Chapter:1

Reintroduction to Audit and Assurance

By: Wasequl H Reagan, Partner, Mahfel Huq & Co.

Chapter 1: Reintroduction to Audit and Assurance

Key Areas covered:

▪ Assurance defined
▪ The elements
▪ Levels of assurance
▪ Benefits of Assurance
▪ Audit defined
▪ The benefits of being audited
▪ Audit vs. other assurance compared
• Nature of work undertaken
• Quality of evidence
• Reporting
▪ Summary
▪ Problems and solutions
Chapter 1: Reintroduction to Audit and Assurance

1 Assurance defined

Assurance engagement is one in which a practitioner expresses a conclusion

designed to enhance the degree of confidence of the intended users other than the
responsible party about the outcome of the evaluation or measurement based on
sufficient and appropriate evidence of a subject matter against criteria.
Chapter 1: Reintroduction to Audit and Assurance

2. The 7 elements of assurance

PRUSCAS
Chapter 1: Reintroduction to Audit and Assurance

3 Levels of assurance

In accordance with the International Framework there are two types of

assurance engagement:
Positive Expression: e.g. “In our opinion management has operated an
effective system of internal control.”
Negative Expression: e.g. “Nothing has to come to our attention that
indicates material internal control weakness.”
No report on an assurance engagement can ever provide absolute assurance,
because of the evidence availability.

Assurance type Assurance level Opinion/Conclusion Example

Reasonable High Positive Audit of financial
statements
Limited Moderate Negative Review of a
business plan or
financial
information
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4. Benefits of assurance
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Chapter 1: Reintroduction to Audit and Assurance

Example
Case:
Predator Ltd, a large listed company, is considering taking over Target Ltd, a
small, family owned company. Predator has asked Talbot and Co, chartered
accountants, to carry out due diligence in relation to this prospective
purchase. They want them to review the financial statements of the last three
years and ensure that they were prepared under IFRS/IAS. They also want
them to review the budgets for the coming 12 months and ensure that they
are reasonably and internally consistent.

Question:
Identify the Elements and benefits of this engagement??
Chapter 1: Reintroduction to Audit and Assurance

Solution:

The 7 elements of the assurance service are the following:

▪ Practitioner: Talbot and Co.
▪ Responsible Party: Target Ltd management
▪ Users: Predator Ltd management
▪ Subject matter: Financial Statements/budgets
▪ Criteria: IFRS/IAS/reasonable and internally consistent
▪ Sufficient and appropriate evidence: Talbot and Co. will plan and carry out work to
obtain sufficient appropriate evidence
▪ A written report: Talbot &Co. will provide a conclusion in a written report.

The benefits of this service to Predator Ltd are that:

They are given assurance that the financial statements are in line with IFRS/IAS
and therefore are understandable and comparable with other companies they
might be considering for takeover.
They are given assurance that the budgets are reasonable and internally
consistent and therefore can be trusted as an indicator of the company’s future
operating ability.
They can therefore make an informed decision about whether to buy Target and
for how much.
Chapter 1: Reintroduction to Audit and Assurance

Example
Case:
During the night of 7 June 20×3 strong gales caused the brick chimney of the
factory to crash through the roof the Hancock Ltd.'s assembly area.
Production was severely disrupted for a period of two months.

In addition to claiming from its insurers for the cost of repairing the premises
and for the equipment and inventories destroyed in the accident, the
company is also including a considerable claim under the loss of profit and
have requested the company’s auditors to review this claim and provide an
assurance report which they will submit with it to the insurers.

Question:
What advantages would the directors expect to gain from having this report?
Chapter 1: Reintroduction to Audit and Assurance

5. Audit defined

Definition

Audit of financial statements: The objectives of an audit of financial

statements is to enable the auditor to express an opinion as to whether the
financial statements are prepared, in all material respects, in accordance with
an applicable financial statements give a true and fair view. This is an
expression of reasonable assurance.
Chapter 1: Reintroduction to Audit and Assurance

Example: How audit is an assurance engagement

The key criteria of an assurance engagement can be seen in an audit as follows:

-Three party involvement

The shareholders (users)
The board of directors (the responsible party)
The audit firm (the practitioner)
-Subject matter
The financial statement

-Relevant criteria
Law and accounting standards

-Evidence
The auditors is required by International Standards on Auditing (ISAs) to obtain sufficient and appropriate evidence
to support the audit opinion.

