ACCA Paper F AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM Lecture DATE: Autumn 2008 TUTOR: Learning Objectives At the end of this session students should be able to:• • • • • • Appreciate the purpose of assurance services Have an understanding of the nature of assurance services Distinguish between an audit, a review and agreed upon procedures Understand the concept of Corporate Governance including the FIRC’s Combined Code on corporate governance and the regulatory environment in which auditing takes place Have knowledge and understanding of the statutory requirements of an audit, the rights and duties of auditors and the regulatory framework which applies to auditors Distinguish between the role of the internal and external auditors Introduction to Paper F Examination The aim of Paper F8, Audit and Assurance is to develop knowledge and understanding of the process of carrying out the assurance engagement and its application in the context of the professional regulatory framework It will be assumed that candidates have knowledge of Paper F3, Financial Accounting and Paper F4, Corporate and Business Law The accounting standards examined in Paper F3 could form the basis of questions on how to apply auditing procedures in respect of those standards Going forward, candidates will take knowledge of Paper F8 into Paper P1, Professional Accountant, and Paper P7, Advanced Audit and Assurance It will be assumed that candidates understand why an audit is required (for Paper P1), and already know the basics of audit procedures (for Paper P7) Examination Structure All Questions must be answered Audit procedures, and the application of these procedures to a specific scenario ( 30 marks) This question will always be based on a scenario, and will be broken down into a series of sub-questions, which will examine a range of audit procedures Candidates will need to analyse the scenario to identify the appropriate points to make in their answers The use of computers will be present and questions on this area will be based on computerised systems Detailed knowledge of how to use computerassisted audit techniques (CAATs) will not be expected Questions will focus on specific income statement and balance sheet entries Possible questions will cover audit procedures, identification of system weaknesses, writing of management letters, and whether systems meet their objectives (internal audit focus) 2 Short factual questions based on International Standards on Auditing (ISAs) and other key areas (10 marks) Do not rote learn ISAs, but understand the key principles underlying auditing Risk and audit approach (20 marks) More specialised audit areas (20 marks) Collection of audit evidence, closedown, reporting (20 marks) Examination answer style required: A structured answer with clearly identifiable and separable points is preferable to a continuous flow of text However, answers in note form are not acceptable Use columnar format where appropriate and break down answers into manageable sections If the question requirement specifically requested a memo format please so The volume of writing does not necessarily mean a pass standard Candidates presenting two or three supplementary answer books not achieve a pass standard, but candidates presenting just over half a main answer book can achieve a pass If asked to specify audit tests, candidates must also provide an explanation and reason for these tests, and state for example, ‘checking from the invoice back to the order to ensure completeness of invoicing’ The purpose of assurance for financial and non-financial information An assurance engagement as opposed to an audit is one in which the professional accountant evaluates or measures a subject matter that is the responsibility of another party, against suitable criteria and expresses an opinion that provides the intended user with a level of assurance about the subject matter Subject matter could include data, systems, processes or behavior The subject matter must be identifiable, capable of measurement and of being subject to procedures Levels of assurance Reasonable Assurance: The subject matter materially conforms to the criteria “ Limited Assurance: There is no reason to believe that the subject matter does not conform with the criteria (Negative assurance) What is an audit? An exercise whose objective is to enable auditors to express an opinion whether the financial statements are prepared in all material respects, in accordance with an identified financial reporting framework The auditor has to an express an opinion, whether or not the financial statements ‘give a true and fair view or present fairly, in all material respects True = information is Factual and conforms with reality, is not false Conforms with required standards and laws The accounts have been correctly extracted from accounting records Fair = Information is Free from discrimination and bias Is in compliance with expected standards and rules The accounts reflect commercial substance It is not the auditor’s responsibility to prepare and present the financial statements This is the responsibility of the directors There are certain misconceptions about the role of the auditor and this gap between what the auditors actually and what people think they is known as the expectations gap The opinion is expressed to the shareholders An audit provides a high but not absolute level of assurance, expressed in the audit report as reasonable assurance Reasonable assurance is not a guarantee of correctness but an assurance of truth and fairness within a reasonable margin of error Materiality: An item is said to be material if its omission or misstatement would reasonably influence the economic decisions of the individuals to whom the audit report is addressed The item can be qualitative or quantitative Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement It is important that the auditors ensure that the financial statements are free from material error for the following reasons: – There is a legal requirement to audit financial statements and present an opinion on those financial statements If the auditors not detect a material error then their opinion on the financial statements could be incorrect – The auditor has a responsibility to the members to ensure that the financial statements