Icaew CR Part 01 6e

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Icaew CR Part 01 6E
Financial Reporting (Institute of Chartered Accountants of Pakistan)
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The Institute of Chartered Accountants in England and Wales
CORPORATE
REPORTING
Edition 6
Study Manual
www.icaew.com

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Corporate Reporting
The Institute of Chartered Accountants in England and Wales
ISBN: 978-1-50971-980-8
Previous ISBN: 978-1-78363-796-6
First edition 2013

Sixth edition 2018
All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system or transmitted in any form or by any means,
graphic, electronic or mechanical including photocopying, recording,
scanning or otherwise, without the prior written permission of the
publisher.
The content of this publication is intended to prepare students for the

ICAEW examinations, and should not be used as professional advice.
British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library
Originally printed in the United Kingdom on paper obtained from

traceable, sustainable sources.
The publishers are grateful to the IASB for permission to reproduce
extracts from the International Financial Reporting Standards including
all International Accounting Standards, SIC and IFRIC Interpretations
(the Standards). The Standards together with their accompanying
documents are issued by:
The International Accounting Standards Board (IASB)
30 Cannon Street, London, EC4M 6XH, United Kingdom.
Email: [email protected] Web: www.ifrs.org
Disclaimer: The IASB, the International Financial Reporting Standards
(IFRS) Foundation, the authors and the publishers do not accept
responsibility for any loss caused by acting or refraining from acting in
reliance on the material in this publication, whether such loss is caused
by negligence or otherwise to the maximum extent permitted by law.
Copyright © IFRS Foundation
All rights reserved. Reproduction and use rights are strictly limited. No
part of this publication may be translated, reprinted or reproduced or
utilised in any form either in whole or in part or by any electronic,
mechanical or other means, now known or hereafter invented,
including photocopying and recording, or in any information storage
and retrieval system, without prior permission in writing from the IFRS
Foundation. Contact the IFRS Foundation for further details.
The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the
'Hexagon Device', 'IFRS Foundation', 'eIFRS', 'IAS', 'IASB', 'IFRS for
SMEs', 'IASs', 'IFRS', 'IFRSs', 'International Accounting Standards' and
'International Financial Reporting Standards', 'IFRIC', 'SIC' and 'IFRS
Taxonomy' are Trade Marks of the IFRS Foundation.
Further details of the Trade Marks including details of countries where
the Trade Marks are registered or applied for are available from the
Licensor on request.
© ICAEW 2019
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Welcome to ICAEW
As the future of our profession, I'd like to personally welcome you to ICAEW.
In a constantly changing and volatile environment, the role of the accountancy profession has
never been more important to create a world of strong economies, together. ICAEW Chartered
Accountants make decisions that will define the future of global business by sharing our
knowledge, skills and insight.
By choosing our world-leading chartered accountancy qualification, the ACA, you are not only
investing in your own future but also gaining the skills and values to meet the challenges of
technological change and contribute to future business success.
Joining over 150,000 chartered accountants and over 27,000 fellow students worldwide, you are
now part of something special. This unique network of talented and diverse professionals has
the knowledge, skills and commitment to help build local and global economies that are
sustainable, accountable and fair.
You are all supported by ICAEW as you progress through your studies and career: we will be
with you every step of the way to ensure you are ready to face the fast-paced changes of the
global economy. Visit page viii to review the key resources available as you study.
It's with our training, guidance and support that our members, and you, will realise career
ambitions, develop insights that matter and maintain a competitive edge.
I wish you the best of luck with your studies and look forward to welcoming you to the
profession.
Michael Izza
Chief Executive
ICAEW
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Contents
 Permitted texts vii
 Key resources viii
 Skills within the ACA x
Principles and Regulations in Corporate Reporting and Auditing
1. Introduction 1
2. Principles of corporate reporting 53
Ethics and Governance
3. Ethics 111
4. Corporate governance 165
The Modern Audit Process
5. The statutory audit: planning and risk assessment 219
6. The statutory audit: audit evidence 293
7. The statutory audit: evaluating and testing internal controls 381
8. The statutory audit: finalisation, review and reporting 421
Reporting Performance
9. Reporting financial performance 489
10. Reporting revenue 553
11. Earnings per share 601
Assets and Liabilities
12. Reporting of assets 641
13. Reporting of non-financial liabilities 709
Financing
14. Leases, government grants and borrowing costs 737
15. Financial instruments: presentation and disclosure 787
16. Financial instruments: recognition and measurement 813
17. Financial instruments: hedge accounting 881
Remuneration
18. Employee benefits 957
19. Share-based payment 1005
Business Combinations
20. Groups: types of investment and business combination 1069
Reporting Foreign Activities
21. Foreign currency translation and hyperinflation 1193
Taxation
22. Income taxes 1257
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Financial Statement Analysis

23. Financial statement analysis 1 1325
24. Financial statement analysis 2 1393
25. Assurance and related services 1475
26. Environmental and social considerations 1531
27. Internal auditing 1573
 Index 1603
The Corporate Reporting module enables you to apply technical knowledge, analytical
techniques and professional skills to resolve compliance and business issues that arise in the
context of the preparation and evaluation of corporate reports and from providing audit
services.
Questions within the Study Manual should be treated as preparation questions, providing you
with a firm foundation before you attempt the exam-standard questions. The exam-standard
questions are found in the Question Bank.
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Permitted texts
At the Professional and Advanced Levels there are specific texts that you are permitted to take
into your exams with you. All information for these texts, the editions that are recommended for
your examinations and where to order them from, is available on icaew.com/permittedtexts.
Professional Level exams Permitted text
Audit and Assurance 
Financial Accounting and Reporting 
Tax Compliance 
Business Strategy and Technology 
Financial Management 
Business Planning No restrictions
Advanced Level exams
Corporate Reporting No restrictions

Strategic Business Management No restrictions
Case Study No restrictions
The exams which have no restrictions include the following:

 Business Planning: Banking;
 Business Planning: Insurance;
 Business Planning: Taxation;
 Corporate Reporting;
 Strategic Business Management; and
 Case Study.
This means you can take any hard copy materials into these exams that you wish, subject to
practical space restrictions.
Although the examiners use the specific editions listed to set the exam (as listed on our website),
you may use a different edition of the text at your own risk.
This information, as well as what to expect and what is and is not permitted in each exam is
available in the Instructions to Candidates. You will be sent the instructions with your exam
admission details. They can also be viewed on our website at icaew.com/exams.
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Key resources
We provide a wide range of resources and services to help you in your studies. Here is some of
what we have to offer.
Take a look at the online resources available to you on icaew.com/examresources:
Syllabus, skills development and technical knowledge grids

This gives you the full breakdown of learning outcomes for each module, see how your skills and
technical knowledge will grow throughout the qualification.
Study guide
This guides you through your learning process, putting each chapter and topic of the Study
Manual into context and showing what learning outcomes are attached to them.
Exam webinars
The pre-recorded webinars focus on how to approach each exam, plus exam and study tips.
Past exams and mark plans

Each exam is available soon after it has been sat, with mark plans available once results have
been released. Remember that if you're accessing an exam from 2018, it may not reflect exams
for 2019. To access exam-standard questions that reflect the current syllabus, go to the Question
Bank.
Errata sheets
These are available on our website if we are made aware of a mistake within a Study Manual or
Question Bank once it has been published.
Exam software
You need to become familiar with the exam software before you take your exam. Access a
variety of resources, including exam guide, practice software, webinars and sample exams at
icaew.com/cbe
Student support team

Our dedicated student support team is here to help and advise you throughout your training,
don't hesitate to get in touch. Email [email protected] or call +44 (0)1908 248 250 to
speak to an adviser.
Vital and Economia

Vital is our quarterly ACA student magazine. Each issue of Vital is packed with interesting articles
to help you with work, study and life. Read the latest copy at icaew.com/vital.
What's more, you'll receive our monthly member magazine, Economia. Read more at
icaew.com/economia.
Online student community

The online student community is the place where you can post your questions and share your
study tips. Join the conversation at icaew.com/studentcommunity.
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Tuition
The ICAEW Partner in Learning scheme recognises tuition providers who comply with our core
principles of quality course delivery. If you are not receiving structured tuition and are interested
in doing so, take a look at our recognised Partner in Learning tuition providers in your area, at
icaew.com/dashboard.
CABA
Access free, confidential support to help you take care of your wellbeing, at work and at home.
CABA's services are available to you, and your family, face-to-face, over the phone and online.
Find out more at caba.org.uk.
ICAEW Business and Finance Professional (BFP)

This exciting new designation has been developed as a form of recognition for professionals
who have gained the essential knowledge, skills and experience necessary for a successful
career in business and finance. Once you have completed the ICAEW CFAB qualification or the
Certificate Level of the ACA, you are eligible to apply towards gaining BFP status. Start your
application at icaew.com/becomeabfp.
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Skills within the ACA

Professional skills are essential to accountancy and your development of them is embedded
throughout the ACA qualification.
The following shows the professional skills that you will develop in this particular module. To see
the full skills development grids, please go to icaew.com/examresources.
Assimilating and using information

Understand the situation and the requirements
 Demonstrate understanding of the business context
 Identify and understand the requirements
 Recognise new and complex ideas within a scenario
 Identify the needs of customers and clients
 Explain different stakeholder perspectives and interests
 Identify risks within a scenario
 Identify elements of uncertainty within a scenario
 Identify ethical issues including public interest and sustainability issues within a scenario
Identify and use relevant information
 Interpret information provided in various formats
 Evaluate the relevance of information provided
 Use multiple information sources
 Filter information provided to identify critical facts
Identify and prioritise key issues and stay on task
 Identify business and financial issues from a scenario
 Prioritise key issues
 Work effectively within time constraints
 Operate to a brief in a given scenario
How skills are assessed: students may be required to:
 have a detailed knowledge and understanding of relevant regulations in financial reporting,
auditing and ethics, which will need to be related to practical business scenarios and
applied to any data provided. The data provided will focus on technical compliance and
understanding;
 respond to instructions from a line manager, a client request or from other senior
personnel. The requests may be specific, or they may be more general requiring
interpretation and judgement to be applied by the student;
 evaluate the quality and relevance of information provided in the context of a particular
assignment;
 evaluate inconsistencies in information provided from multiple sources;
 use different sources and types of evidence to confirm, or question, financial statement
assertions applying professional scepticism; and
 evaluate the ethical implications of making information available including confidentiality
and transparency.
Structuring problems and solutions
Structure data
 Structure information from various sources into suitable formats for analysis
 Identify any information gaps
 Frame questions to clarify information
 Use a range of data types and sources to inform analysis and decision making
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 Structure and analyse financial and non-financial data to enhance understanding of

business issues and their underlying causes
 Present analysis in accordance with instructions and criteria
Develop solutions
 Identify and apply relevant technical knowledge and skills to analyse a specific problem
 Use structured information to identify evidence-based solutions
 Identify creative and pragmatic solutions in a business environment
 Identify opportunities to add value
 Identify and anticipate problems that may result from a decision
 Identify a range of possible solutions based on analysis
 Identify ethical dimensions of possible solutions
 Select appropriate courses of action using an ethical framework
 Identify the solution which is the best fit with acceptance criteria and objectives
 Define objectives and acceptance criteria for solutions
 apply technical knowledge, analytical techniques and professional skills to resolve
compliance and business issues that arise in the context of the preparation and evaluation
of corporate reports and from providing audit services;
 structure problems and solutions in scenario based questions which may be presented in
the following forms:
– Mini case – in the context of auditing but with significant corporate reporting emphasis.
This may be technical, compliance or interpretive (for example including analytical
procedures).
– Financial statement analysis – including technical aspects of corporate reporting.
– Technical question on aspects of audit and corporate reporting (which may include
assurance, internal audit).
 consider ethical problems in reporting, assurance and business scenarios;
 formulate, evaluate and implement accounting and reporting policies;
 measure and recognise assets and obligations on reported financial performance;
 consider the impact and interaction of applicable accounting principles, bases and
standards;
 consider the appraisal of remuneration policies on reported performance; and
 evaluate reporting issues in relation to group scenarios and overseas activities.
Applying judgement
Apply professional scepticism and critical thinking
 Recognise bias and varying quality in data and evidence
 Identify faults in arguments
 Identify gaps in evidence
 Identify inconsistencies and contradictory information
 Assess interaction of information from different sources
 Exercise ethical judgement
Relate issues to the environment
 Appreciate when more expert help is required and always appropriately challenge and
critically review the expert's work
 Identify related issues in scenarios
 Assess different stakeholder perspectives when evaluating options
 Appraise corporate responsibility and sustainability issues
 Appraise the effects of alternative future scenarios
 Appraise ethical, public interest and regulatory issues
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 use technical knowledge and professional judgement to identify, explain and evaluate
alternatives and to determine the appropriate solutions to compliance issues, giving due
consideration to the needs of clients and other stakeholders. The commercial context and
impact of recommendations and ethical issues will also need to be considered in making
such judgements.
 demonstrate judgement in the following ways:
– selecting between technical choices;
– filtering data to identify critical elements;
– prioritising information, issues or tasks;
– identifying omissions in the information;
– evaluating inconsistencies in information;
– distinguishing between the various qualities of the data provided;
– evaluating the impact of economic and political factors;
– evaluating the effects of known events;
– evaluating the appropriateness of accounting policy choice and estimation selection;
– evaluating options;
– comparing the effects of a range of estimates, outcomes or financial treatments;
– assessing the materiality of errors;
– exercising ethical judgement;
– identifying key linkages; and
– drawing appropriate conclusions from data provided to satisfy specified objectives and
assessing the materiality of errors and omissions.
Concluding, recommending and communicating
Conclusions
 Apply technical knowledge to support reasoning and conclusions
 Apply professional experience and evidence to support reasoning
 Use valid and different technical skills to formulate opinions, advice, plans, solutions,
options and reservations
Recommendations
 Present recommendations in accordance with instructions and defined criteria
 Make recommendations in situations where risks and uncertainty exist
 Formulate opinions, advice, recommendations, plans, solutions, options and reservations
based on valid evidence
 Make evidence-based recommendations which can be justified by reference to supporting
data and other information
 Develop recommendations which combine different technical skills in a practical situation
Communication
 Present a basic or routine memorandum or briefing note in writing in a clear and concise
style
 Present analysis and recommendations in accordance with instructions
 Communicate clearly to a specialist or non-specialist audience in a manner suitable for the
recipient
 Prepare the advice, report, or notes required in a clear and concise style
 draw conclusions from data, facts, calculations, judgments and own analysis;
 draw conclusions from complex assurance engagements;
 identify weaknesses in financial information systems and their potential consequences;
 distinguish between the qualities of data provided or other evidence generated;
 develop risk management solutions in an audit and corporate reporting environment;
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 create report/memorandum in response to a specific technical issue and in accordance with

client requirements;
 draft reasoned, practicable advice that is clear and concise, supported by calculations or
analysis of technical/business issues identified;
 use judgement to select the most appropriate audit procedures in the context of risks
identified;
 justify a specific recommended action when a variety of options are available; and
 explain the limitations of their conclusions or recommendations.
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CHAPTER 1
Introduction
Introduction
TOPIC LIST
1 Using this Study Manual
2 The importance of corporate reporting
3 The role and context of modern auditing
4 Legal responsibilities of directors and auditors
5 International standards on auditing
6 Audit quality control
7 Laws and regulations

Summary and Self-test
Technical reference
Answers to Interactive questions
Answers to Self-test

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Introduction
Learning outcomes Tick off
 Comment on and critically appraise the nature and validity of items included in
published financial statements including how these correlate with an understanding
of the entity
 Appraise and explain the role and context of auditing
 Prepare appropriate audit documentation

 Explain the nature and purpose of quality assurance (both at the level of the firm
and the individual audit) and assess how it can contribute to risk management
Specific syllabus references for this chapter are: 9(a), 10(a), 10(b), 14(h).
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1 Using this Study Manual C

H
A
Section overview P
T
 This section gives a brief outline of how this Study Manual is structured and why. E
R
• The key point is that the Corporate Reporting paper is integrated, so financial reporting
and auditing must be studied together. 1
1.1 The importance of integration

The aim of the Corporate Reporting module is as follows:
To enable candidates to apply technical knowledge, analytical techniques and professional
skills to resolve compliance and business issues that arise in the context of the preparation
and evaluation of corporate reports and from providing audit services.
Candidates will be required to use technical knowledge and professional judgement to
identify, explain and evaluate alternatives and to determine the appropriate solutions to
compliance issues, giving due consideration to the needs of clients and other stakeholders.
The commercial context and impact of recommendations and ethical issues will also need
to be considered in making such judgements.
It is clear from this that the application of technical knowledge (financial reporting, audit,
assurance and ethics) is integrated, so it is appropriate that these areas are studied together
where possible.
At earlier levels you will have tended to study subjects in isolation, but this is no longer
appropriate at Advanced Level, and indeed in the real world.
1.2 How this Study Manual is structured

1.2.1 Principles and regulations in financial reporting and auditing
This chapter and Chapter 2 cover the role and context of auditing and general principles of
corporate reporting. This will largely be revision, but some of the regulations and standards will
have changed since your earlier studies. The aim is to set the more specialised topics, and the
integrated areas, in context.
1.2.2 Ethics and governance

Chapters 3 and 4 look at ethics and corporate governance. These topics underpin corporate
reporting and auditing, and ethical matters come up in all kinds of contexts, both in the exam
and in your working life as a professional. It is necessary to cover all relevant audit principles first
because, in the later chapters on reporting performance and position, the principles are applied
in audit focus sections.
1.2.3 The modern audit process

In Chapters 5 to 8 we revise and build on the auditing material covered at the Professional Level.
This will put you in the position where you can consider the audit and assurance issues in
relation to specific financial reporting topics, the aim being to study financial reporting and
auditing together.
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1.2.4 Financial reporting chapters

Chapters 9 to 22 deal with the financial reporting and auditing of specific areas:
 Reporting performance
 Assets and liabilities
 Financing
 Remuneration
 Business combinations
 Reporting foreign activities
 Taxation
The financial reporting aspects are covered first, followed by an 'audit focus' section for each
topic, looking at the specific audit issues arising from the financial reporting of that area,
generally with examples and/or questions. For example, the chapter on share-based payment
has at the end a section on auditing share-based payment.
Audit focus sections may in turn be split into general and specific sections. For example,
Chapter 9 Reporting Financial Performance covers general issues, including creative accounting,
for which auditors need to be alert. However, a more specific section will refer back to standards
and the auditing of, for example, related party disclosures, which has its own designated
ISA (UK) and particular risks. These sections allow scope for integrated examples or questions
covering both corporate reporting and auditing elements.
Finally the Self-test questions at the end of chapters will contain integrated questions where
relevant.
1.2.5 Financial analysis chapters

Once you have a thorough understanding of the financial reporting and related auditing issues,
including analytical procedures, you will be in a position to analyse and interpret the financial
statements. You will not have studied financial analysis before, so Chapter 23 provides an
introduction, and Chapter 24 deals with more advanced topics.
1.2.6 Assurance and other related services

The Study Manual concludes with coverage of assurance and related services, which can more
easily be understood in the context of the knowledge you have gained in the earlier chapters.
2 The importance of corporate reporting
Section overview
 Corporate reporting embraces financial reporting, and both are different from
management accounting.
• Financial statements are used to make economic decisions by a wide range of users.
• All users require information regarding:
– financial position
– financial performance
– changes in financial position

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2.1 What is corporate reporting?

C
H
2.1.1 Financial reporting A
P
Financial reporting is the process of identifying, measuring and communicating economic T
information to others so that they may make decisions on the basis of that information and E
assess the stewardship of the entity's management. R
Financial reporting involves: 1
 recording transactions undertaken by a business entity;

 grouping similar transactions together which are appropriate to the business; and
 presenting periodic results.
Financial reporting focuses on the preparation of published financial information. Typically, this
information is made available annually or half-yearly (sometimes quarterly) and is presented in
formats laid down or approved by governments in each national jurisdiction.
2.1.2 Corporate reporting
Corporate reporting is a broader term than financial reporting, although the two are often used
interchangeably. As will be evident from this Study Manual and the exam it prepares you for,
corporate reporting covers reports other than financial statements, in particular auditors'
reports, but also assurance, internal audit and environmental reports. The definition of corporate
reporting varies and could include integrated reporting, corporate governance, corporate social
responsibility and other narrative reporting such as the Management Commentary.
In the context of professional accountancy examinations, a corporate reporting paper is
generally higher level than a financial reporting paper. In the context of your examination,
Corporate Reporting is a more appropriate title because the paper is not just on financial
reporting.
General principles relating to corporate reporting are set out in the IASB Conceptual Framework
for Financial Reporting (Conceptual Framework), which is covered in Chapter 2, together with
regulatory matters and selected IFRSs that set out principles and frameworks.
2.1.3 Management accounting

By contrast, management accounting or reporting is internal reporting for the use of the
management of a business itself. Internal management information can be tailored to
management's own needs and provided in whatever detail and at whatever frequency (eg,
continuous real-time information) management decides is best suited to the needs of their
business.
The distinction is not so clear-cut, in that management decisions may be affected by external
reporting issues, for example, if a director's bonus depends on profit. These matters are covered
in Chapter 24 on the more advanced aspects of financial analysis.
Interactive question 1: Management decisions

Can you think of another example of a way in which management decisions may be influenced
by external reporting requirements?
See Answer at the end of this chapter.

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2.2 Entity
Most accounting requirements are written with a view to use by any type of accounting entity,
including companies and other forms of organisation, such as a partnership. In this Study Manual,
the term 'company' is often used, because the main focus of the syllabus is on the accounts of
companies and groups of companies, but IFRS generally refer to entities.
2.3 Financial statements

The principal means of providing financial information to external users is the annual financial
statements. Financial statements provide a summary of the performance of an entity over a
particular period and of its position at the end of that period.
A complete set of financial statements prepared under IFRS comprises the following:
 The statement of financial position
 The statement of profit or loss and other comprehensive income or two separate
statements being the statement of profit or loss and the statement of other comprehensive
income (statements of financial performance)
 The statement of changes in equity (another statement of financial performance)
 The statement of cash flows
 Notes to the financial statements
The notes to the financial statements include the following:
 Accounting policies ie, the specific principles, conventions, rules and practices applied in
order to reflect the effects of transactions and other events in the financial statements
 Detailed financial and narrative information supporting the information in the primary
financial statements
 Other information not reflected in the financial statements, but which is important to users
in making their assessments (an example of this would be the disclosures relating to
contingent assets or liabilities)
The individual elements that are included in the financial statements are covered in detail later in
this chapter.
2.4 Requirement to produce financial statements

Limited liability companies are required by law to prepare and publish financial statements
annually. The form and content may be regulated primarily by national legislation, and in most
cases must also comply with Financial Reporting Standards.
In the UK, all companies must comply with the provisions of the Companies Act 2006
(CA 2006). The key impact of this is as follows:
 Every UK registered company is required to prepare financial statements for each financial
year which give a true and fair view.
 The individual (and some group) financial statements may be prepared:
– in accordance with the CA 2006 (as regards format and additional information
provided by way of notes); or
– in accordance with international accounting standards.

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2.5 Financial reporting standards

C
Company financial statements must also comply with relevant reporting standards. In the UK H
A
these are as follows.
P
 Financial reporting standards T
E
The main financial reporting standard is FRS 102, The Financial Reporting Standard R
Applicable in the UK and Republic of Ireland. 1
 IFRS
These are issued by the IASB. UK companies whose securities are traded in a regulated
public market eg, the London Stock Exchange, must prepare group accounts in accordance
with IFRS.
Note. These learning materials assume the preparation of financial statements in accordance
with IFRS. If you studied under UK GAAP for the Financial Accounting and Reporting Paper,
you should first study the ICAEW Corporate Reporting: IFRS Supplement, which supports the
transition from UK GAAP to IFRS.
Unincorporated entities are exempt from the above requirements but may need to follow other
regulation eg, charities must comply with the Charities Act. Incorporated charities must prepare
their financial statements in accordance with the CA 2006 (ie, the IFRS option is not open to
them).
Point to note:
The term UK GAAP refers to all the rules, from whatever source, which govern UK accounting. In
the UK, this is seen primarily as a combination of:
 Company law (mainly CA 2006)
 Accounting Standards
 Stock Exchange requirements
In the UK, GAAP has no statutory or regulatory authority or definition (unlike some other
countries such as the US), although the use of the term is increasingly common in practice.
2.6 Fair presentation

IAS 1, Presentation of Financial Statements requires financial statements to 'present fairly' the
financial position and performance of an entity.
'Present fairly' is explained as representing faithfully the effects of transactions. In general terms
this will be the case if IFRS are adhered to. IAS 1 states that departures from international
standards are only allowed:
 in extremely rare cases; and
 where compliance with IFRS would be so misleading as to conflict with the objectives of
financial statements as set out in the Conceptual Framework, that is to provide information
about financial position, performance and changes in financial position that is useful to a
wide range of users.
2.7 Judgements and financial statements

Although IFRS narrow down the range of acceptable alternative accounting treatments, there
are still many areas which are left to the discretion of the directors of the company. On the
whole, the concept of faithful representation should result in transactions being 'presented
fairly'. However, commercial and financial considerations may result in pressure being brought
to bear to account for and report transactions in accordance with their strict legal form rather
than their true substance. This can raise ethical questions for a professional accountant.

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2.8 Users of financial statements

The form and content of financial statements must be influenced by the use to which they are
put. The IASB Conceptual Framework emphasises that financial statements are used to make
economic decisions, such as:
 to decide when to buy, hold or sell an equity investment
 to assess the stewardship or accountability of management
 to assess an entity's ability to pay and provide other benefits to employees
 to assess security for amounts lent to the entity
 to determine taxation policies
 to determine distributable profits and dividends
 to prepare and use national income statistics
 to regulate the activities of entities
Much of the information needed for these different decisions is in fact common to them all.
Financial statements aimed at meeting these common needs of a wide range of users are known
as 'general purpose' financial statements.
We can identify the following users of financial statements:
 Present and potential investors
 Employees
 Lenders
 Suppliers and other trade payables
 Customers
 Governments and their agencies
 The public
Their specific information needs and how these needs may be addressed are covered in
Chapter 23, the first of two chapters on financial analysis. In most cases the users will need to
analyse the financial statements in order to obtain the information they need. This might include
the calculation of accounting ratios.
2.9 Objective of financial statements

The objective of financial statements is to provide information about the reporting entity's
financial position and financial performance that is useful to a wide range of users in making
economic decisions.
This objective can usually be met by focusing exclusively on the information needs of present
and potential investors. This is because much of the financial information that is relevant to
investors will also be relevant to other users.
2.10 Accountability of management

Management also has a stewardship role, in that it is accountable for the safekeeping of the
entity's resources and for their proper, efficient and profitable use. Providers of risk capital are
interested in information that helps them to assess how effectively management has fulfilled this
role, but again this assessment is made only as the basis for economic decisions, such as those
about investments and the reappointment/replacement of management.
It is also the case that in a smaller entity the owner and manager can be the same individual.
Financial reporting helps management to meet its need to be accountable to shareholders, and
also to other stakeholders (eg, employees or lenders), by providing information that is useful to
the users in making economic decisions.
However, financial statements cannot provide the complete set of information required for
assessing the stewardship of management.

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2.11 Financial position, performance and changes in financial position

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All economic decisions are based on an evaluation of an entity's ability to generate cash and of H
A
the timing and certainty of its generation. Information about the entity's financial position,
P
performance and changes in financial position provides the foundation on which to base such T
decisions. E
R
2.11.1 Financial position 1

An entity's financial position covers:
 the economic resources it controls;
 its financial structure (ie, debt and share finance);
 its liquidity and solvency; and
 its capacity to adapt to changes in the environment in which it operates.
Investors require information on financial position because it helps in assessing:
 the entity's ability to generate cash in the future;
 how future cash flows will be distributed among those with an interest in, or claims on, the
entity;
 requirements for future finance and ability to raise that finance; and
 the ability to meet financial commitments as they fall due.
Information about financial position is primarily provided in a statement of financial position.
2.11.2 Financial performance

The profit and the comprehensive income earned in a period are used as the key measures of an
entity's financial performance. Information about performance and variability of performance is
useful in:
 assessing potential changes in the entity's economic resources in the future;
 predicting the entity's capacity to generate cash from its existing resource base; and
 forming judgements about the effectiveness with which additional resources might be
employed.
Information on financial performance is provided by:
 the statement of profit or loss and other comprehensive income
 the statement of changes in equity
2.11.3 Changes in financial position

Changes in financial position can be analysed under the headings of investing, financing and
operating activities and are presented in a statement of cash flows.
Cash flow information is largely free from the more judgemental allocation and measurement
issues (ie, in which period to include things and at what amount) that arise when items are
included in the statement of financial position or performance statements. For example,
depreciation of non-current assets involves judgement and estimation as to the period over
which to charge depreciation. Cash flow information excludes non-cash items, such as
depreciation.
Cash flow information is therefore seen as being factual in nature, and hence more reliable than
other sources of information.
Information on the generation and use of cash is useful in evaluating the entity's ability to
generate cash and its need to use what is generated.

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3 The role and context of modern auditing
Section overview
 The audit provides assurance to shareholders.
• The audit enables the auditor to form an opinion as to whether the financial statements
give a true and fair view.
• An expectation gap may exist between what shareholders expect the audit to achieve and
what it is designed to achieve.
• You should be familiar with the audit process from your earlier studies.
• All companies, except those meeting exemption criteria, must have an annual external
audit.
• The Companies Act sets down the responsibilities of the directors and auditors.
3.1 Purpose of the audit

Audits serve a fundamental purpose in helping to enforce accountability and promote
confidence in financial reporting. Directors are delegated responsibility for managing the affairs
of the company by the owners; in effect they act as trustees for the shareholders. The audit
provides a mechanism for shareholders to help ensure that the directors are acting in the
company's best interests and therefore plays a fundamental stewardship role.
ISA (UK) 200, Overall Objectives of The Independent Auditor and the Conduct of an Audit in
Accordance with International Standards on Auditing (UK) sets out the purpose of an audit as
follows:
The purpose of an audit is to enhance the degree of confidence of intended users in the
financial statements. This is achieved by the expression of an opinion by the auditor on
whether the financial statements are prepared, in all material respects, in accordance with
an applicable financial reporting framework.
3.2 Part of the economic infrastructure

The audit is also a vital function of economic activity. For that economic activity to continue to
flourish there has to be trust.
While the audit has a crucial role to play in providing assurance to shareholders, it cannot be
seen in isolation. For example, the directors of the company have a role to play in the
preparation of financial statements that show a true and fair view. The audit has to be seen in the
context of a range of interwoven laws, regulations and guidance, all of which promote good
corporate governance. (We will look at corporate governance in detail in Chapter 4.)
3.3 The expectation gap

The primary role of the auditor is to perform an independent examination of the financial
statements and to form an opinion. You should be very familiar with this concept from your
earlier studies. The audit opinion will provide reasonable assurance (a high but not absolute
level of assurance) that the financial statements give a true and fair view; it does not provide a
certificate that they are completely accurate and free from every error or fraud, no matter how
small. ISA 200 explains that absolute assurance is not possible due to inherent limitations of the
audit, including those resulting from the following factors:
 The nature of financial reporting; many items involve judgement and assessments of
uncertainties

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 The use of selective testing

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 Inherent limitations of internal control H
A
 The fact that most evidence is persuasive rather than conclusive P
T
 The impracticability of examining all items within a class of transactions or account balance E
R
 The possibility of collusion or misrepresentation for fraudulent purposes
1
 The fact that the work undertaken by the auditor is permeated by judgement
In some instances an 'expectation gap' can lead to difficulties arising from the difference
between what shareholders expect an audit to achieve and what it is designed to achieve. The
public increasingly expect the following types of questions to be answered:
 Is the company a going concern?
 Is the company managed effectively?
 Is there an adequate system of controls?
 Is the company susceptible to fraud?
3.4 The audit opinion

The key judgement made by the auditor is whether the financial statements give a true and fair
view. While there is no legal definition for these terms, 'true' and 'fair' are normally taken to
mean the following:
Definition
True: The information in the financial statements is not false and conforms to reality.
In practical terms this means that the information is presented in accordance with accounting
standards and law. The financial statements have been correctly extracted from the underlying
records and those records reflect the actual transactions which took place.
Definition
Fair: The financial statements reflect the commercial substance of the company's underlying
transactions and the information is free from bias.
You will have come across examples of the application of substance over form in your financial
reporting studies.
The problem with making judgements such as these is that they can be called into question,
particularly where others have the benefit of hindsight. The major defence that the auditor has in
this situation is to show that the work was performed with due skill and care and that the
judgements made about truth and fairness were reasonable based on the evidence available at
the time. We will look at quality control in section 6 of this chapter.
3.5 The audit process

You will have covered the audit process in your earlier studies. The following diagram
summarises the key points you should be familiar with. Chapters 5 to 8 of this Study Manual
cover the audit in more detail.

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Client acceptance/ Considerations

continuance • Legal
• Ethical
• Practical
Establish • Letter of
re-evaluate engagement
• Obtain an understanding of the

Plan the audit entity
• Evaluate internal control
• Assess risks
• Establish materiality
Develop the audit • Audit strategy

approach • Audit planning
Audit internal • Tests of controls

control • Sampling
Audit business • Analytical procedures

processes • Tests of details
• Sampling
• Analytical procedures
Evaluate results • Additional procedures?
Issue audit • Consider other reporting

report requirements
Figure 1.1: The audit process

Point to note:
ISA 260 requires the auditor to promote and engage in two-way communication with those
charged with governance throughout the audit process. In particular, auditors must:
 communicate clearly with those charged with governance the responsibilities of the auditor
in relation to the financial statement audit, and an overview of the planned scope and
timing of the audit;
 obtain from those charged with governance information relevant to the audit; and
 provide those charged with governance with timely observations arising from the audit that
are significant and relevant to their responsibility to oversee the financial reporting process.
(ISA 260.9)
ISA 200 requires that the audit should be planned and performed with an attitude of
professional scepticism. Professional scepticism is covered in detail in Chapter 5.

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3.6 Statutory audit requirement

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All companies except those meeting exemption criteria must have an audit. H
A
The basic principle is that all companies registered in the UK should be audited. However, in the P
early 1990s certain very small companies were granted an exemption. In September 2012, the T
E
UK Government announced that, for accounting periods ending on or after 1 October 2012, the R
audit exemption criteria would be aligned with the small company criteria stated under the
Companies Act 2006 satisfying at least two of the following: 1
 Annual turnover must be £6.5 million or less.

 The balance sheet total must be £3.26 million or less.
 The average number of employees must be 50 or fewer.
The above threshold has now been revised by Statutory Instrument 2015/980 and applies for
periods beginning on or after 1 January 2016:
At least two out of the three conditions must be met and for two consecutive years.
Even if the above conditions are met the exemption cannot be taken if the company is ineligible.
An ICAEW Helpsheet summarises the situation in the following diagram:
Relevant for periods beginning on or after: 1 January 2016.
Does the company qualify as dormant Does the company meet the
under the Companies Act 2006? requirements of s480 and s481
(s1169) YES (see notes 4-5 below)? YES
NO NO
Does the company qualify as small Is the company part of a group?

under the Companies Act 2006?
NO NO
(s382)
YES
YES
AUDIT REQUIRED
Is the company excluded from audit
exemption per CA06 s384/s478) YES
(see note 1 below)
NO
Was the company part of a group

(for any part of the year)? Is it a subsidiary company?
NO NO
YES YES
Does the group qualify as a small Does it meet all the conditions per
group (for the whole period)? s479A
(CA06s383) NO (see note 2 below)? NO
YES YES
Was it at any time during the year

Is the group ineligible (for any part
a company as listed in s479B
of the year)? (CA06 s384) YES (see note 3 below)? YES
NO NO
AUDIT EXEMPT
Figure 1.2: Eligibility for audit exemption

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Note 1: s478:
A company is not entitled to take audit exemption per section 477 (small companies) if it was at
any time within the financial year in question:
(1) A public company (listed or unlisted)
(2) A company that:
(a) is an authorised insurance company, a banking company, an e-money issuer, a Markets
in Financial Instruments Directive (MiFID) investment firm or a UCITS management
company, or
(b) carries on insurance market activity
(3) A special register body as defined in section 117(1) of the Trade Union and Labour
Relations (Consolidation) Act 1992 (c52) or an employers' association as defined in section
122 of that Act or Article 4 of the Industrial Relations (Northern Ireland) Order 1992
(SI 1992/807) (NI5).
Note 2: s479A:
(1) A company is exempt from the requirements of this Act relating to the audit of individual
accounts for the financial year if:
(a) it is itself a subsidiary company
(b) its parent undertaking is established under the law of an EEA state
(2) Exemption is conditional upon compliance with all of the following conditions:
(a) All members of the company must agree to the exemption in respect of the financial
year in question.
(b) The parent undertaking must give a guarantee under section 479C in respect of that
year.
(c) The company must be included in the consolidated accounts drawn up for that year or
to an earlier date in that year by the parent undertaking in accordance with:
(i) the provisions of the Seventh Directive (83/349/EEC), or
(ii) International accounting standards.
(d) The parent undertaking must disclose in the notes to the consolidated accounts that
the company is exempt from the requirements of this Act relating to the audit of
individual accounts by virtue of this section; and
(e) The directors of the company must deliver to the registrar on or before the date they
file the accounts for that year:
(i) A written notice of the agreement referred to in subsection 2(a)
(ii) The statement referred to in section 479C (1)
(iii) A copy of the consolidated accounts referred to in subsection 2(c)
(iv) A copy of the auditor's report on those accounts, and
(v) A copy of the consolidated annual report drawn up by the parent undertaking
(3) This section has effect subject to section 475(2) and (3) (requirements as to statements
contained in balance sheet) and section 476 (rights of members to require an audit).
Note 3: s479B:
A company is not entitled to the exemption conferred by section 479A (subsidiary companies) if
it was at any time within the financial year in question:
(1) A quoted company as defined in section 385(2) of this Act,

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(2) A company that:

C
(a) Is an authorised insurance company, a banking company, an e-money issuer, a MiFID H
investment firm or a UCITS management company, or A
P
(b) Carries on insurance market activity T
E
(3) A special register body as defined in section 117(1) of the Trade Union and Labour R
Relations (Consolidation) Act 1992 (c52) or an employers' association as defined in section
1
122 of that Act or Article 4 of the Industrial Relations (Northern Ireland) Order 1992
(SI 1992/807) (NI5).
Note 4: s480:
(1) A company is exempt from the requirements of this Act relating to the audit of accounts in
respect of a financial year if:
(a) it has been dormant since its formation, or
(b) it has been dormant since the end of the previous financial year and the following
conditions are met.
(2) The conditions are that the company:
(a) as regards its individual accounts for the financial year in question –
(i) is entitled to prepare accounts in accordance with the small companies regime
(see sections 381 to 384), or
(ii) would be so entitled but for having been a public company or a member of an
ineligible group, and
(b) is not required to prepare group accounts for that year.
(3) This section has effect subject to:
(a) section 475(2) and (3) (requirements as to statements to be contained in balance
sheet),
(b) section 476 (right of members to require audit), and
(c) section 481 (companies excluded from dormant companies exemption).
Note 5: s481:
A company is not entitled to the exemption conferred by section 480 (dormant companies) if it
was at any time within the financial year in question a company that:
(a) is a traded company as defined in section 474(1),
(b) is an authorised insurance company, a banking company, an e-money issuer, a MiFID
investment firm or a UCITS management company, or
(c) carries on insurance market activity
© The Institute of Chartered Accountants in England and Wales, 2016. All rights reserved.
Notice, however, even if a small company met these criteria, it must still have its accounts
audited if this is demanded by a member, or members, holding at least 10% of the nominal
value of the issued share capital or holding 10% of any class of shares; or – in the case of a
company limited by guarantee – 10% of its members in number. The demand for the financial
statements to be audited should be in the form of a notice to the company, deposited at the
registered office at least one month before the end of the financial year in question. The notice
may not be given before the financial year to which it relates.

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In addition, a company should have an audit, irrespective of size, if it is:

 a regulated company, such as Financial Conduct Authority regulated businesses and
insurance providers (S 478); or
 a public company.
Point to note:
The criteria use UK accounting terminology rather than IFRS terminology as they are required by
UK law.
The wisdom of exempting SMEs from audit has been questioned, following experiences in
Sweden and Denmark. This is discussed in Chapter 2 Section 3.3.
4 Legal responsibilities of directors and auditors
4.1 Companies Act 2006

The legal responsibilities regarding directors and auditors are currently contained in the
Companies Act 2006 (CA 2006). The majority of the auditing requirements of the Act came into
force for periods on or after 6 April 2008.
4.2 Directors' responsibilities

These duties are as follows:
(a) 'Enlightened shareholder value' duty
The CA 2006 requires directors to act in a way that they consider, in good faith, would be
most likely to promote the success of the company for the benefit of its members as a
whole. In doing so they should consider such factors as:
 the likely long-term consequences
 the interests of employees
 relationships with customers and suppliers
 the impact of the company's operations on the community and the environment
 the desirability of maintaining a reputation for high standards of business conduct
 the need to act fairly as between members of the company
(b) Duty of skill and care
Directors have the responsibility to take reasonable steps to ensure the safeguard,
insurance, etc, of the company's assets.
A director is required to:
 exhibit a degree of skill that can reasonably be expected
 take such care as an ordinary man might be expected to take on his behalf
(c) Conflicts of interest
Directors should not place themselves where their personal interest conflicts with their duty
to the company. Directors will be personally liable to the company for any loss suffered by
the company. (Regal (Hastings) Ltd v Gulliver 1942)
If a director has an interest in a contract to which his company is party, the company may in
certain circumstances void the contract.
(d) Fraudulent trading
Directors will be responsible should the company trade with the intent to defraud creditors
if they are knowingly party to such conduct. Responsibility will arise whether or not the
company is in the course of winding up.

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(e) Wrongful trading

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Where a company is in the course of winding up, the provisions of wrongful trading may H
apply. An action may be brought against the director if at some time before the A
commencement of the winding up the person knew or ought to have concluded there was P
T
no reasonable prospect of avoiding liquidation. E
R
(f) Theft
1
If a company obtains property or pecuniary advantage by deception and the director has
consented, then the director will be liable as well as the company.
(g) Accounting records
A company is required to keep adequate accounting records, which are sufficient to show
and explain the company's transactions. Failure to do so may render every officer of the
company liable to a fine or imprisonment.
In addition to the statutory requirement, the directors have an overriding responsibility to
ensure they have adequate information to enable them to fulfil their duty of managing the
company's business.
(h) Annual accounts
Directors have a number of responsibilities with regard to the annual accounts. The
directors are required to:
– select suitable accounting policies and apply them consistently;
– make judgements and estimates that are prudent;
– state whether applicable accounting standards have been followed, subject to any
material departures disclosed and explained in the financial statements;
– prepare the financial statements on a going concern basis unless it is an inappropriate
assumption; and
– ensure the financial statements are delivered to Companies House within the specified
time.
A statement of directors' responsibilities should be included in the financial statements.
(i) Directors' and officers' insurance
Generally a company cannot indemnify a director against a liability arising from an act of
negligence, default or breach of duty. However, this statutory provision does not prevent a
company from buying and maintaining insurance against such a liability.
(j) Safeguarding the assets
Responsibility to safeguard the assets of the company includes the prevention and
detection of fraud. One of the main ways in which this duty can be carried out is to
implement an effective system of controls.
4.3 Directors' loans and other transactions

4.3.1 Background
The CA 2006 imposes restrictions on dealings between a company and its directors in order to
prevent directors taking advantage of their position. These restrictions are probably the main
legal safeguard available against directors abusing their position in a company. The disclosures
ensure that shareholders and other stakeholders will be informed about all the significant
transactions entered into by a company with its management that might benefit those
individuals.

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This is an important area for the auditor because he has a specific duty to disclose details of
directors' transactions in the auditor's report if not disclosed elsewhere. The information is very
sensitive, and it is difficult to audit due to materiality, complexity and the potential lack of any
formal documents.
4.3.2 Definitions
The following definitions are relevant to your understanding of this issue.
Definitions
Persons connected with a director: These include:
 directors' spouses, minor (including step) children
 a company with which a director is associated (ie, controls > 20% voting power)
 trustee of a trust whose beneficiaries include the director or connected person
 partner of the director or connected person
Loan: A sum of money lent for a time to be returned in money or money's worth.
Quasi-loan: The company agrees to pay a third party on behalf of the director, who later
reimburses the company (eg, personal goods bought with company credit card).
Credit transaction: A transaction where payment is deferred (eg, goods bought from company
on credit terms).
4.3.3 Members' approval

The following rules apply to all companies:
 Loans > £10,000 must be approved by the members of the company. In order for the
resolution to be passed members must be provided with details of the nature of the
transaction, the amount of the loan and the purpose for which it is required and the extent
of the company's liability.
 Advances for legitimate business expenditure do not require approval. However, the value
of any transaction is not allowed to exceed £50,000.
The following rules apply to public companies (or companies associated with public
companies).
 Loans > £10,000 made to persons connected with a director must be approved by the
members of the company.
 Quasi-loans > £10,000 made to directors or connected persons must be approved by the
members of the company.
 Credit transactions > £15,000 for the benefit of a director or a connected person must be
approved by the members of the company.
 Where transactions are entered into without the required approval the transaction is
voidable at the instance of the company.
4.3.4 Disclosure
For all loans etc, to directors, disclose:
 its amount
 an indication of the interest rate
 principal terms
 any amounts repaid

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4.3.5 Other transactions and contracts

C
Directors' interests in contracts H
A
Directors may have a personal interest in contracts planned or made by the company, eg, P
because they are also directors of another company. T
E
Directors must declare interests in contracts to the board of directors at the earliest opportunity. R
Substantial property transactions between company and directors also require approval by 1
members. A transaction is substantial if:
 Value > £100,000; or
 Value > 10% of company's net assets (per latest accounts).
Exception: the transaction is not substantial if < £5,000 (de minimis limit).
If not approved, the transaction is voidable by the company.
Service contracts
Members must approve long service contracts for directors (> 2 years).
Service contracts must be open to inspection by members.
In examining directors' service contracts, auditors should check particularly that:
 company and each director are complying wholly with terms of contract; and
 terms themselves comply with Companies Act requirements and are consistent with
company's articles.
4.4 Auditors' responsibilities

Under the CA 2006, it is the external auditor's responsibility to do the following:
(a) Form an independent opinion on the truth and fairness of the financial statements
(b) Confirm that the financial statements have been properly prepared in accordance with the
relevant financial reporting framework and the CA 2006
(c) State in their auditor's report whether in their opinion the information given in the directors'
report is consistent with the financial statements
The auditor will also report by exception on the following:
 Whether proper returns, adequate for audit purposes, have been received from branches
 Whether the accounts agree with the underlying records
 Whether adequate accounting records have been kept
 Whether all necessary information and explanations have been obtained
 In the case of a quoted company whether the auditable part of the directors' remuneration
report has been properly prepared
If the accounts (or directors' remuneration report) omit or incorrectly disclose information on
directors' emoluments, loans and other transactions, the correct disclosure must be included in
the auditor's report (due to the particularly sensitive nature of this information and its
importance to users of the accounts).
The auditor also has a duty towards other information in accordance with ISA (UK) 720, The
Auditor's Responsibilities Relating to Other Information (see Chapter 8).

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5 International standards on auditing
Section overview
 The FRC is responsible for UK Audit Standards.
• The International Auditing and Assurance Standards Board (IAASB) issues ISAs.
• In 2016, the FRC revised corporate governance guidance, ethical guidance and auditing
standards in response to the implementation of the EU Audit Regulation and Directive and
changes to IAASB standards.
5.1 FRC Update

The FRC structure is summarised in the diagram below:
FRC Board
Codes &
Conduct
Standards
Committee
Committee
Audit & Corporate

Assurance Reporting Review
Council Committee Financial
Reporting
Review Panel
Corporate Audit Quality
Reporting Review
Council Committee
Tribunal
Actuarial Case
Council Management
Committee
Figure 1.3: FRC structure

5.1.1 FRC Board
The role of the FRC Board is as follows:
 To set high standards of corporate governance through the UK Corporate Governance
Code
 To set standards for corporate reporting and actuarial practice
 To monitor and enforce accounting and auditing standards
 To oversee regulatory activities of the actuarial profession and professional accountancy
bodies
 To operate independent disciplinary arrangements for public interest cases
The FRC Board is supported by two committees, the Codes and Standards Committee and the
Conduct Committee.
Point to note:
The FRC is now responsible for Auditing Standards. Previously these were issued by the APB.

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5.1.2 Codes and Standards Committee

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The Codes and Standards Committee is responsible for advising the FRC Board on the H
maintenance of an effective framework of UK Codes and standards for Corporate Governance, A
P
Stewardship, Accounting, Auditing and Assurance and Actuarial technical standards. The Codes
T
and Standards Committee also advises on influencing the wider regulatory framework and on E
the FRC's research programme. It advises the FRC Board on the Annual Plan for Codes and R
Standards work and for making appointments to, and overseeing the work of, the Councils.
1
It comprises FRC Board members together with others with particular technical expertise,
including practising professionals. The FRC Board and the Codes and Standards Committee are
advised by three Councils covering Corporate Reporting, Audit and Assurance, and Actuarial
work (see sections 5.1.4 and 5.1.5 below).
5.1.3 Conduct Committee

The Conduct Committee is responsible for overseeing the FRC's Conduct Division. Its
responsibilities include overseeing:
 monitoring of recognised supervisory and recognised qualifying bodies
 audit Quality Reviews
 corporate reporting reviews
 professional discipline
 oversight of the regulation of accountants and actuaries
The Conduct Committee is supported by three subcommittees: the Audit Quality Review
Committee, the Case Management Committee and the Corporate Reporting Review Committee
(see sections 5.1.6 – 5.1.8).
FRC's Conduct division
The Conduct division encompasses the FRC's monitoring, oversight and disciplinary functions
through a number of teams.
5.1.4 Audit and Assurance Council

The Audit and Assurance Council is responsible for:
 providing strategic input and thought leadership on audit and assurance matters;
 considering and advising the FRC Board on draft Codes and Standards (or amendments
thereto);
 considering and commenting on proposed developments in relation to international Codes
and Standards and regulations; and
 considering and advising on research proposals and other initiatives.
Up to half the members can be practising members of the auditing profession.
5.1.5 Corporate Reporting Council and Actuarial Council

The role of the Corporate Reporting Council and the Actuarial Council is essentially the same as
that of the Audit and Assurance Council but in relation to accounting and financial reporting and
actuarial matters respectively.
5.1.6 Audit Quality Review Committee

The Audit Quality Review Committee helps ensure the consistency and quality of the FRC's
monitoring work. Its functions include the following:
 Agreeing the assessment of the standard of audit work for individual audits reviewed
 Approving letters summarising the key findings from reviews of individual audit
engagements

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 Agreeing the contents of public reports on individual firms in relation to audit quality
 Determining conditions or sanctions for acceptance by auditors or audit firms (and referring
matters to the Conduct Committee to consider action under one of the FRC's disciplinary
schemes)
 Recommend to the Conduct Committee any draft report setting out key findings from the
FRC's audit quality review activities
5.1.7 Case Management Committee

The Case Management Committee advises on the handling of disciplinary cases.
5.1.8 Corporate Reporting Review Committee

Responsibilities include the following:
 Opening an inquiry
 Appointing a Review Group
 If appropriate, referring any matter to the Conduct Committee to consider action under one
of the FRC's disciplinary schemes
5.2 Interaction between FRC and IAASB Standards

The system in the UK currently works as follows:
IAASB
Issues
ISA as
FRC (previously APB) used by
ISA
Modifies UK
Auditors
FRC
Adopts
Figure 1.4: Interaction between FRC and IAASB standards
5.3 International Auditing and Assurance Standards Board

5.3.1 Pronouncements
The IAASB was set up by the International Federation of Accountants (IFAC), which nominates a
majority of its members – others are nominated by the Forum of Firms – to issue professional
standards. It issues the following standards:
 International Standards on Auditing (ISAs)
 International Standards on Assurance Engagements (ISAEs) (applicable to assurance
engagements which are not audits)
 International Standards on Related Services (ISRSs) (applicable to other, non-assurance
engagements)
 International Standards on Quality Control (ISQCs) (applicable to all engagements carried
out under any of the IAASB's standards)
 International Standards on Review Engagements (ISREs) (to be applied in the review of
historical financial information)

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It also issues the following practice statements:

C
 International Auditing Practice Notes (IAPNs). These provide practical assistance to the H
auditor and may help the auditor in: A
P
– obtaining an understanding of the circumstances of the entity, and in making T
E
judgements about the identification and assessment of risks of material misstatement;
R
– making judgements about how to respond to assessed risks, including judgements
1
about procedures that may be appropriate in the circumstances; or
– addressing reporting considerations, including forming an opinion on the financial
statements and communicating with those charged with governance.
To date, one IAPN has been issued, IAPN 1000, Special Considerations in Auditing Financial
Instruments. This is covered in Chapter 16.
 International Review Engagement Practice Statements, International Assurance
Engagement Practice Statements and International Related Services Practice Statements
are issued to serve the same purpose for implementation of ISREs, ISAEs and ISRSs
respectively.
5.3.2 Authority of ISAs

ISAs are to be applied in the audit of historical financial information.
In exceptional circumstances, an auditor may judge it necessary to depart from an ISA in order
to more effectively achieve the objective of an audit. When such a situation arises, the auditor
should be prepared to justify the departure.
5.3.3 Working procedures

The working procedures of the IAASB can be summarised as follows.
 The Public Interest Activity Committee identifies potential new projects based on a review
of national and international developments.
 A project task force is established to develop a new standard based on research and
consultation.
 There is transparent debate as the proposed standard is presented at an IAASB meeting
which is open to the public.
 Exposure drafts are posted on the IAASB's website for public comment.
 Comments and suggestions are discussed at a further IAASB meeting, which is open to the
public and if substantive changes are made a revised exposure draft is issued.
 The final ISA is issued after approval by IFAC's Public Interest Oversight Board, which
reviews whether due process has been followed and clears the ISA for publication.
5.4 IAASB Projects

In 2009 the IAASB completed its Clarity Project, during which it reissued existing ISAs, with the
aim of making the requirements within them clearer.
Under this project, each ISA has the following:
 A stated overall objective
 Clarified obligations, by use of the word 'shall' where a requirement of the ISA is set out
 Less ambiguity
 Improved readability

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These standards are effective for audits of financial statements for periods beginning on or
after December 2009.
Since this time the IAASB has continued to make improvements to its standards resulting from a
number of subsequent projects.
In 2015, a series of new and revised standards were issued on auditor reporting. The most
notable change was the introduction of ISA 701, Communicating Key Audit Matters in the
Independent Auditor's Report which requires auditors of listed companies to communicate Key
Audit Matters.
In 2015, the conclusion of the Disclosures Project resulted in revised auditing standards. A press
release issued by IAASB on 15 July 2015 describes the purpose of this project as follows:
"The revisions to the standards aim to focus auditors more explicitly on disclosures throughout
the audit process and drive consistency in auditor behaviour in applying the requirements of the
ISAs."
Changes have also been made in relation to auditor's responsibilities for other information
accompanying financial statements.
5.5 FRC
5.5.1 FRC pronouncements
The following summary diagram is provided in the FRC Scope and Authority of FRC Audit and
Assurance Pronouncements.
International Standards on Quality Control (UK) Quality Control

Ethical Standard and Ethical
Standards
International Standards Statements Standard for

Standards for of Standards Assurance Engagement
on Auditing Investment for Reporting on Client Standards
(UK) Reporting Accountants Assets
Practice Notes,
Bulletins Bulletins Bulletins Guidance
SORPs and
Bulletins
Audits Investment Other

Circulars Assurance
Engagements
Figure 1.5: Structure of FRC audit and assurance pronouncements

The FRC makes three categories of pronouncements in relation to audit:
 Auditing standards (quality control, engagement and ethical)
 Practice notes
 Bulletins

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It also issues Standards for reviews of interim financial statements performed by the auditor of
the entity and Standards providing assurance on client assets to the Financial Conduct Authority. C
H
A
5.5.2 Relationship between ISAs and UK standards P
T
International Accounting Standards (IASs) have been adopted by all EU listed companies for E
accounting periods commencing on or after 1 January 2005. R
Since that time the EU has been working towards the adoption of ISAs for the audit of all EU 1
financial statements. In the UK, the APB (now FRC) decided to replace all its own standards –
Statements of Auditing Standards (SASs) – with the equivalent ISAs for audits of financial
statements covering accounting periods beginning on or after 15 December 2004.
The adoption of the ISAs at that time did not mean that the substance of UK auditing standards
was abandoned. In areas where SASs were more advanced than ISAs, or where there were
additional UK legal requirements, additions to the ISA text were made to add enhanced
requirements, considerations or procedures. This was indicated in their title – 'International
Standards on Auditing (UK and Ireland)'. This additional material was clearly differentiated from
the international standards, and over time, the APB (now FRC) hoped to be able to withdraw
such supplementary material as relevant ISAs were revised by IAASB.
5.5.3 Harmonisation – Clarity standards for UK and Ireland

When the APB (now FRC) first issued the ISAs (UK and Ireland) in December 2004, these
standards were based on the IAASB ISAs in issue at that time. The APB Work Programme
highlighted the need for the APB to be at the forefront of international developments by
contributing to IAASB work projects and, in particular, the development of Europe-wide auditing
standards following amendments to the Eighth EC Directive, resulting in EU statutory auditors
being required to carry out audits in accordance with ISAs.
The APB contributed to the Clarity Project and many of its recommendations were accepted
and, as a result, the number of supplementary requirements needed for the ISAs (UK and
Ireland) was significantly reduced.
The Clarified ISAs (UK and Ireland) were issued as exposure drafts in April 2009 and the final
versions were issued in October 2009. These standards applied to audits of accounting periods
ending on or after 15 December 2010.
5.5.4 Implementation of EU Audit Regulation and Directive

The FRC has recently completed its implementation of the EU Audit Regulation and Directive. At
the same time it has taken the opportunity to revise its standards in line with the IAASB projects
on disclosures, auditor's reports and other information accompanying financial statements. As a
result final drafts of the revised Corporate Governance Code (and revised Guidance on Audit
Committees) were issued in April 2016. A revised Ethical Standard and revised International
Standards on Auditing (UK) were issued in June 2016. The revised standards apply for
engagements relating to financial periods commencing on or after 17 June 2016. One of the key
issues is the impact on the audit if the client is a public interest entity.
This is defined in the Companies Act 2006 (s494A).
Definition
Public interest entity:
 An issuer whose transferable securities are admitted to trading on a regulated market (ie, all
UK-listed companies except those on the AIM and ISDX growth markets)
 A credit institution (in the UK, a bank or building society)
 An insurance undertaking

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Point to note:
The June 2016 revised ISAs are styled ISA (UK) (previously (UK and Ireland). Unless indicated
otherwise, this Manual refers to ISAs (UK).
5.6 Brexit
In June 2016, a referendum was held in the UK in which the electorate voted to leave the
European Union. For the next two years at least however, the UK will remain an EU member state
and as a result, as indicated by Michael Izza (ICAEW CEO) in a statement made on 24 June 2016
the situation is that: "Existing legislation and regulation remains in place until amended or repealed
by the UK Parliament". Article 50 was triggered by the UK Government on 29 March 2017,
resulting in a two-year process of leaving the EU. Prime Minister Theresa May called a snap
General Election in June 2017, which resulted in her losing her overall majority, which has
hampered negotiations. However in June 2018, the European Union (Withdrawal) Act 2018 was
passed into law.
Michael Izza has also stressed the importance of an 'amicable separation' confirming that: "We
will be talking to governments and other key stakeholders in London and in Brussels on those
issues that matter to our members, particularly the future relationship between the UK and the
EU."
While the focus so far has been on the implementation of Brexit with the setting up and staffing
of new departments, some of the practical steps that will need to be taken will depend upon the
deal that is secured. The demands of other member countries will determine what Brexit finally
looks like, and it is probable that the two years allowed under Article 50 will not be enough time
to get all the new arrangements in place. Article 50 has never been invoked before; the terms of
Britain's exit will involve the unravelling of 43 years' worth of treaties and agreements, so it is
likely to take a very long time. Some UK government departments will be significantly affected
(such as the Home Office, as it deals with immigration). As well as this, a new trade deal between
the EU and the UK needs to be set up.
6 Audit quality control
Section overview
 Quality control procedures should be adopted:
– at the firm level; and
– on an individual audit.
• Professional bodies also have a responsibility to develop quality control standards and
monitor compliance.
• Audit documentation is an important part of quality control.
• It provides evidence of work done to support the audit opinion.
• Significant matters must be documented.
• Audit working papers should be reviewed.
6.1 Principles and purpose

Audit quality is not defined in law or through regulations, nor do auditing standards provide a
simple definition.

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Although each stakeholder in the audit will give a different meaning to audit quality, at its heart
it is about delivering an appropriate professional opinion supported by the necessary evidence C
H
and objective judgements. A
P
Many principles contribute to audit quality including good leadership, experienced judgement,
T
technical competence, ethical values and appropriate client relationships, proper working E
practices and effective quality control and monitoring review processes. R
The standards on audit quality provide guidance for firms on how to achieve these principles. 1
6.2 Quality control at a firm level

The fact that auditors follow ISAs provides a general quality control framework within which
audits should be conducted. There are also specific quality control standards. ISQC (UK) 1
(Revised June 2016), Quality Control for Firms that Perform Audits and Reviews of Financial
Statements and other Assurance and Related Services Engagements deals with quality control at
a firm level. You have studied ISQC 1 in Audit and Assurance at the Professional Level, although
the revised standard includes a number of new specific requirements relevant to the UK. A
summary of the key points is provided below.
6.2.1 Objective of ISQC 1

The objective set by ISQC 1 is for the firm to establish and maintain a system of quality control
designed to provide it with reasonable assurance that the firm and its personnel comply with
professional standards and regulatory and legal requirements, and that reports issued by the
firm or engagement partners are appropriate in the circumstances.
In the UK the firm must be able to demonstrate to the competent authority (Financial Reporting
Council or Recognised Supervisory Body) that the firm's policies and procedures are
appropriate given the scale and complexity of the firm's activities.
6.2.2 Elements of a system of quality control

ISQC 1 identifies the following six elements of the firm's system of quality control.
(1) Leadership responsibilities for quality within the firm
The standard requires that the firm implements policies such that the internal culture of the
firm is one where quality is considered essential. Such a culture must be inspired by the
leaders of the firm, who must sell this culture in their actions and messages. In other words,
the entire business strategy of the audit firm should be driven by the need for quality in its
operations.
The firm's managing partners are required to assume ultimate responsibility for the firm's
system of quality control. They may appoint an individual or group of individuals to oversee
quality in the firm. Such individuals must have:
 sufficient and appropriate experience and ability to carry out the job
 the necessary authority to carry out the job
(2) Ethical requirements
Policies and procedures should be designed to provide the firm with reasonable assurance
that the firm and its personnel comply with relevant ethical requirements and in particular
independence requirements.
In the UK the firm must have organisational and administrative arrangements for dealing
with and recording incidents which have, or may have, serious consequences for the
integrity of the firm's activities.

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The policies and procedures should be in line with the fundamental principles, which
should be reinforced by:
 the leadership of the firm
 education and training
 monitoring
 a process to deal with non-compliance
At least annually, the firm should obtain written confirmation of compliance with its policies
and procedures on independence from all firm personnel required to be independent by
ethical requirements.
(3) Acceptance and continuance of client relationships and specific engagements
A firm should only accept, or continue with, a client where:
 it has considered the integrity of the client and does not have information that the
client lacks integrity;
 it is competent to perform the engagement and has the capabilities, including time
and resources, to do so; and
 it can comply with ethical requirements, including appropriate independence from the
client.
In the UK, the firm must assess its compliance with FRC's Ethical Standard regarding
independence and objectivity, whether the firm has competent personnel, time and
resources and whether the key audit partner is eligible for appointment as statutory auditor.
For the audit of a public interest entity the firm must assess:
 whether the firm complies with the FRC's Ethical Standards requirements on audit fees
and prohibition of the provision of non-audit services requirements;
 whether the conditions of the Audit Regulation (Regulation (EU) No 537/2014) are
complied with for the duration of the audit engagement; and
 the integrity of the members of the supervisory, administrative and management
bodies of the public interest entity.
(4) Human resources
The firm's overriding desire for quality will necessitate policies and procedures on ensuring
excellence in its staff, to provide the firm with 'reasonable assurance that it has sufficient
personnel with the competence, capabilities and commitment to ethical principles
necessary to perform engagements in accordance with professional standards and
applicable and regulatory requirements, and to enable the firm or engagement partners to
issue reports that are appropriate in the circumstances'.
In the UK, the firm must ensure that those directly involved in the audit have appropriate
knowledge and experience. In addition the remuneration of an individual on the audit
should not be linked to the amount of revenue that the firm receives for providing non-audit
services from that client.
The following resources issues are relevant:
 Recruitment  Performance evaluation
 Capabilities  Competence
 Career development  Promotion
 Compensation  The estimation of personnel needs
The firm is responsible for the ongoing excellence of its staff, through continuing
professional development, education, work experience and coaching by more experienced
staff.

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The assignment of engagement teams is an important matter in ensuring the quality of an

individual assignment. C
H
This responsibility is given to the audit engagement partner. The firm should have policies A
P
and procedures in place to ensure that:
T
E
 key members of client staff and those charged with governance are aware of the
R
identity of the audit engagement partner;
1
 the engagement partner has appropriate capabilities, competence and authority to
perform the role; and
 the responsibilities of the engagement partner are clearly defined and communicated
to that partner.
The engagement partner should ensure that he assigns staff of sufficient capabilities,
competence and time to individual assignments so that he will be able to issue an
appropriate report.
(5) Engagement performance
The firm should take steps to ensure that engagements are performed correctly; that is, in
accordance with standards and guidance. Firms often produce a manual of standard
engagement procedures to give to all staff so that they know the standards they are working
towards. These may be electronic.
Ensuring good engagement performance involves a number of issues:
 Direction
 Supervision
 Review
 Consultation
 Resolution of disputes
Many of these issues will be discussed in the context of an individual audit assignment (see
below).
The firm should have policies and procedures to determine when a quality control reviewer
will be necessary for an engagement. This will include all audits of financial statements for
listed companies and in the UK also applies to public interest entities. When required, such
a review must be completed before the report is signed (and in the UK before the
additional report to the audit committee is issued in accordance with ISA (UK) 260 (Revised
2016)).
The firm must also have standards as to what constitutes a suitable quality control review.
In particular, the following issues must be addressed:
 Discussion of significant matters with the engagement partner
 Review of the financial statements or other subject matter information of the proposed
report
 Review of selected engagement documentation relating to significant judgements the
engagement team made and the conclusions it reached
 Evaluation of the conclusions reached in formulating the report and considering
whether the proposed report is appropriate
In the UK, where the engagement quality control reviewer is providing a safeguard in
relation to a threat to independence potentially arising from the provision of non-audit
services, this threat must be specifically addressed.

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For listed companies in particular, the review should include:

 the engagement team's evaluation of the firm's independence in relation to the
specific engagement;
 significant risks identified during the engagement and the responses to those risks;
 judgements made, particularly with respect to materiality and significant risks;
 whether appropriate consultation has taken place on matters involving differences of
opinion or other difficult or contentious matters, and the conclusions arising from
those consultations;
 the significance and disposition of corrected and uncorrected misstatements identified
during the engagement;
 the matters to be communicated to management and those charged with governance
and, where applicable, other parties such as regulatory bodies; and
 whether documentation selected for review reflects the work performed in relation to
the significant judgements and supports the conclusions reached.
In the UK for audits of financial statements of public interest entities the engagement quality
control reviewer must be an individual who is eligible for appointment as auditor but has
not been involved in the audit to which the review relates.
(6) Monitoring
The standard states that firms must have policies in place to ensure that their quality control
procedures are:
 relevant
 adequate
 operating effectively
In other words, they must monitor their system of quality control. Monitoring activity should
be reported on to the management of the firm on an annual basis.
There are two types of monitoring activity, an ongoing evaluation of the system of quality
control and cyclical inspection of a selection of completed engagements. An ongoing
evaluation might include such questions as 'has it kept up to date with regulatory
requirements?'.
An inspection cycle would usually fall over a period such as three years, in which time at
least one engagement per engagement partner would be reviewed.
The people monitoring the system are required to evaluate the effect of any deficiencies
found. These deficiencies might be one-offs. Monitors will be more concerned with
systematic or repetitive deficiencies that require corrective action. When evidence is
gathered that an inappropriate report might have been issued, the audit firm may want to
take legal advice.
Corrective action:
 Remedial action with an individual
 Communication of findings with the training department
 Changes in the quality control policies and procedures
 Disciplinary action, if necessary
In the UK, additional guidance is given regarding external monitoring in the context of a group
audit.
Point to note:
All quality control policies and procedures should be documented and communicated to the
firm's personnel.

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In addition to the six elements discussed above, in the UK the firm must ensure that partners,
directors, members or shareholders of the firm (or partners, directors, members or shareholders C
H
of any affiliate of the firm) cannot intervene in the carrying out of the work such that the firm's A
independence and objectivity is jeopardised. P
T
The firm is also required to have: E
R
 sound administrative and accounting procedures;
 internal quality control mechanisms which are designed to secure compliance with 1
decisions and procedures at all levels of the firm's working structure;

 effective risk assessment procedures; and
 effective arrangements for the control and safeguard of information processing systems.
6.2.3 Documentation of the system of quality control

The revised ISA states that in the UK audit documentation must be retained for a period which is
not less than six years from the date of the auditor's report.
6.2.4 Practical application

The 2006 ICAEW Audit and Assurance Faculty publication Quality Control in the Audit
Environment: A Practical Guide for Firms on Implementing ISQC (UK and Ireland) 1 recommends
that firms take the following key steps to give them confidence that they are compliant with
ISQC 1:
(a) Document the operation of the quality control system.
(b) Lead from the top giving a consistent message on the importance of quality control.
(c) Always act ethically in accordance with relevant standards and pronouncements.
(d) Accept only those engagements where the firm is confident it can provide a service in
compliance with requirements with particular emphasis on integrity and competencies.
(e) Recruit, develop and support capable and competent staff giving due attention to the firm's
human resources policies and procedures.
(f) Deliver quality audits consulting when needed and meeting requirements for engagement
quality control review.
(g) Monitor and seek continuous improvement of the firm's system of quality control and carry
out a periodic objective inspection of a selection of completed audit engagements.
Point to note:
While the guide is based on the superseded standard the basic principles are still relevant.
6.3 Quality control on an individual audit

You will have studied this issue in the previous Audit and Assurance paper. A summary of the
key points in ISA (UK) 220 (Revised June 2016), Quality Control for an Audit of Financial
Statements is provided below.
6.3.1 Policies and procedures

ISA 220 states that the objective of the auditor is to implement quality control procedures at the
individual engagement level. The engagement partner is ultimately responsible for quality
control on an individual engagement.
The policies and procedures for quality control on individual audits parallel those for the firm
outlined above. For example, ethical requirements must be considered. In addition, however, of
particular significance for individual audits are the procedures of direction, supervision and
review.

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(a) Direction
At the planning stage, but also during the audit, the engagement partner ensures that the
members of the engagement team are informed of:
 their responsibilities
 the objectives of the work to be performed
 the nature of the entity's business
 risk issues
 problems that may arise
 detailed approach to the audit engagement
(b) Supervision
Supervision includes:
 tracking the progress of the audit engagement;
 considering the capabilities of individual members of the engagement team and that
they understand their instructions;
 addressing issues that arise and modifying the audit approach if appropriate; and
 identifying matters for consultation or consideration by more experienced members of
the audit engagement.
(c) Review
Reviewing concerns the inspection of work by engagement members by more senior
members of the same engagement. This includes ensuring that:
 the work has been carried out in accordance with professional and regulatory
requirements;
 significant matters have been raised for further consideration;
 appropriate consultations have taken place and have been documented;
 where appropriate the planned audit work is revised;
 the work performed supports the conclusions;
 the evidence obtained is sufficient and appropriate to support the audit opinion; and
 the objectives of the engagement have been achieved.
The revised ISA also includes specific guidance in relation to the engagement quality
control review for audits of the financial statements of public interest entities in the UK. The
purpose of the engagement quality control review is 'to provide an objective evaluation, on
or before the date of the auditor's report, of the significant judgments the engagement
team made and the conclusions it reached in formulating the auditor's report'. In particular
the review must consider the following:
 The independence of the firm from the entity
 The significant risks and measures taken to manage them
 Reasoning in relation to materiality and significant risks
 Any request for advice from external experts and the implementation of the advice
 The nature and scope of corrected and uncorrected misstatements
 The subjects discussed with the audit committee/management/supervisory
bodies/competent authorities/third parties
 Whether information on the audit file supports the opinion in the auditor's report and
additional report to the audit committee

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(d) Hot and cold reviews

C
Hot file reviews are carried out before the auditor's report is issued. Their purpose is to H
identify any weaknesses in the application of audit procedures or to assess if results from A
P
audit procedures have been misinterpreted. They can be done for higher risk audits. Such
T
reviews are usually undertaken by an audit partner not connected with the audit. E
R
Cold file reviews are carried out after the auditor's report has been issued. Their primary
purpose is to determine compliance with ethical and auditing standards and relevant 1
legislation, and to consider whether the audit work has been carried out in accordance with
the firm's own procedures, thereby identifying any weaknesses in the firm's quality control
procedures, and how these can be improved upon. Cold reviews are carried out by suitably
qualified individuals who are independent of the client and have had no involvement in the
audit work. Small firms and sole practitioners may be required to arrange external reviews
at least once every three years if there is no suitable reviewer available from within the
organisation. A cold file review will result in identification of any areas of non-compliance
and the formulation of a suitable action plan with the firm.
6.4 Assuring the quality of professional services

IFAC Statement of Membership Obligations 1 (SMO 1) (Revised), Quality Assurance sets out the
requirements of an IFAC member body with respect to quality assurance review systems for its
members who perform audits, review and other assurance and related services engagements of
financial statements. It covers many of the issues dealt with by ISQC 1 and ISA 220 but addresses
them largely from the perspective of the role of the professional bodies eg, ICAEW. SMO 1 was
revised in November 2012 and has an effective date of 1 January 2014. The revised SMO
includes an applicability framework that provides guidance on how to address obligations
where organisations have varying degrees of responsibility for meeting the requirements of the
SMO:
(a) Where IFAC members have direct responsibility, they must implement all the requirements
of the SMO.
(b) Where IFAC members have no responsibility for this area, they must use their best
endeavours to encourage those responsible to follow the requirements of the SMO and
assist in their implementation if appropriate.
(c) Where responsibility is shared, they must implement those that they are responsible for and
use their best endeavours to encourage those responsible for the remainder to follow the
requirements of the SMO.
In particular, SMO 1 (revised) makes the following points.
IFAC believes that the following objectives have worldwide applicability and that member
bodies should strive to achieve them.
(a) Member bodies must identify and undertake actions to have ISQC 1 and other relevant
standards adopted and implemented and requirements established for firms to implement
a system of quality control in their jurisdiction. Firms are responsible for implementing
policies and procedures that comply with ISQC 1.
(b) Member bodies must assist their members to understand the objectives of quality control,
and implement and maintain appropriate systems of quality control. This assistance can
take various forms, such as continuing professional development guidelines and
implementing programmes that enable firms to obtain an independent confidential
assessment of their quality control policies and procedures.
(c) Member bodies must develop quality review programmes designed to evaluate whether
firms (or an individual partner) have established appropriate quality control policies and
procedures and are complying with those. A cycle-based, risk-based or mixed approach for

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selecting firms for quality assurance review must be used. All firms or partners performing
audits must be considered in the selection process.
(d) Member bodies must require quality assurance review teams to follow procedures that are
based on published guidelines. The procedures should include reviews of audit working
papers and discussions with appropriate personnel.
(e) The quality assurance team leader must issue a written report on completion of the review
assignment, including a conclusion on whether the firm's system of quality control has been
designed to meet the relevant standards and whether the firm has complied with its system
of quality control during the review period. Reasons for negative conclusions should be
given, with recommendations for areas of improvement.
(f) Member bodies must require firms to make improvements in their quality control policies and
procedures where improvement is required. Corrective action should be taken where the firm
fails to comply with relevant professional standards. Educational or disciplinary measures may
be necessary.
6.4.1 FRC Audit Quality Thematic Review
In March 2017, the FRC issued Audit Quality Thematic Review: Firms' audit quality control
procedures and other quality initiatives to support the continuous improvement in audit quality
in the UK. Some new areas of best practice were identified (such as adopting different 'lines of
defence' for a firm's procedures to interact effectively) but also some areas for further work (such
as more senior members of the audit team reviewing audit work) arose too.
Interactive question 2: Addystone Fish
You are an audit senior working for the firm Addystone Fish. You are currently carrying out the
audit of Wicker Ltd, a manufacturer of waste paper bins. You are unhappy with Wicker's
inventory valuation policy and have raised the issue several times with the audit manager. He
has dealt with the client for a number of years and does not see what you are making a fuss
about. He has refused to meet you on site to discuss these issues.
The former engagement partner to Wicker retired two months ago. As the audit manager had
dealt with Wicker for so many years, the other partners have decided to leave the audit of Wicker
largely in his hands.
Requirement
Comment on the situation outlined above.
6.5 Audit documentation

Audit documentation is a key part of the overall quality control framework during the course of
an audit. All audit work must be documented: the working papers are the tangible evidence of
all work done in support of the audit opinion. ISA (UK) 230 (Revised June 2016), Audit
Documentation provides guidance on this issue.
In your previous studies, you have learnt the practical issues surrounding how audit papers
should be completed. The key general rule to remember concerning what to include in a
working paper is:
What would be sufficient to enable an experienced auditor, having no previous connection
with the audit to understand the nature, timing, and extent of the audit procedures
performed to comply with the ISAs and applicable legal and regulatory requirements and
the results of the audit procedures and the audit evidence obtained, and significant matters
arising during the audit and the conclusions reached thereon, and significant professional
judgements made in reaching those conclusions. (ISA (UK) 230.8 (Revised June 2016))

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The key reason for having audit papers therefore is that they provide evidence of work done.
They may be required in the event of litigation arising over the audit work and opinion given. C
H
The ISA sets out certain requirements about what should be recorded, such as the identifying A
characteristics of the specific items being tested. P
T
It also sets out points an auditor should record in relation to significant matters. These include: E
R
 discussions undertaken with directors;
1
 how the auditor addressed information that appeared to be inconsistent with his
conclusions in relation to significant matters; and
 in the UK, concerns about the entity's ability to continue as a going concern.
If an auditor felt it necessary to depart from customary audit procedures required by audit
standards, he should document why, and how the different test achieved audit objectives.
The ISA also contains details about how the audit file should be put together and actions in the
event of audit work being added after the date of the auditor's report (for example, if
subsequent events result in additional procedures being carried out). You should be familiar
with these points from your earlier studies.
The revised standard adds that in the UK, the assembly of the final audit file should be completed
no later than 60 days from the date of the auditor's report. It also states that the auditor must retain
any other data and documents that are important in supporting the auditor's report.
6.6 Review of working papers

We shall briefly revise here the review of working papers. Review of working papers is
important, as it allows a more senior auditor to evaluate the evidence obtained during the
course of the audit for sufficiency and reliability, so that more evidence can be obtained to
support the audit opinion, if required. It is an important quality control procedure.
Work performed by each assistant should be reviewed by personnel of appropriate experience
to consider whether:
 the work has been performed in accordance with the audit programme;
 the work performed and the results obtained have been adequately documented;
 any significant matters have been resolved or are reflected in audit conclusions;
 the objectives of the audit procedures have been achieved; and
 the conclusions expressed are consistent with the results of the procedures performed and
support the audit opinion.
The following should be reviewed on a timely basis.
 The overall audit strategy and the audit plan
 The assessments of inherent and control risks
 The results of control and substantive procedures and the conclusions drawn including the
results of consultations
 The financial statements, proposed audit adjustments and the proposed auditors' report
In some cases, particularly in large complex audits, personnel not involved in the audit may be
asked to review some or all of the audit work, the auditors' report etc. This is sometimes called a
peer review or hot review.

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Interactive question 3: Documentation (revision)

Viewco is a manufacturer of TVs and Blu-ray players. It carries out a full physical inventory count
at its central warehouse every year on 31 December, its financial year end. Finished goods are
normally of the order of £3 million, with components and work in progress normally
approximately £1 million.
You are the audit senior responsible for the audit of Viewco for the year ending 31 December
20X1. Together with a junior member of staff, you will be attending Viewco's physical inventory
count.
Requirements
(a) Explain why it is necessary for an auditor to prepare working papers.
(b) State, giving reasons, what information the working papers relating to this inventory count
attendance should contain.
Interactive question 4: TrucksToGo Ltd

You are the audit senior on the audit of TrucksToGo Ltd. You are supervising the work of a
relatively inexperienced audit junior. The junior has been carrying out audit procedures on the
assertions of completeness and existence of non-current assets. According to the junior, audit
procedures have been completed and the memo below has been produced outlining some of
the issues found during the audit.
Memo: Issues identified during audit
The directors have confirmed that there are no further non-current assets to include in the
financial statements. This representation was received in a meeting with the Finance Director
and recorded on the audit file at this time.
Part of the existence work on non-current assets included obtaining a sample of assets from the
asset register and then physically verifying those assets. Unfortunately, a significant number of
assets were not available for verification – the vehicles were in use by the company and therefore
not on the premises. As an alternative, vehicles on the premises were agreed back to the asset
register.
A number of vehicles were noted on the company premises in a poor state of repair; for
example, engines missing. On inquiry, the vehicle manager confirmed that the vehicles were
under repair. I am therefore happy that the vehicles belonged to the company and no further
action is necessary.
I have reached the conclusion that all non-current assets are correctly stated and valued in the
financial statements.
Requirement
Explain to the junior why the evidence collected is insufficient, and detail the action necessary to
complete the audit procedures. Refer to your objectives in reviewing audit documentation as a
format for your answer.

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7 Laws and regulations C

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Section overview P
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The auditor is responsible for obtaining sufficient appropriate audit evidence regarding E
compliance with laws and regulations that have a direct effect on the financial statements. R
7.1 Revision
The responsibilities of the auditor for laws and regulations are covered in ISA (UK) 250A
(Revised December 2017), Consideration of Laws and Regulations in an Audit of Financial
Statements. You have covered the principles contained in this standard in your earlier studies. A
summary of the key points is included below.
The objectives of the auditor are:
(a) To obtain sufficient appropriate audit evidence regarding compliance with the provisions of
those laws and regulations generally recognised to have a direct effect on the
determination of material amounts and disclosures in the financial statements;
(b) To perform specified audit procedures to help identify instances of non-compliance with
other laws and regulations that may have a material effect on the financial statements; and
(c) To respond appropriately to non-compliance or suspected non-compliance with laws and
regulations identified during the audit. (ISA 250A.11)
An audit cannot detect non-compliance with all laws and regulations.
Definition
Non-compliance: Refers to acts of omission or commission by the entity, either intentional or
unintentional, which are contrary to the prevailing laws or regulations. Such acts include
transactions entered into by, or in the name of, the entity, or on its behalf, by those charged with
governance, management or employees. Non-compliance does not include personal misconduct
(unrelated to the business activities of the entity) by those charged with governance, management
or employees of the entity. (ISA 250A.12)
7.2 Responsibility of management for compliance

Management are responsible for ensuring that a client's operations are conducted in
accordance with laws and regulations.
The following policies and procedures, among others, may assist management in discharging its
responsibilities for the prevention and detection of non-compliance.
 Monitor legal requirements and ensure that operating procedures are designed to meet
these requirements.
 Institute and operate appropriate systems of internal control, including internal audit and
an audit committee.
 Develop, publicise and follow a code of conduct.
 Ensure that employees are properly trained and understand the code of conduct.
 Monitor compliance with the code of conduct and act appropriately to discipline
employees who fail to comply with it.
 Engage legal advisers to assist in monitoring legal requirements.
 Maintain a register of significant laws with which the entity has to comply within its
particular industry and a record of complaints.

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7.3 Responsibility of the auditors

The auditor's responsibilities depend on whether or not the law or regulation has a direct effect
on the financial statements as follows:
The auditor shall obtain sufficient appropriate audit evidence regarding compliance with
the provisions of those laws and regulations generally recognised to have a direct effect on
the determination of material amounts and disclosures in the financial statements.
(ISA 250A.14)
These laws and regulations may relate to:
 the form and content of financial statements;
 accounting for transactions under government contracts;
 laws determining the circumstances under which a company is prohibited from making a
distribution except out of available profits; and
 laws which require auditors expressly to report non-compliance, such as not keeping
proper records.
For other laws and regulations the auditor is required to perform audit procedures to help
identify instances of non-compliance. Procedures would include inquiring of management and
those charged with governance and inspecting correspondence with relevant licensing or
regulatory authorities.
Specific requirements also apply in the UK, such as those related to tax legislation.
(ISA 250A.A12–1)
Written representations from management are also important. The standard requires the auditor
to obtain written representations. (ISA 250A.17)
7.4 Procedures when non-compliance is discovered

The ISA requires the following approach:
If the auditor becomes aware of information concerning an instance of non-compliance or
suspected non-compliance, the auditor shall obtain:
 understanding of the nature of the act and the circumstances in which it has occurred; and
 further information to evaluate the possible effect on the financial statements.
(ISA 250A.19)
When evaluating the possible effect on the financial statements, the auditor should consider:
 the potential financial consequences, such as fines, penalties, damages, threat of
expropriation of assets, enforced discontinuation of operations and litigation;
 whether the potential financial consequences require disclosure; and
 whether the potential financial consequences are so serious as to call into question the true
and fair view (fair presentation) given by the financial statements.
If the auditors suspect there may be non-compliance they should discuss the matter with
management and those charged with governance.
Such discussions are subject to the laws concerning 'tipping off'. If information provided by
management is not satisfactory, the auditor should consult the entity's lawyer and, if necessary,
their own lawyer on the application of the laws and regulations to the particular circumstances.

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7.5 Reporting of non-compliance

C
7.5.1 To management H
A
ISA 250A requires the following: P
T
Unless all of those charged with governance are involved in management of the entity, and E
therefore are aware of matters involving suspected non-compliance already communicated by R
the auditor, the auditor shall communicate with those charged with governance matters 1
involving non-compliance with laws and regulations that come to the auditor's attention during
the course of the audit, other than when the matters are clearly inconsequential.
If, in the auditor's judgement, the non-compliance is believed to be intentional and material, the
auditor shall communicate the matter to those charged with governance as soon as practicable.
If the auditor suspects that management or those charged with governance are involved in non-
compliance, the auditor shall communicate the matter to the next higher level of authority at the
entity, if it exists, such as an audit committee or supervisory board. Where no higher authority
exists, or if the auditor believes that the communication may not be acted upon or is unsure as to
the person to whom to report, the auditor shall consider the need to obtain legal advice.
(ISA 250A.23–.25)
In the UK, the auditor may report if the non-compliance is believed to be intentional or material.
It does not have to be both. Communication of matters is subject to compliance with legislation
relating to 'tipping off'.
7.5.2 To the users of the auditor's report

If the auditor concludes that the non-compliance has a material effect on the financial
statements, and has not been adequately reflected in the financial statements, the auditor shall,
in accordance with ISA (UK) 705, express a qualified opinion or an adverse opinion on the
If the auditor is precluded by management or those charged with governance from obtaining
sufficient appropriate audit evidence to evaluate whether non-compliance that may be material
to the financial statements has, or is likely to have, occurred, the auditor shall express a qualified
opinion or disclaim an opinion on the financial statements on the basis of a limitation on the
scope of the audit in accordance with ISA (UK) 705.
If the auditor is unable to determine whether non-compliance has occurred because of
limitations imposed by the circumstances rather than by management or those charged with
governance, the auditor shall evaluate the effect on the auditor's opinion in accordance with
ISA (UK) 705. (ISA 250A.26–.28)
7.5.3 To regulatory and enforcement authorities
Confidentiality is an issue again here, but it may be overridden by the law, statute or the courts
of law. The auditor should obtain legal advice. If the auditor has a statutory duty to report, a
report should be made without delay.
Alternatively, it may be necessary to make disclosures in the public interest. In practice it will
often be extremely difficult for an auditor to decide whether making a disclosure in the public
interest is warranted. The auditor should obtain professional advice.
7.6 Withdrawal from the engagement

As is the case for fraud or error, withdrawal may be the only option if the entity does not take the
remedial action the auditor thinks is necessary, even for non-material matters.

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7.7 Reporting to regulators

In the UK, ISA (UK) 250B (Revised June 2016) Section B, The Auditor's Statutory Right and Duty to
Report to Regulators of Public Interest Entities and Regulators of Other Entities in the Financial
Sector applies. This deals with circumstances where the auditor of an entity subject to statutory
regulation is required to report direct to a regulator information which comes to the auditor's
attention in the course of the audit work.
The auditor is required to bring matters to the attention of the appropriate regulator when:
(a) the auditor concludes that it is relevant to the regulator's functions having regard to such
matters as may be specified in statute or any related regulations; and
(b) in the auditor's opinion there is reasonable cause to believe it is or may be of material
significance to the regulator. (ISA 250B.8)

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Summary and Self-test C

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Summary P
T
E
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Corporate Reporting
1
Financial Reporting Audit Assurance Ethics
Financial Analysis
Audit
Statutory Auditing
audit standards
Legal International standards Clarity Laws and

responsibilities on auditing Project regulations
Purpose of ISAs
Directors Auditors
Set by IAASB
and FRC
• Enhanced Opinion Apply to audit

shareholder
and assurance
value
work
• Transactions
with
Quality control
company
standards – ISQC 1
Standards are Sections of

required at: ISQC1
Firm
level • Leadership
• Ethics
Audit • Clients
level • HR
• Engagements
• Monitoring

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Self-test
Answer the following questions.
1 Performance and position
Explain the terms 'performance' and 'position', and identify which of the financial
statements will assist the user in evaluating performance and position.
2 LaFa plc
The WTR audit firm has 15 partners and 61 audit staff. The firm has offices in 3 cities in one
country and provides a range of audit, assurance, tax and advisory services. Clients range
from sole traders requiring assistance with financial statement production to a number of
small plcs – although none is a quoted company.
LaFa plc is one of WTR's largest clients. Due to the retirement of the engagement partner
from ill health last year, LaFa has been appointed a new engagement partner. WTR
provides audit services as well as preparation of taxation computations and some advisory
work on the maintenance of complicated costing and inventory management systems. The
audit and other services engagement this year was agreed on the same fee as the previous
year, although additional work is required on the audit of some development expenditure
which had not been included in LaFa's financial statements before. Information on the
development expenditure will be made available a few days before audit completion 'due
to difficulties with cost identification' as stated by the Finance Director of LaFa. LaFa's
management were insistent that WTR could continue to provide a similar level of service for
the same fee.
Part way through the audit of WTR, Mr W, WTR's quality control partner, resigned to take up
a position as Finance Director in SoTee plc, LaFa's parent company. SoTee is audited by a
different firm of auditors. Mr W has not yet been replaced, as the managing board of WTR
has yet to identify a suitable candidate. Part of the outstanding work left by Mr W was the
implementation of a system of ethical compliance for all assurance staff whereby they would
confirm in writing adherence to the ICAEW Code of Ethics and confirm lack of any ethical
conflict arising from the code.
Requirement
Identify and explain the risks which will affect the quality control of the audit of LaFa.
Suggest how the risks identified can be reduced.
3 Bee5
You are the audit manager in charge of the audit of Bee5, a construction company. The
client is considered to be low risk; control systems are generally good and your assurance
firm, Sheridan & Co, has normally assisted in the production of the financial statements
providing some additional assurance of the accuracy and completeness of the statements.
During the initial planning meeting with the client you learn that a new Finance Director has
been appointed and that Bee5 will produce the financial statements this year; the services
of your firm's accounts department will therefore not be required. However, Bee5 has
requested significant assurance work relating to a revision of its internal control systems.
The current accounting software has become less reliable (increased processing time per
transaction and some minor data loss due to inadequate field sizes). The client will replace
this software with the new Leve system in the next financial year but requires advice on
amending its control systems ready for this upgrade.
Requirement
Discuss the impact on the audit approach for Bee5 from the above information. Make
specific reference to any quality control issues that will affect the audit.
Now go back to the Learning outcomes, in the Introduction. If you are satisfied you have
achieved these objectives, please tick them off.

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Technical reference C
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A
P
1 What is financial reporting? T
 Financial reporting is the provision of financial information about a Concept Frame E
R
reporting entity that is useful to existing and potential investors, (OB2)
lenders and other creditors in making decisions about providing 1
resources to the entity.
Corporate reporting is a broader concept, which covers other reports,
such as audit or environmental reports.
 Financial statements comprise statement of financial position, IAS 1 (10)
statement of profit or loss and other comprehensive income,
statement of changes in equity, statement of cash flows and notes.
2 Purpose and use of financial statements
 Users' core need is for information for making economic decisions. Concept Frame
(OB2)
 Objective is to provide information on financial position (the entity's Concept Frame
economic resources and the claims against it) and about transactions (OB12)
and other events that change those resources and claims.
 Financial position: Concept Frame
(OB13)
– Resources and claims
– Help identify entity's strengths and weaknesses
– Liquidity and solvency
 Changes in economic resources and claims: Concept Frame
(OB15–16)
– Help assess prospects for future cash flows
– How well have management made efficient and effective use of
the resources
 Financial performance reflected by accrual accounting. Concept Frame
(OB17)
 Financial performance reflected by past cash flows. Concept Frame
(OB20)
3 ISA 200
 Purpose of an audit ISA 200.3
 General principles of an audit ISA 200.14–.24
4 ISQC 1
 Objective ISQC 1.11
 Elements of a system of quality control ISQC 1.16–.16D2
 Importance of documenting procedures ISQC 1.17
 Leadership ISQC 1.18–.19
 Ethical requirements ISQC 1.20–.20D1
 Independence ISQC 1.21–.21D1
 Acceptance and continuance ISQC 1.26
 Human resources ISQC 1.29–.29D2
 Engagement performance ISQC 1.32–.32D1
 Monitoring ISQC 1.48–.48D3

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5 ISA 220
 Leadership responsibilities ISA 220.8
 Ethical requirements ISA 220.9
 Acceptance and continuance ISA 220.12
 Assignment of engagement teams ISA 220.14
 Engagement performance ISA 220.15
6 ISA 230
 Purposes of audit documentation. ISA 230.2–.3
 Should enable an experienced auditor to understand the procedures ISA 230.8–.8D1
performed, the results and evidence obtained and significant matters
identified.
 Auditors must document discussions of significant matters with ISA 230.10
management.
 Inconsistencies regarding significant matters must be documented. ISA 230.11
 Departures from relevant requirements in ISAs must be documented. ISA 230.12
 The identity of the preparer and reviewer must be documented. ISA 230.9
7 ISA 250
 Categories of laws and regulations ISA 250A.6
 Objectives ISA 250A.11 & ISA
250B.8
 Auditor's responsibilities ISA 250A.13–.14
 Reporting ISA 250A.23

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Answers to Interactive questions C

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Answer to Interactive question 1 P
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Where IFRS allows a choice of accounting policy, directors may wish to select the policy that E
R
gives the most favourable picture, rather than the one which is most useful to users of financial
statements. For example, they may wish to adopt the direct, rather than the indirect, method of 1
preparing a statement of cash flows if they believe that gives a more favourable view of the
company's liquidity and solvency in the eyes of a lender, such as a bank. Auditors need to be on
the lookout for this kind of manipulation.
Answer to Interactive question 2

Several quality control issues are raised in the scenario.
Engagement partner
An engagement partner is usually appointed to each audit engagement undertaken by the firm,
to take responsibility for the engagement on behalf of the firm. Assigning the audit to the
experienced audit manager is not sufficient.
The lack of audit engagement partner also means that several of the requirements of ISA 220
about ensuring that arrangements in relation to independence and directing, supervising and
reviewing the audit are not in place.
Conflicting views
In this scenario the audit manager and senior have conflicting views about the valuation of
inventory. This does not appear to have been handled well, with the manager refusing to discuss
the issue with the senior.
ISA 220 requires that the audit engagement partner takes responsibility for settling disputes in
accordance with the firm's policy in respect of resolution of disputes required by ISQC 1. In this
case, the lack of engagement partner may have contributed to this failure to resolve the
disputes. In any event, at best, the failure to resolve the dispute is a breach of the firm's policy
under ISQC 1. At worst, it indicates that the firm does not have a suitable policy concerning such
disputes as required by ISQC.

(a) Working papers are necessary for the following reasons:
 To assist the engagement team to plan and perform the audit
 To assist members of the engagement team responsible for supervision to direct and
supervise the audit procedures, and to discharge their review responsibilities in
accordance with ISA 220
 To enable the engagement team to be accountable for its work
 As a record of matters of continuing significance to future audits
 To enable the conduct of quality control reviews and inspections in accordance with
ISQC 1
 To enable the conduct of external inspections in accordance with applicable legal,
regulatory or other requirements

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(b)
Information Reasons
(1) Administration
 Client name  Enables an organised file to be
 Year end produced
 Title
 Date prepared  Enables papers to be traced if lost
 Initials of preparer  Any questions can be addressed to the
appropriate person
 Seniority of preparer is indicated
 Initials of senior to indicate review of  Evidence that guidance on planning,
junior's work controlling and recording is being
followed
 Evidence of adherence to auditing
standards
(2) Planning
 Summary of different models of TVs  Enables auditor to familiarise himself
and blu-ray players held and the with different types of inventory lines
approximate value of each
Summary of different types of raw
material held and method of
counting small components
Summary of different stages of WIP
identified by client
 Time and place of count  Audit team will not miss the count
 Personnel involved  Auditor aware who to address
questions/ problems to
 Copy of client's inventory count  Enables an initial assessment of the
instructions and an assessment of likely reliability of Viewco's count
them
 Assists in determining the amount of
procedures audit team need to do
 Enables compliance work to be carried
out; that is, checking Viewco staff follow
the instructions
 Plan of warehouse  To ensure all areas covered at count
 Clear where to find different
models/components
 Location of any third party/moving
inventory clear
 Details of any known old or slow  Special attention can be given to these
moving lines at count; for example, include in test
counts

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Information Reasons
C
 Scope of test counts to be  Ensures appropriate amount of H
A
performed that is, number/value of procedures performed based on initial P
items to be counted and method of assessment T
selection. For Viewco probably E
 Clear plan for audit team R
more counting of higher value
finished goods 1
(3) Objectives of attendance; that is, to  Reporting partner can confirm if

ensure that the quantity and quality of appropriate/adequate procedures
inventory to be reflected in the financial performed
statements is materially accurate
(4) Details of procedures performed  Provides evidence for future reference
and documents adherence to auditing
standards
 Enables reporting partner to review the
adequacy of the procedures and
establish whether it meets the stated
objective
A. Details of controls testing procedures  Enable reassessment of likely reliability
performed – observing Viewco's of Viewco's count
counters and ensuring they are following
 Enables assessment of chances of items
the instructions and conducting the
being double-counted or omitted
count effectively, for example:
 Note of whether the area was
systematically tidied
 Note of whether or how counted
goods are marked
 Note of how Viewco records and
segregates any goods still moving
on count day
 Note of adequacy of supervision  Enables assessment of overall standard
and general impression of counters of count and hence likely accuracy
 Note whether counters are in teams  Evidence of independent checks may
of two and whether any check enhance reliability
counts are performed
B. Details of substantive procedures
performed:
 Details of items of raw materials or
finished goods test counted:
– From physical inventory to  Evidence to support the accuracy and
client's count sheet completeness of Viewco's count sheets
– From Viewco's count sheets to  Evidence to support the existence of
physical inventory inventory recorded by Viewco
For both of the above note inventory
code, description, number of units
and quality. Use a symbol to indicate
agreement with Viewco's records

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Information Reasons
 Details of review for any old/obsolete  Details can be followed up at final audit
inventory, for example and the net realisable value
dusty/damaged boxes. Note code, investigated
description, number of units and
problem
 Details of review of WIP
– Assessment of volume of part  Evidence in support of accuracy of
complete items of each stage quantity of WIP
– Assessment of appropriateness  Details can be followed through at final
of degree of completion audit to final inventory sheets
assigned to each stage by
 Basis for discussion of any description
Viewco (could describe items at
various stages)
 Copies of:
– Last few despatch notes  Enables follow up at final audit to
ensure cut-off is correct; that is, goods
– Last few goods received notes
despatched are reflected as sales,
– Last few material requisitions goods received as purchases and items
– Last few receipts to finished in WIP are not also in raw materials and
goods finished goods
 Copies of client's inventory count  Enables follow up at final audit to

sheets (where number makes this ensure that Viewco's final sheets are
practical) intact and no alterations have occurred
(5) Summary of results  Senior/manager can assess any
consequences for audit risk and
In particular:
strategy and decide any further
 Details of any problems procedures needed
encountered
 Provides full documentation of issues
 Details of any test count that could require a judgemental
discrepancies and notes of decision and could ultimately be the
investigation into their causes basis for a qualified opinion
 Details of any representations by the
management of Viewco
(6) Conclusion  Indicates whether or not the initial
objective has been met and whether
there are any implications for the audit
opinion

 Has the work been performed in accordance with the audit programme?
The non-current asset procedure of agreeing non-current asset details from the asset
register to the actual asset is to confirm the existence of the asset – in other words, that the
asset should be included in the register. Agreeing physical asset details back to the register
tests for the assertion of completeness, not existence; that is, all assets that should be
recorded in the register are recorded – not that assets in the register do exist. The audit
procedure has therefore not been completed in accordance with the audit programme.

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I recommend that the existence test is completed as specified. However, where physical
existence of the asset cannot be determined by seeing the asset, then alternative evidence C
H
such as the log book is obtained. A
P
 Have the work performed and the results obtained been adequately documented? T
E
Adequate documentation normally means that written representations by management are
R
recorded in writing, either in a paper document or through use of email or other electronic
communication system that can be traced back to the client. Regarding the completeness 1
of non-current assets, it is unclear how the representation from the director was received –
although it appears that this was only verbal. The difficulty with verbal evidence is that it can
be disputed at a later date.
I recommend that the director's representation is obtained in writing.
 Have any significant matters been resolved or are reflected in audit conclusions?
The fact that some vehicles were found obviously not in working order is cause for concern.
While your primary task was satisfying the assertions of existence and completeness, where
assets are obviously unusable, this fact needs to be recorded. The issue is that assets may
well be overvalued in the financial statements; in practice the asset values need to be
compared to the carrying amounts in the asset register and, where the asset will no longer
be used, complete write-off or disposal considered.
While no further action may be necessary on completeness and existence, I recommend
that you prepare a list of the assets which are in a poor state of repair so additional
valuation procedures can be performed on them.
 Have the objectives of the audit procedures been achieved?
As already noted, the objectives of audit procedures have not been achieved. There is still
insufficient evidence to confirm the existence and completeness of non-current assets.
I recommend that the procedures you were carrying out are completed as detailed in the
audit programme.
 Are the conclusions expressed consistent with the results of the work performed and do
they support the audit opinion?
The conclusion on the assertions of completeness and existence is incorrect. Your memo
states that assets were correctly stated and valued.
The point is not valid for two reasons.
First, audit procedures have not been completed correctly (see the point on completeness
testing for example) which means that the assertion of completeness cannot be confirmed.
Second, the audit procedures carried out do not relate to the valuation of those assets.
Valuation procedures include the auditing of depreciation and not simply ascertaining the
condition of those assets at the end of the reporting period.
I recommend that when audit procedures are complete that the conclusion is amended to
match the assertions being audited.

