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ACCA Paper F8 (INT)Audit and Assurance

For exams in 2012

Notes

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ACCA F8 (INT) Audit and Assurance

Page | 2 2012 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for anyother purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Alwaysobtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these noteswill be accepted by the ExP Group.

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Contents

About ExPress Notes 3

1. Audit Reports 72. Ethics 123. Auditor Appointment 154. Audit Letters 195. Audit Risk 236. Internal Control 267. Internal Control & Audit in a Computer

Environment 298. Internal Audit 329. Audit Evidence 3410. Inventory 3711. Subsequent Events 4012. Going Concern 4313. Corporate Governance 46


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Chapter 1

Audit Reports

STARTBig Picture

The one thing all statutory audits of limited liability companies have in common is that at theend of the day an independent auditor has to issue a report to the shareholders as the

owners of the company.

The auditors must report their opinion in respect of two main issues:

1. Whether the financial statements give a true and fair view (or present fairly in allmaterial respects) the companys financial position and performance, and

2. Whether the financial statements have been properly prepared in accordance withany relevant professional recommendations and/or statutory provisions.

Although the auditors report is produced after all the detailed field work has been

completed, it is perhaps important to give it consideration at a fairly early stage in your

studies. After all, if you know exactly what you are aiming at, it is perhaps that much easier

to hit the target!

Exam questions relating to audit reports occur on a regular basis and so this should be seen

as a fairly high priority area in your studies. Such questions may be purely knowledge based

or of a more practical nature, whereby you are asked to recommend an appropriate form of

report to be issued based on a given client scenario.


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Alternatively, the examiner may give you a draft audit report and ask you to identify and

explain in what respects the report is not satisfactory.

KEY TERMINOLOGY

ISA 700 The Auditors Report on Financial Statements identifies the key elements of the

auditors report (these must be learned and you should be prepared to give a brief

explanation of the purpose of each element):

1. Title2. Addressee3. Introductory paragraph4. Statement of responsibilities of management5. Statement of responsibilities of the auditors6. Scope paragraph7. Opinion8. Auditors signature9. Date of report10.Auditors address

KEY KNOWLEDGEModified Audit Reports

The standard audit report may be modified, such modification may or may not result in the

auditors giving a qualified opinion. It is important to remember that modification of the

audit report will only be required if there is some material issue.

With the practical type of question always make sure that you use any information available

in the scenario to help you assess materiality in a sensible way, vague references to the fact

that you would consider materiality will NOT impress the examiner.

For example, let us say you are given the information that a companys profit before tax

(PBT) is $1,000,000 and that the company has failed to make provision for a known bad

debt of $150,000. State the obvious by saying that at 15% of PBT the bad debt is material,

in that a standard benchmark would be to consider an item impacting on PBT as being

material if it is in the range of 5% to 10% of such PBT.


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It is also important when assessing materiality to remember that this must be considered so

far as the user and not the preparer of financial statements is concerned. A useful working

definition of materiality may be taken as

transactions and other events are likely to be seen as material in the context of a companys

financial statements if their omission, misstatement or non-disclosure would matter to a

proper understanding of such financial statements on the part of a potential user.

KEY KNOWLEDGEModified Audit Reports with Unqualified Opinion

Sometimes there may be matters relating to the financial statements which, whilst fully andadequately disclosed within the financial statements, the auditor considers worthy of

bringing to the particular attention of users.

The auditor achieves this by including in the audit report an additional paragraph known as

an emphasis of matter paragraph. This paragraph will be self-contained and will NOT

otherwise impact on the standard wording of an unmodified report.

Key points to remember in relation to the use of such paragraph are:

it should have a separate heading it should be positionedAFTERthe opinion paragraph it must be made clear that the audit opinion is not qualified and so this paragraph

should start with words such as Without qualifying our opinion we draw attention to

....

Past examiners reports have indicated that many candidates have been unclear as to how

and when to make proper use of an emphasis of matter paragraph. It is important,

therefore, that you are totally happy with this aspect of audit reports.

Examples of where the use of such paragraph would be appropriate include:

where there the financial statements have been prepared on a going concern basis,but this is dependent upon some significant uncertainty which is fully and adequately

disclosed in the notes to the financial statements

where there is a material inconsistency between the financial statements and theDirectors Report and the adjustment required to remove the inconsistency would

need to be made in the Directors Report but the directors are not prepared to make

such adjustment.


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KEY KNOWLEDGEModified Audit Reports with Qualified Opinion

According to ISA 700, there are two main circumstances which might give rise to the

auditors deciding that is necessary for them to qualify their audit opinion:

1. Limitation on scope which arises where the auditor has been unable to carry outsome audit work which normally they would have expected to perform and/or where

the circumstances are such that audit evidence which the auditor would normally

expect to be available for some reason does not exist.

