Liabilities and capital

IAS 37

Trade accounts payable and

purchases

Topic List
Trade accounts payable and purchases
Accruals
Long term liabilities
Provisions and contingencies
Capital and other issues

Auditors should be aware of the

possibility of understatement of payables

This chapter covers a number of liabilities

which a company might have. The auditor
must consider the possibly of understatement
of liabilities, particularly if the client has
liquidity problems, or is seeking further credit
from someone, for example, the bank.
Suppliers and lenders are a good source of
external evidence. Auditors may also test
purchases by analytical review

There are two detailed objectives with

regard to trade accounts payable:
Is cut off correct between goods received and
invoices received?
Do trade accounts payable represent the bona
fide amounts due by the company?
Trade accounts payable listing
Check that the listing has been extracted
correctly from the purchase ledger.
Reconcile the total with the purchase ledger
control account.
Check that the list of balances adds up.

Completeness, rights and obligations,

existence
The key test is a comparison of supplier
statements with the purchase ledger balances.
Supplier statements are third party evidence.

Ratio of trade creditors to inventory

Additional tests include tracing purchases and
other expenses from the nominal ledger to the
purchase ledger and invoices. Are they valid
for the company/authorised?

However, it is sometimes necessary to

circularise suppliers.
Examples of such situations are:
Supplier statements are
unavailable/incomplete
Internal controls are weak and material
misstatement of liabilities is feared as a
consequence
Suspicion that client is understating
deliberately

Cut off (completeness)

Check from the last goods received
note (from inventory count) to the ledger
or list of accruals.
Review the schedule of accruals to
check that goods received after the year
end are not included.
Review invoices and credit notes
after the year end to ensure that those
relating to prior year are included.
Reconcile batch postings around the year
end, to ensure that invoices are posted in
the correct period.

Purchases and expenses

Occurrence/completeness
Analytical procedures are important.
Consider:
Level of puchases/expenses month by
month
Effect of quantities purchased
Effect of changing prices
Ratio of purchases to trade payables
2

 Scrutinise post year end payments to see

if any should have been accrued
Consider basis for round sum accruals
(comparable to last year?)

Tax creditors
Income tax: Likely to be one months
deductions. Check amount paid to the tax
authority.
Sales tax: Check reasonableness to next
return. Verify amount paid in year to
cashbook.

Wages and salaries

General accruals

As a general rule, accruals lend themselves to

being audited by analytical review as they
should be comparable to prior years. Other
substantive procedures are noted here
Check calculation of accruals and trace
back to supporting documentation
Review ledger accounts to ensure all
accruals have been included

Analytical procedures will give some

assurance on pay liabilities. However, auditors
may also carry out tests such as:
Checking remuneration per payroll to
personnel records
Confirm existence of employees by
meeting them
Check calculations on the payroll
Check validity of deductions to
supporting documentation.
Confirm net pay to bank.

Long term liabilities

The key financial statement assertions are:
Completeness: whether all long term
liabilities have been disclosed
Valuation: whether interest payable has
beencalculated correctly and included in
the right period
Disclosure: whether long term loans are
correctly disclosed
Audit procedures
Obtain/prepare a schedule of loans
Agree opening balances to prior year and
check the adds
Compare the balances to the general
ledger
Check lenders to any register of lenders
(egdebenture holders)
Trace additions and repayments to cash
book
Confirm repayment conforms to
agreement
Verify borrowing limits per the articles are
not exceeded
Obtain direct confirmation from lenders
4

Review minutes and cash book to ensure

that all loans have been included
are those due after more than one year.
Usually they are debentures, loan stock
and things like bank loans.

Provision
is a liability of uncertain timing or amount. A
liability is a present obligation arising from
past events......resulting in an outflow of
resources.

