Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

CHAPTER 2
BASIC CONCEPTS OF AUDITING
LO # LEARNING OBJECTIVE

PART A – FINANCIAL STATEMENTS

LO 1 FINANCIAL STATEMENTS

LO 2 FINANCIAL REPORTING FRAMEWORKS

LO 3 WHAT IS MEANT BY TRUE AND FAIR VIEW

PART B: RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT

LO 4 RESPONSIBILITIES OF MANAGEMENT & TCWG

LO 5 OVERALL OBJECTIVES (OR RESPONSIBILITIES) OF AUDITOR/AUDIT

LO 6 RESPONSIBILITIES OF STAKEHOLDERS / EXPECTATION GAP

LO 7 ESSENTIALS FOR PROPER CONDUCT OF AUDIT

PART C: REGULATORY ENVIRONMENT OF AUDITING

LO 8 INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD (IAASB)

LO 9 INTERNATIONAL STANDARDS ON AUDITING (ISAs)

PART D: CASE STUDIES’ PERSPECTIVE

LO 10 APPLICATION OF PROFESSIONAL SKEPTICISM IN CASE STUDIES

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

PART A – FINANCIAL STATEMENTS

Auditor shall check whether financial statements have been prepared in accordance with
framework, and give true and fair view.

LO 1: FINANCIAL STATEMENTS:
Financial statements means structured representation of historical (i.e. past) financial information.

Components of financial statements depend on AFRF, and usually include:

1. Statement of financial position.
2. Statement of profit or loss, and Other Comprehensive income.
3. Statement of changes in equity.
4. Cash Flow Statement.
5. Notes to the financial statements, including summary of significant accounting policies and
other explanatory information.

CONCEPT REVIEW QUESTION

Q. 1
What parts of a company’s annual report are covered by an audit report? (02 marks)
(ICAEW Professional Stage – September 2006)

LO 2: FINANCIAL REPORTING FRAMEWORKS:

A financial reporting framework is a set of criteria used to prepare financial statements.

Types of Frameworks:
There are many types of frameworks e.g. :
1. General Purpose (for wide range of users), and Special Purpose (for specific users).
2. Fair presentation Framework, and Compliance Framework.

Fair Presentation Framework:

Fair presentation framework is a financial reporting framework that requires compliance with
requirements of the framework and contains acknowledgment that, to achieve fair presentation, it
may be necessary for management:
 To provide disclosures in addition to specific requirements of framework or
 To depart from a requirement of framework

In Fair presentation framework, auditor expresses opinion whether:

 “financial statements give true and fair view in accordance with the framework”, or
 “financial statements are presented fairly, in all material respects, in accordance with the
framework”. (Both phrases are equivalent)

An example is International Financial Reporting Standards.

Compliance Framework:
Compliance framework is a financial reporting framework that requires compliance with
requirements of the framework, and does not contain acknowledgements which are contained in
fair presentation framework (regarding additional disclosures or departure from requirements of
framework to achieve fair presentation).

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In Compliance framework, auditor expresses opinion whether “financial statements are prepared,
in all material respects, in accordance with the framework”.

An example is Tax-basis Framework.

Applicable Financial Reporting Framework (AFRF):

AFRF is the financial reporting framework adopted by management and Those Charged With
Governance (TCWG), in preparation of financial statements considering legal requirements, nature
of entity, nature of financial statements, and purpose of financial statements.

AFRF includes financial reporting standards (e.g. IFRS or US GAAP), and may be supplemented by
law or regulation.

If AFRF is other than IFRS, jurisdiction of framework shall also be mentioned in financial statements
and auditor’s report.

Study Tips
1. Auditor shall accept proposed audit engagement, only if AFRF is acceptable.
2. Management means persons responsible for operational and managerial duties (e.g. CFO, CEO).
TCWG means persons responsible for Overseeing the strategic direction and Accountability (e.g. Directors).

CONCEPT REVIEW QUESTION

Q. 2
Differentiate between the Fair presentation framework and Compliance framework (04)
(ICAP, CAF 09 Level – Spring 2012)
(ICAP’s Official Question Bank for CAF 09 – Q. # 101i)

LO 3: WHAT IS MEANT BY TRUE AND FAIR VIEW:

Term “true and fair view” or “fair presentation” have no legal definition. Generally:
 true means free from errors, and
 fair means free from undue bias in preparation or presentation of financial statements.

