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

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

Attempt-wise Marks [Chapter 2]

8

4
3 3
2

0 0 0 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 S23 A23 S24

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.
In-depth analysis of examinability with particular reference to Autumn 2024 will be explained in class.

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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 also has some 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. Independence:
Independence means auditor should be free to perform audit procedures without any bias or
influence. Auditor should be Independent of:
 Financial interests with client.
 Family and personal relationships with client.
 Employment with client.
(This concept will be discussed in detail in Chapters # 6 & 7)

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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. 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)

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, ③professional
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 with 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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 Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

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

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

Audit report only covers Financial Statements (i.e. 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
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.

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 i.e. establishing
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.

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Auditing – Study Notes Chapter 2: Basic Concepts of Auditing

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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