Contingent asset/liability

is a possible asset/liability arising from past

events whose existence will be confirmed only
by the occurrence of one of more uncertain
future events not whollly within the entitys
control, or (liability) a present obligation
that arises from past events but is not
probable that a transfer of economic benefits
will be required, or the amount cannot be
measured with reasonable certainty.
Audit procedures
Obtain details of provisions/contingencies
Review correspondence

 Discuss with directors

Check whether payments have been
made in respect of provisions in the post
balance sheet period
Review correspondence with solicitors pre
and post year end
Consider past provisions were they
subsequently required?
Recalculate all the provisions to ensure
correct
Ensure disclosures made about
contingencies
Consider the nature of the clients
business (would you expect to see other
provisions for example, for warranties?)

Capital and other issues

Share (equity) capital
Auditors should ensure that the directors have
observed their legal duties in regard to share
capital and reserves (for example, not
distributed undistributable reserves).
Statutory books
5

Verify that the disclosures made in the FS

agree to the statutory books and that the
books agree to the returns made to the
Registrar.
Have the statutory books been
maintained/updated properly?
Consider whether the accounting records
are sufficient to fulfil the directors legal
duties.
Key audit procedures
Agree authorised share capital to the
memorandum.
Verify share transfer details and cash
payments to cash book.
Agree dividends paid to cash book and to
the minutes of the AGM where the
dividend was proposed.
Check calculation of movement on
reserves.
Directors emoluments
Confirm properly approved
Confirm properly accounted for
Review service contracts
Corridor adequacy of disclosure

Audit reviews and

finalisation
Topic List
Going concern
Subsequent events
Management representations
Other information
Overall review of financial statements
Going concern is an extremely important audit
review. If the going concern basis is not
appropriate, the financial statements will be
materially affected.
The post balance sheet date period is vital for
the auditor in obtaining audit evidence. ISA
560 outlines audit guidance regarding
subsequent events.

Going concern
Going concern assumption
An entity is ordinarily viewed as continuing in
business for the foreseeable future with
neither the intention nor the necessity of
liquidation, ceasing trading or seeking
protection from its creditors
6

ISA 570 Going concern gives guidance.

1. Auditor responsibilities
2. Planning and risk assessment
3. Evaluation
4. Further procedures
5 Reporting
1. Auditor responsibilities
The auditors are responsible for considering
the appropriateness of the going concern
assumption, and the existence of any
material uncertainties in relation to going
concern which should be disclosed in the FS
2. Planning and risk assessment
In obtaining an understanding of the entity,
the auditor should consider whether anything
casts doubt on the entitys going concern
status. If management have undertaken a
preliminary assessment of going concern, the
auditor should review it. The auditor should
remain alert throughout the audit for any
factors which would indicate problems
(examples given below).
.

Examples
Financial
Net liabilities
Fixed term borrowing approaching
maturity without realistic prospect of
renewal/repayment
Negative operating cash flows
Adverse financial ratios
Substantial operation losses
Inability to pay creditors
Inability to finance new products
Operating
Loss of key
management/markets/franchise
Labour difficulties/supply shortage
Other
Major legal proceedings/non compliance

3. Evaluation
The auditors should consider:
Process used by directors
The assumptions used
The plans for future action

4. Further procedures
Analyze and discuss cash
flow/profit/other
forecasts/interim financial information
with
management
Review the terms of debentures/
loan agreements
Read minutes of meetings
Make enquiries of lawyers regarding legal
claims
Confirm financial support from third
parties Consider unfulfilled orders
Review events after the period end.
5. Reporting
Going concern assumption appropriate but a
material uncertainty exists.
Adequately disclosed unqualified opinion but
modified report with emphasis of matter
(ISA 570 provides example)
(If there are significant, multiple uncertainties
disclaimer may be appropriate).

