ACCA Paper P7 (INT) Advanced Audit & Assurance Class Notes December 2011 Lecturer: Contents INTRODUCTION TO THE PAPER2 CHAPTER 1 – REGULATORY ENVIRONMENT3 CHAPTER 2 – PROFESSIONAL AND ETHICAL CONSIDERATIONS8 CHAPTER 3 – PRACTICE MANAGEMENT13 CHAPTER 4 – ASSIGNMENTS I: THE AUDIT OF FINANCIAL STATEMENTS16 CHAPTER 5 – ASSIGNMENTS II: GROUP AUDITS42 CHAPTER 6 – AUDIT REPORTS AND OTHER REPORTS45 CHAPTER 7 – ASSIGNMENTS III: OTHER ASSIGNMENTS57 CHAPTER 8 – CURRENT ISSUES AND DEVELOPMENTS63 INTRODUCTION TO THE PAPER AIM OF THE PAPER
The aim of the paper is to apply relevant knowledge, skills and exerciseprofessional judgement in analysing, evaluating and concluding and reporting onthe assurance engagement and other audit and assurance issues in the context of best practice and current developments. In simpler terms, this means a very practical exam, in which students need to lookat real situations and identify relevant issues to an auditor (or other assuranceprovider), and how those issues may be addressed. OUTLINE OF THE SYLLABUS 1. Regulatory Environment 2. Professional and Ethical Considerations . Practice Management 4. Audits of Historical Financial Statements 5. Other Assignments 6. Reporting 7. Current Issues and Developments FORMAT OF THE EXAM PAPER The syllabus is assessed by a three hour paper-based examination, with 15 minutesof reading time. The examination consists of: ? two compulsory questions, totalling 50-70 marks, and covering several areasof the syllabus within a single scenario, and ? a choice of two from three questions totalling 30-50 marks, which are each likely to focus mostly on a single syllabus area.
CHAPTER 1 – REGULATORY ENVIRONMENT EXAM QUESTIONS ?Define “Money Laundering”, and explain the auditor’s responsibilities. ?Comment on the need for ethical guidance for accountants on money laundering. (Pilot Paper Q5 ) ? Explain the auditor’s responsibilities relating to the laws and regulations that apply to a client’s business. INTERNATIONAL REGULATORY FRAMEWORKS Regulatory framework In each country, regulation comes from a number of sources. Since this is largely arevision area from F8, and is not examined very often on P7, the Notes here aredeliberately brief.
Regulation is necessary in many industries, and audit/assurance is no exception. So many people rely on the information produced by organisations, and as a resultthose who give assurance on that information fulfil a vital role. If work was notregulated, there would be too much variety in how work was done, and a majorthreat to quality control. Summary of regulators The ACCA To be an auditor, you need to be authorized in your country to audit. In the UK(and throughout Europe) this is done by requiring you to be a member of aRecognised Supervisory Body (RSB) and ACCA is one of these.
The ACCA ensures auditors are suitably qualified, monitors behaviour, and qualitycontrol. The IAASB The International Audit & Assurance Standards Board sets International AuditStandards (ISA). Many countries have either adopted these in full, or based theirown national audit standards very closely on them. The IAASB is part of the International Federation of Accountants (IFAC). The FRC The Financial Reporting Council in the UK regulates UK financial reporting, includingcorporate governance. Its various bodies set UK accounting standards and the UKCorporate Governance Code.
Most countries have their own version of the FRC. Public Oversight Board Given recent corporate scandals, there has been a trend for setting up independentbodies to oversee the “experts”. IFAC has an oversight board, but individualcountries also have their own (in the UK, the POB). Accountants and auditors usedto be self-regulating, but too many failures (e. g. Enron) have put a stop to this. Corporate governance Corporate Governance now appears on many of the ACCA exam papers, with mostof the detail on paper P1 and F8.
As such, detailed questions on P7 are relativelyunlikely. Chapter 1 of the P7 Study Text has a useful reminder of the main areas, which arenot repeated here as they should be revision. There is just one area that is important enough to get a brief mention in these notes: Audit Committees Audit Committees have been a requirement for US listed companies since the1970s, and are also part of the UK Corporate Governance Code. Audit Committees are a sub-committee of the Board of Directors, and are typicallymade up only of Independent Non-Executive Directors.
Their main roles: ?To oversee the company’s financial reporting, internal control systems, andrisk management processes. ?To help appoint and monitor the performance of the internal audit function.? To improve the independence of internal audit (e. g. by considering thebenefits of outsourcing it). ?To act as the main contact point for external auditors, to improve their independence. ?To suggest a firm of external auditors. ?To monitor the quality of both internal and external audit work. MONEY LAUNDERING AND THE AUDITOR Definition
The process by which criminals attempt to hide the true source of their funds in an attempt to make it look like their funds have come from legitimate sources. Inmany countries, the definition is even broader, and possessing or transferring theproceeds of ANY crime can be money laundering. For example, breaching health and safety regulations in order to save money makes the company a money launderer – it possesses the cost savings, and these were saved by committing a crime. Audit responsibilities In the past, it was felt that too often auditors and accountants were failing to notice(or maybe failing to look! that their clients had unexplainable funds, or that some of their business transactions had no obvious business logic. Over the past 20 years, and particularly since 2000, there has been an international attempt to tighten laws on money laundering, and to force professionals (especially accountants) to do more. This has been lead by the Financial Action Task Force(FATF) on Money Laundering, which has around 30 of the leading Economies of theWorld as members. The ACCA has issued Technical Fact Sheet 94 to provide guidance to audit firms. The main obligations are: To make sure you know who your client really is, and to confirm where they get their money from (“Customer Due Diligence”). ?To report any suspicions of money laundering to the relevant authority (in theUK, the Serious Organised Crime Agency – SOCA).? Not to tip off a client when you have suspicions. Any failure to do the above can result in prison – so this needs to be taken very seriously! Accountancy firms are required to have detailed procedures in place to show that they are following the rules. Poor quality policies and procedures can lead to firms being fined. Practical things for audit firms to do Appoint an MLRO (Money Laundering Reporting Officer) whose job is to make sure all other ML processes are in place in the Firm, and to decide whether suspicions raised by staff should be reported externally to SOCA. The MLRO is likely to be a partner. ?Have Know Your Client (KYC) procedures – the better you know your client, the easier it is to spot odd transactions and behaviour. ?Check the identity of all new clients (e. g. by checking passports of directors,Companies House searches on the company itself, its directors and who own sit). ?Train all relevant staff in ML processes, and in how to spot suspicious transactions.
