Auditing Study Notes Chapter 1 Introduction to Assurance Services

CHAPTER ONE
INTRODUCTION TO ASSURANCE SERVICES

ICAP'S STUDY TEXT

LO # LEARNING OBJCTIVE
REFERENCE*
ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE 1.1.2, 1.1.3, 1.1.4,
LO 1
SERVICE 1.5.1
LO 2 DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT 1.2.3
TYPES OF ASSURANCE AND WHY ABSOLUTE ASSURANCE
LO 3 1.2.1, 1.2.2, 1.5.2
CANNOT BE PROVIDED
1.2.3 (Definition),
LO 4 TYPES OF ASSURANCE ENGAGEMENTS
1.1.1

*Explanation of Reference:
First digit in Study Texts Reference represents chapter number, second and third digits represents
section and sub-section number. Contents in brackets (if any) represent part of the sub-section
which is covered by the learning objective.

Coverage from Question Bank:

After completion of this chapter, you will be able to attempt following questions in ICAP's Question
Bank:
Q. # 2 (available in practice set Q. # 4)

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Auditing Study Notes Chapter 1 Introduction to Assurance Services

LO 1: ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE SERVICES:

Origin of Assurance Services:
Since the Industrial Revolution in 18th century, businessmen started forming Joint Stock Companies
to do business. In many situations, people who managed the business (called management and
directors) were different from those who owned the business (called shareholders). Management
and Directors had role of stewardship (i.e. they look after the assets of the company and manage
them on behalf of shareholders) or agent (i.e. they act in accordance with instructions of
shareholders). To judge the performance of management and directors, shareholders asked them to
prepare statements about financial performance and financial position of company (these
statements are now called financial statements) and to provide them these statements.

Soon after, it was recognized that financial statements prepared by managers/directors presented
best-view of business instead of true-and-fair-view due to some Incentive (e.g. bonus) or
Pressure (e.g. fear of removal) faced by management. Thus credibility of financial statements was
questioned.

To enhance the credibility/confidence/assurance on these financial statements, an expert person

(called assurance provider or auditor) was hired by shareholders to verify financial statements.
This person:
is independent of both managers/directors and shareholders.
gives his report/opinion whether financial statements given true and fair view in all
material respects.

Role of auditors was recognized in a great way. Now a days, audits are performed either because:
they are required by law (called statutory audits e.g. all companies in Pakistan are required
by law to get their annual financial statements audited before they are given to
shareholders)
they are not required by law but are voluntarily performed because of value-added benefits
of audits (called non-statutory auditors e.g. sole-proprietorships, partnerships and NGOs
etc. undergoing an audit)

Benefits of Assurance Services:

In todays world, assurance providers are engaged not only to meet statutory requirements but
many other benefits are also obtained by shareholders from such assurance services e.g. assurance
services:
1) Enhance credibility of financial statements for shareholders.
2) Identify weaknesses in entitys internal control system and assurance providers suggest
recommendations to management.
3) Confirm management that they have performed their statutory and non-statutory duties.
4) Are check on employees. Therefore, they behave positively.
5) Provide facilitation in:
o Sale of Business or Shares.
o Obtaining bank loans.
o Filing tax returns.

In addition to shareholders, some other stakeholders also get benefits from audit of F/S.

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Auditing Study Notes Chapter 1 Introduction to Assurance Services

Disadvantages of Assurance Services:

1) Audit takes time and cost.
2) Entity/Organization has to share its confidential information with auditor.
3) Management/Directors often think audit as a disturbing activity instead of a value added
activity.
4) Audit does not provide 100% (i.e. absolute) assurance that financial statements are free
from errors or frauds.

CONCEPT REVIEW QUESTION

What are the advantages of an audit to an organization? (05 marks)
(CA Certificate Stage Spring 2004)

LO 2: DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT:

Assurance Engagement:
Assurance engagement means an engagement in which a
practitioner (i.e. assurance provider) obtains evidence about
evaluation of a subject matter against suitable criteria, and expresses
his conclusion to enhance the confidence of the intended users (other
than the responsible party).