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1 Performance and position
Performance
The financial performance of a company comprises the return it obtains on the resources it
controls. Performance can be measured in terms of the profits and comprehensive income
of the company and its ability to generate cash flows.
Management will be assessed on their skill in achieving the highest level of performance,
given the resources available to them.
Information on performance can be found in:
 the statement of profit or loss and other comprehensive income;
 the statement of changes in equity; and
 the statement of cash flows.
Position
The financial position of the company is evaluated by reference to:
 its economic resources and claims;
 its capital structure ie, its level of debt finance and shareholders' funds; and
 its liquidity and solvency.
The user of the financial statements can then make assessments on the level of risk, ability
to generate cash, the likely distribution of this cash and the ability of the company to adapt
to changing circumstances.
The statement of financial position is the prime source of information on a company's
position but the statement of cash flows will also indicate a company's cash position over a
period of time.
2 LaFa plc
Culture of WTR
The quality control auditing standard, ISQC 1, requires that the firm implements policies
such that the internal culture of the firm is one where quality is considered essential. Such a
culture must be inspired by the leaders of the firm, who must sell this culture in their actions
and messages. In other words, the entire business strategy of the audit firm should be
driven by the need for quality in its operations.
In the WTR audit firm, there appears to be a lack of leadership on quality control. Two issues
give rise for concern:
(1) First, the partner in quality control resigned during the audit of LaFa plc and has not
been replaced. This means that there is no one person in charge of maintaining quality
control standards in the audit firm. There is the risk that deficiencies of quality control
will go undetected.
(2) Second, WTR is under fee pressure from LaFa plc to complete the audit and provide
other services for the same fee as last year, even though the scope of the audit has
increased. There is the risk that audit procedures will not be fully carried out to ensure
that the tight budget is met. Lack of a comprehensive quality control review (the quality
control partner resigning as noted above) increases the risk of poor quality work.
The quality control partner should be replaced as soon as possible, while the fee situation
with LaFa should be monitored – any potential cost overrun must be discussed with the
client and where necessary additional fees agreed.

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Ethical requirements
C
Policies and procedures should be designed to provide the firm with reasonable assurance H
that the firm and its personnel comply with relevant ethical requirements. A
P
In WTR, it is not clear that staff will comply with the code. While professional staff will be T
members of ICAEW or a similar body, and therefore subject to the ethical requirements of E
R
their professional body, precise implementation has not been confirmed within WTR. While
it is unlikely that staff will knowingly break the ethical code, there is still room for inadvertent 1
breach. For example, partners may not be aware of the full client list of WTR and hold
shares in an audit client. Similarly, audit staff may not be aware of WTR's policy on
entertainment and therefore accept meals, for example, over these guidelines.
The guidelines should be circulated and confirmed by all staff as soon as possible.
Client acceptance
A firm should only accept, or continue with, a client where it:
 has considered the integrity of the client and does not have information that the client
lacks integrity;
 is competent to perform the engagement and has the necessary time and resources;
and
 can comply with ethical requirements including appropriate independence from the
client.
While there is little indication that LaFa lacks integrity, the client is placing fee pressure on
WTR. The client has also indicated that information regarding development expenditure
may not be available during the audit and will be subject to a separate audit check just
before the signing of the financial statements and auditor's report. There could be an
attempt to 'force' an unmodified auditor's report when WTR should take more time (and
money) auditing development expenditure. There is therefore a risk that LaFa management
is losing some integrity and WTR need to view other management evidence with increased
scepticism.
The audit of LaFa plc this year includes development expenditure. As this is a new audit
area, the audit partner of LaFa should have ensured that the audit team, and WTR as a
whole, had staff with the necessary experience to audit this item. Lack of competence
increases audit risk, as the area may not be audited correctly or completely.
Mr W accepting the position of Finance Director at SoTee appears to place the
independence of WTR with LaFa in jeopardy. As Finance Director of the parent company,
Mr W will be in a position to influence the management of LaFa, and potentially the financial
information being provided by that company. While SoTee is not an audit client, the audit
partner in WTR must ensure that no undue influence is being placed on LaFa. If, however,
this is the case, then WTR must consider resignation from the audit of LaFa.
Monitoring of audit
The audit firm must have policies in place to ensure that quality control procedures are
implemented and maintained.
Regarding the audit of LaFa, there is some risk that control quality regarding audit
monitoring will be compromised because:
 the audit partner is new, and may therefore not have extensive knowledge of the audit
client; and
 there appears to be a tight audit deadline for auditing development expenditure.

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To decrease audit risk, it will be appropriate to maintain similar audit staff from last year (eg,
retain the audit senior and manager) and WTR could consider a second partner review to
ensure WTR quality control standards have been followed.
3 Bee5
Client acceptance
In previous years Bee5 has required a standard audit from your assurance firm. However,
this year there is a request for additional assurance regarding the internal control systems.
This work will not only raise the amount of income generated from the client but will also
require the use of specialist staff to perform the work.
Before accepting the engagement for this year Sheridan & Co must ensure the following:
(a) That income from Bee5 is not approaching 15% of the firm's total income. If income is
approaching this level then additional independence checks may be required, such as
an independent internal quality control review.
(b) That staff familiar with the Bee5 internal control system are available to provide the
assurance work. If these skills are not available then Sheridan & Co must either hire
staff with those skills or decline the work on internal control systems. Sheridan & Co
must also ensure that they will not be taking responsibility for designing, implementing
or maintaining internal control as under the FRC Revised Ethical Standard 2016 this
would be a management decision-making activity.
Plan the audit – evaluate internal control
The current internal control system is due to be upgraded in the next financial year. There is
therefore no impact on the current year's audit as a result of this change. However, the
reason given by the client for the upgrade relates to reliability issues with the current
control systems.
The control system used by Bee5 must still be evaluated to determine the extent to which
the system is still reliable. Where deficiencies are identified then control risk will increase.
There will be consequent impact on the audit approach as noted below.
Develop the audit approach
An increase in control risk will cause detection risk to increase. The impact on the audit will
be an increased level of substantive testing to obtain sufficient confidence on assertions
such as completeness and accuracy.
There will be a further impact on the quality control of the audit. Commencing the audit
with the expectation of finding control deficiencies means that audit staff must be selected
carefully. It may not be appropriate to send junior trainees with restricted experience to the
client unless their work is closely monitored and carefully reviewed.
Audit internal control – tests of controls
As noted above, detailed tests of control on the accounting system will be limited.
However, reliance will still be obtained from the overall control environment.
Evaluate results
The higher risk associated with the audit this year means that a quality control review will be
appropriate for this client. Sheridan & Co needs to maintain the integrity of work performed
as well as ensuring that the audit opinion is correct. Part of the planning process will be to
book the time of the quality control partner.

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CHAPTER 2
Principles of
corporate reporting
Introduction
TOPIC LIST
1 The regulatory framework
2 The IASB Conceptual Framework
3 Other reporting frameworks
4 IFRS 13, Fair Value Measurement
5 IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors
6 Current issues in corporate reporting

Technical reference

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Introduction
 Explain the impact of accounting principles and bases of measurement in corporate

reporting, for example fair value measurement
 Appraise corporate reporting regulations, and related legal requirements, with
respect to presentation, disclosure, recognition and measurement
 Explain and appraise accounting standards that relate to the impact of changes in
accounting policies and estimates
 Explain and evaluate the impact of underlying assumptions on financial statements
 Identify and explain current and emerging issues in corporate reporting

 Formulate and evaluate accounting and reporting policies for single entities and
groups of varying sizes and in a variety of industries
 Explain how different methods of recognising and measuring assets and liabilities
can affect reported financial position and explain the role of data analytics in
financial asset and liability valuation
 Identify and explain corporate reporting and assurance issues in respect of social
responsibility, sustainability and environmental matters for a range of stakeholders
 Critically evaluate accounting policies choices and estimates, identifying issues of
earnings manipulation and creative accounting
Specific syllabus references for this chapter are: 1(a)–(e), 2(c), 3(a)

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1 The regulatory framework
Section overview
 Financial reporting is the provision of financial information to those outside the entity.
• The organisation responsible for setting IFRS comprises the International Financial
Reporting Standards Foundation (IFRS Foundation), the Monitoring Board, the
International Accounting Standards Board (IASB), the IFRS Advisory Council (Advisory
Council) and the IFRS Interpretations Committee (Interpretations Committee).
• The process of setting IFRS is an open dialogue involving co-operation between national
and international standard setters.
C
H
A
1.1 The IFRS Foundation P
IASCF was formed in 2001 as a not-for-profit corporation and was the parent entity of the IASB. T
E
In 2010 it was renamed as the IFRS Foundation. The IFRS Foundation is an independent R
organisation and its trustees exercise oversight and raise necessary funding for the IASB to carry
out its role as standard setter. It also oversees the work of the IFRS Interpretations Committee 2
(formerly called the International Financial Reporting Interpretations Committee (IFRIC)) and
the IFRS Advisory Council (formerly called the Standards Advisory Council (SAC)). These are
organised as follows:
IFRS Foundation is responsible for:

Funding
Appointment of members of IASB, IFRS
Advisory Council and IFRS Interpretations
Committee
IASB is responsible for: IFRS Advisory Council is responsible for:

All technical matters in general Input on IASB's agenda
In particular, the preparation and issue of Input on IASB's project timetable and
International Financial Reporting Standards priorities
Advise on standard-setting projects
Supporting IASB in promotion/adoption of
IFRS Interpretations Committee is
IFRS throughout the world
responsible for:
Interpretation and application of
International Financial Reporting Standards
Figure 2.1: IFRS Foundation
1.2 Membership
Membership of the IFRS Foundation has been designed so that it represents an international
group of preparers and users, who become IFRS Foundation trustees. The selection process of
the 22 trustees takes into account geographical factors and professional background. IFRS
Foundation trustees appoint the IASB members.
The Monitoring Board ensures that the trustees carry out their duties in accordance with the
IFRS Foundation Constitution.
ICAEW 2019 Principles of corporate reporting 55

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1.3 The IASB

The IASB is responsible for setting accounting standards. It is made up of 15 full-time members
and has no particular geographical dominance. Members have a variety of backgrounds and
include the following:
 Auditors
 Preparers of financial statements
 Users of financial statements
 Academics
1.4 Objectives of the IASB

The Preface to IFRSs states that the objectives of the IASB are as follows:
(a) To develop, in the public interest, a single set of high quality, understandable, enforceable
and globally accepted financial reporting standards based on clearly articulated principles.
These standards should require high quality, transparent and comparable information in
financial statements and other financial reporting to help investors, other participants in the
various capital markets of the world and other users of the information to make economic
decisions.
(b) To promote the use and rigorous application of those standards.
(c) In fulfilling the above objectives to take account of, as appropriate, the needs of a range of
sizes and types of entities in diverse economic settings.
(d) To promote and facilitate the adoption of IFRSs through the convergence of national
accounting standards and IFRSs.
1.5 The purpose of accounting standards

The overall purpose of accounting standards is to identify proper accounting practices for the
preparation of financial statements.
Accounting standards create a common understanding between users and preparers on how
particular items, for example the valuation of property, are treated. Financial statements should
therefore comply with all applicable accounting standards.
1.6 Application of IFRS

Within each individual country local regulations govern, to a greater or lesser degree, the issue
of financial statements. These local regulations include accounting standards issued by the
national regulatory bodies or professional accountancy bodies in the country concerned.
Over the last 25 years, however, the influence of IFRS on national accounting requirements and
practices has been growing. For example:
(a) Since 2005, all EU companies whose securities are traded on a regulated public market
such as the London Stock Exchange must prepare their consolidated accounts in
accordance with IFRS. (Note that although group financial statements must follow IFRS the
individual financial statements do not need to.)
(b) In the UK, unquoted companies are permitted (but not required) to adopt IFRS.
1.7 Setting of IFRS

The overall agenda of the IASB is initially set by discussion with the IFRS Advisory Council. The
process for developing an individual standard involves the following steps.

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Step 1
During the early stages of a project, the IASB may establish an Advisory Committee or working
group to give advice on issues arising in the project. Consultation with the Advisory Committee
and the Advisory Council occurs throughout the project.
Step 2
The IASB may develop and publish a Discussion Paper for public comment.
Step 3
Following the receipt and review of comments, the IASB would develop and publish an
Exposure Draft for public comment.
Step 4
Following the receipt and review of comments, the IASB would issue a final International C
H
Financial Reporting Standard. A
P
The period of exposure for public comment is normally 120 days. However, in some
T
circumstances, proposals may be issued with a comment period of not less than 30 days. Draft E
IFRS Interpretations are exposed for a 60-day comment period. R
2
1.8 Scope and authority of IFRS
The Preface to IFRSs makes the following points:
(a) IFRSs apply to all general purpose financial statements ie, those directed towards the
common information needs of a wide range of users.
(b) The IASB's objective is to require like transactions and events to be accounted for and
reported in a like way. The IASB intends not to permit choices in accounting treatment.
The IASB is reconsidering those transactions and events for which IFRSs permit a choice of
accounting treatment with the objective of reducing the number of those choices.
(c) Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the
main principles, but both types have equal authority.
(d) Any limitation of the applicability of a specific IFRS is made clear in that standard.
1.9 UK regulatory framework

UK companies produce their financial statements in line with the requirements of:
 the Companies Act 2006; and
 IFRS; or FRS 100 to 103.
This is covered in more detail in section 3.
2 The IASB Conceptual Framework
Section overview
The IASB Framework for the Preparation and Presentation of Financial Statements was the
conceptual framework on which all IASs and IFRSs were based up to 2010. It is gradually being
replaced by the Conceptual Framework for Financial Reporting. The extant framework determines:
 how financial statements are prepared; and
• the information they contain.
A revised version of the Conceptual Framework was published in March 2018. This does not come
into force until January 2020, but you should have an awareness of the changes as a current issue.

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2.1 Conceptual Framework

The IASB Framework for the Preparation and Presentation of Financial Statements was produced
in 1989 and is gradually being replaced by the new Conceptual Framework for Financial
Reporting. This is the result of an IASB/FASB joint project and is being carried out in phases. The
first phase, comprising Chapters 1 and 3, was published in September 2010. Chapter 2 entitled
'The reporting entity' has not yet been published. The current version of the Conceptual
Framework includes the remaining chapters of the 1989 Framework as Chapter 4.
The Conceptual Framework for Financial Reporting is currently as follows:
Chapter 1: The objective of general purpose financial reporting
Chapter 2: The reporting entity (to be issued)
Chapter 3: Qualitative characteristics of useful financial information
Chapter 4: Remaining text of the 1989 Framework:
 Underlying assumption
 The elements of financial statements
 Recognition of the elements of financial statements
 Measurement of the elements of financial statements
 Concepts of capital and capital maintenance
In this chapter we have already introduced some of the concepts dealt with by the Conceptual
Framework.
We will now look specifically at each section in turn.
2.2 Introduction to the Conceptual Framework

The introduction provides a list of the purposes of the Conceptual Framework:
(a) To assist the board in the development of future IFRSs and in its review of existing IFRS
(b) To assist the board in promoting harmonisation of regulations, accounting standards and
procedures relating to the presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by IFRS
(c) To assist national standard-setting bodies in developing national standards
(d) To assist preparers of financial statements in applying IFRS and in dealing with topics that
have yet to form the subject of an IFRS
(e) To assist auditors in forming an opinion as to whether financial statements comply with IFRS
(f) To assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRS
(g) To provide those who are interested in the work of the IASB with information about its
approach to the formulation of IFRS
The Conceptual Framework is not an IFRS and so does not overrule any individual IFRS. In the
(rare) case of conflict between an IFRS and the Conceptual Framework, the IFRS will prevail.
2.3 Chapter 1: The objective of general purpose financial reporting

The Conceptual Framework states that:
"The objective of general purpose financial reporting is to provide information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity."

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These users need information about:

 the economic resources of the entity;
 the claims against the entity; and
 changes in the entity's economic resources and claims.
Information about the entity's economic resources and the claims against it helps users to
assess the entity's liquidity and solvency and its likely needs for additional financing.
Information about a reporting entity's financial performance (the changes in its economic
resources and claims) helps users to understand the return that the entity has produced on its
economic resources. This is an indicator of how efficiently and effectively management has used
the resources of the entity and is helpful in predicting future returns.
The Conceptual Framework makes it clear that this information should be prepared on an C
H
accruals basis.
A
Information about a reporting entity's cash flows during a period also helps users assess the P
T
entity's ability to generate future net cash inflows and gives users a better understanding of its E
operations. R
2
2.4 Chapter 3: Qualitative characteristics of useful financial information
2.4.1 Overview
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
The two fundamental qualitative characteristics are relevance and faithful representation.
There are then four enhancing qualitative characteristics which enhance the usefulness of
information that is relevant and faithfully represented. These are: comparability, verifiability,
timeliness and understandability.
The key issues can be summarised as follows:
Qualitative characteristics
Faithful
Relevance representation
Complete Neutral Free from Substance

Nature of Materiality error overform
transaction (implied)
Enhancing characteristics
Comparability Verifiability Timeliness Understandability
Constraint
Cost vs benefit
Figure 2.2: Qualitative Characteristics

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2.4.2 Relevance
Relevant financial information can be of predictive value, confirmatory value or both. These
roles are interrelated.
Definition
Relevance: Relevant financial information is capable of making a difference in the decisions
made by users.
Information on financial position and performance is often used to predict future position and
performance and other things of interest to the user eg, likely dividend, wage rises. The manner
of presentation will enhance the ability to make predictions eg, by highlighting unusual items.
The relevance of information is affected by its nature and its materiality.
Definition
Materiality: Information is material if omitting it or misstating it could influence decisions that
users make on the basis of financial information about a specific reporting entity.
Information may be judged relevant simply because of its nature (eg, remuneration of
management). In other cases, both the nature and materiality of the information are important.
Materiality is not a qualitative characteristic itself (like relevance or faithful representation)
because it is merely a threshold or cut-off point.
2.4.3 Faithful representation

Financial reports represent economic phenomena in words and numbers. To be useful, financial
information must not only represent relevant phenomena but must also faithfully represent the
phenomena that it purports to represent. The user must be able to depend on it being a faithful
representation.
Definition
Faithful representation: A perfectly faithful representation should be complete, neutral and free
from error.
A complete depiction includes all information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations.
A neutral depiction is without bias in the selection or presentation of financial information. This
means that information must not be manipulated in any way in order to influence the decisions
of users.
Free from error means there are no errors or omissions in the description of the phenomenon
and no errors made in the process by which the financial information was produced. It does not
mean that no inaccuracies can arise, particularly where estimates have to be made.
Substance over form
This is not a separate qualitative characteristic under the Conceptual Framework. The IASB says
that to do so would be redundant because it is implied in faithful representation. Faithful
representation of a transaction is only possible if it is accounted for according to its substance
and economic reality.

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Definition
Substance over form: The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal
form.
Most transactions are reasonably straightforward and their substance, ie, commercial effect, is
the same as their strict legal form. However, in some instances this is not the case, as can be
seen in the following worked example.
Worked example: Sale and repurchase agreement

C
Ashton Ltd sells goods to Berry Ltd for £10,000, but undertakes to repurchase the goods from H
Berry Ltd in 12 months' time for £11,000. A
P
The legal form of the transaction is that Ashton has sold goods to Berry, as it has transferred T
legal title. To reflect the legal form, Ashton Ltd would record a sale and show the resulting profit, E
R
if any, in profit or loss for the period. In 12 months' time when legal title is regained, Ashton Ltd
would record a purchase. There would be no liability to Berry Ltd in Ashton Ltd's statement of 2
financial position until the goods are repurchased.
The above treatment does not provide a faithful representation because it does not reflect the
economic substance of the transaction. After all, Ashton Ltd is under an obligation from the
outset to repurchase the goods and Ashton Ltd bears the risk that those goods will be obsolete
and unsaleable in a year's time.
The substance is that Berry Ltd has made a secured loan to Ashton Ltd of £10,000 plus interest
of £1,000. To reflect substance, Ashton Ltd should continue to show the goods as an asset in
inventories (at cost or net realisable value, if lower) and should include a liability to Berry Ltd of
£10,000 in payables. Ashton Ltd should accrue for the interest over the duration of the loan.
When Ashton Ltd pays £11,000 to regain legal title, this should be treated as a repayment of the
loan plus accrued interest.
Other examples of accounting for substance:

(a) Leases
Accounting for finance leases under IAS 17, Leases (which is covered in Chapter 14) is an
example of the application of substance as the lessee includes the asset in its statement of
financial position even though the legal form of a lease is that of renting the asset, not
buying it.
(b) Group financial statements
Group financial statements are covered in detail in Chapters 20 and 21. The central
principle underlying group accounts is that a group of companies is treated as though it
were a single entity, even though each company within the group is itself a separate legal
entity.
2.4.4 Enhancing qualitative characteristics

Comparability
Comparability is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among, items. Information about a reporting entity is more useful
if it can be compared with similar information about other entities and with similar information
about the same entity for another period or another date.

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Consistency, although related to comparability, is not the same. It refers to the use of the same
methods for the same items (ie, consistency of treatment) either from period to period within a
reporting entity or in a single period across entities.
The disclosure of accounting policies is particularly important here. Users must be able to
distinguish between different accounting policies in order to be able to make a valid
comparison of similar items in the accounts of different entities.
Comparability is not the same as uniformity. Entities should change accounting policies if those
policies become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over
time.
Verifiability
Verifiability helps to assure users that information faithfully represents the economic
phenomena it purports to represent. It means that different knowledgeable and independent
observers could reach consensus that a particular depiction is a faithful representation.
Timeliness
Information may become less useful if there is a delay in reporting it. There is a balance between
timeliness and the provision of reliable information.
If information is reported on a timely basis when not all aspects of the transaction are known, it
may not be complete or free from error.
Conversely, if every detail of a transaction is known, it may be too late to publish the information
because it has become irrelevant. The overriding consideration is how best to satisfy the economic
decision-making needs of the users.
Understandability
Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information diligently. Some phenomena
are inherently complex and cannot be made easy to understand. Excluding information on those
phenomena might make the information easier to understand, but without it those reports
would be incomplete and therefore misleading. Therefore matters should not be left out of
financial statements simply due to their difficulty, as even well-informed and diligent users may
sometimes need the aid of an adviser to understand information about complex economic
phenomena.
2.4.5 The cost constraint on useful financial reporting

This is a pervasive constraint, not a qualitative characteristic. When information is provided, its
benefits must exceed the costs of obtaining and presenting it. This is a subjective area and there
are other difficulties: others, not the intended users, may gain a benefit; also, the cost may be
paid by someone other than the users. It is therefore difficult to apply a cost-benefit analysis, but
preparers and users should be aware of the constraint.
2.5 Chapter 4: The elements of financial statements

2.5.1 Overview
Transactions and other events are grouped together in broad classes and in this way their
financial effects are shown in the financial statements. These broad classes are the elements of

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The Conceptual Framework lays out these elements as follows.

Elements of financial statements
Financial position in the statement of Performance in the income statement and

financial position statement of comprehensive income
• Assets • Income
• Liabilities • Expenses
• Equity
Figure 2.3: Elements of financial statements

Contributions from equity participants and distributions to them are shown in the statement of
C
changes in equity. H
A
2.5.2 Definitions of elements P
T
E
Element Definition Comment R
Asset A resource controlled by an entity as a Technically, the asset is the access to 2

result of past events and from which future future economic benefits (eg, cash
economic benefits are expected to flow to generation), not the underlying item
the entity. of property itself (eg, a machine).
Liability A present obligation of the entity arising An obligation implies that the entity
from past events, the settlement of which is is not free to avoid the outflow of
expected to lead to the outflow from the resources.
entity of resources embodying economic
benefits.
Equity The residual amount found by deducting all Equity = ownership interest = net
the entity's liabilities from all the entity's assets. For a company, this usually
assets. comprises shareholders' funds (ie,
capital and reserves).
Income Increases in economic benefits in the form Income comprises revenue and
of asset increases/liability decreases not gains, including all recognised gains
resulting from contributions from equity on non-revenue items (eg,
participants. revaluations of non-current assets).
Expenses Decreases in economic benefits in the form Expenses include losses, including all
of asset decreases/liability increases not recognised losses on non-revenue
resulting from distributions to equity items (such as write downs of non-
participants. current assets).
Note the way that the changes in economic benefits resulting from asset and liability increases
and decreases are used to define:
 Income
 Expenses
This arises from the 'balance sheet approach' adopted by the Conceptual Framework which
treats performance statements, such as the statement of profit or loss and other comprehensive
income, as a means of reconciling changes in the financial position amounts shown in the
statement of financial position.
These key definitions of 'asset' and 'liability' will be referred to again and again in these learning
materials, because they form the foundation on which so many accounting standards are based.
It is very important that you can reproduce these definitions accurately and quickly.

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2.5.3 Assets
We can look in more detail at the components of the definitions given above.
Assets must give rise to future economic benefits, either alone or in conjunction with other
items.
Definition
Future economic benefit: The potential to contribute, directly or indirectly, to the flow of cash
and cash equivalents to the entity. The potential may be a productive one that is part of the
operating activities of the entity. It may also take the form of convertibility into cash or cash
equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing
process lowers the cost of production.
In simple terms, an item is an asset if:

 it is cash or the right to cash in future eg, a receivable, or a right to services that may be
used to generate cash eg, a prepayment; or
 it can be used to generate cash or meet liabilities eg, a tangible or intangible non-current
asset.
The existence of an asset, particularly in terms of control, is not reliant on:
 physical form (hence intangible assets such as patents and copyrights may meet the
definition of an asset and appear in the statement of financial position – even though they
have no physical substance); or
 legal ownership (hence some leased assets, even though not legally owned by the
company, may be included as assets in the statement of financial position (see Chapter 14)).
Transactions or events in the past give rise to assets. Those expected to occur in future do not in
themselves give rise to assets.
2.5.4 Liabilities
Again we look more closely at some aspects of the definition.
An essential feature of a liability is that the entity has a present obligation.
Definition
Obligation: A duty or responsibility to act or perform in a certain way. Obligations may be
legally enforceable as a consequence of a binding contract or statutory requirement. However,
obligations also arise from normal business practice, custom and a desire to maintain good
business relations or act in an equitable manner.
As seen above, obligations may be:

(a) legally enforceable as a consequence of a binding contract or statutory requirement. This is
normally the case with amounts payable for goods and services received; or
(b) the result of business practice. For example, even though a company has no legal
obligation to do so, it may have a policy of rectifying faults in its products even after the
warranty period has expired.
A management decision (to acquire an asset, for example) does not in itself create an
obligation, because it can be reversed. But a management decision implemented in a way
which creates expectations in the minds of customers, suppliers or employees becomes an

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obligation. This is sometimes described as a constructive obligation. This issue is covered more
fully in Chapter 13 in the context of the recognition of provisions.
Liabilities must arise from past transactions or events. For example, the sale of goods is the past
transaction which allows the recognition of repair warranty provisions.
Settlement of a present obligation will involve the entity giving up resources embodying
economic benefits in order to satisfy the claim of the other party. In practice, most liabilities will
be met in cash but this is not essential.
Interactive question 1: Asset or liability?
Question Fill in your answer

C
(a) Oak plc has purchased a patent for £40,000. H
A
The patent gives the company sole use of a
P
particular manufacturing process which will T
save £6,000 a year for the next five years. E
R
(b) Elm plc paid John Brown £20,000 to set up a
2
car repair shop, on condition that priority
treatment is given to cars from the company's
fleet.
(c) Sycamore plc provides a warranty with every
washing machine sold.
2.5.5 Equity
Equity is the residual of assets less liabilities, so the amount at which it is shown is dependent on
the measurement of assets and liabilities. It has nothing to do with the market value of the
entity's shares.
Equity may be sub-classified in the statement of financial position providing information which is
relevant to the decision-making needs of the users. This will indicate legal or other restrictions
on the ability of the entity to distribute or otherwise apply its equity.
In practical terms, the important distinction between liabilities and equity is that creditors have
the right to insist that the transfer of economic resources is made to them regardless of the
entity's financial position, but owners do not. All decisions about payments to owners (such as
dividends or share capital buyback) are at the discretion of management.
2.5.6 Performance
Profit is used as a measure of performance, or as a basis for other measures (eg, earnings per
share (EPS)). It depends directly on the measurement of income and expenses, which in turn
depend (in part) on the concepts of capital and capital maintenance adopted.
Income and expenses can be presented in different ways in the statement of profit or loss and
other comprehensive income, to provide information relevant for economic decision-making.
For example, a statement of profit or loss and other comprehensive income could distinguish
between income and expenses which relate to continuing operations and those which do not.
Items of income and expense can be distinguished from each other or combined with each
other.
Income
Both revenue and gains are included in the definition of income. Revenue arises in the course of
ordinary activities of an entity. (We will look at revenue in more detail in Chapter 10.)

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Definition
Gains: Increases in economic benefits. As such, they are no different in nature from revenue.
Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains eg, on revaluation of non-current assets.
A revaluation gives rise to an increase or decrease in equity.
These increases and decreases appear in the statement of profit or loss and other
comprehensive income.
(Gains on revaluation, which are recognised in a revaluation surplus, are covered in Chapter 12.)
Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in
the course of ordinary activities of an entity.
Definition
Losses: Decreases in economic benefits. As such, they are no different in nature from other
expenses.
Losses will include those arising on the disposal of non-current assets. The definition of
expenses will also include unrealised losses.
2.6 Chapter 4: Recognition of the elements of financial statements

2.6.1 Meaning of recognised
An item is recognised when it is included in the statement of financial position or statement of
profit or loss and other comprehensive income.
Definition
Recognition: The process of incorporating in the statement of financial position or statement of
profit or loss and other comprehensive income an item that meets the definition of an element
and satisfies the following criteria for recognition:
 It is probable that any future economic benefit associated with the item will flow to or from
the entity.
 The item has a cost or value that can be measured with reliability.
Points to note:
1 Regard must be given to materiality.
2 An item which fails to meet these criteria at one time may meet them subsequently.
3 An item which fails to meet the criteria may merit disclosure in the notes to the financial
statements. (This is dealt with in more detail by IAS 37, Provisions, Contingent Liabilities and
Contingent Assets which is covered in Chapter 13.)
2.6.2 Probability of future economic benefits

Probability here refers to the degree of uncertainty that the future economic benefits associated
with an item will flow to or from the entity. This must be judged on the basis of the
characteristics of the entity's environment and the evidence available when the financial
statements are prepared.
The Conceptual Framework does not give a definition of 'probable'. A working definition is
"more likely than not".

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2.6.3 Reliability of measurement

The cost or value of an item in many cases must be estimated. The use of reasonable estimates
is an essential part of the preparation of financial statements and does not undermine their
reliability. Where no reasonable estimate can be made, the item should not be recognised
(although its existence should be disclosed in the notes).
2.6.4 Recognition of items

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on
the definition of recognition given above.
Item Recognised in When
Asset The statement of It is probable that the future economic benefits will flow to C
H
financial position the entity and the asset has a cost or value that can be A
measured reliably. P
T
Liability The statement of It is probable that an outflow of resources embodying E
financial position economic benefits will result from the settlement of a present R
obligation and the amount at which the settlement will take
2
place can be measured reliably.
Income The statement of An increase in future economic benefits related to an
profit or loss and increase in an asset or a decrease of a liability has arisen that
other can be measured reliably.
comprehensive
income
Expenses The statement of A decrease in future economic benefits related to a decrease
profit or loss and in an asset or an increase of a liability has arisen that can be
other measured reliably.
comprehensive
income
Points to note:
1 There is a direct association between expenses being recognised in profit or loss for the
period and the generation of income. This is commonly referred to as the accruals basis or
matching concept. However, the application of the accruals basis does not permit
recognition of assets or liabilities in the statement of financial position which do not meet
the appropriate definition.
2 Expenses should be recognised immediately in profit or loss for the period when
expenditure is not expected to result in the generation of future economic benefits.
3 An expense should also be recognised immediately when a liability is incurred without the
corresponding recognition of an asset.
2.7 Chapter 4: Measurement of the elements of financial statements

For an item or transaction to be recognised in an entity's financial statements it needs to be
measured as a monetary amount. IFRS uses several different measurement bases but the
Conceptual Framework refers to just four.
The four measurement bases referred to in the Conceptual Framework are as follows:
(1) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the
fair value of the consideration given to acquire them at the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for the obligation
or, in some circumstances (for example, income taxes), at the amounts of cash or cash
equivalents expected to be paid to satisfy the liability in the normal course of business.

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(2) Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be
required to settle the obligation currently.
(3) Realisable (settlement) value
(a) Realisable value. The amount of cash or cash equivalents that could currently be
obtained by selling an asset in an orderly disposal.
(b) Settlement value. The undiscounted amounts of cash or cash equivalents expected to
be paid to satisfy the liabilities in the normal course of business.
(4) Present value. A current estimate of the present discounted value of the future net cash
flows in the normal course of business.
Historical cost is the most commonly adopted measurement basis, but this is usually combined
with other bases eg, an historical cost basis may be modified by the revaluation of land and
buildings.
2.8 Chapter 4: Concepts of capital and capital maintenance

The final section of the Conceptual Framework is devoted to a brief discussion of the different
concepts of capital and capital maintenance, pointing out that:
 the choice between them should be made on the basis of the needs of users of financial
statements; and
 the IASB has no present intention of prescribing a particular model.
2.8.1 Financial capital and capital maintenance
Definition
Financial capital maintenance: Under a financial concept of capital maintenance, such as
invested money and invested purchasing power, capital is synonymous with the net assets or
equity of the entity.
The financial concept of capital is adopted by most entities.

This concept measures capital as the equity in the statement of financial position. Profit is only
earned in an accounting period if the equity at the end of the period is greater than it was at the
start, having excluded the effects of distributions to or contributions from the owners during the
period.
Monetary measure of capital
Financial capital is usually measured in monetary terms eg, the pound sterling or the euro. This
is the concept applied in historical cost accounting. This measure can be quite stable over short
periods of years, but is debased by quite low rates of general inflation over longer periods, such
as 20 years. So comparisons between capital now and capital 20 years ago are invalid, because
the measurement instrument is not constant.
Constant purchasing power
A variant on the monetary measure of financial capital is the constant purchasing power
measure. On this basis, the opening capital (ie, equity) is uprated by the change in a broadly
based price index, often a retail prices index, over the year. Also, the transactions during the
year are uprated by the change in the same index. A profit is only earned if the capital at the end
of the year exceeds these uprated values. (The value of the uprating is taken to equity, but is not
regarded as a profit, merely a 'capital maintenance' adjustment.) So this capital maintenance
adjustment can be thought of as an additional expense. Comparisons over a 20-year period will
be more valid if the capital 20 years ago is uprated for general inflation over that 20-year period.

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However, there is no reason why inflation measured by a retail prices index should be at all close
to the inflation experienced by an individual company. The physical capital maintenance
concept (see below) seeks to address this.
2.8.2 Physical capital and capital maintenance
Definition
Physical capital maintenance: Under a physical concept of capital, such as operating capability,
capital is regarded as the productive capacity of the entity based on, for example, units of output
per day.
C
This concept looks behind monetary values, to the underlying physical productive capacity of the H
entity. It is based on the approach that an entity is nothing other than a means of producing A
P
saleable outputs, so a profit is earned only after that productive capacity has been maintained by a T
'capital maintenance' adjustment. (Again, the capital maintenance adjustment is taken to equity E
and is treated as an additional expense in the statement of profit or loss and other comprehensive R
income.) Comparisons over 20 years should be more valid than under a monetary approach to 2
capital maintenance.
The difficulties in this approach lie in making the capital maintenance adjustment. It is basically a
current cost approach, normal practice being to use industry-specific indices of movements in
non-current assets, rather than to go to the expense of annual revaluations by professional
valuers. The difficulties lie in finding indices appropriate to the productive capacity of a
particular entity.
Worked example: Capital maintenance concepts

Meercat plc purchased 20,000 electrical components on 1 January 20X7 for £10 each. They
were all sold on 31 December 20X7 for £250,000. On that date the replacement cost of an
electrical component was £11.50. The general rate of inflation as measured by the general price
index was 12% during the year.
Profit could be calculated as follows:
Financial capital
Financial capital maintenance
maintenance (constant purchasing Physical capital
(monetary terms) power) maintenance
£ £ £
Revenue 250,000 250,000 250,000
Cost of sales
20,000  10 (200,000)
20,000  11.2 (224,000)
20,000  11.5 (230,000)
Profit 50,000 26,000 20,000
2.9 Underlying assumptions

The term 'underlying assumptions' can have a specific or a general meaning.
(a) The 1989 Framework, now Chapter 4 of the revised Conceptual Framework, states that the
going concern assumption is the underlying assumption. Thus, the financial statements
presume that an entity will continue in operation indefinitely or, if that presumption is not
valid, disclosure and a different basis of reporting are required. (The Framework used to
have accruals as a second underlying assumption, but this is now in IAS 1, leaving going
concern as the only underlying assumption.)

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(b) The term 'underlying assumption' may also overlap with 'fundamental accounting
concepts', found in IAS 1, Presentation of Financial Statements (accruals, going concern,
consistency, materiality, offsetting).
2.10 Revised Conceptual Framework (March 2018)

The IASB issued a revised Conceptual Framework in March 2018. The revised document
improves on the 2010 Conceptual Framework by:
 'Filling the gaps' by providing guidance on presentation and disclosure
 Updating the content
 Clarifying certain areas
The revised Conceptual Framework comes into force in January 2020. The 2010 Conceptual
Framework is still the examinable document, but you should be aware of the main contents and
changes in the 2018 version, as this is an important current issue.
The chapters of the new Conceptual Framework are:
1 The objective of general purpose financial reporting
2 Qualitative characteristics of useful financial information
3 Financial statements and the reporting entity
4 The elements of financial statements
5 Recognition and derecognition
6 Measurement
7 Presentation and disclosure
8 Concepts of capital and capital maintenance
The following sections consider some of the changes in the new Conceptual Framework.
2.10.1 The objective of general purpose financial reporting

The general objective of general purpose financial reporting of the 2010 Conceptual Framework
is retained, however there is a greater emphasis on providing information that allows users to
assess the stewardship of management, ie how effectively and efficiently management has used
the reporting entity's resources.
2.10.2 Qualitative characteristics of useful financial information

The two fundamental and four enhancing characteristics of the 2010 Conceptual Framework are
retained, however there is additional emphasis in the following areas:
 In order to faithfully represent financial information, economic substance must be reflected
rather than legal form.
 Neutrality (an element of faithful representation) is supported by the exercise of prudence
ie, the exercise of caution when making judgements under conditions of uncertainty.
Prudence does not allow for the understatement or overstatement of items in the financial
statements. Prudence as a concept was referred to in the original Framework but was not
included in the 2010 Conceptual Framework.
 Measurement uncertainty affects whether information is useful; it does not prevent
information from being useful, however in some cases the most relevant information has
such a high level of measurement uncertainty that the most useful information is less
relevant but subject to lower measurement uncertainty.
The guidance in the remaining chapters of the Conceptual Framework is heavily related to the
characteristics of relevance and faithful representation.

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2.10.3 Financial statements and the reporting entity

Neither the original Framework nor the 2010 Conceptual Framework included guidance on the
reporting entity. The new Conceptual Framework clarifies that a reporting entity is an entity that
is required to, or chooses to, prepare financial statements. It can be a single entity or a
proportion of an entity or it can comprise more than one entity (ie, a group). A reporting entity is
not necessarily a legal entity.
2.10.4 The elements of financial statements

The definitions of asset and liability have been refined and the definitions of income and
expenses updated to reflect this.
The definition of an asset is refined to:
C
H
 clarify that an asset is the economic resource related to economic benefits rather than the
A
actual inflow of benefits; P
T
 remove the requirement for an inflow of economic benefits to be 'expected'; the new E
definition makes it clear that there is no requirement for economic benefits to be certain or R
even likely; and
2
 clarify that a low probability of economic benefits may affect recognition decisions and the
measurement of an asset.
The definition of a liability is refined to:
 clarify that a liability is the obligation to transfer economic resource rather than the actual
outflow of economic benefits;
 remove the requirement for an outflow of economic benefits to be 'expected'; and
 identify that an obligation is a duty or responsibility that an entity has 'no practical ability to
avoid'.
2.10.5 Recognition and derecognition

The 2018 Conceptual Framework requires that an item is recognised in the financial statements
if recognition would result in both relevant information and a faithful representation. There is no
longer a recognition criterion that an in- or outflow of economic benefits should be probable.
New derecognition guidance is also introduced:
 An asset is derecognised when the entity loses control of all or part of the asset.
 A liability is derecognised when the entity no longer has a present obligation for all or part
of the recognised liability.
2.10.6 Measurement
Two main measurement bases are referenced in the Conceptual Framework:
 Historical cost
 Current value (which includes fair value, value in use, fulfilment value and current cost)
Guidance on choosing a measurement basis is provided, with an emphasis on providing
relevant information that faithfully represents an item. Faithful representation is affected by
measurement inconsistency and measurement uncertainty.
2.10.7 Presentation and disclosure

Guidance on presentation and disclosure is new to the 2018 version of the Conceptual
Framework.

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There is particular consideration of presenting income and expenses within profit or loss or
other comprehensive income:
 In principle all income and expenses are included within profit or loss;
 In exceptional circumstances the IASB may include income or expenses arising from a
change in value of an asset or liability as OCI if this results in more relevant information or a
more faithful representation; and
 In principle items of OCI are recycled to profit or loss in a future period when this results in
more relevant information or a more faithful representation.
2.10.8 Concepts of capital and capital maintenance

This chapter comprises material carried forward from the 2010 Conceptual Framework with
minor changes for consistency of terminology.
3 Other reporting frameworks
Section overview
 This Study Manual (and your exam) focuses on IFRS, but there are other reporting
frameworks you need to know about, particularly those that relate to smaller entities.
 The IASB issued an IFRS for small and medium-sized entities (SMEs) in 2010. It is designed
to facilitate financial reporting by small and medium-sized entities in a number of ways.
 FRS 102 is derived from the IFRS for Small and Medium-sized Entities. It is one of the recent
financial reporting standards replacing old UK GAAP. It can be used by UK unlisted
groups and by listed and unlisted individual entities.
3.1 Small and medium-sized enterprises (SMEs)
3.1.1 Scope and application of IFRS

Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRS are
not intended to be applied to immaterial items, nor are they retrospective. Each individual IFRS
lays out its scope at the beginning of the standard.
Within each individual country local regulations govern, to a greater or lesser degree, the issue
of financial statements. These local regulations include accounting standards issued by the
national regulatory bodies and/or professional accountancy bodies in the country concerned.
IFRS concentrates on essentials and is designed not to be too complex, otherwise the standards
would be impossible to apply on a worldwide basis.
IFRS does not override local regulations on financial statements. Entities should simply disclose
whether IFRS is complied with in all material respects. Entities in individual countries will attempt
to persuade local authorities, where current regulations deviate from IFRS, that the benefits of
harmonisation make local change worthwhile.
3.1.2 Application of IFRS to smaller entities

Big GAAP/little GAAP divide
In most countries the majority of companies or other types of entity are very small. They are
generally owned and managed by one person or a family. The owners have invested their own
money in the business and there are no outside shareholders to protect.

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Large entities, by contrast, particularly companies listed on a stock exchange, may have
shareholders who have invested their money, possibly through a pension fund, with no
knowledge whatsoever of the company. These shareholders need protection and the
regulations for such companies need to be more stringent.
It could therefore be argued that company accounts should be of two types.
(1) 'Simple' ones for small companies with fewer regulations and disclosure requirements
(2) 'Complicated' ones for larger companies with extensive and detailed requirements
This is sometimes called the big GAAP/little GAAP divide.
Possible solutions
There are two approaches to overcoming the big GAAP/little GAAP divide:
C
(1) Differential reporting ie, producing new reduced standards specifically for smaller H
A
companies, such as the UK FRS 105 or the IFRS for SMEs (see below) P
T
(2) Providing exemptions for smaller companies from some of the requirements of existing E
standards R
Differential reporting 2
Differential reporting may have drawbacks in terms of reducing comparability between small
and larger company accounts.
Furthermore, problems may arise where entities no longer meet the criteria to be classified as
small.
Exemptions from IFRS
Some IFRSs do not have any bearing on small company accounts; for example, a company with
equity not quoted on a stock exchange has no need to comply with IAS 33, Earnings per Share.
Also, an entity with a small local market may find IFRS 8, Operating Segments to be superfluous.
Other standards always have an impact. In particular, almost all small companies will be affected
by the IFRSs on the following:
 Property, plant and equipment
 Inventories
 Presentation of financial statements
 Events occurring after the reporting period
 Taxes on income
 Revenue
 Provisions and contingencies
Does this mean that companies below a certain size should be exempt from other IFRS? An
alternative approach would be to reduce the exposure of small companies to IFRS on a standard
by standard basis. For those 'core' standards listed above, small companies would be required
to follow all or most of their provisions. For more complicated standards, small companies
would face nothing but very brief general obligations.
It is difficult to see how the IASB could impose any kind of specific size limits to define small
companies if such an approach were adopted. Instead, it might specify that size limits which are
already given in national legislation or standards could be adopted for the purpose.
Cost of compliance
If the cost of compliance exceeds the benefits to users, an entity may decide not to follow an
IFRS. This applies to all reporting entities, not just smaller ones. However, smaller entities are
more likely to make use of this exception.
For example, impairment reviews can be time consuming and a smaller entity may not have
sufficient staff to spare to carry out these reviews.

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Materiality
Another point to note is that IFRSs apply to material items. In the case of smaller entities, the
amount that is material may be very small in monetary terms. However, the effect of not
reporting that item may be material in that it would mislead users of the financial statements. A
case in point is IAS 24, Related Party Disclosures. Smaller entities may well rely on trade with
relatives of the directors/shareholders and this needs to be disclosed.
3.1.3 International Financial Reporting Standard for Small and Medium-sized Entities
The IFRS for Small and Medium-Sized Entities (IFRS for SMEs) was published in 2009 and revised
in 2015. It is only 230 pages, and has simplifications that reflect the needs of users of SMEs'
financial statements and cost-benefit considerations.
It is designed to facilitate financial reporting by SMEs in a number of ways.
 It provides significantly less guidance than full IFRS.
 Many of the principles for recognising and measuring assets, liabilities, income and
expenses in full IFRS are simplified.
 Where full IFRS allows accounting policy choices, the IFRS for SMEs allows only the easier
option.
 Topics not relevant to SMEs are omitted.
 Significantly fewer disclosures are required.
 The standard has been written in clear language that can easily be translated.
Scope
The IFRS is suitable for all entities except those whose securities are publicly traded and financial
institutions such as banks and insurance companies. It is the first set of international accounting
requirements developed specifically for SMEs. Although it has been prepared on a similar basis
to full IFRS, it is a standalone product and will be updated on its own timescale.
There are no quantitative thresholds for qualification as an SME; instead, the scope of the IFRS is
determined by a test of public accountability. As with full IFRS, it is up to legislative and
regulatory authorities and standard setters in individual jurisdictions to decide who is permitted
or required to use the IFRS for SMEs.
Effective date
The IFRS for SMEs does not contain an effective date; this is determined in each jurisdiction. The
IFRS will be revised only once every three years. It is hoped that this will further reduce the
reporting burden for SMEs.
Accounting policies
For situations where the IFRS for SMEs does not provide specific guidance, it provides a
hierarchy for determining a suitable accounting policy. An SME must consider, in descending
order:
 The guidance in the IFRS for SMEs on similar and related issues
 The definitions, recognition criteria and measurement concepts in section 2 Concepts and
Pervasive Principles of the standard
The entity also has the option of considering the requirements and guidance in full IFRS dealing
with similar topics. However, it is under no obligation to do this, or to consider the
pronouncements of other standard setters.

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Overlap with full IFRS

In the following areas, the recognition and measurement guidance in the IFRS for SMEs is like
that in the full IFRS.
 Provisions and contingencies
 Hyperinflation accounting
 Events after the end of the reporting period
 Taxation
 Property, plant and equipment
Omitted topics
The IFRS for SMEs does not address the following topics that are covered in full IFRS.
C
 Earnings per share H
 Interim financial reporting A
 Segment reporting P
T
 Classification for non-current assets (or disposal groups) as held for sale E
R
Examples of options in full IFRS not included in the IFRS for SMEs
2
 Revaluation model for intangible assets and property, plant and equipment
 Financial instrument options, including available-for-sale, held-to-maturity and fair value
options
 Choice between cost and fair value models for investment property (measurement depends
on the circumstances)
 Options for government grants
Principal recognition and measurement simplifications

(a) Financial instruments
Financial instruments meeting specified criteria are measured at cost or amortised cost. All
others are measured at fair value through profit or loss. The procedure for derecognition
has been simplified, as have hedge accounting requirements.
(b) Goodwill and other indefinite-life intangibles
These are always amortised over their estimated useful life (or 10 years if it cannot be
estimated).
(c) Investments in associates and joint ventures
These can be measured at cost, but fair value must be used if there is a published price
quotation.
(d) Research and development costs and borrowing costs must be expensed.
(e) Defined benefit plans
All actuarial gains and losses are to be recognised immediately (in profit or loss or other
comprehensive income). All past service costs are to be recognised immediately in profit or
loss. To measure the defined benefit obligation, the projected unit credit method must be
used. (Note that IAS 19 has been revised and has incorporated several of these
simplifications.)
(f) Held-for-sale assets
There is no separate held-for-sale classification; holding an asset or group of assets for sale
is an indicator of impairment.

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(g) Biological assets

SMEs are to use the cost less depreciation and impairment model unless the fair value is
readily determinable, in which case the fair value through profit or loss model is required.
(h) Equity-settled share-based payment
If observable market prices are not available to measure the fair value of the equity-settled
share-based payment, the directors' best estimate is used.
Likely effect
Because there is no supporting guidance in the IFRS for SMEs, it is likely that differences from
the full IFRS will arise, even where the principles are the same. Most of the exemptions in the
IFRS for SMEs are on grounds of cost or undue effort. However, despite the practical advantages
of a simpler reporting framework, there will be costs involved for those moving to the IFRS –
even a simplified IFRS – for the first time.
Advantages and disadvantages of the IFRS for SMEs
Advantages
 It is virtually a 'one stop shop'.
 It is structured according to topics, which should make it practical to use.
 It is written in an accessible style.
 There is considerable reduction in disclosure requirements.
 Guidance not relevant to private entities is excluded.
Disadvantages
 It does not focus on the smallest companies.
 The scope extends to 'non publicly accountable' entities. Potentially, the scope is too wide.
 The standard will be onerous for small companies.
 Further simplifications could be made. These might include the following:
– Amortisation for goodwill and intangibles
– No requirement to value intangibles separately from goodwill on a business combination
– No recognition of deferred tax
– No measurement rules for equity-settled share-based payment
– No requirement for consolidated accounts (as for EU SMEs currently)
– All leases accounted for as operating leases with enhanced disclosures
– Fair value measurement when readily determinable without undue cost or effort
3.2 SMEs in the UK
3.2.1 UK financial reporting

UK companies must produce their financial statements in line with the requirements of:
 The Companies Act 2006; and
 Accounting standards, whether IFRS or the UK Financial Reporting Standards.
(FRS 100–105)
Companies whose shares or debt are traded on a regulated securities exchange have been
required to prepare their consolidated financial statements in accordance with IFRS since 2005.
(This requirement does not apply to the separate financial statements of the parent company or
the separate financial statements of any subsidiaries, although it is permissible to use IFRS for
these as well.) From 2007 onwards this regulation also applied to companies whose share
capital or debt was traded on the London Alternative Investment Market (AIM).

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All other companies can choose whether to prepare both consolidated and separate financial
statements in accordance with UK GAAP or IFRS. However, when a company chooses to change
the basis of preparation to IFRS, it cannot subsequently change back to using UK GAAP.
3.2.2 UK GAAP
The current financial reporting framework came into effect in 2015 in the UK and Ireland. The
UK's Financial Reporting Council (FRC) has published six standards.
 FRS 100, Application of Financial Reporting Requirements which sets out the overall
reporting framework. It does not contain accounting requirements in itself but rather
provides direction as to the relevant standard(s) for an entity (whether EU-adopted IFRSs,
FRS 101, FRS 102 or FRS 105).
• FRS 101, Reduced Disclosure Framework which permits disclosure exemptions from the C
H
requirements of EU-adopted IFRSs for certain qualifying entities.
A
• FRS 102, The Financial Reporting Standard applicable in the UK and Republic of Ireland P
T
which replaced all previous FRSs, SSAPs and UITF Abstracts. The FRS was revised in 2015 E
and 2018. R
• FRS 103, Insurance Contracts which consolidates existing financial reporting requirements 2
for insurance contracts.
• FRS 104, Interim Financial Reporting which specifies the requirements (adapted from
IAS 34) for interim financial reports.
• FRS 105, The Financial Reporting Standard applicable to the Micro-entities Regime which
concerns the smallest entities.
The options available for preparing financial statements are summarised below, with a tick
indicating that that type of entity is permitted to follow the stated framework.
FRS 102 FRS 102 EU-

Section (and FRS adopted
Type FRS 105 1A 103) FRS 101 IFRS
Entities eligible for micro

    
entities regime
Entities eligible for small
   
companies regime
Entities not micro or small
and not required to apply   
EU-adopted IFRS
The most important UK standard is FRS 102, which introduces a single standard framework on
the IFRS for SMEs (see above).
3.2.3 FRSSE
The Financial Reporting Standard for Smaller Entities (FRSSE) was withdrawn in 2016. Entities
formerly or currently applying the FRSSE will need to apply one of the regimes set out above.
3.2.4 FRS 101, Reduced Disclosure Framework

FRS 101, Reduced Disclosure Framework – Disclosure Exemptions from EU-adopted IFRS for
Qualifying Entities, was published alongside FRS 100. It applies to the individual accounts of
qualifying entities, being entities which are included in publicly available consolidated accounts.
The recognition, measurement and disclosure requirements of EU-adopted IFRS are applied, but
with a reduction in the required level of disclosure.

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3.2.5 Statements of recommended practice (SORPs)

If an entity's financial statements are prepared in accordance with the FRSSE or FRS 102, SORPs
will apply in the circumstances set out in those standards.
3.2.6 FRS 102, The Financial Reporting Standard applicable in the UK and Republic of Ireland
FRS 102 introduces a single standard based on the IFRS for SMEs, replacing almost all extant
FRSs, SSAPs and UITF abstracts. Where an entity applies FRS 102 and also has insurance
contracts, FRS 103 is also applicable.
FRS 102 was amended in 2015. The main changes are:
(a) A new Section 1A Small Entities is included. This sets out the presentation and disclosure
requirements for a small entity that chooses to apply the small entities regime. However,
these entities must still apply the recognition and measurement requirements set out in the
existing sections of FRS 102.
(b) Qualifying entities may take advantage of certain disclosure exemptions from the standard.
(c) Where (rarely) an estimate of the useful economic life of goodwill and intangible assets
cannot be made, the maximum useful life allowed is increased from 5 to 10 years.
(d) Minimum requirements are set out for entities wishing to take advantage of the flexibility to
adapt statutory balance sheet and profit and loss formats set out in the new Accounting
Regulations.
(e) Where the entity has the choice of settling share-based payments in cash or shares, the
default accounting treatment has been reversed. Previously they were treated by default as
cash-settled, whereas now they will normally be accounted for as equity-settled.
(f) Reversal of any impairment of goodwill is now prohibited.
FRS 102 was revised again in March 2018. The changes related to:
 Basic financial instruments and hedging
 Pension obligations
 Small entities
 Fair value hierarchy disclosures
 Notification of shareholders
 Directors' loans – optional interim relief for small entities
 Matters arising from the 2017 triennial review
While the changes have not yet taken effect and are not examinable, it is important to be aware
that regular revision to FRS 102 is to be expected, as IFRS changes, with consequent effects on
the IFRS for SMEs, and then FRS 102, which is based on the latter.
3.2.7 Statement of compliance

Where an entity prepares its financial statements in accordance with FRS 101 or FRS 102, a
statement of compliance needs to be included in the notes.
3.2.8 Interpretation of equivalence
FRS 101 and FRS 102 permit certain exemptions from disclosures subject to equivalent
disclosures being included in the consolidated financial statements of the group to which an
entity belongs.
The Companies Act exempts, subject to certain conditions, an intermediate from the
requirement to prepare consolidated financial statements where its parent is not established
under the law of an EEA state. One of the conditions is that the group accounts are drawn up in
a manner equivalent to consolidated accounts so drawn up.
The Application Guidance to FRS 100 provides guidance on interpreting the meaning of
equivalence in both of these cases.

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3.2.9 Scope of FRS 102 vs scope of IFRS for SMEs

The IFRS for SMEs applies to SMEs that do not have public accountability and publish general
purpose financial statements. In contrast, the scope of FRS 102 is as set out in the table above.
FRS 102:
[…] is a single financial reporting standard that applies to the financial statements of entities
that are not applying EU-adopted IFRS, FRS 101 or the FRSSE … [It] aims to provide entities
with succinct financial reporting requirements. The requirements in the FRS are based on
the IASB's IFRS for SMEs issued in 2009. The IFRS for SMEs is intended to apply to the
general purpose financial statements of, and other financial reporting by, entities that in
many countries are referred to by a variety of terms including 'small and medium-sized',
'private' and 'non-publicly accountable'.
C
The IFRS for SMEs is a simplification of the principles in IFRS for recognising and measuring H
assets, liabilities, income and expenses; in most cases it includes only the simpler A
P
accounting treatment where IFRS permits accounting options, it contains fewer disclosures
T
and is drafted more succinctly than IFRS. While respondents to FRED 44 welcomed E
simplification, many did not support the removal of accounting options where those R
options were permitted in extant FRS. As a consequence, the ASB amended the IFRS for
2
SMEs to include accounting options in current FRS and permitted by IFRS, but not included
in the IFRS for SMEs. (FRS 102 Summary)
Listed UK groups are required to prepare their consolidated financial statements in accordance
with the IFRS. FRS 102 may be applied by any other entity or group, including parent and
subsidiary companies within a listed group. A company applying FRS 102 is reporting under the
Companies Act. FRS 102 can also be used by entities that are not companies and therefore not
subject to company law.
Qualifying entities may take advantage of certain disclosure exemptions within the standard. A
qualifying entity for this purpose is a member of a group where the parent of that group
prepares publicly available consolidated financial statements intended to give a true and fair
view of the position and performance of the group and that member is included in the
consolidation.
The key exemptions (not to be confused with the exemptions available under FRS 101) are:
 preparation of a statement of cash flows;
 certain financial instrument disclosures;
 certain share-based payment disclosures;
 disclosure of key management personnel compensation; and
 reconciliation of shares outstanding in the period.
Entities that are required to disclose earnings per share or segment information in their financial
statements should also apply IAS 33, Earnings per Share and/or IFRS 8, Operating Segments.
FRS 102 is effective for accounting periods beginning on or after 1 January 2015. It is also
applicable to public benefit entities.
3.2.10 Statutory 'true and fair override'

The Companies Act 2006 (CA 2006) requires that where compliance with its accounting rules
would not lead to a true and fair view, those rules should be departed from to the extent
necessary to give a true and fair view.
Where the override of the statutory accounting requirements is invoked eg, to comply with an
accounting standard, the Act requires disclosure of the particulars of the departure, the reason
for it and the financial effect.
The CA 2006 also states that where compliance with its disclosure requirements is insufficient to
give a true and fair view, additional information should be disclosed such that a true and fair
view is provided.

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This statutory true and fair override replaces paragraph 3.7 of the IFRS for SMEs, which deals
with: "the extremely rare circumstances when management concludes that compliance with a
requirement in this IFRS would be so misleading that it would conflict with the objective of
financial statements of SMEs set out in section 2 of the IFRS".
3.2.11 FRS 104 Interim Financial Reporting

FRS 104 Interim Financial Reporting was issued in March 2015 and is effective for accounting
periods beginning on or after 1 January 2015. The Standard is based on IAS 34, Interim Financial
Reporting (see Chapter 10) with some amendments. It is intended for use in the preparation of
interim financial reports for entities applying FRS 102, but may also be used as a basis for
preparing interim reports by those entities applying FRS 101, Reduced Disclosure Framework. It
replaces the existing Accounting Standards Board (ASB) Statement Half-yearly financial reports,
issued in 2007.
FRS 104 specifies the minimum components for an interim financial report. These are as follows:
(a) A condensed statement of financial position.
(b) Either a single condensed statement of comprehensive income or a separate condensed
statement of comprehensive income and a separate condensed income statement. The
selection must be consistent with the latest annual financial statements.
(c) A condensed statement of changes in equity.
(d) A condensed statement of cash flows (unless the entity will not be presenting a statement of
cash flows in its next annual financial statements).
(e) Selected explanatory notes.
If a complete set of financial statements is published in the interim report, those financial
statements should be in full compliance with FRS 102. If the condensed financial statements are
published, they should include, as a minimum, each of the headings and sub-totals included in
the most recent annual financial statements and the explanatory notes required by FRS 104.
3.2.12 FRS 105, The Financial Reporting Standard Applicable to the Micro-entities Regime
FRS 105, The Financial Reporting Standard Applicable to the Micro-entities Regime is a new
accounting standard applicable to the smallest entities. It was published in July 2015 and is
effective for accounting periods beginning on or after 1 January 2016.
Key features of the standard are as follows:
(a) A single accounting standard for use by companies qualifying as micro-entities and
choosing to apply the micro-entities regime.
(b) Based on FRS 102 with significant simplifications to reflect the nature and size of micro-
entities.
(c) Comprises 28 sections, each dealing with a specific area of accounting.
(d) Micro-entities must prepare a balance sheet and profit and loss account.
(e) Other primary statements are not required.
(f) Only limited disclosures needed.
(g) Accounts prepared in accordance with the regulations are presumed by law to give a true
and fair view.
(h) No deferred tax or equity-settled share-based payment amounts are recognised.
(i) Accounting choices set out in FRS 102 are removed. No capitalisation of borrowing costs or
development costs.
(j) All assets are measured based on historical cost, with no fair value measurement normally
allowed.

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3.3 Auditing smaller entities

At this point, it is useful to look at small and medium enterprises from an audit perspective.
3.3.1 Small company audit exemption

As we have seen in Chapter 1 the audit exemption limit has been revised. The exemption limit is
based on the criteria for a small company in accordance with CA 2006. To qualify as a small
company a company must satisfy at least two of the following:
C
3.3.2 Benefits of SME audit exemptions H
A
Exemptions for SMEs from the requirement to be audited were granted in the UK partly on the P
grounds that audit is an administrative burden. This view has been challenged in an Information T
Paper published by Accountancy Europe in February 2018, entitled Rediscovering the Value of E
R
SME Audit. The Information Paper deals with recent developments in Sweden and Denmark.
2
Sweden abolished the audit requirement for SMEs in 2010, but the Swedish National Audit
Office questioned the value of this abolition in a 2017 report: Abolition of Audit Obligation for
Small Limited Companies – A Reform where Costs Outweigh Benefits. Contrary to expectations,
the abolition of the requirement did not enhance growth or save costs. Furthermore, the move
had certain disadvantages: transparency was reduced, the financial statements were prone to
errors and the risk of economic crime, including tax evasion, increased as did the risk of business
insolvency.
Based on these findings, the Swedish National Audit Office recommended reintroducing the
requirement for SMEs to be audited. This has had implications for Denmark. While the
exemption threshold was raised in 2006, 2010 and 2013, this approach is being questioned in
the light of the Swedish findings, and the Danish Ministry of Business will now carry out a study
into the consequences.
The report concludes by acknowledging that Sweden and Denmark have taken a pragmatic,
fact-based approach to this issue, and recommending that this is rolled out at a European level.
3.3.3 International standards on auditing for small companies

Unlike the IFRSs, there are no separate auditing standards applying specifically to smaller entities.
This is based on the view that 'an audit is an audit' and that users who receive auditors' reports need
to have confidence in the auditor's opinions, whether they are in relation to large or small entity
However, there is an acknowledgement that small and medium enterprises do pose specific
challenges to the auditor in certain areas. Some of the ISAs that you have already studied
highlight how their requirements should be applied to small company audits.
3.3.4 ISA (UK) 210 (Revised June 2016), Agreeing the Terms of Audit Engagements
The owner of a small company may not be aware of directors' and auditors' responsibilities,
particularly if the accounts preparation is outsourced. A primary purpose of the engagement
letter is to clarify these responsibilities. ISA 210.A21 states that it may be useful in this situation
to remind management that the preparation of the financial statements remains their
responsibility.

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3.3.5 ISA (UK) 220 (Revised June 2016), Quality Control for an Audit of Financial Statements
The audit of a smaller entity must still be compliant with ISAs. Most of these audits are
conducted using one audit partner, one manager and one audit senior so, although assignment
and delegation are taking place, it may be difficult to form an objective view on the judgements
made in the audit.
The standard (ISA 220.A29) points out that firms must set their own criteria to identify which
audits require a quality review (in addition to audits of listed entities, where such reviews are
mandatory). In some cases, none of the firm's audit engagements may meet the criteria that
would subject them to such a review.
3.3.6 ISA (UK) 230 (Revised June 2016), Audit Documentation

A small audit team may have an excellent understanding of the audit client, but it is important to
ensure that working papers meet the standard required by the ISA and to prepare audit
documentation that can be understood by an experienced auditor, as the documentation may
be subject to review by external parties for regulatory or other purposes.
The standard (ISA 230.A16–.A17) does allow for the following:
(a) The documentation being less extensive than for the audit of a larger entity
(b) Where the engagement partner performs all the audit work, matters that are normally
documented solely to instruct or inform members of the team, or to provide evidence of
review, will not be included
(c) Various aspects of the audit may be recorded together in a single document
Point to note:
Practice Note 26 (revised) Guidance on Smaller Entity Documentation provides guidance on how
the ISA requirements can be applied to smaller entities.
3.3.7 ISA (UK) 240 (Revised June 2016), The Auditor's Responsibilities Relating to Fraud in an
Audit of Financial Statements
Within small companies, the lack of control procedures can contribute to a higher risk of
employee fraud and error. On the other hand, a smaller entity may not have a written code of
conduct but may have developed a culture of integrity and ethical behaviour through oral
communication and management example.
The presence of a dominant owner-manager can be an important factor in the overall control
environment, with the need for management authorisation compensating for the lack of other
controls. However, this can be a potential deficiency in internal control, due to the opportunity
for management to override controls.
ISA 240 requires discussion among the audit team of the susceptibility of the entity to material
frauds or errors. This discussion is still required for a small entity but is often overlooked due to
the size of the audit team.
In addition, ISA 240 requires auditors to ask management about their assessment of risk of fraud
and error. Even if management do not have a system of assessing risk, the enquiry should still be
made, as it provides valuable information about the control environment, although in smaller
entities management's assessment may only focus on the risks of employee fraud or
misappropriation of assets. (ISA 240.A13)
3.3.8 ISA (UK) 300 (Revised June 2016), Planning an Audit of Financial Statements
Due to the lack of complexity, audit planning documentation may be scaled back for a small
entity. With a smaller team, co-ordination and communication are easier. A planning meeting or
general conversation may be sufficient, and notes made about future issues during last year's
audit will be particularly useful.

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Standard audit programmes or checklists may be used, provided that they are tailored to the
circumstances of the engagement, including the auditor's risk assessments.
In the smallest audits, carried out entirely by the audit partner, questions of direction, supervision
and review do not arise. Forming an objective view on the appropriateness of judgements made in
the course of the audit can present problems in this case and, if particularly complex or unusual
issues are involved, it may be desirable to consult with other suitably experienced auditors or the
auditor's professional body. (ISA 300.A11, .A15 & .A19)
3.3.9 ISA (UK) 320 (Revised June 2016), Materiality in Planning and Performing an Audit
The standard highlights that in an owner-managed business the profit before tax for the year
may be consistently nominal, as the owner may take most of the profits as remuneration, so it
may be more appropriate to use profit before remuneration as the basis for estimating C
H
materiality. (ISA 320.A8)
A
Another practical issue is that at the planning stage it is often difficult to calculate materiality as a P
T
percentage of key figures eg, of assets, revenue or profit, as the draft accounts may be E
unavailable for a small business. Trial balance figures may have to be used instead. R
The auditor will need to use judgement in applying materiality when evaluating results. 2
3.3.10 ISA (UK) 550, Related Parties

In a small entity, related party transactions between the company and its directors and their
families may be significant but smaller entities may have no documented processes or controls
for dealing with related party relationships and transactions. The auditor will have to obtain an
understanding of the related party relationships and transactions through enquiry of
management and observation of management's oversight and review activities. (ISA 550.A20)
The auditor's in-depth knowledge of the smaller entity will assist in identification of related
parties (for example, other entities controlled by the owner management) which will also help
the auditor to assess the risk of any transactions being unrecorded or undisclosed.
3.3.11 ISA (UK) 570 (Revised June 2016), Going Concern

The size of an entity may affect its ability to withstand adverse conditions. Small entities may be
able to respond quickly to exploit opportunities, but may lack reserves to sustain operations.
Risks of particular relevance to small entities are:
 that banks and other lenders may cease to support the entity; and
 the possible loss of a principal supplier, major customer or key employee, or of the right to
operate under a licence, franchise or other legal agreement. (ISA 570.A5–.A6)
It is unlikely that budgets and forecasts will be available for the auditor to review. In many
businesses the principal source of finance may be a loan from the owner-manager.
If an entity is in difficulty, its survival may depend on the owner-manager subordinating his loan
in favour of banks or other financial institutions. In this case, the auditor would inspect sufficient,
appropriate evidence of the subordination.
If an entity depends on funds from the owner-manager, the auditor will consider their current
financial position and may ask for a written representation to confirm the owner-manager's
understanding. (ISA 570.A13)

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Section overview
 IFRS 13, Fair Value Measurement gives extensive guidance on how the fair value of assets
and liabilities should be established.
 IFRS 13 aims to:
– define fair value
– set out in a single IFRS a framework for measuring fair value
– require disclosures about fair value measurements
 IFRS 13 defines fair value as "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".
 Fair value is a market-based measurement, not an entity-specific measurement. It focuses
on assets and liabilities and on exit (selling) prices. It also takes into account market
conditions at the measurement date.
 IFRS 13 states that valuation techniques must be those which are appropriate and for
which sufficient data are available. Entities should maximise the use of relevant observable
inputs and minimise the use of unobservable inputs.
4.1 Background
In May 2011, the IASB published IFRS 13, Fair Value Measurement. The project arose as a result
of the Memorandum of Understanding between the IASB and FASB (2006) reaffirming their
commitment to the convergence of IFRS and US GAAP. With the publication of IFRS 13, IFRS and
US GAAP now have the same definition of fair value and the measurement and disclosure
requirements are now aligned. A standard on fair value measurement is particularly important in
the context of a worldwide move towards IFRS.
4.2 Objective
IFRS 13 aims to:
 define fair value
 set out in a single IFRS a framework for measuring fair value
 require disclosures about fair value measurements
Definition
Fair value: "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." (IFRS 13)
The previous definition used in IFRS was "the amount for which an asset could be exchanged, or
a liability settled, between knowledgeable, willing parties in an arm's length transaction".
The price which would be received to sell the asset or paid to transfer (not settle) the liability is
described as the 'exit price' and this is the definition used in US GAAP. Although the concept of
the 'arm's length transaction' has now gone, the market-based current exit price retains the
notion of an exchange between unrelated, knowledgeable and willing parties.

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4.3 Scope
IFRS 13 applies when another IFRS requires or permits fair value measurements or disclosures.
The measurement and disclosure requirements do not apply in the case of:
(a) share-based payment transactions within the scope of IFRS 2, Share-based Payment;
(b) leasing transactions within the scope of IAS 17, Leases; and
(c) net realisable value as in IAS 2, Inventories or value in use as in IAS 36, Impairment of Assets.
Disclosures are not required for:
(a) plan assets measured at fair value in accordance with IAS 19, Employee Benefits;
(b) plan investments measured at fair value in accordance with IAS 26, Accounting and
Reporting by Retirement Benefit Plans; and C
H
(c) assets for which the recoverable amount is fair value less disposal costs under IAS 36, A
Impairment of Assets. P
T
E
4.4 Measurement R
Fair value is a market-based measurement, not an entity-specific measurement. It focuses on 2

assets and liabilities and on exit (selling) prices. It also takes into account market conditions at
the measurement date. In other words, it looks at the amount for which the holder of an asset
could sell it and the amount which the holder of a liability would have to pay to transfer it. It can
also be used to value an entity's own equity instruments.
Because it is a market-based measurement, fair value is measured using the assumptions that
market participants would use when pricing the asset, taking into account any relevant
characteristics of the asset.
It is assumed that the transaction to sell the asset or transfer the liability takes place either:
(a) in the principal market for the asset or liability; or
(b) in the absence of a principal market, in the most advantageous market for the asset or
liability.
The principal market is the market which is the most liquid (has the greatest volume and level of
activity) for that asset or liability. In most cases the principal market and the most advantageous
market will be the same.
IFRS 13 acknowledges that when market activity declines, an entity must use a valuation
technique to measure fair value. In this case the emphasis must be on whether a transaction
price is based on an orderly transaction, rather than a forced sale.
Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a feature of the
asset or liability, but may be taken into account when determining the most advantageous
market.
Fair value measurements are based on an asset or a liability's unit of account, which is specified
by each IFRS where a fair value measurement is required. For most assets and liabilities, the unit
of account is the individual asset or liability, but in some instances may be a group of assets or
liabilities.
Worked example: Unit of account

A premium or discount on a large holding of the same shares (because the market's normal
daily trading volume is not sufficient to absorb the quantity held by the entity) is not considered
when measuring fair value: the quoted price per share in an active market is used.

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However, a control premium is considered when measuring the fair value of a controlling
interest, because the unit of account is the controlling interest. Similarly, any non-controlling
interest discount is considered where measuring a non-controlling interest.
Worked example: Principal (or most advantageous) market

An asset is sold in two active markets, Market X and Market Y, at £58 and £57 respectively.
Valor Co does business in both markets and can access the price in those markets for the asset
at the measurement date as follows.
Market X Market Y
£ £
Price 58 57
Transaction costs (4) (3)
Transport costs (to transport the asset to that market) (4) (2)
50 52
Remember that fair value is not adjusted for transaction costs. Under IFRS 13, these are not a
feature of the asset or liability, but may be taken into account when determining the most
advantageous market.
If Market X is the principal market for the asset (ie, the market with the greatest volume and level
of activity for the asset), the fair value of the asset would be £54, measured as the price that
would be received in that market (£58) less transport costs (£4) and ignoring transaction costs.
If neither Market X nor Market Y is the principal market for the asset, Valor must measure the fair
value of the asset using the price in the most advantageous market. The most advantageous
market is the market that maximises the amount that would be received to sell the asset, after
taking into account both transaction costs and transport costs (ie, the net amount that would be
received in the respective markets).
The maximum net amount (after deducting both transaction and transport costs) is obtainable in
Market Y (£52, as opposed to £50). But this is not the fair value of the asset. The fair value of the
asset is obtained by deducting transport costs but not transaction costs from the price received
for the asset in Market Y: £57 less £2 = £55.
4.4.1 Non-financial assets

For non-financial assets the fair value measurement looks at the use to which the asset can be
put. It takes into account the ability of a market participant to generate economic benefits by
using the asset in its highest and best use.
4.5 Valuation techniques

IFRS 13 states that valuation techniques must be those which are appropriate and for which
sufficient data are available. Entities should maximise the use of relevant observable inputs and
minimise the use of unobservable inputs.
The standard establishes a three-level hierarchy for the inputs that valuation techniques use to
measure fair value:
Level 1 Quoted prices (unadjusted) in active markets for identical assets or liabilities that the
reporting entity can access at the measurement date.
Level 2 Inputs other than quoted prices included within Level 1 that are observable for the
asset or liability, either directly or indirectly eg, quoted prices for similar assets in active
markets or for identical or similar assets in non-active markets or use of quoted interest
rates for valuation purposes.

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Level 3 Unobservable inputs for the asset or liability ie, using the entity's own assumptions
about market exit value.
4.5.1 Valuation approaches
The IFRS identifies three valuation approaches.
(1) Income approach. Valuation techniques that convert future amounts (eg, cash flows or
income and expenses) to a single current (ie, discounted) amount. The fair value
measurement is determined on the basis of the value indicated by current market
expectations about those future amounts.
(2) Market approach. A valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable (ie, similar) assets,
liabilities or a group of assets and liabilities, such as a business. C
H
(3) Cost approach. A valuation technique that reflects the amount that would be required A
currently to replace the service capacity of an asset (often referred to as current P
T
replacement cost). E
R
Entities may use more than one valuation technique to measure fair value in a given situation. A
change of valuation technique is considered to be a change of accounting estimate in 2
accordance with IAS 8, and must be disclosed in the financial statements.
4.5.2 Examples of inputs used to measure fair value
Asset or liability Input

Level 1 Equity shares in a listed Unadjusted quoted prices in an active market
company
Level 2 Licensing arrangement Royalty rate in the contract with the unrelated party at
arising from a business inception of the arrangement
combination
Cash generating unit Valuation multiple (eg, a multiple of earnings or revenue
or a similar performance measure) derived from
observable market data eg, from prices in observed
transactions involving comparable businesses
Finished goods inventory Price to customers adjusted for differences between the
at a retail outlet condition and location of the inventory item and the
comparable (ie, similar) inventory items
Building held and used Price per square metre derived from observable market
data eg, prices in observed transactions involving
comparable buildings in similar locations
Level 3 Cash generating unit Financial forecast (eg, of cash flows or profit or loss)
developed using the entity's own data
Three-year option on Historical volatility ie, the volatility for the shares derived
exchange-traded shares from the shares' historical prices
Interest rate swap Adjustment to a mid-market consensus (non-binding)
price for the swap developed using data not directly
observable or otherwise corroborated by observable
market data
4.6 Measuring liabilities

Fair value measurement of a liability assumes that the liability is transferred at the measurement
date to a market participant, who is then obliged to fulfil the obligation. The obligation is not
settled or otherwise extinguished on the measurement date.

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4.6.1 Entity's own credit risk

The fair value of a liability reflects the effect of non-performance risk, which includes but is not limited
to the entity's own credit risk. This may be different for different types of liability.
Worked example: Entity's own credit risk

Black Co and Blue Co both enter into a legal obligation to pay £20,000 cash to Green Co in
seven years.
Black Co has a top credit rating and can borrow at 4%. Blue Co's credit rating is lower and can
borrow at 8%.
Black Co will receive approximately £15,200 in exchange for its promise. This is the present
value of £20,000 in seven years at 4%.
Blue Co will receive approximately £11,700 in exchange for its promise. This is the present value
of £20,000 in seven years at 8%.
4.7 IFRS 13 and business combinations

Fair value generally applies on a business combination. This topic is covered in Chapter 20,
together with some further examples.
4.8 Disclosure
An entity must disclose information that helps users of its financial statements assess both of the
following:
(a) For assets and liabilities that are measured at fair value on a recurring or non-recurring
basis, the valuation techniques and inputs used to develop those measurements
(b) For recurring fair value measurements using significant unobservable inputs (Level 3), the
effect of the measurements on profit or loss or other comprehensive income for the period.
Disclosure requirements will include:
(i) reconciliation from opening to closing balances
(ii) quantitative information regarding the inputs used
(iii) valuation processes used by the entity
(iv) sensitivity to changes in inputs
4.9 Was the fair value project necessary?

The IASB is already considering the matter of the measurement basis for assets and liabilities in
financial reporting as part of its Conceptual Framework project. It could therefore be argued that
it was not necessary to have a separate project on fair value. The Conceptual Framework might
have been the more appropriate forum for discussing when fair value should be used as well as
how to define and measure it.
However, it has been argued that a concise definition and clear measurement framework is
needed because there is so much inconsistency in this area, and this may form the basis for
discussions in the Conceptual Framework project.
The IASB has also pointed out that the global financial crisis has highlighted the need for:
 clarifying how to measure fair value when the market for an asset becomes less active; and
 improving the transparency of fair value measurements through disclosures about
measurement uncertainty.

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4.9.1 Advantages and disadvantages of fair value (versus historical cost)
Fair value
Advantages Disadvantages
 Relevant to users' decisions  Subjective (not reliable)
 Consistency between companies
 Hard to calculate if no active market
 Predicts future cash flows
 Time and cost C
H
 Lack of practical
A
experience/familiarity P
T
 Less useful for ratio analysis (bias) E
R
 Misleading in a volatile market
2
Historical cost
Advantages Disadvantages
 Reliable  Less relevant to users' decisions
 Less open to manipulation
 Need for additional measure of
 Quick and easy to ascertain
recoverable amounts (impairment test)
 Matching (cost and revenue)
 Practical experience and familiarity  Does not predict future cash flows
Figure 2.4: Advantages and disadvantages of fair value versus historical cost
5 IAS 8, Accounting Policies, Changes in Accounting

Estimates and Errors
Section overview
This is an overview of material covered in earlier studies.
5.1 Fair accounting policies

(a) Accounting policies are determined by applying the relevant IFRS or IFRIC and considering
any relevant Implementation Guidance issued by the IASB for that IFRS/IFRIC.
(b) Where there is no applicable IFRS or IFRIC management should use its judgement in
developing and applying an accounting policy that results in information that is relevant
and reliable. Management should refer to:
(1) the requirements and guidance in IFRSs and IFRICs dealing with similar and related
issues; and
(2) the definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the Framework.
Management may also consider the most recent pronouncements of other standard-setting
bodies that use a similar conceptual framework to develop standards, other accounting
literature and accepted industry practices if these do not conflict with the sources above.

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(c) An entity shall 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 shall
be selected and applied consistently to each category.
5.2 Changes in accounting policies

(a) These are rare: only if required by statute/standard-setting body/results in reliable and
more relevant information.
(b) Adoption of new IFRS: follow transitional provisions of IFRS. If no transitional provisions:
retrospective application.
(c) Other changes in policy: retrospective application. Adjust opening balance of each
affected component of equity ie, as if new policy has always been applied.
(d) Prospective application: this is not allowed unless it is impracticable to determine the
cumulative effect of the change.
(e) Disclosure: an entity should disclose information relevant to assessing the impact of new
IFRSs/IFRICs on the financial statements where these have been issued but have not yet
come into force.
5.3 Changes in accounting estimates

 Estimates arise because of uncertainties inherent within them; judgement is required but
this does not undermine reliability.
 Effect of a change in accounting estimate should be included in profit or loss in:
– period of change, if change affects only current period; or
– period of change and future periods, if change affects both.
5.4 Errors
(a) Prior period errors: correct retrospectively where material.
(b) This involves:
(i) either restating the comparative amounts for the prior period(s) in which the error
occurred; or
(ii) 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.
(c) Only where it is impracticable to determine the cumulative effect of an error on prior
periods can an entity correct an error prospectively.
Interactive question 2: Accounting errors

During 20X7 Lubi Co discovered that certain items had been included in inventory at
31 December 20X6, valued at £4.2 million, which had in fact been sold before the year end. The
following figures for 20X6 (as reported) and 20X7 (draft) are available.
20X6 20X7 (draft)
£'000 £'000
Sales 47,400 67,200
Cost of goods sold (34,570) (55,800)
Profit before taxation 12,830 11,400
Income taxes (3,880) (3,400)

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Net profit 8,950 8,000
Retained earnings at 1 January 20X6 were £13 million. The cost of goods sold for 20X7 includes
the £4.2 million error in opening inventory. The income tax rate was 30% for 20X6 and 20X7.
Requirement
Show the profit or loss section of the statement of profit or loss and other comprehensive
income for 20X7, with the 20X6 comparative, and retained earnings.
5.5 Possible developments C

H
IAS 8 has been relatively uncontroversial and has not been amended since 2005. However, the
A
IASB is currently engaged in three projects relating to IAS 8: P
T
(a) Accounting Policy Changes – proposed amendments to IAS 8 E
R
This project addresses the issue of changes in accounting policy made by reporting entities
as a result of agenda decisions issued by the IFRS Interpretations Committee. As agenda 2
decisions are not mandatory, such a change in policy is voluntary and so IAS 8 requires it to
be applied retrospectively. In order not to discourage accounting policy changes in these
circumstances, the proposed amendments would allow relief from full retrospective
application if the costs of determining the effects of the change in policy exceed the
expected benefits of applying it retrospectively.
(b) Accounting Policies and Accounting Estimates – proposed amendments to IAS 8
This project was the result of inconsistency in practice in the way in which entities
distinguish between accounting policies and accounting estimates. As a result the IASB is
proposing to amend the definition of accounting policies within IAS 8 and add a definition
of accounting estimates.
The proposed definition of accounting policies is "the specific principles, measurement
bases and practices applied by an entity in preparing and presenting financial statements".
This definition is more concise than the existing definition and more consistent with the
wording used in other standards.
The proposed definition of accounting estimates is 'judgements or assumptions used in
applying an accounting policy when, because of estimation uncertainty, an item in financial
statements cannot be measured with precision.'
(c) Definition of Material – proposed amendments to IAS 1 and IAS 8
The IASB is proposing to align the definitions of material in IAS 1 and IAS 8. In due course
this definition will be extended to the Materiality Practice Statement (see below) and the
new Conceptual Framework.
You do not need to know these in detail, just to have an overall awareness as a current
issue.

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6 Current issues in corporate reporting
Section overview
This section covers several areas in which the IASB is developing new accounting standards.
Recent changes are ripe for examination if they are the subject of a full IFRS. While proposed
changes (EDs, Discussion Papers) will not be examined in detail, it is important to show an
awareness of them.
Tutorial note
Current issues are covered in this Study Manual within the chapters in which the topic appears,
so that the changes/proposed changes appear in context.
6.1 Leasing
The IASB issued IFRS 16, Leases in January 2016. The standard replaces IAS 17 with effect from
1 January 2019. The new standard adopts a single accounting model applicable to all leases by
lessees, thereby, for lessees, abolishing the distinction between operating and finance leases
and bringing all leases into the statement of financial position. This is covered as a current issue
in Chapter 14.
6.2 Revenue
The IASB worked for several years on a new standard on revenue to replace IAS 18, Revenue
and IAS 11, Construction Contracts, which were felt to be unsatisfactory. In 2014 it published
IFRS 15, Revenue from Contracts with Customers, which is covered in Chapter 10.
6.3 Financial instruments

IFRS 9, Financial Instruments, issued in 2009 and reissued in 2014, has replaced IAS 39. This
standard is covered in Chapter 16.
6.4 Insurance
IAS 4, Insurance Contracts was issued in 2004. It was always intended to be an interim solution
permitting the continued use of most pre-existing national reporting frameworks, whilst seeking
to prevent certain undesirable practices. Insurance companies reporting under IFRS 4 were able
to adopt widely divergent practices making comparison between insurers difficult, particularly
when across different jurisdictions. Although it addresses most of the key matters to accounting
for insurance, there is significant latitude permitted in relation to a number of key issues,
especially the issue of discounting provisions.
The US has a number of standards and guidance on accounting for insurance. FASB and the
IASB agreed in 2008 to collaborate on developing a new insurance standard, however the two
bodies subsequently decided to go their separate ways in the development of a comprehensive
framework for accounting for insurance contracts issued by an entity.
The IASB project to develop a comprehensive framework for insurance contracts culminated in
the publication of IFRS 17, Insurance Contracts in May 2017. IFRS 17 introduces a
comprehensive reporting framework for insurance contracts that is intended to result in
insurance companies producing financial statements which are more comparable, consistent
and transparent. IFRS 17 is covered as a current issue in Chapter 12.

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6.5 Revision of the Conceptual Framework

In March 2018 a revised Conceptual Framework was issued. The key features are summarised in
section 2.10 of this chapter.
6.6 Disclosure initiative

6.6.1 Overview
The IASB's disclosure initiative is a broad-based undertaking exploring how disclosures in IFRS
financial reporting can be improved. It is made up of a number of projects, the third of which, a
Practice Statement on materiality was completed in September 2017.
The disclosure initiative was formally begun in 2012. Subsequently IASB undertook a constituent C
survey on disclosure and held a disclosure forum designed to bring together securities H
A
regulators, auditors, investors and preparers. This led to the issue of Feedback Statement
P
Discussion Forum – Financial Reporting Disclosure in May 2013, which outlined the IASB's T
intention to consider a number of further initiatives, including short-term and research projects. E
R
The disclosure initiative is intended to complement the work being done on the Conceptual
Framework project. 2
6.6.2 Current status

Three projects, the amendments to IAS 1 and IAS 7 and a Practice Statement on materiality, are
complete. The remainder are at the ED stage or the research stage.
6.7 Practice Statement on materiality

The IASB issued Practice Statement 2: Making Materiality Judgements in September 2017. This
is a tool to aid management in using judgement to decide what information is material and what
is not; it is a non-mandatory document and does not have the status of an IFRS.
6.7.1 General characteristics of materiality

The Statement refers to the definition of materiality contained within the 2010 Conceptual
Framework:
"Information is material if omitting it or misstating it could influence decisions that users make on
the basis of financial information about a specific reporting entity. In other words, materiality is
an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to
which the information relates in the context of an individual entity's financial report."
(Conceptual Framework for Financial Reporting, para QC11)
Materiality is pervasive to the preparation of financial statements and affects recognition,
measurement, presentation and disclosure.
When considering whether information is material, a company should consider its own
circumstances and the needs of primary users of its financial statements ie, investors, lenders
and other creditors.
6.7.2 Interaction with local laws and regulations

The Practice Statement clarifies that a company's financial statements must comply with
requirements of IFRS, including those relating to materiality.
Providing additional information to meet local legal or regulatory requirements is allowed by
IFRS, even if that information is not material, provided that it does not obscure material
information.

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6.7.3 Making materiality judgements

The Practice Statement includes a four-step process that entities may find useful in making
materiality judgements:
Step 1
Identify information that has the potential to be material. This step requires consideration of IFRS
requirements and the common information needs of primary users.
Step 2
Assess whether the information identified is material. Both quantitative and qualitative factors
should be considered.
Step 3
Organise the information within the draft financial statements so that it supports clear and
concise communication.
Step 4
Review the information provided as a whole, considering whether it is material individually and
in combination with other information. At this stage information may need to be added or
removed.
6.7.4 Specific topics

Specific guidance is provided on how to make materiality judgements on prior period
information, errors, covenants and in interim reporting.
6.8 Blue Book and Red Book

Your exam is based on the 2018 'Blue Book', officially called 2018 IFRS Consolidated Without
Early Application. This contains all official pronouncements that are mandatory on 1 January 2018.
It does not include IFRSs with an effective date after 1 January 2018.
The Blue Book differs from the Red Book (officially called 2018 International Financial Reporting
Standards), which includes all pronouncements issued at the publication date, including those that
do not become mandatory until a future date. It includes standards that are effective on 1 January
2018 and in the future, but not the standards that they will replace. It is normally printed in two
volumes. (The Red Book is more appropriate for preparers of financial statements who wish to adopt
any of the standards early.)
6.9 Pointing forward to the future: approach to current issues

While the Blue Book is the basis for exam questions, an overview of current issues will be
needed in order to understand the potential problems preparers of financial statements will be
facing. Current issues, as indicated above, are dealt with within the context of the topics. For a
useful overview of what is to come, below is an extract from the IASB Work Plan, as at
October 2017.

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Project Next milestone Expected date
Accounting Policies and Accounting Decide project direction October 2018

Estimates (Amendments to IAS 8)
Accounting Policy Changes Exposure Draft feedback December 2018
(Amendments to IAS 8)
Business Combinations under Discussion Paper 2nd half 2019
Common Control
Classification of Liabilities as Current IFRS amendment October 2018
or Non-current (Amendments to
IAS 1) C
H
Financial Instruments with Discussion Paper feedback 1st half 2019 A
Characteristics of Equity P
T
Costs Considered in Assessing Exposure Draft December 2019 E
R
whether a Contract is Onerous
(Amendments to IAS 37) 2
Definition of a Business IFRS amendment October 2018

(Amendments to IFRS 3)
Disclosure Initiative — Accounting Exposure Draft Publish Research
Policies Summary
Disclosure Initiative — Definition of Exposure Draft December 2018
Material (Amendments to IAS 1 and
IAS 8)
Goodwill and impairment Discussion Paper or
Exposure Draft
Dynamic risk management Core model 1st half 2019
Improvements to IFRS 8, Operating Feedback statement December 2018
Segments (Amendments to IFRS 8
and IAS 34)
Management Commentary Exposure Draft 1st half 2019
Primary Financial Statements Discussion Paper or Exposure 1st half 2019
Draft
Share-based Payment Project Summary October 2018
Taxation in Fair Value Measurements Exposure Draft
(Amendments to IAS 41)
(Source: www.ifrs.org/projects/work-plan/)

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Summary
Financial Accounting The process of identifying,

measuring and communicating
economic information to others
ICAEW Code IASB Conceptual

Financial statements Not-for-profit entities
of Ethics Framework
Statement of financial position Regulated by:

Statement of profit or loss and other Local Legislation
comprehensive income SORPs
Statement of changes in equity IPSAS
Statement of cash flows
Notes
Purpose Underlying Qualitative Capital maintenance

Elements
and use assumption characteristics concepts
Going concern
Financial Financial
position performance
Relevance
Asset Liability Equity Income Expense
Faithful
representation
Definitions
Enhancing
characteristics
Recognition
Comparability
Measurement
Verifiability
Timeliness
Understandability

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UK GAAP
FRS 100 – sets out the Framework
IFRS UK GAAP Framework

Framework
Apply EU – Qualifying entities – Small entities

All other entities
adopted IFRS FRS 101 – with FRS 102
FRS 102 – FRSUKI
reduced disclosures Section 1A C
H
A
P
T
Smallest entities – E
FRS 104, FRS 105 R
FRS 103, Insurance
Internal Financial
Contracts applies
Reporting – for 2
to entities using
use by entities
FRS 102
applying FRS 102
UK companies must produce financial statements in accordance with the Companies Act 2006
and accounting standards, whether IFRS or UK FRS 100 to 105.
IFRS for Small and

Medium-sized Entities
Considerations in developing IFRS for Small and Medium-

a set of standards for SMEs sized Entities
IFRS 13, Fair Value

Measurement
Definition of fair value: 3-level hierarchy: Valuation

• Market participants Level 1 – quoted prices in approaches
• Orderly transaction active markets
• Market-based not Level 2 – other observable
entity-based inputs
Level 3 – unobservable
inputs
Disclosures

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Self-test
IASB Conceptual Framework
1 What are the conditions which the Conceptual Framework identifies as necessary if the
going concern basis is to be used for the preparation of financial statements?
2 According to the Conceptual Framework, what are the characteristics of information which is
faithfully represented?
IFRS for Small and Medium-sized Enterprises

3 Smerk
Smerk is a private pharmaceuticals company that meets the definition of an SME under
national legislation and wishes to comply with the IFRS for Small and Medium-sized Entities
for the year ended 31 December 20X6 (with one year of comparative data). The directors
are seeking advice on how to address the following accounting issues. The entity currently
prepares its financial statements under full IFRS.
(a) Smerk has significant amounts of capitalised development expenditure in its financial
statements, £3.2 million at 31 December 20X5 (£2.8 million at 31 December 20X4),
relating to investigation of new pharmaceutical products. The amount has continued
to rise during the current year even after the amortisation commenced relating to
some products that began commercial production.
(b) Smerk purchased a controlling interest (60%) of the shares of a quoted company in a
similar line of business, Rock, on 1 July 20X6. Smerk paid £7.7 million to acquire the
investment in Rock and the fair value of Rock's identifiable assets and liabilities has
been calculated as £9.5 million at the date of acquisition. The value on the stock
market of the non-controlling interests that Smerk did not purchase was £4.9 million.
The directors do not feel in a position to estimate reliably the useful life of the
goodwill due to the nature of the business acquired.
(c) Smerk purchased some properties for £1.7 million on 1 January 20X6 and designated
them as investment properties under the cost model. No depreciation was charged,
as a real estate agent valued the properties at £1.9 million at the year end.
Requirement
Discuss how the above transactions should be dealt with in the financial statements of
Smerk for the year ending 31 December 20X6, with reference to the IFRS for SMEs.
IFRS 13, Fair Value Measurement

4 Vitaleque
Vitaleque, a public limited company, is reviewing the fair valuation of certain assets and
liabilities in light of the introduction of IFRS 13, Fair Value Measurement.
It carries an asset that is traded in different markets and is uncertain as to which valuation to
use. The asset has to be valued at fair value under International Financial Reporting
Standards. Vitaleque currently only buys and sells the asset in the African market. The data
relating to the asset are set out below.

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Year to 30 November 20X2 North American European African

market market market
Volume of market – units 4m 2m 1m
Price £19 £16 £22
Costs of entering the market £2 £2 £3
Transaction costs £1 £2 £2
Additionally, Vitaleque had acquired an entity on 30 November 20X2 and is required to fair
value a decommissioning liability. The entity has to decommission a mine at the end of its
useful life, which is in three years' time. Vitaleque has determined that it will use a valuation
technique to measure the fair value of the liability. If Vitaleque were allowed to transfer the
liability to another market participant, then the following data would be used.
Input Amount C
Labour and material cost £2m H
Overhead 30% of labour and material cost A
P
Third-party mark-up – industry average 20% T
Annual inflation rate 5% E
Risk adjustment – uncertainty relating to cash flows 6% R
Risk-free rate of government bonds 4%
2
Entity's non-performance risk 2%
Vitaleque needs advice on how to fair value the liability.
Requirement
Discuss, with relevant computations, how Vitaleque should fair value the above asset and
liability under IFRS 13.
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors

5 Kamao
Statement of financial position extracts for the Kamao Company show the following.
31 December 20X7 31 December 20X6
£'000 £'000
Development costs 812 564
Amortisation (180) (120)
632 444
The capitalised development costs related to a single project that commenced in 20X4. It
has now been discovered that one of the criteria for capitalisation has never been met.
Requirement
According to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, by
what amount should retained earnings be adjusted to restate them as at 31 December
20X6?
6 Hookbill
The Hookbill Company was updating its inventory control system during 20X7 when it
discovered that it had, in error, included £50,000 in inventories in its statement of financial
position as at year to 31 December 20X6 relating to items that had already been sold at that
date. The 20X6 profit after tax shown in Hookbill's financial statements for the year to
31 December 20X6 was £400,000.
In the draft financial statements for the year to 31 December 20X7, before any adjustment
for the above error, the profit after tax was £500,000.
Hookbill pays tax on profits at 25%.

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Requirement
According to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, what
figures should be disclosed for profit after tax in the statement of profit or loss and other
comprehensive income of Hookbill for the year ended 31 December 20X7, for both 20X7
and the comparative year 20X6?
7 Carduus
The Carduus Company manufactures motorboats. It has invested heavily in developing a
new engine design. As a result, by 1 January 20X2 it had capitalised £72 million of
development costs, which it was amortising over 10 years on a straight-line basis from that
date.
Until 1 January 20X7, Carduus's new engine had been selling well and making substantial
profits. However, a new competitor then entered the market, such that revised estimates
were that the new engine would cease to generate any economic benefits after
31 December 20X9 and that the remaining amortisation period should be to this date on a
straight-line basis. The entry of the new competitor led to an impairment review, but no
impairment loss was identified.
Retained earnings at 31 December 20X6 were £400 million. Profit before tax and any
amortisation charges was £70 million for the year ended 31 December 20X7.
Requirement
Ignoring tax, determine the retained earnings figure for Carduus at 1 January 20X7 in the
financial statements for the year to 31 December 20X7 and the profit before tax for the year
then ended after adjusting for the change in amortisation according to IAS 8, Accounting
Policies, Changes in Accounting Estimates and Errors.
8 Aspen
The Aspen Company was drawing up its draft financial statements for the year to
31 December 20X7 and was reviewing its cut-off procedures. It discovered that it had, in
error, at the previous year end, omitted from inventories in its statement of financial position
a purchase of inventories amounting to £100,000 made on the afternoon of 31 December
20X6. The related purchase transaction and the trade payable had been correctly recorded.
The retained earnings of Aspen at 31 December 20X6 as shown in its 20X6 financial
statements were £4,000,000. In the draft financial statements for the year to 31 December
20X7, before any adjustment of the above error, the profit after tax was £800,000. Aspen
pays tax on profits at 30%.
Requirement
According to IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, what
figures should be disclosed in the financial statements of Aspen for the year ended
31 December 20X7 for profit after tax for the year and for retained earnings at
1 January 20X7?
9 Polson
The Polson Company appointed Rayner as finance director late in 20X7. One of Rayner's
initial tasks was to ensure that a thorough review was carried out of Polson's accounting
policies and their application in the preparation of Polson's consolidated financial
statements for the year ended 31 December 20X6. This review identified the following
issues in relation to the 20X6 consolidated financial statements which were approved for
publication early in 20X7.
(1) The £840,000 year-end carrying amount of a major item of plant in a wholly-owned
subsidiary comprised costs incurred up to 31 December 20X6. Depreciation was
charged from 1 January 20X7 when the item was for the first time working at normal

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capacity. The depreciation charge takes account of residual value of £50,000 on

30 September 20Y4, the end of the item's useful life. The overall construction and
installation of the item was completed on 30 September 20X6, when the item was first
in full working order. Between 1 October and 31 December 20X6 the item was running
below normal capacity as employees learnt how to operate it. The year-end carrying
amount comprises: costs incurred to 30 September 20X6 of £800,000 plus costs
incurred in October to December 20X6 of £50,000 less £10,000 sales proceeds of the
output sold in October to December.
(2) On 1 January 20X6 Polson acquired a 30% interest in The Niflumic Company for
£240,000, which it classified in its consolidated financial statements as an investment in
equity instruments under IFRS 9, Financial Instruments. Polson has representation on
Niflumic's board of directors. Niflumic's shares are dealt in on a public market and the C
year-end carrying amount of £360,000 was derived using the market price quoted on H
that date. The fair value increase of £90,000 (£360,000 – £240,000 less 25% deferred A
P
tax) was recognised in an available-for-sale reserve in equity. In its year ended
T
31 December 20X6 Niflumic earned a post-tax profit of £80,000 and paid no E
dividends. R
(3) At 31 December 20X6 the total trade receivables in a 60% owned subsidiary was 2
£360,000 according to the accounting records, while the separate list of customers'
balances totalled £430,000. The accounting records were adjusted by adding the
difference to both the carrying amount of trade receivables and revenue. It was
revealed that the difference arose from double-counting certain customers' balances
when taking the list out.
The 20X6 consolidated financial statements showed £400,000 as the carrying amount of
retained earnings at the year end. The effect of taxation is immaterial in respect of the item
of plant and the trade receivables adjustment.
Requirement
Determine the following amounts for inclusion as comparative figures in Polson's 20X7
consolidated financial statements after the adjustments required by IAS 8, Accounting
Policies, Changes in Accounting Estimates and Errors.
(a) The carrying amount of the item of plant at 31 December 20X6
(b) The increase/decrease in equity at 31 December 20X6 in respect of the investment in
Niflumic
(c) The carrying amount of retained earnings at 31 December 20X6
Now go back to the Learning outcomes in the Introduction. If you are satisfied you have

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Technical reference
Point to note:
The whole of the Conceptual Framework and Preface to International Financial Reporting
Standards is examinable. The paragraphs listed below are the key references you should be
familiar with.
1 What is financial reporting?

