CLARIFIED INTERNATIONAL STANDARDS ON AUDITIING WHAT DOES IT MEAN FOR AUDITORS IN THE UK AND IRELAND?
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1 CLARIFIED INTERNATIONAL STANDARDS ON AUDITIING WHAT DOES IT MEAN FOR AUDITORS IN THE UK AND IRELAND? By: Danielle McWall, BSc (Hons), ACA, MBA, MIIA. Examiner - P1 Auditing Background Following the many recent company scandals, international regulators became more focused on the audits of public companies and the quality of auditing standards. As a result, the International Auditing and Assurance Standards Board (IAASB) reexamined their standards and commenced the Clarity Project in New Clarified International Standards on Auditing (ISAs) (UK and Ireland) were issued in October 2009 and apply to audits of financial statements for periods ending on or after 15 December It has been suggested that many auditors are not ready to apply the new standards and this article is an attempt to simplify the changes and ensure students studying auditing are ready to adopt the new standards in their work. Clarified ISAs (UK and Ireland) The new ISAs (UK and Ireland) actually incorporate the ISAs issued by the IAASB 2 as a result of the Clarity Project. However, the Auditing Practices Board (APB) in the UK has in certain cases augmented the standards with additional detail. This is an attempt to ensure that UK and Irish legal and regulatory requirements are covered by the new ISAs in addition to ensuring they address our specific cultural and business contexts. Any changes by the APB are clearly shaded in the standards and this identifies where the standard is different from the IAASB one. Structure of Clarified Standards The changes in the standards as a result of the Clarity project include the following: Detailed objective shown for each ISA; Requirements shown separately (prior to this the requirements tended to be shown in bold font in the Auditing Standard); Clarification of the obligations imposed on the auditor by the requirements of the ISAs in an attempt to eliminate any ambiguity; Improving readability and understandability; and Reducing complexity. As a result all ISAs now have a similar structure set out in the following table: Section Introduction Contents Purpose, scope and subject matter of the ISA as well as auditor s responsibilities and responsibilities of others in relation to the ISA. 1 APB Staff paper Summary of the main Changes in the New ISAs (UK and Ireland) October With the exception of ISA 700 Forming an Opinion and Reporting on Financial Statements. The APB have instead issued a clarified version of ISA (UK and Ireland) 700 The Auditor s Report on Financial Statements. This addresses current UK Company legislation and provides for a more concise auditor s report. In ROI, the version of ISA 700 that should be followed for the time being is the 15 December 2004 version. Page 1 of 8
2 Section Objective Definitions Requirements Application and other explanatory material Contents Clear statement of the objective of the auditor in the context of the ISA. Definitions of applicable terms included in the ISA to assist understanding. Each objective is supported by clearly stated requirements always expressed as the auditor shall and for this reason Clarified ISAs are sometimes known as the Shall Standards. Explains more precisely what a requirement means and contains valuable information for the auditor on how to comply with the requirements of the standard. At present the final set of Clarified standards comprise an International Standard on Quality Control, ISQC 1, and 33 ISAs. 3 A full list of all standards can be found on the APB website. Main Changes As a result of the Clarity Project there are 2 merged standards, 12 revised standards and 2 new standards. Other standards are clarified but without significant revision. The following tables outline the main changes for auditors as a result of the adoption of the new standards: Merged ISAs ISA 540 Audit of Accounting Estimates and ISA 545 Auditing Fair Value Measurements and Disclosures merge to become: ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures Auditors need to understand the process and update their permanent information as a result. They will also need to: Assess risk Document accounting estimates Perform audit procedures including reviewing prior year estimates and test management s estimation uncertainty (more procedures will be needed where risk is assessed as high) Obtain written representations Document conclusions Document issues of management bias and communicate to those charged with governance under ISA 260. Revised ISAs ISA 200 Objective and General Principles Governing an Audit of Financial Statements In conducting an audit of financial statements, the overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, 3 ISA 250 and ISA 720 each contain 2 parts A and B. Page 2 of 8
3 whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and (b) To report on the financial statements, and communicate as required by the ISAs (UK and Ireland), in accordance with the auditor s findings. Key points to note are: The need to comply with the IFAC Ethical Code 4 Being alert is mentioned in the standard and the need for professional scepticism and professional judgement Need to read the ISAs to ensure compliance with all relevant ISAs ISA 210 Agreeing the Terms of Audit Engagements The auditor is required to perform specific procedures to establish whether the preconditions for an audit are present including: (a) Determining whether an acceptable financial reporting framework is applied in the preparation of the financial statements. (b) Obtaining the agreement of management 5 that it acknowledges and understands its responsibility for the preparation of the financial statements in accordance with the applicable financial reporting framework; for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and to provide the auditor with access to all information of which management is aware that