Chapter 2 Basic Concepts of Auditing

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

CHAPTER TWO BASIC CONCEPTS OF AUDITING LO #

ICAP'S STUDY TEXT REFERENCE*

LEARNING OBJCTIVE

PART A – FINANCIAL REPORTING FRAMEWORK LO 1

FINANCIAL REPORTING FRAMEWORKS

LO 2

WHAT IS MEANT BY TRUE AND FAIR VIEW

Q. # 59(c i) of Question Bank 1.1.3 (True and fair view)

PART B – RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT

1.3.9 (Responsibility of management…)

LO 3

MANAGEMENT’S (AND TCWG’S) RESPONSIBILITIES

LO 4

AUDITOR’S RESPONSIBILITIES/OBJECTIVE

1.4.5

LO 5

STAKEHOLDERS’ RESPONSIBILITIES

15.4.2

PART C – SCOPE OF AUDIT LO 6

SCOPE OF AUDIT

LO 7

ESSENTIALS OF PROPER CONDUCT OF AUDIT

1.4.6 (excluding Audit Field work) 1.4.4(Professional judgment), 3.1.2

PART D – REGULATORY ENVIRONMENT OF AUDITING INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC) INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN (ICAP)

LO 8 LO 9

AUTHORITY/STATUS OF INTERNATIONAL STANDARDS ON AUDITING (ISAs)

LO 10

1.4.1, 1.4.2, 1.4.3, 1.4.4 1.3.9 1.4.4 (Other International Standards)

*Explanation of Reference: First digit in Study Text’s Reference represents chapter number, second and third digits represents section and sub-section number. Contents in brackets (if any) represent part of the sub-section which is covered by the learning objective.

Coverage from Question Bank: After completion of this chapter, you will be able to attempt following questions in ICAP's Question Bank:  Q. # 4 (available in practice set Q. # 3)  Q. # 59 ci (available in practice set Q. # 1) 1

By: Muhammad Asif, ACA

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

PART A – FINANCIAL REPORTING FRAMEWORK LO 1: FINANCIAL REPORTING FRAMEWORKS AND APPLICALBE FINANCIAL REPORTING FRAMEWORK:

A financial reporting framework is a set of criteria used to prepare financial statements. There are two main types of financial reporting frameworks i.e. Compliance Framework and Fair Presentation Framework

Compliance Framework: Compliance framework is a financial reporting framework that requires compliance with requirements of the framework, and does not contain acknowledgment of fair presentation framework. For example, Tax-basis Framework. Fair Presentation Framework: Fair presentation framework is a financial reporting framework that requires compliance with requirements of the framework, and contains acknowledgment that, to achieve fair presentation, it may be necessary for management:  To provide additional disclosures beyond requirements of framework or  To depart from a requirement of framework For example, IFRS. Applicable Financial Reporting Framework/AFRF: AFRF is the financial reporting framework which management adopts in preparation of financial statements considering legal requirements, nature of entity, nature of financial statements, and purpose of financial statements.

LO 2: WHAT IS TRUE AND FAIR VIEW:

If AFRF is a fair presentation framework, auditor also checks whether financial statements presents true and fair view.

True and Fair View: The term “True and Fair View” has not been defined in the Companies Ordinance 1984 or in ISAs or in IASs. Therefore, it is the most difficult and judgmental aspect of audit. Generally,  true means “free from error” and  fair means “free from undue bias in financial statements or the way in which they are presented”. Study Tip Terms “give true and fair view” and “present fairly, in all material respects” are equivalent. However, first term is more common in practice. 2

By: Muhammad Asif, ACA

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

PART B – RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT LO 3: MANAGEMENT’S (AND TCWG’S) RESPONSIBILITIES:

In an audit of financial statements, management (and where applicable TCWG) is responsible: 1. For the preparation of financial statements in accordance with AFRF. This responsibility includes:  Selecting the applicable financial reporting framework (AFRF).  Applying appropriate accounting policies and reasonable accounting estimates.  Prevention and detection of fraud. 2. For design, implementation and operating effectiveness of internal control which is necessary to prepare financial statements in accordance with AFRF; and 3. To provide the auditor with: i. Access to all information relevant to the preparation of the financial statements of which management is aware; ii. Additional information that the auditor may request from management for the purpose of the audit engagement; and iii. Unrestricted access to persons within the entity to obtain audit evidence. Study Tips 1. Same responsibilities are included in Engagement Letter and in Auditor’s Report. 2. “Premise of an audit” means management has acknowledged and understands that it has above responsibilities.

