chapter 1

Reintroduction to audit and assurance

Contents
Introduction Examination context Topic List 1 2 Assurance defined Audit defined

Summary and Self-test Technical reference Answers to Self-test Answers to Interactive questions

The Institute of Chartered Accountants in England and Wales, March 2009

Audit and assurance

Introduction

Learning objectives
Revise the concept of assurance from Assurance Paper Revise the concept of audit from Assurance Paper Understand the specific benefits of an audit

Tick off

Practical significance
In the recent past, the services provided by accounting practices were mainly restricted to accounts preparation, audit and tax. Audits were virtually the only assurance engagements in existence and nearly all companies required an audit. Consequently, most accountants worked on audits at some point in their careers. More recently there have been developments which have tended to split the traditional view that assurance firms provide audit and other services in one package. Factors such as The restriction on which companies are legally required to have audits Pressure to maintain auditor independence post-Enron, and The growth in other types of assurance service being requested from, and offered by, accounting practices

mean that there are now many more assurance services being carried out and the more general concept of assurance is a very important issue for practices indeed. Now trainees might train in an assurance department but never actually attend an audit.

Stop and think

Why is assurance more widely required in the modern world?

Working context
If you are training in practice, you are likely to spend some training time working in an assurance department and being involved in work on audits or other assurance engagements. If you work in industry, you might be involved from the other side!

Syllabus links
This chapter revises key concepts from your Assurance paper.

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

Examination context

Exam requirements
This chapter is revision of what you have previously been examined on in your Assurance paper. You will need an understanding of what assurance services are, and in particular, audit, brought forward from your lower level paper to answer any questions at this level.

The Institute of Chartered Accountants in England and Wales, March 2009

Audit and assurance

1 Assurance defined
Section overview
An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users, other than the responsible party, about the outcome of the evaluation or measurement of a subject matter against criteria. Key elements are: three party involvement, subject matter, suitable criteria, sufficient appropriate evidence, written report. Different levels of assurance may be given in assurance assignments, reasonable and limited. An audit is an example of an assurance engagement giving reasonable assurance.

Definition
Assurance engagement: An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.

Assurance engagements include primarily audits but also other services such as reports on internal control and review of a business plan.

1.1

The elements
Any assurance engagement needs: A responsible party A practitioner A user of the report A subject matter Criteria Sufficient appropriate evidence to support the conclusion A written report containing a conclusion

The engagement will be governed by its terms of engagement (found in an engagement letter). The engagement will need to be: Planned Performed Concluded upon Reported on

1.2

Levels of assurance
Remember that in accordance with the International Framework there are two types of assurance engagement: Reasonable assurance engagements, which result in a positive expression of opinion and where the level of assurance given is deemed to be high, and Limited assurance engagements, which result in negative assurance and where the level of assurance given is deemed to be moderate.

Engagements could be either type, and this would need to be specified in the terms of engagement.

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

So for a report on the effectiveness of management's system of internal control, it might be agreed that the report should read: 'In our opinion management has operated an effective system of internal control' a positive form of opinion deriving from a reasonable assurance engagement or 'Nothing has come to our attention that indicates material internal control weakness' a negative form of assurance deriving from a limited assurance engagement. No report on an assurance engagement can ever provide absolute assurance, because of the nature of the evidence available. Assurance type Reasonable Limited Assurance level High Moderate Opinion/conclusion Positive Negative Example Audit Review of a business plan

1.3

Benefits of assurance
A key feature of assurance services is that they are provided by independent professionals who therefore give an objective, unbiased opinion. They give the following benefits to users: Enhances the credibility of the information being reported on Reduces the risk of management bias, error or even fraud in the information being reported on Draws the attention of the user to any deficiencies in the information being reported on They ensure that high quality, reliable information circulates in the market They give investors added faith in the market They improve the reputation of organisations trading in the market

Assurance services also give added credibility to the wider share market:

Worked example: Assurance engagement

Predator Ltd, a large listed company, is considering taking over Target Ltd, a small, family owned company. Predator has asked Talbot and Co, chartered accountants, to carry out due diligence in relation to this prospective purchase. They want them to review the financial statements of the last three years and ensure that they were prepared under BFRS/BAS. They also want them to review the budgets for the coming 12 months and ensure that they are reasonably and internally consistent. You can see the elements of the assurance service as these: Practitioner: Talbot and Co Responsible party: Target Ltd management Users: Predator Ltd management Subject matter: Financial statements/budgets Criteria: BFRS/BAS/reasonable and internally consistent

Talbot and Co will plan and carry out work to obtain sufficient appropriate evidence to support their assurance opinion, which will be given in a written report. The benefits of this service to Predator Ltd are that: They are given assurance that the financial statements are in line with BFRS/BAS and therefore are understandable and comparable with other companies they might be considering for takeover. They are given assurance that the budgets are reasonable and internally consistent and therefore can be trusted as an indicator of the companys future operating ability. They can therefore make an informed decision about whether to buy Target and for how much.

The Institute of Chartered Accountants in England and Wales, March 2009

Audit and assurance

Interactive question 1: Benefits of assurance

[Difficulty level: Exam standard]

During the night of 7 June 20X3 strong gales caused the brick chimney of the factory to crash through the roof of Hancock Ltds assembly area. Production was severely disrupted for a period of two months. In addition to claiming from its insurers for the cost of repairing the premises and for the equipment and inventories destroyed in the accident, the company is also including a considerable claim under the loss of profits provision of its policy. The directors have prepared detailed calculations of the loss of profit and have requested the companys auditors to review this claim and provide an assurance report which they will submit with it to the insurers. What advantages would the directors expect to gain from having this report? See Answer at the end of this chapter.

2 Audit defined
Section overview
An audit is still a key example of an assurance service in Bangladesh, where all registered companies are required to have audits by law. An audit is an exercise designed to enable an auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. An auditor usually expresses a conclusion as to whether the financial statements 'give a true and fair view'. The benefits of audit are much the same as the benefit of assurance services generally. Users of financial statements subject to an audit are given assurance that the financial statements meet legal requirements as well as accounting ones.

Definition
Audit of financial statements: The objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. The form the audit conclusion takes is that auditors state whether the financial statements give a true and fair view. This is an expression of reasonable assurance.

Worked example: How audit is an assurance engagement

The key criteria of an assurance engagement can be seen in an audit as follows. (1) Three party involvement The shareholders (users) The board of directors (the responsible party) The audit firm (the practitioner)

(2) Subject matter The financial statements

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

(3)

Relevant criteria Law and accounting standards

(4) Evidence The auditor is required by Bangladesh standards on auditing (BSAs) to obtain sufficient and appropriate evidence to support the audit opinion. (5) Written report in a suitable form As required by BSA 700 the audit report is a written report issued in a prescribed form.

2.1

The benefits of being audited

The case for the audit for those companies where it is not required by statute usually revolves around the protection of those who, apart from management, nevertheless have a financial interest in the company.

Banks and other providers of finance

Minority shareholders Partners Donor agencies for NGOs

In a White Paper, the UK Department of Trade and Industry made the very valid point that if the purpose of the audit was to protect shareholders who are not involved with managing the business and the vast majority of smaller companies were owner managed, what purpose did the audit serve for those companies? Many would argue (and the auditors of smaller companies have found this to be true) that, in many cases, the audit is valued by management because: They value having their business scrutinised by another set of professional eyes It provides additional assurance to third parties such as taxation authorities concerning the reliability of the financial statements A growing business will one day require an audit Audit may have subsidiary benefits, such as the auditors recommending improvements in company systems.

Interactive question 2: Review and audit compared [Difficulty level: Exam standard]
The directors of Connelly Ltd are concerned about the reliability and usefulness of the monthly financial management information that they receive. As a result, the companys auditors have been engaged to review the system and the information it generates, and to report their conclusions. Contrast this assignment with the statutory audit of the companys financial statements with regard to the scope of the assignment and to the report issued. See Answer at the end of this chapter.

