ACCA P7 (INT) Advanced Audit & Assurance - Study Text

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Chapter 15: Current issues

3.2 Transnational Audit Committee

TAC is a committee of IFAC. It represents and meets the needs of the Forum of

Firms, which are firms which participate in transnational auditing.

Specific responsibilities of the TAC include:

 Identifying audit practice issues. When the issues suggest changes in auditing or

assurance standards may be required, recommend to the appropriate IFAC

standard setting boards that the issue be reviewed.

 Providing a forum to discuss ‘best practices’ in areas including quality control,

auditing practices, independence, and training and development.

 Proposing members to the IFAC Regulatory Liaison Group and identifying

qualified candidates to serve on IFAC standard setting boards.

 Acting as a formal conduit for interaction among transnational firms and

international regulators and financial institutions with regard to audit quality,

systems of quality control, and transparency of international networks.

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Small companies

 An audit is an audit

 Audit exemption for small companies

 The audit of smaller entities

4 Small companies

4.1 An audit is an audit

‘An audit is an audit’ is a phrase that may be used to argue that the essential

features of all audits are the same, regardless of the nature or size of the entity

under audit.

There is some truth in this view. For example, all audits are regulated by ISAs, and

all audits result in an opinion from the auditor about whether the financial

statements give a ‘true and fair view’.

However, the audit process itself differs significantly between clients, depending

on:

 the key characteristics of the client (such as the size of the client and its

operations), and

 the audit strategy adopted for that client.

The entity’s size is a key feature of an entity that has a significant impact on the

audit approach. Smaller entities may require a very different audit approach from

large entities.

4.2 Audit exemption for small companies

Many countries do not require ‘small’ companies to undergo a statutory annual

audit. However, the definition of ‘small company’ varies between countries. For

example:

 in the UK legislation currently exempts from audit all companies with annual

revenue not exceeding £6.5 million.

 in the US, only companies listed with the SEC are required to have an annual

audit.

It is worth noting that small companies which are exempt from the statutory audit

requirement may choose voluntarily to have an audit of their financial statements.

There has been much debate surrounding the issue of audit exemption for small

entities. You should be aware of the arguments for and against exemption.

Chapter 15: Current issues

Arguments for audit exemption for small entities

There are various arguments in favour of the view that small companies should

have an exemption from statutory external audits.

 Audit costs are high: the resources could be spent by smaller entities to obtain

more useful financial services.

 Providers of loan finance (for example, banks) will normally attach their own

specific conditions to borrowings. These conditions are often independent of the

content of the borrower’s financial statements.

 Filing deadlines for the accounts of smaller companies are often long after the

reporting date. The audited financial statements are therefore often ‘out of date’

and of limited use, by the time they become available for inspection.

 Many countries allow smaller companies to publish ‘abbreviated’ financial

statements. Consequently only a limited amount of audited information is

available to users of the statements.

Arguments against audit exemption

There are also various arguments against the view that small companies should

have an exemption from statutory external audits. Some of these arguments

emphasise the potential benefits of annual audits.

 If the financial statements have been prepared by a part-qualified accountant, an

audit provides some assurance that they provide a true and fair view and do not

contain material misstatements.

 The audit is valuable, especially to user groups other than the shareholders (such

as trade suppliers, tax authorities), by giving them some reassurance about the

financial statements of small entities.

 Shareholders, especially minority shareholders, should be entitled to receive

financial statements from the entity that have been independently audited.

 The external audit imposes a level of discipline on companies, in matters relating

to accounting and internal control. The auditors can advise management on

ways of improving internal control.

 The audit may identify areas where efficiency and cost savings can be made by

the entity. These savings would have the effect of reducing the overall cost of the

audit.

 If a small company expects to approach its bank in the future to ask for loan

finance, the bank may demand to see audited financial statements (for the

purpose of assessing the loan application).

 The tax authorities are more likely to accept audited financial statements as a

valid basis for computing the company’s tax liability.

 If the small company expects to grow, it will become large enough at some time

in the future to require a statutory annual audit. If there are material errors in its

financial statements, the cost of its first statutory audit could be high.

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4.3 The audit of smaller entities

Standard audit practice requires the auditor to gain an understanding of the

business and its environment in developing an audit strategy. Applying this

principle to the audit of smaller entities will allow the auditor to focus attention on

the main features of the client, which will affect the audit approach.