Suspicious transactions ?Transactions that pass through several companies or countries, especially when there is no obvious reason for doing so. ?Multiple small transactions of a similar nature, rather than one large individual transaction. ?The creation of complicated groups of companies when a simpler solution appears to exist. ?The creation of a new company that is never actually used to trade. Cash-based businesses have always been a favorite for money launderers, as they can pass their illegal funds through the company and claim that it is sales revenue. Because it is cash, there may be very little (if any) proof of where it came from.
Example Mr Sowerby is a very successful international drugs dealer, and he has $10millionof cash that he wishes to “launder”, so that he can spend it without fear of being questioned as to where he earned it. He builds a gym, and fills it with top of the range equipment, and opens for business. He will probably have to use mostly legitimate money to do this, as attempts to pay contractors and suppliers in cash may be greeted with suspicion. Now the gym is open and has members, he adds fake members to the membership records and pays their fees in cash, using his drugs money.
He may have to set up these fake members with addresses of friends, so that if anyone chose to check, they would get the answer Mr Sowerby wants! Notice that he is quite happy to lose some of his money in order to make it legitimate. Before he gets the money as business profits, it will be taxed – but it is worth it, to allow him to spend the remainder. Observations ?Many businesses refuse to accept cash in excess of a certain limit, as they are afraid that any large cash figure accepted may have come from illegal sources ?
Any cash based business is useful for money laundering – casinos and launderettes for example. How could An Auditor Spot This? ?Analytical procedures – comparing the number of members on the register with the amount who actually turn up at the gym, or considering whether the membership numbers are reasonable for the area in which the gym is located. ?Being aware that a gym is a potential money laundering business! Situations that could lead to money laundering offences ?A client under a tax investigation … if problems are found, the evaded tax is the proceeds of crime. Client making “facilitation payments” (i. e. bribes) to help smooth certain transactions (e. g. paying an official a fee to ensure a contract is won). ?Having clients in political positions makes them “politically exposed persons” (PEP), who have the power to enrich themselves with public money. As such, auditors should treat such clients with extra care, ensuring they fully understand the source of all of their funds. The need for ethical guidance Money Laundering situations may be complex, so ethical guidance would be useful in the following ways: ? In helping to understand the heavy legal burden. In providing a framework of how to address situations not covered by law or previous experience. ?In helping to resolve conflicts between client confidentiality, and the need to report externally. ?In helping to guide an outgoing auditor in what he can say to an incomingauditor as part of the “professional clearance” process. ?In helping to guide auditors working in countries where there are no / limited money laundering laws. ?In helping to understand the interaction between money laundering and the audit report, and other reports to clients and 3rd Parties.
LAWS AND REGULATIONS AFFECTING CLIENTS Responsibility of the auditor Auditors cannot know and understand every law and regulation that affects everyclient, but they should aim to be aware of those that could materially affect theFinancial Statements. By doing this, they are more likely to spot breaches, even if management do nottell them (or are themselves not aware). Where breaches are found, that the auditor considers material: ? Report the breach to management (it is their ultimate responsibility, not theauditor’s, to ensure the company is not breaking laws). If the breach involves management, report to the highest level possible (e. g. Audit Committee). ?If the breach involves the highest level possible, may need to take legal advice and consider whether the lack of integrity necessitates resignation by the auditor ? Consider the effect of the breach on the accuracy of the Financial Statements– it may result in a qualified audit report. ?If laws are new, or have been announced but precise detail is yet to be agreed by government, it may be difficult to assess the effect on the company, and may affect the Going Concern assessment. In some cases, a breach may have external reporting consequences. CHAPTER 2 – PROFESSIONAL AND ETHICAL CONSIDERATIONS EXAM QUESTIONS ?Identify the ethical and other professional issues relating to the above situations and state what action, if any, should be taken (Pilot Paper Q5). ?To whom are auditors held liable for poor audit work? ?How can an audit firm restrict their liability? THE CODE OF ETHICS It is essential that accountants have the public’s trust. As such, ethical behavior is critical to the reputation of the accountancy profession, and to the value of accountancy and audit work.
IFAC have a Code of Ethics, and most accounting bodies (including ACCA) have adopted virtually all of its content. In 2009 the IFAC Code was updated – an explanation of the changes can be found in chapter 8 Current Issues. Fundamental principles These were met at Paper F8, and so no explanations are provided – refer to Chapter 2 of the Study Text if you need a detailed reminder: ? Integrity ?Objectivity ?Professional competence and due care ?Confidentiality ?Professional behaviour. Why a “Conceptual Framework”, not rules? ?Would be impossible to have rules for every situation ?Rules prevent the use of thought As professionals, we should be able to rely on accountants to use professional judgement ? In many cases, there may not be a “right” answer ?Depending on your morals, 2 different people may believe there are 2 very different “right” answers! Objectivity It is essential that auditors (and anyone giving an opinion) be, and be seen to be objective. Threats ?Self-Interest ? undue dependence on a single client ? overdue fees ? gifts and hospitality ? loans to/from client ? contingency fees ? lowballing ? owning shares in client. ?Self-Review ? other services ? preparation of the accounting records being audited. Intimidation ? family relationships ? undue dependence on a single client ? financial / business relationship with client ? second opinion received from another firm. • Familiarity ? family relationships ? acting for a client for several years. • Advocacy ? contingency fees ? legal services ? negotiating with banks, tax authorities on client’s behalf. Safeguards ?Rotate audit staff (especially senior audit staff). ?Do not allow shares to be held in client companies. ?Use separate teams for other services. ?Remind management that they remain responsible for all company decisions. If asked for a second opinion from a non-client, refuse to provide an opinion unless allowed to consult with their current auditor. ?No contingency fees. ?No single client to exceed a set % of the audit firm’s total revenues. Confidentiality The general rule is simple – do not disclose client information to anybody. However, there are exceptions: ? Where the law requires disclosure (e. g. money laundering) ? Where the client gives permission ?Where it is deemed to be in the “public interest” ?Where the ACCA are investigating the auditor’s work. Wherever there is doubt, a consultation with a lawyer would be wise.