is relevant to the preparation of the financial statements; plus additional information that the auditor may request; and unrestricted access to persons within the entity. ISA 260 Communication of Audit Matters with Those Charged with Governance The auditor shall communicate in writing if, in the auditor s professional judgement, oral communication would not be adequate. Written communications need not include all matters that arose during the course of the audit. Matters to be communicated include: The responsibilities of the auditor The overview of the planned scope and timing of the audit Significant findings from the audit No need to communicate any more if there are no issues. Specific items to be communicated: Auditor s views on significant qualitative aspects of the entity s accounting practices 4 Incorporated into the APB Code of Ethics for Auditors 5 It should be noted that the revised ISA 580, Written Representations, requires the auditor to obtain written representations from management concerning the fulfilment of these responsibilities Page 3 of 8
4 Significant difficulties encountered during the audit Unless those charged with governance are involved in managing the entity; significant discussions with management and management representations requested. There should be a process of two-way communication and any oral communication should be documented. ISA 320 Materiality in Planning and Performing an Audit Significant changes for auditors with this standard include new terms for overall materiality; performance materiality; and benchmarking. Methodology (e.g. percentages to be used) is not included in the standard. It should be noted that performance materiality is not the same as tolerable error and represents the amount(s) set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole (many firms are using 60%). ISA 402 Audit Considerations Relating to Entities using Service Organisations The revision of ISA 402 was intended to respond to the increasing use of service organisations by entities and the increasing complexity of such relationships. The revised ISA 402 is also intended to enhance the consistency of auditor performance. The requirements of the standard include: Specifying matters included in the understanding of how the user entity uses the services of a service organisation. Where the auditor s risk assessment includes an expectation that controls at the service organisation are operating effectively, specifying procedures the auditor performs to obtain audit evidence about the operating effectiveness of those controls, including: (a) Obtaining a Type 2 report, if available; (b) Performing appropriate tests of controls at the service organisation; or (c) Using another auditor to perform tests of controls at the service organisation on behalf of the auditor. Specifying procedures to be performed if the auditor plans to use a report from a service auditor as audit evidence, including: o being satisfied as to the service auditor s professional competence and independence, and the adequacy of the standards under which the report was issued; and o in relation to Type 2 reports, procedures to determine whether the service auditor s report provides sufficient appropriate audit evidence about the effectiveness of the controls to support the Page 4 of 8
5 user auditor s risk assessment. ISA 505 External Confirmations The auditor shall maintain control over the confirmation requests. If management refuse to allow the auditor to perform external confirmation procedures the auditor shall enquire into the reason for refusal; evaluate the implications; and perform alternative procedures where possible. The auditor must evaluate the reliability of the confirmations received and if not received perform alternative procedures. Negative confirmation requests provide less persuasive evidence therefore, they should not be performed as the sole substantive procedures unless: The risk of material misstatement is low; The population comprises a large number of small balances; A very low exception rate is expected; and The auditor is not aware of any circumstances that would cause recipients to disregard requests. ISA 550 Related Parties Auditors need to use a risk based approach which includes understanding the entity (ISA 315) ; assessing the risks (ISA 320) and responding to the risks by considering fraud risk indicators (ISA 240) since there is a considerable risk of fraud in related party transactions. Audit team discussion is key and should include: The nature and extent of relationships and transactions An emphasis on maintaining professional scepticism throughout the audit Circumstances or records that might indicate the existence of related parties The attitude of management Key points for the auditor include: Documentation of understanding of related parties Documentation of relevant audit team discussion Remaining alert to the possibility of related parties and address any unidentified related parties Review of significant transactions outside the entity s normal course of business Obtaining written representations from management. ISA 580 Management Representations Now linked more closely with ISA 240 The Auditor s Responsibilities Relating to Fraud in an Audit of Financial Statements Written representations are required and should be on client s headed paper. Page 5 of 8
