Professional Scheme
Relevant to Paper 2.6

Examinations often contain a mix of theoretical and practical questions. Students often prefer practical questions when given a choice because, although they take longer to read, the issues to be dealt with are spelt out and the answer lies within the question. Theoretical questions contain relatively little information and it is up to the student to make sure that the key areas are covered. It is a great mistake, however, to think that it is necessary to know absolutely everything about a particular subject before attempting to answer it, because with a little imagination and common sense, a lot can be made of an average amount of knowledge. In any case, theoretical questions are sometimes compulsory so it is important to be confident in your approach to them, regardless of how good you are at learning theory!

Theoretical questions can cover a very wide range of subjects. Subjects covered in recent examination papers include audit risk, audit evidence, internal controls, the audit of a particular account area such as inventories, receivables, the audit of estimates, and ethical issues. All of these areas can be examined from both a practical and a theoretical angle. The purpose of this article is to show how an average level of knowledge can be presented well in order to obtain maximum marks, and we will look at a number of different questions in order to achieve this.

The following question is an extract adapted from a recent examination paper:

Question 1
(a) Consider the relative reliability and independence of the following types of evidence from third parties:

(i) replies to a circularisation of receivables to confirm trade receivables;

(ii) vendors� statements to confirm accounts payable balances (6 marks).

Three important points should be made at the outset.

• it is not necessary to learn the name or number of the relevant SAS (Statement of Auditing Standards) or ISA (International Standard on Auditing) in order to obtain good marks; there are over 30 examinable documents and you are not being examined on your ability to learn long lists parrot-fashion!
• it is always helpful to break a question down into its constituent elements as far as possible. In this case, we have part (i) and part (ii), but we also have as many as three other parts; we are asked about the reliability of the evidence, and the independence of the evidence, and the relative reliability and independence of the two types of evidence;
• most students will be able to offer one or two points in answer to the question, the real skill to be learned is in developing those points in order to obtain four or five marks in order to be sure of a pass.

A typical student answer to this question might appear as follows:

Answer 1 (a)
(i) Replies to a circularisation of receivables are both independent and reliable because they come from outside the company and they are written evidence. However, they are not reliable to the extent that customers do not always put the correct balance on the circularisation and many do not reply.

(ii) Vendors� statements to confirm accounts payable balances are also independent and reliable because they come from outside the company and are written evidence. They are more likely to be accurate than replies to circularisations.

This answer is OK, but only just, and barely a pass. The student clearly understands the basics: that written evidence is better than verbal evidence and that third party evidence is better than client-generated evidence. However, there is no actual mention of verbal evidence or internally-generated evidence by way of contrast. Nor is there any explanation of why third party evidence is better than internally-generated evidence or why in practice vendors� statements are more likely to be accurate than replies to circularisations. There is also certain amount of repetition, and very little attempt to consider the merits of the two types of evidence, despite the fact that there is clearly some understanding of issues such as control of documentation.

A student producing an answer such as the one above might well say.... �oh yes, I know all that, I just didn�t think I had to write it down�. Remember that marks can only be awarded for what is written down, the marker cannot award marks for what is in the student�s head!

The following is a better answer:

Answer 1(a) � Improved
(a) Receivables circularisations and vendors� statements.

• replies to a receivables circularisation and vendors statements are both good independent (third-party) evidence because they are generated outside the company;
• third-party evidence is better than internally-generated evidence (such as receivables or payables ledgers) because there is less likelihood that it has been altered or falsified in any way;
• both types of evidence are also reliable because they are written evidence; verbal evidence alone is always of very little value.

The relative merits the two types of evidence is as follows:

(i) receivables circularisations

• there is no motive for the client�s customers either to reply to the circularisation or to take the care to reply to it accurately � it is common for there to be a high level of non-replies (particularly where the customer is unable to pay) and a certain number of inaccurate replies (either due to disputes or errors) and to this extent circularisations are often unreliable;
• receivables circularisations test the client�s customers� payables ledgers; payables ledgers are generally less accurate than receivables ledgers and as such circularisations are less reliable than vendors� statements;

(ii) vendors� statements

• vendors� statements are often sent on a monthly basis, are part of the day to day running of the business and are subject to normal internal controls and as such are more likely to be accurate than receivables circularisations;
• unlike receivables circularisations, vendors� statements are not tainted with the requirement for the close involvement of both auditor and client and as such vendors� statements are more reliable than receivables circularisations.

Note the title in this answer (no marks, but it does make the answer easier to read), the length (just about right for the ten minutes available) and the way the points are split up (making it easier to identify individual points). The following question is also an adapted extract from a recent examination paper:

Question 2
(a) Explain the approaches adopted by auditors in obtaining sufficient, appropriate audit evidence regarding accounting estimates (3 marks);

(b) Identify and describe the procedures for obtaining audit evidence (5 marks).