The Institute of Chartered Accountants in England and Wales, March 2009

Audit and assurance

Interactive question 3: Benefits of an audit

[Difficulty level: Easy]

Acrylics Ltd was established in June 20X0 to produce acrylic products which are used as display units in the retail industry. The shares are owned equally by two executive and two non-executive directors. The companys revenue increased steadily over the first two years of trading. The results for the first year of trading indicated an operating profit margin of 15%, and the management accounts for the second year of trading indicate that this has increased to 18%. The directors are currently negotiating a contract worth CU600,000 to supply a major retailer which has over 100 outlets throughout the country. The company will require an increased overdraft facility to fulfil the order. The finance director of Acrylics Ltd has prepared a business plan for submission to the companys bankers in support of a request for a larger overdraft facility. The plan includes details of the companys products, management, markets, method of operation and financial information. The financial information includes profit and cash flow forecasts for the six months ending 31 December 20X2, together with details of the assumptions on which the forecasts are based and the accounting policies used in compiling the profit forecast. The companys bankers require this financial information to be reviewed and reported on by independent accountants. The company was required by its bankers to have an audit of its financial statements for the year ended 30 June 20X1. Your firm conducted this audit in accordance with auditing standards and issued an unqualified report. Requirements (a) Describe the benefits, in addition to continuance of its overdraft facility, to the company and its directors and shareholders from having an audit of its annual financial statements.

(b) Explain how and why the level of assurance provided by a report on profit and cash flow forecasts differs from the level of assurance provided by an audit report on annual financial statements. See Answer at the end of this chapter.

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

Summary and Self-test

Summary

Audits conducted under Companies Act 1994

The Institute of Chartered Accountants in England and Wales, March 2009

Audit and assurance

Self-test
Answer the following questions. 1 2 Define an assurance engagement. Any assurance engagement requires which of the following elements? A B C D 3 A user A responsible party A subject matter Criteria

In a reasonable assurance engagement, a negative conclusion is drawn. True False

An audit is a limited assurance engagement. True False

Which of the following is not a potential benefit of having an audit? A B C D Management may value having their business scrutinised by a set of professional eyes Assurance may be given to parties other than management who have a financial interest in the company An audit is likely to be required in the near future by a growing company Fraud will be uncovered by the auditors

Exam-style question 6 Treetops Ltd Your firm acts as external auditor for Treetops Ltd, a company whose principal business activity is the manufacture and export of hammocks. The companys managing director has also requested a meeting with you. He has recently discovered that his purchase ledger clerk has diverted CU10,000 of company funds into his own bank account. The managing director wants to know why this was not discovered during the course of your audit for the year ended 29 February 20X4. The companys retained profit for that year was CU350,000. Requirements (a) Briefly describe the advantages to the directors and shareholders of Treetops Ltd of continuing to have a full audit under the Companies Act 1994. (4 marks)

(b) Provide examples of four other types of assurance engagement where the scope of the work is agreed between the assurance firm and the company. For each engagement identified, briefly set out the nature of the assurance given in the accompanying report and, where applicable, identify potential users of the report other than the companys management. (8 marks) Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved these objectives, please tick them off.

10

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

Technical reference
1 Assurance defined

BSA 200.8 (generic reference for audit/assurance engagements) BSA 200.2

2 Audit defined

The Institute of Chartered Accountants in England and Wales, March 2009

11

Audit and assurance

Answers to Self-test
1 An assurance engagement is one in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. All of the elements listed are required, as well as a practitioner and sufficient and appropriate evidence, leading to a written expression of opinion. False. A positive opinion is given in a reasonable assurance engagement. False. It is a reasonable assurance engagement. D although an audit may act as a deterrent to fraud, it does not certify that one has not occurred. We shall look at the responsibilities of auditors in relation to fraud in the next chapter. Treetops Ltd (a) Benefits of audit The credibility of financial information would be enhanced. Enhances the value of accounts for business valuation purposes in the event of a sale. Authorities such as National Board of Revenue (NBR) can have more faith in the figures. Avoids the future cost of extra work by the auditor when audit exemption limits are exceeded. Avoids a potential future qualification over the opening inventory figure. Makes it easier to raise finance. May act as a deterrent to fraud/management abusing assets/reduce risk of management bias. More reliable information results in more informed decisions. Provides management/shareholders with assurance that the financial statements are true and fair/prepared in accordance with accounting standards. By-products of the audit such as identification of weaknesses and recommendations should reduce risk and improve performance (management letter). Imposes discipline on management and accounts staff if they know that the figures will be subject to third party scrutiny, and therefore encourages best practice. Gives management comfort that they are complying with their professional responsibilities/the accounts comply with the Companies Act.

