Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

CHAPTER TWO
BASIC CONCEPTS OF AUDITING
LO #

ICAP'S STUDY TEXT

REFERENCE*

LEARNING OBJCTIVE

PART A FINANCIAL STATEMENTS

LO 1

WHAT IS INCLUDED IN COMPLETE SET OF

FINANCIAL STATEMENTS

N/A

FINANCIAL REPORTING FRAMEWORK AND ITS

TYPES

Q. # 59(c i) of Question
Bank

PART B FINANCIAL REPORTING FRAMEWORK

LO 2

LO 3

WHAT IS MEANT BY TRUE AND FAIR VIEW

1.1.3 (True and fair view)

PART C RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT

LO 4

MANAGEMENTS
RESPONSIBILITIES

LO 5

LO 6

(AND

TCWGS)

1.3.9 (Responsibility of
management)

AUDITORS RESPONSIBILITIES/OBJECTIVE

1.4.5

STAKEHOLDERS RESPONSIBILITIES

15.4.2

PART D SCOPE OF AUDIT

LO 7

SCOPE OF AUDIT

LO 8

ESSENTIALS OF PROPER CONDUCT OF AUDIT

PART E REGULATORY ENVIRONMENT OF AUDITING

L O9

INTERNATIONAL
ACCOUNTANTS (IFAC)

LO 10

FEDERATION

OF

AUTHORITY/STATUS/APPLICATION
OF
INTERNATIONAL STANDARDS ON AUDITING
(ISAs)

1.4.6 (excluding Audit Field

work)
1.4.4(Professional
judgment), 3.1.2
1.4.2 (excluding Producing
a new ISA),
1.4.3, 1.4.4 (Preface to .)
1.4.4 (ISA & Other
International Standards)

Coverage from Question Bank:

After completion of this chapter, you will be able to attempt following questions in ICAP's Question
Bank:
Question # in ICAPs
Question Bank

Q. # 4a (Core concepts)

Q. # 59 ci (Wedge & Co)

Type of Question

Concept Review Question

Concept Review Question

Question # in ICAPs
Question Bank

Q. # 4b (Core concepts)

Q. # 101a (Rake Enterprises)

Type of Question
Case Study

Concept Review Question

By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

PART A FINANCIAL STATEMENTS

LO 1: WHAT IS INCLUDED IN COMPLETE SET OF FINANCIAL STATEMENTS:
A complete set of financial statements includes following elements:
Balance-sheet
Profit and loss account/Income Statement
Cash flow statement
Statement of changes in equity
Notes to the accounts

CONCEPT REVIEW QUESTION

What parts of a companys annual report are covered by an audit report?
(02 marks)
(ICAEW Professional Stage September 2006)

PART B FINANCIAL REPORTING FRAMEWORK

LO 2: FINANCIAL REPORTING FRAMEWORK AND ITS TYPES:

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

There are two main types of financial reporting frameworks i.e. Compliance Framework and Fair
Presentation Framework.

Compliance Framework:
Compliance framework is a financial reporting framework that requires compliance with
requirements of the framework, and does not contain acknowledgement for fair representation
framework (regarding additional disclosures or departure from requirements of framework).
An example is Tax-basis 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
An example is International Financial Reporting Standards.

Applicable Financial Reporting Framework/AFRF:

AFRF is the financial reporting framework which management adopts
in preparation of financial statements considering legal requirements,
nature of entity, nature of financial statements, and purpose of
financial statements.

By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

CONCEPT REVIEW QUESTION

Differentiate between the following:
(i) Fair presentation framework and compliance framework

(04 marks)
(CA Inter Spring 2012)

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

In a fair presentation framework, financial statements should present true and fair view.

The term True and Fair View has not been defined in the Companies Ordinance 1984 or in ISAs or
in IFRSs. Therefore, it is the most judgmental and difficult aspect of audit. Generally,
Financial statements are True when:
o data is correctly transferred from accounting records to financial statements, and
o financial statements are free from factual errors, and
o financial statements comply with accounting standards and local regulations.
Financial statements are Fair when:
o financial statements are free from undue bias in financial statements, and
o financial statements show substantive over form and consistency.
Study Tip
Terms give true and fair view and present fairly, in all material respects are
equivalent. However, first term is more common in practice.

CONCEPT REVIEW QUESTION

Briefly discuss the term true and fair view in the context of an audit.