And resigning from a client does NOT mean that the auditor is now free to disclose any information that he wishes!!! Conflicts of interest Conflicts of interest can be very difficult situations. The most common is between 2 clients, where what is good for one client is bad for the other. Thus the auditor cannot help one client without harming the other … an impossible situation! Managing conflicts of interest ?Before accepting a new client, consider the likelihood of conflicts with existing clients … it may be best to refuse. ?Where a conflict is possible: ? Send separate teams of staff … … from separate offices, if possible ? different partner at the head of each team ? a 3rd partner to oversee that the teams are kept apart ? stricter confidentiality rules to avoid crossover of paperwork and information ? tell both clients of the conflict, and what the firm is doing to manage it ? consider resignation from one, or both, clients. THE AUDITOR AND FRAUD This is a rare subject at this high level, as it is also on the F8 exam. As such, the Notes are very brief – consult Chapter 3 of the Study Text for more detail. Some Definitions Fraud is defined as the use of deception to gain an unfair advantage.
Misstatement in the FS could be caused by fraud (assets may be overstated if they have in fact been stolen, or FS info may be deliberately misstated to paint aparticular picture of the company to allow fraudsters to gain through bonuses, higher share price, or simply keeping their jobs). An Error is an unintentional misstatement. As well as mistakes in the FS (deliberate or otherwise), there could be other Irregularities (e. g. missing information). Auditor responsibilities for fraud A company’s Board of Directors has the primary legal responsibility for the prevention and detection of fraud.
However, the audit process is naturally suited to finding fraud, and fraud is highly likely to affect the truth and fairness of the Financial Statements, so the auditor has significant responsibility. A key concept here is skepticism. Auditors should not accept any information presented to them unless there is sufficient supporting evidence. The auditor is responsible for planning their work in such a way as to maximize the likelihood of identifying all material misstatements, whether fraud or error. The engagement team should discuss fraud during planning, risks should be assessed, and the audit process adapted as necessary.
This requires a deep understanding of the client, to understand the motivations and opportunities that might exist. The auditor may also have to report externally when a fraud is suspected, and will need to consider whether to continue to act for a client where fraud is suspected/proved. Future role of auditor For many years, an expectation gap has existed and it is clear that the public believes/expects auditors to be far more active in detection of fraud (and possibly in prevention as well). In recent years, the redrafting of ISA 240 has made clear that the auditor’s role is no longer “watchdog” and is much more “bloodhound”.
In the next few years, auditors may be expected to report on a company’s internal controls (as they already do in the US under SOX), and other increases in duties relating to fraud at clients are highly likely. AUDITOR LIABILITY To whom are auditors liable? Shareholders as a body The auditor is effectively employed by the company (the shareholders as a body) to perform a service for a fee. If the service is poorly/negligently performed, it is highly likely that the shareholders have a claim against the auditor for any losses they have suffered. This is true of all assignments, not just audits. Third parties
To be liable to a 3rd Party, the following conditions must exist: ? There was a duty of care at the time the audit opinion was given O Auditor knew, when giving the opinion, the 3 rd Party would rely on the audit opinion O Reliance on the audit opinion was a reasonable action. ?The audit work was negligent. ?Losses have been suffered as a result of this negligence. The auditor can issue a disclaimer to cancel a duty of care to 3rd Parties. There are a number of legal cases that have helped to clarify the current position, but no detailed knowledge of cases is expected. How liable might the auditor be?
In general, if an auditor has been negligent and people have lost out as a result, it would seem right that the auditor should compensate the losses. However, the quantity of compensation has long been a point of debate. The main issue is that when people lose money it is usually due to some mismanagement of the company, fraud, or accounting errors – all of which are primarily the responsibility of the directors. If the auditor fails to spot the problem, then there is likely to be some fault in the audit work, but the auditor is not the only one to blame so should not be required to pay all the compensation!
In addition, if auditors are required to pay massive compensation claims, there is a danger that no audit firm is willing to accept high-risk clients. Possible Solutions In some countries, including the UK, there are legal ways in which liability can be restricted: ? Put a disclaimer to all 3rd Parties in the Audit Report(in the UK, most firms did this as a result of the 2001 Bannerman case – whether the disclaimer stands up in law is yet to be tested). ?Become an LLP. This removes the unlimited liability of being a standard partnership, as only those partners directly found to be negligent could be found guilty. Become a limited company. This removes liability, but has massive tax and reporting consequences. ?Government-set liability cap. There would be a maximum amount that an audit firm could be sued for. ?Proportionate liability would allow compensation to be split in the proportion of wrongdoing. ?Allow audit firms to agree a system with each client’s shareholders. If both parties agree, any restriction would be allowed (a government could decide to overturn any “Limited Liability Agreement” which it felt was unfair). Expectation gap revisited
As noted above (see Fraud section), there is an expectation gap between what the public thinks auditors do (or should do), and what the audit profession actually does. During the recent Banking Crisis, many in auditing have said that “the audit profession had a good crisis” – meaning that audits had been done properly and there was no suggestion (yet! ) that auditors had been negligent or unprofessional. However, others have said that if auditing cannot forewarn that major international banks are too optimistic in their asset valuation and risk management, then there is something wrong with auditing and it needs to be changed.
Any extra responsibilities for auditors would cause liability issues – every job an auditor does creates a risk of another legal case – and audit firms are unlikely to accept more responsibilities without the liability implications also being discussed and an acceptable conclusion being reached. CHAPTER 3 – PRACTICE MANAGEMENT EXAM QUESTIONS ?For the above scenario, outline the quality control issues and how they might be resolved. ?For the above scenarios, explain the professional issues raised by the planned publicity, advertising and fee proposals. ?Suggest the factors a firm should consider when tendering for work. Suggest the factors a firm should consider when deciding whether to accept anew assignment. QUALITY CONTROL Given the importance of the work done by accountants and auditors, and the reputation damage to both the firm and the profession when that work is of poor quality, it is clear that quality control is extremely important. Quality control within the firm At the overall level of the Firm, several things can be done: ? Appoint a Quality Control Partner, to ensure quality is considered at the highest level. ?Have documented processes for staff to follow. ?Ensure staff are trained in these processes. ?Have strict recruitment policies. Ensure appraisal processes recognise quality (and the lack of it). ?Ensure overall Environment is one where quality is rewarded, and poor quality is punished. ?Careful selection of assignment teams, based on skills, experience, overall workload etc. ?Cold Review process where a selection of completed assignments are checked to help future work be done better. Quality control on each assignment ?All work is suitably: >Directed >Supervised >Reviewed. ?Suitable consultation with others, where matters are unclear. ?Hot Review (before the work is finished) of any assignment where the risk of mistakes is higher. Careful thought about which member of the team should perform and review each task, and the best time for that task to be performed. ?All work to be suitably planned and documented. ?Careful procedures on acceptance / continuance of client relationships. ADVERTISING, FEES, AND TENDERING Advertising and publicity All businesses need to consider how they will attract clients. However, advertising and publicity are by their nature in the public eye, so care must be taken not to do anything that could be considered “unprofessional”, as this may damage the reputation of the firm, or the profession as a whole.