The key issue in deciding the audit approach is likely to be internal control, and the

limited nature of the control system.

 Segregation of duties is likely to be weak, due to the restricted numbers of staff

employed by smaller entities.

 Owners or senior management are likely to dominate all major aspects of the

business activities. This is useful as a form of supervisory control, but the

internal controls over management themselves are likely to be very weak and

ineffective.

 In an expanding business, senior management may be closely involved in

developing the business, leaving them with little time for supervisory controls or

for implementing and monitoring other controls.

 Record-keeping and documentation of system and controls may be informal and

inadequate. This further weakens the internal control system.

Audit approach to smaller entities

The table below summarises the main additional points for the auditor to consider

when dealing with a smaller entity.

Area Comment

Acceptance of the

audit appointment

The auditor should be aware of the possible risks to

independence, resulting from:

 close involvement with management

 pressure by management to reduce the audit fee.

Engagement letter

This formalises the relationship between the auditor and

the client.

If necessary, it separates the accounts preparation

function from the auditing function.

Planning and

recording

This process will be similar to the audit engagement for

larger entities, but is likely to be simpler. The audit team

may be very small so communication and co-ordination

should be easier. A brief memorandum prepared at the

completion of the previous audit, updated in the current

period based on discussion with the owner-manager,

may be sufficient as the documented audit strategy for

the current audit.

Accounting systems

The accounting systems may not be adequate for audit

purposes, and the auditor may not be able to rely on the

controls in place. As a result, control risk is likely to be

high.

Chapter 15: Current issues

Substantive

procedures

Substantive procedures are likely to form the basis of the

audit work, if controls are weak. However, it is difficult

to reach a conclusion on the completeness of accounting

records, where the audit is based only on substantive

procedures.

Audit evidence

High-quality evidence may be more difficult to find than

in a larger entity.

Materiality

A smaller entity’s profit before tax may be consistently

negligible, as the bulk of any profit may be taken out by

the owner-manager as remuneration. A benchmark such

as profit before remuneration and tax might therefore be

more relevant.

Analytical

procedures

Smaller entities may not have interim or monthly

financial statements which can be used for analytical

review purposes. ISA 315 suggests that the auditor may

be able to use an early draft of the entity’s year-end

financial statements.

Management

representations

These are often more important in smaller entities than

large entities. However, the auditor must look for

evidence to support the management representations.

Going concern

A smaller entity may be more able to quickly respond to

opportunities, but it may also be more vulnerable to a

bank withdrawing support. The continued financial

support of the owner-manager may be vital to the

survival of the entity and the auditor will need to assess

the risk of that support failing.

Audit report

There may be insufficient evidence as to the

completeness and accuracy of the records, which may

lead to a qualified audit opinion.

Review of financial

statements

This is the same as for the audit of any other company,

except that smaller entities may be exempt from certain

reporting requirements (for example, from the

application of certain requirements of International

Financial Reporting Standards).

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Paper P7 (INT)

Advanced audit and assurance

CHAPTER

Current issues II

Contents

1 The impact of social and environmental matters

on the statutory audit

2 Social and environmental reports and audits

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The impact of social and environmental matters on the statutory audit

 ISA 250: Consideration of laws and regulations in an audit of financial

statements

 Other relevant ISAs

 IAPS 1010: The consideration of environmental matters in the audit of

financial statements

 Substantive procedures to detect a material misstatement due to

environmental matters

1 The impact of social and environmental matters on

the statutory audit

1.1 ISA 250: Consideration of laws and regulations in an audit of financial

statements

As discussed in a previous chapter, ISA 250 requires the auditor to obtain sufficient

appropriate evidence in respect of non-compliance with laws and regulations which

might be expected to have a direct effect on material amounts and disclosures in the

financial statements. Non-compliance could be over a variety of social or

environmental matters such as:

 health and safety legislation

 equal opportunities legislation, or

 anti-pollution legislation.

Social or environmental matters can have a direct impact on the statutory audit.

This is because a breach of social or environmental legislation may have a material

impact on the financial statements. For example, if an entity is in breach of social or

environmental legislation (or other regulations):

 it may need to include a provision for fines or penalties in its financial

statements

 it may need to disclose a contingent liability for a possible settlement in a court

case, where the entity is facing a civil lawsuit for damages arising from a breach

of environmental or social regulations

 it may be required by law to improve working conditions or rates of pay, which

will affect labour costs

 it may be necessary to write down the value of certain assets due to impairment.