are materially correct – There are also other users of the financial statements who will include the taxation authorities and the bank that may have may have made a loan to the company They will want to see ‘true and fair’ accounts The auditors must therefore ensure that the financial statements are free from material misstatement to avoid any legal liability to third parties if they audit the financial statements negligently The limitations of an audit are:1 Not objective Items checked on a sample basis Provides opportunity for collusion or fraud There is a time lag between preparation of financial statements and the audit report Types of Audits External audit: Gives confidence in the integrity of corporate reporting for the benefit of stakeholders and society as a whole by providing an external and objective view on the reports given by management The auditor’s report is usually addressed to the shareholders as the principal stakeholders Purpose of external audit (i) The external audit derives from the separation of the ownership and management of assets Those who own assets wish to ensure that those to whom they have entrusted control are using those assets efficiently This is known as the ‘stewardship’ function (ii) The requirement for an independent audit helps to ensure that financial statements are free of bias and manipulation for the benefit of users of financial information (iii) Companies are owned by shareholders but they are managed by directors (in very small companies, owners and managers are the same, but many such companies are not subject to statutory audit requirements.) (iv) The requirement for a statutory audit is a public interest issue: the public is invited to invest in enterprises, it is in the interests of the capital markets (and society as a whole) that those investing so in the knowledge that they will be provided with ‘true and fair’ information about the enterprise This should result in the efficient allocation of capital as investors are able to make rational decisions on the basis of transparent financial information (v) The requirement for an audit can help prevent investors from being defrauded, although there is no guarantee of this because the external audit has inherent limitations Reducing the possibility of false information being provided by managers to owners is achieved by the requirement for external auditors to be independent of the managers upon whose financial statements they are reporting (vi) The purpose of the external audit under International Standards on Auditing is for the auditor to obtain sufficient appropriate audit evidence on which to base the audit opinion This opinion is to the effect that the financial statements give a ‘true and fair view’ (or ‘present fairly in all material respects’) of the position, performance (and cash flows) of the entity This opinion is prepared for the benefit of shareholders Internal audit: An independent, objective assurance and consulting activity designed to add value and improve and organisation’s operation Objective is to assist management and staff in the effective discharge of their duties Value for money audit: An investigation into whether or not the use of resources is economic, efficient and effective To identify and recommend ways in which the return for resources employed may be maximised An audit is distinguished from the following engagements:- Review engagement Provides moderate level of assurance, expressed as negative assurance Negative assurance is a statement of what the auditor does not know as opposed to what he believes (positive assurance.) The objective of a review is to enable the auditor to give an opinion whether the anything has come to his attention that would mean that the financial statements are not properly prepared (do not give a true and fair view) on the basis of the procedures which not constitute an audit Agreed upon procedures or compilations No assurance is provided It is only a report on factual findings A compilation presents in the form of financial statements information that is the representation of management without expressing assurance Compilation of a financial projection involves assembling prospective statements based on assumptions of a responsible party, considering appropriateness of presentation, and issuing a compilation report No assurance is provided on the statements or underlying assumptions Stages of an audit process: 1 Agree the terms of engagement 2 Understand the entity being audited 3 Assess risk 4 Plan the audit and make assessments of materiality 5 Gather Audit evidence 6 Make judgements and express opinion Audit Committee - The board should establish an audit committee of at least three members, who should all be independent non-executive directors The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience The main roles and responsibilities of the audit committee include • Monitoring the integrity of the financial statements of the company • Review the company’s internal financial controls and the company’s internal control and risk management systems • Monitoring and reviewing the effectiveness of the company’s internal audit function • Making recommendations to the board • Reviewing and monitoring the external auditor’s independence and objectivity and the effectiveness of the audit process • The audit committee should have primary responsibility for making a recommendation on the appointment, reappointment and removal of the external auditors 10 Contingent Asset A possible asset that arises from past events, and Whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the enterprise An enterprise must recognise a provision if:• A present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), • Payment is probable ('more likely than not'), and • The amount can be estimated reliably The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date In reaching its best estimate, the company should take into account the risks and uncertainties that surround the underlying events Expected cash outflows should be discounted to their present values, where the effect of the time value of money is material In measuring a provision consider future events as follows: • Forecast reasonable changes in applying existing technology • Ignore possible gains on sale of assets • Consider