CHARTERED INSTITUTE OF RISK & SECURITY MANAGEMENT

PROFESSIONAL DIPLOMA IN RISK & SECURITY MANAGEMENT

AUDITING AND ACCOUNTING

Module RSM 103

Published by: Chartered Institute of Risk & Security Management

12 Highfield Road
Southerton
Harare, Zimbabwe

Chartered Institute of Risk & Security Management is a distance teaching and openlearning
institution.

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 To the student

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this module.
 CHARTERED INSTITUTE OF RISK & SECURITY MANAGEMENT

"The Six Hour Tutorial Sessions"

As you embark on your studies with the Chartered Institute of Risk & Security Management
(CIRSM) by open and distance learning, we need to advise our students so that they can make
the best use of our modules and other learning materials, your time and the lecturers who attend
to you virtually. The most important point that students need to note is that in e-learning, there
are no lectures like those found in conventional face-to-face learning. Instead, there are learning
packages that may comprise written modules, audio recordings, video recordings and other
referral materials for extra reading. All these including WhatsApp, Telegram, Twits, Blogs,
Skype, telephone and email can be used to deliver learning to students. As such, at CIRSM, we
expect the lecturers to lecture to students virtually on the stipulated six-hour tutorials designed
to give students robust introductory knowledge to their programmes. We believe that the
teaching and learning task is accomplished by the learning package that students receive at
registration.

What then is the purpose of the six-hour tutorial for each course on offer?
At CIRSM, like any other e-learning programmes, the students are at the core of learning. After
they receive the learning packages and other learning materials, it is obvious that they will
come across concepts/ideas that may not be that easy to understand or that are not so clearly
explained. They may also come across issues that they do not agree with, that actually conflict
with the practice that they are familiar with. Through interaction and discussion groups, friends
can bring ideas that are totally different and new and arguments may begin. Students may also
find that an idea is not clearly explained and they may remain with more questions than
answers. They need someone to help them in such matters. This is where the six-hour tutorial
comes in.
For it to work, you need to know that:
 This is one requirement in e-learning

 The lecturer has to introduce the course adequately for students to progress on
their own.
  The student should prepare questions, queries, clarifications, for the topics to
the discussed. For the lecturer to help you effectively, give him/her the concerns
beforehand so that in cases where information has to be gathered, there is
sufficient time to do so. If the questions can get to the lecturer at least two weeks
before the tutorial, that will create enough time for thorough preparation.

In the tutorial, the students are expected and required to take part all the time through
contributing in every way possible. They can give their views, even if they are wrong, (many
students may hold the same wrong views and the discussion will help correct the errors), they
still help them learn the correct thing as much as the correct ideas.

There is also need for both students and the lecturer to be open-minded, frank, inquisitive and
should leave no stone unturned as they analyze ideas and seek clarification on any issues. It
has been found that if tutorials are done correctly, students do better in assignments and
examinations because their ideas are streamlined. By introducing the six-hour tutorial, CIRSM
hopes to help students come in touch with the lecturers who mark their assignments, assess
them, and guide them in preparing for writing examinations and assignments and who run
students’ general academic affairs. This helps students to settle down in their course having
been advised on how to go about their learning.
Professional networking with students is, therefore, upheld by CIRSM.

The six-hour tutorials should be so structured that the tasks for each session are very clear.
Work for each session, as much as possible, follows the structure given below.

Session I (Two Hours)

Session I should be held at the beginning of the semester. The main aim of this session is to
guide you, the student, on how you are going to approach the course. During the session, you
will be given the overview of the course, how to tackle the assignments, how to organize the
logistics of the course and formation of study groups that you will belong to. It is also during
this session that you will be advised on how to use your learning materials effectively.

Session II (Two Hours)

This session comes in the middle of the semester to respond to the challenges, queries,
experiences, uncertainties, and ideas that students are facing as they go through the course. In
thissession, difficult areas in the module are explained through thecombined effort of the students
and the lecturer. It should also givedirection and feedback where students have not done well in
thefirst assignments as well as reinforce those areas where performance in the first assignments
is good.

Session III (Two Hours)

The final session, Session III, comes towards the end of the semester. In this session, students
polish up any areas that they still need clarification on. The lecturer gives students feedback on
the assignments so that they can use the experiences for preparation for the end of semester
examination.

Note that in all the three sessions, students identify the areas that their lecturer should give help.
They also take a very important part in finding answers to the problems posed. As students, you are
the most important part of the solutions to your learning challenges.

Conclusion
In conclusion, we should be very clear that six hours is too little for lectures and this does not
limit, in view of the provision of fully self-contained learning materials in the package, to
look for supplementary sources to augment this module. We, therefore, urge students not
only to attend the six-hour tutorials for this course, but also to prepare oneself to contribute
in the best way possible so as to maximize beneficiation.

BEST WISHES IN YOUR STUDIES.

CIRSM
PREFACE

Chapter 1: Responsibilities, Functions and Qualities of the Auditor

Chapter 2: Historical Evolution of Auditing Objectives and the Audit

Chapter 3: The Audit Firm

Chapter 4: Professional Liability of an Auditor

Chapter 5: Basic Procedure for Obtaining Audit Evidence

Chapter 6: Reporting of Audit Findings

Chapter 7: Company Law Requirements

Chapter 8: Cash Flow Statements

Chapter 9: Analysis and Interpretation of Financial Information as to Management and

Stakeholders

Chapter 10: Financial Statements for Close Corporations

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CHAPTER 1: RESPONSIBILITIES, FUNCTIONS AND QUALITIES OF THE AUDITOR

Rights of an auditor.

• Every auditor of a company shall have a right of access at all times to the books, accounts,
vouchers and securities of a company and shall be entitled to require from the officers of the
company such information and explanations as he thinks necessary.

• Every auditor of a holding company shall have a right to attend a general meeting of the
company and receive all notices relating to any general meeting of the company.

• The auditor is entitled to be heard at any general meeting which he attends.

Legal background.

• The companies Act lays down the legal background to an audit that includes the appointment of
an auditor, the disqualification for appointment as auditor and the rights and duties.

Appointment and remuneration of an auditor

• The first auditors of a company shall be appointed by the directors within one month of issue of
the certificate that the company is entitled to commence business in the case of a public company
and other companies within one month of the issue of the certificate of incorporation.

• An auditor so appointed shall hold office until the conclusion of the first Annual General meeting.

• The directors shall at each AGM appoint an auditor to hold office from the conclusion of that
meeting until the conclusion of the next AGM.

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• The directors may fill any casual vacancy in the office of auditor but while any such vacancy
continues, the continuing auditor, if any, may act.

• The remuneration of the auditor of a company shall be fixed by the company in general meeting,
or in such manner as the company in general meeting may determine.

• Any sums paid by the company in respect of the auditors` expenses shall be deemed to be included
in the remuneration.

Disqualification from appointment as auditor

• None of the following persons shall be qualified for appointment as auditors of a company:

 An officer or servant of the company

 A person who is a partnerof a company

 A person who is an employer or an employee of an officer or servant of a company.

 A body corporate

 A person who is an officer or servant of a body corporate

 A person who by himself or his partner or his employee regularly performs the duties of secretary
or bookkeeper of the company.

Resignation and removal of the auditor

• Auditors may be removed from office by resolution of the company at an Annual General

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• Meeting for which a notice of twenty-eight days is required.

• The company must send such a notice of the resolution to the auditorin writing.

• The auditoris then given an opportunity to make presentations in writing with copies of
presentations sent to all members.

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• Auditors may be removed so as to strengthen audit independence by appointing another

auditor.

• Auditors who qualifytheir opinion on the financial statements cannot be removed by

directors for qualifying the financial statements.

• When resigning the auditorshould notify the company in writing.

• The notice must be accompanied by any circumstancesto be brought to the attention of

members or creditors or a statement that no such circumstancesexist.

CODE OF ETHICS

• The auditor`s objectivity must be beyond question if he is to report as an auditor.

• The objectivity can only be assured if the auditoris seen to be independent.

• Independence may be threatened or appear to be threatened in the following circumstances:

1. Undue dependence on an audit client

• The auditor’s objectivity is likely to be jeopardised where the fees for audit and other
recurring work paid by one client or group of clients exceeds 15% of the grosspractice
income or 10% of the grosspractice income in the case of listed and other public interest
companies.

• A new practice seeking to establish itself or an established practice seeking to reduce its
activities may not be able to comply with this criteria.

2. Overdue fees

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• The existence of significant overdue fees from an audit client or a group of connected clients may
be a threat to objectivity similar to that of a loan.

3. Actualor threatened litigation

• Litigation between the auditorand the client is likely to represent a breakdown in the relationship
of trust between them.

4. Family and other personal relationships

• Problems may arise where a practice or anyone closelyconnected with it has a mutual business
interest with a client, and an officer or an employee of a client or where an officer or
employee is closelyconnected with a partneror staff member.

5. Beneficial interests in shares and other investments

• A practice should ensure that it should not have as an audit client a company in which a partneror
employee or anyone closelyconnected with a partneror employee who is a holder of a
beneficial investment nor should it employ on the audit a member of staff, if that member
of staff or a person closelyconnected with him is a beneficial holder of such investment.

6. Loans

• A practice or anyone closelyconnected with it should not, either directly or indirectly or by

way of a trust or other intermediary:

• Make a loan to or guarantee borrowings by a company or organisation audited by the

practice.

• Accept a loan from such a company or organisation.

• Have borrowings guaranteed by such a company or organisation

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• This rule is not intended to preclude a loan, overdraft or home mortgage being accepted from
an audit client financial institution in the normalcourse of business and on normalcommercial
terms by a partneror staff member.

7. Goods and Services: Hospitality

• Goods or services should not be accepted by a practice or anyone closelyconnected with it

unless the value of any such benefit is modest.

• Acceptance of undue hospitality poses a similar threat.

8. Provision of other services

• There is no objection in principle to a practice providing to a client, services additional to

the audit.

• However, care must be taken not to perform management functions or make management
decisions.

• In the case of many audit clients, it is common to provide a range of accountancy services,
which may include participation in the preparation of accounting records.

• In the case of a listed company or public interest company audit client a practice should not
participate in the preparation of accounting records except in :

(a) In relation to assistance of a mechanical nature for example consolidations and tax provisions.

• (b) In emergency situations.

Conflict of interests

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• There is, on the face of it, nothing improper in having two or more clients whose interests
may be in conflict provided that the work that the auditorundertakes is not in itself, likely to
be the subjectof conflict between the clients.

• Where the acceptance or continuance of an engagement would even with safe guards,
materially prejudice the interests of a client, the appointment should not be accepted or
continued.
• Where the auditorbecomes aware of possible conflicts between the interests of two or more
clients, all reasonable steps should be taken to manage them.

• These steps may include someor all of the following safeguards :

• The use of different partners and teams for different engagements.

• Standing instructions to prevent the leakage of confidential information between different

teams and sections within the audit firm.

• Regular review of the situation by a senior partneror compliance officer not personally
involved with either client.

• Advising one or both clients to seek additional independent advice.

Scope of an audit

• The term scope of an audit refers to the audit procedures necessary to achieve the objective
of an audit that is n audit should be conducted in accordance with International

• Standards on Auditing, rules of professional conduct, legislation and the terms of an audit
engagement.

Responsibility for the financial statements.

• The auditoris responsible for forming and expressing an opinion on the financial statements.

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• The responsibility for preparing and presenting the financial statements rests with
management.

• The audit of financial statements does not relieve management of its responsibility.

• The auditorshould comply with the code of ethics for professional accountants issued by the
International Federation of Accountants.

The principles include :

(a)Independence

(b)Integrity

(c)Objectivity

(d)Professional competence and due care

(e)Confidentiality

(f)Professional behaviour

(g)Technical standards

• The auditorshould conduct an audit in accordance with International Standards on

Auditing.

• The auditorshould plan and perform the audit with an attitude of professional scepticism
recognising that circumstancesmay exist which cause the financial statements to be
materially misstated.

Responsibility for the detection of fraud and error

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• The responsibility rests with management through the implementation and continued
operation of an adequate system of internal controlwhich reduces the possibility of fraudand
error. Audit objective

• The objective of an audit of financial statements is to enable the audit to express an opinion
on such financial statement.

• The auditorcarries out procedures designed to obtain reasonable assurance that the financial
statements are properly drawn in all material respects.

• The auditorshould therefore plan his audit so that he a reasonable expectation or discovery
of material misstatementsresulting from fraud and error.

Inherent limitations of an audit.

• While the existence of an effective system of internal controlreduces the probability of

misstatementsof financial information resulting from fraudand error, there will always be
somerisk of internal controls failing to operate as designed.

Nature and Rationale of Auditor liability: ‘fair and reasonable’punishment?

Over the past two decades the bill for litigation settlements of Big Four audit firms alone has run
into billions of dollars. Examples include Deloitte’s 2005 settlement of $250m regarding its audit
of insurance company Fortress Re and PWC’s $229m settlement in the lawsuit brought by the
shareholders of audit client Tyco in 2007.

Auditor liability is increasingly concerning, both in terms of audit quality and the reputation of the
profession but also in terms of the cost to the industry and the barriers this creates to competition
within the audit market.

Types of liability

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Auditors are potentially liable for both criminal and civil offences. The former occur when
individuals or organisations breach a government imposed law; in other words criminal law
governs relationships between entities and the state. Civil law, in contrast, deals with disputes
between individuals and/or organisations.

Criminal offences

Like any individual or organisation auditors are bound by the laws in the countries in which they
operate. So under currentcriminal law auditors could be prosecuted for acts such as fraudand
insider trading.

Audit is also subjectto legislation prescribed by the Companies Act 2006. This includes many
sections governing who can be an auditor, how auditors are appointed and removed and the
functions of auditors.

One noteworthy offence from the Companies Act is that of ‘knowingly, or recklessly causing a
report under section495 (auditor’s report on company’s annual accounts) to include any matter
that is misleading, false or deceptive in a material particular’ (s.507).

This means that auditors could be prosecuted in a criminal court for either knowingly or recklessly
issuing an inappropriate audit opinion.

Civil offences

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There are two pieces of civil law of particular significance to the audit profession; contract law
and the law of tort. These establish the principles for auditorliability to clients and to third parties,
respectively.

Under contract law parties can seek remedy for a breach of contractual obligations. Therefore,
shareholders can seek remedy from an auditorif they fail to comply with the terms of an
engagement letter. For example; an auditorcould be sued by the shareholders, which was the case
in the PWC settlement to Tyco shareholders referred to above.

Under the law of tort auditors can be sued for negligence if they breach a duty of care towards a third
party who consequently suffers someform of loss.

Case History

The application of the law of tort in the auditing profession, and the way in which auditors seek to
limit their exposure to the ensuing liabilities, has been shaped by a number of recent landmark
cases. The most notable of these are Caparo Industries Plc (Caparo) v Dickman (1990) and Royal
Bank of Scotland (RBS) vs Bannerman Johnstone MacLay (Bannerman) (2002).

In the first case Caparo pursued the firm Touche Ross (who later merged to form Deloitte & Touche)
following a series of share purchases of a company called Fidelity plc. Caparo alleges that the
purchase decisions were based upon inaccurate accounts that overvalued the company. They also
claimed that, as auditors of Fidelity, Touche Ross owed potential investors a duty of care. The claim
was unsuccessful; the House of Lords concluded that the accounts were prepared for the existing
shareholders as a class for the purposes of exercising their class rights and that the auditor had no
reasonable knowledge of the purpose that the accounts would be put to by Caparo.

It was this case that provided the current guidance for when duty of care between an auditor
and a third party exists. Under the ruling this occurs when:

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• The loss suffered is a reasonably foreseeable consequence of the defendant’s conduct

• there is sufficient ‘proximity’ of relationship between the defendant and the pursuer, and

• it is 'fair, just and reasonable' to impose a liability on the defendant.

In the second case RBS alleged to have lost over £13m in unpaid overdraft facilities to insolvent
client APC Ltd. They claimed that Bannerman had been negligent in failing to detect a fraudulent
and material misstatement in the accounts of APC. The banking facility was provided on the basis
of receiving audited financial statements each year.

In contrast to Touche Ross, who had no knowledge of Caparo’s intention to rely upon the audited
financial statements, Bannerman, through their audit of the banking facility letter of APC, would
have been aware of RBS’s intention to use the audited accounts as a basis for lending decisions.
For this reason it was upheld that they owed RBS a duty of care. The judge in the Bannerman
case also, and crucially, concluded that the absence of any disclaimer of liability to third parties
was a significant contributing factor to the duty of care owed to them.

Joint and several liability

The guidance for when an auditor may be liable, either under criminal or civil law, appears to be
clear and largely uncontroversial. The same cannot be said of the nature of the fines and
settlements, which remains a hotly debated issue.

Before discussing this, it is worth making the point that auditors are only found liable in cases
where they have breached their responsibilities to perform work with professional competence
and due care and to act independently of their clients. There is therefore little argument that they
should face the penalties of their own failures and that parties that have suffered as a result should
be able to seek adequate compensation.

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The main criticism of the current system is that the penalties incurred by the audit profession are
unfairly high. This arises from the civil law principle of ‘joint and several liability’ enforced in
the UK (as well as the US). This means that even if there are multiple culpable parties in a
negligence case the plaintiff may pursue any one of those parties individually for the entire damages
sought.

So for example, if a director fraudulently misstates the financial statements, the company’s
management fail to detect this because of poor controls and the auditor performs an inadequate
audit leading to the wrong audit opinion, it would be fair to say all three parties are at fault.
Shareholders seeking compensation for any consequent losses, however, could try and recover the
full loss from only one of those three parties.

Given that many of the cases arise when companies are facing financial difficulties, as with the
examples cited above, and that any individuals involved are unlikely to possess sufficient
assets to settle the liabilities, the audit firm, who may be asset rich and possess professional
indemnity insurance, is often the sole target for financial compensation.

Regardless of the perceived fairness, this situation does create a number of challenges for the
profession, namely:

1. The increasing cost to the industry, firstly from defending and settling claims but also from
spiralling insurance premiums.

2. The potential for consequent increases in audit fees to cover these rising costs.

3. The overall lack of sufficient insurance cover in the sector in comparison to the size of some
of the claims.

4. The lack of competition in the audit market for large (listed) entities.

With regard to the final point, auditor liability is not the sole reason for the lack of competition in
the audit of listed entities but it is a significant barrier to entering that market. Currently only the

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Big Four firms have adequate insurance and asset cover to be able to audit an extensive range of
listed clients. It may simply be too risky for smaller firms to take on such clients. Given that
settlements against the Big Four have topped $300m, one large negligence case could easily
bankrupt a mid-tier firm.

MANAGING EXPOSURE TO LIABILITY

Audit quality

There are a number of ways in which audit firms can manage their exposure to claims of
negligence. Perhaps the most obvious is not being negligent in the first place. In practical terms
this means rigorously applying International Standards on Auditing and the Code of Ethics for
Professional Accountants and paying close attention to the terms and conditions agreed upon in
the engagement letter.

Of course, improvements in quality controls in comparison to current levels would not happen
without investment from the audit firms. With pressure to reduce audit fees it is unlikely that firms
will want to commit to further increases in cost unless it is perceived that such action will lead to
long-term reductions in legal and insurance costs

Disclaimers of liability

One of the outcomes of the Bannerman case was the potential exposure of auditors to litigation
from third parties to whom they have not disclaimed liability. As a result it became common to
include a disclaimer of liability to third parties in the wording of the audit report.

Disclaimers may not entirely eliminate liability to third parties but they do reduce the scope for
courts to assume liability to them. It should be noted that whilst this should reduce the threat of
litigation in the UK, this protection may not extend overseas because the disclaimer is based on a
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ruling from a UK court case. It also provides no protection from the threat of litigation from clients
under contract law.

There are also critics of the ‘Bannerman Paragraph,’ who believe that its presence devalues the
audit report. They argue that the disclaimer acts as a barrier to litigation, which reduces the pressure
to perform good quality audits in the first place. It is plausible that this reduces the credibility of
the audit report in the eyes of the reader.

Liability Limitation Agreements

Since 2008 auditors have been permitted, under the terms of the Companies Act, to use Liability
Limitation Agreements (LLAs) to reduce the threat of litigation from clients. LLAs are clauses
built into the terms of an engagement that impose a cap on the amount of compensation that can
be sought from the auditor.These must be approved by shareholders annually and be upheld by
judges as ‘fair and reasonable’ when cases arise.

Whilst this may sound straightforward it has created problems, including how to define the cap (ie
as a fixed monetary amount, a multiple of the fee, proportionate liability on a case by case basis).
It is also difficult to decide what is fair and reasonable when setting the terms of the engagement
because this is done before any potential litigation,or the scale of potential litigation, is known to
the auditor and the client. This is therefore open to the interpretation of the courts. At which point
the level of compensation may as well lie at the discretion of the courts in the first place.