2. Disagreement exists between the auditors and client management in relation tosome aspect of the financial statements.

The type of qualified opinion to be given will depend not just on the circumstances as

indicated above, but also on how serious the limitation on scope or disagreement is namely

is it:

1. Material but not pervasive, that is to say that the limitation on scope or disagreementis confined to one particular aspect of the financial statements, such that the auditor

is able to say that except for this matter the financial statements give a true and

fair view etc.

2. Material and pervasive, that is to say that the nature of the limitation on scope ordisagreement is such that it will impact on the overall view given by the financial

statements. In such situation if it is caused by limitation on scope, the auditor should

give a Disclaimer of Opinion, whereas if it is because ofdisagreement, they should

give anAdverse Opinion.

The circumstances giving rise to a qualified audit opinion should be described in a separateparagraph which appears BEFORE the opinion paragraph. Wherever possible, the auditor

should quantify the qualification circumstances as this should make it easier for the reader

to appreciate its significance.


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SUMMARY DIAGRAM OF APPROACH TO PRACTICAL AUDIT REPORT QUESTIONS


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Chapter 2

Ethics

STARTBig Picture

Ethics is at the heart of the ACCA examination syllabuses featuring to a greater or lesser

extent in over half of the papers that you take on route to qualification as a Chartered

Certified Accountant.

Whilst not necessarily appearing as a question every time in the real exam, it must be seen

as a key area for your studies.

The fundamental principles of professional ethics as outlined by IFAC have been adopted by

ACCA and must be learned. It is important to appreciate that ACCA have adopted a

principles based approach to ethics so whilst there are specific recommendations in someareas (which must be learned) if you are faced with a practical question where you are not

aware of any specific guidance having been issued, you must always go back to basics and

apply the fundamental principles.

Of particular importance to the auditor are the provisions relating to auditor independence.


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KEY TERMINOLOGY

The fundamental principles of professional ethics as outlined in the IFAC Code of Ethics is a

very important TOPIC.You might like to use TOPIC as a useful mnemonic to help you

remember these principles.

Technical (professional) competence and due care must be exercised by all members at all

times. Members have a responsibility to act in accordance with best practice and to keep

themselves technically up to date.

Objectivity must be demonstrated by not allowing personal interest or influence of others to

effect a members professional judgement.

Professional behaviour must be demonstrated by members at all times, in both their private

and business life, so as not to be seen to take any action which might bring the profession

into disrepute.

Integrity requires that members are always honest and do not knowingly allow themselves

to be associated with anything dishonest so far as others are concerned.

Confidentiality requires that under normal circumstances members should at all times

respect confidentiality with regard to a clients affairs so far as third parties are concerned

and that members should not make use of client information for personal gain.

KEY KNOWLEDGEThreats to Ethical Behaviour

The ACCA Code of Ethics recognises a number of threats to a members ethical professional

behaviour. Whilst such threats apply generally, they are particularly relevant when

considering the question ofauditor independence.

It is always worth remembering the following It will never be sufficient for an auditor to

claim that he was independent in fact, he must always be clearly seen to have been

independent in practice.

The five threats are:


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1. Self-interest - e.g. owning shares in a client company2. Self-review e.g. providing accounting services to an audit client3. Familiarity e.g. acting as auditor to a company where a close relative is the CEO4. Intimidation e.g. continuing to act as auditor to a company which has started legal

proceedings against the audit firm

5. Advocacy e.g. acting on a clients behalf in negotiations to raise new finance forthe company

Safeguards against threats

As part of its quality control procedures, a professional firm must establish its own

formalised procedures for the identification and management of such threats. Additionally,

general safeguards may be seen as being:

Those created by the ACCAe.g. requirement for potential members to complete anethics module

Those created by members themselves e.g. ensuring that CPD requirements are met


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Chapter 3

Auditor Appointment

STARTBig Picture

In that you are taking the International variant of Paper F8, you are not required to have aknowledge of any specific company law requirements relating to auditors.

However, it should be borne in mind that your examiner is also examiner for the UK variant,

and being UK based whilst not requiring specific knowledge of UK legislation, tends to take

this as an example of good practice generally!

You need to be aware of provisions relating to:

Appointment of auditors Auditors rights Auditors duties Auditors resignation Removal of auditors


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KEY KNOWLEDGEAppointment of Auditors

Key points to note are:

Normally made by members at companys AGM Often provision made for initial appointment to be made by directors, who may also

fill a casual vacancy

Under corporate governance provisions approval of audit committee required If previous auditors, professional clearance should be obtained Before accepting nomination auditors should consider quality control matters such as

independence, potential conflicts of interest, professional competence etc

KEY KNOWLEDGEAuditor Rights

Often provided under local statute, where not, sort of thing that should be covered by

engagement letter, usual matters covered being rights to:

have access to all company books, records etc at all times obtain all information and explanations considered necessary from company

management and staff

receive notice of, to attend and be heard at all general meetings of the company onmatters relating to the financial statements and/or their own appointment

to resign and request directors to convene GM of company where there aresurrounding circumstances connected with the resignation

to make representations to shareholders where there is attempt to remove themfrom office with which they do not concur