The general principles are as follows: Clarity and accuracy There should be no comments that could be misleading, or that are simply not true No unsubstantiated claims Statements such as “we are the best auditors in London” cannot be included …unless the firm were voted “Best Auditors in London” at some awards ceremony …but the advertisement would need to make reference to this fact. No adverse comments about fellow professionals Comments such as “we are so much better than KPME” are not acceptable. General professionalism
Adverts should avoid doing anything that might damage the reputation of the profession – a naked parade through the streets handing out leaflets would be inappropriate, for example! Use of the ACCA name and logo It should be clear that the firm is registered with the ACCA, but is a separate organisation. Fees Generally speaking, fees should be charged which reflect the work done. Most firms operate a system of charge-out rates for each member of staff, so that the bill is simply hours worked multiplied by the relevant rates. However, there are some issues: Contingency Fees
We met these when studying ethics – they are banned! Lowballing This is the process of offering a very low fee in order to win business, in the hope of making the money back with increased fees in the future, or by selling additional services at a premium. In most countries, lowballing is not banned. However, some countries have tried to stop it happening, by insisting that audit fees are at least a minimum % of the client’s sales revenue. The ACCA position is that lowballing is acceptable (although it is preferable NOT to do it), as long as: ? Quality of work is not affected The client is told that the fee is lower than standard. Tendering for work Exercise A company has grown rapidly and finds itself needing to appoint an external audit firm for the first time. Your Firm has been invited to tender. What content should go into your Firm’s presentation? PROFESSIONAL APPOINTMENTS Why companies change auditors There are many reasons: ?Disagreement over the audit fee ?Audit firm considered too small (e. g. client has grown rapidly) ? Personality conflict ?Independence reasons ?Conflict of interest ?Audit firm chooses not to seek re-election. Issues when considering a client
Other than those already considered in earlier sections of the Notes – ethics, money laundering etc. : ? Does firm have the time to do the audit and meet client deadlines ? Does firm have the staff and resources ?Professional clearance – any issues raised by the outgoing auditors ? Ensure that outgoing firm correctly removed / resigning ?Assess integrity of the client and its directors? Assess risk of the client. It may be possible to obtain some audit paperwork from the outgoing auditor. There are legal issues involved, although in the UK there are moves to make it easier for the incoming firm to get such information from the outgoing firm.
The auditor must also ensure that “the necessary preconditions for an audit” are in place – an audit cannot take place unless the company can confirm that their financial statements follow an accepted system of financial reporting (if no standards have been followed, there would be nothing for the auditors to check against), and management must confirm they understand their own responsibilities in allowing the auditors to carry out the audit process. This last point leads us neatly to ... Engagement letter Once all issues have been dealt with, the audit firm sends an engagement letter (a contract) to the client, and both parties sign it.
More details about engagement letters can be found in Chapter 5 of the study text– but this should be revision from paper F8 (2. 6), and is rarely examined at this higher level. CHAPTER 4 – ASSIGNMENTS I: THE AUDIT OF FINANCIAL STATEMENTS SYLLABUS CONTENT 1. Planning ?Assessment of risk, materiality, and other matters in the planning process. 2. Evidence gathering ?The use of various audit techniques to get evidence about the truth and fairness of all items in the Financial Statements (note – any area covered in P2 (3. 6) Corporate Reporting is examinable here). 3.
Completion phase ?The assessment of going concern, corresponding figures, other information, subsequent events and other completion phase audit activities. EXAM QUESTIONS ?Identify the business risks associated with the above company, and how these might best be managed. ?Identify the business risks associated with the above company, and how these might relate to financial statement risk. ?Identify the financial statement risks associated with the above company. ?Identify the audit risks associated with the above company, and how the auditor may seek to address them. Suggest the audit procedures that may be carried out (or the audit evidence that may be collected) for the following areas of the Financial Statements. ?Discuss the extent to which analytical procedures could be used during substantive testing for the above client. ?Explain the importance of subsequent events to the audit. ?Explain the auditor’s responsibilities towards corresponding figures. ?Explain the auditor’s responsibilities towards the going concern assessment. ?Explain the auditor’s responsibilities towards Other Information. AUDIT PLANNING
Risk based approaches to auditing The audit risk approach You should be familiar with the audit risk model from earlier studies on F8 (2. 6),but here is some brief revision: Audit Risk = Inherent Risk x Control Risk x Detection Risk Audit Risk is the risk of giving the wrong audit opinion … primarily, the risk that there are material mistakes in the Financial Statements and the auditor fails to detect them during substantive testing. The risk of material mistakes in the Financial Statements is called Financial Statement Risk, and is made up of 2 elements: Inherent Risk– the risk of material mistakes occurring due to the nature of the company and its business transactions. ?Control Risk– the risk that the inherent risks are not prevented or detected by the company’s Control Systems. Auditors assess Financial Statement Risk by: ?Assessing Inherent Risk. ?Assessing Control Risk -Do the controls look good in theory -Are they actually operating properly (Control Tests). If Financial Statement Risk is HIGH then the auditor needs to keep Detection Risk LOW, by increasing the quantity of substantive tests, sending a more experienced audit team etc.
Problems with the audit risk approach A number of academics and leading audit firms were concerned that there were weaknesses with the audit risk approach: ? Either lots of detailed substantive tests got done, or a combination of detailed control tests and substantive tests got done … but whichever approach was taken, there was a heavy focus on detail ? This could result in missing bigger issues –major fraud, or problems with going concern ? Detailed tests are likely to be done by relatively junior staff … meaning: ? Even less chance of big issues being spotted, due to a lack of experience ?