changes in legislation only if virtually certain to be enacted  London School of Business and Finance 2008 of 40 33 Restructuring by sale of Accrue a provision only an operation binding sale agreement after a Restructuring by closure Accrue a provision only after a or reorganisation detailed formal plan is adopted and announced publicly A Board decision is not enough Warranty Accrue a provision (past event was the sale of defective goods) Land contamination Accrue a provision if the company's policy is to clean up even if there is no legal requirement to so (past event is the obligation and public expectation created by the company's policy) Customer refunds Accrue if the established policy is to give refunds (past event is the customer's expectation, at time of purchase, that a refund would be available) Offshore oil rig must be Accrue a provision when installed, removed and sea bed and add to the cost of the asset restored Abandoned leasehold, Accrue a provision four years to run CPA firm must staff No provision (there is no obligation to training for recent provide the training) changes in tax law A chain of retail stores is No provision until a an actual fire (no self-insured for fire loss past event) Self-insured restaurant, Accrue a provision (the past event is people were poisoned, the injury to customers) lawsuits are expected but none have been filed yet Major overhaul or repairs Onerous contract No provision (no obligation) (loss-making) Accrue a provision  London School of Business and Finance 2008 of 40 34 Disclosures Reconciliation for each class of provision: Opening balance Additions • • • • • • Used (amounts charged against the provision) Released (reversed) Closing balance For each class of provision, a brief description of: Nature Timing Uncertainties Assumptions Reimbursement  London School of Business and Finance 2008 of 40 35 Audit Tests:1 Any amount retained as reasonably necessary for the purpose of providing for any liability or loss which is either likely to be incurred or certain to be incurred but uncertain as to amount or as to the date on which it will arise The provision is debit balance and the effect on profit or loss Is for likely or certain future payment Where the amount or the date of payment is uncertain Review post balance sheet event (outcome after the balance sheet date) Contingences: Pending legal actions Review the client’s records for recording of the claims and disputes and the procedures for bringing these to the attention of the board Review the correspondences with the solicitors Discuss with management regarding possible outcome of claims (Obtain letter of representation) Examine solicitor’s fees note against bank payment recording in the client’s books and records Obtain written assurances from directors with an estimate of the possible ultimate liabilities  London School of Business and Finance 2008 of 40 36 Check the disclosure in the balance sheet Debentures: Audit of debentures: Obtain a schedule detailing the debentures due at the beginning of the year, addition and redemption during the year and final debentures at year ended Obtain copies of debentures certificates and verify the details and filed in permanent file Check the opening balances from previous years working papers file Obtain copy of director’s minutes for any approvals for addition to debentures Vouch repayments with debentures certificates, cash book to check the correct amount is paid Vouch interest payments with debentures certificates, cash book to check the correct interest is paid Agree total amount outstanding with register of debenture holders If loan is secured, verify charge is registered with relevant regulatory authority Check the disclosure requirements  London School of Business and Finance 2008 of 40 37 Audit of share capital: Audit Procedures: Ensure the issue within limit of Memorandum and articles of the companies Ensure the issue is subject to directors minute Verify the internal control procedures/Custody of unused certificate Ensure and verify the shareholder details Ensure the cash receipts for the share issue Review the counter-foils for the share certificates for sequence of issues Vouch the payment of underwriting and other fees Determine the total of shares of each class as stated in the balance sheet and obtain a list of shareholding, which in total should agree with the balance sheet total  London School of Business and Finance 2008 of 40 38 Other relevant standards: IAS : ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS • Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements • • A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or related expense, resulting from reassessing the expected future benefits and obligations associated with that asset or liability Disclose: • * The nature and amount of a change in an accounting estimate that has an effect in the current period or is expected to have an effect in future periods • • * If the amount of the effect in future periods is not disclosed because estimating it is impracticable, this fact should be disclosed  London School of Business and Finance 2008 of 40 39 • Prior period errors are omissions from, and misstatements in, a company’s financial statements for one or more prior periods arising from a failure to use, or misuse of, reliable information that was available and could reasonably be expected to have been obtained and taken into account in preparing those statements Such errors result from mathematical mistakes, mistakes in applying accounting policies, oversights or misinterpretations of facts, and fraud Disclosures relating to prior period errors include: The nature of the prior period error; • for each prior period presented, to the extent practicable, the amount of the correction: o for each financial statement line item affected; and o for basic and diluted earnings per share (only if the entity is applying IAS 33); • the amount of the correction at the beginning of the earliest prior period presented; and • if retrospective restatement is impracticable, an explanation and description of how the error has been corrected  London School of Business and Finance 2008 of 40 40 ACCA Paper F8 AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM Autumn 2008 Lecture Application of the Going Concern Concept to