Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

CHAPTER 2
BASIC CONCEPTS OF AUDITING
ICAP Question
ICAP Study Text
LO # LEARNING OBJECTIVE Para References
Bank
References

PART A – FINANCIAL STATEMENTS:

LO 1 FINANCIAL STATEMENTS 1.1 Part [Ch. # 1] None

LO 2 WHAT IS MEANT BY TRUE AND FAIR VIEW 1.3 Part [Ch. # 1] Q # 127
1.1 Part [Ch. # 1],
LO 3 FINANCIAL REPORTING FRAMEWORKS 5.2 Part [Ch. # 14]
Q # 103i

PART B: RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT:

LO 4 RESPONSIBILITIES OF MANAGEMENT & TCWG 1.5 [Ch. # 1] Q # 4a

OVERALL OBJECTIVES (OR RESPONSIBILITIES) OF

LO 5 4.6 Part [Ch. # 1] Q # 8a, 165a
AUDITOR/AUDIT
RESPONSIBILITIES OF STAKEHOLDERS / EXPECTATION
LO 6 4.2 [Ch. # 14] Q # 135a
GAP
LO 7 ESSENTIALS FOR PROPER CONDUCT OF AUDIT 4.6 Part [Ch. # 1] Q # 4b, 111e

PART C: REGULATORY ENVIRONMENT OF AUDITING:

LO 8 INTRODUCTION TO IFAC AND IAASB 4.2, 4.4 [Ch. # 1] None

LO 9 INTERNATIONAL STANDARDS ON AUDITING (ISAs) 4.3, 4.5 [Ch. # 1] None

PART D: CASE STUDIES’ PERSPECTIVE:

APPLICATION OF PROFESSIONAL SKEPTICISM IN CASE
LO 10 None None
STUDIES

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Attempt-wise Marks (Chapter 2)

4
3 3
2
0 0 0 0 0 0 0 0 0 0 0 0 0
S14 A14 S15 A15 S16 A16 S17 A17 S18 A18 S19 A19 S20 A20 S21 A21 S22 A22

Overview of the Chapter:

This chapter discusses some terms frequently used in audit profession, responsibilities of different parties
involved in audit and regulatory authorities of auditing profession.

Examinability of the Chapter:

Although, examiner may ask question from any concept in any way. However, based on my past experience:
 Usually, a case study requiring application of professional skepticism is tested from this chapter.
Situations discussed in LO 10 are very likely to be tested in exam in case studies.
 “Professional Skepticism” and “Expectation Gap”, and “Management’s Responsibilities” are favorite
topics of examiner for a question of reproduction.

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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.

Complete set of financial statements include:

1. Statement of financial position (i.e. Balance Sheet)
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.

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: 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. 2
Discuss the concept of fair presentation (true and fair view) in relation to the financial statements. (02)
(ICAP, CAF 08 Level – Spring 2017, Q. # 6b)
(ICAP’s Question Bank for CAF 08 – Q. # 127)

LO 3: 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.

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

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).

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, country of framework shall also be mentioned in financial statements
and auditor’s report.

Study Tips
1. Auditor shall not accept proposed audit engagement, if AFRF is NOT 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. 3
Differentiate between the Fair presentation framework and Compliance framework (04)
(ICAP, CAF 08 Level – Spring 2012, Q. # 5ci)
(ICAP’s Question Bank for CAF 08 – Q. # 103i)

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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 identifying AFRF, preparing financial statements in accordance with AFRF,
applying appropriate accounting policies and reasonable estimates.
2. For design, 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 08 Level – Autumn 2009, Q. # 1a)
(ICAP’s Question Bank for CAF 08 – Q. # 4a)

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
 To report on financial statements which includes auditor’s opinion, and
 To communicate auditor’s findings as required by ISAs (e.g. to directors, regulators).

CONCEPT REVIEW QUESTION

Q. 5
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 Question Bank for CAF 08 – Q. # 165a)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

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.

CONCEPT REVIEW QUESTION

Q. 6
Explain the term ‘Expectation Gap’ in the context of an audit and give three examples of expectation gap. (04)
(ICAP, CAF 08 Level – Autumn 2015, Q. # 1a)
(ICAP’s Question Bank for CAF 08 – Q. # 135a)

CASE STUDY
Q. 7
Salman is a new employee in the financial reporting department of Eagle Company, a midsize publicly-held company with
annual profit of Rs 75 million.
As Eagle Company prepared for its annual audit, his manager came to him to complain about the auditors. Their audit fees
was so high, yet every year they never found all of the mistakes made by the staff in Eagle Company. One year, he
explained, they even missed a Rs. 5,000 fraud.
Required:
(a) How can Salman convince his manager about value that the company receives from an audit? (02)
(b)How can Salman explain that missing a Rs. 5,000 fraud does not indicate that the auditors performed an ineffective
audit? (02)
(c)How can Salman explain that missing a Rs. 5,000,000 fraud does not indicate that the auditors performed an ineffective
audit? (02)

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 in:

 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).
 Reporting stage (in drawing conclusions based on evidence obtained)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

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.

