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Auditing – Study Notes

Chapter 1 Introduction to Assurance Services

CHAPTER ONE

INTRODUCTION TO ASSURANCE SERVICES

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*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. # 2 (available in practice set Q. # 4)

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Auditing – Study Notes

Chapter 1 Introduction to Assurance Services

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Origin of Assurance Services:

Since the Industrial Revolution in 18 th century, businessmen started forming Joint Stock Companies to do business. In many situations, people who managed the business (called management and directors) were different from those who owned the business (called shareholders). Management and Directors had role of stewardship (i.e. they look after the assets of the company and manage them on behalf of shareholders) or agent (i.e. they act in accordance with instructions of shareholders). To judge the performance of management and directors, shareholders asked them to prepare statements about financial performance and financial position of company (these statements are now called ‘financial statements’) and to provide them these statements.

Soon after, it was recognized that financial statements prepared by managers/directors presented “best-view” of business instead of “true-and-fair-view” due to some Incentive (e.g. bonus) or Pressure (e.g. fear of removal) faced by management. Thus credibility of financial statements was questioned.

To enhance the credibility/confidence/assurance on these financial statements, an expert person (called assurance provider or auditor) was hired by shareholders to verify financial statements. This person:

is independent of both managers/directors and shareholders.

gives his report/opinion whether financial statements given true and fair view in all material respects.

Role of auditors was recognized in a great way. Now a days, audits are performed either because:

they are required by law (called statutory audits e.g. all companies in Pakistan are required by law to get their annual financial statements audited before they are given to shareholders)

they are not required by law but are voluntarily performed because of value-added benefits of audits (called non-statutory auditors e.g. sole-proprietorships, partnerships and NGOs etc. undergoing an audit)

Benefits of Assurance Services:

In today’s world, assurance providers are engaged not only to meet statutory requirements but

many other benefits are also obtained by shareholders from such assurance services e.g. assurance services:

1)

2) Identify weaknesses in entity’s internal control system and assurance providers suggest

Enhance credibility of financial statements for shareholders.

3)

4)

5)

recommendations to management. Confirm management that they have performed their statutory and non-statutory duties. Are check on employees. Therefore, they behave positively. Provide facilitation in:

statutory and non-statutory duties. Are check on employees. Therefore, they behave positively. Provide facilitation in:
statutory and non-statutory duties. Are check on employees. Therefore, they behave positively. Provide facilitation in:

o

Sale of Business or Shares.

o

Obtaining bank loans.

o

Filing tax returns.

In addition to shareholders, some other stakeholders also get benefits from audit of F/S.

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By Muhammad Asif, ACA

Auditing – Study Notes

Chapter 1 Introduction to Assurance Services

Disadvantages of Assurance Services:

1)

Audit takes time and cost.

2)

Entity/Organization has to share its confidential information with auditor.

3)

Management/Directors often think audit as a “disturbing activity” instead of a “value added activity”.

4) Audit does not provide 100% (i.e. absolute) assurance that financial statements are free from errors or frauds.

CONCEPT REVIEW QUESTION What are the advantages of an audit to an organization?

(05 marks)

(CA Certificate Stage – Spring 2004)

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Assurance Engagement: “Assurance engagement” means an engagement in which a practitioner (i.e. assurance provider)
Assurance Engagement:
“Assurance engagement” means an engagement in which a
practitioner (i.e. assurance provider) obtains evidence about
evaluation of a subject matter against suitable criteria, and expresses
his conclusion to enhance the confidence of the intended users (other
than the responsible party).

Elements of Assurance Engagement:

Every assurance engagement consists of following 5 elements:

Element

Explanation (with respect to assurance on financial statements)

A three party relationship

1. Intended users (the parties for whom subject matter and assurance report is prepared i.e. shareholders, bankers) 2. A responsible party (the party which prepares subject matter i.e. management) and 3. A practitioner (the party which provides assurance on subject matter i.e. auditor)

A subject matter

Subject matter is the data which responsible party is required to prepare i.e. Financial Statements

Suitable Criteria

Criteria means Framework (i.e. rules and regulations) under which financial statements are prepared and evaluated e.g. IFRS or Laws. Suitable means it should be selected appropriately.

Evidence

Evidence means information on which practitioner’s conclusion is based. Evidence should be sufficient and appropriate.

Written Assurance Report

It is a page which is written in standard format. It includes conclusion of practitioner, and it is provided by practitioner to intended users.

CONCEPT REVIEW QUESTION List down the basic elements of an assurance engagement.

(03 marks)

(CA Certificate Stage – Spring 2003)

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By Muhammad Asif, ACA

Auditing – Study Notes

Chapter 1 Introduction to Assurance Services

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“Assurance” means confidence with which a practitioner expresses his conclusion. Assurance adds credibility in financial statements, however level of credibility depends on type of assurance provided.

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Levels/Types of Assurance:

There are three levels/types of assurance i.e.

Absolute Assurance It is a perfect level of assurance.

Reasonable Assurance (also called High Level or Positive Assurance) It is a high but not absolute level of assurance which is expressed in positive form of conclusion e.g. “in our opinion, financial statements give true and fair view”.

