P7 Standards FB

Standards revision, Audit Risks
&
Procedures
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IAS/IFRS List
IAS-1 IAS-28 IFRS-8
IAS-2 IAS-32 IFRS-9
IAS-8 IAS-33 IFRS-10
IAS-19 IAS-40
IAS-20 IAS-41
IAS-21 IFRS-2
IAS-23 IFRS-3
IAS-24 IFRS-5
IAS-27 IFRS-7
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IAS 1 Presentation of financial
statements
 In most jurisdictions the structure and content of financial statements are
defined by local law. IASs are, however, designed to work in any
jurisdiction and therefore require their own set of requirements for
presentation of financial statements. This is provided in IAS 1, revised June
2011.
 A complete set of financial statements comprises:
 a statement of financial position
 either
– a statement of profit or loss and other comprehensive income, or
– a statement of profit or loss plus a statement showing other
comprehensive income
 a statement of changes in equity
 a statement of cash flows
 accounting policies and explanatory notes.
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Exceptional items
 Exceptional items is the name often given to material items of income and
expense of such size, nature or incidence that disclosure is necessary in order to
explain the performance of the entity.
The accounting treatment is to:
 include the item in the standard statement of profit or loss line disclose the
nature and amount in notes.
 In some cases it may be more appropriate to show the item separately on the
face of the statement of profit or loss.
 Examples include:
 write down of inventories to net realisable value (NRV)
 write down of property, plant and equipment to recoverable amount
 Restructuring
 gains/losses on disposal of noncurrent assets
 discontinued operations
 litigation settlements
 reversals of provisions
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 IAS 1 stipulates that financial statements shall present fairly the financial
position, financial performance and cash flows of an entity. Fair presentation
requires the faithful representation of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for
assets, liabilities, income and expenses set out in the Conceptual Framework.
 The following points made by IAS 1 expand on this principle.
(a) Compliance with IFRS should be disclosed
(b) All relevant IFRS must be followed if compliance with IFRS is disclosed
(c) Use of an inappropriate accounting treatment cannot be rectified either
by disclosure of accounting policies or notes/explanatory material
 IAS 1 states what is required for a fair presentation.
(a) Selection and application of accounting policies
(b) Presentation of information in a manner which provides relevant,
reliable, comparable and
understandable information
(c) Additional disclosures where required
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 The current/non-current distinction
An entity must present current and non-current assets as separate
classifications on the face of the statement of financial position. A
presentation based on liquidity should only be used where it provides
more relevant and reliable information, in which case all assets and
liabilities must be presented broadly in order of liquidity. Similarly
for liabilities.
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Audit Risk
 There is a risk of incorrect presentation of FS
 Risk that IAS & IFRS may not completely applied in
preparation of FS
 Risk that compliance with IFRS may not be disclosed
 Risk of inconsistency of accounting policies
 Risk that assets and liabilities may be incorrectly classified
 Risk that FS may not be prepared on correct basis (Going
concern or break-up basis)
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Procedures
 Review the overall presentation of FS to confirm the
compliance with IAS-1
 Review the “compliance with IFRS” disclosures
 Apply analytical procedures to confirm the consistency of
accounting policies
 Review classification of assets and liabilities to confirm
compliance with IAS-1
 Enquire the basis of preparing FS from the management
and confirm reasonableness
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IAS 2 Inventories
Inventories are valued at the lower of cost and net
realisable value (NRV)
Costs include costs of purchase, conversion and others
incurred in bringing inventory to its present location
and condition
Standard costing is allowed if standard cost is
approximately equal to actual cost.
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Audit Risks
 There is a risk that NRV may be lower then cost but still
recorded at cost
 Standard cost may be outdated
 Audit team may not be competent enough to value the WIP
 Risk of completeness and existence of inventory of the
warehouses not visited
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Procedures
 Inventory is typically audited in two halves:
 Attendance at client’s stocktake
 The audit work done on the final audit visit.
Audit tests – stocktake attendance

 Select a sample of inventory items from the inventory records and physically
inspect them
 Select a sample of inventory items that can be seen in the warehouse, and
trace to the inventory records to verify included
 Ask client’s staff if any of the items in the warehouse belong to other
companies, and if necessary obtain written management representation to
confirm all inventory on site belongs to the company
 If company inventory is held at other locations, obtain written representations
from people at these locations to confirm the inventory is there
 Take copies of the final GDN and GRN of the accounting year, so that cut-off
can be tested in detail at the final audit visit
 When at the stocktake, make a note of any items in the warehouse that
appear to be old, damaged, or are returns
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Audit tests – final audit visit
 Agree figures from the inventory records tested at the stocktake, to the final
inventory figures in the Financial Statements
 Select the last few GDNs before the year end, and locate the corresponding
sales invoice, making sure that the sale and receivable are recorded before
the year-end
 Repeat the above test for GDNs immediately after the year-end, testing that
the sale and receivable are recorded after the year-end
 Repeat both of the above tests for GRNs and purchase invoices
NRV
 For a sample of inventory held at the year-end, inspect post year-end sales
invoices to confirm that the prices that were achieved were above cost.
 For items held at the year-end that remain unsold:
 Obtain aged inventory analysis to highlight the oldest item
 Obtain management representation confirming board’s belief that the
items will be sold, and for more than cost
 Inspect current standard price lists to verify they are in excess of cost.
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IAS 8 Accounting policies, changes in
accounting estimates and errors
 IAS 8 deals with changes in accounting estimates, changes in accounting
policies and errors.
 Accounting policies
Accounting policies are determined by applying the relevant IAS,IFRS or IFRS
Interpretation and considering any relevant Implementation Guidance issued by the
IASB for that IFRS/Interpretation.
Where there is no applicable IFRS or Interpretation management should use its
judgement in developing and applying an accounting policy that results in information
that is relevant and reliable.
 An entity must select and apply its accounting policies for a period consistently for
similar transactions, other events and conditions, unless an IFRS or an IFRIC specifically
requires or permits categorisation of items for which different policies may be
appropriate. If an IFRS or an IFRIC requires or permits categorisation of items, an
appropriate accounting policy must be selected and applied consistently to each category.
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Changes in accounting policies
 Accounting for changes of policy
 The same accounting policies are usually adopted from period to period, to
allow users to analyse trends over time in profit, cash flows and financial
position. Changes in accounting policy will therefore be rare
and should be made only if:
(a) The change is required by an IFRS; or
(b) The change will result in a more appropriate presentation of events or
transactions in the financial statements of the entity, providing more reliable
and relevant information.
 The standard highlights two types of event which do not constitute changes in
accounting policy:
(a) Adopting an accounting policy for a new type of transaction or event not
dealt with previously by the entity
(b) Adopting a new accounting policy for a transaction or event which has
not occurred in the past or which was not material
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 A change in accounting policy must be applied retrospectively.
Retrospective application means that the new accounting policy is
applied to transactions and events as if it had always been in use. In
other words, at the earliest date such transactions or events occurred,
the policy is applied from that date.
 Prospective application is no longer allowed under the revised IAS
8 unless it is impracticable (see Key Terms) to determine the
cumulative effect of the change.
 Adoption of an IFRS
 Where a new IFRS is adopted, resulting in a change of accounting
policy, IAS 8 requires any transitional provisions in the new IFRS itself
to be followed. If none are given in the IFRS which is being adopted,
then you should follow the general principles of IAS 8.
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Disclosure
 Certain disclosures are required when a change in accounting policy
has a material effect on the current
period or any prior period presented, or when it may have a material
effect in subsequent periods.
a) Reasons for the change/nature of change
b) Amount of the adjustment for the current period and for each period
presented
c) Amount of the adjustment relating to periods prior to those included
in the comparative information
d) The fact that comparative information has been restated or that it is
impracticable to do so
 An entity should also disclose information relevant to assessing the
impact of new IFRS on the financial statements where these have not
yet come into force.
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Changes in accounting estimates
 Changes in accounting estimate are not applied retrospectively.
 The rule here is that the effect of a change in an accounting
estimate should be included in the determination of net profit or loss
in one of:
a) The period of the change, if the change affects that period only
b) The period of the change and future periods, if the change affects
both
 Changes may occur in the circumstances which were in force at the
time the estimate was calculated, or perhaps additional information or
subsequent developments have come to light.
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Errors
Prior period errors must be corrected retrospectively.
This involves:
 Either restating the comparative amounts for the prior period(s) in
which the error occurred, or
 When the error occurred before the earliest prior period presented,
restating the opening balances of assets, liabilities and equity for that
period, so that the financial statements are presented as if the error
had never occurred.
 Only where it is impracticable to determine the cumulative effect of
an error on prior periods can an entity correct an error prospectively.
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Audit Risks
 Risk of inconsistency of accounting policies adopted
 Change in accounting policies may not be permitted by
standard
 Adequate and relevant disclosures may not be provided for
change in accounting policies and new standards adopted.
 Change in accounting estimates may not be applied in
accordance with IAS-8
 Errors may not be adjusted retrospectively
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Procedures
 Apply analytical procedures to confirm the consistency of
accounting policies
 Confirm whether the change in accounting policy is
according to IAS-8
 Confirm change in accounting estimates are applied
correctly
 Confirm errors are adjusted correctly
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IAS 10: Events after the reporting
period
 IAS 10 sets out the criteria for recognising events occurring after the
reporting date.
 Events occurring after the reporting period are those events, both
favourable and unfavourable, that occur between the end of the
reporting period and the date on which the financial statements are
authorised for issue. Two types of events can be identified:
 Those that provide evidence of conditions that existed at the end of the
reporting period – adjusting
 Those that are indicative of conditions that arose after the reporting
period – non-adjusting
 Between the end of the reporting period and the date the financial
statements are authorised (ie for issue outside the organisation),
events may occur which show that assets and liabilities at the end of
the reporting period should be adjusted, or that disclosure of such
events should be given.
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Events requiring adjustment
Examples of adjusting events would be:
 Evidence of a permanent diminution in property value prior to the year
end
 Sale of inventory after the reporting period for less than its carrying
value at the year end
 Insolvency of a customer with a balance owing at the year end
 Amounts received or paid in respect of legal or insurance claims which
were in negotiation at the year end
 Determination after the year end of the sale or purchase price of assets
sold or purchased before the year end
 Evidence of a permanent diminution in the value of a long-term
investment prior to the year end
 Discovery of error or fraud which shows that the financial statements
were incorrect
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Events not requiring adjustment
 The standard gives the following examples of events
which do not require adjustments:
 Acquisition of, or disposal of, a subsidiary after the year end
 Announcement of a plan to discontinue an operation
 Major purchases and disposals of assets
 Destruction of a production plant by fire after the reporting period
 Announcement or commencing implementation of a major
restructuring
 Share transactions after the reporting period
 Litigation commenced after the reporting period
 But note that, while they may be non-adjusting, some events after the
reporting period will require
disclosure.
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Audit Risks & Procedures
There is risk that events may not be identified,
adjusted or disclosed in the correct period.
Detailed testing should be performed to identify
events that requires adjustment or disclosures in the
current year FS.
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IAS 12 “Income Taxes”
 Deferred Tax
 Deferred tax is not a liability to the tax authorities, but rather an
accounting adjustment.
 It arises because the profit before tax for accounting purposes is not the
same amount as taxable profits for taxation purposes.
 This is due to permanent and temporary differences.
 Permanent differences are amounts which represent income, or an
expense, for accounting purposes, but are not taxable / allowable for
tax purposes e.g. client entertaining.
 Temporary differences are amounts which represent income or an
expense for accounting purposes, and also for tax purposes, but in
different periods e.g. depreciation vs capital allowances.
 Deferred tax adjusts for the effects of temporary differences, but not
permanent differences.
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Deferred tax should be dealt with by:
 calculating the temporary difference
 applying the tax rate to the temporary difference
 accounting for the resulting deferred tax asset or liability
 A temporary difference is calculated by comparing the carrying value of
an asset or liability with its ‘tax base’.
 The ‘tax base’ of an asset or liability is the amount attributed to that
asset or liability for tax purposes
 If the carrying value > tax base, this is a taxable temporary difference
and results in a deferred tax liability.
 If the tax base > carrying value, this is a deductible temporary
difference and results in a deferred tax asset.
 The tax rate applied to the temporary difference should be that which
is expected to apply to the period when the asset is realised or the
liability is settled, based on tax laws in place by the reporting date.
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 The change in a deferred tax asset or liability is accounted for in the
financial statements:
Deferred Tax Liability Deferred Tax Asset