Another problem lies with the shareholders; what motivation do they have for agreeing to terms
that could potentially reduce their ability to recover any losses they incur due to the negligence
of other parties? Once again this may be perceived as a barrier to litigation that audit firms can
hide behind, reducing the pressure to perform good quality audits.

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CURRENT POSITION

All the methods described contribute to the management of auditor liability but it seems none of
them have provided the protection the profession needs to become truly competitive. Remember,
the profession is not asking for exemption from litigation,rather that it does not shoulder the
entire burden of litigation where others may also be to blame.

In June 2008, the European Commission recommended that member states find a way to limit
auditor liability to try and encourage competition in the audit of listed companies and to protect
EU capital markets. Given the different legal systems involved the recommendation leaves it to
member states to determine an appropriate method but suggests that the solution:

• should not apply in cases of misconduct

• would be ineffective if it did not extend to third parties, and

• should ensure fair compensation of damaged parties.

Whilst no firm decision has been reached in the UK there are an increasing number of advocates
for a ‘proportional’ system of liability replacing the current ‘joint and several’ one. Under this
proposal the audit firm would accept their proportion of the blame in a negligence case and would
pay that proportion of the compensation. This system, as introduced in Australia in 2004, would
ensure a fair outcome for the plaintiff without placing the entire financial burden upon the audit
profession. It would also meet the EC recommendations listed above.

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CHAPTER 2: HISTORICAL EVOLUTION OF AUDITING OBJECTIVES AND THE

AUDIT

Definition

Auditing can be defined as a systematic process by which a competent, independent person

objectively obtains and evaluates evidence regarding assertions about an economic entity or event
for a purpose of forming an opinion about and reporting on the degree to which the assertion
conforms to an identified set of standards.

The History of Auditing

• Auditing has developed from what in the 12th century, was primarily a check of the
accounting for stocks and revenues by authorised officers of the Exchequer of England into
a sophisticated professional assurance services performed by independent auditors for the
interest of their clients and other users of financial statements.

• The historical perspective of auditing is very important given the current shift away from
traditional accounting and auditing services to a broad variety of assurance services.

• The role of auditing first appeared in the United Kingdom in the 1800s.

• The development of the auditing role is very much an account of Court case decisions at the
end of that century.

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The increasing use of the company form of business organisation led to the growth to
managers who handled large sums of capital on behalf of shareholders.

• In 1844 the Joint Stock Companies Act stipulated that “Directors shall cause the books of
the Company to be balanced and a full and fair Balance Sheet to be made up”.

• The Act then provided for appointment of auditors who were empowered to examine the
accounts of the company.

• In 1900 the appointment of an auditor became compulsory for all public companies to
appoint an auditor and in 1948 auditors were required to have appropriate professional
qualifications.

Objectives of an audit

• According to International Standard on Auditing 200 Objectives and General Principles

Governing an Audit of Financial Statements , the objective of an audit “ is to enable the
auditor to express an

opinion whether the financial statements are prepared in all material respects in
accordance with an identified financial reporting framework .

• This framework might be International Financial Reporting Standards or the National

Standards of a particular country.

• The auditor shall make a report to the members of the accounts examined by him on every
balance sheet income statement, and all group accounts laid before the company in general
meeting during his term of office and the report shall contain the following statement :

 “Whether in his opinion , the balance sheet and income statement of the company or group
of companies are properly drawn up in accordance with legislation so as to give a true an

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fair view of the company’s affairs at the date of its balance sheet and income statement for
its` financial year ended on that date.”

• The primary purpose of an audit is to establish whether, in the auditor`s opinion, the
financial statements are a true and fair reflection of the company’s financial position.

• If he does not believe that they are, then he will decline to confirm them or issue a qualified
report.

• The auditor shall include in his report, statements which in his opinion are necessary if :

• He has not obtained all the information and explanations which to the best of his knowledge
and belief were necessary for the purpose of the audit.

• So far as appeared from his examination proper book of accounts have not been kept by the
company.

• Proper returns adequate for the purpose of the audit have not been received from the
branches not visited by him.
• The company’s balance sheet and income statement are not in agreement with the book of
accounts and returns from the branches.

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INTERNATIONAL STANDARDS ON AUDITING

SECTION 1

Integrity and Objectivity

• Integrity implies not merely honesty but fair dealing and truthfulness. The principle of
objectivity imposes the obligation on all professional accountants to be fair, intellectually
honest and free of conflicts of interest.

Professional accountants serve in many different capacities and should demonstrate their
objectivity in varying circumstances. Professional accountants in public practice undertake
assurance engagements, and render tax and other management advisory services. Other
professional accountants prepare financial statements as a subordinate of others, perform
internal auditing services, and serve in financial management capacities in industry,
commerce, the public sector and education. They also educate and train those who aspire to
admission into the profession. Regardless of service or capacity, professional accountants
should protect the integrity of their professional services, and maintain objectivity in their
judgment.

• In selecting the situations and practices to be specifically dealt within ethics requirements
relating to objectivity, adequate consideration should be given to the following factors:

 Professional accountants are exposed to situations which involve the possibility of pressures
being exerted on them. These pressures may impair their objectivity.

 (b) It is impracticable to define and prescribe all such situations where these possible
pressures exist. Reasonableness should prevail in establishing standards for identifying
relationships that are likely to, or appear to, impair a professional accountant’s objectivity.
 (c) Relationships should be avoided which allow prejudice, bias or influences of others to
override objectivity.

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 (d) Professional accountants have an obligation to ensure that personnel engaged on

professional services adhere to the principle of objectivity.

 (e) Professional accountants should neither accept nor offer gifts or entertainment which
might reasonably be believed to have a significant and improper influence on their
professional judgment or those with whom they deal. What constitutes an excessive gift or
offer of entertainment varies from country to country but professional accountants should
avoid circumstances which would bring their professional standing into disrepute.

SECTION 2

Resolution of Ethical Conflicts

• From time to time professional accountants encounter situations which give rise to conflicts
of interest. Such conflicts may arise in a wide variety of ways,ranging from the relatively
trivial dilemma to the extreme case of fraud and similar illegal activities. It is not possible
to attempt to itemize a comprehensive check list of potential cases where conflicts of
interest might occur. The professional accountant should be constantly conscious of and be
alert to factors which give rise

to conflicts of interest. It should be noted that an honest difference of opinion between a

professional accountant and another party is not in itself an ethical issue. However, the
facts and circumstances of each case need investigation by the parties concerned.

• It is recognized,however, that there can be particular factors which occur when the
responsibilities of a professional accountant may conflict with internal or external demands
of one type or another. Hence:

 There may be the danger of pressure from an overbearing supervisor, manager, director* or
partner; or when there are family or personal relationships which can give rise to the
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possibility of pressures being exerted upon them. Indeed, relationships or interests which
could adversely influence, impair or threaten a professional accountant’s integrity should be
discouraged.

 A professional accountant may be asked to act contrary to technical and/or professional

standards.

 A question of divided loyalty as between the professional accountant’s superior and the
required professional standards of conduct could occur.

 Conflict could arise when misleading information is published which may be to the
advantage of the employer or client and which may or may not benefit the professional
accountant as a result of such publication.

In applying standards of ethical conduct professional accountants may encounter problems

in identifying unethical behavior or in resolving an ethical conflict. When faced with
significant ethical issues, professional accountants should follow the established policies of

the employing organization to seek a resolution of such conflict. If those policies do not
resolve the ethical conflict, the following should be considered:

 Review the conflict problem with the immediate superior. If the problem is not resolved with
the immediate superior and the professional accountant determines to go to the next higher
managerial level, the immediate superior should be notified of the decision. If it appears that
the superior is involved in the conflict problem, the professional accountant should raise the
issue with the next higher level of management. When the immediate superior is the Chief
Executive Officer (or equivalent) the next higher reviewing level may be the Executive
Committee, Board of Directors, Non-Executive Directors, Trustees,
Partners’ Management Committee or Shareholders.
 Seek counseling and advice on a confidential basis with an independent advisor or the
applicable professional accountancy body to obtain an understanding of possible courses of
action.

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 If the ethical conflict still exists after fully exhausting all levels of internal review, the
professional accountant as a last resort may have no other recourse on significant matters
(e.g., fraud) than to resign and to submit an information memorandum to an appropriate
representative of that organization.

• Furthermore, in some countries local laws, regulations or professional standards may

require certain serious matters to be reported to an external body such as an enforcement
or supervisory authority.

• Any professional accountant in a senior position should endeavor to ensure that policies are
established within his or her employing organization to seek resolution of conflicts.

• Member bodies are urged to ensure that confidential counseling and advice is available to
members who experience ethical conflicts.

SECTION 3

Professional Competence

• Professional accountants should not portray themselves as having expertise or experience

they do not possess.

• Professional competence may be divided into two separate phases:

 Attainment of professional competence

The attainment of professional competence requires initially a high standard of general education
followed by specific education, training and examination in professionally relevant subjects, and
whether prescribed or not, a period of work experience. This should be the normal pattern of
development for a professional accountant.
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• Maintenance of professional competence

(i) The maintenance of professional competence requires continuing awareness of

developments in the accountancy profession including relevant national and international

pronouncements on accounting, auditing and other relevant regulations and statutory

requirements.

(ii) A professional accountant should adopt a program designed to ensure quality control
in the performance of professional services consistent with appropriate national and
international pronouncements.

SECTION 4

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Confidentiality

• Professional accountants have an obligation to respect the confidentiality of information

about a client’s or employer’s affairs acquired in the course of professional services. The
duty of confidentiality continues even after the end of the relationship between the
professional accountant and the client or employer.

• Confidentiality should always be observed by a professional accountant unless specific

authority has been given to disclose information or there is a legal or professional duty to
disclose.

• Professional accountants have an obligation to ensure that staff under their control and
persons from whom advice and assistance is obtained respect the principle of confidentiality.

• Confidentiality is not only a matter of disclosure of information. It also requires that a

professional accountant acquiring information in the course of performing professional
services does neither use nor appear to use that information for personal advantage or for the
advantage of a third party.

• A professional accountant has access to much confidential information about a client’s or

employer’s affairs not otherwise disclosed to the public. Therefore, the professional

accountant should be reliedupon not to make unauthorized disclosures to other persons.

This does not apply to disclosure of such information in order properly to discharge the
professional accountant’s responsibility according to the profession’s standards.

• It is in the interest of the public and the profession that the profession’s standards relating to
confidentiality be defined and guidance given on the nature and extent of the duty of

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confidentiality and the circumstances in which disclosure of information acquired during the
course of providing professional services shall be permitted or required.

• It should be recognized,however, that confidentiality of information is part of statute or

common law and therefore detailed ethical requirements in respect thereof will depend on the
law of the country of each member body.

• The following are examples of the points which should be considered in determining whether
confidential information may be disclosed:

(a) When disclosure is authorized. When authorization to disclose is given by the client or
the employer the interests of all the parties including those third parties whose interests
might be affected should be considered.

b) When disclosure is required by law. Examples of when a professional accountant is

required by law to disclose confidential information are:

(i) To produce documents or to give evidence in the course of legal proceedings; and

(ii)To disclose to the appropriate public authorities infringements of the law which come to
light.

(c) When there is a professional duty or right to disclose:

(i) To comply with technical standards and ethics requirements; such disclosure is not
contrary to this section;

(ii) To protect the professional interests of a professional accountant in legal proceedings;

(iii) To comply with the quality (or peer) review of a member body or professional body;
and

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(iv) To respond to an inquiry or investigation by a member body or regulatory body.

• When the professional accountant has determined that confidential information can be
disclosed, the following points should be considered:

(a) Whether or not all the relevant facts are known and substantiated, to the extent it is
practicable to do so; when the situation involves unsubstantiated fact or opinion,
professional judgment should be used in determining the type of disclosure to be made, if
any;

(b) What type of communication is expected and the addressee; in particular, the
professional accountant should be satisfied that the parties to whom the communication is
addressed are appropriate recipients and have the responsibility to act on it; and

(c) Whether or not the professional accountant would incur any legal liability having
made a communication and the consequences thereof.

In all such situations, the professional accountants should consider the need to consult legal
counsel and/or the professional organization(s) concerned.

Tax Practice

• A professional accountant rendering professional tax services is entitled to put forward the
best position in favor of a client, or an employer, provided the service is rendered with
professional competence, does not in any way impair integrity and objectivity, and is in the
opinion of the professional accountant consistent with the law. Doubt may be resolved in
favor of the client or the employer if there is reasonable support for the position.

• A professional accountant should not hold out to a client or an employer the assurance that
the tax return prepared and the tax advice offered are beyond challenge. Instead, the
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professional accountant should ensure that the client or the employer are aware of the
limitations attaching to tax advice and services so that they do not misinterpret an expression
of opinion as an

assertion of fact.

• A professional accountant who undertakes or assists in the preparation of a tax return should
the client or the employer that the responsibility for the content of the return rests primarily
with the client or employer. The professional accountant should take the necessary steps to
ensure that the tax return is properly prepared on the basis of the information received.

• Tax advice or opinions of material consequence given to a client or an employer should be

recorded, either in the form of a letter or in a memorandum for the files.

• A professional accountant should not be associated with any return or communication in

which there is reason to believe that it:

(a) Contains a false or misleading statement;

(b) Contains statements or information furnished recklessly or without an real knowledge of

whether they are true or false; or

(c) Omits or obscures information required to be submitted and such omission or obscurity
would mislead the revenue authorities.

• A professional accountant may prepare tax returns involving the use of estimates if such use
is generally acceptable or if it is impractical under the circumstances to obtain exact data.
When estimates are used, they should be presented as such in a manner so as to avoid the
implication of greater accuracy than exists. The professional accountant should be satisfied
that estimated amounts are reasonable under the circumstances.

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• In preparing a tax return, a professional accountant ordinarily may rely on information

furnished by the client or employer provided that the information appears reasonable.
Although the examination or review of documents or other evidence in support of the
information is not required, the professional accountant should encourage, when appropriate,
such supporting data to be provided.

In addition, the professional accountant:

(a) Should make use of the client’s returns for prior years whenever feasible;

(b) Is required to make reasonable inquiries when the information presented appears to be
incorrect or incomplete; and

(c) Is encouraged to make reference to the books and records of the business operations.

• When a professional accountant learns of a material error or omission in a tax return of a

prior year (with which the professional accountant may or may not have been associated), or
of the failure to file a required tax return, the professional accountant has a responsibility to:
(a) Promptly advise the client or employer of the error or omission and recommend that
disclosure be made to the revenue authorities.

Normally, the professional accountant is not obligated to inform the revenue

authorities, nor may this be done without permission.

(b) If the client or the employer does not correct the error the professional accountant:

(i) Should inform the client or the employer that it is not possible to act for them in
connection with that return or other related information submitted to the authorities; and

(ii) Should consider whether continued association with the client or employer in any
capacity is consistent with professional responsibilities.

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(c) If the professional accountant concludes that a professional relationship with the
client or employer can be continued, all reasonable steps should be taken to ensure that
the error is not repeated in subsequent tax returns.

(d) Professional or statutory requirements in some countries may also make it

necessary for the professional accountant to inform the revenue authorities that there is
no longer any association with the return or other information involved and that acting
for the client or employer has ceased. In these circumstances, the professional accountant
should advise the client or employer of the position before informing the authorities and
should give no further information to the authorities without the consent of the client or
employer unless required to do so by law.

Cross Border Activities

• When considering the application of ethical requirements in cross border activities a number
of situations may arise. Whether a professional accountant, is a member of the profession in
one country only or is also a member of the profession in the country where the services are
performed should not affect the manner of dealing with each situation.

• A professional accountant qualifying in one country may reside in another country or may
be temporarily visiting that country to perform professional services. In all circumstances,
the professional accountant should carry out professional services in accordance with the
relevant technical standards and ethical requirements. The particular technical standards
which should be followed are not dealt within this section.In all other respects, however, the
professional accountant should be guided by the ethical requirements set out below.

• When a professional accountant performs services in a country other than the home country
and differences on specific matters exist between ethical requirements of the two countries
the following provisions should be applied:

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(a) When the ethical requirements of the country in which the services are being
performed are less strict than the IFAC Code of Ethics, then the

IFAC Code of Ethics should be applied.

(b) When the ethical requirements of the country in which services are being performed
are stricter than the IFAC Code of Ethics, then the ethical requirements in the country where
services are being performed should be applied.

(c) When the ethical requirements of the home country are mandatory for services
performed outside that country and are stricter than set out in

(a) and (b) above, then the ethical requirements of the home country should be applied.

Publicity*

• In the marketing and promotion of themselves and their work,professional accountants

should:

(a) Not use means which brings the profession into disrepute;

(b) Not make exaggerated claims for the services they are able to offer, the qualifications

they possess, or experience they have gained; and (c) Not denigrate the work of other

accountants.

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CHAPTER 3: THE AUDIT FIRM

The audit firm should implement quality controlpolicies and procedures designed to ensure that all
audits are conducted in accordance with International Standards on Auditing.

Factors affecting the nature, timing and extent of a firm’s quality control policies and
procedures.

 Size and nature of its practice

 Its geographic dispersion

 Its organization and appropriate cost/benefit considerations

The Big Four are the four largest professional services networks in the world, offering audit,
assurance, tax, consulting, advisory, actuarial, corporate finance and legal services. They handle the
vast majority of audits for publicly traded companies as well as many private companies. It is
reported that the Big Four audit 99% of the companies in the FTSE 100, and 96% of the companies
in the FTSE 250 Index, an index of the leading mid-cap listing companies.

The Big Four firms are shown below, with their latest publicly available data.

Firm Revenues Employees Revenue per Fiscal year Headquarters

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Deloitte $36.8 bn 244,400 $150,573 2016 United States

PwC $35.9 bn 223,468 $160,649 2016 United Kingdom EY $29.6 bn 231,000 $128,139 2016
United Kingdom

KPMG $25.4 bn 188,982 $134,510 2016 Netherlands

Professional requirements

Personnel in the firm are to adhere to the principles of Independence, Integrity, Objectivity,
Confidentiality and Professional behavior.

The firm should communicate the above to personnel at all levels within the firm as follows:

• Inform personnel of the firm’s policies and procedures and advise them that they are expected
to be familiar with them.

• Emphasize independence of mental attitude in training programmes and in supervision and

review of audits.

• Inform personnel on a timely basis of those entities to which independent policies apply. I.
Prepare and maintain for independence purposes a list of the firm’s clients and of other
entities e.g. client’s associate companies to which independence policies apply

II. Make the list available to personnel who need to determine their independence. III.
Establish procedures to notify personnel of changes in the list.

The firm should also monitor compliance with policies and procedures relating to independence,
integrity, objectivity, confidentiality and professional behavior. The firm should:

• obtain from personnel; periodic written representations ordinarily on an annual basis, stating
that:

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i. they are familiar with the firm’ policies and procedures ii. prohibited investments are
not held and were not held during the period iii. prohibited relationships do not exist,
and transactions prohibited by the firm policy have not occurred.

• Assign responsibility for resolving exceptions to a person or group with appropriative

authority

• Assign responsibility for obtaining representations and reviewing independence compliance

files for completeness to a person or group with appropriate authority

• Reviewing periodically the firm’s association with clients to ascertain whether any areas of
involvement may or may be seen to impair the firm’s independence.

Obtaining professional work

A member may not in any circumstances obtain or seek professional work for either himself or
another in a manner contrary to the fundamental principles.

In particular, a member may not obtain or seek professional work by cold calling nor a practicing
member give any commission, fee, or reward to a third party for the introduction of a client.

Fees
A member is entitled to be fairly remunerated taking into consideration:

• Value of service to client

• Customary (market) charges

• Other special circumstances Auditing and Accounting Fees

These are based on:

• Skill and knowledge required

• Level/ experience of persons necessarily engaged on the assignment

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• Time necessarily occupied

• Degree of responsibility

Contingent fees

• In principle not allowed

• Contingent fees may not be charged in respect of work related to the audit/ attest function

Commissions

• In principle, commissions may impair objectivity and independence because the practitioner
has a financial interest in the transaction.

• A practitioner should not

 Pay a commission to obtain a client

 Accept a commission from a third party for referring products/servicesto a client.

Consulting Services

“Assessment services” are engagements in which the auditor examines or evaluates a past, present,
or future aspect of operations and renders information to assist management in making decisions.
These engagements need to be as timely as possible and usually don’t include specific
recommendations for management. Examples of this type of consulting engagements would be the
assessment of controls in a system design, such as assessing the adequacy of internal control in a
proposed accounts payable system. Other examples might be: (1) the study and evaluation of the
proposed restructure of the organization to reflect the most practical, economical, and logical
alignment, or (2) estimating the savings from outsourcing process.