-Written report in a suitable form

As required by ISA 700 the audit report is a written report issued in a prescribed form.
Chapter 1: Reintroduction to Audit and Assurance

6 The benefits of being audited

Audit is important
for a company by
following these
keys:
▪ Scrutinized
▪ Additional
assurance
▪ Requirement
▪ Subsidiary benefits

The case for the audit for those companies where it is

not required by statute usually revolves around the
protection of those who, apart from management,
nevertheless have a financial interest in the company.
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6 Benefits or merits of Auditing

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Example

Case:
The directors of Connelly Ltd are concerned about the reliability and
usefulness of the monthly financial management information that they
receive.

As a result, the company’s auditors have been engaged to review the

system and the information it generates, and to report their conclusions.

Requirement:
Contrast this assignment with the statutory audit of the company’s
financial statements with regard to the scope of the assignment and to
the report issued.
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Q. What is the difference between audit engagement and assurance engagement?

Chapter 1: Reintroduction to Audit and Assurance

Summary
Chapter 1: Reintroduction to Audit and Assurance
Question No. 1
The University of Downton (the University) has recently bought a disused freehold factory adjacent to its campus. The
University wants to expand and has received planning permission to demolish the factory and construct an engineering
workshop and classrooms for teaching purposes. Rob Grantham, the University’s finance director, has prepared cash flow
forecasts in respect of the expansion plans for the five years ending 31 December 20X9, which are to be submitted to the
University’s bank in support of a loan to finance the project. The University has requested that your firm examines and
provides an assurance report on the cash flow forecasts. Rob has provided the following additional information about the
project:
• Three firms have submitted tenders for the demolition and site clearance work and these are awaiting evaluation by the
University.
• Tenders have not yet been invited for the building contract but the build cost has been estimated by the University’s
director of estates at f2,500 per square meter.
• Landscaping works are expected to be minimal as the new building will occupy the whole of the site.
• The University currently has no engineering provision, therefore all equipment for the workshops and classrooms will be
purchased.
• The whole project will be managed on behalf of the University by Crawley and Co, a firm of quantity surveyors.
• The University is applying for a government grant to help with the building cost. The grant amounts to 40% of the building
cost and is payable to the University on completion of the build. However, the grant is conditional on the workshop and
classrooms being in use by 1 September 20X6.
• To help finance the project the University is planning to sell playing fields, identified by the University’s estates strategy as
being surplus to requirements, to a property developer.
• Investment appraisals show that, once completed, the project is expected to generate additional cash inflows from
student fees which will be in excess of the additional running costs incurred.
Your firm is currently finalizing its terms of engagement with the University for the review of the cash flow forecasts. Rob
has asked for an explanation of the following phrases used in your firms draft engagement letter:
(1) “we will request from management written confirmation concerning representations made to us in connection with the
examination.”
(2) “The level of assurance will not be the same as for an external audit.”
Chapter 1: Reintroduction to Audit and Assurance

Requirements
1. From the information provided in the scenario, identify the key receipts and payments that
you would expect to be included in the cash flow forecasts for the five years ending 31
December 20X9 in respect of the expansion plans. For each receipt and payment, you should
identify the specific matters you would consider when reviewing the reasonableness of the
assumptions underlying that receipt or payment. (12 marks)