(05 marks)
(CA Inter Spring 2004)

(04 marks)
(ACCA F8 December 2010)

Explain the concept of TRUE and FAIR presentation.

PART C RESPONSIBILITIES OF PARTIES INVOLVED IN AUDIT

LO 4: MANAGEMENTS
RESPONSIBILITIES:

(AND

THOSE

CHARGED

WITH

GOVERNANCE)

In an audit of financial statements, management (and where applicable TCWG) is responsible:

1. For preparation and presentation of financial statements in accordance with AFRF. This
responsibility includes:
Selecting financial reporting framework to be used in preparation and presentation
of financial statements.
Selecting appropriate accounting policies and applying them consistently.
Making judgments and estimates that are reasonable and prudent.
2. For such internal control which management and TCWG determine necessary for
preparation of financial statements that are free from material misstatement (whether due
to error or fraud); and
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By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

3. To provide the auditor all:

i. relevant information (i.e. relevant to the preparation of the financial statements);
ii. additional information (i.e. requested by auditor for the purpose of audit); and
iii. unrestricted access to personnel (i.e. to obtain audit evidence).
Study Tip
Premise of an audit means management (and where applicable TCWG) has
acknowledged and understands that it has responsibilities as described above.
CONCEPT REVIEW QUESTION
Briefly highlight the managements responsibilities relating to the financial statements? (07 marks)
(CA Inter Autumn 2009)

LO 5: AUDITORS OVERALL RESPONSIBILITIES/ OBJECTIVES:

In an audit of financial statements, auditors overall objectives/primary responsibilities are:

To obtain reasonable assurance whether financial statements are free from material
misstatement (due to error or fraud) to enable auditor to express opinion whether financial
statements are prepared in accordance with AFRF.
To report on financial statements to shareholders, and
To communicate as required by ISAs, in accordance with the auditors findings (e.g. to
communicate weaknesses in internal control to management and TCWG, or to communicate
misstatements identified after audit report to shareholders).
CONCEPT REVIEW QUESTION
What is the primary/overall objective of an audit?

(04 marks)
(CA Inter Autumn 2001)

LO 6: STAKEHOLDERS RESPONSIBILITIES:

It is the responsibility of general public (i.e. stakeholders) to understand and eliminate expectation
gap so that scope of audit is not misunderstood.

Expectation Gap:
Expectation Gap is the difference between what general public perceives about role and
responsibilities of auditor and what statutory role and responsibilities of auditor are.
Public expectations are usually higher than auditors statutory 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 is responsible to detect all misstatements.
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By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

4. Auditor has a responsibility to prevent and detect all frauds.

5. Unmodified report assures efficiency and effectiveness of management; and that entity will
be Going Concern.
6. Auditor provides absolute assurance (i.e. he certifies or guarantees that financial statements
are correct).

Consequences of Expectation Gap:

There is increasing tendency to file legal actions against auditors without any valid basis.

How to Reduce Expectation Gap:

Expectation gap can be reduced by:
Public awareness on scope of audit and responsibilities of auditor.
Steps taken by SECP and ICAP e.g. through implementation of Code of Corporate
Governance.
Expanding and improving the format of auditors report.
Mentioning managements responsibilities, auditors responsibilities and inherent
limitations of audit in Engagement Letter.
Mentioning managements responsibilities, auditors responsibilities and brief description
of audit in Auditors Report.
CONCEPT REVIEW QUESTION
What are the principal misunderstandings made by lay users of audited financial statements that
are commonly referred to as The Expectation Gap?
(02 marks)
(ICAEW September 2007)
Outline the measures adopted in the country to address the expectations gap.
(02 marks)
(ICAEW March 2011)

PART D SCOPE OF AUDIT

LO 7: SCOPE OF AUDIT:

Scope of audit means nature, timing and extent of audit procedures which are necessary to achieve
the overall objective of audit (i.e. to obtain reasonable assurance).
Scope of audit of an entity is determined considering:
1) Requirements of International Standards on Auditing (ISAs).
2) Requirements of local laws and regulations.
3) Auditors Professional Judgment.
4) Terms of Engagement between auditor and client.

CONCEPT REVIEW QUESTION

What is your understanding of the term scope of an audit?