LO 4: AUDITOR’S OVERALL OBJECTIVE/RESPONSIBILITY:

Auditor’s Primary responsibility/Overall objective is:  To obtain reasonable assurance that financial statements are free from material misstatement (whether due to error or fraud); and express an opinion on financial statements (through auditor’s report) and  To communicate in accordance with the auditor’s findings. (e.g. communication to TCWG if there is non-compliance of laws and regulation or significant deficiencies in internal control). To meet overall objective, auditor is also responsible to: • Perform procedures in accordance with ISAs and regulatory and professional requirements. • Apply professional judgment and professional skepticism in planning and performing audit. • Comply with code of ethics. Study Tip These responsibilities are included in Engagement Letter as well as in Auditor’s Report.

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By: Muhammad Asif, ACA

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

LO 5: STAKEHOLDERS’ RESPONSIBILITIES:

It is the responsibility of general public (i.e. stakeholders) to understand and eliminate expectation gap so that scope of audit is not misunderstood. Expectation Gap: Expectation Gap is the difference between ‘what general public perceives of role and responsibilities of auditor’ and ‘what statutory role and responsibilities of auditor are’.

Some Common Misunderstandings (i.e. Expectation Gap) about Audit: Some examples of misunderstandings in public’s expectations are as follows: 1. Auditor checks all transactions of entity. 2. Auditor has a duty to detect and prevent fraud. 3. Auditor is responsible to detect all misstatements. 4. Auditor provides absolute assurance (guarantee) about F/S. 5. Audit assures that entity will be Going Concern.

Consequences of Expectation Gap: There is increasing tendency to file legal actions against auditors without any valid basis.

How to Reduce Expectation Gap:  By steps taken by SECP and ICAP e.g. changes in Code of Corporate Governance to strengthen the role and responsibilities of directors for good internal control and accounting systems.  By expanding the format of auditor’s report.  By mentioning Management’s Responsibilities, Auditor’s Responsibilities and Inherent limitations of audit in Engagement Letter.  By mentioning Management’s Responsibilities and Auditor’s Responsibilities in Auditor’s Report.

PART C – SCOPE OF AUDIT

LO 6: SCOPE OF AUDIT:

Scope of audit means nature, timing and extent of audit procedures which are necessary to achieve the overall objective of audit (i.e. to obtain reasonable assurance that financial statements are free from material misstatement). Scope of audit is determined by ISAs, legal and professional requirements and auditor’s professional judgment.

An audit also includes:  Assessment of risk of material misstatement. In making risk assessment, auditor considers understanding of entity and understanding of internal control relevant to preparation of financial statements.  evaluating appropriateness of accounting policies, reasonableness of accounting estimates and overall presentation of financial statements Study Tip If auditor is unable to obtain reasonable assurance about financial statements, this is called “Limitation on Scope of Audit” or precisely “Scope Limitation”.

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By: Muhammad Asif, ACA

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

LO 7: ESSENTIALS OF PROPER CONDUCT OF AUDIT:

For the successful completion of a good audit, it is necessary that auditor has following attributes throughout the audit engagement: Characteristic Professional Judgment

Professional Skepticism

Explanation Professional Judgment is the application of Cumulative Audit Knowledge, Experience and Training, in different circumstances to reach an appropriate course of action or conclusion. Application of professional judgment is necessary to comply with ISAs. Professional skepticism is an attitude which includes questioning mind (being alert to circumstances which may indicate possible misstatement), and critical assessment of audit evidence. Consequently, auditor should not believe everything management tells. He should remain alert to circumstances that indicate the possibility/risk of misstatement or fraud.

PART D – REGULATORY ENVIRONMENT OF AUDITING LO 8: INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC):

International Federation of Accountants: IFAC is the global organization of professional accountants dedicated to serving the public interest by strengthening the profession in the area of auditing, ethics, professional education and public sector. IFAC’s mission is to serve the public interest by:  development of high-quality standards and guidance  Facilitating the adoption and implementation of standards and guidance  promoting the value of professional accountants worldwide  Speaking out on public interest issues IFAC includes following four boards:  International Auditing and Assurance Standards Board (IAASB);  International Accounting Education Standards Board (IAESB);  International Ethics Standards Board for Accountants (IESBA); and  International Public Sector Accounting Standards Board (IPSASB).