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KEY KNOWLEDGEAuditors Duties

Once again may vary from country to country, but main duties and responsibilities would

normally be seen as being:

to report to shareholders whether financial statements give a true and fair view andhave been properly prepared in accordance with relevant legislation and/or relevant

accounting standards

to consider implications for audit reporting on financial statements of consistency ofother financial information published together with the financial statements

to review and report on effectiveness of companys internal control systems undercorporate governance /stock exchange provisions in the case of listed companies

to qualify audit opinion where necessary to provide proper notice on resignation to detect material fraud and other irregularities to maintain independence

KEY KNOWLEDGE

Auditors Resignation

The main concern here is that auditors should not be able to just fade away quietly in order

to avoid an awkward situation, leaving shareholders and others who place reliance upon

their work, in the dark about important issues of which the auditors are aware.

Taking UK provisions as an example therefore, the key points are:

auditors must deposit formal written notice of their resignation at the companysregistered office

such notice must be accompanied by a positive/negative statement as to whether intheir opinion there are any surrounding circumstances requiring communication to

the members or loan creditors of the company

where there are surrounding circumstances, the auditors may request the directorsto convene a GM so that the members may have the opportunity of questioning

them further


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KEY KNOWLEDGERemoval of Auditors

Once again we can take the UK provisions as being a good example of good practice:

special notice must be given of the resolution proposing a change in auditors auditors must be notified of resolution and, if they wish to contest, have the right, at

the companys expense, to pre-circularise their representations to the members as to

why they should remain in office

at the meeting auditors may again put forward their position before the vote takesplace

removal will require the passing of an ordinary resolution (simple majority)


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Chapter 4

Audit Letters

STARTBig Picture

There are a number of what we might call standard audit situation letters through which the

auditors will communicate with those responsible for corporate governance within a client

company. These are:

1. Engagement letter2. Management letter3. Management representation letter

Whilst it is highly unlikely that you would ever be asked to reproduce one of these letters in

full, it is quite common to find a question on one or other of them where you are to explain

its nature and purpose and to perhaps outline its typical main contents. It is possible that

you might be asked to produce an extract from one of these letters. In the case of the

Management Representationletter on occasions the examiner has asked what action theauditor should take if client management refuse to provide such letter.

You should also give some thought in your studies to situations where the auditors

communicate with third parties seeking direct confirmation from them as part of the process

of gathering audit evidence, principally from:


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1. Banks2. Customers3. Suppliers4. Selling agents5. Consignees6. Legal representatives

KEY KNOWLEDGEEngagement Letter

Purpose

Serves as a contractual agreement between the auditor and client. Helps to avoid future

misunderstanding about mutual roles and responsibilities.

Frequency

At commencement of any new audit assignment following prior discussion and agreement of

terms of engagement with client management. Thereafter new engagement letter should be

sent whenever terms are materially varied. In practice new engagement letter is usually sent

if significant changes in composition of client senior management.

Content

Typical content of an audit engagement letter would include reference to the following:

Audit objectives Management responsibilities Relevant legislation Relevant professional standards Audit procedures Liaison with internal audit Risk assessment Use of experts Auditor access rights Auditor/client communications Deadlines Reporting format Fee basis Dispute settlement procedures Request for confirmation


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KEY KNOWLEDGEManagement Letter

Purpose

To report to management where the auditor has identified weaknesses in the companys

internal control systems. Such weaknesses may be:

1. Inherent weaknesses identified by the auditor when initially evaluating the clientscontrol systems; or

2. Weaknesses identified where the auditors tests of control reveal that a system is notworking as intended.

Frequency

Whenever it is considered necessary by the auditor, but usually it will be produced on an

annual basis.

Content

Normal content of such letter would include:

Details of material weaknesses identified Identification of possible consequences of such weaknesses Auditors recommendations to eliminate weaknesses Caveat Disclaimer

KEY KNOWLEDGEManagement Representations Letter

Purpose

The main purposes of such letter may be seen as:

It serves as a useful reminder to management that it is their responsibility toproduce financial statements giving a true and fair view and complying with relevant

regulations and standards

To provide audit evidence where no alternative sources may be available To comply with best practice


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Frequency

Management representations will have been obtained at various stages during the conduct

of the audit, but the formal documentation of these should be obtained on an annual basis,as close as possible to the signing off of the audit report.