Inadequate disclosure
Qualified/adverse opinion
Going concern assumption
inappropriate adverse opinion
Management unwilling to extend
assessment consider the need to
modify the report due to limitation on
scope

Subsequent events ISA 560

IAS 10
Include events between the period end and
the date of the auditors report, and events
subsequent to the report.
There are two types, those that provide further
evidence of conditions that existed at the
period end and those that are indicative of
conditions that arose subsequent to the period
end
Prior to the audit report being signed
Auditors should carry out audit procedures to
obtain evidence about subsequent events,
including:

If directors issue different financial statements

due to the effect of subsequent events, the
auditors should:
Audit procedures
Enquiries of management
Reading minutes of meetings of those
charged with governance
Reviewing most recent financial
information
Examples: enquiries of management
What is the status of items involving
subjective data included in the FS?
Are there any new commitments
(borrowing/ guarantees) in the new year?
Have there been any issues of capital?
Have there been any major events?
Are there any unusual accounting
treatment adjustments?
After the audit report has been signed
The auditors do not have any obligation to
perform procedures, or make enquiries after
the date of their report.
Before issued to members

Carry out relevant audit procedures so as

to issue opinion
Issue new audit report in the place of the
old one
After issue
If directors issue different financial statements
due to the effect of subsequent events, the
auditors should:
Carry out relevant audit procedures so as
to issue an opinion
Review steps taken by management to
inform those already in receipt of the
original FS
Issue a new audit report
If the directors do not issue a new report
in either situation and the auditors feel
they should, the
auditors should take action to prevent
people from relying on their report.

3. Action if management refuse to

provide
written confirmation of representations

Management Representation
ISA 580
Auditors receive many representations
from
management during the course of an audit,
and some may be critical to obtaining
sufficient,
appropriate audit evidence. An example,
which
the auditors must get, is acknowledgement
from
the directors of their responsibility for the
financial statements which the auditors have
audited.
Guidance is given in ISA 580 Management
representations
1. Representations by management as
audit evidence
2. Basic elements of a management
representation letter
10

Form of written confirmations

Representation letter from management
Letter from the auditors acknowledged in
writing by the directors
Minutes of meeting where such a letter
was approved
1. Representations by management as
audit evidence
ISA 580.4 The auditor should obtain written
representations from management on matters
material to the FS when other sufficient,
appropriate audit evidence cannot reasonably
by expected to exist.
When auditors receive such representations
they
should:
Seek corroborative evidence
Evaluate whether the representations
seem consistent/reasonable
Consider whether the individuals involved
should be reasonably informed

Should be restricted to matters where

the
auditor is unable to obtain independent
corroborative evidence and could not
reasonably expect it to be available:
Where knowledge of the facts is
confined to management
Where the matter is principally one
of judgement or opinion

If management refuse to sign the

management representation letter
The auditor should consider whether they
should rely on other (less significant )
representations made during the audit

Other information ISA 720

2. Basic elements of a management
representation letter
The letter should be:
Addressed to the auditors
Contain specified information
Appropriately dated
Approved by those who have the specific
knowledge.
Auditors will normally request that the
letter is signed by senior executive
officer/senior financial officer.

Includes:
Directors report
Chairmans statement
Operating and financial review
Financial summaries

3. If management refuse to sign

However, they should try to resolve:

11

Auditors have no responsibility to report

that other information is properly stated.
An audit is
only an expression of the truth and
fairness of the FS.

 Material misstatements contained

therein
Inconsistencies between other
information & the FS
The auditors may also have a statutory duty
to review the directors report.

Overall review of financial

statements

Towards the end of their audit, the auditors

should review the financial statements to
ensure
that they are reasonable, and consistent with
evidence obtained, so that they can draw
a conclusion on truth and fairness.
1. Compliance with accounting
regulations
2. Review for consistency and
reasonableness
1. Accounting regulations
The auditors should examine the
accounting policies, considering:
12

What policies are usually adopted in the

industry
Whether there is substantial authoritative
support for the policy
Whether departures are necessary for a
true and fair view
Whether the FS reflect the substance of
the underlying transactions
Some accounting standards allow a
choice of methods, which often have a
material effect.
2. Consistency and reasonableness
Do FS adequately reflect explanations
received?
Are there any new factors in
presentation?
Do analytical procedures produce
expected results?
Has the presentation been unduly
affected by directors wishes?
What is the potential impact of
unadjusted errors?
The auditors should summarise unadjusted

(immaterial) errors and consider the

materiality
and the potential effect of adjusting them.
It should include their best estimate of errors
are unavailable.
They may ask the directors to adjust. If they
refuse: consider the impact on the audit
report.