(03 marks)
(CA Final, Winter 1998)

By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

LO 8: ESSENTIALS OF PROPER CONDUCT OF AUDIT:

For the successful completion of a good audit, it is necessary that auditor exercises following
attributes throughout the audit engagement:

Professional Judgment:
Definition:
Professional Judgment is the application of Cumulative Audit Knowledge, Experience and Training,
within the context of auditing, accounting and ethical standards, in different circumstances of audit
to reach an appropriate course of action or conclusion.
Areas where professional judgment is applied:
in assessing risk of material misstatement.
in determining whether an item is material.
in planning and performing nature, timing and extent of audit procedures
in evaluating whether sufficient appropriate evidence has been obtained or there is need to
obtain more evidence.
in evaluation of managements judgments and estimates.

Professional Skepticism:
Definition:
Professional skepticism is an attitude that includes:
a questioning mind
being alert to conditions which may indicate possible misstatement (due to error or fraud),
and
critical assessment of audit evidence.
It does not mean to disregard past honesty and integrity of client or disbelieve everything client
says. Rather, it means not to accept anything without corroborative evidence.

Importance of Professional Skepticism in planning and performing an audit:

Professional skepticism increases audit quality and reduces risk of overlooking unusually
circumstances and inappropriate conclusion. Therefore, ISAs require auditor to maintain
professional skepticism throughout the audit (especially in complex and highly judgmental areas).

Professional skepticism requires and ensures that:

1. if there are any judgments and estimates of management, they are tested without bias.
2. if there is any contradictory evidence, it is further investigated to resolve the matter.
3. if there is any indication of fraud, it is followed up.
4. if there is any doubt over reliability of evidence, reliability is evaluated.

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 later chapters.)

By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

CONCEPT REVIEW QUESTION

The International Standards of Auditing require an auditor to exercise professional judgment in
planning and performing an audit of financial statements. Define professional judgment. Identify
the areas regarding which an auditor should exercise professional judgment during an audit.
(07 marks)
(ICMA Pakistan, Summer 2013)
Explain the meaning of the term professional skepticism, and discuss its importance in planning
and performing an audit.
(05 marks)
(ACCA P7 June 2015)

PART E REGULATORY ENVIRONMENT OF AUDITING

LO 9: INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC):

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.

IFAC supports the development of profession in the area of auditing, ethics, professional education
and public sector by following activities:
development of high-quality standards and guidance
facilitating the adoption and implementation of standards and guidance
promoting the value of professional accountants worldwide
speaking out on public interest issues

IFAC includes following four boards:

International Auditing and Assurance Standards Board (IAASB);
International Accounting Education Standards Board (IAESB);
International Ethics Standards Board for Accountants (IESBA); and
International Public Sector Accounting Standards Board (IPSASB).

International Auditing and Assurance Standards Board (IAASB):

IAASB is one of the boards within IFAC. It is a standard-setting body which enhances quality and
consistency of assurance practice throughout the world by 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.
3. IAASB also issues International Auditing Practice Statements (IAPS) to help auditors in
implementing ISAs and to promote good auditing practice in general.
CONCEPT REVIEW QUESTION
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 marks)
(CA Inter -Autumn 2006)
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By: Muhammad Asif, ACA

Auditing Study Notes

Chapter 2 Basic Concepts of Auditing

Explain briefly the role of International Auditing and Assurance Standards Board (IAASB).
(04 marks)
(CA Inter -Spring 2008)

LO 10: AUTHORITY/STATUS/APPLICATION OF INTERNATIONAL STANDARDS ON

AUDITING (ISAs):

Authority/Status of an ISA:
In Pakistan, audit is conducted in accordance ISAs. ISAs are written in the context of audit of
financial statements and contain:
objectives,
required procedures to meet objectives and
explanatory material on application of procedures.
Therefore, it is compulsory for auditors to comply with all required procedures of all adopted ISAs.
Exception to application of ISA:
A required procedure will not be performed if it is not relevant.

A required procedures will also not be performed if it is not practicable. However, in this case,
auditor shall document:
reason of departure from required procedure, and
alternative procedures performed to obtain evidence/assurance.
CONCEPT REVIEW QUESTION
Explain the status of International Standards on Auditing.