Advantages/Importance of Professional Skepticism:

Professional skepticism ensures that auditor does not:
 Overlook unusual circumstances.
 Over-generalize when drawing conclusions from audit observations.
 Use 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)

Some examples of situations causing threat to independence are:

 Inducements
 Financial interests
 Business relationships
 Family and personal relationships
 Employment with audit client
 Providing non-assurance services

CONCEPT REVIEW QUESTION

Q. 8
Briefly discuss the concept of ‘Professional skepticism’. (03)
(ICAP, CAF 08 Level – Spring 2016, Q. # 6e)
(ICAP’s Question Bank for CAF 08 – Q. # 111e)

Q. 9
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 08 Level – Autumn 2019, Q. # 2a)

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

PART C – REGULATORY ENVIRONMENT OF AUDITING

LO 8: INTRODUCTION TO IFAC AND IAASB:

International Federation of Accountants (IFAC):
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/roles:
1. It develops and promotes standards for assurance 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. IAPS do not
have same authority as ISAs.

Types of International Standards issued by IAASB:

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

 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. 10
Explain briefly the role of International Auditing and Assurance Standards Board (IAASB). (04)
(ICAP, CAF 08 Level – Spring 2008, Q. # 1)

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.

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. 11
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)

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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)
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.

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

CONCEPT REVIEW QUESTION

Q. 12
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)

CASE STUDY
Q. 13
This question consists of a number of items pertaining to an auditor’s risk analysis for a company. Indicate whether each
of the following factors are likely to increase, or decrease risk of material misstatement. Explain your decision.
1. During current year, Adam Sugar Mills Limited (ASML) became profitable first time since last 4 years.
2. ASML’s board of directors is controlled by Adam, the majority shareholder, who also acts as the chief executive officer.
3. The internal auditor reports to the CFO, and the CFO reports to Adam.
4. The accounting department has experienced a high rate of turnover of key personnel.
5. During 2012, ASML changed the method of preparing its financial statements from the cash basis to the accrual basis
under generally accepted accounting principles.
6. During the year, litigation filed against ASML in 2010 was withdrawn. It was alleged that the company discharged
pollution into locality. Disclosures made in previous financial statements have been removed from current year’s financial
statements.
7. During December 2012, ASML signed a contract to lease equipment from an entity owned by ASML’s parent company.
8. A public offering of ASML’s share is planned for late 2013.

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APX 1: SUGGESTED SOLUTION TO CONCEPT REVIEW QUESTIONS & CASE STUDIES:

Q. 1
An audit report has two main parts:
1. Financial Statements
2. Other Information (e.g. directors’ report)

Audit report only covers Financial Statements (Balance Sheet, P&L Account, Statement of changes in equity, Cash Flow
Statement, Notes to the Accounts). Auditor does not check accuracy of Other Information.

Q. 2
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.

Examiners’ Comments:
The overall performance in this part was quite poor. Only few of the candidates who had studied and could understand the
question’s requirements responded well and secured good marks. However, most of the candidates completely deviated from
the concept and related requirements outlined in the question.

Marking Plan:
 Discussion on the concept of ‘fair presentation 2.0 marks
.

Q. 3
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

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).

An example is Tax-basis Framework.

Examiners’ Comments:
This was fairly well answered by the majority of students.

Q. 4
Management is responsible:
1. For preparation and presentation of financial statements in accordance with AFRF.
This includes identifying AFRF, preparing financial statements in accordance with AFRF, applying appropriate
accounting policies and reasonable estimates.
2. For design, 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.

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 Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Q. 5
Responsibilities of Directors regarding financial statements:
Directors are responsible:
1. To prepare and present financial statements in accordance with AFRF.
1. For design, implementation and operating effectiveness of necessary internal controls;
2. To provide necessary information to auditor, for the purpose of audit.

Management is also responsible for specific responsibilities e.g. to prevent and detect fraud.

Responsibilities of Auditor regarding financial statements:

 To obtain reasonable assurance whether financial statements are free from material misstatement (whether
due to error or fraud), and
 To report on financial statements which includes auditor’s opinion, and
 To communicate auditor’s findings as required by ISAs (e.g. to directors, regulators).

Q. 6
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.

Examiners’ Comments:
The requirement of this part of the question was to explain the term ‘expectation gap’ and to give three examples thereof. The
performance was above average as generally the candidates performed well. However, some students explained it as the
difference between expected and actual results of the tests performed by the auditor. Some of them explained it as the
differences between the management and the auditor.