 Financial reporting is the provision of financial information Concept Frame (OB2)
about a reporting entity that is useful to existing and potential
investors, lenders and other creditors in making decisions
about providing resources to the entity.
 Financial statements comprise statement of financial position, IAS 1 (10)
statement of profit or loss and other comprehensive income,
statement of changes in equity, statement of cash flows and
notes.
2 Purpose and use of financial statements

 Users' core need is for information for making economic Concept Frame (OB2)
decisions
 Objective is to provide information on financial position (the Concept Frame (OB12)
entity's economic resources and the claims against it) and
about transactions and other events that change those
resources and claims
 Financial position: Concept Frame (OB13)
– Resources and claims
– Help identify entity's strengths and weaknesses
– Liquidity and solvency
 Changes in economic resources and claims: Concept Frame (OB15–16)
– Help assess prospects for future cash flows
– How well have management made efficient and effective
use of the resources
 Financial performance reflected by accrual accounting Concept Frame (OB17)
 Financial performance reflected by past cash flows Concept Frame (OB20)
3 Qualitative characteristics of useful financial information

 Two fundamental qualitative characteristics are relevance and Concept Frame (QC5)
faithful representation
 Relevance = capable of making a difference to decisions Concept Frame (QC6)
– Predictive and confirmatory values Concept Frame (QC7)
– Materiality Concept Frame (QC11)
 Faithful representation Concept Frame (QC12)
– Complete, neutral and free from error
 Four enhancing qualitative characteristics Concept Frame (QC19)
– Comparability, verifiability, timeliness and
understandability

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4 Cost constraint on useful financial reporting

 Costs (of preparing and analysing) financial information must Concept Frame (QC35)
be justified by the benefits of reporting it
5 Underlying assumption
 Going concern Concept Frame (4.1)
6 Elements of financial statements

 Asset: A resource controlled by the entity as a result of past Concept Frame (4.4)
events and from which future economic benefits are expected
to flow to the entity.
C
 Liability: A present obligation of the entity arising from past Concept Frame (4.4) H
A
events, the settlement of which is expected to lead to the P
outflow from the entity of resources embodying economic T
benefits. E
R
 Equity: The residual interest in assets less liabilities; that is, Concept Frame (4.4)
net assets. 2
 Income (comprising revenue and gains): Increases in Concept Frame (4.25, 4.29)
economic benefits in the form of asset increases/liability
decreases, other than contributions from equity.
 Expenses (including losses): Decreases in economic benefits Concept Frame (4.25, 4.33)
in the form of asset decreases/liability increases, other than
distributions to equity.
7 Recognition
 An asset or a liability should be recognised in financial Concept Frame (4.38)
statements if:
– it is probable that any future economic benefits
associated with the item will flow to or from the entity;
and
– its cost or value can be measured with reliability.
8 Measurement
 Historical cost Concept Frame (4.55)
 Current cost
 Realisable value
 Present value
9 Capital maintenance
 Financial capital: Concept Frame (4.57)
– Monetary
– Constant purchasing power
 Physical capital
10 IASB
 Objectives of IASB Preface (6)
 Scope and authority of IFRS Preface (7–16)
 Due process re IFRS development Preface (17)

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Overview
11 Future of UK GAAP
 FRS 102 is derived from the IFRS for SMEs. It is one of the new
financial reporting standards replacing old UK GAAP. It can
be used by UK unlisted groups and by listed and unlisted
individual entities.
Overview
12 IFRS for SMEs
 There are many considerations as to whether the same or a different set of IFRSs should
apply to SMEs. The IFRS for SMEs applies to companies without public accountability (rather
than using a size test).
 The IFRS for SMEs retains the core principles of 'full' IFRS, but reduces choice of accounting
treatments and introduces a number of simplifications to reduce the reporting burden on
SMEs.

 Fair value is defined as the price that would be received to sell an IFRS 13.9
asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.
 Market-based measure IFRS 13.2
 Three-level hierarchy IFRS 13.72
14 IAS 8, Accounting Policies, Changes in Accounting Estimates and

Errors
IAS 8.7–13
15 Accounting policies
IAS 8.14–31
16 Change in accounting policies
 Retrospective application is applying a new accounting policy as if that
policy had always been applied
 If impracticable to determine the period-specific effects, apply
prospectively
17 Changes in accounting estimates IAS 8.32–40
18 Prior period errors IAS 8.5, IAS 8.42 and IAS 8.49

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Question Answer
(a) Oak plc has purchased a patent for £40,000. This is an asset, albeit an intangible one.
The patent gives the company sole use of a There is a past event, control and future
particular manufacturing process which will economic benefit (through cost saving).
save £6,000 a year for the next five years.
(b) Elm plc paid John Brown £20,000 to set up This cannot be classed as an asset. Elm plc
C
a car repair shop, on condition that priority has no control over the car repair shop and it H
treatment is given to cars from the is difficult to argue that there are future A
company's fleet. economic benefits. P
T
(c) Sycamore plc provides a warranty with every This is a liability. The business has an E
R
washing machine sold. obligation to fulfil the terms of the warranty.
The liability would be recognised when the 2
warranty is issued rather than when a claim is
made.

20X6 20X7
£'000 £'000
Sales 47,400 67,200
Cost of goods sold (W1) (38,770) (51,600)
Profit before tax 8,630 15,600
Income tax (W2) (2,620) (4,660)
Profit for the year 6,010 10,940
Retained earnings
Opening retained earnings
As previously reported 13,000 21,950
Correction of prior period
error (4,200 – 1,260) – (2,940)
As restated 13,000 19,010
Closing retained earnings 19,010 29,950
WORKINGS
(1) Cost of goods sold 20X6 20X7

£'000 £'000
As stated in question 34,570 55,800
Inventory adjustment 4,200 (4,200)
38,770 51,600
(2) Income tax 20X6 20X7
£'000 £'000
As stated in question 3,880 3,400
Inventory adjustment (4,200  30%) ( (1,260) 1,260
2,620 4,660

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IASB Conceptual Framework
1 Neither the intention nor the need to liquidate or curtail materially the scale of its
operations.
2 It should be complete, neutral and free from error.
IFRS for Small and Medium-sized Enterprises
3 Smerk
(a) Development expenditure
The IFRS for SMEs requires small and medium-sized entities to expense all internal
research and development costs as incurred unless they form part of the cost of
another asset that meets the recognition criteria in the IFRS. The adjustment on
transition to the IFRS for SMEs must be made at the beginning of the comparative
period (1 January 20X5) as a prior period adjustment. Thus the expenditure of
£2.8 million on research and development should all be written off directly to retained
earnings. Any amounts incurred during 20X5 and 20X6 must be expensed in those
years' financial statements and any amortisation charged to profit or loss in those years
will need to be eliminated.
(b) Acquisition of Rock
The IFRS for SMEs requires goodwill to be recognised as an asset at its cost, being the
excess of the cost of the business combination over the acquirer's interest in the net
fair value of the identifiable assets, liabilities and contingent liabilities. Non-controlling
interests at the date of acquisition must therefore be measured at the proportionate
share of the fair value of the identifiable assets and liabilities of the subsidiary acquired
(ie, the 'partial' goodwill method).
After initial recognition the acquirer is required to amortise goodwill over its useful life
under the IFRS for SMEs. If an entity is unable to make a reliable estimate of the useful
life of goodwill, the life is presumed to be 10 years.
Goodwill will be calculated as:
£m
Consideration transferred 7.7
Non-controlling interests (at % FVNA: 9.5  40%) 3.8
Fair value of identifiable net assets at acquisition (9.5)

2.0
Amortisation (2.0/10 years  6/12) (0.1)
1.9
The amortisation of £0.1 million must be charged to profit or loss in 20X6.
(c) Investment properties
Investment properties must be held at fair value through profit or loss under the IFRS
for SMEs where their fair value can be measured without undue cost or effort, which
appears to be the case here, given that an estate agent valuation is available.
Consequently a gain of £0.2 million (£1.9m – £1.7m) will be reported in Smerk's profit
or loss for the year.

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IFRS 13, Fair Value Measurement

4 Vitaleque
(a) Fair value of asset
North American European African
Year to 30 November 20X2 market market market
Volume of market – units 4m 2m 1m
£ £ £
Price 19 16 22
Costs of entering the market ( 2) ( 2) n/a
Potential fair value 17 14 22
Transaction costs (1) ( 2) (2)
Net profit 16 12 20
C
H
Notes A
P
1 Because Vitaleque currently buys and sells the asset in the African market, the
T
costs of entering that market are not incurred and therefore not relevant. E
R
2 Fair value is not adjusted for transaction costs. Under IFRS 13, these are not a
feature of the asset or liability, but may be taken into account when determining 2
the most advantageous market.
3 The North American market is the principal market for the asset because it is the
market with the greatest volume and level of activity for the asset. If information
about the North American market is available and Vitaleque can access the
market, then Vitaleque should base its fair value on this market. Based on the
North American market, the fair value of the asset would be £17, measured as the
price that would be received in that market (£19) less costs of entering the market
(£2) and ignoring transaction costs.
4 If information about the North American market is not available, or if Vitaleque
cannot access the market, Vitaleque must measure the fair value of the asset using
the price in the most advantageous market. The most advantageous market is the
market that maximises the amount that would be received to sell the asset, after
taking into account both transaction costs and usually also costs of entry; that is,
the net amount that would be received in the respective markets. The most
advantageous market here is therefore the African market. As explained above,
costs of entry are not relevant here, and so, based on this market, the fair value
would be £22.
5 It is assumed that market participants are independent of each other,
knowledgeable, and able and willing to enter into transactions.
(b) Fair value of decommissioning liability
Because this is a business combination, Vitaleque must measure the liability at fair
value in accordance with IFRS 13, rather than using the best estimate measurement
required by IAS 37, Provisions, Contingent Liabilities and Contingent Assets. In most
cases there will be no observable market to provide pricing information. If this is the
case here, Vitaleque will use the expected present value technique to measure the fair
value of the decommissioning liability. If Vitaleque were contractually committed to
transfer its decommissioning liability to a market participant, it would conclude that a
market participant would use the inputs as follows, arriving at a fair value of
£3,215,000.

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Input Amount
£'000
Labour and material cost 2,000
Overhead: 30%  2,000 600
Third-party mark-up – industry average: 2,600  20% 520
3,120
Inflation adjusted total (5% compounded over three years): 3,120  1.053 3,612
Risk adjustment – uncertainty relating to cash flows: 3,612  6% 217
3,829
Discount at risk-free rate plus entity's non-performance risk
(4% + 2% = 6%): 3,829 ÷ 1.063 3,215
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors

5 Kamao
£444,000
Per IAS 8.42 a correction of a material error should be applied retrospectively by restating
the opening balances of assets, liabilities and equity for the earliest prior period presented.
6 Hookbill
20X7: £537,500
20X6: £362,500
20X7 20X6
£ £
Draft profit after tax 500,000 400,000
Inventory adjustment 50,000 (50,000)
Tax thereon at 25% (12,500) 12,500
Revised profit after tax 537,500 362,500
The comparative amounts for the prior period should be restated, per IAS 8.42.
Correction of opening inventory will increase profit for the current period, by the amount of
the after-tax adjustment. Conversely, the closing inventory for the previous period is
reduced, thereby reducing profit by the after-tax effect of the adjustment.
7 Carduus
Retained earnings: £400m
Profit before tax: £58.0m
The change in useful life is a change in an accounting estimate which is accounted for
prospectively (IAS 8.36). So retained earnings brought forward remain unchanged, at £400
million.
The carrying amount of development costs at 1 January 20X7 (halfway through their
previously estimated useful life) is (£72m  5/10) £36 million. Writing this off over three
years gives a charge of £12 million per annum. So the profit before tax is £70m – £12m =
£58m.
8 Aspen
Profit after tax: £730,000
Retained earnings: £4,070,000
The comparative amounts for the prior period should be restated, per IAS 8.42.
The correction of opening inventories will decrease profit for the current period, by the
after-tax value of the adjustment. Thus current period profits are £800,000 – (£100,000 
70%) = £730,000.

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The closing inventories of the previous period are increased by the same amount. So
retained earnings are £4,000,000 + (£100,000  70%) = £4,070,000.
9 Polson
(a) £776,562
(b) (£66,000)
(c) £318,562
All these matters give rise to prior period errors which require retrospective restatement of
financial statements as if the prior period error had never occurred (IAS 8.5).
(a) Recognition of cost in the carrying amount of PPE should cease when it is in the
condition capable of being operated in the manner intended, so on 30 September
20X6, and depreciation should begin on the same date (IAS 16.20 and 55). So gross C
cost should be adjusted to £800,000 (£840,000 – £50,000 + £10,000) and H
A
depreciation, taking into account overall useful life and residual value, charged for P
3 months, so £23,438 ((£800,000 – £50,000)  1/8  25%). The restated carrying T
amount is £776,562 (£800,000 – £23,438). E
R
(b) The investment in The Niflumic Company is an associate and should be accounted for
2
according to IAS 28, not IFRS 9.
The value of the investment will therefore increase by 30% of Niflumic's post-tax profit
rather than according to fair values.
£
Amount recognised in other components of equity 90,000
30%  Niflumic's profit after tax (retained earnings) 24,000
Adjustment to equity (66,000)
(c)
£
Draft retained earnings 400,000
(1) Reduction in carrying value of plant (£840,000 – £776,562) (63,438)
(2) Niflumic's earnings (£80,000  30%) 24,000
(3) Error in trade receivables (£70,000  60%) (42,000)
318,562
Trade receivables, revenue and therefore profit were overstated by £70,000 in respect
of the trade receivables. Polson's share is 60%, so end-20X6 retained earnings must be
reduced by £42,000.
The share of Niflumic's profits is recognised in retained earnings, not in a separate
reserve, giving rise to an increase of £24,000.

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CHAPTER 3
Ethics
Introduction
TOPIC LIST
1 The importance of ethics
2 Ethical codes and standards
3 Ethics: financial reporting focus
4 Ethics: audit and assurance focus
5 Making ethical judgements
6 Money laundering regulations
Appendix 1
Appendix 2

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Introduction
 Identify and explain ethical issues in reporting, assurance and business scenarios
 Explain the relevance, importance and consequences of ethical issues

 Evaluate the impact of ethics on a reporting entity, relating to the actions of
stakeholders
 Recommend and justify appropriate actions where ethical issues arise in a given
scenario
 Design and evaluate appropriate safeguards to mitigate threats and provide
resolutions to ethical problems
Specific syllabus references for this chapter are: 19(a)–(e)

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1 The importance of ethics
Section overview
 Ethical behaviour is essential to maintain public confidence.
• Guidance is provided in professional codes of conduct and ethical standards.
1.1 Introduction
In general terms, ethics is a set of moral principles and standards of correct behaviour. Far from
being noble ideals which have little impact on real life, they are essential for any society to
operate and function effectively. Put simply, they help to differentiate between right and wrong,
although their application often involves complex issues, judgement and decisions. While
ethical principles can be incorporated into law, in many cases their application has to depend on
the self-discipline of the individual. This principle can be seen to apply to society as a whole, the
business community and the accounting profession.
1.2 Ethics in business

Business life is a fruitful source of ethical dilemmas because its whole purpose is material gain,
the making of profit. Success in business requires a constant search for potential advantage over
others and business people are under pressure to do whatever yields such an advantage. As a
result, organisations have become increasingly under pressure to act, and to be seen to be
C
acting, ethically. In recent years, many have demonstrated this by publishing ethical codes, H
setting out their values and responsibilities towards stakeholders. A
P
In some instances, businesses may be forced to adopt a more ethical approach. In 2013, many T
bank chief executives saw a pay cut for the first time in years. This was partly due to tightened E
R
regulations which now require banks to align executive pay more closely to risks and
performance. Arguably more forceful, however, are the investor revolts arising as a result of 3
shareholders' anger at rising pay in a time of falling profits and reduced dividend payouts.
1.3 Ethics and the accounting profession

The IESBA Code of Ethics for Professional Accountants (IESBA Code) states:
"A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act
in the public interest."
The public interest is considered to be the collective well-being of the community of people and
institutions the professional accountant serves. These include the following:
 Clients
 Lenders
 Governments
 Employers
 Employees
 Investors
 The business and financial community
 Others who rely on the work of the professional accountant
For the work of the accountant in practice or in business to maintain its value, the accountant
must be respected and trusted. The individual professional accountant therefore has a duty and
a responsibility to maintain the reputation of the profession and the confidence of the public.
ICAEW 2019 Ethics 113

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1.4 Ethics and the individual

While legislation and professional bodies have their part to play through issuing guidance, the
importance of the integrity of the individual cannot be overestimated. Its ethical consequences
are potentially very significant in deciding, for example, whether to whistleblow on questionable
practice at work, despite pressure from colleagues or superiors or negative consequences of
doing so.
The devastating effect of the ethical choices of one individual can be seen in the following
summary of the role played by Betty Vinson, an accountant at WorldCom.
Worked example: WorldCom

WorldCom, the US long-distance telephone carrier, is 'credited' with being responsible for a
fraud that created the largest bankruptcy in US history. This reportedly resulted in a fine of $500
million, which at the time was the largest fine ever imposed by the Securities and Exchange
Commission (SEC).
The problems began for WorldCom in mid-2000. Its operating costs were increasing sharply
due to the fees which it had to pay to other companies for use of their telephone networks. Its
chief executive officer and chief financial officer had had to inform Wall Street of lower than
expected profits for the second half of the year and there was increasing pressure to improve
results. Betty Vinson was working for WorldCom at this time as a senior manager in the
corporate accounting division. She was asked by her boss to falsify the accounts in order to
increase profits. This was achieved primarily by capitalising line costs rather than treating them
as operating expenses. While Betty Vinson considered resignation due to the pressure she was
put under to falsify the results, she continued to work for WorldCom until early 2002 and was
promoted from senior manager to director with an increase in salary of $30,000. Over an
18-month period she had helped to falsify records at the request of her bosses, increasing
profits by $3.7 billion.
By March 2002 questions were being asked by internal audit. Vinson decided to disclose the
details of the falsified records to the FBI, the SEC and the US Attorney. She had hoped that her
testimony could be exchanged for immunity from prosecution; however, this was not the case. In
October 2002 she pleaded guilty to two counts of conspiracy and securities fraud (carrying a
maximum sentence of 15 years) and in October 2003 she was charged with entering false
information on company documents (carrying a maximum sentence of 10 years).
Interactive question 1: Ethics and the individual

List the factors which you think may have affected Betty Vinson's decision to make the fraudulent
entries.
What other courses of action could she have taken?
One of the other courses of action that Betty Vinson could have taken would have been to blow
the whistle – expose the fraud she was asked to participate in either within or outside the
organisation. Admittedly, as the highest levels of management were involved in the WorldCom
case, making an internal disclosure would have fallen on deaf ears at best, or at worst caused
Betty Vinson to lose her job. However, Betty Vinson could have considered making an external
disclosure: to the professional regulatory body of which she was a member, to public regulators,
or, perhaps as a last resort, to the media. A timely disclosure could have brought the fraudulent
activities to an end, mitigating their disastrous consequences.

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In the UK, the Public Interest Disclosure Act 1998 (PIDA 1998) aims to protect whistleblowers
who raise genuine concerns about malpractice in organisations, including the following:
 Crimes
 Civil offences (including negligence, breach of contract and breach of administrative law)
 Miscarriages of justice
 Dangers to health and safety and/or the environment
 Attempts to cover up any of the above
The Act overrides the confidentiality clauses which may be contained in employment contracts,
and provides recourse to the employment tribunal should the whistleblower be victimised.
The text of PIDA 1998, as well as useful examples of whistleblowing cases, can be found on the
website of the charity Public Concern at Work: www.pcaw.org.uk
2 Ethical codes and standards
Section overview
 The accounting profession has developed principles-based codes, including the IESBA
Code and the ICAEW Code of Ethics.
• The ICAEW Code centres around five fundamental principles and a professional
accountant is responsible for recognising and assessing potential threats to these
C
fundamental principles. H
A
• Where threats are identified, a professional accountant must then implement safeguards P
to eliminate these threats or reduce them to an acceptable level. T
E
R
2.1 IESBA and ICAEW Codes 3
As a key aspect of reputation and professionalism is ethical behaviour, the accounting
profession has developed ethical codes of conduct. These include:
 The IESBA Code of Ethics for Professional Accountants (IESBA Code)
 The ICAEW Code of Ethics (ICAEW Code)
The IESBA Code provides ethical guidance internationally for IFAC members. The ICAEW Code
has been derived from the IESBA Code but in places contains additional guidance or requirements.
Therefore compliance with the ICAEW Code will ensure compliance with the IESBA Code.
You should be familiar with the ICAEW Code and IESBA Code from your previous studies and the
remainder of this section revises some of the key points covered at Professional Level.
The ICAEW Code is principles-based and members are responsible for:
 identifying threats to compliance with the fundamental principles;
 evaluating the significance of these threats; and
 implementing safeguards to eliminate them or reduce them to an acceptable level.
The guidance in the Code is given in the form of:
 fundamental principles; and
 illustrations as to how they are to be applied in specific situations.
The Code applies to all members, students, affiliates, employees of member firms and, where
applicable, member firms, in all their professional and business activities, whether remunerated
or voluntary.

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It is important to note therefore that adhering to the Code is equally important for a member
working in business as it is for a member working in practice, even though the ethical codes are
sometimes perceived to be associated more with the accountant in practice.
ICAEW is committed to enforcing the Code through disciplining members who do not meet
reasonable ethical and professional expectations of the public and other members.
A copy of the ICAEW Code is included in the Member's Handbook and is available at
www.icaew.com.
2.2 FRC Revised Ethical Standard 2016

It is essential that an auditor's independence is not compromised while carrying out an audit
engagement. Therefore the FRC has developed Revised Ethical Standard 2016 which was issued
in June 2016. The basic principles have been covered in detail at Professional Level in the Audit
and Assurance paper. This is covered in section 4.
3 Ethics: financial reporting focus
Section overview
 This section provides a summary of some key points covered in the ethics learning
material in the Financial Accounting and Reporting paper at Professional Level.
• Here we primarily consider the application of the ICAEW Code to the accountant in
business involved in a financial reporting environment (we look at the accountant in
practice in section 4).
3.1 Fundamental principles

Professional accountants are expected to follow the guidance contained in the fundamental
principles in the ICAEW Code in all their professional and business activities. The professional
accountant should also follow the requirements in the illustrations. However, they should be
guided not just by the terms but also by the spirit of the Code.
The Code sets out five fundamental principles, the spirit of which must always be complied with.
(1) Integrity
A professional accountant should be straightforward and honest in all professional and
business relationships.
A professional accountant should not be associated with reports, returns, communications
or other information where they believe that the information:
 contains a materially false or misleading statement;
 contains statements or information furnished recklessly; or
 omits or obscures information required to be included where such omission or
obscurity would be misleading.
(2) Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of
others to override professional or business judgements.

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(3) Professional competence and due care

A professional accountant has an obligation to:
 maintain professional knowledge and skill at the level required to ensure that a
client/employer receives competent professional services based on current
developments in practice, legislation and techniques; and
 act diligently and in accordance with applicable technical and professional standards.
Professional competence may be divided into two separate phases:
 Attainment of professional competence – initial professional development
 Maintenance of professional competence – continuing professional development
(CPD)
Diligence encompasses the responsibility to act in accordance with the requirements of an
assignment, carefully, thoroughly and on a timely basis.
(4) Confidentiality
A professional accountant should:
 respect the confidentiality of information acquired as a result of professional and
business relationships;
 not disclose any such information to third parties without proper and specific
authority (unless there is a legal or professional duty to disclose); and
C
 not use such information for the personal advantage of themselves or third parties. H
A
The professional accountant must maintain confidentiality even in a social environment and P
even after employment with the client/employer has ended. T
E
A professional accountant may be required to disclose confidential information: R
 where disclosure is permitted by law and is authorised by the client or employer; 3
 where disclosure is required by law, for example:

– Production of documents or other provision of evidence in the course of legal
proceedings
– Disclosure to the appropriate public authorities of infringements of the law that
come to light; and
 in cases where disclosure may be in the public interest (recent developments on
non-compliance with laws and regulations (NOCLAR) in section 4.1 are relevant here).
(5) Professional behaviour
A professional accountant should comply with relevant laws and regulations and should
avoid any action that discredits the profession.
In marketing and promoting themselves professional accountants should not bring the
profession into disrepute. That is, they should not make:
 exaggerated claims for the services they are able to offer, the qualifications they
possess or experience they have gained; or
 disparaging references or unsubstantiated comparisons to the work of others.

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3.2 Threats
Compliance with these fundamental principles may potentially be threatened by a broad range
of circumstances. Many of these threats can be categorised as follows:
(a) Self-interest threat – The threat that a financial or other interest of a professional accountant
or of an immediate or close family member will inappropriately influence the professional
accountant's judgement or behaviour.
Examples of circumstances that may create such threats include the following:
 Financial interests, loans or guarantees
 Incentive compensation arrangements
 Inappropriate personal use of corporate assets
 Concern over employment security
 Commercial pressure from outside the employing organisation
(b) Self-review threat – The threat that a professional accountant will not appropriately evaluate
the results of a previous judgement made by the professional accountant.
(c) Advocacy threat – The threat that a professional accountant will promote a client's or
employer's position to the point that the professional accountant's objectivity is
compromised.
(d) Familiarity threat – The threat that due to a long or close relationship with a client or
employer, a professional accountant will be too sympathetic to their interests or too
accepting of their work.
Examples of circumstances that may create such threats include:
 a professional accountant in business, who is in a position to influence financial or non-
financial reporting or business decisions, where an immediate or close family member
would benefit from that influence;
 long association with business contacts influencing business decisions; and
 acceptance of a gift or preferential treatment, unless the value is clearly insignificant.
(e) Intimidation threat – The threat that a professional accountant will be deterred from acting
objectively by threats, either actual or perceived.
Examples of circumstances that may create such threats include the following:
 Threat of dismissal or replacement in business, of yourself, or of a close or immediate
family member, over a disagreement about the application of an accounting principle
or the way in which financial information is to be reported
 A dominant personality attempting to influence the decision-making process, for
example with regard to the awarding of contracts or the application of an accounting
principle
3.3 Safeguards
There are two broad categories of safeguards which may eliminate or reduce such threats to an
acceptable level:
Safeguards created by the profession, legislation or regulation
Examples are:
 Educational, training and experience requirements for entry into the profession
 CPD requirements
 Corporate governance regulations

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 Professional standards
 Professional or regulatory monitoring and disciplinary procedures
 External review by a legally empowered third party of reports, returns, communication or
information produced by a professional accountant
 Effective, well-publicised complaints systems operated by the employing organisation, the
profession or a regulator, which enable colleagues, employers and members of the public
to draw attention to unprofessional or unethical behaviour
 An explicitly stated duty to report breaches of ethical requirements
Safeguards in the work environment
Examples are:
 The employing organisation's systems of corporate oversight or other oversight structures
 The employing organisation's ethics and conduct programmes
 Recruitment procedures in the employing organisation emphasising the importance of
employing high calibre, competent staff
 Strong internal controls
 Appropriate disciplinary processes
 Leadership that stresses the importance of ethical behaviour and the expectation that
C
employees will act in an ethical manner
H
A
 Policies and procedures to implement and monitor the quality of employee performance
P
 Timely communication to all employees of the employing organisation's policies and T
E
procedures, including any changes made to them, and appropriate training and education R
given on such policies and procedures
3
 Policies and procedures to empower and encourage employees to communicate to senior
levels within the employing organisation any ethical issues that concern them without fear
of retribution
 Consultation with another appropriate professional accountant
3.4 Ethical conflict resolution

When evaluating compliance with the fundamental principles, a professional accountant may be
required to resolve a conflict in complying with the fundamental principles.
A professional accountant may face pressure to:
 act contrary to law or regulation;
 act contrary to technical or professional standards;
 facilitate unethical or illegal earnings management strategies;
 lie to, or otherwise mislead, others; in particular:
– the auditor of the employing organisation, and
– regulators; or
 issue, or otherwise be associated with, a financial or non-financial report that materially
misrepresents the facts, for example:
– financial statements,
– tax compliance,
– legal compliance, and
– reports required by securities regulators.

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3.5 Preparation and reporting of information

Accountants will often be involved in the preparation and reporting of information that may be:
 made public; or
 used by others inside or outside the employing organisation.
The accountant should:
 prepare or present such information fairly, honestly and in accordance with relevant
professional standards;
 present financial statements in accordance with applicable financial reporting standards; or
 maintain information for which they are responsible in a manner which:
– describes clearly the true nature of the business transactions, assets or liabilities;
– classifies and records information in a timely and proper manner; and
– represents the facts accurately and completely in all material respects.
3.6 Acting with sufficient expertise

An accountant should only undertake significant tasks for which they have, or can obtain,
sufficient specific training or expertise.
Circumstances that threaten the ability of the accountant to perform duties with the appropriate
degree of professional competence and due care include:
 insufficient time for properly performing or completing the relevant duties;
 incomplete, restricted or otherwise inadequate information for performing the duties
properly;
 insufficient experience, training and/or education; and
 inadequate resources for the proper performance of the duties.
Safeguards that may be considered include:
 obtaining additional advice or training;
 ensuring that there is adequate time available for performing the relevant duties;
 obtaining assistance from someone with the necessary expertise; and
 consulting where appropriate with:
– superiors within the employing organisation,
– independent experts; or
– ICAEW.
3.7 Financial interests

An accountant may have financial interests, or may know of financial interests of immediate or
close family members, that could in certain circumstances threaten compliance with the
fundamental principles.
Examples of circumstances that may create self-interest threats are if the accountant or family
member:
 Holds a direct or indirect financial interest in the employing organisation and the value of
that interest could be directly affected by decisions made by the accountant.
 Is eligible for a profit-related bonus and the value of that bonus could be directly affected
by a decision made by the accountant
 Holds, directly or indirectly, share options in the employing organisation, the value of which
could be directly affected by decisions made by the accountant

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 Holds, directly or indirectly, share options in the employing organisation which are, or will
soon be, eligible for conversion
 May qualify for share options in the employing organisation or performance-related
bonuses if certain targets are achieved
Safeguards against such threats may include the following:
 Policies and procedures for a committee independent of management to determine the
level or form of remuneration of senior management
 Disclosure of all relevant interests and of any plans to trade in relevant shares to those
charged with the governance of the employing organisation, in accordance with any
internal policies
 Consultation, where appropriate, with superiors within the employing organisation
 Consultation, where appropriate, with those charged with the governance of the employing
organisation or relevant professional bodies
 Internal and external audit procedures
 Up to date education on ethical issues and the legal restrictions and other regulations
around potential insider trading
3.8 Inducements
An accountant, or their immediate or close family, may be offered an inducement such as:
C
 gifts;
H
 hospitality; A
 preferential treatment; or P
T
 inappropriate appeals to friendship or loyalty.
E
R
An accountant should assess the risk associated with all such offers and consider whether the
following actions should be taken: 3
 Immediately inform higher levels of management or those charged with governance of the
employing organisation.
 Inform third parties of the offer, for example a professional body or the employer of the
individual who made the offer, or seek legal advice.
 Advise immediate or close family members of relevant threats and safeguards where they
are potentially in positions that might result in offers of inducements (for example as a result
of their employment situation).
 Inform higher levels of management or those charged with governance of the employing
organisation where immediate or close family members are employed by competitors or
potential suppliers of that organisation.
In addition to the ICAEW Code, accountants operating in businesses linked to the UK should be
aware of the Bribery Act 2010. Under the Bribery Act, there are four categories of criminal
bribery offences:
(1) Offering, promising or giving a bribe to another person
(2) Requesting, agreeing to receive or accepting a bribe to another person
(3) Bribing a foreign official
(4) Failing to prevent bribery (corporate offence)

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One particular point to note is that the Bribery Act has a very wide judicial reach: it applies to
any persons with a 'close connection' to the UK. This is defined to include the following:
 British citizens
 Individuals ordinarily resident in the UK
 Businesses incorporated in the UK
 Any business which conducts part of its business in the UK, even though it is not
incorporated in the UK
Worked example: FIFA

The 2018 football World Cup in Russia was widely regarded as a success both on and off the
field, due to the engagement of fans with their Russian hosts and the quality of the football
viewed by audiences across the world. Yet only three years earlier, the organising body of the
World Cup, FIFA, was being investigated for widespread corruption among many of its most
senior officials.
Like any high-profile sporting administrator, FIFA has always attracted criticism, but the decision-
making processes for awarding both the 2018 and 2022 tournaments came under intense
scrutiny following accusations of bribery and corruption among those responsible for deciding
on host countries. After an internal investigation, FIFA concluded that the bidding process was
fair, although it did not release its report to the public in full, leading to the resignation of the
investigation's independent author in protest.
The accusations continued until 2015, when criminal investigations were launched by the US and
Swiss authorities which eventually led the leadership structure to remove a number of long-
standing 'big' personalities including overall FIFA president Sepp Blatter and his European
counterpart Michel Platini: both men were banned from football for 8 years by FIFA's ethics
committee.
Although the US investigation in 2015 centred on bribes to senior officials of around US$2
million, sums thought to be in excess of US$150 million have also been mentioned in association
with illegal payments to secure media and marketing rights to future tournaments. FIFA made
more than US$2 billion from the 2014 World Cup tournament held in Brazil.
The new leadership of FIFA faces a massive task in restoring faith in the transparency of its own
governance arrangements and the public perception of football and its engagement on the
global stage.
(Source: BBC News, www.bbc.co.uk/news/world-europe-32897066)
3.9 Conflicts of interest

An accountant should take reasonable steps to identify circumstances that could pose a conflict
of interest.
Examples might be:
 an accountant in public practice, competing directly with a client, or having a joint venture
or similar arrangement with a major competitor of a client;
 an accountant performing services for clients whose interests are in conflict; or
 clients are in dispute with each other in relation to the matter or transaction in question.

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Safeguards should include:

 notifying the client of the firm's business interest or activities that may represent a conflict of
interest, and obtaining their consent to act in such circumstances;
 notifying all known relevant parties that the professional accountant is acting for two or
more parties in respect of a matter where their respective interests are in conflict and
obtaining their consent to so act; and
 notifying the client that the accountant does not act exclusively for any one client in the
provision of proposed services and obtaining their consent to so act.
3.10 General duty to report

Under ICAEW's Bye-laws it is the duty of every member, where it is in the public interest to do
so, to report to the Institute any facts or matters indicating that a member and/or firm or
provisional member may have become liable to disciplinary action. In determining whether it is
in the public interest to report such facts or matters, regard shall be had to such guidance as the
Council shall give from time to time.
This general duty to report to the Institute under the Bye-laws is separate from the duty to report
money laundering to the National Crime Agency; this latter duty arises from legislation.
3.11 Practical significance

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Accountants working within a financial reporting environment can come under pressure to H
improve the financial performance or financial position of their employer. Finance managers A
who are part of the team putting together the results for publication must be careful to withstand P
T
pressures from their non-finance colleagues to indulge in reporting practices which dress up E
short-term performance and position. Financial managers must be conscious of their R
professional obligations and seek appropriate assistance from colleagues, peers or
3
independent sources.
Visit www.ccab.org.uk and click 'Press & Publications > Discussion papers and Guidance'. On
that webpage, under the heading 'Ethical Dilemmas Case Studies' from 2012 are links to a
number of very useful, practical case studies covering ethical dilemmas relevant to accountants –
including a set of case studies specific to accountants in practice.
4 Ethics: audit and assurance focus
Section overview
 This section focuses on ethical guidance most relevant to accountants in practice
providing assurance services and builds on the material covered in the Assurance paper at
Certificate Level and the Audit and Assurance paper at Professional Level.
 It also provides detail of recent changes to the relevant ethical codes and standards:
– IESBA Code
– ICAEW Code
– Revised Ethical Standard 2016
 The key points from Certificate and Professional Levels are also summarised within this
section, with additional information included at Appendices 1 and 2 to this chapter.

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Interactive question 2: Ethical risks

From your knowledge brought forward from your previous studies, and any practical experience
of auditing you may have, write down as many potential ethical risk areas concerning audit as
you can in the areas below. (Some issues may be relevant in more than one column.)
Personal interests Review of your own work Disputes Intimidation
4.1 Development of the 2018 IESBA Code
4.1.1 Content changes

A number of changes have been made to the 2016 edition of the IESBA Code primarily resulting
from the conclusion of the NOCLAR (non-compliance with laws and regulations) project.
This project addressed professional accountants' responsibilities when they become aware of
non-compliance or suspected non-compliance with laws and regulations committed by a client
or employer. The IESBA Code states that the objectives of the professional accountant are as
follows:
 To comply with the principles of integrity and professional behaviour
 By alerting management or, where appropriate, those charged with governance of the
employing organisation, to seek to:
– enable them to rectify, remediate or mitigate the consequences of the identified or
suspected non-compliance; and
– deter the commission of the non-compliance where it has not yet occurred.
 To take such further action as appropriate in the public interest (IESBA Code: para. 260.4)

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Where the professional accountant becomes aware of information concerning instances of non-
compliance or suspected non-compliance the following procedures are required. The
professional accountant must:
 obtain an understanding of the matter;
 address the matter;
 determine whether further action is needed;
 consider any imminent breaches; and
 consider any additional documentation requirements. (IESBA Code: para 260.12-23)
In January 2017, the IESBA issued a close off document: Addressing the Long Association of
Personnel with an Audit or Assurance Client. This states that for audits of Public Interest Entities
an individual cannot act as the engagement partner, the individual appointed as responsible for
the engagement quality control review or any other key audit partner role (or a combination of
these roles) for a period of more than seven cumulative years (para. R540.5). It also includes the
following 'cooling off' periods where the individual has acted in the role for seven cumulative
years (para. R540.11–13):
 Engagement partner: five consecutive years
 Individual responsible for the engagement quality control review: three consecutive years
 Individual who has acted in any other capacity as key audit partner: two consecutive years
A previous close off document from 2016 provided guidance on two further areas which are
now included in the 2018 IESBA Code: Preparation and presentation of information (section 220)
and Pressure to breach the fundamental principles (section 270). While these are presented in
the context of the professional accountant in business, the auditor should consider these C
H
expectations which have now been explicitly raised as part of their audit approach. A
P
When preparing or presenting information, a professional accountant shall: T
E
(a) Prepare or present information in accordance with a relevant reporting framework, where R
applicable;
3
(b) Prepare or present the information in a manner that is intended neither to mislead nor to
influence contractual or regulatory outcomes inappropriately;
(c) Exercise professional judgement to:
(i) Represent the facts accurately and completely in all material respects
(ii) Describe clearly the true nature of business transactions or activities; and
(iii) Classify and record information in a timely and proper manner
(d) Not omit anything with the intention of rendering the information misleading or of
influencing contractual or regulatory outcomes inappropriately. (IESBA Code: para R220.4)
A professional accountant shall not allow pressure from others to result in a breach of
compliance with the fundamental principles or place pressure on others that the accountant
knows, or has reason to believe, would result in the other individuals breaching the fundamental
principles. (IESBA Code: para R270.3)
4.1.2 Structural changes

In addition to the content changes mentioned above, the IESBA has changed the format and
structure of the 2018 Code as follows:
 Guide to the code
 International Code of Ethics for Professional Accountants (including International
Independence Standards)
 Preface
 Part 1 – Complying with the Code, fundamental principles and conceptual framework

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 Part 2 – Professional accountants in business

 Part 3 – Professional accountants in public practice
 International independence standards: Part 4A Independence for audit and review
engagements and 4B Independence for assurance engagements other than audit and
review engagements
 Glossary, including list of abbreviations
 Effective dates (mostly 15 June 2019)
This restructured Code is now referred to as the International Code of Ethics for Professional
Accountants (including International Independence Standards).
4.2 FRC Revised Ethical Standard 2016

In June 2016, the FRC issued Revised Ethical Standard 2016 (Ethical Standard). This one
standard covers the independence requirements for auditors, reporting accountants and for
engagements to report to the Financial Conduct Authority. The revised standard has come
about as the result of:
 EU reforms resulting from the Audit Regulation and Directive; and
 closer alignment with the IESBA Code following an FRC review.
It is arranged in two parts. Part A sets out overarching principles and supporting ethical
provisions while Part B considers the practical application of these in a series of sections as
follows:
Section 1: General requirements and guidance
Section 2: Financial, Business, Employment and Personal Relationships
Section 3: Long Association with Engagements and with Entities Relevant to Engagements
Section 4: Fees, Remuneration and Evaluation Policies, Gifts and Hospitality, Litigation
Section 5: Non-audit/Additional services
Section 6: Provisions Available for Audits of Small Entities
An article in the ICAEW publication Audit & Beyond (May 2016) and ICAEW Audit News Issue 56
identifies the key changes made from the introduction of the FRC Revised Ethical Standard in
2016 as follows:
(a) Changes that affect all statutory audits (not just those of public interest entities)
 The need for the auditor to be independent is now subject to a 'third party test' ie,
would an objective, reasonable and informed third party conclude that the auditor's
independence has been compromised.
 Personal independence requirements cover a greater range of individuals in the audit
firm, including those at the disposal of or under the control of the firm.
 Greater emphasis on the risks to independence posed where the auditor acts as an
advocate of management.
(b) Changes that affect audits of public interest entities
 A prohibition of the provision of certain non-audit services by the auditor.
 Revised requirements on partner rotation and 'cooling off' periods.
 Where non-audit services are permitted they are limited to no more than 70% of the
audit fee, calculated on a rolling three-year basis.
In addition, there is now a statutory requirement for an audit tender to be carried out at
least every 10 years, with mandatory rotation of an audit firm at least every 20 years.

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For listed non-public interest entities (primarily AIM companies) the previous requirements for
listed entities broadly apply. There are some relaxations for entities with a market capitalisation
of under €200 million.
Further details are provided in Appendix 1 of this chapter.
4.3 ICAEW Code

The ICAEW Code is based on the IESBA Code. The current version of the ICAEW Code has
applied since 1 January 2011. The ICAEW website includes the following statement from 2018
regarding the recent changes to the IESBA Code:
"ICAEW has been involved in the IESBA restructuring work, both directly and as a consultee. The
restructured IESBA Code is a considerable improvement for users in terms of ease of use and
navigation, and we propose to adopt it as the basis of the next iteration of the ICAEW Code. At
the same time, we will pick up changes made by IESBA since our 2011 revision."
(Source: www.icaew.com/en/technical/ethics/icaew-code-of-ethics/changes-to-icaew-code-of-
ethics-arising-from-iesba-code-restructure)
While the new Codes will both adopt the same structural changes to mirror each other, the
content will be substantially the same (plus for ICAEW auditors, the FRC Revised Ethical
Standard still provides guidance on independence). The new ICAEW Code is expected to be
introduced in January 2020.
C
4.4 Threats and safeguards H
A
The IESBA Code, the ICAEW Code and the FRC Revised Ethical Standard 2016 are based on the P
T
principle that integrity, objectivity and independence are subject to various threats and that E
safeguards must be in place to counter these. R
The majority of threats fall into the following categories: 3
Threat Example
Self-interest threat Undue dependence on total fees from a client

Self-review threat Reporting on the operation of financial systems after being involved
in their design or implementation
Management threat Where the audit firm has been involved in the design, selection and
implementation of financial information technology systems
(This threat is included in the FRC Ethical Standard only)
Advocacy threat Acting as an advocate on behalf of an assurance client in litigation or
disputes with third parties
Familiarity or trust threat A member of the engagement team having a close or immediate
family relationship with a director of the client
Intimidation threat Being threatened with dismissal or replacement in relation to a client
engagement
(a) The current ICAEW Code still considers that there are two general categories of safeguard:
 Safeguards created by the profession, legislation or regulation
 Safeguards within the work environment
(b) Safeguards in the work environment may differ according to whether a professional
accountant works in public practice, in business or in insolvency.

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(c) When evaluating safeguards, the auditor should consider what a reasonable and informed
third party, having knowledge of all relevant information, including the significance of the
threat and the safeguards applied, would conclude to be unacceptable.
4.5 Professional appointment

The Appendix to section 210 of the current ICAEW Code sets out the following procedures:
(a) The prospective auditor should explain to the prospective client that they have a
professional duty to communicate with the existing auditor.
(b) The client should be requested to confirm the proposed change to the existing auditor
and to authorise the existing auditor to co-operate with the prospective auditor.
(c) Where this authorisation is received the prospective auditor should write to the existing
auditor and request the disclosure of any information which might be relevant to the
successor's decision to accept or decline the appointment.
(d) The prospective auditor should then consider whether to accept or decline the
appointment in the light of the information received from the existing auditor.
(e) The existing auditor is required to respond promptly to requests for information; however,
where inquiries are not answered, the prospective auditor should write to the existing
auditor by recorded delivery stating an intention to accept the appointment within a
specified period of time.
(f) The prospective auditor is allowed to assume that silence implies that there are no adverse
comments to be made. However, the fact that no reply was received should be considered
as part of the overall decision-making process.
ICAEW published an Ethics Helpsheet on Changes in a Professional Appointment which gives
some practical guidance on how various types of information that might be obtained from the
existing auditor could affect the decision on whether to accept or decline the appointment,
including this table:
Matters which should not

affect the decision to act but
Matters which should affect Matters which might affect which might be helpful
the decision to act the decision to act information
Fraud Client fails or refuses to permit Fee dispute.

predecessor permission to
discuss their affairs.
Accounting irregularities Predecessor fails to respond Client willing but unable to
to correspondence. settle outstanding fees.
Tax/VAT evasion Client has been economical Predecessor subject of
with the truth in the past. complaint by client.
Client has demonstrably Work obtained by improper Non-professional client traits
misled predecessor means. (eg, religious beliefs contrary
to your own).
Point to note:
As a result of the Deregulation Act 2015 the provisions of the Companies Act 2006 regarding
the notifications made by the auditor on ceasing to hold office have been simplified. The new
provisions apply in relation to financial years beginning on or after 1 October 2015.

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The auditor of a non-public interest company does not need to send a statement of
circumstances to the company if:
 the auditor's term of office has ended; or
 the reason for leaving is an exempt reason (and there are no matters to bring to the
attention of shareholders or creditors).
Exempt reasons are as follows:
 The auditor is ceasing to practise.
 The company qualifies as exempt from audit.
 The auditor is ceasing to act for a subsidiary as the financial statements are to be audited by
group auditors as part of the group audit.
 The company is being liquidated.
4.6 Access to information by successor auditors

As a result of the implementation of the Companies Act 2006 when the predecessor auditor
ceases to hold office, if requested by the successor auditor, the predecessor auditor must allow
the successor access to all relevant information in respect of its audit work. This includes access
to relevant working papers.
ICAEW's Audit and Assurance Faculty has produced a technical release AAF 01/08 to assist
auditors in managing the process in relation to this access.
C
Some of the key points in this guidance are as follows: H
A
(a) The request should be made after the successor has been formally appointed. P
T
(b) The successor should consider whether to make a request and the extent of that request. E
(c) The request should be as specific as possible. There are specific references to reviewing a R
predecessor's audit work in: 3

 ISA (UK) 510 (Revised June 2016), Initial Engagements – Opening Balances
 ISA (UK) 710, Comparative Information – Corresponding Figures and Comparative
Financial Statements
 ISA (UK) 300 (Revised June 2016), Planning an Audit of Financial Statements
(d) The predecessor should be prepared to assist the successor by providing oral or written
explanations.
(e) It is reasonable for the successor to makes notes of its review.
(f) There is no obligation to allow copying of papers, but it would be reasonable to allow
copying of extracts of the books and records of the client, analyses of financial statement
figures and documentation of the client's systems and processes.
(g) Providing access to working papers in this way is not a breach of confidentiality because it is
done in order to comply with a mandatory requirement. (A letter from the predecessor to
the successor should be copied to the client as a matter of courtesy.)
4.7 Confidentiality
Information received in confidence should not be disclosed except in the following
circumstances.

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Where disclosure is permitted by law and This might include circumstances where an
is authorised by the client or the employee has committed a fraud and the
employer management are in agreement that the police
should be informed.
Where disclosure is required by law For example:
 Production of documents or other provision of
evidence in the course of legal proceedings
 Disclosure to the appropriate public authorities
of infringements of the law that come to light eg,
reporting of suspected regulatory breaches in
respect of financial service and investment
business to the Financial Conduct Authority
Where there is a professional duty or In this instance disclosure can be made if it is in the
right to disclose, when not prohibited by 'public interest' to do so.
law
Confidential information should not be used for personal advantage or the advantage of third
parties eg, insider trading.
Applying this guidance will involve difficult judgements, particularly in making the decision as to
whether disclosure is in the public interest. Other specific matters which may need to be
considered include:
 ISA (UK) 240 (Revised June 2016), The Auditor's Responsibilities Relating to Fraud in an
Audit of Financial Statements;
 ISA (UK) 250A (Revised December 2017), Consideration of Laws and Regulations in an Audit
of Financial Statements; and
 anti-money laundering legislation.
4.8 Conflicts of interest

Conflicts of interest and confidentiality are related matters. Where a conflict of interest arises,
one of the key issues is whether it will be possible to keep information confidential.
Section 220 of the current ICAEW Code states that there is nothing improper in a firm having
two clients whose interests are in conflict provided that adequate safeguards are in place which
ensure that the work performed for one client does not disadvantage another.
Safeguards would include:
 notifying the affected parties of the conflict of interest and obtaining permission to
act/continue to act;
 using separate engagement teams;
 procedures to prevent access to information eg, physical separation of teams and audit
evidence;
 clear guidelines for members of the engagement team on issues of security and
confidentiality;
 the use of confidentiality agreements signed by employees; and
 regular reviews of the application of safeguards by a senior individual not involved with the
relevant client engagement.
Where safeguards do not mitigate the risks sufficiently the professional accountant should not
accept the engagement or should cease to act for one of the parties.

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Interactive question 3: Stewart Brice

You are the Ethics Partner at Stewart Brice, a firm of chartered accountants. The following
situations exist.
Teresa is the audit manager assigned to the audit of Recreate, a large quoted company. The
audit has been ongoing for one week. Yesterday, Teresa's husband inherited 1,000 shares in
Recreate. Teresa's husband wants to hold on to the shares as an investment.
The Stewart Brice pension scheme, which is administered by Friends Benevolent, an
unconnected company, owns shares in Tadpole Group, a listed company with a number of
subsidiaries. Stewart Brice has recently been invited to tender for the audit of one of the
subsidiary companies, Kermit Co.
Stewart Brice has been the auditor of Kripps Bros, a limited liability company, for a number of
years. It is a requirement of Kripps Bros' constitution that the auditor owns a token £1 share in
the company.
Requirements
Comment on the ethical and other professional issues raised by the above matters.
Identify the ethical and professional issues Stewart Brice would need to consider.
C
5 Making ethical judgements H
A
P
T
Section overview E
R
 The application of ethical guidance requires skill and judgement and relies on the integrity
3
of the individual.
• The ICAEW Code provides a framework for the resolution of ethical conflicts.
• In the exam, you will be expected to identify ethical issues and evaluate alternative courses
of action.
5.1 Resolving ethical conflicts

Although there are a number of sources of ethical guidance, resolving ethical issues can be
complex. As you have seen in your earlier studies (see also Appendices 1 and 2), there are some
specific rules which can be applied, but current UK ethical guidance is primarily principles-
based.
The application of these principles requires a degree of skill and the onus is placed on the
integrity and judgement of the individual in weighing up the facts of the situation. In addition, it
may mean that in certain circumstances there is more than one acceptable outcome.
The ICAEW Code recognises that conflicts in the application of fundamental principles may
need to be resolved. When providing a service the professional accountant must take into
account:
 the client's requirements; and
 the public interest.
Where these are in conflict, the public interest should take priority.
The ICAEW Code sets out a framework that accountants can follow when faced with these
issues, which you may find useful when considering ethical problems in the exam.

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The ICAEW Code suggests that the resolution process should consider the following:
Relevant facts This may involve:

Do I have all the relevant facts?  referring to the organisation's policy, procedures,
Am I making assumptions? code of conduct and previous history; or
 discussing the matter with trusted managers and
Is it my problem or can anyone else
employees.
help?
Relevant parties These may include those directly affected eg,
shareholders, employees and employers but may also
Who are the individuals, organisations
include the community at large.
and key stakeholders affected?
How are they affected?
Are there conflicts between different
stakeholders?
Who are your allies?
Ethical issues involved These include:
Would these ethical issues affect the  professional ethical issues;
reputation of the accountancy  organisational ethical issues; and
profession?  personal ethical issues.
Would they affect the public interest?
Fundamental principles related to This will involve reference to the relevant ethical
the matter in question guidance eg, ICAEW Code.
What are the threats to the
fundamental principles?
Are there safeguards in place which
can reduce or eliminate the threats?
Established internal procedures The professional accountant may find it useful to discuss
Does your organisation have policies ethical conflict issues with:
and procedures to deal with this  immediate superior;
situation?  the next level of management;
How can you escalate concerns within  a corporate governance body; or
your organisation?  other departments eg, legal, audit, human resources.
Is there a whistleblowing procedure? Consideration should also be given to the point at
which help is sought from external sources eg, ICAEW.
Generally it would be preferable for the conflict to be
resolved without external consultation.
Alternative courses of action The following should be considered:
Have all the consequences been  The organisation's policies, procedures and
discussed and evaluated? guidelines
Will the proposed course of action  Applicable laws and regulations
stand the test of time?
 Universal values and principles adopted by society
Would a similar course of action be
 Long- and short-term consequences
undertaken in a similar situation?
Would the course of action stand  Symbolic consequences
scrutiny from peers, family and  Private and public consequences
friends?

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Where the conflict is significant and cannot be resolved, the accountant would need to seek
legal advice. After exhausting all other possibilities and depending on the nature of the conflict,
the individual may conclude that withdrawal from the engagement team or resignation from the
firm/employing organisation is appropriate.
Point to note:
Withdrawal/resignation would be seen very much as a last resort.
5.2 Exam context

Ethical issues will have been examined in earlier papers. However, at the Advanced Level you
will be faced with more complex situations. More emphasis will be placed on your ability to use
your judgement in the light of the facts provided, rather than testing your knowledge of the
ethical codes and standards in detail. In some instances, the correct action may be uncertain and
it will be your ability to identify the range of possible outcomes which will be important rather
than concluding on a single course of action.
You should also be aware that the term 'ethics' will be used in a much broader sense than it has
been in the earlier Assurance and Audit and Assurance papers. It is likely to be combined with
financial reporting and business issues where you may be required to assess the ethical
judgements made by others, including management. You may also be asked to consider the
issue from the point of view of the accountant in practice and the accountant in business.
The following Interactive question demonstrates these points.
C
H
A
Interactive question 4: Revenue recognition P
T
You are the auditor of Bellevue Ltd for the year ended 31 December 20X8. The company
E
provides information to the financial services sector and is run by the Managing Director, Toby R
Stobbart. It has a venture capital investment of which part is in the form of a loan. The investment
agreement details a covenant designed to protect the loan. This states an interest cover of two is 3
required as a minimum ie, the company must be able to cover interest and loan principal
repayments with profits at least twice.
70% of the revenue of the business is subscription based and contracts are typically three years
in duration. 30% of the revenue is for consultancy work which is billed on completion of the
work. Consultancy projects are for a maximum of two months.
During the previous year the management performed a review of the subscription revenue and
concluded that 40% of this represented consultancy work and should therefore be recognised in
the first year of the contract rather than being recognised over the duration of the contract as
had previously been the case. The audit file for 20X7 indicates that this treatment had been
questioned vigorously by the audit manager but had been agreed with the audit partner, James
Cowell. James Cowell subsequently left the firm abruptly.
You have received a copy of the 20X8 draft accounts which show an interest cover of 2.02 for
20X7 and 2.01 for 20X8. You have also been told that a similar review of subscription income
has been made for 20X8, with 40% being reclassified as consultancy work as in the previous
year.
Requirement
What are the issues that you as auditor would need to consider in this situation?

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6 Money laundering regulations
Section overview
 This section provides a summary of some key points covered in the Audit and Assurance
paper at Professional Level.
• Changes to money-laundering regulations were made on 26 June 2017 and the Money
Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer)
Regulations 2017 are now in force. These changes were made in order to improve the
2007 regulations.
• Here, we consider an overview of the money laundering regulations in the UK, and how
they affect the work of accountants in practice.
6.1 New money laundering regulations – key changes from 2007

The EU issued its fourth anti-money laundering directive on 26 June 2015 aimed at enhancing
consistency across member states. The provisions were incorporated in national law on
26 June 2017. The main changes between the 2007 and 2017 regulations relate to amending
the approach to customer due diligence, seeking to prevent new means of terrorist financing
(including through e-money and prepaid cards), improving the transparency of beneficial
ownership of companies and trusts and effectively enforcing sanctions.
Relevant persons (ie, those covered by the money laundering regulations 2017) now include all
gambling providers, not just those who hold a casino operating licence. However the new
regulations do not apply to those engaging in financial activity on a very occasional basis, with a
turnover less than £100,000 (this is an increase of £64,000 compared to the 2007 regulations).
The new requirements are summarised below.
General risk assessment
The new regulations are more prescriptive in terms of risk assessment and due diligence
procedures and require specific procedures to be undertaken to assess the business's potential
exposure to money laundering and terrorist financing. This includes a report by the relevant
person on customers, countries of operation, products and services, transactions, delivery
channels and the size and nature of the business. This report must also be translated into written
policies and procedures.
Officer responsible for compliance
Firms must now appoint a money laundering compliance principal (MLCP) who must be on the
board of directors or a member of senior management (sole practitioners with no employees
are exempt from this requirement). Firms must also have a nominated officer (who receives
internal suspicious activity reports and assesses whether a suspicious activity report should be
made to the National Crime Agency, NCA). Under the old regulations, firms had to appoint a
money laundering reporting officer (MLRO) and this person can act as MLCP and nominated
officer if sufficiently senior.
The new regulations also require firms to assess the skills, knowledge, conduct and integrity of
employees involved in identifying, mitigating and preventing or detecting money laundering
and terrorist financing.
Internal controls
The new regulations state that firms must establish an independent audit function to assess the
adequacy and effectiveness of a firm's anti-money laundering policies, controls and procedures.

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Policies, controls and procedures

Firms must have policies, controls and procedures in place to prevent money laundering and
terrorist financing and conform with data protection requirements. Firms must maintain written
records of training. Firms with overseas branches and subsidiaries must establish group-wide
policies and controls that comply with UK regulations. Specifically, if the branch or subsidiary
operates in an EEA state, it must comply with the regulations of that state; if it operates outside
of the EEA then it must comply with the UK regulations.
Due diligence and reliance on third parties
Client due diligence must still be performed under the new regulations, both before
establishing a new business relationship and when factors have been identified that result in a
change to the risk assessment. Owners and beneficial owners must still be identified but under
the new regulations, sole reliance on Companies House cannot be placed.
Simplified due diligence is more restricted under the 2017 regulations, where automatic
simplified due diligence ceases. Instead relevant persons need to consider both customer and
geographical risk factors in deciding whether simplified due diligence is applicable. The new
regulations also have a black list of high risk jurisdictions which, if involved in a transaction, make
enhanced due diligence and additional risk assessment necessary.
The regulations define a list of situations where enhanced due diligence applies:
 where there is a high risk of money laundering or terrorist financing;
 in any business relationship with a client established in a high-risk country; C
H
 if the client is a politically exposed person (PEP) or a family member or known close A
associate of a PEP; P
T
 in any case where the client has provided false or stolen identification documentation; and E
R
 in cases where there are complex and unusually large transactions or an unusual pattern of
transactions and the transactions do not seem to have any apparent economic or legal 3
purpose.
The regulations set out factors that could indicate that enhanced due diligence is necessary such
as customer risk factors, product, service, transaction or delivery channel risk factors, and
geographical risk factors.
Third parties can still be relied upon for carrying out due diligence as long as the third party is
subject to the Money Laundering 2017 regulations or a similar regime. However, the conditions
for reliance on a third party for due diligence are prescriptive in that the third party must provide
the customer due diligence information and enter into a written agreement in which is agrees to
provide copies of all customer due diligence information within two working days.
Politically exposed persons (PEPs)
The regulations require that firms have procedures in place to identify whether a client, or the
beneficial owner of a client, is a PEP or a family member (spouse, civil partner, children and
parents) or known close associate of a PEP.
PEPs are defined by the legislation as individuals entrusted with prominent public functions,
other than as a middle ranking or more junior official. PEPs include heads of state, members of
parliament, members of supreme courts and ambassadors amongst others.
Known close associates are defined as individuals known to have joint beneficial ownership of a
legal entity or a legal arrangement or any other close business relations with a PEP, or
individuals who have sole beneficial ownership of a legal entity or a legal arrangement which is
known to have been set up for the benefit of a PEP.

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Where a PEP is identified, the regulations require the following as a minimum:

 Senior management approval for the relationship
 Adequate measures to establish the source of funds and wealth
 Enhanced ongoing monitoring of the relationship
Enhanced due diligence procedures must continue for 12 months after a PEP ceases to be a
client, but this does not apply to family members or known associates of a PEP.
The new regulations now encompass both foreign PEPs and domestic PEPs. This means
enhanced due diligence requirements for a wider range of individuals who have been trusted
with prominent public functions both within the UK and overseas.
New criminal offence
Under the new regulations, any individual who recklessly makes a statement in the context of
money laundering which is false or misleading commits an offence which is punishable by a fine
and/or up to two years in prison.
6.2 The wide scope of money laundering

The definition of money laundering is covered by the Proceeds of Crime Act 2002, which
defines money laundering deliberately in very general terms. Money laundering means
exchanging money or assets that were obtained from criminal activity for money or other assets
that are 'clean'. The 'clean' money or assets do not then have an obvious link with any criminal
activity. Money laundering also includes money that is used to fund terrorism, however it is
obtained.
In the UK, a person is deemed to commit a money laundering offence when they:
(a) conceal criminal property (for example, converting the proceeds of criminal conduct into
another currency);
(b) enter into an arrangement regarding criminal property (for example, an accountant in
practice who advises a client involved in money laundering on the acquisition of a
business); or
(c) acquire, use or possess criminal property (this includes acquiring criminal property for
'inadequate consideration' – for example, an adviser receiving a payment of professional
fees from a client involved in money laundering offences that is significantly above the value
of the professional services performed).
Criminal property is also rather widely defined as the benefits of criminal conduct. It includes
those benefits gained indirectly, or partly, from criminal conduct. Criminal conduct includes:
 tax evasion;
 illegally saved costs (failure to comply with environmental regulations or health and safety
requirements); and
 offences committed overseas that are criminal offences under UK law (including bribery).
In addition, those working within the regulated sector – this includes auditors, insolvency
advisers, external accountants and tax advisers – need to be aware of an additional offence:
failure to disclose. We will look at this in the section below.

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6.3 The professional accountant's responsibilities
6.3.1 The duty to report

If an accountant has knowledge or suspicion, or reasonable grounds for suspicion, that money
laundering is taking place at a client, that accountant must report it. It is important to note the
words 'grounds for suspicion' – if an accountant waits for incontrovertible evidence, it might be
too late.
The money laundering regulations override the accountant's duty of confidentiality towards the
client. Therefore, accountants have always had to tread a fine line of discretion between their
duty to their client and the public interest.
If a client is doing well and you do not understand where the money has come from, after
exhausting all reasonable lines of inquiry then you have grounds for suspicion and a duty to
report without 'tipping off' either:
 the client; or
 anyone who could prejudice an inquiry into the matter.
ISA (UK) 250A was revised in December 2017 to include the following guidance:
"In the UK, legislation relating to money laundering, terrorist financing and proceeds of crime
imposes additional responsibilities on the auditor. The Appendix contains further guidance on
these responsibilities." (ISA (UK) 250A: para A6-1)
The Appendix to ISA (UK) 250A discusses the 2017 money laundering regulations in more detail C
– in essence, there is now a legal obligation for UK auditors to fulfil beyond the professional H
requirements of the auditing standards. A
P
T
6.3.2 Report to whom? E
R
Accountants must report to the nominated official (MLCP) in their assurance firm, which fulfils
their responsibility. 3
The MLCP then has to decide on whether to report the matter to the National Crime Agency
and, if appropriate, to make the report.
The legislation protects professionals from any claims for breach of confidentiality even where
suspicions are later proved to be ill-founded.
6.4 Offences and penalties

Failing to report and comply with the regulations – including the provision of suitable training –
are offences under the legislation.
Remember, 'tipping off' is also an offence.
The penalties for non-compliance by accountants can be severe – for some offences a jail term of
14 years is a possibility.

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Appendix 1
1 Integrity, objectivity and independence
1.1 Exam focus

You will have covered the ethical guidance on integrity, objectivity and independence in your
earlier studies. At the Advanced Level, however, a greater emphasis will be placed on your
ability to apply this knowledge. Ethical dilemmas which you may be required to deal with will be
less clear-cut and the requirements of the question will not always specifically indicate that
ethical issues need to be considered. Instead information will typically be embedded within the
question and you will need to demonstrate your skill in identifying the ethical issue and its
implications.
This Appendix is based on the FRC Revised Ethical Standard 2016 and the current ICAEW Code.
It provides a summary of the key points. It has been structured around the ethical issues, as this
is the way that it will be examined at the Advanced Level.
Definitions
Integrity: Being trustworthy, straightforward, honest, fair and candid; complying with the spirit as
well as the letter of the applicable ethical principles, laws and regulations; behaving so as to
maintain the public's trust in the auditing profession; and respecting confidentiality except
where disclosure is in the public interest or is required to adhere to legal and professional
responsibilities. (Ethical Standard Part A s123)
Objectivity: Acting and making decisions and judgments impartially, fairly and on merit (having
regard to all considerations relevant to the task in hand but no other), without discrimination,
bias, or compromise because of commercial or personal self-interest or the undue influence of
others, and having given due consideration to the best available evidence.
(Ethical Standard Part A s123)
Independence: Freedom from conditions and relationships which, in the context of an
engagement, would compromise the integrity or objectivity of the firm or covered persons.
(Ethical Standard Part A s123)
Covered person: A person in a position to influence the conduct or outcome of the engagement
Close family: A non-dependent parent, child or sibling
Person closely associated with: This is:
(a) a spouse, or partner considered to be equivalent to a spouse in accordance with national
law;
(b) a dependent child;
(c) a relative who has lived in the same household as the person with whom they are
associated for at least one year;
(d) a firm whose managerial responsibilities are discharged by, or which is directly or indirectly
controlled by, the firm/person with whom they are associated, or by any person mentioned
in (a), (b) or (c) or in which the firm or any such person has a beneficial or other substantially
equivalent economic interest; or
(e) a trust whose managerial responsibilities are discharged by, or which is directly or indirectly
controlled by, or which is set up for the benefit of, or whose economic interests are

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substantially equivalent to, the firm/person with whom they are associated or any person
mentioned in (a), (b) or (c).
Public interest entity: These are:
(a) an issuer whose transferable securities are admitted to trading on a regulated market;
(b) a credit institution (in the UK a bank or building society); or
(c) an insurance undertaking.
Entity relevant to the engagement: An entity with respect to which the firm and covered persons
are required to be independent. In the case of an audit engagement, the entity relevant to the
engagement is the audited entity.
1.2 Non-involvement in Management Decision-taking

This is a key principle in the Ethical Standard. It identifies the following as judgements and
decisions which should not be taken by the firm or a covered person:
 Setting policies and strategic decisions
 Directing and taking responsibility for the actions of the entity's employees
 Authorising transactions
 Deciding which recommendations of the firm or other third parties should be implemented
C
 Taking responsibility for the preparation and fair presentation of the financial statements in H
A
accordance with the applicable financial reporting framework P
T
 Taking responsibility for the preparation and presentation of subject matter information in E
the case of an other public interest assurance engagement R
 Taking responsibility for designing, implementing and maintaining internal control 3
1.3 Self-interest threat

Financial interests The parties listed below are not allowed to own a direct
financial interest or an indirect material financial interest in
an audited entity:
 The audit firm
 Any partner in the audit firm
 Any person in a position to influence the conduct and
outcome of the engagement ie, a covered person (eg, a
member of the engagement team)
 Any person closely associated with any such partner or
covered person (Ethical Standard s.2.3D)
The following safeguards will therefore be relevant:
 Disposing of the interest
 Removing the individual from the team if required
 Keeping the audited entity's audit committee informed
of the situation
 Using an independent partner to review work carried
out if necessary

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Business relationships (eg, Firms, covered persons and persons closely associated
operating a joint venture between with them must not enter into business relationships with
the firm and the client) any entity relevant to the engagement, or its management
or its affiliates except where those relationships involve the
purchase of goods on normal commercial terms and which
are not material to either party or would be
inconsequential in the view of an objective, reasonable and
informed third party. (Ethical Standard s.2.29)
Where a business relationship exists that is not permitted
and has been entered into by the following parties:
(a) The firm: either the relationship is terminated or the
firm does not accept/withdraws from the engagement
(b) A covered person: either the relationship is terminated
or that person is excluded from any role in which they
would be a covered person
(c) A person closely associated with a covered person:
either the relationship is terminated or the covered
person is excluded from any role in which they would
be a covered person. (Ethical Standard s.2.31)
Employment with assurance client When a partner leaves the firm they may not be appointed
as a director or to a key management position/ member of
the audit committee with an audited entity, having acted as
statutory auditor or key audit partner in relation to that
audit before the end of:
(a) in the case of a public interest entity, two years; and
(b) in any other case, one year. (Ethical Standard s.2.51)
Where a partner approved as statutory auditor is
appointed as a director, a member of the audit committee
or to a key management position having previously been a
covered person:
(a) in the case of a partner, at any time during the two
years before the appointment; or
(b) in the case of another person, at any time during the
year before the appointment
the firm must resign from the engagement where possible
under applicable law or regulation. (Ethical Standard
s.2.53)
The firm cannot accept another engagement for the entity
until:
(a) in the case of a partner, a two-year period; or
(b) in the case of another person, a one year period.
Governance role The audit firm, a partner or employee of an audit firm shall
not perform a role as an officer or member of the board of
an entity relevant to the engagement. (Ethical Standard
s.2.61)

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Family and personal relationships Where a covered person or any partner in the firm
becomes aware that a person closely associated with them
is employed by an entity and that person is in a position to
exercise influence on the accounting records and financial
statements relevant to the engagement they should be
excluded from any role in which they would be a covered
person eg, they should be removed from the audit team.
Where a covered person or any partner in the firm
becomes aware that a close family member who is not a
person closely associated with them is employed by an
entity and that person is in a position to exercise influence
on the accounting records and financial statements
relevant to the engagement they should report the matter
to the engagement partner to take appropriate action.
(Ethical Standard s.2.59)
If it is a close family member of the engagement partner,
the matter should be resolved in consultation with the
Ethics Partner/Function.
Gifts and hospitality Gifts, favours or hospitality should not be accepted unless
an objective, reasonable and informed third party would
consider the value to be trivial and inconsequential. (Ethical
C
Standard s.4.61D) H
A
Loans and guarantees Firms, covered persons and persons closely associated P
with them must not enter into any loan or guarantee T
arrangement with an audited entity that is not a bank or E
R
similar institution, and the transaction is made in the
ordinary course of business on normal business terms and 3
is not material to the entity. (Ethical Standard s.2.23 – 2.25)
Overdue fees Firms should guard against fees building up, as the audit
firm runs the risk of effectively making a loan. Where the
amount cannot be regarded as trivial the engagement
partner and ethics partner must consider whether it is
necessary to resign. The ICAEW Code (s.290.223) states
that, generally, the payment of overdue fees should be
required before the assurance report for the following year
can be issued.
Percentage or contingent fees An audit cannot be undertaken on a contingent fee basis.
Non-audit/additional services must not be undertaken on a
contingent fee basis where the fee is material to the audit
firm or the outcome of the service is dependent on a future
or contemporary audit judgement which relates to a
material matter in the financial statements of an audited
entity. (Ethical Standard s.4.14)

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High percentage of fees The Ethical Standard includes a new 70% cap in respect of
non-audit services provided to an audit client as follows:
(a) Total fees for non-audit services provided to a public
interest entity audit client must be limited to no more
than 70% of the average fees paid in the last three
consecutive financial years for the audit.
(b) Total fees for such services provided by the audit firm
must be limited to no more than 70% of the average of
the fees paid to the audit firm in the last three
consecutive financial years for the audits of the entity.
(Ethical Standard s4.34R)
Where total fees (audit and non-audit services) from an
audited entity are expected to regularly exceed 15% of the
annual fee income of the audit firm (10% in the case of a
public interest entity or other listed entity), the firm should
resign or not stand for reappointment. Where total fees
from an audited entity are expected to regularly exceed
10% of the annual fee income, but will not regularly exceed
15% (5% and 10% in the case of a public interest entity or
other listed entity) the audit engagement partner should
disclose that fact to the ethics partner and those charged
with governance of the audited entity and consider
whether appropriate safeguards should be applied to
reduce the threat to independence.
Lowballing Where the fee quoted is significantly lower than would
have been charged by the predecessor firm, the
engagement partner must be satisfied that:
 the appropriate staff are used and time is spent on the
engagement; and
 all applicable assurance standards, guidelines and
quality control procedures have been complied with.
The engagement partner must be able to demonstrate that
the engagement has assigned to it sufficient partners and
staff with appropriate time and skills, irrespective of the fee
charged.
Fees must not be influenced or determined by the
provision of non-audit/additional services to an entity.
1.4 Self-review threat

Service with an assurance client Individuals who have been a director or officer of the client,
or an employee in a position to exert direct and significant
influence over the financial statements on which the firm
will express an opinion should not be assigned to the audit
team. (ICAEW Code s.290.144)
The Ethical Standard states that in this situation the
individual should be excluded from any role in which they
would be a covered person for a period of two years
following the date of leaving the entity.

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Preparing accounting records and The Ethical Standard (s.5.155) prohibits the provision of
financial statements accounting services where:
(a) the entity is a listed entity (that is not an SME listed
entity); or
(b) for any other entity if those accounting services would
involve the firm undertaking the role of management.
Where accounting services are provided, safeguards
include:
 using staff members other than engagement team
members to carry out work;
 a review of the accounting services provided by a
partner or other senior staff member with relevant
expertise who is not a member of the engagement
team; and
 a review of the engagement by a partner or other
senior staff member with relevant expertise who is not
a member of the engagement team.
The ICAEW Code (s.290.174) allows firms to prepare
accounts for financial statements for listed audited entities,
C
in an emergency situation. This exemption has been H
removed from the FRC guidance. A
P
Provision of other services The EU Audit Regulation and Directive has banned the T
E
provision of certain non-audit services for public interest R
entities. These prohibitions have largely been adopted by
the FRC in the Ethical Standard. 3
For other entities, while in principle the provision of other

services is allowed, the threat of self-review must be
considered particularly where the matter in question will be
material to the financial statements. Safeguards may
mitigate the threats in some circumstances although the
Ethical Standard does include a number of instances where
the provision of the service would be inappropriate
irrespective of any safeguards. In particular, the service
should not be provided where the audit firm would
undertake part of the role of management.
 Valuation services
Valuation services to public interest entities are
prohibited.
For other listed entities that are not SMEs valuation
services cannot be provided where the valuation would
have a material effect on the entity's financial
statements.
For all other companies the restriction applies where the
valuation involves a significant degree of subjective
judgment and has a material effect on the financial
statements.

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 Taxation services
The firm must not provide the following tax services to a
public interest entity audit client:
– Preparation of tax form
– Tax services relating to payroll and customs duties
– Calculation of direct tax, indirect tax and deferred tax
– Provision of tax advice
For other audit clients the basic principle is that a tax
service can be provided where the service would not
involve the firm in undertaking a management role. (Ethical
Standard s.5.89)
For listed companies that are not SMEs a firm cannot
provide a service to prepare current or deferred tax
calculations that are material to the financial statements.
(Ethical Standard s.5.92)
 Internal audit services
The provision of internal audit services for a public
interest entity is prohibited.
For other audit clients the service cannot be provided
where the firm would place significant reliance on the
internal audit work performed by the firm or where the
firm would undertake the role of management (Ethical
Standard s.5.53)
 Corporate finance services
The following services are prohibited for public interest
entities:
– Services linked to the financing, capital structure and
allocation, and investment strategy of the audited
entity, except providing assurance services in relation
to the financial statements eg, issuing comfort letters
in connection with a prospectus
– Promoting, dealing in or underwriting shares
 Information technology services
Provision of services which involve designing and
implementing internal control or risk management
procedures related to the preparation and/or control of
financial information or designing and implementing
financial information technology systems is prohibited
for public interest entities. The prohibition apples in the
12 months before appointment as auditors as well as the
period of appointment.
Information technology services can be provided for
other audit clients provided the system concerned is not
important to a significant part of the accounting system
or to the production of the financial statements. (Ethical
Standard s.5.63)

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 Litigation support services

Valuation services including valuations performed in
connection with litigation support services are
prohibited in respect of public interest entities.
For other listed entities which are not SME listed entities
litigation support should not be provided where it
involves the estimation by the firm of the outcome of a
pending legal matter that could be material to the
financial statements. (Ethical Standard s.5.67)
For other entities the restriction applies where the
matter is potentially material and there is a significant
degree of subjectivity.
1.5 Advocacy threat

Arises where the assurance firm is The Ethical Standard prohibits the provision of legal
in a position of taking the client's services for public interest entities with respect to:
part in a dispute or somehow
 the provision of legal counsel;
acting as their advocate.
 negotiating on behalf of the audit client; and
Examples:  acting in an advocacy role in the resolution of litigation.
 If the firm carried out For other entities legal services should not be provided C
corporate finance work for the H
where it would involve acting as the solicitor formally
A
client; eg, if the audit firm were nominated to represent the client in resolution of a dispute P
involved in advice on debt or litigation which is material to the financial statements T
restructuring and negotiated (Ethical Standard s.5.107). E
R
with the bank on the client's
behalf. 3
 If the firm offered legal

services to a client and, say,
defended them in a legal case.
1.6 Familiarity threat

Long association The Ethical Standard requires compliance with Article 17 of
the EU Audit Regulation on audit firm rotation. As
previously referred to, there is a requirement that for public
interest entities an audit tender must be carried out at least
every 10 years, with mandatory rotation of an audit firm at
least every 20 years.
The Ethical Standard also requires all firms to monitor the
relationship between staff and established clients.
The general provision in the Ethical Standard is that when
engagement partners, key partners involved in the audit
and partners and staff in senior positions have a long
association with the audit, the firm must assess the threats
to objectivity and independence and apply safeguards to
reduce the threats to an acceptable level. Once an audit
engagement partner has held this role for a continuous
period of 10 years, careful consideration must be given as
to whether the audit firm's objectivity and independence is
impaired.

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The standard states the following for listed companies:

 No one should act as audit engagement partner for a
continuous period longer than five years. (Ethical
Standard s.3.11)
 The engagement partner may continue in this position
for an additional two years where the audit committee
decide that this is necessary to safeguard the quality of
the audit. Safeguards must be applied and disclosure
made to the shareholders. (Ethical Standard s.3.15)
 Individuals who have acted as audit engagement
partner for a period of five years should not
subsequently participate in the audit until a period of
five years has elapsed. (Ethical Standard s.3.11)
 No one should act as engagement quality reviewer or
key partner involved in the audit for a continuous
period of more than seven years (and when an
engagement quality control reviewer or a key partner
involved in the audit becomes the audit engagement
partner the combined service should not be more than
seven years). (Ethical Standard s.3.20)
 Anyone who has acted as engagement quality
reviewer for seven years should not return to that
position for at least five years. (Ethical Standard s.3.20)
 Anyone who has acted as key partner involved in the
audit for seven years should not return to that position
for at least two years. (Ethical Standard s.3.20)
The ICAEW Code (s 290.151) states that for the audit of
listed entities:
 The engagement partner and individuals responsible
for engagement quality control review should be
rotated after a predefined period, normally no more
than seven years, and should not return to the
engagement until a period of two years has elapsed.
Recruitment For a public interest entity the firm is prohibited from
searching for candidates and undertaking reference checks
in respect of management who will be in a position to exert
significant influence over the preparation of the accounting
records or financial statements.
For all entities the firm must not provide recruitment
services which would involve the firm taking responsibility
for the appointment of any director (Ethical Standard
s.5.109). In addition for a listed entity which is not an SME
the firm must not provide recruitment services in relation to
key management. (Ethical Standard s.5.111)
For entities other than public interest senior members of
the audit team may interview prospective directors or
employees and advise on the candidate's technical
competence. (Ethical Standard s.5.115)

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1.7 Intimidation threat

Litigation Generally, assurance firms should seek to avoid litigation
eg, where a client threatens to sue or does sue. If this type
of situation does arise, the following safeguards should be
considered:
 Disclosing to the audit committee the nature and
extent of the litigation
 Removing specific affected individuals from the
engagement team
 Involving an additional professional accountant on the
team to review work
Where litigation threatens independence the normal
course of action would be to resign. However, the firm is
not required to resign immediately in circumstances where
a reasonable and informed third party would not regard it
in the interests of the shareholders for it to do so. This
might be the case where:
 the litigation was started as the engagement was
about to be completed and shareholders would be
adversely affected by the delay; or C
H
 on legal advice, the firm deems that the litigation is A
designed solely to bring pressure to bear on the P
T
auditor's opinion. E
R
1.8 Management threat 3
Arises when the audit firm  If there is informed management (ie, management
undertakes work which involves capable of making independent judgements and
making judgements and taking decisions on the basis of the information provided)
decisions that are the safeguards may be able to mitigate the threat.
responsibility of the management
 If there is no informed management, it is unlikely that
the threat can be avoided if the work is undertaken.
Point to note:
A given situation may give rise to more than one threat.

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Appendix 2
1 Provisions available for small entities
1.1 Exam focus

Section 6 of the Revised Ethical Standard 2016 covers this issue. It relaxes the ethical rules for
smaller entities by making use of exemptions and some additional disclosures. It applies where
the client qualifies as a small company under the Companies Act 2006 and covers three issues
dealt with by the Ethical Standards. In your exam you may need to consider ethical issues, as
they affect smaller companies specifically.
1.2 Key points

Fee dependence Where total fees for audit and non-audit services from a
non-listed audited entity will regularly exceed 10% of
the annual fee income of the firm but will not regularly
exceed 15%, no external independent quality control
review is required. Instead this must be disclosed to the
ethics partner and those charged with governance.
Non-audit services The restrictions on the provision of non-audit services
are waived, but:
 there needs to be 'informed management';
 the audit firm needs to extend its cycle of cold
reviews; and
 the departure needs to be mentioned in the
auditor's report.
Partners joining audit clients The provisions concerning partners joining audit clients
are waived provided there is no threat to the audit
team's integrity, objectivity and independence.
Disclosure should be made in the auditor's report.

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Summary
Ethical conflict – Reporting
resolution procedure Ethics misconduct
• Establish relevant facts To ICAEW

• Identify relevant parties
• Issues involved
• Apply fundamental principles
• Use internal procedures Accountants in
Auditor
• Alternative courses of action business
FRC Revised Pressures to improve

Ethical IESBA code ICAEW Code
financial
Standard performance/position
2016 of employer
Changes:
• Content
• Structure Fundamental Threats Safeguards
principles
Part A: Overarching principles • Integrity • Self-interest • Professional, C

and supporting ethical provisions • Self-review legislation/regulation H
• Objectivity
• Management (professional training, A
Part B • Professional CPD, regulatory
competence and due • Advocacy P
Section 1: General requirements monitoring, external
and guidance care • Familiarity T
review
• Confidentiality • Intimidation E
Section 2: Financial, business, • Work environment (firm
• Professional behaviour R
employment and personal and engagement team
relationships level)
3
Section 3: Long association with
engagements and with entities
relevant to engagements
Section 4: Fees, remuneration and
evaluation policies, gifts and
hospitality, litigation
Section 5: Non-audit/additional
services
Section 6: Provisions available
for audits of small entities

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Self-test
1 Easter
You are a partner in a firm of chartered accountants. The following issues have emerged in
relation to three of your clients:
(1) Easter is a major client. It is listed on a major exchange. The audit team consists of eight
members, of whom Paul is the most junior. Paul has just invested in a personal pension
plan that invests in all the listed companies on the exchange.
(2) While listed, Easter has subsidiaries in five different European countries. Tax regimes in
those countries vary on the absolute rate of tax charged as well as expenses allowable
against taxable income. The Finance Director of Easter has indicated that the Easter
group will be applying management charges between different subsidiaries to take
advantage of favourable tax regimes with the five countries. The FD reminds you that
another firm offering assurances services, Bunny & Co, has already approved the
management charges as part of a special review carried out on the group and the FD
therefore considers the charges to be legal and appropriate to Easter.
(3) You are at the head of a team carrying out due diligence work at Electra, a limited
company which your client, Powerful, is considering taking over. Your second in
command on the team, Peter, who is a manager, has confided in you that in the course
of his work he has met the daughter of the Managing Director of Electra, and he is
keen to invite her on a date.
(4) Your longest standing audit client is Teddies, which you have been involved in for ten
years, with four years as engagement partner. You recently went on an extended cruise
with the Managing Director on his yacht. The company is not a public interest entity or
listed entity.
(5) You are also aware that the executive directors of Teddies were recently voted a
significant increase in bonus by their audit committee. The financial statements of
Teddies do show a small improvement in net profit, but this does not appear to justify
the extent of bonus paid. You are also aware that the Finance Director of Teddies is a
non-executive director of Grisly, while the Senior Independent Director of Teddies is
the Finance Director of Grisly.
Requirement
Comment on the ethical and other professional issues raised by the above matters.
(Note: Your answer should outline the threat arising, the significance of the threat, any
factors you have taken into account and, if relevant, any safeguards you could apply to
eliminate or mitigate against the threat.)
2 Saunders plc
Bourne & Berkeley is an assurance firm with a diverse range of audit clients. One client,
Saunders plc, is listed on the stock exchange. You are the engagement partner on the
audit; you have been engagement partner for four years and have an experienced team of
eight staff to carry out the audit. The audit is made slightly more complicated because
Bourne & Berkeley rent office space from Saunders plc. The total rental cost of that space is
about 10% of the total income from Saunders plc. Office space is made available to other
companies, including Walker Ltd, another of your audit clients. You are aware from the
audit of Walker Ltd that the company is close to receivership and that the rent arrears is
unlikely to be paid by Walker to Saunders.
In an interesting development at the client, the Finance Director resigned just before the
audit commencing and the board asked Bourne & Berkeley for assistance in preparing the
financial statements. Draft accounts were available, although the final statutory accounts
had not been produced.

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As part of your review of the draft accounts you notice that the revenue recognition policy
includes an estimate of future revenues from the sale of deferred assets. One of the
activities of Saunders plc is the purchase of oil on the futures market for delivery and resale
between 6 and 12 months into the future. As the price of oil rises, the increase has been
taken to the statement of profit or loss and other comprehensive income. When queried,
the directors of Saunders state that while the accounting policy is new for the company, it is
comparable with other firms in the industry and they are adamant that no amendment will
be necessary to the financial statements. They are certain that other assurance firms will
accept the policy if asked.
Requirement
Discuss the ethical and professional issues involved with the planning of the audit of
Saunders plc.
3 Marden plc
At 6pm on Sunday evening a text message arrives for you from your audit manager, John
Hanks, stating:
"Please check your email urgently"
On checking your email, you find the following message.
I hope you had a good weekend. Instead of coming into the office tomorrow morning I
would like you to go to a client called Marden plc. I know you have not worked on this
client before so I am emailing you some background information (Exhibit 1). One of C
our audit juniors, Henry Ying, was at Marden's head office last week working on the H
A
interim audit and he has come up with a schedule of issues that are worrying me
P
(Exhibit 2). Henry does not have the experience to deal with these, so I would like you, T
as a senior, to go out there and prepare a memorandum for me which sets out the E
financial reporting implications of each of these issues. I would also like you to explain R
in the memorandum the ethical issues that arise from these issues and the audit 3
procedures required for each of the matters on Henry's schedule. I will visit Marden on
Tuesday to speak to the directors.
John
Requirement
Prepare the memorandum requested by your audit manager.
Exhibit 1: Background information

Marden plc operates a fleet of 10 executive jets available for private hire. The jets are based
in Europe, the US and the Far East, but they operate throughout the world. The company is
resident in the UK.
The jets can be hired for specific flights, for short periods or for longer periods. For
insurance purposes, all planes must use a pilot employed by Marden. All the jets are owned
by Marden.
Marden has an Alternative Investment Market listing. Ordinary share capital consists of five
million £1 shares. The ownership of share capital at 1 January 20X6 was:
Directors 25%
Financial institutions 66%
Crazy Jack Airlines plc 9%
The company uses an interest rate of 10% to discount the cash flows of all projects.
The accounting year end is 31 December.

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Exhibit 2: Interim audit issues

Prepared by Audit Junior: Henry Ying
In respect of the interim audit of the financial statements for the year to 31 December 20X6
the following issues have arisen.
(1) Marden appears to have inadvertently filed an incorrect tax return for last year showing
a material understatement of its corporation tax liability for that year and has therefore
paid significantly less corporation tax than it should have. Our firm is not engaged as
tax advisers. The directors are now refusing to inform HM Revenue & Customs of the
underpayment, as they say that 'it is in the past now'. I am not sure of our firm's
obligations in this matter.
(2) One of the directors, Dick Tracey, owns a separate travel consultancy business. He buys
unused flying time from Marden to sell to his own clients. In the year to 31 December
20X6 to date he has paid Marden £30,000 for 100 hours of flying time made available.
(3) On 16 September 20X6 a major customer, Stateside Leisure Inc, gave notification to
Marden that the service it had been receiving was poor and it was therefore
considering terminating its long-term contract with the company. The contract
amounted to 15% of Marden's revenue and 25% of its profit in 20X5. The directors did
not make an immediate announcement of this and so the share price did not initially
change. Four directors sold a total of 200,000 shares in Marden plc on 2 October
20X6. Stateside Leisure Inc terminated the contract on 1 November 20X6 and the
directors disclosed this to the London Stock Exchange the same day. The price per
share then fell immediately from £7.50 to £6.
(4) Our audit fee for the year to 31 December 20X5 is still outstanding and is now overdue
by five months.
(5) I have selected a sample jet to be physically inspected. I selected this jet because it
does not appear to have flown since December 20X5. The jet in question cost £6 million
on 1 January 20W8 and has a useful life of 10 years with a residual value of £1 million.
Each jet is expected to generate £2 million income per year net of expenses.
The directors say that this jet is located in the US, but they have offered to fly a member
of our audit team out there in one of their executive jets. They insist that a jet needs to
go there anyway so there would be no cost to Marden by making transport available to
us.
(6) On 28 August 20X6 Crazy Jack Airlines plc – a large, listed company which operates a
discount airline – acquired 1 million shares in Marden from financial institutions. On
20 October 20X6 Crazy Jack Airlines plc announced to the London Stock Exchange
that it intends to make a bid for the entire share capital of Marden and at the same time
requested that our firm, as Marden's auditors, should carry out the due diligence work
in respect of the bid.

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Factors
 The request was made by her superiors.
 Financially she may have felt pressure to keep her job.
 Potential prospect of being rewarded through promotion and pay rises.
 Inability to decide how to deal with the situation.
Other courses of action
She could have:
 refused to make the adjustments;
 brought the matter to the attention of other senior members of staff eg, internal audit;
 resigned;
 sought advice from her relevant professional body;
 sought legal advice; or
 reported the matter to the relevant authorities eg, SEC at an earlier stage.
Answer to Interactive question 2 C

H
Personal interests Review of your own work Disputes Intimidation A
P
Undue dependence on an Auditor prepares the Actual litigation Any threat of T
E
audit client due to fee accounts with a client litigation by the R
levels client
3
Overdue fees becoming Auditor participates in Threatened Personal
similar to a loan management decisions litigation with a relationships with
client the client
An actual loan being Provision of any other Client refuses to Threat of any
made to a client services to the client pay fees and services being put
they become out to tender
long overdue
Contingency fees being
offered
Accepting commissions
from clients
Provision of lucrative other

services to clients
Relationships with persons

in associated practices
Relationships with the

client
Long association with

clients

lOMoARcPSD|5054551
Personal interests Review of your own work Disputes Intimidation
Beneficial interest in
shares or other
investments
Hospitality

(1) Teresa is at present a member of the assurance team and a member of her immediate
family owns a direct financial interest in the audit client. This is unacceptable.
In order to mitigate the risk to independence that this poses on the audit, Stewart Brice
needs to apply one of two safeguards:
 Ensure that the connected person divests the shares
 Remove Teresa from the engagement team
Teresa should be appraised that these are the options and removed from the team while a
decision is taken whether to divest the shares. Teresa's husband appears to want to keep
the shares, in which case Teresa should be removed from the team immediately.
The firm should appraise the audit committee of Recreate of what has happened and the
actions it has taken. The partners should consider whether it is necessary to bring in an
independent partner to review audit work. However, given that Teresa's involvement is
subject to the review of the existing engagement partner and she was not connected with
the shares while she was carrying out the work, a second partner review is likely to be
unnecessary in this case.
(2) The audit firm has an indirect interest in the parent company of a company it has been
invited to tender for by virtue of its pension scheme having invested in Tadpole Group.
This is no barrier to the audit firm tendering for the audit of Kermit Co.
Should the audit firm win the tender and become the auditors of Kermit Co it should
consider whether it is necessary to apply safeguards to mitigate against the risk to
independence on the audit as a result of the indirect financial interest.
The factors that the partners will need to consider are the materiality of the interest to either
party and the degree of control that the firm actually has over the financial interest.
In this case, the audit firm has no control over the financial interest. An independent
pension scheme administrator is in control of the financial interest. In addition, the interest
is unlikely to be substantial and is therefore immaterial to both parties. It is likely that this
risk is already sufficiently minimal as to not require safeguards. However, if the audit firm felt
that it was necessary to apply safeguards, it could consider the following:
 Notifying the audit committee of the interest
 Requiring Friends Benevolent to dispose of the shares in Tadpole Group
(3) In this case, Stewart Brice has a direct financial interest in the audit client, which is
technically forbidden by ethical guidance. However, it is a requirement of any firm auditing
the company that the share be owned by the auditors.
The interest is not material. The audit firm should safeguard against the risk by not voting
on its own re-election as auditor. The firm should also strongly recommend to the company
that it removes this requirement from its constitution, as it is at odds with ethical
requirements for auditors.

lOMoARcPSD|5054551

The issues to consider would include the following:
 Whether the management have made the decision to make the change in accounting
treatment of a proportion of the subscription income on a valid and ethical basis.
 Management are under pressure not to breach the loan covenants. With the change in
timing of the recognition the interest cover is only just achieved in both 20X7 and 20X8.
This suggests that without this change the covenant would be breached indicating that
profit levels are sensitive.
 The auditor's responsibility to stakeholders.
 In this case the auditor would have a legal and moral responsibility to the venture capitalists
who have invested in Bellevue Ltd, to ensure that profits are fairly stated.
 The implications of the disagreement with the treatment by the audit manager in 20X7
which was overruled by the partner. This is now of particular concern, as the audit partner
has left the firm abruptly. This potentially raises questions about the integrity of the partner.
 Whether there is sufficient evidence to support the conclusion that some of the subscription
fees are consultancy in nature and should therefore be recognised as the work is
completed ie when the performance obligation is satisfied (IFRS 15) rather than being
recognised over the duration of the contract.
 Whether fees treated as subscription fees in previous years should have been recognised
C
as consultancy fees resulting in the need for a prior-period adjustment. H
A
 The basis on which the figure of 40% was established and whether there is evidence to P
support this estimation, particularly as this is exactly the same percentage as applied in T
20X7. E
R
 The overall increase in audit risk due to the need to comply with the loan agreement.
3

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1 Easter
(1) In relation to Easter, there is a threat of self-interest arising, as a member of the audit
team has an indirect financial interest in the client.
The relevant factors are as follows:
 The interest is unlikely to be material to the client or Paul, as the investment is
recent and Paul's interest is in a pool of general investments made in the
exchange on his behalf.
 Paul is the audit junior and does not have a significant role on the audit in terms of
drawing audit conclusions or audit risk areas.
The risk that arises to the independence of the audit here is not significant. It would be
inappropriate to require Paul to divest his interest in the audit client. If I wanted to
eliminate all elements of risk in this situation, I could simply change the junior assigned
to my team, but such a step is not vital in this situation.
(2) Regarding the management charges, there is a threat that the management charges
are accepted as correct, simply because another assurance firm has recommended
those charges to Easter. To query the charges could imply a lack of trust in Bunny, with
the possible effect of bringing the profession into disrepute. There is a risk that you as
the assurance professional may not have the necessary knowledge to determine
whether or not Easter has been acting correctly. There is also an intimidation threat in
that the client is implying the charges are valid as another assurance firm has
recommended the changes.
The relevant factors to take into account include the following:
 The legality or otherwise of the transactions. Information concerning the
management charges must be obtained and compared to the law, not only of the
individual countries but also of the EU as a whole. It remains a possibility that Easter
has acted in accordance with laws of individual jurisdictions, but not the EU overall.
 Your level of knowledge. Where necessary, specialist advice must be obtained

from the taxation department to determine the legality or otherwise of the
transactions.
 The materiality of the management charges involved and the reduction in the
taxation expense. Given that Easter is attempting to minimise its taxation charge,
then the amounts are likely to be material and therefore as the audit firm, the
transactions will have to be audited.
 Your knowledge of Bunny & Co. The assurance firm may well be skilled in advising
on this type of issue, in which case there is likely to be less of an issue with the
legality of the charges. However, if the reputation of Bunny is suspect, then
additional work on the management charges may be required.
The intimidation threat is significant; it is unlikely that Easter would expect your firm to
query the charges as another professional firm has confirmed them. A discussion with
the FD may be required to confirm the purposes of the audit and the extent of
evidence required to reach an audit opinion. Material transactions affecting the
financial statements and taxation charges must be subject to standard audit
procedures.

lOMoARcPSD|5054551
Your potential lack of knowledge is relatively easy to overcome. Specialist advice can
be obtained from the taxation department, with a tax manager/partner being present
in any discussion with the client to determine legality of the management charges.
(3) In relation to Powerful, two issues arise. The first is that the firm appears to be
providing multiple services for Powerful, which could raise a self-interest threat. The
second is that the manager assigned to the due diligence assignment wants to engage
in a personal relationship with a person connected to the subject of the assignment,
which could create a familiarity or intimidation threat.
With regard to the issue of multiple services, insufficient information is given to draw a
conclusion as to the significance of the threat. Relevant factors would be such matters
as the nature of the services, the fee income and the team members assigned to each.
Safeguards could include using different staff for the two assignments. The risk is likely
to be significant only if one of the services provided is audit, which is not indicated in
the question.
In relation to the second issue, the relevant factors are these:
 The assurance team member has a significant role on the team as second in
command.
 The other party is closely connected to key staff member at the company being
reviewed.
 Timing.
C
In this situation, the firm is carrying out a one-off review of the company, and timing is a H
key issue. Presently Peter does not have a personal relationship which would A
significantly threaten the independence of the assignment. In this situation, the P
T
safeguard is to request that Peter does not take any action in that direction until the
E
assignment is completed. If he refuses, then I may have to consider rotating my staff on R
this assignment, and removing him from the team.
3
(4) In relation to Teddies, there is a risk that my long association and personal relationship
with the client will result in a familiarity threat. This is compounded by my acceptance
of significant hospitality on a personal level.
The relevant factors are as follows:
 I have been involved with the client for 10 years and have a personal relationship
with client staff.
 The company is not a listed or public interest company.
 It is an audit assignment.
The risk arising here is significant but, as the client is not listed, it is not insurmountable.
However, it would be a good idea to implement some safeguards to mitigate against
the risk. I could invite a second partner to provide a hot review of the audit of Teddies,
or even consider requesting that I am rotated off the audit of Teddies for a period, so
that the engagement partner is another partner in my firm. In addition, I must cease
accepting hospitality from the directors of Teddies unless it is clearly insignificant.
Other options that can be considered include rotation of the engagement partner and
other senior audit staff in an attempt to remove the conflict of interest. Finally, if the
independence issue cannot be resolved then the audit firm may also consider resigning
from the audit of Teddies.
(5) It appears that there are cross-directorships between Teddies and Grisly. In other
words, at least one executive in Teddies assists in setting the bonuses of directors in
Grisly, and at least one executive in Grisly is involved in setting the bonuses of directors
in Teddies. This issue provides an independence threat for those directors, especially
so if the FDs are members of a professional body such as ICAEW.

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There is a further point, that you as engagement partner are aware of the issue, but
your independence may be compromised by the cruise with the managing director.
There is also the issue of the lack of clear reporting obligations in this situation. Most
codes of corporate governance require the directors of the company to make
statements of compliance with that code, and in many situations cross-directorships are
not explicitly banned.
Factors to consider include:
 Whether the directors are members of a professional body. If so, the engagement
partner could tactfully ask whether there are independence conflicts and how these
will be resolved.
 The level of bonuses awarded in Grisly. If these appear to be nominal then the
issue of lack of independence regarding the bonuses in Teddies is reduced.
 Whether Teddies has audit and remuneration committees and whether these are
effective in determining director remuneration and communicating concerns of
the auditor to the board. As auditor, you have access to the audit committee but
not the remuneration committee. So there is no precise way of raising concerns
with the remuneration committee.
 To a certain extent, the association threat of being linked to a client where the
code of corporate governance may not be being followed.
As the engagement partner, it would be appropriate to mention the perceived lack of
independence with the Finance Director. This may be directly rather than via the audit
committee due to the lack of communication you have with the remuneration
committee. The result of any communications must be documented in the audit file,
even where communication is simply verbal.
The association risk is probably minimal, although will increase where your firm also
provides assurance services to Grisly. Where there are significant and continued
breaches of the code of governance, then your firm may consider not acting for
Teddies in the future. Provision of additional disclosure is compromised by lack of
reporting obligations and your independence issue with the managing director of
Teddies.
2 Saunders plc
(a)  The rental of the premises from an audit client represents a business relationship
which poses a potential threat to objectivity.
 Bourne & Berkeley would be able to continue to act if the arrangement is:
– in the ordinary course of business;
– on an arm's length basis; and
– not material to either party.
 In this case the rental income is likely to be material to the audit client, as it
represents 10% of total income.
 The audit firm would need to take immediate steps to terminate either the client
or the business relationship.
(b)  The FRC Revised Ethical Standard prohibits accounts preparation work for listed
company audit clients.
 In this case it is likely that the preparation of the financial information will involve
the auditor in making subjective judgements, as the internal reporting format will
need to be converted into the statutory format. Decisions will need to be made
about, for example, the level and nature of disclosures. This would constitute an
accountancy service and would not be allowed.

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(c)  There is a conflict of interest here. While it may be in the interest of Saunders plc
for the auditor to disclose the information regarding the recoverability of the debt,
this information is confidential, as it was obtained in the course of audit work
performed for Walker Ltd. Disclosure of this information to Saunders plc would
breach the duty of confidentiality.
 Section 220 of the ICAEW Code requires that the auditor should disclose a conflict
of interest to the parties involved. In this case, however, the situation is
complicated by the fact that the conflict of interest has had a practical
consequence rather than simply being a potential problem. In addition, it may be
difficult to make the communication without revealing confidential information.
 The firm should consider whether there were sufficient procedures in place to
prevent the conflict of interest occurring in the first place.
 The ICAEW Code states that the auditor should take steps to identify
circumstances that could pose a conflict of interest and to put in place any
necessary safeguards eg, use of separate audit teams.
 If procedures were inadequate this may have implications for other clients.
 If the balance is not material further action is unlikely to be necessary. If the
balance is material the situation will need to be addressed.
 Saunders plc may be aware of the potential irrecoverability of the debt and an
allowance for an irrecoverable receivable may have been made in the financial
statements. C
H
 If an adjustment has been made and the auditor is in agreement with it no further A
action would be required. P
T
 Independent evidence may be available which would indicate that the debt was E
irrecoverable. For example, there may have been correspondence between R
Saunders plc and Walker Ltd concerning the payment of the balance. There may 3
also be evidence in the public domain, for example newspaper reports and the
results of credit checks. However, the auditor would need to consider how this
evidence was used, particularly if it was sought as a result of having the
confidential information.
 The audit manager could consider requesting Walker Ltd to communicate with
Saunders plc.
 This may not be acceptable to Walker Ltd, who may feel that any communication
would not be in their interest. It may also make any future relationship between
the auditor and Walker Ltd difficult.
 If the issue cannot be resolved and the balance is material the auditor will not be
able to form an audit opinion. Bourne & Berkeley will need to consider resigning as the
auditor of Saunders plc.
(d) Revenue recognition policy
It appears that Saunders plc is attempting to implement a change in accounting policy
which increases revenue, while at the same time intimidating the auditors to accept this
policy. There is an implied threat that Bourne & Berkeley will be removed from office if
the accounting policy is not accepted.
Factors to consider include the following:
 The materiality of the amounts involved. Given that the accounting policy is an
attempt to increase revenue, the amount is likely to be material – again it would be
unlikely that the directors would want to spend the time and effort if this was not
the case.