19/20: Reports
Topic List
Auditors report
Modified reports
Communication
Other reports
In the exam you may be required to:
Describe how a particular qualification
differs from the standard report
Give extracts from audit reports

Auditors report
ISA 700:The standard report
13

INDEPENDENT AUDITOR'S REPORT

[Appropriate Addressee]
Report on the financial statements
We have audited the accompanying financial
statements of ABC Company, which comprise
the balance sheet as at December 31, 20X1,
and the income statement, statement of
changes in equity and cash flow statement for
the year then ended, and a summary of
significant accounting policies and other
explanatory notes.
Management's responsibilities for the
financial statements
Management is responsible for the preparation
and fair presentation of these financial
statements in accordance with International
Financial Reporting Standards. This
responsibility includes: designing,
implementing and maintaining internal control
relevant to the preparation and fair
presentation of financial statements that are
free from material
misstatement, whether due to fraud or error;
selecting and applying appropriate accounting
policies; and making accounting estimates
that are reasonable in the circumstances.

Auditor's responsibility
Our responsibility is to express an opinion on
these financial statements based on our
audit.We conducted our audit in accordance
with International Standards on Auditing.
Those standards require that we comply with
ethical
requirements and plan and perform the audit
to obtain reasonable assurance whether the
financial statements are free from material
misstatement.
An audit involves performing procedures to
obtain audit evidence about the amounts and
disclosures in the financial statements. The
procedures selected depend on the auditor's
judgement, including the assessment of the
risks of material misstatement of the financial
statements, whether due to fraud or error. In
making those risk assessments, the auditor
considers internal control relevant to the
entity's preparation and fair presentation of
the financial statements in order to design
audit procedures that are appropriate in the
circumstances, but not for the purpose of

14

expressing an opinion on the effectiveness of

the entity's internal control. An audit also
includes evaluating the appropriateness of
accounting policies used and the
reasonableness of accounting estimates made
by management,
as well as evaluating the overall presentation
of the financial statements.
We believe that the audit evidence we have
obtained is sufficient and appropriate to
provide a basis for our audit opinion.
Opinion
In our opinion, the financial statements give a
true and fair view of (or "present fairly, in all
material respects,") the financial position of
ABC Company as of December 31, 20X1, and
of its financial performance and its cash flows
for
the year ended in accordance with
International Financial Reporting Standards.
Report on other legal and regulatory
requirements
[Form and content of this section of the
auditor's report will vary depending on the

nature of the auditor's other reporting

responsibilities.]
[Auditor's signature]
[Date of the auditor's report]
[Auditor's address]

Modified reports

Modifications to the independent

auditors report
ISA 701 deals with situations where the
auditor cannot issue an unqualified opinion.
There are two circumstances under which the
audit report will be modified.
Matters that do not affect the auditors
opinion: emphasis of matter
Matters that do affect the auditors
opinion
o Limitation on scope qualified
opinion/disclaimer
o Disagreement qualified
opinion/adverse opinion
For a matter to affect the auditors
opinion it must be material to the
financial statements.
15

In certain circumstances, an auditors report

may be modified by adding an emphasis of
matter paragraph to highlight a matter
affecting the financial statements which is
included in a note to the financial
statements that
more extensively discusses the matter.
The addition of such an emphasis of matter
paragraph does not affect the auditors
opinion.
The auditor may also modify the auditors
report by using an emphasis of matter
paragraph(s) to report matters other than
those affecting the financial statements
The ISA distinguished between going
concern and other significant uncertainties.
An example paragraph relating to going
concern is laid out in the relevant standard.
ISA 701 gives the following example for more
general matters.
Without qualifying our opinion we draw
attention to Note X to the financial
statements. The Company is the defendant in

a lawsuit alleging infringement of certain

patent rights and claiming royalties and
punitive damages. The Company has filed a
counter action, and preliminary hearings and
discovery proceedings on both actions are in
progress. The ultimate outcome of the matter
cannot presently be determined, and no
provision for any liability that may result has
been made in the financial statements.
Matters that do not affect the auditors
opinion
Limitation on scope
If material:
...Except for...might opinion, where auditors
disclaim the opinion on a particular aspect of
financial statements.
If pervasive:
Disclaimer of opinion given, where auditors
state
they are unable to form an opinion.
Must explain what evidence they were looking
for and what possible effect the matter for
which they have no evidence might have on
FS.
Examples
16