Some students might attempt to answer part (a) on the basis of their practical knowledge of obtaining audit evidence in relation to an estimate such as depreciation, for example, and such an answer might score well. However, some students might be unclear as to the exact nature of an estimate and many would have little idea about the theory. This is one example of an area in which the theory is short, straightforward and has many applications, so it is worth learning.

Part (b) is straightforward provided the question is read carefully; the procedures for obtaining audit evidence are required; procedures such as the examination of documentation, the performance of analytical calculations, sampling and so on. The question does not require a discussion of audit methods such as tests of controls and substantive testing. If you are an auditor in practice you do not need to know the theory here, all you need to think of is what sort of procedures you apply on a day to day basis. If you are not in practice, but you work for a large company, think about the sort of procedures your internal audit department performs � they are very similar to the procedures external auditors perform. Students in a hurry often simply list the procedures. This is not enough (and will not attract a pass mark) because the question specifically asks for a description.

The following answer covers all the main areas:

Answer 2
(a) Accounting estimates

• accounting estimates are amounts appearing in the financial statements that are not capable of precise determination. A wide category of significant figures in the financial statements fall under the heading of �accounting estimate�. Examples of accounting estimates include depreciation charges, provisions for the profit or loss on the sale of assets, inventory valuations, the provision for doubtful debts, provisions for warranty claims and similar uncertain liabilities such as tax provisions.

There is a three-stage process to the audit of accounting estimates. Auditors should:

(i) review and test the process used by management to arrive at the estimate, which will involve reviewing the basis on which the estimate has been made to establish whether the assumptions are reasonable (e.g., compare the percentage of debts not recovered in practice with the provision for doubtful debts);

(ii) perform their own calculation of the estimate to be made;

(iii)review events after the period-end.

Sometimes, a review of events after the period-end is all that is necessary. For example, if an agreement to sell an asset before the period-end is finalised after the period-end, the profit or loss will no longer be an estimate and there will therefore be no need to review assumptions or for the auditors to perform their own calculation.

(b) Audit evidence

• procedures for the collection of audit evidence include the following:

(i) inspection of documentary evidence such as invoices, ledgers daybooks and the financial statements and inspection of tangible assets (to provide evidence relating to audit objectives such as completeness and existence);

(ii) computation (and re-computation) of e.g., the expected tax charge, the depreciation charge, accruals and prepayments and other calculated figures in the financial statements (to provide evidence relating to accuracy);

(iii)analytical procedures providing evidence as to the completeness and accuracy of e.g., payroll charges, depreciation charges, other profit and loss charges, sales, depreciation and other figures capable of being predicted;

(iv) observation of processes and procedures such as those performed at the inventory count, often in order to provide evidence as to the proper functioning of internal controls;

(v) enquiry, both within the audited entity and outside, in the form of receivables circularisations, inventory circularisations, correspondence with lawyers etc. (sampling procedures would be included under this heading).

The answer to part (a) above is more detailed than would be necessary in order to obtain full marks � the answer to part (b) is of roughly the correct length.

Finally, a theoretical question on the responsibilities and duties of auditors, also from a recent paper.

Question 3
SAS 100 and ISA 200, both entitled Objectives and general principles governing an audit of financial statements, deals with, amongst other things, the responsibility for financial statements and the concept of reasonable assurance.

Paragraph 8 of the ISA states that:

�An audit in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. Reasonable assurance is a concept relating to the accumulation of audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process.�

The effect on the audit is explained in paragraph 9:

�However, there are inherent limitations in an audit that affect the auditor�s ability to detect material misstatements.�

And paragraph 10:

�Also, the work undertaken by the auditor to form an opinion is permeated by judgement...�

Similar wording is found in the SAS.

(a) State the respective responsibilities for financial statements of the management of the entity and of it�s external auditors (6 marks);

(b) Describe the inherent limitations facing auditors in undertaking their work (6 marks);

(c) Describe the significant types of judgements made by auditors

(i) in gathering evidence (4 marks);

(ii) in arriving at an opinion on the financial statements (4 marks).

In relation to part (a), most students would be able to jot down a few notes to the effect that the auditor�s responsibility is to form an opinion as to the fair presentation (or truth and fairness) of the financial statements, in accordance with an identified financial reporting framework, and that management�s responsibility is to prepare the financial statements. Most students would also be able to state that in relation to part (b), inherent limitations facing auditors include the fact that not all transactions can be tested and maybe that �reasonable assurance� means that there is some possibility that the financial statements are not fairly presented. In relation to part (c), part (ii) would probably present little difficulties to students who understood the differences between the different types of modified audit reports but in relation to part (i), almost all evidence gathering involves the exercise of judgement � selecting good examples is the key. The statements most students are able to make as set out above will gain marks, but maybe not enough marks for a pass. How can they be expanded and developed to be sure of a pass?