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 The accounting policies adopted by similar firms in the industry. The directors of
Saunders have noted that the income recognition policy is the same as other firms
in the industry. Accounts of similar firms need to be obtained and the accounting
policies checked. If the policies are the same as Saunders, and the technical
department of Bourne & Berkeley confirm that the policy follows GAAP, then no
modification of the auditor's report will be required, although audit evidence will
be obtained to confirm the correct application of the policy. If the revenue
recognition policy is inappropriate, then additional discussion will be required
with the directors to determine whether they will continue with the policy, and risk
a modified report, or amend the policy.
 Whether the directors would actually seek to remove Bourne & Berkeley if the
revenue recognition policy does not follow GAAP and the auditor's report will be
modified. The audit firm needs to document the situation and be prepared to
provide a statement on why it is being removed in accordance with Companies
Act requirements.
Bourne & Berkeley will find it difficult to remove the intimidation threat. Advice can be
obtained from the ethics partner, although it is unlikely that the firm's position can be
defended by agreeing to an accounting policy if this does not follow GAAP. Bourne &
Berkeley will need to maintain its integrity by insisting that appropriate accounting
policies are followed, even where this risks losing an audit client.
3 Marden plc
Memorandum
To: Audit manager
From: Audit senior
Date: XX-XX-XX
Subject: Accounting issues of Marden plc
(1) Understatement of tax liability
Audit and ethics
The understatement of the tax liability is an illegal act by the client. Tuesday's meeting
offers the opportunity to attempt to persuade the client even at this late stage.
Consider whether a partner needs to be at the meeting given the ethical importance of the
issue.
The key issue is the conflict between our duty to report and our duty of confidentiality.
According to ICAEW ethical requirements in terms of reporting, this may be:
 where there is a duty to disclose
 where there is a right to disclose
Suggested actions if the client continues to refuse to disclose to HMRC:
 Our views should be put in writing to the client
 Report to the audit committee if there is one
 Refer the matter to senior personnel in our firm – eg, the ethics partner
 The firm must consider whether to cease to act for the client
 Consider whether this is a 'whistleblowing' incident in the public interest
Financial reporting
If there is a material unrecognised liability in the financial statements then we need to
consider whether the financial statements give a true and fair view. Any material
understatement of the tax provision would need to be disclosed in the auditor's report.

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The level of detail as to the cause of the misstatement raises confidentiality

considerations.
(2) Related party transaction
Audit and ethics
The audit issue in this case is that there is a potential conflict of interest between a
director and the body of shareholders.
Directors also have a fiduciary duty to act in the interests of all shareholders. Directors
must not place themselves in a position where there is a conflict of interest between
their personal interests and their duty to the company (Regal (Hastings) Ltd v Gulliver).
In certain circumstances the company may void such contracts.
More specifically, the audit risk in this case is that the price of £30,000 for the use of the
jet might not be an arm's length price in terms of an hourly rate for this type of hire. At
£300 per hour including the pilot's time there is a risk that the director, Dick Tracey,
may be exploiting his position.
The Companies Act imposes restrictions on the dealings of directors with companies in
order to prevent directors taking advantage of their position. This applies even where
the directors are shareholders, but particularly where the interests of non-controlling,
or outside, shareholders may be damaged.
If there has not been knowledge and approval of the transactions by the other
directors then there may be an issue of false accounting by Dick Tracey. C
H
Audit procedures: A
P
 Review provisions in Articles of Association regarding directors' contracts with the T
company E
R
 Examine the terms of the contract(s) ascertaining the nature of the hire
agreements 3
 Ascertain whether any similar arm's length hires took place and at what prices (see
evidence of such agreements where appropriate)
 Ascertain whether the other directors were aware of the nature and extent of the
hire contracts (eg, review correspondence)
 Review board minutes to see if the hire contracts have been considered and
formally approved by the board
Financial reporting
Transactions involving directors are required to be disclosed in the financial statements
by both the Companies Act 2006 and IAS 24, Related Party Disclosures.
A director is part of key management personnel and thus is a related party of the
company. According to IAS 24 the transaction should be disclosed irrespective of its
materiality. However, the name of the director need not be disclosed.
As a result, the hire fees are likely to be deemed to be a related party transaction and
thus the following disclosures should be made:
 Amounts involved
 Amounts due to or from the related party
 Irrecoverable debt write-offs to or from the related party

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(3) Directors' share trading

Audit and ethics
There are two issues in this case:
 The failure to make a timely disclosure for personal gain by the directors
 The consequences of the underlying event of the loss of a major contract
The failure to announce the loss of the contract might leave the directors in breach of
their fiduciary duty to shareholders, as they may have manipulated the market for their
own gain.
Consider taking legal advice as to whether an illegal act has been committed, as the
initial communication from Stateside in September was only about poor service. The
formal notification of the contract being terminated by Stateside was immediately
communicated to the London Stock Exchange by the directors.
Consider also taking advice as to whether stock market rules have been breached by
the directors individually and by the company. This might affect quality of markets and
may be contrary to insider trading laws.
Regarding the underlying event of the loss of a major customer, consideration needs
to be given as to whether going concern is affected by the loss of such a large contract
(eg, if the service is poor, will other major contracts be lost?).
Financial reporting
Consider whether any provision is necessary once advice is received on whether the
company has committed an illegal act (as opposed to the directors themselves) or has
been in breach of regulations. Provisions might include fines or other penalties
imposed by the courts or regulators.
If there has been a significant decline in activity, then impairment needs to be
considered on the jets if their value in use has decreased.
Consider recoverability of amounts outstanding from Stateside Leisure Inc.
(4) Audit fee outstanding
Audit and ethics
It may be that the matter of the overdue fees can be resolved amicably at Tuesday's
meeting.
If, however, the fee remains outstanding, it may be a threat to our independence. This
may be because it biases our opinion against the client. Alternatively, it may be that we
do not wish to put the client's going concern at risk, as this may reduce the likelihood
of us receiving payment.
In effect, the overdue fee may be similar to a loan to the client which is not permitted.
Actions may include the following:
 A review by an independent partner (perhaps the ethics partner) who is not
involved in the audit to agree that the objectivity of the engagement staff is not
affected. This should really have been completed before commencement of the
audit so it is now a matter of urgency.
 If legal action is necessary to recover the fees it would not be possible for us to
continue acting for the client, as the Revised Ethical Standard 2016 forbids, in
most circumstances, auditors acting for clients where there is actual or potential
litigation between the two parties.

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Financial reporting
A provision should be made for the audit fee outstanding.
(5) Physical inspection of jets
Audit and ethics
There are two issues here.
 The fact that one jet appears not to have been used
 The offer of 'free' transport on an executive jet may be deemed as a gift
The fact that a jet has not been used for some time may have a number of possible
causes.
 Technical problems – the jet may not be serviceable. We need to establish
whether this is the case (eg, hire an independent local aircraft engineer) then
consider impairment testing.
 Lack of markets – there may be insufficient demand to warrant using the plane.
This seems less likely, as the plane has not been used at all. Examine usage of
other Marden planes in the US.
 Unrecorded usage – the jet may be being used but the usage is unrecorded and
income understated. Alternatively, it might mean that improper use is being made
of the company's assets (eg, by management).
C
Regarding the 'free' flight, excessive gifts are not permitted. However, if the flight were
H
merely for the purpose of the audit check and there were no added benefits A
(additional destinations, trips etc) then it may be permissible if agreed by the ethics P
partner. T
E
Alternatively, a local firm of auditors could be used. The check might not just be the R
physical verification of the asset but also usage records (eg, flying logs, pilots' time). 3
Financial reporting
The jet has not been used for some time and therefore impairment testing needs to be
considered.
Technical problems – The jet may not be fully serviceable, in which case it needs to be
reviewed for impairment according to IAS 36 as both fair value and value in use may be
affected.
The carrying amount at 31 December 20X6 of the jet is £1.5 million (ie, £6m – [£5m 
9/10])
The value in use, if fully operational (assuming year-end operating cash flows and
including the residual amount) is:
(£2m + £1m)/1.1 = £2.73m
Thus, there is no impairment if the plane is fully operational (the fair value less costs of
disposal calculation is not necessary as the value in use exceeds the carrying amount).
However, if the plane is not operational then both next year's net operating inflow and
the residual value are likely to be affected. In this case an impairment charge of
£1.5 million (less the present value of any residual value obtainable for a non-
operational jet) may be required.
Lack of markets – There may be insufficient demand to warrant using the plane. This
will affect value in use but perhaps not the residual value. Again, impairment testing
may be needed as according to IAS 36 value in use may be affected.

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If the jet is not operational next year, but can be sold for a residual value of £1 million
next year (although selling immediately would be a better option in this case) the
impairment charge is:
£1.5m – £1m/1.1 = £0.59m
Unrecorded usage – This may mean that any depreciation based on the amount of
flying time may be understated.
Any impairment on this aircraft might have further implications for impairment of other
aircraft if the cause is market based rather than technically based.
(6) Due diligence assignment
Audit and ethics
Acceptance of the due diligence assignment is not permitted, as there would be a
conflict of interest between our role as auditor of Marden and a due diligence role for
the bidder for Marden, Crazy Jack Airlines plc.
The acquisition of one million shares would take Crazy Jack Airlines to a 29% holding
(Note: 30% is the maximum permitted by the stock exchange before an offer needs to
be made to all shareholders). The offer is therefore for the remaining shares. This is a
key audit risk, as directors still hold a significant amount of the shares and this may
influence their financial reporting, as the share price will be affected by the bid.
It might be noted that the announcement was made during the period that the share
price was artificially inflated due to the Stateside Leisure Inc announcement, and this
may ultimately affect the bid.
Financial reporting
There is no direct effect on the financial statements; however, consider:
 if the bid process is going into next year and the bid is to be defended, then a
provision may need to be made for defence costs; and
 if the bid process is going into next year, then disclosure of the bid as a non-
adjusting event after the reporting date may be.

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CHAPTER 4
Corporate governance
Introduction
TOPIC LIST
1 Relevance of corporate governance
2 Corporate governance concepts
3 The UK Corporate Governance Code
4 Role of the board
5 Associated guidance
6 Corporate governance: international impact
7 Corporate governance and internal control
8 Evaluation of corporate governance mechanisms
9 Communication between auditors and those charged with governance
Technical reference

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Introduction
 Describe and explain the nature and consequences of corporate governance and
accountability mechanisms in controlling the operating and financial activities of
entities of differing sizes, structures and industries
 Explain the rights and responsibilities of the board, board committees (eg, audit
and risk committees), those charged with governance and individual executive and
non-executive directors, with respect to the preparation and audit of financial
statements
 Describe and explain the rights and responsibilities of stakeholder groups (eg,
executive management, bondholders, government, securities exchanges,
employees, public interest groups, financial and other regulators, institutional and
individual shareholders) with respect to the preparation and audit of financial
statements
 Evaluate and appraise appropriate corporate governance mechanisms
 Explain and evaluate the nature and consequence of relevant corporate
governance codes and set out the required compliance disclosures
 Explain the OECD principles of corporate governance
 Explain the respective responsibilities of those charged with governance and
auditors for corporate risk management and risk reporting
auditors in respect of internal control systems
 Explain and evaluate the role and requirement for effective two-way
communication between those charged with governance and auditors
 Describe and explain the roles and purposes of meetings of boards and of
shareholders
Specific syllabus references for this chapter are: 13(a)–(j)

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1 Relevance of corporate governance
Section overview
• Concerns about the adequacy of financial reporting, a number of high profile corporate
scandals in the 1990s and concerns about excessive directors' remuneration highlighted
the need for effective corporate governance.
• Corporate governance can be defined as the system by which organisations are directed
and controlled.
• The UK Corporate Governance Code was revised in April 2016.
1.1 Introduction
Corporate governance potentially covers a wide range of issues and disciplines from company
secretarial and legal through business strategy, executive and non-executive management and
investor relations to accounting and information systems.
Corporate governance issues came to prominence in the UK in the late 1980s. The main drivers
associated with the increasing demand for developments in this area included the following:
(a) Financial reporting
Issues concerning financial reporting were raised by many investors and were the focus of
much debate and litigation. Shareholder confidence in what was being reported in many
instances was eroded. While corporate governance development is not just about better
financial reporting requirements, the regulation of creative accounting practices, such as off
balance sheet financing, has led to greater transparency and a reduction in risks faced by
investors.
(b) Corporate scandals
The early 1990s saw an increasing number of high profile corporate scandals and collapses,
including Polly Peck International, BCCI and Maxwell Communications Corporation. This
prompted the development of governance codes in the early 1990s. However, the scandals
since then outside the UK, including Enron, have raised questions about further measures C
that may be necessary and the financial crisis in 2008–2009 triggered widespread H
A
reappraisal of governance systems. More recently as noted in the FRC's annual report on P
the implementation of the UK Corporate Governance and Stewardship Codes, T
Developments in Corporate Governance and Stewardship 2016 (issued in January 2017), E
R
investigations into BHS and Sports Direct have resulted in the announcement by the
Business, Energy and Industrial Strategy (BEIS) Select Committee of an inquiry into 4
corporate governance focusing on executive pay, directors' duties and board composition.
(c) Excessive directors' remuneration
Directors being paid excessive salaries and bonuses has been seen as one of the major
corporate issues for a number of years. While CEOs have argued that their packages reflect
the global market, shareholders and employees are concerned that these are often out of
step with the remuneration of other employees and do not reflect the performance of the
company.
For example in 2015, the shareholders of retailer Sports Direct raised objections about the
company's executive remuneration scheme lowering the threshold at which performance-
related bonuses would be payable while still pursuing working practices that treated workers
poorly.
ICAEW 2019 Corporate governance 167

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In the UK s.439A of CA 2006 requires a quoted company's director's remuneration policy to be

approved by a binding shareholders' vote at least every three years. The actual amounts of
remuneration are subject to an annual advisory vote on the remuneration report.
1.2 What is corporate governance?

There are a number of different definitions of corporate governance. The following definition is
taken from the Cadbury Report and is still relevant in the context of the UK Corporate
Governance Code. (We will look in more detail at corporate governance reports in sections 3
and 5.)
Definition
Corporate governance: The system by which organisations are directed and controlled.
An alternative definition is: The set of processes, customs, policies, laws and institutions affecting
the way in which an entity is directed, administered or controlled. Corporate governance serves
the needs of shareholders, and other stakeholders, by directing and controlling management
activities towards good business practices, objectivity and integrity in order to satisfy the
objectives of the entity.
In essence, corporate governance:

 involves the management and reduction of risk;
 specifies the distribution rights and responsibilities among different participants in the
corporation, such as the board, managers, shareholders and other stakeholders;
 spells out the rules and procedures for making decisions on corporate affairs;
 provides the structure through which objectives are set; and
 provides the means of attaining the objectives and monitoring performance.
It can be argued that good corporate governance:
 provides a framework for an organisation to pursue its strategy in an ethical and effective
way and offers safeguards against the misuse of resources, human, financial, physical or
intellectual;
 can attract new investment into companies, particularly in developing nations; and
 underpins capital market confidence in companies.
1.3 Features of poor corporate governance

The scandals over the last 30 years have highlighted the need for guidance to tackle the various
risks and problems that can arise in organisations' systems of governance.
1.3.1 Domination by a single individual

A feature of many corporate governance scandals has been boards dominated by a single
senior executive, with other board members merely acting as a rubber stamp. Sometimes the
single individual may bypass the board to act in their own interests. Even if an organisation is not
dominated by a single individual, there may be other weaknesses. The organisation may be run
by a small group centred round the chief executive and chief financial officer, and appointments
may be made by personal recommendation rather than a formal, objective process.

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1.3.2 Lack of involvement of board

Boards that meet irregularly or fail to consider systematically the organisation's activities and
risks are clearly weak. Sometimes the failure to carry out proper oversight is due to a lack of
information being provided.
1.3.3 Lack of adequate control function
An obvious deficiency is a lack of internal audit.
Another important control deficiency is lack of adequate technical knowledge in key roles, for
example in the audit committee or in senior compliance positions. A rapid turnover of staff
involved in accounting or control may suggest inadequate resourcing, and will make control
more difficult because of lack of continuity.
1.3.4 Lack of supervision
Employees who are not properly supervised can create large losses for the organisation through
their own incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the
employee whose trading losses caused the collapse of Barings Bank, was not challenged
because he appeared to be successful. Leeson was able to run up losses because he was in
charge of dealing and settlement, a systems deficiency or lack of segregation of key roles that
has featured in other financial frauds.
1.3.5 Lack of independent scrutiny
External auditors may not carry out the necessary questioning of senior management because of
fears of losing the audit, and internal audit do not ask awkward questions because the chief
financial officer determines their employment prospects. Often corporate collapses are followed
by criticisms of external auditors, such as the Barlow Clowes affair where poorly planned and
focused audit work failed to identify illegal use of client monies.
1.3.6 Lack of contact with shareholders
Often board members may have grown up with the company but lose touch with the interests
and views of shareholders. One possible symptom of this is the payment of remuneration
packages that do not appear to be warranted by results.
1.3.7 Emphasis on short-term profitability
C
Emphasis on success or getting results can lead to the concealment of problems or errors, or H
A
manipulation of accounts to achieve desired results.
P
T
1.3.8 Misleading accounts and information E
Often misleading figures are symptomatic of other problems (or are designed to conceal other R
problems) but clearly poor quality accounting information is a major problem if markets are 4
trying to make a fair assessment of the company's value. Giving out misleading information was
a major issue in the UK's Equitable Life scandal, where the company gave contradictory
information to savers, independent advisers, media and regulators.
1.4 Risks of poor corporate governance

Clearly the ultimate risk is of the organisation making such large losses that bankruptcy
becomes inevitable. The organisation may also be closed down as a result of serious regulatory
breaches, for example misapplying investors' monies.

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Worked example: VW
During 2015, it became apparent that car manufacturer Volkswagen (VW) had created software
in its vehicles that was deliberately intended to allow its diesel vehicles to incorrectly pass
engine emission tests which are used throughout the motor industry. Many observers have
pointed out that such a practice could not have occurred without senior management approval:
if this was the case, it suggests serious ethical flaws in the company's governance; if not, it still
points to a company that is not in control of its staff.
2 Corporate governance concepts
Section overview
Corporate governance concepts include the following:
• Fairness
• Openness/transparency
• Independence
• Probity/honesty
• Responsibility
• Accountability
• Reputation
• Judgement
• Scepticism
• Innovation
One view of governance is that it is based on a series of underlying concepts. These are
important, as good corporate governance depends on a willingness to apply the spirit of the
guidance as well as the letter of the law.
2.1 Fairness
The directors' deliberations and also the systems and values that underlie the company must be
balanced by taking into account everyone who has a legitimate interest in the company, and
respecting their rights and views. In many jurisdictions, corporate governance guidelines
reinforce legal protection for certain groups, for example minority shareholders.
2.2 Openness/transparency
In the context of corporate governance, transparency means corporate disclosure to
stakeholders. Disclosure in this context obviously includes information in the financial
statements, not just the numbers and notes to the accounts but also narrative statements such as
the directors' report and the operating and financial review. It also includes all voluntary
disclosure; that is, disclosure above the minimum required by law or regulation. Voluntary
corporate communications include the following:
 Management forecasts
 Analysts' presentations
 Press releases
 Information placed on websites
 Other reports such as standalone environmental or social reports
The main reason why transparency is so important relates to the agency problem; that is, the
potential conflict between owners and managers. Without effective disclosure the position could
be unfairly weighted towards managers, since they normally have far more knowledge of the

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company's activities and financial situation than owners/investors. Reducing this information
asymmetry requires not only effective disclosure rules but also strong internal controls that
ensure that the information disclosed is reliable.
2.3 Independence
Independence is an important concept in relation to directors (as well as auditors). Corporate
governance reports have increasingly stressed the importance of independent non-executive
directors; directors who are not primarily employed by the company and who have very strictly
controlled other links with it. They should be free from conflicts of interest and in a better
position to promote the interests of shareholders and other stakeholders. Freed from pressures
that could influence their activities, independent non-executive directors should be able to carry
out effective monitoring of the company in conjunction with independent external auditors on
behalf of shareholders and other stakeholders.
2.4 Probity/honesty
Hopefully this should be the most self-evident of the principles, relating not only to telling the
truth but also to not misleading shareholders and other stakeholders by presenting information
in a biased way.
2.5 Responsibility
For management to be held properly responsible, there must be a system in place that allows
for corrective action and penalising mismanagement. Responsible management should do,
when necessary, whatever it takes to set the company on the right path.
The board of directors must act responsively to, and with responsibility towards, all stakeholders
of the company. However, the responsibility of directors to other stakeholders, both in terms of
to whom they are responsible and the extent of their responsibility, remains a key point of
contention in corporate governance debates.
2.6 Accountability
C
Corporate accountability refers to whether an organisation (and its directors) are answerable in H
some way for the consequences of their actions. A
P
The board of directors is accountable to shareholders (see section 3). However, making the T
accountability work is the responsibility of both parties. Directors, as we have seen, do so E
R
through the quality of information that they provide, whereas shareholders do so through their
willingness to exercise their responsibility as owners, which means using the available 4
mechanisms to query and assess the actions of the board.
As with responsibility, one of the biggest debates in corporate governance is the extent of
management's accountability towards other stakeholders, such as the community within which
the organisation operates.
2.7 Reputation
In the same way, directors' concern for an organisation's reputation will be demonstrated by the
extent to which they fulfil the other principles of corporate governance. There are purely
commercial reasons for promoting the organisation's reputation, namely that the price of
publicly traded shares is often dependent on reputation and hence reputation can be a very
valuable asset of the organisation.

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2.8 Judgement
Judgement means the board making decisions that enhance the prosperity of the organisation.
This means that board members must acquire a broad enough knowledge of the business and
its environment to be able to provide meaningful direction to it. This has implications not only
for the attention directors have to give to the organisation's affairs but also for the way the
directors are recruited and trained.
The complexities of senior management mean that the directors have to bring multiple
conceptual skills to management that aim to maximise long-term returns. This means that
corporate governance can involve balancing many competing people and resource claims
against each other.
2.9 Integrity
Definition
Integrity: Straightforward dealing and completeness. What is required of financial reporting is
that it should be honest and that it should present a balanced picture of the state of the
company's affairs. The integrity of reports depends on the integrity of those who prepare and
present them.
Integrity can be taken as meaning someone of high moral character, who sticks to principles no
matter the pressure to do otherwise. In working life, this means adhering to principles of
professionalism and probity. Straightforward dealing in relationships with the different people
and constituencies whom you meet is particularly important; trust is vital in relationships and
belief in the integrity of those with whom you are dealing underpins this.
This definition highlights the need for personal honesty and integrity of preparers of accounts.
This implies qualities beyond a mechanical adherence to accounting or ethical regulations or
guidelines. At times accountants will have to use judgement or face financial situations which
aren't covered by regulations or guidance, and on these occasions integrity is particularly
important.
Integrity is an essential principle of the corporate governance relationship, particularly in relation to
representing shareholder interests and exercising agency. As with financial reporting guidance,
ethical codes don't cover all situations and therefore depend for their effectiveness on the qualities
of the accountant. In addition, we have seen that a key aim of corporate governance is to inspire
confidence in participants in the market and this significantly depends on a public perception of
competence and integrity.
2.10 Scepticism
You should be familiar with the concept of 'professional scepticism' from your earlier auditing
studies: sound governance practices should also consider the importance of being sceptical
about all parts of the business, regardless of whether they have displayed any evidence of
dysfunctional behaviour. For example, if performance continues to exceed industry averages,
even in periods of economic downturn, it could be symptomatic of fraudulent financial
reporting.
2.11 Innovation
Change happens; factors such as technological advances, social behaviour, market expectations
and even freak weather conditions can all have significant impacts on organisations and their
stakeholders, which means that governance structures need to be agile and responsive in order
to stay relevant.

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3 The UK Corporate Governance Code
Section overview
• The FRC has issued the UK Corporate Governance Code.
• The Code applies to all companies with a premium listing of equity shares on the London
Stock Exchange, regardless of whether they are incorporated in the UK or elsewhere.
• The UK Corporate Governance Code includes five main principles.
• The UK Corporate Governance Code includes a number of disclosure requirements.
3.1 Overview
The application of the principles described above can be seen in corporate governance codes
of best practice. The UK Corporate Governance Code (the Code), first issued by the Financial
Reporting Council (FRC) in June 2010, replaced the Combined Code on Corporate Governance.
Corporate governance guidance in the UK has been continually reviewed since it was first issued
in 1992. The 2010 Code resulted from the financial crisis in 2008–9 which triggered widespread
reappraisal, locally and internationally, of the governance systems which might have alleviated it.
The UK Corporate Governance Code was further revised in September 2012 as part of the FRC's
ongoing response to the recent global recession and financial crisis which emphasises the
importance of increased transparency in the way directors report on their activities, including
their management of risk.
Following a consultation in late 2013, the FRC published a further revised UK Corporate
Governance Code in September 2014, this time targeting the going concern, executive
remuneration, and risk management reporting. The changes, made in response to the Sharman
Inquiry in 2012, are controversial with companies and investors. The changes around the
assessment of going concern by companies, in particular, have been criticised for failing to
address the investors' concerns, and placing a heavy risk management and reporting burden on
boards.
The most recent update to the UK Corporate Governance Code was issued in April 2016. The
changes are the result of the implementation of the EU Audit Regulation and Directive and are C
effective for financial years commencing on or after 17 June 2016. (Changes have also been H
A
made to Guidance on Audit Committees.) The changes, which are relatively modest are as P
follows: T
E
 The audit committee is required to have "competence relevant to the sector in which the R
company operates". (C.3.1)
4
 The provision that FTSE 350 companies are expected to put the audit out to tender at least
every 10 years has been removed. (This has now been replaced with the EU Audit
Regulation and Directive requirement for mandatory tendering and rotation of the audit
firm.)
 The audit committee report within the annual report must provide "advance notice of any
retendering plans". (C.3.8)
3.1.1 Compliance
The UK Corporate Governance Code applies to all companies with a Premium Listing although
any company can adopt it on a voluntary basis as a benchmark of best practice.
All companies incorporated in the UK or elsewhere and listed on the Main Market of the London
Stock Exchange must disclose in their annual reports how they have applied the principles of

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the Code. The Listing Rules require listed companies to make a disclosure statement in two
parts:
(1) The company has to report on how it applies the principles in the UK Corporate
Governance Code. The form and content of this part of the statement are not prescribed,
the intention being that companies should have a free hand to explain their governance
policies in the light of the principles, including any special circumstances applying to them
which have led to a particular approach.
(2) The company has either to confirm that it complies with the Code's provisions or to provide
an explanation where it does not.
Point to note:
This 'comply or explain' approach has been widely welcomed by both company boards and
investors for the flexibility it offers.
The introduction to the UK Corporate Governance Code makes the following points:
 An alternative to following a provision may be justified if good governance can be achieved
by other means.
 When responding to disclosures shareholders should take the company's individual
circumstances into account.
 Explanations should not be evaluated by shareholders in a mechanistic way.
 Departures from the Code should not be treated automatically as breaches.
Following discussions with senior investors and companies, the FRC has published a report
called What Constitutes an Explanation under 'Comply or Explain'? which explores what a
meaningful explanation for non-compliance should include. The report can be found on the
FRC's website. This should not be tested in detail in the exam, but provides a useful background
on the current developments of the comply or explain approach.
(Source: FRC, What Constitutes an Explanation under 'Comply or Explain'?, 2012.
www.frc.org.uk/getattachment/a39aa822-ae3c-4ddf-b869-db8f2ffe1b61/what-constitutes-an-
explanation-under-comply-or-exlpain.pdf [Accessed: 30 October 2018])
The UK Corporate Governance Code does not apply to:
 AIM companies (AIM companies still need to either 'comply' or 'explain' using a recognised
corporate governance code, but it does not need to be the UK Corporate Governance
Code); or
 companies below FTSE 350 (this exemption applies to certain provisions only).
3.2 Principles of good corporate governance

The UK Corporate Governance Code is based on five main principles:
 Leadership
 Effectiveness
 Accountability
 Remuneration
 Relations with shareholders
These are supported by supporting principles and more detailed Code provisions.

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The key details of the UK Corporate Governance Code are summarised below. Section 4 of this
chapter looks at the role of the board in more detail.
Leadership
The role of the Every company should be headed by an effective board which is collectively
board responsible for the long-term success of the company.
The board should meet sufficiently regularly to discharge its duties
effectively. There should be a formal schedule of matters specifically
reserved for its decision.
Division of There should be a clear division of responsibilities at the head of the
responsibilities company between the running of the board and the executive responsibility
for the running of the company's business. No one individual should have
unfettered powers of decision. The roles of the chairman and chief executive
should not be exercised by the same individual.
The chairman The chairman is responsible for leadership of the board and ensuring its
effectiveness on all aspects of its role. The chairman should promote a
culture of openness and ensure constructive relations between executive
and non-executive directors.
A chief executive should not go on to be chairman. If exceptionally this is the
case, major shareholders should be consulted in advance.
Non-executive As part of their role as members of a unitary board, non-executive directors
directors should constructively challenge and help develop proposals on strategy.
Non-executive directors should scrutinise management performance and the
reporting of performance. They should satisfy themselves on the integrity of
financial information and that financial controls and systems of risk management
are robust.
They are also responsible for determining executive director remuneration
and appointing and removing executive directors.
The chairman should hold meetings with the non-executive directors without
C
the executives present. H
A
The non-executive directors should appraise the chairman's performance at P
least annually. T
E
R
Effectiveness
4
Composition of The board and its committees should have the appropriate balance of skills,
the board experience, independence and knowledge of the company to enable them
to discharge their respective duties and responsibilities effectively.
The board should include an appropriate combination of executive and
non-executive directors such that no individual or small group of individuals
can dominate the board's decision taking.
Except for smaller companies, non-executive directors should comprise at
least half the board (excluding the chairman). A smaller company should
have at least two non-executive directors.
The board should identify in the annual report each non-executive director it
considers to be independent.

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Effectiveness
Appointments to There should be a formal, rigorous and transparent procedure for the
the board appointment of new directors to the board.
There should be a nomination committee, which should lead the process for
board appointments and make recommendations to the board. A majority
of members on the nomination committee should be independent non-
executive directors.
Non-executive directors should be appointed for specified terms. Any terms
beyond six years should be subject to rigorous review.
The annual report should include a description of the work of the nomination
committee, including the board's process for board appointments.
Commitment All directors should be able to allocate sufficient time to the company to
discharge their responsibilities effectively.
The board should not agree to a full-time executive director taking on more
than one non-executive directorship in a FTSE 100 company nor the
chairmanship of such a company.
Development All directors should receive induction on joining the board and should
regularly update and refresh their skills and knowledge.
Information and The board should be supplied in a timely manner with information in a form
support and of a quality appropriate to enable it to discharge its duties. The
company secretary is responsible for ensuring good information flows and
for advising the board through the chairman on all governance matters.
Evaluation The board should undertake a formal and rigorous annual evaluation of its
own performance and that of its committees and individual directors.
The board should state in the annual report how performance evaluation of
the board, its committees and its individual directors has been conducted.
Evaluation of the board of FTSE 350 companies should be externally
facilitated at least every three years. The identity of the facilitator should be
disclosed in the financial statements.
Re-election All directors should be required to submit themselves for re-election at
regular intervals (at least once every three years).
Directors of FTSE 350 companies should be subject to annual election. Non-
executive directors who have served longer than nine years should be
subject to annual re-election.
Accountability
Financial The board should present a fair, balanced and understandable assessment
reporting of the company's position and prospects.
The directors should explain in the annual report their responsibility for
preparing the annual accounts and an explanation of their business model.
They must state that they consider the annual report and accounts is fair,
balanced and understandable.
The annual report should also include a statement by the auditors about
their reporting responsibilities.
The directors should report whether the business is a going concern, and
identify any material uncertainties to the company's ability to continue to do
so over a period of at least 12 months from the date of approval of the

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Accountability
Risk The board is responsible for determining the nature and extent of the
management significant risks it is willing to take in achieving its strategic objectives. The
and internal board should maintain sound risk management and internal control systems.
control The directors are required to confirm in the annual report that they have
carried out a robust assessment of the principal risks facing the company.
This should include those that would threaten the business model, future
performance, solvency or liquidity.
Taking account of the company's current position and principal risks, the
directors should explain in the annual report how they have assessed the
prospects of the company, over what period they have done so and why
they consider that period to be appropriate. The directors should state
whether they have a reasonable expectation that the company will be able
to continue in operation and meet its liabilities as they fall due over the
period of their assessment, drawing attention to any qualifications or
assumptions as necessary.
The board should, at least annually, conduct a review of the effectiveness of
the company's risk management and internal control systems and report on
that review in the annual report.
Audit The board should establish formal and transparent arrangements for
committees and considering how they should apply the corporate reporting and risk
auditors management and internal control principles and for maintaining an
appropriate relationship with the company's auditor.
The board should establish an audit committee of at least three (two for
smaller companies) independent non-executive directors. At least one
member of the audit committee should have recent and relevant financial
experience.
The audit committee as a whole should have competence relevant to the
sector in which the company operates.
The main role and responsibilities of the audit committee should be set out
in written terms of reference, which should be made available. C
Where requested by the board, the audit committee should provide advice H
A
on whether the annual report is fair, balanced and understandable. P
The audit committee should monitor and review the effectiveness of internal T
E
audit activities. Where there is no internal audit function the audit committee R
should consider annually whether there is a need for one.
4
The audit committee should have primary responsibility for making a
recommendation on the appointment and removal of the external auditor.
The annual report should include a description of the work of the audit
committee, including how it has assessed the effectiveness of the external
audit, the approach taken to the appointment/reappointment of the external
auditor and advance notice of any tendering plans. The report should also
include an explanation of how auditor objectivity and independence is
safeguarded where non-audit services are provided.

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Remuneration
The level and Executive directors' remuneration should be designed to promote the long-
components of term success of the company. Performance-related elements should be
remuneration transparent, stretching and rigorously applied.
Performance-related schemes should include provisions that would enable
the company to recover sums paid or withhold the payment of any sum, and
specify the circumstances in which it would be appropriate to do so.
Levels of remuneration for non-executive directors should reflect the time
commitment and responsibilities of the role. Remuneration for non-
executive directors should not include share options or other performance-
related elements. If, exceptionally, options are granted, shareholder
approval should be sought in advance and any shares acquired by exercise
of the options should be held until at least one year after the non-executive
director leaves the board. Holding of share options could be relevant to the
determination of a non-executive director's independence.
The remuneration committee should carefully consider what compensation
commitments (including pension contributions) their directors' terms of
appointment would entail in the event of early termination. The aim should
be to avoid rewarding poor performance.
Notice or contract periods should be set at one year or less.
Procedure There should be a formal and transparent procedure for developing policy
on executive remuneration and for fixing remuneration packages of
individual directors. No director should be involved in setting their own
remuneration.
A remuneration committee, made up of at least three (two for smaller
companies) independent non-executive directors, should make
recommendations about the framework of executive remuneration, and
should determine specific remuneration packages.
The board should determine the remuneration of non-executive directors.
Shareholders should be invited specifically to approve all new long-term
incentive schemes and significant changes to existing schemes, except in
the circumstances permitted by the Listing Rules.
Relations with
shareholders
Dialogue with There should be dialogue with shareholders based on the mutual
shareholders understanding of objectives. The board as a whole has responsibility for
ensuring that a satisfactory dialogue with shareholders takes place.

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Relations with
shareholders
Constructive use Boards should use the annual general meeting (AGM) to communicate with
of general investors and encourage their participation.
meetings
Notice of the AGM and related papers should be sent to shareholders at
least 20 working days before the meeting.
The chairmen of audit, remuneration and nomination committees should be
available to answer questions and all directors should attend.
Shareholders should be able to vote separately on each substantially
separate issue.
Companies should count all proxies and announce proxy votes for and
against on all votes on a show of hands.
Companies should explain how they intend to engage with shareholders
where a significant percentage of shareholders have voted against any
resolution.
Points to note:
1 When the UK Corporate Governance Code was first issued it contained guidance regarding
institutional investors in a schedule. This guidance has now been replaced by the UK
Stewardship Code (see section 5.1).
2 The FRC has issued its revised Guidance on Audit Committees in June 2016. This includes
the requirement that the audit committee must perform an annual assessment of the
independence and objectivity of the external auditor and must approve non-audit services
(para 66 & 72).
3.3 Disclosure requirements of the UK Corporate Governance Code

The disclosure requirements are as follows:
(a) Statement of compliance with the main principles in the UK Corporate Governance Code
C
A narrative statement of how the company has applied the main principles set out in the UK H
A
Corporate Governance Code, in a manner that enables shareholders to evaluate how the P
principles have been applied. T
E
(b) Statement of compliance with the provisions in the UK Corporate Governance Code R
A statement as to whether or not the company has complied with the relevant provisions in 4
the Code, disclosing any provisions not complied with throughout the period under review
and the company's reasons for non-compliance.
The role of the board
A statement of how the board operates.
The names of the chairman, the chief executive, the senior independent director and the
chairmen and members of the board committees.
Number of meetings of the board and individual attendance by directors.
The chairman
Where a chief executive is appointed chairman, the reasons for their appointment (this only
needs to be done in the annual report following the appointment).
The names of the non-executive directors whom the board determines to be independent, with
reasons where necessary.

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The impact of any changes to the other significant commitments of the chairman during the year
should be explained.
Appointments to the board
Description of the work of the nomination committee, including the process used for board
appointments.
Description of the board's policy on diversity, including gender; any measurable objectives that
it has set for implementing the policy, and progress on achieving the objectives.
An explanation if neither an external search consultancy nor open advertising is used in the
appointment of the chairman or non-executive directors.
If an external search consultancy is used, a statement whether it has any other connection with
the company.
Evaluation
A statement of how performance evaluation of the board, its committees and its directors has
been conducted.
Financial and business reporting
An explanation from the directors of their responsibility for preparing the accounts and a
statement by the auditors about their reporting responsibilities.
A statement that the directors consider the annual report and accounts is fair, balanced and
understandable.
An explanation by the directors of the business model.
Companies should state whether they consider it appropriate to adopt the going concern basis
of accounting and identify any material uncertainties to their ability to continue to do so over a
period of at least 12 months from the date of approval of the financial statements.
Risk management and internal control
Confirmation by the directors that they have carried out a robust assessment of the principal
risks facing the company, including those that would threaten its business model, future
performance, solvency or liquidity.
A statement from the directors explaining how they have assessed the prospects of the
company, the period of assessment and why the period of assessment is considered to be
appropriate. The directors should state whether they have a reasonable expectation that the
company will be able to continue in operation and meet its liabilities as they fall due over the
period of their assessment. The expectation is that the period of assessment for these purposes
will be significantly longer than the 12 months required to determine whether the going concern
basis of accounting is appropriate.
(In its annual report on the implementation of the UK Corporate Governance and Stewardship
Codes, Developments in Corporate Governance and Stewardship 2016 (issued in January 2017),
the FRC found that the most frequently used time horizon for this disclosure was three years,
followed by five years.)
A report on the board's review of the effectiveness of the company's risk management and
internal controls systems.
Audit committees and auditors
The reasons for the absence of an internal audit function where there is none.

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A separate section describing the work of the audit committee in discharging its responsibilities,
including:
(a) significant issues that it considered in relation to the financial statements, and how these
issues were addressed;
(b) an explanation how it has assessed the effectiveness of the external audit process and the
approach taken to the appointment or reappointment of the external auditor, including the
length of tenure of the current audit firm and when a tender was last conducted; and
(c) if the external auditor provides non-audit services, an explanation of how auditor objectivity
and independence is safeguarded.
The levels and components of remuneration
A description of the work of the remuneration committee where an executive director serves as
a non-executive director elsewhere.
Where remuneration consultants have been appointed, whether they have any other connection
with the company.
Dialogue with shareholders
The steps the board has taken to ensure that the board, particularly non-executive directors,
develop an understanding of the views of major shareholders about their company.
Interactive question 1: UK Corporate Governance Code

Compliance with the UK Corporate Governance Code is a London Stock Exchange requirement
for listed companies. It is recommended for other companies. Some argue that the Code should
be mandatory for all companies.
Requirements
(a) Discuss the benefits of the UK Corporate Governance Code to shareholders and other
interested users of financial statements.
(b) Discuss the merits and drawbacks of having such provisions in the form of a voluntary code.
C
H
A
P
4 Role of the board T
E
R
Section overview 4
• The board should be responsible for taking major policy and strategic decisions.
• Directors should have a mix of skills and their performance should be assessed regularly.
• Appointments should be conducted by formal procedures administered by a nomination
committee.
• Division of responsibilities at the head of an organisation is most simply achieved by
separating the roles of chairman and chief executive.
• Independent non-executive directors have a key role in governance. Their number and
status should mean that their views carry significant weight.

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4.1 Scope of role

The guidance in the UK Corporate Governance Code is developed in the FRC publication
Guidance on Board Effectiveness (2011). If the board is to act effectively, its role must be defined
carefully. The Code suggests that the board should have a formal schedule of matters
specifically reserved to it for decision. Some would be such decisions as mergers and takeovers
that are fundamental to the business and therefore should not be taken just by executive
managers. Other decisions would include acquisitions and disposals of assets of the company
or its subsidiaries that are material to the company and investments, capital projects, bank
borrowing facilities, loans and their repayment, and foreign currency transactions, all above a
certain size (to be determined by the board).
Other tasks the board should perform include:
 monitoring the chief executive officer;
 overseeing strategy;
 monitoring risks and control systems;
 monitoring the human capital aspects of the company in regard to succession, morale,
training, remuneration etc; and
 ensuring that there is effective communication of its strategic plans, both internally and
externally.
Worked example: Role of the board

For the voluntary sector, the UK's Good Governance, A Code for the Voluntary and Community
Sector stresses the board of trustees' role in ensuring compliance with the objects, purposes
and values of the organisation and with its governing document. The Code stresses that the
board must ensure that the organisation's vision, mission, values and activities remain true to its
objects.
The Code also lays more stress than the governance codes targeted at listed companies on
trustees focusing on the strategic direction of their organisation and not becoming involved in
day to day activities. The chief executive officer should provide the link between the board and
the staff team, and the means by which board members hold staff to account. Where in smaller
organisations trustees need to become involved in operational matters, they should separate
their strategic and operational roles.
4.2 Attributes of directors

In order to carry out effective scrutiny, directors need to have relevant expertise in industry,
company, functional area and governance. The board as a whole needs to contain a mix of
expertise and show a balance between executive management and independent non-
executive directors. New and existing directors should also have appropriate training to develop
the knowledge and skills required.
4.2.1 Nomination committee

In order to ensure that balance of the board is maintained, the board should set up a
nomination committee, to oversee the process for board appointments and make
recommendations to the board. The UK Corporate Governance Code recommends that a
majority of the committee members should be independent non-executive directors.

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The nomination committee needs to consider the balance between executives and independent
non-executives, the skills and knowledge possessed by the board, the need for continuity and
succession planning and the desirable size of the board. Recent corporate governance
guidance has laid more stress on the need to attract board members from a diversity of
backgrounds.
4.2.2 Commitment
On appointment of the chairman, the nomination committee should be responsible for
reviewing the time required for the role. Non-executive directors should undertake that they will
have sufficient time to meet what is expected of them. Other significant commitments should be
disclosed to the board.
4.3 Possession of necessary information

As we have seen above, in many corporate scandals, the board was not given full information.
The UK Corporate Governance Code states that the chairman is responsible for ensuring that
the directors receive accurate, timely and clear information. Directors should seek clarification
where necessary.
4.4 Performance of board

Appraisal of the board's performance is an important control over it. The performance of the
board should be assessed once a year. (For FTSE 350 companies this should be externally
facilitated every three years.) Separate appraisal of the chairman and chief executive should also
be carried out, with links to the remuneration process.
4.5 Board membership and division of responsibilities

All reports acknowledge the importance of having a division of responsibilities at the head of an
organisation. The simplest way to do this is to require the roles of chairman and chief executive
to be held by two different people.
The Code states that the chief executive would only become chairman in exceptional
circumstances. The board should consult major shareholders in advance and should set out its
reasons to shareholders at the time of the appointment and in the next annual report. C
H
Worked example: Director influence A
P
Another area of concern is whether individual directors are exercising disproportionate T
influence on the company. For example, Boots prohibited the chairman of the remuneration E
committee from serving on the audit committee and vice versa. R
4
4.6 Non-executive directors
Non-executive directors have no executive (managerial) responsibilities.
Non-executive directors should provide a balancing influence, and play a key role in reducing
conflicts of interest between management (including executive directors) and shareholders.
They should provide reassurance to shareholders, particularly institutional shareholders, that
management is acting in the interests of the organisation.
Worked example: Sources of non-executive directors

Non-executive directors may come from a number of sources:
• Companies operating in international markets could benefit from having at least one non-
executive director with international experience.
• Lawyers, accountants and consultants can bring skills that are useful to the board.

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• Listed companies should consider appointing directors of private companies as non-

executive directors.
• Including individuals with charitable or public sector experience but strong commercial
awareness can increase the breadth of diversity and experience on the board.
4.6.1 Role of non-executive directors

The role of non-executive directors can be summarised as follows:
 Strategy: Non-executive directors should contribute to, and challenge the direction of,
strategy.
 Performance: Non-executive directors should scrutinise the performance of management in
meeting goals and objectives, and monitor the reporting of performance.
 Risk: Non-executive directors should satisfy themselves that financial information is accurate
and that financial controls and systems of risk management are robust.
 Directors and managers: Non-executive directors are responsible for determining
appropriate levels of remuneration for executives, and are key figures in the appointment
and removal of senior managers and in succession planning.
4.6.2 Advantages of non-executive directors

Non-executive directors can bring a number of advantages to a board of directors.
 They may have external experience and knowledge which executive directors do not
possess. The experience they bring can be in many different fields. They may be executive
directors of other companies, and thus have experience of different ways of approaching
corporate governance, internal controls or performance assessment. They can also bring
knowledge of markets within which the company operates.
 Non-executive directors can provide a wider perspective than executive directors, who may
be more involved in detailed operations.
 Good non-executive directors are often a comfort factor for third parties, such as investors
and creditors.
 It has been suggested that there are certain roles non-executive directors are well suited to
play. These include 'father-confessor' (being a confidant for the chairman and other
directors), 'oil-can' (intervening to make the board run more effectively) and acting as 'high
sheriff' (if necessary taking steps to remove the chairman or chief executive).
 The most important advantage perhaps lies in the dual nature of the non-executive
director's role. Non-executive directors are full board members who are expected to have
the level of knowledge that full board membership implies. At the same time, they are
meant to provide the so-called strong, independent element on the board. This should
imply that they have the knowledge and detachment to be able to assess fairly the
remuneration of executive directors when serving on the remuneration committee, and to
be able to discuss knowledgeably with auditors the affairs of the company on the audit
committee.
4.6.3 Problems with non-executive directors

Nevertheless there are a number of difficulties connected with the role of non-executive director.
 In many organisations, non-executive directors may lack independence. There are in
practice a number of ways in which non-executive directors can be linked to a company, as
suppliers or customers for example. Even if there is no direct connection, potential non-
executive directors are more likely to agree to serve if they admire the company's chairman
or its way of operating.

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 There may be a prejudice in certain companies against widening the recruitment of non-
executive directors to include people proposed other than by the board or to include
stakeholder representatives.
 High-calibre non-executive directors may gravitate towards the best-run companies, rather
than companies which are more in need of input from good non-executives.
 Non-executive directors may have difficulty imposing their views on the board. It may be
easy to dismiss the views of non-executive directors as irrelevant to the company's needs.
This may imply that non-executive directors need good persuasive skills to influence other
directors. Moreover, if executive directors are determined to push through a controversial
policy, it may prove difficult for the more disparate group of non-executive directors to
oppose them effectively.
 It has been suggested that not enough emphasis is given to the role of non-executive
directors in preventing trouble, in warning early on of potential problems. When trouble
does arise, non-executive directors may be expected to play a major role in rescuing the
situation, which they may not be able to do.
 Perhaps the biggest problem which non-executive directors face is the limited time they can
devote to the role. If they are to contribute valuably, they are likely to have time-consuming
other commitments. In the time they have available to act as non-executive directors, they
must contribute as knowledgeable members of the full board and fulfil their legal
responsibilities as directors. They must also serve on board committees. Their responsibilities
mean that their time must be managed effectively, and they must be able to focus on areas
where the value they add is greatest.
4.6.4 Independence of non-executive directors

Various safeguards can be put in place to ensure that non-executive directors remain
independent. A number of factors will be considered, including if the director:
 has been an employee of the company within the last five years;
 has, or has had within the last three years, a material business relationship with the
company either directly, or as a partner, shareholder, director or senior employee of a body
that has such a relationship with the company;
C
 receives additional remuneration from the company apart from a director's fee, participates H
in the company's share option or a performance-related pay scheme, or is a member of the A
company's pension scheme; P
T
 has close family ties with any of the company's advisers, directors or senior employees; E
R
 holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies; 4
 represents a significant shareholder; or

 has served on the board for more than nine years from the date of their first election.
Whenever a question scenario features non-executive directors, watch out for threats to, or
questions over, their independence.

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4.6.5 Current developments and further reading

The Code continues to evolve, as the financial crisis, the public outcry over disproportionate
executive remuneration, the growing focus on shareholder participation and the changing
regulatory environment all make the need for effective corporate governance codes more
topical than ever. The next version of the UK Corporate Governance Code comes into effect at
the start of 2019. In summary, the main changes to the Code for 2019 include the following:
 Workforce and stakeholders: There is a new Provision to enable greater board
engagement with the workforce to understand their views. The Code asks boards to
describe how they have considered the interests of stakeholders when performing their
duty under Section 172 of the 2006 Companies Act.
 Culture: Boards are asked to create a culture which aligns company values with strategy
and to assess how they preserve value over the long-term.
 Succession and diversity: To ensure that the boards have the right mix of skills and
experience, constructive challenge and to promote diversity, the new Code emphasises the
need to refresh boards and undertake succession planning. Boards should consider the
length of term that chairs remain in post beyond nine years. The new Code strengthens the
role of the nomination committee on succession planning and establishing a diverse board.
It identifies the importance of external board evaluation for all companies. Nomination
committee reports should include details of the contact the external board evaluator has
had with the board and individual directors.
 Remuneration: To address public concern over executive remuneration, the new Code
emphasises that remuneration committees should take into account workforce
remuneration and related policies when setting director remuneration. Importantly
formulaic calculations of performance-related pay should be rejected. Remuneration
committees should apply discretion when the resulting outcome is not justified.
(Source: www.frc.org.uk/news/july-2018/a-uk-corporate-governance-code-that-is-fit-for-the)
ICAEW has published numerous articles and thought-leadership projects on the Corporate
Governance section of its website: www.icaew.com/en/technical/corporate-governance. We
would recommend that you use this link to keep abreast of the current UK and international
developments around corporate governance.
It would also be beneficial to read around the subject by visiting the FRC's sections on corporate
governance, found at: www.frc.org.uk/Our-Work/Corporate-Governance-Reporting.aspx
5 Associated guidance
Section overview
• The UK Stewardship Code aims to enhance the relationship between companies and
institutional investors.
• The FRC provides guidance on risk management and internal control.
• The FRC has issued specific guidance on audit committees.
5.1 The UK Stewardship Code

5.1.1 Introduction
The UK Stewardship Code, issued in July 2010, aims to enhance the quality of engagement
between investors and companies to help improve long-term returns to shareholders and the
efficient exercise of governance responsibilities. The FRC views this as complementary to the UK

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Corporate Governance Code. The Stewardship Code sets out good practice contained in seven
Principles to which institutional investors should aspire. As with the UK Corporate Governance
Code, the Stewardship Code should be applied on a 'comply or explain' basis. This involves
providing a statement on the institution's website that contains the following:
 A description of how the principles of the Stewardship Code have been applied
 Disclosure of specific information as required under the Principles
 An explanation of the elements of the Stewardship Code which have not been complied
with
The UK Stewardship Code was revised in September 2012. The key changes were as follows:
 Clarification of the aim and definition of stewardship
 Clearer delineation of the varying responsibilities of different types of institutional investors
 Editing of the text to create greater consistency across the Code
 Provision of more information on how the Code is expected to be implemented
The seven Principles of the Code remain unchanged.
5.1.2 The Principles of the Code

The seven Principles of the UK Stewardship Code are as follows.
(1) Institutional investors should publicly disclose their policy on how they will discharge their
stewardship responsibilities.
Stewardship activities include monitoring and engaging with companies on such matters as
strategy, performance, risk, capital structure and corporate governance, including culture
and remuneration.
Disclosure should include how investee companies will be monitored, the strategy on
intervention, internal arrangements, the policy on voting and the policy on considering
explanations made in relation to the UK Corporate Governance Code.
(2) Institutional investors should have a robust policy on managing conflicts of interest in
relation to stewardship and this policy should be publicly disclosed.
An institutional investor's duty is to act in the interests of all clients and/or beneficiaries
when considering matters such as engagement and voting. C
H
(3) Institutional investors should monitor their investee companies. A
P
Investee companies should be monitored to determine when it is necessary to enter into an T
active dialogue with their boards. This monitoring should be regular, and the process E
R
checked periodically for its effectiveness.
4
Institutional investors should carefully consider explanations given for any departure from
the UK Corporate Governance Code and be prepared to enter a dialogue if they do not
accept the company's position.
(4) Institutional investors should establish clear guidelines on when and how they will escalate
their activities as a method of protecting and enhancing shareholder value.
Instances where institutional investors may want to intervene include when they have
concerns about the company's strategy and performance, its governance or its approach to
the risks arising from social and environmental matters. If companies do not respond
constructively to investor intervention they should consider the need to escalate their action.
(5) Institutional investors should be willing to act collectively with other investors where
appropriate.
Collaborative engagement may be most appropriate at times of significant corporate or wider
economic stress, or when the risks posed threaten the ability of the company to continue.

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(6) Institutional investors should have a clear policy on voting and disclosure of voting activity.
Institutional investors should vote on all shares held. They should publicly disclose voting
records. If they abstain or vote against a resolution, they should inform the company in
advance.
(7) Institutional investors should report periodically on their stewardship and voting activities.
Those that act as agents should regularly report to their clients details of how they have
discharged their responsibilities. These reports are likely to comprise qualitative and
quantitative information.
5.2 The FRC's Guidance on Risk Management, Internal Control and Related
Financial and Business Reporting
In 2014, the FRC issued its Guidance on Risk Management, Internal Control and Related Financial
and Business Reporting, replacing and combining its earlier guidance on Internal Control:
Revised Guidance for Directors on the Combined Code and Going Concern and Liquidity Risk:
Guidance for Directors of UK Companies.
The aim of this current guidance is to provide a high level overview of factors that boards must
consider in terms of the design, implementation, monitoring and review of risk management
and control systems.
It is worth mentioning that it was the Turnbull Report, issued in 1999, that was the precursor to
current guidance on internal control. Although the Turnbull Report predates the UK Corporate
Governance Code, its principles are still relevant. The FRC risk guidance is considered in more
detail in section 7 which covers corporate governance and internal control.
5.3 Audit committees

In December 2017, the FRC's Audit and Assurance Lab published project outcomes under the
title 'Audit Committee Reporting' which explored how investors' confidence in the audit process
could be improved by the external reporting of audit committees and their work in the annual
report.
In summary, the Lab found the following.
 The demanding role of the audit committee is valued by investors and could be
emphasised further to support its importance.
 A meaningful and constructive dialogue between non-executives and investors is helpful,
but requires engagement from both sides to make the audit committee effective.
 The audit committee report is seen as a vital way of supporting this dialogue, but it must be
presented in such a way as to focus on key issues.
 External auditor appointment and tendering issues need to ensure that quality and auditor
independence are both prioritised, regardless of who the auditor actually is.
 Investors are keen to know about the factors (including, but not limited to, non-audit work)
affecting the effectiveness, objectivity and independence of the external auditor.
 Significant issues and their resolution by audit committees need to be reported to address
any uncertainties over their impact.
 Whether handled by the audit committee or not, information on internal control, risk
management systems and internal audit is valued by investors and must be disclosed.

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6 Corporate governance: international impact
Section overview
• Corporate governance models differ around the world, but the following principles and
legislation are widely recognised:
– The G20/OECD Principles of Corporate Governance (G20/OECD Principles)
– The Sarbanes–Oxley Act in the US (SOX)
– The UK Corporate Governance Code (covered in earlier sections)
• The G20/OECD Principles resulted from market pressure for standardisation of
governance guidelines.
• The G20/OECD Principles are non-binding but are intended to assist governments, stock
exchanges, investors and companies. They cover the following six areas:
– Ensuring the basis for an effective corporate governance framework
– The rights of shareholders
– The equitable treatment of shareholders
– The role of stakeholders
– Disclosure and transparency
– The responsibilities of the board
• The introduction of SOX in the US resulted from the Enron scandal.
• SOX is a 'rules-based' rather than 'principles-based' approach to improving corporate
governance.
• The Act applies to all companies that are required to file accounts with the Securities and
Exchange Commission. This includes non-US companies who list their shares in the US
and therefore affects companies worldwide.
• SOX has resulted in increased compliance costs for companies.
6.1 G20/OECD Principles of Corporate Governance

C
6.1.1 Convergence of international guidance H
A
Because of increasing international trade and cross-border links, there is significant pressure for
P
the development of internationally comparable practices and standards. Accounting and T
financial reporting is one area in which this has occurred. Increasing international investment E
R
and integration of international capital markets has also led to pressure for standardisation of
governance guidelines, as international investors seek reassurance about the way their 4
investments are being managed and the risks involved.
6.1.2 OECD guidance
The Organisation for Economic Co-operation and Development (OECD) has carried out an
extensive consultation with member countries, and developed a set of principles of corporate
governance that countries and companies should work towards achieving. The OECD has stated
that its interest in corporate governance arises from its concern for global investment.
Corporate governance arrangements should be credible and understood across national
borders. Having a common set of accepted principles is a step towards achieving this aim.
The OECD developed its Principles of Corporate Governance in 1998 and issued a revised
version endorsed by the G20 in November 2015. They are non-binding principles, intended to
assist governments in their efforts to evaluate and improve the legal, institutional and regulatory
framework for corporate governance in their countries.

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They are also intended to provide guidance to stock exchanges, investors and companies. The
focus is on stock exchange listed companies, but many of the principles can also apply to private
companies and state-owned organisations.
The G20/OECD Principles deal mainly with governance problems that result from the separation
of ownership and management of a company. Issues of ethical concern and environmental
issues are also relevant, although not central to the problems of governance.
Between February 2009 and February 2010 the OECD issued a number of documents regarding
the corporate governance lessons which can be learnt from the recent financial crisis.
6.1.3 G20/OECD Principles

The G20/OECD Principles are grouped into six broad areas:
(1) Ensuring the basis for an effective corporate governance framework
The corporate governance framework should promote transparent and fair markets, and
the efficient allocation of resources. It should be consistent with the rule of law and support
effective supervision and enforcement.
(2) The rights and equitable treatment of shareholders and key ownership functions
Shareholders should have the right to participate and vote in general meetings of the
company, elect and remove members of the board and obtain relevant and material
information on a timely basis. All shareholders of the same class of shares should be treated
equally, including minority shareholders and overseas shareholders. Impediments to cross-
border shareholdings should be eliminated.
Capital markets for corporate control should function in an efficient and timely manner.
(3) Institutional investors, stock markets and other intermediaries
Institutional investors acting in a fiduciary capacity should disclose their corporate
governance and voting policies with respect to their investments and should disclose how
they manage material conflicts of interest. Parties providing advice to investors should
disclose and minimise conflicts of interest. Votes should be cast in line with the directions
of the owners of the shares.
(4) The role of stakeholders
Rights of stakeholders should be protected. All stakeholders should have access to
relevant information on a regular and timely basis. Mechanisms for employee participation
should be permitted to develop. Stakeholders, including employees, should be able to
freely communicate their concerns about illegal or unethical relationships to the board and
public authorities.
(5) Disclosure and transparency
Timely and accurate disclosure must be made of all material matters regarding the
company, including the financial situation, company objectives and non-financial
information, major share ownership, including beneficial owners and voting rights,
remuneration of members of the board and key executives, information about the board
(including their qualifications), related party transactions, foreseeable risk factors, issues
regarding employees and other stakeholders and governance structures and policies.
Information should be prepared and disclosed in accordance with standards of accounting
and financial and non-financial reporting. An annual audit should be conducted by an
independent, competent and qualified auditor following relevant auditing standards. The
auditor must exercise due professional care in the conduct of the audit. Information must
be disseminated through proper channels.
(6) The responsibilities of the board
The board is responsible for the strategic guidance of the company and for the effective
monitoring of management. Board members should act on a fully informed basis, in good

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faith, with due diligence and care and in the best interests of the company and its
shareholders. They should treat all shareholders fairly. The board should be able to
exercise independent judgement; this includes assigning independent non-executive
directors to appropriate tasks.
6.2 Sarbanes–Oxley
6.2.1 The Enron scandal
The most significant scandal in the US in recent years has been the Enron scandal, when one of
the country's biggest companies filed for bankruptcy. The scandal also resulted in the
disappearance of Arthur Andersen, one of the Big Five accountancy firms who had audited
Enron's accounts. The main reasons why Enron collapsed were overexpansion in energy
markets, too much reliance on derivatives trading which eventually went wrong, breaches of
federal law, and misleading and dishonest behaviour. However, inquiries into the scandal
exposed a number of weaknesses in the company's governance.
(a) A lack of transparency in the accounts
This particularly related to certain investment vehicles that were not recognised in the
statement of financial position. Various other methods of inflating revenues, offloading
debt, massaging quarterly figures and avoiding taxes were employed.
(b) Ineffective corporate governance arrangements
The company's management team was criticised for being arrogant and overambitious and
there were potential conflicts of interest.
(c) Inadequate scrutiny by the external auditors
Arthur Andersen failed to spot or question dubious accounting treatments. Since
Andersen's consultancy arm did a lot of work for Enron, there were allegations of conflicts
of interest.
(d) Information asymmetry
That is, the agency problem of the directors/managers knowing more than the investors.
The investors included Enron's employees. Many had their personal wealth tied up in Enron
shares, which ended up being worthless. They were actively discouraged from selling them. C
H
Many of Enron's directors, however, sold the shares when they began to fall, potentially
A
profiting from them. P
T
(e) Executive compensation methods E
R
These were meant to align the interests of shareholders and directors, but seemed to
encourage the overstatement of short-term profits. Particularly in the US, where the tenure 4
of chief executive officers is fairly short, the temptation is strong to inflate profits in the hope
that share options will have been cashed in by the time the problems are discovered.
6.2.2 The Sarbanes–Oxley Act 2002

In the US the response to the breakdown of stock market trust caused by perceived
inadequacies in corporate government arrangements and the Enron scandal was the Sarbanes–
Oxley Act 2002. The Act applies to all companies that are required to file periodic reports with
the Securities and Exchange Commission (SEC). The Act was the most far-reaching US
legislation dealing with securities in many years and has major implications for public
companies. Rule-making authority was delegated to the SEC on many provisions.
Sarbanes–Oxley shifts responsibility for financial probity and accuracy to the board's audit
committee, which typically comprises three independent directors, one of whom has to meet
certain financial literacy requirements (equivalent to non-executive directors in other
jurisdictions).

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Along with rules from the SEC, the Sarbanes–Oxley Act (SOX) requires companies to increase
their financial statement disclosures, to have an internal code of ethics and to impose
restrictions on share trading by, and loans to, corporate officers.
Effectively the SOX legislates that companies and their boards must comply with provisions
derived from principles similar to the OECD Principles and those contained in the UK Corporate
Governance Code. However, this rules based approach has drawn criticism for its 'one size fits
all' approach and there have been concerns that it unnecessarily burdens smaller entities.
Unlike the UK Corporate Governance Code, which adopts a 'comply or explain' approach, the
SOX is strictly rules-based, with penalties imposed for non-compliance. There is a continuing
debate around which approach is the more effective. It is argued that the UK's more flexible
model:
 provides best practice guidance that can be applied to the varying circumstances of
different companies;
 prevents the development of a mechanistic, 'box-ticking' approach to decision-making and
the use of legalistic loopholes to avoid compliance with guidance; and
 focuses on the spirit of the guidance and encourages responsibility and the exercise of
professional judgement.
On the other hand, supporters of a rules-based approach argue that compliance with such
guidance is easier since the requirements are prescriptive and leave little room for
misunderstanding. Furthermore, rules-based approaches are easier to enforce.
6.2.3 Detailed provisions of the Sarbanes-Oxley Act
These are as follows:
(a) Public Oversight Board
The Act set up a new regulator, the Public Company Accounting Oversight Board, to
oversee the audit of public companies that are subject to the securities laws.
The Board has powers to set auditing, quality control, independence and ethical standards
for registered public accounting firms to use in the preparation and issue of audit reports
on the financial statements of listed companies. In particular, the Board is required to set
standards for registered public accounting firms' reports on listed company statements on
their internal control over financial reporting. The Board also has inspection and
disciplinary powers over firms.
(b) Auditing standards
Audit firms should retain working papers for at least seven years and have quality control
standards in place, such as second partner review. As part of the audit they should review
internal control systems to ensure that they reflect the transactions of the client and provide
reasonable assurance that the transactions are recorded in a manner that will permit
preparation of the financial statements in accordance with generally accepted accounting
principles. They should also review records to check whether receipts and payments are
being made only in accordance with management's authorisation.
(c) Non-audit services
Auditors are expressly prohibited from carrying out a number of services, including internal
audit, bookkeeping, systems design and implementation, appraisal or valuation services,
actuarial services, management functions and human resources, investment management,
and legal and expert services. Provision of other non-audit services is only allowed with the
prior approval of the audit committee.

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(d) Quality control procedures

There should be rotation of lead or reviewing audit partners every five years and other
procedures such as independence requirements, consultation, supervision, professional
development, internal quality review and engagement acceptance and continuation.
(e) Auditors and audit committee
Auditors should discuss critical accounting policies, possible alternative treatments, the
management letter and unadjusted differences with the audit committee.
(f) Audit committees
Audit committees should be established by all listed companies.
All members of audit committees should be independent and should therefore not accept
any consulting or advisory fee from the company or be affiliated to it. At least one member
should be a financial expert. Audit committees should be responsible for the appointment,
compensation and oversight of auditors. Audit committees should establish mechanisms
for dealing with complaints about accounting, internal controls and audit.
(g) Corporate responsibility
The chief executive officer and chief financial officer should certify the appropriateness of
the financial statements and that those financial statements fairly present the operations
and financial condition of the issuer. If the company has to prepare a restatement of
accounts due to material non-compliance with standards, the chief financial officer and
chief executive officer should forfeit their bonuses.
(h) Off balance sheet transactions
There should be appropriate disclosure of material off balance sheet transactions and
other relationships (transactions that are not included in the accounts but that impact on
financial conditions, results, liquidity or capital resources).
(i) Internal control reporting
Annual reports should contain internal control reports. We look at this aspect in more detail
in section 7 when we consider internal control.
(j) Whistleblowing provisions
C
Employees of listed companies and auditors will be granted whistleblower protection H
against their employers if they disclose private employer information to parties involved in A
P
a fraud claim. T
E
6.2.4 Impact of Sarbanes–Oxley in the US R
The biggest expense involving compliance that companies are incurring is fulfilling the 4
requirement to ensure their internal controls are properly documented and tested. US
companies had to have efficient controls in the past, but they are now having to document them
more comprehensively than before, and then have the external auditors report on what they
have done.
The Act also formally stripped accountancy firms of almost all non-audit revenue streams that
they used to derive from their audit clients, for fear of conflicts of interest.
For lawyers, the Act strengthens requirements on them to whistleblow internally on any
wrongdoing they uncover at client companies, right up to board level.
6.2.5 International impact of Sarbanes–Oxley

The Act also has a significant international dimension. About 1,500 non-US companies,
including many of the world's largest, list their shares in the US and are covered by Sarbanes–
Oxley. There were complaints that the new legislation conflicted with local corporate

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governance customs and, following an intense round of lobbying from outside the US, changes
to the rules were secured. For example, German employee representatives, who are non-
management, can sit on audit committees, and audit committees do not have to have board
directors if the local law says otherwise, as it does in Japan and Italy.
Also, as the US is such a significant influence worldwide, arguably Sarbanes–Oxley may influence
certain jurisdictions to adopt a more rules-based approach.
6.2.6 Criticisms of Sarbanes–Oxley

Sarbanes–Oxley has been criticised in some quarters for not being strong enough on certain
issues, for example the selection of external auditors by the audit committee, and at the same
time being over-rigid on others. Directors may be less likely to consult lawyers in the first place if
they believe that legislation could override lawyer-client privilege.
In addition, it has been alleged that a Sarbanes–Oxley compliance industry has sprung up
focusing companies' attention on complying with all aspects of the legislation, significant or
much less important. This has distracted companies from improving information flows to the
market and then allowing the market to make well-informed decisions. The Act has also done
little to address the temptation provided by generous stock options to inflate profits, other than
requiring possible forfeiture if accounts are subsequently restated.
Most significantly, perhaps, there is recent evidence of companies turning away from the US
stock markets and towards other markets such as London. Many observers have suggested that
this was partly due to companies tiring of the increased compliance costs associated with
Sarbanes–Oxley implementation. In addition, the nature of the regulatory regime may be an
increasingly significant factor in listing decisions.
7 Corporate governance and internal control
Section overview
• The FRC publication Risk Management, Internal Control and Related Business and
Financial Reporting (based on the Turnbull Report) sets out best practice on internal
control for UK-listed companies.
• Turnbull emphasises that a risk-based approach to establishing a system of internal
control should be adopted.
• Directors should have a defined process for the review of effectiveness of control.
• International companies listed in the US must comply with Sarbanes–Oxley.
7.1 The Turnbull Report and the FRC Risk Guidance

7.1.1 Introduction
We looked briefly at the FRC's Risk Management, Internal Control and Related Business and
Financial Reporting (also known as the Risk Guidance) in section 5.2.
Published in September 2014, the Risk Guidance revised, integrated and replaced existing FRC
guidance on internal control and going concern, and reflected changes made to the UK
Corporate Governance Code.
7.1.2 Objectives of the Risk Guidance

The objectives of the Risk Guidance, based on those in the Turnbull Report, are to encourage
companies to adopt a risk-based approach to establishing a system of internal control ie, to

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manage and control risk appropriately rather than eliminate it. This should enable companies to
achieve their business objectives while being responsive to the risks they face.
The Risk Guidance emphasises the importance of an embedded and ongoing process of
identifying and responding to risks. Thus a company must:
 establish business objectives;
 identify the key risks associated with these;
 agree the controls to address the risks; and
 set up a system to implement the decision, including regular feedback.
The guidance aims to reflect sound business practice, as well as to help companies comply with
the internal control requirements of the Code.
7.1.3 Responsibilities of directors, management and employees

The responsibilities of directors, management and employees to implement the Risk Guidance
are as follows.
Directors
 Ensure the design and implementation of appropriate risk management and internal
control systems
 Determine the nature and extent of the principal risks faced and the organisation's risk
appetite
 Ensure that appropriate culture and reward systems have been embedded throughout the
organisation
 Agree how the principal risks should be managed or mitigated
 Monitor and review the risk management and internal control systems, and the
management's process of monitoring and reviewing
 Ensure sound internal and external information and communication processes are in place
and communicate with external stakeholders on risk management and internal control
In addition, as part of the responsibilities outlined above, the board has responsibility for
determining the organisation's going concern status and making related disclosures in the
financial statements. C
H
Management A
P
 Implement board policies on risk and control T
 Provide the board with timely information E
 Establish clear internal responsibilities and accountabilities at all levels of the organisation R
Employees 4
 Acquire the necessary knowledge, skills, authority etc to establish, operate and monitor the
system of internal controls
7.1.4 Review of internal financial control

Section 4 paragraph 28 of the Risk Guidance defines risk management and internal control
systems as "the policies, culture, organisation, behaviours, processes, systems and other aspects
of a company that:
 facilitate its effective and efficient operation by enabling it to assess current and emerging
risks, respond appropriately to risks and significant control failures and to safeguard its
assets;
 help to reduce the likelihood and impact of poor judgement in decision-making; risk-taking
that exceeds the levels agreed by the board; human error; or control processes being
deliberately circumvented;

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 help ensure the quality of internal and external reporting; and

 help ensure compliance with applicable laws and regulations, and also with internal policies
with respect to the conduct of business."
A risk management and internal control system is likely to include the following:
 Risk assessment – process to identify major risks and assess their impact
 Management and monitoring of risks – including controls processes (segregation of duties,
authorisation, etc)
 Information and communication systems – include monthly reporting, comparison with
budgets etc, as well as non-financial performance indicators
 Monitoring – procedures designed to ensure risks are monitored and the internal controls
continue to be effective (audit committees, internal audit, etc)
Point to note:
These components should remind you of the five components of internal control identified in
ISA (UK) 315, Identifying and Assessing the Risks of Material Misstatement Through
Understanding the Entity and its Environment.
Many perceive the overall control environment as the key component of internal control. Its
importance can be seen in the following Worked example.
Worked example: Control environment

Imagine a hotel group whose management prides itself on being 'lean and mean'.
Head office puts in controls to match this obsession. Each hotel is a separate company. Every
manager has their targets. The group has budgets and is measured by those budgets. But the
key target by which the business is run is occupancy rates.
The managers make sure that the hotels are full by reducing the room rates quite substantially.
These low rates do not filter through the system until a long time later. So their management
system leads to a totally ineffective system where expectations are high and the important
controls are not there at all – because the control environment is inappropriate.
7.1.5 Disclosure of compliance with the Risk Guidance

The Risk Guidance recommends that the assessments and processes used to manage and
monitor risk should inform disclosures in the annual reports and financial statements. The
disclosures comprise the following:
 The principal risks facing the company and how they are managed or mitigated
 Whether the directors have a reasonable expectation that the company will be able to
continue in operation and meet its liabilities as they fall due
 The going concern basis of accounting
 Reporting on the review of the risk management and internal control system, and the main
features of the company's risk management and internal control system in relation to the
financial reporting process
There is an expectation that the period used by the company in assessing whether the going
concern basis of accounting is appropriate will be significantly longer than 12 months (see
section 3.3).

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7.1.6 Example narrative statement

The following is an extract from a narrative statement on internal control, taken from the
corporate governance statement of W H Smith as part of its Annual Report for 2017. W H Smith
is a well-known UK high street retailer, selling stationery and books and is listed on the FTSE in
the UK. It is therefore obliged to report on compliance with the UK Corporate Governance
Code. The full statement and related annual report and financial statements can be found on
W H Smith's website at www.whsmithplc.co.uk.
Corporate Governance Report (extract)
Matters reserved for the Board
The Board manages the Company through a formal schedule of matters reserved for its
decision, with its key focus being on creating long-term sustainable shareholder value. The
significant matters reserved for its decision include: the overall management of the Company;
approval of the business model and strategic plans including acquisitions and disposals;
approval of the Company’s commercial strategy and operating and capital expenditure
budgets; approval of the Annual report and financial statements, material agreements and
nonrecurring projects; treasury and dividend policy; control, audit and risk management;
executive remuneration; and corporate social responsibility.
The Board has a forward timetable of business to ensure that it allocates sufficient time to key
areas. The timetable is flexible enough for items to be added to any particular agenda as
necessary. The Board’s annual business includes Chief Executive’s reports, including business
reports, financial results, strategy and strategy updates, including in-depth sessions on specific
areas of the business and strategic initiatives, risk management, dividend policy, investor
relations, health and safety, Board evaluation, governance and compliance, communications
and the Annual report.
Risk management
The Board has overall responsibility for the Group’s system of risk management and internal
control (including financial controls, controls in respect of the financial reporting process and
operational and compliance controls) and has conducted a detailed review of its effectiveness
during the year, to ensure that management has implemented its policies on risk and control.
This review included receiving reports from management, discussion, challenge, and
assessment of the principal risks. No significant failings or weaknesses were identified from this
C
review. In addition, the Board also received presentations from management on higher risk H
areas, for example, cyber risk, risks arising from the process of exiting the European Union and A
growing international expansion. The Board has established an organisational structure with P
T
clearly defined lines of responsibility which identify matters requiring approval by the Board. E
Steps continue to be taken to embed internal control and risk management further into the R
operations of the business and to deal with areas that require improvement which come to the
4
attention of management and the Board. Such a system is, however, designed to manage rather
than eliminate the risk of failure to achieve business objectives, and can only provide reasonable
and not absolute assurance against material misstatement or loss.
The Board confirms that there is an ongoing process for identifying, evaluating and managing
principal risks faced by the Group, including those risks relating to social, environmental and
ethical matters. The Board confirms that the processes have been in place for the year under
review and up to the date of this report and that they accord with the FRC Guidance on Risk
Management, Internal Control and Related Financial and Business Reporting (the ‘Risk
Management and Internal Control Guidance’). The processes are regularly reviewed by the
Board. The principal risks and uncertainties facing the Group can be found in the Strategic
report on pages 20 to 24.
Further information on internal controls and risk management can be found in the Audit
Committee report on pages 33 to 36.

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7.2 International focus

As we discussed earlier, large international companies may be listed in the US and are required
to comply with the US Sarbanes–Oxley Act (SOX).
The key difference between SOX and the UK approach to corporate governance is that while the
UK Corporate Governance Code is principles-based, SOX is rules-based. By contrast to the UK's
'comply or explain' approach, most of the SOX regulations are enshrined in legislation, with
penalties for non-compliance.
One area of this Act that has sparked widespread debate has been section 404 relating to the
assessment of internal control. Under SOX, management and the auditors must report on the
adequacy of the company's internal control over financial reporting. Working to implement,
document and test controls to the degree required to make an assertion that the controls are
adequate can be a costly and time-consuming process.
Annual reports for companies affected by SOX should contain internal control reports that state
the responsibility of management for establishing and maintaining an adequate internal control
structure and procedures for financial reporting. Annual reports should also contain an
assessment of the effectiveness of the internal control structure and procedures for financial
reporting. Auditors should report on this assessment.
Companies should also report whether they have adopted a code of conduct for senior financial
officers and the content of that code.
7.2.1 Example of internal control report under SOX
The following extract has been taken from the annual report for 31 December 2017 of
Coca-Cola Enterprises, Inc.
Management's report on internal control over financial reporting

Management of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting as such term is defined in Rule 13a-15(f) under the Securities
Exchange Act of 1934 (“Exchange Act”). Management assessed the effectiveness of the
Company’s internal control over financial reporting as of December 31, 2017. In making this
assessment, management used the criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (2013 Framework) (“COSO”) in Internal Control—
Integrated Framework. Management has excluded from the scope of its assessment of internal
control over financial reporting the operations and related assets of Coca-Cola Beverages Africa
Proprietary Limited (“CCBA”), which the Company began consolidating in October 2017. The
operations and related assets of CCBA were included in the consolidated financial statements of
The Coca-Cola Company and subsidiaries and constituted 8 percent of total assets and 8
percent of consolidated net income as of and for the year ended December 31, 2017. Based on
this assessment, management believes that the Company maintained effective internal control
over financial reporting as of December 31, 2017.
The Company’s independent auditors, Ernst & Young LLP, a registered public accounting firm,
are appointed by the Audit Committee of the Company’s Board of Directors, subject to
ratification by our Company’s shareowners. Ernst & Young LLP has audited and reported on the
consolidated financial statements of The Coca-Cola Company and subsidiaries and the
Company’s internal control over financial reporting. The reports of the independent auditors are
contained in this annual report.
(Source: www.coca-
colacompany.com/content/dam/journey/us/en/private/fileassets/pdf/2018/2017-10K.pdf)
The report above can be contrasted with the compliance statement in section 7.1.6. Under SOX,
a positive statement that management believes the company maintained effective internal
control is needed. For the UK listed company, the disclosure is in relation to the existence of an
ongoing process for identifying, evaluating and managing risks and a summary of the process

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for reviewing internal control effectiveness and, where necessary, addressing control
weaknesses.
8 Evaluation of corporate governance mechanisms
Section overview
• The auditor is required to review the statement of compliance with the UK Corporate
Governance Code made by directors.
• This review includes the statement on control effectiveness.
• The auditor will need to perform procedures to obtain appropriate evidence to support
the compliance statement made by the company.
8.1 Auditors' responsibilities

As we have seen in section 3, companies are required to provide a two-part disclosure
regarding compliance with the provisions of the UK Corporate Governance Code. The Stock
Exchange Listing Rules require auditors to review parts of the statement which relate to certain
provisions in the Code.
These include sections which deal with the following matters.
 Respective responsibilities of directors and auditors (Code Section C.1.1)
 Review of the effectiveness of risk management and internal controls (Code Section C.2.1)
(see section 8.2 below)
 Provisions relating to audit committees (Code Sections C.3.1 to C.3.8)
The listing rules also require auditors to review the annual statement by the directors that the
business is a going concern.
The auditor also needs to review that the following disclosures are made correctly, in relation to
each director.
 Amount of each element in the remuneration package and information on share options
C
 Details of long term incentive schemes for directors H
 Money purchase schemes A
 Defined benefit schemes P
T
The auditor's report should then include details of any non-compliance with these requirements. E
R
In order to conduct the review the auditor will need to obtain audit evidence to support the
compliance statement. Bulletin 2006/5 The Combined Code on Corporate Governance: 4
Requirements of Auditors Under the Listing Rules of the Financial Services Authority identifies the
following general procedures as those usually performed by the auditor:
(a) Reviewing the minutes of the meetings of the board of directors, and of relevant board
committees
(b) Reviewing supporting documents prepared for the board of directors or board committees
that are relevant to those matters specified for review by the auditor
(c) Making enquiries of certain directors (such as the chairman of the board of directors and
the chairman of relevant board committees) and the company secretary
(d) Attending meetings of the audit committee at which the annual report and accounts,
including the statement of compliance, are considered and approved for submission to the
board of directors

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Points to note:
1 Bulletin 2006/5 predates the introduction of the UK Corporate Governance Code and
therefore still refers to the Combined Code, its predecessor.
2 The guidance in Bulletin 2006/5 on directors' statements on going concern has been
replaced by guidance in Bulletin 2009/4 Developments in Corporate Governance Affecting
the Responsibilities of Auditors of UK Companies (see section 8.3 below).
These Bulletins have not been updated to reflect the changes made to the ISAs (UK) revised in
June 2016.
8.2 Internal control effectiveness

The Code requires that the board should, at least annually, conduct a review of the
effectiveness of the company's system of internal controls and report to shareholders that they
have done so.
Bulletin 2006/5 considers what auditors should do in response to this statement on internal
controls by the directors.
The guidance states that the auditors should concentrate on the review carried out by the
board. The objective of the auditors' work is to assess whether the company's summary of the
process that the board has adopted in reviewing the effectiveness of the system of internal
control is supported by the documentation prepared by the directors and reflects that process.
The auditors should make appropriate enquiries and review the statement made by the board
in the annual report and the supporting documentation.
Auditors will have gained some understanding of controls due to their work on the accounts;
however, what they are required to do by auditing standards is narrower in scope than the
review performed by the directors.
Auditors are therefore not expected to assess whether the directors' review covers all risks and
controls, and whether the risks are satisfactorily addressed by the internal controls. To avoid
misunderstanding on the scope of the auditors' role, the Bulletin recommends that the following
wording be used in the auditor's report.
"We are not required to consider whether the board's statements on internal control cover
all risks and controls, or form an opinion on the effectiveness of the company's corporate
governance procedures or its risk and control procedures."
(Source: Bulletin 2006/5 para. 37)
The Bulletin also points out that it is particularly important for auditors to communicate quickly
to the directors any material weaknesses they find, because of the requirements for the directors
to make a statement on internal control.
The directors are required to consider the material internal control aspects of any significant
problems disclosed in the accounts. Auditors' work on this is the same as on other aspects of the
statement; the auditors are not required to consider whether the internal control processes will
remedy the problem. The auditors may report by exception if problems arise, such as:
 the board's summary of the process of review of internal control effectiveness does not
reflect the auditors' understanding of that process;
 the processes that deal with material internal control aspects of significant problems do not
reflect the auditors' understanding of those processes; or
 the board has not made an appropriate disclosure if it has failed to conduct an annual
review, or the disclosure made is not consistent with the auditors' understanding.
The Bulletin has not been updated to reflect changes made to the ISAs (UK) revised in June
2016. ISA (UK) 720 (Revised June 2016) , The Auditor's Responsibilities Relating to Other
Information is relevant when considering the corporate governance statement. The corporate

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governance statement is covered in ISA 720 (UK) (Revised June 2016) as statutory other
information ie, "Those documents or reports that are required to be prepared and issued by the
entity … in relation to which the auditor is required to report publicly in accordance with law or
regulation". In the UK, this statutory other information includes the directors' report, strategic
report and the separate corporate governance statement. This ISA requires that auditor's report
always includes a separate section headed 'Other Information' and this is covered in more detail
in Chapter 8, section 6.5.
The Bulletin Compendium of illustrative auditor's reports on United Kingdom private sector
financial statements for periods commencing on or after 17 June 2016 includes example
wording which the auditor will include when a material misstatement of the other information,
arising from an inconsistency between the other information and the financial statements, is
identified.
8.3 Going concern

The Listing Rules require the directors of certain listed companies to include in the annual
financial report a statement that the business is a going concern. Bulletin 2009/4 Developments
in Corporate Governance Affecting the Responsibilities of Auditors of UK Companies sets out the
auditor's review responsibilities with respect to this statement as follows:
 Reviewing the documentation prepared by or for the directors which explains the basis of
the directors' conclusion with respect to going concern
 Evaluating the consistency of the directors' going concern statement with the auditor's
knowledge obtained in the course of the audit
 Assessing whether the directors' statement meets the disclosure requirements of the FRC
guidance
The Bulletin also states that where the annual report includes a corporate governance statement
the auditor is required to form an opinion as to whether the information given is consistent with
the financial statements.
Point to note:
ISA (UK) 570 (Revised June 2016), Going Concern requires that for entities where the directors
make a statement in the financial statements regarding going concern as part of their
application of the UK Corporate Governance Code, the auditor must report by exception in a C
H
separate section of the audit report under the heading 'Conclusions related to Going Concern'
A
whether the auditor has anything material to add or draw attention to in relation to this P
statement. (ISA 570 is covered in detail in Chapter 8.) T
E
R
8.3.1 Guidance on going concern
4
In March 2011, the FRC announced the launch of an inquiry led by Lord Sharman to identify
lessons for companies and auditors addressing going concern and liquidity risk. In June 2012
the Sharman Inquiry Final Report and Recommendations was issued. The panel made five
recommendations. The key points are as follows:
 The FRC should take a more systematic approach to learning lessons relevant to its
functions when significant companies fail or suffer significant financial or economic distress
but nonetheless survive.
 The FRC should seek to engage with the IASB and the IAASB to agree a common
international understanding of the purposes of the going concern assessment and financial
statement disclosures about going concern.
 The FRC should review the Guidance for Directors to ensure that going concern assessment
is integrated with the directors' business planning and risk management processes and:
– includes a focus on both solvency and liquidity risks, whatever the business;

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– may be more qualitative and longer term in outlook in relation to solvency risk than in
relation to liquidity risk; and
– includes stress tests both in relation to solvency and liquidity risks that are undertaken
with an appropriate level of prudence. Special consideration should be given to the
impact of risks that could cause significant damage to stakeholders, bearing in mind
the directors' duties and responsibilities under the Companies Act 2006.
 The FRC should move away from a model where disclosures about going concern risks are
only highlighted when there are significant doubts about the entity's survival.
 The FRC should consider inclusion of an explicit statement in the auditor's report as to
whether the auditor has anything to add or emphasise in relation to the disclosures made
by the directors about the robustness of the process and its outcome, having considered
the directors' going concern assessment process.
These recommendations have been reflected in the 2014 revision of the UK Corporate
Governance Code, which we discussed in section 4 and in the FRC document Risk Management,
Internal Control and Related Business and Financial Reporting. Appendix A sets out guidance for
directors for assessing whether to adopt the going concern basis of accounting, assessing
whether there are material uncertainties and reporting issues. In particular it states the following:
 The threshold for departing from the going concern basis of accounting is very high.
 Directors must determine whether there are any material uncertainties that might cast
significant doubt on the continuing use of the going concern basis.
 To be useful disclosures of material uncertainties must explicitly identify them as such.
In April 2016, the FRC issued Guidance on the Going Concern Basis of Accounting and
Reporting on Solvency and Liquidity Risk. This provides guidance to directors of companies that
do not apply the UK Corporate Governance Code. This states the following:
 All companies must assess the appropriateness of the going concern basis of accounting
and document the assessment in sufficient detail.
 Directors should consider a period of at least 12 months from the date the financial
statements are authorised for issue.
 Directors should consider threats to solvency and liquidity.
 The strategic report must include a description of the principal risks and uncertainties
facing the company.
Point to note:
The Companies Act requires all companies that are not small or micro to prepare a strategic
report. This must contain a fair review of the company's business and a description of the
principal risks and uncertainties it faces.
9 Communicatsion between auditors and those charged with

governance
Section overview
• Auditors have to communicate various audit-related matters to those charged with
governance.
• This section summarises and builds on the important points covered by the Audit and
Assurance paper at Professional Level.
• In particular there have been some recent revisions to ISA 260 relating to the audit of
entities reporting on how they have applied the UK Corporate Governance Code.

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9.1 Communication during the audit

Two standards are relevant here:
 ISA (UK) 260 (Revised June 2016), Communication With Those Charged With Governance
 ISA (UK) 265, Communicating Deficiencies in Internal Control to Those Charged With
Governance and Management
The revisions to ISA 260 include the need to consider the implications of ISA (UK) 701,
Communicating Key Audit Matters in the Independent Auditor's Report and enhanced auditor
reporting for all public interest entities (PIEs) and listed companies.
Definition
Governance: The term used to describe the role of persons with responsibility for overseeing
the strategic direction of the entity and obligations related to the accountability of the entity.
This includes overseeing the financial reporting process. Those charged with governance may
include management only when it performs such functions. (In the UK, those charged with
governance include the directors (executive and non-executive) and members of the audit
committee. In the UK, management will not normally include non-executive directors.)
9.1.1 Objectives
ISA 260 states that the objectives of the auditor are to (ISA 260.9):
(a) communicate clearly with those charged with governance the responsibilities of the auditor in
relation to the financial statement audit and an overview of the planned scope and timing of the
audit;
(b) obtain from those charged with governance information relevant to the audit;
(c) provide those charged with governance with timely observations arising from the audit that
are significant and relevant to their responsibility to oversee the financial reporting process;
and
(d) promote effective two-way communication between the auditor and those charged with
governance.
The auditor must communicate audit matters of governance interest arising from the audit of
financial statements with those charged with governance of an entity. The scope of the ISA is C
H
limited to matters that come to the auditor's attention as a result of the audit; the auditors are
A
not required to perform procedures to identify matters of governance interest. P
T
The auditor must determine the relevant persons who are charged with governance and with E
whom audit matters of governance interest are communicated. R
The auditors may communicate with the whole board, the supervisory board or the audit 4
committee depending on the governance structure of the organisation. To avoid
misunderstandings, the engagement letter should explain that auditors will only communicate
matters that come to their attention as a result of the performance of the audit. It should state
that the auditors are not required to design procedures for the purpose of identifying matters of
governance interest.
The letter may also do the following:
 Describe the form which any communications on governance matters will take
 Identify the relevant persons with whom such communications will be made
 Identify any specific matters of governance interest which it has agreed are to be
communicated

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Matters to be communicated
Matters would include:
The auditor's Including that:

responsibilities in
 the auditor is responsible for forming and expressing an opinion on
relation to the
the financial statements; and
financial
statements  the audit does not relieve management or those charged with
governance of their responsibilities.
Planned scope Including:
and timing of the
 how the audit proposes to address the significant risks of material
audit
misstatement from fraud or error;
 how the auditor plans to address areas of higher assessed risks of
material misstatement;
 the auditor's approach to internal control;
 application of materiality;
 the extent to which the auditor will use an auditor's expert;
 when ISA (UK) 701 applies, the auditor's preliminary views about
matters that may be areas of significant auditor attention in the audit
and therefore may be key audit matters; and
 the auditor's planned approach to significant changes in the
applicable reporting framework, environment financial condition or
activities.
When the auditor is required or decides to communicate key audit matters
ISA 260 requires that the overview of the planned scope and timing of the
audit must also include communicating about the most significant
assessed risks of material misstatement identified by the auditor.

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Significant Including:
findings from the
 the auditor's views about accounting policies, accounting estimates
audit
and financial statement disclosures;
 significant difficulties, if any, encountered during the audit (eg, delays
in provision of required information, brief time in which to complete
audit, unavailability of expected information);
 significant matters arising during the audit that were discussed or
subject to correspondence with management;
 written representations the auditor is requesting;
 circumstances that affect the form and content of the auditor's report;
and
 other significant matters, including material misstatements or
inconsistencies in other information that have been corrected.
Entities that are required or choose to report on the application of the UK
Corporate Governance Code must communicate to the audit committee
information relevant to the board and the audit committee in fulfilling their
responsibilities under the Code.
For audits of the financial statements of public interest entities the auditor
is required to submit an additional report in writing to the audit committee
explaining the results of the audit and information including:
 a declaration of independence;
 identity of key audit partners;
 a description of the scope and timing of the audit;
 a description of the methodology used;
 the quantitative level of materiality applied;
 events or conditions that may cast significant doubt on the entity's
ability to continue as a going concern;
C
 significant deficiencies in the control system; and H
A
 significant difficulties encountered and significant matters arising from P
T
the audit.
E
R

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Auditor In the case of listed entities matters include:

independence
 a statement that relevant ethical requirements regarding independence
have been complied with;
 all relationships (including total fees for audit and non-audit services)
which may reasonably be thought to bear on independence; and
 the related safeguards that have been applied to eliminate/reduce
identified threats to independence.
In the case of public interest entities, the auditor must:
 confirm to the audit committee annually in writing that the firm and
partners, senior managers and managers, conducting the audit are
independent; and
 discuss with the audit committee the threats to the auditor's
independence and the safeguards applied.
9.1.2 Communication process

The auditor must communicate with those charged with governance the form, timing and
expected general content of communications.
The communication process will vary with the circumstances, including:
 the size and governance structure of the entity;
 how those charged with governance operate; and
 the auditor's view of the significance of the matters to be communicated.
For example, reports of relatively minor matters to a small client may be best handled orally via a
meeting or telephone conversation.
Before communicating matters with those charged with governance the auditor may discuss
them with management, unless that is inappropriate. For example, it would not be appropriate
to discuss questions of management's competence or integrity with management.
Written representation should be sought from those charged with governance that explains
their reasons for not correcting misstatements brought to their attention by the auditor.
9.1.3 Adequacy of the communication process

The auditor must evaluate whether the two-way communication with those charged with
governance has been adequate for the purpose of the audit and, if not, must consider the effect
on the assessment of the risks of material misstatement and the ability to obtain sufficient,
appropriate evidence.
Interactive question 2: Reporting responsibilities

In each of the cases listed below identify to whom the auditor would initially report.
(1) The auditor has obtained evidence that the operations manager has committed a fraud
against the company.
(2) The auditor has obtained evidence that the finance director has committed a fraud against
the company.
(3) Disagreement with an accounting policy.
(4) The auditor is suspicious that the board of directors are involved in money laundering
activities.

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9.1.4 Reporting deficiencies in internal control

Auditors may also issue a report on control deficiencies to management. These reports were a
key element in your earlier studies in auditing.
ISA (UK) 265, Communicating Deficiencies in Internal Control to Those Charged with Governance
and Management specifies a threshold of significance at which deficiencies in internal control
should be communicated to those charged with governance.
Definition
Significant deficiency in internal control: Significant deficiencies in internal control are those
which in the auditor's professional judgement are of sufficient importance to merit the attention
of those charged with governance.
Matters that the auditor may consider in deciding whether deficiencies are significant include
the following:
 Likelihood of the deficiencies leading to material misstatements in future
 Susceptibility to fraud of related assets and liabilities
 Subjectivity and complexity of determining estimated amounts, such as fair value estimates
 The financial statement amounts exposed to the deficiencies
 The volume of activity in the account balance or class of transactions
 The importance of the controls to the financial reporting process
 The cause and frequency of the exceptions detected
 The interaction of the deficiency with other deficiencies in internal control
Recap of key qualities of a report to management
(a) It should not include language that conflicts with the opinion expressed in the audit report.
(b) It should state that the accounting and internal control system were considered only to the
extent necessary to determine the auditing procedures to report on the financial
statements and not to determine the adequacy of internal control for management
purposes or to provide assurances on the accounting and internal control systems.
(c) It will state that it only discusses deficiencies in internal control which have come to the C
auditor's attention as a result of the audit and that other deficiencies in internal control may H
exist. A
P
(d) It should also include a statement that the communication is provided for use only by T
management (or another specific named party). E
R
(e) The auditors will usually ascertain the actions taken, including the reasons for those
4
suggestions rejected.
(f) The auditors may encourage management to respond to the auditor's comments, in which
case any response can be included in the report.

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Summary
Main areas of:
− Shareholders − rights of − PCAOB established
− Shareholders − treatment of − Company requirements −
− Stakeholders audit committees etc
− Disclosure/transparency − Internal controls
− Board responsibility − Reporting (including
director affirmation)
Rules-based not
G20/OECD Principles Sarbanes–Oxley Act
principles-based
International impact
Rule-based not
Corporate governance Internal control
principle-based
Tumbull
UK Stewardship Associated UK Corporate Governance Code

Code: role of guidance
institutional investors
Main Disclosure Auditor's Main

sections requirements responsibilities concepts
Listed companies − Fairness

Corporate Review and report
− Transparency
governance non-compliance re:
− Independence
report − Respective
− Probity
responsibilities
of directors and − Responsibility
− Leadership − Accountability
auditors
− Effectiveness − Reputation
− Effectiveness of
− Accountability internal controls − Judgement
− Remuneration − Audit committee
− Relations with shareholders provisions
− Going concern
− Directors'
remuneration

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Self-test
1 SPV
SPV is listed on the stock exchange of a central European country. The company
manufactures a wide range of pharmaceutical products, including modern drugs used in
preventing and treating diseases. SPV has three factories where drugs are produced and
one research and development facility.
The board of directors comprises the chairman/CEO, three executive and two non-
executive directors (NEDs). Separate audit and remuneration committees are maintained,
although the chairman has a seat on both those committees. The NEDs are appointed for
two and usually three four-year terms of office before being required to resign. The internal
auditor currently reports to the board (rather than the financial accountant) on a monthly
basis, with internal audit reports normally being actioned by the board.
There have recently been problems with the development of a new research and
development facility. On a number of occasions the project has fallen behind schedule and
the costs have been much greater than expected. Because of developments that have taken
place elsewhere in the pharmaceuticals industry while the project was being completed,
concern has been expressed that the facility cannot now represent value for money. A
couple of large institutional investors have raised concerns about this, and have indicated
their intention to raise the issue at the annual AGM and possibly vote against the accounts.
Throughout the project one of the non-executive directors criticised the way the project had
been approved and monitored. She claimed that the board had been led by the senior
managers in the research and development department and had acted as no more than a
rubber stamp for what they wanted to do. She is threatening to resign at the AGM on the
grounds that the board is failing to function effectively and she does not wish to be held
responsible for decisions on which she has had no effective input. As a result, the other
non-executive director has also raised questions about the way the board is functioning.
Requirements
(a) Explain the main responsibilities of the board, identifying the ways in which SPV's
board appears to have failed to fulfil its responsibilities. C
H
(b) Evaluate the structures for corporate governance within SPV, recommending any A
amendments you consider necessary to those structures. P
T
2 Hammond Brothers E
R
Hammond Brothers, a road haulage company, is likely to be seeking a stock exchange
listing in a few years' time. In preparation for this, the directors are seeking to understand 4
certain key recommendations of the international corporate governance codes, since they
realise that they will have to strengthen their corporate governance arrangements. In
particular the directors require information about what the governance reports have
achieved in:
 defining the role of non-executive directors;
 improving disclosure in financial accounts;
 strengthening the role of the auditor; and
 protecting shareholder interests.
Previously the directors have received the majority of their income from the company in the
form of salary and have decided salary levels among themselves. They realise that they will
have to establish a remuneration committee but are unsure of its role and what it will need
to function effectively. The directors have worked together well, if informally; there is a lack

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of formal reporting and control systems both at the board and lower levels of management.
There is also currently no internal audit department.
The directors are considering whether it will be worthwhile to employ a consultant to advise
on how the company should be controlled, focusing on the controls with which the board
will be most involved.
Requirements
(a) Explain the purpose and role of the remuneration committee, and analyse the
information requirements the committee will have in order to be able to function
effectively.
(b) Explain what is meant by organisation and management controls and recommend the
main organisation and management controls that Hammond Brothers should operate.

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Technical reference
A Leadership
 Role of the board UK Corporate Governance Code A.1
 Division of responsibilities UK Corporate Governance Code A.2
 The chairman UK Corporate Governance Code A.3
 Non-executive directors UK Corporate Governance Code A.4
B Effectiveness
 Composition of the board UK Corporate Governance Code B.1
 Appointments to the board UK Corporate Governance Code B.2
 Commitment UK Corporate Governance Code B.3
 Re-election UK Corporate Governance Code B.7
C Accountability
 Risk management and internal control UK Corporate Governance Code C.2
 Audit committee and auditors UK Corporate Governance Code C.3
D Remuneration
 Level and components UK Corporate Governance Code D.1 &

Schedule A
E Relations with shareholders
 Dialogue with shareholders UK Corporate Governance Code E.1
F Institutional shareholders UK Stewardship Code
C
H
A
P
T
E
R

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(a) Benefits of the UK Corporate Governance Code
Shareholders
Of key importance to the shareholders are the suggestions that the UK Corporate
Governance Code makes in respect of the AGM. In the past, particularly for large listed
companies, AGMs have sometimes been forbidding and unhelpful to shareholders. The
result has been poor attendance and low voting on resolutions.
The UK Corporate Governance Code requires that separate resolutions are made for
identifiably different items which should assist shareholders in understanding the proposals
laid before the meeting.
It also requires that director members of various important board committees (such as the
remuneration committee) be available at AGMs to answer shareholders' questions.
Internal controls
Another important area for shareholders is the emphasis placed on directors monitoring
and assessing internal controls in the business on a regular basis. While it is a statutory
requirement that directors safeguard the investment of the shareholders by instituting
internal controls, this additional emphasis on quality should increase shareholders'
confidence in the business.
Directors' re-election
The requirements of the Code make the directors more accessible to the shareholders.
They are asked to submit to re-election every three years as a minimum. They are also
asked to make disclosure in the financial statements about their responsibilities in relation
to preparing financial statements and going concern.
Audit committee
Lastly, some people would argue that the existence of an audit committee will lead to
shareholders having greater confidence in the reporting process of an entity.
Other users
The key advantage to other users is likely to lie in the increased emphasis on internal
controls, as this will assist the company in operating smoothly and increasing visibility of
operations, which will be of benefit to customers, suppliers and employees.
(b) Voluntary code
Adherence to the UK Corporate Governance Code is not a statutory necessity, although it is
possible that in the future such a Code might become part of company law.
Advantages
The key merit of the Code being voluntary for most companies is that it is flexible.
Companies can review the Code and make use of any aspects which would benefit their
business.
If they adopt aspects of the Code, they can disclose to shareholders what is being done to
ensure good corporate governance, and what aspects of the Code are not being followed,
with reasons.
This flexibility is important, for there will be a cost of implementing such a Code, and this
cost might outweigh the benefit for small or owner-managed businesses.