“Facilitation services” are engagements in which the auditor assists management in

examining organizational performance for the purpose of promoting change. The auditor
does not judge organizational performance in this role. Rather, the auditor guides
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management in identifying organizational strengths andopportunities for improvement. Such

engagements include control

selfassessment, benchmarking, business process reengineering support, assistance in developing

performance measurement, and strategic planning support.
The final type of consulting service on the assurance/consulting continuum is “remediation
services.” This represents the most extreme and threatening type of consulting activity in terms of
incompatibility with providing assurance, and yet has always been present to a degree in all internal
audit functions. These are engagements in which the auditor assumes a direct role designed to
prevent or remediate known or suspected problems on behalf of the client. Such an engagement
might be as innocuous as developing and delivering a training seminar on internal controls.
Certainly such training is a common and valuable service provided by many internal audit functions
for their organizations, yet it is clearly a management function. Or an engagement could involve
the drafting of policies for cash handling or writing the organization’s code of conduct. Such
activities begin to make auditors nervous about their ability to objectively audit these areas at a later
date, but what auditor has not seen the words written in an audit recommendation to illustrate what
sort of policy the auditee might implement a year later word for word in the auditee’s policy manual?
Finally,in the extreme, such engagements include the augmenting of operating personnel, in which
the auditor actually performs operating functions for a period of time or even on a permanent basis.

Issues in Providing Assurance Services

In providing assurance services there are numerous issues with which practitioners are currently
struggling. Some have been issues for many years; others have recently come to the forefront
because of changes that advances in technology have brought to business practices. These issues
can be categorized into four areas:

• Level of assurance

• The relation of evidence to type and level of assurance

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• Providing assurance outside the organization

• The nature of assurance in fraud investigation

Each of these areas offers researchers a challenging set of problems that can be productively
approached with a variety of methodologies.

Level of Assurance

Does each assurance engagement that internal audit conducts provide the same level of assurance?
In one sense the Standards require that sufficient evidence be collected to support the reported
conclusions, but do these conclusions vary in the amount of reliance the user should place in the
auditor’s work? In the traditional financial attestation audit there is presumed to be, at least in
theory, some same minimal level of assurance across audits. It is not clear this same presumption
holds for internal audit assurance engagements. Further, financial attestation standards in many
parts of the world explicitly recognize the levels of assurance based on the engagement design. For
example, in U.S. auditing standards one can have positive assurance, negative or limited assurance,
or no assurance based on the engagement design (audit/examination, review, compilation). The
U.S. governmental auditing standards have proposed to adopt a similar approach (GAO, 2002c,
Chapter 6).
Would such distinctions be useful in internal audit? What type of criteria would be necessary to
distinguish the levels?

The Institute of Internal Auditors Research Foundation

At a more basic level, this raises the fundamental issue of effectiveness of the communication
regarding assurance in internal audit reporting. Are the users of the reports attributing the amount
of assurance the internal auditor intended to communicate? Do all users interpret this the same
way or does it vary as one moves from immediate operations to executive management to the
board? Also, as there is little standardization in reporting format, how do factors such as whether
or not an explicit opinion is given, the detail of the reporting, the extent that audit procedures are
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described, the quantification of the impact of findings, etc., influence the degree of assurance the
user ascribes to the report? Enhancing the Value of Audit

Audit Quality

In considering audit quality, focus is often placed on input and process factors, such as standards,
methodology, education and training, etc. These are certainly essential, but we should not stop
there. Consider the importance of output factors: what users of financial statements see and read
on which they base their perceptions and conclusions of audit quality. The current developments
in auditor reporting, therefore,are very important. Also consider, for example, context factors
such as culture, corporate governance, and the regulator regime and litigation environment. They
have the potential to impact financial reporting and directly or indirectly audit quality, and
auditors need to respond properly to them. Finally,consider all those involved in the financial
reporting process— from the auditor,who is ultimately responsible for audit quality, to
management, regulators and inspectors, audit committees, and users.Their roles, and the
interactions they have, influence the environment in which audits are conducted, and their actions
can meaningfully and positively contribute to audit quality.

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CHAPTER 4: PROFESSIONAL LIABILITY OF AN AUDITOR

1. Auditors are accountable in law for their professional conduct.

2. This responsibility arises under common law and statute law.

3. Responsibility under common law may be under contract to clients or in certain

circumstances, to third parties to whom a legal duty of care may be owed.

1. There is a growing concern that too often following a business failure and alleged fraudulent
financial reporting the plaintiffs and their legal representatives prey on the auditors regardless
of degree of fault, simply because the auditors may be the only party left with sufficient
financial resources to indemnify the plaintiffs’ losses.

Liability to shareholders and third parties

2. Auditors are liable under statute and common law to the shareholders for any negligent
performance of statutory duties.

3. Auditors are also liable for cases of fraud and defamation in the same manner as any other
citizen.

4. Negligence if proven to be willful may constitute a conspiracy with management to defraud

the company or other parties.

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5. Some auditors have found themselves in Court on the criminal charge of fraud after issuing
unqualified reports on financial statements subsequently found to be misleading.

6. In respect of the provision of auditing services auditors are liable to compensate the plaintiff
if the plaintiff is able to prove that:

1. A duty of care is owed to the plaintiff

2. (b) The audit is negligently performed or the opinion negligently given

3. (c) The plaintiff has suffered a quantifiable loss as a result of the auditor’s negligence.

The extent of the auditor’s responsibility in performing an audit is contained in Kingston

Cotton Mills Co Case of 1896.

Kingston Cotton Mills Co (No2) (1996) 2 Ch 279

Facts of the Case

1. For several years the manager of Kingston Cotton Mills had been exaggerating the quantities
and values of the company’s stocks so as to fraudulently overstate the company’s profits.

2. This came to light when the company was unable to pay its debts and its true financial position
was revealed.

3. The auditor had relied on a certificate signed by the manager and ensured that the amount
appearing in the accounts as being as “per manager’s certificate”.

4. In line with contemporary practice, the auditor did not physically observe stocks or attempt
to verify the valuation of individual items.

5. Neither did the auditor reconcile stocks with the opening balance and purchases and sales
made during the year, all of which would have alerted the auditor that something was amiss.

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Judgment: As regards stocks, Justice Lindley had the following to say:

“I confess that I cannot see that their omission to check his*manager’s] returns was a breach of
their duty to the company. It is no part of the auditor’s duty to take stock. No–one contends that it
is. He must rely on other people for details of the stock in-trade in hand. In the case of a cotton
mill he must rely on some skilled person for the materials necessary to enable him to enter the
stocks-in trade at its proper value in the balance sheet.

In relation to the auditor’s responsibilities in general particularly the detection of fraud, the following
points from the judgment of Justice Lopes are important:

“It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and
caution which a reasonably competent, careful and cautious would use. What is reasonable skill,
care and caution must depend on the particular circumstances of each case. An auditor is not bound
to be detective,or as was said, to approach his work with suspicion or with a foregone conclusion
that there is something wrong. He is a watchdog and not a bloodhound. He is justified in believing
in tried servants of the company in whom confidence is placed by the company. He is entitled to
assume that they are honest, and to rely upon their representations, provided he takes reasonable
care. If there is anything calculated to Excite suspicion, he should probe it to the bottom but, in the
absence of anything he is only bound to be reasonably cautious and careful.
The duties of auditors must not be rendered too onerous. Their work is responsible and laborious,
and the remuneration moderate.

Auditors must not be made responsible for not tracking out ingenious and carefully laid schemes
of fraud, where there is nothing to arouse their suspicion and when those frauds are perpetrated by
tried servants of the company and are undetected for several years by the directors. So to hold will
make the work of an auditor intolerable”.

6. The Kingston Cotton Mill Case laid some fundamental auditing principles such as the “watch
dog” rule and the notion of reasonable skill and care.
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Liability to third parties

7. A third party (a person who has no contractual relationship with the auditor) may sue the
auditor for negligence and claim damages.

8. The plaintiff (third party) must prove that:

I. the auditor owes a duty of care.

II. the defendant has breached the appropriate standard of care (has been negligent) III. the
plaintiff has suffered loss resulting from the defendant`s breach.

In Herdley Byrne vs Heller & Partners Case [1964] it was stated that a duty of care exists where
there is a special relationship between the parties(where the auditor knew or ought to have
known) that the audited accounts would be made available to and would be relied upon by a
particular person or group of persons.

1. In Caparo Indusries vs Dickman and others [1990] case it was held that a duty of care was
not owed to potential investors or take over bidders having regard to the lack of proximity
between the auditor and potential investors.

2. Fidelity Company was taken over by Caparo Industries.

3. Fidelity accounts had been audited by Touche Ross.Caparo alleged that the accounts
overstated profits of Fidelity PLC and that its purchases of shares and takeover bid were
all made in reliance on the audited accounts.

FRAUD AND ERROR

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1. Fraud is intentional misrepresentation of financial information by one or more individuals

among management, employees and third parties and which results in misstatement of
financial information and may involve :

2. Manipulation, falsification, or alteration of records and documents.

3. Suppression or omission of the effects of transactions from records and documents

4. Misappropriation of assets.

5. Recording of transactions without substance

6. Misapplication of accounting policies.

7. Error is unintentional mistake in financial statements and may involve:

8. mathematical or clerical mistakes in accounting records

9. oversight or misrepresentation of facts

10. Misapplication of accounting policies.

Responsibility for the detection of fraud and error

1. The responsibility rests with management through the implementation and continued
operation of an adequate system of internal control which reduces the possibility of fraud
error. Inherent limitations of and audit

2. While the existence of an effective system of internal control reduces the probability of
misstatements of financial information resulting from fraud and error, there will always be
some risk of internal controls failing to operate as designed.

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3. Any system of internal controls may be ineffective against fraud involving collusion among
employees or fraud committed by management.

Conditions which increase risk of fraud and error (indicators)

4. The following conditions may indicate the existence of fraud and error:

1. (a) questions with respect to the integrity or competence of management.

2. (b) unusual pressures within the entity

3. (c) unusual transactions

4. (d) problems in obtaining sufficient appropriate audit evidence

Procedures where indications of fraud or error and fraud exist

1. Consider potential effect on the financial statements(materiality)

2. Perform additional procedures as necessary to confirm or dispel suspicion of fraud and error

1. If unable to obtain evidence to confirm or dispel suspicion of fraud and error, the auditor
should consider the possible effect on the financial statements or should take legal advice
before rendering any report or withdrawal from the engagement.

2. The auditor should communicate to management on a timely basis if fraud and error is
actually found to exist or if he believes fraud or error may exist even if the potential effect
on the financial statements is immaterial.

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CHAPTER 5: BASIC PROCEDURE FOR OBTAINING AUDIT EVIDENCE

AUDIT PLANNING

• The auditor should plan the audit work so that the audit will be performed in an effective
manner. Planning means developing a general strategy and a detailed approach for the expected
nature, timing and extent of the audit.

Purposes of planning

1 .Planning helps to unsure that appropriate attention is denoted to important areas of the audit.

2.Potential problems are identified and the work is completed expeditiously.

3.Planning assists in proper assignment to audit assistants.

4. Planning co-ordinates work done by the auditor and other experts.

Extent of planning

• The extent of planning varies according to:

1.Thesize of the entity.

2.The complexity of the audit

3.Theauditor`s experience with the client entity.

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4.Knowledge of the business

Preliminary arrangements

• When planning the auditor may discuss audit procedures and the overall audit plan with
management, audit committee and the client`s staff in order to improve the efficiency and
effectiveness of the audit.

The overall audit plan

• Matters to be considered in developing the overall audit plan include:

1. Knowledge of the business

• General economic factors and industry conditions affecting the entity`s business.

• Characteristics of the entity, management structure and financial performance.

• Management competence.

2. Understanding the accounting and internal control system

• Accounting policies adopted by the entity.

• Reliance to be placed on the tests of internal control and substantive procedures. 3. Risk and
Materiality

Assessment of inherent and control risks

• Setting of materiality levels. • Possibility of misstatements

• Identification of complex accounting areas.

4. Nature, timing and extent of procedures • Possible

change of emphasis on specific audits
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• Reliance on internal audit.

5. Co-ordination, Direction and Supervision

• Involvement of experts

• Staffing and quality control

• Use of another auditor Audit Programme

• The auditor should develop anddocument an audit programme setting out the nature, timing
and extent of planned audit procedures required to implement the audit plan.

• During the course of the audit, the audit plan and audit programme should be revised where
necessary.

Example : Audit programme – Credit Sales

1.- Select the names of some new customers from the sales ledger.

• Trace to the relevant application forms completed by the customer.

• Note that established credit limits are in line with the company`s criteria.

2.- Agree invoice details to the corresponding customer orders and delivery notes for selected sales
transactions.

3.- Check delivery notes for:

• Signature of the foreman who agreed items to be delivered with that of the order forms and
the delivery notes.

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Signature of the gate keeper who checked the number of parcels leaving the premises with
the delivery note.

• Signature of the customer accepting delivery of the goods.

4 Check entries in the sales journal with the copies of the invoices paying particular attention to the
dates, names of customers ,the amounts and the nature of the sales.

5 Check additions of the sales journal including cross additions in analysis columns

6 Check the postings of selected invoices to customer`s accounts in the sales journal.

KNOWLEDGE OF THE BUSINESS

• In performing an audit of financial statements, the auditor should have or obtain knowledge
of the business sufficient to identify and understand the events, transactions and practices
that in the auditor’s judgement may have a significant effect on the financial statements or
the audit report.

Obtaining the knowledge (sources of information)

• The auditor can obtain knowledge of the industry and the entity from a number of sources
that include:

• Previous experience with the entity.

• Discuss with people within the entity (directors, managers, employees).

• Discuss with the internal audit staff and review of internal audit reports.

• Discussion with other auditors and advisors of the client.

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• Publications related to the client’s industry (govt statistics, surveys trade journals, financial
newspapers.

• Visit the client’s premises.

• Documents produced by the entity (financial statistics, minutes of board meetings,budgets,

accounting manuals).

Using the knowledge

• Knowledge of the business assists the auditor in the following ways:

Assessing risks and identifying potential problems.

• Planning and performing the audit efficiently and effectively.

• Evaluating and assessing audit evidence including assessing conflicting information.

• Identifying areas where specific audit skills and or consideration may be required.

• Identifying related parties and related party transactions

• Recognising unusual transactions.

AUDIT WORKING PAPERS

ISA 230 Documentation states that the auditor “should document matters which are important
in providing evidence to support the audit opinion and evidence that the audit was carried
out in accordance with International Standards on Auditing.

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Working papers should be “sufficiently complete anddetailed to provide an overall understanding of

the audit”.

Working papers should record:

(a) planning information

(b) the work done and when it was done (c

) results and conclusions.

The extent of working papers is a matter of professional judgement and it is neither necessary nor
practical to record every matter.

Auditors are required to record all matters which are important in supporting the report and in
particular on all significant matters that require the exercise of judgement.

Working papers should not be made available to third parties without the client’s consent and
extracts from the working papers can be made available to the client entirely at the discretion of
the auditor.

Appropriate procedures should be undertaken to maintain the confidentiality and safe custody of
working papers and for their retention for a sufficient period to meet regulatory requirements.

Contents of working papers

(a) Information likely to be of continuing importance on recurring audits such as the

organisation’s constitutional documents and other information concerning the legal and
organisation structure of the entity.

(b) Audit planning information and time budgets.

(c ) Details of the internal control and accounting systems of the business including the auditor’s
evaluation and assessment of risk.
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(d) Details of audit work carried out, including notes of errors, action taken and conclusions drawn,
including work carried out by other auditors.

(e) Supporting schedules to financial statements.

(f) Audit conclusions including significant and unusual matters.

(g) Copies of approved financial statements and auditor’s reports, letters of representation,
engagement letters, letters of weakness.

Audit working papers are usually filed in two separate files:

(a) Permanent files

(b) Current file

The Permanent Audit File

The purposes of the permanent audit file are:

(a) to document information which is of recurring value regarding items appearing in the financial
statements.

(b) to document information of a permanent nature regarding the client’s business.

(c ) to give audit staff new to the audit, information regarding the client’s affairs and the nature of
the audit.

Typical Permanent Audit File Contents

(i) Copies of the company’s initial founding documents.

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(ii) Nature and history of the business.

(iii) Registered office, management structure, products, industry, personnel.

(iv) Details of the accounting system, accounting manuals, and statistical information.

(v) Leases, title deeds, royalty agreements, stock exchange undertakings.

(vi) Group structure.

(vii) Other professional advisors that is lawyers, bankers, stock brokers, insurers.

(viii) Letter of engagement and time budgets.

(ix) Copies of management letters.

(x) Control over branch and site visits.

The Current Audit File

The purposes of the current audit file are:

(a) To provide a record of the work planned.

(b) To detail the work carried out.

(c) To ensure the reporting partner reviewing the audit to satisfy himself that an adequate examination
for audit purposes have been made for the client’s affairs.

Contents of the Current File

(a) A copy of the signed financial statements.

(b) Copies of all reports issued to the client.

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(c) Letters of weakness.

(d) Letters of representation. (e) Planning programme.

(f) Budget and fee estimates.

(g) Audit programmes.

(h) Third party confirmations and certificates.

(i) Client’s trial balance.

(j) Tests of control and substantive procedures carried out.

(k) Extracts from members’ meetings.

INTERNAL CONTROL AND RISK ASSESSMENT

• One of the first tasks in an audit engagement is obtaining an understanding of the accounting
and internal control system.

• The internal control system consists of the control environment and control procedures.

• The understanding must be sufficient to enable the auditor to design procedures for obtaining
evidence applicable to the separate assertions.

• The understanding of the accounting and internal control system should enable the auditor to
make a preliminary assessment as to the probable effectiveness of internal controls.

• All companies should maintain internal controls that will provide reasonable assurance that
fraudulent financial reporting will be prevented or subject to early detection.

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• Internal control is a process, effected by an entity’s board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives
in the following categories:

(a) reliability of financial reporting.

(b) compliance with applicable laws and regulations.

(c) effectiveness and efficiency of operations.

• Before commencing an audit on an entity’s financial statements, the auditor must have a thorough
understanding of the entity’s accounting system.

Control Procedures

Control procedures are those policies and procedures in addition to the control
environment, that management has established to ensure as far as possible, that specific
entity objectives will be achieved.

(a) Information Processing Controls

• Proper authorisation procedures to ensure that transactions are authorised by personnel acting
within the scope of their authority.

• Authorisations may be general or specific.

• General control relate to general transactions and specific authorisation apply to nonroutine
transactions or routine transactions that exceed a certain limit.

• Authorisation controls are also important in limiting access to assets, documents and records.

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(b) Segregation of Duties

• Segregation of duties ensures that individuals do not perform incompatible duties.

• Duties are considered incompatible from a control stand point when it is possible for an
individual to commit an error or irregularity and then be in a position to conceal it in the
normal course of his or her duties.

• Responsibility for executing a transaction, recording the transaction and maintaining

custody of the assets resulting from the transaction should be assigned to different
individuals or departments. (c ) Physical Controls

• Physical controls limit access to assets and important records.

• Direct controls include initiating measures for the safe keeping of assets, documents and
records.

• Indirect controls apply to the preparation or processing of documents such as sales orders.

• When computers are used, passwords can be used to control access.

CONTROL ENVIRONMENT

• The control environment means the overall attitude, awareness and actions of management
regarding internal control and its importance in the entity.

Numerous factors comprise the control environment.

• Amongst these are:

Integrity and ethical values.

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•
• Commitment to competence.

• Management’s philosophy and operating style.

• Organisational structure.

Assignment of authority andresponsibility.

• Internal Audit.

• Use of information technology.

• Human resource policies and practices. • Board of directors and audit committee.
Limitations of Internal Controls

• Internal controls can provide reasonable assurance to management and the board of
directors regarding the achievement of an entity’s objectives.

Reasons for limitations

(a) Management Override

• Management can overrule prescribed policies or procedures for illegitimate purposes such
as personal gain.

• Override practices include making deliberate misrepresentations to auditors and others

such as by issuing false documents to support the recording of fictitious sales transactions.

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•
(b) Mistake in judgement

• Management may exercise poor judgement in making business decisions or in performing

routine duties because of inadequate information or time constraints.

(c ) Collusion

• Individuals acting together such as employees or management may be able to perpetrate

and conceal an irregularity so as to prevent its detection by the internal
control system. (d) Breakdowns

Breakdowns in established controls may occur because personnel misunderstand

instructions or make errors due to carelessness or distractions.
Changes in personnel or in systems or procedures may also contribute to breakdowns.

• Understanding and documenting the internal control system

• The auditor should understand and document the internal control system.

• Relevant documents and records of the entity should be inspected including organisation
charts, policy manual, charts of accounts, journals and source documents.

• To reinforce the understanding of internal control system the auditor should perform walk
through tests.

• A few transactions within each major class of transactions is traced through the transaction
trail and the related control policies and procedures are identified and observed.

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•
• Documentation in the working papers may take the form of completed questionnaires,
flow charts and narrative memoranda.