Audits DATE: Spring 2008 TUTOR: ISA 570 GOING CONCERN Actions that an auditor should carry out to try and ascertain whether an entity is a going concern:“During planning and performing audit procedures and in evaluating the results the auditors should consider the appropriateness of management assumptions when preparing the financial statements of the enterprise” Since financial statements are prepared on the assumption of going concern, it is essential for the auditor to give positive consideration to the applicability of the going concern basis at the planning stage and throughout the audit Risk evaluation and findings during the audit may uncover indicators of going concern problems: Operational problems: Continued Trading loss Forced reduction in operation Loss of key suppliers or customers Litigation with customers and suppliers Increased competitions Dependence on one product Financial problems: Net current liabilities Funding operations from overdue VAT/PAYE Excess borrowing to finance daily obligations Loan defaults Cancellation of capital projects Inability to pay debts as and when due Refusals to renew/extend overdraft limits Personnel problems: Loss of key personnel Prolonged industrial disputes If the above indicators are detected, the auditor should seek evidence to support the going concern assumption The evidence includes:1 Profit and cash flow projection covering the period at least 12 months from the date the directors approve the financial statements Examine orders received and contracts signed Holding company or bank support Directors support Audit Procedures (Tests) For Going Concern: ISA 570 requires that the auditor, when forming an opinion as to whether financial statements gives a true and fair view should consider the entity’s ability to continue as a going concern and make any relevant disclosure in the financial statements Audit Procedures: Assess the adequacy of the means by which the directors have satisfied themselves that the adoption of the going concern basis is appropriate Examine all relevant evidences available to support the going concern status Review the director’s business review and their assessment of the future Assess the systems or other means by which the directors have identified warnings of future risks and uncertainties Examine budgets and other future plans and assess the reliability of such budgets by references to past performances Examine management accounts and other reports of recent activities Obtain confirmation of existing bank borrowing facilities and suppliers credits Review the board minute for any discussion of going concern matters Enquire of the director’s plan for resolving any issue that may threaten the going concern of the company Consider obligations undertakings guarantee with lenders, suppliers and group companies for giving or receiving support Review management’s plans for future actions based on its going concern assessment – Gather additional sufficient and appropriate audit evidence to confirm whether or not a material uncertainty exists regarding the going concern concept – Seek written representations from management regarding its plans for future action – Obtain information from company bankers regarding continuance of loan facilities – Review receivables ageing analysis to determine whether there is an increase in days – which may also indicate cash flow problems Audit procedures if the company is not considered to be a going concern – Discuss the situation again with the directors Consider whether additional disclosures are required in the financial statements or whether the financial statements should be prepared on a ‘break up’ basis – Explain to the directors that if additional disclosure or restatement of the financial statements is not made then the auditor will have to modify the audit report – Consider how the audit report should be modified Where the directors provide adequate disclosure of the going concern situation, then an emphasis of matter paragraph is likely to be appropriate to draw attention to the going concern disclosures – Where the directors not make adequate disclosure of the going concern situation then qualify the audit report making reference to the going concern problem The qualification will be an ‘except for’ opinion or an adverse opinion depending on the auditor’s opinion of the situation Impact on the audit report: Based on the audit evidence obtained, the auditor should determine if in his judgement a material uncertainty exists related to events or conditions that alone or in aggregate may cast significant doubt on the entity’s ability to continue as a going concern If there is a “significant level of concern” but company is still a going concern, then issue an unqualified audit report but with explanatory paragraph in the basis of opinion section Highlight the existence of material uncertainty relating to the event or condition that may cast significant doubt on the entity’s ability to continue as going concern and draws attention to the note in the financial statement that discloses the matter If adequate disclosure is not made in the financial statements the auditor should express a qualified or adverse opinion as appropriate The report should include reference to the fact that there is a material uncertainty that may cast significant doubt about the entity’s ability to continue as a going concern If in the auditor’s judgement the entity will not be able to continue as a going concern, the auditor should express an adverse opinion if the financial statements have been prepared on a going concern basis If disclosure in the financial statement regarding going concern is inadequate then issue a qualified audit opinion based on disagreement  London School of Business and Finance 2007 Page of 7 ... knowledge of Paper F8 into Paper P1, Professional Accountant, and Paper P7, Advanced Audit and Assurance It will be assumed that candidates understand why an audit is required (for Paper P1), and... external auditor and management 35 36 ACCA Paper F8 AUDIT AND INTERNAL REVIEW INTERNATIONAL STREAM Lecture 2: Audit Evidence, Sampling and Documentation DATE: Autumn 20 08 TUTOR: Learning Objectives:...Introduction to Paper F Examination The aim of Paper F8, Audit and Assurance is to develop knowledge and understanding of the process