Where the auditor cannot receive all the

information and explanations necessary to his
audit, eg absence of accounting records,
because of accident or concealment, failure by
management to provide written
representations
Disagreement
If material:
...Except for opinion, where auditors disagree
with one material aspect of the financial
statements.
If pervasive:
Adverse opinion (that is, the account do not
give a true and fair view) given, if the
disagreement substantially affects the true
and fair view.
Examples
Circumstances giving rise to disagreement
might
include:
inappropriate accounting policies
disagreement over facts/figures in the FS
disagreement over level of disclosure in
the FS

 failure to comply with relevant legislation

or other requirements.

Expectations gap
the difference between the apparent public
perceptions of the responsibilities of auditors
on the one hand (and hence the assurance
that their involvement provides) and the legal
and
professional reality on the other The standard
report that we have looked at is the effort by
IAASB to close the expectations gap.
It is believed that it addresses certain specific
issues.
(a) Misunderstanding of the nature of FS eg
that the balance sheet is a fair valuation or
that amounts are stated precisely.
(b) Misunderstandings as to the type and
extent
of work undertaken by auditors.
(c) Misunderstandings about the level of
assurance provided eg that an unqualified
audit report means no fraud has been

17

committed, or that absolute assurance is

given.

Internal audit reports

There are two types of internal audit report:
Risk based
Performance enhancement
All internal audit assignments are likely to
result in a formal report.
In business there is a generally accepted
report
format, which the auditors should make use
of:
Terms of reference
Executive summary (summarising
conclusions drawn from the assignment)
Introduction
Body of the report
Appendices
Likely features of an internal review
report
Dated
Marked draft or final

Marked as modified after comment

Distribution list
Executive summary will contain:
Background and objectives of the assignment,
major outcomes, key risks identified, key
action
points, summary of the work left to do.
External review reports
REVIEW REPORT TO...
We have reviewed the accompanying balance
sheet of ABC Company at December 31, 20XX,
and the related statements of income and
cash flows for the year then ended. These
financial statements are the responsibility of
the Companys management. Our
responsibility is to issue a report on these
financial statements based on our review.
We conducted our review in accordance with
the International Standard on Auditing (or
refer to relevant national standards or
practices) applicable to review engagements.
This Standard requires that we plan and
perform the review to obtain moderate
assurance as to whether the financial
statements are free of material misstatement.
18

A review is limited primarily to inquiries of

company personnel and analytical procedures
applied to financial data and thus provides
less assurance than an audit. We have not
performed an audit and,
accordingly, we do not express an audit
opinion.
Based on our review, nothing has come to our
attention that causes us to believe that the
accompanying financial statements do not
give a true and fair view (or are not presented
fairly, in all material respects,) in accordance
with International Accounting Standards.
Date
AUDITOR
Address
This internationally accepted review
engagement report gives an expression of
negative assurance.
Negative assurance is assurance given in
the absence of any matters arising indicating
the contrary.
If matters do come to the attention of the
auditor, he should describe those matters.

audit is given in ISA 260 Communication of

audit matters with those charged with
governance.
Impact
Effect on report
Material Express a qualified opinion of
negative assurance.
Pervasive
Express an adverse opinion
that the
financial statements do not give a
true and fair view
If there has been a limitation in the auditors
scope, he should describe the limitation.
Impact
Effect on report
Material to one area Express a qualified
opinion
of negative assurance due
to amendments which
might be required if the
limitation did not exist
Pervasive
Do not provide any
assurance