Questionnaires

• An internal control questionnaire consists of a series of questions about accounting and

control policies and procedures which the auditor considers necessary to prevent material
misstatements in the financial statements.

• The questions are usually phrased so that either a “ Yes” or “No” or N/A answer results,
with a “Yes” answer indicating a favourable condition.

AUDIT MATERIALITY

• The auditor should consider materiality and its relationship with audit risk when
conducting an audit.

Information is material if its omission or misstatement could influence the economic

decisions of its users taken on the basis of the financial statements.

Materiality depends on the size of the item or error judged in the particular circumstances
of its omission or misstatement.

Materiality

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•
• The objective of an audit of financial statements is to enable the auditor to express an
opinion whether the financial statements are prepared in all material respects, in
accordance with an applicable financial reporting frame work.

• The assessment of what is material is a matter of professional judgement.

In designing the audit plan the auditor establishes an acceptable materiality level so as to
detect qualitatively material misstatements.

• However, both the amount (quantity) and nature (quality) of misstatements need to be
considered for example failure to disclose the breach of regulatory requirements when it
is likely that the imposition of regulatory restrictions will significantly impair operating
capability.

• The auditor needs to consider the possibility of misstatements of relatively small amounts
that cumulatively could have a material effect on financial statements.

• The auditor considers materiality at both the overall financial statement level and in
relation to classes of transactions, accounting balances and disclosures.

• Materiality should be considered by the auditor when determining the nature, timing and
extent of audit procedures, and evaluating the effects of misstatements.

• Relationship between materiality and audit risk.

• There is an inverse relationship between materiality and the level of audit risk.

• The higher the materiality level the lower the audit risk and vice versa.

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•
• When planning for specific audit procedures, if the auditor determines that the acceptable
materiality level is lower, audit risk is increased.

• The auditor would compensate for this by:

(a) reducing the assessed risk of material misstatement by carrying out extended or

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additional tests of control or

(b) reducing detection risk by modifying the nature, timing and extent of planned substantive
procedures.

Evaluating the effects of misstatements

• The auditor should assess whether the aggregate of uncorrected misstatements that had
been identified during the audit is material.

• The aggregate of uncorrected misstatements comprises:

 specific misstatements identified by the auditor.

 the auditor’s best estimate of other misstatements which cannot be specifically

identified.
If the auditor concludes that the misstatement may be material, the auditor needs to
consider reducing audit risk by extending audit procedures or requesting management to
adjust the financial statements.

• If management refuses to adjust the financial statements and the results of extended audit
procedures do not enable the auditor to conclude that the aggregate of uncorrected
misstatement is not material, the auditor should consider appropriate modification of the
auditor’s report.

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AUDIT RISK

• Audit risk is the risk that the auditor will get the audit opinion wrong.

• In practice, this nearly always means that the auditor will fail to qualify an audit report
that he should have qualified.

• In order for this situation to arise, there needs to be a material error in the accounting
records or the financial statements which was not corrected before the financial
statements were published and which the auditor did not refer to in the audit report.

Audit risk model

Audit risk is the product of inherent risk, control risk and detection risk.

• Inherent risk is the susceptibility of an assertion to error which individually or when

aggregated with other errors could material to the financial statements before considering
the effect, if any, of related internal controls e.g:

• integrity of management
• competence and commitment of staff

• time pressure as a result of unrealistic deadlines being set for reporting dates.

• Inherent risk is assessed as high if the integrity of management is questionable or the

competence of staff is questionable.

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• Control risk is the risk that an error which could occur and which individually or when
aggregated with others could be material to the financial statements will be prevented or
detected on a timely basis with the internal controls.

• Control risks arises because the accounting systems lacks in built internal controls to
prevent inaccurate, incomplete and invalid transaction recording or due to the intrinsic
limitations of internal controls such as collusion among employees or management
overriding controls. The auditor’s assessment of control risk involves two phases
namely:

 a preliminary assessment of control risk once the auditor has enquired into the
accounting system and has identified controls on which it might be effective and
efficient to rely in conducting the audit.

• a final assessment of control risk after the performance of compliance test aimed at
determining whether or not controls to be relied upon by the auditor were performed
adequately as they were designed and they were applied throughout the whole period of
intended reliance.

• The auditor would assess control risk as high if internal controls are insufficient to
prevent or timely detect errors.

• Detection riskis the risk that the auditor’s procedures will fail to detect errors which,
individually or when aggregated with others could be material to the financial statements
due to the following:

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1.Time pressures because of unrealistic budgets

2.Lack of competence and application.

3.Failure to consult with senior staff when in doubt.

4.Lack of commitment.

• The level of detection risk the auditor can accept is influenced by the assessment of
inherent and control risks together.

• The lower the auditor’s combined assessment of inherent and control risk, the higher the
detection risk and vice versa.

Use of the model

• In order to make use of the model it is important to realise that only some elements of
the model are within the auditor’s control.

• In particular the auditor can do little about inherent risks and control risks.

• The auditor can however make detection risk as low as possible.

• The auditor will need to do less substantive testing if inherent risk or control risks are
low.

• If the system of internal control is good then control risk will be low leading to less
substantive testing.

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On the other hand the auditor might decide to take no comfort from inherent or control
factors and to base the audit opinion purely on substantive procedures including
analytical reviews.

AUDIT EVIDENCE

• Audit evidence means the information obtained by the auditor in arriving at the
conclusions on which the audit opinion is based.

• Sufficient appropriate audit evidence

• Sufficiency is a measure of quality of audit evidence and appropriateness is the measure

of quality of audit evidence.

• The auditor’s judgement as to what constitutes appropriate audit evidence is influenced

by factors such as:

 nature of the accounting and internal control systems and control risk

 materiality of the item being examined

 experience gained during previous audits source and reliability

of
information available.

• The aspects of accounting and internal control systems which the auditor would obtain
audit evidence are:
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• Design - whether the accounting and internal control systems are suitably designed to
prevent and or detect and correct material misstatements.

• Operation- whether the systems exist and have operated effectively throughout the
period.

Nature and reliability of audit evidence

• The reliability of audit evidence is influenced by it’s source and by it’s nature and is
dependent on the individual circumstances under which it was obtained.

• Audit evidence is more reliable when it is obtained from independent sources outside the
entity.

• Audit evidence that is generated internally is more reliable where the related internal
controls are effectives.

• Audit evidence obtained directly by the auditor is more reliable than audit evidence
obtained indirectly.

• Documentary audit evidence is more reliable than oral audit evidence.

Audit evidence obtained from original documents is more reliable than evidence provided
by facsimiles.

Procedures of obtaining audit evidence

• The auditor should use one or more of the following procedures in gathering audit
evidence:
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Inspection

• This consist of the examination of supporting documents, records, or tangible assets for
example the inspection of plant and machinery against the asset register.

Observation

• This consists of looking at a process or procedure being performed by others for example
the observation of a stock count.

Enquiry and confirmation

• This consists of the response to an enquiry to corroborate information contained in the

accounting records for example debtor’s circularisation.

Computation

• This consists of checking the arithmetic accuracy of documents and accounting records

or performing independent calculations for example performing a bank reconciliation.

Analytical procedures

• This consists of the analysis of ratios, trends and relationships and the investigation of
fluctuations.

• Financial information is compared with prior periods, budgets and forecasts and industry
averages.

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• Relationships are considered between elements of financial and non financial

information.

ANALYTICAL PROCEDURES

• The auditor should apply analytical procedures as risk assessment procedures to obtain
an understanding of the entity and its environment.

• Analytical procedures means evaluation of financial information made by a study of

plausible relationship among both financial and non financial data.
Analytical procedures also encompass both investigation of identified fluctuations and
relationships that are inconsistent with other relevant information or deviate
significantly from predicted amounts.

Nature and purpose of analytical procedures

• Analytical procedures include the consideration of comparison of the entity` financial

information with for example;

 Comparable information for prior periods.

 Anticipated results of the entity such as budgets of forecasts.

 similar industry information such as a comparison f the entity’s ratio of sales to

accounts receivable with industry averages or with other entities of comparable
size in the entity`s industry.

Analytical procedures also include consideration of relationships:

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• Amongst elements of financial information that will be expected to conform to a

predictable pattern based on the entity’s experience such as gross margin percentage.

• Between financial information and relevant non-financial information such as payroll

costs to number of employees.

• Analytical procedures are used for the following purposes:

 As risk assessment procedures to obtain an understanding of the entity and it’s

environment

 As substantive procedures when their use can be more efficient and effective than
tests of details in reducing the risk of material misstatements at the assertion level
to an acceptably low level.

 As an overall review of the financial statements at the end of the audit. Extent of
use

• Factors determining the extent of use of substantive procedures include:

 the closeness of relationships between the items of data.

 analytical procedures are more appropriate when relations are plausible and
predictable for example commission and sales revenue.

 the availability and reliability of financial data.

 the relevance of information available

 the comparability of the available information.

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Extent of reliance

• Factors determining the extent of reliance on substantive analytical procedures include:

 the risk that analytical procedures will fail to identify a material misstatement.
the less significant an account balance or class of transactions, the more
reliance can be placed on analytical procedures.

 a reduction in the extent of tests of detail will be justified where significant

fluctuations and inconsistencies have been corroborated.

• Income and expenditure accounts tend to be more predictable than balance sheet items.

• Non recurring accounting entries such as asset revaluations do not lend themselves to
effective analytical procedures.

• If control risk is high more reliance on tests of details for drawing conclusions may be
required.

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• Investigating unusual items

• When analytical procedures identify significant fluctuations or relationships that are

inconsistent with other relevant information or that deviate from predicted amounts, the
auditor should investigate and obtain adequate explanation and appropriate corroborative
audit evidence.

• The investigation of unusual fluctuations and relationships ordinarily begins with enquiries
of management followed by:

 comparing management’s responses with the auditor’s understanding of the entity

and other audit evidence obtained during the course of the audit.

 consideration of the need to apply procedures based on the results of such enquiries
if management is not able to provide an explanation or if the explanation is not
considered adequate.

GOING CONCERN

• The going concern concept is defined as the assumption that the enterprise will continue in
operational existence in the foreseeable future.

• This means that the income statement and balance sheet assume no intention or necessity to
liquidate or curtail significantly the scale of operations.

• If financial statements are not prepared on a going concern basis, that fact should disclosed,
together with the reasons for such a treatment.
When preparing financial statements, management must make an assessment of the
enterprise’s ability to continue as a going concern.
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• The auditor will then consider management’s assessment.

• Management should generally look ahead at least one year from the balance sheet date, in
assessing the validity of the going concern basis, but there are circumstances in which it is
appropriate to look further ahead.

• This depends on the nature of the business and the associated risks.

• In the absence of a clear note to the contrary, there is a presumption that the financial
statements have been prepared on a going concern basis.

Indicators of problems

• Events or conditions which individually or collectively may cast significant doubt about
going concern are:

(1) Financial

• Net liability or net current liability position.

• Fixed term borrowings approaching maturity without prospects of renewal or repayment.

• Excessive reliance on short term borrowings to finance long term assets.

• Indications of withdrawals of financial support by lenders.

• Net cash outflows.

• Adverse financial ratios.

• Substantial operating losses.

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• Deterioration in the value of assets used to generate cash flows.

Arrears or discontinuance of dividends.

• Inability to pay payables on due dates.

(2) Operating

• Loss of key management without replacement.

• Loss of major markets, franchise, licence or principal supplier. Labour difficulties or

shortage of important supplies.

(3) Other

• Noncompliance with capital or other statutory requirements.

• Pending legal or regulatory proceedings against the entity which if successful, result in
claims that are unlikely to be satisfied.

• Changes in legislation or government policy extended to adversely affect the entity.

The auditor’s responsibility

• In planning the audit, the auditor should consider whether there are events or conditions
which may cast significant doubt on the entity’s ability to continue as a going concern.

• The auditor should remain alert of evidence or conditions which may cast significant doubt
on the entity’s ability to continue as a going concern throughout the audit.

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• If such events or conditions are identified, the auditor should, in addition to performing the
procedures, consider whether they affect the auditor’s assessment of audit risk.

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•
The auditor should evaluate management ’s assessment of the ability to continue as a going
concern.

• The auditor does not have a responsibility to design procedures other than enquiries of
management to test for indications of problems beyond the period of at least twelve months
assessed by management.

• Additional audit procedures when events or conditions are identified

• Where events or conditions have been identified which may cast significant doubt on the
entity’s ability’s to continue as a going concern, the auditor should:

 Review management’s plans for future actions based on it’s going concern assessment.

 Gather appropriate audit evidence to confirm or dispel whether or not a material uncertainty
exists through carrying out additional or extended audit procedures considered necessary
by the auditor.

 Seeking written representations from management regarding it’s plans for future action.
Possible procedures

• Analysing anddiscussing cash flows and profitforecasts with management.

Analysing the entity’s latest available financial statements after the balance sheet date.

• Enquiring from the entity’s lawyers regarding the existence of litigation and claims and the
reasonableness of management’s assessment of their outcome and the estimate of their
financial implications.

• Audit conclusions and reporting

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On completion of the detailed audit testing the auditor must now consider whether or not
the organisation is a going concern.

• If it is considered that the organisation is not a going concern or that there is some doubt then
the auditor needs to discuss the issues with the organisation’s management to determine how
the financial statements are best prepared.

• The auditor should report going concern problems and if material the auditor may qualify
the audit report.

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U nit Six

CHAPTER 6: REPORTING OF AUDIT FINDINGS

What is the 'Auditor's Report'

The auditor's report is recorded in the annual report, the auditor's report tests to see that a
corporation's financial statements comply with GAAP. This is sometimes referred to as the clean
opinion.

An auditor's report is considered an essential tool when reporting financial information to users,
particularly in business. Since many third-party users prefer, or even require financial information
to be certified by an independent external auditor,many auditees rely on auditor reports to certify
their information in order to attract investors, obtain loans, and improve public appearance. Some
have even stated that financial information without an auditor's report is "essentially worthless"
for investing purposes.

Auditor's reports are important to users of financial statements because they inform users of the
auditor's opinion as to whether or not the statements are fairly stated or whether no conclusion can
be made with regard to the fairness of their presentation. Users especially look for any deviation
from the wording of the standard unqualified report and the reasons and implications of such
deviations. Having standard wording improves communications for the benefit of users of the
auditor’s report. When there are departures from the standard wording, users are more likely to
recognize and consider situations requiring a modification or qualification to the auditor’s report
or opinion.

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The unqualified audit report consists of:

1. Report title Auditing standards require that the report be titled and that the title includes the word
independent.

2. Audit report address The report is usually addressed to the company, its stockholders, or the
board of directors.

3. Introductory paragraph The first paragraph of the report does three things: first, it makes the
simple statement that the CPA firm has done an audit. Second, it lists the financial statements that
were audited, including the balance sheet dates andthe accounting periods for the income
statement and statement of cash flows. Third, it states that the statements are the responsibility
of management and that the auditor's responsibility is to express an opinion on the statements
based on an audit.

4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the
audit. The remainder briefly describes important aspects of an audit.

5. Opinion paragraph. The final paragraph in the standard report states the auditor's conclusions
based on the results of the audit.

6. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the audit.

7. Audit report date. The appropriate date for the report is the end of fieldwork, when the auditor
has gathered sufficient appropriate evidence to support the opinion.

The information in the scope paragraph includes:

1. The auditor followed generally accepted auditing standards.

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2. The audit is designed to obtain reasonable assurance about whether the statements are free of
material misstatement.

3. Discussion of the audit evidence accumulated.

4. Statement that the auditor believes the evidence accumulated was appropriate for the
circumstances to express the opinion presented.

The purpose of the opinion paragraph is to state the auditor's conclusions based upon
the results of the audit evidence. The most important information in the opinion
paragraph includes:

1. The words "in our opinion" which indicate that the conclusions are based on professional
judgment.

2. A restatement of the financial statements that have been audited and the dates thereof or a
reference to the introductory paragraph.

3. A statement about whether the financial statements were presented fairly and in accordance with
generally accepted accounting principles.

An unqualified report may be issued under the following five circumstances:

1. All statements—balance sheet, income statement, statement of retained earnings, and statement
of cash flows—are included in the financial statements.

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2. The three general standards have been followed in all respects on the engagement.

3. Sufficient evidence has been accumulated and the auditor has conducted the engagement in a
manner that enables him or her to conclude that the three standards of field work have been met.

4. The financial statements are presented in accordance with generally accepted accounting
principles. This also means that adequate disclosures have been included in the footnotes and
other parts of the financial statements.

5. There are no circumstances requiring the addition of an explanatory paragraph or modification of

the wording of the report.

The introductory, scope and opinion paragraphs are modified to include reference to
management’s report on internal control over financial reporting, and the scope of the auditor’s
work and opinion on internal control over financial reporting. The introductory and opinion
paragraphs also refer to the framework used to evaluate internal control.Two additional
paragraphs are added between the scope and opinion paragraphs that define internal control and
describe the inherent limitations of internal control.

When adherence to generally accepted accounting principles would result in misleading financial
statements there should be a complete explanation in a separate paragraph. The separate
paragraph should fully explain the departure and the reason why generally accepted accounting
principles would have resulted in misleading statements. The opinion should be unqualified, but
it should refer to the separate paragraph during the portion of the opinion in which generally
accepted accounting principles are mentioned.

An unqualified report with an explanatory paragraph or modified wording isthe same as a standard
unqualified report except that the auditor believes it is necessary to provide additional information

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about the audit or the financial statements. For a qualified report, either there is a scope limitation
(condition 1) or a failure to follow generally accepted accounting principles (condition 2). Under
either condition, the auditor concludes that the overall financial statements are fairly presented.

Two examples of an unqualified report with an explanatory paragraph or modified

wording are:

1. The entity changed from one generally accepted accounting principle to another generally
accepted accounting principle.

2. A shared report involving the use of other auditors.

When another CPA has performed part of the audit, the primary auditor issues one of the following
types of reports based on the circumstances.

1. No reference is made to the other auditor.This will occur if the other auditor audited an
immaterial portion of the statement, the other auditor is known or closely supervised, or if the
principal auditor has thoroughly reviewed the other auditor's work.

2. Issue a shared opinion in which reference is made to the other auditor.This type of report
is issued when it is impractical to review the work of the other auditor or when a portion of the
financial statements audited by the other CPA is material in relation to the total.

3. The report may be qualified if the principal auditor is not willing to assume any
responsibility for the work of the other auditor.A disclaimer may be issued if the segment audited
by the other CPA is highly material.

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Even though the prior year statements have been restated to enhance comparability, a separate
explanatory paragraph is required to explain the change in generally accepted accounting
principles in the first year in which the change took place.

Changes that affect the consistency of the financial statements may involve any of the
following:

a. Change in accounting principle

b. Change in reporting entity

c. Corrections of errors involving accounting principles.

An example of a change that affects consistency would be a change in the method of computing
depreciation from straight line to an accelerated method. A separate explanatory paragraph is
required if the amounts are material. Comparability refers to items such as changes in estimates,
presentation, and events rather than changes in accounting principles. For example, a change in
the estimated life of a depreciable asset will affect the comparability of the statements. In that
case, no explanatory paragraph for lack of consistency is needed, but the information may require
disclosure in the statements.

The three conditions requiring a departure from an unqualified opinion are:

1. The scope of the audit has been restricted. One example is when the client will not permit the
auditor to confirm material receivables. Another example is when the engagement is not agreed

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upon until after the client's year-end when it may be impossible to physically observe
inventories.

2. The financial statements have not been prepared in accordance with generally accepted
accounting principles. An example is when the client insists upon using replacement costs for
fixed assets.

3. The auditor is not independent. An example is when the auditor owns stock in the client's
business.

A qualified opinion states that there has been either a limitation on the scope of the audit or a
departure from GAAP in the financial statements, but that the auditor believes that the overall
financial statements are fairly presented. This type of opinion may not be used if the auditor believes
the exceptions being reported upon are extremely material, in which case a disclaimer or adverse
opinion would be used. An adverse opinion states that the auditor believes the overall financial
statements are so materially misstated or misleading that they do not present fairly in accordance
with GAAP the financial position, results of operations, or cash flows.

A disclaimer of opinion states that the auditor has been unable to satisfy him or herself as
to whether or not the overall financial statements are fairly presented because of a significant
limitation of the scope of the audit, or a no independent relationship under the Code of
Professional Conduct between the auditor and the client.

Examples of situations that are appropriate for each type of opinion are as follows:

Disclaimer

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Material physical inventories not observed and the inventory cannot be verified through other
procedures.

Lack of independence by the auditor.

Adverse

A highly material departure from GAAP.

Qualified

Inability to confirm the existence of an asset which is material but not extremely material in value.

The common definition of materiality as it applies to accounting and, therefore, to audit reporting
is:

A misstatement in the financial statements can be considered material if knowledge of the

misstatement would affect a decision of a reasonable user of the statements.

