ACCA AAA advanced audti and assurance

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 the word about OpenTuition ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Advanced Audit and Assurance (AAA) (INT/UK) INTRODUCTION TO ADVANCED AUDIT AND ASSURANCE (AAA) (INT/UK) REGULATION, LEGAL MATTERS AND QUALITY CONTROL What is Assurance? Corporate Governance and Auditor Regulation Appointment as an Auditor Professional Ethics Money Laundering Responding to Non-Compliance with Laws and Regulations (NOCLAR) Auditors’ Liability Fraud, Error, the Evaluation of Misstatements and Reporting Control Weaknesses Quality Control AUDIT PLANNING AND RISK ASSESSMENT 10 11 12 Audit planning Risk Question Practice on Risk AUDIT EVIDENCE 13 14 15 16 17 18 19 20 Audit Evidence A Summary of Important Accounting Standards Audit evidence: Computer Assisted Audit Techniques Audit evidence Provided by Third Parties Audit evidence Provided by Internal Audit Outsourced Accounting Functions Written Representations Related Parties THE AUDIT OF GROUP FINANCIAL STATEMENTS 21 Group Audits THE FINAL STAGES OF AN AUDIT 22 23 24 25 Events Occurring After the Reporting Period/Subsequent Events The Auditor’s Report 1: Overall Structure The Auditor’s Report 2: Going concern The Auditor’s Report 3: Types of Audit Opinion OTHER ASSIGNMENTS 26 27 28 29 30 31 32 Types of Assignment Reporting on Prospective Financial Information Forensic Audits Social and Environmental Auditing Due Diligence Reports The Audit of Performance Information in the Public Sector (International Syllabus only) Auditing aspects of insolvency (UK Syllabus only) 11 17 23 29 33 37 41 45 49 55 61 69 75 83 85 87 89 93 95 99 107 109 117 121 125 127 133 137 141 143 151 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Access FREE ACCA Advanced Audit and Assurance online resources on OpenTuition: AAA Lectures (complete course) To fully benefit from these notes you should watch our free AAA lectures ACCA AAA Flashcards Practice key terms and concepts using our AAA flashcards! ACCA AAA Forums Get help from other students Ask AAA Tutor Post questions to a ACCA tutor visit https://opentuition.com/acca/aaa/ Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures INTRODUCTION TO ADVANCED AUDIT AND ASSURANCE (AAA) (INT/UK) Warning! Do not even think of studying this paper if you haven’t already studied paper Strategic Business Reporting (SBR)/Corporate Reporting (P2).  In every AAA paper, there is at least one question dealing with audit risk and/or audit evidence Audit risk is the risk that there might be a material misstatement in the financial statements Whenever there is such a risk, the auditor must decide how to respond and that usually means carrying out more audit work to gather more audit evidence What you need to realise is that material misstatements can be caused by two types of error: ๏ The amount is wrong ๏ The item has not been treated in line with the relevant accounting standards or financial reporting standards For example, if the company incurs research and development expenditure, not only does the auditor have to obtain evidence about the amount of expenditure, but must also collect evidence that the expenditure has been written off or capitalised in line with IAS 38 Therefore, if the expenditure has been capitalised, the auditor must collect evidence that the project is technically viable, that the company can fund its completion….and so on If you not know the standard, you cannot plan to collect the right evidence Every accounting standard studied in SBR/P2 sets out rules that govern how amounts in financial statement are to be displayed and therefore each standard has implications for auditors The ‘maturity’ of answers required Consider this: During attendance at a stocktake at a client who makes jars of preserved food, a pack of 12 jars falls from its shelf in the warehouse and the jars shatter The contents smell awful and it is obvious that pack contained food that had gone bad What audit issues does this incident cause and how should the auditors respond? At the AA level you might simply have said that the pack had to be written off At AAA, the incident raises many more issues See if you can think what they might be This is discussed in the lecture for Chapter 12 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Topics in AAA, not in AA The main additions are: ๏ Business risk (audit risk, but not business risk, was in AA) ๏ The audit of groups ๏ Non-audit assurance (eg forecasts, budgets etc) ๏ Environmental and social auditing ๏ The audit of performance information in the public sector ๏ Professional liability Most AA topics appear again in AAA but to a more detailed level Professional ethics remain very important You will not be asked to evaluate an accounting system to identify weaknesses in internal control Syllabus 4.1 Aim To analyse, evaluate and conclude on the assurance engagement and other audit and assurance issues in the context of best practice and current developments 4.2 Objectives On successful completion of this paper, candidates should be able to: ๏ Recognise the legal and regulatory environment and its impact on audit and assurance practice ๏ Demonstrate the ability to work effectively on an assurance or other service engagement within a professional and ethical framework ๏ Assess and recommend appropriate quality control policies and procedures in practice management and recognise the auditor’s position in relation to the acceptance and retention of professional appointments ๏ Identify and formulate the work required to meet the objectives of audit assignments and apply the International Standards on Auditing ๏ Evaluate findings and the results of work performed and draft suitable reports on assignments ๏ Identify and formulate the work required to meet the objectives of non-audit assignments ๏ Understand the current issues and developments relating to the provision of audit-related and assurance services Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 5 Approach to examining the syllabus The syllabus is assessed by a hour 15 minute paper-based examination The examination is constructed in two sections Questions in both sections will be largely discursive However, calculations will be expected, for example to be able to assess materiality and calculate relevant ratios where appropriate Part A Case study (50%) Set at the planning stage of the audit Candidates will be provided with detailed information and be required to address a range of requirements from syllabus sections A, B, C and D Four professional marks are available in Section A Part B Two compulsory 25 mark questions, predominately based around a short scenario One question will always predominantly come from syllabus section E (completion, review and reporting) The other question can be drawn from any other syllabus area Syllabus section G, Current Issues, may be examined in Section A or Section B, but is unlikely to to form the basis of any question on its own Full details are shown on syllabus available from the ACCA’s site: Advanced Audit & Assurance (INT) – syllabus & study guide September 2018 to June 2019 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures REGULATION, LEGAL MATTERS AND QUALITY CONTROL Chapter WHAT IS ASSURANCE? Audit and assurance We start with a little bit of revision of AA, and indeed you will be making use of AA skills throughout AAA (such as suggesting audit evidence to look for) The paper is called ‘Advanced Audit and Assurance’ and we start by explaining what is meant by the terms ‘audit’ and ‘assurance’ It is often not possible to check things for yourself, whether quality, accuracy, performance or existence: you might not have the skills or the time, or you might be in the wrong location Therefore you must rely on someone else to give you assurance This means you have to decide: ๏ What standards should be applied? ๏ What represents ‘good’, ‘acceptable’ or ‘unacceptable? ๏ How much checking should be done? All checking and assurance has an associated cost Audit is one form of assurance We will see that in AAA other forms of assurance might have to be described and discussed too, such as providing assurance to a bank that a company’s cash flow budget is not a work of fantastic fiction or that a take-over target is not hiding horrific liabilities An audit is defined as: the independent examination of and expression of opinion on the financial statements of an entity by a duly appointed auditor in pursuit of that appointment The important words here are ‘independent’ and ‘opinion’ Independence is essential and underlies the value of auditing - and of all other forms of assurance Opinion really means that one auditor or accountant could look at a set of financial statements (or a cash budget) and disagree with the opinion of another Judgment is essential to all assurance: there are no certainties and there are no certifications of correctness or accuracy Auditing is the most regulated form of assurance you will meet in AAA Legislation, International Auditing Standards and accounting standards all lay down rules about how auditing should be carried out and how financial statements should be prepared Other forms of assurance are much less uniform and this can cause a problem unless the work to be performed is precisely agreed between auditor and client at the very start For example, if you are asked to give assurance about a cash flow Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures forecast you need to find out if it is a one, three or five year budget as the work and difficulties are very different in each case Elements of an assurance engagement 2.1 The elements of an assurance engagement The following are the five elements of an assurance engagement: (1) A three party relationship involving a practitioner, a responsible party, and intended users (2) Appropriate subject matter (for example the financial statements, a budget, a take-over target) (3) Suitable criteria (for example accounting standards) (4) Sufficient appropriate evidence (5) A written assurance report in the form appropriate to a reasonable assurance engagement or a limited assurance engagement Item on the list is sufficient appropriate evidence and if assurance had to be summed up in one word ‘EVIDENCE’ would be it Assurance is not based on the auditor guessing or hoping that something is the case All assurance is based on gathering sufficient appropriate evidence and if the required evidence is not available then assurance cannot be given It will be said again, but when it comes to the audit of financial statements evidence is required about two elements: ๏ Is the amount substantially correct? ๏ Do the presentation and disclosures conform to the accounting standards? There is no point in tracing research and development expenditure back to invoices supporting the accuracy of the amounts if you not also give assurance that the amounts have been written off or capitalised in line with the IAS 38 Evidence is needed to support the treatment of the amounts 2.2 Professional scepticism A practitioner should plan and performs an assurance engagement with an attitude of professional scepticism to obtain sufficient appropriate evidence about whether the subject matter information is free of material misstatement An attitude of professional scepticism means the practitioner questions the validity of evidence and is alert to evidence that brings into question the reliability of documents or representations Scepticism means that you don’t know It does not mean that the practitioner assumes everyone is dishonest or that figures have been deliberately misrepresented Nor does it mean that you believe all figures and statements are correct It means you are aware that we can all be subject to optimism (perhaps too much), human error, giving quick answers because we are short of time, and misunderstanding It also recognises that sometimes people are deliberately misleading or dishonest Scepticism means that evidence is required to test statements or assumptions You could almost summarise the process of assurance in the phrase ‘collect evidence that supports everything that is being claimed’ Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Sufficiency is the measure of the quantity of evidence Appropriateness is the measure of the quality of evidence - its relevance and its reliability The reliability of evidence is influenced by its source and by its nature, and is dependent on the individual circumstances under which it is obtained, eg documentary evidence is better then oral, directly obtained evidence better then evidence provided by a client 2.3 Assurance Report The practitioner provides a written report containing a conclusion There are two types of assurance reports: In a reasonable assurance engagement the practitioner’s conclusion is worded in the positive form, for example: “In our opinion internal control is effective, in all material respects, based on XYZ criteria.” It is called ‘reasonable’ because the practitioner will never give guarantees Only reasonable assurance is ever given In a limited assurance engagement the conclusion is worded in the negative form, for example, “Based on our work described in this report, nothing has come to our attention that causes us to believe that internal control is not effective, in all material respects, based on XYZ criteria.” 2.4 Examples: Positive ๏ The financial statements show a true and fair view ๏ The value of amount of inventory lost is $x Negative ๏ We have discovered nothing wrong with the financial statements ๏ The basis of the forecast is not unreasonable ๏ There is no evidence of discrimination in the appointment All statutory audits attempt to provide positive assurance ie the financial statements show a true and fair view There are some types of assurance assignment where giving a positive assurance is not possible For example, it would be impossible to give assurances that a budget is correct because it depends on so many assumptions and factors that cannot be verified with certainty, such as the state of the economy next year, competitors’ plan and sales forecasts A practitioner would not express an unqualified conclusion for either type of assurance engagement when: There is a limitation on the scope of the practitioner’s work ie sufficient appropriate evidence cannot be obtained; or The assertion is not fairly stated, and the subject matter information is materially misstated (ie the assertion is incorrect) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 10 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 11 Chapter CORPORATE GOVERNANCE AND AUDITOR REGULATION Why corporate governance is needed Corporate governance is the system by which companies are directed and controlled Auditing financial statements adds to their credibility and this enables shareholders to better understand how the directors and company have performed Principles of corporate governance The Organisation of Economic Cooperation Development (OECD) put forward some principles of corporate governance: ๏ Corporate governance frameworks should protect shareholders’ rights, ensuring fair treatment of all shareholders, particularly minority and foreign shareholders For example all shareholders should have access to the same information ๏ The corporate governance framework should also recognise the rights of all stakeholders, not just shareholders, and should encourage active cooperation between the entities and stakeholders in creating wealth, jobs and sustainability of financially sound entities ๏ There should be disclosure and transparency ๏ The corporate governance framework should ensure that timely accurate information is made available in all material matters ๏ Responsibility of the board is also covered, and the corporate governance framework should ensure the strategic guidance of the entity, effective monitoring of management by the board and the board’s accountability to the entity and their shareholders In particular the board should set its own objectives, monitor its own performance and have its own performance assessed Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 12 The UK Corporate Governance Code The OECD principles are put into effect in a variety of ways in different countries The UK Corporate Governance Code can be referred to as an example of best practice The code states that the purpose of corporate governance is to facilitate effective entrepreneurial and prudent management that can deliver long-term success of the company Note the conflict between between being prudent and being entrepreneurial Comply or explain The code has no force in law and is enforced on listed companies through the Stock Exchange Listed companies are expected ‘‘comply or explain’’ and this approach is the trademark of corporate governance in the UK Listed companies have to state that they have complied with the code or else explain to shareholders why they haven’t This allows some flexibility and non-compliance might be acceptable in some circumstances The UK and most of Europe have adopted a principles based approach rather than a procedural approach to Corporate Governance Broad principles are set out but then companies decide how to put those into operation This can provide flexibility and adaptability In the USA most corporate governance is regulated through statute, The Sarbanes-Oxley Act This takes a procedural approach that is much more prescriptive, requiring both directors and auditors to sign off documentation stating that the rules have been followed Criminal charges can follow if the Act is not followed The code then goes on to list the main principles of the code: Main principles ๏ Leadership ๏ Effectiveness ๏ Accountability ๏ Remuneration ๏ Relations with shareholders Leadership ๏ Every company should be headed by an effective board which is collectively responsible for the long term success of the company ๏ There should be a clear division … between the running of the board and the executive responsibility for the running of the company’s business No one individual should have unfettered powers of decision This means that the roles of CEO and Chairman should not be performed by one person as that concentrates too much power in that person ๏ The chairman is responsible for leadership of the board ๏ Non-executive directors (NEDs) must be appointed to the board and they should constructively challenge and help develop proposals on strategy NEDs sit in at board meeting and have full voting rights, but not have day-to-day executive or managerial responsibility Their function is to monitor, advise and warn the executive directors Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 13 Effectiveness ๏ The board should have an appropriate balance of skills, experience, independence and knowledge In large companies NEDS should be at least 50% of the board; in small companies there should be at least NEDS ๏ New directors should be appointed by a Nomination Committee to ensure a formal, rigorous and transparent procedure for their appointment The Nomination Committee consists of NEDs This provision is to prevent directors appointing their friends and colleagues to the board and ensures that the best people for the job are considered and appointed ๏ All directors should be able to allocate sufficient time to company business ๏ There should be induction on joining the board and a programme to update and refresh directors’ skills and knowledge ๏ The board should be supplied in a timely manner with necessary information ๏ The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors ๏ All directors should be submitted for re-election at regular intervals Accountability ๏ The board should present a balanced and understandable assessment of the company’s position and prospects ๏ The board is responsible for determining the … significant risks …and should maintain sound risk management and internal control systems ๏ The board should establish formal and transparent arrangements for applying the corporate reporting, risk management and internal control principles, and for maintaining an appropriate relationship with the company’s auditor This means that an Audit Committee (NEDs again) should be established to liaise with both internal and external auditors Before audit committees, the finance director liaised with auditors, but this was not satisfactory because the finance director was often the person responsible for accounting problems Therefore auditors were often reporting problems to the person who caused them The directors are responsible for establishing an internal control system and must review the need for internal audit ๏ Note that is is management who are responsible for ensuring that an effective system of internal control operates to: ‣ achieve the orderly and efficient conduct of business ‣ safeguard assets, prevent and detect fraud and error ‣ ensure the accuracy and completeness of the accounting records ‣ allow the timely preparation of financial information Remuneration ๏ Levels of remuneration should be sufficient to attract, retain and motivate directors of sufficient quality… but avoid paying more than is necessary ๏ A significant proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance In other words, profit-related pay is encouraged Directors should not receive high pay irrespective of company performance ๏ There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors No director should be involved in deciding his or her own remuneration This means that a Remuneration Committee (NEDs) should be formed to fix directors’ remuneration Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 14 Relations with shareholders One of the problems with achieving good corporate was encouraging shareholders to take an active interest in the company Too often they did not fully participate at AGMs and would wave through motions This passive attitude might well have been encouraged by directors to move power towards them and away from members The code therefore specifies: ๏ 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 AGM to communicate with investors and to encourage their participation The role of the audit committee The audit committee is now very important part of corporate governance Review of internal audit Financial Statements Review of internal control Special investigations Liaison with external auditors: • Scope of external audit • Forum to link directors/auditors • Deal with auditors’ reservations • Obtain information for auditors Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 15 The committee should be dominated by non-executive directors The functions are as follows: ๏ They will review the work of internal audit Companies don’t have to have an internal audit department, but corporate governance rules now stated that management should keep the need for internal audit on the review ๏ From time to time the audit committee may launch special investigations For example, if a fraud had been discovered within the organisation the audit committee may ask for a report on how it happened and how to prevent it in the future With regard to functions specifically useful to the external auditors, the audit committee: ๏ Will review the system of internal control Corporate governance now imposes on management the requirement that they implement a system of internal control ๏ Must be willing to receive information from whistle-blowers ๏ Make recommendations to the board and members about the appointment, reappointment and removal of the external auditors and agree the terms of engagement Liaise on the process of appointing auditors and setting their fees (Note that the external auditors are appointed by members in general meeting, but the audit committee is likely to make recommendations.) ๏ Annually assess the independence, objectivity and effectiveness the external auditors including confirming that there are no self-interest or familiarity issues and that partners and staff are rotated properly ๏ Ensure that audits are properly planned and meet with the auditors to discuss matters such as materiality, audit team composition and quality control procedures ๏ Act as a forum to link directors and auditors Auditors will typically write to the audit committee about any problems they may be having on the audit or obtaining all the information they require If the auditors are worried in some way about the financial statements they will raise those concerns with the audit committee ๏ If the auditors can’t find information in any other way and feel perhaps they are being obstructed, they can go to the audit committee and explain the problem and the audit committee can try and investigate on their behalf ๏ The audit committee will also review any significant judgements or other issues affecting the financial statements that management has prepared and also assess the external auditor’s handling of these matters and will report to the board n the effectiveness of the external process ๏ Review the management letter sent to the company by the auditors ๏ The audit committee should also be involved in decisions whether or not to use the external auditors for non-audit services: skills, approval and non-approval for certain services, ensuring any threats to independence and objectivity are reduced to acceptable levels and monitoring the fees for those services and the total fee for all services provided by the external auditor Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 16 Regulation of auditors Auditors are regulated by: ๏ Professional bodies (eg ACCA) ACCA is a recognised supervisory body that supervises qualifications, behaviour and quality ๏ National bodies In the UK and Ireland, the Financial Reporting Council This regulates auditors and accountants and sets the UK’s Corporate Governance Code In the USA the Auditing Standards Board regulates auditors ๏ International bodies (eg IFAC, the International Federation of Accountants) The purposes of IFAC are to serve public interest, strengthen the worldwide accountancy profession, establishing and promoting adherence to high-quality professional standards The IFAC has a number of committees such as: ‣ IAASB (International Auditing and Assurance Standards Board): ISAs and other assurance standards ‣ The International Ethics Standards Board for Accountants (IESBA): IFAC Code of Ethics ‣ TAC (Transnational Auditors Committee): international dimension of audits ๏ The Public Interest Oversight Board This has representatives from a wide variety of users of financial statements It provides independent oversight throughout the entire process of standard-setting to ensure that standard-setting is responsive to stakeholder needs, is accountable and transparent IFAC ISAs are adopted by the FRC in the UK which has local regulatory power Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 17 Chapter APPOINTMENT AS AN AUDITOR Overview of the audit process Appointment Plan the audit Understand entity Assess risk of material misstatement Respond to risk Expect effective controls Expect ineffective controls Satisfactory Report significant deficiencies to those charged with governance to management and all weaknesses to management Restricted substantive tests Full substantive tests Tests of controls Unsatisfactory Overall review of F/S Report to management Auditor’s report This is an important and useful diagram and it sets out the stages or approach to an audit Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 18 Marketing professional services The ACCA Rulebook sates that professional accountants can inform the public about their services using advertising and other form of promotion, subject to the general requirement that the medium shall not reflect adversely on the professional accountant, ACCA or the accountancy profession It is recognised that there can be a conflict between some of the ethical principles, for example, a selfinterest threat and complying with the principle of professional behaviour The professional accountant in public practice must be honest and truthful and must not: ๏ Make exaggerated claims for services, experience etc or be misleading in other ways ๏ Make disparaging references or unsubstantiated comparisons to the work of another ๏ Bring the ACCA, the accountancy profession or other accountants into disrepute If fees are mentioned, promotional material must state the basis of charging and great care has to be taken that readers are not mislead about the services offered and the fees that will be charged It is possible to compare fees with those of other firms provided the comparison is not misleading If commissions are paid or received (for example, by recommending software package), full disclosure of the commercial arrangement must be made Tendering for professional services Often, to obtain new work, accountants will be asked to submit a tender in competition with other firms Before submitting a tender, contact must be made with the existing or previous accountant (see section 5, below) to see if there are any reasons why the appointment should not be accepted The fees quoted can can be whatever the accountant thinks appropriate, but there can be threats to compliance with the fundamental principles For example, if the fee were so low that it would be difficult to carry out the work to the required standard of competence and due care The IESBA states that: ๏ Auditors should perform high quality audits irrespective of the audit fee charged ๏ Adequate time must be planned and spent to enable the audit to be performed in accordance with the technical and professional standards ๏ Audit personnel with appropriate expertise and experience should be assigned to the work ๏ Two-way communication between the auditors and those charged with governance to mitigate the threats that can arise from fee pressure Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 19 There is no set format for a tender document, but a little thought will show that something like the following would be usual for a tender for audit work: ๏ A brief introduction to the accountancy firm ๏ Areas of expertise and specialisms ๏ A reiteration of the requirements of the client (to confirm understanding) and suggestions for other work that might be needed ๏ An outline of the proposed audit approach For example: ‣ Planning ‣ Assessment of the internal control system ‣ Testing internal control and reporting on control weaknesses (interim audit timing might be suggested) ‣ Possible use of internal audit for some aspects of the audit ๏ Timing of the final audit and suggested dates for audit report signature ๏ Work be done at the final audit stage (eg attend stock take and certain branches etc) ๏ Planned use of computer assisted audit techniques ๏ Quality control steps and systems that the firm uses to ensure that a ‘good’ audit will be performed ๏ Key partner’s and manager’s name Details of audit team composition ๏ Fee and the basis of its calculation Invoicing arrangements and terms of payment Before you say ‘yes’ (and continuance decisions) It is, of course, flattering to be asked to be the auditor of a company Now only does it feed one’s ego, it also promises more income for the firm However, auditors must exercise great caution: they must be confident that they can carry out the work profitably, ethically, competently, incurring an acceptable level of risk and avoiding damage to their reputation The following need to be investigated: ๏ Are they professionally qualified to act? Is it legal and ethical for them to so? For example, they shouldn’t accept an appointment if the fees from that appointment are above the suggested 15% limit for public interest companies Are there issues of familiarity or self-review? ๏ Do they have adequate resources in terms of staff, time, and expertise? Can the new work be carried out when the client wants without adversely affecting existing clients? If the potential audit client acts in a specialist area of business and the auditors have no prior experience of that, it would be very unwise for them to accept the appointment ๏ Investigate the client, its management, and directors Many firms of auditors have access to databases which, for example, will allow them to search on directors’ names to see if any of the directors have been banned from being directors of companies because of their past behaviour They may discover that it is too risky to become the auditor of a company if they have no trust in the honesty of the directors The audit fee is often modest, why risk your reputation by undertaking an audit where the directors are likely to be fraudulent? ๏ Consider the nature of the industry or business If there is a risk of criminal involvement or money laundering it might be better to stay clear Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ Money laundering regulations (covered in a later chapter) require auditors to ‘know their client’: ownership, commercial rationale, sources of funds etc ๏ Communicate with present auditors There is a professional requirement to this and it is essential to find out why the old auditors are retiring or being removed ๏ Is the accounting framework that will be used by the potential client acceptable? ๏ Consider politically exposed persons These are people who have or who have had positions of political influence For example, politicians, senior military personnel, senior civil servants Unfortunately, there is a history of many of these individuals having profited from corruption and they might still have influence that permits the misuse of public funds, the improper awarding of contracts and large-scale money laundering ๏ The potential client’s credit-rating ๏ Preconditions for the audit: will the financial reporting framework used be acceptable and management understand and accept their responsibilities for preparing the financial statements and for supplying the auditors with all the information they require? 