2. Draft a response to Rob which:

(a) lists the general representations that should be obtained from management as part of the
assurance work on the cash flow forecasts and explains why such representations are
required; and
(b) explains how and why the level of assurance provided by the report on the cash flow
forecasts differs from the level of assurance provided by an auditor’s report on annual financial
statements. (8 marks)
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Solution:
1. Key receipts and matters to consider
Funds received from bank
The amount should be consistent with the amount needed to execute the expansion plan and the receipt should precede the start of
the building work.
Sale proceeds of playing fields
This should be a prudent estimate and in line with the market value of similar land. The estimate should be checked to a valuer’s report,
if available. Enquire if planning permission has been obtained for the playing fields as this will affect the valuation and inspect the
planning permission application. Inspect correspondence with the developer for evidence of likelihood of the sale proceeding and any
indication of the sales value.
Government grant
The timing of the receipt in the cash flow forecast should be after the completion of the new workshop and classrooms. The feasibility
of completion by September should be assessed, referring to the grant letter where necessary for the detailed conditions of the grant.
The size of the grant should be 40% of the building costs included in the cash flow forecast payments and this calculation should be
checked.
Student fees
The receipt from student lees be based on the number of students multiplied by the fee per student and this calculation should be
checked. The number of students should be consistent with the capacity of new workshop and classrooms. The fee per student should
be in line with current rates. Total fees should increase in September when the new building is in use and these should be in excess of
the additional running costs incurred for the new workshop and classrooms.
VAT receipts
Enquiries should be made as to the VAT status of the new building. An analytical procedure based on the VAT rate and the materials
purchased should be performed. Repayments of VAT should be received at appropriate intervals, for example, quarterly or monthly.
Key payments and matters to consider
Interest on bank loan and repayments of capital
Prudent assumptions should be made regarding interest payments, for example, in line with market rates or consistent with those cited
in correspondence with the bank and should be based on the principal outstanding. Repayments of capital should be consistent with
those cited in correspondence with the bank.
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Demolition and clearance payments
These payments should be based on the tenders received, which should be inspected.
Building costs
Enquiries should be made with the director of estates as to how he/she arrived at the estimate of building
costs of f 2,500 per square meter. The qualifications and experience of the director of estates should be
considered and working papers, if available, reviewed. The estimate of f2,500 per square meter should be
compared to building costs for other similar buildings and an independent surveyor or architect consulted to
confirm whether this is a reasonable estimate.
The estimate should be checked to see if it is in line with design and architect’s plans, if available. The
calculation of f2,500 per square meter multiplied by the size of the new building should be checked for
accuracy. The timing of any retention payments in the cash flow forecast should also be considered.

Quantity surveyor (project management) payments

These costs should be either fixed fee or a percentage of building costs and should be in line with market
rates or the letter of engagement with Crawley and Co, if available.

New equipment costs

These costs should be as per quotes or catalogue prices and in line with number and size of the new
workshop and classrooms,

.
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Running costs of the new building

The running costs such as utility costs, insurance and maintenance should be consistent with the size of the
new engineering workshop and classrooms.

Staff costs
The number of classes and the average class size should be considered when reviewing the reasonableness
of staff costs and the timing of payments to HMRC should be monthly in arrears.

General
The timing of payments should be consistent with the progress of the building work. For example, the
demolition payment should be at the start of the project, the payments for construction should be
throughout the building phase of the contract and the payments for equipment should be in advance of the
opening of the new workshop and classrooms in September 20X6. The increase in the running costs should
be after September once the workshop and classrooms are in use. The assumptions should take into account
inflation and key variables should be subjected to sensitivity analysis .
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2 (a) General representations

The general representations that should be obtained are:

The intended use of the forecast

This is to ensure that the audit firm is aware of all users of the forecast and that there are no unforeseen users which could
impact on the risk associated with the engagement. This representation reduces the extent of the reporting accountants
liability and exposure to potential claims.

The completeness of significant management assumptions

The knowledge of the assumptions used to compile the forecast is largely confined to management. The reporting accountant
cannot undertake the examination of the forecast unless all assumptions are adequately disclosed. The reporting accountant
reports on the reasonableness; of assumptions and therefore needs confirmation, via a representation, that they are complete
and free from management bias.

Managements acceptance of its responsibility for the forecast

The reporting accountant is not responsible for preparation of the forecast and is only responsible for examining and providing
an assurance report on the forecast. This representation reduces the expectation gap and any misunderstandings regarding the
responsibilities of the respective parties.
Chapter 1: Reintroduction to Audit and Assurance
2 (b) Level of assurance

A report on the cash flow forecast provides limited/moderate assurance as to the credibility of the financial
information. The conclusion is expressed negatively in the form of nothing has come to our attention that
causes us to believe that the assumptions do not provide a reasonable basis for the forecast.

An auditor’s report on annual financial statements provides reasonable assurance as to their credibility. It
provides a high, but not absolute, level of assurance that the financial statements are free from material
misstatement. The conclusion is expressed positively in the form of in our opinion the financial statements
give a true and fair view of the state of the company’s affairs, have been properly prepared in accordance
with the relevant reporting framework and have been prepared in accordance with the requirements of the
Companies Act 1994.

