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New auditing regime: checklist

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8th Nov 2011
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The tax and audit season is now upon us with many preparing for the January madness for self-assessment tax returns and gearing up for the December year ends, says Steve Collings.

We’ve now (more or less) gone first cycle with the clarified International Standards on Auditing (ISAs) and feedback from practitioners is that they are generally coping well with the new regime. With the planning about to start for December year ends, it seems sensible to offer some quick recaps relating to the new auditing regime to ensure that practitioners are complying with the new requirements. This article will not go into every single ‘new’ aspect of the clarified ISAs but aims to offer some guidance to practitioners on the more critical parts which might affect an SME audit particularly as some practitioners dealing with SME clients may only have one or two audit clients.

Engagement letters

All engagement letters should have been re-issued to clients to comply with the provisions in ISA 210 Agreeing the Terms of Audit Engagement. The engagement letters need to be re-issued following the requirement in the clarified ISA 210 for the preconditions of an audit to be present prior to accepting appointment as auditor. The auditor must also assess whether the financial reporting framework to be applied is acceptable, and in the UK the framework will either be UK GAAP or EU-adopted IFRS. 

The preconditions of an audit (all of which must be present) are as follows:

  •  the use of an acceptable financial reporting framework (UK GAAP or IFRS)
  • obtaining confirmation from the client’s management that they acknowledge their responsibilities for the preparation of the financial statements
  • ensuring management acknowledge their responsibilities for internal controls insofar as ensuring that such controls will enable the financial statements to be free from material misstatement, whether due to fraud or error

The letter of engagement must also confirm that management will provide the auditor with:

  • access to all information that management is aware of and which is relevant to the preparation of the financial statements
  • any other information which the auditor may request for the purposes of the audit
  • unrestricted access to persons within the entity who will provide the auditor with relevant audit evidence

Analytical procedures

As part of the normal audit planning routine, auditors are required to adopt the use of analytical procedures at the planning stage as well as during the course of the audit fieldwork and at the completion stage of the audit. Analytical procedures will help to identify those ‘key’ areas of the financial statements to which the auditor should focus their attention. For example, if gross profit margins have reduced disproportionately from one year to the next the auditor must devise procedures to substantiate the reasons for such a reduction and ask questions such as ‘has stock been valued correctly?’, ‘are cut-offs correct?’ and ‘is turnover complete?’ 

Regulators have criticised firms recently for failing to use analytical procedures correctly. In particular, failing to properly adopt analytical procedures at the required stages. Analytical procedures applied at, or near the end, of the audit are done so in order to form an opinion as to whether the financial statements as a whole are consistent with the auditor’s expectations. The intention is to allow the auditor to consider whether their conclusions, which have been drawn as a result of the procedures applied during the audit, corroborate those conclusions in relation to the individual components or elements of the financial statements. Typical techniques which can be used as analytical procedures include:

  • Ratio analysis
  • Review of prior period financial information
  • Reasonableness tests
  • Profit and loss account expenditure review

Fraud

Don’t forget that ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements requires the audit team to discuss the susceptibility of the financial statements to material misstatement due to fraud. Auditors are also required to justify their reasons if they consider fraud in relation to revenue recognition to be not applicable to the client.

In addition, the audit team are also required under ISA 550 Related Parties to discuss the susceptibility of the financial statements to misstatement due to fraud and error with related parties. Don’t forget this important change brought about by the Clarity Project and make sure you document the team discussion.

Accounting estimates

Financial statements always contain some degree of estimate – for example depreciation. The auditor is required under ISA 540 Auditing Accounting Estimates to adopt a more risk-based approach. The auditor has to gain an understanding as to how the entity arrives at estimates for the financial statements as well as considering any potential management bias relating to individual accounting estimates. For those of you dealing with smaller audits, ISA 540 does acknowledge that the process to arrive at accounting estimates is likely to be fairly simplistic and under the control of the owner of the business, but you do still need to demonstrate compliance with ISA 540.

Materiality

A new concept of ‘performance materiality’ has been introduced into ISA 320 Materiality in Planning and Performing an Audit’ which I have written about previously. The standard itself does not prescribe how performance materiality is to be calculated. Materiality must be determined at the planning stage of the audit and performance materiality is applied to those areas of the financial statements which are high risk or sensitive. You would normally apply performance materiality to at least directors transactions and related parties. 