International Auditing and Assurance Standards Board: IAASB is one of the boards within IFAC. It serves the public interest by enhancing quality and consistency of auditing and assurance practice throughout the world. It is a standard-setting body which issues standards to be applied in providing the audit, review and related services. It also provides facilitation in adoption and implementation of international standards. Following types of international standards are issued by IAASB:  International Standards on Assurance Engagements (ISAEs). These are applied on all types of assurance engagements (i.e. on Audits and Review).  International Standards on Auditing (ISAs). These are applied on audit of financial statements. 5

By: Muhammad Asif, ACA

Auditing – Study Notes

Chapter 2 Basic Concepts of Auditing

 International Standards on Review Engagements (ISREs). These are applied on review of financial statements.  International Standards on Related Services (ISRSs). These are applied on Agreed upon Procedures Engagement and Compilation Engagement.  International Standards on Quality Controls (ISQCs). These are applied for all of the above engagement.

IASB also issues International Auditing Practice Statements (IAPS) to help auditors in implementing ISAs and to promote good auditing practice in general.

Process of Producing a new ISA by IAASB:  A subcommittee of IAASB determines an appropriate subject matter to issue a new ISA or to revise an existing ISA.  After study and research, an exposure draft is produced for consideration by IAASB.  If exposure draft is approved by IAASB, it is circulated to member bodies and is published on IAASB website.  Comments and proposed amendments are considered by IAASB and draft is amended as necessary.  Finally exposure draft is issued an ISA or IAPS.

LO 9: INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN (ICAP):

At national level, auditors can be regulated by their own professional bodies (called self-regulation) or/and by government (called independent/state-regulation). In Pakistan, ICAP is the professional body regulating auditors. Role of ICAP is as follows: − Offers professional qualification to become auditor in Pakistan. − Establishes procedures to ensure professional competence of auditors e.g. Continuing Professional Development (CPD) of members, Quality Control Reviews of audits (QCR). − Maintains a list of “registered auditors” for public. − Adopts international accounting and auditing standards for implementation in Pakistan and also provides guidance on their implementation.

LO 10: AUTHORITY/STATUS OF INTERNATIONAL STANDARDS ON AUDITING (ISAs): In Pakistan, ISAs are adopted by ICAP (being a member of IFAC). ICAP has adopted most of ISAs.

In Pakistan, format of auditor’s report states that audit was conducted in accordance with auditing standards as applicable in Pakistan, therefore, it is compulsory for auditors to comply with all required procedures of all adopted ISAs unless:  a required procedure is not relevant, or  a required procedure is not practicable and is necessary to depart. In this case auditor has to document reason of departure from required procedure and alternative procedures performed to obtain evidence.

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 2 Basic Concepts of Auditing

CHAPTER TWO BASIC CONCEPTS OF AUDITING QUESTIONS CONCEPT REVIEW QUESTIONS

Q.1

Differentiate between the following:  Fair presentation framework and compliance framework

Q. 2

Briefly discuss the term “true and fair view” in the context of an audit. (05 marks) (CA Certificate Stage – Spring 2004)

Q.3

(a) Briefly highlight the management’s responsibilities relating to the financial statements?

LO1

LO2 LO3 LO7

(04 marks)

(CA Certificate Stage – Spring 2012)

(07 marks)

(b) During the audit team planning meeting, a member of the audit team passed a comment that based on past experience with the client, he was confident that the management of the client was honest and there was no issue as regards management integrity or risk of fraud in the Company. The audit manager responded that the auditor should always maintain an attitude of professional skepticism throughout the audit. Required: Briefly describe ‘Audit Skepticism’ and elaborate on the response of the audit manager. (08 marks) (CA Certificate Stage – Autumn 2009)

(04 marks)

Q.4

What is the primary objective of an audit?

Q.5

What is the “expectation gap” and how could it be removed or reduced by the auditing profession?

Q.6

What is the scope of an audit? Also discuss as to who is responsible to prepare financial statements.

LO4 LO5

LO3 LO6

(CA Certificate Stage – Autumn 2001)

(04 marks) (CA Final, Summer 1994) (07 marks)

(CA Certificate Stage – Spring 2002)

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 2 Basic Concepts of Auditing

Q. 7

Briefly describe the meaning of professional judgment.

Q.8

During the course of the audit of Smart Services Limited for the year ended March 31, 2010, the auditor noted certain contradictions between the results of inquiries from company’s legal advisor and the representation provided by the management in respect of certain contingencies.