Difficult to give clients “added value”. ?The approach was time consuming, and was not making the best use of advances in IT. Business risk / top-down approach The business risk / top-down approach starts by considering risks to the business itself – this is necessarily going to focus on high-level issues likely to concern investors. Once business risks are identified: ? The auditor can consider how these business risks are likely to create Financial statement risks ?Audit work can then be directed at these financial statement risks? The auditor can add value to the client by suggesting how business risks could be managed.
The approach requires more time to be spent understanding the client so planning time is likely to increase compared with the audit risk approach. However, this creates efficiency later in the audit: ? When assessing control systems, the knowledge of the client allows more time to be spent on the control environment, rather than extensive testing of detailed control procedures ? When performing substantive tests, the knowledge of the client allows more focus on Analytical procedures, rather than substantive tests of detail (Enquiry, Inspection, Observation, and Recalculation).
Both of these issues are likely to save time … and both require the use of more experienced, senior members of the audit team. The involvement of more senior staff should solve the other problems of the audit risk approach – an inability to add value, and an inability to spot bigger issues with the client. Some audit strategy issues There are a number of choices for the auditor that can make a big difference to audit efficiency: 1. Audit Plan v Audit Strategy? The audit strategy sets the overall scope, timing and direction of the audit. It will include the decision on how much to rely on the company’s internal controls (see below).
The audit plan is the more detailed process which sets out the work to be done in order to achieve the chosen strategy. Audit plans will include materiality assessment, preliminary analytical procedures, detailed risk assessment and audit procedures planned in response to the assessed risks. 2. Rely on Controls, or do a Full Substantive audit? If controls are weak, there is no choice – a full substantive audit is the only option. However, if controls appear strong, there is a choice: ? Spend time testing controls, in the hope that substantive tests can then be reduced ?
Invest no time testing controls, and just do a full substantive audit anyway. Whichever approach is expected to get the required amount of audit evidence the quickest, is the approach that will be selected. 3. How much can we use Analytical Procedures? Analytical Procedures are one of the most efficient forms of substantive audit test – so in most cases, the more they can be used, the better! However, it is generally easier to use analytical procedures when: ? The client is NOT new ?There are no major changes in the client’s business since last year ? There are other companies similar to the client, for comparison purposes ?
The company is well controlled, meaning detailed statistics can be trusted ? There are lots of estimates in the Financial Statements, as there may not be much other evidence available! 4. Materiality Reminders from F8As learned on F8, materiality is a measurement of the potential importance of an error or omission to those reading the financial statements. Remember that items may be material due to their relative size, or due to their nature. Materiality is initially set at the Planning stage, and this may require the use of estimated/budgeted/prior year figures. As the audit progresses, materiality may need to be reassessed (e. . as draft figures are altered due to errors being discovered). Remember that all small errors are noted, and then added up at the end of the audit to see if the cumulative effect is itself material. For some areas of the financial statements, the auditor may decide that a specific (usually smaller) materiality level should be set. Also, auditors may allocate smaller materiality figures to each area of the financial statements, knowing that errors in each section might sum up to an error which is material at the overall FS level. Such smaller/specific materiality figures are called Performance Materiality.
RISK QUESTIONS IN THE EXAM These are on virtually every high level audit exam paper that the ACCA has ever sat, and P7 students can expect to see at least one question, almost certainly compulsory, on every P7 exam paper. The questions need thought, and a lot of practice, because: ? There are different types of risk that can be examined, but the scenarios often look very similar … so it would be easy to answer with the wrong type of risk and score zero. ?The questions tend to be fairly repetitive, so practice should ensure that you are very well prepared for whatever company the examiner gives you on exam day!
Audit risk questions The exam technique is the same as for the lower level audit paper F8 (2. 6) … but the scenario is likely to have some more complicated things in it. The key is to remember you are looking for audit risks – so explanations need to be relevant to the auditor. Example LNA is a company that sells laptop computers to shops throughout the UK. Just over a year ago, LNA paid $1million for a 5-year exclusive right to sell the EK69model in the UK market. Sales of the EK69 were excellent for the first few months, but sales have been falling in the last 2 months, partly because f repeated technical faults with the most recent batch sold. What are the audit risks? ?The 5-year right is an intangible asset which should have been capitalized on purchase. It should be amortized over its 5 year life, and probably therefore has a carrying value of $0. 8m at present. ?The fall in sales represents evidence that the value of the right may have been impaired. ?In fact, with the speed of technical change in computers, it seems unlikely that sales of any laptop would stay high for 5 years. ?Therefore, there is a risk that the right is overvalued on the Balance Sheet. Any inventory of the EK69 may also be overstated, as technical faults may bring NRV below cost. ?If this product is very important to LNA, or if the reputation damage from the faults is high, the company’s going concern status could be in doubt. There may be a lack of disclosure of these doubts in the Notes to the Financial Statements. Tips for Audit Risk questions ?If an audit risk question goes on to ask what audit work you would do for “X”,then “X” must surely be an audit risk – so put it in your answer to the audit risk bit of the question! ?Most audit risk answers are full of inherent risks, with very few control or detection risks.
Financial statement risk questions Remember, Financial Statement Risk is inherent risk and control risk – so it is simply audit risk without considering detection risk issues. So if a question asks for financial statement risks, you simply need to identify why their FS could be materially wrong. Questions in recent years have been very repetitive, with common issues being: ? Inaccurately estimated provisions ?Impaired assets (especially intangibles) ?Failure to disclose going concern risks ?Preparation of the FS on a going concern basis when the company does not appear to be a going concern ? Overvalued inventory.
Business risk questions Business Risks are risks to the business! In other words, they are risks to the future success of the company, so it is the company, rather than the company’s financial statements, that needs to be focussed on. You need to know very little to answer business risk questions. There are hundreds of different types of business risks – just use the information in the question. Business risk and financial statement risk Sometimes questions combine business risk and financial statement risk, requiring you to: ? Identify the business risks ?Explain how these link to financial statement risks.