2 3 4 5

Exam-style question 6

(b) Four other types of assurance engagement Fraud investigation The conclusion/assurance will be based on the extent of the work carried out. The report will Identify likely causes of fraud Attempt to quantify the level of fraud. Legal experts in a court case The Police Internal or external auditors.

Potential users would be

12

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

Working capital reports/reports on inventory and trade receivables recoverability The report will state whether Trade receivables are likely to be received Inventory can be sold profitably in the near future. Potential buyers Investors Banks Internal or external auditors

Potential users would be

Internal control reports Such a report would Comment on the effectiveness of internal controls and highlight weaknesses Make suggestions for the improvement of controls. Regulatory bodies Shareholders Internal or external auditors.

Potential users would be

Reports on business plans/cash flow forecasts The assurance given would be negative/limited/moderate, i.e. Nothing has come to our attention. The report would state whether The business plan/forecasts have been prepared in line with stated assumptions Nothing has come to light to indicate that the assumptions are not a reasonable basis for the plan The accounting policies used are consistent with the annual accounts The plan is consistent with the past performance of the company. Bankers Other lenders External auditors.

Potential users would be

Tutorial note Additional credit was given for mentioning the following alternative engagements ( mark for each, up to a maximum of 2 in total for all types of engagement identified). Value for money studies Environmental audit Circulation reports Cost/benefit reports Due diligence Branch audit Review of specific business activities Internal audit Report on website security

The Institute of Chartered Accountants in England and Wales, March 2009

13

Audit and assurance

Answers to Interactive questions

Answer to Interactive question 1

Advantages of report regarding loss of profits Independent opinion from external source Enhanced credibility of compilation of claim Confirmation that data subjected to review and examination Comfort to insurers that risk of inflated claim reduced Could accelerate processing of claim

Answer to Interactive question 2

SCOPE This assignment Agree between parties Restricted to instructions Statutory audit In accordance with Companies Act 1994 In accordance with audit regulations In accordance with BSAs REPORT This assignment Addressed to board Format wholly discretionary Private report Statutory audit Addressed to members On true and fair view Format prescribed Report in public domain

Answer to Interactive question 3

(a) Benefits, additional to continuance of overdraft facility, of having an audit: Shareholders who are not involved in the day-to-day management of the company (nonexecutives) will have assurance that their interests are protected (i.e. company assets are not abused). Financial information is likely to be more reliable, resulting in more informed decisions. An audit improves a companys governance management benefits from: Assurance that they are complying with their statutory responsibilities (including the prevention and detection of fraud, as the audit may act as a deterrent) By-products of the audit, such as the identification of weaknesses and recommendations for improvement Reducing risks and improving performance.

An audit imposes financial discipline which is useful for growing companies. It may be easier to obtain credit, as suppliers and credit rating agencies regard the additional assurance provided by an audit important.

14

The Institute of Chartered Accountants in England and Wales, March 2009

REINTRODUCTION TO AUDIT AND ASSURANCE

(b) How and why the level of assurance provided by a report on profit and cash flow forecasts differs from the level of assurance provided by an audit report on annual financial statements. An audit conducted in accordance with auditing standards provides a high level of assurance which is reasonable but not absolute. The delay between the balance sheet date and the date of the audit report means that even items such as provisions/estimates can often be substantiated. A review of forecasts is only likely to provide a moderate level of assurance. This is because financial statements are based on historical information, and forecasts are based on assumptions which are subject to uncertainty.

The Institute of Chartered Accountants in England and Wales, March 2009

15

Audit and assurance

16

The Institute of Chartered Accountants in England and Wales, March 2009