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Disadvantages
Critics would argue that a voluntary code allows companies that should comply with the
Code to get away with non-compliance unchallenged.
They would also argue that the type of disclosure made to shareholders about degrees of
compliance could be confusing and misleading to shareholders and exacerbate the
problems that the Code is trying to guard against.

(1) The auditor would report the matter to those charged with governance (ISA 260/240).
(2) The auditor would report the matter to any other member of the board, for example the
chief executive or the chairman. Where there is doubt about the integrity of those charged
with governance as a whole, the auditor will need to seek legal advice as to the appropriate
course of action. This may include reporting to third parties eg, police or a regulatory
authority (ISA 240).
(3) This would be reported to and discussed with those charged with governance (ISA 260). If
the disagreement is material and is not changed, the auditors will also report to the
shareholders via the modified opinion in the audit report.
(4) The auditor should report suspicions of money laundering activities to the firm's Money
Laundering Compliance Principal (MLCP). The MLCP will then decide on the next
appropriate step which may involve making disclosure to the National Crime Agency.
C
H
A
P
T
E
R

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1 SPV
(a) Role of board
Each individual board of directors will take on particular tasks peculiar to their own
company and these will be different from company to company. However, there are
three key tasks that will be addressed by all boards of directors to one degree or
another.
Strategic management
The development of the strategy of the company will almost certainly be led by the
board of directors. At the very least they will be responsible for setting the context for
the development of strategy, defining the nature and focus of the operations of the
business and determining the mission statement and values of the business.
Strategic development will also consist of assessing the opportunities and threats
facing the business, considering, developing and screening the strategic proposals
and selecting and implementing appropriate strategies. Some or all of this more
detailed strategic development may be carried out by the board, but also may be
delegated to senior management with board supervision.
In the case of SPV, the board appears to have had inadequate involvement in the
development of strategy. While the board may use advice from expert managers, the
board should also have challenged what they provided and carried out its own
analysis; possible threats from rivals appear to have been inadequately considered.
Control
The board of directors is ultimately responsible for the monitoring and control of the
activities of the company. They are responsible for the financial records of the
company and that the financial statements are drawn up using appropriate accounting
policies and show a true and fair view. They are also responsible for the internal checks
and controls in the business that ensure the financial information is accurate and the
assets are safeguarded.
The board will also be responsible for the direction of the company and ensuring that
the managers and employees work towards the strategic objectives that have been
set. This can be done by the use of plans, budgets, quality and performance indicators
and benchmarking.
Again what has happened with the projects appears to indicate board failings. It seems
that the board failed to spot inadequacies in the accounting information that
managers were receiving about the new project, and did not ensure that action was
taken by managers to control the overruns in time and the excessive costs that the
accounting information may have identified. The board also seems to have failed to
identify inadequacies in the information that it was receiving itself.
Shareholder and market relations
The board of directors has an important role externally to the company. The board is
responsible for raising the profile of the company and promoting the company's
interests in its own and possibly other marketplaces.
The board has an important role in managing its relationships with its shareholders.
The board is responsible for maintaining relationships and dialogue with the
shareholders, in particular the institutional shareholders. As well as the formal dialogue
at the AGM many boards of directors have a variety of informal methods of keeping

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shareholders informed of developments and proposals for the company. Methods

include informal meetings, company websites, social reports and environmental
reports.
The institutional shareholders' intention to vote against the accounts is normally seen
as a last resort measure, if other methods of exercising their influence and
communicating their concerns have failed. This indicates that the board has failed to
communicate effectively with the institutional shareholders.
(b) Suggestions for corporate governance
Composition of the board
Corporate governance requirements normally indicate that the board of directors
should comprise equal numbers of executive and non-executive directors. By having
only two non-executive directors, SPV may not be following requirements. SPV needs
to appoint at least one more non-executive director to the board.
There is also a lack of any relevant financial experience amongst the non-executive
directors. Corporate governance regulations normally suggest that at least one NED
has financial experience so they can effectively monitor the financial information that
the board is reviewing. Making the new appointee an accountant would help to fulfil
this requirement.
Role of chairman/CEO
Corporate governance regulations normally require that the roles of the chairman (the
person running the board) and the CEO (the person running the company) are split.
The reason for this is to ensure that no one person has too much influence over the
running of the company. The roles of chairman and CEO at SPV should be split at the
earliest opportunity.
Appointment and nomination committees
The chairman of the board is normally allowed to sit on the audit and remuneration
committees to ensure that decisions made are in agreement with the overall
objectives. Issues that are not clear with the current structures relate to the composition
of those committees. Corporate governance requirements indicate these committees
will normally comprise NEDs, including the senior NED. This is to limit the extent of C
H
power of the executive directors. SPV needs to ensure that this requirement is being A
followed. P
T
Service contracts E
R
Service contracts for NEDs should be for a specified term. Any term beyond six years
should be subject to rigorous review and should take into account the need for 4
progressive refreshing of the board. The duration of contracts is limited to ensure that
payments for early termination of contracts are not excessive. The reappointment
provisions apply to ensure that new NEDs are being appointed as directors on a
regular basis. NEDs who have been on the board for a few years may become too
familiar with the operations of the company and therefore may not provide the
necessary external independent check that they are supposed to do.
Service contracts need to be limited and any over six years should be reviewed.
Internal audit
The internal audit department usually does not report to the financial accountant, as
that person may have a vested interest in not taking any action on the reports,
especially where reports are critical of the accountant. In that sense, reporting to the
board is acceptable.

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However, the board as a whole may not have the time to review internal audit reports
and may be tempted to ignore them if they are critical of the board itself. Corporate
governance regulations indicate that the internal audit department should report to
the audit committee with reports being forwarded to the board. This ensures that the
report is heard by the NEDs, who can then ensure that internal audit recommendations
are implemented where appropriate by the board.
In SPV, the internal auditor needs to report to the audit committee, for reasons already
mentioned above.
2 Hammond Brothers
(a) Purpose and role of remuneration committee
The purpose of the remuneration committee is to provide a mechanism for
determining the remuneration packages of executive directors. The scope of the
review should include not only salaries and bonuses, but also share options, pension
rights and compensation for loss of office.
The committee's remit may also include issues such as director appointments and
succession planning, as these are connected with remuneration levels.
Constitution of remuneration committee
Most codes recommend that the remuneration committee should consist entirely of
non-executive directors with no personal financial interest other than as shareholders
in the matters to be decided. In addition, there should be no conflict of interests
arising from remuneration committee members and executive directors holding
directorships in common in other companies. Within Hammond, there is a requirement
to first appoint NEDs and then ensure that the remuneration committee is comprised
of these individuals. The current system of the directors deciding their own salary is
clearly inappropriate; there is no independent check on whether the salary levels are
appropriate for the level of experience of the directors or their salary compared with
other similar companies.
Functioning of remuneration committee
The UK Corporate Governance Code states that 'there should be a formal and
transparent procedure for developing policy on executive remuneration and for fixing
the remuneration packages of individual directors'. The committee should pay
particular attention to the setting of performance-related elements of remuneration.
Within Hammond, the vast majority of remuneration is based on salary; there is little
element of performance-related pay. Governance guidelines indicate that
remuneration should be balanced between basic salary and bonuses. Hammond's
remuneration committee needs to increase the bonus element of remuneration to
focus directors more onto improving the performance of the company. However,
conditions for receipt of performance-related remuneration should be designed to
promote the long-term success of the company. Consideration should be given to the
possibility of reclaiming variable components in exceptional circumstances of
misstatement or misconduct.
Reporting of remuneration committee
A report from the committee should form part of the annual accounts. The report
should set out company policy on remuneration and give details of the packages for
individual directors. The chairman of the committee should be available to answer
questions at the AGM, and the committee should consider whether shareholder
approval is required of the company's remuneration policy. The remuneration
committee will then ensure that disclosure is correct.

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Information requirements
In order to assess executive directors' pay on a reasonable basis, the following
information will be required.
1 Remuneration packages given by similar organisations
The problem with using this data is that it may lead to upward pressure on
remuneration, as the remuneration committee may feel forced to pay what is paid
elsewhere to avoid losing directors to competitors.
2 Market levels of remuneration
This will particularly apply for certain industries, and certain knowledge and skills.
More generally the committee will need an awareness of what is considered a
minimum competitive salary.
3 Individual performance
The committee's knowledge and experience of the company will be useful here.
4 Organisation performance
This may include information about the performance of the operations which the
director controls, or more general company performance information such as
earnings per share and share price.
(b) Main concerns of board
The board's principal concern is with controls that can be classified as organisation or
management.
Organisation controls
Organisation controls are designed to ensure everyone is aware of their
responsibilities, and provide a framework within which lower level controls can
operate. Key organisation controls include the following.
1 Structure
The board should establish an appropriate structure for the organisation and
delegate appropriate levels of authority to different grades. C
H
2 Internal accounting system A
P
The board should ensure that the system is providing accurate and relevant T
information on a regular basis. Good quality information will enable the board to E
R
assess whether targets are being met or losses are possible.
3 Communication 4
Communication of organisation policies and values through manuals and other

guidance to staff is essential. It is not clear from the scenario whether Hammond
actually has any of these controls in place; however, from the relatively informal
basis in which the company has been run, it is unlikely that detailed controls have
been implemented.

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Management controls
Management controls are designed to ensure that the business can be effectively
monitored. Key management controls include the following.
1 Monitoring of business risks on a regular basis
This should include assessment of the potential financial impact of contingencies.
2 Monitoring of financial information
Management should be alert for significant variations in results between branches
or divisions or significant changes in results.
3 Use of audit committee
The committee should actively liaise with the external and internal auditors, and
report on any deficiencies discovered. The committee should also regularly
review the overall structure of internal control, and investigate any serious
deficiencies found.
4 Use of internal audit
Internal audit should be used as an independent check on the operation of
detailed controls in the operating departments. Internal audit's work can be
targeted as appropriate towards areas of the business where there is a risk of
significant loss should controls fail. As there is no internal audit department at
present, the board will need to establish one and define its remit.
The overall lack of controls is concerning, given the objective to obtain a listing.
The directors will need to implement the recommendations of the UK Corporate
Governance Code to ensure that a listing can be obtained.

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CHAPTER 5
The statutory audit:

planning and risk
assessment
Introduction
TOPIC LIST
1 Overview of the audit process
2 Audit planning
3 Professional scepticism
4 Understanding the entity
5 Business risk model
6 Audit risk model
7 Creative accounting
8 Materiality
9 Responding to assessed risks
10 Other audit methodologies
11 Information technology and risk assessment
12 Big data
13 Data analytics and artificial intelligence (AI)
Technical reference

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Introduction
 Evaluate and explain current and emerging issues in auditing including

developments in the use of big data, data analytics and artificial intelligence
 Identify the components of risk and how these components may interrelate
 Appraise the entity and the, potentially complex, economic environment within
which it operates as a means of identifying and evaluating the risk of material
misstatement
 Identify the risks, including analysing quantitative and qualitative data, arising from,
or affecting, a potentially complex set of business processes and circumstances and
assess their implications for the engagement
 Identify significant business risks (including those arising from cyber security and
cloud-based accounting systems) and assess their potential impact upon the
financial statements and the audit engagement
 Evaluate the impact of risk and materiality in preparing the audit plan, for example
the nature, timing and extent of audit procedures
 Evaluate the components of audit risk for a specified scenario, for example the
interactions of inherent risk, control risk and detection risk, considering their
complementary and compensatory nature
 Show professional scepticism in assessing the risk of material misstatement, having
regard to the reliability of management
 Prepare, based upon planning procedures, an appropriate audit strategy and
detailed audit plan or extracts
 Analyse and evaluate the control environment for an entity based on an
understanding of the entity, its operations and its processes
 Evaluate an entity's processes for identifying, assessing and responding to business
and operating risks as they impact on the financial statements
 Explain and evaluate the relationship between audit risk and audit evidence
Specific syllabus references for this chapter are: 10(c), 11(a)–(e), 11(g), 11(h), 11(j), 12(a), 12(b),
14(a)

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1 Overview of the audit process
Section overview
The audit is designed to enable the auditor to obtain sufficient, appropriate evidence.
1.1 Overview
While there may be variations between specific procedures adopted by individual firms, the
audit process as set out in auditing standards is a well-defined methodology designed to enable
the auditor to obtain sufficient, appropriate evidence.
This process can be summarised in a number of key stages:
Client acceptance/
1 establishing
engagement terms
Establish materiality
2
and assess risks
Plan and design

3
the audit approach
4 Audit of internal
control
5 Tests for evidence
Complete the
6 audit and evaluate
results
7 Issue audit report
Figure 5.1: Summary of audit process

In this chapter we will consider stages 1 to 4. In Chapter 6 we will consider stage 5, and in
Chapter 8, stages 6 and 7. However, it is important not to view the audit as a series of discrete
stages and individual audit procedures. For example, it can be argued that all audit procedures
which provide evidence are risk assessment procedures whether they are conducted during
planning, control evaluation, substantive testing or completion. The audit process will adopt a
strategy where complementary evidence is acquired and evaluated from a range of sources. The C
H
process is repeated until the auditor has obtained sufficient, appropriate audit evidence which is A
adequate to form an opinion. P
T
E
R
ICAEW 2019 The statutory audit: planning and risk assessment 221

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2 Audit planning
Section overview
You should be familiar with the basic planning process.
2.1 Introduction
Auditors are required to plan their work to ensure that attention is paid to the correct areas of
the audit, and the work is carried out in an effective manner.
In order to produce this plan the auditor must do the following:
 Understand the business, its control environment, its control procedures and its accounting
system
 Assess the risk of material misstatement
 Determine materiality
 Develop an audit strategy setting out in general terms how the audit is to be carried out and
the type of approach to be adopted
 Produce an audit plan which details specific procedures to be carried out to implement the
strategy taking into account all the evidence and information collected to date
You have already covered planning and risk assessment issues in your earlier studies. The
relevant ISAs are:
 ISA (UK) 210 (Revised June 2016), Agreeing the Terms of Audit Engagements
 ISA (UK) 300 (Revised June 2016), Planning an Audit of Financial Statements
 ISA (UK) 315 (Revised June 2016), Identifying and Assessing the Risks of Material
Misstatement Through Understanding of the Entity and Its Environment
 ISA (UK) 320 (Revised June 2016), Materiality in Planning and Performing an Audit
 ISA (UK) 330 (Revised July 2017), The Auditor's Responses to Assessed Risks
A number of issues are developed in the remainder of this chapter; however, it is assumed that
you are already familiar with the basic principles of planning and risk assessment. A summary of
these and other related ISAs can be found in the technical reference section at the end of the
chapter.
3 Professional scepticism
Section overview
The auditor must maintain an attitude of professional scepticism throughout the audit.
3.1 Requirement
Definition
Professional scepticism: An attitude that includes a questioning mind, being alert to conditions
which may indicate possible misstatement due to error or fraud, and a critical assessment of
audit evidence.

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Professional scepticism includes being alert to:

 audit evidence that contradicts other audit evidence;
 information that brings into question the reliability of documents and responses to
enquiries to be used as audit evidence;
 conditions that may indicate possible fraud; and
 circumstances that suggest the need for audit procedures in addition to those required by
the ISAs.
ISA (UK) 200 (Revised June 2016), Overall Objectives of The Independent Auditor and the
Conduct of an Audit in Accordance with International Standards on Auditing requires that the
auditor 'shall plan and perform an audit with professional scepticism recognising that
circumstances may exist that cause the financial statements to be materially misstated'.
Maintaining professional scepticism throughout the audit reduces the risks of overlooking
unusual circumstances, overgeneralising when drawing conclusions and using inappropriate
assumptions in determining the nature, timing and extent of the audit procedures and
evaluating the results. ISA 200 also makes the following points:
(a) The auditor may accept records and documents as genuine unless there is reason to
believe the contrary. Where there is doubt, for example where there are indications of
possible fraud, the auditor must investigate further and determine whether to modify or
increase the audit procedures.
(b) A belief that management and those charged with governance are honest and have
integrity does not relieve the auditor of the need to maintain professional scepticism.
The same points are reiterated in ISA (UK) 240, The Auditor's Responsibilities Relating to Fraud in
an Audit of Financial Statements. This standard emphasises that where there are potential fraud
issues the auditor's professional scepticism is particularly important when considering the risks
of material misstatement.
3.2 Importance of professional scepticism

The importance of professional scepticism cannot be overemphasised. An effective and
compliant audit cannot be carried out without it.
Given that it is fundamental that professional scepticism is applied for all audits of financial
statements, the audit engagement partners of audit firms must lead by example and firms
should ensure that professional scepticism is given the degree of prominence it warrants during
the training of audit staff.
Following the global financial crisis in 2008 and 2009 a common theme in a number of regulator
reports was that professional scepticism could have been more clearly demonstrated by
auditors when looking at a number of audit areas. It continues to be at the top of the agenda for
regulators and standard setters, including the IAASB in their 2018 update of the IESBA Code of
Ethics as well as the Financial Reporting Council (FRC). In the FRC's annual report for 2012/2013,
C
the importance of embedding the exercise of professional scepticism in the culture of audit H
firms, and in audit work, is highlighted as key to improving audit quality. A
P
This section deals with the theoretical background of professional scepticism and the use of T
professional scepticism in an audit planning context. We will look at professional scepticism E
R
again in the more practical context of audit fieldwork in Chapter 6.
5

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3.3 Briefing paper

In March 2012 the Auditing Practices Board (APB) (now FRC) issued a briefing paper,
Professional Scepticism: Establishing a Common Understanding and Reaffirming its Central Role
in Delivering Audit Quality. This document is unusual in comparison to other briefing papers, as
it is discursive in style and draws analogies from a diverse group of areas. This approach has
been adopted to encourage international debate on this issue. The document is in seven
sections. These are summarised below.
3.3.1 Section 1 Introduction

This aims to put the document into context. It states that the purpose of the document is to set
out the APB's considered views on the nature of auditor scepticism and its role in the audit,
given the significance of scepticism to the quality of individual audits.
3.3.2 Section 2 Exploring the roots of scepticism and identifying lessons for its role in the
conduct of an audit
Section 2 considers the philosophical origins of scepticism in ancient Greece and how it later
influenced scepticism in the scientific method that flourished in the 17th century. The paper
explains that the following can be learnt from early Greek philosophical scepticism:
 The essence of scepticism is doubt and doubt stimulates informed challenge and inquiry.
The sceptics' doubt stimulated them to challenge conventional wisdom and inquire after a
better understanding of the nature of knowledge.
 In the face of doubt the sceptics would suspend their judgement about the truth.
 In its extreme form scepticism is not pragmatic as it may lead to the conclusion that no
judgements about the truth can be made.
Section 2 also looks at the relationship between doubt and trust in the context of scepticism. It
argues that where levels of both are low there is uncertainty which will either lead to the
indefinite suspension of judgement or stimulate inquiry to pursue the truth or falseness of the
assertion. Only when trust or doubt are sufficiently high will belief in the assertion be accepted
or rejected.
3.3.3 Section 3 Scientific scepticism and the scientific method

This section seeks to provide insight into the mindset required to develop the audit strategy and
plan and to evaluate the audit evidence obtained by demonstrating how science has developed
a sceptical approach that now commands respect. It states that scientists are required to:
(a) critically appraise existing theories, actively looking for alternative plausible mechanisms of
cause and effect that are consistent with their rigorous assessment of the empirical
(observed) evidence;
(b) undertake experiments that are repeatable and transparent, to look for evidence that
contradicts rather than supports the validity of a given theory; and
(c) suspend judgement about the validity of any given theory (ie, to defer making an active
decision to believe or disbelieve it) until it has both survived destructive testing and has
been subjected to critical experiments the evidence from which makes it possible to
conclude that one theory is superior to all other current plausible theories.
While the subject matter of scientific and audit inquiry are different and there are limitations to
the analogy between the two, elements of the scientific method suggest critical audit activities
which will underpin appropriate scepticism in the audit:
(a) Empirical observation suggests developing a good understanding of the business of the
audited entity and the environment.

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(b) Constructing falsifiable hypotheses suggests actively considering that material

misstatements may exist and designing audit tests to identify them, rather than only
considering how well the evidence obtained by management supports their conclusion that
there are none.
(c) Transparency and repeatability suggest the importance of documentation in underpinning
transparency and repeatability of the audit work to internal reviewers and external
inspectors.
3.3.4 Section 4 The origins of the modern audit

Section 4 seeks to provide further insight into the mindset of the auditor by considering the
nature of the agency relationships, and the resultant need for assurance that gave rise to early
auditing traditions from the 14th century onwards. The origins of the modern audit can be seen
in the tradition of auditing household servants in manorial estates. This was then built on by the
Joint Stock Companies Act of 1844 which included a default provision for auditors to be
appointed.
Historically, the audit was essentially a check, carried out on behalf of a principal by their trusted
associate or agent, on the fidelity of the other agents to whom the principal's resources were
entrusted. The trust that existed between principal and auditor was a critical ingredient. The
strong bond between the principal and the auditor and the principal's need for assurance about
the fidelity of those to whom they had entrusted their assets would have determined the mindset
of the auditor. That would have guided the appropriate degree of scepticism in the auditor
when questioning those entrusted with the principal's assets.
This issue of fidelity remains an issue today; however, the development and increased
complexity of business activity and the increased size and reach of businesses combined with
the technological advances mean that there are many other areas in relation to which
shareholders (and other users) seek information and reassurance. This suggests that while the
sceptical mindset is a constant, the degree of action taken by a sceptical auditor is a 'sliding
scale', responsive to both the expectations of shareholders (and other stakeholders) and what
emerges as the audit proceeds.
The paper also states that scepticism should embed the perspective of shareholders and other
stakeholders in the making of all audit judgements. Because of this, the APB believes that when
undertaking a modern audit the following factors accentuate the need for the auditor to be
especially vigilant and aware of their responsibilities for the exercise of professional scepticism:
(a) There is the potential for auditors not to be sceptical or thought not to be sceptical because
they are engaged and paid by the company in a way that is relatively detached from
shareholders. This emphasises the need for strong governance generally and, in particular,
the role of audit committees in assessing and communicating to investors whether the
auditors have executed a high quality, sceptical audit.
(b) Auditors have strong working relationships with management and audit committees, which
may lead them to develop trust that may lead to either a lack of, or reduced, scepticism.
(c) The audit firms' business model encourages a culture of building strong relationships with C
clients. This introduces the risk of the auditor putting their interests ahead of those of the H
A
shareholders and could lead the audit firm and the auditor to develop trust or self-interest P
motivations that may compromise either their objectivity or their willingness to challenge T
management to the extent required. E
R
The auditor must lean against unjustified trust in management developing. There is also a risk
5
that audit committees' views may be seen too readily as a surrogate for those of the
shareholders. Just addressing the concerns of the audit committee does not necessarily amount
to meeting the expectations of shareholders.

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3.3.5 Section 5 Conclusions about professional scepticism in the audit

Section 5 sets out the APB's conclusions from the foregoing analysis as to what a sceptical audit
looks like and suggests that professional scepticism is the cornerstone of audit quality. In
particular, it makes the following statements with regards to an appropriately sceptical audit:
(a) The auditor's risk assessment process should involve a critical appraisal of management's
assertions, actively looking for risks of material misstatement.
(b) The auditor develops a high degree of knowledge of the entity's business and the
environment in which it operates, sufficient to enable it to make its risk assessment through
its own fresh and independent eyes rather than through the eyes of management.
(c) This enables the auditor to make informed challenge of consensus views and to consider
the possible incidence of low probability high impact events. The traditional pyramid
structure of the audit team may not always be appropriate and different models may need
to be explored, such as including experienced business people on the team.
(d) The auditor designs audit procedures to consider actively if there is any evidence that
would contradict management assertions not only to consider the extent to which
management has identified evidence that is consistent with them.
(e) The auditor must be satisfied that:
(i) there has been sufficient inquiry and challenge;
(ii) sufficient testing of management's assertions has been undertaken;
(iii) the quality of the resulting evidence obtained has been critically appraised and judged
by the auditor to be sufficiently persuasive; and
(iv) where there are plausible alternative treatments of an item in the financial statements (such
as different valuation bases) an assessment has been made as to whether one is superior
and whether sufficient disclosure of the alternatives has been given, in order to give a true
and fair view.
(f) The auditor approaches and documents audit judgements and audit review processes in a
manner that facilitates challenge and demonstrates the rigour of that challenge.
(g) The auditor's documentation of audit judgements is conclusive rather than conclusionary and
therefore always sets out not only the auditor's conclusion but also their rationale for the
conclusion.
3.3.6 Section 6 Fostering conditions necessary for auditors to demonstrate the appropriate
degree of professional scepticism
This section sets out the APB's views about the conditions that are necessary for auditors to
demonstrate the appropriate degree of professional scepticism. It highlights the APB's
expectations of individual auditors, engagement teams and audit firms as follows:
Individual auditors
 Develop a good understanding of the entity and its business
 Have a questioning mind and are willing to challenge management assertions
 Assess critically the information and explanations obtained in the course of their work and
corroborate them
 Seek to understand management motivations for possible misstatements of the financial
statements
 Investigate the nature and cause of deviations or misstatements identified and avoid
jumping to conclusions without appropriate audit evidence

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 Are alert for evidence that is inconsistent with other evidence obtained or calls into
question the reliability of documents and responses to inquiries
 Have the confidence to challenge management and the persistence to follow things
through to a conclusion
Engagement teams
 Have good business knowledge and experience
 Actively consider in what circumstances management numbers may be misstated, whether
due to fraud or error
 Develop a good understanding of the entity and its business in order to provide a basis for
identifying unusual transactions and share information on a regular basis
 Partners and managers are actively involved in assessing risk and planning the audit
procedures to be performed
 Partners and managers actively lead and participate in audit team planning meetings to
discuss the susceptibility of the entity's financial statements to material misstatement
 Partners and managers are accessible to other staff during the audit and encourage them to
consult with them on a timely basis
 Engagement teams document their key audit judgements and conclusions, especially those
reported to the audit committee, in a way that clearly demonstrates that they have
exercised an appropriate degree of challenge to management and professional scepticism
 Partners and management bring additional scepticism to the audit by carrying out a diligent
challenge and review of the audit work performed and the adequacy of the documentation
prepared
Audit firms
 The culture within the firm emphasises the importance of:
– understanding and pursuing the perspective of the shareholders;
– coaching less experienced staff to foster appropriate scepticism;
– sharing experiences/consultation with others about difficult audit judgements; and
– supporting audit partners when they need to take and communicate difficult audit
judgements.
 Scepticism is embedded in the firm's training and competency frameworks used for
evaluating and rewarding partner and staff performance.
 The firm requires rigorous engagement quality control reviews that challenge engagement
teams' judgements and conclusions.
 Firm methodologies and review processes emphasise the importance of, and provide
practical support for auditors in:
C
– developing a thorough understanding of the entity's business and its environment; H
A
– identifying issues early in the planning cycle to allow adequate time for them to be P
T
investigated and resolved;
E
R
– rigorously taking such steps as are appropriate to the scale and complexity of the
financial reporting systems, to identify unusual transactions; 5
– changing risk assessments, materiality and the audit plan in response to audit findings;
– documenting audit judgements in a conclusive rather than a conclusionary manner;

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– raising matters with the Audit Committee regarding the treatment or disclosure of an
item in the financial statements where the auditor believes that the treatment adopted
is different to the perspective of the shareholders; and
– ensuring that disclosures of such matters are carefully assessed.
This section also emphasises the supporting role that can be played by Audit Committees and
management.
3.3.7 Section 7 Taking these matters forward

The final section of the paper considers the ways in which the APB plans to take this issue
forward, particularly by stimulating debate. It acknowledges that currently it is possible to follow
the 'letter' of existing standards without conducting a truly sceptical audit. It also acknowledges
that standards may have to be improved in future to address this.
4 Understanding the entity
Section overview
• The auditor obtains an understanding of the entity in order to assess the risks of material
misstatement.
• Information will be sought regarding the industry in which the business operates and the
different business processes within the entity itself.
4.1 Procedures
ISA 315 (UK) (Revised June 2016) paragraph 3 states that: "the objective of the auditor is to
identify and assess the risks of material misstatement, whether due to fraud or error, at the
financial statement and assertion levels, through understanding the entity and its environment,
including the entity's internal control, thereby providing a basis for designing and implementing
responses to the assessed risks of material misstatement".

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Document and communicate risk assessment

Understand and identify risks
arising from the entity and its
environment, including relevant
internal controls Assertions:
Classes of transactions
Discuss risks amongst engagement
team Occurrence; Completeness; Accuracy;
Cutoff; Classification
Identify risk of material Account balances

misstatement at the financial
statement and assertion levels Existence; Rights and obligations;
Completeness; Valuation and
allocation
Evaluate the design and
determine the implementation Presentation and disclosure
of controls relevant to the audit
and for risks which cannot be Occurrence; Rights and obligations;
reduced to an acceptable level Completeness; Classifications and
with substantive procedures only understandability; Accuracy and
measurement
Determine whether any risks are

so significant that they require
special audit consideration
Figure 5.2: Audit risk assessment

(Source: ICAEW Audit and Assurance Faculty, Auditing Standards – All Change: A Short Guide to
Selected International Standards on Auditing (UK and Ireland), 2004)
You will have studied the financial statement assertions in your earlier studies and you will find a
more detailed recap including changes resulting from the June 2016 revised standards in
Chapter 6.
ISA 315 (UK) (Revised June 2016) sets out various methods by which the auditors may obtain this
understanding:
 Enquiries of management and others within the entity
 Analytical procedures
 Observation and inspection
 Audit team discussion of the susceptibility of the financial statements to material
misstatement
 Prior period knowledge (subject to certain requirements)
C
The auditors must use a combination of the top three techniques, and must engage in H
discussion for every audit. The auditor may use their prior period knowledge, but must carry out A
procedures to ensure that there have not been changes in the year meaning that it is no longer P
T
valid. E
R
The ISA sets out a number of areas of the entity and its environment that the auditor should gain
an understanding of. These are summarised as follows: 5
 Industry, regulatory and other external factors

 Nature of the entity

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 The entity's selection and application of accounting policies, including reasons for any
changes
 Objectives, strategies and related business risks
 Measurement and review of the company's performance
 Internal control relevant to the audit
The purpose of obtaining the understanding is to assess the risks of material misstatement in the
financial statements for the current audit. The ISA says that "the auditor shall identify and assess
the risks of material misstatement at the financial statement level, and at the assertion level for
classes of transactions, account balances and disclosures".
It requires the auditor to take the following steps:
Step 1
Identify risks throughout the process of obtaining an understanding of the entity
Step 2
Evaluate whether the risks relate pervasively to the financial statements as a whole
Step 3
Relate the risks to what can go wrong at the assertion level
Step 4
Consider the likelihood of misstatement (including the possibility of multiple misstatements)
Step 5
Consider the likelihood of the risks causing a material misstatement
Notice therefore that the stages of the planning process often take place simultaneously rather
being performed in sequence. For example, as the auditor learns more about the business, certain
risks will come to light as a result. So the auditor is both gaining an understanding of the business
and identifying risk by adopting the same procedures. We will look at risk specifically in sections 5
and 6 of this chapter.
Worked example: Ockey Ltd
The audit team at Ockey Ltd has been carrying out procedures to obtain an understanding of
the entity. In the course of making enquiries about the inventory system, they have discovered
that Ockey Ltd designs and produces tableware to order for a number of high street stores. It
also makes a number of standard lines of tableware, which it sells to wholesalers. By the terms of
its contracts with the high street stores, it is not entitled to sell unsold inventory designed for
them to wholesalers. Ockey Ltd regularly produces 10% more than the high street stores have
ordered, in order to ensure that they meet requirements when the stores do their quality control
check. Certain stores have more stringent control requirements than others and regularly reject
some of the inventory.
The knowledge above suggests two risks, one that the company may have obsolescent inventory,
and another that if its production quality standards are insufficiently high, it could run the risk of
losing custom.
We shall look at each of these risks in turn and relate them to the assertion level.
Inventory
If certain items of the inventory are obsolescent due to the fact that it has been produced in excess of
the customer's requirement and there is no other available market for the inventory, then there is a
risk that inventory as a whole in the financial statements will not be carried at the appropriate value.
Given that inventory is likely to be a material balance in the statement of financial position of a
manufacturing company, and the value could be up to 10% of the total value, this has the capacity to
be a material misstatement.

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The factors that will contribute to the likelihood of these risks causing a misstatement are matters
such as:
 whether management regularly review inventory levels and scrap items that are
obsolescent;
 whether such items are identified and scrapped at the inventory count; or
 whether such items can be put back into production and changed so that they are saleable.
Losing custom
The long-term risk of losing custom is that in the future the company will not be able to operate
(a going concern risk). It could have an impact on the financial statements, if sales were
disputed, revenue and receivables could be overstated; that is, not carried at the correct value.
However, it appears less likely that this would be a material problem in either area, as the
problem is likely to be restricted to a few customers, and only a few sales to those customers.
Again, review of the company's controls over the recording of sales and the debt collection
procedures of the company would indicate how likely these risks to the financial statements are
to materialise.
Some risks identified may be significant risks (indicated by the following factors), in which case
they present special audit considerations for the auditors:
 Risk of fraud
 Its relationship with recent developments
 The degree of subjectivity in the financial information
 The fact that it is an unusual transaction
 It is a significant transaction with a related party
 The complexity of the transaction
Routine, non-complex transactions are less likely to give rise to significant risk than unusual
transactions or matters of director judgement because the latter are likely to have more
management intervention, complex accounting principles or calculations, greater manual
intervention or lower opportunity for control procedures to be followed.
When auditors identify a significant risk, if they have not done so already, they should evaluate
the design and implementation of the entity's controls in that area.
4.2 Industries and processes

During the initial planning phase, the audit firm will need to obtain information about the
specific nature of the entity being audited and the different business processes within the entity
itself.
4.2.1 Industry
The type of entity being audited will have a significant impact on the audit plan. For example:
Service industry Manufacturing industry C

H
Little or no inventory Complex costing systems to allocate costs to A
P
inventory and work in progress T
E
Focus on salaried employees Many production staff based paid on hours R
worked including various overtime and
incentive schemes 5
Payment by commission May have payment by piece rates

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Service industry Manufacturing industry
Sales dependent on services provided Sales dependent on products sold

Relatively little investment in plant and Large investment in plant and equipment;
equipment; office space main building cost office space relatively small in comparison to
production facilities
An understanding and appreciation of these differences will assist the auditor in identifying risk
areas and in developing an appropriate audit approach.
From the auditor's point of view, the different entities will result in a different audit approach for
each entity. For example, the lack of inventory in service industries will obviously mean less time
will be devoted to that area. Conversely, the use of complicated costing systems will require use
of specialist computer-auditors to identify, record and test various computerised systems.
4.2.2 Business processes

From the comments above, it is possible to identify the different business processes that the
auditor will need to focus on. The five main processes are summarised in the diagram below.
Financing Purchasing
Obtaining capital by borrowing Acquiring goods to support
or third parties investing in the production and sales of
company company’s own products
Human resources
Revenue
Procedures for hiring, training,
Generating revenue through
sales of goods and obtaining Business processes evaluating, promoting and in
some situations making
cash from debtors
employees redundant
Inventory management
Process of accumulating and
allocating costs to inventory
and work in progress
Figure 5.3: Business processes

An understanding of each process focuses the auditor's attention on specific parts of the
business.
Process Audit focus
Financing Verification of new share issues / confirming current account and loan
balances and where necessary bank support for the business.
Purchasing Audit of the purchases transaction cycle and payables balance.
Human resources Audit of wages and salaries, including bonuses linked to production and
commission on sales.
Inventory Audit of work in progress systems, including year-end inventory valuation
management and identification of inventory below cost price.
Revenue Audit of sales transaction cycle and receivables balance.
The actual audit approach will depend partly on the audit methodology used.

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5 Business risk model
Section overview
• Business risk is the risk arising to the business that it will not achieve its objectives.
• Corporate governance guidelines emphasise the importance of risk management
processes within a business.
• The business risk model of auditing requires the auditor to consider the entity's process of
assessing business risk and the impact this might have in terms of material misstatement.
5.1 Business risk

Business risk is the risk arising to entities that they will not achieve their objectives. It includes
risks at all levels of the business.
Business risks can be classified into three categories.
(1) Financial risks
(2) Operating risks
(3) Compliance risks
Definitions
Financial risks: Risks arising from the company's financial activities (eg, investment risks) or the
financial consequences of operations (eg, receivables risks).
Examples: going concern, market risk, overtrading, credit risk, interest rate risk, currency risk,
cost of capital, treasury risks.
Operating risks: Risks arising from the operations of the business.
Examples: loss of orders; loss of key personnel; physical damage to assets; poor brand
management; technological change; stock-outs; business processes unaligned to objectives.
Compliance risks: Risks arising from non-compliance with laws, regulations, policies, procedures
and contracts.
Examples: breach of company law, non-compliance with accounting standards; listing rules;
taxation; health and safety; environmental regulations; litigation risk against client.
The UK's adoption of the General Data Protection Regulation as part of EU law could also be
included here, although compliance is just as important for auditors as it is for their clients!
Business risk may be caused by many factors, or a combination of factors, including the
following:
 Complex environment C
H
 Dynamic environment
A
 Competitors' actions P
 Inappropriate strategic decision-making T
E
 Operating gearing
R
 Financial gearing
 Lack of diversification 5
 Susceptibility to currency fluctuations
 Inadequate actual or contingent financial resources
 Dependence on one or few customers
 Regulatory change or violation

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 Adequacy and reliability of suppliers

 Overtrading
 Developing inappropriate technology
 Macroeconomic instability
 Poor management
5.2 Business risk management

Most working environments now have some form of risk management system. In Chapter 4 we
discussed the UK Corporate Governance Code and the FRC's Guidance on risk management,
internal control and related financial and business reporting that highlight its importance.
Typically the process of risk management for the business is as follows:
 Identify significant risks which could prevent the business achieving its objectives
 Provide a framework to ensure that the business can meet its objectives
 Review the objectives and framework regularly to ensure that objectives are met
In practice, each of these stages is complex.
5.3 Audit methodology: business risk model

5.3.1 Principle behind the model
ISA 315 requires that auditors consider the entity's process for assessing its own business risks,
and the impact that this might have on the audit in terms of material misstatements. Auditors
consider the following:
 What factors lead to the problems which may cause material misstatements
 What the audit can contribute to the business pursuing its goals
The business risk audit approach tries to mirror the risk management steps that have been taken
by the directors. In this way, the auditor will seek to establish that the financial statement
objectives have been met, through an investigation into whether all the other business
objectives have been met by the directors.
The application of the business risk model (BRM) is therefore related to the client's:
 objectives
 business strategy
 risk management procedures
 industry environment
 economic environment
This approach to the audit has been called a 'top down' approach, because it starts with the
business and its objectives and works back down to the financial statements, rather than working
up from the financial statements which has historically been the approach to audit involving
detailed tests of transactions and balances. The BRM therefore looks at the 'big risks' that may
significantly threaten the valuation, profitability or even the going concern of the business.
Those who support this approach argue that the key audit risks are more likely to relate to the
failure of the company's strategy than the misstatement of a transaction.
The following table demonstrates the way in which business risks can have implications for the
financial statements and therefore the audit.
Principal risk Immediate Financial Statement implications

Economic pressures causing reduced unit Inventory values (IAS 2)
sales and eroding margins Going concern
Economic pressures resulting in demands for Receivables recoverability
extended credit

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Principal risk Immediate Financial Statement implications

Product quality issues related to inadequate Inventory values – net realisable value and
control over supply chain and transportation inventory returns
damage
Customer dissatisfaction related to inability Going concern
to meet order requirements
Customer dissatisfaction related to invoicing Receivables valuation

errors and transportation damage
Unacceptable service response call rate Going concern
related to poor product quality Litigation – provisions and contingencies
Inventories – net realisable value
Out of date IT systems affecting Anywhere
management's ability to make informed
decisions
Extensive use of freelance and contract Employees' NI (may be understated if
labour resulting in issues regarding their freelancers/contract workers are deemed to be
employment status employees)
Fines – provisions and contingencies
Interactive question 1: Financial risk

On 1 January 20X8 a steel production company has significant steel inventories with a total value
of £20 million.
To protect the inventory from changes in value, the entity enters into a futures contract on a
commodities exchange to fix the selling price in 18 months' time. This is the first time that the
entity has entered into this type of transaction.
Requirements
(a) Identify the business risk in this situation.
(b) Identify the issues which the auditor would need to consider.
5.3.2 Impact on audit procedures

This can be summarised as follows:
Audit procedure Effect of business risk model
Tests of controls As the auditor pays greater attention to the high level controls used by
directors to manage business risks, controls testing will be focused on
items such as the control environment and corporate governance rather C
than the detailed procedural controls tested under traditional H
approaches. A
P
Analytical Analytical procedures are used more heavily in a business risk T
E
procedures approach, as they are consistent with the auditor's desire to understand
R
the entity's business rather than to prove the figures in the financial
statements. 5
Detailed testing The combination of the above two factors, particularly the higher use of
analytical procedures, will result in a lower requirement for detailed
testing, although substantive testing will not be eliminated completely.

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Interactive question 2: Audit procedures

You are using the business risk model in the statutory audit of a major international pharmaceutical
company.
You are told that the key determinant of profitability is the development of new types of drug,
which are superior to those of competitors. This is achieved by significant investment in research
and development (R&D). However, you are also informed that such drugs may take as many as
10 years before gaining regulatory approval for use. One major R&D project is a joint venture
with another pharmaceutical company.
Requirements
Outline:
(a) the key risks facing the company
(b) controls that management might use to mitigate such risks
(c) audit procedures to be carried out in respect of such risks
Interactive question 3: Identifying business risks

KidsStuff Ltd imports children's toys from a supplier in the Far East into its warehouse in
Liverpool and distributes them to retailers throughout the UK. The company was set up by
Joseph Cooper 40 years ago and is managed by Joseph and his two sons. The company had
experienced reasonable growth until the last five years, but recent performance has been poor
and the company now relies on a substantial overdraft. Joseph feels that the decline is due in
part to the competitiveness of the market and the trend towards computer games. KidsStuff Ltd
does not have a strong market presence in this area but this is currently being addressed by
Joseph's son, Neil, who is confident that performance has improved.
You have received the following email from the engagement partner.
From: Allan Partner
To: Audrey Senior
Subject: KidsStuff Ltd
I know you are about to start work on your planning of this audit. Can you make sure that you
specifically identify the business risks faced by KidsStuff Ltd and set out the effect of those on the
audit. Can you also make a list of the further information you need in order to plan the audit so
that I can request it from the directors?
Requirement
Respond to the engagement partner's email.
6 Audit risk model
Section overview
• Audit risk is the risk that the auditors may give an inappropriate opinion when the financial
statements are materially misstated.
• The risk of material misstatement is made up of inherent risk and control risk.

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• The audit risk model expresses the relationship between the different components of risk
as follows:
Audit risk = Inherent risk  Control risk  Detection risk
• Business risk forms part of the inherent risk associated with the financial statements.
• Information gained in obtaining an understanding of the business is used to assess
inherent risk.
• Assessment of control risk involves assessing the control environment and control
activities.
6.1 Audit risk
Definitions
Audit risk: The risk that auditors may give an inappropriate audit opinion when the financial
statements are materially misstated. Audit risk has two key components: risk of material
misstatement in financial statements (financial statement risk) and the risk of the auditor not
detecting the material misstatements in financial statements (detection risk). The risk of material
misstatement breaks down into inherent risk and control risk.
Inherent risk: The susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement that could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.
Control risk: The risk that a misstatement could occur in an assertion about a class of transaction,
account balance or disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity's internal control.
Detection risk: The risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements.
Point to note:
The ISAs do not ordinarily refer to inherent risk and control risk separately but rather to the
combined 'risks of material misstatement'. Firms may assess them together or separately
depending on their preferred methodology and audit techniques.
6.2 Audit methodology: the audit risk model

The audit risk model (ARM) expresses the relationship between the different components of risk
as follows:
AR = IR  CR  DR C
H
In using this model the auditor will follow three key steps: A
P
(1) The auditor will set a planned level of audit risk for each account balance or class of T
E
transaction. R
(2) Inherent risk and control risk are assessed, either separately or in combination. This will 5
involve an assessment of business risk and the risk of material misstatement (due to fraud or
error).
(3) Detection risk is then set at an appropriate level by 'solving' the audit risk equation.

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This approach can be demonstrated as follows:
Example Audit risk Inherent risk Control risk Detection risk
1 Acceptable High High Low

2 Acceptable Low High Moderate
3 Acceptable High Low Moderate
This model will then assist in the determination of the extent and type of procedures to be
performed. For example, the higher the assessment of inherent and control risk, the lower the
assessment of detection risk resulting in more evidence being obtained from the performance
of substantive procedures.
Points to note:
1 One of the criticisms of the ARM is the 'compensatory' approach it takes. In the table above,
high inherent and control risk is compensated for by low detection risk. Arguments have
been put forward that evidence should be complementary rather than compensatory.
2 Inherent risk and control risk are either 'high' or 'low' in the above table. This 'all or nothing'
approach is adopted by some audit firms. Thus, for instance, where there is a significant risk
event with respect to an audit area, then the inherent risk would always be deemed to be
high. Other audit firms may see risk as a spectrum with, for instance, an intermediate rating
of 'moderate risk' where there would be some reliance gained from inherent assurance,
despite there being some measure of risk observed.
6.2.1 The risk assessment process

This can be summarised as follows:
Perform risk assessment procedures

to obtain an understanding of the
entity and its environment, including
internal control
Identify business risks that may

result in material misstatements
in the financial statements
Evaluate the entity’s response to

those business risks and obtain
evidence of their implementation
Assess the risk of material misstatement

at the assertion level and determine the
audit procedures that are necessary
based on that risk assessment
Figure 5.4: Risk assessment process

(Source: Auditing and Assurance Services International Edition, 2005. Aasmund Eilifsen, William
F. Messier Jr, Steven M. Glover, Douglas F. Prawitt)

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Point to note:
Notice the relationship between business risk (which we looked at in detail above) and audit
risk. Business risk includes all risks facing the business. In other words, inherent audit risk may
include business risks.
In response to business risk, the directors institute a system of controls. These will include
controls to mitigate against the financial aspect of the business risk. These are the controls that
audit control risk incorporates.
Therefore, although audit risk is very financial statements focused, business risk does form part
of the inherent risk associated with the financial statements (ie, is part of financial statement risk)
not least because, if the risks materialise, the going concern basis of the financial statements
could be affected.
The following illustrates the link between business risk and financial statement risk:
Business risk Financial statement risk
Computer viruses could lead to significant loss Uncertainties over going concern may not be
of sales fully disclosed
Weaknesses in cyber security and corporate Provisions relating to breaches of regulations
data security could result in breaches of data may be omitted or understated
protection law and other regulations resulting
in financial penalties
The business may suffer losses from credit Losses arising from frauds may not be
card fraud recognised in the financial statements
6.2.2 Inherent risk

As we saw in section 6.1, the risk of material misstatement is made up of:
 inherent risk
 control risk
Inherent risk is the risk that items will be misstated due to characteristics of those items, such as
the fact they are estimates and that they are important items in the accounts. The auditors must
use their professional judgement and the understanding of the entity they have gained to assess
inherent risk. If no such information or knowledge is available then the inherent risk is high.
Factors affecting client as a whole
Integrity and attitude to risk of directors Domination by a single individual can cause
and management problems
Management experience and knowledge Changes in management and quality of financial
management
Unusual pressures on management Examples include tight reporting deadlines, or
market or financing expectations C
H
Nature of business Potential problems include technological A
obsolescence or overdependence on single product P
T
Industry factors Competitive conditions, regulatory requirements, E
R
technological developments, changes in customer
demand 5
Information technology Problems include lack of supporting

documentation, concentration of expertise in a few
people, potential for unauthorised access

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Factors affecting individual account balances or transactions
Financial statement accounts prone to Accounts which require adjustment in previous

misstatement period or require high degree of estimation
Complex accounts Accounts which require expert valuations or are
subjects of current professional discussion
Assets at risk of being lost or stolen Cash, inventory, portable non-current assets
(computers)
Quality of accounting systems Strength of individual departments (sales,
purchases, cash etc)
High volume transactions Accounting system may have problems coping
Unusual transactions Transactions for large amounts, with unusual
names, not settled promptly (particularly
important if they occur at period end)
Transactions that do not go through the system,
that relate to specific clients or are processed by
certain individuals
Staff Staff changes or areas of low morale
Interactive question 4: Inherent risks from financial reporting policies

Fonesforall is a mobile phone network provider with its own retail outlets. It is currently offering
the following package for £30 per month.
ZX4 mobile phone handset
12-month subscription to the network
300 'free' call minutes per month (for 12 months)
500 'free' texts per month (for 12 months)
Any unused call minutes or texts may be carried forward to the following month
The fair value of this package is estimated to be £500
Requirement
Identify the risks associated with the treatment of revenue in relation to this package in the
financial statements of Fonesforall.
See Answer at the end of the chapter.
6.2.3 Control risk

Control risk is the risk that client controls fail to detect material misstatements. A preliminary
assessment of control risk at the planning stage of the audit is required to determine the level of
controls and substantive testing to be carried out.
In this respect, a key initial audit question is "how does management control the business?". An
understanding of this issue is a key element in an initial assessment of control risk.
Substantive and reliance strategies
For an ongoing client, the auditor will already have significant information on file regarding the
control systems at the audit client. The audit strategy will therefore focus on updating this
control information.
For a new client, a judgement on audit strategy will normally be deferred until after a more
detailed understanding of internal control is obtained. For the new client, the auditor will obtain
information on the control systems and then perform an initial testing of those controls to
determine whether or not they are working correctly. Where these risk assessment procedures

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indicate that controls are not working correctly, then it is unlikely that the auditor will place
reliance on those controls, as control risk will be set to maximum. Substantive procedures will be
used instead. However, if the risk assessment procedures indicate that controls are working
correctly, then some reliance will be placed on internal controls. Control risk may be set only as
either 'high' or 'low' in an all or nothing approach, as previously noted. Alternatively, there may
be a possibility of setting control risk to an intermediate amount(s) within some firms' audit
methodologies.
So, providing an initial determination of the nature, timing and extent of audit procedures, two
possible audit strategies are normally identified:
 Substantive strategy – focusing on substantive testing (ie, tests of details and analytical
procedures)
 Reliance strategy – focusing on tests of controls and reliance from inherent assurance
Points to note:
1 There will not be one strategy for the entire audit. Each business process or specific audit
assertion will be allocated its own strategy. Similarly, each audit assertion may be allocated
a different 'mix' of reliance and substantive strategy.
2 Auditing standards do require some substantive testing for each material class of
transactions, account balances and disclosure, so the audit strategy for any one assertion
will never be completely a reliance strategy.
3 However, it is possible (but unusual) that substantive testing may comprise entirely of
analytical procedures, without any tests of details being carried out.
An auditor is more likely to follow a reliance strategy where:
 an entity uses electronic data interchange to initiate orders; there will be no paper
documentation to verify;
 an entity provides electronic services to its customers eg, an internet service provider or
telephone company. No physical goods are produced, with all information being collected
and billing carried out electronically; and
 the test is for understatement.
An auditor is more likely to follow a substantive strategy where:
 there are no controls available for a specific audit assertion;
 the controls are assessed as ineffective;
 it is inefficient to test the effectiveness of the controls; and
 the test is for overstatement.
Whichever strategy is chosen, the auditor will document the reasons for choosing that strategy
and then perform detailed auditing procedures in accordance with that strategy.
Control environment
Within an entity, the control system works within the control environment. A poor control
environment implies that the control system itself will also be poor, because the entity does not
place sufficient emphasis on having a good control environment.
C
So, the control environment sets the philosophy of an entity effectively influencing the 'control H
consciousness' of directors and employees. The importance of the enforcement of integrity and A
P
ethical values was illustrated in July 2011, with the closure of the News of the World newspaper T
resulting from phone hacking allegations. E
R

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Factors affecting the control environment include:
Factor Explanation
Communication and An organisation should try to maintain the integrity and ethical
enforcement of integrity standing of the employees. Membership of a professional body
and ethical values helps enforce ethical standards for professional staff. Ethics in other
areas are maintained by ensuring rules do not encourage unethical
conduct (eg, unrealistically high sales targets to earn commissions).
Commitment to Each job should have a job description showing the standards
competence expected in that job. Employees should then be hired with the
competences to carry out the job without compromising on the
quality of work produced.
Participation by those Those charged with governance should take an active role in
charged with ensuring ethical standards are maintained. For example, the audit
governance committee should ensure that directors carry out their duties
correctly in the context of the audit. Similarly, those charged with
governance must ensure appropriate independence from the
company they are governing.
Management Management should set the example of following ethical and quality
philosophy standards. Where management establish a risk management system
and regularly discuss the effect of risks on an organisation then the
auditor will gain confidence that the overall control environment is
effective.
Structure of the The structure of the organisation should ensure that authority is
organisation delegated appropriately so that lower management levels can
implement appropriate risk management procedures. However,
responsibility for risk management overall is maintained by the
board.
Reporting hierarchy Within the organisation's hierarchy, each level of management has
responsibilities for risk included in their job description. There
should also be a clear reporting system so that objectives for risk
management are communicated down the hierarchy, while
identified risks are communicated back up the hierarchy for action.
HR policies and HR policies should have appropriate policies for ensuring the
procedures integrity of staff, both for new employees and for continued training
and development.
From a review of these factors, the auditor will form an opinion on the effectiveness of the
control environment. The auditor will also consider the means by which the entity monitors
controls eg, by the internal audit department. This in turn affects the opinion on how well the
internal control systems will be implemented and operated.
Control risk will also increase where specific events occur within an organisation. Events that
tend to increase control risk include the following:
 Use of new technology
 New or substantially amended information systems
 Hiring of new personnel, especially into key management roles
 Changes to the regulatory or operating environment
 Significant growth in the organisation
 Restructuring of the company or group
 Expansion of overseas operations

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Control activities
Having assessed the control environment, the auditor will then identify and assess the control
activities carried out by management. Control activities in this context are the policies and
procedures that help ensure management's directives are carried out.
Control activities that the auditor will investigate include:
Control Explanation
activity
Physical Controls to ensure the security of assets including data files and computer
controls programs (eg, not simply tangible assets such as company motor vehicles).
Segregation Segregation of the authorisation of transactions, recording of transactions and
of duties custody of any related assets. For example, employees receiving cash should
not be responsible for recording that cash in the receivables ledger – teeming
and lading could occur.
Performance Reviews to check the performance of individuals are carried out on a regular
reviews basis. The review includes comparing actual performance against agreed
standards and budgets and accounting/obtaining reasons for any variances.
Information These are controls to check the completeness, accuracy and authorisation of the
processing processing of transactions. Two types of controls are generally recognised:
controls
 General controls – over the information processing environment as a whole,
for example to ensure the security of data processing operations and
maintenance of adequate backup facilities.
 Application controls – over the processing of individual transactions, again
ensuring the completeness and accuracy of recording.
Where the auditor is satisfied regarding the ability of the control environment to process
transactions correctly and control activities to identify deficiencies in that processing, then
control risk can be set to a low figure. Obviously, where the control environment is weak, and
control activities are missing, then control risk will be set to a higher level.
Control activities for transaction assertions
Within each class of transactions, the auditor will ensure that specific audit assertions have been
achieved. Remember that for each assertion, a different 'mix' of control and substantive
procedures may be used.
For each of the audit assertions relevant to transaction testing, specific control activities are normally
available.
The assertions and control activities are summarised below.
Assertion Explanation Typical control activities

C
Occurrence Transactions and events that have  Segregation of duties H
been recorded have occurred and A
 Daily/monthly reconciliation of P
pertain to the entity
subsidiary records with an T
independent review E
R
 Prenumbering of documents (with
5
completeness of numbering
confirmed)

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Assertion Explanation Typical control activities
Completeness All transactions and events that  Segregation of duties

should have been recorded have
 Prenumbering of documents (with
been recorded, and all related
completeness of numbering
disclosures that should have been
confirmed)
included in the financial statements
have been included  Daily/monthly reconciliation of
subsidiary records with an
independent review
Accuracy Amounts and other data relating to  Internal confirmation of amounts
recorded transactions and events and calculations
have been recorded appropriately,
 Monthly reconciliation of
and related disclosures have been
subsidiary records by an
appropriately measured and
independent person
described
Cut-off Transactions and events have been  Procedures for the prompt
recorded in the correct accounting recording of transactions
period
 Internal verification of cut-off at
year end
Classification Transactions and events have been  Agreeing transactions against
recorded in the proper accounts chart of accounts
 Internal verification of the accuracy
of posting
Monitoring controls
The auditor should also assess the means by which management monitors internal control over
financial reporting. In many entities internal auditors fulfil this function. The impact on the audit
of the existence of an internal audit function is dealt with in ISA (UK) 610 (Revised 2016), Using
the Work of Internal Auditors.
6.2.4 Detection risk

Detection risk is the risk that audit procedures will fail to detect material errors. Detection risk
relates to the inability of the auditors to examine all evidence. Audit evidence is usually persuasive
rather than conclusive so some detection risk is usually present, allowing the auditors to seek
'reasonable confidence'.
The auditor's inherent and control risk assessments influence the nature, timing and extent of
substantive procedures required to reduce detection risk and thereby audit risk.
6.2.5 Risk assessment and data analytics

Data analytics tools may be used in risk analysis. Data analytics is discussed further in section 13.
Interactive question 5: Audit risk

Forsythia is a small limited company offering garden landscaping services. It is partly owned by
three business associates, Mr Rose, Mr White and Mr Grass, who each hold 10% of the shares.
The major shareholder is the parent company, Poppy Ltd. This company owns shares in 20
different companies, which operate in a variety of industries. One of them is a garden centre,
and Forsythia regularly trades with it. Poppy Ltd is in turn wholly owned by a parent, White
Holdings Ltd.

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The management structure at Forsythia is simple. Of the three non-corporate shareholders, only
Mr Rose has any involvement in management. He runs the day to day operations of the company
(marketing, sales, purchasing etc) although the company employs two landscape gardeners to
actually carry out projects. The accounts department employs a purchase clerk and a sales clerk,
who deal with all aspects of their function. The sales clerk is Mr Rose's daughter, Justine. Mr
Rose authorises and produces the payroll. The company ledgers are kept on Mr Rose's personal
computer. Two weeks after the year end, the sales ledger records were severely damaged by a
virus. Justine has a single printout of the balances as at the year end, which shows the total owed
by each customer.
Forsythia owns the equipment which the gardeners use and pays them a salary and a bonus
based on performance. Mr Rose is remunerated entirely on a commission basis relating to sales
and, as a shareholder, he receives dividends annually, which are substantial.
Forsythia does not carry any inventories. When materials are required for a project, they are
purchased on behalf of the client and charged directly to them. Most customers pay within the
60-day credit period, or take up the extended credit period which Forsythia offers. However,
there are a number of accounts that appear to have been outstanding for a significant period.
Justine and her father do not appear to have a very good working relationship. She does not live
at home and her salary is not significant. However, she appears to have recently purchased a
sports car, which is not a company car.
The audit partner has recently accepted the audit of Forsythia as a new client. You have been
assigned the task of planning the first audit.
Requirement
Identify and explain the audit risks arising from the above scenario.
7 Creative accounting
Section overview
• There is a spectrum of activity with respect to accounting policy choice. Creative
accounting attempts to change users' perceptions of the performance and position of a
business.
• The occurrence of creative accounting depends on both incentives and opportunity.
• The consequences of creative accounting depend upon a range of factors that change
over time but are specific to individual companies.
• Creative accounting can be overt (disclosed) or covert (not disclosed).
• Red flags exist which may indicate that creative accounting practices have taken place.
C
• Empirical evidence supports the notion that creative accounting occurs on a widespread H
basis. A
P
T
E
7.1 Introduction R
One of the factors affecting the overall level of financial statement risk is the potential for
5
creative accounting.
Directors have choices and they may exercise those choices to recognise values that do not
reflect economic reality. A prime example is the choice of the cost model when an asset's
fair value is significantly higher than cost. (Note: If an asset's fair value and value in use were

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lower than cost, then an impairment would be required under IAS 36 and directors would
not have the discretion to disclose at cost.) Directors are more likely to make use of their
discretion to mislead financial statement users if they have the opportunity (eg, imprecise
accounting regulations, weak auditors) and incentives (eg, approaching the breach of a
debt covenant, an impending takeover, profit-based bonus) to do so.
Creative accounting is covered from a financial reporting perspective in Chapter 24.
7.2 The nature of creative accounting
Definition
Creative accounting: The active manipulation of accounting results for the purpose of creating
an altered impression of the underlying financial position or performance of an enterprise by
using accounting rules and guidance in a spirit other than that which was intended when the
rules were written.
This well-documented practice is a potential problem for auditors in assessing the underlying
performance and position of a company and recent evidence suggests that it is one of the major
issues facing financial reporting.
Accounting measures involve a degree of subjectivity, choice and judgement and it would be
wrong to describe all such activity as creative accounting. Moreover, creative accounting
normally falls within permitted regulation and is not therefore illegal. It is therefore often a
question of fine judgement as to when creative accounting is of such an extent that it becomes
misleading.
The spectrum of creative accounting practices may include the following (commencing with the
most legitimate):
 Exercise of normal accounting policy choice within the rules permitted by regulation (eg,
first in, first out and average cost for inventory valuation)
 Exercise of a degree of estimation, judgement or prediction by a company within
reasonable bounds (eg, non-current asset lives)
 Judgement concerning the nature or classification of a cost (eg, expensing and capitalising
costs)
 Systematic selection of legitimate policy choices and estimations to alter the perception of
the position or performance of the business in a uniform direction
 Systematic selection of policy choice and estimations that fall on the margin of permitted
regulation (or are not subject to regulation) in order to alter materially the perception of the
performance or position of the business
 Setting up of artificial transactions to create circumstances where material accounting
misrepresentation can take place
 Fraudulent activities
It can thus be a matter of fine judgement for an auditor as to where within this spectrum creative
accounting becomes unacceptable.
Companies may also seek to manipulate the perception of their performance and position by
altering underlying transactions, rather than just the way they are recorded. Accounting
regulation seeks to limit the effects of this behaviour in a number of ways as previously
discussed. Nevertheless, while it may seek to report faithfully transactions that actually take

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place, it cannot regulate for transactions which do not take place, or which are delayed in order
to manipulate the perception of performance or position. These might include:
 deferring discretionary expenditure (eg, maintenance costs, R&D);
 changing the timing of the sale of investments or other assets; or
 delaying investment or financing decisions.
Worked example: Tesco

UK grocer Tesco suffered from an accounting scandal which arose because the company
delayed and deducted millions of pounds from suppliers and also charged its suppliers twice for
money owed, in order to improve its financial position. The accounting treatment resulted in an
overstatement of profits of £263 million in its half-year results in 2014. Three of the company's
senior directors were charged with fraud by abuse of power and fraud by false accounting. The
company and its auditors, PwC, were investigated by the SFO, FCA and FRC.
The latest position on this scandal is that Tesco has been ordered to pay a fine of £129 million
and £85 million in compensation to investors who bought shares or bonds between 29 August
and 19 September 2014, under a deferred prosecution agreement.
The former auditor of the company, PwC, was also under investigation by the FRC but in June
2017, the investigation was closed and the firm avoided official censure over the scandal.
7.3 Causes of creative accounting – opportunity

The causes of creative accounting have two key elements:
(1) Opportunity
(2) Incentives
Where these two elements both exist then the risks of creative accounting taking place are
greatest. This section looks at opportunity. The following section looks at incentives.
It is important for the auditor to be aware of the causes of creative accounting in order to
highlight the circumstances, where there is the greatest risk or incentives for creative accounting
to take place.
The causes of opportunity for creative accounting include the following:
 Subjectivity – Areas of subjectivity lend themselves to a greater degree of choice,
judgement and uncertainty.
 Complexity – Complex industries and transactions are difficult to regulate precisely and
give more scope for manipulation.
 Inadequate corporate governance – Inadequate or inappropriate controls over directors
may permit greater discretion.
 Insufficiently independent auditors – Auditors may come under increased managerial C
pressure to approve creative accounting practices. H
A
 Imprecise regulations – Where regulations are imprecise or inadequate, companies have P
greater scope to exercise discretion, and auditors have a poor benchmark to challenge the T
E
selected accounting procedures. R
 Inadequate sources of information – Where reliable sources of audit evidence exist (eg, to
5
challenge management estimations) the scope for effective manipulation is more limited.
 Inadequate penalties – Where creative accounting is discovered to have misled users, the
penalties for the company, and for the directors, are regarded by some as inadequate to
provide sufficient disincentives.

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7.4 Causes of creative accounting – incentives

The following have been put forward as incentives for companies/managers engaging in creative
accounting:
 Income smoothing – Companies normally prefer to show a steady trend of growth in profits,
rather than volatility with significant rises and falls. Income smoothing techniques (eg,
declaring higher provisions and deferring income recognition in good years) contribute to
reducing volatility in reported earnings.
 Achieving forecasts – Where forecasts of future profits have been made, reported earnings
may be manipulated to tie in with these forecasts.
 Profit enhancement – This is where current year earnings are boosted to enhance the short-
term perception of performance.
 Maintain or boost share price – Where markets can be made to believe that increased
earnings represent improved underlying commercial performance, then share price may
rise, or at least be higher than it would be in the absence of creative accounting.
 Accounting-based contracts – Where accounting-based contracts exist (eg, loan covenants,
profit-related pay) then any accounting policy that falls within the terms of the contract may
significantly impact on the consequences of that contract. For example, the breach of a
gearing-based debt covenant may be avoided by the use of off balance sheet financing.
 Incentives for directors – There may be personal incentives for directors to enhance profit in
order to enhance their remuneration. Examples might include: bonuses based on earnings
per share (EPS), or share incentive schemes and share option schemes that require a given
EPS before they become operative. Directors may also benefit more indirectly from creative
accounting by increasing the security of their position.
 Taxation – Where accounting practices coincide with taxation regulations there may be an
incentive to reduce profit in order to reduce taxation. In these circumstances, however, it
may be necessary to convince not only the auditor but also HMRC.
 Regulated industries – Where an industry is currently, or potentially, regulated then there
may be an incentive to engage in creative accounting to reduce profit in order to
influence the decisions of the regulator. This may include utilities where regulators may
curtail prices if it is perceived that excessive profits are being earned. It may also be
relevant to avoid a reference to the Competition Commission.
 Internal accounting – A company as a whole may have reason to move profits from division
to division (or subsidiary to subsidiary) in order to affect tax calculations or justify the
closure/expansion of a particular department.
 Losses – Companies making losses may be under greater pressure to enhance reported
performance.
 Commercial pressures – Where companies have particular commercial pressures to
enhance the perception of the company there is increased risk of creative accounting; for
example, a takeover bid, or the raising of new finance.
Thus, a range of stakeholders may have incentives to engage in creative accounting. In
particular, however, an appropriate degree of professional scepticism should be applied where
benefits arise for directors, as they are also the group responsible for implementing creative
accounting practices.

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7.5 The consequences of creative accounting

It is important for the auditor to understand the consequences of creative accounting, as:
 It enables an understanding of the motivations and reasons for the company's directors to
engage in the practice. (For instance, the existence and nature of a debt covenant that may
be affected by creative accounting.)
 It enhances the understanding of whether the practice is material ie, whether it would
reasonably influence decisions made.
 It enables an understanding of the continued impact of a particular creative accounting
practice in future years' financial statements and whether the impact will be sustainable year
on year.
The consequences of creative accounting depend crucially upon whether or not it is disclosed.
Overt creative accounting refers to practices, which may change reported profits or the
statement of financial position, but that are disclosed externally to financial statement users.
Examples may include:
 not depreciating non-current assets
 capitalising development costs
 significant provisioning
 changing depreciation policy
Covert creative accounting refers to practices that are used to enhance profitability or asset
values but are not disclosed. Examples might be:
 the timing of revenue recognition on complex long-term transactions
 the treatment of overhead allocations
 many decisions to capitalise or expense cash outlays
As a result, such covert practices are not readily identifiable by outside users, who are thus
unable, in some cases, to distinguish increases in reported earnings arising as a result of
accounting manipulation, from those arising from improvements in substantive underlying
transactions. The potential consequences of covert creative accounting (eg, for share price
movements) are therefore likely to be more substantial than for overt creative accounting.
7.6 Sustainability
Some creative accounting practices are sustainable in the long term while others may only serve to
enhance the current year's profit, but only with the effect that future profits are correspondingly
reduced.
Sustainable practices may include the following:
 Income smoothing – assuming it is smoothed at a normal level of profitability, it may be
sustained indefinitely
 Off balance sheet financing
Unsustainable practices include the following: C
H
 Capitalisation of expenses – if, for instance, annual development costs are inappropriately A
P
capitalised and amortised over 10 years then, after that period, assuming constant
T
expenditure, the profit will be equivalent for either write-off or amortisation policies E
(though not the statement of financial position) as there will be 10 amounts of 10% R
amortisation recognised in profit or loss
5
 Revenue recognition – bringing forward the recognition of revenues may initially enhance
profit, but at the cost of reducing future profits

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7.7 Some specific consequences

Share price effects
Where creative accounting practices are disclosed then one would expect that, in a semi strong
efficient market, investors would see through the manipulation and correctly price shares, with
creative accounting having little effect. However:
 the market may not always be efficient;
 accounting-based contracts may be affected; and
 complex series of transactions may mean that markets fail to appreciate fully the impact of
creative accounting.
Covert creative accounting is likely to include all the above effects but in addition, even where
the market is semi-strong efficient, it cannot always 'see through' the creative accounting and
shares could be mispriced. This may result in shareholders suffering an undue loss.
Recent revelations regarding creative accounting have resulted in significant falls in the share
prices of the companies concerned providing evidence of previous mispricing. However, shares
prices also fell in other companies, as markets generally placed less trust in reported earnings
and auditors were perceived as being unable to prevent creative accounting.
Accounting-based contracts
Whether creative accounting is covert or overt, it can affect the application of accounting-based
contracts, so long as the selected accounting treatment falls within the terms of that contract.
Typically, a restrictive covenant on gearing, or interest cover, may be avoided by enhancing
equity or earnings. This may benefit one stakeholder (eg, shareholders) but disadvantage
another (eg, debtholders).
7.8 Red flags and detection

The best detection techniques for creative accounting are a good knowledge of financial
reporting regulations and a good understanding of the business. There may, however, be more
general techniques and indicators that can suggest that a company is engaging in creative
accounting practice. These include the following:
 Cash flows – Operating cash flows are systematically out of line with reported operating
profits over time.
 Reported income and taxable income – Is financial reporting income significantly out of line
with taxable income with inadequate explanation or disclosure?
 Acquisitions – Where a significant number of acquisitions have taken place, there is
increased scope for many creative accounting practices.
 Financial statement trends – Indicators include: unusual trends, comparing revenue and
EPS growth, atypical year-end transactions, flipping between conservatism and aggressive
accounting from year to year, level of provisions compared to profit indicating smoothing,
EPS trend, timing of recognition of exceptional items.
 Ratios – Ageing analyses revealing old inventories or receivables, declining gross profit
margins but increased net profit margins, inventories/receivables increasing more than
sales, gearing changes.
 Accounting policies – Consider if there is the minimum disclosure required by regulation,
changes in accounting policies, examine areas of judgement and discretion. Consider risk
areas of off balance sheet refinancing, revenue recognition, capitalisation of expenses,
significant accounting estimates.
 Changes of accounting policies and estimates – Is the nature, effect and purpose of these
changes adequately explained and disclosed?

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 Management – Estimations proved unreliable in the past, minimal explanations provided.

 Actual and estimated results – Culture of always satisfying external earnings forecasts,
absence of profit warnings, inadequate or late profit warnings leading to 'surprises', interim
financial statements out of line with year-end financial statements.
 Incentives – Management rewarded on reported earnings, profit-orientated culture exists,
other reporting pressures eg, a takeover.
 Audit qualifications – Are they unexpected and are any auditors' adjustments specified in
the audit report significant?
 Related party transactions – Are these material and how far are the directors affected?
The above is not a comprehensive list, but merely includes some main factors. Also, it is not
suggested that the above practices necessarily mean there is creative accounting but, where a
number of these factors exist simultaneously, then the auditor should be put 'on inquiry' to make
further investigations.
7.9 Examples of creative accounting techniques

A number of examples of creative accounting have been given above and throughout these
learning materials in the context of their application. The following list draws some of these
together and provides further examples under key headings. The list is not meant to be
comprehensive.
7.9.1 Timing of operating expenses

 Underprovisioning in poor years
 Overprovisioning in good years
 Manipulation of reserves
 Aggressive capitalisation of costs
 Optimistic asset lives
 Accelerating expenses in good years
 Increased write-downs and write-offs in good years
 Exceptional gains timed to offset exceptional losses
7.9.2 Revenue recognition

 Premature recognition of revenues
 Recording out of period revenue
 Recognition of revenue of service contracts before the service being performed
 Recognition of sales before physical movement of goods
 Front-end recognition of sales that should be spread over more than one accounting
period
C
 Percentage of completion estimates in construction industry
H
 Cut-off misapplied A
P
T
7.9.3 Off balance sheet financing E
R
In some circumstances transactions may be structured in order to allow a particular accounting
treatment (eg, making a finance lease appear to be an operating lease) rather than presenting 5
the fairest view. This is one of the primary reasons for the large quantity of disclosure standards
(as against measurement standards) in previous years.

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8 Materiality
Section overview
• Materiality considerations are important at the planning stage.
• An item might be material due to its nature, value or impact on readers of financial
statements.
8.1 Revision of materiality
Definition
ISA (UK) 320, Materiality in Planning and Performing an Audit states that the auditor's frame of
reference for materiality should be based on the relevant financial reporting framework. IAS 1
gives the following definition:
Materiality: Omissions or misstatements of items are material if they could, individually or
collectively, influence the economic decisions that users make on the basis of the financial
statements. Materiality depends on the size and nature of the omission or misstatement judged
in the surrounding circumstances. The size or nature of the item, or combination of both, could
be the determining factor.
Materiality criteria
An item might be material due to its:
Nature Given the definition of materiality that an item would affect the readers of the
financial statements, some items might by their nature affect readers.
Examples include transactions related to directors, such as remuneration and
contracts with the company.
Value Some items will be significant in the financial statements by virtue of their size;
for example, if the company had bought a piece of land with a value which
comprised three-quarters of the asset value of the company, that would be
material. That is why materiality is often expressed in terms of percentages (of
assets, of profits).
Impact Some items may by chance have a significant impact on financial statements;
for example, a proposed journal which is not material in size could convert a
profit into a loss. The difference between a small profit and a small loss could
be material to some readers.
Although there are general guidelines on how materiality might be calculated in practice, the
calculation involves the application of judgement. It should be reassessed throughout the
course of the audit as more information becomes available. Note that as materiality has both
quantitative and qualitative aspects risk assessment must include the analysis of both
quantitative and qualitative data.
Users' needs
The auditor must consider the needs of the users of the financial statements when setting
materiality. The ISA indicates that it is reasonable for the auditor to assume that users:
 Have a reasonable knowledge of the business and economic activities and accounting and
a willingness to study the information in the financial statements with reasonable diligence

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 Understand that financial statements are prepared and audited to levels of materiality
 Recognise the uncertainties inherent in the measurement of amounts based on the use of
estimates, judgement and the consideration of future events
 Make reasonable economic decisions on the basis of the information in the financial
statements
8.2 Applying materiality

The application of materiality to an audit can be summarised in three key steps:
Establish a preliminary judgement

Step 1
about materiality
Determine performance
Step 2
materiality
Estimate likely misstatements and

Step 3 compare totals to the preliminary
judgement about materiality
Figure 5.5: Steps in applying materiality on an audit

Steps 1 and 2 would normally be performed as part of the planning process. Step 3 is normally
performed as part of the review stage of the audit when the auditor evaluates the audit
evidence.
Auditors of companies applying the UK Corporate Governance Code are required to make
significant disclosures in the auditor's report about how they have applied materiality in their audit.
8.2.1 Preliminary judgement

Materiality considerations during audit planning are extremely important. The assessment of
materiality at this stage should be based on the most recent and reliable financial information
and will help to determine an effective and efficient audit approach. Materiality assessment will
help the auditors to:
 determine the amount of audit work necessary to facilitate audit efficiency and
effectiveness;
 put audit risk in context;
 decide whether to use sampling techniques;
 determine the applicability of accounting standards which normally apply only to material
items;
C
 evaluate uncorrected misstatements during the audit; and H
A
 evaluate what level of error is likely to lead to a modified audit opinion. P
T
E
In specifying materiality, an auditor should establish a benchmark (or benchmarks) to which a R
percentage factor is applied. Factors that may affect the identification of an appropriate
benchmark include the following: 5
 The elements of the financial statements

 Items on which the attention of the users tends to be focused

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 The nature of the entity, where it is in its life cycle and the industry and economic
environment in which it operates
 The entity's ownership structure and the way it is financed
 The relative volatility of the benchmark
The following benchmarks are typically used:
Benchmark Threshold
Profit before tax Approx. 5%

Adjusted profit before tax Approx. 5%
Total revenue Approx. 1%
Total assets Approx. 1–2%
Equity Approx. 1–2%
(The benchmarks suggested above are based on information from the FRC publication
Extended Auditor's Reports: A review of Experience in the First Year, 2015.)
The following points should be noted:
 There is some variation used in the methods to determine materiality within and between
audit firms.
 Multiple measures are sometimes used to determine materiality.
 Adjusted profit before tax and profit before tax are the most commonly used measures.
Determining the level of materiality is a matter of professional judgement, rather than applying
benchmarks mechanically. In applying such judgements, the auditor should consider any
relevant qualitative factors, including:
 whether it is a first-year engagement;
 deficiencies in controls;
 material misstatements in prior years;
 risk of fraud;
 significant management turnover;
 unusually high market pressures;
 sensitivity of covenants in loan agreements to changes in the financial statements; and
 effect of changes in results on earnings trends.
The auditor's assessment of materiality is then communicated in the auditor's report
(ISA 700.38(c)). By far the most common level of materiality for listed company auditors is 5% of
adjusted profit before tax. It is also necessary to determine a materiality threshold for reporting
any unadjusted differences to the audit committee. This will be much lower than overall
materiality, and may be communicated in the auditor's report.
In the case of a group audit, the group auditor will also set materiality for the group as a whole,
as well as component materiality for any component auditors. Component materiality is always
less than group materiality.
8.2.2 Performance materiality

The preliminary assessment of materiality, as referred to above, is in the context of the financial
statements as a whole. However, if the audit procedures are planned solely to detect individually
material misstatements this would:
 overlook the fact that the aggregate of individually immaterial misstatements could cause
the financial statements to be materially misstated; and

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 leave no margin for possible undetected misstatements.

Further materiality levels must therefore be set before audit procedures are designed and
performed. The requirement to do so was introduced into ISA 320 as part of the IAASB's Clarity
Project, and these lower materiality levels are referred to as performance materiality. Seen as a
'working level of materiality', performance materiality is a concept that most experienced
auditors would have applied throughout their careers.
The auditor must set an amount or amounts at less than the materiality for the financial
statements as a whole and this is known as performance materiality. This could be set in two
ways:
(1) as a judgemental estimate to reduce the probability that the aggregate of uncorrected and
undetected misstatements exceeds the materiality for the financial statement as a whole; or
(2) specific materiality levels may be set for particular classes of transactions, account balances
or disclosures that could have a particular influence on users' decisions in the particular
circumstances of the entity.
Different levels of materiality may therefore be used in the various audit procedures carried out.
The following example illustrates, in a simplistic way, the role of performance materiality in an
audit.
Worked example: Performance materiality

The auditor of Company A has set materiality for the financial statements as a whole at £100,000.
During the audit, the following misstatements were identified:
(1) Misclassification of abortive research and development expenses as an intangible asset of
£41,000. This is the only intangible asset on the statement of financial position.
(2) Overstatement of non-current assets by £50,000 due to cut-off errors.
(3) Overstatement of receivables by £29,000 representing the unpaid balance from a customer
which has been liquidated during the period.
Considering each of the misstatements on an individual basis, the auditor may overlook the
misstatements above. This would give rise to an aggregate of uncorrected misstatements of
£120,000 – exceeding materiality for the financial statements as a whole.
In addition, the uncorrected misstatement (1) could have misled the users of the financial
statements, whose attention would have been drawn to the company's new, and only, intangible
assets.
The auditor would avoid the risk of giving an inappropriate audit opinion by applying
performance materiality:
(1) Set a general performance materiality at £50,000 to reduce the probability that the
aggregate of uncorrected misstatements would exceed materiality for the financial
statements as a whole: This would identify misstatement (2) as requiring adjustment. C
H
(2) Set performance materiality specific to intangible assets at £40,000 to reflect the specific A
risks associated with this account: This would identify misstatement (1) as requiring P
adjustment. T
E
(3) Now, provided management agrees to correct misstatements (1) and (2), the only R
adjustment which remains uncorrected is misstatement (3). At £29,000, this is now less than 5
30% of materiality for the financial statements as a whole.

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Performance materiality should be used in both the planning and fieldwork stages of the audit.
In the November 2011 issue of the ICAEW Audit & Assurance Faculty newsletter, the article
'Living in a material world' by David Gallagher usefully sets out four circumstances in which
performance materiality can be applied:
At the planning stage:
(1) to determine when no work is necessary, and where evidence is required, the extent of that
evidence; and
(2) to help identify which items to test (for example, if a substantive test of detail approach is
adopted, the auditor may consider selecting all items above performance materiality first,
and then consider whether any, and if so how many, further items should be sampled).
At the fieldwork stage:
(3) to help evaluate the results of sample tests (for example, if on a particular test the
extrapolated difference of potential misstatements is less than materiality, the auditor may
conclude that sufficient audit evidence had been obtained in this area); and
(4) to help evaluate the results of analytical procedures (for example, if the results of a
reasonableness test produced a difference between the predicted and actual amounts
which is less than performance materiality, the auditor may conclude that sufficient audit
evidence had been obtained in this area).
Students who work in an audit practice may have come across tolerable misstatement (previously
called 'tolerable error') in carrying out audit engagements. Essentially, tolerable misstatement is an
example of how the concept of performance materiality is applied to sampling (points (b) and (c)
above).
What constitutes sufficient audit evidence, and the different audit procedures, are covered in
further detail in Chapter 6. However, you should already be familiar with these topics from your
earlier studies.
8.2.3 Estimation of likely misstatements

Towards the end of the audit, the auditor will aggregate the misstatements from each account
balance, class of transaction or disclosure (including both known and likely misstatements) and
compare this with the preliminary assessment of materiality. Where additional information has
come to light the preliminary assessment of materiality may need to be revised. If this is the
case, the circumstances should be adequately documented. Comparison of the aggregated
misstatements and materiality will determine whether the financial statements require
adjustment.
Like materiality for the financial statements as a whole, performance materiality is linked to audit
risk. Where the audit risk has been revised during an audit, and the materiality level for the
financial statements as a whole has been reduced, the auditor must consider whether
performance materiality also needs to be revised. This may affect the nature, timing and extent
of further audit procedures.
8.2.4 Auditor's report

Auditors of companies applying the UK Corporate Governance Code must disclose the
materiality level used in the audit for the financial statements as a whole. This area is covered in
more detail in Chapter 8 of this Study Manual, but for now it may be helpful to see a real-life
example of such a disclosure. For instance, PwC's auditor's report for Barclays plc (in relation to
the 2016 Annual Report) included the following statement.
"Overall group materiality [was set at]: £320 million [which represents] 5% of Barclays Core profit
before tax excluding notable items. The use [of this measure of profit] is appropriate as it reflects
the underlying business management is focusing upon and will be what is left once disposals
from Non-core have occurred."
(Source: www.home.barclays/content/dam/barclayspublic/docs/InvestorRelations/
AnnualReports/AR2016/Barclays%20PLC%20Annual%20Report%202016.pdf)

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Deloitte's auditor's report for Tesco plc (in relation to the 2016 Annual Report) includes the
following description of the basis on which materiality was derived, making reference to the
effect on the materiality level of the change of auditors.
"We determined materiality for the Group to be £50 million (2014/15: materiality determined by
the previous auditor of £50 million). Professional judgement was applied in determining an
appropriate level of materiality and we considered a number of profit based and other measures
with reference to the Group's performance. We concluded that it was appropriate to determine
materiality with reference to the Group's average profitability over a three year period (2013/14,
2014/15, and 2015/16), adjusted for exceptional items.
In our professional judgement, we believe that the use of an adjusted profit measure is
appropriate as the amounts which have been excluded from the Group's profit before tax are
one-off items which would otherwise skew the level of materiality determined and are not
reflective of the Group's trading activity. However, we capped the materiality determined to that
applied by the previous auditor in the light of the Group's lower level of profit in the current year
and as a result of 2015/2016 being our first year of appointment."
(Source: www.tescoplc.com/media/264194/annual-report-2016.pdf)
Ernst and Young's auditor's report for J Sainsbury plc (in relation to the 2016 Annual Report)
provides information about both overall materiality and performance materiality as follows:
"We determined materiality for the Group to be £31.9 million, which is 5% of profit before tax
excluding one-off items of £90 million as described in note 3. We believe that this materiality
basis provides us with the best assessment of the requirements of the users of the financial
statements. This is consistent with the approach taken by auditors in the prior period.
On the basis of our risk assessments, together with our assessment of the Group's overall control
environment and this being our first period of engagement, our judgement was that
performance materiality was approximately 50% of our planning materiality, namely £16 million."
(Source: www.about.sainsburys.co.uk/~/media/Files/S/Sainsburys/documents/
reports-and-presentations/annual-reports/annual-report-2016.pdf)
8.3 Problems with materiality

As discussed above, materiality is a matter of judgement for the auditor. Therefore, prescriptive
rules will not always be helpful when assessing materiality. A significant risk of prescriptive rules
is that a significant matter, which falls outside the boundaries of the rules, could be overlooked,
leading to a material misstatement in the financial statements.
The percentage guidelines of assets and profits that are commonly used for materiality (eg,
those referred to in section 8.2.1) must be handled with care. The auditor must bear in mind the
focus of the company being audited.
In some companies, post-tax profit is the key figure in the financial statements, as the level of
dividend is the most important factor in the accounts.
In owner-managed businesses, if owners are paid a salary and are indifferent to dividends, the
key profit figure stands higher in the statement of profit or loss and other comprehensive
income, say at gross profit level. Alternatively in this situation, the auditor should consider a C
figure that does not appear on the statement of profit or loss and other comprehensive income: H
profit before directors' salaries and benefits. A
P
Some companies are driven by assets rather than the need for profits. In such examples, higher T
materiality might need to be applied to assets. In some companies, say charities, costs are the E
R
driving factor, and materiality might be considered in relation to these.
While rules or guidelines are helpful to auditors when assessing materiality, they must always 5
keep in mind the nature of the business they are dealing with. Materiality must be tailored to the
business and the anticipated user of financial statements, or it is not truly materiality. The
extracts from auditors' reports included in section 8.2.4 above demonstrate how these principles
are applied in practice.

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The FRC published Audit Quality Thematic Review: Materiality in December 2017 and found
that the quality and frequency of materiality judgements displayed by audit firms was improving:
for example, in three out of the eight firms visited, the FRC found that performance materiality
was reduced to reflect the increased risk presented by the first year of audit. The review did
conclude that the disclosure of judgements associated with materiality could be explained
further by auditors within the auditor's extended report and that there should be greater
dialogue about materiality between audit committees and their external auditors to ensure full
visibility of the audit approach, but overall, there was optimism that this area was seeing some
improvement in quality.
Interactive question 6: Materiality (1)

You are the manager responsible for the audit of Albreda Ltd. The draft consolidated financial
statements for the year ended 30 September 20X6 show revenue of £42.2 million (20X5
£41.8 million), profit before taxation of £1.8 million (20X5 £2.2 million) and total assets of
£30.7 million (20X5 £23.4 million). In September 20X6, the management board announced
plans to cease offering 'home delivery' services from the end of the month. These sales
amounted to £0.6 million for the year to 30 September 20X6 (20X5 £0.8 million). A provision of
£0.2 million has been made at 30 September 20X6 for the compensation of redundant
employees (mainly delivery van drivers).
Requirement
Comment upon the materiality of these two issues.
Interactive question 7: Materiality (2)

You are the auditor of Oscar Ltd and are in the process of planning the audit for the year ended
31 December 20X8. In the past the audit of this company has been straightforward. The
following information is available:
20X8 20X7
£'000 £'000
Total assets 1,800 1,750
Total revenue 2,010 1,900
Profit before tax 10 300
Materiality has been calculated by a colleague as follows:
Profit before tax = £10,000  5% = £500
Requirement
Comment on the suitability of the planning materiality figure.
9 Responding to assessed risks
Section overview
Further audit procedures should be designed in response to the risks identified.

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As a result of the auditor's risk assessment and assessment of materiality an audit strategy will
be developed in response. ISA (UK) 330 (Revised July 2017), The Auditor's Responses to
Assessed Risks makes the following points in this context which you should be familiar with.
9.1 Overall responses

The auditor should design and implement overall responses to address the risks of material
misstatement at the financial statement level. This may include the following:
 Emphasising to the audit team the need to maintain professional scepticism in gathering
and evaluating audit evidence
 Assigning more experienced staff, those with special skills or using experts
 Providing more supervision
 Incorporating additional elements of unpredictability in the selection of further audit
procedures
The auditor may also make general changes to the nature, timing or extent of audit
procedures, for example by performing substantive procedures at the period end instead of at
an interim date. These decisions will take into account the auditor's assessment and
understanding of the control environment.
9.2 Audit procedures responsive to risks of material misstatement at the

assertion level
The auditor is required to design and perform procedures which will address the risks identified.
The ISA emphasises the link between further audit procedures and the risk assessment process.
Factors which the auditor will consider include the following:
 The reasons for the risk assessment at the assertion level for each class of transaction,
account balance or disclosure
 The likelihood of material misstatement due to the particular characteristics of the class of
transaction, account balance or disclosure involved
 Whether the risk assessment takes account of relevant controls and so requires the auditor
to obtain evidence to determine whether the controls are operating effectively
The auditor shall obtain more persuasive audit evidence the higher the assessment of risk.
The auditor will then determine the nature, timing and extent of further audit procedures. We
will look at this aspect of the audit in detail in Chapter 6.
9.3 Evaluating the sufficiency and appropriateness of audit evidence obtained

Based on the audit procedures performed and the evidence obtained, the auditor should
conclude whether sufficient, appropriate audit evidence has been obtained to reduce the
risk of material misstatement to an acceptably low level. While this will be considered by the C
auditor throughout the audit, it is of particular relevance at the review stage of the audit. We H
A
will consider this in more detail in Chapter 6. P
T
E
9.4 Documentation R
The ISA emphasises the need to document the link between the audit procedures and the 5
assessed risks. These matters should be recorded in accordance with ISA (UK) 230 (Revised
June 2016), Audit Documentation. You should be familiar with the principles of this ISA from
your earlier studies.

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10 Other audit methodologies
Section overview
Other audit methodologies include:
• systems audit;
• transaction cycle approach; and
• balance sheet audit approach.
10.1 Introduction
In this chapter we have looked in detail at the business risk model and the audit risk model.
However there are a number of other audit approaches which may be adopted.
10.2 Systems audit

An auditor may predominantly test controls and systems, but substantive testing can never be
eliminated entirely. It is always used in conjunction with another approach.
You should be familiar with the systems and controls approach to auditing from your previous
studies.
Management are required to implement a system of controls which is capable of fulfilling its
duty of safeguarding the assets of the shareholders.
Auditors assess the system of controls put in place by the directors and ascertain whether they
believe it is effective enough for them to be able to rely on it for the purposes of their audit.
If they believe that the system is effective, they carry out tests of controls to ensure that the
control system operates as it is supposed to. If they believe that the control system is ineffective,
they assess control risk as high and undertake higher levels of substantive testing.
The key control objectives and procedures over the main cycles of sales, purchases and wages
were studied at length in your previous studies. If you do not feel confident in what they are, you
should go back to your learning materials in these areas and revise them now.
An auditor may choose predominantly to carry out substantive tests on the transactions and
balances of the business in the relevant period, but if internal control systems are particularly
weak then no amount of substantive testing may give adequate assurance (eg, if point of sales
controls over cash receipts are inadequate, then substantive testing may never detect material
understatement of revenues).
Two approaches to substantive testing are:
 the transaction cycle approach; and
 the balance sheet approach.
10.3 Transaction cycle approach

Cycle testing is in some ways closely linked to systems testing, because it is based on the same
systems.
When auditors take a cycle approach, they test the transactions which have occurred, resulting
in the entries in the statement of profit or loss and other comprehensive income (for example,
sales transactions, inventory purchases, asset purchases, wages payments, other expenses).
They would select a sample of transactions and test that each transaction was valid and
complete and processed correctly throughout the cycle. In other words, they substantiate the
transactions which appear in the financial statements.

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The key business cycles are outlined below. Remember that you know what the processes
should be in the cycle (you have assessed the system and controls previously). Under this
approach, you are ensuring that individual transactions were processed correctly. Hence, the
cycles outlined below should correspond to the controls processes you are already aware of.
You should be aware of

controls over ordering
Take
orders
Document
orders
Receive
payment Chase
payment
Despatch Send Make

invoice statement order
Account for Raise

invoice invoice
You should be aware of the Despatch

controls over recording and
accounting order
Raise goods
despatched note
Figure 5.6: Sales cycle

You should be aware of
Raise controls over ordering
requisition
Supplier will Purchasing

extend credit in department
the future raise order
Send payment
Receive goods
C
Carry on H
production A
Raise goods P
Record and received note T
account for invoice E
R
Accounts 5
department match
You should be aware of controls GRN to invoice
over accounting and recording
Figure 5.7: Purchases cycle

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The auditor should be able to find an audit trail for each transaction, for example in the
purchases cycle:
 Requisition
 Invoice
 Order
 Ledger and daybook entries
 GRN
 Payment in cash book/cheque stub
10.4 Balance sheet approach

An alternative to the cycles (or transactions) approach to auditing is to take the balance sheet
approach. This is the most common approach to the substantive part of the audit, after controls
have been tested.
The statement of financial position (balance sheet) shows a snapshot of the financial position of
the business at a point in time. It follows that if it is fairly stated and the previous snapshot was
fairly stated then it is reasonable to undertake lower level testing on the transactions which
connect the two snapshots; for example, analytical procedures.
Under this approach, therefore, the auditors seek to concentrate efforts on substantiating the
closing position in the year, shown in the statement of financial position, having determined that
the closing position from the previous year (also substantiated) has been correctly transferred to
be the opening position in the current year.
You should be aware of the financial statement assertions and the substantive tests in relation to
the major items on the statement of financial position from your previous studies. We will also
review these in more detail in Chapter 6.
10.4.1 Relationship with business risk approach

The substantive element of an audit undertaken under a business risk approach is restricted due
to the high use of analytical procedures. However, the element of substantive testing which
remains in a business risk approach can be undertaken under the balance sheet approach.
In some cases, particularly small companies, the business risks may be strongly connected to the
fact that management is concentrated in one person. Another feature of small companies may
be that their statement of financial position is uncomplicated and contains one or two material
items, for example receivables or inventory.
When this is the case, it is often more cost effective to undertake a highly substantive balance
sheet audit than to undertake a business risk assessment, as it is relatively simple to obtain the
assurance required about the financial statements from taking that approach.
10.4.2 Limitations of the balance sheet approach

When not undertaken in conjunction with a risk-based approach or systems testing, the level of
detailed testing can be high in a balance sheet approach, rendering it costly.

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11 Information technology and risk assessment
Section overview
• A huge number of organisations now use computer systems to run their businesses and to
process financial information.
• The main risks associated with using computerised systems include infection by viruses
and access by unauthorised users. Both these risks could potentially have a very damaging
effect on the business.
• This means that a number of the controls which the directors are required to put into place
to safeguard the assets of the shareholders must be incorporated into the computer
systems.
• Auditors have to assess the effectiveness of the controls in place within computer systems
and can do this by performing a systems audit as part of their initial assessment of risk
during the planning stage of the audit.
11.1 The use of information technology

Most organisations and businesses, even very small entities, now use information technology
(IT) to some degree. The first use of a computerised accounting system is thought to have been
back in 1954 by General Electric, and rapid advances in computer technology since then are
allowing companies to conduct business globally, making them indispensable and essential to
an entity's operations.
However, the increasing use of computer systems brings with it certain risks to the business
which can also have an impact on the risk of the financial statements being misstated. These
risks have increased with the development of the internet in the last few years and with it the
facility for transactions to be conducted electronically.
11.2 Risks associated with the use of computerised systems

Cyber-security is becoming an increasingly important issue for businesses to address. The two
key business risks of organisations using computerised systems are as follows:
 The system being put at risk by a virus or some other fault or breakdown which spreads
across the system
 The system being invaded by an unauthorised user, who could then:
– affect the smooth operation of the system; or
– obtain commercially sensitive information.
Worked example: British Airways

In May 2017, IT failures at British Airways resulted in hundreds of flights at Heathrow and Gatwick C
airports being cancelled and thousands of passengers disrupted. There have been suggestions H
that the failure could have been avoided if the company had not outsourced its IT work. In 2016 A
P
the company made hundreds of its IT staff redundant and outsourced its IT services to India. The T
failure in May led to planes not being able to take off, baggage not being allowed to move and E
boarding passes not being able to be issued to passengers. R
A few days after the failure, the Chief Executive of British Airways' parent company stated that the 5
disruption had been caused by an engineer disconnecting a power supply, leading to a power
surge when it was reconnected.

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Worked example: NHS

Also in May 2017, the NHS was affected by a global cyber attack which resulted in patients'
operations being cancelled, ambulances being diverted and some patient records being
unavailable in England and Scotland. The attack affected not just the UK but almost 100 other
countries and originated from malware that was using technology stolen from the National
Security Agency in the USA. The malware blocks access to PC files until a ransom is paid, in this
case $300. There was no confirmation from the UK government that NHS patient data had been
backed up. The attacks used software called WanaCryptor 2.0 or WannaCry which made use of a
vulernability in Windows – Microsft had issued an update to fix this in March 2017 but not all
computers had installed this.
Risks and relevant controls related to cyber-security are dealt with in more detail in Chapter 7.
11.3 Systems audit

As part of any audit, auditors are required to assess the quality and effectiveness of the
accounting system. Increasingly, this necessarily includes a consideration of the computer
systems in place within the organisation.
The following are the key areas they are likely to concentrate on to establish how reliable the
systems are:
 Management policy
 Segregation of duties
 Security
You should be aware that these are important control considerations in a computer
environment. The details that the auditor will consider within each area are outlined below.
Management policy
 Does management have a written statement of policy with regard to computer systems?
 Is it compatible with management policy in other areas?
 Is it adhered to?
 Is it sufficient and effective?
 Is it updated when the systems are updated?
 Does it relate to the current system?
Segregation of duties
 Is there adequate segregation of duties with regard to data input?
 Are there adequate system controls (eg, passwords) to enforce segregation of duties?
Security
 Is there a security policy in place?:
– Physical security (locked doors/windows)
– Access security (passwords)
– Data security (virus shields)
 Is it adhered to?
 Is it sufficient and effective?
11.4 Internal controls in a computerised environment

ISA 315 specifically requires the auditor to gain an understanding of the entity's accounting
systems and control environment as part of the risk assessment process at the planning stage of
the audit. Today, almost any accounting system and control an auditor will encounter will involve
some form of IT.