The phrase “True and fair view” indicates that judgment is applied in preparation of financial
statements by management, and in expressing opinion by auditor.

CONCEPT REVIEW QUESTION

Q. 3
Discuss the concept of fair presentation (true and fair view) in relation to the financial statements. (02)
(ICAP, CAF 09 Level – Spring 2017, Q. # 6b)
(ICAP’s Official Question Bank for CAF 09 – Q. # 125)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

PART B – RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT

LO 4: RESPONSIBILITIES OF MANAGEMENT AND TCWG:

An audit is conducted on the premise that management (and where applicable TCWG) is
responsible:
1. For preparation and presentation of financial statements in accordance with AFRF.
This includes to identify AFRF, prepare and present financial statements in accordance with
AFRF, selecting and applying appropriate accounting policies and reasonable estimates.
2. For design and implementation and operating effectiveness of such internal controls which
are necessary for preparation of reliable financial statements;
3. To provide auditor with:
a. all relevant information,
b. additional information requested by auditor, and
c. unrestricted access to persons within the entity to obtain evidence.

Management is also responsible for specific responsibilities e.g. to prevent and detect fraud, and to
provide written representation to auditor at end of audit.

CONCEPT REVIEW QUESTION

Q. 4
Briefly highlight the management’s responsibilities relating to the financial statements? (04)
(ICAP, CAF 09 Level – Autumn 2009)
(ICAP’s Official Question Bank for CAF 09 – Q. # 4a)
Q. 5
Discuss as to who is responsible to prepare financial statements. (02)
(ICAP, CAF 09 Level – Spring 2002)

LO 5: OVERALL OBJECTIVES (OR RESPONSIBILITIES) OF AUDITOR/AUDIT:

The overall objectives of the auditor are:
 To obtain reasonable assurance whether financial statements are free from material
misstatement (whether due to error or fraud), and issue audit report on the financial
statements, and
 To communicate matters which are required by ISAs (e.g. to directors, regulators).

CONCEPT REVIEW QUESTION

Q. 6
What is the primary/overall objective of an audit? (03)
(ICAP, CAF 09 Level – Autumn 2001)
Q. 7
The purpose of an external audit and its role are not well understood. You have been asked to write some material for
inclusion in your firm’s training materials dealing with these issues in the audit of large companies.
Required:
Draft an explanation dealing with the purpose of an external audit and its role in the audit of large companies, for the
inclusion in your firm’s training materials.
(ICAP’s Official Question Bank for CAF 09 – Q. # 8a)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Q. 8
You are the audit manager of Rake Enterprises, a limited liability company. The company’s annual revenue is over Rs 100
million.
Required:
Compare the responsibilities of the directors and auditors regarding the published financial statements of Rake
Enterprises.
(ACCA, Fundamentals Level F8 – June 2005)
(ICAP’s Official Question Bank for CAF 09 – Q. # 163a)

LO 6: RESPONSIBILITIES OF STAKEHOLDERS / EXPECTATION GAP:

It is the responsibility of stakeholders to understand and eliminate expectation gap so that scope of
audit is not misunderstood.

Expectation Gap:
Expectation gap means public perception of the role and responsibilities of the external auditor is
different (and is usually higher) from his statutory role and responsibilities.

Some Common Misunderstandings (i.e. Expectation Gap) about Audit:

1. Auditor prepares financial statements.
2. Auditor checks 100% transactions of entity during the accounting period.
3. Auditor provides absolute assurance (i.e. he certifies or guarantees that financial statements
are correct in all respects, and can be relied for all decision making purposes).
4. Auditor is responsible to prevent and detect fraud.
5. Auditor is responsible to express opinion on internal controls.

Consequences of Expectation Gap:

It increases tendency of users to make wrong decisions on the basis of audit report, and to file legal
actions against auditors on frivolous basis (i.e. without any valid basis).