20 Communication with existing auditors If the auditor is approached by new audit client, if it’s a new business and this is the first audit there will be no previous auditors to communicate with and new auditors must make their own decision If it is not a new business and there is an existing auditor then the new auditor must ask the client for permission to contact the old auditor If permission is not given, the appointment should be declined Why would permission not given? Is a client trying to conceal something? Why else would they not allow a new auditor to communicate with the existing auditor? Assuming permission is given the new auditor will write to the old auditor for information The old auditor can’t simply send that information to the new auditor because that is confidential, and the old auditor has to ask the client for permission in turn If that permission is not given the new auditor should decline the appointment because again the client is trying to stop communication between the old and new auditors If the old auditor provides information then the new auditor is more fully equipped to make their accept or reject decision If the existing auditor decides not to provide information the new auditor should try to persuade the old auditor to provide it, but otherwise might have to rely on information as been found in other ways Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 21 The engagement letter Upon appointment, auditors should send an engagement letter to their new client Engagement letters are often regarded as rather dull documents, sent once and then forgotten However, they are of crucial importance because they set out the contractual relationship between the auditor and the client If the engagement letter is not sent out it’s very difficult for an auditor subsequently to complaint that the client hasn’t done what was expected, or it might be difficult for the auditor to defend the firm against a claim that the auditor has not done what was expected Engagement letters: ๏ Define the auditor’s responsibilities ๏ Provide written evidence of the auditor’s acceptance of the appointment ๏ Should be send to the board of directors or audit committee prior to the first audit ๏ Identify any reports to be produced in addition to the audit report For example, for banking or insurance clients who may come under additional scrutiny ๏ Should be updated for all changes For example, if the auditor begins to undertake tax work for the client Typical contents of an engagement letter ๏ Description of the objective of an audit: to determine whether or not the financial statement show a true and fair view ๏ Defining responsibilities: management’s are to prepare the financial statements and to set up a system of internal control It is the auditor’s responsibility to audit the financial statements ๏ Reference to the applicable reporting framework For example, a particular company’s act or a particular national legislation, ๏ Emphasis that audits depend on sampling that there are no guarantees The audit look for only material misstatements It will examine records on a test bases that can only give a reasonable assurance ๏ The auditors will state that they expect unrestricted access to the company’s records and they expect full explanations for any queries they might have ๏ They will state that the audit report is a matter between them and the addressees of the audit report (the members of company) and that the audit report should not be provided or relied upon by other parties ๏ There will be certain matters about planning the audit, such as arranging the interim audit and final audit, attending the stock take, organising a circularisation of receivables, and liaison with the internal audit department ๏ Almost certainly there will be something about fees, and remember fees should never be absolute They should be estimate but subject to the proviso that if more work needs to be done, it will be done and additional fees will be required ๏ Description of the expected relationship between the external auditor and internal audit; how the work of internal audit might be reviewed and then relied on by the external auditors Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 22 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 23 Chapter PROFESSIONAL ETHICS Introduction It was mentioned in the previous chapter that before accepting an appointment, the auditor must ensure that the appointment will be ethical Ethics is seen as the unique selling proposition of professional accountants If they not adhere strictly to ethical principles, how could they continue to earn good fees? What is the point in paying someone for advice or assurance if they cannot be trusted or believed? The ACCAs guide to professional ethics is based on the IESBA’s Code of Ethics It sets out certain fundamental principles about how its members should behave It also recognises how its members could be subject to certain threats which would compromise their behaviour, and suggests ways in which members can safeguard themselves against the operation of those threats The ethical framework recognises that there are: ๏ Ethical principles to be followed ๏ These are subject to risks ๏ Accountants should use safeguards to avoid or to respond to risks by reducing them to acceptable levels The guide applies to all members of ACCA and also to all ACCA students Note that its operation is not restricted to auditors and covers ACCA members working in industry and commerce Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 24 Fundamental principles The ACCA’s fundamental principles are as follows: ๏ First, integrity, basically this means that members should be honest, straightforward If they see something is amiss, they should say so and shouldn’t try to conceal it; they shouldn’t ‘turn a blind eye’; they shouldn’t try to be ambiguous; they should state things plainly ๏ Secondly, objectivity, members should be influenced by the facts and the facts only They must avoid bias, conflict of interest and undue influence ๏ Third, members should exercise professional competence and due care They must keep themselves up-to-date with legislation and recent developments They shouldn’t take on work which they are not qualified for or for which they have no skills They must be diligent, they must be careful ๏ Fourth, confidentiality Members, particularly perhaps those who are auditors, have access to information that is highly confidential and which is price sensitive That information must be held confidentially Members should not disclose confidential information unless they have a legal or professional duty to so An example of a legal duty to disclose information can arise if a member thinks that a client or the person they are working for is involved in money laundering Many countries have very strong regulations nowadays so that money laundering suspects should be reported to the authorities Note that it is now easier to disclose information to authorities if it is in the public interest to do (see Chapter x on Laws and Regulations) ๏ Finally, members should show professional behaviour They should comply with the law and they should avoid any actions which discredit the profession So, for example, when they are trying to advertise their services they shouldn’t say that other members are bad or poor They should confine themselves to promoting what they are good at; they shouldn’t criticise other professionals Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 25 Threats to professional ethics Threats to professional ethics arise from ๏ Self-interest ๏ Self-review ๏ Advocacy ๏ Familiarity ๏ Intimidation Note also there are management threats, where the auditor performs managerial functions for the client These are not listed by the IESBA, but covered under several of the above, such as self-interest, familiarity and advocacy Where such threats exist, the auditor must put in place safeguards that eliminate them or reduce them to clearly insignificant levels Safeguards apply at three levels: ๏ Safeguards in the work environment, ๏ Safeguards that increase the risk of detection, and ๏ Specific safeguards to deal with particular cases If the auditor is unable to implement fully adequate safeguards, the auditor must not carry out the work 3.1 Self-interest threats Self-interest threats are the following: ๏ Financial: For example if an auditor owns shares in the client, the auditor could be accused of wanting the client’s profits to look good, so that the share price rises thereby enriching the auditor ๏ Close business relationships are also threats For example, if a partner retired from an audit partnership and then immediately went to work for a client, they could be accused for having lined themselves up for a job and to that they perhaps did not their audit rigorously A period of at least two years should pass before an ex-partner takes up an appointment with a client Having a partner on the client board is also unacceptable ๏ Loans and guarantees from the client to the auditor should be looked at carefully If the audit client is a bank and it makes a loan on a normal business terms to a member of the audit staff, for example a mortgage, this would normally be regarded as acceptable If however the bank (the audit client) makes a large loan into the partnership then this again could leave the audit firm open to accusations of having being treated faithfully by the bank Certainly no loans or financial relationships should exist between a client and an auditor if it is not normal business for the client to make loans ๏ Overdue fees put the auditor at some risk as there is a possibility that client will never pay those fees This could lead to accusations that the auditor has not qualified the audit report to reduce the likelihood that a worried creditor triggers the company’s liquidation If there are overdue fees the auditor should not make the situation worse and should not incur any more chargeable time until those fees have been settled If fees remain outstanding, the auditor should resign ๏ Contingent fees are obviously dangerous A contingent fee, for example, would be where the auditor is paid a small fee if the auditor report is qualified, but a larger fee if the audit report is clean Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ High percentage fees If the auditor earns a high percentage of total income from one audit client, then the auditor will rely too much on that client and can’t afford to lose them This can give the client too much leverage over the auditor For a public interest company, such as a company listed on a stock exchange, the maximum proportion of fees arising form that client should not be more than 15% of total fees in two consecutive years No figure is mentioned for non-public interest companies, but auditors need to be mindful of this threat ๏ Low-balling refers to the practice of quoting a very low audit fee to a client and then hope that profits would be made another work awarded by the client This means really that the audit does not pay for itself so how, therefore, could a proper audit be done? Winning an audit is a competitive business and the audit fee is an important factor to clients However, an auditor could find it difficult to claim that a proper audit has been carried out if a loss were made on the audit Fees should be profitable for the auditor ๏ Recruiting staff on behalf of a client should not be undertaken The danger here is that if members of staff are recruited by the auditor, particularly financial staff, then subsequently the auditor might be reluctant to criticise the performance of those staff members as the advice they gave on recruitment looks bad Similar considerations should be taken into account when the auditor performs any management function for the client 26 3.2 Self review threats Self review threats arise when an auditor does work for a client and that work may then be subject to self-checking during the subsequent audit For example, if the auditor prepares the financial statements, and then has to audit them, or the auditor performs internal audit services and then has to check that the system of internal control is operating properly Auditors could obviously be reluctant to criticise the work which their own firms have earlier undertaken, and this could interfere with independence and objectivity Generally auditors must be very careful when undertaking such work Certainly it is common for auditors to additional work for their clients, but what is important that the work is done by an entirely different team from the audit firm Really, checking your own work is a waste of time 3.3 The supply of other services The issue of auditor supplying multiple services to their clients, such as taxation and management consultancy, is a controversial one and there are both pros and cons For example, auditors will know a great deal about the operations of their clients and this can make the performance of other work much more efficient If entirely new companies have to be brought in to supply these services, much of the information they find out about the client will already be known by the auditor and there is a real duplication of effort The danger, of course, is that the auditors come to rely too heavily on the fees earned from the other work and are therefore reluctant to risk losing a client because of an adverse audit opinion Large audit firms can at least use separate departments, though this may be difficult with small firms In United States, listed companies are not allowed to obtain other services from their auditor This is to ensure that the auditor is independent and performs only the audit In most jurisdictions, there are no hard and fast rules but the overall guidance on ethics relating to objectivity and independence should be adhered to Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 27 3.4 Advocacy threats Advocacy is where the assurance or audit firm promotes a point of view or opinion to the extent the subsequent objectivity is compromised An example would be where the audit firm promotes the shares in a listed company or supports the company in some sort of dispute Advocacy can interfere with professional scepticism As always, the audit firm should weigh up the risks to its objectivity, integrity and independence and should withdraw from performing further work if those risks are too high 3.5 Familiarity threats Familiarity threats arise because of the close relationship between members of the assurance or audit firm and the client The close relationship can arise by friendship, family or through business connections There is no general definition of what’s meant by close relationships, but if you were an auditor and your brother was the Finance Director of a client firm then there probably is a close relationship! If however the finance director was a remote cousin of yours, there might not be a close relationship Note that there does not have to be any family or legal relationship: friendship can threaten independence and integrity Familiarity undermines professional scepticism When dealing with close business relationships between the auditor and the client firm, the ACCA suggests, the lead partner should be changed at least every five years and other partners involve change at least every seven years This is to prevent too close a relationship and friendship growing between the two parties The problem is that when a close relationship does grow, objectivity and skepticism are liable to be lost 3.6 Intimidation The final groups of threats are intimidation threats These can deter the assurance team from acting properly Examples could be threatened litigation, blackmail, or there might even be physical intimidation, though it is to be hoped that that is rare Blackmail could be more subtly applied and might relate back, for example, to a period where the auditor was not acting in accordance with the required ethical standards 3.7 Conflict of interest This is not a a standard threat, but the phenomenon is included here because it has figured in exams An example is where the auditor has two clients and one of the clients wants to buy the other The auditor has been asked to advise the purchaser The conflict of interest arises because the auditor will have detailed knowledge about the target company: costs, mark-ups, budgets etc which would be very useful to the purchaser Even if no confidential information was supplied, there can be the suspicion that it might be and you can understand why clients might feel uncomfortable In such a situation, the accountant should inform both parties They might say that they are not bothered, but even then the accountant must judge whether he or she would be seen to be independent and if there is a risk to reputation the work should be turned down Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 28 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 29 Chapter MONEY LAUNDERING Introduction Money laundering is a process whereby the proceeds of criminal activity are converted into assets appearing to have a legitimate origin Dirty money is made clean-looking The money typically comes from extortion, drugs, prostitution, illegal gambling, illegal arms sales and people-trafficking The stages of money laundering The process of money laundering can be described in the following three steps: ๏ Placement: this is the process of introducing the money into a legitimate business activity so that its origins appear bona fide Methods include: ‣ Blending funds: mixing the dirty money with legitimate cash such as boosting the cash takings of a business Tax will have to be paid, but that’s a small price if the remainder of the money is safe-guarded ‣ Gambling: winnings are artificially increased and this can be used to explain the source of the funds ‣ Currency smuggling: move the cash to a lax jurisdiction where few questions will be asked You will notice that cash transactions facilitate placement because cash is relatively difficult to trace compared to bank or credit transactions ๏ Layering: repeated transfer of money through different bank accounts and different countries in an attempt to conceal or camouflage its origins That way, even if the placement process becomes known to the authorities it becomes difficult for them to trace the cash and recover it ๏ Integration: the movement of previously laundered money into the economy so that the money can be safely used Examples include the purchase of assets such as expensive cars and art works and jewellery Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 30 Legislation Many countries now have legislation attacking money laundering and the proceeds of crime and also to interfere with money being used by terrorism organisations As well as creating criminal offences for the immediate perpetrators of the crimes the legislation can also cover the behaviour and responsibilities of auditors and accountants In the UK the Proceeds of Crime Act 2002 sets out five types of offence: ๏ Concealing, disguising, converting or transferring money that is from the proceeds of crime ๏ Entering into an arrangement to launder the proceeds of crime or having the suspicion that money laundering is taking place yet not reporting it ๏ Acquisition, use and possession of criminal property ๏ Failure to disclose ๏ Tipping off The penalties are severe For example, taking part in money laundering attracts a maximum prison sentence of 14 years and/or a fine Note that if the prosecution can show that a defendant had a even suspicion that money had criminal origins that the defendant can be found guilty of these crimes So, ‘turning a blind eye’ is no defence Obviously an accountant could be directly participating in or abetting money laundering, but here we will assume you are all ethical and won’t take part in that However, it is easier to inadvertently commit some of the other offences For example, suspicions would be expected to arise if: ๏ You work in a bank and see a customer dealing in large amounts of cash without any reasonable explanation of their origin ๏ You are an auditor and see cash passing through various banks accounts for no apparent reason Tipping off is the offence of acting in a way that discloses to the potential suspect information that is likely to prejudice an investigation So, saying to a client “I think this is money laundering and I am going to report my suspicions to the authorities” is clearly tipping off However, what if you repeatedly ask for evidence about a transaction? The client then knows that you might be suspicious and that your next step is to report the matter However, if you make no enquiries at all or inadequate enquiries, you might fail to uncover a perfectly innocent explanation Auditors also not want junior members of the audit team taking this into their own hands and directly informing the authorities Junior member of the team are relatively inexperienced and might simply be jumping to the wrong, but dramatic, conclusions Instead, all suspicions should be reported to the auditing firm’s money laundering reporting officer This is a person who has sufficient experience and seniority to be able to make reliable decisions about when matters ought to be reported to the authorities Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 31 Auditors’ responsibilities ๏ ‘Know your client’ Proper identification of the people involved, the ownership of companies, the economic rationale of the business, the sources of funds ๏ Appointment of a Money Laundering Reporting Officer (MLRO) ๏ Train staff to identify the types and patterns of transaction that might indicate money laundering ๏ Establish a system for the reporting of suspicions to the MLRO ๏ Include a paragraph in the engagement letter setting out the auditor’s responsibilities in respect of money laundering ๏ Maintain records detailing how the regulations have been complied with Risk factors for money laundering ๏ A cash-based business ๏ Many similar deposits and withdrawals in various bank accounts for not obvious reason ๏ Many jurisdiction involved in the transfer of money ๏ The use of tax havens ๏ Bearer bonds or cheques ๏ Higher profits than could be reasonably expected ๏ Poor documentation for transactions ๏ Secrecy Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 32 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 33 Chapter RESPONDING TO NON-COMPLIANCE WITH LAWS AND REGULATIONS (NOCLAR) Introduction This chapter deals with how the auditor should respond to a client’s failure to comply with laws and regulations Potentially, non-compliance will lead to fines, penalties and damages and these should be recognised as liabilities or contingent liabilities Additionally, non-compliance might cause going concern issues if the company is then prohibited from trading or the non-compliance damages the reputation of the company to such an extent that its survival is threatened ISA 250 Consideration of Laws and Regulations in the Audit of Financial Statements is relevant In addition the IESBA issued their final pronouncement on Responding to Non-Compliance with Laws and Regulations (NOCLAR) in July 2016 NOCLAR is defined as comprising acts of commission or omission, intentional or unintentional, committed by a client or those charged with governance…contrary to the prevailing laws and regulations The new rules permit professional accountants to more easily set aside their duty of confidentiality Management’s and auditor’s responsibilities ISA 250 states that “It is the responsibility of management, with the oversight of those charged with governance, to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulations… including the provisions of laws and regulations that determine reported amounts and disclosures in an entity’s financial statements” Management’s responsibilities will be easier to meet if there is a good internal control system, an internal audit department and an audit committee ISA 250 also states “ the auditor is not responsible for preventing non-compliance and cannot be expected to detect non-compliance with all laws and regulations” However, overall the auditor is responsible for identifying material misstatements whether caused by fraud or error but the ISA recognises that the risk of the auditor failing to detect material misstatements arising because of non-compliance can be increased because: ๏ There are many laws and regulations that not directly affect the financial statements and these will not be part of the information reviewed by the auditor ๏ Non-compliance might be accompanied by deliberate concealment ๏ Whether an act amounts to non-compliance is ultimately a matter for the court or regulators Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 34 ISA 250 distinguishes the auditor’s responsibilities for compliance between: ๏ The provisions of laws that have a direct effect on the financial statements (eg tax and pension laws) Here, the auditor must obtain sufficient appropriate audit evidence regarding compliance with these laws This is, essentially a positive confirmation ๏ The provisions of other laws that not directly affect the FS but where there might be material penalties or where the operation of the business is jeopardised Here, the auditor’s responsibility is limited to undertaking procedures to help the identification of non-compliance where this could have a material effect on the financial statements This is, essentially, a negative confirmation Audit procedures to assess compliance ๏ Obtain an understanding of the client’s regulatory environment and how the client complies ๏ Obtain sufficient appropriate audit evidence where the laws and regulations directly affect the FS ๏ In respect of other laws, the auditor should (i) enquire of management as to whether the entity is on compliance and (ii) inspect correspondence with relevant licensing authorities ๏ Remain alert during the audit that other audit procedures might detect non-compliance ๏ Ask for written representations from management declaring that all known incidents of noncompliance and which should be taken into account in the preparation of the FS have been disclosed to the auditor ๏ In the absence of identified or suspected non-compliance the auditor is not required to carry out audit procedures to confirm compliance other than those listed above Non-compliance is identified or suspected The auditor must: ๏ Understand the nature of the non-compliance and evaluate the possible effects on the FS ๏ Discuss the matter with management and those charged with governance if appropriate ๏ If sufficient information about the suspected non-compliance cannot be obtained the auditor must consider the effect of this lack of sufficient appropriate evidence on the audit opinion ๏ The auditor should consider the effects of non-compliance on other aspects of the audit such as risk assessment and the reliability of written representations [In other words, the directors may have shown that they consider compliance to be voluntary If they act like this in one area how many other incidents of non-compliance might exist?] Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 35 Reporting non-compliance All incidents of non-compliance should be reported to those charged with governance (unless trivial) If the auditor believes non-compliance is deliberate, this should be communicated to those charged with governance If those charged with governance are complicit in the non-compliance, and there is no higher level of authority (such as a holding company board or audit committee) then the auditor should take legal advice Under the NOCLAR provisions in the IESBA guidance the auditor should ๏ Advise management and those charged with governance to take timely and appropriate action to remedy the non-compliance ๏ Deter further non-compliance ๏ Disclose the matter to the appropriate authority where required by law or regulation or this is in the public interest The auditor must assess management’s response then decide if further action is required in the public interest This requires professional judgement: would a reasonable and informed third party be likely to conclude that the auditor has acted in the public interest? Further action might be for the auditor to make a disclosure to the regulatory authorities Simply withdrawing form the engagement is NOT a substitute to this and, indeed, the new guidance was wary of auditors solving their problem simply by resigning Whether the auditor should disclose the matter to the authorities depends on the damage that might be done to investors, employees members of the public and so on Examples where disclosure is likely to be justified include: ๏ Bribery ๏ The sale of harmful products ๏ Tax evasion ๏ Behaviour likely to damage financial markets If the disclosure is made in good faith it will not be considered to be a breach of confidentiality If non-compliance has a material effect on the FS that has not been reflected in the FS, then the audit opinion will have to be modified (qualified or adverse) If the auditor is prevented from investigating the matter then the audit opinion will have to be modified (qualified or disclaimer) It is important that all discussions, findings and disclosures are well-documented as there is obviously a high risk to the auditor of fallout from these incidents Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 36 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 37 Chapter AUDITORS’ LIABILITY Introduction Auditors’ and accountants’ liability can arise from three branches of the law: ๏ Statute: for example if the accountant has been appointed as a liquidator of a company they can be regarded as officers of the company and could be subject to criminal proceedings This is rare ๏ Contract law: the letter of engagement sets out what the auditors and the client will For example the auditors undertake to give reasonable assurance about the financial statements If the auditors carry out their work with due care and skill they will not be liable under contract law ๏ Tort law: the tort of negligence allows any injured party, not necessarily a party who has a contractual relationship with the auditor, to pursue the auditor for damages if they have suffered loss caused by the auditor’s negligence This is the area where there is potentially most difficulty The tort of negligence An injured party has to show three things if the tort of negligence is to be proved: ๏ That a duty of care exists The act of the accountant must be sufficiently close to the damage (proximity) This is presumed to exist between an auditor and the audit client However, with other relationships this is more difficult to establish ๏ That the duty of care was breached ๏ That the breach caused financial loss Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 38 The duty of care For a duty of care to be owed by an auditor to a third party, then: ๏ The auditor knew or should have known that that person would rely on the auditor’s work ๏ The third party has sufficient proximity (effectively, ‘close enough’ to reasonably rely on the auditor’s work) ๏ It must be ‘fair, just and reasonable’ to impose a liability on the auditor Some cases illustrate these principles: Caparo Industries v Dickman (1990) Caparo sued an auditor after buying shares in a company they claimed was overvalued because of inaccurate financial statements They claimed that the auditor owed potential investors a duty of care The claim was unsuccessful as it was held by the court that the financial statements are prepared for the current shareholders and that the auditor had no knowledge that Caparo would use the information for their share-purchasing decision Royal Bank of Scotland v Bannerman (2002) Bannerman was the auditor and issued a ‘clean’ audit report for a client The client was a customer of the Royal Bank of Scotland and used the financial statements to support a successful loan application The financial statements contained a serious misstatement arising from a fraud The claim was successful The court held that the auditor would have known that the bank would have used the audited accounts as part of their lending decisions and therefore owed the bank a duty of care The court stated that if the audit report had contained a disclaimer warning that only members of the company should rely on the audit report then there