Increase Dr tax charge Dr deferred tax asset
Cr deferred tax liability Cr tax charge
Decrease Dr deferred tax liability Dr tax charge
Cr tax charge Cr deferred tax asset
 A deferred tax asset or liability may not be discounted

 Where the item to which the deferred tax relates is recorded as part of
other comprehensive income, the deferred tax relating to that item is
also recorded as part of other comprehensive income e.g.revaluations.
 A deferred tax asset should only be recognised to the extent that it is
probable that taxable profit will be available against which it can be
utilised.
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BUSINESS COMBINATIONS
 When assets acquired and liabilities assumed in a business
combination are recognised at their fair values at acquisition, this
creates a temporary difference when the tax bases of the assets and
liabilities are not affected by the business combination or are affected
differently. For example, when the carrying amount of an asset is
increased to fair value but the tax base of the asset remains at cost to
the previous owner, a taxable temporary difference arises which results
in a deferred tax liability.
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Audit Risks
 There may be the risk that deferred tax asset or liability is not created
 There may be the risk that incorrect tax rates have been used to
calculate deferred tax asset or liability
 Deferred tax asset is recorded even recoverability cannot be
demonstrated
 Similarly, there is a risk that deferred tax implications are not
accounted. For example on:
 Revaluation
 Share Based Payment (IFRS-2)
 Business Combination
 Development
 Provisions
 Tax Losses
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Procedures
 Obtain a copy of the deferred tax workings and the corporation tax
computation
 Check the arithmetical accuracy of the deferred tax working
 Agree the figures used to calculate timing differences to those on the tax
computation and the financial statements
 Consider the assumptions made in the light of your knowledge of the business
and any other evidence gathered during the course of the audit to ensure
reasonableness
 Agree the opening position on the deferred tax account to the prior year
financial statements
 Review the basis of the provision to ensure:
– It is line with accounting practice under IAS 12
– It is suitably comparable to practice in previous years
– Any changes in accounting policy have been disclosed
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IAS 16 Property, plant and equipment
 Recognition of non-current assets
IAS 16 Property, plant and equipment lists the following as components of cost:
 Purchase price, less any trade discount or rebate
 Import duties and non-refundable purchase taxes
 Directly attributable costs of bringing the asset to working condition for its intended use,
eg:
 The cost of site preparation
 Initial delivery and handling costs
 Installation costs
 Testing
 Professional fees (architects, engineers)
 Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the
site on which it is located
 However, the following should not be included in the cost of the asset, and should be
recognised as an expense.
 Administration and other general overhead costs
 Start-up and similar pre-production costs
 Initial operating losses before the asset reaches planned performance
 Any incidental costs.
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 Valuation of non-current assets
 The market value of land and buildings usually represents fair value, assuming existing
use and line of business. Such valuations are usually carried out by professionally
qualified valuers.
 How should any increase in value be treated when a revaluation takes place? The debit
will be the increase in value in the statement of financial position, but what about the
credit? IAS 16 requires the increase to be credited to a revaluation surplus (ie part of
owners' equity), unless the increase is reversing a previous decrease which was
recognised as an expense. To the extent that this offset is made, the increase is recognised
as income; any excess is then taken to the revaluation surplus.
 The frequency of valuation depends on the volatility of the fair values of individual
items of property, plant and equipment. The more volatile the fair value, the more
frequently revaluations should be carried out. Where the current fair value is very
different from the carrying value then a revaluation should be carried out.
 Most importantly, when an item of property, plant and equipment is revalued, the whole
class of assets to which it belongs should be revalued.
 All the items within a class should be revalued at the same time, to prevent selective
revaluation of certain assets and to avoid disclosing a mixture of costs and values from
different dates in the financial statements. A rolling basis of revaluation is allowed if the
revaluations are kept up to date and the revaluation of the whole class is completed in a
short period of time.
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 Overhauls
 Where an asset requires regular overhauls in order to continue to operate, the
cost of the overhaul is treated as an additional component and depreciated over
the period to the next overhaul.
 Retirements and disposals
 When an asset is permanently withdrawn from use, or sold or scrapped,
and no future economic benefits are expected from its disposal, it should be
withdrawn from the statement of financial position. Gains or losses are the
difference between the estimated net disposal proceeds and the carrying
amount of the asset. They should be recognised as income or expense in profit
or loss.
 Derecognition
 An entity is required to derecognise the carrying amount of an item of
property, plant or equipment that it disposes of on the date the criteria for the
sale of goods in IAS 18 Revenue would be met. This also applies to parts of an
asset.
 An entity cannot classify as revenue a gain it realises on the disposal of an item of
property, plant and equipment.
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Audit Risks
 The key risk in relation to initial recognition is of costs being
incorrectly recognised as assets, when they should in fact have been
expensed to the statement of profit or loss.
 If there is a contract, Co should recognise a provision for demolition
costs as an unavoidable legal obligation would have been created. The
financial statement risk is that in this situation, Co fails to recognise a
provision and associated expense within the Profit or Loss.
 There may also be the risk of using incorrect discount factor for the
calculation of decommissioning cost as it is discounted to present value
resulting incorrect cost and provision being recognized.
 According to IAS 16 Property, Plant and Equipment and IAS 23
Borrowing Costs. Directly attributable finance costs must be capitalised
during the period of construction of the processing line, and if they
have not been capitalised, non-current assets will be understated and
profit understated.
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Audit Risks
 There is a risk that independent valuer not being used for the revaluation, resulting
incorrect and biased figures to be included in the SFP and incorrect gain being
recognized in OCI.
 Despite the valuations be performed by an independent expert, we should be alert to the
risk that non-current assets could be overstated in value.
 There is also a risk that depreciation was not re-measured at the point of the revaluation,
leading to understated expenses.
 There is risk of cherry picking. IAS 16 requires that all assets of same class should be
revalued.
 There is risk that depreciation is not being charged on the revalued amount resulting in
understatement of depreciation charge.
 The revaluation should also have a deferred tax consequence, as the revaluation gives rise
to a taxable temporary difference. If a deferred tax liability is not recognised the
statement of financial position is at risk of misstatement through understated liabilities.
 Finally, a further audit risk is incorrect or inadequate disclosure in the notes to the
financial statements. IAS 16 Property, Plant and Equipment requires extensive disclosure
of matters such as the methods and significant assumptions used to estimate fair values,
the effective date of the revaluation, and whether an independent valuer was used, as well
as numerical disclosures.
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Audit Risks
 Overhauling
 There is a risk that overhauling is being made part of the asset cost rather being
treated and depreciated separately resulting in incorrect figures and presentation in
FS.
 Disposal
 There may be the risk that the disposed asset is not being removed from the asset
register and SFP resulting in overstatement of assets.
 There is a risk that the gain/loss on disposed asset is not calculated correctly.
 In case of replacement of assets there may be the risk of incorrect cost being
recognized.
 Derecognition
 There is a risk that the substance of transaction is more a financing arrangement than a
genuine sale. If the Co has retained operational control of the assets and is still exposed
to the risk and the reward associated with the properties. Therefore the assets should
remain on the statement of financial position, with the proceeds received on the ‘sale’
recognized as a liability. There should be no profit recorded on the transaction.
 Finally, as the ‘sale’ is in reality a finance arrangement, it is likely that Co should accrue
finance charges. The total finance charge associated with the sale and repurchase
arrangement should be allocated over the period of the finance. It is likely that finance
charges are understated due to the lack of inclusion of finance cost in relation to the sale
and repurchase arrangement.
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Procedures
 Inspect the purchase invoice to look for cost of purchase.
 Review the other elements of cost being capitalized by management and agree back to
their relevant invoices.
 Ensure only elements permitted by IAS 16 are being capitalized by reviewing them.
 Recalculate the cost of an asset and compare to the asset register.
 Enquire management is there any requirement to dismantle or decommission the site so
that provision should be checked.
 Review the Statement of Financial position for decommissioning provision being created
by management.
 Review the discount factor used in the calculation of dismantling cost and compare it to
the company’s cost of capital.
 For Subsequent Measurement:
 Review the accounting policies for the classification of assets to cost model or revaluation
model.
 Review the reasonableness of accounting estimates for example Depreciation Method, Useful
Lives and scrap values etc.
 Ensure consistency is being applied in the application of accounting policies and principles.
 Review minutes of the meeting where management decided to buy the asset, to capital
replacement budgets, to past practice in the business to look
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Procedures: Revaluation
 Inspect the independent valuers report to confirm fair value
 Recalculate the carrying value of asset at revaluation date
 Recalculate the revaluation gain/loss by comparing carrying value with
revalued amount and confirm to OCI
 Recalculate the depreciation charge on revalued amount
 Inspect depreciation charge in the Profit or Loss and compare with
auditors calculated figure
 Review the notes to ensure all assets of same class have been revalued
 Review the notes to ensure adequate disclosures have been provided in
accordance with IAS 16
 Inspect the SFP to look for deferred tax liability being created by
management.
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Procedures
 Review the asset register for presentation of overhauling as a separate
component.
 Recalculate the depreciation charge.
 Inspect the asset register to look for asset being removed from the
register.
 Physically inspect the asset to ensure the disposed asset is not present
at the site.
 Recalculate the gain/loss of disposed asset by comparing the CV at
disposal date with sale proceeds.
 Review the sale agreement to look for risks and rewards are being
transferred and there is no managerial involvement.
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IAS 17 “Leases”
 Lease: An agreement whereby the lessor conveys to the lessee in return for a payment or
series of payments the right to use an asset for an agreed period of time.
 The key principle is: substance over legal form.
 Finance lease: A lease that transfers substantially all the risks and rewards incident to
ownership
of an asset. Title may or may not eventually be transferred.
 Operating lease: A lease other than a finance lease.
 Finance lease
 Capitalise asset on SOFP (at lower of fair value and present value of minimum lease
payments)
 Set up finance lease liability on SOFP (current and non-current)
 Split payments between finance charge and capital
 Charge depreciation (over shorter of lease term and useful life)
 Operating lease
 Charge rentals on a systematic basis over lease term
 Accruals or prepayments for rental in SOFP
 Rental expense in P/L
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 Disclosures: finance leases
 Net carrying amount at year-end for each class of asset
 Reconciliation between total of minimum lease payments at year-end and their present
value
 Total of minimum lease payments at year-end and their present value (< 1 year, 1–5 years,
> 5 years)
 Disclosures: operating leases
 Total of future minimum lease payments under non-cancellable operating leases (< 1
year, 1–5 years, > 5 years)
 Sale and leaseback transactions