1.2 Other relevant ISAs

There are some other ISAs that include a reference to social or environmental

aspects of the external audit.

Chapter 16: Current issues II

ISA 315: Identifying and assessing the risks of material misstatement through

understanding the entity and its environment

The auditor should evaluate the environmental risks facing a client entity, and the

controls that are in place to manage those risks. ISA 315 therefore requires the

auditor to be aware of:

 relevant environmental legislation

 the nature of the production processes used by the entity, and

 the general impact of the entity’s activities on its physical environment.

Environmental risks will include:

 contingent liabilities arising from legal claims against the entity, as a result of

environmental damage or a breach of environmental protection regulations

 provisions that may be required for restoration costs

 expenditure that may be required to modify or clean the production processes

and re-design products, in order to meet environmental regulations.

ISA 330: The auditor’s responses to assessed risks

ISA 330 requires the auditor to design audit procedures that take into consideration

the environmental risk assessment. Designing suitable audit procedures to assess

environmental risk will probably require a high level of professional judgement

from the auditor. In particular, judgement may be required as to whether a liability

exists, and if so, how it should be measured. As a result:

 the auditors may need to take advice from external experts, and

 written management representations should be obtained about the

environmental risks.

ISA 540: Audit of accounting estimates

ISA 540 includes a requirement that the auditor should review the approach taken

by management to making estimates that relate to environmental risks.

1.3 IAPS 1010: The consideration of environmental matters in the audit of

financial statements

Environmental matters are defined by IAPS 1010 as:

 initiatives to prevent, reduce or repair damage to the environment or to conserve

resources

 consequences of violating environmental laws or regulations, and

 consequences of environmental damage.

For many companies, environmental matters are not significant. However, where

environmental matters are significant there may be a risk of material misstatement

in the financial statements. For example, environmental risks may be significant for

an oil exploration company, a chemical production company or a provider of

energy from nuclear power.

Paper P7: Advanced audit and assurance (International)

The following examples are given of environmental matters that might affect the

financial statements:

 The introduction of new environmental laws and regulations may lead to an

impairment of assets. For example, new laws may be introduced relating to

assets containing dangerous substances such as asbestos. When this happens,

entities may be required to recognise the impairment of non-current assets that

contain the substance.

 An entity may be guilty of non-compliance with legal requirements concerning

environmental matters, such as emissions or waste disposal. In some cases, there

may be new environmental legislation with retrospective effect. In all these

circumstances, the entity may be required to make accruals for remediation

work, and for paying compensation or legal costs.

 Some entities incur environmental obligations as a direct by-product of their

core businesses. This applies, for example, to companies in the extraction

industries (oil and gas exploration or mining), chemical manufacturers and

waste management companies.

 A provision may be required as a result of constructive obligations that the

entity incurs from a voluntary initiative. For example, an entity may have

identified contamination of land. Although under no legal obligation, it may

have decided to remedy the contamination (or it may be expected to remedy the

contamination, because of its past actions), because of its concern for its long-

term reputation and its relationship with the community.

 An entity may need to disclose in the financial statements the existence of a

contingent liability where the expense relating to environmental matters cannot

be reasonably estimated.

 In extreme situations, non-compliance with certain environmental laws and

regulations may affect the ability of an entity to continue as a going concern.

This may affect the disclosures and the basis of preparation of the financial

statements.

Risk assessment and internal control

IAPS 1010 states that in order to obtain a general understanding of relevant

environmental laws and regulations, the auditor should carry out the following

procedures:

 The auditor should use his existing knowledge of the entity’s industry and

business.

 The auditor should ask the management of the entity questions about the

environmental laws and regulations that may be expected to have a

fundamental effect on the operations of the entity.

 The auditor should also ask the management of the entity questions about the

entity’s policies and procedures regarding compliance with relevant

environmental laws and regulations. Managers with responsibility for

environmental matters should be questioned, as well as senior management.

 The auditor should discuss with management the policies or procedures that the

entity has adopted for identifying, evaluating and accounting for litigation

claims and assessments.

ACCA P7 (INT) Advanced Audit &amp; Assurance - Study Text - 2010 (Emile Woolf Publishing)

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ACCA P7 (INT) Advanced Audit & Assurance - Study Text - 2010 (Emile Woolf Publishing)