would be no duty of care to third parties Conclusion The courts have been reluctant to extend the concept of duty of care to third parties such as suppliers, lenders and potential investors Auditors will have exercised sufficient professional care if: ๏ They keep up to date with current approaches to auditing ๏ They apply ISAs and ethical standards and safeguards ๏ They comply with the terms of the engagement letter ๏ They apply an adequate system of quality control: assignment of staff, direction of staff, review of work ๏ They undergo adequate supervision and education and training Since the Bannerman case it has become routine for auditors to include a disclaimer clause in their reports For example: “Under section xxx we have a duty as auditors to report on the annual financial statements of the company This duty only extends to a report to the members of a company as a whole and not to an Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 39 individual shareholder or group of shareholders or to a third party who uses or places reliance on our opinion in order to make a decision to enter any type of transaction with the company.” However, there is criticism of disclaimer clauses because they can be seen as devaluing the audit report: ๏ How can it be that the financial statements show a true and fair view for the shareholders but for no one else? ๏ If the disclaimer clause reduces the chance of litigation then the auditors might not take as much care whilst performing the audit Reducing exposure to audit liability In addition to the measures set out above, auditors can make use of the following to reduce their exposure: ๏ Professional indemnity insurance This will pay compensation to injured parties in cases of negligence ๏ Fidelity insurance: Insures against the dishonesty of staff or partners ๏ Incorporation: Instead of being a normal partnership where the partners have unlimited liability, the firm becomes a limited liability partnership The partners’ personal wealth is protected ๏ Liability limitation agreements The engagement letter includes a cap on the amount of compensation payable to clients This gives no protection against third party claims ๏ Proportional liability Under this system the auditor and the client would share the burden of paying compensation to injured third parties Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 40 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 41 Chapter FRAUD, ERROR, THE EVALUATION OF MISSTATEMENTS AND REPORTING CONTROL WEAKNESSES Definitions Fraud is the deliberate falsifying of records or misappropriation of company assets Fraud can be: ๏ Fraudulent financial reporting For example, overstating profits to attract investors and lenders ๏ Misappropriation of assets For example, the theft of cash, inventory or non-current assets Error is the innocent misstatement of amounts or loss of assets Misstatement is when something has not been shown or treated properly in the financial statements A misstatement can be caused by either error or fraud A misstatement can be: ๏ An incorrect amount ๏ Incorrect presentation ๏ Incorrect disclosure Fraud It is management’s responsibility to prevent and detect fraud – not the auditor’s It is management’s duty to ensure that there is a good and effective system of internal control as this will greatly decrease the risk of fraud and increase the risk of detection Auditors are not expected to find every fraud, but they are expected (with reasonable assurance) to find material misstatements, whether innocent or fraudulent They are expected to exercise professional scepticism and to follow up any suspicions that they might have, for example if the results of analytical procedures not make sense Once a suspected fraud or error is discovered the auditor must perform more audit work, such as: ๏ Discovering how the fraud or error occurred ๏ Discovering if the incident is isolated or is part of a larger pattern ๏ Consider applying computer assisted auditing techniques to look for similar patterns within the records (for example, all orders placed with a particular supplier) ๏ Estimating the financial effect Although the auditor seeks to give reasonable assurance that the financial statements are free for material misstatement, note that ‘reasonable assurance’ must mean that not every material Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 42 misstatement will necessarily be discovered even if the audit has been carried out diligently It is accepted that the chance of a material fraud being undetected is greater than a material error being undetected because fraudsters seek to conceal their activities For example, by creating forged documents or by collusion with other parties Fraud required three conditions: ๏ Incentive to commit the fraud ๏ Opportunity to commit the fraud ๏ Attitude to go through with the fraud At the planning state the susceptibility of an entity to fraud should be discussed both amongst the audit team and with management of the client The following make fraud easier: ๏ Lack of segregation of duties so that one person is in charge of all parts of a transaction ๏ Poor internal control in general ๏ Poor IT system control ๏ Complex transactions so that is is difficult to check if they are being carried out correctly ๏ Many estimates involved ๏ Easy-to-steal assets: cash, compact but high-value inventory ๏ Complex group structures so that related party transactions are difficult to discover ๏ Pressure to perform All instances of fraud should be reported to those charged with governance It is important, even for what appears to be a small fraud, to investigate how long it has been going on for, how much is involved and who is behind the fraud Management bias ‘Management bias’ occurs when managers are under pressure or simply want to produce certain financial results For example: ๏ Their bonus depends on hitting a profit target ๏ Their job depends on a level of performance ๏ The business is going to be floated on the stock exchange so that good profits will allow a higher flotation price ๏ The business is going to be bought by another and the purchase price be will be influenced by performance In these situations auditors should be wary of managers being more optimistic than is warranted so that the value of inventory, recoverability of receivables, profit budgets and construction contract profitability are overstated and potential liabilities are understated At some point optimism and wishful thinking will become more like deliberate misstatement and fraud: making demonstrably undue claims about company performance and the deliberate omission of liabilities Management bias is a common element of AAA questions: many describe bonus schemes or buy-outs and you must respond to these by recognising that additional audit risk that inevitably arises Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 43 Evaluation of misstatements identified ISA450 requires auditors to accumulate misstatements identified during the audit other than those which are clearly trivial The triviality threshold will generally be much lower than the materiality threshold ๏ All misstatements accumulated during the audit should be communicated to the appropriate level of management in a timely basis ๏ Management asked to correct them or explain why not Often the audit committee will be involved in these discussions Misstatements can be categorised as: ‣ Factual (definitely incorrect, like a mistake when adding up the stock-take sheets) ‣ Judgemental (where the auditor and client have different opinions, such as the valuation of inventory or recoverability of debts) ‣ Projected The auditors best estimate of the error of a population based on the error rate in the audit sample ๏ The categorisations affect how much negotiation or compromise is acceptable when it comes to amending the financial statements Essentially, no room for compromise with factual misstatements, an intense discussion for judgements errors and for projected errors, rather than request an alteration to the financial statements, more testing might be appropriate to estimate the projected error more accurately and more convincingly ๏ Obtain written representations from management that they believe uncorrected misstatements are not material ๏ Assess materiality of uncorrected misstatements individually and in aggregate Note that the auditors should check that the originally established materiality levels are still appropriate now that they are possession of much more information at the end of the audit If management refuses to correct a misstatement which the auditor thinks is material then the auditor will have to issue either a qualified or adverse opinion Note that some individual misstatements can be lower than the materiality level of the financial statements as a whole For example, misstatements relating to compliance or which decrease directors’ earnings or which hide trends in the results Note it is management’s responsibility to correct errors in the financial statements Auditors cannot unilaterally adjust the financial statements that have been prepared by management If is seems that management or those charged with governance are responsible for committing the fraud then this implies that management integrity cannot be expected and the auditor, after legal advice, should withdraw form the audit Reporting deficiencies in internal controls If deficiencies in internal controls are found, the auditor should perform further work to determine the extent of the errors After the deficiencies have been discovered and investigated, the auditor must determine if they are ‘significant deficiencies’ ISA 265, Communication Deficiencies Internal Control defines a significant deficiency as one that is sufficiently serious that it should be brought to the attention of those charged with governance Factors influencing this include: ๏ The likelihood that the deficiencies will lead to financial misstatement Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations ๏ The susceptibility to loss or fraud of the related asset or liability ๏ The financial statement amounts exposed to the deficiencies ๏ The volume of activity exposed to the deficiency Watch free ACCA AAA lectures 44 The auditor must communicate in writing significant deficiencies in internal control to those charged with governance on a timely basis Other deficiencies should be communicated to management at the appropriate level Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 45 Chapter QUALITY CONTROL Introduction Quality control in auditing doesn’t just mean an audit properly: that could just be down to good luck It means that these must be a system of quality control which substantially ensures that all audits are executed properly and which provides documentary evidence that quality control procedures have been applied effectively Quality control ISA 220 Quality Control for an Audit of Financial Statements states that quality control systems, quality control policies and quality control procedures are the responsibility of the audit firm In particular, responsibility for the quality of each audit resides with the partner in charge of the audit Under International Standard for Quality Control (ISQC 1), the firm has an obligation to establish and maintain a system of quality control to provide it with reasonable assurance that: (1) The firm and its personnel comply with professional standards and applicable legal and regulatory requirements; and (2) Reports issued by the firm or engagement partners are appropriate in the circumstances (3) Note again the use of the word ‘system’ You will know that under the Code of Ethics for Professional Accountants to avoid self-interest threats firms have to ensure that no one involved in an audit owns shares in the audit client and that fees from any one client must not be too great However, these safeguards cannot be left up to chance Auditing firms need systems in place that will ensure that ethical codes are not broken and will provide evidence that quality has been maintained To comply with the self-interest rules just mentioned, the quality control system might require that each year: ‣ Every member of the audit staff must sign a declaration stating that they not own client shares ‣ A partner should review fees and sign a declaration that fee limits have not been exceeded The ISQC quality control requirements refer to six key areas: ๏ Leadership The firm must establish policies and procedure designed to promote an internal culture that recognises that quality is essential in performing engagements ๏ Ethics (covered earlier in these notes) Throughout the audit engagement, the engagement partner shall remain alert, through observation and making inquiries as necessary, for evidence of non-compliance with relevant ethical requirements by members of the engagement team ๏ Acceptance and continuance of client relationships and audit engagements The firm must ensure that appropriate procedures regarding the acceptance and continuance of client relationships and audit engagements have been followed, and shall determine that conclusions reached in this regard are appropriate Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ Human resources The firm shall establish policies and procedures designed to provide reasonable assurance that it has sufficient personnel with the competence, capabilities and commitment to ethical principles to properly perform the audit to enable an appropriate auditor’s report to be issued Responsibility for each engagement is assigned to an engagement partner and policies and procedures must be in place to assign appropriate personnel to each engagement ๏ Engagement performance Direction, supervision, reviews, consultation and performance should be of a standard to enable an appropriate auditor’s report to be issued ๏ Monitoring To ensure that the quality control procedures adequate, relevant and are operating properly ๏ Note that many of the requirements of a quality control system can be remembered by the acronym SACRED (or SCARED!): 46 ‣ Supervision ‣ Assignment ‣ Competence ‣ Review ‣ Ethics ‣ Direction Public interest audits Public interest audits, such as the audit of listed companies, should undergo an Engagement Quality Control Review Here, an independent reviewer (normally another partner) will be appointed to perform an objective evaluation of the significant judgments made by the engagement team, and the conclusions reached in formulating the auditor’s report This evaluation shall involve: (1) Discussion of significant matters with the engagement partner; (2) Review of the financial statements and the proposed auditor’s report; (3) Review of selected audit documentation relating to the significant judgments the engagement team made and the conclusions it reached; and (4) Evaluation of the conclusions reached in formulating the auditor’s report and consideration of whether the proposed auditor’s report is appropriate For audits of listed entities, the engagement quality control reviewer shall also consider the following: Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures (1) The engagement team’s evaluation of the firm’s independence in relation to the audit engagement; (2) Whether appropriate consultation has taken place on matters involving differences of opinion or other difficult or contentious matters, and the conclusions arising from those consultations; and (3) Whether audit documentation selected for review reflects the work performed in relation to the significant judgments and supports the conclusions reached 47 Reviews carried out before the audit report is signed are known as hot reviews As explained above, these are required for listed companies Reviews carried out after the audit report is signed are known as cold reviews They will not help the audit for the year being reviewed, but they will help to keep quality standards up in the future Audit documentation It is impossible to plan, supervise, control and review an audit and audit evidence without proper audit documentation Audit documentation is necessary to: ๏ Demonstrate that audit planning has been carried out ๏ Show that the detailed audit work has been carried out properly An audit really means collecting sufficient appropriate evidence that will support the auditor’s opinion on the financial statements It is essential that this evidence is recorded so that, if need be, the auditor can demonstrate that a proper audit was performed ๏ Enable senior staff to review the work of junior staff The review process is essential in carrying out a competent audit: the work of junior staff is reviewed by their supervisor, the supervisor’s work is reviewed by the manager, and finally the partner, who will sign the audit report, will review everyone else’s work Review is not possible without recording the work carried out and evidence obtained ๏ Enable Engagement Quality Control Reviews to be carried out ๏ Help the audit team in future years An immensely useful planning exercise at the start of the audit is to examine last year’s file Were there problems? Were there any errors? How did last year’s audit team go about gathering evidence? ๏ Encourage a methodical, high-quality approach The audit documentation contains information documenting the client’s accounting system, the tests that have to be performed (eg select 20 invoices at random and ensure that they are authorised) As each part of the audit is completed the audit program is signed off by the person who carried it out Outstanding matters are easy to see Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 48 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 49 AUDIT PLANNING AND RISK ASSESSMENT Chapter 10 AUDIT PLANNING Overview Appointment Plan the audit Understand entity Assess risk of material misstatement Respond to risk Expect effective controls Expect ineffective controls Satisfactory Report significant deficiencies to those charged with governance to management and all weaknesses to management Restricted substantive tests Full substantive tests Tests of controls Unsatisfactory Overall review of F/S Report to management Auditor’s report Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 50 All audits start by: ๏ Planning ๏ Understanding After these stages auditor can assess the risk of material misstatement and respond to that risk We will see later how the risk of material misstatement can be broken down into several causes, but if you are dealing with a relatively new company with inexperienced staff, and which has high value, portable inventory and many cash transactions, you will probably see that the risk of material misstatement is relatively high If the auditors conclude that is the case then they have to plan for their audit work to reduce the risk of material misstatement finding its way into the financial statements Audit planning Audit planning is very important and the auditors state in the audit report that the they state they planned and performed their audit Planning must be documented 2.1 The reasons why planning is important: ๏ If you don’t plan it you won’t carry out the audit effectively You would not know something as obvious as when the year-end is, or how many branches or factories a company has, or how many staff members you may need to conduct the audit, or whether the company has a lot of valuable inventory ๏ You have to think both of a general strategy and a detailed approach For example, in some very large companies auditors not visit all the branches every year They may visit only a quarter of the branches one year, another quarter the next year and so on They have to decide whether or not to attend a stock take They may have to decide whether or not opinions from other experts are required For example, on the adequacy of the company’s pension scheme 2.2 The planning objectives are: ๏ To give appropriate attention to important areas Is there a high inventory? Is there a high volume of cash transactions? Are debtors particularly significant? Important areas will certainly be material areas, and materiality is discussed below ๏ To identify potential problems For example, if the company has recently changed its computerised accounting system there may well have been problems at the switch-over time, and staff may still be inexperienced ๏ To carry out the work expeditiously That really means reasonably quickly and efficiently ๏ To ensure that the right numbers of staff are in the audit team with the right skills They have to be timetabled so that the work for this client and other clients can be accommodated ๏ To coordinate, if necessary, with other parties For example, the internal audit department of the company ๏ To facilitate review The work performed in an audit is subjected to many reviews The audit staff member in-charge of the audit first of all reviews the working papers, then the audit manager will review them, and finally the partner in-charge will review them All of this has to be timetabled and time must also be left to clear the review points, for example, if additional work is required Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 51 Understanding the entity Pretty much inseparable from the planning process is the process of gaining an understanding of the entity This includes: ๏ Nature of the entity We have to understand the nature of the entity For example, we simply have to understand what it does: is it in a financial sector, the retail sector, the manufacturing sector? This may seen trivial but it may help you to think of a new audit client You can often tell very little from the name of the client You have to go and find out about the entity itself ๏ Particular regulations Banks, insurance companies, and many other operations in the financial sector are subject to regulation and sometimes the auditor has to ensure that these regulations have been adhered to ๏ Accounting policies We need to understand what the entity’s accounting policies are; different entities have different ways of valuing inventories perhaps If you are a building company you will have specific accounting policies with regard to taking profits from construction contracts ๏ Objectives and strategies The auditors must gain an understanding of the entity’s, objectives, and strategies The entity’s management defines objectives, and strategies are devised to try and achieve those objectives ๏ Nature of business risks Business risks can arise from circumstances which mean that the company’s objectives and strategies may not be achieved Business risk is broader than the risk of material misstatement of the financial statements Most business risks will eventually have financial consequences and therefore an effect on the financial statements It is important for the auditors, therefore, to understand what the risks are ๏ Internal controls The auditor has to gain an understanding of the entity’s internal controls Whether they exist and to what extent they are expected to operate ๏ The control environment This refers to the context in which the internal controls operate The management of some companies have a very high regard for careful control, for careful recording, and for attention to detail Other management teams may have less regard for this For example, they may be far more interested in making a sale, which is of course important, but are not so interested in recording that sale correctly They will see some aspects of internal control as being nuisance ๏ How does management identify business risks? It is important for management to identify business risks Management has a real expertise of the business sector and if they can’t identify business risks it can be relatively difficult for the auditor to ensure that all business risks have been covered ๏ Financial performance Finally, the auditor should obtain an understanding of the measurement and review of the entity’s financial performance Performance measures and the review indicate to the auditor aspects of the entity’s performance that management and others considered be important Obtaining an understanding of the entity’s performance measures assists the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatements Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 52 Materiality One of the key areas of planning is to assess materiality An audit gives only a reasonable assurance that the financial statements are free from material misstatement, so it is essential to know what is meant by ‘material’ ๏ A matter is material if it omission or misstatement would reasonably influence the economic decisions by a user of the audit report ๏ It is affected by the size and nature of the misstatement The auditor’s judgment flows all the way through the audit process, from planning and deciding the amount of work that should be done, to deciding what action should be taken should errors be found in the accounts When judging materiality, the audit partner has to make a judgement as to whether the misstatement would be likely to alter decisions made by an user of the audit report For example, if a misstatement would cause an investor to keep those shares rather than selling those shares, then has been a real effect on that investor and the misstatement would be material If misstatements are so small that they don’t really spark any reaction in the members, then they are rather superficial That’s not to say that auditors don’t want to get things right, but errors only really matter when they trigger incorrect action Materiality has to be decided for the financial statements as a whole and it is the audit partner’s judgements about whether or not a statement is material Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 53 Guidance on materiality It’s all very well saying that a matter is material if it would reasonably influence decisions upon a user of the audit report, but that gives very little guidance to the audit team (or to you when you are doing a question) Therefore, some rules of thumb have been developed These are only guidelines, but if something is wrong to the extent of: ๏ 0.5% to 1% of revenue, ๏ 1% to 2% of total assets or ๏ 5% to 10% of profit then you should assume that the matter is material These percentages should take into account the auditor’s knowledge of which items users will focus on, the nature of the entity (life cycle/ environment), its ownership, structure and financing and the volatility of the benchmark IT IS VERY COMMON FOR AAA EXAM QUESTIONS TO PROVIDE TURNOVER, ASSET AND PROFIT FIGURES YOU MUST USE THESE FIGURES TO WORK OUT ESTIMATES OF MATERIALITY In a real audit a running total of errors is kept so that there net effect can be calculated However, when designing and carrying out audit tests and when noting down errors, smaller amounts should be set for materiality to reduce the risk that misstatements in aggregate exceed financial statement materiality This is known as performance materiality: the materiality that is important in the performance of the audit work Errors which are less than the suggested guidelines could still be regarded as being material An error which turns a small loss into a small profit could cause unfounded optimism in some situations, perhaps a feeling that the company has turned a corner So, although in absolute terms, the size of an error is relatively small, the way in which the accounts are then interpreted could lead to unreasonable decisions being made Therefore, you can talk about both quantitative and qualitative materiality Finally, there are some amounts in the financial statements where no errors are tolerable For example, there is often a statutory duty to disclose directors’ remuneration and that has to be stated with absolute accuracy All misstatements identified should be communicated to management who should be asked to correct them or to explain why not The auditors must assess the materiality of uncorrected statements and obtain written representations from management that they believe uncorrected misstatements to be not material If management refuse to correct an error that the auditor thinks is material then the auditor will issue a modified (critical) audit report Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 54 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 55 Chapter 11 RISK The sources of risk ISA 315, states that the auditor should: “…obtain an understanding of the entity and its environment sufficient to identify and assess the risk of a material misstatement in the financial statements” The total risk of material misstatement can be split into two: ๏ Business risks ๏ Audit risks Business risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the entities ability to achieve its objectives and execute its strategies The business risks can itself be split into: ๏ Strategic risk ๏ Operational risk ๏ Financial risk ๏ Compliance risk Financial risks could arise because of high borrowings and a rise in interest rates This will put to business under severe pressure and could increase the risk of material misstatement, perhaps with regards to going concern problems Operational risks arise from operational errors For example, if the products are made incorrectly then there might be warranty claims and a loss of reputation Compliance risks arise from a failure to comply with regulations This can mean that the business has large penalties or fines to pay or it may result in the business been prevented from continuing to trade Reporting risks arise from not reporting on time or sufficiently accurately The auditor does not have a responsibility to identify or assess all business risks, but an understanding of business risks increases a likelihood of identifying risks of material misstatement At the AA level, business risk was not considered, but it is very relevant to AAA Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 56 Business risk It is, of course, not the auditor’s duty to manage a business and its risks or even to warn audit clients about business risks It is the directors’ and management’s responsibility to run the business for the benefit of shareholders Auditors cannot be expected to have expertise in the huge variety of business risks that are suffered by their many clients Provided the financial statements properly report on what has happened in the business (for example, that stocks of a poorly selling product has been written down appropriately) the audit report is not affected: the FS are showing a true and fair view So why is business risk important to auditors? Well, it is important because business risk will often cause audit risk ie that business risk causes a material misstatement in the financial statements that is not detected by the auditors who then issue an inappropriate opinion For example: Business risk Possible audit risk Strategic: out-of date products Stock might not sell at above cost and should be written down Strategic: operations in a country where the economy has become poor Perhaps the directors want to divest and the subsidiary has to be valued appropriately Perhaps the fair values of the non-current assets are almost worthless and must be written down Operational: a batch of products has been poorly Sales returned, goods scrapped, compensation manufactured to be paid Operational: computer virus in the accounting system that deletes records What are the receivables (and other balances)? Financial risk: rise in interest rates Could cause going concern doubts Financial risk: changes in exchange rates Could cause contacts to become unprofitable or products to be non-competitive with consequent valuation issues Compliance risk: improper recruitment of staff that contravenes equality legislation Possible fines, hence contingent liabilities Compliance risk: failure to comply with health and safety legislation Possible fines, damages, loss of licence to operate Hence liability and going concern issues Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 57 Audit risk Audit risk is the risk that the financial statements contain a material misstatement that the auditors have not discovered so that the auditors give an inappropriate opinion on the published financial statements (Strictly, it could also refer to the auditors modifying their report when the financial statements are fine - but that’s rare, if it has happened at all.) Audit risk depends on three factors, and the relationship is described as: Risk of material misstatement AR = IR x CR x DR Audit Risk Control risk Inherent Risk Detection Risk Sampling Risk Non-sampling Risk ๏ Inherent risk = the risk of an error occurring in the first place, without any controls being present ๏ Control risk = the risk that the organisation’s control procedures not prevent, detect and correct the error ๏ Detection risk = the risk that the auditor does not discover the error Inherent risk is increased by factors such as: ๏ Time pressure on staff ๏ Inexperienced staff ๏ Lack of training ๏ Complicated transactions ๏ Complicated reporting requirements eg complex ISAs ๏ Pressure to perform ๏ New procedures or new systems ๏ New areas of business If there are no controls any errors will find their way onto the draft