 An asset is sold and then leased back. The resulting lease may be an operating lease or a
finance lease.
 Finance lease: profit on disposal is deferred and then amortised over the period of the
lease.
 Operating lease: any profit or loss on disposal is recognised immediately
 You can see that the classification of the lease is likely to have a material effect on
the financial statements. If the lease is a finance lease, the statement of financial
position will show substantial assets and liabilities. The net effect will be minimal, but
the face of the statement of financial position will be materially different from what it
would be if it was an operating lease.
It is important that the auditor ensures that the classification (which would fall under
the assertion existence) is correct. Other important assertions are valuation, and rights
and obligations.
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Audit Risks
 According to IAS 17 Leases, an indicator of a finance lease is that the lease term
is for the major part of the economic life of an asset. Under IAS 17, for a lease to
be classified as a finance lease, the present value of minimum lease payments
(the amount capitalised) should amount to at least substantially all of the fair
value of the asset. Also the risk and reward should be transferred at the
cessation of the lease. There may be the risk that the accounting treatment
is incorrect, i.e incorrect classification of lease. Resulting property,
plant and equipment and non-current liabilities are overstated. The
finance cost will be overstated if any interest accrued on the lease has
been included. Operating expenses are understated as lease payments should
have been included in this heading, and so profits are likely to be overstated.
However, operating expenses will currently contain depreciation charges for
the leased asset, which will need to be reversed. The overall impact on
operating expenses could be minimal as the two adjustments will offset each
other to an extent.
 The auditor needs to be alert to the possibility of sale and leaseback
transactions. If there is a sale and leaseback, then he needs to check that the
profit on disposal of the asset is treated in line with IAS 17. There is a risk of
incorrect accounting treatment.
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Procedures
 Classification and rights and obligations
 Obtain a copy of the lease agreement
 Review the lease agreement to ensure that the lease has been correctly classified according to
IAS 17
 Review the board minutes for the classification of lease
 Valuation (finance leases)

 Obtain a copy of the client's workings in relation to finance leases
 Check the additions and calculations of the workings
 Ensure that the interest has been accounted for in accordance with IAS 17
 Recalculate the interest
 Agree the opening position
 Agree any new assets to lease agreements
 Verify lease payments in the year to the bank statements
 Using the lease contract, confirm the length of the lease and compare it to the estimated life of
the property
 Recalculate the present value of minimum lease payments and compare them with the fair
value of the leased property at the inception of the lease (the fair value should be obtained
from the lease contract)
43
Procedures
 Valuation (operating leases)
 Agree payments to the bank statements (if material)
 Inspect the amount on the lease agreement
 Disclosure
 Ensure the finance leases have been properly disclosed in the financial statements
44
IAS 19 “Employee benefits”
 There are two types or categories of post-employment benefit plan: defined contribution
plans and defined benefit plans.
 Accounting for payments into defined contribution plans is straightforward.
 The obligation is determined by the amount paid into the plan in each period.
 There are no actuarial assumptions to make.
 If the obligation is settled in the current period (or at least no later than 12 months after
the end of the current period) there is no requirement for discounting
 IAS 19 requires:
 Contributions to a defined contribution plan should be recognised as an expense in the
period they are payable (except to the extent that labour costs may be included within
the cost of assets).
 Any liability for unpaid contributions that are due as at the end of the period should be
recognized as a liability (accrued expense).
 Any excess contributions paid should be recognised as an asset (prepaid expense), but
only to the extent that the prepayment will lead to, eg a reduction in future payments or a
cash refund.
 Disclosure is required of a description of the plan and the amount recognised as an
expense in the period
45
 Accounting for defined benefit plans is more complex, although the
2011 revisions to IAS 19 have meant that this area is no longer as
complicated as it once was.
 The future benefits (arising from employee service in the current or
prior years) cannot be estimated exactly, but whatever they are, the
employer will have to pay them, and the liability should therefore be
recognised now. To estimate these future obligations, it is necessary to
use actuarial assumptions.
 The obligations payable in future years should be valued, by
discounting, on a present value basis. This is because the obligations
may be settled in many years' time.
 If actuarial assumptions change, the amount of required contributions
to the fund will change, and there may be actuarial gains or losses. A
contribution into a fund in any period is not necessarily the total for
that period, due to actuarial gains or losses.
46
 An outline of the method used for an employer to account for the expenses and
obligation of a defined benefit plan is given below
 Step 1 Determine the deficit or surplus:
 An Actuarial technique (the Projected Unit Credit Method), should be
used to make a reliable estimate of the amount of future benefits employees
have earned from service in relation to the current and prior years.
 The benefit should be discounted to arrive at the present value of the defined
benefit obligation and the current service cost.
 The fair value of any plan assets should be deducted from the present value
of the defined benefit obligation
 Step 2 The surplus or deficit determined in Step 1 may have to be adjusted if a
net benefit asset has to be restricted by the asset ceiling.
 Step 3 Determine the amounts to be recognised in profit or loss:
 Current service cost
 Any past service cost and gain or loss on settlement
 Net interest on the net defined benefit (asset)
47
 Step 4 Determine the re-measurements of the net defined benefit (asset),
to be recognised in other comprehensive income:
 Actuarial gains and losses
 Return on plan assets (excluding amounts included in net interest on the net
defined benefit liability (asset)
 Any change in the effect of the asset ceiling (excluding amounts included in
net interest on the net defined benefit liability (asset)
 In the statement of financial position, the amount recognised as a defined
benefit liability (which may be a negative amount, ie an asset) should be:
 The present value of the defined obligation at the year end, minus
 The fair value of the assets of the plan as at the year end (if there are any)
out of which the future obligations to current and past employees will be
directly settled
 IAS 19 includes the following specific requirements.
 The plan assets should exclude any contributions due from the employer but not yet
paid.
 Plan assets are reduced by any liabilities of the fund that do not relate to employee
benefits, such as trade and other payables.
48
 All of the gains and losses that affect the plan obligation and plan asset
must be recognised. The components of defined benefit cost must
be recognised as follows in the statement of profit or loss and other
comprehensive income:
Component Recognised in:

(a) Service cost Profit or loss
(b) Net interest on the net defined benefit Profit or loss
liability
(c) Re-measurements of the net defined benefit Other comprehensive
liability income
49
Audit Risks
 Risk of assets or liabilities on the plan not recognized appropriately
 Risk of understatement of expenses
 Risk of incorrect gains/losses recognized in OCI
50
Procedures
Scheme assets (including quoted and  Ask directors to reconcile the scheme
unquoted securities, debt instruments, assets valuation at the scheme year end date
properties) with the assets valuation at the reporting
entity's date being used for IAS 19 purposes
 Obtain direct confirmation of the scheme
assets from the Investment custodian
 Consider requiring scheme auditors to
perform procedures
Scheme liabilities  Auditors must follow the principles of ISA

620 Using the work of an auditor's expert to
assess whether it is appropriate to rely on the
actuary's work
 Specific matters would include
– The source data used
– The assumptions and methods used
– The results of actuaries' work in the light of
auditors' knowledge of the business and
results of other audit procedures
51
Actuarial source data is likely to include:
 Scheme member data (for example, classes
of member and contribution details)
 Scheme asset information (for example,
values and income and expenditure items)
Actuarial assumptions (for Auditors will not have the same expertise as
example, mortality rates, actuaries and are unlikely to be able to
termination rates, retirement age challenge the appropriateness and
and changes in salary and reasonableness of the assumptions. Auditors
benefit levels) can, however, through discussion with
directors and actuaries:
Actuarial assumptions (for example,
mortality rates, termination rates, retirement
age and changes in salary and benefit levels)
 Obtain a general understanding of the
assumptions and review the process used to
develop them
 Compare the assumptions with those
which directors have used in prior years
52
 Consider whether, based on their
knowledge of the reporting entity and the
scheme, and on the results of other audit
procedures, the assumptions appear to be
reasonable and compatible with those used
elsewhere in the preparation of the entity's
 Obtain written representations from
directors confirming that the assumptions
are consistent with their knowledge of the
business
Items charged to operating  Discuss with directors and actuaries the

