chapter 01: Introduction to assurance services

Question 1

Discuss the concepts of stewardship and accountability in the context of a limited company.

Answer 1

Steward:
Stewardship is the practice of managing other person’s property In a limited company, directors have a stewardship role
They look after the assets of the company, and manage them on behalf of shareholders.

Accountable:
In a limited company, directors are agents of the shareholder and are accountable to them. Directors show their
Accountability to shareholders by preparing annual financial statements and presenting them to the shareholders for
Their decision making.

Question 2

You are the senior menager in a small audit firm and your responsibilities include obtaining new clients. New Health Food
is a family owned partnership with 3 stores. In discussing the business, you learned that New Health Food is thinking of
expanding to a fourth store in a nearby city but is undecided about how to finance the expansion. They are considering
either borrowing from a bank or from the existing owners. The owners are 2 brothers and 2 sisters, 3 of whom actively
manage 1 store each, and the fourth will manage the new store next year.
Required:
Explain which factors would suggest that New Health Food shou d have an audit and which factors would suggest that an
audit is not required.

Answer 2

Factors suggesting audit is necessary:

1. One family member and owner not actively involved in business may require audit.
2. If the partnership borrows from bank, then an external audit may be required by bank.

Factors suggesting audit is not necessary:

1. There is no conflict of interest between owners and managers because whole business is managed by owners
   Themselves.
2. New Health Food is not a company, therefore its audit is not required by law.
3. It borrowing is arranged from owners, there will be no need for an audit.

Case Study Tip:

You should learn first lesson of attempting case studies from this question i.e.. “Do not go beyond facts
Presented in the case.” For example, it will be wrong to include all advantages of audit here as factors
Suggesting audit is necessary.

Question 3

Briefly explain any four elements of an assurance engagement.

Answer 3

1.Three party relationship:
Intended users
The parties who require subject matter and assurance report e.g. shareholders, bankers.

Responsible party:
The party which is responsible for preparation of subject matter i.e. directors/management). And

Practitioner:
The professional who verifies subject matter and provides assurance on it i.e. auditor in an audit.

2. A subiect matter
   Subject matter ic the information prepared by responsible party, and is verified by practitioner e.g. Historical financial
   Statements, or Casi flow forecast.

3.A Suitable Criteria:
Criteria means framework/basis (i.e. standard rules and regulations) which is used by responsible party to prepare
Subject matter (e.g. financial statements), and used by practitioner to evaluate subject matter.

Suitable means it should be selected appropriately.

4. Evidence:
   Evidence is the information used by practitioner in arriving at the conclusion on which his report is based.

Evidence should be Sufficient and Appropriate.

Question 4

In response to an audit engagement letter sent to Roof Limited (RL), Mr. Aziz Aslam, the new chief executive of RL has
requested your firm to provide absolute assurance in the audit report
Required:
Draft an appropriate reply mentioning any four reasons why the above request cannot be complied with.

Answer 4

Absolute assurance cannot be provided because of inherent limitation of audit.

Following are inherent limitations of audit:

1. Nature of financial statements (estimates, judgments and uncertainties are involved e.g. in accounting Estimates).
2. Fraud involving collusion and complex techniques, or involving senior management are harder to detect.
3. Time and Cost limitation (Therefore, auditor plans aur.it in such a way that he directs its efforts on risky areas, and uses sampling)
4. There are always some inherent limitations in client’s internal control system.

Question 5

Briefly explain with examples, the different levels of assurance that can be provided to an assurance client.

Answer 5

Different levels of assurance that can be provided to an assurance client:

1. Reasonable Assurance
2. Limited Assurance

Explanation:
Reasonable Assurance:
It is a high, but not absolute, level of assurance expressed in positive form of conclusion i.e.
“In our opinion, financial statements give true and fair view of financial position of ABC Limited at December 31, 20X1 and its financial performance and cash flow for the year then ended in accordance with IFRS.”

Limited Assurance:
It is a moderate level of assurance, expressed in negative form of conclusion i.e.
“Based on our review, nothing has come to our attention that causes us to believe that these financial statements do not give a true and fair view of the financial position of ABC Limited as at December 31. 20X1, and its financial performance and cash flows for the year then ended, in accordance with IFRS”

Examples:
Example of Reasonable Assurance: Audit of historical financial statements.
Example of Limited Assurance: Review of historical financial statements, or review of cash flow forecast

Question 6

Amjad is the chief executive and major shareholder of a newly incorporated private limited company. He has offered your firm to be the first external auditor of the company. During a meeting, he was of the viewpoint that statutory audit exists because it has been legally mandated and it does not add value to business. However, he believes that audit helps in finding all major frauds within the company.
Required:
Discuss how you will respond to the viewpoints of Amjad regarding the audit of financial statements.