The easiest way to understand the differences between the question types is with an example: Example PGC is a company that buys and sells in a number of different countries around the world. What are the audit risks? What are the business risks? How could these business risks link to financial statement risks? EVIDENCE GATHERING On the P7 exam students can expect to be required to suggest audit procedures for specific matters raised in a company scenario. Whereas on F8 this audit work is likely to involve relatively simple areas of accounting (inventory valuation, depreciation, bad debts etc. , on P7 the questions could involve audit work on virtually any area of the Financial Statements. Strictly speaking, any accounting standard on the P2 syllabus could be examined on the P7 exam paper. However, because some students are still attempting P7 before P2 due to the transition to the new ACCA syllabus, it is likely that the majority of standards that arise on P7 will continue to be F7 rather thanP2. This section of the syllabus requires 2 things: ?A thorough knowledge of the accounting standards, so that accounting issues can be identified from a scenario in the exam ?
The ability to suggest audit procedures to address those accounting issues. As such, this section of the Notes takes you through all of the relevant accounting areas, highlighting the main points of each standard and the most likely audit work. Question technique Accounting Matters If a question asks for Matters, the main issues are: ?What is the correct accounting treatment in this situation? ?Is the company’s accounting treatment correct or not? ?How materials are the mistakes they are making? Evidence / Procedures When a question asks for audit procedures, remember that there are some useful checklists: ? What documents would be available. Any 3rd Parties who can provide written confirmations. ?Would awritten management representation help. ?What post year-end events may have occurred, that would help assess the year-end accounting treatment. ?Could this have happened in previous years – if so compare. Another way to think of the above issues is by using the AEIOU mnemonic (Analytical procedures, Enquiry and confirmation, Inspection, Observation and RecalcUlation) Reliance on experts As well as using external confirmations as a form of evidence (e. g. from the client’s bank, suppliers, customers etc. ), auditors may sometimes need to seek help from other experts (i. . not accountants/auditors). The increase in the use of the fair value concept is one major reason for the increased desire to seek external help on an audit. The use of such experts creates risks, and these need to be addressed: ?if the expert comes from outside the audit firm, they will not be subject to the audit firm’s quality control procedures ? if they do not understand the context of an audit, their expert advice may lack usefulness (and may in fact result in the wrong audit opinion) As such, auditor’s experts must be carefully selected, and their competence, objectivity etc. ust be without question. They must understand the audit, and the auditor must understand how the expert does their work (to ensure it is relevant to the audit process, proper quality control etc. )Where a client supplies their own expert, they can never be deemed to be objective. Also, the auditor must not refer to the reliance on an expert in the audit report –this might suggest the auditor is not wholly responsible for the audit opinion, which of course they are.
If the laws of their country force a reference to the expert to be made, the auditor must add a note to the audit report making clear that they retain full responsibility for the audit opinion (this is the same situation in a Group audit where there are Component Auditors). External auditors may wish to place reliance on the client’s internal audit provider, as they may have done work that is very relevant to the external auditor. Similar issues as explained above will need to be considered before any reliance can be placed. IAS 1-Presentation of financial statements
This standard has all the basic accounting concepts in it. Nothing major for the P7exam, but INT students should note that: ?The Balance Sheet is now the Statement of Financial Position ? The Income Statement is now the Statement of Comprehensive Income. Items that would previously have moved through Reserves (e. g. a revaluation surplus) will now be reported at the bottom of the S of CI. Accounting issues Companies will typically prepare Financial Statements under the Going Concern concept. If the company has going concern doubts, these should be disclosed in the Financial Statements.
If the company is not considered a going concern, its Financial Statements should be presented under an alternative basis. Audit work Auditors should assess the going concern status of clients by: ? Reviewing the latest trading results of the company, by inspecting management accounts after the year end. ?Assessing the cash the company has (e. g. by agreeing bank statements, loan agreements etc. ) and the cash the company could generate: -Assets that could be sold -Assets that could be used as security for a loan -Receivables that could be collected (or sold to a factor). ?Assessing the state of the industry. Obtaining a written representation from the Board that the company is a going concern. ?Assessing company forecasts for reasonableness. IAS 2-Inventories Accounting issues Should be valued at the lower of cost or net realisable value (NRV). Not much for P7 students here, as most of the IAS 2 issues were examined under Paper F8. However: ? All methods of inventory valuation that are likely to produce a reasonable valuation are allowed (note – LIFO is banned! ). ?If inventory is purchased on credit, but there is an interest charge for the delayed payment, the interest charge is NOT part of cost.
Audit work Cost should be agreed to: ?Invoices (if purchased) ?Materials requisitions / timesheets / personnel records if manufactured ? If manufactured, overhead absorption method would need to be reassessed for reasonableness. NRV should be agreed to: ? Post year-end selling prices / invoices. Stockt ake attendance should ensure that the quantities are correct. IAS 7-Statement of cash flows Very little here for the P7 exam. Various Notes can be presented in different ways, and if a new method is chosen in one year, the prior year presentation would need to be changed as well.
IAS 8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS Prior period adjustments Where: ?an accounting policy is changed in the current year ?an error is discovered in a prior year the prior year figures should be restated. Watch dates in questions carefully ……. Audit work ?Agree events to whatever documentation exists. ?Inspect Financial Statements to verify disclosure of PPA. IAS 10-Events after the reporting period Accounting issues Events that occur after the year-end are usually relevant to the next year’s Financial Statements. However, some post year-end events can be important: ?
Adjusting Events are those that provide new information about thecompany’s position at the year end. ?Non-Adjusting Events may be disclosable if they are important enough tomatter to shareholders. ?Any event becomes adjusting if it affects going concern. Audit work This will depend entirely on the issue in the question – but since such events can be audited right up to the date the audit report is signed, investigation of all post year-end evidence is vital. IAS 11-Construction contracts Accounting issues If a contract‘s outcome can be reliably estimated, a share of profits should be recognised at the year end, depending on the % completed.
The main accounting issues are: ? Whether the method of measuring completeness of the contract is reasonable. ?Whether all costs and revenues are included in the correct contract. ?Whether on loss making contracts, the full loss has been accounted for. Audit work To assess whether a contract is profitable: ?Assess future contract estimates for reasonableness ?Agree contract income back to the contract document itself. To assess loss-making contracts: ? Investigate all transfers of costs and revenues between contracts to ensure correct.
IAS 37-Provisions, contingent liabilities, and contigent assets This has been one of the most examined accounting areas on the exam in recent years. There are several examples, and being estimates they are naturally harder to audit than areas of fact. Accounting issues Provisions are required where: ?There is an obligation existing at the year end (either legal or constructive) ? A future payment (or other transfer of economic benefits) is probable ? The amount can be estimated If all these conditions are in place, a liability is recorded on the Balance Sheet (Statement of Financial Position).