profit (current service cost, past factors affecting current service cost (for
service cost, gains and losses on example, a scheme closed to new entrants
may see an increase year on year as a
settlements and curtailments,
percentage of pay with the average age of the
interest) workforce increasing)
53
IAS 20 “Accounting for government grants
and disclosure of government assistance”
 Government grants and assistance are accounted for under IAS 20
Accounting for government grants and disclosure of government
assistance. They may be either revenue or capital grants relating to the
assets or income.
 Only recognise grants when reasonable assurance that:
 Entity will comply with any conditions attached
 Entity will actually receive the grant
54
ACCOUNTING FOR REVENUE GRANTS
 The receipt of a revenue grant is recorded by:
 Dr Cash
 Cr Deferred income (liability)
 The grant held as deferred income is then released to the income
statement over the period in which the related expenditure is incurred:
 Revenue grants which are made to subsidise specific expenditure are
recognised in the P or L in the period in which that expenditure is
recognised.
 Revenue grants which are made to held achieve a non-financial goal are
recognised P or L in which the costs of meeting that goal are
recognised.
 The credit to the P or L may be:
 presented as a separate item of income; or
 deducted from the related expense which is then shown net.
55
ACCOUNTING FOR CAPITAL GRANTS
 IAS 20 allows two treatments with regard to the recognition of a capital
grant:
1. Deduct grant from cost of the non- 2. Record grant separately as deferred
current asset to which it relates income.
Dr Cash Dr Cash
Cr Non-current asset Cr Deferred income
Depreciate the net cost of the non- Release the deferred income to the P or L
current asset over its useful life. over the useful life of the non-current
Therefore both the grant and the full asset.
cost of the non-current asset are spread
over the useful life of the asset.
56
Disclosures:
 Accounting policy adopted
 Nature and extent of government grants recognized
 Unfulfilled conditions and other contingencies
GRANTS TO REIMBURSE PREVIOUSLY INCURRED COSTS
 Grants which relate to costs already incurred should be recognised in the
income statement in the period in which they become receivable.
Repayment of government grants
 If a grant must be repaid it should be accounted for as a revision of an accounting
estimate (see IAS 8).
 Repayment of a grant related to income: apply first against any unamortised deferred
income set up in respect of the grant; any excess should be recognised immediately as an
expense.
 Repayment of a grant related to an asset: increase the carrying amount of the asset or
reduce the deferred income balance by the amount repayable. The cumulative additional
depreciation that would have been recognised to date in the absence of the grant should
be immediately recognized as an expense.
 It is possible that the circumstances surrounding repayment may require a review of the
asset value and an impairment of the new carrying amount of the asset.
57
Audit Risks
 There is a risk that conditions of recording grant are not met
 Also there may be the risk of incorrect value being recognized in
respect of government grant
 There is a risk that income is immediately recorded rather deferred
income
 There may be the risk of incorrect accounting treatment being
performed
 There may be the risk of inconsistency in applying accounting policies
 There may be the risk of inappropriate disclosures being provided
 In case of conditions not met, provisions should be created. There is a
risk that provision of repayment of grant is not created.
58
Procedures
 Obtain documentation relating to the grant and confirm that it should
be classified as revenue or capital grant
 Agree the value to documentation (eg a letter outlining the details of
the grant, or a copy of an
application form sent by the client)
 Read the conditions attached to the grant
 Enquire management how they intend to achieve the conditions of
grant and inspect progress to date
 Physically inspect the asset in case of grant related to assets
 Review the accounting treatment performed and confirm consistency
in the policies applied
 Review the disclosures to ensure these are made according to IAS 20
 Agree receipt of the grant to bank statements
 Discuss the basis of accounting with the directors to ensure that the
method used is the best method.
 Ensure that any changes in accounting method are disclosed.
59
IAS 21”The Effects of Changes in Foreign
Exchange Rates”
 Individual company
Perhaps the most immediate audit risk here is that the entity fails to comply with
the accounting requirements of IAS 21 The Effects of Changes in Foreign Exchange
Rates. For an individual company conducting trade in foreign currencies, there are
two separate accounting issues: conversion and translation.
 Conversion is uncontroversial, and relates to an entity conducting transactions in a
foreign currency, and which incurs exchange gains/losses in relation to these
transactions. The rule is simple: the gain or loss on conversion is recognised directly
in profit or loss in the period in which it occurs. The principal risk here is of the
wrong exchange rate being used, resulting in misstatement of the gain/loss in the
financial statements.
 Translation is more complex. Translation is required at the end of an accounting
period when a company still holds assets or liabilities in its statement of financial
position which were obtained or incurred in a foreign currency. IAS 21 distinguishes
between monetary items and non-monetary items. The basic rule is that monetary
items (eg cash, receivables) should be retranslated using the rate ruling at the end of
each accounting period. Non-monetary items are left at the amount recognised at the
date of the transaction.
60
Audit Risk
 Foreign currency transactions – initial recognition
 According to IAS 21 The Effects of Changes in Foreign Exchange Rates, foreign currency
transactions should be initially recognised having been translated using the spot rate, or
an average rate may be used if exchange rates do not fluctuate significantly. The risk on
initial recognition is that an inappropriate exchange rate has been used in the translation
of the amount, causing an inaccurate expense, current liability and inventory valuation to
be recorded, which may be over or understated in value.
 Foreign currency transactions – exchange gains and losses
 Further risk arises in the accounting treatment of balances relating to foreign currency at
the year end. Payables denominated in a foreign currency must be retranslated using the
closing rate, with exchange gains or losses recognized in profit or loss for the year. The
risk is that the year end retranslation does not take place, or that an inappropriate
exchange rate is used for the retranslation, leading to over or understated current
liabilities and operating expenses.
 Risk also exists relating to transactions that are settled within the year, if the correct
exchange gain or loss has not been included in profit. Inventory should not be
retranslated at the year end as it is a non-monetary item, so any retranslation of
inventory would result in over or undervaluation of inventory and profit.
61
Procedures
 Audit procedures here would therefore include:
 Check that foreign currency transactions are recorded at the historic
rate on initial recognition (and in the statement of profit or loss)
 Check that monetary items included in the statement of financial
position at the year end are translated at the closing rate of exchange
 Check that non-monetary items are translated at the historical rate of
exchange
62
IAS 23 “Borrowing costs”
 IAS 23 deals with the treatment of borrowing costs, often associated with
the construction of self-constructed assets, but which may also be
applied to an asset purchased that takes time to get ready for use/sale.
 Borrowing costs. Interest and other costs incurred by an entity in
connection with the borrowing of funds.
 Qualifying asset. An asset that necessarily takes a substantial period of
time to get ready for its intended use or sale.
 Accounting treatment
 Where an entity borrows money specifically to acquire or construct a
qualifying asset, all of the actual borrowing costs incurred, less any income
from the temporary investment of the money borrowed, must be
capitalised.
 Where money is borrowed centrally from a number of sources, and to fund
a number of projects, the borrowing costs to be capitalised as part of the
cost of a non-current asset must be calculated based on the weighted
average cost of general borrowings.
63
 All eligible borrowing costs must be capitalised.
Examples of borrowing costs include:
 Interest on bank overdrafts, short and long-term borrowings
 Amortisation of discounts or premiums related to borrowings
 Amortisation of ancillary costs incurred with arrangement of borrowings
 Finance charges for finance leases
 Exchange differences as far as they are an adjustment to interest costs
 PERIOD OF CAPITALISATION
 The capitalisation of borrowing costs commences when:
 Expenditure on the asset has commenced, and
 Borrowing costs are being incurred, and
 Activities necessary to prepare the asset for its intended use are in progress.
 The capitalisation of borrowing costs ceases when substantially all the activities
necessary to prepare the qualifying asset for its intended use or sale are complete.
 If construction of the asset is suspended due to industrial action, for example, then
the capitalisation of borrowing costs is also suspended.
64
 DISCLOSURE OF BORROWING COSTS
 The following should be disclosed in relation to borrowing costs:
 The amount of borrowing costs capitalised during the period
 The capitalisation rate used to determine the amount of borrowing costs
eligible for capitalisation
65
Audit Risk
 There is risk that basic criteria of capitalization is not met. That is
“where an entity borrows money specifically to acquire or construct a
qualifying asset, all of the actual borrowing costs incurred, less any
income from the temporary investment of the money borrowed, must
be capitalised.”
 There may be the risk of incorrect expense being capitalized:
 Incorrect interest rate being used in the calculation of interest. Where
money is borrowed centrally from a number of sources, and to fund a
number of projects, the borrowing costs to be capitalised as part of the
cost of a non-current asset must be calculated based on the weighted
average cost of general borrowings.
 Also there may be the risk of interest being capitalized for wrong
period.
 Finally there may be the risk of disclosures not being provided
according to IAS 23.
66
Procedures
 Interest can often be audited by analytical procedures, as it has a
predictable relationship with loans (for example, bank loans or
debentures).
Alternatively it can be verified to payment records (bank
statements) and loan agreement documents.
However, if borrowing costs are capitalised in accordance with IAS 23
the auditor should carry out the following procedures
 Agree figures in respect of interest payments made to statements from
lender and/or bank statements
 Ensure interest is directly attributable to construction
 Review the period of capitalization
 Enquire the management when the asset made available for use
67
IAS 24 Related Parties
 A related party transaction is a transfer of resources, services, or obligations
between related parties, regardless of whether a price is charged.
 A party is related to an entity if:
 directly, or indirectly through one or more intermediaries, the party:
 controls, is controlled by, or is under common control with, the entity (this
includes parents, subsidiaries and fellow subsidiaries);
 has an interest in the entity that gives it significant influence over the entity; or
 has joint control over the entity;
 the party is an associate (as defined in IAS 28 Investments in Associates) of the
entity;
 the party is a joint venture in which the entity is a venturer (see IAS 31 Interests
in Joint Ventures);
 the party is a member of the key management personnel of the entity or its
parent;
68
 The following are deemed not to be related parties of an entity:
 two enterprises simply because they have a director or key manager in
common;
 two venturers who share joint control over a joint venture;
 providers of finance, trade unions, public utilities, government
departments and agencies in the course of
 their normal dealings with an enterprise; and
 a single customer, supplier, franchiser, distributor, or general agent with
whom an enterprise transacts a
 significant volume of business merely by virtue of the resulting
economic dependence.
69
 DISCLOSURE OF RELATED PARTY TRANSACTIONS
 As IAS 24 is primarily about disclosing related party transactions there is a
significant amount of disclosure required.
 If an entity has entered into related parties transactions during the accounting
period, they must disclose the nature of the related party relationship as well as
information about the transactions and outstanding balances necessary for an
understanding of the potential effect of the relationship on the financial
statements.
 These disclosure would be made separately for each category of related parties
and would include:
 the amount of the transactions.
 the amount of outstanding balances, including terms and conditions and
guarantees.
 provisions for doubtful debts related to the amount of outstanding
balances.
 expense recognised during the period in respect of bad or doubtful debts
due from related parties.
70
Audit Risk
The main risk is related to the related party disclosures
may not be provided.
71
Procedures
 Taking complete understanding of the entity to identify related parties
 Review of the related parties identified by the management
 Being skeptical throughout the audit to identify transactions not at
arms length
72
IAS 33 “Earnings per share”
 Accounting for earnings per share is governed by IAS 33 Earnings per
share. It requires that companies of a certain size disclose their
earnings per share for the year.
 Basic earnings per share should be calculated by dividing the net
profit or loss for the period attributable to ordinary equity holders by
the weighted average number of ordinary shares outstanding during
the period as follows.
Net profit /(loss) attributable to ordinary shareholders
Weighted average number of ordinary shares outstanding during the
period
73
 Diluted earnings per share is calculated by adjusting the net profit
attributable to ordinary shareholders and the weighted average number