Content

Typical content will include the following:

Confirmation of directors responsibilities for financial statements Confirmation that all necessary information and explanations have been provided to

the auditors

Confirmation of facts, where knowledge of such facts is confined to management Confirmation of directors estimates and judgement used in the preparation of the

financial statements

Steps to be taken if directors refuse to provide representation letter

1. Discuss with management reasons for refusal and try to resolve any contentiousarea.

2. If management still not prepared to provide, ask if they would be prepared to minuteacceptance of auditors version.

3. If not prepared to do this, consider whether any further audit work required.4. If auditor feels that there is insufficient audit evidence without management

representations should consider possibility of qualifying audit opinion on grounds of

limitation on scope.


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Chapter 5

Audit Risk

STARTBig Picture

As noted elsewhere, an auditor must as part of his assessment of a clients internal control

systems consider the risks to which a clients business is exposed and the extent to which

there maybe some material misstatement in the clients financial statements as a

consequence of not identifying and managing such risks in an appropriate manner.

Consideration of risk is therefore to be seen as an integral part of a modern day audit. Not

surprisingly, risk related questions have been and are likely to continue to be a regular

feature in the exams.

Some questions in the past have given marks simply for giving appropriate definitions for

key terms, whilst others have asked you to identify risks relating to a given scenario.

On the practical questions it is important to note carefully the verb used by the examiner in

the question requirement. If you are asked to list the risks that you can see in the scenario,

then mere identification will get you the marks. On the other hand, if you are asked to

explain the risks, then mere identification may start the mark earning process, but will not

get you all of the marks on offer as you must state clearly why it is a risk.


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KEY TERMINOLOGY

AUDIT RISKis very simply the overall risk that the auditor gives an inappropriate audit

opinion in his report.

Eg. if an auditor gave an unqualified opinion, when in fact the company was not a going

concern, then shareholders and others placing reliance on this report in making economic

decisions relating to their dealings with the company might suffer financial loss.

Audit riskis seen as being made up of 3 elements:

AUDIT RISK = INHERENT RISK x CONTROL RISK x DETECTION RISK

The auditor must assess inherent risk and control risk but cannot influence them, they are

what they are. The only element which the auditor can influence directly is detection risk,

which he must do in order to have overall an acceptable level of audit risk.

Inherent riskis the risk that there may be material errors or misstatements in the clients

financial statements, before giving consideration to any internal controls that may have been

established.

Eg. in a high tech company there is high risk of obsolescent inventory which if not

recognised could result in a material overstatement of both profits and asset values.

Control riskis the risk that the clients internal control systems will fail to prevent or detect

material errors or misstatements.

Eg. if there is not effective segregation of duties then there is a much higher risk of

employee fraud, without the need for collusion, going undetected.

Detection riskis the risk that the auditors tests and enquiries will fail to detect material

errors or misstatements in the transactions and balances reflected in the clients financial

statements.

Eg the detection risk is always greater with a new client because the auditors have had less

time to build up their knowledge and understanding of the clients business and the risks to

which it is exposed.

Detection risk is seen to include the elements of:

1. Sampling risk eg. if the auditorselects too small a sample size, it may not berepresentative of the population from which it is drawn, resulting in the auditor

reaching an invalid conclusion about that population.


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2. Non-sampling risk is any other risk that might result in the auditor arriving at thewrong audit conclusion eg. if client management were to deliberately provide the

auditor with misleading information and explanations.

From an exam point of view it is important not to confuse audit riskwith Business Risk.

Business riskis the risk that a company will fail to meet its strategic objectives or that the

policies adopted will be inappropriate. Business risk is to a large extent tied up with the

fundamental accounting assumption ofgoing concern.

Business risk may also be seen as being made up of 3 main elements:

1. Operational risk eg. shortage of essential raw materials for manufacturing process2. Financial risk eg. foreign exchange losses when trading internationally3. Compliance risk eg. payment of fines for breach of anti-pollution legislation

It is important to note carefully the question requirement as to what type of risk you have

been asked to consider when analysing a given scenario.

So if the question scenario makes it clear that the company is trading in different currency

zones then:

1. Business risk = foreign exchange losses reduce companys profitability2. Audit risk = overstatement of profit if foreign exchange losses are not properly

recognised


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Chapter 6

Internal Control

STARTBig Picture

In practice, the clients system of internal control is very much one of the foundation stones

upon which the audit is based. Not surprisingly therefore in almost every exam you are likely

to find that your knowledge and understanding of some aspect of internal control will be

tested.

In terms of practical questions, you should, as always, read the question scenario carefully,

but in the absence of any clear indication to the contrary, the following assumptions should

normally be applied:

You are dealing with the audit of a large limited liability company, with all that thiswould imply in terms of the formalised internal control systems you could expect to

be in place.

That you work for a large professional firm of accountants, with all that this wouldimply in terms of the knowledge, experience and resources you would expect to be

available to you.

That the client has a computerised accounting system, with all that this would implyin terms of the general and application internal controls that you would expect to be

in place and the extent to which you would consider making use ofCAATs in your

audit work.