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The management policies, segregation of duties and security issues established by the
organisation are examples of the internal control activities in a computerised environment.
There are two categories of internal controls: general controls and application controls.
General IT controls are the policies and procedures that relate to many IT applications at the
same time. They support application controls by maintaining the overall integrity of information
and security of data. Examples include procedure manuals, password protection and back-up
facilities.
Application controls are manual or automated procedures that typically operate at a business
process level and apply to the processing of transactions by individual applications. They are
designed to ensure the integrity of the accounting records: that transactions occurred, are
authorised, and are completely and accurately recorded and processed. Examples include edit
checks of input data and numerical sequence checks with manual follow up of exception
reports.
You should already be familiar with these two types of controls from your earlier studies. We will
look at them in further detail in Chapter 7.
Worked example: EY GAM

The Big Four accountancy firm EY has developed its own Global Audit Methodology (EY GAM)
which is applied by its audit teams worldwide. EY GAM sets out a risk-based approach to audit,
accessed via the firm's internal email server, that includes the following:
 Requirements: the firm's typical audit process
 Supplementary guidance: requirements and guidance on specific situations that may arise
in the course of an audit
 Supporting forms, templates and examples: checklists and working paper templates to
document audit procedures, as well as best practice illustrations
The figure below shows a simplified version of the EY GAM Roadmap. As you can see, EY GAM
covers the entire audit process, from preliminary client engagement procedures through to
archiving the audit work papers. The requirements, guidance and templates relating to each
part of the process are classified into specific steps: clicking on the tab relating to 'determine
PM, TE, and SAD nominal amount', for example, will open a database of information relating to
the determination of materiality levels.
Planning and risk Strategy and risk Conclusion and

identification assessment Execution reporting
Identify SCOTs, significant
Complete preliminary disclosure processes and related IT
Understand service requirements, determineaudit scope, and establish the team
engagement activities applications Execute tests of controls Prepare summary of audit

Understand differences
Team planning event and discussion of fraudand error
SCOTs and Sig

disclosure Understand and
Understand the business processes evaluate the
Reassess combined risk assessments
FSCP Execute tests of journal entries

and perform other mandatory Perform financial statement
Perform
fraud procedures procedures
walkthroughs
Wrap-up the engagement
Determine the need for Understand

specialized skill on the team
Post-interim event
ITGCs
Select controls Design and Prepare summary review
to test execute tests of memorandum
Understand entity-level ITGCs Update tests Update tests
controls of controls of ITGCs
Evaluate ITGCs
Identify risks of material Make combined risk assessments

Perform overall review and C
approval
misstatement due to fraud H
and determine responses Design tests of controls
A
Design tests of journal entries and Prepare and deliver client P
Determine PM, TE, and SAD other mandatory fraud procedures Perform substantiveprocedures communications
nominal amount T
Design Plan general
substantive audit
E
Identify significant accounts procedures procedures
Perform general audit Complete documentation and R
and disclosures and relevant procedures archive engagement
assertions
Prepare audit strategies memorandum
5
Figure 5.8: EY GAM Roadmap

(Source: https://acra.gov.sg/uploadedFiles/Content/Public_Accountants
/Professional_Resources/Conference_Materials/2012/03TanSengChoon.pdf)

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EY GAM is supplemented by GAMx, the audit support platform designed to ensure consistent
application of the firm's audit methodology. GAMx provides a secure online team-collaboration
environment where the audit team members create, record, review and share the results of audit
procedures and conclusions. A chat function allows audit team members to communicate with
each other in real time without having to log on to the firm's intranet – a useful thing at certain
client sites!
Besides GAMx, a variety of in-house analytics and audit sampling tools provide a range of
computer-assisted audit techniques that audit teams can use.
EY's Transparency Report 2013, setting out its audit methodology and quality assurance
systems, can be found via this link:
www.ey.com/Publication/vwLUAssetsPI/UK_Transparency_Report_2013/$FILE/EY_UK_Transpar
ency_Report_2013.pdf
The report (page 19) points out that "EY GAM [...] emphasises applying appropriate professional
scepticism in the execution of audit procedures." Accordingly, the walkthrough template
embedded in EY GAM contains specific sections requiring the audit team to consider whether
any observations noted during the walkthrough of controls indicate the potential for
management override of controls. Audit teams are required to complete a checklist, confirming
that they have applied professional scepticism while carrying out audit procedures.
12 Big data
Section overview
Big data is a broad term for data sets which are large or complex.
12.1 Big data

Advances in technology have helped to make data an increasingly important resource in
business. Making use of the insights that can be gained from data analysis has made data
management a strategic issue for many organisations. The increased emphasis on the
importance of data has given rise to the now widely used terms of big data and data analytics
(Data analytics is discussed in more detail in section 13). As businesses have changed the way
that they use data, auditors have had to respond to the opportunities and challenges that this
development has created.
Definition
Big data: A term that describes those "datasets whose size is beyond the ability of typical
database software to capture, store, manage and analyse." (McKinsey Global Institute, Big data:
The next frontier for innovation, competition and productivity, 2011).
Today, organisations have access to greater quantities of data than in the past, with vast
amounts of transactional data available from a number of internal and external sources, such as
suppliers and customers.
The growth in the amount of data now available has been largely fuelled by increasing internet
usage and by developments in communication methods such as wireless networks, social media
sites and smartphones. An increasing number of organisations have embraced the so-called
'internet of things' by embedding sensor technologies, such as RFID tags (Radio Frequency

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Identification) and tracking devices, into their operations to gather data from a diverse range of
activities. Companies including British Gas, an energy supplier in the UK, have introduced so-
called smart meters as a way of measuring the amount of electricity consumers are using on a
daily basis. Such meters also allow home owners to better manage their household energy costs
as the meter records and wirelessly transmits the level of energy consumption back to the
energy provider.
Leading data analytics software firm, SAS, offers the following explanation of big data.
"Big data is a term that describes the large volume of data – both structured and unstructured –
that inundates a business on a day-to-day basis. But it's not the amount of data that's important.
It's what organisations do with the data that matters. Big data can be analysed for insights that
lead to better decisions and strategic business moves."
(Source: SAS, Big data – What it is and why it matters. [Online] Available at: www.sas.com)
12.2 Features of big data

As explained in the ICAEW IT Faculty document Big data and analytics – what's new? big data is
often characterised by the 3 Vs:
 Large volumes of data
 High-velocity data
 Wide variety of data
Doug Laney, an analyst with technology research firm Gartner, also suggests that big data can
be defined with reference to the three Vs of volume, velocity and variety.
Volume
The vast quantities of data generated are a key feature of big data. Advances in technology and
data analytics software have enabled very large data sets to be processed. This is helping
organisations to gain a deeper understanding of customer requirements. For example,
organisations can collect large amounts of external data about their customers from customers'
use of the internet and social media. This data can now be combined with internally generated
data for example, from customer loyalty cards or transactions recorded at shop tills, to build up
a more detailed profile of the customer. The volume aspect of big data has challenged the
strategic capabilities of many organisations wishing to exploit its potential. Most notably, these
have involved enhancing existing IT infrastructures through the use of cloud computing
architectures so that they are capable of holding greater amounts of data.
Velocity
Velocity refers to the speed at which 'real time' data flows into the organisation and the speed at
which the data is processed by the organisation's systems to produce a meaningful output.
Many online retailers have developed capabilities which enable them to record the movements
and 'clicks' made by a customer when using the organisation's website. As such, online retailers
are now able to build up a better picture of those products and services the customer found
most interesting as opposed to only recording the final sale transaction with the customer.
C
Analysing the customers' clicks while still visiting the website has enabled online retailers to H
recommend relevant additional items for purchase based on those items already viewed. Online A
websites including Amazon and eBay use this tactic to encourage customers to make extra P
T
purchases. E
R
Variety
5
Variety is concerned with the diverse range of forms that big data can take. An increasing
amount of data generated comes in an unstructured form, ie, data which is not easy to hold in a
database. Unstructured data may take the form of words used by people on social media sites
such as Facebook and Twitter, along with shared content such as photographs or video

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recordings. Capturing, processing and storing unstructured data presents further challenges to
organisations which may need to develop their existing IT/IS capabilities to be able to firstly
store such data and secondly extract meaning from the data they hold. Data which is too large,
moves too fast or fails to fit neatly with existing IT infrastructures reduces the value which can be
derived from it.
The three Vs of big data can also be extended to include an additional characteristic: veracity.
Veracity
Veracity (value) is concerned with the truthfulness of the data collected. For data to have any
value when being used for decision-making in an organisation, it needs to be truthful, ie, it must
not present a bias or contain inconsistencies. The use of poor quality data may have expensive
and far reaching consequences for those organisations which rely on it for making strategically
important decisions. For example, an organisation may decide to introduce a type of product in
the belief that there is sufficient customer demand for it when in reality this may not be the case.
The trend in big data is being propelled by three factors: a growth in computer power, new
sources of data and infrastructure for knowledge creation. The combination of these three
factors is enabling businesses to use data in ways which were not previously possible or viable.
In particular they are using big data to:
 gain insights eg, using more granular data about customers;
 predict the future eg, customer service functions personalise services based on predictions
about individual customers; and
 automate non-routine decisions and tasks eg, using machine learning techniques to
automate a medical diagnosis.
Like business, auditors have had to respond to the changing environment brought about by big
data. Historically auditors have reviewed structured data (eg, transactions recorded in the
general ledger) however the analysis of unstructured data can provide new insights (eg, data
extracted from emails, texts and social media). Audit firms have invested heavily in recent years
in data analytics tools which will enable them to use this data to better understand their clients,
identify risks and add value.
13 Data analytics and artificial intelligence (AI)
Section overview
Some firms are currently investing in data analytics to provide a better quality audit and to
reduce risk and liability for the auditor. Recent developments in artificial intelligence (AI) have
made this kind of technology more sophisticated thus increasing its potential.
13.1 Data analytics

Large firms in particular have been developing a data analytics offering with many clients now
expecting their auditors to adopt this approach. However with the growing range of generic
data analytics tools becoming available it is also becoming more relevant to small and medium
sized firms too.
There are many definitions of data analytics.

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Definitions
Data analytics: The process of collecting, organising and analysing large sets of data to discover
patterns and other information which an organisation can use for its future business decisions.
Closely linked to the term data analytics is data mining.
Data mining: The process of sorting through data to identify patterns and relationships between
different items. Data mining software, using statistical algorithms to discover correlations and
patterns, is frequently used on large databases. In essence, it is the process of turning raw data
into useful information.
The ICAEW Audit and Assurance faculty document Data analytics for external auditors describes
data analytics as follows:
"Data analytics involves the extraction of data using fields within the basic data structure, rather
than the format of records. A simple example is Power view, an Excel tool which can filter, sort,
slice and highlight data in a spreadsheet and then present it visually in variety of bubble, bar and
pie charts."
In simpler terms data analytics is about examining raw data with the purpose of drawing
conclusions about it. The Audit and Assurance faculty document identifies the following as
commonly performed data analytics routines:
 Comparing the last time an item was bought with the last time it was sold, for cost/NRV
purposes
 Inventory ageing and how many days inventory is in stock by item
 Receivables and payables ageing and the reduction in overdue debt over time by customer
 Analysis or revenue trends split by product or region
 Analyses of gross margins and sales, highlighting items with negative margins
 Matches of orders to cash and purchases to payments
 'Can do did do testing' of user codes to test whether segregation of duties is appropriate,
and whether any inappropriate combinations of users have been involved in processing
transactions
 Detailed recalculations of depreciation of fixed assets by item, either using approximations
(such as assuming sales and purchases are mid-month) or using the entire data set and
exact dates
 Analyses of capital expenditure v repairs and maintenance
 Three-way matches between purchases/sales orders, goods received/despatched
documentation and invoices
Data analytics can also draw on external market data as well as internal data, for example third-
party pricing sources and foreign exchange rates can be accessed to recalculate the valuation of
investments. ('Coming your way' by Katherine Bagshaw and Phedra Diomidous, Audit and
C
Beyond, 2016).
H
Data analytics can analyse unstructured data as well as structured data. For example an analysis A
P
of emails could be a more effective means of identifying fraud than an analysis of journals. Data T
analytics tools allow the auditor to analyse this type of information in a level of detail which E
would not be possible manually. R

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13.2 Improved audit quality

One of the key drivers behind the use of data analytics is improved audit quality. The Audit and
Assurance faculty document identifies the following as the unique features of data analytics
which contribute to improved risk assessment:
 The ability to graphically visualise results: this makes it easier to drill down to the underlying
data and obtain a better understanding of findings
 Sophistication, and the breadth of interrogation options: this includes wide-ranging query
and filter options
 Ease of use by non-specialists: the identification of anomalies, outliers and trends could
highlight issues that would otherwise have gone unnoticed
 Scale and speed: resulting in time efficiencies
By using data analytics tools the auditor can navigate much bigger data sets much faster than
before so that while the analyses performed are not fundamentally different to those performed
in the past they are now at a more granular level. The quality of the analyses is enhanced and
therefore the judgments made on the basis of this information are enhanced too.
For example, the following is taken from PwC's 'Halo for Journals'
Figure 5.9: Example of data analytics tools

(Source: ICAEW Audit and Assurance Faculty: Data analytics for external auditors
(Illustration from PwC Halo))
This might suggest that someone from outside the department is posting journals. Data analytics
can be used to 'drill down' into the data in order to identify which journals need to be tested. In
this way substantive procedures are better directed.
Example 1: Extract and examine all journal entries credit entries to the Revenue Account where
the corresponding debit is not either receivables or cash (which would be the normal expected
entries). These extracted exceptions can then be investigated.
Example 2: Extract and examine all journal entries which are: Dr PPE account; Cr an expense
account. This would be an unusual entry in the normal course of business and there is a risk of
creative accounting by capitalising expenditure that should be expensed. These can be
investigated including requiring management explanations.
The Audit and Beyond article also highlights the role of data analytics in supporting the
application and demonstration of professional scepticism. For example, predictive data analytics
tools might be used to help assess the reasonableness of management representations.
A recent article by KPMG 'Data, Analytics and Your Audit' discusses the impact of big data and
how it affects auditors. The article emphasises that the use of data by auditors is not a new thing by

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any means since auditors have always had to analyse data. Data analytics allows auditors to
analyse data at much greater speeds than before. For example, data analytics will allow auditors to
sample much higher volumes of transactions up to 100% in some cases, which will allow auditors
to identify high risk transactions over a vast array of data and in minutes rather than over weeks.
The article cites the example of a clothing retailer and shows how data analytics can allow auditors
to evaluate the three-way match between purchase orders, delivery confirmations and invoice
documentation in a graphical way that can show account relationships and transaction flows and
control issues over segregation of duties. Data analytics can also be used to examine supplier
relationships (supplier contracts, payment terms, controls over procurement processes etc).
The article includes a very useful table on the use of data analytics which is shown below.
Area Use of data analytics
Revenue and accounts receivable Identify discrepancies in price and quantity

between invoices, sales orders and shipping
documentation
Identifies stockouts and customer orders
coming in faster than shipped products
Segregation of duties Identifies areas of increased risk
Highlights internal control deficiencies
through inefficient segregation of duties
Purchases and accounts payable Identifies significant or unusual items such as
invoice price discrepancies against original
purchased products
Shows purchase trends and activities with
suppliers that are unauthorised or where
there are concentrations of spending
activities
Supply chain Identifies risks resulting from the
concentration of suppliers in a particular
region
Can highlight possible issues if suppliers are
affected by regional disruptions
13.3 Technical challenges

While data analytics can be seen as the solution to many problems it is also the cause of new
ones.
13.3.1 Data capture, extraction, validation and transformation

In order to apply data analytics effectively the auditor needs to be able to extract data from the C
H
client's system in a usable format. In order to do so they need to be able to interface with clients'
A
systems. This can involve a considerable amount of investment in mapping different systems, P
particularly where they are bespoke to the client. T
E
The issue of 'transformation' also has to be addressed. This relates to the way in which data is R
made useable. This normally involves changing the data by simplifying it. Before changes are
5
made careful thought is required regarding the impact this will have on the quality of the
evidence.

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13.3.2 Data protection

Confidentiality and security of information are critical issues. This is particularly the case where
there is the potential for the creation of new personal data when analyses refer to individuals. In
these cases the auditor must ensure that relevant data protection laws and regulations are
complied with.
13.3.3 Quality
Data analytics tools must be developed to the highest quality assurance standards. As the Audit
and Assurance Faculty document indicates procedures should include pilot and parallel running
with the 'normal' audit process together with contingency plans should the software crash.
There also need to be proper controls to ensure that individuals using the tools are using them
properly.
13.3.4 Data retention

The audit process has always allowed the auditor access to and retention of information which is
not its own. However the scope of data analytics is such that the volume has reached a new
scale. While there are differing views about the amount of information that should be retained
and how long it should be kept there is a consensus that 'If an item has been tested, information
about it should be retained such that it could be identified again if necessary'.
13.4 Data analytics and auditing standards

Current auditing standards are risk-based. They require risk analysis, controls testing and
sampling against a 'materiality' benchmark. It could be argued that data analytics and its
possibilities challenges these concepts and therefore the audit itself. Two aspects of the audit in
particular are potentially affected as the technology is developing:
Tests of controls
ISAs require evaluation and testing of controls where the auditor is to rely on them, as a means
of obtaining comfort that transactions processed by the system are properly recorded in the
financial statements. However if auditors are able to use data analytics tools which allow them to
see what has happened to all of the transactions and these tools show that they are properly
valued and recorded why would the auditor need to test the controls applied in the system?
Sampling
Sampling has historically been adopted on the basis that it is not cost-effective (or necessary if
risk assessment has been performed) to audit 100% of all balances in the financial statements.
Again data analytics could challenge this principle. For example if it is possible to examine 100%
of the invoices automatically, both cheaply and efficiently why would the auditor choose to
examine only a sample?
13.5 Current developments
13.5.1 IAASB Request for input

The IAASB has set up a Data Analytics Working Group to determine how developments in IT
including data analytics might be reflected in new or revised standards. In September 2016 it
issued Request for input: Exploring the growing use of technology in the audit, with a focus on
data analytics. This aimed to inform stakeholders of the ongoing work by the IAASB in this area,
but also to obtain stakeholder input, particularly with respect to whether all of the relevant
considerations have been identified.
It makes the following points.

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Data analytics and the financial statement audit – benefits

 The quality of the financial statement audit can be enhanced by the use of data analytics.
 The use of data analytics enables the auditor to obtain a more effective and robust
understanding of the entity (in an increasingly complex and high volume data environment),
improving the application of professional scepticism and professional judgement.
 The auditor is able to obtain audit evidence from the analysis of larger populations.
 The auditor obtains a better insight into the entity and its environment which in turn
provides the entity with additional information to inform its own risk assessment and
business operations.
Data analytics and the financial statement audit – limitations
 Auditors need to have a clear understanding of the data they are analysing and in particular
the relevance to the audit.
 Being able to test 100% of a population does not change the fact that reasonable assurance
is provided.
 The use of data analytics does not replace the need for professional judgement and
professional scepticism, particularly in relation to accounting estimates and qualitative
information.
 Care must be taken not to have 'overconfidence' in technology ie, adopting the attitude
that if a computer software program produced it, it must be right.
Technology and the ISAs
 The ISAs do not prohibit, nor stimulate, the use of data analytics.
 ISAs need to be robust and relevant, however they must be based on principles which drive
appropriate auditor performance rather than being tied to current practice or trends.
 Technology solutions can increase the amount of time which auditors can spend on
judgemental aspects of analysis as the amount of time spent on manual analysis is reduced.
 There is a current challenge to fit audit evidence derived from data analytics into the current
audit evidence model set out in the ISAs.
 A lack of reference to data analytics in ISAs (with the exception of CAATs) may act as a
barrier to their adoption more widely.
 The lack of reference in ISAs to data analytics could also suggest that their use does not
reduce the procedures required by ISAs, even where these may appear to have been made
redundant as a result of the information gained from the use of data analytics.
 Risks arise where new techniques are used for which there is no strong framework within
the standards.
Unanswered questions
The IAASB document identifies a number of unanswered questions and challenges.
Data acquisition C
H
Entity data being transferred to the auditor raises security and privacy issues together with A
P
storage problems for large volumes of data. T
E
Conceptual changes R
The approach, information required and questions asked of the client may be quite different to
5
the traditional approach which may be challenging for the client.

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Legal and regulatory challenges

These may relate to data security and potential restrictions on data being transferred from one
jurisdiction to another.
Resource availability
There may not be sufficient centralised resources with the required IT expertise to support the
engagement teams.
Maintaining oversight
There are challenges for oversight authorities and regulators who may have little experience of
data analytics themselves.
Investment in re-training
Training will be required to change the auditor's mind set to that required where data analytics
has been used.
Next steps
The IAASB states that an evolutionary, rather than revolutionary process should be adopted.
ISAs need to take account of the changing technological developments but care must be taken
not to commence standard-setting activities prematurely to avoid unintended consequences.
(Source: Request for Input: Exploring the Growing Use of Technology in the Audit, with a Focus
on Data Analytics, IAASB, 2016. Available from:
www.ifac.org/system/files/publications/files/IAASB-Data-Analytics-WG-Publication-Aug-25-
2016-for-comms-9.1.16.pdf [Accessed 14 March 2017])
13.5.2 FRC Audit Quality Thematic Review

In January 2017 the FRC issued Audit Quality Thematic Review: The Use of Data Analytics in the
Audit of Financial Statements. The purpose of this review was to look at firms' policies and
procedures in respect of data analytics and to make comparisons between firms to identify areas
of good practice and areas of weakness. The review was based on the use of audit data analytics
at the six largest firms in the UK: BDO LLP, Deloitte LLP, Ernst & Young LLP, Grant Thornton UK
LLP, KPMG LLP and KPMG Audit plc and PricewaterhouseCoopers LLP.
Use of data analytics
The review document notes that the use of data analytics in the audit is not as prevalent as the
market might expect. At the time of the review the only standard tool used widely (ie, accepted
norm) by all six firms was journal entry testing. General ledger analysis/third party tools were
used regularly (ie, part of the standard auditor 'tool kit') by three firms, with two more using
them in a limited capacity. Revenue analytics tools were used widely by one firm and on a
limited basis by another whilst derivatives valuation tools were used regularly by one firm only.
Process analytics tools and impairment modelling tools were either used on a limited basis or
not at all.
Audit quality
The review identified that the use of audit data analytics could improve audit quality in a number
of ways including the following:
 Deepening the auditor's understanding of the entity
 Facilitating the focus of audit testing on the areas of highest risk through stratification of
large populations
 Aiding the exercise of professional scepticism
 Improving consistency and central oversight in group audits

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 Enabling the auditor to perform tests on large or complex data sets where a manual
approach would not be feasible
 Improving audit efficiency
 Identifying instances of fraud
 Enhancing communications with audit committees
From its observations of specific applications the Review team observed the following examples
of audit data analytics being used to produce good quality audit evidence:
 Tracing individual revenue transactions to debtors and subsequent cash received
 Reproduction of debtors aging
 Valuation of financial instruments
 Tracing supplier income to agreements and cash received
 Recalculation of fund management fees based on value of assets under management
Data capture for use in audit data analytics
The review notes that 'effective and efficient data capture is the key to the successful use of audit
data analytics'. At an early stage the audit team needs to ascertain whether the quality of the
data that can be provided by the entity's management is sufficient to support the analytic which
is to be used. In many instances specialist staff may be used to perform data capture and this
may mean that the audit team, the data analytics specialists and the data may be in different
geographical locations. This may create issues in relation to data governance, security and
privacy.
Appropriate use of audit analytics tools
The Review document states that 'Audit teams need to have a clear understanding of the
purpose of the audit data analytics technique to ensure that they obtain sufficient and
appropriate audit evidence'. This is of particular relevance at the planning stage of the audit.
The Review indicates that the following areas need to be considered when deciding whether to
use an audit data analytics tool:
 Whether the tool is a 'good match' for the client's specific environment
 The need to ensure that all relevant assertions are still covered for the balance being tested
 Whether testing in other areas needs to be flexed to provide the necessary supporting
evidence for the use of audit data analytics
Evidencing of audit data analytics
The Review emphasises the point that audit documentation should enable an experienced
auditor to understand the nature, timing and extent of the audit procedures performed,
including where data analytics have been used. In particular it notes that the data analytics
specialists must be considered as part of the audit team. Auditing standards in relation to
evidence and documentation therefore cover the data analytics specialists' work as they do any
other audit work.
C
H
A
P
T
E
R

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13.5.3 Artificial intelligence (AI)
Definitions
Artificial intelligence (AI): Technology to help improve decisions made by machines, based on
machine learning, in an attempt to make better decisions than humans can. AI requires pattern
recognition and learning, rather than relying on a series of complex rules, so is not the same as
expert systems, which failed to grasp the complexities of the real world and were unable to
adapt to dynamic situations.
Current examples of AI include Amazon's Alexa and Apple's Siri where small digital devices are
able to respond to voice commands when completing requests such as online searches and
connection to other smart devices (such as those that might control lighting and heating in a
house).
AI is also starting to have more widespread use in driver-less cars and forecasting algorithms for
companies. AI needs to consider both forms of decision-making: intuitive (based on instincts)
and reasoned (based on logic).
There are similarities to the 'dot com' boom at the start of the 21st century because no-one is
really sure how far the possibilities afforded by AI could go.
AI and auditors – opportunities and issues
There is an increasing role of AI as part of audit data analytics, in automated and smart auditing
of populations, not just samples, thus reducing human error. AI-driven data analytics offer
efficiencies, better insight and added value for both accountants and their clients as they can
handle large data volumes while the system learns but it will not get tired or make mistakes. AI
could support stronger forensic auditing techniques as well (see Chapter 25).
Accountancy applications exist too, such as increased automation in transaction processes and
systems, greater analysis of data to differentiate between 'rogue' (eg fraud) and 'normal' activity
and better predictions and forecasts on complex areas such as revenue.
AI is not 100% perfect though - what about unusual situations with little previous data to use for
this machine learning to occur? Currently, while it is in development, AI still requires significant
investment to become mainstream and effective and for auditors to be able to direct this AI and
interpret its findings.
Nonetheless, there is still great potential (indeed, there may be no choice to adopt once it gains
enough traction) which will lead to change and adaptation in the profession: there could be less
backward-looking review, and more forward-looking advisory work instead. There could even
be scope to determine further uses of AI, such as whether AI can apply professional scepticism
without a human's judgement present.

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Summary
Audit planning
Professional Understanding
scepticism the entity
Risks: Use of Risk Materiality Performance

• System breakdown IT assessment materiality
• Unauthorised access
Internal controls:
• General IT controls Business Audit
• Application controls risk model risk model
Data analytics
Financial risk Responding to Risk of material
Operating risk assessed risk misstatement
Compliance risk Detection risk
Creative
accounting
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Self-test
1 Gates Ltd
You are an audit senior at Bob & Co and have received the following email.
From: Roy Bob, Audit partner
To: Jackie Smith, Audit senior
Subject: Gates Ltd
We are about to take on the audit of Gates Ltd, a wholly owned subsidiary of a US parent
company.
Gates Ltd produces computer software for the military for battlefield simulations. It also
produces 'off the shelf' software products for other customers. I am concerned about the
accounting issues related to these products. Based on the following information, would you
please identify and comment on the accounting issues.
 The military software usually takes at least three years to develop. The military insists
on fixed price contracts. Once the software has been authorised for use by the
customer, Gates Ltd supplies computer support services, which are charged on the
time spent by the software engineers on site.
 The 'off the shelf' packages are not sold to customers, but are issued under a licence
giving the right to use the software for a typical period of three years. The licence fee is
paid up front by customers and is non-refundable. As part of the licence agreement
Gates Ltd supplies maintenance services without additional charge for the three-year
period.
Again, based on the above regarding the military software and the 'off the shelf' packages,
please can you also set out the audit issues arising.
As a firm we are keen to adopt cutting-edge audit techniques and are in the process of
developing data analytics software. I am considering the use of data analytics tools for the
audit of Gates Ltd next year and am due to discuss this idea with the audit committee next
month. As an IT company itself, the board of Gates Ltd is very interested in this approach. I
am putting together some initial thoughts for my meeting and would like you to make some
short notes for me, setting out the benefits and challenges of using data analytics as an
audit tool.
Requirement
Respond to the partner's email.
2 Suttoner plc
Suttoner plc (Suttoner) operates in the food processing sector and is listed on the London
Stock Exchange. You are a member of its internal audit department. The company
purchases a range of food products and processes them into frozen or chilled meals, which
it sells to major supermarkets in Europe and North America.
The company structure
The company sells food through five subsidiaries, each of which is under the control of its
own managing director who reports directly to the main board. Each subsidiary has
responsibility for, and is located in, its own sales region. The regions are the UK, the rest of
Western Europe, Eastern Europe, the US and Canada. Food is produced in only two
subsidiaries, the UK and the US. Head office operates central functions, including the legal,
finance and treasury departments.

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The board has asked the managing directors of each subsidiary to undertake a risk
assessment exercise, including a review of the subsidiary's procedures and internal
controls. This is partly due to a review of the company's compliance with the provisions of
FRC's Guidance on Risk Management, Internal Control and Related Financial and Business
Reporting and also because Suttoner has been severely affected by two recent events and
now wishes to manage its future risk exposure.
Recent events
(1) In renegotiating a major contract with a supermarket Suttoner refused to cut its price
as demanded. As a result a major customer was lost.
(2) Later in the year the company had been cutting costs by sourcing food products from
lower-cost suppliers. In so doing it acquired contaminated pork which made several
consumers ill. A major health and safety inspection led to the destruction of all
Suttoner's pork inventories throughout Europe, due to an inability to trace individual
inventories to source suppliers. More significantly, many supermarkets refused to
purchase goods from Suttoner for several months thereafter.
As a result of these events the company's cash flow was severely disrupted, and significant
additional borrowing was needed.
The board's view
In guiding the risk assessment exercise, the board has set clear objectives for subsidiaries to
achieve: sales growth, profit growth and effective risk management. Additionally, the board
wishes to foster integrity and competence supported by enhancing human resource
development.
The board requires managing directors of each subsidiary to report to them annually on
these objectives and on internal controls. Otherwise, they have considerable autonomy on
pricing, capital expenditure, marketing and human resource management. The UK and US
subsidiaries, which process raw foodstuffs, are free to choose their suppliers. The other
three subsidiaries may purchase only from the UK or US subsidiaries.
Over a number of years each subsidiary has been managed according to the nature and
experience of its managing director, and this has resulted in different styles and levels of
control being established locally.
Email from the head of internal audit
From: Ben Jones

To: Joe Lyons
Subject: Risk assessment exercise
Joe,
As you know, we are scheduled to update our risk assessment exercise. Can you please
take the following on board for me and produce something by Wednesday afternoon?
Firstly, I need you to identify, classify and comment on the key compliance, operating and C
financial risks to which the company is exposed. On the back of this, can you then draft a H
A
note for the finance director to send to the other directors, advising them as to the extent
P
and the likelihood of the three most significant risks identified. For each of these, can you T
identify appropriate risk management procedures. E
R

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Finally, can you draft a note in accordance with the FRC's Guidance on Risk Management,
Internal Control and Related Financial and Business Reporting (formerly the Turnbull Report)
which we can put in our financial statements in relation to 'Control environment and control
activities'.
Cheers.
Ben
Requirement
Respond to the email from Ben Jones.

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Technical reference
1 ISA 210
 Agreement of terms of audit engagements ISA 210.9
ISA 210.10,
– Principal contents of the engagement letter A23–.25 &
Appendix 1
2 ISA 300
 Preliminary engagement activities ISA 300.6
 Planning activities ISA 300.7–.11
 Documentation ISA 300.12
3 ISA 315
 Risk assessment procedures ISA 315.5–.10
 Understanding the entity and its environment ISA 315.11–.24
 Assessing the risks of material misstatement ISA 315.25–.29
 Financial statement assertions ISA 315.A124
4 ISA 320
 Definition of materiality ISA 320.2
 Relationship between materiality and planning ISA 320.10–.11
5 ISA 330
 Overall responses to risk assessment ISA 330.5
– Response at assertion level ISA 330.6–.7
– Evaluation of sufficiency and appropriateness of evidence ISA 330.25
C
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(a) The risk is the risk of changes in value of the steel inventory due to changes in the price of
the commodity. This is a financial or market risk.
(b) The auditor would need to consider the following:
 Whether the futures contracts are to be used in a fair value hedge of the steel
inventory.
 Whether the required criteria have been met ie, the hedging relationship has been
formally designated and the hedge is 'effective'.
 Whether adequate documentation can be produced, including details of:
– identification of the hedging instrument;
– the hedged item;
– nature of the risk being hedged; and
– how hedge effectiveness will be calculated.
 If hedge accounting is to be used, the risk of incorrect accounting treatment. This risk is
increased due to the entity's lack of experience in dealing with this type of transaction.
 Whether the accounting rules of IFRS 9, Financial Instruments (or IAS 39 if those rules
are applied) have been complied with.
The derivative should be recognised as a financial asset at fair value and any gain
recognised in profit or loss.
 The way in which fair value has been established.
(a) Key risk (b) Controls to mitigate (c) Audit procedures
 Failure of internal R&D  Constant monitoring  Review of failed projects,

projects with exit strategies controls exercised and
timing of exit
 Write-off of any capitalised
R&D
 Excessive expenditure  Regular reviews of  Cost-benefit review

on R&D benefits against costs for
 Comparison to similar
each drug, each R&D
companies
unit and each period
 Review of R&D cost control
and budgetary procedures

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(a) Key risk (b) Controls to mitigate (c) Audit procedures
 Insufficient new drugs in  Monitoring effectiveness  Consider sustained going

the pipeline to sustain of R&D function concern
profitability
 Consideration of  Review plausibility of
adequate expenditure alternative strategies
levels
 Consider alternative
strategies (eg, increases
in generic drug
production)
 Alternative uses for
existing drugs
 Development of new  Consider effectiveness  Review patent registration

drugs by competitors of patent protection by other companies
 Consider possibility of  Review projected impact on
licensing client
 Quantification of effects  Consider writing off any
capitalised R&D
 Joint venture failure,  Clear contractual rights  Review contractual

disagreement or decline and obligations arrangements and technical
progress
 Transparency and
communication
 Technical monitoring of
procedures similar to
internal systems above
 Inadequate financial  Short-term and long-  Consider actual and

resources to sustain term financial budgets potential financial
R&D with actual and resources
contingent financing
 Evidence from bankers and
arrangements
other finance providers or
their agents
 Changes in health  Monitor political  Review trends in health

spending or health statements and policies spending and prospective
regulation by regulation in key markets
 Political lobbying
governments in major
 Review client's
geographical markets  Consider impacts of
governmental monitoring
changes on profitability
procedures and C
H
information gained
A
therefrom P
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Business risks faced by KidsStuff Ltd
 Exposure to foreign exchange risk if imports are not denominated in sterling.
 One major supplier – too reliant on one source.
 Distance from supplier makes resolving production errors more difficult.
 Children's toy market tends to be seasonal – could require significant working capital for
periods of the year.
 Strict health and safety rules over children's toys could be breached.
 May be heavily reliant on the skills of Joseph Cooper who will now be close to retirement.
 If unable to keep up with market trends the company will not be able to continue trading.
 Penetration of the computer games market would require significant investment which may
not pay off.
 The overdraft is likely to be an expensive form of financing.
 The overdraft could be withdrawn.
Effect of risks on the audit
 The going concern basis of preparation may not be appropriate due to many of the
business risks eg, reliance on overdraft.
 Payables, purchases and inventories could all be misstated if incorrect exchange rates are
used.
 Exchange gains and losses may be incorrectly accounted for or miscalculated.
 The overseas supplier is likely to have a material payables balance but evidence may be
difficult to obtain.
 Importing extends delivery times and makes cut-off more difficult to administer.
 Last year's toys in inventories may well be obsolete.
 Provisions may be required for fines or legal claims in respect of health and safety breaches.
 If the year end is pre-busy season, inventories are likely to be material.
 If the year end is post-busy season, receivables are likely to be material.
 The bank may use the accounts in determining whether or not to renew the overdraft – a
duty of care should be considered.
 Neil Cooper may bias the accounts to show an improved performance.
Further information required
 Management accounts for the year to date
 Budgeted results for the year
 Audited financial statements for the previous year(s)
 Correspondence from the bank regarding the overdraft
 Correspondence with the previous auditor regarding: previous audit issues
 Visits to client/notes to ascertain the client's systems
 Trade journals
 Health and safety legislation for the industry
 Minutes of board meetings
 Legal costs and correspondence with solicitors as evidence for litigation risk

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Risks associated with accounting treatment include the following.
 Nature of the contract
This contract is essentially a number of goods and services bundled into one contract. This
fact adds complexity to the accounting treatment and therefore adds risk. Where the
elements can be separated and sold as individual items they should be recognised as if
they were independent of each other. In this case it would be possible to sell the handset,
access to the network, the call minutes and the texts individually so separate recognition
would be appropriate.
 Revenue recognition policy not in accordance with principles of IFRS 15
A distinction will need to be made between the different elements of the package as these
are separate performance obligations. Revenue from the sale of the handset should be
recognised when this performance obligation has been met. This will normally be at the
point that the contract is signed and the customer takes receipt of the handset. Alternatively
if the handset is sent to the customer it will be at the point of delivery.
Use of the network would be treated as the rendering of a service. As the service is
provided equally over the 12-month period of the contract, the revenue attached to this
element should be recognised on a straight-line basis.
The free calls and texts would also be treated as the rendering of a service. However, this
service will not necessarily be received on an equal basis each month (as not all free
calls/texts may be used each month and may be carried over). The allocation should be
based on the best estimate of how the free calls and texts will be used over the life of the
contract. This will involve a large amount of estimation which increases audit risk. Where the
allocation can be based on historical information eg, average usage on similar packages
risk will be reduced.
 Each component of the package may be valued incorrectly
The package is effectively a bundle of goods and services with a fair value of £500 sold at a
discount of £140 (£500 – £360). If there is a specific discount policy this should be applied
to the individual components. For example, the whole of the discount could relate to the
handset, in which case the whole of the discount would be deducted from the fair value of
the phone. If there is no specific policy an alternative allocation method would be required
eg, on a pro rata basis. The auditor would need to ensure that the basis used is reasonable.

Audit risks
 Inherent
– Related party transactions/group issues
– Receivables
C
– Fraud – possible indicators, professional scepticism H
– Profit-driven management A
– Credit extended – accounting/law and regulations P
T
 Control E
R
– Lack of segregation of duties
5
– PC/virus
– Suspicion of fraud?
– Key man

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 Detection
– First audit
– Opening balances and comparatives – audited?
Audit risks – inherent
Related parties and group issues
Forsythia is part of a complicated group structure. This raises several issues for the audit:
 There is a risk of related party transactions existing and not being properly disclosed in the
financial statements in accordance with IAS 24.
 Similarly, there is a risk that it will be difficult to ascertain the controlling party for disclosure.
 There are likely to be some group audit implications. The firm may be required to
undertake procedures in line with the group auditors' requirements if Forsythia is to be
consolidated.
Receivables
Forsythia is a service provider, and it extends credit to customers. This is likely to mean that
trade receivables will be a significant audit balance. However, there is limited audit evidence
concerning trade receivables due to the effects of a computer virus. There are also indicators of
a possible fraud.
Fraud?
There are various factors that may indicate a sales ledger fraud has taken/is taking place:
 Lack of segregation of duties
 Extensive credit offered
 The virus only destroyed sales ledger information – too specific?
 Poorly paid sales ledger clerk – with expensive lifestyle
 Sales ledger clerk is daughter of rich shareholder and they do not have a good relationship
None of these factors necessarily point to a fraud individually, but added together raise
significant concerns.
Profit-driven management
Mr Rose is motivated for the financial statements to show a profit for two reasons:
 He receives a commission (presumably sales driven, which impacts on profit).
 He receives dividends as shareholder, which will depend on profits.
There is a risk that the financial statements will be affected by management bias.
Credit extended
We should ensure that the credit extended to customers is standard business credit. There are
unlikely to be any complications, for example interest, but if there were, we should be aware of
any laws and regulations which might become relevant, and any accounting issues which would
be raised.
Audit risk – control
There are three significant control problems at Forsythia.
Segregation of duties
There appears to be a complete lack of segregation of duties on the three main ledgers. This
may have led to a fraud on the sales ledger. The fact that there is no segregation on payroll is
also a concern, as this is an area where frauds are carried out.

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Lack of segregation of duties can also lead to significant errors arising and not being detected
by the system. This problem means that control risk will have to be assessed as high and
substantial substantive testing be undertaken.
Personal computer
A PC is used for the accounting system. This is likely to have poor built-in controls and to further
exacerbate the problems caused by the lack of segregation of duties.
The security over PCs is also often poor, as has been the case here, where a virus has destroyed
evidence about the sales ledger.
Key man
The fact that Mr Rose is dominant in management may also be a control problem, as he can
override any controls that do exist. There are also risks if he were ever to be absent, as most
controls appear to operate through him and there are no alternative competent senior
personnel.

Home delivery sales
The appropriate benchmark of materiality with regard to the home delivery sales is revenue, as
the home delivery sales form part of the total revenue of the company.
£0.6 million is 1.4% of the total revenue for 20X6 (see W1 below).
An item is generally considered to be material if it is in the region of 1% of revenue, so the home
delivery services are material.
Provision
The appropriate benchmark of materiality with regard to the provision is total assets and profit,
as the provision impacts both the statement of financial position (it is a liability) and the
statement of profit or loss and other comprehensive income (it is a charge against profit).
£0.2 million is 0.65% of total assets in 20X6 (see W2 below). As an item is generally considered
to be material if it is in the region of 1–2% of total assets, the provision is not material to the
However, £0.2 million is 11% of profit before tax for 20X6 (see W3 below). An item is considered
material to profit before tax if it is in the region of 5%. Therefore, the provision is material to the
statement of profit or loss and other comprehensive income.
WORKINGS
0.6 million
(1)  100 = 1.4%
42.2 million
0.2 million
(2)  100 = 0.65%
30.7 million
C
0.2 million H
(3)  100 = 11% A
1.8 million
P
T
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 Although the materiality calculation is based on a benchmark commonly used ie,
percentage of profit before tax, in this case the resulting figure does not seem appropriate.
 This is due to the fact that the profit figure of the business is volatile (£300,000 in the
previous year) and does not seem to be representative of the size of the business in terms
of its assets or revenue.
 In instances like this where the company is close to breaking even, total assets or revenue
may be a more suitable basis. Alternatively, if profits are to be used, an average figure over
a number of years would give rise to a more appropriate materiality balance.
 Materiality as it is currently set is extremely low. The consequence of this is that it would
result in substantially increased audit procedures which would be inefficient.

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1 Gates Ltd
Accounting issues
(a) Military contracts
Long-term contract accounting
The software development should be accounted for under IFRS 15, Revenue from
Contracts with Customers. Specifically, it is a fixed price contract, ie, where the revenue
arising is fixed at the outset of the contract. Under such contracts there is an element of
certainty about the revenue accruing, but not about the costs which will arise. For a
fixed price contract the contractor should be able to measure reliably the total contract
revenues and be able to identify and measure reliably both the costs that have been
incurred and those that will be incurred to complete the project. The contractor should
also assess whether it is probable that payment will be received under the contract.
As the contracts are fixed price there is an increased risk of the contracts being loss-
making, and such losses must be provided for in full.
Computer support
As the amount billed relates directly to the hours spent on site, it would be appropriate
to recognise this as revenue when charged.
(b) 'Off the shelf' packages
Licence and maintenance costs
An argument could be proposed to recognise this revenue on receipt, given that it is
non-refundable, and paid after the development work has been completed and the
costs incurred.
However, under IFRS 15, Revenue from Contracts with Customers it is generally not
appropriate to recognise revenue based on payments received under the contract, as
stage payments set out under the terms of the contract often bear little resemblance to
the actual services performed. This is a contract in which a performance obligation (the
provision of services) is satisfied over time. Revenue relating to the licence should
therefore be recognised as the services are provided, ie as the performance obligation
is satisfied.
The maintenance costs should be recognised on a basis that reflects the costs incurred
which might be based on the frequency of maintenance calls, probably related to the
previous history of maintenance calls.
Audit issues
Inherent risks
 Given the nature of the business and the military contracts, physical and electronic C
security and controls are a major issue. H
A
 Long-term contract accounting involves significant judgements with respect to future P
T
contract costs. Judgement increases the likelihood of errors or deliberate E
manipulation. This area is particularly difficult to audit given the specialised nature of R
the business, and we will need to ensure that we have personnel with the right
5
experience assigned to the audit.
 There is a risk with long-term contract accounting of misallocation of contract costs –
particularly away from loss-making contracts.
 The maintenance provision is an estimate and, again, susceptible to error.

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Detection risks
 The nature of the military contracts may mean that we are unable to review all the
information because of the Official Secrets Act. This could generate a limitation on
scope.
Notes re data analytics
Benefits
 Enhanced audit quality
 Increased sophistication and breadth of interrogation options
 Enables us to obtain audit evidence from larger populations efficiently
 Analysis at a more granular level enhancing the basis on which judgements are made
 Results in a more effective and robust understanding of the entity improving the
application of professional scepticism and professional judgement
 Ability to graphically visualise results increasing ease of use and interpretation
 Provides the entity with additional information to better inform its own risk assessment
and business operations
Challenges
 We need to ensure that the development of the software is properly managed so that a
high quality audit tool is developed.
 There may be issues with data capture, extraction, validation and transformation.
 Need to consider security and privacy issues together with storage problems for the
large volumes of data.
 There may be restrictions on data being transferred from one jurisdiction to another.
 We may have insufficient in-house resources with relevant IT expertise to use the data
analytics software and/or to provide central support.
 Need to consider how we use data analytics whilst still complying with the
requirements of ISAs (which do not yet address the changes in approach brought
about by the use of data analytics).
 The use of data analytics changes the nature of the information required and questions
asked of the client. The client may find this challenging.
 We need to ensure that professional scepticism and judgement continue to be applied
and that we do not have 'overconfidence' in the technology.
2 Suttoner plc
Identification and classification of risks
Compliance risks
Health and safety regulations – Risk of closure of plant and/or destruction of food if
contamination arises from purchasing, processing, storing or distribution activities.
Accounting regulations – Need to comply with regulations in several different countries.
May need to restate for group accounting purposes to comply with IFRSs if those countries
have domestic GAAP that differs from IFRSs.
Taxation – Need to comply with tax regulations, particularly in respect of transfer pricing
between divisions in different countries.

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Litigation risk – Arising from the possibility of food poisoning. Risks include litigation
against the company by those individuals affected and for loss of reputation by
supermarkets.
Operating risks
Loss of major customers – Supermarkets may regularly renegotiate contracts and, in so
doing, find alternative suppliers. The loss of one such customer this year may be part of a
trend.
Power of customers to reduce price – Even where contracts with supermarkets are retained,
the renegotiation may be on less favourable terms, resulting in a loss of profits.
Lack of goal congruence by divisional MDs – Significant autonomy at divisional level may
mean reduced co-ordination and the pursuit of conflicting goals.
Geographically dispersed supply chain – Given that processing is concentrated in only two
centres, there are significant distances involved in the supply chain. This may lead to risks of
failure to supply on time and significant low temperature transport and storage costs.
Perishable nature of inventory – The deterioration of perishable food may involve several
risks, including inventory valuation, costs of inventory losses and unobserved perishing,
which may lead to further food poisoning and loss of reputation.
Measuring divisional performance (arbitrary transfer prices) – There is trade between
divisions arising from the supply of distribution divisions from processing divisions. As the
companies are separate subsidiaries, there are implications for attesting the profit of
individual companies, given the arbitrariness of transfer prices. Moreover, the impact of
transfer prices on taxation and their acceptance under separate tax regimes creates
additional risk in respect of the taxable profit of separate subsidiaries.
Control systems – The loss of inventory was greater due to the inability to trace the
contamination to specific inventories. This deficiency in inventory control systems magnifies
any effects from contamination risks of this type.
Generalised food scares – Food scares which are not specific to the company but which
arise from time to time may create a reluctance by consumers to purchase some types of
the company's product portfolio.
Financial risks
Foreign exchange risk – This includes economic, transaction and translation risk.
 Economic risk – refers to adverse movements in the exchange rate making goods less
competitive in overseas markets or making inputs relatively more expensive
 Transaction risk – refers to the situation where in the period between contracting and
settlement adverse movements in the exchange rate make the contract less profitable
 Translation risk – refers to the risk of the consolidated statement of financial position
showing the assets of overseas subsidiaries at a reduced value due to adverse exchange
rate movements C
H
Borrowing – gearing risk/liquidity – Increased financial gearing due to the additional A
borrowing in the year will make future earnings more volatile. P
T
Going concern problems if further contamination scares occur – The loss of business due to E
the contamination of one of the company's products meant that additional borrowing was R
needed: this may create questions of going concern if a further incident arises. 5
Control of financial resources at divisional level – The fact that divisional MDs have
significant autonomy has meant that different styles and methods of control have been
used. This may be a cause for concern about potential variations in control.

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BRIEFING NOTES
To: Finance Director
Prepared by: Internal auditor
Date: 6 November 20X1
Subject: Extent and likelihood of three key risks
Food scare
Low probability – if appropriate controls are put in place over food quality.
High impact – arising from loss of inventory, loss of reputation, possible loss of contracts/
customers, litigation risk, closure on health grounds.
Proposed course of action – quality control procedures, contingency plans, better inventory
identification to locate and minimise infected inventory.
Loss of customer
High probability – assuming that such contracts are being renegotiated on a regular basis.
Impact depends on whether:
 sales are concentrated with a few customers;
 new customers can be generated; or
 the loss of customers is systematic, in which case the cumulative impact may be
significant.
Proposed course of action – maintain customer relationships, compete on price and non-
price issues, develop a wider customer base.
Foreign exchange
High probability – some (and possibly significant) foreign currency movements over time
are very likely.
High impact – potentially, the effects of a major currency movement may be significant,
although this would depend on the actions taken to moderate such effects. There may also be
a favourable currency impact arising from East European currencies becoming more readily
acceptable in trading.
Proposed course of action – hedge in the short term (where appropriate and where the cost
of doing so is not significant), back to back financing (eg, borrow in US dollars to finance US
operations), consider acceptability of East European currencies before significant
development in these countries.
Notes to the financial statements
Control environment and control activities
The company is committed to ensuring that a proper control environment is maintained.
There is a commitment to competence and integrity, together with the communication of
clear objectives to all divisions. These are underpinned by a human resources policy that
develops quality with integrity.
The organisational structure has been developed to delegate authority with accountability
to ensure that control and consistency are maintained, having regard to an acceptable level
of risk. Managing directors report on the control environment on a regular basis to the
board. Moreover, the performance of each division is reported and reviewed regularly.
This year the board has undertaken a specific review to assess key risks and to ensure that
appropriate information and monitoring is being received.

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CHAPTER 6

audit evidence
Introduction
TOPIC LIST
1 Revision of assertions
2 Sufficient, appropriate audit evidence
3 Sources of audit evidence
4 Selection of audit procedures
5 Analytical procedures
6 Audit of accounting estimates
7 Initial audit engagements – opening balances
8 Using the work of others
9 Working in an audit team
10 Auditing in an IT environment
11 Professional scepticism in the audit fieldwork stage
Appendix
Technical reference

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Introduction
 Determine analytical procedures, where appropriate, at the planning stage using

technical knowledge of corporate reporting, data analytics and skills of financial
statement analysis
 Evaluate, where appropriate, the need for, and extent of reliance to be placed on
expertise from other parties to support audit processes including when to
challenge the extent and working practices of other parties
 Determine audit objectives for each financial statement assertion
 Determine for a particular scenario what comprises sufficient, appropriate audit
evidence
 Design and determine audit procedures in a range of circumstances and
scenarios, for example identifying an appropriate mix of tests of controls, analytical
procedures and tests of details
 Demonstrate how professional scepticism should be applied to the process of
gathering audit evidence and evaluating its reliability including the use of client-
generated information and external market information in data analytics
 Demonstrate and explain, in the application of audit procedures, how relevant
ISAs affect audit risk and the evaluation of audit evidence
 Evaluate, applying professional judgement, whether the quantity and quality of
evidence gathered from various audit procedures, including analytical procedures
and data analytics, is sufficient to draw reasonable conclusions
 Recognise issues arising whilst gathering assurance evidence that should be
referred to a senior colleague
Specific syllabus references for this chapter are: 11(f), 11(i), 14(b)–(g), 14(i)

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1 Revision of assertions C
H
A
Section overview P
T
Evidence is obtained in respect of each assertion used by the auditor. E
R
6
1.1 Introduction
As we have seen, audit work is about reducing risk – the risk that the financial statements
include material misstatements. At the most basic level, the financial statements simply consist
of the following information about the entity:
 Revenues
 Costs
 Assets
 Liabilities
 Capital
These items will have certain attributes if they are included correctly in the financial statements.
These attributes are referred to as financial statement assertions.
1.2 Financial statement assertions
Definition
Assertions: The representations by management, explicit or otherwise, that are embodied in the
financial statements, as used by the auditor to consider the different types of potential
misstatement that may occur.
By approving the financial statements, the directors are making representations about the
information therein. These representations or assertions may be described in general terms in a
number of ways.
For example, if the statement of financial position includes a figure for freehold land and
buildings, the directors are asserting that:
 the property concerned exists;
 it is either owned by the company outright or else the company has suitable rights over it;
 its value is correctly calculated; and
 there are no other items of a similar nature which ought to be included but which have
been omitted.
 it is disclosed in the financial statements in a way which is not misleading and is in
accordance with the relevant 'reporting framework' eg, international accounting standards.
ISA (UK) 315 (Revised June 2016), Identifying and Assessing the Risks of Material Misstatement
Through Understanding of the Entity and its Environment states that "the auditor shall identify
and assess the risks of material misstatement at the financial statement level and the assertion
level for classes of transactions, account balances and disclosures to provide a basis for
designing and performing further audit procedures" (ISA 315.25). It gives examples of assertions
in these areas. Depending on the nature of the balance, certain assertions will be more relevant
than others.
ICAEW 2019 The statutory audit: audit evidence 295

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Point to note:
The assertions have been revised to reflect changes made to the IAASB ISA. The main change is
that there is no longer a separate group of assertions about presentation and disclosure.
Assertions used by the auditor
Assertions about Occurrence: Transactions and events that have been recorded or disclosed
classes of have occurred and pertain to the entity.
transactions,
Completeness: All transactions and events that should have been recorded
events, and
have been recorded, and all related disclosures that should have been
related
included have been included.
disclosures, for
the period under Accuracy: Amounts and other data relating to recorded transactions and
audit events have been recorded appropriately and related disclosures have
(ISA 315.A124(a)) been appropriately measured and described.
Cut-off: Transactions and events have been recorded in the correct
accounting period.
Classification: Transactions and events have been recorded in the proper
accounts.
Presentation: transactions and events are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant
and understandable in the context of the requirements of the applicable
financial reporting framework.
Assertions about Existence: Assets, liabilities and equity interests exist.
account
Rights and obligations: The entity holds or controls the rights to assets, and
balances, and
liabilities are the obligations of the entity.
related
disclosures, at Completeness: All assets, liabilities and equity interests that should have
the period end been recorded have been recorded, and all related disclosures that should
(ISA 315.A124(b)) have been included in the financial statements have been included.
Accuracy, valuation and allocation: Assets, liabilities and equity interests
have been included in the financial statements at appropriate amounts and
any resulting valuation or allocation adjustments have been appropriately
recorded and related.
Classification: Assets, liabilities and equity interests have been recorded in
the proper accounts.
Presentation: Assets, liabilities and equity interests are appropriately
aggregated or disaggregated and clearly described, and related
disclosures are relevant and understandable in the context of the
requirements of the applicable financial reporting framework.
1.2.1 Summary
We have seen that there are 12 assertions applying in different ways to different items in the
You can summarise them in the following four questions:
(1) Should it be in the financial statements at all?
(2) Is it included at the right amount?
(3) Are there any more?
(4) Has it been properly disclosed and presented?

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The following table shows how the assertions fit with these questions:
C
Transactions, events Account balances and H
A
and related related disclosures at P
disclosures the period end T
E
Should it be in the Occurrence Existence R
accounts at all?
Cut-off Rights and obligations 6
Is it included at the Accuracy Accuracy, valuation and

right amount? allocation
Are there any more? Completeness Completeness
Is it properly Classification Classification
disclosed and
Presentation Presentation
presented?
Interactive question 1: Financial statement assertions (1)

Complete the table below.
 Identify procedures to satisfy the four key questions.
 Identify the financial statement assertions that these procedures will satisfy.
Audit area Key question Examples of procedures Assertions
Non-current assets Should it be in the Physically verify Existence

accounts at all?
Rights and
obligations
Is it included at the right Inspect invoices/contracts Accuracy,
amount? valuation and
Check depreciation
allocation
Are there any more?
Is it properly disclosed
and presented?
Receivables Should it be in the
accounts at all?
Is it included at the right
amount?
Are there any more?
and presented?

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Payables Should it be in the

accounts at all?
amount?
Are there any more?
and presented?
Inventory Should it be in the

accounts at all?
amount?
Are there any more?
and presented?
Interactive question 2: Financial statement assertions (2)

For the points (a) to (c) below identify and explain the most relevant financial statement
assertions. Assume that the year end is 31 December 20X7 in each case.
(a) Fine plc is proposing to award share options to five directors. The proposal is to issue
100,000 options to each of the five individuals on 1 September 20X7 (the grant date) at an
exercise price of £7 per share. The scheme participants will need to have been with the
company for at least three years before being able to exercise their options. It is believed
that all the directors will satisfy this condition. Other relevant information is as follows:
1 September 20X7 31 December 20X7
£ £
Market price per share 7.00 8.20 (estimated)
Fair value of each option 3.00 5.70 (estimated)
(b) Wigwam plc has purchased goods worth £750,000 from Teepee Ltd on an arm's length
basis. Wigwam owns 40% of the ordinary share capital in Teepee.
(c) Deakin plc issued 10,000 6% convertible bonds at par value of £10 on 31 December 20X7.
On this date the market interest rate for similar debt without the option to convert was 10%.
Each bond is convertible into four ordinary shares on 31 December 20X9.

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2 Sufficient, appropriate audit evidence C

H
A
Section overview P
Auditors need to obtain sufficient, appropriate audit evidence. T
E
R
2.1 Importance 6
ISA (UK) 500, Audit Evidence states that the objective of the auditor is to obtain sufficient,
appropriate audit evidence to be able to draw reasonable conclusions on which to base the
auditor's opinion.
The importance of obtaining sufficient, appropriate audit evidence can be demonstrated in the
Arthur Andersen audit of Mattel Inc.
Worked example: Mattel Inc

This is a complex case but in simple terms Mattel Inc inflated its reported earnings by using a
technique which came to be known as 'bill and hold'. This involved billing customers for future
sales. While the sale was recorded immediately (with invoices often prepared without the
knowledge of the customer) the merchandise was not shipped. To support these sales Mattel
produced false sales orders, invoices and bills of lading. The bills of lading were signed by
employees as both themselves and the carrying company. They were then stamped 'bill and
hold'. Problems which arose when the goods were actually sold were dealt with by making other
fraudulent entries in the books.
When Arthur Andersen audited accounts receivable they sent accounts receivable confirmations
to customers. These were returned with many substantial discrepancies due to the 'bill and hold'
entries. As part of the reconciliation process the auditors reviewed copies of bills of lading to
serve as confirmation that the goods had been shipped. However, the auditors did not question
the term 'bill and hold' even though it was clearly stamped on the documents and did not
appear to notice that the same individual had signed as both representatives of Mattel Inc and
the shipping company. A number of entries were questioned and the audit senior who reviewed
the working papers noted that additional explanations were required but no further
investigation actually took place.
(Source: Principles of Auditing: An Introduction to International Standards on Auditing,
Rick Hayes, Roger Dassen, Arnold Schilder, Phillip Wallage, 2005)
2.2 Sufficient and appropriate evidence

'Sufficiency' and 'appropriateness' are interrelated and apply to both tests of controls and
substantive procedures.
Sufficient evidence relates to the quantity of evidence gathered. However, it is not simply a
question of 'more is better', as different sources can be more or less persuasive. Broadly
speaking, however, it is possible to say that the greater the risk of misstatement, the greater the
quantity of evidence required.
However, the standards are clear that if the auditor decides to perform more comprehensive
testing eg, by selecting a bigger sample the extra work must contribute to the reduction of risk.
Appropriateness relates to the quality of evidence. ISA 500 amplifies this term by saying that
evidence should be:
 relevant
 reliable
Relevance deals with the logical connection with the purpose of the audit procedure and, where
appropriate, the assertion under consideration.

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Reliability is influenced by the source and nature of the evidence; however, you should be
familiar with the following generalisations from your earlier studies:
 Audit evidence is more reliable when it is obtained from independent sources outside the
entity.
 Audit evidence that is generated internally is more reliable when the related controls
imposed by the entity are effective.
 Audit evidence obtained directly by the auditor (for example, observation of the
application of a control) is more reliable than audit evidence obtained indirectly or by
inference (for example, inquiry about the application of a control).
 Documentary evidence is more reliable, whether paper, electronic or other medium (for
example, a written record of a meeting is more reliable than a subsequent oral
representation of the matters discussed).
 Original documents are more reliable than photocopies or faxes.
2.2.1 Audit data analytics
The FRC Audit Quality Thematic Review: The Use of Data Analytics in the Audit of Financial
Statements indicates a number of issues which need to be considered at the planning stage of
the audit which relate to sufficiency and appropriateness of audit evidence. These are as follows:
 Considering whether a tool is a 'good match' for the client's specific environment
 Ensuring that all relevant assertions are covered
 Whether testing in other areas needs to be flexed to provide the necessary supporting
evidence for the use of audit data analytics
The FRC Review was covered in more detail in Chapter 5.
The issue of reliability of data also needs to be re-assessed as data analytics includes the
interrogation of a wider range of sources of information than might have traditionally been the
case. For example expectations regarding reliability relating to information generated by the
client's accounting system will be different to those relating to the reliability of information
generated by analytics procedures performed on emails.
Interactive question 3: Audit evidence – revision
"The objective of the auditor is to […] obtain sufficient appropriate audit evidence to be able to
draw reasonable conclusions on which to base the auditor's opinion." (ISA 500.4)
Requirement
Discuss the extent to which each of the following sources of audit evidence is appropriate and
sufficient.
(a) Oral representation by management in respect of the completeness of sales where the
majority of transactions are conducted on a cash basis.
(b) Flowcharts of the accounting and control system prepared by a company's internal audit
department.
(c) Year-end suppliers' statements.
(d) Physical inspection of a non-current asset by an auditor.
(e) Comparison of revenue and expenditure items for the current period with corresponding
information for earlier periods.
(f) A proof in total calculation performed by the auditor to validate the interest expense
relating to a bank loan.

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2.3 The work of a management's expert as audit evidence

C
H
A
Definition
P
Management's expert: An individual or organisation possessing expertise in a field other than T
E
accounting or auditing whose work in that field is used by the entity to assist the entity in R
preparing financial statements.
6
Certain aspects of the preparation of financial statements may require expertise such as actuarial
calculations (relevant to accounting for pensions) or valuations (where the fair value alternative is
used for non-current assets). The entity may employ such experts or may engage the services of
external experts. ISA 500 includes guidance on the considerations that arise for the external
auditor in using this information as audit evidence.
If this work is significant to the audit the external auditor shall:
 evaluate the competence, capabilities and objectivity of the expert;
 obtain an understanding of the work of the expert; and
 evaluate the appropriateness of the expert's work as audit evidence for the relevant
assertion.
Note: Situations where the external auditor requires the assistance of an expert in obtaining
audit evidence are covered by ISA (UK) 620 (Revised June 2016), Using the Work of an Auditor's
Expert (see section 8.1 of this chapter).
2.4 Triangulation
Forming an audit opinion is a question of using professional judgement at all times and
judgements have to be made about the nature, the quality and the mix of evidence gathered. It
is also essential that individual items of evidence are not simply viewed in isolation but instead
support other evidence and are supported by other evidence. This approach views evidence
from different sources as predominantly complementary, rather than compensatory. This
strategy of acquiring and evaluating complementary evidence from a range of sources is
referred to as triangulation. This approach is an application of the general principle that
evidence obtained from different sources, that presents a consistent picture, is mutually
strengthening and gives greater reliance than merely increasing the amount of evidence from a
single source. The consequence of overreliance on one specific type and source of evidence can
be seen in the case of the collapse of Parmalat.
Worked example: Overreliance on confirmations

One of the largest examples of overreliance on one type of audit confirmation was the Parmalat
collapse of 2003.
Parmalat Finanziaria Spa is an Italian-based company. Its main operating subsidiary Parmalat Spa
dealt with dairy produce around the world. On 24 December 2003 Parmalat Spa filed for
bankruptcy. How could this happen to a company that employed 36,000 employees, operated
in 30 countries and was Italy's biggest food maker? The answer is simply forged documentation!
Parmalat allegedly had €3.95 billion worth of cash and marketable securities in an account at the
Bank of America but under the name of Bonlat Financing Corporation. In 2002 Grant Thornton,
the auditors of Bonlat, had requested confirmation of the balances from Bank of America. Three
months later a reply was received by post, not fax, confirming the balance. It later transpired that
this letter was a forgery and Bank of America confirmed this in a press release. The Parmalat
CEO left Italy on the day of this press release. The €3.95 billion worth of cash and securities
simply did not exist.

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In retrospect, additional evidence rather than simply one (forged) letter should have been
obtained for the cash balance. The case shows that even external confirmations and letters from
other auditors should be treated with some scepticism where the amounts involved are very
material.
(Source: Principles of Auditing: An Introduction to International Standards on Auditing,
Hayes, Dassen, Schilder and Wallage, 2005)
3 Sources of audit evidence
Section overview
Sources of audit evidence include:
• Tests of controls (covered in Chapter 7)
• Substantive procedures
3.1 Tests of controls

You will have covered tests of controls in your earlier studies. We cover evaluation of controls
and tests of controls in more detail in Chapter 7; however, a key point to remember is even if
evaluated and tested controls are considered strong enough to rely on, there is still a need to
carry out some substantive testing.
3.2 Substantive procedures

ISA (UK) 330 (Revised July 2017), The Auditor's Responses to Assessed Risks states that
irrespective of the assessed risk of material misstatement, the auditor shall design and perform
substantive procedures for each material class of transactions, account balance and disclosure.
There are two key types of substantive procedure.
 Substantive analytical procedures. These are generally more applicable to large volumes of
transactions that tend to be predictable over time. We will look at these in detail in
section 5.
 Tests of details. These are ordinarily more appropriate to obtain audit evidence regarding
certain assertions about account balances. We will see how these are applied to key aspects
of the financial statements as we work through the remainder of the chapter.
4 Selection of audit procedures
Section overview
Methods of obtaining audit evidence include:
• inquiry
• observation
• inspection
• recalculation
• reperformance
• external confirmation
• analytical procedures

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The procedures used are selected according to the nature of the balance being audited and the
assertion being considered. Audit procedures may be carried out using data analytics tools as C
H
discussed in Chapter 5. A
P
T
4.1 Types of procedure E
R
Auditors obtain evidence by using one or more of the following procedures.
6
4.1.1 Inquiry
Definition
Inquiry: Consists of seeking information of knowledgeable persons both financial and non-
financial within the entity or outside the entity.
Examples
Inquiry includes obtaining responses to formal written questions and asking informal questions
in relation to specific audit assertions. The response to inquiries provides the auditor with
information that was not previously possessed or may corroborate information obtained from
other sources. The strength of the evidence depends on the knowledge and integrity of the
source. Where the result of inquiry is different from other evidence obtained, then reasons for
that difference must be sought and the information reconciled.
Business focus
Common uses of inquiry are as follows:
 Written representations – where management have information not available from any other
source
 Asking employees about the internal control systems and effectiveness of the controls they
are operating
Remember it is not normally sufficient to accept inquiry evidence by itself – some corroboration
will be sought. The US court case of Escott et al. v Bar Chris Corporation 1968 ruled that the
auditor was negligent in not following up answers to management inquiries. The judge
indicated that the auditor was too easily satisfied with glib answers and that these should have
been checked with additional investigation.
4.1.2 Observation
Definition
Observation: Consists of looking at a procedure or process being performed by others.
Examples
Observation is not normally a procedure to be relied on by itself. For example, the auditor may
observe a non-current asset, such as a motor vehicle. However, this will only prove the vehicle
exists; other assertions such as rights and obligations will rely on other evidence such as invoices
and valuation possibly on the use of specialist valuers or documentation.
Business focus
Observation is commonly used in the business processes of inventory management. After
inventory has been purchased, an organisation holds raw materials, work in progress and
finished goods in its warehouses and factories. Observation is used to determine that the

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inventory exists, it is valued correctly (looking for old and slow-moving inventory) and that
inventory is complete in the organisation's books. Note the link to audit assertions here.
Additionally, the auditor will be observing the internal control systems over inventory,
particularly in respect to perpetual inventory checking and any specific procedures for year-end
inventory counting. You should be familiar with the audit procedures in respect of attendance at
an inventory count from your Assurance studies.
Observation may also be used in the human resource business process. The auditor will observe
employees operating specific controls within the internal control system to determine the
effectiveness of application of those controls, as well as the ability of the employee to operate
the control. However, the act of observing the employee limits the value of the evidence
obtained; many employees will amend their work practices when they identify the auditor
observing them.
4.1.3 Inspection
Definition
Inspection: Means the examination of records, documents or tangible assets.
Examples
By carrying out inspection procedures, the auditor is substantiating information that is, or should
be, in the financial statements. For example, inspection of a bank statement confirms the bank
balance for the bank reconciliation which in turn confirms the cash book figure for the financial
statements.
Business focus
Inspection assists with the audit of most business processes. For example:
 Financing: inspection of loan agreements to confirm the term and repayment details (part
of the completeness of disclosure in the financial statements)
 Purchasing: inspection of purchase orders to ensure that the order is valid and belongs to
the company (occurrence assertion among others)
 Human resources: inspection of pay and overtime schedules as part of wages audit
 Inventory management: inspection of the work in progress ledger confirming cost
allocation to specific items of work in progress (valuation assertion)
 Revenue: inspection of sales invoices to ensure that the correct customer has been invoiced
with the correct amount of sales (completeness and accuracy assertions)
Inspection of assets that are recorded in the accounting records confirms existence, gives
evidence of valuation, but does not confirm rights and obligations.
Confirmation that assets seen are recorded in accounting records gives evidence of
completeness.
Confirmation to documentation of items recorded in accounting records confirms that an asset
exists or a transaction occurred. Confirmation that items recorded in supporting documentation
are recorded in accounting records tests completeness.
Cut-off can be verified by inspecting the reverse population; that is, checking transactions
recorded after the end of the reporting period to supporting documentation to confirm that
they occurred after the end of the reporting period.

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Inspection also provides evidence of valuation/accuracy, rights and obligations and the nature
of items (presentation and classification). It can also be used to compare documents (and hence C
H
test consistency of audit evidence) and confirm authorisation. A
P
4.1.4 Recalculation T
E
R
Definition
6
Recalculation: Consists of checking the arithmetical accuracy of source documents and
accounting records.
Examples
Recalculation obviously relates to financial information. It is deemed to be a reliable source of
audit evidence because it is carried out by the auditor.
Business focus
Recalculation relates to most business processes. For example:
 Financing: calculation of interest payments
 Purchasing: accuracy of purchase orders and invoices
 Inventory management: valuation of work in progress
 Revenue: recalculation of sales invoices
Recalculation is particularly effective when carried out using computer-assisted audit techniques
(CAATs), as the computer can perform the whole of the inventory calculation (for example) in a
short time period. Data analytics may also be used. For example data analytics routines may be
used to perform detailed recalculations of depreciation on non-current assets by item.
Approximations could be used (eg, assuming sales and purchases are mid-month) or by using
the entire data set and exact dates.
4.1.5 Reperformance
Definition
Reperformance: Means the auditor's independent execution of procedures or controls that were
originally performed as part of the entity's internal control.
Examples
Auditors will often reperform some of the main accounting reconciliations, such as the bank
reconciliation or reconciliations of individual supplier balances to supplier statements. It is also
deemed to be a reliable source of audit evidence because it is carried out by the auditor.
Business focus
Reconciliations are a key control over many transaction cycles in the business, and if performed
properly are an effective means of identifying accounting errors or omissions. If they are
performed by an individual who is not involved in the day to day accounting for the underlying
transactions they can be a deterrent against fraudulent accounting.

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4.1.6 External confirmation
Definition
External confirmation: Audit evidence obtained as a direct written response to the auditor from
a third party.
Examples
A typical example of confirmation evidence is obtaining a response from a debtors'
circularisation (see Appendix for revision on this area). The evidence obtained is highly
persuasive, as it comes from an independent external source.
Key characteristics of any confirmation are as follows:
 Information is requested by the auditor.
 The request and response are in writing and the response is sent direct to the auditor.
 The response is from an independent third party.
 The confirmation is usually required to be positive (a response is expected) rather than
negative (a non-reply is assumed to confirm information provided to the third party).
Business focus
Confirmations are normally used in the following business processes:
 Financing: agreement of bank balances, loan amounts outstanding etc, (see Appendix)
 Inventory: confirmation of inventory held at third parties
 Revenue: confirmation of amounts due from debtors and payable to creditors (see
Appendix)
4.1.7 Analytical procedures

We will look at these in section 5.
4.2 Application of procedures to specific areas of the financial statements

You should be familiar with the basic principles behind the audit of key balances in the financial
statements from your Assurance studies. This section demonstrates the application of these
principles, looking in particular at non-current assets.
4.2.1 Tangible assets

The major risks of misstatement in the financial statements are due to:
 expenses being capitalised as non-current assets (existence assertion);
 tangible assets being carried at the wrong cost or valuation (accuracy, valuation and
allocation assertion);
 tangible assets being carried at the wrong cost or valuation due to charging inappropriate
depreciation, or not depreciating (accuracy, valuation and allocation assertion); and
 tangible assets being carried at the wrong cost or valuation due to impairment reviews not
being carried out appropriately (accuracy, valuation and allocation assertion).

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Interactive question 4: Audit procedures revision of tangible assets

C
Your firm acts as auditors to Xantippe Ltd, a manufacturer of industrial components. You have H
been presented with the financial statements for the year to 31 December 20X6, which include A
P
the following information in connection with property, plant and equipment. T
E
At At
R
1 January 31 December
20X6 Additions Disposals 20X6 6
£ £ £ £
Cost
Freehold property 80,000 – – 80,000
Plant and machinery 438,000 62,000 (10,000) 490,000
Motor vehicles 40,500 13,000 – 53,500
558,500 75,000 (10,000) 623,500
At Charge At
1 January for 31 December
20X6 year Disposals 20X6
£ £ £ £
Depreciation
Freehold property 8,000 1,600 – 9,600
Plant and machinery 139,500 47,000 (3,000) 183,500
Motor vehicles 20,000 10,200 – 30,200
167,500 58,800 (3,000) 223,300
Requirements
(a) Explain the factors that should be considered in determining an approach to the audit of
property, plant and equipment of Xantippe Ltd.
(b) State the procedures you would perform in order to reach a conclusion on property,
plant and equipment in the financial statements of Xantippe Ltd for the year ended
31 December 20X6.
Impairment of non-current assets

An asset is impaired when its carrying amount (depreciated cost or depreciated valuation)
exceeds its recoverable amount. Management are required to determine if there is any
indication that the assets are impaired.
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, Impairment
of Assets 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 necessary, modify their report on grounds of disagreement (not conforming
with IAS 36) if management refuse to carry 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.
For auditors, the key issue is that recoverable amount requires estimation. As estimation is
subjective, this makes it a risky area for auditors.
Management have to determine if recoverable amount is higher than carrying amount. It may
not have been necessary for them to estimate both fair value and value in use because, if one is

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higher than carrying amount, then the asset is not impaired. If it is not possible to make a
reliable estimate of net realisable value, then it is necessary to calculate value in use. Net
realisable value is only calculable if there is an active market for the goods, and would therefore
be audited in the same way as fair value. Costs of disposal such as taxes can be recalculated by
applying the appropriate tax rate to the fair value itself. Delivery costs can be verified by
comparing costs to published rates by delivery companies, for example, on the internet.
If management have calculated the value in use of an asset or cash-generating unit, then the
auditors will have to audit that calculation. The following procedures will be relevant.
Value in use
 Obtain management's calculation of value in use.
 Reperform calculation to ensure that it is mathematically correct.
 Compare the cash flow amounts 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 much similar assets are valued
at 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.
If the asset is impaired and has been written down to recoverable amount, the auditors should
review the financial statements to ensure that the write-down has been carried out correctly and
that the IAS 36 disclosures have been made correctly.
4.2.2 Intangible assets

Accounting guidance for intangibles is given in IAS 38, Intangible Assets and IFRS 3, Business
Combinations. The types of assets you are likely to encounter under this heading include the
following:
 Patents
 Licences
 Trademarks
 Development costs
 Goodwill
The major risks of misstatement in the financial statements are due to:
 expenses being capitalised as non-current assets (existence assertion);
 intangible assets being carried at the wrong cost or valuation (accuracy, valuation and
allocation assertion);
 intangible assets being carried at the wrong cost or valuation due to charging inappropriate
amortisation, or not amortising (accuracy, valuation and allocation assertion); and
 intangible assets being carried at the wrong cost or valuation due to impairment reviews
not being carried out appropriately (accuracy, valuation and allocation assertion).
In order to address these, the auditor should carry out the following procedures.

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Completeness
C
 Prepare analysis of movements on cost and amortisation accounts. H
A
Rights and obligations P
T
 Obtain confirmation from a patent agent of all patents and trademarks held. E
 Verify payment of annual renewal fees. R
Accuracy, valuation and allocation 6
 Review specialist valuations of intangible assets, considering:

– qualifications of valuer
– scope of work
– assumptions and methods used
 Confirm that carried down balances represent continuing value, which are proper charges
to future operations.
Additions (rights and obligations, valuation and completeness)
 Inspect purchase agreements, assignments and supporting documentation for intangible
assets acquired in period.
 Confirm that purchases have been authorised.
 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.
5 Analytical procedures
Section overview
• Analytical procedures are used as part of risk assessment and are required to be used as
part of the final review process.
• Analytical procedures may be used as substantive procedures.
5.1 Use of analytical procedures

Analytical procedures are used throughout the audit.
 ISA (UK) 315 (Revised June 2016), Identifying and Assessing the Risks of Material
Misstatement through Understanding of the Entity and its Environment deals with their use
as risk assessment procedures.

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 ISA (UK) 520, Analytical Procedures requires that analytical procedures are used near the
end of the audit when forming an overall conclusion as to whether the financial statements
are consistent with the auditor's understanding of the entity.
Analytical procedures may also be used as substantive procedures.
Auditors should not normally rely on analytical procedures alone in respect of material balances
but should combine them with tests of detail.
However, ISA 330 paragraph A43 points out that the combination will depend on the
circumstances, and that the auditor may determine that performing only analytical procedures
will be sufficient to reduce audit risk to an acceptably low level; for example, where the auditor's
assessment of risk is supported by audit evidence from tests of controls.
This is an area of the audit where the use of data analytics tools can be particularly effective, in
support of judgements and providing greater insights. Data analytics tools are able to draw on a
wider range of data as compared to traditional methods. For example interest and foreign
exchange rates, changes in GDP and other growth metrics could be used. External market data
may also be relevant.
5.2 Practical techniques

Ratio analysis is one of the key techniques which the auditor will use when performing analytical
procedures. You have looked at the relevant ratios in detail in your Assurance studies. A brief
summary is provided below.
5.2.1 Ratio analysis

When carrying out analytical procedures, auditors should remember that every industry is
different and each company within an industry differs in certain aspects.
Important Gross profit margins, in total and by product, area and months/quarter (if
accounting possible)
ratios Receivables ratio (average collection period)
Inventory turnover ratio (inventory divided into cost of sales)
Current ratio (current assets to current liabilities)
Quick or acid test ratio (liquid assets to current liabilities)
Gearing ratio (debt capital to equity capital)
Return on capital employed (profit before interest and tax to total assets less
current liabilities)
Related items Payables and purchases
Inventory and cost of sales
Non-current assets and depreciation, repairs and maintenance expense
Intangible assets and amortisation
Loans and interest expense
Investments and investment income
Receivables and irrecoverable debts expense
Receivables and sales
Ratios mean very little when used in isolation. They should be calculated for previous periods
and for comparable companies. The permanent file should contain a section with summarised
accounts and the chosen ratios for prior years.

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In addition to looking at the more usual ratios the auditors should consider examining other
ratios that may be relevant to the particular client's business, such as revenue per passenger C
H
mile for an airline operator client, and fees per partner for a professional office. A
P
5.2.2 Other techniques T
E
Other analytical techniques include:
R
(a) Simple comparisons
6
A simple year on year comparison could provide very persuasive evidence that an expense
such as rent is correctly stated, providing that the auditor has sufficient knowledge of the
business, for example knowing that the same premises have been leased year on year and
that there has been no rent review.
(b) Examining related accounts
Examining related accounts in conjunction with each other could provide evidence that a
balance is fairly stated. Often revenue and expense accounts are related to asset and
liability accounts and comparisons should be made to ensure relationships are reasonable.
(c) Reasonableness tests
These involve calculating the expected value of an item and comparing it with its actual
value, for example, for straight-line depreciation.
(Cost + Additions – Disposals)  Depreciation % = Recognised in profit or loss
This may include the comparison of non-financial as well as financial information.
For example, in making an estimate of employee costs, probably for one specific
department, such as manufacturing, the auditor might use information about the number of
employees in the department, as well as rates of pay increases.
(d) Trend analysis
This is a sophisticated statistical technique that can be used to compare this period with the
previous period. Information technology can be used in trend analysis, to enable auditors
to see trends graphically with relative ease and speed.
Methods of trend analysis include the following:
 Scattergraphs
 Bar graphs
 Pie charts
 Any other visual representations
 Time series analysis
 Statistical regression
Time series analysis involves techniques such as eliminating seasonal fluctuations from sets
of figures, so that underlying trends can be analysed. This is illustrated in the figure below.
Sales
(1)
(2)
Months
June December June
Figure 6.1: Time series analysis

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Line (1) in the diagram shows the actual sales made by a business. There is a clear seasonal
fluctuation before Christmas. Line (2) shows a level of sales with 'expected seasonal fluctuations'
having been stripped out.
In this analysis the seasonal fluctuations have been estimated. This analysis is useful, however,
because the estimate is likely to be based on past performance, so the conclusion from this is
that there might be a problem:
 Sales are below the levels of previous years.
 Sales are below expectation.
5.3 Analytical procedures as risk assessment procedures

ISA 315(6) requires that risk assessment procedures include analytical procedures.
Analytical procedures are usually carried out at the planning stage of the audit because:
 it is a tool which assists in the identification of risk; and
 the result helps the auditor to plan the audit approach.
The benefits of adopting this technique are that:
 it helps to focus on the key priorities, as it is a 'top down' procedure; and
 it is an efficient procedure, due to its focus on key priorities.
5.3.1 Technique
Although ISA 520 deals with analytical procedures in the context of substantive procedures the
same basic techniques would be applied when using analytical procedures as risk assessment
procedures. The key stages in the process are as follows:
 Interpretation
 Investigation
 Corroboration
When potential problem areas have been identified, one of the key questions to ask is 'why?'.
The statement of profit or loss and other comprehensive income
To apply this in more detail think about the client's statement of profit or loss and other
The key question must be:
Why did the client make more (or less) money this year?
Profit before tax
Revenue Margin Overhead
Volume Selling Costs Product Fixed Variable

price mix
More customers Different products Strategic decisions

Different customers Different suppliers Market forces
More spend per customer Different markets One-offs
New outlets One-offs Fraud and error
One-offs Fraud and error
Fraud and error
Figure 6.2: Statement of profit or loss

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Changes in revenue must depend on changes in either:

C
 volumes; or H
 prices. A
P
Alternatively, it could be a combination of the two. T
E
Changes in margins must have something to do with changes in: R
 selling prices 6
 cost prices
 product mix
Changes in overheads will need to be identified line by line, but you might like to consider the
different impacts of changes in:
 fixed overheads
 variable overheads
The boxes at the bottom of the diagram give some suggestions for the reasons why. The
suggestions are not intended to be exhaustive, but they should give you a good basis for an
answer to an analytical procedures type question.
A similar approach needs to be taken both to statement of financial position areas and those
efficiency ratios which link statement of financial position figures to the performance ratios.
5.3.2 Financial and non-financial factors

ISA 520 stresses the need to consider the use of non-financial information eg, employee
numbers and available selling space. Non-financial performance indicators can be found within
the financial statements. In particular, an operating and financial review, or possibly the
chairman's statement, may serve as useful indicators as they attempt to comment on both the
past and the future of the company. However, care must be taken in assessing the reliability of
this information, as indicators may have been selected to ensure a positive message is
conveyed.
Interactive question 5: Analytical procedures (1)

You are planning the audit of Darwin Ltd for the year ended 31 December 20X7. You are
currently engaged in the interim audit during November 20X7. The company manufactures and
distributes light fittings for both internal and external use. Approximately 40% of revenue is
generated from overseas customers.
You have been provided with the following operating information.
10 months to 10 months to Year to 31
31 October 20X7 31 October 20X6 December 20X6
£'000 £'000 £'000
Revenue 27,187 23,516 27,068
Cost of sales 16,040 14,966 17,175
Gross profit 11,147 8,550 9,893
Operating expenses 5,437 4,938 5,678
Operating profit 5,710 3,612 4,215
Gross profit margin 41% 36% 37%
Operating profit margin 21% 15% 16%
Inventories 5,160 4,320 4,080
Requirement
Based on the operating information identify and explain the potential audit risks.

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Libby Ltd is a ladies fashion retailer operating a chain of shops in the South-East of England from
a head office in Guildford. Your firm has been the auditor of Libby Ltd for some years.
During the current year one shop was closed and the product range of the remaining eight
shops was extended to include accessories and footwear.
The company has a computerised accounting system and the audit manager is keen to ensure
that the audit is as efficient as possible.
As senior in charge of the audit you are currently planning the audit procedures for trade
payables and you have obtained draft financial statements from the client.
Extracts from the draft financial statements:
Year ended 31 March
Statement of profit or loss and other Draft 20X7 Actual 20X6
comprehensive income
£'000 £'000
Revenue 8,173 5,650
Gross profit 1,717 1,352
As at 31 March
Statement of financial position Draft 20X7 Actual 20X6
£'000 £'000
Non-current assets 2,799 2,616
Current assets 1,746 1,127
Trade payables 991 718
Other payables 514 460
Requirements
(a) State what observations you can draw from the extracts from the draft financial statements
and how they may affect your audit of trade payables.
(b) Indicate how audit software could be used in the audit of trade payables to achieve a more
efficient audit.
5.4 Analytical procedures as substantive procedures

5.4.1 Factors to consider
There are a number of factors which the auditors should consider when deciding whether to use
analytical procedures as substantive procedures. You will have covered these in your Assurance
studies. A brief reminder is given below.
Factors to consider Example
The suitability of particular Substantive analytical procedures are generally more

analytical procedures for given applicable to large volumes of transactions that tend to
assertions be predictable over time, such as analysis involving
revenue and gross profit margins.
The reliability of the data from This will depend on factors such as:
which the auditors' expectations are
 the source of the information; and
developed
 the comparability of the data; industry comparison
may be less meaningful if the entity sells specialised
products.

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Factors to consider Example

C
H
The detail to which information can Analytical procedures may be more effective when A
be analysed applied to financial information or individual sections of P
an operation such as individual factories and shops. T
E
The nature of information Financial: budgets or forecasts. R
Non-financial: eg, the number of units produced or sold. 6
The relevance of the information Whether the budgets are established as results to be
available expected rather than as tough targets (which may well
not be achieved).
The knowledge gained during The effectiveness of the accounting and internal controls.
previous audits
The types of problems giving rise to accounting
adjustments in prior periods.
Factors which should also be considered when determining the reliance that the auditors should
place on the results of substantive analytical procedures are:
Reliability factors Example
Other audit procedures directed Other procedures auditors undertake in reviewing the
towards the same financial collectability of receivables, such as the review of
statements assertions subsequent cash receipts, may confirm or dispel questions
arising from the application of analytical procedures to a
schedule of customers' accounts which lists for how long
monies have been owed.
The accuracy with which the Auditors normally expect greater consistency in comparing
expected results of analytical the relationship of gross profit to sales from one period to
procedures can be predicted another than in comparing expenditure which may or may
not be made within a period, such as research and
advertising.
The frequency with which a A pattern repeated monthly as opposed to annually.
relationship is observed
Reliance on the results of analytical procedures depends on the auditor's assessment of the risk
that the procedures may mistakenly identify relationships (between data) when in fact there is a
material misstatement (that is, the relationships do not in fact exist). It also depends on the
results of investigations that auditors have made if substantive analytical procedures have
highlighted significant fluctuations or unexpected relationships.
5.4.2 Substantive analytical procedures
In practical terms, the use of substantive analytical procedures involves four distinct steps:
(1) Firstly, formulate expectations
(2) Secondly, compare expected value with the actual recorded amount
(3) Thirdly, obtain possible reasons for variance between expected value and recorded
amount
(4) Fourthly, evaluate impact of any unresolved differences between the expected and
recorded amounts on the audit and financial statements

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Each of these steps is explained below.

Formulate expectations
The auditor develops an expectation of figures in the financial statements using prior year
financial statements, budgets, industry information etc. The expectation should be developed so
that any material difference between this and the actual values in the financial statements
indicates a potential misstatement. The auditor must also evaluate whether the expectation is
sufficiently precise to identify a misstatement.
To carry out this procedure, the auditor will need access to industry data and environmental
factors affecting that industry. Access to the financial statements is not required at this time, as
this could prejudice the expectations of the auditor.
Example
The auditor is confirming the accuracy of salary expense in the statement of profit or loss and
other comprehensive income.
The prior year salary figure can be obtained from the prior year financial statements. This year's
salary can be estimated using the average number of employees (from personnel records) and
the average salary again from personnel records. Changes in number of staff can be checked as
reasonably accurate from knowledge of the industry sector (expanding or declining?) and initial
knowledge of the client's business (expanding or contracting?). Average number of employees
multiplied by average salary should give an approximate salary cost for the financial statements.
Compare expected value with the actual recorded amount
The auditor compares the expected value with the actual amount in the financial statements. In
making this comparison, the auditor must decide the amount of deviation which will be allowed
between the expected and actual figures – in other words, set a materiality limit. As assessed risk
increases, the amount of difference considered acceptable without investigation decreases. If
the difference between the two figures exceeds this materiality threshold then further
investigation will be required in an attempt to explain the difference. If the difference is below
the materiality threshold then no further investigation will be necessary.
The actual salary expense in the statement of profit or loss and other comprehensive income can
be found. Assuming that salary cost does not involve overtime, then the estimated amount and
the actual should be relatively close – materiality is likely to be set at, say, 10% difference
between the two figures.
Obtain possible reasons for variances
The auditor attempts to identify reasons for the difference between the expected figure and the
actual figure in the financial statements. The level of investigation depends to some extent on
the accuracy of the auditor's expected figure. If the expected figure is precise, then more
investigation will be expected. Conversely, if the expected figure has a larger element of
imprecision, then it is less likely that any difference is due to misstatement and therefore less
investigation work will be performed. (The auditor should have assessed whether expectations
were capable of sufficiently precise measurement before adopting analytical procedures.)
Corroboration of any difference will normally start by obtaining written representations from
management. However, these representations should be treated with scepticism due to the
inherent problem of reliability of this source of evidence. Evidence from other sources will be
required to ensure that written representations are accurate.
If the expected and actual salary expenses are more than 10% different, then further work is
needed to determine why this is the case. Initial discussions with management may highlight
areas where costs will be different eg, expansion in the last month of the year may skew the
average number of managers to a larger number than expected. Or a salary increase late in the
year may also inflate expectations of average salary. These written representations will be
checked back in detail to the salary records.

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Evaluate impact of any unresolved differences

C
Finally, the auditor will evaluate the impact of any unresolved differences on audit procedures H
and the financial statements. A large difference may mean that additional substantive A
P
procedures are required on the account balance to determine its accuracy. Any small remaining
T
difference may be ignored as immaterial. E
R
Hopefully, differences in expected and actual salaries will be resolved and any remaining
residual difference will be immaterial. However, where differences remain, additional 6
substantive testing of the salaries figure will be required.
Point to note:
As indicated in the Ernst & Young publication How Big Data and Analytics are Transforming the
Audit, where analytics tools are used in this instance the four steps indicated above are not
followed in the same way. One of the key differences is that unusual transactions or
misstatements are identified based on the analysis of data, usually without the auditor
establishing an expectation. Auditing standards do not currently reflect this approach as they
pre-date the use of these techniques.
(Source: How Big Data and Analytics are Transforming the Audit, 2015. Available from:
www.ey.com/en_gl/assurance/how-big-data-and-analytics-are-transforming-the-audit
[Accessed on 10 April 2017])
5.5 Analytical procedures at the completion stage

ISA 520 states that analytical procedures performed when forming an overall conclusion are
intended to corroborate conclusions formed during the audit. This assists the auditor in forming
their opinion. The steps for carrying out analytical procedures at the completion stage of the
audit may be very similar to those used as part of the risk assessment process at the planning
stage. However, they are applied in a different way:
(a) Interpretation
The individual carrying out the analytical procedures reads through the financial statements
and interprets them, considering the absolute figures themselves and the relevant ratios.
(b) Investigation
When analytical procedures are used as risk assessment procedures or as a substantive
procedure the aim is to identify potential problems. The problems are then investigated
during fieldwork by making inquiries and gathering audit evidence.
In the UK, considerations when carrying out such procedures may include the following:
(a) Whether the financial statements adequately reflect the information and explanations
previously obtained and conclusions previously reached
(b) Whether the procedures reveal any new factors which may affect presentation or
disclosures in the financial statements
(c) Whether the procedures produce results which are consistent with the auditor's knowledge
of the entity's business
(d) The potential impact of uncorrected misstatements identified during the course of the audit
If analytical procedures identify a previously unrecognised risk of material misstatement, then
the auditor should reassess risk and modify the audit plan and perform further procedures as
required.

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From a practical point of view it is worth remembering the following:

(a) For the smaller client, the working papers supporting the final analytical procedures may
well be simply an update of the work done at the planning stage.
(b) For the larger client, the review becomes much more of a specific exercise.
(c) The financial statements used for the analytical procedures need to incorporate any
adjustments made as a result of the audit.
5.6 Analytical procedures and other engagements

In this section we have been looking at the role of analytical procedures in the audit process.
However, the skills and techniques involved may be applied to other aspects of the professional
accountants' work.

Harrison plc is a small jewellers based in Hatton Garden in London. Over the years it has built up
an impressive client portfolio, and boasts names from high society as regular customers. You
have recently joined the engagement team.
Harrison plc now needs to restructure its long-term and short-term financing in order to facilitate
future growth, and has provided your firm with the following data to make an assessment of its
liquidity. The firm is also looking to re-evaluate its performance measures and is seeking advice
on what might be the most appropriate non-financial performance measures.
The following is an extract from the financial information provided by Harrison plc for the year
ended 30 September 20X4.
Revenue £2.0m
Purchases £1.2m
Cost of sales £1.5m
£
Non-current assets 550,000
Inventory 300,000
Receivables 150,000
Cash 100,000
Payables (100,000)
1,000,000
Ordinary shares of 25p each 250,000

Reserves 350,000
7% preference shares of £1 each 250,000
15% unsecured loan stock 150,000
1,000,000
The ordinary shares are currently quoted at 125p each, the loan stock is trading at £85 per £100
nominal, and the preference shares at 65p each.
Requirement
Evaluate the financial performance of the company.

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6 Audit of accounting estimates C

H
A
Section overview P
T
Accounting estimates are a high risk area of the audit, as they require the use of judgement. E
R
ISA (UK) 540 (Revised June 2016), Auditing Accounting Estimates, Including Fair Value 6
Accounting Estimates, and Related Disclosures provides guidance on the audit of accounting
estimates contained in financial statements and requires auditors to obtain sufficient,
appropriate audit evidence regarding accounting estimates.
Definition
Accounting estimate: An approximation of a monetary amount in the absence of a precise
means of measurement.
The ISA gives the following examples of estimates, other than fair value estimates:
 Allowances to reduce inventory and receivables to their estimated realisable value
 Depreciation method or asset useful life
 Provisions against the carrying amount of an investment where there is uncertainty
regarding its recoverability
 Provision for a loss from a lawsuit
 Outcome of construction contracts in progress
 Provision to meet warranty claims
The following are examples of fair value estimates:
 Complex financial instruments, which are not traded in an active and open market
 Share-based payments
 Property or equipment held for disposal
 Certain assets and liabilities acquired in a business combination, including goodwill and
intangible assets
Directors and management are responsible for making accounting estimates included in the
financial statements. These estimates are often made in conditions of uncertainty regarding the
outcome of events and involve the use of judgement. The risk of a material misstatement
therefore increases when accounting estimates are involved.
Audit evidence supporting accounting estimates is generally less than conclusive and so
auditors need to exercise greater judgement than in other areas of an audit.
Accounting estimates may be produced as part of the routine operations of the accounting
system, or may be a non-routine procedure at the period end. Where, as is frequently the case, a
formula based on past experience is used to calculate the estimate, it should be reviewed
regularly by management (eg, actual vs estimate in prior periods).
If there is no objective data to assess the item, or if it is surrounded by uncertainty, the auditors
should consider the implications for their report.

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6.1 Audit procedures

Auditors must gain an understanding of the procedures and methods used by management to
make accounting estimates to gain evidence of whether estimates are reasonable given the
circumstances and appropriately disclosed if necessary. It will also aid the auditors' planning of
their own procedures.
This ISA says that the auditor should adopt the following approaches:
(a) The auditor shall obtain an understanding of the following as part of the process of
understanding the business:
(i) The requirements of the applicable financial reporting framework
(ii) The means by which management identifies transactions, events and conditions that
may give rise to the accounting estimates
(iii) How management makes the accounting estimate
(b) The auditor shall review the outcome of accounting estimates included in the prior period
financial statements. (The purpose of this is to assess the risks of misstatement in the
current period estimates, not to question the judgements made in prior periods.)
(c) The auditor shall evaluate the degree of estimation uncertainty associated with the
accounting estimate and assess whether this gives rise to significant risks.
(d) Based on the assessed risks the auditor will determine whether the financial reporting
framework has been properly applied and whether methods for making estimates are
appropriate and have been applied consistently.
(e) The auditor will also do the following:
(i) Determine whether events occurring up to the date of the audit report provide
evidence regarding the accounting estimate
(ii) Test how management made the accounting estimate (including evaluation of
measurement method and assumptions)
(iii) Test the operating effectiveness of controls together with appropriate substantive
procedures
(iv) Develop a point estimate (the single most plausible value based on the available
information) or a range (a range of values that are all plausible in the light of the
available information) derived from audit evidence to evaluate management's point
estimate.
(f) The auditor shall consider whether specialist skills or knowledge are required in order to
obtain sufficient, appropriate audit evidence.
(g) For accounting estimates which give rise to significant risks the auditor should also
evaluate the following:
(i) Whether management has considered alternative assumptions or outcomes
(ii) Whether the significant assumptions used are reasonable
(iii) Management intent to carry out specific courses of action and its ability to do so, where
these affect the accounting estimate
(iv) Management's decision to recognise, or to not recognise, the accounting estimate
(v) The selected measurement basis
(h) The possibility of management bias must be considered by the auditor.
(i) Written representations will be obtained from management as to whether management
believes that significant assumptions used in making accounting estimates are reasonable.

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6.2 Evaluation of results of audit procedures

C
ISA 540 (18) states that 'The auditor shall evaluate, based on the audit evidence, whether the H
A
accounting estimates in the financial statements are either reasonable in the context of the
P
applicable financial reporting framework, or are misstated.' T
E
Misstatements in this context would be: R
(a) the difference between management's point estimate and the auditor's point estimate 6
based on audit evidence; or
(b) the difference between management's point estimate and a range of values that the auditor
has established based on the audit evidence.
The auditor shall also consider whether the disclosures relating to accounting estimates are
adequate and in accordance with the applicable financial reporting framework.
6.3 Key audit matter

Where an accounting estimate has been identified as having a high estimation uncertainty the
auditor may conclude that it is a key audit matter that requires disclosure in accordance with
ISA (UK) 701, Communicating Key Audit Matters in the Independent Auditor's Report. Alternatively
the auditor may consider it necessary to include an Emphasis of Matter in accordance with
ISA 706 (Revised June 2016), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the
Independent Auditor's Report.
ISA 701 and 706 are covered in detail in Chapter 8.
7 Initial audit engagements – opening balances
Section overview
• Opening balances are those account balances which exist at the beginning of an
accounting period.
• The auditor will perform audit procedures to ensure that those balances are accurately
stated.
• Specific procedures may be required where the opening balances were not audited by
the current audit firm.
7.1 Opening balances

Opening balances are those account balances which exist at the beginning of the period.
Opening balances are based on the closing balances of the prior period and reflect the effects of:
 transactions and events of prior periods; and
 accounting policies applied to the prior period.
ISA (UK) 510 (Revised June 2016), Initial Audit Engagements – Opening Balances provides
guidance on opening balances:
 when the financial statements of an entity are audited for the first time; and
 when the financial statements for the prior period were audited by a predecessor auditor.

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7.2 Requirements
The auditor shall obtain sufficient, appropriate audit evidence about whether the opening
balances contain misstatements that materially affect the current period's financial statements
by:
 determining whether the prior period's closing balances have been correctly brought
forward to the current period or, when appropriate, have been restated;
 determining whether the opening balances reflect the application of appropriate
accounting policies; and
 performing one or more of the following:
– Where the prior year financial statements were audited, reviewing the predecessor
auditor's working papers to obtain evidence regarding the opening balances
– Evaluating whether audit procedures performed in the current period provide
evidence relevant to the opening balances
– Performing specific audit procedures to obtain evidence regarding the opening
balances.
When the prior period's financial statements were audited by another auditor, the current
auditor may be able to obtain sufficient, appropriate audit evidence regarding opening
balances by reviewing the predecessor auditor's working papers. (As noted in Chapter 3, in
audits carried out under the UK Companies Act 2006, when the predecessor auditor ceases to
hold office, if requested by the successor auditor, the predecessor auditor must allow the
successor access to all relevant information in respect of its audit work. This includes access to
relevant working papers. Access to this information is also required by ISQC 1).
The nature and extent of audit procedures necessary to obtain sufficient, appropriate audit
evidence on opening balances depends on matters such as the following.
 The accounting policies followed by the entity
 The nature of the account balances, classes of transactions and disclosures and the risks of
material misstatement in the current period's financial statements
 The significance of the opening balances relative to the current period's financial
statements
 Whether the prior period's financial statements were audited and, if so, whether the
predecessor auditors' opinion was modified
In the UK, for audits of public interest entities, the auditor must obtain an understanding of the
predecessor auditor's methodology in order to obtain details required for the report to the audit
committee as required by ISA 260.16R2.
If the auditor obtains audit evidence that the opening balances contain misstatements, that
could materially affect the current period's financial statements, the auditor shall perform such
additional audit procedures as are appropriate in the circumstances to determine the effect on
the current period's financial statements.
7.2.1 Specific audit procedures

For current assets and liabilities some audit evidence may be obtained as part of the current
period's audit procedures. For example, the collection (payment) of opening accounts
receivable (accounts payable) during the current period will provide some audit evidence of
their existence, rights and obligations, completeness and valuation at the beginning of the
period.

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In the case of inventories, however, the current period's audit procedures on the closing
inventory balance provide little audit evidence regarding inventory on hand at the beginning of C
H
the period. A
P
Therefore, additional procedures may be necessary, such as:
T
E
 observing a current physical inventory count and reconciling it back to the opening
R
inventory quantities;
6
 performing audit procedures on the valuation of the opening inventory items; and
 performing audit procedures on gross profit and cut-off.
A combination of these procedures may provide sufficient, appropriate audit evidence.
For non-current assets and liabilities, some audit evidence may be obtained by examining the
accounting records and other information underlying the opening balances. In certain cases, the
auditor may be able to obtain some audit evidence regarding opening balances through
confirmation with third parties, for example for long-term debt and investments. In other cases,
the auditor may need to carry out additional audit procedures.
7.2.2 Consistency of accounting policies

The auditor shall obtain sufficient, appropriate audit evidence about whether the accounting
policies reflected in the opening balances have been consistently applied in the current period's
financial statements, and whether changes in the accounting policies have been appropriately
properly accounted for and adequately presented and disclosed in accordance with the
applicable financial reporting framework.
7.2.3 Prior period balances audited by a predecessor auditor

When the prior period's financial statements were audited by a predecessor auditor, the current
auditor must read the most recent financial statements and predecessor auditor's report for
information relevant to opening balances. The current auditor may be able to obtain sufficient,
appropriate evidence regarding opening balances by performing this review depending on the
professional competence and independence of the predecessor auditor. Relevant ethical and
professional requirements guide the current auditor's communications with the predecessor
auditor.
If there was a modification to the opinion, the auditor must evaluate the effect of the matter
giving rise to the modification in assessing the risks of material misstatement in the current
period's financial statements.
7.3 Audit conclusion and reporting

"If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening
balances, the auditor shall express a qualified opinion or disclaim an opinion on the financial
statements, as appropriate.
"If the auditor concludes that the opening balances contain a misstatement that materially
affects the current period's financial statements, and the effect of the misstatement is not
appropriately accounted for or not adequately presented or disclosed, the auditor shall express
a qualified opinion or an adverse opinion, as appropriate." (ISA 510.10–11)
Note: The Appendix to the ISA gives illustrations of auditors' reports with modified opinions
relating to opening balances. While these have been updated to reflect the changes made to
the equivalent IAASB ISA they have not been tailored for the UK.