Conditions that affect the auditor's determination of materiality include:

• Potential users of the financial statements

• Dollaramounts of the following items: net income before taxes,total assets, current assets,
current liabilities, and owners' equity

Nature of the potential misstatements—certain misstatements, such as fraud, are likely to be more
important to users of the financial statements than other misstatements.

Materiality for lack of independence in audit reporting is easiest to define. If the auditor lacks
independence as defined by the Code of Professional Conduct, it is always considered highly
material and therefore a disclaimer of opinion is always necessary. That is, either the CPA is

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independent or not independent. For failure to follow GAAP, there are three levels of materiality:
immaterial, material, and highly material.

The auditor's opinion may be qualified by scope limitations caused by client restrictions or by
limitations resulting from conditions beyond the client's control.The former occurs when the
client will not, for example, permit the auditor to confirm material receivables or physically
observe inventories. The latter may occur when the engagement is not agreed upon until after
the client's year-end when it may not be possible to physically observe inventories or confirm
receivables.

A disclaimer of opinion is issued if the scope limitation is so material that the auditor cannot
determine if the overall financial statements are fairly presented. If the scope limitation is caused
by the client's restriction the auditor should be aware that the reason for the restriction might be
to deceive the auditor.For this reason, a disclaimer is more likely for client restrictions than for
conditions beyond anyone's control.

When there is a scope restriction that results in the failure to verify material, but not pervasive
accounts, a qualified opinion may be issued. This is more likely when the scope limitation is
for conditions beyond the client's control than for restrictions by the client.

A report with a scope and an opinion qualification is issued when the auditor can neither perform
procedures that he or she considers necessary nor satisfy him or herself by using alternative
procedures, usually due to the existence of conditions beyond the client's or the auditor's control,
but the amount involved in the financial statements is not highly material. An important part of a
scope and opinion qualification is that it results from not accumulating sufficient audit evidence,

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either because of the client's request or because of circumstances beyond anyone's control. A
report qualified as to opinion only results when the auditor has accumulated sufficient appropriate
evidence but has concluded that the financial statements are not correctly stated. The only
circumstance in which an opinion only qualification is appropriate is for material, but not highly
material, departures from GAAP.

The three alternative opinions that may be appropriate when the client's financial statements are
not in accordance with GAAP are an unqualified opinion, qualified as to opinion only and adverse
opinion. Determining which is appropriate depends entirely upon materiality. An unqualified
opinion is appropriate if the GAAP departure is immaterial (standard unqualified) or if the auditor
agrees with the client's departure from GAAP (unqualified with explanatory paragraph). A
qualified opinion is appropriate when the deviation from GAAP is material but not highly material;
the adverse opinion is appropriate when the deviation is highly material.

The AICPA has such strict requirements on audit opinions when the auditor is not independent
because it is important that stockholders and other third parties be absolutely assured that the
auditor is unbiased throughout the entire engagement. If users develop the attitude that auditors
are not independent of management, the value of the audit function will be greatly reduced, if not
eliminated.

When the auditor discovers more than one condition that requires a departure from or a modification
of a standard unqualified report, the report should be modified for each condition.

An exception is when one condition neutralizes the other condition. An example would be when
the auditor is not independent and there is also a scope limitation. In this situation the lack of
independence overshadows the scope limitation. Accordingly, the scope limitation should not be
mentioned.

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Under current auditing standards, auditors are not required to read information contained in
electronic sites, such as the company’s Web site, that also contain the company’s audited financial
statements and the auditor’s report. Auditing standards do not consider electronic sites to be
“documents.” This is different from the auditor’s responsibility for published (hard copy)
documents that contain information in addition to audited financial statements and the auditor’s
report. In this latter example, the auditor is responsible for reading other information that is
published with audited financial statements and the auditor’s report to determine whether it is
materially inconsistent with information in the audited financial statements.

THE NEW AUDITOR'S REPORT

The International Auditing and Assurance Standards Board (IAASB) finalised its project on
auditor reporting in 2015, which resulted in a set of new and revised standards on auditor reporting
as well as revised versions of ISA, 570 Going Concern and a number of other International
Standards on Auditing (ISAs).

Candidates attempting RSM 102 are required to have a sound understanding of auditor’s reports
and are reminded that the new standards issued by the IAASB as a result of this project are
examinable. Candidates are also strongly advised to ensure that they have an up-to-date text to
study from because the changes to the auditor’s report are significant.

The important matter is primarily on: the requirements of the new ISA 701, Communicating Key
Audit Matters in the Independent Auditor’s Report; how ISA 701 interacts with the other
reporting standards (ISA 705 and 706); and the new reporting requirements in ISA 570
(Revised), Going Concern.

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Candidates often find auditor’s reports a challenging part of the syllabus and in preparation
for exams , it is imperative that candidates can:

 describe the different elements of the auditor’s report;

 determine the most appropriate type of audit opinion in a given scenario, often through an
explanation of why a certain opinion is appropriate which will test the application of the
candidate’s knowledge

 understand the issues that may arise during the course of an audit that could require an

Emphasis of Matter or Other Matter paragraph to be included in the audit report, and
identify Key Audit Matters (KAM) that are required to be disclosed in an auditor’s report.

Candidates will not be expected to draft an auditor’s report in RSM 102, but may be asked to
present reasons for an unmodified or a modified opinion, or the inclusion of an Emphasis of
Matter paragraph.

Candidates may also be presented with extracts from an auditor’s report and be asked to
critically appraise the extracts, or challenge the proposed audit opinion. Candidates are
therefore reminded to ensure they have a sound understanding of the relevant Syllabus and
Study Guide and ensure the revision phase in the lead-up to the examination includes plenty of
examstandard question practise, particularly if this is an area of the syllabus which a candidate
finds challenging.

KEY AUDIT MATTERS (KAM)

In January 2015 the IAASB issued ISA 701, Communicating Key Audit Matters in the

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Independent Auditor’s Report. This standard is required to be applied to the audit of all listed
entities. The objectives of ISA 701 are for the auditor to:

determine those matters which are to be regarded as KAM; and communicate those matters
in the auditor’s report.

The term ‘key audit matters’ is defined in ISA 701 as:

‘Those matters that, in the auditor’s professional judgment, were of most significance in the audit
of the financial statements of the current period. Key audit matters are selected from matters
communicated with those charged with governance.’

DETERMINATION OF KAM

The definition in paragraph 8 of ISA 701 states that KAM are selected from matters which are
communicated with those charged with governance. Matters which are discussed with those
charged with governance are then evaluated by the auditor who then determines those matters
which required significant auditor attention during the course of the audit. There are three matters
which the ISA requires the auditor to take into account when making this determination:

Areas which were considered to be susceptible to higher risks of material misstatement or which
were deemed to be ‘significant risks’ in accordance with ISA 315 (Revised), Identifying and
Assessing the Risks of Material Misstatement through Understanding the Entity and Its
Environment.

Significant auditor judgments in relation to areas of the financial statements that involved
significant management judgment. This might include accounting estimates which have been
identified by the auditor as having a high degree of estimation uncertainty.

The effecton the audit of significant events or transactions that have taken place during the period.

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The auditor must determine which matters are of most significance in the audit of the financial
statements and these will be regarded as KAM.

COMMUNICATING KAM

Once the auditor has determined which matters will be included as KAM, the auditor must ensure
that each matter is appropriately described in the auditor’s report including a description of:

Why the matter was determined to be one of most significance and therefore a key audit matter, and

How the matter was addressed in the audit (which may include a description of the auditor’s
approach, a brief overview of procedures performed with an indication of their outcome and any
other key observations in respect of the matter).

REPORTING IN LINE WITH ISA 570, GOING CONCERN

Exam questions might ask the candidate to recognise indicators that an entity may not be a going
concern, or require candidates to arrive at an appropriate audit opinion depending on the
circumstances presented in the scenario. It may be the case that candidates are presented with a
situation where the auditor has concluded that there are material uncertainties relating to going
concern and the directors have made appropriate disclosures in relation to going concern and
candidates must understand the new auditor reporting requirements in this respect.

The auditor’s work in relation to going concern has been enhanced in ISA 570 (Revised), Going
Concern and the revised ISA includes additional guidance relating to the appropriateness of
disclosures when a material uncertainty exists. Under the previous version of ISA 570, if the
auditor concluded that the going concern basis of accounting is appropriate, but a material

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uncertainty exists and this material uncertainty had been adequately disclosed in the financial
statements, the auditor would include an Emphasis of Matter paragraph immediately after the
Opinion paragraph which would be cross-referenced to the relevant disclosure note in the
financial statements. The auditor would also emphasise that their opinion is not modified in
respect of the material uncertainty. This requirement has changed in the revised ISA 570 and the
use of an Emphasis of Matter paragraph is no longer appropriate.

Under ISA 570 (Revised), if the use of the going concern basis of accounting is appropriate but a
material uncertainty exists and management have included adequate disclosures relating to the
material uncertainties the auditor will continue to express an unmodified opinion, but the auditor
must include a separate section under the heading ‘Material Uncertainty Related to Going
Concern’ and: draw attention to the note in the financial statements that discloses the matters
giving rise to the material uncertainty, and state that these events or conditions indicate that a
material uncertainty exists which may cast significant doubt on the entity’s ability to continue as
a going concern and that the auditor’s opinion is not modified in respect of the matter.

The section headed ‘Material Uncertainty Related to Going Concern’ is included immediately
after the Basis for Opinion paragraph but before the KAM section.It should be noted that where
the uncertainty is not adequately disclosed in the financial statements the auditor would
continue to modify the opinion in line with ISA 705, Modifications to the Opinion in the
Independent Auditor’s Report.

Over and above the new reporting requirements under ISA 570, candidates need to understand how
issues identified regarding going concern interact with the requirements of ISA 701. By their very
nature, issues identified relating to going concern are likely to be considered a key audit matter
and hence need to be communicated in the auditor’s report. Where the auditor has identified

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conditions which cast doubt over going concern, but audit evidence confirms that no material
uncertainty exists, this ‘close call’ can be disclosed in line with ISA 701. This is because while
the auditor may conclude that no material uncertainty exists, they may determine that one, or
more,matters relating to this conclusion are key audit matters. Examples include substantial
operating losses, available borrowing facilities and possible debt refinancing, or non-compliance
with loan agreements and related mitigating factors.

In summary if a confirmed material uncertainty exists it must be disclosed in accordance with

ISA 570 and where there is a ‘close call’ over going concern which has been determined by the
auditor to be a KAM it will be disclosed in line with ISA 701. This is illustrated in the following
example:

Example – unmodified audit opinion but material uncertainty exists in relation to going concern and
the disclosures are adequate

Report on the Audit of the Financial Statements (extract)

Opinion

In our opinion, the accompanying financial statements present fairly, in all material respects, the
financial position of the Company as at 31 December 2015, and its financial performance and its
cash flows for the year then ended in accordance with International Financial Reporting Standards
(IFRSs).

Basis for opinion

We conducted our audit in accordance with International Standards on Auditing (ISAs). Our

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responsibilities under those standards are further described in the Auditor’s Responsibilities for
the Audit of the Financial Statements section of our report. We are independent of the Company
in accordance with the ethical requirements that are relevant to our audit of the financial statements
in Farland, and we have fulfilled our other ethical responsibilities in accordance with these
requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our opinion.

Material uncertainty related to going concern

We draw attention to Note 6 in the financial statements, which indicates that the Company incurred
a net loss of $125,000 during the year ended 31 December 2015 and, as of that date,
the Company’s current liabilities exceeded its total assets by $106,000. As stated in Note 6, these
events or conditions, along with other matters as set forth in Note 6, indicate that a material
uncertainty exists that may cast significant doubt on the Company’s ability to continue as a going
concern. Our opinion is not modified in respect of this matter.

Key audit matters

Key audit matters are those matters that, in our professional judgment, were of most significance
in our audit of the financial statements of the current period. These matters were addressed in the
context of our audit of the financial statements as a whole, and in forming our opinion thereon,
and we do not provide a separate opinion on these matters. In addition to the matter described in
the Material Uncertainty Related to Going Concern section,we have determined the matters
described below to be the key audit matters to be communicated in our report.

[Include a description of each key audit matter]

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APPLICATION OF ISA 701 WHEN A QUALIFIED OR ADVERSE OPINION IS ISSUED

ISA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report outlines the
requirements when the auditor concludes that the audit opinion should be modified. ISA 705
(Revised) requires that the auditor includes a Basis for Qualified/Adverse Opinion section in the
auditor’s report. When the auditor expresses a qualified or adverse opinion, the requirement to
communicate other KAM is still relevant and hence will still apply.

When the auditor issues an adverse opinion it means that the financial statements do not give a
true and fair view (or present fairly) because the auditor has concluded that misstatements,
individually and in aggregate, are both material and pervasive to the financial statements.

Depending on the significance of the matter(s) which has resulted in the auditor expressing an
adverse audit opinion, the auditor might determine that no other matters are KAM. In this situation,
the auditor will deal with the matter(s) in accordance with applicable ISAs and include a reference

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to the Basis for Qualified/Adverse Opinion or the Material Uncertainty Related to Going Concern
section(s) in the KAM section of the report as illustrated below.

Example – Qualified ‘except for’ opinion issued but no key audit matters
The audit of Turquoise Industries Co has been completed and the auditor discovered a material
amount of research expenditure which had been capitalised as an intangible asset in
contravention of IAS 38 Intangible Assets. The finance director refused to derecognise the
research expenditure as an intangible asset and include it in profit or loss and the auditor
therefore issued a qualified ‘except for’ opinion on the basis of disagreement with the entity’s
accounting treatment for research expenditure.

The auditor has concluded that there are no KAM which require to be communicated in the audit
report. The KAM section of the report will therefore be as follows:

Key audit matters

Except for the matter described in the Basis for Qualified Opinion section,we have determined that
there are no key audit matters to communicate in our report.

When the auditor has expressed an adverse opinion on the financial statements and
communicates KAM, it is important that the descriptions of such KAM do not imply that the
financial statements as a whole are more credible in light of the adverse opinion.

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DISCLAIMER OF OPINION ISSUED

A disclaimer of opinion is issued when the auditor is unable to form an opinion on the financial
statements. ISA 705 states that when the auditor expresses a disclaimer of opinion then the
auditor’s report should not include a KAM section.

EMPHASIS OF MATTER AND OTHER MATTER PARAGRAPHS

Emphasis of Matter and Other Matter paragraphs are still retained in ISA 706 (Revised),
Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report
and the concepts involved have not been overridden by the new ISA 701 requirements. The
IAASB have noted that in some cases, matters which the auditor considers to be KAM will relate
to issues that are presented and/or disclosed in the financial statements. Therefore,
communicating these as KAM under ISA 701 will serve as the most useful and meaningful
mechanism for highlighting the importance of the matter.

Candidates should appreciate that when the auditor communicates matters as KAM, the intention
is to provide additional information beyond that which would be included in an Emphasis of
Matter paragraph. In recognition of this ISA 706 (Revised) states:

The auditor is prohibited from using an Emphasis of Matter paragraph or an Other Matter
paragraph when the matter has been determined to be a KAM. To that end, the IAASB has
emphasised that the use of an Emphasis of Matter paragraph is not a substitute for a description of
individual KAM.

If a KAM is also determined to be fundamental to users’ understanding, the auditor may present
this issue more prominently in the KAM section.Alternatively, the auditor might also include
additional information in the KAM description to indicate the importance of the matter.

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There may be a matter which is not determined to be a KAM, but which, in the auditor’s
judgement is fundamental to users’ understanding and for which an Emphasis of Matter
paragraph may be considered necessary.

IMPAIRMENT TESTING ON GOODWILL

IFRS 3, Business Combinations requires goodwill to be tested for impairment at each reporting
date and the annual impairment test may be regarded as a KAM where the carrying amount of
goodwill is material. Impairment tests are inherently complex and judgmental and therefore
management’s assessment process may also be a KAM.

EFFECTS OF NEW IFRSS

New accounting standards may be introduced by the International Accounting Standards Board
(such as IFRS 15, Revenue from Contracts with Customers) that will involve a material change
of accounting treatment. For example, IFRS 15 requires the application of a new framework in
respect of revenue recognition, and hence the implementation of IFRS 15 may give rise to the
new accounting requirements becoming a KAM as they will impact on the reporting entity’s
financial position and performance.

VALUATION OF FINANCIAL INSTRUMENTS, AND OTHER ASSETS AND

LIABILITIES AT
FAIR VALUE Significant measurement uncertainties in some financial instruments (for example
those for which quoted prices are not available) may give rise to the valuation of financial
instruments becoming a KAM because such valuations would invariably rely on entitydeveloped
models. This can also apply to other assets and liabilities, particularly those measured using fair
value techniques which can be complex and subjective.

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Please note that the examples above are included for illustrative purposes and do not form an
exhaustive list of all issues that could be identified as KAM.

AUDIT ENGAGEMENT LETTERS

• Purposes of an engagement letter.

• An engagement letter documents and confirms the auditor’s acceptance of engagement,

objectives and scope of the audit, the extent of the responsibility of the client and the form
of any audit reports.

• The engagement letter avoids misunderstanding between the auditor and the client with
respect to the engagement.

• An engagement letter normally contains the following matters:

 Objective of the audit of financial statements and managements’ responsibility for the
preparation of financial statements.

 Managements’ responsibility for the preparation of financial statements.

 Basis on which fees are computed and other billing arrangements. Provision of accounting
and other services such as taxation.

Example of an engagement letter

Deloitte & Touche

Kenilworth Gardens

1 Kenilworth Road

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Highlands

Harare

Zimbabwe

To the directors Old Mutual Limited

The purpose of this letter is to set out the basis on which we are to act as auditors of the company
and its subsidiaries and the respective areas of responsibility of the directors and of ourselves.

Responsibility of directors and auditors.

1. As directors of the above company, you are responsible for ensuring that the company
maintains proper accounting records and for preparing financial statements which give a true
and fair view and have been prepared in accordance with the Companies Act. You are also
responsible for making available to us as and when required, all the company’s accounting
records and all other relevant records and related information, including minutes of all
management and shareholder’s meetings.

2. We have a statutory responsibility to report to the members whether in our opinion the
financial statements give a true and fair view of the state of the company’s affairs and of the
profit or loss for the year and whether they have been properly prepared in accordance with the
Companies Act. In arriving at our opinion we are required to consider the following matters,
and report on any in respect of which we are not satisfied:

(a) whether proper accounting records have been kept by the company and proper returns adequate
for our audit have been received from branches not visited by us;

(b) whether the company`s balance sheet and income statement are in agreement with the
accounting records;

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(c) whether we have obtained all the information and explanations which we think necessary for
the purposes of our audit; and

(d) whether the information in the director’s report is consistent with the financial statements.

In addition, there are certain other matters which, according to circumstances, may need to be
dealt with in our report.

Where the financial statements do not give full details of the directors’ remuneration or of their
transactions with the company the Companies Act requires us to disclose such matters in our
report.

We have a professional responsibility to report if the financial statements do not comply in any
material respect with International Accounting Standards, unless in our opinion the
noncompliance is justified in the circumstances.

Our audit will be conducted in accordance with International Standards issued by the Auditing
Practices Board, and will include such tests of transactions and of the existence, ownership and
valuation of assets and liabilities as we consider necessary. We shall obtain an understanding of
the accounting and internal control systems in order to assess their adequacy as a basis for the
preparation of the financial statements and to establish whether proper accounting records have
been maintained by the company. We shall expect to obtain such appropriate evidence as we
consider sufficient to enable us to draw reasonable conclusions there from.

The nature and extent of our procedures will vary according to our assessment of the company’s
system and, where we wish to replace reliance on it, the internal control system, and may cover
any aspect of the business’s operations. Our audit is not designed to identify all significant
weaknesses in the company’s systems but, if such weaknesses come to our notice during the course
of our audit which we think should be brought to your attention, we shall report them to you. Any
such report may not be provided to third parties without our prior consent. Such consent will be
granted only on the basis that such reports are not prepared with the interest with the interests of

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anyone other than the company in mind and that we accept no duty or responsibility to any other
party as concerns the report.

As part of our normal audit procedures, we may request you to provide written confirmation of
oral representations which we have received from you during the course of the audit on matters
having a material effect on financial statements.

In order to assist us with the examination of your financial statements, we shall request sight of
all documents or statements, including the chairman’s statement and directors` report which are
due to be issued with the financial statements. We are also entitled to attend all general meetings
of the company and to receive notices of all such meetings.

The responsibility for safeguarding the assets of the company and for the prevention of fraud, error
and non-compliance with laws rests with yourselves.

However, we shall endeavour to plan our audit so that we have a reasonable expectation of
detecting material misstatements in the financial statements or accounting records, but our
examination should not be relied upon to disclose all such material misstatements or frauds.

Where appropriate we shall not be treated as having notice, for the purposes of our audit
responsibilities, of information provided to members of our firm other than those engaged on
the audit.