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Essential features of any good system of internal control

As a useful aide memoire when asked to evaluate a described system of internal control

within a question scenario, you could make use of the mnemonic PCRAM.

Plan of organisation

Custody procedures

Recording procedures

Authorisation procedures

Management supervision

NB. When evaluating any system of internal control, it is important to recognise that partof the whole system which we call internal control should include what we call internal check

(segregation of duties) and also internal audit.

Steps in auditors consideration and approach to a clients internal control

systems

1. Ascertaindetails of clients systems (interview, ICQs, etc).2. Recorddetails of client systems (narrative notes, flowcharts, etc).3. Confirm details of client systems (walk through test).4. Evaluate the client systems. If system is assessed as being sound then proceed to

step 5. If system is assessed as being inherently weak, then there is no purpose to

carrying out tests of control in that area. Such weaknesses should be discussed with

client management and formally documented in a management letter. In this area of

the clients activities it will then be necessary to design and carry out an extended

programme ofsubstantive testing.

5. Test the client systems (tests of control).6. Assess the results of tests of control. If tests of control confirm that the system is

working satisfactorily then proceed to step 6. If tests of control reveal that a system

evaluated as being sound in theory is not workingsatisfactorily in practice then

proceed as in step 4 where system was evaluated as being inherently weak.

7. Design and carry out limited programme of substantive testing.


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Chapter 7

Internal Control & Audit inComputer Environment

STARTBig Picture

As indicated in the section on internal control, in the exam room you should assume that

client has a computerised accounting system, unless clearly told otherwise.

In recent times where the examiner has set questions specifically referring to auditing in a

computer environment, his subsequent reports have suggested that he has been

disappointed with the general standard of candidates answers!

Clearly, therefore, this is an area which you need to study quite carefully as it is likely to be

revisited on a fairly regular basis.

KEY TERMINOLOGY

The basic requirements for an effective system of internal control do not of course change

simply because a computer is brought into the business environment. However, computers


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bring with them their own additional control considerations. Specifically, internal control in a

computer environment is normally considered under 2 main headings:

1. General Controls These relate to the environment within which computer systemsare developed, operated and maintained. They will therefore be relevant to allapplications. They are often sub-divided into administration controls and systems

development controls. They may be either manual or programmed.

2. Application ControlsThese relate to those activities which have beencomputerised and are concerned with the completeness and accuracy of the

processing of authorised data and the maintenance of computer files. As with

general controls, they may be either manual or programmed.

Essential features of any good system of internal control in a computerenvironment

To help you in learning some of the important practical aspects of internal control systems in

a computer environment we can again perhaps make use of a series of mnemonics.

GENERAL CONTROLS ADMINISTRATION CONTROLS (DOFF)

Division of duties and responsibilities eg. between IT and user department staff

Operator controls eg. use of passwords

File controls eg. regular file back-ups

Fire precautions and standby arrangements eg. contingency planning

GENERAL CONTROLS SYSTEMS DEVELOPMENT CONTROLS (CAST)

Conversion procedures eg. parallel running

Authorisation, acceptance and amendment procedures eg. sign off procedures

Standardisation eg. use of SSADM

Testing eg program logic checks

APPLICATION CONTROLS(IPOF)

Input controls eg. data verification by means of double-keying


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Processing controls eg. data validation by means of check digit

Output controls eg. actioning of error reports

File maintenance controls eg. checking amendments to standing data

Alternative audit approaches

There are generally seen as being 3 main alternative approaches to the audit of a

computerised accounting system:

1. Auditing around the computerHere the concentration of audit effort is on the inputs to and outputs from the

clients computer system.

2. Auditing through the computerMaking use of CAATs, principally:

Test data Audit software eg. selection of data for further testing

3. Auditing within the computerMaking use of embedded audit facilities such as:

ITF Integrated Test Facility SCARF Systems Control and Review File


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Chapter 8

Internal Audit

STARTBig Picture

Whilst no longer specifically included in the title of the paper, as it was under the old

syllabus, questions relating to internal audit have and are likely to continue to appear in thereal exam on a regular basis.

So far as listed companies are concerned, corporate governance frameworks would normally

expect the establishment of an internal audit function as a key element of a companys

internal control systems, where it does not exist, management should reassess the need for

it on an annual basis.

KEY TERMINOLOGY

The IIA defines internal auditing as follows>

Internal auditing is an independent, objective assurance and consulting activity designed to

add value and improve an organisations operations.


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It helps an organisation accomplish its objectives by bringing a systematic disciplined

approach to evaluate and improve the effectiveness of risk management, control and

governance processes.

FUNDAMENTAL DIFFERENCES BETWEEN INTERNAL AND EXTERNAL AUDITORS

Both internal auditors and external auditors will have a major interest in the effectiveness of

a companys internal control systems. Both are assurance providers and as such will make

use of similar techniques and procedures.