Marking Plan:
 Explanation of expectation gap 1.0 marks
 01 mark each for any three examples of expectation gap 3.0 marks
.

Q. 7
(a) Audit increases credibility of financial statements, as most of the misstatements are identified. Auditor identifies
deficiencies in entity’s internal control system, and gives recommendations to management to improve it.
(b) This misstatement is immaterial (01 mark). Materiality level is 3,750,000 (= 75,000,000 * 5%)(01 mark).
(c)Although this misstatement is material (01 mark), but auditor provides Reasonable Assurance (01 mark) for material
misstatement due to inherent limitations of audit (01 mark).

Q. 8
Professional skepticism is an attitude that includes:
a. a questioning mind,
b. being alert to conditions which indicate possible misstatement (due to error or fraud), and
c. 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.

Examiners’ Comments:
This part was generally well answered. However, many candidates discussed professional excellence rather than professional
skepticism.

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 Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Marking Plan:
 Brief discussion on the concept of Professional Skepticism 3.0 marks
.

Q. 9
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.

Examiners’ Comments:
Few examinees did not mention that how professional skepticism helps throughout the audit.

Marking Plan:
 Importance of maintaining professional skepticism 1.0 marks
 Discussing briefly the reason of maintaining professional skepticism 2.0 marks

Passing Percentage:
15%

Q. 10
IAASB is one of the boards within IFAC, and performs following activities:
1. It develops and promotes standards for assurance 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. IAPS do not have same authority as ISAs.

Examiners’ Comments:
This was a straight forward question and tested the role of IAASB and the purpose of pronouncements issued by it. Few
students were able to correctly mention about its activities such as development of International Standards on Auditing,
Review Engagements and Assurance Engagements. The purpose of the pronouncements issued by it [Link]
benchmarks for high quality auditing and assurance standards, providing guidance to auditors and other professional
accountants were mentioned by very few of the candidates. A sizeable number of students did not attempt the question at all.
Majority of the answers were in the generalized form and addressed irrelevant matters.

Q. 11
(i)
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.

(ii) An auditor is required to follow all ISAs except when a required procedure is:
 not relevant or
 not practicable.

Q. 12
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.

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Examples:
An auditor particularly apply professional skepticism in the situation when there is:
1. Intended sale of shares/business, or acquiring loan.
2. Management’s bonuses based on financial performance.

Q. 13

Sr.
Decision Explanation
#
(1) Risk will increase. Unusual growth/profitability indicates a risk of material misstatement.
Domination of management by a single person or small group without compensating
(2) Risk will increase. controls. That person may act in his own best interest and will have opportunity for
financial statement fraud.
A deficiency in internal control increases risk of material misstatement. Independence
(3) Risk will increase. of internal auditor is impaired if he reports to management (i.e. CFO) instead of TCWG
(i.e. Board of Directors or Audit Committee).
Turnover in key personnel increases risk of material misstatement because
(4) Risk will increase.
inexperienced and untrained staff may cause errors.
Changes in accounting/regulatory requirements increase risk of material
(5) Risk will increase
misstatement because misstatements are likely to occur on initial application.
Pending litigation and contingent liabilities cause risk of material misstatement. They
(6) Risk will decrease
are withdrawn, so risk is reduced.
Complex Transactions and Significant related party transactions increase risk of
(7) Risk will increase
material misstatement.
There is a risk of material misstatement in business segments likely to be sold to show
(8) Risk will increase. improved financial performance and financial position to buyer to receive higher
price.

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PRACTICAL INSIGHT AND REAL WORLD CASES [Just for Reading]:

Practical Insight
(Need of Professional Skepticism)

It is a common saying in auditing profession that 10% of people will never commit fraud, 10% will always commit
fraud and 80% will commit fraud if they think they can escape.

In a survey conducted in America, it was reported that 60% of students cheated in a test and 80% of studnets lied to
their parents about their results/educational activities. Think for a while, will such students tell the truth to
shareholders and auditors in their professional life if telling lie results in their bonuses, promotion etc.?

Real World Case

A small business owner hired his best (but unemployed) friend as accountant and gave him full access to business and
accounting. After some period, the owner terminated his best friend to reduce expenses because business was not
profitable. Later, owner found that cash receipts from customers became double the amount previously shown by
‘friend’ accountant. Upon investigation, it was discovered that accountant had stolen $450,000 from business, whereas
owner withdrew only $80,000 during this period. ‘Best’ friend cum accountant, even made loans to the owner to keep
business going, saying “a friend in need is a friend indeed”

Is relationship of client with auditor stronger than relationship with parents or friends? You can believe no one in real
life. Everyone can lie for his personal gains.

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