6 If they are not received or if management s integrity would indicate that the letter is unreliable then you should disclaim your audit opinion. ISA 600 Special Considerations - The Audit of Group Financial Statements (Including the Work of Component Auditors The group auditor has overall responsibility for the group audit engagement. The core concepts that need to be understood by the group auditor are: Scoping decisions Materiality considerations Understanding the component auditor including their compliance with ethical requirements such as independence; professional competence and regulatory environment Involvement in the component auditor s work For significant components the group auditor shall be involved in the component auditor s risk assessment. ISA 620 Using the Work of an Auditor s Expert Acknowledges that experts might be used for other purposes during the audit not just measurement of account balances and also the possibility that the wider use of fair value accounting may require more frequent use of experts by the auditor. There is more specification of audit procedures, in particular regarding the agreement of work to be performed and evaluating the reasonableness of the expert s findings as detailed below. The auditor shall agree, in writing when appropriate, on the following matters with the auditor s expert: (a) The nature, scope and objectives of that expert s work; (b) The respective roles and responsibilities of the auditor and that expert; (c) The nature, timing and extent of communication between the auditor and that expert, including the form of any report to be provided by that expert; and (d) The need for the auditor s expert to observe confidentiality requirements. The auditor shall evaluate the adequacy of the auditor s expert s work for the auditor s purposes, including: (a) The relevance and reasonableness of that expert s findings or conclusions, and their consistency with other audit evidence; (b) If that expert s work involves use of significant assumptions and methods, the relevance and reasonableness of those assumptions and methods in the circumstances; and (c) If that expert s work involves the use of source data that is significant to that expert s work, the relevance, completeness, and accuracy of that source data. Page 6 of 8
7 If the auditor determines that the work of the auditor s expert is not adequate for the auditor s purposes, the auditor shall: (a) Agree with that expert on the nature and extent of further work to be performed by that expert; or (b) Perform additional audit procedures appropriate to the circumstances. ISA 705 Modifications to the Opinion in the Independent Auditor s Report and ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor s Report The APB has adopted ISAs 705 and 706 with a small amount of supplementary guidance (e.g. to draw attention to the auditor s legal obligations with regard to making a statement when ceasing to hold office). This is not expected to lead to a significant change in practice regarding modifications of auditor s reports. 6 New ISAs ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance Only significant deficiencies need to be reported. Suggested that the communication is called a Letter of Recommendation (previously referred to as a Management Letter or Letter of Weakness ). Where there are previously reported deficiencies it should not prevent them form being reported again and need to ask why nothing has happened and identify that the failure to act may itself be a significant deficiency. Two way communication is advised. Report should include: A description of the deficiency Possible effect Recommendation (can t do this for a listed company and need to be careful that this is listed as a non audit service under Ethical Standard 5) Client response ISA 450 Evaluation of Misstatements identified During the Audit There should be a summary of unadjusted errors and these need to be evaluated in the context of materiality. Those items that are clearly trivial can be excluded but the indicators of what is clearly trivial should be documented and management need to acknowledge them as clearly trivial. 6 6 APB Staff paper Summary of the main Changes in the New ISAs (UK and Ireland) October Page 7 of 8
8 New ISAs Practice Note 26 Guidance on Smaller Entity Guidance Documentation has example documentation. Quality Standard ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Services Egagements Six elements of a quality control system: Leadership responsibilities for quality within a firm Ethical requirements Acceptance and continuance of client relationships and specific engagements Human resources Engagement performance Monitoring Needs to be adequately documented by the audit firm. Where to go from here? To get the most out of the new ISAs and ensure the audit is efficient and effective it is important to: 1. Read the standards and pay particular attention to the objective and requirements. It might be more appropriate to read the application part of the standard and the explanatory material in line with the requirements to assist understanding. It is important to remember that the wording of all standards has changed not just the ones noted in the tables above. 2. Read any guidance offered by the APB e.g. Practice Note 26 Guidance on Smaller Entity Guidance Documentation. 3. Limit the audit files to audit working papers only and use permanent files wisely. Don t copy all documents seen, it is sufficient to document that it was inspected. 4. Keep audit programmes clear and concise outlining what needs to be done to meet the objectives of the audit. Don t do things just because you did them last year. 5. Management need to keep control of the audit and ensure quality is maintained. Conclusion Although the structure of the new ISAs is consistent and improves readability and understandability, it must be noted that there are many more specific requirements for auditors under the new standards. The old standards had c. 470 requirements outlined in bold text and the new ISAs have c.700 identified as the auditor shall. It is also important to be aware that alertness, professional scepticism and adherence to ethical standards need to be maintained throughout the audit and this idea runs across the standards. With the Clarified ISAs on our doorstep for all audits of financial statements for periods ending on or after 15 December 2010, it is now more important than ever that auditors understand what is required of them and ensure they can deliver efficient, effective audits. Page 8 of 8
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