A review provides less assurance than an audit. The reason is that an audit is based on historical information
which can be verified to a greater degree whereas the examination of a forecast is based on assumptions
and judgements about the future which is subject to uncertainty.
Chapter 1: Reintroduction to Audit and Assurance
Question No. 2

The directors of Styleco Ltd an external audit client of your firm, are planning to expand the business. The
expansion is to be funded by borrowings and the directors have been negotiating with the company’s bankers
in order to increase borrowings. The directors have prepared profit and cash flow forecasts for the three years
ending 31 March in support of the request for funding. The company’s bankers require this information to be
reviewed and reported on by independent accountants and the board of directors has requested that your firm
undertakes this review.
Styleco designs and sells high quality home accessories and clothing which are sold by mail order and over
the internet. Customers pay for goods at the time of order and the company operates a policy whereby
customers who are not satisfied with any purchase are entitled to a full refund if they return the product,
undamaged, within three months of receipt. In recent years the level of returns has been approximately 8% of
revenue. All products are made exclusively for Styleco by suppliers based in the United Kingdom and
overseas. It is company policy to pay all suppliers 1 0 working days following the week of delivery of the
goods.
The company currently operates from a warehouse in the south of England, but the directors wish to expand
the business by opening retail outlets in cities throughout England so that customers can see and touch the
products they are buying. The directors have identified three potential properties, in the premier shopping
areas of London, Bath and Chester. These are leasehold properties with rent payable quarterly in advance.
The directors intend to have the properties fitted out to a very high standard in line with the company t s
corporate image and will use specialist contractors to undertake this work. There will be electronic point-of-
sales systems and customers will be able to pay by cash, credit or debit cards.
Each outlet will be run by a manager helped by a mixture of full and part-time staff. One of the company’s
objectives is to provide a high level of service and knowledgeable advice to its customers and the company
8hns to reflect this in the staffing levels and remuneration of its employees. All outlet staff, including
managers, will be paid at rates above those paid by other companies in the retail sector and will be eligible for
an annual bonus linked to the performance of the outlet.
Chapter 1: Reintroduction to Audit and Assurance

Requirements
1 From the information provided above, identify the specific matters you would consider
when reviewing the reasonableness of the assumptions underlying the receipts and payments included in the cash
flow forecast for the three years ending 31 March 20X2. (13 marks)

2 Compare the purpose and scope of a review of the profit and cash flow forecasts for three years ending 31 March
20X2 with that of a statutory external audit. (7 marks)
Chapter 1: Reintroduction to Audit and Assurance
Answer to requirement 1

Styleco Ltd

The following matters should be considered when reviewing the reasonableness of the assumptions underlying the receipts and payments:
Receipts
The loan from the bank is shown in the cash flow forecast as an inflow of cash before any major outflows of cash. The amount of the loan should be sufficient to fund
the expansion and allow the company to pay its debts as they fall due while staying within any overdraft facility.
In respect of receipts from sales, whether:
the inflows reflect a gradual increase in receipts (possibly causing a decline in internet and mail order receipts) as the retail outlets are opened and take into account
seasonal fluctuations;
growth expectations are feasible over the three years in light of the economic climate and are supported by market research; and the inflows have been subjected to
sensitivity analysis.

Payments
• Payments for fixtures and fittings are complete (i.e. include electronic point-of-sales systems CCTV etc.), supported by quotes and are included before the opening of
the outlets.
• Payments for advertising, recruitment and training are also reflected before the opening of the outlets.
• Payments to suppliers reflect the company’s payments policy and the exchange rates used to translate payments have been subjected to sensitivity analysis.
• Refunds are reflected and recognize that the level of returns may be different for the retail outlets compared with mail order and the internet (i.e., they may be lower
than 8% as customers see the goods before purchasing).
• Commission in respect of credit card transactions is in accordance with the terms of the contract with the credit card companies.
• Rent is included quarterly in advance from the date of acquisition of the lease and rent reviews are taken into account.
• Payments to employees reflect the higher rate of remuneration and include bonuses which should be based on the company’s formula and paid on the due dates.
• Payments relating to heat and light, waste disposal, insurance and servicing costs reflect the size of the outlet and, where relevant, the location of the outlet.
• Payments for professional fees such as architects, lawyers and reporting accountants have been included.
• Interest payments reflect the level of borrowings and are based on interest rates in line with market expectations and have been subjected to sensitivity analysis. In
addition, interest and any loan instalments are paid on the due dates.
• Payments to NBR include TDS, VAT and corporation tax and are consistent with the profit forecast and are paid on the due dates.
• Payments reflect additional costs such as increased operating costs of head office and shipping costs from warehouse to outlets.
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Answer to requirement 2