How to Reduce Expectation Gap:

Expectation gap can be reduced by:
1. Mentioning management’s responsibilities, and auditor’s responsibilities in Engagement
Letter and Auditor’s Report.
2. Expanding and improving the format of auditor’s report to clarify responsibilities of auditor.
3. Implementation of regulations to explain responsibilities of management/directors e.g.
Code of Corporate Governance by SECP.
4. Public awareness on scope of audit and responsibilities of auditor.

CONCEPT REVIEW QUESTION

Q. 9
Explain the term ‘Expectation Gap’ in the context of an audit and give three examples of expectation gap. (04)
(ICAP, CAF 09 Level – Autumn 2015)
(ICAP’s Official Question Bank for CAF 09 – Q. # 133a)
Q. 10
You are the audit manager of Polycrafts Limited for two years. During the audit for the year ended 30th June, 2017, the
management communicated to you a misstatement identified in previous year accounting entries that was not corrected
by the auditors. Management is of the view that auditor is responsible for identifying all the misstatements, whether due
to fraud or error.
(a) Explain the term “Expectation Gap”. (03)
(b) Discuss whether you agree with the views expressed by the management. (03)
(c) List down the factors due to which auditor is unable to provide absolute assurance. (05)
(PIPFA – Winter 2017)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Q. 11
What is the “expectation gap” and how could it be removed or reduced by the auditing profession? (04)
(ICAP, CFAP 06 Level – Winter 1993)

LO 7: ESSENTIALS FOR PROPER CONDUCT OF AUDIT:

1. Professional Judgment:
Professional Judgment is the application of Cumulative Audit Knowledge, Experience and
Training (within the context of accounting, auditing, and ethical standards), to reach an
appropriate course of action or conclusion during an audit.

Areas where Professional Judgment is applied:

 Planning of audit (e.g. in risk assessment, in determination of materiality).
 Performance of audit (e.g. in deciding nature, timing and extent of audit procedures, in
evaluating sufficiency and appropriateness of audit evidence).

2. Professional Skepticism:
Professional skepticism is an attitude that includes:
i. a questioning mind,
ii. being alert to conditions which indicate possible misstatement (due to error or fraud),
and
iii. critical assessment of audit evidence.

Even if management has shown honesty and integrity in past, still auditor shall apply
professional skepticism in planning and performing the audit. He shall corroborate every
assertion of management, by obtaining persuasive evidence.

Importance of Professional Skepticism:

Professional skepticism is necessary:
 To identify risk of material misstatements.
 To critically assess audit evidence, and
 To determine sufficiency and appropriateness of audit evidence.

Professional skepticism helps to avoid:

 Overlooking unusual circumstances.
 Over-generalizing when drawing conclusions from audit observations.
 Using inappropriate assumptions in determining audit procedures, and evaluating
results.

3. Independence:
Independence means auditor should be free to perform audit procedures without any bias or
influence. Auditor should be Independent of financial, personal and employment relations with
client.
(This concept will be discussed in detail in Chapters # 6 & 7.)

CONCEPT REVIEW QUESTION

Q. 12
Briefly discuss the concept of ‘Professional skepticism’. (03)
(ICAP, CAF 09 Level – Spring 2016)
(ICAP’s Official Question Bank for CAF 09 – Q. # 109e)

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Q. 13
During the audit team planning meeting, a member of the audit team passed a comment that based on past experience
with the client, he was confident that the management of the client was honest and there was no issue as regards
management integrity or risk of fraud in the Company. The audit manager responded that the auditor should always
maintain an attitude of professional skepticism throughout the audit.
Required:
Briefly describe ‘Audit Skepticism’ and elaborate on the response of the audit manager. (04)
(ICAP, CAF 09 Level – Autumn 2009)
(ICAP’s Official Question Bank for CAF 09 – Q. # 4b)
Q. 14
Aslam is a junior member of your audit team. During an informal discussion with your team members, Aslam has inquired
you about the reasons of emphasizing on professional scepticism when honesty and integrity of the management is not
questionable based on prior experience. Briefly respond to the inquiry of Aslam. (03)
(ICAP, CAF 09 Level – Autumn 2019, Q. # 2a)

PART C – REGULATORY ENVIRONMENT OF AUDITING

LO 8: INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD:

International Federation of Accountants:
IFAC is the worldwide leader of audit profession. It is the global organization of professional
accountants dedicated to serving the public interest.