The external auditor should approach internal audit as any other aspect of internal control

before placing any reliance upon the work of internal audit to perhaps reduce the level of

some of their own testing. Key factors to consider in assessing the potential reliability of the

work of internal audit will include such matters as:

Qualifications Experience Quality of audit documentation Independence Management response to internal auditor recommendations

Effective co-operation between the two sets of auditors can help to avoid unnecessary

duplication of effort, with a consequent benefit of time and cost savings. However, it is

important for the external auditor to always be aware of certain fundamental differences as

indicated below:

INTERNAL AUDITOR EXTERNAL AUDITOR

SCOPE MANAGEMENT ISAs + REGULATIONS

APPROACH MANAGEMENT ISAs + REGULATIONS

RESPONSIBILITY MANAGEMENT SHAREHOLDERS

NB under Corporate Governance provisions, the head of internal audit should be appointed

by and report to the Audit Committee. The Audit Committee should also be responsible for

determining the nature and scope of the work of internal audit.

TYPICAL AREAS OF INTERNAL AUDIT INVOLVEMENT

These would include, but not be restricted to the following (any of which you need to be

prepared to write briefly about):

VFM audits (the 3 Es) IT audit Financial audit Operational audit


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Chapter 9

Audit Evidence

STARTBig Picture

Examination questions relating to audit procedures and evidence are a regular feature in allexaminations. Whilst the majority of marks are likely to be awarded for demonstrating your

ability to apply knowledge in a practical way, some marks may well be available for purely

theoretical knowledge. It also perhaps goes without saying that you need to know the

theory as the critical start point in your studies.

KEY KNOWLEDGEFinancial Statement Assertions

In the production of financial statements, the client management are in fact making a

number of assertions. The auditors need to obtain audit evidence that these assertions are

reasonable if they are to form an opinion as to whether the financial statements give a true

and fair view and comply with relevant statutory and other obligations in relation to their

form and content.


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RELIABLE

In most instances, the auditors will base their opinion upon a variety of evidence rather than

a single source. In considering the comparative reliability of the different forms of evidencewhich may be available the following general rules may be applied:

1. Documentary evidence will be more reliable than oral evidence.2. Putting the different forms of documentary audit evidence in ascending order of

comparative reliability, they may be seen as:

(i) Client originated and client maintained eg. inventory records(ii) Third party originated but client maintained eg. supplier invoice(iii) Evidence obtained directly from third party eg. bank confirmation letter(iv) Auditor generated eg. any audit working paper detailing audit work

performed and conclusion reached

AUDIT PROCEDURES RELATING TO AUDIT EVIDENCE

ISA 500 indicates 8 procedures some combination of which may be adopted by auditors in

order to obtain audit evidence:

1. Inspection of records or documents2. Inspection of tangible assets3.

Observation4. Enquiry

5. Confirmation6. Recalculation7. Reperformance8. Analytical procedures


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Chapter 10

Inventory

STARTBig Picture

The area of inventory has always been a popular area for examination questions. In practice

inventory is often one of the most significant items in the clients financial statements. If

inventory is a material item and it is materially misstated, then it will impact directly both on

the Income Statement and the Statement of Financial Position.

Over the years there have been many frauds relating to inventory manipulation, quite simply

because if management are so inclined it is one of the easiest areas to fiddle!

Exam questions might test your knowledge and understanding of internal control

considerations or audit procedures or valuation requirements or perhaps some combination

of these.

Although we are looking here specifically at inventory, because of its popularity with

examiners over the years, remember you could be asked what audit procedures you would

carry out with any of the items typically appearing in a companys financial statements.


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KEY KNOWLEDGEMain Audit Considerations

The main internal control considerations relating to inventory will require that effective

authorisation, recording and custody procedure exist to control the movements in inventory

and that there should be regular checking of physical quantities against the stock records.

Where inventory is a material item in the clients financial statements and whenever it is

practicable to do so, the auditors must satisfy themselves as to the effectiveness of the

clients stocktaking procedures, by observation on a test basis whilst stocktaking is in

progress.

It is important to recognise that it is not part of the auditors duty to take stock nor to value

it, but they do have a responsibility to consider the effectiveness of the clients stocktaking

procedures and the reasonableness of the subsequent inventory valuation.

To a large extent, therefore we can usefully consider what work we might do BEFORE,

DURING and AFTER the clients stocktaking. As a useful exercise when you have a spare 5

minutes take a blank piece of paper and under these 3 headings see if (in point form) you

can come up with the following sort of ideas.

BEFORE

Review previous year working papers Obtain and review client stocktaking instructions Consider sales method Consider stock locations Consider need for independent experts Confirm date and timing of stock count Liaise with internal auditors Allocate and brief own staff

DURING

Observe procedures Test counts Re-counts Note third party inventories Notes re cut-off Notes re condition


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AFTER

Follow up on attendance notes Routine tests on inventory records Analytical procedures Test valuation Review disclosure Obtain management representations

The above is not necessarily a fully comprehensive list but should give a good flavour for the

level of detail that might be required.