Other reports ISA 260

Guidance on reporting to management and

other non shareholders as a by product of
19

Governance is the term used to describe the

role of persons entrusted with the supervision,
control and direction of the entity. Those
charged with governance ordinarily are
accountable for ensuring that the entity
achieves its objectives, with regard to
reliability of financial reporting effectiveness
and efficiency of operations, compliance with
applicable laws and reporting to interested
parties. Those charged with governance
include
management only when it performs such
functions.
Communication may be with the whole board,
the supervisory board or the audit committee.
Matters should be discussed with those
charged with governance on a sufficiently
prompt basis that they can react to what the
auditor has said. The auditor should determine
whom those charged with governance are.

Matters which the communications should

include are:
General approach and overall scope
Selection of, or changes in, significant
accounting policies
The potential effect on the FS of any
material risks, and exposures, eg pending
litigation, that are required to be
disclosed in the account
Significant audit adjustments
Expected modifications to the audit
report
Significant matters arising, for example,
internal control issues, questions
regarding management integrity, and
fraud involving management.
Material uncertainties affecting the
organisations ability to continue as a
going concern
Significant disagreements with
management
Other matters mentioned in terms of
engagement

20

Letter of weakness /
Management letter

The auditors may also discuss with

management control weaknesses observed as
part of the audit. If this is formally reported, it
would usually take the following form:
WEAKNESS
IMPLICATION
RECOMMENDATION
In writing or orally?
The auditors will be affected by such matters
as:
The size
Operating structure
Legal structure
Communication process of the entity
Nature, sensitivity and significance of the
matters being communicated
Statutory and regulatory requirements
The arrangements made re periodic
meetings or reporting of significant
matters

21: Not for profit

organisations
External and internal auditors might both have
to carry out work in not for profit
organisations.
A charity

21

is a common form of not for profit

organisation.
A charity is any institution established for
charitable purposes and subject to the control
of the law as such.
Charitable purposes includes:
Relief of poverty
Advancement of education
Advancement of religion
Purposes to benefit community
Accounts may include:
Statement of financial activities
(SOFA)
In some cases a summary income
and expenditure account
Balance sheet showing the assets,
liabilities and funds of the charity
Cash flow statement (where
required) and notes
Auditors report on the truth and
fairness of the FS
Planning
Auditors should consider:
The scope of the audit

Recommendations of Charity
Commissioners Accounting policies
Changes in the sector in which the charity
operates
Past experience of the system
Key audit areas
Detail in FS on which auditors to report
Risk
Problem areas
Donations (not supported by invoice
/equivalent documentation)
Legacies (income recognition)
Grants (often subject to conditions)
Restricted funds (uses are restricted as
per deed/benefactor)
Grants to beneficiaries (must be bona
fide)
Branches (charities SORP requires
inclusions in main accounts)
Inherent risk
Factors include: complexity/extent
of regulation, significance of
donations and cash receipts, lack of
predictable income, restricted funds,
restrictions imposed by charitys
22

governing documents, tax rules,

sensitivity of key statistics, balance
of maintaining resources/building up
funds.
Control risk
Factors include: time committed
and degree of involvement by
trustees, skills of trustees,
independence of trustees from each
other, division of duties.
Control environment: segregation
of duties a very key area in small
charities.
Two key problems
Lack of segregation of duties
Use of unqualified staff

Audit evidence
Consider
understatement/incompleteness in
income
Overstatement of grants or assets
Misanalysis or misuse of funds
Misstatement of assets like donated
properties
Existence of restricted funds in foreign
branches
Overall view
Consider if accounting policies are
appropriate. Analytical procedures might be
restricted due to lack of predictable income
etc, but charities
should have budget or strategy information
available.
Reporting
The form of the audit report is dictated by the
Charitys constitution but it should conform to
ISA
700 criteria.
The financial statements should have been
prepared in accordance with any charities
23

legislation, so that fact should be referred to in

the audit report.
Where charities are not governed by statute,
the auditors report will depend upon the
scope of the assignment.

24