Clarified ISAs: emerging issues

The ‘clarified’ International Standards on Auditing (ISAs) have been with us for nearly two years.  However, issues are emerging which frequently trip audit firms up – sometimes due to audit software omitting a requirement of the ISAs or incorrectly interpreting part of an ISA.  This article aims to flag up the more common issues which practitioners are falling foul of so that quality assurance visits by the various professional bodies can run more smoothly.

There are generally three stages to the audit:

• The planning stage;
• The fieldwork stage; and
• The completion stage.

Planning

This section of the audit file is one of two areas (the other being the completion stage) that lends itself to a whole host of problems during file reviews.  Many file reviewers cite a lack of planning as the main reason why audit files are generally not up to standard.  During a file review, the reviewer will be on alert to make sure that there has been an audit team meeting, and that this team meeting has been documented.  Simply ticking a box to inform a reviewer that a team meeting has taken place is not sufficient – the meeting must be documented.

Related parties

The clarified ISA (UK and Ireland) 550 Related Parties specifically requires the audit team to discuss the susceptibility of the financial statements to material misstatement due to fraud in relation to transactions with related parties.  This is in addition to a requirement for the audit team to discuss the susceptibility of the financial statements to material misstatement in relation to fraud as per ISA (UK and Ireland) 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements.  Again, it is important that this is specifically documented to ensure the audit firm can demonstrate compliance with ISAs.

Performance materiality

Performance materiality was a new concept introduced into the clarified ISAs and this seems to be causing an element of confusion also among practitioners.  Financial statement materiality is calculated at the planning stage and is generally calculated using the averaging method (for example, 1% of turnover, 10% of pre-tax profit and 2% of gross assets).  However, ISA (UK and Ireland) 320 Materiality in Planning and Performing an Audit also requires a calculation of performance materiality.  The definition of performance materiality contained in the UK and Ireland ISA 320 is not written in ‘plain English’.  In a nutshell, performance materiality is a reduced financial statement materiality level which is applied to sensitive or high risk areas of the financial statements and it is generally expected to be applied (at a minimum) to related party transactions and directors’ remuneration/transactions.

The clarified ISA (UK and Ireland) 320 does not offer a pre-determined formula for calculating performance materiality.  However a way of calculation could be to reduce financial statement materiality by (say) 75% and use this figure as performance materiality.  It is important to emphasise that the amount by which financial statement materiality is reduced to arrive at a performance materiality level will all depend on the levels of risk associated with the audit client.

It is also worth pointing out that materiality levels are not ‘set in stone’ at the planning stage – they must be revised if circumstances are encountered during the audit fieldwork that may call into question the original calculation of materiality (such as the discovery of fraud or a failing in internal controls).

Fraud and revenue recognition

If the audit firm deems fraud in relation to revenue recognition to be ‘not applicable’ then it is important that the auditor documents the reasons why this is the case.  In reality the presumption that fraud in relation to revenue recognition is not applicable would very rarely be applied.  However, a case where this could arise is if the client is the subsidiary of a parent and hasn’t raised any sales during the accounting period.

Audit fieldwork

While the procedures to audit certain areas of the financial statements (fixed assets, debtors, creditors etc) have not significantly changed, there are cases where the audit firm may not have generated sufficient and appropriate audit evidence.  Throughout the UK and Ireland ISAs you will come across the term ‘sufficient and appropriate’ rather a lot.

‘Sufficient’ refers to the quantity, as well as the quality, of the audit evidence, while ‘appropriate’ refers to the quality of the audit evidence gathered as well as to the relevance and reliability of the audit evidence.  Audit evidence should also be documented sufficiently for quality control reasons in order that it can be referred to at a later date, as well as for evaluation purposes prior to the audit partner issuing the audit report.

Accounting estimates

A new ISA was issued during the clarity project, that of ISA (UK and Ireland) 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.  This new ISA outlines specific procedures the auditor must adopt when it comes to auditing accounting estimates.  In particular, paragraph 13 (a) to (d) requires the auditor to undertake one, or more, of the following taking into consideration the nature of the accounting estimate:

• Determine whether events occurring up to the date of the auditor’s report provide audit evidence regarding the accounting estimate.
• Test how management made the accounting estimate and the data on which is it based.  In doing so, the auditor shall evaluate whether the method of measurement used is appropriate in the circumstances and the assumptions used by management are reasonable in light of the measurement objectives of the applicable financial reporting framework.
• Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures.
• Develop a point estimate or a range to evaluate management’s point estimate. For this purpose:
  • If the auditor  uses assumptions or methods that differ from management’s, the auditor shall obtain an understanding of management’s assumptions or methods sufficient to establish that the auditor’s point estimate or range takes into account relevant variables and to evaluate any significant differences from management’s point estimate.
  • If the auditor concludes that it is appropriate to use a range, the auditor shall narrow the range, based on audit evidence available, until all outcomes within the range are considered reasonable.

With regards to accounting estimates, it is also a requirement of ISA (UK and Ireland) 540 for the auditor to review accounting estimates which were made in the previous period.  An article on the audit of accounting estimates will be produced shortly because this is an area which is causing considerable problems for many auditors.