KEY KNOWLEDGEValuation of Inventory

It is important to remember that accounting knowledge assumed for Paper F8 is that

examined in Paper F7. It is an important part of your preparation therefore, to as necessary

revise those Accounting Standards which are examinable under F7.

The aggregate figure for inventories in the Statement of Financial Position (classified under

appropriate headings) should be shown at the lower of costAND net realisable value.

However, when looking at individual items of inventory, or groups of similar items, the test

should be made for the lower of cost ORnet realisable value.

COST should include all expenditure incurred in getting the item in question to its present

location and condition up to the stage where it is in a saleable condition. Cost should as

necessary include costs of conversion, given production at a normal level of capacity.

Whatever method is used to determine cost, it should give as close as possible an

approximation to the actual cost.

NET REALISABLE VALUE should be taken as the estimated proceeds of sale less ALLestimated further costs to be incurred.

In the exam room be prepared to do some fairly basic calculations to demonstrate that you

properly understand the principles involved.


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Chapter 11

Subsequent Events

STARTBig Picture

Subsequent events is another of the classic question areas which may well require you to

combine your assumed accounting knowledge with auditing knowledge. Whilst pure

knowledge questions must not be ruled out, the attraction of this syllabus area to the

examiner has perhaps always been the fact that it is an area which readily lends itself to a

very practical scenario based question.

KEY TERMINOLOGY

Subsequent Events

Relate to events occurring or facts emerging after the accounting period end, but before

formal approval of the financial statements by a companys management.


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Adjusting Events

Are those which relate to an item or condition existing at the SOFP date, where the

subsequent events assist in forming an opinion as to the amount properly attributable tosuch item or condition, where at the SOFP date there was some doubt about the value.

Eg. making provision at the year end because of the subsequent insolvent liquidation of a

customer, where the amount outstanding at the year end was still unpaid at the time of the

subsequent liquidation.

Non-adjusting Events

Are those which do not alter the year end position, but which would have had a material

impact on the financial statements if they had occurred prior to the year end. Such non-

adjusting events should be communicated by way ofnotes to the financial statements.

Eg. The destruction by fire shortly after the year end of one of a companys warehouses.

As auditors we should give careful consideration to those events which at first sight may

appear to be non-adjusting, but which might be seen to impact on going concern, which

could mean that in fact they need to be treated as adjusting events.

KEY KNOWLEDGE

Audit Approach Proactive Period

Up to the date of signing the audit report , the auditor must be proactive in seeking out

audit evidence relating to subsequent events, in order to consider whether or not the client

has dealt with such events in an appropriate manner.

Typical audit procedures

During the period where best practice requires the auditor to be proactive in relation to

subsequent events typical procedures would include, but not necessarily be restricted to:

Discussions with management and subsequent review of company procedures fordealing with subsequent events

Examining minutes of board and board committee meetings Review of management forecasts, budgets and management accounts Routine audit work which naturally takes auditor into subsequent period eg. tests

relating to sales and purchases cut-off

Obtaining management representations


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KEY KNOWLEDGEAudit Approach Reactive Period

After signing the audit report, the auditor need only be reactive to subsequent events. In

other words, if there is some late event which if the auditor had known about it earlier

would have impacted on the financial statements and/or the auditors opinion thereon, he

must react by taking appropriate action.

What constitutes appropriate action will obviously depend on the actual nature and timing

of events, but might include:

Discussions with management on their proposed reaction Revision/withdrawal of earlier report Addressing company AGM/GM Seeking further advice


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Chapter 12

Going Concern

STARTBig Picture

You will be aware from earlier financial reporting studies, that going concern is one of thefundamental assumptions underlying the preparation of all general purpose financial

statements.

Appropriate application of this assumption is vital if the financial statements are to give a

true and fair view.

In the current economic climate, with many businesses failing every day this is certainly a

topical issue from an exam point of view.

Examination questions in this area often have an element relating to audit reporting. In

practice, a going concern qualification is perhaps one of the most difficult for an auditor to

give, because of the very real danger that the audit report may become a self-fulfilling

prophesy. Usually when such questions have appeared the examiner has expressed

disappointment with the standard of many candidates answers.

Going concern considerations may also apply when dealing with questions relating to audit

riskand also subsequent events.


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KEY TERMINOLOGY

Going concern

The concept ofgoing concern is based upon the assumption that the business will continue

to exist as a viable commercial entity for the foreseeable future, without the need for any

significant cut-back in its present level of activity.

Foreseeable future is normally taken as being a minimum of 12 months from the current

accounting date. If for any reason, management consider a shorter period, then there

should be a note to the financial statements indicating what that shorter period is and

managements reasons for choosing it.