Evaluation of misstatements

Auditors are now required to apply the provisions in a new ISA – that of ISA 450 Evaluation of Misstatements Identified During the Audit. In a nutshell all misstatements have to be communicated to management on a timely basis unless they are ‘clearly trivial’. This means that auditors will have to use their judgement and determine a level for ‘clearly trivial’ items at the planning stage of the audit.

The auditor has to evaluate the misstatements identified during the audit in order to determine whether (or not) the audit strategy needs to be changed depending on the nature and circumstances of the misstatements identified. In addition, the auditor also has to reassess materiality (both financial statement and performance materiality) to ensure that it remains appropriate. Sometimes materiality is often calculated at the planning stage but later forgotten about. 

Management would also be requested to correct all misstatements identified during the audit and if they refuse, the auditor must obtain an understanding of their reasons for refusing to adjust any misstatements. If management don’t want to correct the misstatements on the basis that they are immaterial, don’t forget to obtain a written representation from management and those charged with governance that they believe the effect of uncorrected misstatements is immaterial both individually and in totality (to which, of course, the auditor must also concur).

Going concern

It is not up to the auditor to determine whether the going concern presumption is appropriate (or not). This responsibility rests with management regardless of what the client might think. The auditor’s responsibility is to consider the appropriateness of management’s use of the going concern presumption in the preparation of the financial statements and the adequacy of any related disclosures when there may be doubts about the applicability of the going concern presumption.

Given the fact that some clients may have experienced a disastrous year the auditor has to determine if a material uncertainty exists in relation to the client’s ability to continue as a going concern. Reporting tends to cause some confusion with often an inappropriate opinion being expressed in the auditor’s report. If the going concern presumption is appropriate, but a material uncertainty exists which has been adequately disclosed in the financial statements, then the auditor’s report will be unqualified but modified to add an emphasis of matter paragraph highlighting the existence of a material uncertainty (which will also be cross-referenced to the relevant disclosure note in the financial statements). This emphasis of matter paragraph must also emphasise that the auditor’s report is not qualified in this respect.

If, in the auditor’s opinion, the going concern basis is not appropriate, but management have prepared the financial statements on a going concern basis, then the auditor must express an adverse opinion. 

Also, don’t forget that management have to assess going concern for a period of one year from the (expected) date of approval of the financial statements.

Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘The Interpretation and Application of International Standards on Auditing’ (Wiley March 2011) and the author of ‘The AccountingWEB Guide to IFRS’ (Sift Media May 2011).

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Replies (5)

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By Ayesha Bham
08th Nov 2011 18:05

.
Thanks Steve. I wasn't aware of the need to discuss related party issues. Oops.

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By ctkuan
11th Nov 2011 13:44

going concern

Hi Steve

Thanks for the great article.. I wish to clarify with you regarding this statement you made above 'management have to assess going concern for a period of one year from the (expected) date of approval of the financial statements'.  I thought ISA570 requires as a minimum that assessment period to be 12 months from the balance sheet date (instead of the date of approval of the financial statements)

Hope to hear from you.  Many thanks.

 

 

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collings
By Steven Collings
11th Nov 2011 14:34

Going Concern

Hi ctkuan

ISA 570 does say that management's assessment of going concern should be for a period of 12 months from the balance sheet date (see para 18) - this is based on the full ISA issued by IAASB but the UK's APB have 'tweaked' these standards to be UK & Ireland specific (hence why they are referred to as ISA 'pluses').  ISA+ 570 (UK & Ireland) says at paragraph 18-1 that in the UK and Ireland if the period assessed by those charged with governance is less than 12 months from the date of approval of the accounts and TCWG have not disclosed the fact that their assessment is less than 12 months from the date of approval of the accounts, the auditor does so in their report.

Hope that helps.

Best wishes

Steve

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Replying to dialm4accounts:
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By ctkuan
11th Nov 2011 15:34

going concern

Hi Steve

Many thanks for your kind explanations!

Cheers/CT

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By princeusus
11th Nov 2011 19:51

Excellent Article Steve

Many thanks for the recap of pertinent points.

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