The other half of the entry (the debit) usually goes to expenses, thus reducing profit for the year. However, this is not always the case. Where the existence of a year-end obligation and future payment is possible rather than probable, then no liability is recorded. Instead, the situation is disclosed in a Note to the Financial Statements – this is called a contingent liability. If there is a probable inflow which can be reliably estimated, then we have a contingent asset. Despite this inflow being probable, it is NOT recorded as an asset. Prudence dictates that the matter is simply disclosed in a Note.
Provisions and contingencies can arise for many reasons: ? Legal cases that the company might lose. ?Laws or regulations that have been broken. ?Breaches of contract with staff / suppliers etc. ?Products sold under warranty. ?Decommissioning obligations. Audit work Audit work will depend on the situation, but there are some procedures that will be useful in many of the above situations: ? Where the provision is likely to have also been made in prior years, compare prior year provision to actual events to see how accurate last year’s estimate was.
If last year was accurate and the same method of estimation is used this year, some assurance is gained that this year’s figure is reasonable. ?For anything legal, obtain written confirmation of the situation from the company’s lawyers. ?For anything contractual, inspect a copy of the contract / agreement. ?Correspondence with the other parties involved should be inspected. ?If the provision involves a calculation, it should be re-performed (with any assumptions assessed for reasonableness). Goodwill ( part of IFRS-3 Business Combinations) Accounting issues
Goodwill is the difference between the fair value of the consideration paid, less thefair value of the net assets acquired. It is most likely to be seen on the examwhere there has been an acquisition. Goodwill represents an intangible asset. However, unlike most other intangibles, it is not amortised. Instead, goodwill should be assessed for impairment on at least an annual basis. Any fall in performance of an acquired business below the expectation at the date it was acquired would suggest that the business may have been bought at too high a price.
The first asset whose value should be reduced is goodwill. Audit work Since goodwill is the fair value of consideration less the fair value of net assets purchased, audit work should include: ? At the date of purchase, agreeing consideration to purchase contract ? Where any consideration is deferred, assessing any discount rate used forreasonableness ? Where there is contingent consideration, assessing the likelihood that suchconsideration will be paid ? Verifying any valuation work done on the net assets acquired. Research and development costs (part of IAS 38-Intangible Assets) Accounting issues
The costs incurred in developing new products may be an intangible asset, if there is reliable evidence that the new products will generate future economic benefits. To generate benefits, the new products: ? Need to be completed >Which requires the company to have the resources to invest >Which requires no legal barriers to completing the products >Which requires the company to intend to finish the development, andnot divert resources to other projects >Which requires the new product to be technically feasible. ?Needs to sell enough to exceed the development costs. Audit work Inspect project budgets to assess the finance needed to finish thedevelopment. ?Inspect bank letter, loan facilities etc. to assess company’s available finance. ?Inspect Board Minutes to assess company’s intention to complete the project. ?Observe testing of prototype to help assess technical feasibility of the newproduct (may need a technical expert to assist). ?Obtain written confirmation from company’s lawyers that there are no known legal issues in completing the development. ?Obtain written management representation to confirm management intentionsto complete the development. Inspect results of company’s market research to assess future sales of the product. ?If any orders / deposits already received, inspect order forms to confirm. ?Analyse the costs which have been capitalised to confirm they belong to this project. Other intangible assets Accounting issues Any purchased intangibles – rights, licences, brands etc. – should normally be capitalised as intangible assets and amortised over their expected useful lives. Typically, useful lives are assumed to be a maximum of 20 years.
It is allowable to amortise over a period of more than 20 years, or even not to amortise at all … but only if annual impairment reviews are carried out instead. The main accounting issue with intangibles in exam questions tends to be impairment Audit work ?Agree cost of intangible to purchase documentation ?Analyse trend of income generated by the intangible (both in the past, andfuture forecasts) to assess impairment ? Compare accounting treatment with previous examples in this company, andwith similar examples in the industry. IFRS-5 Assets held for sale and discontinued operations
Accounting issues Assets held for Sale Where a company has: ?Decided to sell an asset ?Made the asset ready for sale by the year-end ?Is actively trying to sell the asset at the year-end, and expects a sale within12 months. Then the asset is deemed to be “held for sale”. It should: ? No longer be depreciated ?Be shown separately on the face of the Statement of Position ? Be valued at the lower of book value (i. e. depreciated cost) or NRV. Of course, an asset held for sale could include a subsidiary company, or an entire division of a business. This brings us on to discontinued operations.
Discontinued Operations A discontinued operation is a subsidiary, division, or other clearly separate part of a business that: ? Has been permanently closed, or has been sold, during the accounting year, or ? Is “held for sale” (see above Notes) at the year-end. I f it qualifies as discontinued, the results of this part of the business should be disclosed separately from the rest of the business in the Income Statement. If the segment remains “held for sale” at the year-end, it should be treated on the Balance Sheet as any other “held for sale” asset, as explained above.
Audit work For assets / operations that have been disposed of: ? Agree proceeds to sales documentation and bank statements ? Recalculate any gain or loss on disposal and ensure separately disclosed in Income Statement ? If asset had previously been revalued, ensure any balance on revaluation reserve has been transferred to income reserves (Equity), not included in the year’s profit ? Verify date on sales documentation to prove asset was sold before year end. For assets / operations “held for sale”: ?Inspect Board Minutes to confirm intention to sell Inspect correspondence with agent to confirm company is actively trying to sell the asset ? If company has advertised the asset for sale, inspect advertising documentation ? Obtain management representation to confirm Board’s intention to sell ? Inspect correspondence between company and any interested parties regarding the sale ? If company has made any announcements regarding the plan to sell, inspectcopies and agree date before year end ? Assess asset / operation for impairment, as a plan to sell often indicates asset / operation is not performing as well as company would like.
If a company is planning to close down an operation, it is NOT a discontinued operation unless it was closed before the year end. As a separate issue, closing down (or announcing plans to close down) an operation: ? Strongly suggests the operation is impaired … so if it still to be closed at the year end, it should be assessed for impairment ? Is likely to result in obligations being created (e. g. redundancy and otherclosure costs). IAS-36 Impairment of Assets Accounting issues Assets are at risk of overstatement if their recoverable value is less than their carrying value.