financial statements Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 58 However, good control systems can prevent or detect errors For example: ๏ Good management will ensure that only appropriately qualified or experienced people will process certain transactions ๏ Segregation of duties ensures that each transaction is dealt with by more than one person so that there is an element of checking and supervision ๏ Reconciliations check the accuracy of numerical data ๏ Authorisation and approval lends reliability to transactions ๏ Physical measures safeguard assets ๏ Inspection of assets can detect damaged assets or deliveries not properly made Don’t look upon this too mathematically What it is saying is that auditors will want the audit risk to be low: they don’t want to make an error in their audit opinion If they want the audit risk to be low then the terms on the right hand side of the equation, or at least some of them, have to be low If an error is made in the first place (inherent risk) AND is not identified and corrected by the controls (control risk) then the error will be incorporated into the draft financial statements There is then only one line of defence before the error is distributed to members in their annual financial statements: the audit The error has to occurred The client’s procedures and staff must not have picked that up and corrected it The auditors must have failed to detect it The material error reaches the published financial statementsA udit risk If the auditors believe that the inherent risks together with the control risks are unacceptably high, then they must increase the amount of audit work they perform This reduces the detection risk (the risk that the error is not discovered by the auditors) Risks of undetected material misstatements must be reduced to levels which provide reasonable assurance that material errors are detected Neither inherent risk nor control risk can be influenced by auditors in the short term Inherent risk might be completely impervious to change (for example, a complicated transaction will always be complicated) Control risks might be reduced in the medium term if the audit client takes note of auditors’ letters which set out control weaknesses However, when it comes time to perform the audit on the draft financial statements, the only risk that the auditors can control is the detection risk They must sufficient audit work to manage the overall audit risk Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 59 Causes of material misstatements Material misstatements can occur in two ways: (1) The amount is wrong (2) An accounting or reporting standard has not been properly applied Auditors must find evidence that neither of these has occurred, so auditors need to collect audit evidence about the amount and also about the treatment of the amount in the financial statements Remember, audit evidence is needed about all the relevant assertions So for a non-current asset, evidence is needed about existence, ownership (rights and obligations), accuracy valuation and allocation, completeness, classification, presentation Transactions and events require evidence about occurrence, completeness, accuracy, cut-off classification and presentation Accounting standards often stipulate how amounts should be classified and presented The can also determine cut-off (eg in revenue recognition) and valuation (inventory cannot be valued on a LIFO basis) Detection risk The detection risk itself depends on two components: ๏ Sampling risk This arises because, in most audits, auditors only look at a very small proportion of transactions and documents There is always a risk that they happen to look at all the documents and transactions which are correct and don’t find any which are incorrect That can just be bad luck in sampling and could lead the auditor to too little work Sampling risk can be reduced by examining larger samples ๏ Non-sampling This risk arises from reasons other than sampling For example, if the audit staff were inappropriately qualified then there is a high risk they wouldn’t properly understand what was going on or detect the regularities in the financial statements Nonsampling risk can be reduced by better planning of the audit, and ensuring that audit staff are better trained, have appropriate skills and are that their work is well-supervised and reviewed Good quality control procedures should reduce the non-sampling risk: proper planning, proper assignment of sufficiently skilled staff, proper direction, supervision and review of staff’s work, proper education and training of audit team members Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 60 Where audit risk can be found Audit risk has to be reduced to an acceptable amount at both the ๏ Financial statement level ๏ Assertion levels Dealing first with the assertion level, essentially any single figure which appears in the financial statements is making assertions For example, it is saying something about its size, its accuracy, its valuation, completeness and occurrence There are some figures, for example, director’s emoluments which in the overall scheme of things may not be terribly large, but which by law are required to be disclosed accurately and a relatively small misstatement would mean that the financial statements are not showing a true and fair view Dealing with the financial statement level, all the figures appearing in the financial statements could be true, but overall the financial statements could still not show a true and fair view For example, liquidity issues could be concealed so that the overall effect of the accounts is to be misleading To get a higher assurance at the assertion levels audit procedures must be designed and performed in line with the assessed risks of material misstatement For example, if you are worried about receivables valuation you have to a lot more work verifying the receivables are recoverable Perhaps you could try to wait for several months after year end to see which customers actually pay At a financial statement level just to doing more work as such is probably insufficient You need more experienced and better staff Misstatements at the financial statement level are potentially more subtle and require a higher level of skill to detect Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 61 Chapter 12 QUESTION PRACTICE ON RISK Events, discoveries and accounting issues and implications for the audit A common format of a question on business or audit risk is to present you with notes from a recent planning meeting with a client, or an email from a partner raising certain issues affecting the client You then have to identify the audit risks arising and have to say how you would respond or describe how you would gather sufficient appropriate audit evidence The information is given as a number of paragraphs each usually dealing with one piece of information Generally, each paragraphs will have at least one implication for the audit of the financial statements It is rare to be provided with information that is of little importance A similar question can ask about business risk rather than audit risk There you not have to talk about evidence as we are not yet at the stage of carrying out an audit Remember, auditors are interested in business risks because these frequently lead to audit risks Below is a selection of the type of issues that might be presented to you in exam questions For each, identify the issue(s) raised and what the implications are for the audit Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the lecture as each item is talked about there (1) During an inventory count at a company which makes jam and marmalade, a box containing 12 jars was dropped and the jars were broken It was immediately noticed that the contents had a bad small and had obviously gone off or had been contaminated (2) On the final review of an audit file, the partner in charge discovered that a junior audit assistant had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been posted by the client to Input VAT [Note: VAT on cars is not recoverable.] Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations (3) Watch free ACCA AAA lectures 62 Non-current asset schedule: Motor vehicles Freehold land and buildings Computers 260 10,000 2,000 Additions 50 – 600 Disposals 70 – 400 Cost c/f 240 10,000 2,200 Depreciation b/f 180 600 1,400 Disposals 80 – 100 Charge for year 60 200 220 160 800 1,520 $000 Cost b/f c/f Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10% Cars are years old when sold (4) A television company has built a small village to be used in the filming of a popular and longrunning TV program The village has been build in an area of natural beauty and permission to build was granted on the condition that the village is demolished and the site landscaped on the earlier of filming ceasing and 20 years (5) The first audit of a new client is in progress The holding company imports small decorative items from abroad Its subsidiary trades through 12 take-away pizza shops which are very profitable Dividends are regularly paid by the subsidiary to the holding company During the audit, an inventory count showed that the holding company had imported some modern items which appear to be made of ivory, which is a banned import Invoices for these items traced through goods received notes described them as being made from a synthetic material (6) A large printing machine originally cost $5 million and its accumulated depreciation amounts to $3 million.The sale value of the machine to an overseas buyer in the country of Burunda, net of selling costs, is believed to be 10 million Burundan pounds The exchange rate at year end was Burundan pounds to $1 The value in use, using cash flow projections and a discount rate of 5%, is $1.5 million (7) You are the auditor of a group of companies and one of the subsidiaries has had very poor cash flow and it seems that the bank is unlikely to renew its borrowing facility The finance director of the holding company has told you that it will make the required loan to the subsidiary to keep it solvent (8) A company has changed the way in which it values inventory from the FIFO to the average stock basis and has also changed its depreciation rate on machinery from 20% to 15% Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 63 Business risk As mentioned above, business risks occur when something either has gone wrong or might go wrong in the business In the examples below, identify the business risk and suggest how this might lead to misstatements in the financial statements Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the lecture as each item is talked about there (1) A company has started selling goods on the Internet (2) A company has started to export goods (3) The finance director has recently left and at period end, has not been replaced (4) A company has failed to file its tax return on time (5) An employee was badly injured carrying out his duties (6) A computer virus disrupted the IT system for two days All seems fine now (7) The company changed over from its old to its new IT system part-way through the year The change-over seemed to go smoothy Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 64 Suggested answers 3.1 Audit risk (1) During an inventory count at a company which makes jam and marmalade, a box containing 12 jars was dropped and the jars were broken It was immediately noticed that the contents had a bad small and had obviously gone off or had been contaminated ‣ Obviously that packet will be written off, ‣ The auditor should investigate other inventory to see if this is an isolated incident of contaminated food First choose jars from the same batch, then choose some others at random and perhaps extend to different products ‣ An explanation should be sought from management as to how the contamination might have occurred ‣ Examine records showing previous production problems ‣ If other inventory items cannot be shown to be safe with confidence, they will have to be written down too ‣ A recall scheme might be urgently needed to get customers to return the affected products ‣ If some products have already been sold to consumers, newspaper ads and social media should warn them too and ask them to return goods for a refund ‣ Try to discover if any end-consumers have had health issues after consumption of the product ‣ Assess liabilities for damages and the value of sales to be reversed etc ‣ Examine the company’s insurance policies to see if they have any policies that could help eg public liability insurance ‣ Consider whether the company would survive any adverse publicity (going concern issues) ‣ If the issue concerns a specific brand which is recognised in the SOFP, consider impairment/ write-downs (2) On the final review of an audit file, the partner in charge discovered that a junior audit assistant had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been posted by the client to Input VAT [Note: VAT on cars is not recoverable.] ‣ Make an appropriate journal adjustment for that vehicle ‣ Investigate the treatments of other vehicles acquired as this might not be an isolated mistake Make adjustments as needed ‣ Look at the treatment of other amounts where expenditure is not allowable for VAT (such as entertainment expenditure) ‣ Encourage the company to come clean with the VAT authorities and assess payments due together with any penalties ‣ Review the performance and skill level of the audit team members Consider additional training ‣ The error should have been picked up at earlier reviews ie before getting to partner level Look at the review processes and skills of other staff members Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations (3) Watch free ACCA AAA lectures 65 Non-current asset schedule: Motor vehicles Freehold land and buildings Computers 260 10,000 2,000 Additions 50 – 600 Disposals 70 – 400 Cost c/f 240 10,000 2,200 Depreciation b/f 180 600 1,400 Disposals 80 – 100 Charge for year 60 200 220 160 800 1,520 $000 Cost b/f c/f Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10% Cars are years old when sold ‣ Assess depreciation rates Are these usual for the classes of assets 10% for computers looks low ‣ Following up that point, the cost of computers disposed off is 400, but the accumulated depreciation is only 100 This implies under-depreciation ‣ Freehold land and buildings presumably contain freehold items so these should not be depreciated Depreciation of 2% has been applied to the total amount (4) A television company has built a small village to be used in the filming of a popular and longrunning TV program The village has been build in an area of natural beauty and permission to build was granted on the condition that the village is demolished and the site landscaped on the earlier of filming ceasing and 20 years ‣ Examine the legal agreement with respect to planning permission and the requirement to demolish ‣ The demolition costs must be capitalised as part of the construction costs and a long-term provision set up (FRS15) A difficult estimate ‣ However, this amount needs to be the estimated demolition cost discounted for 20 years at the company’s cost of capital Cost of capital will have to be estimated ‣ The discounting on the provision and the amount capitalised have to be ‘unwound’ over the life of the asset ‣ A depreciation rate of 5% is probably appropriate ‣ Investigate any borrowing costs incurred during construction as these have to be capitalised also (from commencement of construction to when the asset is first brought into use.) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations (5) Watch free ACCA AAA lectures 66 The first audit of a new client is in progress The holding company imports small decorative items from abroad Its subsidiary trades through 12 take-away pizza shops which are very profitable Dividends are regularly paid by the subsidiary to the holding company During the audit, an inventory count showed that the holding company had imported some modern items which appear to be made of ivory, which is a banned import Invoices for these items traced through goods received notes described them as being made from a synthetic material ‣ Note: the first audit of a new client always causes more audit risk, simply because the client, business and systems are all unfamiliar Generally, a more skilled audit team than normal should be assigned for the first audit to reduce detection risk ‣ Pizza shops are largely cash based They are reported as being very profitable Consider the risk of money laundering ‣ Money is going abroad through the import business ‣ The client might have dealt with illegal items (ivory) We need to establish the material used ‣ If the imports are illegal, the client should be encouraged to tell the authorities and any penalties should be estimated and suitable provisions set up ‣ If the material is ivory, or the client will not allow it to be tested, the auditor should withdraw because the integrity of management is in doubt (6) A large printing machine originally cost $5 million and its accumulated depreciation amounts to $3million The sale value of the machine to an overseas buyer in the country of Burunda, net of selling costs, is believed to be 10 million Burundan pounds The exchange rate at year end was Burundan pounds to $1 The value in use, using cash flow projections and a discount rate of 5%, is $1.5 million ‣ The fair value of the asset needs to be considered Current carrying value is $2m NRV = 10/4 = $2.5m Value in use is $1.5m If the exchange rate is steady, the carrying value should be held at $2m However, the exchange rate only needs to fall to Burundian pounds to the S1 before the NRV falls to the current NV Any further fall implies that an impairment adjustment is needed ‣ However, is the asset being held for sale under IFRS5 If so, the asset should not be depreciated and appropriate disclosures need to be made (7) You are the auditor of a group of companies and one of the subsidiaries has had very poor cash flow and it seems that the bank is unlikely to renew its borrowing facility The finance director of the holding company has told you that it will make the required loan to the subsidiary to keep it solvent ‣ The auditors need to see a ‘letter of comfort’ ‣ Board minutes should be examined to see if financial support has been approved ‣ The auditors need to assess if the holding company can provide any support needed ‣ If support seems unlikely or impossible, the subsidiary FS will have to be drawn up on a break-up basis ‣ Costs of liquidation need to be estimated ‣ Loan agreements must be looked at to see if the subsidiaries failure will precipitate the breaching a borrowing covenant Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations (8) Watch free ACCA AAA lectures 67 A company has changed the way in which it values inventory from the FIFO to the average stock basis and has also changed its depreciation rate on machinery from 20% to 15% ‣ Inventory: a change in accounting policy, so a retrospective treatment of the change is needed Last year’s comparatives and opening inventory values need to be brought up to date with respect to the new approach A note to the FS is required ‣ Depreciation: a change of accounting estimate, so a prospective change The current NBV will be depreciated over the remaining useful life of the asset A note to the FS should be included if the change is material 3.2 Business risk (1) A company has started selling goods on the Internet ‣ A risk that the web site, sales processing, goods despatch etc not work properly ‣ Not clear if new receivables will be created or if payment is taken before despatch, so a baddebt risk ‣ Potential data security problems (2) A company has started to export goods ‣ Loss of goods in transit ‣ Bad debts ‣ Will good be popular abroad? (3) The finance director has recently left and at period end, has not been replaced ‣ Lack of supervision and control in the finance department ‣ Can the FS and other management accounting information be prepared properly and on time (4) A company has failed to file its tax return on time ‣ Fines, penalties and perhaps a tax investigation started (5) An employee was badly injured carrying on his duties ‣ Fines, damages ‣ Health and safety investigation ‣ Potential industrial action ‣ Loss of reputation/bad publicity (6) A computer virus disrupted the IT system for two days All seems fine now ‣ Loss of business during that period ‣ Loss of accounting information ‣ Has the accounting system really recommenced without loss or corruption of data? (7) The company changed over from its old to its new IT system part-way through the year The change-over seemed to go smoothy ‣ Disruption at the time of changeover and for some time afterwards as employees get used to the new system Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 68 ‣ There are two accounting systems to be considered One before the change and one after the change [not really a business risk, but the auditors will probably have to almost perform two audits and also look carefully at the transfer of balances between the old and new systems.] Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 69 AUDIT EVIDENCE Chapter 13 AUDIT EVIDENCE For what is audit evidence needed? 1.1 Amounts and compliance with accounting standards Auditors aim to say, with reasonable assurance that the financial statements not contain material misstatements If you remember, we have already emphasised that this means that the financial statements must show figures which are substantially true (think sufficiently accurate) and be presented fairly To avoid misstatements: ๏ the calculation of the amounts ๏ their presentation and ๏ disclosure must comply with the relevant accounting standard(s) A simple example of a misstatement through incorrect treatment is that of a bank loan repayable in months but which is classified as a long term liability If a year loan is repayable by instalments, the liability has to be split into current and noncurrent parts If the auditor is willing to give an assurance about the financial statements then the auditor needs evidence that supports both the amount and its proper treatment under the accounting standards Evidence should be NEAT! Auditors: 1.2 Need Evidence for Amount and Treatment The requirement to know what the accounting standards stipulate and how evidence about their application can be collected is a big change from AA to AAA Many of the ways of collection evidence that you will mention in AAA answers will be identical to those in AA (for example, tracing transactions to original documentation, inspecting assets) However, because AAA tends to deal with more difficult audit challenges, often where matters are not clear-cut and judgement is required The following sources of evidence tend to become more important than they were in AA questions: ๏ Inspect board minutes: you would expect material and difficult matters to be discussed at board meetings ๏ Ensure that the matter is included in the letter or representation ๏ Ask to see impairment reviews that have been prepared by management and examine these critically Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ Raise enquiries with management ๏ Inspect correspondence with third parties, such as lawyers ๏ Examine post period end events: trading levels, prices, use of assets, resolution of disputes etc 70 The assertions Even if we just consider the auditing of the amounts items in the financial statements figure it is important to understand what an amount is asserting (saying or proclaiming) Every figure on the statement of financial position or on the statement of profit or loss (or other documents making up the financial statements) asserts (or says) a number of things For example, a figure of $4m for machinery in non-current assets implies that: ๏ The amount is accurate ๏ It does relate to machinery ๏ The assets exist ๏ The machinery is owned ๏ The assets are fairly valued ๏ All amounts have been included The single figure is asserting all of this and evidence is needed for each assertion each figure makes 2.1 The assertion classifications ISA315 states the following: “…management…makes assertions regarding the recognition, measurement, presentation and disclosure of the various elements of financial statements and related disclosures Assertions used by the auditor to consider the different types of potential misstatements that may occur fall into the following two categories and may take the following forms: Assertions about classes of transactions and events for the period under audit: ๏ Occurrence – transactions and events that have been recorded have occurred and pertain to the entity ๏ Completeness – all transactions and events that should have been recorded have been recorded ๏ Accuracy – amounts and other data relating to recorded transactions and events have been recorded appropriately ๏ Cut-off – transactions and events have been recorded in the correct accounting period ๏ Classification – transactions and events have been recorded in the proper accounts ๏ Presentation – that information is presented correctly For example, required disclosures are made in the notes to the financial statements Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 71 2.2 Assertions about account balances at the period end ๏ Existence – assets, liabilities, and equity interests exist ๏ Rights and obligations – the entity holds or controls the rights to assets, and liabilities are the obligations of the entity ๏ Completeness – all assets, liabilities and equity interests that should have been recorded have been recorded ๏ Accuracy, valuation and allocation – assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded ๏ Classification – transactions and events have been recorded in the proper accounts ๏ Presentation – that information is presented correctly For example, required disclosures are made in the notes to the financial statements Note that these assertions imply that the treatment (eg calculation and classification and disclosure) of the figures is correct and complies with relevant accounting standards Gathering audit evidence The procedures for obtaining audit evidence are: ๏ Analytical procedures (ratios, changes and comparatives) ๏ Enquiry and confirmation For example, asking the directors if they intend to sell or close down any part of the business ๏ Inspection For example, the physical condition of inventories or non-current assets ๏ Observation For example, watch what staff in the warehouse as deliveries are received ๏ RecalcUlation and re-performance For example, recalculate the profits recognised in a construction contract to ensure that they have been correctly carried out You might remember that these five procedures can be remembered by the vowels, A, E, I, O and U There are no other methods of gathering evidence whatsoever Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 72 Analytical procedures Analytical procedures consist of looking at amounts in the financial statements, calculating ratios and then comparing the amounts and ratios to: ๏ Last year’s results ๏ Budgets ๏ Industry standards Also the trends and changes in the company’s financial statements over time will be examined Analytical procedures are a powerful source of evidence and is used in three places: ๏ Planning – If last year’s inventory amounted to 34 days’ of supply and this year amounted to 97, then you have identified an area that will need attention during the audit Why has inventory increased so much? Was this planned? Is there an error? Will it sell? What value should it have? ๏ Substantive tests – If last year’s collection period was 32 days and this years is 31.5, then this gives some confidence that the figures this year are correct Similarly if sales are very close to budget, this implied some support for the figures being correct ๏ Final review – Here, just before the audit report is signed, the partner stands back and looks at the financial statements as a whole Do the figure seem to make sense? Analytical procedures allow the auditor to assess whether or not the financial statements are consistent with their understanding of the entity If they believed that the entity was substantially dealing in cash transactions yet it had a large receivables balance they might wonder why If the receivables balance changes dramatically from one year to the next, but sales hadn’t really changed, the auditors might begin to question the recoverability of those balances If the days of inventory held by the organisation rapidly increased they might begin to worry about the valuation of inventory and whether or not it could all be sold at above cost Auditors can also look at how expenses change from year to year If a business keeps about the same level of activity you wouldn’t expect the expenses such as telephone, post, heating, and lighting to increase much more than the rate of inflation If, however, the telephone costs had increased markedly the auditors need to find out why It might be because the company had gained an important overseas customer and there are now many high cost overseas telephone calls If the increase can’t be explained in a reasonable manner then an error may have been made and wrong amounts may have been posted to the telephone account Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 73 Sufficient, appropriate audit evidence So now we know the various sources of audit evidence (analytical procedures, enquiry and confirmation, inspection, observation, and recalculation and re-performance), but how much audit evidence is needed? ISA 500 states that there should be: ๏ Sufficient ๏ Appropriate audit evidence, to be able to draw reasonable conclusions on which to base an audit opinion Sufficient is to with the quantity of audit evidence Appropriate is to with how relevant and reliable it is With respect to the relevance and reliability of audit evidence we can say that: ๏ External evidence is better than the entities records For example, looking at a bank statement or a bank certificate is very good evidence about how much cash was in the bank account at a particular date ๏ Evidence obtained directly by the auditor is better than evidence passed on by the clients The problem is that if the evidence is passed on by the client you don’t know if it’s complete The client could be suppressing information they don’t want you to see ๏ Audit evidence is better if there is a good internal control system A good internal control system should mean that the checking performed by the client reduces a likelihood of errors been made ๏ Written evidence is much better than oral Someone once said oral evidence isn’t worth the paper it is written on If evidence is oral what evidence can you, the auditor, show to prove you actually received it ๏ Originals are better than photocopies Nowadays with scanners and graphics programs it’s very easy to alter documents and these alterations are very difficult to spot Therefore original contracts and documents of title should be sighted The auditors may take a photocopy to keep on their audit file, but they should be taken from the original documents Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 74 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 75 Chapter 14 A SUMMARY OF IMPORTANT ACCOUNTING STANDARDS Introduction Remember, the financial statements will not show a true and fair view if amounts have not been calculated, displayed or disclosed in line with the accounting standards Auditors must also collect evidence the confirm that the accounting standards have been complied with The information set out below is very much in summary form If you need to go back to SBR material (available on the OpenTuition site) But, actually, the best way to relearn these and see how they are examined in AAA is do lots of past ACCA questions Note that if an IAS or IFRS has been updated since the AAA paper was set, (for example on revenue recognition) the ACCA answers are not changed and will be out of date The summary (alphabetically) 2.1 Accounting policies, estimates and errors (IAS 8) Change to an accounting policy: retrospective effect, so restate opening figures and comparatives Disclose in notes Change to an accounting estimate (eg depreciation rate): prospective effect If material disclose Correction of prior period errors: restate opening and comparatives as though error had not occurred If material, disclose 2.2 Assets (non-current) held for sale and discontinued operations (IFRS 5) Classified as this is: ๏ Management is committed to a plan to sell ๏ Sale is probable (< 1yr away) ๏ Asset immediately available for sale ๏ Being actively marketed at a realistic price ๏ Plan to sell unlikely to be abandoned Measure at the lower of carrying value and fair value less costs of sale (fair value = the buying/selling price between knowledgeable and willing parties in an arms length transaction) No depreciation, even if still in use Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 76 For discontinued operations show the post tax profit of the discontinued operation and the post tax gain or loss (measured to fair value) less costs to sell 2.3 Borrowing costs (IAS 23) Finance costs capitalised when assets are being constructed The period of costs to be capitalised is from the commencement of the construction to when the asset is ready for use 2.4 Construction contracts (IAS 11) If, say 75% complete, recognise 75% of profit Tale expected losses immediately Progress measured by costs, surveys, physical progress SOFP amount is: Costs incurred X add: recognised profit X less: recognised losses (X) less: progress billings (X) = gross amount due to/from customers X 2.5 Contingent liabilities, asset and provisions (IAS 37) A contingent liability is a possible liability arising from past events but the existence of that liability will only be confirmed by future events ๏ If the present obligation probably requires the outflow of resources then a provision is recognised and disclosures are required ๏ If it is a possible obligation that will probably not require the outflow resources, no provision is required but disclosure should be made by way of notes ๏ If the outflow of resources is remote no provision and no disclosure is required A contingent asset is a possible asset arising from past events but whose existence will only be confirmed by future events ๏ If an inflow of economic benefits is virtually certain then the asset is not contingent: it’s a real asset and should be showed in the statement of financial position ๏ If the inflow of economic benefits is merely probable, not virtually certain, then it would be imprudent to recognise that asset in the balance sheet but disclosures by way of a note will be useful and therefore should be made Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 77 2.6 Events after the reporting date (IAS 10) Occur between SOFP and date of approval of the FS Adjusting: more evidence of conditions that existed at date of SOFP; adjust FS Non-adjusting: events that occurred after the end of the reporting period If material disclose by way of note 2.7 Financial instruments (IFRS 9) Essentially, accounting for financial instruments deals with investment in shares, bonds, receivables, how the business accounts for financial liabilities, equity instruments and derivatives Commonest treatment of financial liabilities is to deal with these at amortised cost Each period the liability increases by the finance cost charged and decreases by the cash repaid Financial assets can be equity or debt instruments The commonest treatment of equity instruments is to value them at fair value plus transactions costs Value movements go through other comprehensive income Debt instruments can be valued at (1) Fair value through profit or loss: initial measurement and subsequent measures at fair value and differences recognised as income; or (2) Amortised cost if the business model and cash flow tests are passed Business model test: entity must be holding the financial asset to collect the contractual cash flows from the asset they are entitled to Cash flow test: the cash flows collected must be only of interest and capital (thus ruling out convertible bonds form this treatment 2.8 Foreign exchange (IAS 21) When a transaction occurs translate it into the at the rate at the date of the transaction or at the average rate over the period For example, the purchase of a machine from a foreign supplier For the SOFP, translate monetary items at the closing rate (eg the amount owing to the machine supplier) Non-monetary items are not retranslated and remain at amount they were first translated at (historical rate) The cost of the machine bought is not retranslated Exchange rate differences are recognised in the SPL With respect to subsidiaries, the whole SOFP is translated at the closing rate Income and expenses are translated at the average rate for the period Exchange adjustments on consolidation are taken to reserves until disposal of the component when they are transferred to the SPL Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 78 2.9 Government grants (IAS 20) Recognise only if reasonable assurance the conditions attached to the grant will be met and the grant will be received Income grants: recognise in statement of profit or loss and match against future related costs if any otherwise recognise immediately Capital grants: credit against cost of the asset (thereby reducing depreciation) or treat as a deferred credit of the SOFP and release to the SPL over the life of the asset 2.10 Impairment of assets (IAS 36) Compare carrying value to recoverable amount If CV>RA, write down RA is the higher of NRV and value in use Indicators of impairment include: ๏ Damage ๏ Obsolescence (or fall in the income arising form the use of the asset) ๏ Change in use ๏ Fall in market value ๏ Competitor actions ๏ Operating losses in the business where the asset is used Record in the statement of profit or loss as an expense, but if previously revalued first set against the revaluation reserve 2.11 Intangible assets - research and development (IAS 38) Charge research costs against profits as incurred Development costs can be capitalised provided: ๏ Project is feasible ๏ Asset will generate future economic benefits ๏ Entry has adequate technical, financial and other resources (eg personnel) to complete the project ๏ Expenditure can be reliably measured ๏ Asset will be completed then used or sold by the entity Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 79 2.12 Intangible assets (IAS 38) Capitalise at cost if identifiable, controlled, generation of future economic benefits probable and the cost can be measured reliably Purchased intangibles with a finite life (such as brands and licences) should be amortised over their useful economic lives Purchased intangibles with indefinite life (such as goodwill) should be subjected to an annual impairment review Note that training costs can never be capitalised: they might bring economic benefits, but the company cannot control the costs: employees can leave 2.13 Inventory (IAS 2) Lower of cost and NRV 2.14 Investment property (IAS 40) Held for rental income or capital gains Choose either the cost (depreciate) or fair value method (possible impairment) of valuation Gains and losses on revaluation using the fair value model are recognised in the SPL 2.15 Leases (IFRS 16) Other than low-value assets or short-term leases (less than12 months), all leased assets are recognised in the SOFP as right-of-use assets At the start of the lease the lessee should recognise the present value of future lease payments as a liability The leased asset is also recognised in the SOFP, often as just the matching double entry but professional fees and future dismantling costs would need to be added if present (as with normal property, plant and equipment assets) The asset can subsequently be measured on either the cost or revaluation model Depreciation should be straight line over the period of the lease Each year the liability is increased by the interest charged and reduced by the lease payments The liability must be split between its current and non-current parts 2.16 Operating segments (IFRS 8) Disclose information about each operating segment An OS engages in business activities, its results are regularly reviewed by entity’s chief decision maker and has discrete financial information For separate reporting: Sales at least 10% (includes sales to other segments) of entity’s total revenue; or Profit at least 10% of total profit of all segments making a profit Loss at least 10% of total loss of all segments making a loss Assets at least 10% of entity’s total asset Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 80 2.17 Pensions/employee benefits (IAS 19) Defined contribution: employer (and employee) pay contributions but there is no obligation to pay additional sums after retirement even if the pensions are disappointing Accounting is easy: contributions are simply a period expense Defined benefit: employer (and employee) pay contributions but there is an obligation to pay additional sums after retirement if necessary to increase the pension to the defined benefit amount Accounting is more difficult as deficits might have to be made good Compare: Plan assets and Plan liabilities at present value amounts (actuarial report needed) Show the net asset or liability on the SOFP SPL amounts arise from: ๏ Current service costs (employees have worked another year and contributions will have been made for that year) ๏ Past service costs (change to the present value of a defined benefit obligation arising from past periods’ service and caused by an amendment in the pension terms) ๏ Curtailment component = reduction in pension liabilities because of a reduction in employees covered ๏ Settlement component = when a pension obligation is eliminated (eg an employee moves to another employer and a transfer of pension fund value is made to the new employer’s pension scheme) ๏ Net interest component = is the change in measurement of both the obligations and the fund assets because of the passage of time ๏ Measurement component = changes arising from actuarial alterations 2.18 Property, plant and equipment (IAS 16) Items of property, plant, and equipment should be recognised as assets when: ๏ it is probable that the future economic benefits associated with the asset will flow to the entity, and ๏ the cost of the asset can be measured reliably IAS 16 permits two accounting models: ๏ Cost model The asset is carried at cost less accumulated depreciation and impairment ๏ Revaluation model The asset is carried at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably Under the revaluation model, revaluations should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date If an item is revalued, the entire class of assets to which that asset belongs should be revalued Revalued assets are depreciated in the same way as under the cost model Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 81 2.19 Revenue recognition (IFRS 15) Five-step model framework: (1) Identify the contract(s) with a customer (2) Identify the performance obligations in the contract (3) Determine the transaction price (4) Allocate the transaction price to the performance obligations in the contract (5) Recognise revenue when (or as) the entity satisfies a performance obligation Revenue is recognised as control is passed, either at a point in time or over time Point in time Revenue is recognised when control is passed at a certain point in time Factors that may indicate the point in time at which control passes include, but are not limited to: ๏ the entity has a present right to payment for the asset; ๏ the customer has legal title to the asset; ๏ the entity has transferred physical possession of the asset; ๏ the customer has the significant risks and rewards related to the ownership of the asset; and ๏ the customer has accepted the asset Over time An entity recognises revenue over time if one of the following criteria is met: ๏ the customer simultaneously receives and consumes all of the benefits provided by the entity as the entity performs; ๏ the entity’s performance creates or enhances an asset that the customer controls as the asset is created; or ๏ the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 82 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 83 Chapter 15 AUDIT EVIDENCE: COMPUTER ASSISTED AUDIT TECHNIQUES Technique types These are three types of computer assisted audit techniques, or CAAT: ๏ Audit programs ๏ Test data ๏ Embedded test facilities The techniques can add greatly to audit efficiency and effectiveness For example, audit programs can very quickly read thousands of records, examining each according to the criteria set by the auditor Test data can be used to investigate the operation of accounting programs that could not be easily tested in any other way 1.1 Audit programs Audit programs are used to examine and interrogate clients’ accounting data The auditor will have a program which can read the clients’ files That program can be used for the following: ๏ To select a sample of transactions to investigate ๏ The samples could be automatically stratified ๏ The program might be set to identify odd transactions or balances For example, credit balances on a receivables ledger, or inventory which hasn’t moved for some time ๏ It could also re-perform calculations For example it is important to check that the sum of the receivables accounts add up to the balance shown in the nominal ledger and hence in the financial statements Note that by using audit programs to scan clients’ data every transaction can be examined relatively easily This can be particularly effective in the investigation of fraud where often major amounts are misappropriated by making many small thefts that evade clients’ normal internal controls For example, every payment could be examined to see if any had gone to a particular bank account Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 84 1.2 Test data Test data is used to investigate the operation of clients’ programs The auditor designs and submits data that is then processed by the client’s programs This enables the auditor to check whether or not the clients’ programs are operating correctly and as expected, and whether or not the various controls which were supposed to be present are actually operating For example, what happens if a dispatch entered for a zero quantity, or for a non-existing product, or for a non-existing customer, or a dispatch which would raise the balance on the debtor’s account to above the credit limit Test data would be designed to check that the controls are present There would be some normal items, some unusual items and some extreme or unexpected items The auditor should predict what the client’s program should and then compare those predictions with what the client’s program actually produces A problem with test data is that the auditor is processing artificial false transactions into the client’s system and many clients dislike that Therefore it is usual for test data to be what’s known as ‘dead test data’ This means that it is not actually used on the client’s file but is used on the copy of the client’s file but using the client’s programs Audit programs Examine client data Test data Tests client programs 1.3 Embedded audit facilities Integrated Test Facilities or a System Control and Review File are permanent audit modules within the accounting system During the accounting period certain transactions are also recorded in these files for later examination by the auditor For example, large journal entries, large returns and so on It can be difficult to discover these at the end of the period in a normal accounting system because they will be buried amongst perfectly normal transactions and might have been cleared from the files The review files should be encrypted and locked so that only the auditor can access the information on them Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 85 Chapter 16 AUDIT EVIDENCE PROVIDED BY THIRD PARTIES Introduction Sometimes auditors have use evidence which is provided by third parties: For example: ๏ Using experts in areas where the auditor has little expertise, such as: ‣ Actuaries to evaluate the adequacy of pension scheme funds ‣ Estate agents to value property ‣ Lawyers to estimate a legal liability ‣ Gemologists to value diamonds ‣ Geologists to estimate mineral deposits ๏ Internal audit can be used to perform audit work on parts of a business ๏ Other auditors might be responsible for auditing one of the group’s companies In none of these cases can the audit firm escape its responsibility for providing its own opinion about the financial statements The auditor must still obtain sufficient appropriate audit evidence that any third party’s work does itself provide sufficient appropriate audit evidence: auditors cannot shift blame to an expert if a material misstatement appears in the published financial statements Indeed, reliance on a third party should not normally be disclosed in the audit report as this suggests an attempt to ‘blame-shift’ Classes of expert ๏ An auditor’s expert: possess expertise used to assist the auditor Can be either an internal expert (a partner or member of staff) such as an actuary employed by the auditing firm, or an external expert who is subcontracted to perform the work ๏ Management’s expert: possess the expertise to assist management of the company to prepare the financial statements Can also be internal or external The fact that a management’s expert has prepared figures does not stop the auditor using an auditor’s expert For example, is management’s expert is an employee of the client there are obvious risks that the expert has been influenced by management It can be difficult for an employee to be independent from their employer Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 86 What the auditor has to initially The auditor must be satisfied that the third party: ๏ Has appropriate qualifications ๏ Has the proper experience Qualification does not necessarily mean that the expert has the specific expertise needed A surveyor could be qualified, but specialise in domestic property and that would be no good for the valuation of commercial property ๏ Is independent of the client (otherwise the client could pressurise the third party) ๏ Is professional You will appreciate that forming an opinion on the competence of a third party can be difficult and the auditor should make enquiries from others who have used the expert, discover whether they have used that expert before with satisfactory results and generally try to assess the third party’s reputation The work to be performed by the third party has to be closely defined: ๏ Its nature, scope and objectives ๏ The respective responsibilities of the auditor and the third party have to be defined ๏ The nature, scope and timing of communications must be set out ๏ The expert should be required to observe confidentiality For example, valuable information about a company’s worth can be found by looking at the value of its property portfolio A pension deficit implies bad news for the company What the auditor has to after receiving the report from the third party The auditor cannot verify all the technical calculations or repeat all the work done by the expert (otherwise the auditor would have had no need for the expert) However, the auditor must examine the expert’s work with respect to: ๏ Consistency with other evidence For example, if a property valuer reported a decrease in the value of a client’s property portfolio, yet the newspapers were full of news about a property boom, the auditor should challenge the valuer’s results ๏ Assumptions made For example about the rate of inflation or rate of returns that might be earned on pension funds ๏ Use and accuracy of source data To value property the valuer must start with an up-to-date list of the properties the company owns If the right properties are not listed, the valuation will certainly be incorrect ๏ When the work was carried out to assess if it is still current or whether it has gone out-of-date Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 87 Chapter 17 AUDIT EVIDENCE PROVIDED BY INTERNAL AUDIT Introduction The previous chapter looked at the use of third parties as providers of audit evidence One class of third party is internal audit and this chapter looks in a little more detail at how internal auditors can assist the external auditors The internal audit function Corporate governance rules (at least the UK version) not insist that companies have and internal audit department, but they must keep the need for internal audit under review More and more companies now have internal audit departments These departments carry out work such as: ๏ Assessment of the design and operation of the internal control system ๏ Helping with stock-takes ๏ Verifying the physical existence of non-current assets ๏ Assessing value for money of various activities ๏ Carrying out special investigations, such as investigating a fraud ๏ Assessing the security and operation of the IT system Internal auditors can be company employees but the function can also be outsourced Obviously the internal auditors’ work can be of assistance to external auditors, particularly in their assessment of the internal control system, attending stock-takes and verifying the existence and condition of assets Internal auditors will often examine these matters in much more detail, and perhaps with more insight, than the external auditors However, it is important to note that ISA 610 states that internal audit can be involved in substantive reporting only in areas where only limited judgement is required All areas involving substantial judgement or estimates must be handled by the external auditors Making use of internal audit work As was mentioned earlier, external auditors cannot shift or evade their responsibilities for providing by trying to blame poor internal audit work for any problem that arises External auditors are solely responsible for the audit report and they have to obtain sufficient appropriate evidence that the internal audit work is reliable and of the right standard If internal audit work is going to be relied upon, the external auditor must: Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ Assess the organisational status of the internal audit department Are the internal auditors objective? To whom they report? (Should normally be the audit committee but they should also have access to senior directors) The size of the internal audit department can be relevant A single internal auditor in a company can have a lonely existence, unsupported by colleagues However, a team of 10 internal auditors can provide mutual strength (Note that if the internal audit function is outsourced, it might be more independent and objective than when the internal auditors are employees) ๏ Assess the competence of the internal audit department: are the employees members of a professionals body? Are they qualified? Do they undergo regular training and updates? Do they have time and resources to carry out their work adequately? ๏ Assess if the internal auditors carry out their work in a disciplined and systematic way Are there quality controls? Is there standard documentation? Is the work planned and reviewed? 88 The external auditor should assess if: ๏ The internal audit work was properly planned, executed, supervised, reviewed and documented ๏ Sufficient appropriate evidence had been obtained to enable the internal auditors to draw reasonable conclusions ๏ The conclusions reached aww appropriate and the reports produced are consistent with the results of the work performed The assessment will involve the external auditors reviewing the working papers of the internal audit function Direct assistance Some national jurisdiction (not the UK or Ireland) allow the internal auditors to provide direct assistance to the external auditors This means that the internal auditors perform audit procedures under the direction, supervision and review of the external auditor If internal auditors are being used to give direct assistance, the external auditor must assess the existence of significant threats to objectivity ie can the internal auditors be regarded as being independent? The external auditors must also assess and the level of competence of internal auditors Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 89 Chapter 18 OUTSOURCED ACCOUNTING FUNCTIONS Introduction Outsourcing can be defined as: Hiring a party outside the organisation to perform services and to create goods that would otherwise be performed internally by the organisation’s own employees Outsourcing is often accompanied by off-shoring where the outsourced function is provided by a supplier based overseas Examples of outsourcing functions include: ๏ Logistics (eg delivery of products to customers) ๏ Marketing ๏ Recruitment ๏ Legal services ๏ Production/assembly ๏ Information technology (facilities management) ๏ Receivables ledger management (factoring) ๏ Tax planning and calculations ๏ Payroll ๏ Accounting ๏ Internal audit This chapter deals particularly with the last six functions on this list Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 90 Potential advantages and disadvantages of outsourcing Advantages ๏ Access to specialist expertise ๏ Reduction in cost with efficiency gains ๏ Flexibility in responding to uneven demand ๏ Greater cost certainty through fixed-fee arrangements ๏ Transfer of risk ๏ Unburdens management from having to closely manage the out-sourced function (though the process of out-sourcing does itself have to be managed) ๏ For internal audit, greater independence Disadvantages ๏ Loss of control ๏ Damage to reputation if the outsource company does not perform well ๏ Difficult to reverse (and hence, prices can be steep because the outsource company knows this) ๏ Lack of responsiveness to new requirements ๏ Different aims of the outsourcer and the outsource company leading to a lack of goal congruence ๏ Confidentiality Company and client data are held by another party Impact on the audit Often, the outsource company (the service company) simply becomes a supplier For example, outsourcing delivery of products to a logistics company will have little effect on audit work However, if IT and finance functions are outsourced that means that the financial information, records and processing are the province of a third party and this will impact on the audit The auditor simply cannot ignore what’s is going on with client data at the service company For example, when assessing the valuation of receivables, the auditor would typically examine the client’s aged receivables analysis and ensure that it was properly prepared so that it could be used reliably If a service provider, such as a factor, produces that analysis instead, the auditor simply cannot assume that it has been prepared correctly and base the receivable valuation on that The auditor needs an understanding of the processing and maintenance of client data by the service organisation to be able to draw conclusions about the risk of material misstatement There are two situations: (1) The service company simply processes client’s transactions Here, the client should be able to implement its own controls eg compare input to output, ensure all transactions processed (2) The service company additionally executes and takes responsibility for the client’s transactions Then the client company will have to rely on the controls and procedures within the service company Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 91 The auditor can obtain the required understanding through: ๏ User manuals ๏ System overviews ๏ Technical manuals ๏ Reports by the service organisation (eg internal audit reports) ๏ Reports by the service auditor (such as letters highlighting internal control weaknesses) ๏ Knowledge derived from previous dealing with the service organisation (eg was it reliable in the past) ๏ Comparing data submitted to the service company to information and data received back (for example, are salary changes properly processed?) ๏ Obtain and assess a Type or Type Report (see below) ๏ Ask the service organisation for information ๏ Visit (with permission) the service organisation and carry out audit procedures there ๏ Use (with permission) another auditor to cary out audit procedures at the service organisation ISA 402, Audit Considerations Relating to an entity using a service organisation, refers to two types of report: ๏ Type Report: A report which comprises: A description, prepared by the management of the service organisation about the service company’s control objectives and related controls that have been implemented A report prepared by the service auditor giving reasonable assurance on the suitability of the service company’s systems and control objectives The service auditor is an auditor who at the request of the service company provides an assurance report on the controls of the service organisation ๏ Type Report: A report which comprises: A description, prepared by the management of the service organisation about the service company’s control objectives and related controls that have been implemented and sometimes a description of their operating effectiveness A report prepared by the service auditor giving reasonable assurance on the suitability of the service company’s systems and control objectives, the effectiveness of the controls and a description of the service auditor’s tests of the controls and the results of those tests So the Type Report is more rigorous and useful to external auditors than Type Reports The auditor can also ask management about problems and irregularities in the service company’s work If the auditor cannot obtain sufficient appropriate evidence about the quality and reliability of the processing being carried on by the service organisation, then the audit opinion will have to be modified Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 92 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 93 Chapter 19 WRITTEN REPRESENTATIONS Introduction ISA 580 requires auditors to obtain written representation from management and those charged with governance Written representations are necessary information that the auditor requires and written representations are part of audit evidence However, although they are necessary audit evidence they are not sufficient audit evidence on their own on any of the matters with which they deal Nor written representations affect the nature and extend of other audit evidence that the auditor needs to obtain Purpose The objectives of the auditor are to obtain written representations that: ๏ Management and those charged with governance have properly prepared and presented the financial statements and have provided complete information to the auditor ๏ All transactions have been recorded ๏ Support other audit evidence The written representations should be dated as near as possible to, but not after, the date of the audit report In particular, letters of representation are important where it could be difficult for the auditors to make sure that certain problems not exist, or that management does not have certain intentions or plans If you don’t know about a liability it can be difficult to discover It can also be difficult to discover management plans if they have now been discussed at board meetings and recorded in the board minutes Management representations cannot substitute for other audit evidence except where knowledge has confined to management and where the auditor is relying on the management’s judgment and opinion, for example on the future sale or closure of part of their operation Otherwise, when a letter of representation is received, the auditors should look for corroboration from other sources to support what management has said, and to evaluate whether the representations made by management appear to be reasonable and consistent with other audit evidence that has been obtained by the auditors If the letter of representation is not provided then the auditor must re-evaluate the integrity of management and assess their proposed audit report In general if there is no letter of representation, important audit evidence is missing and the audit report will be modified and a disclaimer of opinion given Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 94 Typical contents of a letter of representation Here are some examples of content of a typical letter of representation: ๏ No material irregularities In other words the directors are not aware of any material frauds that have taken place during the period ๏ The company has complied with all laws and regulations ๏ That they have disclosed all liabilities and these are reflected in the financial statements ๏ That management is not aware of any pending legal actions ๏ That there have been no subsequent events (events occurring after the balance sheet date) which may require the financial statements to be adjusted or if not requiring it to be adjusted, at least requiring some disclosure ๏ That the directors have no plans to shut down any parts of the operations of the organisation If there were plans to shut down part of the organisation that would probably affect the valuation of certain assets ๏ That inventory is valued at the lower of cost of net realisable value ๏ That the directors not believe that there is a going concern problem ๏ That all charges and assets have been disclosed, that is any assets which have been pledged for security of a loan for example, that would affect the rights and obligation assertion of those assets Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 95 Chapter 20 RELATED PARTIES Introduction Related parties can pose real difficulties for auditors because it can be very difficult to detect the relationship and related party transactions Certainly the letter of representation sent by directors to the auditors at the end of the audit would make reference to the fact that either there were no related party transactions or that all have been disclosed For example, one person owns two companies and each company has different auditors If Company A sells goods to Company B at inflated prices, Company B will make artificial losses and Company A artificial profits Perhaps the owner intends to put Company B into liquidation to escape its creditors, but the cash has been safely transferred to Company A It would probably be difficult for the auditors to detect what was going on What is a related party and why are they difficult for auditors? Related parties are defined in IAS 24 The objective of IAS 24 is to ensure that an entity’s financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties A related party is a person or an entity that is related to the reporting entity:  ๏ A person or a close member of that person’s family is related to a reporting entity if that person has control, joint control, or significant influence over the entity or is a member of its key management personnel ๏ An entity is related to a reporting entity if, among other circumstances, it is a parent, subsidiary, fellow subsidiary, associate, or joint venture of the reporting entity, or it is controlled, jointly controlled, or significantly influenced or managed by a person who is a related party.  