Limited Assurance (also called Moderate Level or Negative Assurance) It is a moderate level of assurance which is expressed in negative form of conclusion e.g. “Based on our review, nothing has come to our attention that causes us to believe that financial statements do not give a true and fair view”.

Why absolute assurance cannot be provided:

Auditor cannot provide absolute assurance because audit risk cannot be reduced to Zero due to inherent limitations of assurance/audit. These limitations are discussed below:

Inherent Limitation

Explanation

Nature of Financial Statements

There is often uncertainty / judgment / estimates/ forecasting involved in preparation of financial statements and some areas cannot be accurately calculated/verified e.g. Provision for bad debts, Depreciation, Outcomes of legal cases, Warranty expenses, Intangible assets.

Weaknesses in

Entity’s internal control system over financial statements always has some weaknesses/limitations e.g. because of humans errors.

Internal Control

 

1. Many of the auditor’s procedures are based on his judgment. Therefore, most of the audit evidence is persuasive rather than conclusive.

Nature of Audit Procedures

2. Because of time and cost limitation, auditor checks only a sample of transactions.

3. Audit is not a fraud-examination i.e. audit procedures may not detect a sophisticated and carefully organized fraud.

 

4. Management may not provide complete information to auditor, and

5. Auditor does not have specific legal powers e.g. power to search.

CONCEPT REVIEW QUESTION Briefly describe and explain the limitations of external audit. (05 marks) (PIPFA – Summer 2012)

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By Muhammad Asif, ACA

Auditing – Study Notes

Chapter 1 Introduction to Assurance Services

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There are two types of assurance engagements i.e.

Reasonable Assurance Engagement:

Objective of reasonable assurance engagement is to provide reasonable assurance that financial statements are free from material misstatements. An example is audit of Financial Statements.

Limited Assurance Engagement:

Objective of limited assurance engagement is to provide limited assurance that financial statements are free from material misstatements. An example is review of Financial Statements.

CONCEPT REVIEW QUESTION What do you understand by the term "Assurance Engagement"? Discuss its types. What are its elements?

(09 marks) (ICMA Pakistan – Winter 2007)

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By Muhammad Asif, ACA

Auditing –Practice Set

Chapter 1 Introduction to Assurance Services

CHAPTER ONE

INTRODUCTION TO ASSURANCE SERVICES

QUESTIONS

Q.1

LO1
LO1

Q.2

LO1
LO1

Q.3

LO3
LO3

Q.4

LO3
LO3

Q.5

LO3
LO3

Q.6

LO2
LO2

Q.7

LO4
LO4

CONCEPT REVIEW QUESTIONS

What are the advantages of an audit to an organization?

(05 marks)

(CA CAF Level – Spring 2004)

In achieving the objectives of audit, what possible disadvantages can be suffered by the company. (CA CAF Level – Spring 1995)

Briefly describe what you understand by the terms “reasonable assurance” and “limited assurance”.

(02 marks)

(ICAEW Professional Stage – March 2006)

Distinguish between absolute and reasonable assurance. Identify the type of assurance that is

expected in an audit of the financial statements, clearly outlining the reasons to justify your point of

view.

(08 marks)

Describe THREE limitations of external audits.

(CA CAF Level – Spring 2009)

(03 marks)

(ACCA Foundation Stage – December 2012)

List and explain the elements of an assurance engagement.

(05 marks)

(ACCA Foundation Stage – June 2010)

Describe the level of assurance that the auditor will provide for each of the following engagements, and how the level of assurance is expressed by the auditor:

i.

Audit engagement

ii.

Review engagement

 

(Malaysian Institute of Accountants – September 2010)

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 1 Introduction to Assurance Services

Q.8 Assurance engagement is an independent professional service 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 of a subject matter against criteria. Required: Required:

Briefly explain two types of assurance engagement. (03 marks) (Malaysian Institute of Accountants – March 2012)

Q.9

LO4
LO4

What is the difference between an “assurance engagement” and an “audit engagement”? (02 marks) (CA CAF Level – Spring 2003)

SUGGESTED SOLUTIONS

Q.1

(1) Audit enhances credibility of financial statements for shareholders. (2)Audit Identifies weaknesses in entity’s internal control system and auditor suggests recommendations to management. (3)Audit confirms management that they have performed their statutory and non-statutory duties. (4)Audit is a check on employees. Therefore, they behave positively. (5)Audit provides facilitation in Sale of Business or Shares, Obtaining bank loans, Filing tax returns.

Examiners’ Comments:

It was a basic question that was well answered by the students.

Q.2

(1) Audit takes time and cost. (2) Entity has to share its confidential information with auditor. (3) Management/Directors often think audit as a “disturbing activity” instead of a “value added activity”. (4) Audit does not provide 100% (i.e. absolute) assurance that financial statements are free from errors or frauds.

Q.3

Reasonable Assurance:

It is a high but not absolute level of assurance which is expressed in positive form of conclusion e.g. “in our opinion, financial statements give true and fair view”.