(02 marks)
(ACCA F8 December 2010)

Briefly discuss the authority attaching to International Standards on Auditing (ISAs) with respect to
audit of a limited company in Pakistan.
(CA Inter -Spring 2006)
Why adherence to International Standards on Auditing is important for the auditors? Discuss.
(05 marks)
(CA Inter -Autumn 2003)

By: Muhammad Asif, ACA

Auditing Case Studies

Chapter 2 Basic Concepts of Auditing

CHAPTER TWO (CASE STUDIES)

BASIC CONCEPTS OF AUDITING
APX 1: CASE STUDY RELATING TO AUDITORS RESPONSIBILITIES/EXPECTATION GAP:
Structure of the Case:
In exam, you may be given a case in which a stakeholder (e.g. a shareholder, audit committee or a
bank) will allege that auditor has not fulfilled its responsibilities.

You will be expected to comment on the situation in the light of auditors responsibilities.

Suggested Approach to Answer:

1. You will state auditors responsibilities (if marks permit), and
2. You will analyze whether given situation represents misstatement or weakness in internal
control and will decide accordingly whether auditor has fulfilled its responsibility or not.
Model Case Study From Examination Questions:

Case Study:
You were the engagement partner on the audit of a commercial bank which has a network of more than 200
branches, across the country. During a recent meeting, a member of the audit committee referred to an
instance of irregularity in a branch, whereby the Branch Manager had extended credit to a close relative
without following the banks credit disbursement procedures. The member criticized the auditors for their
failure to highlight such instances.
Required:
As an engagement partner, write a letter to the audit committee explaining your point of view in detail with
specific references to the International Standards on Auditing, wherever applicable. (09 marks)
(CA Final, Winter 2008)
Solution:
View point expressed by member of audit committee is incorrect.
Auditors Primary responsibility/Overall objective is:
To obtain reasonable assurance whether financial statements are free from material misstatement
(due to error or fraud) to enable auditor to express opinion on financial statements,
To report on financial statements and
To communicate in accordance with the auditors findings as required by ISAs. (e.g. to communicate
TCWG significant deficiencies in internal control if identified during the audit).

Granting a credit without following banks procedures is a weakness in Internal Control, not a misstatement
in financial statements. Therefore, responsibility regarding financial statements has been fulfilled.
Although auditor is required to communicate TCWG significant deficiencies in internal control if identified
during the audit; however:

(a) This deficiency may not have been identified during the auditor because auditors work is based on sample basis
or branch manager may have intentionally concealed this fact from auditor which makes it difficult to detect
such irregularities.

(b) Even if identified, this deficiency in internal control may not be significant in auditors judgment.

Last but not least, primary responsibility to design, implement and operate internal control is of
management/TCWG (and not of auditor).

By Muhammad Asif, ACA

Auditing Case Studies

Chapter 2 Basic Concepts of Auditing

APX 2: CASE STUDY RELATING TO APPLICATION OF PROFESSIONAL SKEPTICISM:

Structure of the Case:
In exam, you may be given a situation in which there will be:
inconsistency/contradiction between two sources of evidence, or
client may ask you to rely on his working without detailed investigation.
You will be required to identify appropriate course of action in the situation.

Suggested Approach to Answer:

You will state that:
auditor shall investigate the matter, by applying professional skepticism.
auditor shall determine what further audit procedures are necessary to resolve the matter
(depending on specific situation).
auditor shall also consider the effect of the matter on other aspects of the audit (e.g. on risk
assessment).
Model Case Study From Examination Questions:

Case Study:
During the course of the audit of Smart Services Limited for the year ended March 31, 2010, the auditor
noted certain contradictions between the results of inquiries from companys legal advisor and the
representation provided by the management in respect of certain contingencies.

Considering the above scenario, explain how the attitude of Professional Skepticism would help the
(03 marks)
auditor to deal with such matters?
(ICMA Pakistan Summer 2010)
Solution:
Auditor shall not ignore this inconsistency between inquiries from legal advisor and managements
representation as it increases risk of material misstatement.
Auditor should perform further specific procedures to determine which source of evidence is reliable:
1. further inquiry of management and legal advisor about reasons of difference.
2. inspect documents relating to litigations/contingencies.
3. obtain opinion from third parties e.g. other lawyers.
4. consider subsequent decision of the legal case/contingencies.

In the light of results of procedures performed, auditor shall also consider effect of the matter on other
aspects of the audit.

By Muhammad Asif, ACA