Auditing and assurance revision question and answer

Auditing and Assurance Revision Questions and Answers

a) An auditor should form an opinion on the adequacy of the accounting treatment of an inherent uncertainty disclosed in the financial statements of a company.

i) What is meant the term “inherent uncertainty”? (2 marks)
ii) Explain the treatment of inherent uncertainties in the auditor‘s report. (6 marks)

b) Summarise the principal contents of a statement of directors‘ responsibilities to be included in financial statements. (8 marks)

c) Explain the steps an auditor should take if he concludes that the client has made a departure from an accounting standard in the preparation of the financial statements.
(4 marks)
(Total: 20 marks)

a) An auditor should form an opinion on the adequacy of the accounting treatment of an inherent uncertainty disclosed in the financial statements of a company.

i) Inherent uncertainty
A limitation in (or on) scope gives rise to doubt i.e. uncertainty about the
―true and fair view‖ because it necessarily means that there is insufficient relevant and reliable evidence on which to base the audit opinion. However, this has nothing to do with ―inherent uncertainty,‖ this is quite contrary.

There are some matters for which the auditor will have all necessary i.e. sufficient and appropriate i.e. relevant and reliable, information that can be reasonably expected to be available yet still be unable to form an opinion on it because the nature of the matter is inherently uncertain i.e., it concerns future outcomes.
Hence, going concern and ‗pending litigation‘ are the classic examples of inherent uncertainty, the auditor cannot reasonably expect to know what the verdict of a jury might be in a court case to be held months or fears into the future.

ii) Treatment of inherent uncertainty in audit
Uncertainty applies to the outcome of a financial statement item that is not susceptible to reasonable estimation prior to the balance sheet date. It is another way of saying that notwithstanding the procedures carried out, the auditor cannot obtain reasonable assurance as to how fairly stated an item is. This is usually the case as regards the outcome of court case awards or a client who is heavily reliant on obtaining a key contract or renewal of financing to continue operating as a going concern.

Uncertainties differ from accounting estimates in that accounting estimates are capable of reasonable estimation management in the preparation of financial statements. An uncertainty may relate to the outcome of a lawsuit, the results of tax authorities audit, serious deficiencies in working capital, or failure to comply with the terms of a loan agreement.

In determining whether the financial statements are presented fairly, the auditor should evaluate the materiality of reasonably possible losses, both individually and in the aggregate, upon the resolution of the uncertainties. The auditors‘ consideration of materiality is a matter of professional judgement and such judgement and such judgement is made in the light of surrounding circumstances. In some cases, uncertainties relate primarily to financial position, whereas others more closely pertain to results of operations.

Emphasis of matter with an unqualified opinion
Any uncertainty may result in adding an emphasis of matter to the standard report when;
– There is a probable chance of material loss and management has not made an accrual in the financial statements
– There is a reasonable possibility of a material loss and
• The amount of the possible loss exceeds the auditor‘s judgement about materiality, and
• The likelihood of occurrence is closer to probable than remote

The explanatory paragraph should describe the uncertainty and indicate that its outcome cannot be determined because it depends on future events. As shown below, the explanatory paragraph should follow the opinion paragraph. In this example, the explanatory paragraph is shortened reference to the note in the financial statements. There is no mention of the uncertainty in the other paragraphs of the report.

Independent auditors report
(First three paragraphs same as the standard report)

As discussed in Note X to the financial statements, the company is a defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The company has filed a counteraction, and preliminary hearings and discovery proceedings on both actions are I progress. The ultimate outcome of the litigation cannot presently be determined. Accordingly, no provision for any liability that may result upon adjudication has been made in the accompanying financial statements.

Other types of opinion
Uncertainties will result in expressing other than an unqualified opinion when there is a scope limitation. A scope occurs when sufficient evidential matter does (or did) exist during the audit to support management‘s assertions about the uncertainties. However, such evidence was not availed to the auditor because of management‘s record retention policies or a client imposed restriction. For a scope limitation, the auditor should express a qualified opinion or a disclaimer of opinion. The departures from the standard report are the same as described earlier for other scope limitations.

b) Contents of directors responsibilities
– Ensuring that proper books of accounts are maintained company
– Ensuring that the financial statements as income statement, Balance sheet and cashflow statements have been prepared in accordance with identified relevant reporting framework e.g. international Accounting Statements.
– Timely preparation of financial statements
– Designing an internal control system
– Implementing internal control system
– Ensuring accuracy, completeness of financial statements
– Designing appropriate accounting policies and procedures e.g. for depreciation
– Ensure that accounting policies adopted are consistently applied from period to period
– Ensure that any departure from reporting framework is properly reflected, disclosed in financial statements
– Ensure uniformity in application of International Accounting Standards and accounting policies
– Ensure that they inform the shareholders of the contents in financial statements. They should interpret the policies adopted and other technical financial matters.
– Implementing an internal control system that ensures errors and frauds are detected.
– Ensuring preventive measures are instituted to ensure errors and frauds do not occur
– Where errors and frauds have occurred, ensure that controls are in place to correct such
– Ensure controls are in place to detect errors and frauds in financial statements

c) Steps taken the auditor where client has departed from accounting standard.
– Consider materiality of item. Consider the item in comparison with total of all class of items it relates to
– Consider the impact of departure in financial statements
– Check wither the departure has been properly disclosed and presented ways of a note to financial statements
– Confirm whether the directors have the intention of correcting the departure ensuring compliance in subsequent financial statements
– Consider reasons for departure from directors
– Consider whether the reasons for departure are justified

– Consider the possibility of the directors preparing revised financial statements with the correct financial statements i.e. statements that have complied with all the standards
– If the matter is material and the directors fail to do-operate to either revise the statements or disclose way of note, the auditor should consider qualifying the audit report.

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