Limited Assurance:

It is a moderate level of assurance which is expressed in negative form of conclusion e.g. “Based on our review, nothing has come to our attention that causes us to believe that financial statements do not give a true and fair view”.

Examiners’ Comments:

This question was very well answered overall. Nearly all candidates obtained full marks on this question.

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 1 Introduction to Assurance Services

Q.4

Distinction between absolute and reasonable assurance:

Absolute assurance is a perfect level of assurance.

Reasonable assurance is a high but not absolute level of assurance which is expressed in positive form of conclusion e.g. “in our opinion, financial statements give true and fair view”.

Type of assurance expected in an audit:

Reasonable assurance is provided in an audit.

Reasons why absolute assurance cannot be provided:

(1)There is often uncertainty / judgment / estimates/ forecasting involved in preparation of financial statements and some areas cannot be accurately calculated/verified. (2)Entity’s internal control system over financial statements always has some weaknesses/limitations e.g. because of humans errors. (3)Many of the auditor’s procedures are based on his judgment. Therefore, most of the audit evidence is persuasive rather than conclusive. (4) Because of time and cost limitation, auditor checks only a sample of transactions. (5) Audit is not a fraud-examination i.e. audit procedures may not detect a sophisticated and carefully organized fraud. (6) Management may not provide complete information to auditor, and (7) Auditor does not have specific legal powers e.g. power to search.

Examiners’ Comments:

Seemingly, a significant number of candidates found it to be the easiest question. This question was set to test the candidate’s knowledge about the concept of absolute and reasonable assurance and their relevance in audit, and was based on ISA 200. Most candidates answered it to a pass standard with an encouraging number obtaining 7 or more marks.

Exam Tip This is a poorly drafted question with three sub-parts. As a good practice, whenever a question with sub-parts is drafted, marks are allocated to each part separately to indicate weightage to be given to each sub-part. If such a question appears in your exam, you are advised to answer each part separately and judge yourself weightage to be given.

Q.5

(1)There is often uncertainty / judgment / estimates/ forecasting involved in preparation of financial statements and some areas cannot be accurately calculated/verified. (2)Entity’s internal control system over financial statements always has some weaknesses/limitations e.g. because of humans errors. (3)Many of the auditor’s procedures are based on his judgment. Therefore, most of the audit evidence is persuasive rather than conclusive.

Examiners’ Comments:

Performance was inadequate on this question. This question was left unanswered by a significant minority of candidates. Those who attempted it were often unable to provide more than one relevant

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 1 Introduction to Assurance Services

Q.6

answer. Some candidates seemed to think the question wanted disadvantages of having an audit, rather than the limitations of an audit, these are two different requirements.

Element

Explanation (with respect to assurance on financial statements)

A three party relationship

1. Intended users (the party which requires subject matter and assurance i.e. stakeholders) 2. a responsible party (the party which prepares subject matter i.e. management) and 3. a practitioner (the party which provides assurance on subject matter i.e. auditor)

A subject matter

Subject matter is the information which management is required to prepare i.e. Financial Statements

Suitable Criteria

Criteria means Framework (i.e. rules and regulations) under which financial statements are prepared e.g. GAAP or IFRS. Suitable means it should be selected appropriately.

Evidence

Evidence means information on which practitioner’s conclusion is based. Every conclusion should be backed by sufficient appropriate evidence.

Written Assurance report

It is a page which is written in standard format. It includes conclusion of practitioner, and it is provided by practitioner to intended users.

Q.7

Examiners’ Comments:

A large number of candidates did not attempt this question, and where it was attempted it was inadequately answered. Most candidates who provided an answer clearly did not know what the elements of an assurance engagement were and therefore proceeded to write down anything they knew about assurance. The usual answers focused on positive and negative assurance or on the different types of assurance engagements. Only a small minority of candidates actually understood the requirement and provided valid answers.

 

Audit engagement

 

Review engagement

 

Level of Assurance

Reasonable/High

level

of

Limited/Moderate

level

of

assurance.

assurance.

How Level of assurance is expressed

Positive form of conclusion is expressed in Report.

Negative form of conclusion is expressed in Report.

Q.8

Two types of assurance engagement are:

1. Reasonable Assurance Engagement

2. Limited Assurance Engagement

Reasonable Assurance Engagement:

Objective of reasonable assurance engagement is to provide reasonable assurance that financial statements are free from material misstatements. An example is audit of Financial Statements.

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By: Muhammad Asif, ACA

Auditing –Practice Set

Chapter 1 Introduction to Assurance Services

Limited Assurance Engagement:

Objective of limited assurance engagement is to provide limited assurance that financial statements are free from material misstatements. An example is review of Financial Statements.

Q.9

“Assurance engagement” means an engagement in which a practitioner (i.e. assurance provider) obtains evidence about evaluation of a subject matter against suitable criteria, and expresses his conclusion to enhance the confidence of the intended users (other than the responsible party).

Audit engagement is a type of assurance engagement. Objective of an audit engagement is to provide reasonable assurance that financial statements are free from material misstatements.

Examiners’ Comments:

Students confused the question with engagement letter. Even very few students wrote correctly about the audit engagement.

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By: Muhammad Asif, ACA