KEY KNOWLEDGEAudit Approach

The auditor should always be alert to possible indicators of going concern problems. A

useful starting point for consideration of such indicators may be to relate to the elements of

Business Risk(= Operational Risk x Financial Risk x Compliance Risk) as considered

previously.

It is important that when risks are identified that the auditor also considers the possibility of

mitigating factors which might counter balance the indicator of possible going concern

problems. See examples in following table:

RISK POSSIBLE INDICATOR POSSIBLE MITIGATING

FACTOROPERATIONAL Shortage essential rawmaterials for manufacturingprocess

R & D Dept close to findingsynthetic alternative

FINANCIAL Material FOREX losses New hedging policy

COMPLIANCE Numerous fines for breach ofanti-pollution legislation

New more environmentallyfriendly manufacturingprocess about to come online

Specific audit procedures would include:


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Assessment of current and projected economic environment in which companyoperates

Assessment of state of industry sector in which company operates Review of correspondence files and board minutes for evidence of significant

disputes

Review of subsequent period cash flow and profit forecasts Discuss management procedures and review and obtain management

representations

KEY KNOWLEDGEAudit Report Considerations

As always, the type of audit report to be issued will be dependent upon the circumstances

and the auditors assessment of materiality of the issues involved. The following table

provides a useful summary of the most likely scenarios.

CIRCUMSTANCES REPORT IMPLICATIONS

Going concern basis used and consideredappropriate with no related significantuncertainty

None

Going concern basis used butappropriateness dependent upon somesignificant uncertainty which is fully andadequately disclosed

Unqualified opinion but use emphasis ofmatter paragraph to draw attention todisclosure of significant uncertainty

Going concern basis used butappropriateness dependent upon some

significant uncertainty which is either notdisclosed at all or inadequately disclosed

Qualified opinion on grounds ofdisagreement, probably adverse rather than

except for

Going concern basis used but in auditorsopinion not appropriate

Qualified opinion on grounds ofdisagreement, probably adverse rather thanexcept for

Going concern basis inappropriate butfinancial statements prepared on acceptablealternative basis which is adequatelydisclosed

Unqualified opinion but use emphasis ofmatter paragraph to draw attention tounusual circumstances

Chapter 13


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Corporate Governance

STARTBig Picture

This is not the first time (F4 Corporate and Business Law) you will have come across this

topic and it will not be the last (P1 Professional Accountant)!

Perhaps because of the fact that corporate governance is at the very heart of the later P1paper, questions nowadays are perhaps more likely to be knowledge based, but you should

not rule out entirely the prospect of a practical scenario based question.

Corporate governance is a very topical issue and you can read about important issues on

almost a daily basis in the financial press.

Many countries have developed corporate governance frameworks in response to major

corporate scandals (eg. Enron, Barings, Parmalat etc etc). Some of these frameworks are

rules based such as the Sarbanes-Oxley Act in the US, whilst others are principles based

such as the Combined Code in the UK.

Key points to learn are the main features which are nowadays generally seen as being

indicative of potentially affective corporate governance.

KEY TERMINOLOGY


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WHAT IS CORPORATE GOVERNANCE?

Various definitions have been provided such as:

1. Corporate governance is the system by which organisations are directed andcontrolled.(Cadbury Report)

2. Corporate governance is a set of relationships between a companys directors, itsshareholders and other stakeholders. It also provides the structure through which

the objectives of the company are set, and the means of achieving those objectives

and monitoring performance, are determined.(OECD)

KEY KNOWLEDGEFeatures of Effective Corporate Governance

Balanced Board

Ideally, there should be a balance between executive directors (EDs) and independent non-

executive directors (NEDs) excluding the chairman (independent).

Separation at the top

Ideally, the roles ofChairman and Chief Executive (CEO) should not be combined, but rather

the Chairman should run the board, whilst the CEO runs the company.

Board Committees

The establishment of the following main board committees is indicative of good corporate

governance practices:

1. Audit Committee all NEDs2. Remuneration Committee all NEDs3. Appointments Committee majority NEDs4. Risk Committee majority NEDs

Director training

There should be an effective induction programme for all new directors and thereafter the

company should ensure that there is an on-going programme for CPD for all directors.

Internal Control


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The directors will be responsible for establishing and maintaining an effective system of

internal control. This system should be assessed and reported on by management on an

annual basis. In particular management in such review should give consideration to:

Internal audit Enterprise risk management Corporate ethical culture Corporate social responsibility Whistleblowing facility

Communication with shareholders

Management should encourage smaller investors to participate in company GMs, especially

the AGM, and have a regular dialogue with institutional investors. Institutional investors in

their turn are expected to exercise their voting power responsibly.

Financial reporting

The board needs to present a balanced and understandable assessment of the companys

past performance, present position and future prospects.

(end of ExPress Notes)

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