Elements of Assurance Engagement:

Every assurance engagement consists of following 5 elements:

Element Explanation (with respect to assurance on financial statements)

1. Intended users (the parties for whom subject matter and assurance report
is prepared i.e. shareholders, bankers)
A three party 2. A responsible party (the party which prepares subject matter i.e.
relationship management) and
3. A practitioner (the party which provides assurance on subject matter i.e.
auditor)
Subject matter is the data which responsible party is required to prepare i.e.
A subject matter
Financial Statements
Criteria means Framework (i.e. rules and regulations) under which financial
Suitable Criteria statements are prepared and evaluated e.g. IFRS or Laws.
Suitable means it should be selected appropriately.
Evidence means information on which practitioners conclusion is based.
Evidence
Evidence should be sufficient and appropriate.
Written Assurance It is a page which is written in standard format. It includes conclusion of
Report practitioner, and it is provided by practitioner to intended users.

CONCEPT REVIEW QUESTION

List down the basic elements of an assurance engagement. (03 marks)
(CA Certificate Stage Spring 2003)

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Auditing Study Notes Chapter 1 Introduction to Assurance Services

LO 3: LEVELS OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE

PROVIDED:
Assurance means confidence with which a practitioner expresses his conclusion. Assurance adds
credibility in financial statements, however level of credibility depends on type of assurance
provided.

Levels/Types of Assurance:
There are three levels/types of assurance i.e.

Absolute Assurance
It is a perfect level of assurance.

Reasonable Assurance (also called High Level or Positive Assurance)

It is a high but not absolute level of assurance which is expressed in positive form of conclusion e.g.
in our opinion, financial statements give true and fair view.

Limited Assurance (also called Moderate Level or Negative Assurance)

It is a moderate level of assurance which is expressed in negative form of conclusion e.g. Based on
our review, nothing has come to our attention that causes us to believe that financial statements do
not give a true and fair view.

Why absolute assurance cannot be provided:

Auditor cannot provide absolute assurance because audit risk cannot be reduced to Zero due to
inherent limitations of assurance/audit. These limitations are discussed below:

Inherent Limitation Explanation

There is often uncertainty / judgment / estimates/ forecasting involved in
Nature of Financial preparation of financial statements and some areas cannot be accurately
Statements calculated/verified e.g. Provision for bad debts, Depreciation, Outcomes of
legal cases, Warranty expenses, Intangible assets.
Weaknesses in Entitys internal control system over financial statements always has some
Internal Control weaknesses/limitations e.g. because of humans errors.
1. Many of the auditors procedures are based on his judgment. Therefore,
most of the audit evidence is persuasive rather than conclusive.
2. Because of time and cost limitation, auditor checks only a sample of
Nature of Audit transactions.
Procedures 3. Audit is not a fraud-examination i.e. audit procedures may not detect a
sophisticated and carefully organized fraud.
4. Management may not provide complete information to auditor, and
5. Auditor does not have specific legal powers e.g. power to search.

CONCEPT REVIEW QUESTION

Briefly describe and explain the limitations of external audit. (05 marks)
(PIPFA Summer 2012)

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Auditing Study Notes Chapter 1 Introduction to Assurance Services

LO 4: TYPES OF ASSURANCE ENGAGEMENTS:

There are two types of assurance engagements i.e.

Reasonable Assurance Engagement:

Objective of reasonable assurance engagement is to provide reasonable assurance that financial
statements are free from material misstatements. An example is audit of Financial Statements.

Limited Assurance Engagement:

Objective of limited assurance engagement is to provide limited assurance that financial statements
are free from material misstatements. An example is review of Financial Statements.