Comparison of review with statutory audit

Purpose
• A review of the profit and cash flow forecasts provides limited assurance as to the credibility of the forecast
financial information. A limited assurance engagement reduces the risk to a level that is acceptable in the
circumstances. The conclusion is expressed negatively in the form of nothing has come to our attention which causes
us to believe that these assumptions do not provide a reasonable basis for the forecasts’. In the case of Styleco, the
report is solely for the management to support the application for funding.
• A Statutory audit provides reasonable assurance as to the credibility of the financial statements. A reasonable
assurance engagement reduces the risk to an acceptably low level. It provides a high, but not absolute, level of
assurance that the financial statements are free from) material misstatement. The conclusion is expressed positively
the form of our opinion the financial statements give a true and fair view of the state of the company’s affairs.

Scope
• The work undertaken in examining the forecasts will be less in scope than that of the audit. It will involve checking
the reasonableness of the assumptions and the calculations on the basis of the assumptions. It is likely to include
analytical procedures, enquiry of management and computation. However, an audit will include a wider range of
substantive procedures including transaction and balance testing. The terms of the review of the forecasts will be
agreed by management but may include a reference to ISAE 3400 The Examination of Prospective Financial
Information. The terms of an audit engagement are determined, by the Companies Act 1994 and International
Standards on Auditing (ISA)
Chapter 1: Reintroduction to Audit and Assurance
Question No. 3
Your firm is performing an engagement to review and provide an assurance report on the financial statements of Viper Ltd
(Viper) for the year ended 31 January 20X7. The review was requested by PO Bank plc (PO Bank) which is considering a loan
application from Viper. Viper is not required to have an external audit. The following matters arose when performing the planned
procedures:
• When reviewing the accounting records for significant journal entries, it was noted that the year-end journal to record
prepayments had been posted to the general ledger twice in
error. The journal entries had not been authorized or reviewed and IT controls do not prevent the posting of journals with a
reference number which is identical to an existing journal.
• Your firm’s analytical procedures identified that trade receivables days had increased from 35, at 31 January to 42 at 31
January Viper’s credit terms are 30 days. Enquiries of management revealed that trade receivables included an overdue balance
of 52,000 in respect of Warrior Ltd (Warrior). Warrior has refused to pay the balance because it claims it did not receive the
goods. Viper does not retain evidence that goods have been dispatched from its warehouse or received by its customers. The
directors do not consider
it necessary to make any adjustments to the financial statements in respect of this matter. Viper’s financial statements show
profit before tax for the year ended 31 January 20X7 of 1.2 million.
Requirements
1 State the internal control deficiencies identified when performing the planned procedures. For each deficiency, outline the
possible consequence(s) of the deficiency and provide recommendation(s) to remedy each deficiency. (7 marks)

2 List the differences between a report prepared by a practitioner for an engagement to

review financial statements and the report prepared by auditors for an external audit
engagement of an unlisted company. (3 marks)

3 In respect of Warrior’s overdue balance, state whether you would modify your firm’s assurance report. Give reasons for your
conclusion and describe the modifications, if any, to the assurance report. (4 marks)

4 Outline the possible consequences for your firm of reaching an inappropriate conclusion following the review of the financial
statements of Viper. Describe how firms can mitigate the impact of any financial consequences arising from an inappropriate
Conclusion. (4 marks)
Chapter 1: Reintroduction to Audit and Assurance

Requirements
1 From the information provided above, identify the specific matters you would consider
when reviewing the reasonableness of the assumptions underlying the receipts and payments included in the cash
flow forecast for the three years ending 31 March 20X2. (13 marks)

2 Compare the purpose and scope of a review of the profit and cash flow forecasts for three years ending 31 March
20X2 with that of a statutory external audit. (7 marks)
Chapter 1: Reintroduction to Audit and Assurance
Answer to requirement 1
1 Deficiency
Journal entries are not authorized or reviewed.
Consequences
• Errors may be made in journal entries which would go undetected.
• This might result in a misstatement in the financial statements.
• Fraudulent entries could be made.
Recommendations
• All journal entries should be authorized before being entered into the accounting records.
• A report of all journal entries posted should be regularly reviewed for accuracy and prior authorization.
• Approval and review should be evidenced.
• Employees who are authorized to post journal entries should be restricted through the use of passwords.

