if they accept the engagement, such as ethical threats to
objectivity.
 When performing risk assessment procedures – an auditor should be sceptical when performing risk assessment
procedures at the planning stage of the audit. For example, when discussing the results of analytical procedures
with management, the auditor should not accept management’s explanations at face value, and should obtain
corroboratory evidence for the explanations offered.
 When obtaining audit evidence – the auditor should be ready to challenge management, especially on complex
and subjective matters and matters that have required a degree of judgement to be exercised by management.
The reliability and sufficiency of evidence should be considered, especially where there are risks of fraud. There
may also be specific issues arising during an audit which impacts on professional scepticism – for example, if
management refuses the auditor’s request to obtain evidence from a third party. The auditor will have to
consider how much trust can be placed on evidence obtained from management – for example, evidence in the
form of enquiry with management or written representations obtained from management. ISA 200 states that
‘a belief that management and those charged with governance are honest and have integrity does not relieve
the auditor of the need to maintain professional scepticism or allow the auditor to be satisfied with less than
persuasive audit evidence when obtaining reasonable assurance’.
 When evaluating evidence – the auditor should critically assess audit evidence and be alert for contradictory
evidence that may undermine the sufficiency and appropriateness of evidence obtained.

The auditor should also apply professional scepticism when forming the auditor’s opinion, by considering the overall
sufficiency of evidence to support the audit opinion, and by evaluating whether the financial statements overall are
a fair presentation of underlying transactions and events.

Ultimately, the application of professional scepticism should reduce detection risk because it enhances the
effectiveness of applied audit procedures and reduces the possibility that the auditor will reach an inappropriate
conclusion when evaluating the results of audit procedures.
SPECIFIC APPLICATIONS OF PROFESSIONAL SCEPTICISM

Fraud
ISA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, specifically refers to
professional scepticism stating that ‘when obtaining reasonable assurance, the auditor is responsible for maintaining
professional scepticism throughout the audit, considering the potential for management override of controls and
recognising the fact that audit procedures that are effective for detecting error may not be effective in detecting
fraud’ (ISA 240.8).

ISA 240 goes on to state a specific requirement for the auditor: ‘The auditor shall maintain professional scepticism
throughout the audit, recognising the possibility that a material misstatement due to fraud could exist,
notwithstanding the auditor’s past experience of the honesty and integrity of the entity’s management and those
charged with governance’ (ISA240.12).

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Professional Skepticism AAA Revision Notes

The application paragraphs of ISA 240 emphasise the importance of assessing the reliability of the information to be
used as audit evidence and the controls over its preparation and maintenance. In addition, ISA 240 states that
‘management is often in the best position to perpetrate fraud. Accordingly, when evaluating management’s
responses to inquiries with an attitude of professional scepticism, the auditor may judge it necessary to corroborate
responses to inquiries with other information’ (ISA 240.A17). This is significant in that ISA 240 reminds the auditor
that when management provides the auditor with audit evidence – be that in the form of answers to enquiries,
written representations or other forms of documentary evidence – the auditor should carefully consider the integrity
of that evidence and whether additional corroboratory evidence should be obtained from a more reliable source.

Other aspects of an audit where professional scepticism may be important

The IAASB has issued a Staff Questions and Answers document entitled Professional Scepticism in an Audit of
Financial Statements, which outlines some of the areas of the audit where the use of professional scepticism may
be important. These are outlined below and largely relate to areas of the audit that are complex, subjective or highly
judgmental.
 Accounting estimates – this can include fair value accounting estimates, the use of significant assumptions by
management in developing accounting estimates, and reviewing the judgements and decisions used by
management for management bias in developing accounting estimates.
 Going concern – the auditor should review management’s assessment of going concern and whether
management’s plans are feasible, this being particularly important where there is a significant doubt over the
entity’s ability to continue as a going concern.
 Related party relationships and disclosures – it can be difficult to obtain information on related parties, as
knowledge may be confined to management meaning that the auditor may have to rely on management to
identify all related parties The auditor should also be sceptical when assessing the business rationale behind
related party transactions.
 Consideration of laws and regulations – the auditor should be alert throughout the audit for indications that
there may have been a suspected non‐compliance with laws and regulations.

THE INCREASING IMPORTANCE OF PROFESSIONAL SCEPTICISM

The IAASB Staff Questions and Answers document contains a foreword by Arnold Schilder, IAASB chairman, which
emphasises the increasing need for auditors to apply professional scepticism. One reason for this is the increased
use of judgment and subjectivity in management’s financial reporting decisions. This is due to the application of
International Financial Reporting Standards (IFRS), which are largely principle‐based, and often require the preparers
of financial statements to exercise significant judgment when making decisions on accounting treatments.

The global financial crisis of 2008–2009 also focused attention on professional scepticism. Auditors in many
jurisdictions were criticised for not applying sufficient professional scepticism at that time, particularly in relation to
the audit of fair values, related party transactions and going concern assessments. One of the reasons for the IAASB
issuing the Staff Questions and Answers document was to re‐emphasise the importance of professional scepticism
especially in the audit of financial statements where there is a high risk of material misstatement due to financial
distress.

The UK’s Financial Reporting Council (FRC) has issued a Briefing Paper on professional scepticism which suggests that
professional scepticism is the cornerstone of audit quality. It proposes that the auditor should actively look for risks
of material misstatement, and that this is only possible when a high degree of knowledge of the audited entity’s
business and the environment in which it operates is obtained. The document contains proposals for how audit firms

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Professional Skepticism AAA Revision Notes

can encourage audit teams to approach audits with a sceptical mindset, and it considers that some audit firms may
need to change their culture to allow this to happen.

The IAASB’s Work Plan for 2015–16, Enhancing Audit Quality and Preparing for the Future – issued in December 2014
– prioritises the issues that impact on audit quality, including group audits, quality control, and professional
scepticism. It is clear the professional scepticism is to stay on the agenda of the regulatory authorities for some time
to come, as it is so intrinsically linked to other key audit issues such as audit quality, ethics and independence and,
ultimately, the confidence that the public has in the auditing profession.

CONCLUSION
The IAASB states that ‘the need for professional scepticism cannot be overemphasised’ and that ‘adopting and
applying a sceptical mindset is ultimately a personal and professional responsibility to be embraced by every
auditor’. Given the increasingly complex and subjective nature of IFRS requirements, auditors must be confident to
challenge management on a range of matters relevant to the preparation of the financial statements and the IAASB
and national bodies such as the FRC are keen to support auditors in the application of professional scepticism. This,
they believe, is an essential element of quality control, and in safeguarding the credibility of the audit opinion.

Written by a member of the Paper THE ADVANCED AUDIT & ASSURANCE examining team

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