LO7 LO7

Q. 9

LO8 LO10

Q. 10 N/A

Q. 11 LO4

(CA Inter, Spring 2013)

Considering the above scenario: (i) Define “Professional Skepticism”. (02 marks) (ii) Explain how the attitude of “Professional Skepticism” would help the auditor to deal with such matters? (03 marks) (ICMA Pakistan – Summer 2010)

(a) Discuss briefly the role of the following: (i) International Federation of Accountants (ii) International Auditing and Assurance Standards Board

(03 marks) (03 marks)

(b) Briefly discuss the authority attaching to International Standards on Auditing (ISAs) with respect to audit of a limited company in Pakistan. (03 marks) (CA Certificate Stage – Spring 2006) What do you understand by ‘governance’? Who is normally charged with governance in an (03 marks) organization? (CA Certificate Stage – Spring 2005) CONCEPT APPLICATION QUESTIONS

You were the engagement partner on the audit of a commercial bank which has a network of more than 200 branches, across the country. During a recent meeting, a member of the audit committee referred to an instance of irregularity in a branch, whereby the Branch Manager had extended credit to a close relative without following the bank’s credit disbursement procedures. The member criticized the auditors for their failure to highlight such instances.

Required: As an engagement partner, write a letter to the audit committee explaining your point of view in detail with specific references to the International Standards on Auditing, wherever applicable.

(09 marks) (CA Final – Winter 2008)

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By: Muhammad Asif, ACA

Auditing –Practice Set

Q.1

Chapter 2 Basic Concepts of Auditing

SUGGESTED SOLUTIONS

Fair Presentation Framework: Fair presentation framework is a financial reporting framework that requires compliance with requirements of the framework, and contains acknowledgment that, to achieve fair presentation, it may be necessary for management:  To provide additional disclosures beyond requirements of framework or  To depart from a requirement of framework

Compliance Framework: Compliance framework is a financial reporting framework that requires compliance with requirements of the framework, and does not contain acknowledgment of fair presentation framework. Q. 2

The term “True and Fair View” has not been defined in the Companies Ordinance 1984 or in ISAs or in IASs. Therefore, it is the most difficult and judgmental aspect of audit. Generally,  true means “free from error” and  fair means “free from undue bias in financial statements or the way in which they are presented”. Examiners’ Comments: It was a routine question at this level that was not well answered by the students in general. Most of the students did not define truth and fairness separately. A minority also confused their explanations between true and fair, for example, stating “true means unbiased”.

Q.3

(a) Management has following responsibilities relating to financial statements: 1. For the preparation of financial statements in accordance with AFRF. This responsibility includes: 1. Selecting the applicable financial reporting framework (AFRF). 2. Applying appropriate accounting policies and reasonable accounting estimates. 3. Prevention and detection of fraud. 2. For design, implementation and operating effectiveness of internal control which is necessary to prepare financial statements in accordance with AFRF; and

(b) Audit Skepticism: Professional skepticism is an attitude which includes questioning mind (being alert to circumstances which may indicate possible misstatement), and critical assessment of audit evidence.

Consequently, auditor should not believe everything management tells. He should remain alert to circumstances that indicate the possibility/risk of misstatement or fraud. Elaboration on the response of the audit team manager: 3

By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 2 Basic Concepts of Auditing

Viewpoint expressed by member of the audit team is Incorrect and viewpoint of by audit manager is correct.

Though Professional skepticism does not mean to disregard past experience about competence and integrity of management; but auditor should remain alert in every audit that there may be circumstances that indicate the possibility/risk of misstatement or fraud. A belief that management and those charged with governance are honest and have integrity does not relieve the auditor of the need to maintain professional skepticism or allow the auditor to be satisfied with less than persuasive audit evidence when obtaining reasonable assurance. Q.4

Auditor’s Primary responsibility/Overall objective is:  To obtain reasonable assurance that financial statements are free from material misstatement (whether due to error or fraud); and express an opinion on financial statements (through auditor’s report) and  To communicate in accordance with the auditor’s findings. (e.g. communication to TCWG if there is non-compliance of laws and regulation or significant deficiencies in internal control). To meet overall objective, auditor is also responsible to: • Perform procedures in accordance with ISAs and regulatory and professional requirements. • Apply professional judgment and professional skepticism in planning and performing audit. • Comply with code of ethics.

Q.5

What is the expectation gap: Expectation Gap is the difference between ‘what general public perceives of role and responsibilities of auditor’ and ‘what statutory role and responsibilities of auditor are’. e.g. public thinks that auditor checks all transactions of entity or auditor has a duty to detect and prevent fraud. How could expectation gap be removed or reduced:  By steps taken by SECP and ICAP e.g. changes in Code of Corporate Governance to strengthen the role and responsibilities of directors for good internal control and accounting systems.  By expanding the format of auditor’s report.  By mentioning Management’s Responsibilities, Auditor’s Responsibilities and Inherent limitations of audit in Engagement Letter.  By mentioning Management’s Responsibilities and Auditor’s Responsibilities in Auditor’s Report.