of shares outstanding for the effects of all dilutive potential ordinary
shares.
 These include:
 A separate class of equity shares, which at present is not entitled to
any dividend, but will be entitled in future
 Convertible loan stock or convertible preferred shares
 Options or warrants
 The calculation would be:
Diluted earnings
Diluted weighted average number of shares
74
Audit Risk
 A key audit risk is that the entity fails to meet IAS 33's disclosure
requirements. These are:
 The amounts used as the numerators in calculating basic and diluted
EPS, and a reconciliation of those amounts to the net profit or loss for
the period
 The weighted average number of ordinary shares used as the
denominator in calculating basic and diluted EPS, and a
reconciliation of these denominators to each other
 There is a risk relating to inadequate disclosure, for example, a diluted
EPS needs to be presented, as does a comparative for the previous year.
The incorrect calculation and disclosure of EPS is a significant issue
75
Procedures
 The audit procedures are:
 Obtain a copy of the client's workings for earnings per share. (If a
simple calculation has been used, this can be checked by re-doing the
fraction on the face of the statement of profit or loss and other
comprehensive income.
 Compare the calculation with the prior year calculation to ensure that
the basis is comparable
 Discuss the basis with the directors if it has changed to ascertain if it is
the best basis for the accounts this year and whether the change has
been adequately disclosed
 Recalculate to ensure that it is correct
76
IAS 36 “Impairment of non-current assets”
 An asset is impaired when its carrying amount (depreciated cost or depreciated
valuation) exceeds its recoverable amount. You should be familiar with the
following key terms from your accounting studies.
 Management are required to determine if there is any indication that the assets are
impaired. IAS 36 Impairment of assets specifies the following indicators of possible
impairment.
External sources of information regarding possible impairment:
 Market value declines significantly
 Negative changes in technology, markets, economy or legal environment
 Increases in market interest rates that are likely to affect the discount rate using to
calculate value in use
 Company stock price is below book value.
 Internal sources of information regarding possible impairment:
 Obsolescence or physical damage
 Significant changes with an adverse effect on use, eg asset will become idle, is part of a
restructuring, or is held for disposal
 Internal evidence shows worse economic performance of the asset than was expected.
77
 The auditors will consider whether there are any indicators of
impairment when carrying out risk assessment procedures. They will
use the same impairment criteria laid out in IAS 36 as management do.
If the auditors believe that impairment is indicated, they should
request that management show them the impairment review
that has been carried out. If no impairment review has been
carried out, then the auditors should discuss the need for one with
management, and if management refuse to carry out an impairment
review, qualify their opinion on grounds of a material misstatement
in respect of IAS 36 as a result of management not carrying out an
impairment review.
 If an impairment review has been carried out, then the auditors should
audit that impairment review. Management will have estimated
whether the recoverable amount of the asset/cash generating unit is
lower than the carrying amount.
78
Audit Risk
 The net book value of the properties will be overstated if the carrying value has
not been fully written down to recoverable amount according to IAS 36.
 Similarly expenses will be understated and profits overstated if the impairment
is not being charged.
 For auditors, the key risk is that recoverable amount requires estimation,
which involves management using its judgement. Auditors will need to
consider whether the judgement made by management is reasonable in
accordance with IAS 36.
 The projections or forecast of cashflows for the calculation of VIU may be
inaccurate resulting in incorrect VIU.
 The discount factor used for the calculation of VIU may be inappropriate
resulting in incorrect recoverable value.
 There may also be the risk of inappropriate fair value; independent valuer not
being used; incorrect assumptions are used to assess FV.
 If an asset is being impaired and previously a gain was charged on that asset;
IAS 16 describes that firstly revaluation reserve should be debited and if there
is still any loss remaining then that should be debited to SPL.
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Procedures
 Value in use
 Obtain management's calculation of value in use
 Re-perform calculation to ensure that it is mathematically correct
 Compare the cash flow projections to recent budgets and projections
approved by the board to ensure that they are realistic
 Calculate/obtain from analysts the long term average growth rate for the
products and ensure that the growth rates assumed in the calculation of
value in use do not exceed it
 Refer to competitors' published information to compare how similar assets
are valued by companies trading in similar conditions
 Compare to previous calculations of value in use to ensure that all relevant
costs of maintaining the asset have been included
 Ensure that the cost/income from disposal of the asset at the end of its life
has been included
 Review calculation to ensure cash flows from financing activities and
income tax have been excluded
 Compare discount rate used to published market rates to ensure that it
correctly reflects the return expected by the market.
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 Fair Value
 Inspect the independent valuers report.
 Estimate the fair value by using the assumptions that are made by
management or valuer.
 Perform market research to look for the fair value of the asset.
 Other
 Inspect the statement of financial position and register to ensure asset
is recorded at lower of CV and recoverable amount.
 Review the SPL to look for impairment loss is being charged.
 Confirm that depreciation is being charged on the correct amount; for
example if written down to recoverable amount.
 Enquire management how frequently they perform impairment
reviews.
 Physically inspect the asset to look for condition; as damaged asset or
asset not being used in production may possibly be the indicator of
impairment.
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IAS 37 “Provisions, contingent
liabilities and contingent assets”
 A provision is a liability of uncertain timing or amount.
 A liability is a present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.
 Under IAS 37, an entity should not recognise a contingent asset or a
contingent liability (ie a possible asset or liability). Contingent liabilities and
contingent assets should only be disclosed, not recognised.
 However if the following conditions are met then a provision should be
recognised in relation to a contingent liability.
 There is a present obligation as a result of a past event.
 There will be a probable outflow of resources (<50% likely).
 A reliable estimate can be made.
 Common examples include warranties, legal claims against an entity, onerous
contracts, restructuring costs.
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 AS 37 also gives guidance regarding a number of specific provisions.
These include:
 Provisions for restructuring
A restructuring is a programme that is planned and is controlled by
management and materially changes either:
 The scope of the business undertaken by an entity
 The manner in which that business is conducted
 The IAS gives the following examples of events that would fall
under this definition:
 The sale or termination of a line of business
 The closure of business locations in a country or region or the
relocation of business activities from one country or region to another
 Changes in management structure
 Fundamental reorganisations that have a material effect on the
nature and focus of the entity's operations
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 In order to make a provision an obligation (legal or constructive) must
exist at the period end. In this context, a constructive obligation exists
only in the following circumstances.
 An entity must have a detailed formal plan for the restructuring.
 It must have raised a valid expectation in those affected that it will
carry out the restructuring by starting to implement that plan or
announcing its main features to those affected by it.
 A management or board decision alone would not normally be
sufficient.
 The IAS states that a restructuring provision should include only the
direct expenditures arising from the restructuring.
 Onerous contracts
 An onerous contract is a contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic
benefits expected to be received under it. An example might be a
vacant leasehold property.
 If an entity has a contract that is onerous a provision must be made for
the net loss.
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 Decommissioning provisions
 A provision is only recognised from the date on which the obligating
event occurs.
For example when an oil company initially purchases an oil field it is
put under a legal obligation to decommission the site at the end of its
life. The legal obligation exists therefore on the initial expenditure on
the field and therefore the liability exists immediately. The IAS also
takes the view that the decommissioning costs may be capitalised as an
asset representing future access to oil reserves (ie an asset and a
provision are recognised).
 Contingent assets
Contingent assets should not be recognised, as IAS 37 requires an
entity to be virtually certain that it will receive an inflow of economic
benefits. The asset is only recognised when it is virtually certain that
there is an asset (unlike contingent liabilities, which although not
recognised may nevertheless be provided for).
The recognition of contingent assets in financial statements therefore
represents a risk for auditors, and should be investigated thoroughly
85
Audit Risk
 IAS 37 Provisions, Contingent Liabilities and Contingent Assets states
that a provision should be recognised if the company has a probable
obligation at the year end which can be measured reliably.
 If payment is deemed only possible at the year end, then disclosure of
the contingent liability should be made in a note to the financial
statements.
 Therefore the financial statement risk is both understated liabilities
and overstated profit, if the cash outflow is considered probable but no
provision is made. Alternatively, the risk is incomplete disclosure if the
outflow is considered possible and no note is provided.
86
Procedures
 The audit tests that should be carried out on provisions and contingent assets
and liabilities are:
 Obtain details of all provisions which have been included in the accounts
and all contingencies that have been disclosed
 Obtain a detailed analysis of all provisions showing opening balances,
movements and closing balances
 Determine for each material provision whether the company has a present
obligation as a result of past events by:
 Reviewing of correspondence relating to the item
 Discussion with the directors. Have they created a valid expectation in other
parties that they will discharge the obligation?
 Determine for each material provision whether it is probable that a transfer
of economic benefits will be required to settle the obligation by:
 Checking whether any payments have been made after the year end in
respect of the item
 Reviewing of correspondence with solicitors, banks, customers, the
insurance company and suppliers both pre and post year end
87
 Sending a letter to the solicitors to obtain their views (where
relevant)
 Discussing the position of similar past provisions with the
directors. Were these provisions eventually settled?
 Considering the likelihood of reimbursement
 Recalculate all provisions made
 Compare the amount provided with any post year end payments and
with any amount paid in the past for similar items
 In the event that it is not possible to estimate the amount of the
provision, check that a contingent liability is disclosed in the
accounts
 Consider the nature of the client's business. Would you expect to
see any other provisions, for example, warranties?
 Consider whether disclosures of provisions, contingent liabilities
and contingent assets are correct and sufficient
88
 Contingencies
 Obtaining audit evidence of contingencies
Part of ISA 501 Audit evidence – specific considerations for selected
items covers contingencies relating to litigation and legal claims, which
will represent the major part of audit work on contingencies. Litigation
and claims involving the entity may have a material effect on the
financial statements, and so will require adjustment to/disclosure in
those financial statements.
ISA 501.9
The auditor shall design and perform audit procedures in order to
identify litigation and claims involving the entity which may give rise to
a risk of material misstatement
 Such procedures would include:
 Make appropriate inquiries of management including obtaining
representations
 Review board minutes and correspondence with the entity's lawyers
 Examine legal expense account
 Use any information obtained regarding the entity's business
including information obtained from discussions with any in-house
legal department
89
IAS 38 “Intangible assets”
 An intangible asset is an identifiable non-monetary asset without physical
substance. It may be held for use in the production and supply of goods or
services, or for rental to others, or for administrative purposes. The asset must
be:
 Controlled by the entity as a result of events in the past
 Something from which the entity expects future economic benefits to flow
 Examples of items that might be considered as intangible assets include
computer software, patents, copyrights, motion picture film rights, customer
lists, franchises and fishing rights. An item should not be recognised as an
intangible asset, however, unless it fully meets the definition in the standard.
The guidelines go into great detail on this matter.
 Internally generated goodwill may not be recognised as an asset.
 Most internally generated intangible assets do not meet the recognition
criteria, as their cost cannot be distinguished from the costs of developing a
business as a whole (e.g. brands,mastheads, customer lists)
90
 Intangible assets which are recognised in the financial statements are