Note that subsidiaries, associated companies, joint venture partners and the entity’s pension scheme are related parties You might thing it is easy, for example, to identify when a company is an associate, and this would be expected when producing the group financial accounts But if you were auditing the associate, how would you detect it was an associate of the ‘holding company’ and was trading with another company that was also an associate of that ‘holding company’ and therefore under the influence of the investing entity? Detecting ownership by family members is also very difficult: they might not all have the same family name Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 96 Particular problems can arise if: ๏ Transactions between the parties take place without charge For example, simply moving inventory from one party to the other without any accounting entries will distort profits ๏ Related party transactions are ‘buried’ amongst normal transactions ๏ There are parties that the auditor is unaware of ๏ Complex group structures can make identifying related parties very difficult ๏ Management might try to conceal the relationships ๏ Management simply might not know that certain transactions fall within related party rules There is nothing illegal about a company trading with a related party: this happens all the time in groups However, as described above, the existence of related party transaction increases the chance that transactions are false, not at arms length, have been entered into to defraud other parties or to evade tax Responsibilities It is management’s responsibility to identify and disclose related party transactions However, of course, this does not absolve the auditors from exercising professional scepticism or from trying to obtain evidence about the existence of related party transactions If related party transactions are not identified by management or the auditors there is an increased risk of: ๏ Fraud ๏ Unfair presentation ๏ Non-compliance with the law (eg tax legislation) Audit procedures: These include: ๏ Enquire from management about related party transactions Auditors would have to explain the concepts and give examples to help management ๏ Review last year’s working papers ๏ Review the board minutes ๏ Review the accounting records for unusual transactions CAAT techniques could help here by looking at every significant transaction over the period ๏ Review bank certificates (one company might have given guarantees on behalf of another) ๏ Review principal shareholders of companies with whom the client trades ๏ Ask the directors about their other directors and share ownership ๏ Review correspondence with lawyers ๏ Review investment activities eg the purchase of shares that might indicate that significant control has been acquired ๏ Enquire into the names of pension trustees ๏ Obtain written representation from management Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 97 Disclosures required in the financial statements ๏ Relationships between parents and subsidiaries irrespective of whether there have been transactions between the parties ๏ The amount of the transactions ๏ The amount of outstanding balances and their terms ๏ Allowances for doubtful debts relating to the outstanding balances ๏ The expense recognised in the period in respect of irrecoverable or doubtful debts due from related parties Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 98 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 99 THE AUDIT OF GROUP FINANCIAL STATEMENTS Chapter 21 GROUP AUDITS Introduction Generally, each separate company in the group will have been audited as normal, as though it were a stand-alone company This chapter deals with auditing the group financial statements, for example the consolidated financial statements The audit of group financial statements requires some additional steps and considerations not seen in the audit of individual companies The task is simpler if the auditor of the group financial statements also audits all components of the group Otherwise, the group auditor is having to place reliance on the work of third party auditors The additional work in summary Broadly the additional work is: ๏ What is the proper way to deal with a company’s investments in other companies? ‣ A simple investment ‣ An associated company ‣ A company that must be fully consolidated ๏ The general name for a part of a group is a component company ๏ What happens if the auditor of the group is not the auditor of all companies in the group? ๏ Care is needed with inter-company balances, stock-in-transit and cash in transit ๏ Unrealised profits in inventory (and perhaps on the transfer of non-current assets) must be eliminated ๏ The process of consolidation has to be carefully checked ie that the amounts in each category are added up properly to give the groups totals ๏ The goodwill figure(s) have to be verified and checked that impairment of goodwill is not appropriate ๏ If a company has been acquired part-way through the year then the profits will have to be apportioned: profits prior to acquisition are bought; profits after acquisition are earned ๏ Accounting policies must be uniform through out the group if consolidated ๏ The financial statements of group companies must have the same reporting date if consolidated Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 100 The proper accounting treatment of investments Type of investment Test Appropriate treatment Subsidiary Control: the power to govern the Full consolidation financial and operating policies of an entity The investor has the right to variable returns and these are affected by the exercise of power by the investor Generally presumed to exist if at least 50% of the equity is owned However, owning less than 50% can sometimes be enough to give control (eg if there is a right to appoint board members) Associate One company has significant influence Equity accounting The investment is over another Usually the shareholding initially recognised at cost and the is 20 to 50% carrying amount is then increased or decreased to recognise the investor’s share of the retained profit or loss of the investee after the date of acquisition (ie the post-acquisition change in the investor’s share of the investee’s net assets.) Joint venture A contractual arrangement in which Equity accounting two or more parties undertake an economic activity that is the subject of joint control Responsibility for the group audit report The group auditor has the sole responsibility for expressing an audit opinion on the group financial statements This is so even if the group auditor is not the auditor of all the group components The group engagement partner is responsible for all aspects of the group audit: planning, setting materiality levels, review, seeking more information where necessary and for forming an opinion on the group financial statements Indeed, the group auditor is not allowed to even comment that some components of the group were audited by another firm Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 101 Materiality An important part of the group engagement partner’s responsibility is to consider materiality A matter is material with reference to the group financial statements - not the financial statements of a component Usually this will mean that the materiality limits are higher for group financial statements than for component financial statements (simply because the figures in the group financial statements are usually the sum of the figures in the components) However, it is possible to construct a scenario where materiality levels are smaller in the group financial statements For example: $m Group Holding company Subsidiary A Subsidiary B Profit/(loss) 15 20 (10) Materiality level 10% for each component 1.5 0.5 2.0 1.0 So, the auditor of Subsidiary A will be working to a materiality level of $2m (possible ignoring misstatements up to that amount) but the group materiality level is only $1.5m In addition, a subsidiary might not be a public interest company but the group might be and, generally, the audit of public interest entities is carried out more strictly and this could again give rises to conflicts in materiality levels Therefore, usually the materiality levels for each component will be set substantially lower than the group materiality limit This has to be at a level determined by the group auditor as only that auditor has the necessary overview of the group results Other information required for the group audit The group auditor will also require some information from component companies which is of no relevance to the components For example: Subsidiary A has sold goods at a mark-up to Subsidiary B and these are in closing stock Unrealised profits are a group issue, but not an issue in the financial statements or audit of the individual subsidiaries The component auditor will have to supply this information to the group auditor Similarly, if non-current assets had been transferred Differences in payables/receivables accounts in the separate subsidiaries are not an issue, but on consolidation current accounts will have to be reconciled If the acquisition took place part way through the year, then the results of the acquired company will have to be split into pre- and post- acquisition This is usually done on a time basis, but significant differences in trading before and after acquisition (eg trading is seasonal) could mean that another approach is preferred Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 102 Goods in transit or cash in transit between components will have to be sorted out upon consolidation ๏ Events after the reporting date ๏ Significant control weaknesses ๏ Any known related party transactions ๏ Suspicions of management bias ๏ Adjustments might also be necessary to bring a components FS into line with the accounting policies to be used by the group The component auditor It is clear from the above that the group’s auditor expects a lot of cooperation and expertise from the component auditor There is presumably relatively little problem if the group auditor and the component auditors are part of the same firm using the same documentation and techniques and, of course, it is in their mutual interest to cooperate However, what if the auditors are different? Not only that, but what if they are from different legal and regulatory jurisdictions where, perhaps, the component auditors are not part of a respected professional body or follow International Standards on Auditing or accepted ethical codes (for example governing objectivity and independence)? How can the group auditor judge the competence of the component auditor? Do they have robust quality control systems in place In summary, how can the group auditor place any reliance on work done by the component auditors? These matters should be assessed before the group auditor accepts the engagement to be the group auditor, and if the group auditor is not confident about the work that will be done by others, the engagement should be rejected Nor should the group auditor accept the assignment if the holding company does not promise the full cooperation of its subsidiaries for the group audit Significant components Irrespective of the status of the component auditor, remember that the group auditor has overall responsibility for the group audit opinion so therefore cannot simply accept a component auditor’s opinion without some investigation The amount of investigation depends on whether the component is judged to be a significant component of the group ISA600, The Audit of Group Financial Statements, defines a significant component as: “one that is likely to include significant risks of material misstatement of the group financial statements” Then the group auditor, or another auditor at the request of the group auditor, shall perform on of the following: ๏ An audit performed using either the materiality level determined by the group auditor; or a lower materiality level determined by the other auditor… ๏ An audit of specified account balances relating to the identified specific risks ๏ Specified audit procedures relating to the identified specific risks ISA600 mentions, as an example only, that if a component contributes more than 15% to a group balance then that component might be regarded as significant Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 103 If a component is not significant then only an analytical review needs to be carried out on it at group level To assess the work performed by component auditors the group auditor could issue a questionnaire, or have a meeting with component auditor(s) asking about: ๏ Planning ๏ Work done ๏ Assessment of internal controls ๏ Misstatements discovered and uncorrected The consolidation process Nowadays, much of this will involve transcribing component financial statements onto a spreadsheet then adding like balances to like balances throughout the group Of course, some groups will have a financial accounting package which will automatically perform most of the consolidation process However, you will understand that simply the amount of data that has to be dealt with correctly on a consolidation will introduce a high risk that errors are made: transcribing a figure incorrectly or onto the wrong row or having an error within the spreadsheet formulae Therefore, an important part of the group auditor’s work is to check that the correct amounts from each component company have been identified and included in the consolidation schedules and that these are arithmetically accurate The group auditor then has to check that the appropriate consolidation adjustments have been made The principal adjustments are: ๏ Goodwill and pre-acquisition reserves ๏ Eliminate unrealised inter-company profits ๏ Reconcile control accounts ๏ Adjustments needed to bring the components FS into line for the purposes of consolidation ๏ Fair values to be used where appropriate For any acquisition that happened in the year, any goodwill arising will have to be audited The calculation should be checked: Consolidated good will = Consideration paid + fair value of the non-controlling interest - fair value of the subsidiary’s net identifiable assets Often this becomes: Consolidated goodwill = Consideration paid - Acquirer’s share of the net identifiable assets Audit evidence will involve checking the bank account to see that the acquisition amounts have been paid and inspecting the FS of the new subsidiary as at the date of acquisition and substituting in the fair value of assets and liabilities The proportion of shares bought also needs to be checked and ownership of the acquired shares must be verified Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 104 Subsequently, the goodwill figure will have to be tested for impairment For example, if a component had begun to make a series of losses it would be difficult to sustain the idea that the goodwill on its acquisition was still intact Costs of acquisition must be treated as an expense and not capitalised (IFRS 3) 10 Deferred and contingent consideration Both in practice, and in exam questions, deferred and contingent consideration is often part of an acquisition deal For example: Deferred: $20m paid now and another $10m to be paid in years Contingent: $20 paid now and another $10m to be paid in years IF profits achieve a certain target Obviously, the group’s auditor must inspect the acquisition agreements so that the acquisition terms are fully understood The appropriate accounting treatment of these type of consideration is: ๏ Deferred: the deferred amount must be discounted to its present value and included as part of the acquisition cost eg for the calculation of goodwill Auditing this figure will mean that, as well as inspecting the acquisition agreement, the auditor will have to verify that the discount rate used is appropriate Each year, as the date of payment of the deferred consideration approaches, the goodwill figure and provision for the deferred payment have to be altered as the amount will be discounted by one less year ๏ Contingent: IFRS requires that contingent consideration is includes as part of the consideration for acquisition measured at its fair value as at the acquisition date An exam question will either tell you what this fair value is or how it should be calculated 11 Letter of support (‘comfort letters’) If a subsidiary has a going concern issue and is not confident of support from outside lenders, then its parent company might offer support (ie make a loan to the subsidiary) to enable it to continue trading for the foreseeable future This would allow the subsidiary to eliminate its going concern problem In these circumstances, the group board must provide the group auditor with a ‘letter of comfort’ or ‘ support letter’ in which they set out their intentions But, of course, this letter is a relatively weak form of evidence and the group auditor should look for other evidence that the support for the subsidiary is real For example: ๏ Ensure that the group has the cash resources available to support to subsidiary ๏ Inspect board minutes for evidence that support has been agreed ๏ Inspect correspondence between the parent and the subsidiary or the parent and the relevant bankers ๏ Inspect cash flow budgets to see if the transfer of funds has been incorporated Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 105 12 Joint audits and transnational audits 12.1 Joint audits A joint audit is when two firms of auditors are both appointed and are both responsible for the audit opinion It is a relatively unusual arrangement and has probably come about through the merger of two companies with different auditors as there can then be benefits in the joint approach: ๏ Auditor knowledge about each part of the group is retained ๏ A larger pool of resources available to carry out the audit This might allow the audit to be carried out more quickly ๏ Geographical considerations might make a joint audit more efficient (eg the USA part of the group audited by a US-based firm and the European part audited by a European firm) However, there are certain disadvantages: ๏ Both firms of auditors will require a fee and these will probably total to more than the fee of only one firm doing the whole audit ๏ Different approaches, methods and documentation can cause difficulties ๏ They might clash over the audit opinion ๏ Coordination over the arts of the audit that each carries out might be poor eg there could be a gap in coverage Obviously, before agreeing to be a member of a joint audit arrangement, any auditor should be happy about their fellow-auditor: competence, ethics, experience, reputation Almost certainly, each one of the joint auditors will hope to oust the other auditors and end up as the sole auditor Auditing firms should beware of ethical risks to their objectivity and integrity arising from their attempts to be the client’s favourite auditor 12.2 Transnational audits Transnational audits are NOT the same as international audits International audits simply refer to the audit of a company or group that has operations in more than one country so that auditing has to take place in more than one country A transnational audit is the audit of financial statements where those financial statements will be relied upon outside the audited entity’s home jurisdiction for the purposes of significant lending, investment or regulatory decisions For example, there could be a large company whose operations were entirely within the UK, but whose shares are listed both in London and New York The international use of the financial statements causes some potential problems: ๏ Different (and unexpected) auditing standards might be used ๏ Different (and unexpected) accounting standards might be accepted ๏ Different ethical and quality standards might have been applied ๏ Different corporate governance standards Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 106 In short, there is a danger that the financial statement are misunderstood when looked at by someone from a different country The Forum of Firms (FoF) is an independent association of international firms of accountants who carry out transnational audits The aim is to promote consistent and high quality standards of financial reporting and auditing practices The IFAC Transnational Auditors’ Committee (TAC) is the official link between IFAC and the FoF It can promote the FoF’s objectives and operations and also it encourages members of the FoF to conduct high quality audits Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 107 THE FINAL STAGES OF AN AUDIT Chapter 22 EVENTS OCCURRING AFTER THE REPORTING PERIOD/SUBSEQUENT EVENTS Event Types Now we are going to look at the effect of events which occur after the end of the reporting period but before the financial statements have been approved These events fall into two types ๏ An adjusting event as its name might suggest, means that the accounts have to be adjusted in the light of what’s happened The rule is that adjustments are only put through the accounts if the event produces evidence of conditions that existed at the date of the statement of financial position, in other words at the balance sheet date An example would be a major customer going into liquidation, let’s say at the end of January, the year end being the end of December That event tells us that the receivable at the end of December was probably bad and should have been written off or fully provided against then It’s very unlikely that the customer’s financial position worsened so remarkably during January What the liquidation tells us is that the customer was in the bad situation at the end of December and if only we had known that then the receivable would have been provided against ๏ A non-adjusting event relates to conditions which arose after the date of the statement of financial position A good example is the company’s factory burning down, let’s say in mid January At the end of December the company’s factory was perfectly healthy, it was standing, it was operating, it was a non-current then It was only after the end of the year that it was destroyed If the statement of financial position is telling us the position at the year end, then the factory would have to appear in non-current assets It would be, of course, important to disclose in the notes that the factory was no more This will be a good example of an emphasis of matter paragraph in the audit report Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 108 Active and passive duty Until the audit report is signed auditors have an active duty to look out for events that might tell them more about the financial statements For example, examining cash receipts from year-end debtors, examine sales in the new year to see if inventory was properly valued, examining board minutes The letter of representation would also allude to events after the period end After signing the audit report, the auditors have a passive duty only Occasionally events will occur after the accounts have been signed and issued and these come to the auditor’s attention Exceptionally it may be important for the auditors to alert the addressees of the audit report that something is wrong in the accounts and they will try to persuade the directors to re-issue corrected financial statements Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 109 Chapter 23 THE AUDITOR’S REPORT 1: OVERALL STRUCTURE Introduction Now we begin to look at the auditor's report For many people, this is the only purpose of an audit and it’s one of the few parts of an annual report that they really look at The auditor’s report includes a clear expression of opinion on the financial statements as a whole The two important phrases are: ๏ ‘Opinion’: there is nothing absolute here Different firms of auditors could quite legitimately come to different opinions ๏ ‘Financial statements as a whole’ We are not just looking at the statement of financial position in isolation from the statement of profit or loss or the notes What’s important is the impression given by the financial statements as a whole The audit opinion has to be based on evidence obtained in the course of the audit Indeed if you had to sum up the audit process in just a couple of words it the phrase would be ‘evidence gathering’ Auditors need to collect evidence that will support their opinion on the financial statements Financial statements The auditor’s report refers to financial statements and you need to know what these are They consist of the following: ๏ The statement of financial position (or balance sheet) ๏ The statement of profit or loss and other comprehensive income ๏ The statement of changes in equity ๏ The cash flow statement ๏ The notes to the financial statements including significant accounting policies A director’s report and chairman’s statement included in an annual report are not part of the financial statements However, the auditor may have reporting responsibilities for such "other information" Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 110 The parts of an auditor’s report Now we are going to look at some of the key parts of an auditor’s report 3.1 The title and addressees: Independent Auditor’s Report First of all, it is clearly titled “Independent Auditor’s Report.” That should mean that no one has any doubt about what this document is It next states to whom the audit report is addressed and that’s the members (i.e shareholders) of the company 3.2 The audit opinion and identification of what’s been audited The opinion paragraph comes right at the top of the report An unmodified opinion will state that the financial statements give a true and fair view (or present fairly, in all material respects), and have been prepared in accordance with International Financial Reporting Standards (IFRSs) (The example of the report shown later in this chapter includes an unmodified audit opinion We will see later the various modified opinions that may be expressed if the auditors are unable to say without reservation that the financial statements give a true and fair view.) As appropriate, depending on the type of opinion given, this paragraph can be named: ๏ Opinion ๏ Qualified opinion ๏ Adverse opinion ๏ Disclaimer of opinion The title is modified to alert users about problems The opinion paragraph must: ๏ Identify the entity whose financial statements have been audited ๏ State that the financial statements have been audited ๏ Identify the title of each element of the financial statements and the period audited 3.3 The Basis for Opinion This will refer to compliance with the ISAs (complying with ISAs is key to the basis of opinion) and will refer to the auditor’s responsibilities section of the report It must include an assertion of the auditor’s independence and that other ethical matters have been complied with If the audit opinion has been modified, the explanation would be here too As appropriate, this paragraph would be called: ๏ Basis for opinion ๏ Basis for qualified opinion ๏ Basis for adverse opinion ๏ Basis for disclaimer of opinion Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 111 3.4 Material uncertainty related to going concern (if one) A separate paragraph is required if there is a material uncertainty related to the going concern of the company The need for such a paragraph is covered more fully in the following chapter This paragraph is not a modification of the audit opinion – provided the uncertainty has been adequately disclosed by the directors in the notes to the financial statements 3.5 Key audit matters Key audit matters are those matters that were of most significance during the audit There is then a full description of these matters in accordance with ISA 701 This is covered in more detail below 3.6 Emphasis of matter paragraph (if one) This paragraph is used to draw users’ attention to a matter already properly disclosed in the financial statements For example, a note stating that there had been a fire at the company’s premises after the date of the statement of financial position An emphasis of matter paragraph is not a modification of the audit opinion and It will state that the audit opinion is not modified in this respect If the auditor's report also includes a key audit matters section, the emphasis of matter paragraph may be presented before that section, depending on their relative importance 3.7 Other matters paragraph (if one) This paragraph is used, if necessary, to communicate a matter that is not presented or disclosed in the financial statements which is relevant to the user's understanding of the audit, the auditor's responsibilities or the auditor's report For example, an audit covers the financial statements but does not cover the directors’ report So what if the directors’ report contains something that conflicts with the financial statements? The audit opinion cannot be modified because it does not cover the directors’ report, but perhaps the shareholders need to be alerted to this This can be done in the other matter paragraph headed "Other Information" This is not a modification of the audit opinion Note that the interactions between the going concern section, key audit matters section and emphasis of matter/other matters paragraph are covered in detail in the following chapter Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 112 3.8 Responsibilities of management and those charged with governance for the financial statements This section is very important and points out that it is management’s responsibility to prepare the financial statements in accordance with the International Financial Reporting Standards to maintain the system of internal control and to consider the going concern position of the company 3.9 Auditor’s responsibilities for the audit of the financial statements The auditors’ responsibilities are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes their opinion Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs will always detect a material misstatement when it exists Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements Read carefully in the Illustrative Example (later in this chapter) the details of the auditor's responsibilities, which can be located in an appendix to the auditor's report 3.10 Name of the engagement partner, address of the auditing firm, date the audit report was signed and the auditor’s signature Finally, the auditors must sign the report and must give their address and the date on which it is signed The date of the report is very important because before that date the auditor has an active duty: the audit is not yet over The auditor should still be investigating whether receivables are being paid and inventory is selling at above cost etc After that date the auditor has a passive duty only This means that the auditor is not ‘on the lookout’ for events affecting the truth and fairness of the financial statements, but if any are brought to his attention he might have to act Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 113 ISA 701 Communicating Key Audit Matters in the Independent Auditor's Report The first thing to note is that the auditor only reports on key audit matters ("KAMs") in respect of listed entities 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 (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 The auditor therefore selects only those matters that were of most significance in the audit of the financial statements of the current period and therefore are the key audit matters Key audit matters are therefore identified by: ๏ Starting with all matters communicated with those charged with governance ๏ Determining the matters that required significant auditor attention in performing the audit ๏ The most significant of these are the “key audit matters” If the auditor disclaims an opinion on the financial statements (i.e very rarely), there will be no KAMs section in the auditor's report because the auditor has not obtained the evidence necessary to form an opinion Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 114 Illustrative