Q.6

Scope of an audit: Scope of audit means nature, timing and extent of audit procedures which are necessary to achieve the overall objective of audit (i.e. to obtain reasonable assurance that financial statements are free from material misstatement). Scope of audit is determined by ISAs, legal and professional requirements and auditor’s professional judgment. An audit also includes: 4

By: Muhammad Asif, ACA

Auditing –Practice Set 



Chapter 2 Basic Concepts of Auditing

Assessment of risk of material misstatement. In making risk assessment, auditor considers understanding of entity and understanding of internal control relevant to preparation of financial statements. evaluating appropriateness of accounting policies, reasonableness of accounting estimates and overall presentation of financial statements

Who is responsible to prepare financial statements: It is the responsibility of management and, where appropriate, TCWG to prepare financial statements in accordance with applicable financial reporting framework.

Examiners’ Comments: This was an ISA based question but the students could not answer this part in an organized and concise manner. However, majority of the students managed to pass in this part. Q. 7

Professional Judgment is the application of Cumulative Audit Knowledge, Experience and Training, in different circumstances to reach an appropriate course of action or conclusion. Application of professional judgment is necessary to comply with ISAs.

Q.8

(i) Professional skepticism is an attitude which includes questioning mind (being alert to circumstances which may indicate possible misstatement), and critical assessment of audit evidence. (ii) Auditor should perform further specific procedures to determine which source of evidence is reliable e.g. 1. further inquiry of management and legal advisor about reasons of difference. 2. inspect documents relating to litigations and contingencies. 3. obtain opinion from other lawyers. 4. consider effect of events after the balance sheet date.

Q. 9

Examiners’ Comments: (i) Professional Skepticism: Majority of the examinees could not appropriately define the term. (ii) Ways in which Professional Skepticism is Helpful for Auditor: Majority of examinees failed to explain the application of the attitude of Professional Skepticism to handle and resolve the contradictions between audit evidence collected from two different sources.

(a) (i) IFAC is the global organization of professional accountants dedicated to serving the public interest by strengthening the profession in the area of auditing, ethics, professional education and public sector. IFAC’s mission is to serve the public interest by:  development of high-quality standards and guidance  Facilitating the adoption and implementation of standards and guidance  promoting the value of professional accountants worldwide  Speaking out on public interest issues 5

By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 2 Basic Concepts of Auditing

(ii) IAASB is one of the boards within IFAC. It serves the public interest by enhancing quality and consistency of auditing and assurance practice throughout the world. It is a standard-setting body which issues standards to be applied in providing the audit, review and related services. It also provides facilitation in adoption and implementation of international standards. (b) In Pakistan, ISAs are adopted by ICAP (being a member of IFAC). ICAP has adopted most of ISAs. In Pakistan, format of auditor’s report states that audit was conducted in accordance with auditing standards as applicable in Pakistan, therefore, it is compulsory for auditors to comply with all required procedures of all adopted ISAs

Examiners’ Comments: (a) Students had a surface knowledge of such roles. (b) This part was designed to test the candidates’ knowledge about the applicability of the ISAs in Pakistan. Very few candidates mentioned the relevant points. Q. 10

Meaning of Governance: Governance means act of supervision, direction and control. Who is charged with Governance in an organization: 1. Board Of Directors of company, and 2. Audit Committee

Examiners’ Comments: Very few students knew the exact definition of the term ‘governance’, that is, act of supervision, direction and control. Q. 11

Viewpoint expressed is Incorrect, hence I do not agree with it. Auditor’s responsibility is to obtain reasonable assurance whether financial statements have been prepared in accordance with AFRF and express an opinion on financial statements.

There is no responsibility of auditor in this case on following grounds: 1. Granting a credit without following bank’s procedures is a weakness in Internal Control, not a misstatement in financial statements. Auditor considers internal internal control but for risk assessment and it is not his responsibility to express opinion on internal control. 2. Auditor checks only sample of transactions; therefore auditor is not responsible to detect a certain weakness in internal control or misstatement because it may not have been selected for the purpose of audit. 3. Primary responsibility to design, implement and operate internal control is of management/TCWG.

Examiners’ Comments: Answers to this question were disappointing as the majority of candidates failed to appreciate that the irregularity cited in the scenario did not, in itself, result in a misstatement in the financial statements and consequently its detection was not part of the external auditor’s responsibilities. 6

By: Muhammad Asif, ACA