Deficiency
There are no IT controls to prevent duplicate journal entries.
Consequences
• This may result in errors in the financial statements.
• Time and costs will be incurred to correct these errors.
Recommendations
• Journal entries should have a unique reference.
• IT controls should be introduced that alert users if they try to post a journal with a reference identical to an existing journal entry.
• If IT controls are not possible, an exception report of duplicate journal entries should be regularly reviewed and duplicates followed up
and corrected.
Deficiency
• No evidence of goods dispatched is retained.
• Consequences
• Viper cannot keep track of customers’ orders and orders may be dispatched twice in error
• There is no means to prove goods were received by customer.
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• This reduces the likelihood of enforcing payment from customers and increases the risk of disputes and bad debts.
• There will be a cost associated with attempting to recover receivables and a negative impact on profits and cash flow.
• Orders may not be dispatched at all resulting in loss of customer goodwill.

Recommendations
• A goods dispatched record should be created in the warehouse. Those should be sequentially numbered and the sequence checked
regularly for completeness.
• The customer should sign on delivery to acknowledge receipt of the record should be retained by Viper.
• Dispatch records should be matched to customer orders and a regular review be performed of customer orders to ensure goods have
been dispatched.
• Customers should be provided with a copy of the signed dispatch record in the event of a dispute.

2 Engagement to review financial statements

• Addressee likely to be directors
• Conducted in accordance with ISRE (2400)
• Work limited to inquiries of management and analytical procedures
• Would state ‘we do not express an audit opinion on these financial statements’
• Moderate/limited assurance
• Negative conclusion ‘Nothing has come to our attention....’
• Signed by practitioner/reporting accountant

External audit of unlisted company

• Addressee is the shareholders
• Conducted in accordance with relevant laws/auditing standards
• Reasonable assurance
• Positive opinion
• ‘True and fair view’
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• Prepared in accordance with Companies Act
• Opinion on other matters prescribed by Companies Act, such as the directors report and matters on which the auditor is required to
report by exception Signed by statutory auditor

3. It is unlikely the amounts from Warrior can be recovered as there is no evidence to support the claim for the outstanding invoices.

• The amounts should be written off.

• They amount to 12.7% of profit before tax and are therefore material.
• The firm should issue a modified report/conclusion due to a material misstatement.
• The matter is not pervasive as it only affects one area of the financial statements.
• The firm should express a qualified conclusion stating that ‘except for the effects of the
• matter described nothing has come to our attention…’
• The reason for the qualification should be included in the basis for qualified conclusion
• section of the report.

4. Mitigation of financial consequences

Firms can mitigate financial consequence by:

• setting a liability cap for an agreed monetary amount or specified formula

• agreeing to share losses proportionately with clients
• structuring themselves as Limited Liability Partnerships
• ensuring they have adequate insurance cover in place
• restricting the use of the report by inserting a Bannerman clause in the assurance report.
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Additional reading
• International Federation of Accountants (IFAC), has agreed to amend the following
International Standards on Review Engagements (ISREs) to clarify to which engagements
each respectively is to be applied:
• ISRE 2400, Engagements to Review Financial Statements; and
• ISRE 2410, Review of Interim Financial Information Performed by the Independent Auditor
of the Entity.
• ISAE 3400 International Standard on Assurance engagements
• The issue that had bee the IAASB's attention is that ISRE 2410 applies in the case of a
review by the entity's auditor of interim financial information only, while ISRE 2400
applies to all reviews of historical financial information excluding those conducted by the
entity's auditor. Thus, there would appear to be no directly relevant standard for reviews
by the entity's auditor of historical financial information other than interim financial
information.