measured initially at cost.
 Where an intangible asset has a finite useful life, it is amortised over
that useful life, beginning when the asset is available for use.
 Where an intangible asset has an indefinite useful life, then it is not
amortised, but is tested for impairment annually, and in between if
there are indications of impairment.
 The revaluation model may be adopted for intangible assets only where
a fair value can be established by reference to an active market.
 The key accounting issue with regard to brands is whether the asset is
internally generated or not. Remember, IAS 38 forbids the
capitalisation of internally generated brands. If a brand has been
purchased separately then auditors should test the value of the brand
according to the sales documentation
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 Research & Development
 Expenditure on research is required to be recognised in profit or loss in the
year of expenditure.
 IAS 38 states that the development costs of a project should be recognised as
an asset only when all of the following criteria are met.
 P- The business can demonstrate how future economic benefits will be
generated, either by demonstrating a market exists or the internal usefulness of
the asset.
 I- The business intends to complete the asset and use or sell it.
 R- Adequate technical, financial and other resources will be available to
complete the
development and use or sell the intangible asset.
 A- The business will be able to use or sell the asset.
 T- Completion of the asset will be technically feasible.
 E- Expenditure attributable to the development of the asset can be measured
reliably.
 General overhead expenditure, costs of inefficiencies and operating losses, and
expenditure on training staff to operate the asset should not be capitalised.
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Audit Risk
 The risk is that assets have been recorded which do not meet the criteria for recognition
as an asset, leading to an overstatement of non-current assets.
 There may be the risk that estimates made by management are not reasonable. For
example amortisation rates or frequency of conducting impairment reviews on assets
having infinite life.
 IAS 38 Intangible Assets prohibits the recognition of internally generated brands. If any
of the associated expense has been capitalised as a brand name, this would mean that
non-current assets are overstated, and profit for the year would be overstated.
 The risk is that the asset may be overvalued, for two reasons.
 Firstly, if no amortisation is being charged on the asset, management are assuming that
there is no end to the period in which the brand will generate an economic benefit. This
may be optimistic, and there is a risk that the brand is overvalued, and operating
expenses incomplete if there is no annual write-off. An intangible asset which is not
being amortised should be subject to an annual impairment review according to IAS 38
Intangible Assets. If no such review has been conducted, the asset could be overvalued.
 Secondly, If a significant amount has been spent on promoting the brand name during
the year. This amount should be expensed, and if any has been capitalised, the brand is
overvalued, and operating expenses incomplete.
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Audit Risk
 The risk is that amounts have been capitalised which do not meet the
criteria for recognition as an asset, leading to an overstatement of non-
current assets. Only costs in respect of the development should be
capitalised, subject to meeting the recognition criteria of IAS 38
Intangible Assets. Any costs incurred in planning (Research) must be
expensed. There is a risk that research element is being capitalized.
Secondly development is capitalized even if the criteria of development
is not met.
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Procedures
 Prepare analysis of movements on cost and amortisation accounts
 Obtain confirmation of all patents and trademarks held by a patent agent
 Verify payment of annual renewal fees
 Review specialist valuations of intangible assets, considering:
– Qualifications of valuer
– Scope of work
– Assumptions and methods used
 Confirm carried down balances represent continuing value
 Inspect purchase agreements, assignments and supporting documentation for
intangible assets acquired in period
 Confirm purchases have been authorized
 Verify amounts capitalised of patents developed by the company with supporting
costing records
 Amortisation
 Review amortisation
– Check computation
– Confirm that rates used are reasonable
 Income from intangibles
 Review sales returns and statistics to verify the reasonableness of income derived
from patents, trademarks, licences etc
 Examine audited accounts of third party sales covered by a patent, licence or
trademark owned by the company
95
Procedures
 Goodwill
 Agree consideration to a sales agreement
 Confirm valuation of assets acquired is reasonable
 Check purchased goodwill is calculated correctly
 Check goodwill does not include non-purchased goodwill
 Ensure valuation of goodwill is reasonable by reviewing prior year's
accounts and discussion with the directors
 Ensure impairment review has been carried out at least annually
 Review impairment review for reasonableness
96
Procedures
 The key audit tests largely reflect the criteria laid down in IAS 38
 Check accounting records to confirm:
– Project is clearly defined (separate cost centre or general ledger codes)
– Related expenditure can be separately identified, and certified to
invoices, timesheets
 Confirm feasibility and viability:
– Examine market research reports, feasibility studies, budgets and forecasts
– Consult client's technical experts
 Review budgeted revenues and costs by examining results to date,
production forecasts, advance orders and discussion with directors
 Review calculations of future cash flows to ensure resources exist to
complete the project
 Review previously deferred expenditure to ensure IAS 38 criteria are still
justified
 Check amortisation:
– Commences with production
– Charged on a systematic basis
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IAS 40 “Investment properties”
 A key factor to consider when auditing investment properties is whether one
exists according to the criteria of IAS 40 Investment property.
Investment property is property (land or a building – or part of a building –
or both) held (by the owner or by the lessee under a finance lease) to earn
rentals or for capital appreciation or both, rather than for:
 Use in the production or supply of goods or services or for administrative
purposes, or
 Sale in the ordinary course of business
 Measurement
 They are accounted for according to either the cost model of IAS 16 or the fair
value model of IAS 40
 Where the cost model is applied, investment property is held at cost less
depreciation. It is not revalued
 Where the fair value model is applied, investment property is re-measured to
fair value each year with any changes in fair value recognised in the income
statement. It is not depreciated.
98
Audit Risk
 There may be a risk that definition of IAS 40 is not met
 There may be the risk of inconsistency in applying the two
models
 There may be the risk of incorrect gain/loss charged on
property carrying on FV
 There may be the risk of depreciation being charged on
property carrying on FV
99
Evidence
 Confirm that property meets the IAS 40 definition of investment
property
 Verify rental agreements, ensuring that occupier is not a connected
company and that the rent has been negotiated at arm's length.
 Review the assumptions made by management to assess FV
 Review independent valuer report
 Recalculate the CV of property carried at cost model
 Recalculate gain/loss of property carrying on FV
 Review the disclosures made in the financial statements in relation to
investment properties to ensure that they have been made
appropriately, in accordance with IAS 40.
100
IAS 41 “Agriculture”
 IAS 41 introduces a fair value model to agriculture accounting. This is a major
shift away from the traditional cost model widely applied in primary industry.
 IAS 41 applies to:
 Biological assets (living plants or animals – for example, trees in a plantation or
orchard, cultivated plants, sheep, cattle) related to managed agricultural
activity (for example, raising livestock, forestry, annual or perennial cropping,
fish farming), that are in the process of growing, degenerating, regenerating
and/or procreating and which are expected to eventually result in agricultural
produce (the harvested product of biological assets)
 Agricultural produce at the point of harvest.
 The main issues addressed by IAS 41 are:
 When should a biological asset or agricultural produce be recognised on the
statement of financial position?
 At what value should a recognised biological asset or agricultural produce be
measured?
 How should the differences in value of a recognised biological asset or
agricultural produce between two year end dates be accounted for?
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 Recognition
 IAS 41 specifies the usual tests in order that a biological asset or agricultural
produce be recognised on the statement of financial position, namely:
 Control: the enterprise must have ownership or rights of control akin to
ownership that result from a past event
 Value: future economic benefits are expected to flow to the enterprise from its
ownership or control of the asset
 Measurement: the cost or fair value of the asset must be measured with
reliability.
 Measurement
 Biological assets should be measured initially, and at each year end date
subsequently, at fair value less estimated point-of-sale costs.
 Agricultural produce is measured, at the point of harvest, at fair value less
estimated point-of-sale costs. The point of harvest represents the transition
between accounting for agricultural produce assets under IAS 41 and IAS 2. Fair
value less estimated point-of-sale costs at the point of harvest forms ‘cost’ for
the purposes of IAS 2.
 Point-of-sale costs include commissions to brokers and dealers, levies by
regulatory agencies and commodity exchanges, and transfer taxes and duties.
Point-of-sale costs exclude transport and other costs necessary to get assets to a
market (these are taken into account in arriving at fair value).
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 Gains and losses
 At initial recognition, the fair value (less estimated point-of-sale costs)
of a biological asset is reported as a gain or loss in the statement of
profit or loss. A loss may arise on initial recognition when the
estimated point-of-sale costs exceed the fair value of the asset in its
present state.
 The change in fair value (less estimated point-of-sale costs) of a
biological asset between two year end dates is reported as a gain or loss
in the statemaent or profit or loss.
 A gain or loss arising on initial recognition of agricultural produce at
fair value less estimated point-of-sale costs is included in net profit or
loss for the period in which it arises.
103
 Disclosure
 Extensive disclosure is required by IAS 41, including:
 the aggregate gain or loss for the period on:
– initial recognition of biological assets
– initial recognition of agricultural produce
– change in fair value less estimated point-of-sale costs of biological
assets
 a description of, and the nature of its activities involving, each group of
biological assets
 non-financial measures or estimates of the physical quantities of
agricultural produce output for the period and biological assets as at
the year end date
 methods and significant assumptions in determining fair value
 the fair value less estimated point-of-sale costs of agricultural produce
harvested for the period
 restrictions on title, pledges and commitments in respect of biological
assets
 financial risk management strategies related to agricultural activity
 a reconciliation of changes in the carrying amount of those biological
assets.
104
Audit Risk
 There may be the risk of incorrect accounting treatment. Asset may be
wrongly classified to IAS 41 or the criteria is not being met.
 Also there may be the risk of classifying asset at wrong time.
 Recognizing asset at incorrect values, e.g inappropriate FV or cost at
point of sale
 Also there may be the risk that gain/loss on re-measurement is not
being charged to P or L or incorrect value being charged
 There may be the risk that disclosures are not being provided or
incomplete disclosures being provided
105
Procedures
 Review the disclosures and ensure adequate disclosures are being
provided
 Physically inspect the asset to look for stage
 Review the independent valuer’s report
 Enquire the management about any cost related to point of sale and
ensure its being deducted from the FV
 Review the depreciation charge for Biological assets presented at Cost
less accumulated depreciation
 Review the reasonableness of estimates
106
IFRS 2 “Share-based payment”
 IFRS 2 Share-based payment sets out rules for the measurement of expenses
relating to share-based payment schemes. These arise most commonly in
relation to payments for employee services and professional services
 IFRS 2 Recap
IFRS 2 requires entities to recognise the goods or services received as a result of
share-based payment transactions.
 There are three types of share-based payment transactions.
 Equity-settled share-based payment transactions, in which the entity
receives goods or services in exchange for equity instruments of the entity
 Cash-settled share-based payment transactions, in which the entity
receives goods or services in exchange for amounts of cash that are based on the
price (or value) of the entity's shares or other equity instruments of the entity
 Transactions, in which the entity receives or acquires goods or services and
either the entity or the supplier has a choice as to whether the entity settles the
transaction in cash (or other assets) or by issuing equity instruments
 Share based payment obligation
 Obligation = number of rights expected to vest x fair value x timing ratio
107
 Timing Ratio
 This is simply the position of the year end within the contract.
 Timing ratio = Year end/Vesting period
 Fair Value
 This is the fair value of the rights given to the employees. It’s not the
intrinsic value of the options, nor is it the fair value of the shares.
 However, the recognition depends on the type of share based payment.
There are two types, options and share appreciation rights. They are
almost identical. The fair value is recognised as follows:
Settlement Name Fair Value