example (from ISA 700 (revised)) INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC company Report on the Audit of the Financial Statements Opinion We have audited the financial statements of ABC Company (the Company), which comprise the statement of financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of the Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards (IFRSs) Basis for Opinion We conducted our audit in accordance with International Standards on Auditing (ISAs) Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the Financial Statements section of our report We are independent of the Company in accordance with the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical responsibilities in accordance with these requirements and the IESBA Code We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion Key Audit Matters 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 not provide a separate opinion on these matters [Description of each key audit matter in accordance with ISA 701.] Responsibilities of Management and Those Charged with Governance for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with IFRSs 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 In preparing the financial statements, management is responsible for assessing the Company’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless management either intends to liquidate the Company or to cease operations, or has no realistic alternative but to so Those charged with governance are responsible for overseeing the Company’s financial reporting process Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 115 Auditor’s Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs will always detect a material misstatement when it exists Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional skepticism throughout the audit We also: • Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control • Obtain an understanding of internal control relevant to the audit in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control • Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management • 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 Company’s ability to continue as a going concern If we conclude that a material uncertainty exists, we are required to draw attention in our auditor’s report to the related disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion Our conclusions are based on the audit evidence obtained up to the date of our auditor’s report However, future events or conditions may cause the Company to cease to continue as a going concern • Evaluate the overall presentation, structure and content of the financial statements, including the disclosures, and whether the financial statements represent the underlying transactions and events in a manner that achieves fair presentation We communicate 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 we identify during our audit We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards From the matters communicated with those charged with governance, we determine 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 We describe these matters in our auditor’s report unless law or regulation precludes public disclosure about the matter or when, in extremely rare circumstances, we determine that a matter should not be communicated in our report because the adverse consequences of doing so would reasonably be expected to outweigh the public interest benefits of such communication The engagement partner on the audit resulting in this independent auditor’s report is [name] [Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the particular jurisdiction] [Auditor Address] [Date] Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 116 What is meant by ‘true and fair’? As near as probably matters, the word ‘true’ means that the information is factually correct and not materially misstated ‘Fair’ is a more difficult concept You can have information which is accurate but which is nevertheless presented in a way which is unfair, and which perhaps conceals or does not reflect the commercial substance of transactions For example, it would not be fair to present a bank loan as a non-current liability if, in fact, it is repayable in the next 12 months (i.e a current liability) This would distort the financial position presented because the bank loan would not be included in assessing the company's liquidity as shown, for example, by the current ratio Other reporting responsibilities An auditor’s report will explicitly state whether in the auditor’s opinion the accounts show a true and fair view In some jurisdictions, the auditor may have additional responsibilities to report on matters such as the adequacy of accounting books and records These may be included in the auditor's report under a suitably headed section (e.g "Report on Other Legal and Regulatory Requirements") Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 117 Chapter 24 THE AUDITOR’S REPORT 2: GOING CONCERN Going concern If a material uncertainty exists which is adequately disclosed in the financial statements, the auditor is required to draw attention to the related disclosure in a separate section of the auditor's reported headed“Material Uncertainty Related to Going Concern” For example: “We draw attention to Note 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 to continue as a going concern Our opinion is not modified in respect of this matter.” Generally if the directors or the auditors think the company might not survive into the foreseeable future there is a going concern problem ‘Foreseeable future’ is not defined but under IFRS it should not be less than 12 months from the end of the accounting period UK GAAP (FRS 102) specifies that is should not be less than 12 months from the date of approval of the financial statements Remember: It is for management to make an assessment of an entity’s ability to continue as a going concern The auditor’s responsibilities are to obtain sufficient appropriate audit evidence, conclude and report If the notes not disclose the going concern uncertainty, the auditor must express a modified opinion because inadequate disclosure means that there is an element of the financial statements that does not show true and fair view If there is no realistic possibility of the company surviving the financial statements should be drawn up on a break-up basis and, if not, the audit opinion will most likely be adverse (see Illustration in the last section of the next chapter) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 118 Indicators of going concern uncertainty Signs that the company may have going concern difficulties include the following: ๏ Negative operating cash flows ๏ An inability to pay suppliers when due (and auditors are usually rather sensitive if they see that the payment of creditors has slowed down, so that the company is borrowing more from its suppliers) ๏ Operating losses These not mean that the company is going to fail immediately; going concern tends to be rather more concerned with cash An operating loss can be sustained for a number of years provided that cash doesn’t run out In the longer term, losses usually result in cash flow problems ๏ If the borrowing facilities are coming to an end and the new ones haven’t been agreed, what’s the company going to to repay the loan, when no cash is available? ๏ The loss of key staff or key customers can mean the company is unable to trade or unable to sell its products ๏ Technology changes can render the company’s purpose and main product redundant ๏ Legislative changes may mean that the company’s operations become illegal or the company has to go through some sort of regulatory requirements before it can continue trading and that this is going to be difficult for it ๏ Non-compliance with regulations may mean a business loses its right or license to trade and in such a case the company may simply have to be wound up Non-compliance can also result in crippling penalties and harmful damage to the organisation’s reputation Audit work on going concern uncertainty This can consist of: ๏ Evaluating management’s plans for future actions in relation to its going concern and whether the outcome of these plans are feasible and likely to improve the situation ๏ Where the entity has prepared a cash flow forecast: ‣ Evaluating the reliability of the underlying data generated to prepare the forecast; and ‣ Determining whether there is adequate support for the assumptions underlying the forecast ๏ Considering whether any additional facts or information have become available since the date on which management made its assessment ๏ Requesting written representations from management and, where appropriate, those charged with governance, regarding their plans for future actions and the feasibility of these plans Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 119 Interaction between KAMs, MURGC and EoM ๏ Inevitably, if there are going concern doubts then dealing with these will have been a key audit matter for the auditor, but it is very important to realise that going concern issues are reported only ONCE in the auditor’s report The rules are: ‣ If the auditor concludes that there is material uncertainty with regard to going concern which is adequately disclosed, a MURGC section must be included in the auditor’s report but will NOT be referred to again in the KAM section ‣ If the auditor had been worried about going concern but concludes that in fact, no material uncertainty exists , there will clearly be no MURGC section, but it may be included as a KAM, if it meets the definition of a KAM ๏ If what is regarded as a key audit matter is disclosed in the notes to the financial statements, the KAM does not need to repeat that information but must refer to the relevant note ๏ If an item is communicated in the KAM paragraph, the auditor does not also include it in an EoM paragraph Remember: A KAM is a key AUDIT matter So it is possible that there could be some matter which is fundamental to users’ understanding of the financial statements, which was not a KAM In this case, an EoM paragraph refers the user to an issue that is adequately disclosed in the financial statements (If not adequately disclosed, the audit opinion must be qualified.) Here is an example of an emphasis of matter: We draw attention to Note 27 to the financial statements, which describes the effects of a fire in the Company's warehouse Our opinion is not modified in respect of this matter Note that the financial statements contain a note explaining the effects of the fire The financial statements are therefore as comprehensive and as open as they can be But obviously, the fire has operational and financial implications and to understand the company's position (e.g its ability to pay dividends next year), the users of the financial statements need to be aware of this Conclusion This is easy: matters that might give rise to a KAM, a material uncertainty as to going concern or to an emphasis of matter paragraph appear once and once only in any auditor’s report Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 120 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 121 Chapter 25 THE AUDITOR’S REPORT 3: TYPES OF AUDIT OPINION Unmodified opinion Now we are going to look at the different forms of audit opinion and how other matters relevant to understanding the financial statements are drawn to users attention First and simplest is the unmodified audit opinion This is the audit opinion that you will see in most auditor's reports It simply states that the financial statements show "a true and fair view" (or "present fairly") There are no "ifs" or "buts" An auditor's report with an unmodified opinion may, however, include any (or all) of the following additional sections: ๏ "Emphasis of matter" paragraph; ๏ "Material uncertainty related to going concern" section; ๏ "Other matter" paragraph These matters NOT affect the audit opinion Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 122 Modified audit opinions With respect to modified opinions there are two potential reasons for modification: ๏ The financial statements include one or more material misstatements; or ๏ The auditor has been unable to obtain sufficient appropriate audit evidence There are two degrees of seriousness for each of these problems First let’s look at material misstatement This is where the auditor disagrees with the figure in the financial statements It could be the figure itself or the way the figure is presented or the disclosures which must be made to comply with IFRS First of all, if the misstatement is not material the audit opinion would not be modified, so the first hurdle is a that disagreement must be for a material amount In such a case the auditor would put a paragraph in the report saying except for certain items in other respects the financial statements show a true and fair view: the opinion has been qualified If however misstatements are so significant that it renders the financial statements, as a whole, useless then the auditor would issue an adverse opinion and the auditor would say the financial statements not show a true and fair view The other reason for a modified opinion is where the auditor has been unable to obtain sufficient appropriate audit evidence For some reason the auditor has not been able to get all the information required to draw conclusions If the matter about where there is missing information is material then the auditor will qualify his opinion using an except for paragraph For example, except that we could not verify the adequacy of the trade receivables allowance (i.e for irrecoverable balances), the financial statements showed a true and fair view If, however, the missing information is so significant that the auditors really have no idea whether the financial statements showed, as a whole, a true and fair view, then they will issue a disclaimer of opinion stating that they are unable to form any opinion The choices can be described in a matrix Think of ‘pervasive’ as misstatements or lack of evidence that affects the financial statements as a whole: Nature of circumstance Material but not pervasive Pervasive Financial statements are materially misstated A qualified opinion: Except for Adverse opinion Unable to obtain sufficient, appropriate evidence A qualified opinion: Except for Disclaimer of opinion Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 123 Example of insufficient appropriate audit evidence Here is an example of a qualification due to insufficient appropriate audit evidence Here the problem is material, but does not affect the financial statements as a whole and the report says the auditors are unable to determine the inventory quantities and then says in their opinion, except for the effects of such adjustments for inventory, if any, the financial statements give a true and fair view So this is an ‘except for’: the financial statements are showing a true and fair view except for one particular item which is material enough to cast some doubt on the amount of inventory Qualified Opinion (extract) In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion section of our report, the financial statements give a true and fair view Basis for Qualified Opinion (extract) We were unable to obtain sufficient appropriate evidence about the carrying amount of inventories because we were unable to attend the count of physical inventories at 31 December 20X1 Consequently, we were unable to determine whether any adjustments to this amount was necessary Example of disclaimer of opinion Here is a modified opinion caused by lack of sufficient appropriate audit evidence but which is leading to disclaimer of opinion because multiple elements of the financial statements are affected Disclaimer of Opinion (extract) We not express an opinion on the accompany financial statements Because of the significance of the matter described in the Basis for Qualified Opinion section of our report, we have not be able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these financial statements Basis for Disclaimer of Opinion (extracts) We were not appointed as auditors of the Company until [date] and thus did not observe the physical inventory counts at the beginning and end of the year In addition, the introduction of a new computerised system in [date] resulted in numerous errors in accounts receivable As at the date of this report Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 124 Material misstatement/‘except for’ Qualified Opinion We have audited In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements give a true and fair view… Basis for Qualified Opinion The Company's property, plant and equipment is carried in the statement of financial position at $xxx Management has not depreciated which constitutes a departure from IFRSs The Company's records indicate that had management depreciated , the company would have recognised depreciation of $xxx in the statement of profit or loss The carrying amount in the statement of financial position would have been reduced by the same amount Here is an example of a qualified opinion caused by the auditors believing that there is a material misstatement about something in the financial statements Here the problem is that no depreciation has been provided where they think it should have been Note, where there is a material misstatement auditors will normally be able to quantify its extent and the effect on the profits and is useful to the shareholders for them to that Here the amount of depreciation in dispute is material, but the financial statements as a whole still show a true and fair view Material misstatement/‘adverse opinion’ Finally, a modified opinion caused by one or more material misstatements that are so significant that the auditor feels the financial statements not give a true and fair view Here the matter in dispute is the basis of accounting used in the preparation of the financial statements which is clearly of such significance that the financial statements not show a true and fair view Adverse Opinion We have audited In our opinion, because of the significance of the matter described in the Basis for Adverse Opinion section of our report, the accompanying financial statements not present fairly Basis for Adverse Opinion The Company's financing arrangements expired and is considering filing for bankruptcy a material uncertainty exists The financial statements not adequately disclose this fact Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 125 OTHER ASSIGNMENTS Chapter 26 TYPES OF ASSIGNMENT Introduction This chapter classifies and briefly describes the various types of assignment that accountants might be involved with The main classifications are: ๏ Assurance engagements ๏ Non-assurance engagements Assurance engagements 2.1 Historical information ๏ Reasonable assurance engagement, such as a statutory audit Sometimes known as positive assurance where the auditor can say that something is/is not the case ๏ Limited assurance engagement, such as a ‘mini audit’ where the auditor says that nothing has come to their attention indicating a material misstatement is in the FS Faster and cheaper, but less confidence in the figures is provided ๏ Social and environmental audits 2.2 Other than historical financial information ๏ Prospective financial information (eg cash flow forecasts and budgets) ๏ Due diligence reviews ๏ Internal controls and systems Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 126 Non-assurance engagements 3.1 Review engagements Can be very similar to the mini-audit described above, but can also be applied to reviewing interim financial information, reviewing financial information to see if it has been prepared and presented in accordance with the applicable financial reporting framework 3.2 Agreed upon procedures Where the auditor and client agree on the investigations to be carried out and on the work be done For example, assessing how much has been lost through an incidence of fraud or a warehouse fire Forensic accounting assignments are agreed upon procedures 3.3 Compilation engagements Where the accountant prepares and presents financial information for the client No opinion is expressed Remember that only in statutory audits is the work to be done well-specified For example, statute defines what is reported on (ie the parts of the financial statements); ISAs specify how much of the auditing work is to be carried out and how the auditor should respond to findings (eg attendance at stock-takes) If the accountant is to embark on other types of work it is vital that the work, their approach and the outputs are well-defined at the start Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 127 Chapter 27 REPORTING ON PROSPECTIVE FINANCIAL INFORMATION Introduction For example, the auditor (or other firm of accountants) has been asked to report on: ๏ A capital expenditure budget ๏ A profit forecast ๏ A cash flow budget Often, the report is requested by a potential supplier of capital, such as a bank beginning or renewing a loan agreement, or by a venture capitalist considering the supply of equity finance Strictly, there is a difference between the terms ‘forecast’ and ‘projection’: ๏ Forecast: expected to happen ๏ Projection: not necessarily expected to take place; more of a what-if investigation Positive or negative assurance? Fairly obviously a positive assurance (reasonable assurance) is not possible with reports on prospective financial information Reasonable assurance implies saying that to a reasonable level of confidence there are no material errors in the financial information that is subject to the report It would be a foolhardy accountant would would be willing to say that about any budget or projection The future is simply too uncertain and the forecast subject to many assumptions The best that the accountant can is to offer negative (limited) assurance This simply states that nothing obviously incorrect has been found in the prospective financial report For example, it is arithmetically accurate, that there are no technical errors (such as including depreciation as a cash outflow in a bash flow budget) The accountant must also be satisfied that the assumptions are reasonable and not obviously wrong or overly-optimistic An accountant should not accept an engagement if assumptions clearly unrealistic or results not suitable for intended use For example, a budget showing sales and profits doubling without any convincing reason has probably been drawn up on the basis of making assumptions that give the answer required For example, the sales needed to stay within an agreed overdraft limit Similarly, if finance were being requested to support the opening of an additional shop, the budget for that shop’s results might be reasonable and show a profit, but if the rest of the business were in financial difficulties, presenting a cash flow for the only viable part of the business would not really be suitable for a supplier of loan finance Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 128 Methods The methods available are: ๏ Analytical review ๏ Verification of projected expenditure (eg for capital expenditure budgets) ๏ Scrutiny of assumptions (using a high degree of professional scepticism) What evidence is there that the assumptions are reasonable and, where relevant, consistent with previous results and relationships? Note that with many prospective financial reports, timing of events is often fluid and therefore subject to unwarranted optimism Will the new factory really start producing revenue in one year, or might it more realistically not be until after 18 months? Will customers really pay within two months, or might they often take three months? Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 129 Example Clairvoy Co It is 5/1/2019 and Clairvoy Co is applying to its bank for loan finance The loan would amount to $10,000,000, repayable in equal instalments over the three years 2019, 2020 and 2021 In support of this application, the company has provided a cash flow forecast for the next three years The forecast is shown below: Actual US$0 Budget Budget Budget 2018 2019 2020 2021 Sales 7,000 7,500 8,500 9,000 Cost of sales 2,500 2,700 3,000 3,500 Receipts from sales 6,900 7,400 8,400 9,400 Payments to suppliers 2,500 2,600 2,700 3,000 1,000 1,050 1,100 1,100 Administration 800 850 900 920 Depreciation 100 100 110 120 Other outflows: Wages Capital expenditure Tax 200 520 560 678 772 1,980 2,040 2,912 3,488 B/f cash 500 2,480 4,520 7,432 C/f cash 2,480 4,520 7,432 10,920 Net cash flow Clairvoy Co is not one of your clients, but the company has asked you to provide a report to the bank verifying the cash flow forecast that has been prepared Required: Identify and describe the issues that this work would raise and describe the work that you would to audit the prospective financial information Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 130 Solution - issues to consider The great thing to remember with all types of budgets and forecasts is that nearly everything on the document is an assumption and therefore its reasonableness can always be questioned Remember, question both the amount and its timing If an amount is not an assumption then it must be an historical amount (such as the opening cash balance) and that must be checked too So ALL amounts are open to scrutiny Usually, as here, you would also be asked to state what evidence you would seek for each amount So here we would: ๏ Check the opening cash balance to the cash book balance ๏ Check all actual 2018 amounts to the historical financial statements ๏ Sales have increased 7%, 13% and 6% pa This rate of growth looks impressive (though we don’t know the industry sector) and needs to be justifies by sales budgets, marketing reports, competitor analysis etc ๏ Calculate relevant ratios based on the 2018 figures for use in analytical review of the projections: ๏ GP% = 4,500/7,000 = 64% Note that the GP% has then become 4,800/7,500 = 64%, 5,500/8,500 = 64.7% and 5,500/9,000 = 61% We need to ask (eg the sales director) why this percentage has changed ๏ Wages/sales = 1,000/7,000 = 14% Note that this ratio has then become 14%, 13% and 12% What is causing these efficiency gains? ๏ Administration/sales = 800/7,000 = 11% Not that this ratio has then 11%, 10.6% and 10% Again there are slight efficiency gains that should be investigated ๏ In 2018, 6,900/7,000 cash from sales was received = 98.6% This rises to 99% in 2020 then 104% in 2021 The 2021 figure certainly looks odd and it is not clear why the cash receipts are higher than the sales ๏ In 2018, 100% of purchases were paid for This falls to 2,600/2,700 = 96%, 2,700/3000 = 90% to 3,000/3,500 = 86% More credit is being taken from suppliers and we need to investigate if this is a reasonable assumption For example, talk to buyers and payable ledger supervisors ๏ The timings of receipts from debtors and payments to suppliers need to be examined in detail as timings of receipts and payments are crucial to cash flow budgets ๏ Depreciation shouldn’t appear on the cash flow as it is not a movement of cash ๏ What is the capital expenditure for? Has it been authorised by the board? Is it in the correct year? Is it complete? Is there really no capital expenditure in other periods? Look at board minutes, expansion plans, capital expenditure budgets and authorisations ๏ Are the tax payments calculated properly? ๏ No interest has been included on the cash budget This is material For example, if interest was charged at 5% then $10,000,000 x 5% = $500,000 pa ๏ No capital repayments appear in the cash budget The potential loan agreement should be examined to see what the repayment schedule is As the budget stands there is a forecast $10,920,000 at the end of the three year period That would be enough to cover the loan - not accounting for interest It should also be mentioned that we should perhaps be a little suspicious that we have been asked to this work, yet we are not the company’s auditors It would be normal to ask the auditors to carry out these types of assurance engagement because, as they are normally required urgently, auditors Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 131 can complete the work efficiently because of their client knowledge Of course, the auditors might not have had time or resources to produce a report quickly, but we should be on our guard that we have been approached because we not have detailed knowledge about the company and that makes it easier for the company to mislead us Before starting the work The duties of an auditor are well-defined in both statute and auditing standards For example, statute gives the auditors a right to see any documents they wish and to ask for all explanations they require But, of course, auditors are careful to sent an engagement letters to each client, a copy of which has to be signed and returned The engagement letter sets out the work that will be performed by the auditor and the responsibilities and duties of the client Non-audit work, however, is not well-defined Each job is unique and it is essential that it is welldefined For example, in the cash flow work described above, it would be essential for the accountant to: ๏ Tell the client that the assurance will be limited (negative) not reasonable (positive) ๏ Determine how many years or months the cash flow covers (obviously, the longer the period, the greater the amount of work) ๏ Find out the purpose of the cash-flow and who will receive it The wider its use or distribution the greater the risk to the accountant ๏ Agree with the client that the required explanations and documents will be made available ๏ Agree a fee ๏ Agree a deadline ๏ As noted above, before agreeing to perform the detailed work, the accountant should initially review the cash flow to ensure that the assumptions are not unrealistic Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 132 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 133 Chapter 28 FORENSIC AUDITS Introduction The word ‘forensic’ is found in the terms: ๏ forensic accounting ๏ forensic investigations and ๏ forensic audit In all cases it implies investigating a company’s or person’s financial affairs for legal purposes The investigation might be related to a real or suspected fraud, quantifying an insurance claim, estimating the effects of professional negligence and discovering the assets owned by individuals (such as the proceeds of crime hidden away by a criminal or assets owned by a party to a failed marriage) For the rest of the chapter, we will simply refer to ‘forensic auditing’ General nature of the work Often, but not always, the work performed by the accountant in forensic audits will be used as evidence either in a criminal or civil case Often the accountant will appear as a witness and be subjected to cross-examination Prosecutions or civil claims are invariably defended and the accountants and their work will be expertly challenged by the legal representative of the defendant Any shortcoming or flaws in the audit work will be picked on in an attempt to undermine the whole case It is therefore very important that the accountant’s work, records, findings and conduct are of the highest quality so that their evidence is as solid as possible It would, for example, be harmful to a case if an accountant over-stated an opinion or an alleged finding that could not be substantiated If the accountant cannot justify one statement or conclusion, doubt is cast on them all However, although the accountant will be hired by one or other side of the dispute, the accountant must show integrity (for example, not hiding evidence that is useful to the other side) and objectivity (eg drawing fair and reasonable conclusions about the value of inventory lost in a fire) The accountant is a should be seen as a servant of the court and should help the court to discover the truth as far as possible The accountant should beware of becoming an advocate for one side of the dispute The professional conduct and due care required of the accountant carrying out forensic audits is of a specialist nature and the accountant should not undertake the work without proper training and experience For example, there are considerable skills needed in questioning suspects in a fraud case Specialist skills are needed to trace money as it passes through various bank accounts and various countries in a money-laundering case Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 134 Planning As with all assignments, planning is essential In addition, because each piece of forensic work will be unique, it is essential to agree with the client exactly what work is required Planning will start with a planning meeting where the following will be discussed: ๏ The nature of the investigation and why it is required (eg fraud, money laundering, loss estimation) ๏ The type of report(s) needed (eg quantifying the fraud, finding out how it was perpetrated, determining who was involved and for how long it went on) ๏ Agreement that the investigation team will have full access to whatever documents, information, personnel and explanations they need ๏ What work has been done already For example, has the fraud mechanism been understood and stopped? Have the police been involved? ๏ If the investigation work is likely to become evidence in a court case, the accountant will need to ensure that it is of the highest quality ๏ Determine who will receive the completed report ๏ When can the investigation start? By when is the report needed? ๏ Some preliminary documents might be asked for, such as any insurance policy that might compensate for negligence payments, losses through fraud or fire If the client is not an audit client, then the amount of work that has to be done will be somewhat greater For example, whereas auditors will have documented the accounting system and this might give insights as to how a fraud was perpetrated, if the investigating accountants are not the auditors they will have to start by documenting relevant parts of the system, getting to understand the nature of the business and the reporting structures within it Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 135 Main differences between a regular audit and a forensic audit Regular audit Forensic audit Skills needed Ordinary audit skills Specialist eg how to question witnesses and suspects Predictability Regular, planned Often unexpected and urgent, therefore there might be problems finding the appropriate staff resources: number of staff and possessing the required skills and experience Materiality Not particularly interested in immaterial errors Many frauds are committed by stealing small amounts frequently For example, if a fraudster knows that payments under $100 are not subject to approval by a manager, small frauds of about $90 might be used Computer-assisted audit techniques Used for selecting/finding samples and for testing internal controls Can be used to examine 100% of transactions and this might be needed when materiality is of no importance For example, all payments from the bank could be examined in the search for a specified recipient’s account number Work to be performed and Broadly standard (though for whom differs in detail from audit to audit) and specified by the law and by auditing standards Fairly standard engagement letter Open-ended, non-standard Therefore, must be carefully agreed in advance with the client and an engagement letter issued and agreed Audit reports are for the shareholders Letters setting out control weaknesses go to those charged with governance Interviews Client staff are routinely interviewed about how transactions are performed, what a transaction is, what controls are present etc May need to comply with legal rules on the collection and presentation of evidence in a court of law Generally carried out at the request of management but it could be at the request of an insurance company, a legal firm or the authorities Client staff might additionally be interviewed if they are suspected of carrying out a fraud This requires skill and care The staff member might be entitled to have legal representation and if this is not provided the interview transcripts might not be accepted as evidence Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 136 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 137 Chapter 29 SOCIAL AND ENVIRONMENTAL AUDITING Introduction Environmental and social issues are a source of risk (and opportunity) to companies: ๏ Bad publicity - for example, disparities between the salaries of male and female employees ๏ Good Publicity - for example, a reduction in carbon footprint ๏ Fines - for example, on operating outside permitted hours causing noise that harms those living nearby ๏ Compensation - for example, on the release of pollution that affects fish stocks ๏ Losing customer contracts - for example if a company is implicated in exploiting children ๏ More supervision by the authorities - if an industry has repeatedly not improved it standards Social media allow much greater involvement of many stakeholders - and can also quickly permit harm to be caused to an organisation through Twitter and review sites Initiatives such as integrated reporting and the triple bottom line (profits, people, planet) have meant that more and more companies include social and environmental measures in their annual reports and on their web-sites Assurance reports Assurance reports on social and environmental measures give greater credibility to those measures If no independent assessment were performed why would stakeholders believe what is published? Of course, what company decides to publish relating to these matters is very much the company’s choice (unlike in their financial statements) and the auditor has no power to insist on a particular set of disclosures However, once the company decides on its disclosures, the auditor can be asked to provide assurance In general, the work that the auditor has to carry out for an assurance report is: ๏ Agree the metrics ๏ Check the client’s measurements, calculations and published figures ๏ Report compliance Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 138 Typical areas covered by companies in their environmental and social reporting Social: ๏ Production information relating to socially responsible, safe, reliable products ๏ Data showing progress towards equal opportunities for staff and for fair pay policies ๏ Incidence of industrial injuries ๏ Number of trainees ๏ Number of hours spent on socially useful voluntary activities ๏ Conditions for the workforces of suppliers (eg steps taken to stop suppliers using child-labour) ๏ Fair pricing for purchases Environment: ๏ CO2 emissions/carbon footprint ๏ Release of waste products into the atmosphere or sea or rivers ๏ % of packaging that is recyclable ๏ Reductions in packaging ๏ Freight miles for both purchases and sales ๏ Overall energy consumption ๏ Percentage of energy from renewable sources ๏ Trees planted Planning the assignment Every client could use different sets of measures and different ways of taking measurements and the first step is to find out precisely what work the auditor is expected to carry out What key performance indicators (KPIs) will be used? What are the comparatives? How and when are the measurements made? What evidence does the client use and which will also be available to the auditor? Each KPI should be assessed to see if measurement (and therefore auditing) can be reasonably accurate or if the KPI is too ill-defined The auditors should consider if they have the appropriate competences to audit the KPIs If third party experts are needed, their independence and competence will have to be assessed When is the work to be done? What type of assurance is required: positive/reasonable or negative/limited? Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 139 Potential problems with KPIs and their measurement ๏ Not specific-enough to be meaningful For example, the company reports on serious industrial accidents However, this leaves unanswered what is meant by ‘serious’ ๏ Lack of consistency from one period to the next So, if the definition of ‘serious’, above, were to be altered, the safety record could be manipulated to show improvement ๏ Comparability across industries is likely to be difficult as different firms could measure an identically described measured differently ๏ Record-keeping and internal control systems might not be good enough to permit the figures to be audited For example, how would the auditor know that escapes of waste into the local river are completely recorded? ๏ Is the auditor competent to verify the technology used in the measurements and the calculations that might follow? Example You are the auditor of Kipper Co, which manufactures paper from wood pulp In its annual report the company publishes data on some environmental and social measures The keep performance indicators published are: ๏ The company’s carbon footprint ๏ Its energy efficiency ๏ Release of chemicals into the local river ๏ Incidence of industrial diseases Requirement: What issues are raised by your client’s request? Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 140 Answer notes 7.1 Carbon footprint ๏ What is included: energy used in the factory, transport, energy used by suppliers? Is there any offset from renewable supplies? ๏ What is the metric? For example, it could be in tonnes of CO2 ๏ How does the company assess the chosen KPI? ๏ Does the company propose to use any sort of industry comparatives? 7.2 Energy efficiency ๏ How is this measured? What is meant by efficiency or they just mean energy consumption? ๏ What is the metric and how is it assessed? Will it be possible for us verify the figures? ๏ Is it just the paper-making process or is it the whole undertaking? ๏ Are suppliers’ energy consumption figures included so as to get total energy per tonne of paper produced? 7.3 Release of chemicals into the local river ๏ Does this include all chemicals or just particularly harmful ones? Will the measures be split over different chemicals? ๏ What does the company measure? Litres released is no good without knowing the concentration of the chemicals ๏ How does the company monitor releases? ๏ How can we verify that retrospectively? ๏ How can we verify that the company procedures work correctly? 7.4 Incidence of industrial disease ๏ How is ‘industrial disease’ defined? What diseases are covered? ๏ Is the company simply looking at current employees or are former employees investigated too? (Some diseases might not show up for some time.) ๏ If former employees are included can they all be located and they all cooperate? ๏ What sort of medical reports are provided? ๏ Do other, similar industries, use the same measurements? Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 141 Chapter 30 DUE DILIGENCE REPORTS Introduction These reports are typically required when one company is proposing to take over another Essentially due diligence is fact finding and information gathering: exactly what is being bought? The target company’s published financial statements give some information, but not a lot, and besides the financial statements could be over a year old The FS are retrospective showing what has happened, but what is being bought are the future prospects of the business and the new owner will end up with both the assets and liabilities of the acquired business Type of report: Due diligence work could be either: ๏ An assurance assignment, where the accountant gives an opinion (negative/limited) to the effect that nothing worrying has been found ๏ An agreed upon procedure eg a list of factual findings relating to the subject matter Procedures Often, due diligence assignments are urgent For example, the take-over is happening to rescue a failing company However, the auditor must take care to ensure that there is a comprehensive engagement letter and that staff of the proper skills and experience can be assigned to the job Typically, the engagement letter will cover: ๏ Extent of the work ๏ Type of report ๏ Timescale ๏ A clause saying that any takeover is the decision of the client, not the auditor or accountant ๏ A clause stating that misstatements made by the target company might not be discovered, that all irregularities might not be found and that the work will mainly be in the form of asking for information and performing analytical reviews ๏ A clause stating that the auditor is dependent on the cooperation of the target company’s management ๏ The fee Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 142 Information to be examined This includes: ๏ Budgets ๏ Information about senior employees and their contracts of employment ๏ Liabilities that have arisen since the last SOFP was published ๏ Litigation ๏ Prospects for the business ๏ New products in the pipeline ๏ Industry outlook ๏ Non-current asset information eg age of assets and replacement plans ๏ Lease contracts ๏ Significant contracts, progress, renewal dates, performance ๏ Correspondence with major customers ๏ Proof of payment of corporation tax, employees PAYE, VAT etc ๏ Accident book ๏ Board minutes As was once said, undergoing a due diligence examination is like a firm of accountants asking you to photocopy everything in the office and to send it to them for scrutiny! Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 143 Chapter 31 THE AUDIT OF PERFORMANCE INFORMATION IN THE PUBLIC SECTOR (INTERNATIONAL SYLLABUS ONLY) Introduction Performance information is information about the performance of an organisation against set criteria such as a budget or benchmark For example, information may be produced about how many units of a product are produced or how efficient an employee is in terms of units produced per hour In terms of the public sector this could be number of operations performed in a hospital, or how many times the grass is cut in a council park, or how many school children reach a target literacy level The audit of performance information in the public sector is examining central and local government departments in terms of three main criteria: ๏ Effectiveness: whether the objectives of the department have been met ๏ Efficiency: how well inputs are turned into outputs ๏ Economy: obtaining best value for money For example: A government department is responsible for repairing street-lights The success of that department can be determined using the 3E’s criteria ๏ Effectiveness: Whether each light was repaired within the time limits set by the government department ๏ Efficiency: How many resources were used to fix each light in terms of materials, labour etc potentially against some standard ๏ Economy: The financial budget for fixing lights was not exceeded during a specific period Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 144 The use of performance information In many countries, government departments produce statistical information concerning the performance of that department For example, a local council in the UK (a local council being responsible for provision of services such as refuse collection, street lighting, road maintenance etc to an area of a few hundred square kilometres) will produce information not only on its financial performance but also on other areas such as the amount of refuse recycled or time taken to respond to requests to repair streetlights The main reasons for production of performance information include: ๏ Improvement Targets are set and performance measured against those targets to try and determine how management can be improved For example, if recycling targets are not being met then councils may use performance information to determine which categories of waste are not being recycled and then introduce new systems to (hopefully) improve actual recycling against target ๏ Monitoring Performance information is used to report on the achievement of targets In this sense, local government may have to report back to central government to obtain the necessary funding for next year’s budgets Similarly, performance information can be used as a management tool to determine the amount of performance related pay ๏ Reporting Including performance information in accounts or other external reports partly as a means of showing progress against targets but also as a means of advertising how well those targets have been met For example, meeting a recycling target will be reported not simply to show that the target has been met but also to generate good publicity for the council Taxpayers will therefore be happy with the activities of the council and ultimately this means that the councillors in charge of the council are re-elected(!) From the audit perspective, this means that auditors will have to treat performance information with a high degree of scepticism There will be management bias to show good results not only to maintain or increase funding but also so councillors retain their posts In other words, a lot of performance information may be available, but it may be produced to meet the three objectives above, not because there is any standard (such as the IASs) which require production in a specific format Comparability between different information providers (that is different councils, schools or hospitals etc.) will be difficult as the actual information produced will the different and different standards will be used to produce that information anyway Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 145 Planning the audit of performance information To audit that performance information the auditor needs to know how that information (actual performance and target performance) was produced There are five stages to the production of performance information: (1) Defining a measurement objective (2) Formation of relevant indicators (3) Data collection (4) Data analysis (5) Reporting These stages are explained below along with typical examination procedures that can be used by the auditor Audit procedures for performance information in the public sector can include: ๏ Tests of controls on the systems used to generate performance information (eg managers dating and signing off tasks as they are accomplished) ๏ Performing analytical review to evaluate trends and gauge the consistency of the information (for example, compare to the previous period) ๏ Discussion with management and others responsible for the reporting process about problems both with performance and its adequate recording ๏ Review of minutes of meetings where performance information has been discussed For example, council meetings, school governors’ meetings, health authority meetings ๏ Inspection of performance information source documentation, probably on a sample basis ๏ Recalculation of quantitative performance information measures and their summarisation onto performance reports, again on a sample basis The example of refuse collection is used to illustrate each section In many countries, the residents of each house are provided with a large bin on wheels into which household refuse is placed The local council provide a refuse collection service, so each week the bins are emptied into a refuse collection lorry which takes that refuse to a tip Some councils also provide a recycling service where recyclable refuse is placed in a separate bin and taken for sorting and recycling Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Stage Explanation Examination procedures Defining a measurement objective The process or activity is identified and level of detail to be measured confirmed For example, the number of houses to collect refuse from each day may be considered as an indicator although some allowance might be necessary for different types of houses ‣ Ensure the measurement objective can actually be measured Having decided what to measure, this stage defines how to measure the process or activity To ensure that the measure is appropriate, it must be SMART: ‣ Confirm number of houses in the council area – by reference to detailed maps Formation of relevant indicators 146 ‣ Review the proposed indicator to ensure it is achievable and at the correct level of detail ‣ Ensure 1,000 bins emptied each day is achievable ‣ Specific to the process or activity ‣ Ensure all bins can be emptied each week by dividing ‣ Measurable, that is quantifiable number of properties by 5,000 (1,000 bins over days) and ‣ Achievable there are at least that number ‣ Relevant to the process or activity of refuse teams ‣ Time bound, that is measured over a specific period of time For the refuse collection the objective can be: “Bins to be emptied from all properties in the council area once each week with 1,000 bins emptied each day by each work team” Data collection Data is then collected on each of the SMART indicators identified For refuse collection, each collection team has a predetermined route covering about 1,000 houses and a shift supervisor signs a document confirming refuse bins have been emptied Also confirm that residents can complain (probably online) if their bin is not emptied ‣ Review signature sheets confirming that bins have been emptied ‣ Access online complaints system and determine from this how many bins were not emptied ‣ If necessary, write to a number of residents in the council asking them to confirm their refuse bins were emptied Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Stage Explanation Examination procedures Data analysis The data collected is analysed and compared to the indicators Reasons for performance being above or below standard are identified ‣ Re-calculate the council’s statistics of bins being emptied and confirm accuracy of non-emptied bin % (complaint information already obtained above) 147 For refuse collection, compare results of collections each week (signature sheets) to confirm all bins have been emptied – or where bins are not emptied calculate the % missed Identify any areas or streets where collections are normally below the performance indicator Reporting Finally a report is produced on the whole process or activity, with recommendations made for improvement or change to the activity, the indicators being used or both For refuse collection, from the results above, determine what remedial action is necessary For example, this may mean changing the number of refuse collection teams or targeting specific teams with training where their % of bins not emptied exceed other teams ‣ Obtain and review report ‣ Ensure that the recommendations are congruent with the problems identified in the previous section ‣ Where necessary, discuss actions with the managers in the council to determine whether further remedial action is necessary Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 148 Reporting on performance information In some countries, including the UK, reports on performance information are generally included within the report on the financial results of the government or other department The audit may also be carried out by a government auditor (literally auditors employed by the government in effectively an internal audit role) using specific government reporting standards This means that care must be used in interpreting the reports partly due to possible bias (no truly independent report) and lack of knowledge of the different reporting standards used In terms of non-financial performance information there may not be any reporting standard anyway, potentially making the report even more subjective A typical report is summarised below Remember the format of a standard ISA700 audit report and most of the sections of a report on performance information can at least be “guessed” Section of report Content Title Identifies who the auditor is reporting to – in this case normally the members of the government department Scope of work Identifies what has been audited and the standards used In many countries there will be a specific financial reporting framework for government departments Responsibilities of the chief financial officer and the auditor The report confirms that the chief financial officer prepares the report and the auditor audits the information in that report Scope of the audit Confirms that the auditor has attempted to identify any material misstatement in financial or non-financial information Implication for auditors The auditor will need to understand the financial reporting framework The auditor will also state clearly what information has been audited, normally be identifying the page numbers in the report where the performance information is shown The difficulty for the auditor will be to determine the standard to be applied to non-financial information: how is it measured, is this valid and how “wrong” this information has to be to make a material misstatement Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures Section of report Content Implication for auditors Opinion This will still relate to true and fair view although the reporting standard will be different (government reporting standards as noted above) Again, the auditor will need knowledge of the appropriate reporting standards Report on economy, efficiency and effectiveness This is a separate section of the report where the 3e’s are reported on The auditor will normally state that the 3e’s have to be reported on and whether or not the council has fulfilled its’ responsibilities in this respect (for example, there is proper arrangements in place for securing the economy, efficiency and effectiveness of the council’s resources) Any other objectives such as performance information relating to recycling will be mentioned (remember that the information reported on will be identified in the scope paragraph of the report) if the information is materially incorrect In this case, the reason for the auditor’s report modification will be stated Reasons for the modification include that the performance information is incorrect or there is uncertainty about the figures (which are the two main reasons for modification anyway under ISA 706) 149 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 150 Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 151 Chapter 32 AUDITING ASPECTS OF INSOLVENCY (UK SYLLABUS ONLY) Meaning of insolvency A company is insolvent if the value of its assets is less than its liabilities (i.e the statement of financial position shows a position of net liabilities) If all the company’s assets were sold at carrying amount (‘book value’), the existing liabilities could not be paid This is a more fundamental problem than simply being short of cash ๏ Management’s responsibility for monitoring financial position and performance is especially important when the company has financial difficulties, as cash flow problems can quickly result in insolvency ๏ When facing insolvency, management must consider the interests of creditors (payables), shareholders and other stakeholders ๏ Management must, therefore, prepare and monitor financial statements and cash flow and profit forecasts on a regular basis ๏ The auditor may be asked to advise on whether a company is insolvent, or to review historic or projected financial information ๏ Having up-to-date financial information and taking professional advice may also help to protect directors from legal claims such as wrongful or fraudulent trading Administration or liquidation? The directors of an insolvent company face a difficult decision Should the company continue to trade, in the hope of improvement, or ‘cut its losses’ and cease to trade and be wound up? The auditor may be asked to help resolve this dilemma by evaluating the advantages and disadvantages of the options available, and considering the impact of each on the relevant stakeholders The auditor may also be asked to explain the procedures involved in placing a company into administration or liquidation, as directors will usually have limited knowledge in this area See Chapter 14 of our ACCA Corporate and Business Law (LW) (ENG) notes for a summary of points which are relevant to AAA Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 152 Administration If management decides to try to ‘save’ the company, it can be put into administration, which offers some time and legal protections while formulating a rescue plan The main advantage of this option is that once an administrator is appointed, there is a moratorium over the company’s debts (i.e the creditors cannot present a winding-up petition to the court) ๏ The court will only grant an administration order in response to a petition (by the company, its directors or creditors) if satisfied that: ‣ the company is (or likely to become) insolvent; and ‣ that administration is likely to achieve its purpose ๏ An administrator may be appointed without a court order by a floating chargeholder or the company or its directors ๏ The administrator is given a short period of time (usually eight weeks) to set out a proposal for achieving the aim of the administration or to decide that a rescue is not reasonable ๏ Proposals are accepted or rejected at a creditors’ meeting ๏ The administrator takes over the company’s management and has the power to appoint and remove directors ๏ Administration usually lasts for 12 months, but may be extended (with the creditors’ approval) or end early (if administration is successful) Liquidation (‘winding up’) A company that cannot be saved will cease to trade – assets are sold, liabilities paid (applying the ‘priority rules’ below), and eventually the company will be dissolved Once liquidation proceedings commence share dealings must stop and the directors lose their power to manage the company There are different ways in which the process is initiated: ๏ Compulsory liquidation – usually on the grounds that the company is unable to pay its debts (i.e fails to pay a statutory demand for more than £5,000 within 21 days) A member (for at least six months) may also petition the court for winding up on the ‘just and equitable’ ground ‣ An Official Receiver (an officer of the court) takes control of the company and its assets until a liquidator is appointed ‣ Company ceases new business, floating charges ‘crystallise’ and employs are automatically dismissed ‣ Directors must prepare a ‘statement of affairs’ (i.e details of all assets, liabilities, creditors and any security they hold) ‣ Liquidator investigates the causes of the company’s failure, realises the company’s assets and distributes proceeds in a prescribed order ‣ Liquidator files a final return with the court and the Register of Companies (company is dissolved) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures ๏ Member’s voluntary (‘solvent’) liquidation – can only take place when the directors have made a declaration of solvency Creditors have no involvement in the process as the declaration means they will be paid in full and therefore have no risk exposure Shareholders pass a special resolution (i.e 75% majority) to wind up the company within five weeks of the declaration of solvency and appoint a liquidator The surplus after assets are realised and debts cleared is returned to the members ๏ Creditors’ voluntary (‘insolvent’) liquidation – shareholders must pass a special resolution to start the process but the creditors get to choose the liquidator Both members and creditors appoint representatives to a liquidation committee which supports the liquidator 153 Priority for allocating company assets This is especially important for creditors and shareholders because, by definition, an insolvent company cannot pay everything that is owed The amounts that will be paid on liquidation depend on: ๏ whether debts are secured or unsecured ๏ whether charges over assets are fixed or floating ๏ whether shareholders own preference or equity shares ๏ the costs suffered by the liquidator (generally paid first) ๏ the amount of preferential creditors (including employees’ salaries and other benefits in arrears) Equity shareholders may receive very little, if anything, as they rank last The auditor of an insolvent or potentially insolvent company may be asked to advise on the allocation of company assets See Chapter 14 of our ACCA LW (ENG) notes for the sequence of distribution Benefits of administration If successful, the company will continue as a going concern: ๏ shareholders continue to hold shares and, hopefully, eventually receive a return on their investment (Compared with very little/nothing if the company is wound up.) ๏ for creditors, improved cash flows should allow debts to be repaid and trading relationships can be maintained ๏ continuing employment of some staff (though there may be some redundancies in the rescue plan) (Compared with automatic dismissal in a compulsory liquidation.) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures 154 Fraudulent and wrongful trading These terms are defined in the Insolvency Act 1986 See also Chapter 15 of our ACCA LW (ENG) notes Fraudulent trading (s.213) Wrongful trading (s.214) Definition: Carrying on the business of an insolvent company … … with the intent to defraud the company’s creditors … when it ought to have been concluded that there was no reasonable prospect of avoiding insolvent liquidation (hence creditors would suffer losses) Action can be brought against: any person who is knowingly a company directors (including party to the fraudulent trading shadow directors) only Type of offence criminal offence civil wrong Standard of proof ‘beyond reasonable doubt’ ‘on the balance of probabilities’ Penalties/liabilities Imprisonment (max 10 years) Personal (civil) liability for company’s debts Personal (civil) liability for company’s debts Director’s disqualification (max 15 years) Director’s disqualification (max 15 years) Only on OpenTuition you can find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ... Advanced Audit and Assurance (AAA) (INT/UK) INTRODUCTION TO ADVANCED AUDIT AND ASSURANCE (AAA) (INT/UK) REGULATION, LEGAL MATTERS AND QUALITY CONTROL What is Assurance? Corporate Governance and. ..Free ACCA Notes Free ACCA Lectures Ask ACCA Tutor Free ACCA Tests Find ACCA Study Buddy Spread 
 the word about OpenTuition ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures... find: Free ACCA notes • Free ACCA lectures • Free ACCA tests • Free ACCA tutor support • The largest ACCA community ACCA AAA (INT/UK) March-June 2019 Examinations Watch free ACCA AAA lectures