This risk attaches itself to all assets, both current and non-current,and therefore impairment can arise in many exam scenarios. As well as basic situations such as inventory sold shortly after the year-end atbelow cost, or receivables which go bad after the year-end, impairment could besuggested by under-performing divisions or subsidiaries (resulting in all/any of theassets of that part of the business – the cash generating unit – being overstated). When companies choose to shut down part of their business, the most obvious accounting standard to consider is Discontinued Operations.
However, you should also ask yourself why they are considering closing it down – does this not suggest a problem with this part of the business, and hence impairment? Typically impairment losses will go straight to the Income Statement, and hence there is a natural risk that the directors do not want to recognise this – meaning they may hide evidence from auditors. Audit work ?Compare the results of each part of a business with budgets/forecasts, to establish if the segment is under-performing. ?Assess the present value of future cashflows associated with the asset that might be impaired (e. . projected sales revenue for a brand) and compare with carrying value. ?Monitor events after the year-end (e. g. sale of an asset below carrying value)for evidence of overvalued year-end assets. ?Inspect Board Minutes for evidence of discussions of known problems within dividual assets or parts of the business. IAS 20 Government grants Accounting issues Government Grants (or grants from any other source) are typically received by acompany to assist with the purchase of an asset, or to help towards the expensesof some activity that the government wishes to support or encourage.
For example, to encourage companies to be more environmentally friendly, agovernment might offer to reimburse them for 50% of the cost of investing inenergy-saving machinery. Or to encourage investment in poorer parts of acountry, there may be grants receivable for every new job created, in the form of assistance with paying salaries. Typically, the grant is given for very specific purposes and there will be terms and conditions. If these are breached, the grant is likely to become repayable. If the grant is to help pay expenses (a revenue grant), the grant should bematched against those expenses in the Income Statement / Profit and LossAccount. ?If it is to help pay future expenses, the grant should be credited to Deferred Income on the Balance Sheet and then gradually released as the relatedexpenses are paid by the company. ?If the grant is to help pay for an asset (capital grant), the grant should again be credited to Deferred Income and then released as the related asset isdepreciated, so that again the grant is matched against the related expense(the depreciation) in the Income Statement / Profit and Loss Account. For a capital grant, it might be allowable to net the grant off the cost of the asset, thus automatically ensuring the grant is set off against depreciation charges. However, in many countries this is not an allowable solution, as itresults in “netting off” assets and liabilities (therefore it is banned in the UK,for example). ?Should the term of the grant be broken, the rules of provisions and contingencies apply – so if repayment is probable a provision would beneeded. If repayment is possible rather than probable, a contingent liability would need to be disclosed in the Notes to the Financial Statements.
Audit work ?Inspect the grant agreement, in order to check: -What the grant is helping to pay for -The total amount of the grant (may be future amounts receivable) -the conditions under which it would have to be repaid. ?Inspect cashbook and bank statements to verify receipt of the grant. ?Inspect Board Minutes to assess whether company has done anything (or is about to do anything) that might make the grant repayable. ?Recalculate any release of deferred grant income to ensure it matches with the related expenditure. IAS 40-Investment properties
Accounting issues Sometimes companies buy / lease properties not for their own use, but for their investment potential – to rent out, possibly with a view to selling the building for a profit at some point in the future. These properties are not being used by the company as part of normal operationsto generate operating profit – they are more like an investment in shares, where the rental income replaces the dividends. ?Investment properties are originally recorded at cost. ?Given their nature they are likely to be subject to regular revaluation.
It ishowever possible to leave them at cost and depreciate them like any other asset. ?If being revalued (i. e. held at “fair value”), they should not be depreciated,but they could be Impaired just like any other asset (e. g. if the rental market is weak for a long period of time, the value of the property may be affected). ?All gains and losses on revaluation or impairment of investment properties go to the Income Statement (note the difference from other asset revaluations, where a surplus would usually go to reserves (equity), not profit). A building owned by one group company and leased to another could be an investment property in the separate company FS, but from the group perspective it is owner occupied so is not an investment property in the consolidated FS. ?A building that is part owner-occupied and part leased out can be treated as two separate assets (i. e. the leased out part can be a separate “investment property”, the occupied part a separate “property”). ?There are lots of disclosure requirements (e. g. who did the revaluations, whether any leased assets are being treated as investment properties etc. ). Audit work Remember that investment properties are properties! As such, normal auditwork for properties applies: -Inspect property to confirm existence (and that company is not owner-occupying) -Inspect title deeds and land registry records to confirm ownership -Inspect copy of latest valuation document -Assess independence, qualifications, experience of the valuer -Inspect FS to ensure all necessary disclosures are included. ?Ensure gains and losses on revaluation have gone to the Income Statement. IAS 17 Leases Accounting issues There are 2 types of lease – operating leases and finance leases. Operating leases are treated as rentals. Lease payments are expenses like any others. ?Companies must disclose commitments made under operating leases. ?Finance leases are leases where the rights and obligations of ownership have been transferred to the company using the asset (lessee). Since in substance the asset is “owned”, it is treated as a non-current asset on the balance sheet and depreciated over the life of the lease. ?With finance leases, the “cost” of the asset is the present value of the minimum guaranteed lease payments, the other side of which is treated as a liability. ?As with other assets, if he fair value of the asset is lower than the carryingvalue, then fair value must be used (i. e. the asset has been impaired). ?Lease payments will be split between a reduction in the liability, and a finance charge (just as a loan repayment is partly repaying a loan, and partly interest). ?The liability must be split between current liabilities and non-current liabilities. ?With both operating leases and finance leases, lease commitments must be disclosed between 5 years. Sale and Leaseback ?Where an asset is sold and then leased back to the company, the accounting treatment depends on the nature of the lease in the leaseback. If the leaseback is an operating lease, then in substance the asset has been sold – so a gain or loss on disposal will occur in the normal way. If the gain or loss is not on normal commercial terms (because it is tied in to higher or lower lease payments in the lease agreement), then things change: -If there is a loss on disposal, but it is compensated for by lower leasepayments in the future, then the loss is deferred and amortised to matchthe lower lease payments. -If there is a gain on disposal, it is deferred and amortised over the life of the lease. If the leaseback is a finance lease, then in substanc