Settled in Equity Options Grant Fair Value
Settled in Cash Share Appreciation Rights Current Fair Value
(SAR)
108
 An entity should recognise goods or services received or acquired in a
share-based payment transaction when it obtains the goods or as the
services are received. They should be recognised as expenses unless
they qualify for recognition as assets. Transactions are measured at fair
value.
 Equity-settled transactions:
DEBIT Assets/expense
CREDIT Equity
 Cash-settled transactions:
DEBIT Asset/expense
CREDIT Liability
 Audit risks and evidence
The general audit risk here is that the requirements of IFRS 2 are not
adhered to. This is a complex area of financial reporting, particularly in
practice, and is therefore risky to audit.
109
Audit Risk
 IFRS 2 Share-based Payment requires that an expense should be recognised over the
vesting period, calculated based on the fair value of the share options at the grant
date.
 Market conditions should be taken into account when determining the fair value of
the share options at the grant date and are not to be taken into account for the
purpose of estimating the number of equity instruments that will vest.
 There may be the risk that no expense has been recognised, and so operating
expenses are understated. The corresponding entry to equity has not been made, so
equity is also understated.
 A further issue relating to the measurement of the expense is that it should be
adjusted for the condition relating to executives and senior managers remaining in
employment at the end of the vesting period. A risk of inaccurate measurement of
the expense arises if no assessment of whether an adjustment being necessary is
made, or if the assumptions relating to the continued service of the executives are
unrealistic.
 The share-based payment plan should also have a deferred tax consequence – a
deferred tax asset arises due to the deductible temporary difference arising from the
accounting treatment. There is a risk that assets are incomplete if this is not
recognised in the statement of financial position.
110
Audit Risk
 The expense could be overstated if the assumption regarding all of the shares
vesting is incorrect. The expense should be calculated by considering whether
performance conditions attached to the share options will be met. It is unlikely
that every single employee granted an option will meet the required
performance criteria and therefore a more realistic, lower estimate should be
made of the expense. The expense should be adjusted each year end to account
for staff turnover. If the expense is overstated due to an incorrect assumption,
then the corresponding credit to equity is also overstated.
 In addition, the calculation of the total cost of the share-based payment is
complex, and if any of the components of the calculation are incorrect, then
the expense will be over or understated. For example, the fair value used to
calculate the expense should be the fair value of the granted share options
calculated at the grant date; the use of fair value at any other date is incorrect.
The model used to calculate fair value (e.g. the Black-Scholes Model) must
comply with IFRS 2 Share-based Payment.
 It is also important for the measurement of the expense that it has been
calculated based on the share options being granted midway through the
accounting period.
The auditor will require evidence in respect of all the estimates feeding into the
IFRS 2 calculation, in addition to reperforming the calculation itself for the
expense for the current year.
111
Issue Evidence
Number of employees in scheme/number Revenue scheme details set out in a contractual
of instruments per employee/length of documentation
vesting period.
Number of employees estimated to  Enquire of directors
benefit  Compare to staffing numbers per forecasts
and prediction
Fair value of instruments  For equity-settled schemes check that fair
value is estimated at measurement date
 For cash-settled schemes check that the fair
value is recalculated at the year end and at the
date of settlement
 Check that model used to estimate fair value
is in line with IFRS 2
General Obtain written representations from
management confirming their view that:
 The assumptions used in measuring the
expense are reasonable, and
 There are no share-based payment schemes
in existence that have not been disclosed to the
auditors.
112
IFRS 5 “Non-current assets held for
sale and discontinued operations”
 IFRS 5 Non-current assets held for sale and discontinued operations
applies to non-current assets and disposal groups. A disposal group
is a group of assets and associated liabilities that are to be disposed of
in a single transaction.
IFRS 5 requires that non-current assets and disposals groups that are
'held for sale' should be presented separately in the statement of
financial position. 'Held for sale' here means that the non-current
asset/disposal group's carrying amount will be recovered principally
through a sale rather than through continuing use.
 A number of detailed criteria must be met:
 The asset must be available for immediate sale in its present
condition
 The sale must be highly probable
113
 For sale to be highly probable the following must
apply.
 Management must be committed to a plan to sell the asset
 There must be an active plan to locate a buyer
 The asset must be marketed at a price that is reasonable in relation to its
current fair value
 The sale should be expected to take place within one year from the date of
classification
 It is unlikely that significant changes to the plan will be made or that the plan
will be withdrawn
 A non-current asset held for sale should be measured at the lower of its
carrying amount and fair value less costs to sell. An impairment loss should be
recognised where fair value less costs to sell is lower than the carrying amount.
 Non-current assets held for sale should not be depreciated even if they are still
being used by the entity.
114
Audit Risk
 A disposal group should be classified as held for sale where the assets
are available for sale in their present condition, and the sale is highly
probable, and these conditions are met before the year end. Under
IFRS 5, the assets should be presented separately, measured at the
lower of carrying amount and fair value less costs to sell, and the assets
should no longer be depreciated.
 The financial statement risk therefore is that if the classification
as held for sale is not made, the financial statements will fail to
correctly disclose the disposal group in the statement of
financial position.
 In addition, the assets may be measured incorrectly, for example,
if following the measurement rules of IFRS 5 would result in
impairment of the assets, and if depreciation continues to be charged.
The measurement and depreciation issues would also impact on the
profit for the year, though any misstatement may not be material to
profit.
115
Procedures
 Confirm that the asset meets the definition of an asset held for sale:
 Discuss with management the availability of asset for sale
 Assess management commitment, eg minuted in board minutes
 Evaluate and assess practical steps being taken to sell the asset eg appropriate
real estate agents appointed
 Determine when the sale is expected to take place by assessing progress to date
 Determine and assess the basis on which the sale price has been set
 Discuss with management any significant changes to the plans
 Confirm that the asset has been valued as held for sale in accordance
with IFRS 5 and assess how fair value has been determined.
 Check that the asset has not been depreciated from the date of reclassification.
 Confirm separate disclosure in accordance with IFRS 5.
116
Discontinued operations
 Discontinued operations
 Discontinued operations are accounted for under IFRS 5 Non-current assets
held for sale and discontinued operations. The IFRS requires that certain
disclosures are made for discontinued operations in the statement of profit or
loss and other comprehensive income or in the notes. This may well be
material for the following reasons.
 Potentially material through size
 May be inherently material if the change in operations is a sign of
management policy or a major change in focus of operations
 Essentially, the fact that some operations have been discontinued is of interest
to shareholders, which is why the IFRS 5 disclosures came about.
 IFRS 5 requires that assets which meet the criteria 'held for sale' are shown at
the lower of carrying amount and fair value less costs to sell, and that held for
sale assets are classified separately in the statement of financial position and
the results of discontinued operations are presented separately in the
statement of profit or loss and other comprehensive income.
117
Discontinued operations
 To require separate classification in the statement of profit or loss and other
comprehensive income, discontinued operations must be:
 A component (ie separately identifiable)
 Which represents a separate major line of business/geographical area
 Part of a single co-ordinated plan to dispose of a separate major line of
business/geographical area
 Or is a subsidiary acquired exclusively with a view to resale
 An entity should present and disclose information that enables users of the
financial statements to evaluate the financial effects of discontinued
operations and disposals of non-current assets or disposal groups. This allows
users to distinguish between operations which will continue in the future and
those which will not and makes it more possible to predict future results.
 An entity should disclose the net cash flows attributable to the operating,
investing and financing activities of discontinued operations. These disclosures
may be presented either on the face of the statement of cash flows or in the
notes
118
Audit Risk
 A further consideration is that asset for sale is also likely to meet the
definition of a discontinued operation if it operates as an independent
business division, so it can be distinguished operationally and for
financial reporting purposes. According to IFRS 5, once the
discontinued operations definition is met, its results should be
presented separately in the statement of Profit or Loss. This should
apply to the results for the entire period, and not just the results since
the operation became discontinued. Comparative figures should also
be re-stated. The financial statement risk is that this separate
presentation is not made, or that comparatives not restated.
 A further disclosure risk arises from IFRS 5’s requirement for the net
cash flows of the discontinued operation to be disclosed on the face of,
or in the notes to the statement of cash flows.
119
Procedures
 Relevant audit procedures include:
 Obtaining accounting records for component to ensure it is separately
identifiable
 Review company documentation (such as annual report) to ensure it is
separately identifiable
 Review minutes of meetings/make enquiries of management to ascertain
management's intentions
 To audit whether the disclosures have been made correctly, the auditor
should undertake the following procedures.
 Obtain a copy of the client's workings to disclose the discontinued operations
 Review the workings to ensure that the figures are reasonable and agree to the
 Trace a sample of items disclosed as discontinuing items to backing
documentation (invoices) to ensure that they do relate to discontinued
operations
120
IFRS 8 “Operating segments”
 The disclosure of segmental information is governed by IFRS 8
Operating segments.
 An operating segment is a component of an entity:
 That engages in business activities from which it may earn revenues
and incur expenses (including revenues and expenses relating to
transactions with other components of the same entity)
 Whose operating results are reviewed regularly by the entity's chief
operating decision maker to
make decisions about resources to be allocated to the segment and
assess its performance
 For which discrete financial information is available
 IFRS 8 requires an entity to report financial and descriptive
information about its reportable segments.
121
 Reportable segments are operating segments or aggregations of
operating segments that meet specified criteria:
 Reported revenue, from both external customers and intersegment sales or
transfers, is 10% or
more of the combined revenue, internal and external, of all operating
segments; or
 The absolute measure of reported profit or loss is 10% or more of the
greater, in absolute amount, of (i) the combined reported profit of all
operating segments that did not report a loss and (ii) the combined
reported loss of all operating segments that reported a loss; or
 Assets are 10% or more of the combined assets of all operating segments.
 If the total external revenue reported by operating segments constitutes
less than 75% of the entity's revenue, additional operating segments must
be identified as reportable segments (even if they do not meet the
quantitative thresholds set out above) until at least 75% of the entity's
revenue is included in reportable segments.
122
Audit Risks
 IFRS 8 Operating Segments requires listed companies to disclose in a
note to the financial statements information about the performance of
the various different operating segments of the business. The financial
statement risk is the non-disclosure of information relating to these
operating and geographical segments.
123
Procedures
 The auditor shall obtain sufficient appropriate audit evidence regarding the
presentation and disclosure of segment information in accordance with the
applicable financial reporting framework by:
 Obtaining an understanding of the methods used by management in
determining segment information:
 Evaluating whether such methods are likely to result in disclosure in accordance with
the applicable financial reporting framework
 Where appropriate, testing the application of such methods
 Performing analytical procedures or other audit procedures appropriate in the
circumstances
 Obtain a client schedule of revenue workings
 Discuss with management the basis for the segmentation and ensure that the
basis for
segmentation mirrors that used for internal reporting purposes (IFRS 8)
 Verify a sample of items to backing documentation (invoices) to ensure
disclosure is correct
124
IFRS 9 “Financial instruments”
 Financial instrument: Any contract that gives rise to both a financial
asset of one entity and a financial liability or equity instrument of
another entity.
 Fair value is the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date.
 Derivative: A financial instrument or other contract with all three of
the following characteristics:
 Its value changes in response to the change in a specified interest rate,
financial instrument price, commodity price, foreign exchange rate,
index of prices or rates, credit rating or credit index, or other variable
(sometimes called the 'underlying').
 It requires no initial net investment or an initial net investment that is
smaller than would be required for other types of contracts that would
be expected to have a similar response to changes in market factors.
 It is settled at a future date
125
 Financial assets
Initial recognition of a financial asset is at the fair value of the consideration.
Subsequent to this initial recognition, IFRS 9 requires that financial assets
are classified as measured at either:
 Amortised cost, or
 Fair value
 The IFRS 9 classification is made on the basis of both:
 The entity's business model for managing the financial assets, and
 The contractual cash flow characteristics of the financial asset.