Functions/Role/Activities of IFAC:
IFAC supports the development of profession in the area of ①auditing, ②ethics, ③ professional
education and ④public sector by following activities:
1. development of high-quality standards and guidance.
2. facilitating the adoption and implementation of standards and guidance.
3. promoting the value of professional accountants worldwide.
4. speaking out on public interest issues where professional voice is important.

Boards of IFAC:
IFAC includes following four boards:
1. International Auditing and Assurance Standards Board (IAASB)
2. International Ethics Standards Board for Accountants (IESBA)
3. International Public Sector Accounting Standards Board (IPSASB)
4. International Accounting Education Standards Board (IAESB)

International Auditing and Assurance Standards Board (IAASB):

IAASB is one of the boards within IFAC, and performs following activities:
1. It develops and promotes standards to be applied in providing the audit, review and related
services.
2. It also provides facilitation in adoption and implementation of international standards. In
doing so, IAASB enhances quality and consistency of assurance practice throughout the
world.
3. In addition to ISAs, IAASB also issues International Auditing Practice Statements (IAPS) to
help auditors in implementing ISAs and to promote good auditing practice in general.

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Types of International Standards issued by IAASB:

 Audit is conducted in accordance with ISAs (International Standards on Auditing).

 Review is conducted in accordance with ISREs (International Standards on Review Engagements).
 Other assurance engagements are conducted in accordance with ISAEs (International Standards on Assurance
Engagements).
 Related Services are conducted in accordance with ISRS (International Standards on Related Services).
 ISQCs (International Standards on Quality Control) applies on ALL types of services.

CONCEPT REVIEW QUESTION

Q. 15
International Federation of Accountants (IFAC) provides leadership to the worldwide accountancy profession in serving
the public interest. What activities are undertaken by IFAC to achieve this aim? (04)
(ICAP, CAF 09 Level – Autumn 2006)

Q. 16
Explain briefly the role of International Auditing and Assurance Standards Board (IAASB). (04)
(ICAP, CAF 09 Level – Spring 2008)

LO 9: INTERNATIONAL STANDARDS ON AUDITING (ISAs):

Process of Developing and Issuing a new ISAs:
1. A subject is selected for detailed study.
2. After conducting comprehensive study and research, an exposure draft is produced which is
approved by IAASB and then distributed widely for public comments.
3. Comments and proposed amendments are considered by the IAASB.
4. The new ISA is then published.

Contents of ISAs:
1. Introductory Material, Objectives, Definition.
2. Requirements.
3. Application and Other Explanatory Material (including Appendices).

Authority/Status of ISAs:
In Pakistan, audit is conducted in accordance ISAs. To obtain reasonable assurance, it is compulsory
for auditors to comply with all requirements of all ISAs.

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Exception to follow requirements of ISA:

A required procedure will not be performed if it is:
 not relevant or
 not practicable.

However, if a procedure is not practicable, auditor shall document:

 reason of departure from required procedure, and
 alternative procedures performed to obtain evidence/assurance.

CONCEPT REVIEW QUESTION

Q. 17
International Standards on Auditing (ISAs) are issued by the International Auditing and assurance Standard Board
(IAASB). In this context, explain the following:
(i) The position of these standards relating to external audit process (02)
(ii) The extent to which an auditor must follow ISAs. (02)
(ICMA Pakistan – Fall 2017)

PART D– CASE STUDIES’ PERSPECTIVE

LO 10: APPLICATION OF PROFESSIONAL SKEPTICISM IN CASE STUDIES:

Following situations in case studies must increase your risk:
1. Intended sale of shares/business, or acquiring loan.
2. Unusual growth or decrease of sales.
3. Management’s bonuses based on financial performance.
4. Significant transactions at year end.
5. Imports and Exports.
6. Cash for Sale or purchase is received (or paid) in advance
7. Inconsistency between different sources of evidences e.g.
a. Management Vs. Lawyer
b. Financial Statements Vs. Other Information
c. Debtors’ Confirmation Letter Vs. Amount recorded in sales ledger.
d. Amount Estimated by auditor (through Analytical procedures) Vs. Amount actually Recorded in F/S
8. Going Concern Issues e.g. increased competition, product failures, operating losses
9. Significant related party transactions.
10. Significant Income, Expenses, Assets, and Liabilities are based on estimates.
11. Identified deficiencies in internal controls (e.g. No Approval, Reconciliations or Segregation of duties).
12. Lack of competence or integrity in management or employees.
13. Valuation of inventory (Decrease in sales/demand, Long-standing inventory/increase in inventory, Defective
goods in inventory, Cost of production increases, or Sale price decreases, If product is malfunctioning, New
products are launched by company or competitor, Contract of specialized inventory is cancelled or customer
goes bankrupt, Defective goods returned by customers.)
14. Inventory is held at various locations or Inventory is held with third party or Physical count was not done at
balance sheet date.
15. Additions to fixed assets (Major fixed assets purchased during the year, or Significant capital expenditures
incurred during the year)
16. Revaluation of PPE.
17. Closure of a factory
18. Provision for warranty (Increase in warranty period/complains, Malfunctioning of products)
19. Onerous contracts
20. There is dispute with major debtor e.g. on defective goods (this may require provision for debtors, write-down
of inventory to NRV, and impairment of machinery).
21. There are pending litigations against company (unfair dismissal of staff, serious accident damaging environment
or injuring people, malfunctioning of product)

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22. Other Risks:

a. Risk of inappropriate treatment of contingent liabilities and contingent assets.
b. Restricted time schedule for audit (Audit team may not have time to obtain sufficient appropriate audit
evidence.)
c. Predecessor auditor did not wish to be reappointed, or predecessor auditor expressed modified
opinion.

CONCEPT REVIEW QUESTION

Q. 18
An auditor is required to maintain an attitude of ‘Professional Skepticism’ while conducting an audit of Financial
Statements.
Describe by giving TWO appropriate examples, the term Professional Skepticism. (04)
(PIPFA – Summer 2015)

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APX 1: HINTS & COMMENTS TO CONCEPT REVIEW QUESTIONS:

Q. 1
Annual report contains components of financial statements as well as other information (e.g. directors’ report). However,
audit report covers 5 components of financial statements only (as in LO 1).

Q. 2
Easy question, but don’t forget to give example of each framework with definition (as in LO 2).

Q. 3
Refer to LO 3.

Q. 4
Easy question to be reproduced from notes (as in LO 4).

Q. 5
Management and TCWG. (as in LO 4)

Q. 6
Easy question to be reproduced from LO 5.

Q. 7
Note that question has two parts:
1. purpose of an external audit (i.e. objective of audit), (Ch. 2, LO 5)and
2. role in the audit of large companies (i.e. advantages of audit) (Ch. 1, LO 1)
You must present both parts separately giving suitable headings in your answer.

Q. 8
Easy question to be reproduced from LO 4 and LO 5.

Q. 9
Easy question to be reproduced from LO 6.

Q. 10
(a) Easy question to be reproduced from LO 6. Although examples are not specifically required in question, however, you
must also give some examples to explain the concept.
(b)No. Auditor is not responsible to detect immaterial error or fraud. Further, regarding material error or fraud, auditor
provides only reasonable assurance because of inherent limitations of audit.
(c) This part relates to Chapter # 1 (LO 3: Inherent Limitations).

Q. 11
Easy question to be reproduced from LO 6.

Q. 12
Explanatory line should also be written alongwith 03 points of professional skepticism.

Q. 13
Question has two parts:
1. definition of audit skepticism (i.e. professional skepticism)
2. elaboration. (Students should give some examples of situations in which it is particularly important to apply
professional skepticism. These examples are given in the LO 10).

Q. 14
Refer to importance of Professional Skepticism, in LO 7 subheading “Professional Skepticism”.

Q. 15
Easy question to be reproduced from LO 8. However, students did not perform well in this question.

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Q. 16
Easy question to be reproduced from LO 8. However, students did not perform well in this question.

Q. 17
(i) reproduce “authority/status of ISAs”.
(ii) reproduce “exception to follow requirements of ISA”
Many candidates could not understand in exam what was required.

Q. 18
Easy question to be reproduced from notes.

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