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The auditor shall express a qualified opinion or an adverse opinion as appropriate if they
conclude that:
 the current period's accounting policies are not consistently applied in relation to opening
balances in accordance with the applicable financial reporting framework; or
 a change in accounting policies is not appropriately accounted for or not adequately
presented or disclosed in accordance with the applicable financial reporting framework.
If the prior period auditor's report was modified, the auditor should consider the effect on the
current period's financial statements. For example, if there was a scope limitation in the prior
period, but the matter giving rise to the scope limitation has been resolved in the current period,
the auditor may not need to modify the current period's audit opinion.
The ISA finishes:
"If the predecessor auditor's opinion regarding the prior period's financial statements included
a modification to the auditor's opinion that remains relevant and material to the current period's
financial statements, the auditor shall modify the auditor's opinion on the current period's
financial statements." (ISA 510.13)
8 Using the work of others
Section overview
• In certain situations the auditor will consider it necessary to employ someone else with
different expert knowledge to gain sufficient, appropriate audit evidence.
• If the auditor's client has an internal audit department, the auditor may seek to rely on its
work.
8.1 Using the work of experts: revision

Professional audit staff are highly trained and educated, but their experience and training is
limited to accountancy and audit matters. In certain situations it will therefore be necessary to
employ someone else with different expert knowledge to gain sufficient, appropriate audit
evidence. ISA (UK) 620 (Revised June 2016), Using the Work of an Auditor's Expert covers this
area and the principles included in this standard were covered at Professional Level. The key
points are covered below.
Definition
Auditor's expert: An individual or organisation possessing expertise in a field other than
accounting and auditing, whose work in that field is used by the auditor in obtaining sufficient,
appropriate audit evidence. An auditor's expert may be either an auditor's internal expert (a
partner or staff of the auditor's firm, or a network firm) or an auditor's external expert.
Point to note:
The use of data analytics has increased the need for the use of IT experts in the audit team.
The ISA makes a distinction between this situation and the situation outlined in ISA (UK) 500,
Audit Evidence (see section 2.3 of this chapter) where management use an expert to assist in
preparing financial statements.
When using the work performed by an auditor's expert, auditors should obtain sufficient,
appropriate audit evidence that such work is adequate for the purposes of an audit.

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The following list of examples is given by the ISA of areas where it may be necessary to use the
work of an auditor's expert: C
H
 The valuation of complex financial instruments, land and buildings, plant and machinery, A
P
jewellery, works of art, antiques, intangible assets, assets acquired and liabilities assumed in T
business combinations and assets that may have been impaired E
R
 The actuarial calculation of liabilities associated with insurance contracts or employee
benefit plans 6
 The estimation of oil and gas reserves

 The valuation of environmental liabilities, and site clean-up costs
 The interpretation of contracts, laws and regulations
 The analysis of complex or unusual tax compliance issues
When considering whether to use the work of an expert, the auditors should review the
following:
 Whether management has used a management's expert in preparing the financial
statements
 The nature and significance of the matter, including its complexity
 The risks of material misstatement
 The auditor's knowledge of and experience with the work of experts in relation to such
matters and the availability of alternative sources of audit evidence
8.1.1 Competence, capabilities and objectivity of the auditor's expert

When planning to use the work of an auditor's expert the auditors shall assess the professional
competence (including professional qualifications, experience and resources) of the expert. The
auditor shall evaluate the objectivity of the expert.
This will involve considering:
 the expert's professional certification, or licensing by, or membership of, an appropriate
professional body and the technical performance standards and other requirements, such
as ethical standards of that body;
 the relevance of the expert's competence to the matter for which that expert's work will be
used, including any areas of speciality within that expert's field; and
 the expert's competence with respect to relevant accounting and auditing requirements,
such as assumptions and methods required by the applicable financial reporting
framework.
In considering the objectivity of the expert, the auditor should consider circumstances such as
self-interest threats, advocacy threats, familiarity threat, self-review threats and intimidation
threats as well as the safeguards that may have been put in place to eliminate or reduce these.
In the UK for audits of public interest entities the auditor must obtain confirmation from the
expert regarding their independence. (ISA 620.9R1)
8.1.2 Obtaining an understanding of the field of expertise of the auditor's expert

The auditor needs to have a sufficient understanding in order to be able to:
 determine the nature, scope and objectives of the expert's work for the auditor's purposes;
and
 evaluate the adequacy of that work for the auditor's purposes.

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8.1.3 Agreement with the auditor's expert

Written instructions usually cover the expert's terms of reference and such instructions may
cover such matters as follows:
 The nature, scope and objectives of the expert's work
 The respective roles and responsibilities of the auditor and the expert
 The nature, timing and extent of communication between the auditor and the expert,
including the form of any report to be provided by the expert
 The need for the expert to observe confidentiality requirements
8.1.4 Evaluating the adequacy of the auditor's expert's work

The auditors shall assess the adequacy of the expert's work for audit purposes.
Auditors should assess whether the substance of the expert's findings is properly reflected in the
financial statements or supports the financial statement assertions. It will also require
consideration of:
 the relevance and reasonableness of the expert's findings or conclusions, and their
consistency with other audit evidence;
 the relevance and reasonableness of any significant assumptions and methods used; and
 the relevance, completeness and accuracy of any source data used.
The auditors do not have the expertise to judge the assumptions and methods used; this is the
responsibility of the expert. However, the auditors should seek to obtain an understanding of these
assumptions, to consider their reasonableness based on other audit evidence, knowledge of the
business and so on.
If the results of the expert's work are not adequate for the auditor's purposes, the auditor shall:
 agree with the expert on the nature and extent of further work to be performed by the
expert; or
 perform additional audit procedures appropriate to the circumstances.
8.1.5 Reference to the auditor's expert in the audit report

When issuing an unmodified audit opinion, the auditor should not refer to the work of the expert
unless required by law or regulation to do so (there is no such requirement in the UK).
Such a reference may be misunderstood and interpreted as a qualification of the audit opinion
or a division of responsibility, neither of which is appropriate.
If the auditors issue a modified audit opinion, then they may refer to the work of the expert if such
a reference is relevant to an understanding of the modification. The auditor must also indicate in
the report that the reference does not reduce the auditor's responsibility for the opinion. In such
cases, auditors may need to obtain permission in advance from the expert. If such permission is
not given, then the auditors may have to seek legal advice.
8.1.6 Documentation
In the UK, the auditor must document any request for advice from an auditor's expert and the
advice received. (ISA 620.15D1)

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Interactive question 8: Using an expert – revision

C
(a) As auditor to an oil exploration company, you have ascertained that the useful life of each H
drilling platform is assessed annually on factors such as weather conditions and the period A
P
over which it is estimated that oil will be extracted. You are auditing the useful lives of the T
platforms. E
R
(b) Piles of copper and brass, that can be distinguished with a simple acid test, have been
mixed up. You are attending the inventory count. 6
Requirement
Explain whether it is necessary to use the work of an auditor's expert in these situations. Where
relevant, you should describe alternative procedures.
8.2 Using the work of internal auditors

Using the work of internal auditors is covered at Professional Level in the Audit and Assurance
paper. However, a summary of the key points of ISA (UK) 610 (Revised June 2013), Using the
Work of Internal Auditors is set out below.
8.2.1 Assessment of internal audit

First, the external auditors will determine whether and to what extent to use the work of internal
auditors for the purposes of the audit by evaluating the following
Evaluation of internal audit
Objectivity Consider the status of the function within the entity, who they report to,
whether they have any conflicting responsibilities or restrictions placed on
their function. Consider also to what extent management acts on internal audit
recommendations.
Competence Consider whether internal auditors have adequate resources, technical
training and proficiency, and whether internal auditors possess the required
knowledge of financial reporting. They will also consider whether the internal
auditors are members of relevant professional bodies.
Systematic and Consider whether internal audit is properly planned, supervised, reviewed
disciplined and documented, whether the function has appropriate quality control
approach procedures, audit manuals, work programmes and documentation.
8.2.2 The effect on external audit procedures

The external auditor then must determine the effect of the work of the internal auditors on the
nature, timing or extent of the external auditor's procedures. The factors to consider are as
follows:
 The nature and scope of the internal audit work
 The assessed risks of material misstatement
 The degree of subjectivity involved in the evaluation of the audit evidence
8.2.3 Evaluating specific internal auditing work

The ISA states: "The external auditor shall perform sufficient audit procedures on the body of the
work of the internal audit function as a whole that the external auditor plans to use to determine
its adequacy for the purposes of the audit." (ISA 610.23)
In practice, the evaluation here will consider the scope of work and related audit programmes
and whether the original assessment of the internal audit function remains appropriate.

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Evaluation
Training and Have the internal auditors had sufficient and adequate technical training to
proficiency carry out the work?
Are the internal auditors proficient?
Supervision Is the work of assistants properly supervised, reviewed and documented?
Evidence Has adequate audit evidence been obtained to afford a reasonable basis for
the conclusions reached?
Conclusions Are the conclusions reached appropriate, given the circumstances?
Reports Are any reports produced by internal audit consistent with the result of the
work performed?
Unusual Have any unusual matters or exceptions arising and disclosed by internal audit
matters been resolved properly?
Plan Are any amendments to the external audit plan required as a result of the
matters identified by internal audit?
The nature and extent of the testing of the specific work of internal auditing will depend on the
amount of judgment involved.
The external auditor's procedures must include reperformance of some of the work of the
internal audit function. If the external auditors decide that the internal audit work is not
adequate, they should extend their own procedures in order to obtain appropriate evidence.
8.2.4 Direct assistance

In addition to using specific work done by an internal audit function, the external auditor may
obtain direct assistance from individuals from the internal audit department. Where this is the
case the external auditor:
 obtains written confirmation from those individuals and as an authorised member of the
entity that they will follow instruction from the external audit team and that they will keep
specific matters confidential;
 confirms with the head of internal audit or those charged with governance the role those
individuals will play and the responsibility of the external auditor for quality control and the
audit opinion;
 supervises, reviews and evaluates the work performed;
 ensures that such individuals are only involved in work where self-review or judgement is
not an important part of the procedure; and
 agrees the approach with those charged with governance.
Point to note:
In the UK the use of internal auditors to provide direct assistance is prohibited.
8.3 Service organisations
Definition
Service organisation: A third-party organisation that provides services to user entities that are
part of those entities' information systems relevant to financial reporting.

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ISA (UK) 402, Audit Considerations Relating to an Entity Using a Service Organisation provides
guidance on how auditors carry out their responsibility to obtain sufficient, appropriate audit C
H
evidence when the audit client (called the 'user entity' in the standard) uses such an A
organisation. P
T
The use of service organisations will be discussed in detail in Chapter 7. E
R
9 Working in an audit team 6
Section overview
This section deals with working in an audit team.
The audit engagement partner (sometimes called the reporting partner) must take
responsibility for the quality of the audit to be carried out. They should assign staff with
necessary competences to the audit team.
Some audits are wholly carried out by a sole practitioner (an accountant who practises on their
own) or a partner. More commonly, the engagement partner will delegate aspects of the audit
work such as the detailed testing to the staff of the firm.
As you should already know, the usual hierarchy of staff on an audit engagement is:
Engagement
partner
Audit manager
Supervisors/audit seniors
Audit assistants
Figure 6.3: Audit staff hierarchy
9.1 Direction
The partner directs the audit. They are required by other auditing standards to hold a meeting
with the audit team to discuss the audit, in particular the risks associated with the audit. ISA 220
suggests that direction includes informing members of the engagement team of:
 their responsibilities (including objectivity of mind and professional scepticism);
 responsibilities of respective partners where more than one partner is involved in the
conduct of the audit engagement;
 the objectives of the work to be performed;
 the nature of the entity's business;
 risk-related issues;
 problems that may arise; and
 the detailed approach to the performance of the engagement.

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9.2 Supervision
The audit is supervised overall by the engagement partner, but more practical supervision is
given within the audit team by senior staff to more junior staff, as is also the case with review (see
below). It includes:
 tracking the progress of the audit engagement;
 considering the capabilities and competence of individual members of the team, and
whether they have sufficient time and understanding to carry out their work;
 addressing significant issues arising during the audit engagement and modifying the
planned approach appropriately; and
 identifying matters for consultation or consideration by more experienced engagement
team members during the audit engagement.
9.3 Review
Review includes consideration of whether:
 the work has been performed in accordance with professional standards and regulatory
and legal requirements;
 significant matters have been raised for further consideration;
 appropriate consultations have taken place and the resulting conclusions have been
documented and implemented;
 there is a need to revise the nature, timing and extent of work performed;
 the work performed supports the conclusions reached and is appropriately documented;
 the evidence obtained is sufficient and appropriate to support the auditor's report; and
 the objectives of the engagement procedures have been achieved.
Before the auditor's report is issued, the engagement partner must be sure that sufficient and
appropriate audit evidence has been obtained to support the audit opinion. The audit
engagement partner need not review all audit documentation, but may do so. They must review
critical areas of judgement, significant risks and other important matters.
9.4 Consultation
ISQC 1 states (ISQC 1.34):
"The firm shall establish policies and procedures designed to provide it with reasonable
assurance that:
(a) appropriate consultation takes place on difficult or contentious matters;
(b) sufficient resources are available to enable appropriate consultation to take place;
(c) the nature and scope of, and conclusions resulting from, such consultations are
documented and are agreed by both the individual seeking consultation and the individual
consulted; and
(d) conclusions resulting from consultations are implemented."
The partner is also responsible for ensuring that if difficult or contentious matters arise, the team
carries out appropriate consultation and that such matters and conclusions are properly
recorded.
If differences of opinion arise between the engagement partner and the team, or between the
engagement partner and the quality control reviewer, these differences should be resolved
according to the firm's policy.

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10 Auditing in an IT environment C
H
A
Section overview P
T
The more an organisation uses e-commerce, the greater the risk associated with it. As a E
consequence, there are special considerations for auditors performing the audit of companies R
who use e-commerce. 6
10.1 Introduction
We looked at IT-specific risks in the context of carrying out an audit risk assessment and the role
of data analytics tools in this aspect of the audit in Chapter 5. Most companies now have a
presence on the worldwide web: there are few companies who do not engage in some form of
e-commerce nowadays.
E-commerce introduces specific risks. In this section, we will look at what this means for the
auditor.
Definitions
Electronic data interchange (EDI): A form of computer to computer data transfer. Information
can be transferred in electronic form, avoiding the need for the information to be re-inputted
somewhere else.
Electronic mail (email): A system of communicating with other connected computers or via the
internet in written form.
Electronic commerce (e-commerce): Involves individuals and companies carrying out business
transactions without paper documents, using computer and telecommunications links.
10.2 Engaging in e-commerce

As e-commerce is a very fast-growing area of business, it is an important area for audit. For
example, the trend is increasingly towards cloud-based services. The ICAEW Information
Technology Faculty Helpsheet: Standard terms for the provision of cloud computing services to
clients describes cloud computing as the "storage of data and software on remote computers,
which are then used to deliver services over the internet to the users' preferred devices". This
can be a particularly good option for smaller businesses to handle orders and process
payments. There is no upfront investment and well-established providers offer services at
competitive prices. Obvious advantages include the 'anywhere access', but issues of security
and the stability of providers must be considered. Auditors must have an understanding of these
kinds of developments and the impact that they will have on the business and the audit. The
issues affecting the auditor's appraisal of systems including virtual arrangements and cloud
computing are addressed in Chapter 7.

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A business can engage in e-commerce to a large or small extent. The greater the involvement a
business has with e-commerce, the more the risk associated with it. The extent of involvement is
explored in the following table.
Involvement in e-commerce Risk
Information provision. A website can be used as a marketing device, to provide LOW

information to potential customers, and to enable them to request further
information through an email link.
Transactions with existing customers. Existing customers can be given the
opportunity to track current contracts or initiate others over the website.
Access to new customers. A website can be used as a place where new customers
may initiate transactions with the company.
New business model. A website can be used to diversify into specific web-based
products, for example, data for download. HIGH
There are a variety of business risks specific to a company involved in e-commerce, which will
exist to a greater or lesser degree depending on the extent of involvement.
 Risk of non-compliance with taxation, legal and other regulatory issues
 Contractual issues arising: are legally binding agreements formed over the internet?
 Risk of technological failure (crashes) resulting in business interruption
 Impact of technology on going concern assumption, extent of risk of business failure
 Loss of transaction integrity, which may be compounded by the lack of sufficient audit trail
 Security risks, such as virus attacks and the risk of frauds by customers and employees
 Improper accounting policies in respect of capitalisation of costs such as website
development costs, misunderstanding of complex contractual arrangements, title transfer
risks, translation of foreign currency, allowances for warranties and returns, and revenue
recognition issues
 Overreliance on e-commerce when placing significant business systems on the internet
Many of these issues have implications for the statutory audit and these are discussed in detail
in the next section.
An entity that uses e-commerce must address the business risks arising as a result by
implementing appropriate security infrastructure and related controls to ensure that the identity
of customers and suppliers can be verified, the integrity of transactions can be ensured,
agreement on terms of trade can be obtained, and payment from customers is obtained and
privacy and information protection protocols are established.
In its paper Across Jurisdictions in E-commerce, the ICAEW IT Faculty states that an e-trader
must ensure that it:
 displays and uses accurate information electronically;
 complies with relevant regulations and laws;
 intentionally trades only with specific geographical markets and customers;
 has contracts to facilitate effective transactions;
 monitors its contract process;
 keeps audit trails;
 creates and maintains appropriate levels of security; and
 takes appropriate insurance cover.

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10.3 Considerations for auditors

C
With the withdrawal by IAASB of IAPS 1013, Electronic Commerce – Effect on the Audit of H
A
Financial Statements, there is currently no specific guidance on the special considerations for
P
auditors who are undertaking audits of companies that use e-commerce. The logic is that, given T
the prevalence of e-commerce, this should no longer be viewed as a separate specialist audit E
area, but one to which the principles of any statutory audit should extend. R
However, the following practical points are still relevant. 6
First, the auditor needs to consider whether the staff assigned to the audit have appropriate IT
and internet business knowledge to carry out the audit. The auditor must also ensure that they
have sufficient knowledge of the client's business in accordance with ISA (UK) 315 (Revised June
2016), Identifying and Assessing the Risks of Material Misstatement through Understanding of the
Entity and Its Environment. In particular, the auditor must consider the following:
 The entity's business activities and industry
 The entity's e-commerce strategy
 The extent of the entity's e-commerce activities
 The entity's outsourcing arrangements
Internal controls can be used to mitigate many of the risks associated with e-commerce. The
auditor has to consider the control environment and control procedures in accordance with the
requirements of ISA 315. There may be situations (such as the use of highly automated
e-commerce systems, high transaction volumes, lack of electronic evidence) when the auditor
would have to use tests of control as well as substantive procedures to render audit risk to an
acceptably low level. In these situations, CAATs could be used. (Internal controls and CAATs will
be covered in further detail in Chapter 7.)
When auditing an entity that uses e-commerce, the auditor must consider in particular the issues
of security, transaction integrity and process alignment.
Security
The auditor should consider the following:
 The use of firewalls and virus protection software
 The effective use of encryption
 Controls over the development and implementation of systems used to support e-
commerce activities
 Whether security controls already in place remain effective as new technologies become
available
 Whether the control environment supports the control procedures implemented
Transaction integrity
The auditor must consider the completeness, accuracy, timeliness and authorisation of the
information provided for recording and processing in the financial records, by carrying out
procedures to evaluate the reliability of the systems used for capturing and processing the
information.
Process alignment
This is the way the IT systems used by the entity are integrated with one another to operate
effectively as one system. Many websites are not automatically integrated with the internal
systems of the entity, such as its accounting system and inventory management system, and this
may affect such issues as the completeness and accuracy of transaction processing, the timing of
recognition of sales, purchases and other transactions, and the identification and recording of
disputed transactions.

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11 Professional scepticism in the audit fieldwork stage
Section overview
We looked at professional scepticism in Chapter 5, in the context of audit planning.
Professional scepticism is central throughout the audit process, and therefore must remain at
the top of the agenda as the auditor gathers audit evidence and documents their work.
Ongoing global financial instability has increased the risk of misstatements. The risks centre
particularly around judgemental areas where there may be no clear 'right answer', where the
exercise of professional scepticism is more important than ever.
The areas of particular risk today include the following:
(a) Fraud: Consideration should be given to fraud at audit engagement team meetings. Fraud
must be considered, regardless of how well the auditor knows the client.
(b) Going concern: Smaller entities often lack detailed management information (for example,
profit forecasts), so the auditor needs to consider a broader range of audit evidence. The
client's specific circumstances and the challenges the business faces must be documented,
along with the conclusions reached.
(c) Asset impairment: The recent financial crisis has affected basic assumptions – for example,
the expected future cash flows from long-term non-financial assets such as goodwill, plant
and equipment and intangible assets. Where the audit client has non-financial assets
located in, or related to, struggling economies, the value of such assets should be actively
challenged. Where assets have been impaired, management's assumptions behind the
impairment calculation also need to be scrutinised.
(d) Valuation of receivables and revenue recognition: Besides the likely impact of fraud on
revenue recognition, the liquidity problems faced by companies and governmental
organisations mean that bad debt allowances must be considered. Revenue should be
recognised only when it is probable that future economic benefits will flow to the entity.
Worked example: Building professional scepticism into audit methodology
Audit firms are faced with the tricky task of building the exercise of professional scepticism into
their audit methodology. How does one effectively instil a 'state of mind' into a standardised
process consistently applied by hundreds upon thousands of individual staff members? Let's
look at a real-life example.
One international audit firm does this, partly, by including instructions and reminders about
exercising professional scepticism into its audit working paper templates. For example, the
walkthrough of internal controls template includes the following instructions:
Our inquiries during the walkthrough should include questions that could help to identify
the abuse of controls or indicators of fraud. For example, our follow-up questions might
include asking personnel what they do when they encounter errors, the types of errors
they encounter, what happened as a result of finding errors, and how the errors were
resolved. We might also ask the personnel whether they have ever been asked to override
processes or controls, and to describe the situation, why it occurred, and what happened.

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The working paper template also includes a checklist at the end, which audit staff are required
to initial and date in order to indicate that they have addressed each of the requirements. An C
H
excerpt is reproduced below: A
P
Initials and date T
E
We inquired of the Company personnel about their understanding of R
what was required by the Company's prescribed procedures and 6
controls to determine whether the processing procedures are
performed as originally intended and on a timely basis.
We were alert to exceptions in the Company's procedures and controls.
Our inquiries of Company personnel included follow-up questions that
help to identify the abuse of controls or indicators of fraud.
Requirements
Discuss the following with your peers:

In what ways does this approach help to ensure professional scepticism is exercised in all audits?
In what ways might the impact of this approach be limited?
What other more effective methods can you think of to ensure that audit team members exercise
professional scepticism when performing audit procedures?
The ICAEW Audit and Assurance Faculty released a video in 2011 on professional scepticism
and other key audit issues (www.icaew.com/en/technical/audit-and-assurance/professional-
scepticism).
The video usefully mentioned some questions which auditors should bear in mind as they
perform audit fieldwork:
 Does the reporting reflect the substance of what has happened?
 Does it make sense?
 Are we focusing on the things that are there but missing the things that are not there – but
should be?
 Are there limitations on the scope of our procedures?
 Are management's assumptions and forecasts appropriate?
 Are the assumptions still appropriate given the changing economy?
 What evidence is there besides what management has provided to us?
 Is the evidence contradictory?
In recent years, audit inspections have regularly pointed to the lack of scepticism in the
performance of audits. Two key points emerge from these audit inspection reports:
 Understanding the assumptions made is not enough: Simply finding out what the client has
done is not the same as auditing it. The auditor must challenge the assumptions and
understand how they affect the client's conclusions.
 The exercise of professional scepticism must be documented: Often, judgements were
made demonstrating appropriate scepticism – perhaps resulting from long conversations
with the client – but only the conclusion is documented, with little evidence of the process.
The process of documenting audit evidence and counter-evidence in itself can often help to
identify things that don't make sense.

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The following example is adapted from the transcript of the ICAEW Audit and Assurance
faculty's video on professional scepticism. It illustrates in a helpful way what is meant by
documenting the exercise of professional scepticism.
Worked example: Documenting professional scepticism
Ben is an audit senior. In the process of auditing the client's calculation for the impairment of
accounts receivable, he identified that the discount rate used seemed out of line. He consulted
Sophie, the audit manager, and she agreed that the discount rate appears inappropriate.
Ben then asked the client to explain how the discount rate had been calculated. In the course of
the client's explanation, it became clear that the discount rate had been based on an incorrect
assumption. After two hours of discussions, the client understood the error and agreed to revise
the impairment calculation and adjust the financial statements accordingly.
Ben audited the revised impairment calculation and put it on the audit file. However, simply
documenting the revised calculation would give no indication of the audit work that had been
carried out earlier, nor would it show that professional scepticism had been exercised.
In order for the documentation to be complete, Ben should include a file note to explain the
following:
 What issues were discussed with the client
 What the client said
 What evidence was offered
 What questions he then asked
 What further information was provided
 How he verified the information
 The final conclusion
11.1 Discussion among the engagement team

ISA 240 specifically requires the audit engagement team to have discussions around the
susceptibility of the financial statements to fraud. Such a discussion should focus on how, and
where, material misstatements due to fraud may occur.
Such discussions will facilitate:
 the sharing of insight by the more experienced members of the audit team into how to
identify fraud risks;
 the consideration of an appropriate response to fraud risks, including determining who will
conduct certain audit procedures; and
 the sharing of results from audit procedures with the rest of the audit team, and
determining how any allegations of fraud that come to the auditor's attention will be dealt
with.
It is the audit engagement partner's responsibility to decide which of the matters discussed are
to be communicated to those team members who are not involved in the discussion.

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11.2 Impact of use of audit data analytics

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The use of audit data analytics provides both opportunities and threats to professional H
A
scepticism. It can be argued that the availability of data at a more granular level should provide
P
the auditor with a better understanding of the entity and its environment enhancing the auditor's T
ability to apply professional scepticism. In addition the increased use of technology may reduce E
unintentional bias in audit procedures. R
However care must be taken that confidence in the software is not absolute. Auditors must not 6
believe that the results produced by data analytics tools are infallible. Professional judgement
cannot be replaced by data analytics tools.

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Appendix
This Appendix covers a number of topics which have been dealt with in detail in your earlier
studies. A brief reminder of the key points is provided below.
1 External confirmations
1.1 Introduction
You have covered the basic audit of receivables and cash and bank in your Assurance studies.
This Appendix revisits this topic in the context of ISA (UK) 505, External Confirmations. The
standard sets out guidance on how a confirmation should be carried out and, although it does
not give a list of examples, the principles could be applied to confirmations such as:
 Bank balances and other information from bankers
 Accounts receivable balances
 Inventories held by third parties
 Property deeds held by lawyers
 Loans from lenders
 Accounts payable balances
High profile financial failures such as Barings and Parmalat in Europe heightened awareness of
the use and reliability of external confirmations as audit evidence. Accordingly, some regulatory
authorities in major jurisdictions around the world called for more rigorous requirements
pertaining to the use of confirmations.
The major issue to be dealt with in the revision of this standard during the Clarity Project was to
seek a solution that achieved a balance between the conflicting circumstances in which
regulators and others have been demanding increasing prescription in the use of confirmations,
and the anecdotal evidence from practitioners that responses to confirmation requests may be
unreliable or unobtainable.
ISA 505 refers to the guidance on evidence from ISA (UK) 500, Audit Evidence, and the specific
requirement, now in ISA (UK) 330 (Revised July 2017), The Auditor's Responses to Assessed
Risks, to consider, for each material class of transactions, account balance and disclosure,
whether external confirmation procedures are to be performed as substantive procedures.
1.2 Requirements of ISA 505

1.2.1 Procedures
The auditor maintains control over the confirmation requests, including:
 determining the information to be requested;
 selecting the confirming party;
 designing the confirmation requests, including ensuring that they are correctly addressed
and contain return information for replies to be sent directly to the auditor; and
 sending the requests (and second requests, if needed).

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1.2.2 Management refusal

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If management refuses to allow a confirmation request to be sent, the auditor shall do the H
following: A
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 Enquire as to the reason, and seek evidence as to their validity. (The risk here is that T
management may claim that the confirmation may cause problems in the context of E
R
disputes or litigation, but the auditor must remain sceptical and consider the possibility that
this may be an attempt to deny access to evidence that might indicate the existence of 6
fraud.)
 Evaluate the implications of refusal on the risk assessment.
 Perform alternative procedures.
1.2.3 Results
There is always a risk that responses may be intercepted, altered or be in some other way
fraudulent. The auditor must be alert to any factors that suggest there is any doubt about the
reliability of the responses, such as:
 it was received by the auditor indirectly (for example, was received by the client entity and
passed on to the auditor); or
 it appeared not to come from the originally intended confirming party.
In the case of non-responses, the auditor must obtain alternative evidence, the form and nature
of which will be affected by the account and the assertion in question.
1.2.4 Evaluating the evidence

The auditor must evaluate whether the confirmation results provide relevant and reliable audit
evidence or whether further audit evidence is necessary.
1.3 Confirmation of accounts receivable

1.3.1 Objectives of confirmation
ISA 505 is relevant to confirmation of accounts receivable. This section recaps the practical
application of the standard. The verification of trade accounts receivable by direct
communication is a normal means of providing audit evidence to satisfy the objective of
checking whether customers exist and owe bona fide amounts to the company (existence and
rights and obligations).
Confirmation will produce a written statement from each respondent that the amount owed at
the date of the confirmation is correct. This is, prima facie, reliable audit evidence, being from an
independent source and in 'documentary' form. The confirmation of accounts receivable on a
test basis should not be regarded as replacing other normal audit checks, such as the in-depth
testing of sales transactions, but the results may influence the scope of such tests.
1.3.2 Timing
Ideally the confirmation should take place immediately after the year end and hence cover the
year end balances to be included in the statement of financial position. However, time
constraints may make it impossible to achieve this ideal.
In these circumstances it may be acceptable to carry out the confirmation before the year end
provided that confirmation is no more than three months before the year end and internal
controls are strong.

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1.3.3 Client's mandate

Confirmation is essentially an act of the client, who alone can authorise third parties to divulge
information to the auditors.
The ISA outlines what the auditors' response should be when management refuse permission
for the auditors to contact third parties for evidence.
The auditor must:
 enquire as to management's reasons and seek supporting evidence;
 evaluate the implications on the auditor's assessment of the risks of material misstatement,
including fraud;
 perform alternative audit procedures; and
 consider the implications for the audit opinion.
1.3.4 Positive vs negative confirmation
When confirmation is undertaken the method of requesting information from the customer may
be either 'positive' or 'negative'.
 Under the positive method the customer is requested to confirm the accuracy of the
balance shown or state in what respect they are in disagreement.
 Under the negative method the customer is requested to reply if the amount stated is
disputed.
The positive method is generally preferable, as it is designed to encourage definite replies from
those contacted.
The negative method may be used if the client has good internal control, with a large number of
small accounts. In some circumstances, say where there is a small number of large accounts and
a large number of small accounts, a combination of both methods, as noted above, may be
appropriate.
1.3.5 Sample selection

Auditors will normally only contact a sample of receivables balances. If this sample is to yield a
meaningful result it must be based on a complete list of all debtors. In addition, when
constructing the sample, the following classes of account should receive special attention:
 Old unpaid accounts
 Accounts written off during the period under review
 Accounts with credit balances
 Accounts settled by round sum payments
Similarly, the following should not be overlooked.
 Accounts with nil balances
 Accounts which have been paid by the date of the examination:
1.3.6 Follow up procedures

Auditors must follow up customer disagreements and failure by customers to respond.
Auditors will have to carry out further work in relation to those debtors who:
 disagree with the balance stated (positive and negative confirmation); or
 do not respond (positive confirmation only).
In the case of disagreements, the customer response should have identified specific amounts
which are disputed.

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Reasons for disagreements

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H
There is a dispute between the client and the customer. The reasons for the dispute would have A
to be identified, and provision made if appropriate against the debt. P
T
Cut-off problems exist, because the client records the following year's sales in the current year E
or because goods returned by the customer in the current year are not recorded in the current R
year. Cut-off testing may have to be extended. 6
The customer may have sent the monies before the year end, but the monies were not recorded
by the client as receipts until after the year end. Detailed cut-off work may be required on
receipts.
Monies received may have been posted to the wrong account or a cash in transit account.
Auditors should check if there is evidence of other mis-posting. If the monies have been posted
to a cash in transit account, auditors should ensure this account has been cleared promptly.
Customers who are also suppliers may net off balances owed and owing. Auditors should check
that this is allowed.
Teeming and lading, stealing monies and incorrectly posting other receipts so that no particular
customer is seriously in debt is a fraud that can arise in this area. If auditors suspect teeming and
lading has occurred, detailed testing will be required on cash receipts, particularly on prompt
posting of cash receipts.
When the positive request method is used the auditors must follow up by all practicable means
those debtors who fail to respond. Second requests should be sent out in the event of no reply
being received within two or three weeks and if necessary this may be followed by telephoning
the customer, with the client's permission.
After two, or even three, attempts to obtain confirmation, a list of the outstanding items will
normally be passed to a responsible company official, preferably independent of the sales
accounting department, who will arrange for them to be investigated.
1.3.7 Additional procedures where confirmation is carried out before year end
The auditors will need to carry out the following procedures where their confirmation is carried
out before the year end.
 Review and reconcile entries on the sales ledger control account for the intervening period.
 Verify sales entries from the control account by checking sales day book entries, copy sales
invoices and despatch notes.
 Check that appropriate credit entries have been made for goods returned notes and other
evidence of returns/allowances to the sales ledger control account.
 Select a sample from the cash received records and ensure that receipts have been
credited to the control account.
 Review the list of balances at the confirmation date and year end and investigate any
unexpected movements or lack of them (it may be prudent to send further confirmation
requests at the year end to material debtors where review results are unsatisfactory).
 Carry out analytical procedures, comparing receivables ratios at the confirmation date and
year end.
1.3.8 Evaluation and conclusions

All confirmations, regardless of timing, must be properly recorded and evaluated. All balance
disagreements and non-replies must be followed up and their effect on total receivables
evaluated.

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Differences arising that merely represent invoices or cash in transit (normal timing differences)
generally do not require adjustment, but disputed amounts, and errors by the client, may
indicate that further substantive work is necessary to determine whether material adjustments
are required.
1.4 Bank reports for audit purposes

1.4.1 Planning
The auditors should decide from which bank or banks to request confirmation, having regard to
the risks in relation to relevant financial statement assertions including bank-related information
to be disclosed in notes.
The auditor may be able to identify what banking relationships are in place by reviewing annual
facilities letters from the entity's banks. If no such letters are available, the auditor will ask the
entity's management to provide the information.
Given the importance of cash to an entity's business and its susceptibility to fraud, the auditor
will usually conclude that in the absence of a bank report it will not be possible to obtain
sufficient, appropriate audit evidence from other sources.
In planning the submission of the request, the auditor will:
 determine the date by which the bank report is needed;
 determine whether confirmation is needed of additional information, such as trade finance
transactions and balances; and
 check that the bank has been given valid authority to disclose information to the auditor.
1.4.2 Preparation and despatch of requests and receipt of replies

Control over the content and despatch of confirmation requests is the responsibility of the
auditors. However, banks require the explicit written authority of their customers to disclose
information requested. Where possible this should take the form of an ongoing authority.
Auditors need to satisfy themselves that an authority is in place and up to date. Replies should
be returned directly to the auditors and, to facilitate such a reply, a pre-addressed envelope
should be enclosed with the request.
1.4.3 Content of confirmation requests

The form and content of a confirmation request letter will depend on the purpose for which it is
required and on local practices.
The most commonly requested information is in respect of balances due to or from the client
entity on current, deposit, loan and other accounts. The request letter should provide the
account description number and the type of currency for the account.
It may also be advisable to request information about nil balances on accounts, and accounts
which were closed in the 12 months before the chosen confirmation date. The client entity may
ask for confirmation not only of the balances on accounts but also, where it may be helpful, other
information, such as the maturity and interest terms on loans and overdrafts, unused facilities,
lines of credit/standby facilities, any offset or other rights or encumbrances, and details of any
collateral given or received.
The client entity and its auditors are likely to request confirmation of contingent liabilities, such
as those arising on guarantees, comfort letter, bills and so on.
Banks often hold securities and other items in safe custody on behalf of customers. A request
letter may thus ask for confirmation of such items held by the bank.

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The procedure is simple but important.

C
(a) The banks will require explicit written authority from their client to disclose the information H
requested. A
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(b) The auditors' request must refer to the client's letter of authority and the date thereof. T
Alternatively it may be countersigned by the client or it may be accompanied by a specific E
R
letter of authority.
6
(c) In the case of joint accounts, letters of authority signed by all parties will be necessary.
(d) Such letters of authority may either give permission to the bank to disclose information for
a specific request or grant permission for an indeterminate length of time.
(e) Where practicable the request should reach the bank at least one month in advance of the
client's year end. It is advisable to allow more time at busy periods, such as those covering
December and March year ends. Fast track requests may be made where reporting
deadlines are tight. The request should state both the year-end date and the date of the
authority to disclose.
(f) The auditors should themselves check that the bank response covers all the information in
the standard and other responses.
ISA (UK) 330 (Revised July 2017) (Annexure) and ISA (UK) 505 (para. A4) both discuss how
auditors can find pro-forma templates which have been agreed with the British Bankers'
Association when obtaining bank confirmations in the UK.
2 Sampling
Definition
Audit sampling is defined by ISA (UK), 530.5a, Audit Sampling as:
"The application of audit procedures to less than 100% of items within a population of audit
relevance such that all sampling units have a chance of selection in order to provide the auditor
with a reasonable basis on which to draw conclusions about the entire population."
2.1 Nature of sampling

The audit involves a search for evidence, and sampling is, in part, a method of assessing the
quantity and quality of that evidence. In so doing, an assessment needs to be made of an
acceptable level of sampling risk ie, the risk that the sample will be unrepresentative of the
population.
Sampling can be used to extract evidence for 'tests of details' or for 'tests of controls'.
The stages of sampling involve the following:
(1) Sample design and selection
(2) Testing
(3) Evaluation
However, most research suggests that the proportion of evidence that is derived from sampling,
particularly in respect of tests of details, has declined in recent years in favour of other sources of
evidence. Typically, a small sample of items may be taken by many audit firms for tests of details,
where there are no special circumstances – although the precise number of items tested tends to
vary significantly.

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2.2 Sample design

Is it necessary? – While auditing standards require some substantive testing, they do not require
tests of detail, as analytical procedures alone may be sufficient in some circumstances.
Sample objectives – It is initially necessary to determine the purpose of the sample. This is likely
to be different according to whether the sample is for tests of control or for tests of detail. Even
in the latter case, objectives of assessing completeness, accuracy or validity will influence sample
objectives.
Population – The selection of an appropriate population from which to sample is important.
Consider the following.
 Is the population homogeneous? For example, if larger purchases are subject to more
internal controls than smaller purchases, then all purchase transactions are not subject to
the same risk and may need to be stratified into different samples.
 What is the level of risk expected in the population?
 If testing for understatement (completeness/omission) then it is important to sample from
the population making up the initial record then tracing to the final record.
 If testing for overstatement (completeness/accuracy/validity) then it is important to select
the sample from the population making up the final record then tracing to the initial record.
 Directional testing would not test all items for both over- and understatement. Populations
which consist of debits would only be tested for overstatement and credits only tested for
understatement. Given the duality of double entry, this means that any one transaction is
tested for misstatement.
2.3 Types of sampling

ISA 530 permits either of the two basic methods of sampling:
 Statistical sampling
 Judgement sampling
All types of sampling require the exercise of judgement. However, judgement sampling is so
called as the sample size and selection are based on the auditor's professional judgement rather
than any statistical basis.
The advantages of statistical sampling include the following.
 It provides unbiased sample selection.
 Sample sizes can be based upon probability theory and can more easily be justified in
court.
 It provides greater consistency of judgement between different auditors in similar
circumstances.
 Evaluation of results can more validly be extrapolated into the population.
Disadvantages include the following.
 Excessive sample sizes can arise.
 Significant judgement in assessing the level of assurance required from sampling (relative
to other evidence) is still needed, such that its statistical validity is questionable.
Statistical sampling is now less widely used than was once the case.
Methods of sampling include the following.
Random sampling – Each item in the population has an equal chance of selection.

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Systematic/Interval sampling – Takes a random start and selects every nth item thereafter (ie, at
a constant interval). It is valid if errors are randomly distributed. The interval may be numerical C
H
(eg, order numbers) or by value – monetary unit sampling (ie, every nth £ of purchases). A
P
Block/cluster sampling – The selection of a group of transactions occurring together (eg, a test
T
of all sales in the month of June). This is unlikely to be representative of the population, which E
damages its statistical validity. It is, however, normally quicker to extract the data. R
Haphazard selection – Items are selected without following a structured technique. Care must 6
be taken with respect to sample selection bias and completeness of population. It may be
appropriate where client records are poorly kept. Haphazard selection is not appropriate when
using statistical sampling.
2.4 Sample size

Auditors need to acquire sufficient evidence and this means that determining sample size is
important. Too few items incur undue sampling risk and too many items incur unnecessary costs.
Factors affecting sample size with respect to tests of detail include the following.
 Level of assurance required from sampling – If other sources of evidence are available and
indicate low inherent and control risk then sampling may be reduced.
 Tolerable misstatement or tolerable deviation rate – When testing substantively, this is the
maximum error the auditor is willing to accept in the sample – which is based on the
performance materiality level, but could be set lower for a specific assertion. When tests of
controls are being carried out, this is the number of deviations in the sample the auditor is
willing to accept without changing the initial assessment of control risk.
 Expected misstatement or expected deviation rate – This is the expected level of error and
deviation in the sample.
 Variability of the population – This is not relevant to sampling for tests of control but
increased variability will increase sample sizes for substantive tests.
 The size of the population – Other than for very small populations, the size of the population
has a minimal effect on sample sizes.
Appendix 1 and 2 to ISA 530 contain useful summaries of the factors influencing sample sizes.
2.5 Sample evaluation

For tests of details the auditor is required to project misstatements found.
The misstatements and deviations discovered in the sample need to be extrapolated into the
population in order to draw conclusions about whether the population is materially misstated.
(In order to do this appropriately it is important that the sample was representative of the
population from which it was selected.) Where the estimated misstatement exceeds the
tolerable misstatement then additional evidence may be needed.
Consider also the following.
 While management may adjust for misstatements actually discovered, consideration needs
to be given to misstatements in unsampled items and whether any global adjustment is
appropriate.
 There may be patterns or trends in the misstatements discovered.
 There may be a pattern from previous years, which would add additional insight into the
extent of the misstatement in the population.

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 Size and incidence of misstatements discovered eg, a few large misstatements or many
small misstatements.
 Nature of the misstatements. Are they factual or are they perceived errors of
judgement/opinion?
 Whether they are fraudulent.
 Whether a misstatement relates to the statement of financial position or to the statement of
profit or loss and other comprehensive income.
For tests of controls an unexpectedly high sample deviation rate may lead to an increase in the
assessed risk of material misstatement unless further audit evidence substantiating the initial
assessment is obtained.
Point to note:
Future improvements in technology and the use of audit data analytics may enable auditors to
perform testing on 100% of a population, and to monitor transactions on a more frequent or
even continuous basis (although currently the ability of data analytics to perform 100% testing is
restricted to very limited types of information and audit assertions with respect to that
information).
3 Directional testing
Directional testing is a method of discovering errors and omissions in financial statements.
Directional testing has been discussed in your previous auditing studies. It is a method of
undertaking detailed substantive testing. Substantive testing seeks to discover errors and
omissions, and the discovery of these will depend on the direction of the test.
Broadly speaking, substantive procedures can be said to fall into two categories:
 Tests to discover errors (resulting in over- or understatement)
 Tests to discover omissions (resulting in understatement)
3.1 Tests designed to discover errors

These tests will start with sampling the final accounting records in which the transactions are
recorded and check from the entries to supporting documents or other evidence. Such tests
should primarily detect any overstatement but also note any understatement through causes
other than omission.
3.2 Tests designed to discover omissions

These tests must start from outside the accounting records and then check to those records.
Understatements through omission will never be revealed if the auditor starts with the initial
recording of a transaction (eg, an order form) and traces it through the various documents and
accounts into the financial statements. There would clearly be no chance of selecting items that
have been omitted if sampling was taken from the final accounts.
For most systems auditors would include tests designed to discover both errors and omissions.
The type of test, and direction of the test, should be recognised before selecting the test
sample. If the sample which tested the accuracy and validity of the sales ledger were chosen
from a file of sales invoices then it would not necessarily substantiate the fact that there were no
errors in the sales ledger. The approach known as 'directional testing' applies this testing
discipline.

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3.3 Directional testing and double entry

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The concept of directional testing derives from the principle of double-entry bookkeeping, in H
A
that for every debit there is a corresponding credit (assuming that the double entry is complete
P
and that the accounting records balance). Therefore, any misstatement of a debit entry will T
result in either a corresponding misstatement of a credit entry or a misstatement in the opposite E
direction of another debit entry. R
By designing audit tests carefully the auditors are able to use this principle in drawing audit 6
conclusions, not only about the debit or credit entries that they have directly tested but also
about the corresponding credit or debit entries that are necessary to balance the books. Tests
are therefore designed in the following way.
Test item Example

Test debit items (expenditure or If a non-current asset entry in the nominal ledger of £1,000
assets) for overstatement by is selected, it would be overstated if it should have been
selecting debit entries recorded in recorded at anything less than £1,000 or if the company
the nominal ledger and checking did not own it, or indeed if it did not exist (eg, it had been
value, existence and ownership sold or the amount of £1,000 in fact represented a
revenue expense).
Test credit items (income or Select a goods despatched note and check that the
liabilities) for understatement by resultant sale has been recorded in the nominal ledger
selecting items from appropriate sales account. Sales would be understated if the nominal
sources independent of the ledger did not reflect the transaction at all (completeness)
nominal ledger and ensuring that or reflected it at less than full value (say if goods valued at
they result in the correct nominal £1,000 were recorded in the sales account at £900, there
ledger entry would be an understatement of £100).
In a ledger account for (say) an asset, the balance would be a debit, but there may be both debit
and credit entries in the account. In using directional testing on this asset account balance, the
debit entries would be tested for overstatement and the credit entries for understatement. The
reason is that the understatement of a credit entry would lead to the overstatement of the asset's
debit balance on the account, the verification of which is the primary purpose of the test.
The matrix set out below demonstrates how directional testing is applied to give assurance on
all account areas in the financial statements.
Primary test also gives comfort on
Type of account Purpose of primary test Assets Liabilities Income Expenses
Assets Overstatement (O) U O O U

Liabilities Understatement (U) U O O U
Income Understatement (U) U O O U
Expense Overstatement (O) U O O U
A test for the overstatement of an asset simultaneously gives comfort on understatement of

other assets, overstatement of liabilities, overstatement of income and understatement of
expenses.

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Summary
Audit risk
Should it be there?
Value? Financial statement
Any more? assertions
Disclosure?
Audit evidence
Sufficient Appropriate
Relevant Reliable
Controls
Sources of
Test of details
confidence
Analytical procedures
Client
Sources of
Third party
evidence
Auditor
Objective
Procedures Recording Method
Results
Conclusion
Direction
Statistical
Sampling
Judgemental

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Self-test
C
Answer the following questions. H
A
1 Strombolix plc P
T
Strombolix plc (Strombolix) is a listed company which manufactures and retails paints and E
other decorating products. You are the senior in charge of the audit of Strombolix for the R
year ending 30 June 20X2, which is currently in progress.
6
Background information provided
The company owns a large factory manufacturing paints. These paints are sold retail
through Strombolix's six superstores and they are also sold wholesale to other DIY retailers.
In addition, the six superstores sell a range of other products from different suppliers. The
superstores are each separate divisions, but there are no subsidiaries.
On 23 July 20X2 a bid was announced by Simban plc (Simban) to acquire the entire
ordinary share capital of Strombolix. The directors of Strombolix are contesting the bid and
are anxious to publish the financial statements to indicate that the company is more
profitable than indicated by the Simban offer.
As a result of the bid your audit partner has sent you the following memorandum.
INTERNAL MEMORANDUM
To: A Senior
From: Charles Church (partner)
Date: 24 July 20X2
Subject: Strombolix audit
As you will be aware, Simban made a bid for Strombolix yesterday and this increases the
significance of the financial statements that we are currently auditing.
I am having a preliminary meeting with the finance director on 1 August to discuss the
conduct of the audit. I would like you to prepare notes for me of any audit and financial
reporting issues that have arisen in your work to date that may indicate potential problems.
Also include any general audit concerns you may have arising from the takeover bid.
Let me know what you intend to do about these matters and specify any questions that you
would like me to raise with the finance director.
Further information
The following issues have been reported to you from junior audit staff during the audit to
date.
AUDIT ISSUES
(1) There appears to be a significant increase in trade receivables, due to the fact that
many wholesale customers are refusing to pay a total of £50,000 for recent deliveries
of a new paint that appears to decay after only a few months of use. Some of the
wholesale customers are being sued by their own customers for both the cost of the
paint and the related labour costs. No recognition of these events has been made in
the draft financial statements.
(2) A special retail offer of '3 for 2' on wallpaper purchased from an outside supplier
during the year has been incorrectly recorded, as the offer was not programmed into
the company's IT system. The sales assistants were therefore instructed by store
managers to read the bar codes of only two of the three items, and ignore the third
'free' item. The wallpaper sells for £6 per roll and cost £5 per roll from the supplier. A
total of 20,000 of these rolls were processed through the IT system by sales assistants
during the year.

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The reason for the special offer was that a bonus payment of £90,000 will be due to
Strombolix from the supplier if 40,000 of these rolls of wallpaper are sold by
31 December 20X2. Strombolix has taken 50% of this amount (ie, £45,000) into its draft
statement of profit or loss and other comprehensive income as revenue for the year to
30 June 20X2.
(3) One of the six superstores was opened on 30 May 20X2. The land had been purchased
at a cost of £400,000 on 1 August 20X1, but it was only on 1 September 20X1 that the
company began to prepare an application for planning permission. This was granted
and construction commenced immediately thereafter, being paid for in two progress
payments of £1 million each on 1 December 20X1 and on 1 June 20X2. Construction
was completed, and the store opened, on 30 May 20X2. All the costs were financed by
borrowing at 8% per annum and all the interest incurred up to 30 June 20X2 has been
capitalised as part of the cost of the non-current asset in the draft financial statements.
There was no interest earned on surplus funds from this loan.
Requirement
Draft the notes required by Charles Church's memorandum.
2 AB Milton Ltd
You are the senior in charge of the audit of AB Milton Ltd for the year ended 31 May 20X1.
Details of AB Milton Ltd and certain other companies are given below.
AB Milton Ltd
A building company formed by Alexander Milton and his brother, Brian.
AB Milton Ltd has issued share capital of 500 ordinary £1 shares, owned as shown below.
Alexander Milton 210 42% Founder and director
Brian Milton 110 22% Founder and director
Catherine Milton (Brian's wife) 100 20% Company secretary
Diane Hardy 20 4%
Edward Murray 60 12% Director
Edward Murray is a local businessman and a close friend of both Alexander and Brian
Milton. He gave the brothers advice when they set up the company and remains involved
through his position on the board of directors. His own company, Murray Design Ltd,
supplies AB Milton Ltd with stationery and publicity materials.
Diane Hardy is Alexander Milton's ex-wife. She was given her shares as part of the divorce
settlement and has no active involvement in the management of the company. Alexander's
girlfriend, Fiona Dyson, is the company's solicitor. She is responsible for drawing up and
reviewing all key building and other contracts, and frequently attends board meetings so
that she can explain the terms of a particular contract to the directors. Her personal
involvement with Alexander started in May 20X1 and, since that time, she has spent
increasing amounts of time at the company's premises.
Cuts and Curls Ltd
A poodle parlour, of which 50% of the issued shares are owned by Diane Hardy and 50% by
Gillian Milton, who is Alexander and Diane's daughter.
Cuts and Curls operates from premises owned by AB Milton Ltd for which it pays rent at the
normal market rate.
Campbell Milton Roofing Ltd
A roofing company owned 60% by AB Milton Ltd and 40% by Ian Campbell, the managing
director.
Campbell Milton Roofing Ltd carries out regular work for AB Milton Ltd and also does roofing
work for local customers. Alexander Milton is a director of Campbell Milton Roofing Ltd and
Catherine Milton is the company secretary. All legal work is performed by Fiona Dyson.

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Requirements
C
(a) Based on the information given above, identify the potential related party transactions H
you expect to encounter during the audit of AB Milton Ltd and summarise, giving your A
reasons, what disclosure, if any, will be required in the full statutory accounts. P
T
(b) Prepare notes for a training session for junior staff on how to identify related party E
transactions. Your notes should include the following: R
(1) A list of possible features which could lead you to investigate a particular 6
transaction to determine whether it is in fact a related party transaction
(2) A summary of the general audit procedures you would perform to ensure that all
material related party transactions have been identified
3 TrueBlue Ltd
You are planning the audit of TrueBlue Ltd, a company that has experienced a downturn in
trading over recent years. The finance director has provided you with the following
information for you to review before a planning meeting with him.
Statement of profit or loss and other comprehensive income extracts
20X7 20X6 20X5
£ £ £
Revenue 18,944,487 20,588,370 24,536,570
Cost of sales 14,587,254 14,413,543 17,176,922
Gross profit 4,357,233 6,174,827 7,359,648
Advertising and marketing 554,288 206,688 207,377
Legal costs 14,888 2,889 34,668
Electricity 199,488 204,844 206,488
Travel costs 65,833 30,892 53,588
Audit fee 21,000 21,000 20,488
Statement of financial position extracts
20X7 20X6 20X5
£ £ £
Trade receivables 3,477,481 3,553,609 4,089,783
Trade payables 1,056,090 1,027,380 1,164,843
Cost of sales analysis
20X7 20X6 20X5
£ £ £
Purchases 9,183,388 9,246,420 10,483,588
Other direct costs 6,419,410 6,894,300 7,087,148
Inventory movement (1,015,544) (1,727,177) (393,814)
Requirements
(a) Outline the areas of the financial statements you would discuss with the finance
director at your planning meeting as a result of the analytical procedures that you
perform on these figures, giving your reasons and also set out any further information
you would request.
(b) Explain whether your approach would be different if you had received a tip off that the
finance director has been carrying out a fraud on receipts from receivables and, if it
would be different, outline how it would be different.
(c) Describe how you approach the audit of receivables as a result of the tip off about the
finance director.

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4 Tofalco plc
You are an audit senior in the process of carrying out the final audit for the year ended
30 September 20X0 for Tofalco plc, a construction company with business activities across
the UK and Ireland.
The following message is left on your answer machine by Paul Sykes, Head of Audit.
Good morning Jeremy,

Paul Sykes here. Hope all is well with you.
I have left a memo in your mailbox with the items outstanding on the year-end audit of our client
Tofalco plc.
Please prepare a memo showing the appropriate financial reporting treatment for each item in
the financial statements for the year ended 30 September 20X0 and the audit procedures
required to gain assurance in each area.
I am concerned as the directors appear to be unwilling to provide full details of their related
parties' remuneration and seem to be denying access to the company board minutes. They are
also refusing to recognise the obligations required under IAS 37 with respect to environmental
costs. Please give me your opinion on the effects of these non-compliance issues on audit risk
and on the form of the audit report to be issued.
Tofalco plc have also asked that we advise them on the way they should work with Investo Ltd, a
company to which they plan to outsource their investment activities. Tofalco plc wishes to agree
on terms of co-operation that minimise risks of financial loss, fraud and error. Is there any impact
on our audit going forward?
Finally, can you prepare a list of the ethical issues you foresee on this assignment. They would
be helpful to have to hand.
Call me if you have any queries.
Memorandum
To: Jeremy Wiquad
From: Paul Sykes
Subject: Year-end audit of Tofalco plc – Outstanding points
Construction contracts
Tofalco plc's largest current project is the construction of a water pipeline under the
Mediterranean Sea. The project commenced late in 20X9 and completion is not expected until
20X6.
By 30 September 20X0, the following figures apply.
£m
Sales value of contract 8,500
Costs incurred to date 400
Estimated future costs 7,000
Sales value of work completed to date 560
The directors do not yet believe that the project is sufficiently far advanced for the outcome to
be assessed with any degree of certainty. The company's accounting policy is to take
attributable profit on the basis of the sales value of the work completed.

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Environmental and other provisions

C
Tofalco plc has a number of long-term obligations arising from the local laws on the H
A
environment. Tofalco is obligated to dispose of its scrap machinery in a particular way which P
minimises the damaging effect on the environment. T
E
The machinery held by Tofalco at the year end has a total carrying amount of £25 million and it is R
estimated that the present value of the cost to dispose of these machines will be some £2.5
6
million.
One of Tofalco's biggest customers, Stirly plc, is refusing to pay a sum of £4 million. No
provision has been created by the company and the reasons are unclear as to why Stirly plc is
holding back payment, with management being vague in their explanations and appearing to
be denying access to the company board minutes.
Assets held for sale
On 1 January 20X0, Tofalco plc committed to selling an owner-occupied building which had a
carrying amount of £2.16 million at that date. The building was available for immediate sale from
that date but the company continued to occupy and use the building until 1 February when the
carrying amount was approximately £2.1 million. The recoverable amount is estimated at
£1.7 million. The building has yet to be sold by 30 September 20X0.
Issue of convertible loan stock
On 1 March 20X0, Tofalco plc issued £18 million of convertible loan stock, which is either
redeemable in three years' time for £20 million, or convertible into 500,000 ordinary £1 shares.
The present values of the cash flows, discounted at the interest rate on a debt instrument with
similar terms except that there is no conversion option, are as follows.
£
Present value of principal 15,902,000
Present value of interest 960,000
16,862,000
Related parties
Tofalco plc purchases significant quantities of raw materials from Sandstone Ltd, a company
whose Finance Director is also a shareholder in Tofalco plc. During the year ended 30
September 20X0 alone, Tofalco plc purchased £230 million worth of raw material from
Sandstone Ltd with a credit payment period of three months. The normal credit period provided
within the industry is two months.
Requirement
Respond to Paul Sykes's request.

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Technical reference
1 ISA 210
 Terms of audit engagements ISA 210
2 ISA 402
 Definition ISA 402.8
 Understanding the entity ISA 402.9–.14
 Audit procedures for obtaining audit evidence ISA 402.15–.16
 Reference in audit reports ISA 402.20–.22
3 ISA 315
 List of audit assertions ISA 315.A111
4 ISA 500
 Sufficient and appropriate audit evidence ISA 500.A1–.A6
 Audit procedures for obtaining audit evidence ISA 500.A10–.A25
 Evidence from information produced by a ISA 500.A34–.A48
management's expert
5 ISA 501
 Procedures regarding litigation and claims ISA 501.9–.12, .A17–.A25
6 ISA 505
 Considerations in obtaining external confirmation ISA 505.2–.3
evidence
 External confirmation procedures ISA 505.7–.16
7 ISA 510
 Need to obtain audit evidence ISA 510.3
 Audit procedures ISA 510.5–.9
 Audit conclusions and reporting ISA 510.10–.13
8 ISA 520
 Use of analytical procedures as substantive ISA 520.5, A4–.A10
procedures
 Analytical procedures when forming an overall ISA 520.6, A17–A19
conclusion
9 ISA 530
 Definitions ISA 530.5
 Design of the sample ISA 530.A4–.A9
 Sample size ISA 530.A10–.A13, Appendix 2
 Evaluation of sample results ISA 530.A21–.A23

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10 ISA 540 C
H
 Examples of accounting estimates ISA 540.A6
A
 Risk assessment procedures ISA 540.8–.11 P
 Substantive procedures ISA 540.15–.17 T
 Evaluation of results of audit procedures ISA 540.18 E
R
11 ISA 550 6
 Definitions ISA 550.10
 Risk assessment procedures ISA 550.11–17
 Audit procedures ISA 550.20–.24
 Written representations and reporting ISA 550.26–.27
12 ISA 610
 Evaluating the internal audit function ISA 610.15–.16
 Using the work of internal audit ISA 610.21–.25
13 ISA 620
 Determining the need to use the work of an auditor's ISA 620.7
expert
 Competence, capabilities and objectivity of the ISA 620.9, A14–A20
auditor's expert
 Agreeing the scope of the auditor's expert's work ISA 620.11
 Evaluating the work of the auditor's expert ISA 620.12–.13
 Reference in audit report ISA 620.14–.15
 Documentation ISA 620.15D–1

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Non-current assets Should it be in the Physically verify Existence

accounts at all?
Inspect title Rights and
deeds/invoice/vehicle obligations
registration documents
Board minutes and other
authority thresholds
Is it included at the Inspect invoices/contracts Accuracy,
right amount? valuation and
Check depreciation
allocation
Are there any more? Review other accounts for Completeness
items which should be
capitalised
Check assets physically
verified are included in the
Is it properly Companies Act checklist Classification
disclosed and Presentation
presented?
Receivables Should it be in the Circularisation Existence
accounts at all?
After date cash Rights and
obligations
Inspect invoices
Is it included at the Inspect ageing analysis Accuracy,
right amount? valuation and
After date cash
allocation
Are there any more? Conclusion derived from sales Completeness
completeness testing
Cut-off work
presented?
Payables Should it be in the Suppliers' statement Existence
accounts at all? reconciliation
Conclusion derived from Rights and
purchases testing obligations

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C
H
Payables Is it included at the Suppliers' statement Accuracy, A
right amount? reconciliation valuation and P
allocation T
E
Are there any more? Unpaid invoices review Completeness R
Review payments after year 6

end to check for omitted
liabilities
Cut-off work
Review for obvious omissions
of accruals
Review payables at last year
end to check for omissions this
year
Review knowledge of major
suppliers to check for
omissions
disclosed and
Presentation
presented?
Inventory Should it be in the Attend inventory check – test Existence
accounts at all? from records to test counts
Rights and
Cut-off work obligations
Consider inventory held for
third parties or on
consignment
Is it included at the Inspect invoices and other Accuracy,
right amount? costing evidence valuation and
allocation
Review for slow-moving or
obsolete items
Evidence of slow-moving or
damaged items from inventory
check
Are there any more? Attend inventory check – test Completeness
from test counts to records
Cut-off work
Consider other locations,
inventory held by third parties
on consignment
presented?

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(a) The relevant financial statement assertions would be as follows.
 Completeness
There is a risk that all share-based payments may not have been recognised in the
financial statements, as the provision of the benefit to the employee may not arise until
some point in the future. For example, in this case the options cannot be exercised
until the directors have been with the company for three years. In accordance with
IFRS 2 the service acquired in a share-based payment should be recognised as
received.
 Accuracy
The remuneration expense should reflect the fact that the service received in exchange
for the share-based payment will be received over a period of time ie, three years (see
calculation below). It also needs to be estimated how many of the five directors will
remain with the company and hence how many of the options are likely to vest.
 Accuracy, valuation and allocation
Equity should be increased by the fair value of the options at the grant date (see
calculation below).
Remuneration expense this year and equity recognised in respect of the options will
be:
(5  100,000)  £3/3 years  4/12 = £166,667
(b) The relevant financial statement assertions relate to disclosure as follows.
 Classification
Whether the transaction is a related party transaction. 40% would appear to indicate
the ability of Wigwam plc to exert significant influence assuming no other entity has
control.
 Completeness
Whether there are any other related party transactions between these two parties
and/or whether there are any additional related party relationships.
 Accuracy
If the disclosure states that the transaction is on an arm's length basis this must be
substantiated.
(c) The relevant financial statement assertions are:
 Classification
Whether a bond should be classified as debt or equity. In this case it is a compound
instrument. The liability and equity component will be shown separately.
 Accuracy, valuation and allocation
The liability component should be computed as the present value of the maximum
potential cash flows discounted @ 10% as follows.
Year Cash flow DF @ 10% Net present value
£ £
1 6,000 0.909 5,454
2 106,000 0.826 87,556
Liability 93,010
The residual amount is the equity component (100,000 – 93,010) = £6,990.

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C
Appropriate – relevance H
A
The relevance of audit evidence should be considered in relation to the overall audit objective P
T
of forming an opinion and reporting on the financial statements. The evidence should allow the E
auditor to conclude on the following: R
 Statement of financial position items (existence, rights and obligations, completeness, 6

accuracy, valuation and allocation, classification and presentation)
 Statement of profit or loss items (occurrence, completeness, accuracy, cut-off, classification
and presentation)
(a) The representations by management in respect of the completeness of sales are relevant to
the first of the objectives when gathering evidence on revenue items. Depending on the
system operated by the client and the controls over cash sales there may be no other
evidence as to the completeness of sales.
(b) The flowcharts prepared by the internal audit department will not be directly relevant to the
auditor's opinion on individual figures in the financial statements, but rather when the
auditor is following the requirement in ISA 315 to obtain an understanding of the entity's
information system of recording and processing transactions. The auditor will wish to assess
the adequacy of the system as a basis for the preparation of financial statements so the
flowcharts will be relevant only if they are sufficiently detailed to allow the auditor to carry
out this assessment. The auditor would also wish to make an initial assessment of internal
controls at this stage so the flowcharts will be more relevant if control procedures are
specifically identified.
(c) Year-end suppliers' statements provide evidence relevant to the auditor's conclusions on:
 the completeness of payables, as omissions from the purchase ledger listing would be
identified by comparing statements received to that listing;
 the existence of payables recorded in the purchase ledger;
 the fact that the liabilities are properly those of the entity (for example, the statements
are not addressed to, say, the managing director in his own name); and
 the valuation of payables at the year end with respect to cut-off of invoices and credit
notes, and discounts or allowances.
(d) The physical inspection of a non-current asset is clearly relevant to the auditor's opinion as
to the existence of the asset, and to some extent the completeness of recording of assets;
that is, the auditor can check that all the assets inspected have been recorded. In certain
circumstances evidence relevant to valuation might be obtained; for example, where a
client has written down a building due to impairment in value and the auditor sees it
standing unused and derelict.
(e) The comparison of revenue and expenditure items with prior periods will provide evidence
as to:
 completeness of recording, as omissions can be identified and investigated;
 accuracy, in cases where the auditor has appropriate information on which to base
expectations, for example, if the number of workers has doubled during the year and a
set percentage wage increase had been effected in the year; and
 presentation, as the comparison should highlight any inconsistencies of classification
and treatment from year to year.

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(f) The proof in total calculation will provide evidence as to the accuracy of the interest
expense. Typically this would be calculated by multiplying the interest rate applicable to the
loan to the average amount of the loan for the period. Any significant difference between
the total calculated by the auditor and the amount in the financial statements would need to
be investigated further.
Appropriate – reliable
Reliability of audit evidence depends on the particular circumstances but the standard offers
three general presumptions:
 Documentary evidence is more reliable than oral evidence.
 Evidence obtained from independent sources outside the entity is more reliable than that
secured solely from within the entity.
 Evidence originated by the auditor by such means as analysis and physical inspection is
more reliable than evidence obtained by others.
(a) The oral representations by management would be regarded as relatively unreliable using
the criteria in the standard, as they are oral and internal. In the absence of any external or
auditor-generated evidence, the auditor should ensure that these representations are
included in the letter of representation so that there is at least some documentary evidence
to support any conclusions.
(b) The assessment of how reliable the flowcharts are would depend on the auditor's overall
assessment of the internal audit department. The factors to be considered would include its
degree of independence, the scope of its work, whether due professional care had been
exercised, the technical competence and the level of resource available to the internal audit
department. This assessment should be documented by the external auditor if they are to
make use of the flowcharts in their audit planning and design of tests.
(c) Suppliers' statements would generally be seen as reliable evidence, being documentary
and from sources external to the entity. If the auditor had doubts as to the reliability of this
evidence, it could be improved by the auditor originating similar evidence by means of a
payables circularisation rather than relying on suppliers' statements received by the client.
(d) Physical inspection of a non-current asset is a clear example of auditor-originated evidence,
so would usually be considered more reliable than that generated by others.
(e) Analysis such as this comparison of revenue and expenditure items with the prior periods
would again be termed auditor-generated evidence, and would be considered more
reliable than evidence generated by others. Ultimately the reliability of such audit evidence
depends on the reliability of the underlying data; this should be checked by tests of
controls or substantive procedures.
(f) As above, the proof in total would again be termed auditor-generated evidence, and would
be considered more reliable than evidence generated by others. Ultimately the reliability of
such audit evidence depends on the reliability of the underlying data. Timings of
repayments would need to be considered when calculating the average level of the loan
during the period and the interest rate would need to be agreed to the loan agreement.
Sufficiency
The auditor needs to obtain sufficient relevant and reliable evidence to form a reasonable basis
for their opinion on the financial statements. Their judgements will be influenced by such factors
as:
 their knowledge of the business and its environment;
 the risk of misstatement; and
 the persuasiveness of the evidence.

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(a) To decide if the representations were sufficient with regard to concluding on the
completeness of sales, the auditor would consider: C
H
 the nature of the business and the inherent risk of unrecorded cash sales; A
P
 the materiality of the item (in this case it would appear that cash sales are material); T
E
 any possible management bias; and R
 the persuasiveness of the evidence in the light of other related audit work, for example, 6
testing of cash receipts.
If the auditor believes there is still a risk of material understatement of sales in the light of
the above, they should seek further evidence.
(b) Client-prepared flowcharts are not sufficient as a basis for the auditor's evaluation of the
system. To confirm that the system does operate in the manner described, the auditor
should perform 'walkthrough' checks, tracing a small number of transactions through the
system. There is, however, no need for the auditor to prepare their own flowcharts if they
are satisfied that those produced by internal audit are accurate.
(c) The auditor's decision as to whether the suppliers' statements were sufficient evidence
would depend on their assessment of materiality and the risk of misstatement. Its
persuasiveness would be assessed in conjunction with the results of other audit procedures,
for example substantive testing of purchases, returns and cash payments, and compliance
testing of the purchases system.
(d) Inspection of a non-current asset would be sufficient evidence as to the existence of the
asset (provided it was carried out at or close to the end of the reporting period). Before
concluding on the non-current asset figure in the accounts, the auditor would have to
consider the results of their work on other aspects, such as the ownership and valuation of
the asset.
(e) In addition to the general considerations, such as risk and materiality, the results of a
'comparison' alone would not give very persuasive evidence. It would have to be followed
by a detailed investigation of variances (or lack of variances where they were expected). The
results should be compared to the auditor's expectations based on their knowledge of the
business, and explanations given by management should be verified. The persuasiveness of
the evidence should be considered in the light of other relevant testing, for example tests of
controls in payments systems and substantive testing of expense invoices.
(f) The interest payable on the loan is likely to be relatively low risk but could be material. The
proof in total calculation may be sufficient evidence depending on the level of difference
between the amount expected by the auditor and the actual amount. Any significant
discrepancy would need to be investigated.

(a) Factors to consider:
Materiality
Property, plant and equipment (PPE) is likely to constitute a material proportion of the
assets in the statement of financial position of a manufacturing company. In addition, the
depreciation charge may be material to profit.
Depreciation of plant and machinery is charged to cost of sales, and therefore has a direct
impact on the gross profit margin of the business.
Inherent risk
Although PPE is generally regarded as having low inherent risk, the following factors may
increase the level of risk for Xantippe Ltd.

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 Additions to plant may be misclassified as repairs and recognised in profit or loss.

 Repairs expenditure may be capitalised in error.
 Depreciation has a direct impact on profit and can potentially be manipulated by
changing the expected useful lives of assets.
Control risk
To determine the degree of reliance that can be placed on internal controls, the following
will need to be examined.
 Authorisation of expenditure on new PPE
 Client procedures for periodic review of renewals/repairs accounts
 Client reconciliations between the PPE register and nominal ledger account balances
If reliance can be placed on the above controls, assurance will be obtained that:
 PPE additions are valid business items;
 capital expenditure has been included in PPE; and
 revenue expenditure written off PPE has been accurately recorded.
Strong controls, as confirmed by tests of controls, will enable the level of substantive
procedures to be reduced.
(b) Audit procedures:
Freehold property
 Agree opening balances to prior year working papers/financial statements.
 Inspect the title deeds to the property (or obtain assurance that they are held by the
bank) in order to confirm continuing ownership.
 Inquire whether any valuations have been carried out in the year.
 If any valuation shows a fall in value, propose adjustment (if material).
 Inspect the property to confirm (existence) that no provision for fall in value is
necessary.
 Confirm from the bank letter (and discussions with management) any charges on the
property.
 Confirm all charges are properly disclosed in a note to the financial statements.
 Discuss with directors the reasonableness of their estimate of the useful life of the
freehold buildings.
 Reperform the calculation of depreciation, ensuring that the freehold land is not
depreciated.
Plant and machinery and motor vehicles
 Confirm opening balances to prior year financial statements.
 Obtain a list of additions in the year which reconciles with the total in the financial
statements.
 For a sample of additions – trace to purchase invoices to confirm ownership – review
board minutes/capital expenditure requisition for authorisation.
 Review the list of additions to ensure that all items are of a capital nature.
 For a sample of assets on the register, physically inspect to confirm existence.
 Inspect invoices for motor vehicle additions to confirm that capital cost includes VAT
but excludes road tax.
 If motor vehicle additions involved a trade-in/part-exchange, discuss financial
statement adjustments required with directors (since no disposals accounted for).

lOMoARcPSD|5054551
 Inspect vehicle registration documents to confirm ownership.

C
 Compare the depreciation charge (as a percentage of cost) on a category by category H
basis with that of the prior year to assess reasonableness. A
P
 Reperform depreciation calculations for a sample of assets on the register. T
E
 Obtain a list of disposals in the year which reconciles with the total in the financial R
statements.
6
 For a sample of disposals – trace sales proceeds to sales invoice and cash book –
reperform calculation of profit on disposal and trace to statement of profit or loss and
other comprehensive income.
 Review repairs and renewals accounts to ensure that no items of a capital nature have
been written off.

Audit risks
 Revenue has increased by 15.6% as compared with 10 months to October 20X6. There is a
risk that revenue is overstated. Investigations would be required as to why this increase has
taken place. For example, it could be the result of a change in revenue recognition policy.
Revenue may also have been affected by the translation of foreign currency sales which
make up a significant proportion of total revenue. It may also be that sales prices have
increased and the price lists should be reviewed for changes, including the dates when
changes were made. This includes both official prices and discounting policy. It may also be
that sales volumes or sales mix have changed. This should be reviewed against budgeted
production.
 Gross profit margin has increased. This is because cost of sales has increased by only 7.2%
compared to an increase in revenue of 15.6%. This may indicate that the increase in
revenue was largely as a result of selling price increases (which would not be reflected in
increased costs) rather than volume increases (which would have been reflected in
increased cost of sales). This proposition would be true for a retail company but, as Darwin
is a manufacturing company, there may be an alternative explanation. This is that cost of
sales consists of both variable costs (eg, raw materials) and fixed costs (manufacturing
overheads, such as factory rent). If sales volumes have increased significantly between 20X6
and 20X7 then, if fixed costs are significant, one would not expect costs of sales to vary
proportionately with sales revenue, but would increase by a smaller percentage. The
manufacturing cost structures would therefore need to be reviewed to formulate an
expectation of the relationship between cost of sales and revenue when volumes increase.
There is also a risk that revenue may be overstated due to accounting errors; for example,
items in transit to overseas customers being included in both revenue and year-end
inventories. This would be consistent with the increase in inventory balance. Alternatively, it
could be the result of understatement of purchases.
 Changes in pricing strategy, sales mix or productivity would also have to be considered.
 Operating profit has increased and may be overstated. This could indicate understatement
of operating expenses, for example through inadequate accrual for such expenses.
 Increasing inventory values
Assuming 360 days in a full year then inventory days have increased significantly:
10 months to 31 Oct 20X6 4,320/14,966  300 days = 87 days
10 months to 31 Oct 20X7 5,160/16,040  300 days = 97 days

lOMoARcPSD|5054551
 Inventory may therefore be overstated. This could be as a result of errors in the quantity of
inventory held or errors/changes in the way the inventory has been valued.
 The business appears to be seasonal. In the 10 months to 31 October 20X6 the average
monthly sales were £2,352,000. In the 2 months to 31 December 20X6 average monthly
sales were only £1,776,000. The period to sell the inventory at 31 October 20X7 is therefore
likely to be longer than would be implied by the average sales for the 10-month period, as
2 months of low sales are forthcoming if the pattern of 20X6 is to be repeated. This would
imply inventory days of more than 97 days and thus impairment should be considered.

(a)
Observations Impact on audit of trade payables
 Gross profit margin has fallen from  Business strategy and performance must
24% last year to 21% this year. be discussed with the directors.
The lower margin could arise from
genuine business factors including some
relating to payables such as:
– new suppliers charging higher prices;
and
– increases in the cost of raw materials
used by suppliers.
These factors would have to be confirmed
during the audit of payables.
 Cost of sales has increased by 50%  Where the decline in margin cannot be
while revenue has increased by 45%. adequately explained by business factors,
accounting errors must be considered.
These could include:
– an inaccurate cut-off on goods
received which misstates purchases
and trade payables; and
– misclassification between purchases
and other expenses.
Potential errors would increase the level
of work required on payables.
 Trade payables have increased by  The scope of circularisation and/or

38%, which is less than the increase supplier statement reconciliation work
in cost of sales. may have to be extended if there is an
increased number of suppliers, and these
have not been recorded.

lOMoARcPSD|5054551
Observations Impact on audit of trade payables

C
H
 The trade payables payment period  Information on payment terms with new A
has been reduced slightly from suppliers (eg, for footwear) must be P
61 days last year to 56 days this year. obtained to establish expectations. T
E
 There is a risk of unrecorded liabilities (eg, R
due to omission of goods received not 6
invoiced or inaccurate cut-off in the
purchase ledger).
 Review of subsequent cash payments to
payables should cover the two months
after the year end.
 Other payables have risen by 12% –  Payables for purchases may be

this does not seem consistent with a misclassified as other payables.
reduction in the number of shops.
(b) Use of audit software

Reperformance of calculations:
 To cast the trade payables ledger file balances for comparison of the total with the
balance on the control account in the general ledger.
 To check arithmetic accuracy of individual suppliers' accounts.
Analytical procedures:
 To calculate the payment period by supplier.
 To compare the current year balances with the prior year balances of the major
suppliers at each year end, and report any significant changes for further review.
 To determine the percentage increase or decrease for each account and in total.
Selection of data for substantive procedures:
 To select, from purchase records, a sample of suppliers for circularisation or review of
supplier statement reconciliations.
 To produce a printout of the major trade payables at the year end.
 To produce an exception report of debit balances on the payables ledger.
 To select, from inventory records, receipts immediately before the year end for
matching to goods received not invoiced accruals/trade payables.
 To identify unusual transactions (eg, relating to capital acquisitions through hire
purchase agreements).
 To identify unusual standing data (eg, accounts for inactive suppliers).
Selection of representative samples for tests of controls:
 Of purchases – to test whether they are properly authorised and matched to goods
received notes.
 Of payments – to test whether they are authorised.
Payables circularisation:
 To print requests for statements, monitor replies and produce second requests.

lOMoARcPSD|5054551
Cut-off:
 To identify goods received documentation unmatched on file, for verification of
inventory/payables cut-off.
 To select post year end payments for verification of cash/payables cut-off.
Disclosure:
 To extract total debits to the purchases accounts and total credits in individual
suppliers' accounts for comparison and reconciliation.
 To search 'other payables' for:
– individually significant balances; and
– names of trade payables.

Gearing ratios
Debt
Gearing =
Debt + Equity
(i) Book values

250,000 + 150,000
= 40%
400,000 + 600,000
(ii) Market values

£
Equity (V e ) 1,000,000  125p 1,250,000
Preference (V p ) 250,000  65p 162,500
Loan stock (V d ) 150,000  85% 127,500
1,540,000
162,500 + 127,500
= 18.8%
1,540,000
Comment
There is a significant difference between the book and market values. In particular, the market
obviously places value on the equity of the business, showing a potential confidence in the
company's future. On a market-based measure, gearing appears to be low and would seem
acceptable, although we have no external data to validate this.
Working capital ratios
150,000
Receivable days =  365 = 27 days
2,000,000
The jewellery is sold 27 days (on average) before payment is received. Given the high value of
items, there is a high risk of bad debt. Care must be taken to ensure that credit is granted only to
creditworthy clients.
100,000
Payable days =  365 = 30 days
1,200,000
Harrison plc pays its suppliers after 30 days (on average). This seems a reasonable amount of
time, and there seems to be no pressure on liquidity from this perspective.
300,000
Inventory days =  365 = 73 days
1,500,000

lOMoARcPSD|5054551
Inventory days seem high at 73 days. However, a wide range of different items need to be
displayed in order to attract customers into the shop. C
H
Many items, however, will be made to order, and this should be encouraged – it will help to A
P
reduce the number of inventory days.
T
Non-financial measures E
R
These include the following.
6
 Daily number of items sold
 Repeat business/customers
 Customer satisfaction
 Time taken for 'made to order' items
 Number of repairs/faulty items sold
These types of measures are important for Harrison plc, as the volume of trade will be relatively
small on a daily basis. Each extra sale will generate extra profit, and hence keeping customers
happy and satisfied will improve the overall performance of the shop.

(a) Platforms
It is not necessary to use an auditor's expert to audit the useful lives of the platforms, as
there are many other available sources of evidence. Relevant procedures include the
following:
 Obtaining weather reports to see whether management's determination of useful lives
is consistent with them
 Comparing budgeted oil against actual oil extracted (if the budget was optimistic, so
might the useful life be)
 Reviewing published industry comparators (such as Shell and BP); if the useful lives of
their platforms as published in financial statements is significantly different, discuss
with management why that might be
 Considering whether management's determination of useful lives in the past has been
proved accurate
(b) It is not necessary to use an auditor's expert, as the question states that a 'simple' test is
available. The auditors should confirm that the company will be making use of this test
during the inventory count to separate the inventory. The auditor should reperform the test
on a sample of brass and copper as counted to ensure they have been separated correctly.

lOMoARcPSD|5054551
1 Strombolix plc
BRIEFING NOTE
To: Charles Church (partner)
From: A Senior
Date: 25 July 20X2
Subject: Strombolix audit
Issues on the audit to date
(1) Trade receivables
Issues arising
One type of paint has suffered problems of decay after only a short period of use, and
customers are refusing to pay for recent deliveries. If these claims are valid (as would
be indicated by the fact that the complaints are coming from several different
independent sources) this creates a number of issues.
 The most obvious issue is assessing the need to make provision against, or write
off, the £50,000 of receivables relating to the claim. If the claim is valid the
receivables should be written off immediately.
 Given that the decay only occurs after a few months, at least some of the paint is
likely to have been paid for already: thus repayment in respect of these sales is
due. Under IAS 37, Provisions, Contingent Liabilities and Contingent Assets an
obligating event has occurred (the sale of faulty paint) and there is a probable
transfer of economic benefits which can be reasonably estimated.
 Provision will also need to be made against any inventories that may be held of
this type of paint, as they cannot be sold if faulty. This should include any disposal
costs.
 If wholesale customers of Strombolix are being sued by their own customers, it is
very probable that they will in turn consider litigation against Strombolix. Part of
any claim will be for the paint itself for which provision is to be made as suggested
above. Additionally, however, there is likely to be a claim for the labour cost
involved for the removal of the old paint, in applying new paint and for disruption.
Consideration should be given to making provision for these amounts, but they
are more uncertain in their nature, not least because there does not currently
appear to be any such legal claim against Strombolix. The situation will need to be
monitored up to the time of audit clearance to reassess the situation at that date.
 If wholesale customers of Strombolix are being sued for the faulty paint,
consideration should also be given to making similar provisions in respect of the
sales by Strombolix of the paint to its own retail customers.
 The necessary provisions are specific provisions and would be allowable for
taxation. The tax charge for the year would therefore need to be adjusted to the
extent of any provisions made. The deferred tax charge would need to be
adjusted accordingly.

lOMoARcPSD|5054551
Audit procedures
C
The key audit issue is to establish whether there is a technical fault in the paint. If there H
is, as seems likely, then it will be necessary to establish the extent of the problem by A
P
ascertaining the following in respect of this particular paint.
T
E
 The amount of receivables outstanding
R
 Total sales to date to wholesale and retail customers
6
 Amount of the paint in inventories
 Review any correspondence on the issue
 Review correspondence with the company's solicitors
 Establish whether Strombolix made the paint itself or whether it was purchased
from a supplier, in which case there may be a corresponding claim by Strombolix
 Speak to the company's production/technical director to establish the nature of
the problem and whether any other paints may be affected
 Attempt to estimate the non-material costs which customers may incur in
replacing the faulty paint
 Review returns inwards and customer compliant files from retail customers in
respect of the faulty paint
 Review the latest situation with respect to litigation on a continuing basis up to the
time of audit completion
Questions for finance director
 Does the company accept that it was at fault with respect to this paint?
 What attempts have been made to evaluate liability?
 What is the current status of any litigation against the company?
(2) Inventories
Issues arising
A special retail offer of '3 for 2' on wallpaper purchased from an outside supplier
during the year has been incorrectly recorded, as the offer was not programmed into
the company's IT system. The company also intends to take credit for a proportion of a
quantity bonus payable by the supplier in respect of this product.
There are two key audit issues.
 There has been a systems error which appears to have gone undetected and
unreported for some time. This raises concerns about the operation of the
accounting and internal control systems more generally.
 The extent of the substantive errors needs to be established and adjusted.
Systems errors – inventories
 Establish why the special offer was not programmed into the IT system.
 Establish whether any other such programming omissions occurred.
 Investigate why the error was not reported back to programmers from store
managers who were instructing sales staff to read only two of the three items.
 Consider the level of understanding of store managers of the IT system, and
whether this may have contributed to other similar errors.
 Establish how the error was ultimately detected, and thus what other controls had
failed to detect the problem before its discovery.

lOMoARcPSD|5054551
Substantive errors – inventories

Misstatement relating to special offer
 If the third item in each transaction was unrecorded, the IT records will overstate
inventory. If 20,000 units have been recorded (if they have all been sold through
the special 3 for 2 offer) 10,000 have been unrecorded. This will mean reducing
inventories in the IT records by a maximum of £50,000.
 Adjustment will need to be made for any similar errors discovered by the above
systems review.
Taking credit for bonus
 Strombolix appears to be intending to take credit for part of the supplier's bonus
in its draft financial statements. The bonus is, however, effectively a contingent
asset under IAS 37, as the payment is dependent on making total sales of 40,000
units, including some in the future. If this is only probable, disclosure can be
made, but a pro rata amount cannot be included in the statement of profit or loss
and other comprehensive income in the year to 30 June 20X2.
 If, on the basis of post year end evidence before audit completion, it is virtually
certain that sales of 40,000 units of the product will be made, and that settlement
will be made by the supplier, then a pro rata recognition is appropriate. However,
as the sales appear to be made on the total level of sales made by the supplier to
Strombolix (ie, including the 'free' goods and perhaps any goods still in
inventories), then the credit would be a maximum of £67,500 (ie, (30,000 ÷
40,000)  £90,000) if all sales were through the special offer.
 In the absence of near certainty over attaining the bonus, there is an inventory
valuation problem. If the bonus is not paid, the NRV of any inventories remaining is
less than its cost. For example, a batch of three units would be valued in inventories
at £15 (3  £5), whereas its NRV is only £12 (2  £6). In this case, consideration
should be given to writing down each inventory item to £4 (ie, £12 ÷ 3).
Audit procedures
 Obtain explanations for the systems error.
 Review the company's internal control procedures with respect to the inclusion in
the IT system of non-standard sales arrangements.
 Obtain explanations for the non-reporting of the error by store managers.
 Review the scope for similar errors in the system in respect of both detection and
reporting.
 Consider whether (and if not, why not) the physical inventory count detected the IT
error.
 Evaluate the number of sales of the product made through the '3 for 2' special
offer, as opposed to single purchases.
 Review post year end sales to assess the probability of achieving the bonus
payment from the supplier.
 Consider the adequacy of the inventory provision in the light of the results of the
above.

lOMoARcPSD|5054551

C
 How did the systems error occur in respect of the special '3 for 2' offer? H
A
 Why did it go undetected? P
T
 What is the justification for taking credit for part of the bonus from the supplier E
when the target has not been achieved at the year end? R
(3) Capitalisation of interest 6
Issues arising
The company had a new superstore constructed during the year, and it borrowed to
finance this project. The interest on the borrowing was all capitalised.
IAS 23, Borrowing Costs requires borrowing costs that are directly attributable to the
acquisition, construction or production of a qualifying asset to be capitalised as part of
the cost of the asset. It defines a qualifying asset as one that takes a substantial period
of time to get ready for its intended use or sale (IAS 23.5). The treatment adopted by
the company therefore appears to comply with the IAS providing that the borrowing
costs are 'directly attributable' to construction ie, they would have been avoided if
expenditure on the construction of the asset had not been incurred.
The finance costs on the relevant borrowings become part of the overall asset and are
therefore recognised in profit or loss as the asset is depreciated over its useful life,
rather than as incurred.
Capitalisation should cease when substantially all the activities necessary to get the
asset ready for its intended use or sale are complete (IAS 23.22). It is the availability for
use which is important, not when it is actually brought into use. An asset is normally
ready for its intended use or sale when its physical construction is complete.
It would appear that the interest capitalised in respect of the new superstore is as
follows.
Period Payment for Calculation Interest
capitalised £
1.8.X1–30.6.X2 Land
11
 £400,000  8% 29,333
12
1.12.X1–30.6.X2 Progress payment

7
 £1m  8% 46,667
12

1
 £1m  8% 6,667
12
82,667
Assuming that commencement of preparation for planning permission was the earliest
date at which the company commenced to 'get the asset ready for use', then the
correct interest to be capitalised is as follows.
Period Payment for Calculation Interest
capitalised £
1.9.X1–30.5.X2 Land
9
 £400,000  8% 24,000
12

6
 £1m  8% 40,000
12
– Progress payment – –
64,000
The difference of £18,667 (£82,667 – £64,000) should be treated as a cost for the year
in the statement of profit or loss and other comprehensive income under 'finance
costs'. There should also be a corresponding deduction from the cost of the asset in
the draft financial statements.

lOMoARcPSD|5054551
The amount of borrowing costs that must be capitalised is limited by the requirement
that the total value of the asset (including borrowing costs) should not exceed the
asset's recoverable amount.
The following disclosure should be made where interest is capitalised within non-
current assets.
 Aggregate finance costs included in non-current assets
 Finance costs capitalised in the year (including £64,000 in respect of this
transaction)
 Finance costs recognised in profit or loss (including £18,667 in respect of this
transaction)
 Capitalisation rate used (8%)
Audit procedures
 Loan agreement to be inspected for interest rate and other terms
 Contract for building the superstore and associated documentation to be
inspected – particularly for amounts and dates in this context
 Evidence of the date on which activity commenced to 'get the asset ready for use'
to be inspected eg, preparation for planning permission
 Evidence of the date on which the asset was ready for use to be gathered (eg,
builder's reports and other correspondence)
 Confirm that the policy on interest capitalisation is consistent with that previously
adopted when building other stores
 Why was there a delay between the purchase of land and the commencement of
preparation for planning permission?
 Does he accept that the revised calculation (above) is consistent with IAS 23?
General concerns arising from the takeover bid
The takeover bid is an inherent risk in the context of this audit, particularly as the
directors are attempting to defend the bid. In this case they will be attempting to show
the company in the best possible light. This may involve disclosing the highest possible
profit in the financial statements.
This policy would be consistent with the audit issues discovered, in that there does not
appear to be any provision in respect of receivables or inventory in audit issues (1) and
(2). Similarly, the amount of interest capitalised in (3) appears to present an
overoptimistic figure for profit.
Consideration will thus need to be given to the extent of reliance that can be placed on
management assurances and managerial control in this audit, even if they have proved
reliable in the past.
Moreover, if the financial statements are misstated there is a possibility of litigation
against our firm for third-party negligence if Simban suffers a loss or if it relies on the
financial statements – and we know it is relying on the financial statements for the
purpose of the takeover. To some extent a report of due diligence before takeover
may mitigate some of this risk, but this cannot be relied on entirely.
Consider the impact of time pressure being placed on the audit.
Reconsider materiality levels and the risk assessment in the audit plan in the light of the
takeover bid.

lOMoARcPSD|5054551
2 AB Milton Ltd
C
(a) H
A
Person/entity Related party Why Transaction P
T
Alexander Milton  Director E
R
Brian Milton  Director No
transactions 6
mentioned
Brian's wife  Wife of director
Edward Murray  Director Purchases of

stationery
Murray Design  Entity controlled by a
director
Diane Hardy X No longer close family
and does not have
control or significant
influence
Fiona Dyson  Presumed close family Contracts drawn
and shadow director
Cuts and Curls ? (see below) Rental agreement
Campbell Milton  Sub of AB Milton Work done for AB
Roofing (see below)
Ian Campbell /X Could be considered
key management of
group
Cuts and Curls is not clear cut. For it to be a related party Gillian Milton would need to
be in a position to control Cuts and Curls and then due to her relationship with
Alexander Milton her company would come under the related party umbrella. Gillian
only holds 50% and therefore holds joint control with her mother.
Disclosure
The related party relationship between AB Milton and Campbell Milton Roofing must
be disclosed, as it is a relationship between a parent and a subsidiary. This disclosure
must be provided irrespective of whether a transaction takes place.
For other related party relationships disclosure is only required where a transaction has
taken place. In this case that would apply to the transactions with Edward Murray, Fiona
Dyson and potentially Cuts and Curls. Disclosure is required of the nature of the
related party relationship as well as information about the transaction and any
outstanding balances necessary for users to understand the potential effect of the
relationship. Disclosure should include the following as a minimum:
 A description of the relationship
 A description of the transaction and the amounts included
 The amounts due to or from the related party at the end of the year
 Any other element of the transaction necessary for an understanding of the

lOMoARcPSD|5054551
(b) Notes for staff training sessions:

(1) We are required to assess the risk of undisclosed related party transactions and to
design our audit procedures in response to that risk. A logical place to start the
audit of related party transactions would be to identify all possible related parties.
This would always include the following:
 Directors and shadow directors
 Group companies
 Pension funds of the company
 Associates
It is likely that the other related parties would include the following:
 Key management (perhaps identified by which staff have key man cover)
 Shareholder owning > 20% of the shares
 Close relatives and associates of any of the above
All related party transactions must be disclosed. Related party transactions do not
necessarily have to be detrimental to the reporting entity, but those which are will
be easier to find. The following features, among others, may indicate this:
 Unusually generous trade or settlement discounts
 Unusually generous payment terms
 Recorded in the nominal ledger code of any person previously identified as a
related party (for example, director)
 Unusual size of transaction for customers (for example, if the company were
paying a suspiciously high legal bill for a building company)
(2) Audit procedures to identify related party transactions are as follows.
Risk assessment procedures:
 Discussion by the audit team of the risk of fraud-related misstatements
 Enquiries of management
 Obtaining an understanding of the controls in place to identify related party
transactions
Other procedures might include:
 Identification of excessively generous credit terms by reference to aged trade
accounts receivable analysis
 Identification of excessive discounts by reference to similar reports
 Scrutiny of cash book/cheque stubs for payments made to directors or
officers of the company (probably more realistic for smaller entities)
 Review of board minutes for evidence of approval of related party
transactions (directors are under a fiduciary duty not to make secret profits)
 Written representations from directors to give exhaustive list of all
actual/potential related parties (that is, allow us to make the materiality
assessment, not them)
 Review of accounting rewards for large transactions, especially near the year
end and with non-established customers/suppliers
 Identification of any persons holding > 20% of the shares in the entity by
reference to the shareholders' register

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3 TrueBlue Ltd
C
(a) Discussion with the finance director H
A
Revenue and marketing expense P
T
The trend of falling revenue has continued in 20X7 from previous years. The problem E
seems worse in view of the fact that 20X7 saw a substantial increase in advertising and R
marketing expenditure, without which the fall would presumably have been greater. It
6
is important to investigate this situation and the action taken in relation to it, because
the company could be facing significant going concern problems if its products are no
longer required by the market. However, the revenue fall in 20X7 from 20X6 is not as
significant as from 20X5, and it is possible that the sales trend in 20X6 and the
beginning of 20X7 has been reversed and the company might be beginning to
perform well again.
Additional information required:
 Does the additional marketing spend relate to 20X7 or was it to encourage sales
in the future?
 Were there any sales forecasts produced in connection with the marketing spend?
 Can you provide details of sales month by month to show the revenue pattern
throughout the year, particularly in relation to the marketing spend?
 Does management have other plans/intentions with regard to boosting revenue,
particularly if the additional marketing spend in 20X7 has not produced the
expected results?
Gross profit percentage
The gross profit percentage was stable in 20X6 and 20X5 at 30% but it has dropped in
20X7 to 23%. This implies either that there is a mistake in the figures (for example, an
expense may have been analysed incorrectly; there may have been an error in final
inventory counting or valuation; or some sales may not have been included correctly in
revenue hence it has fallen), or that there has been a change in the cost structure or
sales mix resulting in this fall.
With revenue falling, if sales are also becoming less profitable, the problem outlined
above might be intensified. Alternatively, a new sales mix may be the directors'
approach to solving revenue fall and, in the long term, increased sales at a lower
margin might be the new situation for the company.
Additional information required:
 The reason for the fall in gross profit percentage
 Analysis of sales by month and product
 Further analysis of cost of sales figures
Receivables
The trade receivables balance has fallen over the three years, which is in line with the
fall in revenue. However, it has not fallen at the same rate, which is shown by the fact
that the receivables days calculation shows that debts are now taking six more days to
collect than they were in 20X5. The significant change occurred in 20X7, with the day
calculation falling from 63 to 67 days in 20X7 as opposed to 61 to 63 in 20X6.
The increase could be caused by any of the following factors.
 The marketing event has caused a change in sales patterns/debt collection later in
the year (this would be revealed by analysing detailed sales information outlined
above).

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 Problems with credit control/the company has uncollectible debts on the ledger
that should realistically be written off.
 It is possible that a receivables ledger fraud is being carried out.
Credit control problems would constitute a control deficiency that the auditors should
note and respond to with regard to their audit. They should assess whether the
problems with control extend further than the credit control department, as
widespread control issues could significantly affect risk assessment.
If there is a large amount of old debt on the ledger, a truer picture would be presented
if it were written off. Similarly, a fraud being carried out on the ledger would affect the
true and fair view. Four days represents 1% of the year, and therefore 1% of revenue
(taken on an average basis) and it is therefore a material issue.
Further information required:
 Aged analysis of the receivables ledger to identify whether any significant aged
debts exist which require writing off
 Remittance advices from customers to assess payment patterns
Inventory, cash and liquidity
The inventory movement assessment in the cost of sales analysis shows that inventory
levels at the company have risen consistently at the company over the last three years
so that the inventory balance is now £3 million higher than at the start of 20X5. Direct
production and purchase costs have remained stable over those years, suggesting that
operation levels have not changed to reflect the situation in the market and the falling
sales position. This is likely to have had a devastating impact on the cash position of
the company. The statement of financial position will show a significantly illiquid
position with an inventory pile and a decrease in receivables conversion rate. If it also
shows a significant cash deficit then there are immediate concerns about whether the
company can continue to finance operations.
Further information required:
 Production levels in 20X7 and management's future intentions concerning
production
 Bank statements and statements of cash flows and projections
 Inventory sheets from 20X7 count
 Inventory valuation sheets from 20X7
Other expense items
The other expense items provided in this analysis are immaterial in relation to revenue
and therefore the auditor would not focus on them at the planning meeting.
WORKINGS
(1) Gross profit margin
20X7
4,357,233
= 23%
18,944,487
20X6
6,174,827
= 30%
20,588,370
20X5
7,359,648
= 30%
24,536,570

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(2) Receivables days

C
20X7 H
3,477,481 A
 365 = 67 P
18,944,487 T
E
20X6 R
3,553,609
 365 = 63 6
20,588,370
20X5
4,089,783
 365 = 61
24,536,570
(3) Payables days

20X7
1,056,090
 365 = 42
9,183,388
20X6
1,027,380
 365 = 41
9,246,420
20X5
1,164,843
 365 = 41
10,483,588
(b) If fraud is suspected

The auditor is required to approach their task with an attitude of professional
scepticism. Therefore, in theory, the auditor should not approach the task differently if
fraud has been suggested than they would have before. The questions arising from the
analytical procedures would be the same, and the auditor would still seek to
corroborate the answers and then assess whether they are satisfied with the
corroborated answers. Given that the auditor is required to be aware that fraud is a
possibility whether they have been tipped off or not, the corroboration of the finance
director's answers should have been thorough and based on sources other than the
finance director (such as third-party invoices and the opinions/experience of other
sources in the company) anyway.
If the auditor has been given a tip off that fraud exists, he should pass on that
information to the appropriate level of management. In this case, this would be the
audit committee, as the tip off concerns the finance director.
(c) Approach to the audit of receivables
There is a good source of third-party evidence in relation to the receivables balance;
that is, the customers. Usually trade receivables is audited by means of direct
confirmation. It is likely that the receivables balance at TrueBlue has been audited by a
receivables confirmation in previous years and, if there is a fraud being carried out on
this balance, then it has not been uncovered by the audit procedures. It is possible that
the audit procedures have become repetitive, that the same (largest) customers have
been selected to test year on year and that the finance director has been able to carry
out a small scale fraud on smaller balances less likely to be tested, or that the fraud has
only been carried out in the current year.
The auditors should carry out a receivables confirmation in this year, as it is the best
source of audit evidence. They should increase the sample size to reflect the risk
associated with the balance and extend testing to a larger number of customers than has
previously been the case.

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In addition, the auditors should carry out some transaction testing on sales receipts in
the year, tracing the transactions through the system and trying to match receipts with
invoices on the sales ledger.
If a fraud has been carried out in this area it casts significant doubt on the controls in
this area and the auditors should consider whether controls throughout the accounting
function might also not be operating effectively and what impact that has on the rest of
the audit.
4 Tofalco plc
Memorandum
To: Paul Sykes
From: Jeremy Wiquad
Re: Tofalco plc
The memo below covers the financial reporting and auditing issues raised per your request.
Financial reporting treatment and audit procedures required
 Construction contracts
– Given that the outcome cannot be foreseen reliably, no profit should be
recognised in the current year. Instead, £400 million should be recognised within
cost of sales and, assuming that these costs are recoverable, the same amount
within revenues (therefore showing no profit and no loss). The value of the work
done in the statement of financial position will therefore be £400 million.
Audit procedures to gain assurance include:
– reviewing the contract to confirm the duration and sales value of the contract;
– reviewing the surveyor's report to confirm the value of the work performed to
date;
– examining internal cost reports and confirming items on a sample basis to
invoices; and
– obtaining a written representation from management with regards to the outcome
of the contract.
 Provisions – An environmental provision for the £2.5 million present value of the cost of
disposing of the machines is required per IAS 37 and should be presented within non-
current liabilities. This cost should also be included as part of the cost of the asset. In
subsequent years the liability will increase due to the unwinding of the discount and a
corresponding finance expense will be shown within profit or loss.
– reviewing the law with regards to the environmental provision and the underlying
documentation relating to the £2.5 million estimate provided;
– assessing whether the discount rate used to calculate the present value of the
disposal costs is appropriate; and
– discussing with management if there are other areas/machines that require
equivalent 'environmentally friendly' costs and that these have been provided for.
Include the completeness of these provisions in the company management
representation letter.