 An application of these rules means that equity investments may not be
classified as measured at amortised cost and must be measured at fair
value. This is because contractual cash flows on specified dates are not a
characteristic of equity instruments. In addition, all derivatives are
measured at fair value.
 A debt instrument may be classified as measured at either amortised cost or
fair value depending on whether it meets the criteria above.
126
 Financial liabilities
 As with financial assets, a financial liability is initially measured at the
fair value of the consideration received. Subsequent to this, IFRS 9
requires that financial assets are classified as measured at either:
 Fair value through profit or loss, or
 Amortised cost under the effective interest rate method
 A financial liability is classified at fair value through profit or loss if:
 It is held for trading, or
 Upon initial recognition it is designated at fair value through profit or loss
 Derivatives are always measured at fair value through profit or loss.
127
 Hedge accounting
 Hedging, for accounting purposes, means designating one or more
hedging instruments so that their change in fair value is an offset, in
whole or in part, to the change in fair value or cash flows of a hedged
item.
 A hedged item is an asset, liability, firm commitment, or forecasted
future transaction that:
 Exposes the entity to risk of changes in fair value or changes in future
cash flows, and that Is designated as being hedged.
 A hedging instrument is a designated derivative or (in limited
circumstances) another financial asset or liability whose fair value or
cash flows are expected to offset changes in the fair value or cash flows
of a designated hedged item. (A non-derivative financial asset or
liability may be designated as a hedging instrument for hedge
accounting purposes only if it hedges the risk of changes in foreign
currency exchange rates.)
 Hedge effectiveness is the degree to which changes in the fair value or
cash flows of the hedged item attributable to a hedged risk are offset by
changes in the fair value or cash flows of the hedging instrument.
128
 The main types of hedging relationship are– fair value hedges, cash
flow hedges, and foreign operation net investment hedges.
 Fair value hedge: a hedge of the exposure to changes in the fair value
of a recognised asset or liability, or an identified portion of such an
asset or liability, that is attributable to a particular risk and could affect
profit or loss.
 Accounting Treatment:
 The gain or loss resulting from re-measuring the hedging instrument at
fair value is recognised in profit or loss.
The gain or loss on the hedged item attributable to the hedged risk
should adjust the carrying amount of the hedged item and be
recognised in profit or loss.
129
 Cash flow hedge: a hedge of the exposure to variability in cash flows
that Is attributable to a particular risk associated with a recognised
asset or liability (such as all or some future interest payments on
variable rate debt) or a highly probable forecast transaction (such as An
anticipated purchase or sale), and that could affect profit or loss.
 Accounting Treatment:
 The portion of the gain or loss on the hedging instrument that is
determined to be an effective hedge shall be recognised directly in
equity through the statement of changes in equity.
The ineffective portion of the gain or loss on the hedging instrument
should be recognised in profit or loss.
130
 IFRS 7 Financial instruments: disclosure
IFRS 7 requires entities to make extensive disclosures in relation to
financial instruments, which we will recap briefly here. The standard
requires qualitative and quantitative disclosures about exposure to risks
arising from financial instruments and specifies minimum disclosures
about credit risk, liquidity risk and market risk.
Two types of disclosure need to be made: about the significance of the
financial instruments, and about the nature and extent of risks
arising from the financial instruments.
 Compound financial instruments
 One key requirement of IAS 32 relates to compound financial
instruments. Convertible debt is a commonly-examined example
here, where IAS 32 requires the debt and equity elements of the
instrument to be presented separately in the financial statements.
Accounting in this area requires a level of judgement, which can be
risky from an auditor's point of view. For example, judgement is
required when calculating the present value of debt repayments (eg in
selecting an appropriate discount rate)
131
Audit Risk
 Audit risk will probably be increased by the presence of complex
financial instruments because:
 It may be difficult to understand the nature of financial instruments
and what they are used for, and the risks to which the entity is exposed
 Market sentiment and liquidity can change quickly, placing pressure
on management to manage their exposures effectively
 Evidence supporting valuation may be difficult to obtain
 There may be large Individual payments, which may increase the risk
of misappropriation of assets
 The amounts in the financial statements may not be proportionate to
the level of risk involved
 There may be undue reliance on a few key employees, who may exert
significant influence on the entity's financial instruments transactions,
and whose compensation may be linked to the performance of these
instruments. This may be a risk of fraudulent financial reporting.
132
Audit Risk
 Convertible debentures
 According to IFRS 9 convertible debt instruments should be presented
in the statement of financial position split into two separate
components. This is because the company does not know if it has an
obligation to pay cash on the redemption of the debt, or whether the
debt will be settled by an equity distribution. Therefore, on the receipt
of cash proceeds, the credit entry is split between debt and equity. The
debt is valued by discounting the potential cash outflows to present
value, with the credit entry to equity a residual balancing figure. The
financial statement risk is firstly that split accounting has not been
applied, so the whole of the credit has been recognised as either debt or
equity, and therefore incorrectly recognised in the statement of
financial position. This would then have a further consequence for the
statement of Profit or Loss, as any finance charge calculated on the
basis of an incorrect debt component would then also be incorrectly
measured.
133
Audit Risk
 Forward exchange contracts
 These contracts are derivative financial instruments. As such, they
must be recognised in the statement of financial position at the year
end, as a financial asset or a financial liability, depending on whether
the terms of the derivative contract are favourable or unfavourable at
the reporting date. The financial statement risk is that the derivatives
have not been recognized at all, particularly because when the
contracts are acquired at no cost, so there is no accounting entry when
the contract is taken out. A second risk relates to the valuation of the
derivative asset or liability. This could be complex to calculate, and if
not performed by an experienced specialist, could cause the over or
understatement of the financial instrument recognised, and an
associated incorrect entry recognised in profit. Finally, IFRS 7 Financial
Instruments: Disclosures imposes potentially onerous disclosure
requirements in relation to derivative instruments. The risk is that
disclosures made in the notes to the financial statements are
incomplete.
134
Audit Risk
 Additional finance – measurement and disclosure of loan
 The loan taken out is a financial liability and must be accounted for in
accordance with IFRS 9 Financial Instruments, which states that financial
liabilities must be classified and measured at amortised cost using the effective
interest method (unless an option is taken to measure at fair value). The risk is
that amortised cost has not been applied, meaning that finance costs have not
accrued on the loan. The fact that the finance cost in the draft statement of
Profit or Loss has remained static indicates that this may have happened,
resulting in understated finance costs and understated liabilities.
 There is also a risk that necessary disclosures under IFRS 7 Financial
Instruments: Disclosures have not been made. The notes to the financial
statements should contain narrative and numerical disclosures regarding risk
exposures, and given the materiality of the loan, it is likely that disclosure
would be necessary.
 Hedging Risks
 There is a risk of hedge accounting conditions are not met
 There may be the risk of incorrect gain/loss being recognized in the P or L in
respect of hedged item or instrument
135
Procedures
 External confirmation of bank accounts, trades, and custodian statements – eg direct
confirmation with the counterparty
 Reviewing reconciliations of statements or data feeds from custodians (eg investment
funds) with the entity's own records
 Reviewing journal entries and the controls over the recording of such entries
 Reading individual contracts and reviewing supporting documentation of the entity's
financial instrument transactions, including accounting records
 Testing controls, eg by reperforming controls
 Reviewing the entity's complaints management systems
 Reviewing master netting arrangements to identify unrecorded instruments
 Test how management made the accounting estimate and the data used. Check that
fair value is arrived at in accordance with IFRS 13, using the 'fair value hierarchy'.
 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, eg the
auditor can make his own estimate of the fair value
 Determine whether events occurring up to the date of the auditor's report provide
audit evidence regarding the accounting estimate, eg are there any indicators of
impairment?
136
IFRS 15 Revenue from Contracts with
Customers
 The core principle of IFRS 15 is that an entity shall recognise revenue from the
transfer of promised good or services to customers at an amount that reflects
the consideration to which the entity expects to be entitled in exchange for
those goods and services. The standard introduces a five-step model for the
recognition of revenue.
 The new IFRS 15 adopts a five-step approach to revenue recognition:
C contract: Identify the contracts with a customer.
O obligations: Identify the performance obligations (unbundling).
P price: Determine the transaction price.
A allocate: Allocate the transaction price to the performance obligations.
R revenue: Recognise revenue as entity satisfies performance obligations.
137
 Step one: Contracts may be in different forms (written, verbal or implied), but
must be enforceable, have commercial substance and be approved by the
parties to the contract. The model applies once the payment terms for the
goods or services are identified and it is probable that the entity will collect the
consideration.
 Step two: This is often referred to as ‘unbundling’, and is done at the beginning
of a contract. The key factor in identifying a separate performance obligation is
the distinctiveness of the good or service, or a bundle of goods or services. A
good or service is distinct if the customer can benefit from the good or service
on its own or together with other readily available resources and it is separately
identifiable from other elements of the contract.
 Step three: amount of consideration that an entity expects to be entitled to in
exchange for the promised goods or services. This amount excludes amounts
collected on behalf of a third party – for example, government taxes. An entity
must determine the amount of consideration to which it expects to be entitled
in order to recognise revenue.
 Step four: The allocation is based on the relative standalone selling prices of
the goods or services promised and is made at the inception of the contract. It
is not adjusted to reflect subsequent changes in the standalone selling prices of
those goods or services.
 Step five: An entity satisfies a performance obligation by transferring control
of a promised good or service to the customer, which could occur over time or
at a point in time. The definition of control includes the ability to prevent
others from directing the use of and obtaining the benefits from the asset.
138
 In addition to the five-step model, IFRS 15 sets out how to account for
the incremental costs of obtaining a contract and the costs directly
related to fulfilling a contract and provides guidance to assist entities in
applying the model to licences, warranties, rights of return, principal-
versus-agent considerations, options for additional goods or services
and breakage.
139
Audit Risks
 According to IFRS 15 Revenue from Contracts with Customers, revenue
should only be recognised as control is passed, either over time or at a
point in time. The timing of revenue recognition will depend on the
contractual terms with the customer, with factors which may indicate
the point in time at which control passes including the transference of
the physical asset, transference of legal title, and the customer
accepting the significant risks and rewards related to the ownership of
the asset. It is likely that the payments in advance should be treated as
deferred revenue at the point when the payment is received as the
conditions for recognition of revenue are unlikely to have been met at
this point in time.
140
Procedures
 Compare the overall level of revenue against prior years and budget and investigate any
significant fluctuations.
 Obtain a schedule of sales for the year broken down into the major categories and
compare this to the prior year breakdown and for any unusual movements discuss with
management.
 Calculate the gross margin and compare this to the prior year and investigate any
significant fluctuations.
 Select a sample of sales invoices for larger customers and recalculate the discounts
allowed to ensure that these are accurate.
 Recalculate for a sample of invoices that the sales tax has been correctly applied to the
sales invoice.
 Select a sample of customer orders and agree these to the despatch notes and sales
invoices through to inclusion in the sales ledger to ensure completeness of revenue.
 Select a sample of despatch notes both pre and post the year end, follow these through to
sales invoices in the correct accounting period to ensure that cut-off has been correctly
applied.
 Select a sample of credit notes issued after the year end and follow through to sales
invoice to ensure the returns were recorded in the proper period.
 Review the sale agreement to ensure there is no option to repurchase or any managerial
involvement.
 For the combined goods and services, review the breakdown of goods and services to
ensure both are separately accounted for (in the case of services being provided for more
than one year).
141
Contact for Online Classes
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Mobile 00923009433841
Email [email protected]
Institute NCS University/MARFAT Business School
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Standards revision, Audit Risks

The accounting treatment is to:

Audit tests – stocktake attendance

Deferred Tax Liability Deferred Tax Asset

 A deferred tax asset or liability may not be discounted

 Sale and leaseback transactions

 Valuation (finance leases)

Component Recognised in:

Scheme liabilities  Auditors must follow the principles of ISA

Items charged to operating  Discuss with directors and actuaries the

Settlement Name Fair Value

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