Once we have issued our report we have no further direct responsibility in relation to the
financial statements for that financial year. However, we expect that you inform us of any
material event occurring between the date of our report and of the Annual General Meeting
which may affect the financial statements.

Other services

You have requested that we provide other services in respect of taxation.

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The terms under which we provide these other services are dealt with in a separate letter. We will
also agree in a separate letter of engagement the provision of other services.

Fees
Our fees are computed on the basis of the time spent on your affairs by the partners and our staff
and on the level of skill and responsibility involved.

Unless otherwise agreed, our fees will be billed at appropriate intervals during the course of the
year and will be due on presentation.

Applicable law

This engagement letter shall be governed and construed in accordance with Roman Dutch law
.The Courts of Zimbabwe shall have exclusive jurisdiction relating to any claim, dispute or
difference concerning the engagement and any matter arising from it Each party irrevocably
waives any right it may have to object to an action brought in those Courts, to claim that the
action has been brought in an inconvenient forum, or to claim that those Courts do not have
jurisdiction.

Once it has been agreed, this letter will remain effective, from one audit appointment to another,
until it is replaced.

We shall be grateful if you could confirm in writing your agreement to these terms by signing
and returning the enclosed copy of this letter, or let us know if they are not in accordance with
your understanding of our terms of engagement.

Yours faithfully

Deloitte and Touche

Recurring audits

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• An auditor may decide not to send a new engagement letter each year.

• However, the auditor may decide to send a new engagement letter where there is:

 (i) any indication that the client misunderstands the scope and objective of the audit.

 (ii) any revised or special terms of the engagement

 (iii) a recent change of management

 (iv) any significant change in the nature and size of the client`s business.

 (v) legal requirements.

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7
COMPANY LAW REQUIREMENTS

4 (a) The statutory duties of an auditor are set out in ss.153 and 154 Companies Act (Chapter
24:03). These include the duty:

(i) to make a report to members on the accounts examined by them;

(ii)to state in their report that the accounts of the company and the group accounts are properly
drawn up in accordance with the Companies Act so as to give a true and fair view of the
company’s affairs;
(iii) to include in their report statements which in their opinion are necessary if they have not
obtained all the information and explanations which to the best of their knowledge were
necessary for the purpose of their audit;

(iv) to attend any general meeting of the company. To this end an auditor is entitled to receive
notices of company meetings.

The common law duties of an auditor include the duty:

(i) to act honestly and with reasonable skill, diligence, care and caution. In re Kingston Cotton Mill
Company (1896) the court made the following observation:

‘it is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution
which a reasonably competent, careful and cautious auditor would use ...’

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(ii) to show the company’s true financial position as shown by the books, Tokwane Sawmill
Company Ltd v Filmalter (1975);

(iii) to make sure that the amount of stock stated to exist is a reasonably probable figure but the
auditor has no duty to take stock unless there are suspicious circumstances;

(iv) to act as a watchdog but not a bloodhound.

In re Kingston Cotton Mills (1896), the court made the observation that an auditor is not bound to
be a detective or to approach his work with suspicion or with a foregone conclusion that there is
something wrong.

Lord Denning’s remarks (Fomento v Selsdon Fountain and Others (1958)) are equally instructive.
He remarked that an auditor is not to be confined to the mechanics of checking vouchers and
making arithmetical computations. His vital task is to take care to see that errors are not made, be
they errors of computation or errors of omission or commission of downright untruths. To perform
this task properly, he must come to it with an enquiring mind – not suspicious of dishonesty – but
suspecting that someone may have made a mistake somewhere and that a check must be made to
ensure that there has been none.

(b) (i) The Companies Act [Chapter 24:03] deals with the appointment of an auditor by two
types of companies: a public company and other types of companies, for example, private
companies.

With respect to public companies, s.150(i)decrees that the first auditor(s) shall be appointed by the
directors within one month of the issue of the certificate to commence business. In the case of
other companies (e.g. private), the appointment of the auditor(s) shall be made within one month
of the certificate of incorporation being issued. In either case, an auditor so appointed shall hold
office until the conclusion of the first annual general meeting. If the directorsfail to appoint the

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first auditor(s), the company in general meeting may effect the appointment and if neither the
board of directors nor the company appoints the auditor(s), the Minister of Justice, on the
application of a member of the company, may do so.

Section 150(2) says that every company shall at each annual general meeting appoint an auditor
to hold office from the conclusion of that meeting until the conclusion of the next annual general
meeting. Special notice shall be required for a resolution at a company’s annual general meeting
appointing as auditor a person other than a retiring auditor or providing expressly that a retiring
auditor shall not be reappointed (s.151).

In certain circumstances a private company need not appoint an auditor. Such situations
include the following, if:

(a) the number of members in such company does not exceed ten;

(b) such company is not a subsidiary of a holding company which has itself appointed auditors; and
(c) all the members in such company agree that an auditor shall not be appointed.
(ii) Eligibility for appointment as auditors is governed by s.152 Companies Act (Chapter 24:03).

The sole purpose behind the legislation is to ensure that only persons who are properly supervised
and appropriately qualified are appointed company auditors and that audits by a person so
appointed are carried out properly, with integrity and with a proper degree of independence.

In short, auditors must be recognised as qualified by the institutes regulating the accountancy
profession and be registered auditors. The Companies Act [Chapter 24:03] does not specifically
deal with the qualifications of auditors but it does disqualify certain persons from being appointed
as auditors of a company. So as to ensure their independence, auditors must have no connection
with the company and not be an officer or employee of it.

By and large all disqualified persons are those whose objectivity or independence in auditing
the accounts of a company may be affected by their association in one way or another with the
company. These are:

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(a) an officer or servant of the company;

(b) a person who is a partner of an officer or servant of the company;

(c) a person who is an employer or an employee of an officer or servant of the company; (d) a body
corporate;
(e) a person who is an officer or servant of a body corporate which is an officer of the company;

(f) a person who by themselves or their partner or their employee regularly performs the duties of
secretary or bookkeeper to the company.

The companies act chapter 23:04 subsection 150 has the following provisions

150Appointment and remuneration of auditors

(1) The first auditor of a company shall be appointed by the directors within one month of the
issue of the certificate that the company is entitled to commence business in the case of a company
to which section one hundred and fourteen applies and, in the case of other companies, within one
month of the issue of the certificate of incorporation; and an auditor so appointed shall hold office
until the conclusion of the first annual general meeting:

Provided that—

(i) the company may at a general meeting remove any such auditor and appoint in his place any
other person who has by special notice been nominated for appointment by any member of the
company and of whose nomination notice has been given to the members of the company not less
than fourteen days before the date of the meeting;

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(ii) if the directors fail to exercise their powers under this subsection the company in general
meeting may appoint the first auditor and thereupon the said powers of the directors shall cease;

(iii) if neither the directors nor the company appoint an auditor under this subsection the Minister
may on the application of any member do so.

(2) Every company shall, at each annual general meeting, appoint an auditor to hold office from
the conclusion of that until the conclusion of the next annual general meeting.

(3) Where at an annual general meeting no auditor is appointed or reappointed, the Minister may
appoint a person to fill the vacancy.

(4) The company shall, within one week of the Minister’s power under subsection (3) becoming
exercisable, give him notice of that fact and, if a company fails to give notice as required by this
subsection, the company and every officer of the company who is in default shall be guilty of an
offence and liable to a fine not exceeding level two.

(5) The directors may fill any casual vacancy in the office of auditor but while any such vacancy
continues the surviving or continuing auditor,if any, may act.

(6) The remuneration of the auditor of a company shall be fixed by the company in general
meeting or in such manner as the company in general meeting may determine.

For the purposes of this subsection, any sums paid by the company in respect of the auditor’s
expenses shall be deemed to be included in the expression “remuneration”.
(7) A private company shall not be required to appoint an auditor if— (a) the number of members
in such company does not exceed ten; and

(b) none of the members of such company is—

(i) a public company, whether incorporated under this Act or the law of a foreign country; or

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(ii)a private company which is a subsidiary, as determined in terms of section one hundred and
fortythree, of a public company referred to in subparagraph (i); and

(c) such company is not a subsidiary of a holding company which has itself appointed auditors; and

(d) all the members in such company agree that an auditor shall not be appointed.

[Section as amended by Act No. 22 of 2001]

151 Special notice required of resolution to appoint or remove auditor

Special notice shall be required for a resolution at a company’s annual general meeting appointing
as auditor a person other than a retiring auditor or providing expressly that a retiring auditor shall
not be reappointed.

152 Disqualifications for appointment as auditor

(1) None of the following persons shall be qualified for appointment as auditors of a company—

(a) an officer or servant of the company;

(b) a person who is a partner of an officer or servant of the company;

(c) a person who is an employer or an employee of an officer or servant of the company; (d) a body
corporate;
(e) a person who is an officer or servant of a body corporate which is an officer of the company;

(f) a person who by himself, or his partner or his employee, regularly performs the duties of
secretary or bookkeeper to the company.

Reference in this subsection to an officer or servant shall be construed as not including reference to
an auditor.

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(2) A person shall also not be qualified for appointment as auditor of a company if he is, by virtue
of subsection

(1), disqualified for appointment as auditor of any other body corporate which is that company’s
subsidiary or holding company, or a subsidiary of that company’s holding company, or would be
so disqualified if the body corporate were a company.
(3) Any person who acts as auditor of a company when disqualified as aforesaid shall be guilty
of an offence and liable to a fine not exceeding level five.

7 (a) The Companies Act [Chapter 24:03] says that winding up can either be voluntary or
compulsory. Section 206 specifies the circumstances under which a company may be wound up
by the court (compulsory winding up). The relevant circumstances are as follows:

(i) If the company has by special resolution resolved that the company be wound up by the court.

(ii) If default is made in lodging the statutory report or in holding the statutory meeting. Since s.124
Companies Act exempts

private companies from holding statutory meeting for all intents and purposes, this provision only
affects public companies.

(iii) If the company does not commence its business within a year from its incorporation or suspends
its business for a whole year.

An instructive case which exemplifies this section isNakhooda v Northern Industries Ltd (1950).
A company had been incorporated in 1946. Its objectives were to establish a modern mineral
water factory and a large dry cleaning business.

By 1949 it had not done either and the court granted a winding up petition on the basis that the
company had not ‘commenced business’.

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(iv) If the company ceases to have any members – since the minimum membership of a company is
one person, if that person dies and his shares are not transferred to his heirs, the company ceases
to have members.

(v) If 75% of the paid-up share capital of the company has been lost or has become useless for the
business of the company. This basically means that in that event, the company cannot justify its
existence to have members.

(vi) If the company is unable to pay its debts.

This is probably the most common ground upon which compulsory winding up is granted in
Zimbabwe. Section 205

Companies Act defines the concept of ‘inability to pay debts’ and the requirements are very easy
to satisfy. A creditor who sends a demand involving a sum of at least a hundred dollars and that
sum remains unpaid for three weeks or more in circumstances in which the company has no
lawful or reasonable defence will have proved his case.
(vii) If the court is of the opinion that it is just and equitable for the company to be wound up.

This is the second most important ground upon which the compulsory winding up of companies is
based in Zimbabwe.

The ground covers a very wide range of situations and a comprehensive analysis of the ‘just
and equitable’ principle was done by the court in the well-known English case of Ebrahim v
Westbourne Galleries (1972).

Some of the situations which fall into the ‘just and equitable’ network among others, include (the
list is not exhaustive):

(1) the disappearance of the substratum

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Rhenosterkop Copper Company (1933) in which the substratum of a company, which was formed
to mine copper, was held to have disappeared when it was found that the ground which it was to
mine contained no copper.

(2) deadlock or paralysis in the management of the company. Re Yenidge Tobacco Company
(1916).

(3) Oppression of minorities in which the conduct of the majority is unlawful, harsh, burdensome
and unfair.

(4) Lack of probity in the company’s affairs

In Woolmack v Commercial Vehicle Spares (Pvt) Ltd (1968), where the minority shareholder
complained that the majority shareholder and director had perpetrated a fraud on him by falsifying
the minutes, illegally issuing shares and illegally declaring and paying dividends and that this
constituted dishonesty in the conduct of the company’s affairs.

In summation it can be said that the reasons which justify compulsory winding up as per s.206
Companies Act [Chapter

24:03] are clearly spelt out and preconceived and some of the instances involve open and shut cases.
With specific reference to the ‘just and equitable’ principle as per s.206(g), Chatikobo J in the
famous La Gallerie case (2000) made the apt observation that that particular section has been said
to postulate not facts but only a broad conclusion of law, justice and equity as a ground for winding
up. He observed that: ‘in its terms and effect (the section) confers upon the court a very wide
discretionary power, the only limitation originally being that it had to be exercised judicially with
due regard to the justice and equity of the competing interests of all concerned.’

(b) A company which is experiencing difficulties may either be wound up or, at the discretion of
the court,be placed under judicial management if certain circumstances are proved. Judicial
management has been referred to as a halfway house between life and death of a company.

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It is the discretion of the court to issue a winding up order or a judicial management order. For
example, when a petitioner has established a case for winding up a company to the satisfaction of
the court,the court may, instead of granting a winding up order, issue an order for judicial
management if it has been requested to do so. However, this should be done if the court is of the
opinion that the company will be able, during the judicial management, to recover from its
difficulties and that it has reasonable opportunity to do so.

When, by reason of mismanagement or for any other cause, a company is unable or probably
unable to meet its obligations but it has not become or is prevented from becoming a successful
concern and there is a reasonable probability that if placed under judicial management it will
recover, the court may, if it appears just and equitable grant a judicial management, s.300(b)(ii)
Companies Act
[Chapter 24:03]. Synman J in the case of Lief v Western Credit (Africa) Ltd (1963) (3) SA 344
argued that a winding up order, in its nature, is intended to bring about the dissolution of the
company, whereas the purpose of the judicial management order is to save the company from
dissolution.

An important feature of a winding up order is that upon such an order being granted, creditors
must be paid off. However, judicial management, on the other hand, usually provides for a
moratorium in respect of the company’s debt in the hope that it will lead ultimately to the payment
of all creditors and the resumption by it of normal trading.Furthermore, a winding up order is
usually granted where a company is in fact insolvent, whereas a judicial management order is
usually granted where

a solvent company has run into financial difficulties because of mismanagement and because there
is hope that with better management it will overcome its difficulties. The idea is to give the
company a fighting chance.

Judicial management is a substitution by the court of a new management of a company in place of

the directors. The judicial management order is granted in a situation where to grant a winding up

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order may cause unnecessary prejudice to the shareholders and the creditors of the company. In
fact, the court will be of the opinion that, although the company may be suffering financial
embarrassment due to mismanagement, it may be basically sound.

There are two types of judicial management orders which can be made: the provisional judicial
management order as per s.300 Companies Act and the final judicial management order in terms
of
s.309 of the Act. For the court to grant either a provisional order or a final order, it will in both
cases consider whether there is a reasonable probability of success. So the discretion is with the
court to grant a provisional order as a final order (s.300(9)(ii) of the Act).

In Tenowitz v Tenmy Investments (Pty) Ltd (1979), the court refused to grant a final order of
judicial management because it considered that the applicant had not discharged the onus of
proving that the company would become a successful concern in a reasonable time if such an
order was granted. There are so many reasons which can lead to a company to be put under judicial
management. A company can be placed under judicial management if it is unable to pay its debts,
if there is mismanagement of the company. In this case, the attitude of the courts is generally that
a company should manage its own affairs freely. Unless there has been something illegal,
oppressive or fraudulent on the part of the company, the court will not interfere in its internal
management. In Reich v Harthon Syndicate (Pty) Ltd (1930), the judge observed that the court
has a discretion in deciding whether it is desirable that a company should be put under judicial
management.

The other reason for judicial management is the inability of the company to meet its obligations.
A company may be able to meet its current trade debts but unable to timeously fulfil its
obligations. In such a case, the court will be justified to place the company under judicial
management. Also if the court finds it just and equitable, the company can be under judicial
management. Thus the just and equitable ground is intended to indicate that there must be a
balancing of interests of creditors, in not delaying, for example, their right to obtain money by
calling a halt to an apparently failing company and the interest of members by continuing their
concern despite present difficulties.

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The concept of the company becoming a successful concern presupposes thatit will be able to pay
its debts and meet its obligations

206 Circumstances in which company may be wound up by court

A company may be wound up by the court—

(a) if the company has by special resolution resolved that the company be wound up by the court;

(b) if default is made in lodging the statutory report or in holding the statutory meeting;

(c) if the company does not commence its business within a year from its incorporation or suspends
its business for a whole year;

(d) if the company ceases to have any members;

(e) if seventy-five per centum of the paid-up share capital of the company has been lost or has

become useless for the business of the company; (f) if the company is unable to pay its debts;

(g) if the court is of opinion that it is just and equitable that the company should be wound up.

207 Petition for winding up company

(1) An application to the court for the winding up of a company shall be by petition presented,
subject to this section,by the company or by any creditor or creditors, including any contingent
or prospective creditor or creditors,

contributory or contributories or by all or any of those parties together or separately or, in a

case falling within subsection (2) of section one hundred and sixty-two, by the Minister
accompanied, save in the case of a petition by the Minister, by a certificate of the Master,

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Assistant Master or a magistrate that due security has been found for payment of all fees and
charges necessary for the prosecution of all proceedings until the appointment of a liquidator:

Provided that—

(i) a contributory shall not be entitled to present a petition for winding up a company unless—

(a) the number of members of the company is reduced below two; or

(b) the shares in respect of which he is a contributory, or some of them, were originally allotted to
him or have been held by him and registered in his name for at least six months during the
eighteen months before the commencement of the winding up or have devolved upon him
through the death of a former holder;

(ii) a petition for winding up a company on the ground of default in lodging the statutory
report or in holding the statutory meeting shall not be presented by any person except a member,
nor before the expiration of fourteen days after the last day on which the meeting ought to have
been held;

(iii) the court shall not grant a petition for winding up a company by a contingent or
prospective creditor until a prima facie case for winding up has been established to the
satisfaction of the court.

(2) Where a company is being wound up voluntarily, a petition may be presented by the Master
or by any other person authorized in that behalf under subsection (1) but the court shall not
make a windingup order on the petition unless it is satisfied that the voluntary winding up
cannot be continued with due regard to the interests of the creditors or contributories.

210Commencement of winding up by court

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(1) Where, before the presentation of a petition for the winding up of a company by the court,a
resolution has been passed by the company for voluntary winding up, the winding up of the
company shall be deemed to have commenced at the time of the passing of the resolution.

(2) In any other case, the winding up of a company by the court shall be deemed to commence
at the time of the presentation of the petition for the winding up.

(3) Where the court adjourns the hearing of an application for the winding up of a company by
the court,the applicant shall, unless the court orders to the contrary, advertise the application and
the adjournment in the Gazette.

211 Court may adopt proceedings of voluntary winding up

Where a company is being wound up voluntarily and an order is made for its winding up by the
court, the court may, if it thinks fit, by the same or any subsequent order, confirm all or any of the
proceedings in the voluntary winding up.

Consequences of Winding-Up Order

212 Effect of winding-up order

An order for winding up a company shall operate in favour of all the creditors and of all the
contributories of the company as if the petition had been presented by all creditors and
contributories jointly.

213 Action stayed and avoidance of certain attachments, executions and dispositions and alteration
of status

In a winding up by the court—

(a) no action or proceeding shall be proceeded with or commenced against the company except
by leave of the court and subject to such terms as the court may impose;

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(b) any attachment or execution put in force against the assets of the company after the
commencement of the winding up shall be void;

(c) every disposition of the property, including rights of action, of the company and every transfer
of shares or alteration in the status of its members, made after the commencement of the winding
up, shall, unless the court otherwise orders, be void.

214Transmission of winding-up order to certain officers

(1) The registrar of the court shall forthwith transmit a copy of every provisional and final
windingup order and of every order amending or setting aside the same to the Registrar, Master
and Sheriff and—

(a) in respect of any immovable property within Zimbabwe which appears to be an asset of the
company, to the Registrar of Deeds; and

(b) in respect of any interest in minerals within Zimbabwe which appears to be an asset of the
company, to the Secretary of the Ministry responsible for mines; and

(c) to the messenger of every magistrate’s court by the order whereof it appears that property of
the company is under attachment:

Provided that when the assets of the company are under four hundred dollars in value, and the
court so orders, the movable assets may remain in the custody of such person as the court may
order upon such terms as to security as the court may direct and in that case it shall not be
necessary to transmit a copy of any order to the Sheriff or any messenger.
(2) Upon receipt by the Registrar of Deeds of a winding-up order he shall enter a caveat against
the transfer of any immovable property or the cancellation or cession of any bond registered in
the name of or belonging to the company.

(3) Upon the receipt by the Secretaryof the Ministry responsible for mines of a winding-up order
he shall cause a caveat to be entered against the transfer of any interest whatsoever in minerals

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or the cancellation or cession of any bond registered in the name of or belonging to the
company.