One way of making more of any statement is to ask �why?�, �in what context?�, and �how?�. In relation to the fair presentation of a set of financial statements, one reason why auditors form an opinion is because of the separation of ownership and management, and the need for the owners to have assurance on the financial statements, independent of management assurance. In relation to context, auditors are normally appointed by management to report on annual financial statements, often, but not always, because they are required to do so by law. How do auditors perform their function? By means of risk analysis, tests of controls and substantive tests, and by using their professional expertise to ensure that the financial statements are in fact prepared in accordance with the relevant financial reporting framework.

In relation to part (a)(management�s responsibility) for the preparation of financial statements, the same three questions can be asked; one reason why management is required to prepare financial statements is to account for its stewardship of the organisation�s assets. In any case, most countries have a legal requirement for an audit of companies over a certain size. The context involves management�s control over assets and management�s duty to owners to manage those assets effectively in order to provide a fair return for the owners. How do managers prepare financial statements? Small organisations, if they require an audit often enlist the help of the auditors in preparing financial statements (although it is important for management to recognise that it is still responsible for the preparation of financial statements in such circumstances). Larger organisations normally employ professional accountants internally and they help management as a whole in its responsibility for keeping proper accounting records, selecting accounting policies, arriving at whatever estimates are necessary, forming judgements and preparing financial statements in an appropriate format.

If the information above were split into individual bullet points, there would be a good chance of obtaining full marks on part (a).

In relation to part (b), we need to expand on the original idea of the possibility that the financial statements are not fairly presented. Why might financial statements not be fairly presented? And in what context are financial statements more likely to be misstated? If students are asked these questions they usually come up with some very good answers. All students need to do in the exam room is to make sure that they ask themselves these questions!

The answer to part (b) might appear as follows:

Question 3

(b) Inherent limitations facing auditors include the fact that:

(i) it is no longer possible for auditors to test 100% of the transactions in a company�s accounting records � sampling is necessary and sampling carries with it a quantifiable but small risk of error;

(ii) even if it were possible to test 100% of the transactions in a company�s accounting records, there is always an element of detection risk in that mistakes and errors of judgement can be made in interpreting results;

(iii)large-scale fraud is often deliberately concealed by senior management who collude to prevent it coming to the auditor�s attention and such frauds are very difficult to detect (it is possible to conduct fraud audits but they are expensive and are not necessarily cost-effective because the cost of detection often outweigh the assets recovered as a result of detection);

(iv) auditors rely on the operation of internal controls to provide them with assurance as to the effective operation of a system; there are inherent limitations in the operation of such systems (due to human error, for example);

(v) most audit evidence is persuasive, rather than conclusive in nature;

(vi) the audit report expresses a professional opinion involving the exercise of a high level of professional judgement � the audit opinion is not a guarantee.

In relation to part (c) (i), we can list the need for the exercise of professional judgement in any of the following areas:

• risk assessments (audit, inherent risk, control risk and detection risk all involve a substantial element of professional judgement);
• determining materiality levels based on risk assessments for both the financial statements as a whole and for individual account areas;
• planning the appropriate combination of tests of controls and substantive testing based on initial risk assessments, and adjusting the audit plan as the audit progresses;
• drawing conclusions from analytical procedures;
• setting tolerable error and tolerable deviation rates and drawing conclusions from sampling procedures such as circularisations;
• assessing management representations (their strength and quality);
• assessing the implications of changes in accounting policies or the introduction of new accounting standards.

Students might either list the issues above, or, select a few and go into more detail and simply mention the other areas.

In relation to part (c) (ii), as noted above, provided students understand the basic types of audit report there will be plenty of material available to use in an answer, which might appear as follows:

Question 3
(c) Judgements made by auditors in arriving at the audit opinion:

(i) in arriving at any audit opinion, the auditor should be satisfied that sufficient appropriate evidence has been obtained on the financial statements as a whole and on individual account areas in order to form an opinion;

(ii) if insufficient evidence has been obtained, there has been a limitation in the scope of the audit and the auditor will either issue a qualified opinion in relation to an area which is material (e.g., an �except for� opinion in relation to lack of evidence to support the cash sales figure), or, a disclaimer of opinion on the financial statements as a whole (stating that the auditor is unable to form an opinion at all). The sufficiency of evidence is almost wholly a matter of professional judgement;

(iii) if sufficient evidence has been obtained but the auditor disagrees with accounting treatment or presentation, an �except for� or �adverse� opinion will be issued, depending on the severity of the matter. Again, disagreement is a matter of judgement and different auditors may have different opinions on the same subject;

(iv) auditors also exercise judgement when considering whether to issue an �emphasis of matter� which draws attention to a particular feature of the financial statements (such as financing arrangements).

It is important to remember that very few students have a lot of detailed theory at their fingertips. What distinguishes students in theoretical questions is the ability to make the most of an average level of knowledge by posing questions such as those noted above; why, in what context, and how.