CONCEPT REVIEW QUESTION

What do you understand by the term "Assurance Engagement"?
Discuss its types. What are its elements? (09 marks)
(ICMA Pakistan Winter 2007)

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 Auditing Practice Set Chapter 1 Introduction to Assurance Services

CHAPTER ONE
INTRODUCTION TO ASSURANCE SERVICES
QUESTIONS

CONCEPT REVIEW QUESTIONS

Q.1 What are the advantages of an audit to an organization? (05 marks)

(CA CAF Level Spring 2004)
LO1

Q.2 In achieving the objectives of audit, what possible disadvantages can be suffered by the company.
(CA CAF Level Spring 1995)
LO1

Q.3 Briefly describe what you understand by the terms reasonable assurance and limited assurance.
(02 marks)
LO3 (ICAEW Professional Stage March 2006)

Q.4 Distinguish between absolute and reasonable assurance. Identify the type of assurance that is
expected in an audit of the financial statements, clearly outlining the reasons to justify your point of
LO3 view. (08 marks)
(CA CAF Level Spring 2009)

Q.5 Describe THREE limitations of external audits. (03 marks)

(ACCA Foundation Stage December 2012)
LO3

Q.6 List and explain the elements of an assurance engagement. (05 marks)
LO2 (ACCA Foundation Stage June 2010)

Q.7 Describe the level of assurance that the auditor will provide for each of the following
engagements, and how the level of assurance is expressed by the auditor:
LO4 i. Audit engagement
ii. Review engagement
(Malaysian Institute of Accountants September 2010)

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 Auditing Practice Set Chapter 1 Introduction to Assurance Services

Q.8 Assurance engagement is an independent professional service in which a practitioner

expresses a conclusion designed to enhance the degree of confidence of the intended users other
LO4 than the responsible party about the outcome of the evaluation of a subject matter against criteria.
Required:
Briefly explain two types of assurance engagement. (03 marks)
(Malaysian Institute of Accountants March 2012)

Q.9 What is the difference between an assurance engagement and an audit engagement? (02 marks)
(CA CAF Level Spring 2003)
LO4

SUGGESTED SOLUTIONS

Q.1 (1) Audit enhances credibility of financial statements for shareholders.

(2)Audit Identifies weaknesses in entitys internal control system and auditor suggests
recommendations to management.
(3)Audit confirms management that they have performed their statutory and non-statutory duties.
(4)Audit is a check on employees. Therefore, they behave positively.
(5)Audit provides facilitation in Sale of Business or Shares, Obtaining bank loans, Filing tax returns.

Examiners Comments:
It was a basic question that was well answered by the students.

Q.2 (1) Audit takes time and cost.

(2) Entity has to share its confidential information with auditor.
(3) Management/Directors often think audit as a disturbing activity instead of a value added
activity.
(4) Audit does not provide 100% (i.e. absolute) assurance that financial statements are free from
errors or frauds.

Q.3
Reasonable Assurance:
It is a high but not absolute level of assurance which is expressed in positive form of conclusion e.g.
in our opinion, financial statements give true and fair view.

Limited Assurance:
It is a moderate level of assurance which is expressed in negative form of conclusion e.g. Based on
our review, nothing has come to our attention that causes us to believe that financial statements do
not give a true and fair view.

Examiners Comments:
This question was very well answered overall. Nearly all candidates obtained full marks on this
question.

Exam Tip
Carefully note the requirement of the question. Question requires to describe reasonable
assurance, and not reasonable assurance engagement.

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 Auditing Practice Set Chapter 1 Introduction to Assurance Services

Q.4 Distinction between absolute and reasonable assurance:

Absolute assurance is a perfect level of assurance.

Reasonable assurance is a high but not absolute level of assurance which is expressed in positive
form of conclusion e.g. in our opinion, financial statements give true and fair view.

Type of assurance expected in an audit:

Reasonable assurance is provided in an audit.

Reasons why absolute assurance cannot be provided:

(1)There is often uncertainty / judgment / estimates/ forecasting involved in preparation of
financial statements and some areas cannot be accurately calculated/verified.
(2)Entitys internal control system over financial statements always has some
weaknesses/limitations e.g. because of humans errors.
(3)Many of the auditors procedures are based on his judgment. Therefore, most of the audit
evidence is persuasive rather than conclusive.
(4) Because of time and cost limitation, auditor checks only a sample of transactions.
(5) Audit is not a fraud-examination i.e. audit procedures may not detect a sophisticated and
carefully organized fraud.
(6) Management may not provide complete information to auditor, and
(7) Auditor does not have specific legal powers e.g. power to search.