Changes to the audit plan

There are occasions when an audit may not go according to plan and transactions could be discovered that the auditor was previously unaware (for example undisclosed related parties).  Such transactions or events may call into question the appropriateness of the audit planning prior to the commencement of the detailed fieldwork.  It is important to bear in mind that audit planning is a continuous and iterative process and as a result if circumstances are encountered during the course of the audit that call into question the appropriateness of the original planning, the audit plan must be amended/updated accordingly.  It is also important to document the reasons why the audit plan was amended.

Litigation

When a client has ongoing litigation it can often be the case that the process is long-winded and arduous.  Legal advisers may not be able to confirm a reliable estimate of monetary amounts that a client may have to pay to the claimant if the client is unsuccessful in defending the claim, or the legal adviser may not be able to estimate whether the client will be successful or not.  In such cases FRS 12 Provisions, Contingent Liabilities and Contingent Assets requires the disclosure of a contingent liability in the notes to the financial statements.  Paragraph 97 to FRS 12 says that:

‘In extremely rare cases, disclosure of some or all of the information required by paragraphs 89-94 can be expected to prejudice seriously the position of the entity in a dispute with other parties on the subject matter of the provision, contingent liability or contingent asset.  In such cases an entity need not disclose the information, unless its disclosure is required by law; but should disclose the general nature of the dispute, together with the fact that, and reason why, the information has not been disclosed.’

It is important that the auditor is satisfied that this exemption has been taken appropriately and not simply applied because it exists in the standard.  Ordinarily a law firm will be able to confirm whether disclosure would seriously prejudice the outcome of an ongoing court case, particularly where the auditor deems the case to be of a material nature (or where monetary amounts to settle may be considered material).  Merely accepting the client’s assertion that disclosure may seriously prejudice a case may sometimes not be enough.

The written representation from the client should also confirm completeness of disclosure of all known actual or possible litigation and claims.

Completeness of income

When undertaking substantive testing on income the primary objective is to test income for understatement (on the flip side, debits are tested for overstatement).  The starting point for the substantive testing should always be the ‘source’ of the transaction.  Consider this example:

Sample sizes

Clearly if there are a large number of transactions in a particular audit area, the auditor will test a sample of transactions.  Some audit firms have been criticised in the past for not ensuring that samples are representative of the entire population.  Consider the following example:

Debtors circularisation

A way of confirming the existence assertion of a material debtor balance is to circularise the client’s customer.  Once the letter comes back from the client’s customer it is then checked to see if the balance is in agreement with the customer’s purchase ledger and if it is it is put on the audit file as evidence that the debt exists at the balance sheet date.  However, many audit firms have been criticised for assuming that a customer’s confirmation that a debt exists is sufficient and appropriate audit evidence.  Debtors circularisation letters do not provide any evidence as to the collectability of the debt and do not provide conclusive evidence as to the accuracy of balances so it is important that additional audit procedures (such as after-date cash testing) are applied to trade debtors to ensure debtors are correctly valued in the financial statements.

Audit completion

This is the second key area where file reviewers are often critical of audit firms. It is important that the audit partner who is going to sign the auditor’s report reviews the audit evidence obtained to ensure that it is sufficient and appropriate.  Ultimately the audit file has to ‘tell a story’ and sometimes not enough attention is devoted to this area resulting in comments such as ‘on all files examined, there is a distinct lack of partner involvement and the firm must make radical improvements in this area.’

Review

There should be evidence of audit partner review on file, even if this is a summary document on the current audit file.  The summary document can simply outline the areas reviewed by the audit engagement partner and the partner’s conclusion on each area reviewed.

Whichever method is adopted by the audit firm, it is vital that the audit engagement partner is seen to be closely involved with the audit.  If audit evidence is lacking in material areas of the financial statements, professional regulators will be very quick to criticise the firm which could result in mandatory hot reviews taking place or even withdrawal of the firm’s auditing licence (in more serious situations).  A lack of sufficient and appropriate audit evidence increases audit risk (the risk that the auditor will form an incorrect opinion) and the overall objective is to reduce audit risk to an acceptably low level.

Written representation

ISA (UK and Ireland) 580 Management Representations at Appendix 1 contains a list of specific representations which the auditor needs to obtain from the audit client.  ISA (UK and Ireland) 580 acknowledges that the list of ISAs for which specific written representations should be obtained is not a substitute for considering the requirements and related application and other explanatory material in ISAs (UK and Ireland).

ISA (UK and Ireland) 580 also requires the written representation to be dated on, or immediately prior to, the date of the auditor’s report.  It must never be dated after the date of the auditor’s report.

Uncorrected misstatements

If the auditor has discovered uncorrected misstatements which have not been adjusted for because those charged with governance believe they are immaterial both individually and in aggregate, ISA (UK and Ireland) 450 Evaluation of Misstatements Identified During the Audit requires the auditor to provide those charged with governance with a summary of uncorrected misstatements either in the written representation, or attached to it.

Conclusion

As we progress with the clarified ISAs, there will undoubtedly be more emerging issues which crop up.  However, the points addressed in this article are those which are currently the more familiar pitfalls and which are high on file reviewer’s agendas during the course of quality assurance reviews.

Category: Audit