Answer 6

There are two viewpoints to comment:

Statutory audit does not add value to business:
This viewpoint is wrong. Statutory audit exists because it adds value to business and provide many benefits e.g.
1. It increases credibility of financial statements, as most of the misstatements are identified.
2. It confirms that management is performing its statutory and non-statutory duties (e.g. compliance with corporate governance requirements).
3. Auditor identifies deficiencies in entity’s internal control system, and gives recommendations to improve it
4. It assists in sale or purchase of business.
5. It assists in grant of loan by bank.

Audit helps in finding all major frauds within the company:
This viewpoint is wrong. Auditor does not identify all major frauds within the company because of inherent limitations of
Audit e-g
1. Because of time and cost limitation, auditor checks only a sample of transactions.
2. Fraud involving collusion and complex techniques are harder to detect.
3. Some accounts in financial statements involve estimates/ judgments/ uncertainties which are difficult to calculate and verify.
4. Many of the audit procedures are based on auditor’s judgment which can be faulty.
5. Management may not provide complete information to auditor.
6. Auditor does not have specific legal powers e.g. power to search.

Question 7

Explain the meaning of “assurance” and give two examples of types of assurance which can be provided, distinguishing between the two in terms of the level of assurance offered by each of them.

Answer 7

Meaning of Assurance:
Assurance means “confidence” with which we make a statement/assertion. Levels of assurance that can be provided are Reasonable assurance and Limited assurance. For explanation and examples, refer LO3.
Two examples of types of assurance which can be provided:
1. Reasonable Assurance
2. Limited Assurance

Distinction between two:
Reasonable Assurance:
High, but not absolute level of assurance is provided in this type.
Limited Assurance:
Moderate level of assurance is provided in this type.

Question 8

Distinguish between absolute and reasonable assurance. Identify the type of assurance that is expected in an audit of the financial statements, clearly outlining the reasons to justify your point of view.

Answer 8

Distinction between Absolute and Reasonable assurance:
Absolute assurance means 100% guarantee that financial statements are free from ALL misstatements.

Reasonable Assurance means high, but not absolute, level of assurance expressed in positive form of conclusion.

Type of Assurance expected in audit:
In an audit, reasonable assurance is expected.

Reasons to justify type of assurance in audit:
Inherent Limitations of audit are reasons to provide reasonable assurance (instead of absolute assurance) in an audit.
These are listed below:

1. Nature of financial statements (estimates, judgments and uncertainties are involved e.g., in accounting
   estimates).
2. Nature of audit procedures
   a. Management may not provide complete information to auditor.
   b. Auditor does not have legal powers (eg. power to search)
   c. Fraud involving collusion and complex techniques, or involving senior management are harder to detect.
3. Time and Cost imitation (Therefore, auditor plans audit in such a way that he directs its efforts on risky areas and uses sampling).
4. There are always some inherent limitations in client’s internal control system.
5. Company’s staff may not be available to answer auditor’s questions, or to provide him documents.
6. Many of the audit procedures are based on auditor’s judgment, which may be faulty

Question 9

AG Company approached the Mini-Finance Bank to extend their overdraft limit in order to finance a new project. The bank asked the company to provide cash flow projections and assurance over those projections.
Required:
Explain the type of assurance engagement that will be undertaken by the auditor in the above scenario and form of such assurance. Also explain why such type of assurance is appropriate for cash flow projections.

Answer 9

Type of Assurance that will be undertaken:
Limited assurance engagement (or review engagement) will be undertaken in this situation.

Form of assurance:
Such assurance is expressed in negative form of conclusion.

Why Limited Assurance is appropriate for cash flow projections:
For cash flow projection limited assurance is appropriate because it relates to future and there is more uncertainty and auditor can obtain only moderate level of assurance about future.

Question 10

The following is an extract from an independent auditor’s unmodified report on a profit forecast:
‘Based on our examination of the evidence supporting the assumptions, nothing has come to our attention which causes us to believe that these assumptions do not provide a reasonable basis for the forecast.’
Describe the level of assurance provided by this statement and explain how and why it differs from the level of assurance provided by an audit on annual historical financial statements.

Answer 10

Level of assurance provided by this statement:
Limited or Moderate or Negative level of assurance.

How it differs from assurance provided by an audit:
Limited assurance is provided in negative form of conclusion. Whereas, in audit, assurance is provided in positive form of conclusion.

Why it differs from audit:
In limited assurance, less procedures are performed. In audit, more procedures are performed.

Question 11

Prime Bank Limited, a bank with over hundred branches all over the country, has completed one year of its successful operation. The directors of the bank in their board meeting have appointed Raja, to perform audit of head office and all branches, and to issue report to directors at end.
Is this an assurance engagement? (Give reasons)

Answer 11

This is not an assurance engagement, because there are only two parties involved i.e. practitioner and responsible party. Raja has to submit his report to directors, instead of owners or other third parties.

Tip for students: When a person is appointed by directors to do investigation and to issue report to directors, it is called “internal audit”.
External auditor is one which is appointed by shareholders; and internal auditor is one which is appointed by directors.