Examiners Comments:
Seemingly, a significant number of candidates found it to be the easiest question. This question was set
to test the candidates knowledge about the concept of absolute and reasonable assurance and their
relevance in audit, and was based on ISA 200.
Most candidates answered it to a pass standard with an encouraging number obtaining 7 or more
marks.

Exam Tip
This is a poorly drafted question with three sub-parts. As a good practice, whenever a question with
sub-parts is drafted, marks are allocated to each part separately to indicate weightage to be given to
each sub-part. If such a question appears in your exam, you are advised to answer each part
separately and judge yourself weightage to be given.

Q.5 (1)There is often uncertainty / judgment / estimates/ forecasting involved in preparation of

financial statements and some areas cannot be accurately calculated/verified.
(2)Entitys internal control system over financial statements always has some
weaknesses/limitations e.g. because of humans errors.
(3)Many of the auditors procedures are based on his judgment. Therefore, most of the audit
evidence is persuasive rather than conclusive.

Examiners Comments:
Performance was inadequate on this question. This question was left unanswered by a significant
minority of candidates. Those who attempted it were often unable to provide more than one relevant
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 Auditing Practice Set Chapter 1 Introduction to Assurance Services

answer. Some candidates seemed to think the question wanted disadvantages of having an audit,
rather than the limitations of an audit, these are two different requirements.

Q.6
Element Explanation (with respect to assurance on financial statements)
1. Intended users (the party which requires subject matter and assurance
i.e. stakeholders)
A three party 2. a responsible party (the party which prepares subject matter i.e.
relationship management) and
3. a practitioner (the party which provides assurance on subject matter i.e.
auditor)
Subject matter is the information which management is required to
A subject matter
prepare i.e. Financial Statements
Criteria means Framework (i.e. rules and regulations) under which
Suitable Criteria financial statements are prepared e.g. GAAP or IFRS.
Suitable means it should be selected appropriately.
Evidence means information on which practitioners conclusion is based.
Evidence
Every conclusion should be backed by sufficient appropriate evidence.
Written It is a page which is written in standard format. It includes conclusion of
Assurance report practitioner, and it is provided by practitioner to intended users.

Examiners Comments:
A large number of candidates did not attempt this question, and where it was attempted it was
inadequately answered. Most candidates who provided an answer clearly did not know what the
elements of an assurance engagement were and therefore proceeded to write down anything they
knew about assurance. The usual answers focused on positive and negative assurance or on the
different types of assurance engagements. Only a small minority of candidates actually understood the
requirement and provided valid answers.

Q.7
Audit engagement Review engagement
Reasonable/High level of Limited/Moderate level of
Level of Assurance
assurance. assurance.
How Level of assurance Positive form of conclusion is Negative form of conclusion is
is expressed expressed in Report. expressed in Report.

Q.8 Two types of assurance engagement are:

1. Reasonable Assurance Engagement
2. Limited Assurance Engagement

Reasonable Assurance Engagement:

Objective of reasonable assurance engagement is to provide reasonable assurance that financial
statements are free from material misstatements. An example is audit of Financial Statements.

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 Auditing Practice Set Chapter 1 Introduction to Assurance Services

Limited Assurance Engagement:

Objective of limited assurance engagement is to provide limited assurance that financial statements
are free from material misstatements. An example is review of Financial Statements.

Q.9 Assurance engagement means an engagement in which a practitioner (i.e. assurance provider)
obtains evidence about evaluation of a subject matter against suitable criteria, and expresses his
conclusion to enhance the confidence of the intended users (other than the responsible party).

Audit engagement is a type of assurance engagement. Objective of an audit engagement is to

provide reasonable assurance that financial statements are free from material misstatements.

Examiners Comments:
Students confused the question with engagement letter. Even very few students wrote correctly about
the audit engagement.

5 By: Muhammad Asif, ACA