(4) Every such public officer concerned shall register every copy of an order transmitted to him
and note thereon the day and hour when it is received.

(5) Upon receipt of a copy of any winding-up order the Master shall give notice thereof in the
Gazette.

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8 Unit Eight

CASH FLOW STATEMENTS

Direct versus Indirect Presentations

FASB Statement No. 95 allows two ways to calculate and report a company’s net cash flow from
operating activities on its statement of cash flows.

The Direct Method

Under the direct method, operating cash outflows are deducted from operating cash inflows to
determine the net cash flow from operating activities.

If you choose the direct method, a reconciliation of cash provided by operations to net income is a
required disclosure.

This is the same schedule that appears in a statement prepared using the indirect method

The required information items on a direct method statement of cash flow (per FASB)

Operating Inflows

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Cash collected from customers (including lessees, tenants,licensees,and the like)

Interest and dividends received

Other operating cash receipts, if any

Operating outflows

Cash paid to employees and other suppliers of goods or services (including insurance, advertising
and the like)

Interest paid

Income taxes paid

Other operating cash payments, if any

The Indirect Method

Under the indirect method, net income is adjusted for noncash items related to operations to compute
the net cash flow from operating activities.

If you choose to use the indirect method, you must also disclose interest paid and income taxes paid
during the year.

The indirect operating activities section always starts out with the net income for the period
followed by non-cash expenses, gains, and losses that need to be added back to or subtracted
from net income. These non-cash activities typically include:

Depreciation expense

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Amortization expense

Depletion expense

Gains or Losses from sale of assets

Losses from accounts receivable

The non-cash expenses and losses must be added back in and the gains must be subtracted.

The next section of the operating activities adjusts net income for the changes in asset accounts that
affected cash. These accounts typically include:

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Accounts receivable

Inventory

Prepaid expenses

Receivables from employees and owners

This is where preparing the indirect method can get a little confusing. You need to think about how
changes in these accounts affect cash in order to identify what way income needs to be adjusted.
When an asset increases during the year, cash must have been used to purchase the new asset.
Thus, a net increase in an asset account actually decreased cash, so we need to subtract this
increase from the net income. The opposite is true about decreases. If an asset account decreases,
we will need to add this amount back into the income. Here’s a general rule of thumb when
preparing an indirect cash flow statement:

Asset account increases: subtract amount from income

Asset account decreases: add amount to income

The last section of the operating activities adjusts net income for changes in liability accounts affected
by cash during the year. Here are some of the accounts that usually are used:

Accounts payable Accrued expenses

Direct method

Receipts received from Customers

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Payments paid to Suppliers

Payments paid to Employees

Interest Payments

Income Tax Payments

Listing these payments gives the financial statement user a great deal of information where
receipts are coming from and where payments are going to. This is one of the main advantages
of the direct method compared with the indirect method. Investors, creditors, and management
can actually see where the company is collecting funds from and whom it is paying funds to.
The indirect method doesn’t list these types of details. That’s exactly why FASB recommends that
all companies issue their statement of cash flows in the direct method.

The problem with this method is its difficult and time consuming to create. Most companies
don’t record and store accounting and transactional information by customer, supplier, or
vendor. Business events are recorded with income statement and balance sheet accounts like
sales, materials, and inventory. It’s laborious for most companies to compile the information with
this method.

For example, in order to figure out the receipts and payments from each source, you have to use a
unique formula. The receipts from customer’s equal are net sales for the period plus the beginning
accounts receivable less the ending accounts receivable. Similarly, the payments made to suppliers
is calculated by adding the purchases, ending inventory, and beginning accounts payable then
subtracting the beginning inventory and ending accounts payable.

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If accounts receivable is only used for credit sales and accounts payable is only used for credit
account purchases. This is why most companies don’t issue this method. It’s difficult to gather
the information.

The direct method also requires a reconciliation report be created to check the accuracy of the
operating activities. The reconciliation itself is very similar to the indirect method of reporting
operating activities. It stars with net income and adjusts non-cash transaction like depreciation
and changes in balance sheet accounts. Since creating this reconciliation is about as much work
as just preparing an indirect statement, most companies simply choose not to use the direct
method.

This is the only difference between the direct and indirect methods. The investing and financing
activities are reported exactly the same on both reports.

Cash Flow from Operating Activities: Direct Method

The direct method to calculate cash flow from operating activities involves determination of
various types of cash receipts and payments such as cash receipts from customers, cash paid to
suppliers,cash paid for salaries, etc. and then putting them together under the cash flow from
operating section of cash flow statement. These figures are calculated using the beginning and
ending balances of various accounts of the business and the net increase or decrease in the account.
The exact formulas to calculate various cash inflows and outflows vary. The most importan ones
are given below:

Formulas

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Cash Receipts from Customers =

+ Net Sales

+ Beginning Accounts Receivable

− Ending Accounts Receivable

Cash Payments to Suppliers =

+ Purchases

+ Ending Inventory

− Beginning Inventory

+ Beginning Accounts Payable

− Ending Accounts Payable

Cash Payments to Employees =

+ Beginning Salaries Payable

− Ending Salaries Payable

+ Salaries Expense

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Cash Payments for Purchase of Prepaid Assets = + Ending

Prepaid Rent, Prepaid Insurance etc.

+ Expired Rent, Expired Insurance etc.

− Beginning Prepaid Rent, Prepaid Insurance etc.

Interest Payments =

+ Beginning Interest Payable

− Ending Interest Payable

+ Interest Expense

Income Tax Payments =

+ Beginning Income Tax Payable

− Ending Income Tax Payable

+ Income Tax Expense

In the formulas given above it is assumed that accounts receivable are only used for credit sales.
It is also assumed that all sales are on credit. If there are cash sales as well, then receipts from
cash sales must be included in the cash receipts from customers to obtain a correct figure of cash
flow from operating activities.

Similarly, it is assumed that accounts payable are used merely for purchases on account and that all
purchases are on credit. If there are cash purchases as well, then cash payments for them must be

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included in the cash paid to suppliers. It is important to note that here may be receipts & payments
other than those discussed above.

Once the all the cash inflows and outflows from operating activities are calculated, they are added in
the operating section of cashflows to obtain the net cashflow from operating activities.

The following example shows the format and calculation of cash flows from operating activities using
direct method.

Example

Prepare the cash flows from operating activities section of cash flow statement by direct method using
the following information:

December 31 2011 2010

$28,410
Accounts Receivable $34,130

25,000
Prepaid Rent 20,000

Prepaid Insurance 6,800 6,000

Inventory 23,030 15,450

Accounts Payable 14,590 31,300

Salaries Payable 8,310 5,120

Interest Payable 700 360

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Income Tax Payable 2,340 0

Year Ended December 31 2011 Net

Sales 64,970

Salaries Expense 8,610

Rent Expense 5,000

Insurance Expense 3,200 Interest

Expense 1,650

Solution:

Cash Flow from Operating Activities:

Cash Receipts
From Customers (1) $59,250

Cash Payments
−24,290
To Suppliers (2)

To Employees (3) −5,420

−4,000
For Purchase of Prepaid Assets (4)

−1,310
Interest (5)

Income Tax (6) −0

Net Cash Flow from Operating Activities 24,230

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Working Notes

1) 64,970 + 28,410 - 34,130

2) 23,030 - 15,450 + 31,300 - 14,590

3) 5,120 - 8,310 + 8,610

4) 20,000 + 6,800 + 5,000 + 3,200 - 25,000 - 6,000

5) 360 - 700 + 1,650

6) 0 - 2,340 + 2,340

Indirect methods
Tafira’s balance sheets for his business at 31 December 2011 and 2012 were as follows:

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2011 2012

Fixed assets: $ Equipment at 4800

cost 6000
8000
500
3600 3200
Less depreciation 2400

4000
-
Motor car at cost 4000

1000 5300
3500

-
Less depreciation 3000

200
Office machinery at cost 2000
4800 -

1800

Less depreciation

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Current assets: 2000

3500 7450
Stock
3800 3000 12750
Debtors
11000
Bank
3250
2100

7900 9750
Less current liabilities:

6200
Creditors
2300
1700

Capital at 1 January

Profit for the year

Less drawings 11000 9000

8000 20000
Capital at 31 December 10000

9250

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18000
Loan from father 10750

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7000
2000

11000

12750

There was neither profit nor loss on the sale of the office machinery.
The loan from Tafira’s father was received on 1 January 2012 and carries interest at the rate of 10%
per annum.

Required

A cash flow statement for the year ended 31 December 2012 using the indirect method.

Solution

Tafira

$ $ Cash flow
10400 statement
Net cash inflow from operating activities
for the
year
Returns on investment and servicing of finance ended 31
December
Interest paid (200) 2012

Drawings (9250)

Net cash outflow from return on investments and servicing of finance (9450)

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Taxation (not applicable to sole trader)

Investing activities

Payments to acquire new equipment (2000)

Receipts from sale of office machinery 200

Net cash outflow from investing activities (1800)

Net cash outflow before financing

(850)
Financing

Increase in loans 2000

2000
Net cash inflow from financing
Increase in cash 1150

Reconciliation of operating profit to net cash flow from operating activities

Net profit before interest (9000 + 2000) 9200
Depreciation (800 + 500) 1300

Increase in stock (1500)

Decrease in debtors 800

Increase in creditors 600 10400

Analysis of changes in cash during the year
2100
Balance at start of the year

1150
Net cash inflow

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3250
Balance at end of year

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9 Unit Nine

ANALYSIS AND INTERPRETATION OF FINANCIAL INFORMATION AS TO

MANAGEMENT AND STAKEHOLDERS RATIO ANALYSIS

Key to mastering ratios is the ability to calculate each ratio, and interprete the ratios in terms of
business performance – ie, reach conclusions on business performance based on the results of your
ratios. There is no such thing as in ideal value for a ratio – meaning comes from comparison with
prior periods, comparison with a similar entity (in the same line of business), or comparison with
industry average values.

The ability to analyze financial statements using ratios and percentages to assess the performance
of organizations is a skill that will be tested in CIRSM exam papers. It will also be regularly used
by successful candidates in their future careers.

The Paper RSM 102 syllabus introduces candidates to performance measurement and requires
candidates to be able to 'Discuss and calculate measures of financial performance (profitability,
liquidity, activity and gearing) and non-financial measures'. This chapter will focus on measures
of financial performance and will detail the skills and knowledge expected from candidates in the
Paper RSM 102 exam.

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Paper RSM 102 candidates are expected to be able to calculate key accounting ratios, to know
what they measure, and to explain what particular values mean. The syllabus categorises ratios
into four headings: profitability, liquidity, activity and gearing.

PROFITABILITY

Profitability ratios, as their name suggests, measure the organisation’s ability to deliver profits.
Profit is necessary to give investors the return they require, and to provide funds for reinvestment
in the business. Three ratios are commonly used.

1. Return on capital employed (ROCE): operating profit ÷ (non current liabilities + total
equity) %

2. Return on sales (ROS): operating profit÷ revenue %

3. Gross margin: gross profit÷ revenue %

Return on capital employed

Return on capital employed (sometimes known as return on investment or ROI) measures the return
that is being earned on the capital invested in the business. Candidates are sometimes confused

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about which profit and capital figures to use. What is important is to compare like with like.
Operating profit (profit before interest) represents the profit available to pay interest to debt
investors and dividends to shareholders. It is therefore compared with the long-term debt and
equity capital invested in the business (non-current liabilities + total equity).By similar logic, if we
wished to calculate return on ordinary shareholders funds (the return to equity holders), we would
use profit after interest and tax divided by total equity).

A return on capital is necessary to reward investors for the risks they are taking by investing
in the company. Generally, the higher the ROCE figure, the better it is for investors. It should
be compared with returns on offer to investors on alternative investments of a similar risk.

Return on sales

Return on sales (sometimesknown as operatingmargin) looks at operatingprofit earned as a

percentage of revenue. Again, in simple terms, the higher the better. Poor performance is often
explained by prices being too low or costs being too high.

The ROCE and ROS ratios are often considered in conjunction with the asset turnover ratio. (The
asset turnover ratio is discussed later). They are considered at the same time because:

ROCE = ROS x asset turnover

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This relationship can be useful in exam calculations. For example, if you are told that a business
has a return on sales of 5% and an asset turnover of 2, then its ROCE will be 10% (5% x 2). This
is more than a mathematical trick. It means that any change in ROCE can be explained by either
a change in ROS, or a change in asset turnover, or both.

Gross margin

Return on sales looks at profits after charging non-production overheads. Gross margin on the
other hand focuses on the organisation’s trading activities. Once again, in simple terms, the
higher the better, with poor performance often being explained by prices being too low or costs
being too high.

LIQUIDITY

This measures the ability of the organisation to meet its short-term financial obligations.

Two ratios are commonly used:

4. Current ratio current assets ÷ current liabilities

5. Acid test (current assets – inventory) ÷ current liabilities

Current ratio

The current ratio comparesliabilities that fall duewithin the year with cash balances, andassets
that should turn into cash within the year. It assesses the company’s ability to meet its shortterm
liabilities. Traditionally textbooks tell us that this ratio should exceed 2.0:1 for a company to be

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able to safely meet its liabilities. However, acceptable current ratios vary between industrial
sectors, and many companies operate safely at below the 2:1 level.

A very high current ratio is not necessarily good. It could indicate that a company is too liquid.
Cash is often described as an ‘idle asset’ because it earns no return, and carrying too much cash is
considered wasteful. A high ratio could also indicate that the company is not making sufficient use
of cheap shortterm finance.

Acid test

The acid test (or quick ratio) recognises that inventory often takes a long time to convert into cash.
It therefore excludes inventory values from liquid assets. Traditionally textbooks tell us that this
ratio should exceed 1:1 but once again many successful companies operate below this level.

In practice a company’s current ratio and acid test should be considered alongside the company’s
operating cash flow. A healthy cash flow will often compensate for weak liquidity ratios.

ACTIVITY RATIOS

6. Asset turnover: revenue ÷ (non current liabilities + total equity) ×

7. Receivables days: receivables ÷ credit sales × 365 days

8. Inventory days: inventory ÷ cost of sales × 365 days

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9. Payable days: payables ÷ purchases (or cost of sales) × 365 days

Activity ratios measure an organisation’s ability to convert balance sheet items into cash or sales.
They measure the efficiency of the business in managing its assets.

Asset turnover

This measures the ability of the organisation to generate sales from its capital employed. A possible
variant is non-current asset turnover (revenue ÷ non-current assets). Generally, the higher the
better, but in later studies you will consider the problems caused by overtrading (operating a
business at a level not sustainable by its capital employed). Commonly a high asset turnover is
accompanied with a low return on sales and vice versa. Retailers generally have high asset
turnovers accompanied by low margins: Jack Cohen, the founder of Tesco, famously used the
motto ’Pile it high and sell it cheap’!

Receivable days

This is also known as debtor days. If a company has average accounts receivable of $20,000 on
annual credit sales of $40,000 then on average 50% of its annual credit sales are uncollected. If
credit sales are spread evenly over the year, then this represents 50% of a year’s sales, equivalent
to 183 days, to collect cash from customers. ($20,000/$40,000 ÷ 365 days = 183 days). For
liquidity purposes the faster money is collected the better. Also, generally, the longer customers
are given to pay, the higher the level of bad debts. However, too much pressure on customers to
pay quickly may damage a company’s ability to generate sales.

Inventory days

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Also known as stock days. This is calculated in a very similar way to receivable days. It measures
how long a company carries inventory before it is sold. Again for liquidity purposes the shorter
this period the better, as less cash is tied up in inventory. Also long inventory holding periods can
result in obsolete inventory. On the other hand, too little inventory can result in production
stoppages and dissatisfied customers.

Payable days

Also known as creditor days. Once again this is calculated in a similar way to receivable days.
Because the purchases figure is often not available to analysts external to the business, the cost
of sales figure is often used to approximate purchases. Payable days measures the average
amount of time taken to pay suppliers.Long payment periods are good for the customer’s
liquidity, but can damage relationships with suppliers.

10. GEARING

This relates to an organization’s ability to meet its long-term debts. Two ratios are commonly used.

Capital gearing: non-current liabilities ÷ ordinary shareholders funds % (this is sometimes

described as the debt to equity ratio) or

non-current liabilities ÷ (ordinary shareholders funds + non current liabilities % (sometimes

described

as debt to equity + debt)

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11. Interest cover: operating profit ÷ finance costs

This is sometimes known as income gearing. It looks at how many times a company’s operating
profits exceed its interest payable. The higher the figure, the more likely a company is to be able
to meet its interest payments. Anything in excess of four is usually considered to be safe.

12. Capital gearing

Also known as leverage. Capital gearing looks at the proportions of owner’s capital and borrowed
capital used to finance the business. Many different definitions exist; the two most commonly used
ones are given above. When necessary in the exam, you will be told which definition to use.

A large proportion of borrowed capital is risky as interest and capital repayments are legal
obligations and must be met if the company is to avoid insolvency. The payment of an annual
equity dividend on the other hand is not a legal obligation. Despite its risks, borrowed capital is
attractive to companies as lenders accept a lower rate of return than equity investors due to their
secured positions.Also interest payments, unlike equity dividends, are corporation tax deductible.

Levels of capital gearing vary enormously between industries. Companies requiring high
investment in tangible assets are commonly highly geared. Consequently, it is difficult to
generalise about when capital gearing is too high. However, most accountants would agree that
gearing is too high
when the proportion of debt exceeds the proportion of equity.

Investment Ratios

13. Earnings per share

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Earning per share, also called net income per share, is a market prospect ratio that measures the
amount of net income earned per share of stock outstanding. In other words, this is the amount
of money each share of stock would receive if all of the profits were distributed to the
outstanding shares at the end of the year.

Earnings per share are also a calculation that shows how profitable a company is on a shareholder
basis. So a larger company's profits per share can be compared to smaller company's profits per
share. Obviously, this calculation is heavily influenced on how many shares are outstanding.
Thus, a larger company will have to split its earning amongst many more shares of stock
compared to a smaller company

Earnings per share = total earnings ÷ number of ordinary shares issued Where: total
earnings is net income minus preference dividend

14. Dividend per share

Dividend per share is an important and widely-used shareholder ratio.

A key focus of shareholders is their return on investment. The returns from investing in shares of a
company come in two main forms:

• The payment of dividends out of profits

• The increase in the value of the shares (share price) compared with the price that the
shareholder originally paid for the shares

One very straightforward shareholder ratio (though as we shall see – not a hugely helpful one)
is dividend per share. This shows the value of the total dividend per issued share for the financial
year.

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Quoted public companies usually split the annual dividend into two payments – the "interim"
(paid after six months trading) and the "final" (paid at the end of the financial year). In these
cases, it is necessary to add the two dividend payments together.

Dividend per share= total dividends paid ÷ number of ordinary shares issued

15. Price-Earnings Ratio = Market Price per Share / Earnings per Share

Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate
that the company is under-priced. Conversely, investors expect high growth rate from
companies with high P/E ratio.

16. Dividend Yield Ratio = Dividend per Share / Market Price per Share

Measures the percentage of return through dividends when compared to the price paid for the
stock. A high yield is attractive to investors who are after dividends rather than long-term capital
appreciation.

17. Dividend Pay-out Ratio = Dividend per Share / Earnings per Share

Determines the portion of net income that is distributed to owners. Not all income is distributed since
a significant portion is retained for the next year's operations.

Limitations of Ratio Analysis

The following are some limitations of ratio analysis:

• They are not forward looking or predictive in nature

• Accounts on which they are based uses historical cost information

• They are impacted by the effects of Creative Accounting and Window Dressing

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• Related party transactions may provide a "distorted" view

• Analysis are impacted by the effects of Asset Acquisitions

• Results may be distorted by impacts of Seasonal Trading

• They are impacted by the use of choice and judgement in Accounting Policies

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10Unit Ten

CHAPTER 10: Financial statements for close corporations

The Balance Sheet

The balance sheet provides information on what the company owns (its assets), what it owes
(its liabilities) and the value of the business to its stockholders (the shareholders' equity) as
of a specific date. It's called a balance sheet because the two sides balance out. This makes
sense: a company has to pay for all the things it has (assets) by either borrowing money
(liabilities) or getting it from shareholders (shareholders' equity).

Assets are economic resources that are expected to produce economic benefits for their owner
Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the
company's money or services. Examples include bank loans, debts to suppliers and debts to
employees.

Shareholders' equity is the value of a business to its owners after all of its obligations have been
met. This net worth belongs to the owners. Shareholders'equity generally reflects the amount of
capital the owners have invested, plus any profits generated that were subsequently reinvested in
the company.

The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders\' Equity

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Each of the three segments of the balance sheet will have many accounts within it that document
the value of each segment. Accounts such as cash, inventory and property are on the asset side of
the balance sheet,while on the liability side there are accounts such as accounts payable or
longterm debt. The exact accounts on a balance sheet will differ by company and by industry, as
there is no one set template that accurately accommodates the differences between varying types
of businesses.

Most accounting balance sheets classify a company's assets and liabilities into distinctive
groupings such as Current Assets; Property, Plant,and Equipment; Current Liabilities; etc. These
classifications make the balance sheet more useful. The following balance sheet example is a
classified balance sheet.

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Example of Balance Sheet

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Owner's (Stockholders') Equity

Owner's Equity—along with liabilities—can be thought of as a source of the company's assets.

Owner's equity is sometimes referred to as the book value of the company, because owner's
equity is equal to the reported asset amounts minus the reported liability amounts.

Owner's equity may also be referred to as the residual of assets minus liabilities. These
references make sense if you think of the basic accounting equation: Assets = Liabilities +
Owner's Equity and just rearrange the terms:

Owner's Equity = Assets - Liabilities

"Owner's Equity" are the words used on the balance sheet when the company is a sole
proprietorship. If the company is a corporation, the words Stockholders'Equity are used instead of
Owner's Equity. An example of an owner's equity account is Mary Smith, Capital (where Mary
Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts include:

Common Stock

Preferred Stock

Paid-in Capital in Excess of Par Value

Paid-in Capital from Treasury Stock

Retained Earnings

Accumulated Other Comprehensive Income

Both owner's equity and stockholders' equity accounts will normally have credit balances.

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Contra owner's equity accounts are a category of owner equity accounts with debit balances. (A
debit balance in an owner's equity account is contrary—or contra—to an owner's equity
account's usual credit balance.) An example of a contra owner's equity account is Mary Smith,
Drawing (where Mary Smith is the owner of the sole proprietorship). An example of a contra
stockholders' equity account is Treasury Stock.

Classifications of Owner's Equity On The Balance

Sheet

Owner's equity is generally represented on the balance sheet with two or three accounts (e.g., Mary
Smith,
Capital; Mary Smith, Drawing; and perhaps Current Year's Net Income). See the sample balance sheet
in Part 4.

The stockholders' equity section of a corporation's balance sheet is:

Paid-in Capital

Retained Earnings

Accumulated Other Comprehensive Income

Treasury Stock

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The stockholders' equity section of a corporation's balance sheet is:

Owner's Equity vs. Company's Market

Value

Since the asset amounts report the cost of the assets at the time of the transaction—or less—they
do not reflect current fair market values. (For example, computers which had a cost of $100,000
two years ago may now have a book value of $60,000. However, the current value of the
computers might be just $35,000. An office building purchased by the company 15 years ago at
a cost of $400,000 may now have a book value of $200,000. However, the current value of the
building might be $900,000.) Since the assets are not reported on the balance sheet at their current
fair market value, owner's equity appearing on the balance sheet is not an indication of the fair
market value of the company.

Owner's Equity and Temporary Accounts

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Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause
owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company
performs a service and increases its assets, owner's equity will increase when the Service Revenues
account is closed to owner's equity at the end of the accounting year.

Income statement template

An income statement shows the profit or loss generated by a business over a specific period of
time. This is usually the most closely examined of the financial statements, since it reveals the
operating performance of an entity.

From top to bottom,the template for an income statement is comprised of a header block, a
revenue section,a cost of goods sold section,a general and administrative expenses section,and
an other income and profit or loss section.From left to right, the template includes description
line items, followed by a column containing the period totals for the account aggregations that
comprise each line item.

The descriptions of the line items commonly found in the income statement are as follows:

Header Block

Name of the reporting entity. This is the legal name of the reporting entity, such as "ABC
International, Inc."

Identification of the income statement. This is a report designation, which is "Income

Statement". Reporting period of the income statement. This is the date range for which
revenues and expenses are being reported, such as "for the Year Ended December 31, 20X4".

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Revenue Section

Gross sales. This is the total amount of recognized sales in the period, most of which is likely to
come from invoiced amounts or direct cash receipts.

Sales returns and allowances. This is the amount of returns received back from customers, as
well as allowances given to customers to reduce the total amounts paid. This is essentially a
deduction from gross sales.

Net sales. This is a calculation, which is gross sales minus the sales returns and allowances line item.
The revenue performance of a firm is usually based on this number, not the gross sales figure.

Cost of Goods Sold Section

Cost of goods sold. This is the total of all direct materials, direct labor,and factory overhead
costs consumed during the period. The amount is linked to the number of units sold to
customers during the period. If produced units are not sold, then there is no expense; instead,the
related cost appears in the balance sheet as an inventory asset.

Gross margin. This is a calculation, which is net sales minus the cost of goods sold. It represents the
amount of residual earnings left to pay for general and administrative expenses.

Payroll taxes expense. This is the cost of the taxes associated with wages and salaries, such as the
employer-paid portion of social security taxes.

Rent expense. This is the rental cost of the facilities that a business occupies.

Utilities expense. This is the cost of all heating, air conditioning, electrical, Internet, and telephone
service.

Other Income and Profit or Loss Section

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Operating profit. This is a calculation, which is the gross margin minus all general and
administrative expenses.This figure is commonly reviewed to see the results of core operations
before the impact of financing activities.

Interest income and expense. This is the interest expense associated with borrowing activities,plus
the interest income from investing activities.
Gain or loss from the sale of assets. This is the residual gain or loss resulting from the sale of
company assets.

Before-tax profit or loss. This is a calculation, which is the operating profit minus interest
income and expense, as well as the gain or loss from the sale of assets. This figure essentially
adds the impact of financing activities to the operating profit.

Income tax. This is the calculated amount of income tax owed, based on the taxable pre-tax income
figure.

After-tax profit or loss. This is a calculation, which is the before-tax profit or loss, minus the
income tax figure in the preceding line item. This line item reveals the total profit or loss, net of
all types of activities listed on the income statement.

The number and description of the line items included in this template can vary substantially,
depending on the nature of a business. For example, the types of expenses reported by a services
business will vary greatly from those reported by a retail store, restaurant, car distributorship, or
shipping company

Income Statement Example

Before creating your own, take a look at our sample income statement:

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Income Statement For Crest Shoe Company Inc.

For Year Ending 12/31/00

Sales

Gross Sales $1,139,437 Less Returns $1,805 Net Sales $1,137,632 Less:

Cost of Goods Sold:

$766,259
Gross Profit Less:Operating Expenses:

MARKETING & SALES

Materials $47,036

$247,950
Contract Manufacturing

$76,387
Licensing Payments

Total Cost of Goods Sold $371,373

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Sales & Mktg Salaries $137,243

$13,381
Collateral & Promotions

Advertising
$27,313
Other Sales & Mkt Costs $3,412
$181,349
Total Marketing & Sales Expenses

GENERAL &
ADMINISTRATIVE

Office Salaries $115,823

Rent $49,315

Utilities $17,384

Depreciation $11,939

Other Overhead Costs $28,875

Total General & Administrative $223,336

Total Operating Expenses $404,685

Net Income Before Taxes $361,574

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Taxes $123,862

Net Income $237,712

Below is a comprehensive illustration of Financial Statements

IFRS Taxonomy 2013 – Illustrative examples

Statement of financial position, statement of comprehensive income, and statement of changes

in equity
Examples from IAS 1 (IG 6) representing ways in which the requirements of IAS 1 for the
presentation of the statements of financial position, comprehensive income and statement of
changes in equity might be met using detailed XBRL tagging with the use of XBRL footnotes.

XYZ Group – Statement of financial position as at 31 December 20X7

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(in thousands of currency units)

31 Dec 20X7 31 Dec 20X6

ASSETS

Non-current assets

Property, plant and equipment 350,700 360,020

Goodwill 80,800 91,200

Other intangible assets 227,470 227,470

Investments in associates 100,150 110,770

Investments in equity instruments 142,500 156,000

901,620 945,460

Current assets

Inventories 135,230 132,500

Trade receivables 91,600 110,800

Other current assets 25,650 12,540

Cash and cash equivalents 312,400 322,900

564,880 578,740

Total assets 1,466,500 1,524,200

XYZ Group – Statement of financial position as at 31 December 20X7

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(in thousands of currency units)

EQUITY AND LIABILITIES

Equity attributable to owners of the parent

Share capital 650,000 600,000

Retained earnings 243,500 161,700

Other components of equity 21,200

782,900

Non-controlling interests 70,050 48,600

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Total equity 973,750 831,500

Non-current liabilities

Long-term borrowings 120,000 160,000

Deferred tax 28,800 26,040

Long-term provisions 52,240

Total non-current liabilities 238,280

Current liabilities

Trade and other payables 115,100 187,620

Short-term borrowings 150,000 200,000

Current portion of long-term borrowings 10,000 20,000

Current tax payable 35,000 42,000

Short-term provisions 4,800

Total current liabilities 454,420

Total liabilities
492,750 692,700
Total equity and liabilities

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1,466,500 1,524,200

Examples of statement of profit or loss and other comprehensive income when IFRS 9
Financial Instruments is applied

XYZ Group – Statement of comprehensive income for the year ended 31 December
20X7

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(illustrating the presentation of profit or loss and other comprehensive income in one
statement and the classification of expenses within profit or loss by function) (in thousands of
currency units)

20X7 20X6

Revenue 390,000 355,000

Cost of sales ( 238,000) ( 219,500)

Gross profit 135,500

Other income 20,667 11,300

Distribution costs ( 9,000) ( 8,700)

Administrative expenses ( 20,000) ( 21,000)

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Other expenses ( 2,100) ( 1,200)

Finance costs ( 15,000) ( 18,000)

Share of profit of associates(a) 35,100 30,100

Profit before tax 161,667 128,000

Income tax expense ( 32,000)

Profit for the year from 121,250 96,000 continuing operations

Loss for the year from – ( 30,500) discontinued operations

PROFIT FOR THE YEAR 121,250 65,500 Other comprehensive

income:
Items that will not be reclassified to profit or loss:

Gains on property revaluation 933 3,367

Investments in equity instruments ( 24,000) 26,667

Remeasurements of defined ( 667) 1,333 benefit pension plans

Share of gain (loss) on property 400 ( 700) revaluation of associates(c)

Income tax relating to items that 5,834 (7,667) will not be reclassified(d)

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 RSM 103

(17,500) 23,000

Items that may be reclassified subsequently to profit or loss:

Exchange differences on 5,334 10,667 translating foreign operations(b)

Cash flow hedges(b) ( 667) ( 4,000)

Income tax relating to items that ( 1,167) ( 1,667) may be reclassified(d) 3,500
5,000

Other comprehensive income 28,000 for the year, net of tax

TOTAL COMPREHENSIVE 107,250 93,500 INCOME FOR THE YEAR

XYZ Group – Statement of comprehensive income for the year ended 31 December
20X7

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(illustrating the presentation of comprehensive income in one statement

and the classification of expenses within profit by function)

(in thousands of currency units)

20X7 20X6

Profit attributable to:

Owners of the 97,000 52,400 parent

Non-controlling 24,250 13,100 interests

121,250 65,500

Total comprehensive income attributable to:

Owners of the 85,800 74,800 parent

Non-controlling 21,450 18,700 interests

107,250 93,500

Earnings per share (in currency units): Basic and diluted

0.46 0.30

Alternatively, components of other comprehensive income could be presented in the statement of

comprehensive income net of tax:

Other comprehensive income for the 20X7 20X6 year, after tax:

Items that will not be reclassified to profit or loss:

Gains on property revaluation 600 2,700

Investments in equity instruments ( 18,000) 20,000

Remeasurements of defined benefit ( 500) 1,000 pension plans

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 RSM 103

Share of gain (loss) on property 400 ( 700) revaluation of associates

( 17,500) 23,000

Items that may be reclassified subsequently to profit or loss:

Exchange differences on translating 4,000 8,000 foreign operations

Cash flow hedges ( 500) ( 3,000)

3,500 5,000

Other comprehensive income for the ( 14,000) 28,000

(d)
year, net of tax

(a) This means the share of associates’ profit attributable to owners of the associates, ie it is
after tax and non-controlling interests in the associates.

(b) This illustrates the aggregated presentation, with disclosure of the current year gain or loss
and reclassification adjustment presented in the notes. Alternatively, a gross presentation can be
used.

(c) This means the share of associates’ other comprehensive income attributable to owners of
the associates, ie it is after tax and non-controlling interests in the associates.

(d) The income tax relating to each component of other comprehensive income is disclosed in
the notes.

XYZ Group – Income statement for the year ended 31 December 20X7

(illustrating the presentation of comprehensive income in two statements and

classification of expenses within profit by nature) (in thousands of currency units)

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 RSM 103

20X7 20X6

Revenue 390,000 355,000

Other income 20,667 11,300

Changes in inventories of finished ( 115,100) ( 107,900) goods and work in progress

Work performed by the entity and 16,000 15,000 capitalised

Raw material and consumables used ( 96,000) ( 92,000)

Employee benefits expense ( 45,000) ( 43,000)

Depreciation and amortisation expense ( 19,000) ( 17,000)

Impairment of property, plant and ( 4,000) – equipment

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 RSM 103

Other expenses ( 6,000) ( 5,500)

Finance costs ( 15,000) ( 18,000)

Share of profit of associates(e) 35,100 30,100

Profit before tax 161,667 128,000

Income tax expense ( 40,417) ( 32,000)

Profit for the year from continuing 121,250 96,000 operations

Loss for the year from discontinued – ( 30,500) operations PROFIT FOR THE YEAR
121,250 65,500

Profit attributable to:

Owners of the 97,000 52,400 parent

Non-controlling 24,250 13,100 interests 121,250 65,500

Earnings per share (in currency units):

Basic and 0.46 0.30 diluted

(e) This means the share of associates’ profit attributable to owners of the associates, ie it is after
tax and non-controlling interests in the associates.

XYZ Group – Statement of comprehensive income for the year ended 31 December
20X7

(illustrating the presentation of comprehensive income in two statements)

(in thousands of currency units)

20X7 20X6

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 RSM 103

Profit for the year 121,250 65,500 Other comprehensive income:

Items that will not be reclassified to profit or loss:

Gains on property revaluation 933 3,367

Investments in equity instruments ( 24,000)

26,667

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 RSM 103

Remeasurements of defined benefit pension ( 667) 1,333 plans

Share of gain (loss) on property revaluation of 400 ( 700) associates(f)

Income tax relating to items that will not be 5,834 (7,667) reclassified(g)

(17,500) 23,000

Items that may be reclassified subsequently to profit or loss:

Exchange differences on translating foreign 5,334 10,667 operations

Cash flow hedges ( 667) ( 4,000)

Income tax relating to items that may be (1,167) (1,667) reclassified(g)

3,500 5,000

Other comprehensive income for the year, ( 14,000) 28,000 net of tax

TOTAL COMPREHENSIVE INCOME 107,250 93,500 FOR THE YEAR

Total comprehensive income attributable to:

Owners of the 85,800 74,800 parent

Non- 21,450 18,700

controlling interests

107,250 93,500

Alternatively, components of other comprehensive income could be presented, net of tax. Refer to
the statement of comprehensive income illustrating the presentation of income and expenses in
one statement.

(f) This means the share of associates’ other comprehensive income

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 RSM 103

attributable to owners of the associates, ie it is after tax and

noncontrolling interests in the associates.

(g) The income tax relating to each component of other

comprehensive income is disclosed in the notes.

XYZ Group - Disclosure of components of other comprehensive income

Notes

Page 186 of 187 CIRSM

 RSM 103

Year ended 31 December 20X7

(in thousands of currency units)

20X7 20X6

Other comprehensive income:

Exchange differences on 5,334 10 , 66 translating foreign operations(i) 7

Investments in equity instruments ( 24,00 26 , 66 0) 7

Cash flow hedges:

Gains (losses) ( 4,66 ( 4,000) arising during the 7) year

Less: 3,333 –
Reclassification adjustments for gains
(losses) included in profit or loss

Less: Adjustments 667 ( 667) – ( 4 , 00 for

amounts 0) transferred to initial carrying amount of hedged items

Gains on property revaluation 933 3,367

Remeasurements of defined ( 667) 1,333 benefit pension plans

Share of other comprehensive 400 ( 700) income of associates

Other comprehensive income ( 18,66 37 , 33 7) 4

Income tax relating to components 4,667 ( 9 , 33 of other comprehensive income(j) 4)

Other comprehensive income for ( 14,00 28 , 00

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 RSM 103

the year (h) 0) 0

(h) When an entity chooses an aggregated presentation in the statement of

comprehensive income, the amounts for reclassification adjustments and current
year gain or loss are presented in the notes.

(i) There was no disposal of a foreign operation. Therefore, there is no reclassification

adjustment for the years presented.

(j) The income tax relating to each component of other comprehensive income is
disclosed in the notes.

XYZ Group - Disclosure of tax effects relating to each component of other comprehensive
income

Page 188 of 187 CIRSM

 RSM 103

Notes

Year ended 31 December 20X7

(in thousands of currency

units) 20X7
20X6
Before Tax Net- Befor Tax Net-
-tax (expen of-tax e-tax (expense)ben of-tax amoun se) amoun amou efit amoun t
benefit t nt t

Exchange 5,334 ( 1,334 4,000 10,66 ( 2,667) 8,000 differences ) 7 on

translating foreign operations

Investments ( 24,00 6,000 ( 18,00 26,66 ( 6,667) 20,000 in equity 0)

0) 7 instruments

Cash flow ( 667) 167 ( 500) ( 4,00 1,000 ( 3,000 hedges 0) )

Gains on 933 ( 333) 600 3,367 ( 667) 2,700 property revaluation

Remeasurem ( 667) 167 ( 500) 1,333 ( 333) 1,000 ents of defined benefit pension
plans

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 RSM 103

Share of 400 – 400 ( 700) – other comprehensi ve ( 700) income of associates

Other ( 18,66 4,667 ( 14,00 37,33 ( 9,334) 28,000 comprehensi 7) 0) 4 ve income

XYZ Group – Statement of changes in equity for the 31 year ended

December 20X7

(in thousands of currency units)

Shar Retain Translat Investm Cash ion of Revaluation Total Non- Tota l e capit ed ents
in flow foreign equity s urplus controll equit

al earnin hedges operatio instrume ing y gs ns nts interest

s

Balance 600,0 118,1 ( 4,00 0) 1,600 2,00 0– 717,7 29,80 747,50

at 00 0 0
1 00 00
January
20X6
Changes – 400 – – – – 400 100 500 in accountin g
policy

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 RSM 103

Restated 600,0 118,5 ( 4,00 0) 1,600 2,00 0– 718,1 29,90 748,00

balance 00 0 0
00 00
Changes – – in equity for

20X6 –

( 10 , 0
Dividends – ( 10,0 – – ( 10,0 00)
00) 00)

Total – 53,20 6,400 16,000 ( 2,4 1,600 74,8 18,70 93 , 5

comprehe 0 00) 00 0 00 nsive income for the

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 RSM 103

Total – 96,60 3,200 ( 14,4 ( 400 800 85,8 21,45 107,25 comprehe
0 00) ) 00 0 0 nsive income for the year(l)

Transfer – 200 – – – ( 200) – – – to retained earnings

Balance 650,0 243,5 5,600 3,200 ( 800 2,200 903,7 70,05 973,75 at 00
00 ) 00 0 0

31 December 20X7

(k) The amount included in retained earnings for 20X6 of 53,200 represents profit attributable
to owners of the parent of 52,400 plus actuarial gains on defined benefit pension
plans of 800 (1,333, less tax 333, less non-controlling interests 200). The amount
included in the translation, investments in equity instruments and cash flow hedge
reserves represent other comprehensive income for each component, net of tax and
non-controlling interests, eg other comprehensive income related to investments in
equity instruments for 20X6 of 16,000 is 26,667, less tax 6,667, less non-controlling
interests 4,000. The amount included in the revaluation surplus of 1,600represents
the share of other comprehensive income of associates of (700) plus gains on
property revaluation of 2,300 ( 3,367, less tax 667, less non-controlling interests
400). Other comprehensive income of associates relates solely to gains or losses on
property

Page 192 of 187 CIRSM

 RSM 103

revaluation.

(l)

The amount included in retained earnings for 20X7 of 96,600 represents profit
attributable to owners of the parent of 97,000 plus actuarial losses on defined
benefit pension plans of 400 ( 667, less tax 167, less non-controlling interests
100). The amount included in the translation, investments in equity instruments
and cash flow hedge reserves represents other comprehensive income for each
component, net of tax and non-controlling interests, eg other comprehensive
income related to the translation of foreign operations for 20X7 of 3,200 is 5,334,
less tax 1,334, less non-controlling interests 800. The amount included in the
revaluation surplus of 800represents the share of other comprehensive income of
associates of 400 plus gains on property revaluation of 400 ( 933, less tax 333,
less noncontrolling interests 200). Other comprehensive income of associates
relates solely to gains or losses on property revaluation.

Page 193 of 187 CIRSM