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 Receivables – Per IFRS 9, Financial Instruments (see Chapter 16), receivables are a
financial asset and it appears that an impairment of receivables (the specific debt of C
H
Stirly plc) may be needed. A
P
Audit procedures to gain assurance include: T
E
– attempting to review board minutes and the correspondence file for any
R
discussion of this issue; and
6
– reviewing subsequent events for payment of the amount due.
 Assets held for sale – According to IFRS 5, assets are classified as 'held for sale' when,
among other criteria, management are committed to the sale and the asset is available
for immediate sale. The situation is not entirely clear, but the criteria are probably not
fully met until February 20X0, when the recoverable amount is £1.7 million. Therefore
an impairment adjustment of £0.4 million is required on the transfer of the asset to the
held for sale category. The fact that the building had not been sold by September is
not necessarily a concern, as 12 months have yet to elapse. However, this will be a
matter for review next year.
– reviewing management documentation (eg, correspondence with estate agent
and minutes) which confirms management commitment to sell;
– checking the building is available for sale and not being used internally by the
company;
– checking the selling price is close to the market value of the buildings in the
immediate area; and
– checking the building is advertised for sale and for immediate transfer.
 The issue of convertible loan stock constitutes a compound financial instrument which
needs to be split between its liability and equity components for presentation in the
£
Face value of convertible bonds 18,000,000
PVs of future cash flows of equivalent bonds with no conversion
option 16,862,000 Liability
Equity (warrants) (difference between the above) 1,138,000 Equity
– reviewing the convertible bond certificate for the face value, interest and
conversion terms; and
– recalculating the present value of the cash flows relating to the equivalent bond
without conversion options.
 Related parties – As per IAS 24, given the materiality of the transactions involved, all
details of the relationship between Tofalco plc and Sandstone Ltd need to be disclosed
along with the particulars of the transactions within the notes to the financial
statements.
– obtaining a written representation from management that all related parties have
been disclosed; and
– reviewing invoice file to ensure that all transactions with Sandstone Ltd have been
disclosed.

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Effects of non-compliance on the audit risk and form of the audit report
 Refusal to provide full details means that we are unable to obtain sufficient appropriate
evidence (a limitation on the scope of the audit). If the effect is deemed material, an
'except for' opinion is given. If the effect is deemed 'pervasive', then a disclaimer is
made to the effect that "We do not express an opinion …".
 Failure to disclose full remuneration constitutes a material misstatement
(disagreement) in respect of a legal issue (we conclude that the financial statements
are not free from material misstatement) and materiality by size is not a factor in this
area. As the matter is material irrespective of the sums involved, then an 'except for'
opinion will be given.
 Refusal to recognise obligations under IAS 37 constitutes misstatement
(disagreement). In the event that these costs are material, an 'except for' opinion is
required. In the event they are deemed pervasive, then an adverse opinion is required
stating that the financial statements 'do not give a true and fair view'.
Terms of reference of working relationship with Investo Ltd
Terms need to cover key investment risks (eg, Tofalco must set guidelines and approve
investment policy).
Internal controls with regards to the operation of the relationship (eg, weekly statements
sent to company reconciled with third-party information – eg, contract notes, share
certificates, stock exchange confirmation).
Value for money – fee comparability and return.
Impact on future audits
 Future audits will need to include procedures that address the fact that investment
activities are outsourced to Investo.
 In reaching preliminary risk assessments, assessments will need to be made of the
inherent, detection and control risks related to the investments balance and the terms
of reference the client has with Investo Ltd.
 Controls and processes carried out by Tofalco in relation to Investo's services will need
to be documented and tested (and if the risk is great enough, those present at Investo
also).
 The investments balance may also require substantive testing and so the need to
obtain underlying source documentation from Investo Ltd.
Ethical considerations
 Management integrity appears to be questionable in this assignment. Management
will need to understand the importance of their behaviour and its implications on the
audit and the relationship with the auditor.
 There appears to be non-compliance with the law with regard to environmental
regulations and the disclosure of remuneration paid to related parties. These issues are
non-negotiable and will lead to a modified audit opinion if not addressed by
management.
 We should consider whether it is appropriate for us to accept this assignment given the
problems outlined above. If we do decide to resign, we need to follow legal and
professional procedures – eg, submitting a statement of circumstances to an AGM and
addressing the AGM (if we wish).

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CHAPTER 7

evaluating and testing
internal controls
Introduction
TOPIC LIST
1 Introduction
2 Respective responsibilities of those charged with governance and
auditors
3 Evaluating and testing internal controls
4 Service organisations
5 Internal controls in an IT environment
6 Cyber security and corporate data security
7 Communicating and reporting on internal control
Technical reference

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Introduction
 Analyse and evaluate the control environment for an entity based on an

understanding of the entity, its operations and its processes
 Evaluate an entity's processes for identifying, assessing and responding to
business and operating risks as they impact on the financial statements
 Appraise an entity's accounting information systems and related business
processes relevant to corporate reporting and communication including virtual
arrangements and cloud computing
 Analyse and evaluate strengths and weaknesses of preventive and detective
control mechanisms and processes, highlighting control weaknesses; including
weaknesses related to cyber security and corporate data controls
 Evaluate controls relating to information technology and e-commerce; including
controls associated with cyber security and corporate data security
 Explain and appraise the entity's system for monitoring and modifying internal
control systems
 Devise, explain and evaluate tests of controls
auditors in respect of internal control systems
Specific syllabus references for this chapter are: 12(a)–(g), 13(h)

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1 Introduction
Section overview
 An entity's system of internal controls informs the auditor's assessment of audit risk and
the nature of the audit procedures that would be undertaken during the audit fieldwork
stage.
• In addition to the auditing standards, corporate governance codes (such as the UK
Corporate Governance Code and the Sarbanes–Oxley Code) also prescribe the respective
responsibilities of the auditor and those charged with governance with regards to internal
controls.
C
H
Internal control is an essential aspect of the entity about which the auditor must gain an A
understanding at the start of the audit. The effectiveness of the system of internal controls P
informs the auditor's risk assessment and, consequently, the audit procedures to be carried out T
E
at the audit fieldwork stage. Therefore, internal control will have to be considered throughout R
the audit life cycle – from planning to finalisation and reporting.
7
In this chapter, we will revise the auditor's responsibilities with regards to the system of internal
control and the consideration of internal controls at different stages of the audit. We will then
have a closer look at the implications of service organisations, and the risks and benefits of
internal controls in an IT environment.
As you will have seen already, internal control is central to corporate governance. Therefore, we
will regularly refer back to our discussions on corporate governance in Chapter 4.
2 Respective responsibilities of those charged with

governance and auditors
Section overview
 Auditors are responsible for obtaining audit evidence that provides reasonable assurance
that the financial statements are free of material misstatements, some of which may be
caused by error.
• Management are responsible for designing and implementing a system of internal control
which is capable of preventing, or detecting and correcting, errors in the financial records.
• Auditors are required to assess the system of internal control as part of their audit in order
to determine whether to rely on the system of controls or carry out extended tests of
details.
2.1 Responsibilities of those charged with governance

As you no doubt already know, the responsibility for the design, implementation and
maintenance of an effective system of internal control, one that is capable of preventing, or
detecting and correcting, errors in the financial records, lies with those charged with governance
(TCWG).
Let's revise some key definitions.
ICAEW 2019 The statutory audit: evaluating and testing internal controls 383

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Definitions
Those charged with governance: The person(s) or organisation(s) (for example, a corporate
trustee) with responsibility for overseeing the strategic direction of the entity and obligations
related to the accountability of the entity. This includes overseeing the financial reporting
process. For some entities in some jurisdictions, those charged with governance may include
management personnel, for example, executive members of a governance board of a private or
public sector entity, or an owner-manager.
In the UK, those charged with governance include executive and non-executive directors and
the members of the audit committee.
Error: An unintentional misstatement in financial statements, including the omission of an
amount or a disclosure.
Internal control: A process designed, implemented and maintained by those charged with
governance, management, and other personnel to provide reasonable assurance about the
achievement of the entity's objectives with regard to reliability of financial reporting,
effectiveness and efficiency of operations and compliance with applicable laws and regulations.
It follows that internal control is designed and implemented to address identified business risks
that threaten the achievement of any of these objectives.
2.2 Auditor's responsibilities

As we outlined in your earlier studies, the auditor is required to do the following:
 Assess the system of internal controls to determine whether they are capable of preventing
or detecting and correcting errors (ISA 315)
 Test the internal controls if required (ISA 330)
 Report deficiencies in internal control to TCWG where they have been identified (ISA 265)
As part of assessing the system of internal controls as part of audit risk assessment, the auditor
must do the following:
 Obtain an understanding of controls relevant to the audit
 Evaluate the design of those controls
 Determine whether they have been implemented
The auditor must then test controls if:
 the auditor intends to rely on the operating effectiveness of those controls; or
 substantive procedures alone cannot provide sufficient, appropriate audit evidence.
Finally, the auditor must determine whether the audit work has identified any deficiencies in
internal control and, where these deficiencies are significant, communicate the significant
deficiencies to TCWG in writing on a timely basis.
In the following sections, we will look at each of these stages in further detail.
Effective internal controls form a crucial part of good corporate governance. For a more detailed
discussion on the importance of internal controls, and the auditor's role in relation to internal
controls, please refer back to Chapter 4.

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3 Evaluating and testing internal controls
Section overview
Sources of audit evidence include tests of controls.
3.1 Evaluation of internal controls for audit purposes: revision

Understanding an entity's internal control assists the auditor in identifying types of potential
misstatements and factors that affect the risks of material misstatement, and in designing the
nature, timing and extent of further audit procedures.
C
Step 1 H
A
Initially, the auditor must determine which controls are relevant to the audit. There is a direct P
T
relationship between an entity's objectives and the controls it implements to provide reasonable
E
assurance about their achievement. Many of these controls will relate to financial reporting, R
operations and compliance, but not all the entity's objectives and controls will be relevant to the
7
auditor's risk assessment.
The following factors will inform the auditor's judgement about whether a control is relevant to
the audit:
 Materiality
 The significance of the related risk
 The size of the entity
 The nature of the entity's business, including its organisation and ownership characteristics
 The diversity and complexity of the entity's operations
 Applicable legal and regulatory requirements
 The circumstances and the applicable component of internal control
 The nature and complexity of the system of internal control, including the use of service
organisations (see section 4)
 Whether, and how, a control prevents, or detects and corrects, material misstatement
Step 2
While gaining an understanding of internal controls, the auditor must evaluate the design of the
relevant controls, and determine whether the controls are properly implemented.
Evaluating the design of a control involves considering whether the control, individually or in
combination with other controls, is capable of effectively preventing, or detecting and
correcting, material misstatements.
Implementation of a control means that the control exists and that the entity is using it.
Audit evidence about the design and implementation of a relevant control cannot come from
enquiries of management alone. It must involve other procedures, such as:
 observing the application of the control;
 inspecting documents and reports; and
 tracing transactions through the information system.
Note that obtaining audit evidence at one point in time on the entity's controls is not sufficient to
test the controls' operating effectiveness, unless there is some automation that ensures the
controls operate consistently.

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For example, the audit evidence gathered on the implementation of a manual control does not
demonstrate that the control is operating effectively throughout the period under audit.
However, the audit procedures performed in respect of the implementation of an automated
control may serve as a test of that control's operating effectiveness, because IT processing is
inherently more consistent.
Step 3
Having determined which controls are relevant, and are adequately designed to aid in the
prevention of material misstatements in the financial statements, the auditor can then decide
whether it is more efficient to place reliance on those controls and perform tests of controls in
that area, or to perform substantive testing over that area.
Step 4
If the controls are not adequately designed, the auditor needs to perform sufficient substantive
testing over that financial statement area in light of the apparent lack of control and increased
risk. Any deficiencies are noted and, where appropriate, these will be communicated to
management.
ISA 315 divides internal control into five elements. We summarise the main points below:
Elements of internal control
The control  Communication and enforcement of integrity and ethical values

environment  Commitment to competence
 Participation by TCWG
 Management's philosophy and operating style
 Organisational structure
 Assignment of authority and responsibility
 Human resource policies and practices
The entity's risk The entity's process for the following:
assessment process
 Identifying business risks relevant to financial reporting objectives
 Estimating the significance of the risks
 Assessing the likelihood of their occurrence
 Deciding on actions to address those risks
The information  The classes of transactions that are significant to the financial
system relevant to statements
financial reporting
 The procedures (both IT and manual) by which significant
transactions are initiated, recorded, processed, corrected,
transferred to the general ledger and reported in the financial
statements
 The related accounting records, supporting information, and specific

accounts in the financial statements, in respect of initiating,
recording, processing and reporting transactions
 How the information system captures events and conditions, other

than transactions, that are significant to the financial statements
 The financial reporting process used to prepare the entity's financial

statements, including significant accounting estimates and
disclosures

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Elements of internal control
 Controls surrounding journal entries, including non-standard journal

entries used to record non-recurring, unusual transactions or
adjustments
 How the entity communicates financial reporting roles and
responsibilities and significant matters relating to financial reporting
The revised ISA also adds that this understanding of the information
system includes relevant aspects of that system relating to information
disclosed in the financial statements that is obtained from within or
outside the general and subsidiary ledgers.
C
Control activities  Authorisation H
A
 Performance reviews P
 Information processing T
E
 Physical controls R
 Segregation of duties
7
Control activities relevant to the audit also include those designed to
address the risks of material misstatement in respect of disclosures.
Monitoring of Process to assess the effectiveness of internal control performance over
controls time, and to take necessary remedial actions.
 The sources of the information related to the entity's monitoring
activities
 The basis upon which management considers the information to be
sufficiently reliable for the purpose
May include making inquiries of the internal audit function.
3.2 Tests of controls: revision

You will have covered tests of controls in your earlier studies. The following section provides a
summary of the key points.
Testing of controls means obtaining sufficient, appropriate audit evidence about the operating
effectiveness of the controls in preventing or detecting and correcting material misstatements.
Evidence will be required to show that:
 controls were applied at relevant times during the year; and
 those controls were applied consistently (eg, because controls were performed by different
people or in different locations).
Tests of control may include the following.
(a) Inspection of documents supporting controls or events to gain audit evidence that internal
controls have operated properly eg, verifying that a transaction has been authorised.
(b) Enquiries about internal controls which leave no audit trail eg, determining who actually
performs each function, not merely who is supposed to perform it.
(c) Reperformance of control procedures eg, reconciliation of bank accounts, to ensure they
were correctly performed by the entity.
(d) Examination of evidence of management views eg, minutes of management meetings.
(e) Testing of internal controls operating on computerised systems or over the overall
information technology function eg, access controls.
(f) Observation of controls to consider the manner in which the control is being operated.

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Auditors should consider the following:

 How controls were applied
 The consistency with which they were applied during the period
 By whom they were applied
Tests of controls are distinguished from substantive procedures which are designed to detect
material misstatements in the financial statements.
Deviations in the operation of controls (caused by change of staff etc) may increase control risk
and tests of control may need to be modified to confirm effective operation during and after any
change.
Audit procedures will include the test of control and then other procedures (eg, substantive
and/or analytical procedures) to confirm the operating effectiveness of that control. Overall,
audit procedures may be limited where automated processing is involved, as control errors are
less likely eg, computers tend to make fewer mistakes than humans after a given procedure has
been correctly programmed.
The use of computer-assisted audit techniques (CAATs) is referred to in section 5 below.
Please also refer back to Chapter 4 for the auditor's responsibilities for the evaluation of internal
controls from a corporate governance perspective.
3.2.1 Relationship between tests of controls and risk assessment procedures

Testing of controls should not be confused with risk assessment procedures which were
performed earlier in the audit to assess the design and implementation of controls. However, in
some situations risk assessment procedures may provide persuasive evidence on the operation
of controls. For example, management review of budgets and investigation of variances on a
regular basis is indicative that controls over sales and purchases are operating effectively.
3.2.2 Conclude on the achieved level of control risk

When control testing is complete, residual audit risk to be obtained from substantive testing
must be determined. To determine the remaining detection risk the auditor will use:
 the achieved level of control risk; and
 the assessed level of inherent risk.
This detection risk is then used to decide the nature and timing of the remaining substantive
testing.
4 Service organisations
Section overview
Where the auditor's client uses a service organisation, the auditor may need to obtain evidence
of the accuracy of processing systems within a service organisation.
Definition
A service organisation is a third-party organisation that provides services to user entities that are
part of those entities' information systems relevant to financial reporting.
ISA (UK) 402, Audit Considerations Relating to an Entity Using a Service Organisation provides
guidance on how auditors carry out their responsibility to obtain sufficient, appropriate audit
evidence when the audit client (called the 'user entity' in the standard) uses such an
organisation.

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The ISA mentions the following service organisation services that may be relevant to the audit
(this is not an exhaustive list):
 Maintenance of accounting records
 Other finance functions, such as the tax compliance function
 Management of assets
 Undertaking or making arrangements for transactions as agents of the user entity
4.1 Requirements of the user auditor
Definition
User auditor: An auditor who audits and reports on the financial statements of a user entity. C
H
A
P
The ISA states that the objective of the auditor is 'to obtain an understanding of the nature and T
E
significance of the services provided by the service organisation and their effect on the user R
entity's internal control relevant to the audit, sufficient to identify and assess the risks of material
misstatement' (ISA 402.7). 7
The ISA requires the auditor to understand how the user entity uses the services of the service
organisation. In obtaining an understanding of the entity, the auditor shall consider the
following:
(a) The nature of the services provided by the service organisation
(b) The nature and materiality of the transactions processed or accounts or financial
accounting processes affected by the service organisation
(c) The degree of interaction between the activities of the service organisation and those of the
user entity
(d) The nature of the relationship between the user entity and the service organisation,
including the contractual terms
(e) In the UK, if the service organisation maintains all or part of a user entity's accounting
records, whether those arrangements impact the work the auditor performs to fulfil
reporting responsibilities in relation to accounting records (The wording of UK company
law raises a particular issue, as the wording appears to be prescriptive, requiring the
company itself to keep accounting records. Whether a company 'keeps' records will
depend on the particular terms of the outsourcing arrangement.)
When obtaining an understanding of internal control the auditor shall:
(a) evaluate the design and implementation of controls at the user entity that relate to the
services provided by the service organisation; and
(b) determine whether this gives sufficient understanding of the effect of the service
organisation on the user entity's internal control to provide a basis for the identification and
assessment of risks of material misstatement.
If not then the auditor shall do one or more of the following:
(a) Obtain a report from the service organisation's auditors (there are two different types of
report, see section 4.2 below)
(b) Contact the service organisation, through the user entity
(c) Visit the service organisation and perform procedures that will provide information about
the relevant controls
(d) Use another auditor to perform procedures that will provide information about the relevant
controls

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4.2 Using reports from service auditors
Definitions
Type 1 report:
A report that comprises both of the following:
 A description, prepared by management of the service organisation, of the service
organisation's system, control objectives and related controls that have been designed and
implemented as at a specified date
 A report by the service auditor with the objective of conveying reasonable assurance that
includes the service auditor's opinion on the description of the service organisation's
system, control objectives and related controls and the suitability of the design of the
controls to achieve the specified control objectives
Type 2 report:
A report that comprises both of the following:
 A description, as in a Type 1 report of the system and controls, of their design and
implementation as at a specified date or throughout a specified period and, in some cases,
their operating effectiveness throughout a specified period
 A report by the service auditor with the objective of conveying reasonable assurance that
includes:
– the service auditor's opinion on the description of the service organisation's system,
control objectives and related controls, the suitability of the design of the controls to
achieve the specified control objectives, and the operating effectiveness of the
controls; and
– a description of the service auditor's tests of the controls and the results thereof.
The availability of a report on internal controls generally depends on whether the provision of
such a report is part of the contractual terms between the user entity and the service
organisation.
Before placing reliance on the report, the user auditor shall do the following:
 Consider the service auditor's professional competence and independence from the
service organisation
 Consider the adequacy of the standards under which the report was issued
 Evaluate whether the period covered is appropriate for the auditor's purposes
 Evaluate the sufficiency and appropriateness of the report for the understanding of the
internal controls relevant to the audit
 Determine whether the user entity has implemented any complementary controls that the
service organisation, in the design of its service, has assumed will be implemented
While a Type 1 report may be useful to a user auditor in gaining the required understanding of
the accounting and internal control systems, an auditor would not use such reports as a basis for
reducing the assessment of control risk.
But a Type 2 report may provide such a basis since tests of control have been performed. If this
type of report may be used as evidence to support a lower control risk assessment, a user
auditor would have to consider whether the controls tested by the service organisation auditor
are relevant to the user's transactions (significant assertions in the client's financial statements)
and whether the service organisation auditor's tests of controls and the results are adequate.

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4.3 Responding to the risks of material misstatement

The user auditor shall:
 determine whether sufficient, appropriate audit evidence concerning the relevant
assertions is available from records held at the user entity; and if not
 perform further procedures (or use another auditor to perform those procedures at the
service organisation on the user auditor's behalf).
4.3.1 Tests of controls

This evidence can be obtained by one or more of the following procedures:
 Obtaining a Type 2 report, if available C
 Performing tests of controls at the service organisation H
 Using another auditor to perform tests of controls at the service organisation A
P
T
4.3.2 Substantive procedures E
R
The following procedures may be considered by the auditor:
7
 Inspecting documents and records held by the user entity
 Inspecting documents and records held by the service organisation (access to records held
by the service organisation may be established as part of the contractual arrangement
between the user entity and the service organisation)
 Obtaining confirmation of balances and transactions from the service organisation where
the user entity maintains independent records of balances and transactions
 Performing analytical procedures on the records maintained by the user entity or on the
reports received from the service organisation
 Where a significant proportion of the audit evidence is located at the service organisation,
substantive procedures may need to be performed at the service organisation by the user
auditor or by another auditor on behalf of the user auditor
4.4 Reporting by the user auditor

4.4.1 Modified opinions
If the user auditor is unable to obtain sufficient, appropriate evidence a modified audit opinion
may be required. This could be the case when:
 the user auditor is unable to obtain a sufficient understanding of the services provided by
the service organisation and does not have a basis for assessing the risks of material
misstatement;
 the user auditor's risk assessment includes an expectation that the controls at the service
organisation are operating effectively and the user auditor is unable to obtain sufficient
appropriate evidence about the operating effectiveness of these controls; or
 sufficient, appropriate evidence is only available from records held at the service
organisation, and the user auditor is unable to obtain direct access to these records.
4.4.2 Reference to the work of service auditors

The user auditor shall not refer to the work of a service auditor in the user auditor's report
containing an unmodified opinion unless required by law or regulation to do so. (If such a
reference is required, the user auditor's report must indicate that this does not diminish the user
auditor's responsibility for the audit opinion.)

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If reference to the work of a service auditor is relevant to an understanding of a modification to

the user auditor's opinion, the user auditor's report must indicate that this does not diminish the
user auditor's responsibility for the audit opinion.
5 Internal controls in an IT environment
Section overview
 IT controls comprise general and application controls. General controls establish a
framework of overall control over the system's activities whereas application controls are
specific controls over the applications maintained by the system.
• Computer-assisted audit techniques (CAATs) can be used by the auditor to test
application controls within the client's computer systems.
• Specific considerations will apply where virtual arrangements including cloud computing
are used.
5.1 Introduction
We looked at IT-specific risks in the context of carrying out an audit risk assessment in Chapter 5,
and introduced the use of CAATs in Chapter 6. Here, we will consider IT controls in more detail,
along with how to audit them.
As you should know by now, the internal control activities in a computerised environment fall
within two categories: general controls and application controls.
5.2 General controls

The purpose of general IT controls is to establish a framework of overall control over the
computer information system's activities to provide a reasonable level of assurance that the
overall objectives of internal controls are achieved. They include controls over access security,
data centre and network operations, software acquisition, change and maintenance, and
application system acquisition, development and maintenance. They are sometimes referred to
as supervisory, management or information technology controls. General controls are
considered in detail below.
General controls
Development of Standards over systems design, programming and documentation

computer applications
Full testing procedures using test data
Approval by computer users and management
Segregation of duties so that those responsible for design are not
responsible for testing
Installation procedures so that data is not corrupted in transition
Training of staff in new procedures and availability of adequate
documentation

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General controls
Prevention or detection Segregation of duties

of unauthorised changes
Full records of program changes
to programs
Password protection of programs so that access is limited to
computer operations staff
Restricted access to central computer by locked doors, keypads
Maintenance of program logs
Virus checks on software: use of anti-virus software and policy
prohibiting use of non-authorised programs or files
C
Back-up copies of programs being taken and stored in other H
A
locations P
T
Control copies of programs being preserved and regularly E
compared with actual programs R
Stricter controls over certain programs (utility programs) by use of 7

read-only memory
Testing and Complete testing procedures
documentation of
Documentation standards
program changes
Approval of changes by computer users and management
Training of staff using programs
Controls to prevent Operation controls over programs
wrong programs or files
Libraries of programs
being used
Proper job scheduling
Controls to prevent Physical security over remote terminals
unauthorised
Limited access to authorised personnel only
amendments to data files
Firewalls
User identification controls such as passwords
Encryption of data
Controls to ensure Storing extra copies of programs and data files off site
continuity of operation
Protection of equipment against fire and other hazards
Back-up power sources
Emergency procedures
Disaster recovery procedures eg, availability of back-up computer
facilities
Maintenance agreements and insurance
The auditors will wish to test some or all of the above general controls, having considered how
they affect the computer applications significant to the audit.
General IT controls that relate to some or all applications are usually interdependent controls, ie,
their operation is often essential to the effectiveness of application controls. As application
controls may be useless when general controls are ineffective, it will be more efficient to review
the design of general IT controls first, before reviewing the application controls.

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General IT controls may have a pervasive effect on the processing of transactions in application
systems. If these general controls are not effective, there may be a risk that misstatements occur
and go undetected in the application systems. Although deficiencies in general IT controls may
preclude testing certain IT application controls, it is possible that manual procedures exercised
by users may provide effective control at the application level.
5.3 Application controls

The purpose of application controls is to establish specific control procedures over the
accounting applications in order to provide reasonable assurance that all transactions are
authorised and recorded, and are processed completely, accurately and on a timely basis.
Application controls include data capture controls, data validation controls, processing controls,
output controls and error controls. Examples of application controls are shown in the table
below.
Application controls
Controls over input: Manual or programmed agreement of control totals

completeness Document counts
One for one checking of processed output to source documents
Programmed matching of input to an expected input control file
Procedures over resubmission of rejected items
Controls over input: Programs to check data fields (for example value, reference number,
accuracy date) on input transactions for plausibility
Digit verification (eg, reference numbers are as expected)
 Reasonableness test (eg, sales tax to total value)
 Existence checks (eg, customer name)
 Character checks (no unexpected characters used in reference)
 Necessary information (no transaction passed with gaps)
 Permitted range (no transaction processed over a certain value)
Manual scrutiny of output and reconciliation to source
Agreement of control totals (manual/programmed)
Controls over input: Manual checks to ensure information input is:
authorisation
 authorised; and
 input by authorised personnel.
Controls over Similar controls to input must be in place when input is completed, for
processing example, batch reconciliations
Screen warnings can prevent people logging out before processing is
complete
Controls over master One to one checking
files and standing data
Cyclical reviews of all master files and standing data
Record counts (number of documents processed) and hash totals (for
example, the total of all the payroll numbers) used when master files
are used to ensure no deletions
Controls over the deletion of accounts that have no current balance

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Control over input, processing, data files and output may be carried out by IT personnel, users
of the system, a separate control group and may be programmed into application software.
5.4 The use of CAATs

Computer-assisted audit techniques (CAATs) can assist the auditor in testing application
controls. As you will know from your earlier audit studies, there are generally two types of
CAATs: audit software and test data.
Audit software includes generalised audit software and custom audit software. Generalised
audit software includes programs that allow the auditor to carry out tests on computer files and
databases. An example of a generalised audit software program is ACL.
Generalised audit software allows auditors to perform a number of functions, such as database C
access, sample selection, arithmetic functions, statistical analyses and report generation. H
A
The advantages of generalised audit software include the fact that it is easy to use, limited IT P
programming skills are needed, the time required to develop the application is relatively short, T
E
and entire populations can be examined, thus negating the need for sampling. However, the R
drawbacks of using this type of CAAT are that it involves auditing after the client has processed
the data rather than while the data is being processed, and it is limited to procedures that can 7
be performed on data that is available electronically.
Custom audit software is normally written by auditors for specific audit tasks. It is normally used
in situations where the client's computer system is not compatible with the auditor's generalised
audit software or where the auditor wants to do some testing that might not be possible with the
generalised audit software. However, this type of CAAT can be expensive and time consuming
to develop and may require a lot of modification if the client changes its accounting application
programs.
Test data is used to test the application controls in the client's computer programs. Test data is
first created for processing and it includes both valid and invalid data which is processed on the
client's computer and application programs. The invalid data should therefore be highlighted as
errors. Test data allows the auditor to check data validation controls and error detection
routines, processing logic controls, arithmetic calculations and the inclusion of transactions in
records and files.
The main benefit of test data is that it provides direct evidence on the effectiveness of controls in
the client's application programs. However, its drawbacks include the fact that it is very time
consuming to create the test data, the auditor cannot be certain that all relevant controls are
tested and the auditor must make sure that all valid test data is removed from the client's
systems.
In the table below, we briefly examine ways of testing application controls, including the use of
CAATs to do so.
Testing of application controls
Manual controls If manual controls exercised by the user of the application system are
exercised by the user capable of providing reasonable assurance that the system's output is
complete, accurate and authorised, the auditors may decide to limit
tests of control to these manual controls.
Controls over system If, in addition to manual controls exercised by the user, the controls to
output be tested use information produced by the computer or are contained
within computer programs, such controls may be tested by examining
the system's output using either manual procedures or CAATs. Such
output may be in the form of magnetic media, microfilm or printouts.
Alternatively, the auditor may test the control by performing it with the
use of CAATs.

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Testing of application controls
Programmed control In the case of certain computer systems, the auditor may find that it is
procedures not possible or, in some cases, not practical to test controls by
examining only user controls or the system's output. The auditor may
consider performing tests of control by using CAATs, such as test data,
reprocessing transaction data and, in unusual situations, examining the
coding of the application program.
5.5 Virtual arrangements and cloud computing

Where an audit client uses virtual arrangements and/or cloud computing there are a number of
specific risks and control issues which the auditor needs to address. The ICAEW Information
Technology Faculty document Cloud Adoption: Understanding the Risk of Cloud Services is a
guide for small businesses considering the adoption of a cloud-based strategy, however many
of the issues it raises would also be relevant to the auditor when appraising an entity's system.
The following questions would be relevant as part of this process:
Back-ups
 Does the cloud service take regular back-ups of client data?
 Does the client have its own back-up strategy?
 Is the cloud service's process for restoring data regularly tested?
 Is there a service level agreement regarding data assurance and does the cloud service
perform exercises to ensure that these can be met?
Security
 Is the platform regularly given to third-party 'penetration testers' for potential
vulnerabilities, who vigorously test the platform to determine whether an attacker could
gain unauthorised access?
 Is there an adequate process in place in the event of a security breach being determined?
 Is data held on the platform stored in an encrypted format?
 Is payment data held on a PCI-DSS compliant platform?
 Are there recognised, standard working processes and procedures in place and adopted
(eg, are ISO accreditations held)?
 Is the platform protected against 'denial of service' attacks, where attackers could prevent
access to the service indefinitely by flooding the platform with erroneous traffic or requests
for information?
Compensation for loss
 Are compensation levels for loss of data written into agreements?
Using the service
 Are there contractual commitments regarding availability of service and performance
levels?
 What is the provider's capability to develop new features ie, is there a realistic roadmap?
 To what extent are features integrated?
 Are responsibilities for ongoing support documented?

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6 Cyber security and corporate data security
Section overview
Businesses need to keep their data secure whether it is in hard copy or electronic format. As
business operations increasingly use digital technology the issue of cyber security is an
essential consideration as part of the audit.
6.1 Introduction
There has always been a need for companies to keep information, or data, safe. This might be to
ensure confidentiality of customer details, to protect company 'secrets' or to ensure the integrity C
of data. Where records and data are held in a hard copy format, as would have been the case in H
A
the past, data security centres around physical security. This might simply involve a lock on a
P
filing cabinet. Increasingly, however, data is stored electronically. As a result, if a business is to T
keep its data secure it must address the issue of cyber security. Addressing cyber security E
threats will be a key part of its corporate data security strategy. R
6.2 Nature and consequences of cyber threats

One of the key issues which is transforming the current IT risk landscape is cyber security. As
companies are increasingly involved in digital technology, mobile technology and cloud
computing so the associated risks have also increased. Potential threats may arise from a
number of sources. The Deloitte publication Cybersecurity: The Changing Role of the Audit
Committee and Internal Audit identifies these as follows:
 Cyber criminals
 Hactivists (agenda driven)
 Nation states
 Insiders/partners
 Competitors
 Skilled individual hacker
It also identifies the following risks resulting from an attack:
 Theft of IP/strategic plans
 Financial fraud
 Reputational damage
 Business disruption
 Destruction of critical infrastructure
 Threats to health and safety
(Source: Cybersecurity: The Changing Role of the Audit Committee and Internal Audit p.10,
2015, Deloitte & Touche Enterprise Risk Services Pte Ltd)
The ICAEW IT Faculty document, Audit insights: Cyber Security – Taking Control of the Agenda
highlights the constantly evolving nature of cyber risks as follows:
 Threats change as attackers get more sophisticated and find new ways of breaking into
systems. New attackers also emerge, as easy-to-use tools reduce the level of skill required
to carry out attacks.
 Vulnerabilities change as businesses digitally transform their business models and ways of
working, potentially creating new weaknesses in business processes eg, mobile ways of
working, or adoption of the internet of things.

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 Existing controls and assurance models are superseded by new approaches. For example,
moving to cloud-based systems has made traditional assurance models around IT controls
more difficult to apply.
 The impact of failures increases as businesses capture more data and rely more heavily on
digitally-based services. A slow or poor response to a major breach is very quickly and
publically shared over social media, increasing at least short-term reputational damage.
In addition there are increasing amounts of regulation, particularly regarding data protection
and personal data which companies need to consider. For example, new or forthcoming
legislation in the EU includes the following:
 The General Data Protection Regulation (GDPR) came into force in the UK on 25 May 2018,
bringing it in line with the rest of the EU where similar legislation already exists. The GDPR
updates and replaces the existing regulatory framework around the protection and use of
personal data (see section 6.2.1 below for an overview of this legislation)
 The Network Information Security (NIS) directive, which specifies obligations regarding
cyber security in certain industry sectors, largely associated with the critical national
infrastructure and major information processing activities
In June 2014 the Bank of England announced a new framework for cyber-security testing in the
financial services sector and the Information Commissioner is becoming more proactive in
examining the privacy policies of major technology companies such as Facebook.
(Source: ICAEW IT Faculty document: Audit insights: Cyber Security – Taking Control of the
Agenda p.7)
The number of high profile cases of breaches which have been reported in the press
demonstrates the challenging environment in which companies now operate. For example in
2014 a breach of Apple's iCloud resulted in the publication of the private photos of celebrities.
In August 2015 hackers stole and published details related to more than 30 million individuals
registered with the Ashley Madison online dating website resulting in class suit actions against
the company.
(Source: ICAEW IT Faculty document: Audit insights: Cyber Security – Closing
the Cyber Gap p.4)
6.2.1 GDPR
The following table summarises the key points that are relevant to all accountants in this area.
GDPR components Implications in practice for accountants
Organisations must only collect personal data Data can only be obtained for a legitimate
(including sensitive personal data, such as business need and cannot be collected in case
biometric data used to identify an individual) it might be useful at some stage in the future.
when it can demonstrate that it has a valid This means that accountants need to consider
business need for that data. carefully what data they really need and be
able to justify it:
The GDPR distinguishes between data
controllers who specify how and why data is  This includes data on employees,
processed and data processors who act on the customers and suppliers for all
controller's behalf and deal directly with data accountants and firms
itself. Both are liable under the GDPR.
 For firms, this also includes the details of
any testing completed (eg payroll and
supplier statements)

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GDPR components Implications in practice for accountants
Personal data must be stored securely. It must This can include both physical storage of data
then be deleted when it is no longer required. (eg in filing cabinets) and electronic storage –
given the vast amounts of data generated in
st
the 21 Century due to advances in technology
such as big data and audit data analytics, this
creates a significant risk for all accountants,
especially as many organisations now use
'cloud-based' data storage.
All organisations need to demonstrate how Non-compliance is obviously a significant issue
they have complied with the GDPR – essentially for all accountants, given the potential size of C
this means accountability and transparency of the fines that could be levied. H
all data usage. A
Being able to demonstrate compliance P
Governance protocols require the completion requires an understanding of the original T
E
of a Data Protection Impact Assessment (DPIA) purpose for collecting such data to ensure that R
in situations when risk is enhanced (such as it is lawful and that consent was obtained from
when using new technology or when individuals before any personal data is 7
processing might lead to a high risk to collected.
individuals).
Breaches in the GDPR also need to be
disclosed – fines for non-compliance can reach
either €20 million or 4% of an organisation's
global turnover.
The GDPR confers a series of rights on anyone whose personal data may be collected by an
organisation:
 The right to be informed (usually via some form of privacy notice)
 The right of access to your personal data and confirmation that it is being used
 The right of rectification if errors exist
 The right of erasure (sometimes referred to as 'the right to be forgotten')
 The right to restrict processing should you not wish your data to be used
 The right to data portability across different services should you wish
 The right to object (for example if you object to your data being used for marketing
purposes)
 Rights in relation to automated decision-making and profiling (essentially, to ensure that all
decisions about your data are made using human not machine judgement)
Any non-compliance in relation to any of these rights may lead to fines and penalties, so they should
form part of any DPIA carried out.
(Source: 'Overview of the General Data Protection Regulation (GDPR)', The Information
Commissioner's Office (ICO), 2017)

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Case study: Facebook

Social media platform Facebook has faced a number of challenges following admissions of
illegal data breaches dating back to 2014 when personal data was hacked from the records of
almost 87 million users. The maximum fine payable for these breaches is expected to be
£500,000 according to the UK Information Commissioner, Elizabeth Denham. Under the GDPR
this could rise to 4% of global turnover – for a company that reports revenues of over $10 billion
each quarter, this could mean a fine of up to $1.6 billion if similar offences were committed
under the GDPR – clearly, this new legislation is designed to remind organisations of the
responsibilities they bear when dealing with other people's data.
(Sources: www.bbc.co.uk/news/av/technology-44792675/facebook-
scandal-time-is-running-out-to-fix-
breaches?intlink_from_url=https%3A%2F%2Fwww.bbc.co.uk%2Fnews%2Ftopics%2Fc81zyn088
8lt%2Ffacebook-cambridge-analytica-data-scandal&link_location=live-reporting-map
www.theguardian.com/technology/2018/apr/25/facebook-first-quarter-2018-revenues-
zuckerberg)
6.3 Corporate governance and cyber security

6.3.1 Board of directors
Although there is no specific guidance as such (eg, in Corporate Governance Codes) the
ultimate responsibility for risk assessment and control, from whatever source lies with the board
of directors. In larger organisations responsibility for cybersecurity may lie specifically with the
chief information security officer (CISO). In many smaller organisations it may be the CEO or a
chief risk officer.
6.3.2 Audit committee

As the Deloitte publication Cybersecurity: The Changing Role of the Audit Committee and
Internal Audit explains, the audit committee may perform a useful role in "overseeing risk
management activities and monitoring management's policies and procedures". (Cybersecurity:
The Changing Role of the Audit Committee and Internal Audit p.5).
Responsibilities might include:
 setting expectations and accountability for management;
 assessing the adequacy of resources; and
 liaising with other groups in enforcing and communicating expectations regarding security
and risk.
6.3.3 Internal audit function

The internal audit function can aid in the identification of the company's strengths and
weaknesses. It can evaluate whether there is effective cyber risk management and also evaluate
and review cybersecurity related controls.

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6.4 Cyber risk management

The Deloitte publication suggests that organisations adopt the following 'Framework for Cyber
Risk Management'.
Business Value
1. Governance & Leadership
Board Executive Technology IT Risk

Management Leadership Leadership
3. Capabilities
4. Cyber lifecycle
Infrastructure Identity & Access Protect, detect, respond C
Threat Management
Security Management H
& recover
A
Workforce P
Application Security Data Protection
Management T
5. Solution lifecycle E
Design, build, R
Risk Analytics Third Party Crisis implement & operate
Management Management
7
2. Organisational Enablers
Policies & Risk Identification Stakeholder
Standards Talent & Culture & Reporting Management
Figure 7.1: Framework for cyber risk management

The five functions (governance and leadership, organisational enablers, capabilities, cyber
lifecycle and solution lifecycle) provide a 'strategic view of an organisation's management of
cyber security risks'.
refers to the 'three lines of defence' model. This applies controls, assurance and oversight at
three different levels in the organisation as follows:
 The first line is at an operational level, with controls built into processes and local
management responsible for their operation in practice ie, identifying and managing risks
on a day-to-day basis.
 The second line is at functional specialism level, for example the role of cyber-security
specialists and a chief information officer ie, providing oversight and expertise.
 The third line is at the level of internal audit functions or independent assurance providers
ie, providing assurance and challenge concerning the overall management of the risks.
6.5 Risks external to the entity

As identified in the ICAEW IT Faculty document: Audit insights: Cyber Security – Closing the
Cyber Gap the issue is becoming an increasingly relevant aspect of supply chain risk
management as many high profile security breaches have come as a result of issues at suppliers,
including IT service providers, suppliers of non-IT goods and services and contractors.
Obtaining assurance in this respect is not an easy process meaning that companies are having to
identify where the biggest risk lies rather than simply focusing on the highest value suppliers. In
addition, companies have had to consider widening the scope of assurance processes so that
they apply to all stages of the transaction, rather than just at the procurement stage as has
historically been the case. The most common method used, particularly by large companies, is
questionnaires which are sent to suppliers to enable their processes to be evaluated and risks
identified.

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6.6 Cyber security economics

Implementing effective cyber security measures is expensive and boards need to be able to
justify the level of expenditure to their shareholders. This can be difficult particularly in an
environment where increased investment does not appear to prevent breaches. In the past costs
have been measured against the benefits of reduced losses caused by these breaches. However
as this issue has risen up the board agenda companies are beginning to view the benefits of this
expenditure in a different context. As identified in the ICAEW IT Faculty document: Audit
insights: Cyber Security – Closing the Cyber Gap these could include:
 a brand enhanced by the strong security culture;
 the ability to bid for contracts in a particular supply chain; and
 reduced insurance premiums.
6.7 Audit implications

As with any risk which a business faces the auditor must understand and evaluate the risk
together with the effectiveness of associated controls. In relation to cyber security the auditor
will need to pay particular attention to the control environment and specific control procedures
put in place by management.
6.7.1 Control environment

The following features would be an indication to the auditor that the control environment in
respect of cyber security is strong:
 Responsibility for cyber security elevated to board level, preferably to a designated
individual eg, a risk officer
 Evidence of active board oversight, including clear lines of responsibility and identification
of key business data and associated risks
 Cyber security policies and procedures embedded in operations and monitored for
effectiveness
 Evaluation of the entity's risk appetite and procedures to highlight risks which breach this
level
 Non-executive directors and audit committee members with appropriate skills and training
to understand the issues
 Recruitment of competent in-house professionals with relevant expertise and/or use of
consultants
 Encouragement of communication between IT specialists and the board, internal auditors
and the audit committee
 Creation of an environment where staff are comfortable to report concerns and/or actual
instances of breaches of security without fear of reprisals
includes a series of checklists for boards. Whilst these take the perspective of the business they
provide an indication of what would constitute a strong control environment and the factors
which the auditor should consider when evaluating the control environment.

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Checklist for boards Considerations for the auditor
Be ready to respond Consider the most serious possible breach and ask whether the
organisation, and board, are ready to cope. What would they do
if competitors accessed their IP? How does the business reassure
customers if their data is stolen?
Build intelligence What does the business know about specific threats, the actors
and their possible methods? How have other major breaches
happened, and how do the defences put in place by the business
compare? What are their peers doing to manage their risk? How
can they get ahead of the regulators?
C
Be specific and real How can critical data actually be accessed and by whom? What
H
controls are in place, and how does the business know whether A
they are working? How are any breaches detected? P
T
Link to strategic change How are major strategic initiatives changing the risks? What is the E
R
impact of any M&A activity? What are the risks attached to new
products or market expansion? 7
Attach consequences What behaviour is unacceptable because of cyber risks? How

does the business know if non-compliance is occurring? What
happens to employees who do not follow the rules?
Tailor activities How relevant is cyber security training to specific roles and
responsibilities? Do higher-risk jobs have higher levels of training
and awareness-raising activities? Are staff clear about the
purpose of good cyber behaviour?
Hold boards to the same Are boards expected to follow the same rules as staff? Is the board
level of accountability clear as to the purpose and consequences of non-compliance?
Does the board see itself as a role model for good cyber
behaviour? Do members of the board act as role models?
Remember insider risk What is in place to detect suspicious behaviour or patterns? How
are disgruntled or disaffected staff identified? Does the business
know how much system access potentially disaffected staff have?
Implement cyber-by-design Are new products and services designed with cyber risks in
mind? Do business change projects consider cyber risk early on?
What are the risks of poor design?
Continually review and re- Are designs building in flexibility and resilience to cope with
evaluate changing cyber risks? How often are cyber risks reviewed? How
are changing risks incorporated into existing processes?
Take difficult decisions Is the business prepared to delay major change or strategic
projects if the security is not good enough? Is the business using
a 'sticking plaster' approach to an old infrastructure?
Embed cyber into start-ups If investing in new businesses, are cyber risks considered?
6.7.2 Control procedures

The auditor would also need to identify and evaluate the effectiveness of specific control
procedures. This work is likely to involve the IT audit specialists.

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The Deloitte publication Cybersecurity: The Changing Role of the Audit Committee and Internal
Audit identifies that in order to be effective cyber defence needs to be:
 Secure: Are controls in place to guard against known and emerging threats?
 Vigilant: Can the company detect malicious or unauthorised activity, including the
unknown?
 Resilient: Can we act and recover quickly to reduce impact?
Specific procedures to address these issues could include the following:
 Perimeter defences
 Vulnerability management
 Asset management
 Identity management
 Data protection procedures
 Threat intelligence eg, sharing intelligence with others within the same industry
 Security monitoring
 Behavioural analysis
 Risk analytics
 Incident response procedures
 Forensics
 Business continuity/disaster recovery procedures
 Crisis management
Interactive question 1: NewForm Ltd

NewForm Ltd (NewForm), a client of your firm, has recently established an e-commerce division
within its existing business to provide an additional outlet for its product range, which consists of
upmarket casual wear for adults. An objective in introducing the new division was to have a
completely paperless ordering, payment and despatch system.
The new e-commerce system is administered centrally by NewForm and deals with customer
orders and credit card payments. Customers are able to place orders and pay for the goods
online. Inventories for customer orders are held remotely by Key Distributors (KD), which is a
completely separate business from NewForm. Once online payment by credit card is cleared by
NewForm, despatch details are forwarded to KD electronically. KD then despatches customer
orders. Inventories are ordered by NewForm for delivery direct to KD.
Requirements
(a) In planning the audit of NewForm, identify and explain four key audit risks that may arise
from the development of the new e-commerce division.
(b) Identify and explain the application controls which you think are necessary for the integrity
of the ordering and payments system.

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7 Communicating and reporting on internal control
Section overview
Auditors are required to report to those charged with governance on material deficiencies in
controls which could adversely affect the entity's ability to record, process, summarise and
report financial data potentially causing material misstatements in the financial statements.
The specific responsibilities of the auditor in relation to communicating deficiencies in internal

control are set out in ISA (UK) 265, Communicating Deficiencies in Internal Control to Those
Charged With Governance and Management. The auditor is required to report significant
deficiencies in internal controls, where they have been identified, to those charged with C
governance. H
A
P
Definition T
E
A deficiency in internal control exists when: R
 a control is designed, implemented or operated in such a way that it is unable to prevent, or 7

detect and correct, misstatements in the financial statements on a timely basis; or
 a control necessary to prevent, or detect and correct, misstatements in the financial
statements on a timely basis is missing.
Significant deficiency in internal control: Significant deficiencies in internal control are those
which in the auditor's professional judgement are of sufficient importance to merit the attention
of those charged with governance.
The auditor's responsibilities with regards to communicating deficiencies in internal control to

TCWG and management have been discussed in Chapter 4.

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Summary
Auditor's responsibility:
• Assess
• Test
• Report deficiencies to
those charged with
Responsibility of
governance General
management
controls
Additional audit Application

procedures, Service Internal IT controls
possibly involve organisations controls environment
service auditors
Cyber security
and corporate
Evaluation of data security
Tests of controls
internal controls
Cloud
computing and
• Control environment • Inspect documents virtualisation
• Risk assessment process • Inquiries
• Information system • Reperforming control
relevant for FR procedures
• Control activities • Observation
• Monitoring of controls • Examination of
management views (ie,
board meeting minutes)

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Self-test
1 Dodgy Burgers plc
The board of directors of your client, Dodgy Burgers plc, which runs a chain of 30 burger
restaurants across the country, has just completed a review of the structure of the business
and relevant controls which are in place within the business. This review was completed in
the year ended 31 March 20X8.
A partner of your firm asked for a copy of the report that the directors completed to assist in
the identification of controls that the directors had implemented to mitigate business risk.
The partner would like to use this as a basis for testing and placing reliance on these
controls to reduce the amount of audit work undertaken for the audit for the year ended C
H
31 March 20X8. A
P
Listed below are some extracts from the report. T
E
Health and safety issues
R
This was a key business risk that we identified during our initial strategic review of the
7
company.
The company has had problems in this area in the past, with staff selling burgers before
they had been completely cooked through.
It was felt necessary to ensure that good controls were in place to provide an early warning
system of any breaches of the Health and Safety regulations required by our type of
business.
The following systems have now been introduced.
(1) The new internal audit department set up in September 20X7 will make spot checks on
the various shops to ensure that the new Health and Safety policies are being followed.
Reports of these visits will be sent to the board within two weeks of the visit. The
internal audit department plans to visit all the branches within one year.
(2) All staff will receive Health and Safety training, particularly on the areas of food
handling, storage, preparation, cooking and hygiene. This will be implemented
immediately and by the end of 20X8 we will have trained all staff.
Competition
Our main competitor, Chip Butty, has begun buying properties and setting up shops in the
vicinity of our existing branches within the large city centres. This has been a recurrent
theme through 20X8 so far and we expect this to continue into 20X9. We have identified
this as a threat to our sales income and consider that action is required.
To counteract the potential loss in sales we have embarked on three new marketing
initiatives.
(1) Advertising on all major local television networks, comparing our burgers to the
inferior Chip Butty products
(2) Promoting our new toys, sold in conjunction with Dotty Films, which are free with all
kiddy packs
(3) Employing a part-time member of staff to visit the competition's premises and
reporting on any new initiatives Chip Butty embarks upon
Branch cash controls
As our business is primarily cash based, we were concerned over the potential for theft of
cash takings.

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We have decided to implement a new policy in this area to monitor the takings from each
branch more closely.
All tills in every branch will include a standard float of £150. At the end of each day the
takings will be counted and bagged from each till, leaving the £150 float. A printout from
the till will be made detailing the daily takings. The physical cash will need to be reconciled
to the till balance. Cash will then be banked and the reconciliation emailed to head office.
Discount prices will be set in the till to ensure that no meals can be sold at below the
discounted price.
Increased turnaround in branches
We have identified a capacity problem in our branches, given the limited seating area at
each of the branches during peak times.
Following a cost-benefit review of the branches it was decided not to increase these areas,
as we feel that it would not be cost effective due to the huge increase in rates that would be
incurred, the building costs and lost time due to renovation.
The board is prepared to accept the risk that some customers may be lost during peak
times, but may in the future consider some form of takeaway discount at peak times.
Environmental policy
We felt it was necessary to reassure the public that as a company our policies are
'environmentally friendly' as this was key to a consumer business such as ours. The
increased cost of the packaging products has been passed on in full via a small price
increase, as we have been able to negotiate an excellent package with our suppliers and
the waste contractors.
We have therefore introduced the following.
(1) Recycled packaging in all our branches, which has been clearly labelled to show that it
is made from paper used from managed forests
(2) Waste separation at branches, which is collected on a daily basis by an external
contractor who pays us £30 for each ton of paper and plastic collected
Requirements
(a) Identify the business risks set out in the board report and state the risk category (ie,
financial, operational or compliance). For each risk identified state the strategy
management have adopted to deal with the risk.
(b) For each of the risks identified set out the audit procedures that would need to be
completed before reliance could be placed on the controls in place.
2 Happy Flights plc

Happy Flights plc (HF), a listed company is a low-cost airline that was established 15 years
ago and has since grown rapidly. You are a senior on the audit of HF for its year ended
30 June 20X6.
As part of the audit planning procedures the assignment manager, Geraint Johns, visited
the finance director of HF, Rory Hiller, and identified a number of risk areas (Exhibit 1).
Geraint rang you immediately after the meeting:
I have just been to visit HF and there are a number of issues that have arisen. The audit
team needs to discuss these matters at a planning meeting so we can determine our
approach. I would like you to prepare a memorandum for the meeting which explains
in detail the key audit risks including any cyber-security related issues, arising from
these matters. I would also like you to identify the audit procedures that we will need to

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carry out in respect of each of these risks. If there are any financial reporting issues on
these matters could you also explain these as part of the memorandum.
Exhibit 1: Risk areas
Plane crash
You will be aware that on 20 June 20X6 one of the HF planes crashed with a loss of 56 lives
and a further 121 injuries. The cause of the crash has not yet been established. Indeed, it is
unclear whether HF is to blame. Some legal claims have begun to arrive at HF headquarters
but it is still early in the investigation process. Final settlement, if applicable, may take some
years.
Operating issues
C
HF has suffered declining profits in recent years and recorded an operating loss for the first H
time in the year to 30 June 20X5. As a consequence, there have been continuing cash flow A
problems which have been partially alleviated by special measures adopted this year, P
T
including: E
R
 significant discounts for bookings made, and paid for in full, at least six months before
travel; 7
 extension of operating leases on existing aircraft, rather than leasing new aircraft (all
planes are leased); and
 significant new fixed-term borrowings.
Database system
A new database system for bookings was introduced in January 20X4 by IT consultants. The
purpose of the new system was to allow data on HF's flight availability to be accessed by
travel agents and other flight booking agencies around the world. Agencies can all make
bookings on the same system.
The database system is used not just for bookings but also as part of the receivables
accounting system for agents to collect money from customers and pay to HF after
deducting their commission. The data collected then feeds into the financial statements.
Unfortunately, since installation, the following problems have been discovered, either in the
database system, or relating to operatives using the system:
 It is HF's policy to overbook its flights by 5% of seat capacity. However, there have
been a number of instances where overbookings have far exceeded 5% due to
processing delays.
 The system has crashed on a number of occasions causing delays in processing and
loss of data.
 A computer virus penetrated the system, although it did not cause any damage and
was quickly removed.
 Cash received in advance has been recorded as revenue at the date of receipt by HF.
Requirement
Prepare the memorandum requested by the assignment manager.

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Technical reference
1 ISA 315
 Risk assessment procedures ISA 315.5–.10
 Understanding the entity and its environment ISA 315.11–.24
 Assessing the risks of material misstatement ISA 315.25–.29
 Financial statement assertions ISA 315.A124
2 ISA 330
 Overall responses to risk assessment ISA 330.5
– Response at assertion level ISA 330.6–.7
– Evaluation of sufficiency and appropriateness of evidence ISA 330.25

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Answer to Interactive question

(a) Key risks from the development of the e-commerce division
There are a number of concerns that an auditor of NewForm should address in relation to
its new e-commerce division. However, the general rule is that the scale of risk that is
related to e-commerce is directly proportional to the number of users and the value of their
transactions, which is critical to NewForm's proposal. The key areas are likely to be as
follows.
C
 Consider what cyber security issues have been addressed by the company. For H
example, there may be difficulties with ensuring the integrity of the payments system A
and protecting customer data (including bank details) from hackers, which will result in P
T
an increased focus on revenue from online sales. E
 Cyber attacks could also lead to disruption or suspension of the e-commerce platform R
resulting in loss of sales and reputational damage. 7

 There may be breaches of data protection regulations regarding customer details
resulting from fraud (eg, cyber attacks) or poor procedures. This could result in the
company being exposed to litigation and fines, which may require provisions in the
 Consider what additional inventory control measures have been implemented.
Inventories are presumably fairly high value, and hence will be material to NewForm's
activities. What measures have been implemented to track customer orders? What
procedures have been put in place to deal with returned goods in relation to checking
claims relating to returned goods and authorisation/processing of refunds? This may
be a particular difficulty, given the remote nature of the shipment of goods.
 Assess if NewForm has the technical skills to develop and support a new e-commerce
division of the type proposed.
 Evaluate if consideration has been given to ensuring the continuity of operations, given
the increasing reliance of the business on technology. Specific issues include the
following.
– Lack of resources may undermine effective contingency plans; this may force a
business to accept a higher tolerance of errors in the system, thus leading to a
deeper inherent risk within the organisation
– Inadequate controls surrounding the interaction of e-commerce applications with
other business critical applications
– Undermining of otherwise effective controls, eg, from inadequate recognition and
use of controls, combined with inadequate monitoring of control compliance
 Inventories are held remotely, and thus control over a significant asset is exercised
largely by a third party.
 Online ordering creates problems of security and data protection.
 Lack of audit trail in a paperless system.
 Dependence on a sole distributor.

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(b) Application controls

A number of application controls may be relevant, for example the following:
 Pre-processing authorisation
– Customer password systems
– Credit payment authorisation
– Customer account balance limit tests
 Validation tests
– Consistency with previous orders in terms of value

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1 Dodgy Burgers plc
(a) Business risk and Management (b) Audit procedures to be completed in

category strategy to order to place reliance on the controls in
combat risk place
Health and safety
 Partially cooked  Management  Obtain a copy of the Health and Safety

burgers have been has set up a policy and review to ensure that the
C
sold. Health and policies are adequate. File on the H
Safety training permanent audit file for future reference. A
 This constitutes an P
programme.
operational risk  Hold discussions with the branch T
(failure to comply managers on a sample basis to ensure E
R
will result in the that the policy has been implemented if
company being shut staff do not reach the required standard. 7
down) and
 Review the training course to establish
compliance risk
what procedures are being taught to the
(breach of Health
staff, and what follow up has been
and Safety
implemented if staff do not reach the
regulations).
required standard.
 Internal audit  Assess the internal audit department staff

spot checks on to ensure they have the appropriate
Health and authority, and are technically competent
Safety are to to complete the review.
be carried out  Discuss with the internal audit department
at the how the branches have been selected for
branches. sampling.
 Review copies of the internal audit reports
to identify:
– the issues found;
– how they have been resolved;
– what follow-up work was required; and
– how this was monitored.
 Discuss with the directors how many visits
have been completed in the year and
whether they received all the copies of the
reports.
 Review correspondence files and external
Health and Safety visits during the period
before the internal audit department was
set up.
 Provided that the internal visits are
effective, audit procedures can be limited
to the period before the internal audit
department was set up, as this is likely to
be the higher audit risk area.
New competitor

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combat risk place
 A new competitor  Advertising  Review gross profit margins to assess if

has set up in major campaigns there has been a major impact on sales.
cities within the and
 Discuss with the directors and review the
vicinity of Dodgy promotional
national press to identify what impact this
Burgers plc. gifts.
competition is likely to have and whether
 This constitutes an  New staff or not they are aiming for the same
operational risk member market.
(could lead to going employed to
 Review the advertising expenses account
concern problems visit rivals.
to ensure that adverts have been bought
and, ultimately,
and paid for.
closure).
 Review correspondence from the
 The instigation of a
Advertising Standards Authority to ensure
major advertising
no complaints have been logged as a
campaign itself
result of the advert.
constitutes a
compliance risk  Review contracts with the television
(Advertising companies to ensure that primetime slots
Standards need to had been given.
be complied with).
 Review sales accounts to establish that
 The campaign and sales have increased in the period during
promotional gifts or following the advertising campaigns.
lead to financial risk
 Review the employment records to ensure
(large cash outlay).
that the staff member has been employed
on a part-time basis and review the
contract/job description.
 Review the reports sent to the board to
establish if suitable observations have
been made and have been acted on.
Cash controls
 Risk of theft of cash  New controls  Review returns from branches to head
takings (financial implemented office on a sample basis.
risk). to set till floats
 Discuss the differences identified with
and provide
head office staff and review the action
reconciliations
taken.
to head office
on a daily
basis.

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combat risk place
Limited seating
 Lack of seating in  No strategy There is therefore no control as such to rely

most branches has been put on but there are potential going concern
during peak times in place due to issues.
(operational risk – cost-benefit
 Discuss with branch managers the
loss of customers). considerations
number of customers at peak times, and
but takeaway
the level of complaints re the lack of
discount at C
seating area.
peak times H
may be  Discuss with the directors the impact this A
P
considered in may have in the future if competitors are T
the future. close by to the branches, loss of customer E
may increase. R
 Spot check the branches on a sample 7

basis to establish the customers leaving
without purchasing to confirm the extent
of problem highlighted by the directors.
Recycled products
 A lack of confidence  The use of  Review the contracts with the suppliers to
from the public in recycled ensure that recycled packages are clearly
Dodgy Burgers plc's packaging. specified and the price is comparable to
environmental the original prices of non-recycled
 Waste
policies (operational products.
separations
and compliance
and  Review the branch returns to ensure that
risk).
collections. delivery notes have been signed for the
waste collection and the receipts match
the tonnage collected. Ensure that these
are in line with expectations from the
preliminary analytical procedures on the
accounts.
 Review the new packaging for evidence
that the recycled symbols have been
correctly displayed.
 Discuss with the branch managers if any
further costs have been incurred from
having to separate the waste for
collection, or whether separate bins have
been provided in the branches for the
public to use.

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2 Happy Flights plc

Memorandum
To: Geraint Johns (Assignment Manager)
From: A Senior
Date: 24 July 20X6
Subject: Happy Flights – audit risks
(1) Plane crash
Financial reporting issues
The plane crash occurred in the year to 30 June 20X6, thus potentially gives rise to a
liability that might need to be recognised in the current period. This might include:
 civil litigation by those passengers injured and the relations of those killed;
 criminal penalties against HF and/or its directors;
 if health and safety regulations have been breached then further penalties and
constraints may apply; or
 liability for employees killed and injured.
Any litigation may be in several jurisdictions according to the location of the crash and
the nationality of the passengers, thus the issues may be complex and take some time
to resolve.
While such liabilities may ultimately be substantial they may also turn out to be small if
the fault lies with airport authorities or other causes. It seems likely that these issues will
be unresolved when the financial statements are authorised for issue thus it is unclear
whether a contingency or a provision would arise. If there is significant uncertainty, or if
there is a low probability of a claim, this might indicate a contingency, but more
information would be needed to draw a firmer conclusion (see below).
Audit risks
A key audit risk is the lack of information on which to base a judgement in respect of
the following:
 Whether any liability is probable or only possible
 The amount and timing of such a liability is unlikely to be known at the date of
audit completion
According to IAS 37 where the amount of an obligation cannot be measured with
sufficient reliability then it should be disclosed as a contingent liability. In this case it
would not be recognised in the financial statements. If the information available is still
fundamentally unclear at the date the financial statements are authorised for issue,
then this may be the most appropriate treatment.
If the company is insured then recovery of any insurance should be regarded as a
separate matter from the provision/contingency question.
Going concern – Notwithstanding the treatment of the provision/contingency then
going concern is likely to be an issue. Given that the company is already struggling
financially, any claim may prove to be a significant additional factor in assessing going
concern. However, insurance recovery may be considered in making any such
assessment.
There may, however, be other more immediate going concern issues arising from the
crash other than the settlement of litigation.

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These include:
 reduction in passenger numbers, as the reputation for safety may have
diminished;
 grounding of aircraft by health and safety regulators perhaps resulting in loss of
revenues, cancellations and delays; and
 reconsideration of leasing older planes resulting in additional costs.
Audit procedures
 Review claims against HF received by audit completion.
 Review correspondence with HF's legal advisers and consider taking independent
legal advice regarding the amount and probability of any claim against HF. C
H
 Review any announcements by investigation teams and any correspondence with A
HF regarding causes of the crash and the extent HF was to blame up to the date of P
T
audit completion (eg, 'black box' flight recorder evidence). E
R
 Consider the possibility of counter claims by HF against others responsible for the
crash by considering legal advice. 7
 Review any correspondence with Health and Safety Executive regarding

grounding of planes or possible causes of the crash.
 Review flight bookings since crash for evidence of a decline in reputation and fall in
future sales.
 Assess impact on budgeted cash flows to consider impact on going concern.
(2) Operating issues
 The decline in operating profits is further evidence of going concern problems.
 If the operating leases have been extended then consideration needs to be given
as to whether the new leases are finance leases if the residual value at the end of
the lease on an old plane is small.
Audit risks
The key audit risk is going concern. If there is adequate disclosure in the financial
statements by the directors regarding the uncertainties about going concern then an
unmodified audit opinion will be issued but the audit report will include a separate
section headed 'Material Uncertainty Related to Going Concern'. However, if the
directors do not disclose going concern uncertainties appropriately, it may be
necessary to modify the audit opinion.
The receipt of cash from customers in advance is likely to cause concern if the
company does have going concern issues, as this may amount to fraudulent trading if
the customers, as unsecured creditors, are unable to recover their payment.
The additional borrowing also increases financial risk and makes profit more sensitive
to changes in the level of operating activity.

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Audit procedures
As already noted, cash flow forecasts will need to be reviewed up to the date of audit
completion to assess the future viability of the company. This should include the
following:
 Examining overdraft and other lending facilities (eg, for 'headroom' against
existing liabilities, for interest rates and for capital repayment dates). Build a
picture of future financial commitments.
 Identifying the level of advanced payments and discuss with the directors the issue
of continuing the policy of advanced payments and the implications for fraudulent
trading.
 Examining budgets and cash flow projections as part of going concern. Review to
assess future expected changes in liquidity.
 Examining lease contracts to assess the lease renewals position in order to
ascertain future levels of commitment.
(3) Database system
Audit risks
General systems issues
The nature of the fault needs to be identified ie, there may be issues with the work and
or hardware/software supplied by the consultants. Some of the problems appear to be
with the people operating the systems rather than the system itself. These are
employees of the company so this effect also needs to be assessed.
Cyber security may also be an issue as a virus was able to circumvent existing security
measures.
There appear to be two control risks in the IT system:
 The maintenance and control of the database itself and the information contained
therein
 The online processing of transactions
Separate controls are needed over each of these aspects.
Specific issues
Excess bookings – risks include the following:
 A system error appears to have arisen, as the system should not accept
unintentional double bookings. The level of confidence in the system is thus
reduced, thereby increasing our assessment of control risk.
 Revenue may have been double counted if two bookings have been taken.
System crashing – risks include the following:
 Loss of data is a major problem, as it not only affects operating capability but also
reduces confidence in IT controls over financial statement assertions as the
database feeds into the financial statements.
 There may be a risk of corruption of data as well as loss of data. This may have
been a cause of the above double bookings.
Computer virus – risks include the following:
 Loss of future data if it reoccurs
 Corruption of data
 Loss of confidentiality of information
 Risk of fraud from 'hacking' into system to create false bookings or false payments

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Advance payments recognised as revenue:

 If payments are recognised as revenue on receipt, then revenue is overstated if
payments occur in one financial year and the flight occurs in the next financial
year. The risk is that all such payments recognised in advance have not been
identified.
The key financial reporting issue is the inappropriate recognition of revenue for
advance payments by customers. While this can be corrected in the draft financial
statements in the current year, it may have also have occurred in the previous year. If
material, this should be recognised as a prior period error. Retained earnings brought
forward should be adjusted and the relevant revenue should be correctly recognised
C
in the current year with comparatives adjusted.
H
Audit procedures A
P
The control risk relating to the IT system needs to be established. If reliance cannot be T
E
placed on the IT system it may not be possible to test income for understatement due
R
to lack of relevant, reliable audit evidence. This may lead to a modified audit opinion
on the basis of insufficient evidence (limitation of scope). 7
Regarding online processing, tests of controls with respect to the following may be
relevant:
 Access controls, passwords (eg, review logs of access and user authorisation)
 Programming (review programming faults discovered, actions taken to amend
faults, reoccurrence of same faults)
 Firewall (consider response to virus and why firewall failed to detect it; procedures
for updating firewalls; best practice review)
 Use of CAATs to interrogate the system's ability to detect and prevent errors and
fraud
Regarding database itself:
 Review procedures manuals for database management system. This is the
software that creates, operates and maintains the database.
 Review data independence procedures (the data should be independent of the
application such that the structure of the data can be changed independently of
the application).
 Consider the wider database control environment. This includes the general
controls and who has access to change particular aspects of the database.
 General controls might include: a standard approach for development and
maintenance of application programs; access rights; data resource management;
data security, cyber-security and data recovery.

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CHAPTER 8

finalisation, review
and reporting
Introduction
TOPIC LIST
1 Review and audit completion
2 Subsequent events
3 Going concern
4 Comparatives
5 Written representations
6 The auditor's report
7 Other reporting responsibilities
Appendix
Technical reference

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Introduction
 Review the appropriateness of the going concern basis of accounting and describe
relevant going concern disclosures
 Review events after the reporting period
 Review and evaluate, quantitatively and qualitatively, for example using analytical
procedures and data analytics and artificial intelligence, the results and conclusions
obtained from audit procedures
 Draw conclusions on the nature of the report on an audit engagement, and
formulate an opinion for a statutory audit, which are consistent with the results of
the audit evidence gathered
 Draft suitable extracts for reports (for example any report to the management or
those charged with governance issued as part of the engagement)
Specific syllabus references for this chapter are: 15(a)–(e)

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1 Review and audit completion
Section overview
 Towards the end of an audit, a series of reviews and evaluations are carried out.
• This is an important aspect of quality control.
1.1 Introduction
Auditing initially may be carried out on components, with opinions being formed on elements of
the financial statements in isolation. However, it is essential that auditors step back from the
detail and assess the financial statements as a whole, based on knowledge accumulated during
the audit process. In particular, the following procedures will need to be performed at the
review and completion stage of the audit:
 Consider governance issues
 Review the financial statements
 Perform completion procedures
 Report to the board
 Prepare the auditor's report
Review and reporting issues have been covered in the Audit and Assurance Study Manual at the
Professional Level, however there have been some substantial changes in this area affecting the
auditor's responsibilities relating to 'other information' and auditor's reports in particular. The C
H
following ISAs are relevant to this stage of the audit: A
P
 ISA (UK) 260 (Revised June 2016), Communication With Those Charged With Governance T
E
 ISA (UK) 520, Analytical Procedures R
 ISA (UK) 560, Subsequent Events
8
 ISA (UK) 570 (Revised June 2016), Going Concern
 ISA (UK) 700 (Revised June 2016), Forming an Opinion and Reporting on Financial
Statements
 ISA (UK) 701, Communicating Key Audit Matters in the Independent Auditor's Report
 ISA (UK) 705 (Revised June 2016), Modifications to the Opinion in the Independent
Auditor's Report
 ISA (UK) 706 (Revised June 2016), Emphasis of Matter Paragraphs and Other Matter
Paragraphs in the Independent Auditor's Report
 ISA (UK) 710, Comparative Information – Corresponding Figures and Comparative Financial
Statements
 ISA (UK) 720 (Revised June 2016), The Auditor's Responsibilities Relating to Other
Information
In the remainder of this chapter we will look at a number of key aspects of these ISAs in more
detail. A summary is also provided in the technical reference at the end of the chapter.
1.2 Governance issues

1.2.1 Quality control
We have looked at the importance of quality control in Chapter 1 of this Study Manual. Quality
control is an important consideration throughout the audit. In particular, for the audit of listed
entities, ISA (UK) 220 (Revised June 2016), Quality Control for an Audit of Financial Statements
ICAEW 2019 The statutory audit: finalisation, review and reporting 423

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states that the auditor's report should not be dated until the completion of the engagement
quality control review (ISA 220.19c). This includes ensuring that:
 the work has been carried out in accordance with professional and regulatory
requirements;
 a proper evaluation of the firm's independence was carried out;
 significant matters are given further consideration;
 appropriate consultations have taken place and been documented;
 where appropriate the planned work is revised;
 the work performed supports the conclusions;
 the evidence obtained supports the audit opinion;
 the objectives of the audit have been achieved; and
 the auditor's report is appropriate in the circumstances.
In addition, under Sarbanes–Oxley, a concurring or second partner review should be performed
by another partner not associated with the audit or by an independent reviewer (see Chapter 4
for more details of the Sarbanes–Oxley Act).
In its 'Strategy 2018/21: Budget and Levies 2018/19 (March 2018)' the FRC reiterated that
"promoting high audit quality and assurance" was one of its strategic priorities – this is
underpinned by its ongoing system of monitoring the quality of firms and their work, including
periodic audit quality thematic reviews on issues such as materiality (see Chapter 5).
1.2.2 Governance evidence

Important governance evidence will be obtained from the following sources:
 Written representation letters from management (see later in this chapter)
 Information about contingent liabilities and commitments (Chapter 13)
 Information about related parties (Chapter 9)
1.3 Financial statement review

1.3.1 Introduction
Once the bulk of the substantive procedures have been carried out, the auditors will have a draft
set of financial statements which should be supported by appropriate and sufficient audit
evidence. At the beginning of the end of the audit process, it is usual for the auditors to
undertake an overall review of the financial statements. This review, in conjunction with the
conclusions drawn from the other audit evidence obtained, gives the auditors a reasonable
basis for their opinion on the financial statements. It should be carried out by a senior member
of the audit team, with appropriate skills and experience.
1.3.2 Compliance with accounting regulations

The auditors should consider whether:
 the information presented in the financial statements is in accordance with local/national
statutory requirements; and
 the accounting policies employed are in accordance with accounting standards, properly
disclosed, consistently applied and appropriate to the entity.
An important consideration in assessing the presentation of the financial statements is the
adequacy of disclosure. In addition to the basic Companies Act requirements in the UK and

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compliance with accounting standards, the entity may need to satisfy the requirements of the UK
Corporate Governance Code and/or Sarbanes–Oxley.
When examining the accounting policies, auditors should consider:
 policies commonly adopted in particular industries;
 policies for which there is substantial authoritative support;
 whether any departures from applicable accounting standards are necessary for the
financial statements to give a true and fair view; and
 whether the financial statements reflect the substance of the underlying transactions and
not merely their form.
When compliance with local/national statutory requirements and accounting standards is
considered, the auditors may find it useful to use a checklist.
1.3.3 Review for consistency and reasonableness

The auditors should consider whether the financial statements are consistent with their
knowledge of the entity's business and with the results of other audit procedures, and the
manner of disclosure is fair. The principal considerations are as follows.
 Whether the financial statements adequately reflect the information and explanations
previously obtained and conclusions previously reached during the course of the audit
 Whether the review reveals any new factors which may affect the presentation of, or
C
disclosure in, the financial statements H
 Whether analytical procedures applied when completing the audit, such as comparing the A
P
information in the financial statements with other pertinent data, produce results which T
assist in arriving at the overall conclusion as to whether the financial statements as a whole E
are consistent with their knowledge of the entity's business R
 Whether the presentation adopted in the financial statements may have been unduly 8
influenced by the directors' desire to present matters in a favourable or unfavourable light
 The potential impact on the financial statements of the aggregate of uncorrected
misstatements (including those arising from bias in making accounting estimates) identified
during the course of the audit
1.3.4 Analytical procedures

In Chapter 6, we discussed how analytical procedures are used as part of the overall review
procedures at the end of an audit. The procedures may be similar to those performed at the
planning stage as risk assessment procedures but, at the end of the audit, the purpose of the
procedures is to corroborate the conclusions drawn during detailed testing. This may also
involve reviewing results derived from data analytics tools.
As at other stages, significant fluctuations and unexpected relationships must be investigated
and documented.
1.3.5 Summarising misstatements

During the course of the audit, misstatements will be discovered which may be material or
immaterial to the financial statements. It is very likely that the client will adjust the financial
statements to take account of these during the course of the audit. At the end of the audit,
however, some misstatements may still be uncorrected and the auditors will summarise these
uncorrected misstatements.

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An example is provided below.
Worked example: Schedule of uncorrected misstatements

Statement of
Statement of Statement of Statement of financial
profit or loss financial position profit or loss position
(Current period) (Current period) (Prior period) (Prior period)
Dr Cr Dr Cr Dr Cr Dr Cr
£ £ £ £ £ £ £ £
(a) ABC Ltd
debt unprovided 10,470 10,470 4,523 4,523
(b) Opening/closing inventory
undervalued* 21,540 21,540 21,540 21,540
(c) Closing inventory
undervalued 34,105 34,105
(d) Opening unaccrued expenses
Telephone* 453 453 453 453
Electricity* 905 905 905 905
(e) Closing unaccrued expenses
Telephone 427 427
Electricity 1,128 1,128
(f) Obsolete inventory
write-off 2,528 2,528 3,211 3,211
Total 36,093 35,463 35,463 36,093 9,092 21,540 21,540 9,092
Cancelling items* 21,540 21,540
453 453
905 905
14,553 34,105 34,105 14,553
The summary of misstatements will list misstatements not only from the current year
(adjustments (c) and (e)) but also those in the previous year(s). This will allow misstatements to
be highlighted which are reversals of misstatements in the previous year. For example, in this
instance last year's closing inventory was undervalued by £21,540 (adjustment (b)). Inventory in
the prior year statement of financial position should be increased (Dr) and profits increased (Cr).
At the start of the current accounting period the closing inventory adjustment is reversed out so
that the net effect on the cumulative position is zero. This also applies to the adjustment to last
year's accrued expenses (adjustment (d)). Cumulative misstatements may also be shown, which
have increased from year to year, for example adjustments (a) and (f). It is normal to show both
the statement of financial position and the effect on profit or loss, as in the example given here.
This may also be extended to the entire statement of profit or loss and other comprehensive
income.
1.3.6 Evaluating the effect of misstatements

ISA (UK) 450 (Revised June 2016), Evaluation of Misstatements Identified During the Audit states
that the objective of the auditor is to evaluate:
(a) the effect of identified misstatements on the audit, and
(b) the effect of uncorrected misstatements, if any, on the financial statements. (ISA 450.3)
All misstatements identified during the audit should be accumulated, other than those that are
clearly trivial (ISA 450.5). (The ISA explains that 'clearly trivial' does not mean the same as 'not
material'; it implies something of a wholly different – smaller – order of magnitude.) The auditor
must document any threshold used to define what has been considered to be clearly trivial.

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The aggregate of uncorrected misstatements comprises the following:

(a) Specific misstatements identified by the auditors, including the net effect of uncorrected
misstatements identified during the audit of the previous period if they affect the current
period's financial statements
(b) Their best estimate of other misstatements which cannot be quantified specifically
ISA 450 distinguishes between the following:
 Factual misstatements – about which there is no doubt
 Judgemental misstatements – differences arising from judgements of management
including those concerning recognition, measurement, presentation and disclosure in the
financial statements (including the selection or application of accounting policies) that the
auditor considers unreasonable or inappropriate
 Projected misstatements – the auditor's best estimate of misstatements in populations,
involving the projection of misstatements identified in samples to entire populations
(ISA 450.A6)
If the auditors consider that the aggregate of misstatements may be material, they must consider
reducing audit risk by extending audit procedures or requesting management to adjust the
financial statements (which management may wish to do anyway).
If the aggregate of the uncorrected misstatements that the auditors have identified approaches
the materiality level, the auditors should consider whether it is likely that undetected
C
misstatements, when taken with aggregated uncorrected misstatements, could exceed the
H
materiality level. Thus, as aggregate uncorrected misstatements approach the materiality level A
the auditors should consider reducing the risk by: P
T
 performing additional audit procedures; and E
 requesting management to adjust the financial statements for identified misstatements. R
The schedule will be used by the audit manager and partner to decide whether the client should 8
be requested to make adjustments to the financial statements to correct the misstatements.
1.4 Artificial intelligence (AI)

In Chapter 5 we discussed the advances in audit data analytics and how artificial intelligence (AI)
has helped auditors to increase the scope, detail and accuracy of testing large populations of
data. This software can even be programmed to summarise findings and prioritise the results of
testing, making the process of evaluation more efficient as the parameters that are used to
identify items of significance can now be programmed with much more subtlety (for example,
the patterns of behaviours which may be indicative of fraudulent activity within an account
category such as expenses claims).
2 Subsequent events
Section overview
Auditors must review events after the reporting period and determine whether those events
impact on the year-end financial statements.
2.1 Events after the reporting period

In accordance with ISA (UK) 560, Subsequent Events, subsequent events include:
 events occurring between the period end and the date of the auditor's report; and
 facts discovered after the date of the auditor's report.

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IAS 10, Events After the Reporting Period deals with the treatment in financial statement of
events, favourable and unfavourable, occurring after the period end. It identifies two types of
event:
(1) Those that provide further evidence of conditions that existed at the period end
(2) Those that are indicative of conditions that arose subsequent to the period end
The extent of the auditor's responsibility for subsequent events depends on when the event is
identified.
Point to note:
While ISA 560 does not deal with matters relating to the auditor's responsibilities for other
information obtained after the date of the auditor's report which are addressed in ISA (UK) 720
(Revised June 2016), The Auditor's Responsibilities Relating to Other Information, this type of
other information may bring to light a subsequent event relevant to the application of ISA 560.
2.2 Events occurring up to the date of the auditor's report

The auditor must perform procedures designed to obtain sufficient, appropriate audit evidence
that all events up to the date of the auditor's report that may require adjustment of, or
disclosure in, the financial statements have been identified.
These procedures should be applied to any matters examined during the audit which may be
susceptible to change after the year end. They are in addition to tests on specific transactions
after the period end eg, cut-off tests.
The ISA lists procedures to identify subsequent events which may require adjustment or
disclosure. They should be performed as near as possible to the date of the auditor's report.
Procedures testing subsequent events
Inquiries of Status of items involving subjective judgement/accounted for using

management preliminary data
New commitments, borrowings or guarantees
Sales or destruction of assets
Issues of shares/debentures or changes in business structure
Developments involving risk areas, provisions and contingencies
Unusual accounting adjustments
Major events (eg, going concern problems) affecting appropriateness
of accounting policies for estimates
Other procedures Consider procedures of management for identifying subsequent
events
Read minutes of general board/committee meetings
Review latest accounting records and financial information
Reviews and updates of these procedures may be required, depending on the length of the
time between the procedures and the signing of the auditor's report and the susceptibility of the
items to change over time.
When the auditor becomes aware of events which materially affect the financial statements, the
auditor should consider whether such events are properly accounted for and adequately
disclosed in the financial statements.

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2.3 Facts discovered after the date of the auditor's report but before the
financial statements are issued
The financial statements are the management's responsibility. They should therefore inform the
auditors of any material subsequent events between the date of the auditor's report and the
date the financial statements are issued. The auditors do not have any obligation to perform
procedures, or make inquiries regarding the financial statements after the date of their report.
If, after the date of the auditor's report but before the financial statements are issued, the auditor
becomes aware of a fact that, had it been known to the auditor at the date of the auditor's
report, may have caused the auditor to amend the auditor's report, the auditor shall:
 Discuss the matter with the management;
 Consider whether the financial statements need amendment; and if so
 Inquire how management intends to address the matter in the financial statements.
When the financial statements are amended, the auditors shall do the following:
 Extend the procedures discussed above to the date of their new report
 Carry out any other appropriate procedures
 Issue a new auditor's report dated no earlier than the date of approval of the amended
If the auditor believes the financial statements need to be amended, and management does not
amend them:
C
 If the auditor's report has not yet been released to the entity, the auditor shall modify the H
opinion in line with ISA 705 and then provide the auditor's report. A
P
 If the auditor's report has already been released to the entity, the auditor shall notify those T
who are ultimately responsible for the entity (the management or possibly a holding E
company in a group) not to issue the financial statements or auditor's reports before the R
amendments are made. If the financial statements are issued anyway, the auditor shall take 8
action to seek to prevent reliance on the auditor's report. The action taken will depend on
the auditor's legal rights and obligations and the advice of the auditor's lawyer.
2.4 Facts discovered after the financial statements have been issued
Auditors have no obligations to perform procedures or make inquiries regarding the financial
statements after they have been issued. In the UK, this includes the period up until the financial
statements are laid before members at the annual general meeting (AGM).
When, after the financial statements have been issued, the auditor becomes aware of a fact
which existed at the date of the auditor's report and which, if known at that date, may have
caused the auditor to modify the auditor's report, the auditor should consider whether the
financial statements need revision, discuss the matter with management, and take action as
appropriate in the circumstances.
The ISA gives the appropriate procedures which the auditors should undertake when
management revises the financial statements.
 Carry out the audit procedures necessary in the circumstances.
 Review the steps taken by management to ensure that anyone in receipt of the previously
issued financial statements together with the auditor's report thereon is informed of the
situation.
 Issue a new report on the revised financial statements. (ISA 560.15)
The new auditor's report should include an emphasis of matter paragraph or other matter
paragraph referring to a note to the financial statements that more extensively discusses the

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reason for the revision of the previously issued financial statements and to the earlier report
issued by the auditor. (ISA 560.16)
Where local regulations allow the auditor to restrict the audit procedures on the financial
statements to the effects of the subsequent event which caused the revision, the new auditor's
report should contain a statement to that effect.
Where management does not revise the financial statements but the auditors feel they should be
revised, or if management does not intend to take steps to ensure anyone in receipt of the
previously issued financial statements is informed of the situation, the auditors should consider
taking steps to prevent reliance on their report. The actions taken will depend on the auditor's
legal rights and obligations and legal advice received. In the UK, the auditor has a legal right to
make statements at the AGM.
In the UK, where the auditor becomes aware of a fact relevant to the audited financial statements
which did not exist at the date of the auditor's report, there are no statutory provisions for
revising the financial statements. In this situation, the auditor discusses with those charged with
governance whether they should withdraw the financial statements. Where those charged with
governance decide not to do so, the auditor may wish to take advice on whether it might be
possible to withdraw their report. In either case, other possible courses of action include those
charged with governance or the auditors making a statement at the AGM. (ISA 560.A16-1-3)
Interactive question 1: Subsequent events

You are the auditor of Extraction, an oil company. You have recently concluded the audit for the
year ended 31 December 20X7 and the auditor's report was signed on 28 March 20X8. The
financial statements were also authorised for issue on this date. On 1 April, you are informed
that the company has identified a major oil leak which has caused significant environmental
damage.
Requirement
Identify and explain the implications of the information regarding the oil spill.
3 Going concern
Section overview
 The auditor will test whether the going concern basis of accounting is appropriate to
ensure it applies to the audit client.
• Financial risk is indicated by the following circumstances:
– Financial indications
– Operating indications
– Other indications
3.1 Reporting consequences

If an entity is a going concern it is ordinarily viewed as continuing in business for the foreseeable
future with neither the intention nor the necessity of liquidation, ceasing trading or seeking
protection from creditors pursuant to laws or regulations. Accordingly, assets and liabilities are
recorded on the basis that the entity will be able to realise its assets and discharge its liabilities
in the normal course of business.
However, if management determines that it intends to, or has no realistic alternative but to,
liquidate the entity or cease trading, then the financial statements should not be prepared on

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the going concern basis. This is specified by IAS 10, Events After the Reporting Period. The entity
should instead adopt a basis of preparation that is considered more appropriate in the
circumstances, although no specific guidance is provided in IAS 10. In practice, the most
obvious method is break-up value. Specific accounting consequences will include the need to
consider the following:
 Impairment of assets
 Recognition of provisions eg, for onerous contracts
Disclosure of the change of basis of preparation should be provided in accordance with IAS 1,
Preparation of Financial Statements. In addition, the directors of listed companies must report
specifically on the going concern status of the company under the UK Corporate Governance
Code. They must include a detailed 'viability statement' within the Strategic Report, providing a
broad assessment of the entity's solvency, liquidity, risk management and viability.
3.2 Financial risk

The possibility of a business not being a going concern is one of the financial risks to which a
business is exposed. Financial risks are those risks arising from the financial activities of the
company, for example:
 Raising capital
 The capital structure
 Financial consequences of an operation eg, operating in an overseas environment
As a consequence of the original capital structure or subsequent operation, there may be a risk C
H
due to a shortage of finance or an inability to manage finance in accordance with a company's A
day to day requirements. P
T
ISA (UK) 570 (Revised June 2016), Going Concern identifies events and conditions that may cast E
doubt about the entity's ability to use the going concern basis of accounting: R
(a) Financial 8
 Net liabilities or net current liability position

 Fixed-term borrowings approaching maturity without realistic prospects of renewal or
repayment, or excessive reliance on short-term borrowings
 Indications of withdrawal of financial support by creditors
 Negative operating cash flows indicated by historical or prospective financial
statements
 Adverse key financial ratios
 Substantial operating losses or significant deterioration in the value of assets used to
generate cash flows
 Arrears or discontinuance of dividends
 Inability to pay creditors on due dates
 Inability to comply with terms of loan agreements
 Change from credit to cash-on-delivery transactions with suppliers
 Inability to obtain financing for essential new product development or other essential
investments
(b) Operating
 Management intentions to liquidate the entity or to cease operations
 Loss of key management without replacement
 Loss of a major market, key customer, franchises, licence or principal supplier

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 Labour difficulties
 Shortages of important supplies
 Emergence of a highly successful competitor
(c) Other
 Non-compliance with capital or other statutory or regulatory requirements
 Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that could not be met
 Changes in legislation or government policy
 Uninsured or underinsured catastrophes when they occur (ISA 570.A3)
The significance of such indications can often be mitigated by other factors.
(a) The effect of an entity being unable to make its normal debt repayments may be
counterbalanced by management's plans to maintain adequate cash flows by alternative
means, such as by disposal of assets, rescheduling of loan repayments, or obtaining
additional capital.
(b) The loss of a principal supplier may be mitigated by the availability of a suitable alternative
source of supply.
3.3 ISA 570, Going Concern

ISA 570 was revised in June 2016. The main changes are as follows:
 The revised ISA now refers to 'the going concern basis of accounting' rather than 'the going
concern assumption'.
 It has been revised to take account of the fact that going concern issues may be key audit
matters (KAMs) (KAMs are covered in detail later in this chapter).
 In the UK, the inclusion of a 'Conclusions relating to Going Concern' section where the
auditor concludes that the going concern basis of accounting is appropriate and there is no
material uncertainty.
 Where there is a material uncertainty relating to going concern and the matter is disclosed
adequately a separate section is included under the heading 'Material Uncertainty Related
to Going Concern'. This was previously disclosed in an Emphasis of Matter paragraph.
The following is a summary of the key points from the revised ISA 570:
Management's responsibility
(a) ISA 570 states that when preparing accounts, management should make an explicit
assessment of the entity's ability to continue as a going concern. Most accounting
frameworks require management to do so.
As a result of the 2014 change to the UK Corporate Governance Code there is an
expectation that the period assessed by the company will now be significantly longer than
12 months from the date of approval of the financial statements (see Chapter 4 section 3.3).
(b) When management are making the assessment, the following factors should be
considered:
(1) The degree of uncertainty about the events or conditions being assessed increases
significantly the further into the future the assessment is made.
(2) Judgements are made on the basis of the information available at the time.
(3) Judgements are affected by the size and complexity of the entity, the nature and
condition of the business and the degree to which it is affected by external factors.

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Auditor's responsibilities
(a) When planning and performing audit procedures and in evaluating the results thereof, the
auditor shall consider whether there are events or conditions that may cast significant doubt
on the entity's ability to continue as a going concern.
(b) The auditor's objectives are as follows:
(1) To obtain sufficient appropriate audit evidence regarding, and conclude on, the
appropriateness of management's use of the going concern basis of accounting
(2) To conclude, based on the audit evidence obtained, whether a material uncertainty
exists related to events or conditions that may cast significant doubt on the entity's
ability to continue as a going concern
(3) To report in accordance with ISA 570 (ISA 570.9)
(c) The auditor shall remain alert for evidence of events or conditions and related business
risks which may cast doubt on the entity's ability to continue as a going concern throughout
the audit. If such events or conditions are identified, the auditor shall consider whether they
affect the auditor's assessments of the risk of material misstatement.
(d) Management may already have made a preliminary assessment of going concern. If so, the
auditors would review potential problems management had identified, and management's
plans to resolve them. Alternatively auditors may identify problems as a result of discussions
with management.
(e) The auditor shall evaluate management's assessment of the entity's ability to continue as a C
H
going concern maintaining professional scepticism throughout the audit. The auditors shall A
consider: P
T
 the process management used; E
 the assumptions on which management's assessment is based; and R
 management's plans for future action. 8
(f) If management's assessment covers a period of less than 12 months from the end of the
reporting period, the auditor shall ask management to extend its assessment period to
12 months from the end of the reporting period. In the UK, if the directors have not
considered a year from the date of approval of the financial statements and not disclosed
that fact, the auditor shall disclose it in the auditor's report. (ISA 570.18-1)
(g) Management shall not need to make a detailed assessment if the entity has a history of
profitable operations and ready access to financial resources. In this case, the auditor's
evaluation of the assessment may be made without performing detailed procedures if
sufficient evidence is available from other audit procedures. In the UK, the extent of the
auditor's procedures is influenced primarily by the excess of the financial resources
available to the entity over the financial resources that it requires. (ISA 570.A11-5)
(h) The auditor shall inquire of management as to its knowledge of events or conditions
beyond the period of assessment used by management that may cast significant doubt on
the entity's ability to continue as a going concern. (ISA 570.14)
As the degree of uncertainty increases as an event or condition gets further into the future,
the indications of going concern issues would need to be significant before the auditor
would consider it necessary to take any further action based on this information. The
auditor's responsibility to carry out procedures to identify issues beyond the period of
assessment would normally be limited to inquiries of management. (ISA 570.A14–A15)

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Additional audit procedures

(a) When events or conditions have been identified which may cast significant doubt on the
entity's ability to continue as a going concern, the auditor shall do the following:
(1) Evaluate management's plans for future actions based on its going concern
assessment
(2) Where the entity has prepared a cash flow forecast and analysis of this is significant in
the evaluation of management's plans for future action:
 Evaluate the reliability of the underlying data
 Determine whether there is adequate support for the assumptions underlying the
forecast
(3) Consider whether any additional facts or information have become available since the
date of management's assessment
(4) Seek written representations from management regarding its plans for future action
and the feasibility of these plans
(b) When questions arise on the appropriateness of the going concern assumption, some of
the normal audit procedures carried out by the auditors may take on an additional
significance. Auditors may also have to carry out additional procedures or update
information obtained earlier. The ISA lists various procedures which the auditors shall carry
out in this context.
(1) Analyse and discuss cash flow, profit and other relevant forecasts with management.
(2) Analyse and discuss the entity's latest available interim financial statements.
(3) Read the terms of debentures and loan agreements and determine whether they have
been breached.
(4) Read minutes of the meetings of shareholders, the board of directors and important
committees for reference to financing difficulties.
(5) Inquire of the entity's lawyer regarding litigation and claims.
(6) Confirm the existence, legality and enforceability of arrangements to provide or
maintain financial support with related and third parties.
(7) Assess the financial ability of such parties to provide additional funds.
(8) Evaluate the entity's plans to deal with unfulfilled customer orders.
(9) Perform audit procedures regarding subsequent events to identify those that either
mitigate or otherwise affect the entity's ability to continue as a going concern.
(10) Confirm the existence, terms, and adequacy of borrowing facilities.
(11) Obtain and review reports of regulatory actions.
(12) Determine the adequacy of support for any planned disposals of assets.
(c) Based on the audit evidence obtained, the auditor shall determine if, in the auditor's
judgement, a material uncertainty exists related to events or conditions that, alone or in
aggregate, may cast significant doubt on the entity's ability to continue as a going concern.
The auditor must document the extent of their concern (if any) about the entity's ability to
continue as a going concern.

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Auditor conclusions and reporting

Use of the going concern basis of accounting appropriate and no material uncertainty exists
Where the use of the going concern basis of accounting is appropriate and no material
uncertainty exists, in the UK the auditor must:
 Determine whether a KAM must be disclosed in respect of going concern, and if so include
the KAM in the auditor's report
 Include a separate section in the auditor's report under the heading 'Conclusions relating to
Going Concern'. This should:
– describe the responsibilities of those charged with governance relating to the use of
the going concern basis of accounting and disclosure of material uncertainties;
– describe the auditor's responsibilities including the auditor's reporting responsibilities
if the auditor concludes that management's use of the going concern basis of
accounting is not appropriate or that management has not disclosed material
uncertainties over a period of at least twelve months from the date of approval of the
financial statements;
– for entities which apply the UK Corporate Governance Code, report by exception as to
whether the auditor has anything material to add regarding the directors' statement
about going concern; and
– in other cases, to report by exception as to whether the auditor concludes that
C
management's use of the going concern basis is not appropriate or that management
H
has not disclosed material uncertainties over a period of at least twelve months from A
the date of approval of the financial statements. (ISA 570.21-1–21-2) P
T
Use of going concern basis of accounting appropriate but a material uncertainty exists E
R
(a) The auditor shall determine whether the financial statements:
8
(1) adequately disclose the events and conditions that may cast significant doubt on the
entity's ability to continue as a going concern and management's plans to deal with
these; and
(2) disclose clearly that there is a material uncertainty which may cast significant doubt
about the company's ability to continue as a going concern.
(b) If adequate disclosure is made in the financial statements, the auditor shall express an
unmodified opinion but include a separate section under the heading 'Material Uncertainty
Related to Going Concern'. This must draw attention to the note in the financial statements
that discloses the matter and must state that these events or conditions indicate that a
material uncertainty exists that may cast significant doubt on the entity's ability to continue
as a going concern and that the auditor's opinion is not modified in this respect.
(ISA 570.22)
See Appendix Illustration 6.
Point to note:
This is a change from the previous version of ISA 570, which required the use of an
Emphasis of Matter paragraph to highlight the disclosure of material uncertainties relating
to going concern.
(c) If adequate disclosure is not made in the financial statements, the auditor shall express a
qualified or adverse opinion, as appropriate. In the Basis for Qualified or Adverse Opinion
section of the auditor's report the auditor must state that there is a material uncertainty
which may cast significant doubt on the company's ability to continue as a going concern
and that the financial statements do not adequately disclose this. (ISA 570.23)

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Management unwilling to make or extend its assessment

 If management is unwilling to make or extend its assessment when requested to do so by
the auditor, the auditor shall consider the need to modify the auditor's report as a result of
the inability to obtain sufficient appropriate evidence.
Use of going concern assumption is inappropriate
 If the going concern basis has been used but in the auditor's judgement this is not
appropriate, the auditor shall express an adverse opinion.
Communication with those charged with governance
Unless all those charged with governance are involved with managing the entity the auditor
must communicate with those charged with governance events or conditions that cast
significant doubt on the entity's ability to continue as a going concern, including the following
details:
 Whether the events or conditions constitute a material uncertainty
 Whether management's use of the going concern basis of accounting is appropriate
 The adequacy of related disclosure
 Where applicable the implications for the auditor's report (ISA 570.25)
Significant delay
If there is a significant delay in the approval of the financial statements the auditor must enquire
as to the reasons for this. Where it is believed that the delay could be related to going concern
issues the auditor must perform additional audit procedures and consider the effect on the
auditor's conclusion regarding the existence of a material uncertainty.
3.4 Going concern issues during adverse economic conditions

In December 2008, Bulletin 2008/10 Going Concern Issues During the Current Economic
Conditions was published. This bulletin aimed to provide extra guidance on how to apply
ISA 570 in the specific circumstances of the credit crunch and the last recession.
The document highlights the additional uncertainties that will arise in relation to:
 bank lending intentions and the availability of finance more generally;
 the impact of the recession on a company's own business; and
 the impact of the recession on counterparties, including customers and suppliers.
The guidance stresses that the auditor's judgement on whether to draw attention to going
concern issues in the auditor's report should be based on the facts and circumstances of the
entity itself. The general economic situation does not, of itself, necessarily mean that a material
uncertainty exists about an entity's ability to continue as a going concern.
Auditors need to take account of the current economic circumstances at all stages of the audit.
In planning the audit, risks relating to matters such as inventory obsolescence, goodwill
impairments and cash flows must be considered. Procedures must be performed to evaluate the
adequacy of the means by which the directors have satisfied themselves whether it is
appropriate to adopt the going concern basis. One specific issue noted in the Bulletin is that
bankers may be reluctant to provide positive confirmations to the directors that facilities will
continue to be available. Auditors must consider whether or not the lack of a confirmation
reflects the existence of a material matter regarding going concern (which should be referred to
in the auditor's report).
Reasons for the bank's reluctance that would not be a material matter regarding going concern
(a) The bank responding that in the current economic environment, as a matter of policy, it is
not providing such confirmations to its customers or their auditors.
(b) The entity and its bankers are engaged in negotiations about the terms of a facility (eg, the
interest rate), and there is no evidence that the bank is reluctant to lend to the company.

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(c) The bank renewed a rolling facility immediately before the date of the annual report and is
reluctant to go through the administrative burden to confirm that the facility will be
renewed on expiry.
However, if the auditor concludes that an entity's bankers are refusing to confirm facilities for
reasons that are specific to the entity, this could be a material matter and the auditor will need
to consider the significance of the fact and discuss with directors whether there are alternative
strategies or sources of finance that would justify the use of the going concern basis.
The auditor may decide that it is unnecessary to highlight a going concern issue in the auditor's
report if they consider that:
 alternative strategies are realistic;
 they have a reasonable expectation of resolving any problems foreseen; and
 the directors are likely to put the strategies into place effectively.
Point to note:
This Bulletin has not been updated for the June 2016 revised ISAs.
3.4.1 Other guidance

The responsibility for assessing the company's ability to continue as a going concern and for
disclosing significant uncertainties rests with the directors. The Financial Reporting Council
(FRC) has published Guidance on Risk Management, Internal Control and Related Financial and
Business Reporting in September 2014 which replaces an Update for Directors: Going Concern
C
and Liquidity Risk. This is primarily directed at companies subject to the UK Corporate H
Governance Code and aims to bring together elements of best practice for risk management. A
Appendix A specifically deals with going concern and provides guidance on how to determine P
T
whether to adopt the going concern basis, how to determine whether there are material
E
uncertainties and relevant disclosures. R
In April 2016 FRC issued Guidance on the Going Concern Basis of Accounting and Reporting on 8
Solvency and Liquidity Risks. This provides guidance to directors of companies that do not apply
the UK Corporate Governance Code. This includes principles for best practice. It summarises the
main requirements as follows:
Main requirement Micro-entity Small company Large or

medium-sized
company
Financial statements
Assessment of appropriateness of the   
going concern basis of accounting
Disclosure when there are material × × ×
uncertainties or when the company does
not prepare financial statements on a
going concern basis of accounting
Additional disclosures that may be ×  
required to give a true and fair view
Other relevant financial statement × × 
disclosures
Strategic report
The strategic report must contain a × × 
description of the principal risks and
uncertainties facing the company

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Point to note:
In June 2012, the Sharman Inquiry issued its Final Report and Recommendations. This includes
recommendations regarding going concern assessment and disclosure (see Chapter 4).
Interactive question 2: Going concern

You are the senior on the audit of Truckers Ltd whose principal activities are road transport and
warehousing services, and the repair of commercial vehicles. You have been provided with
extracts from the draft accounts for the year ended 31 October 20X5.
Draft 20X5 Actual 20X4
£'000 £'000
Summary statement of profit or loss
Revenue 10,971 11,560
Cost of sales (10,203) (10,474)
Gross profit 768 1,086
Administrative expenses (782) (779)
Interest payable and similar charges (235) (185)
Net (loss) profit (249) 122
Summary statement of financial position
Non-current assets 5,178 4,670
Current assets
Inventory (parts and consumables) 95 61
Receivables 2,975 2,369
3,070 2,430
Current liabilities
Bank loan 250 –
Overdraft 1,245 913
Trade payables 1,513 1,245
Lease obligations 207 –
Other payables 203 149
3,418 2,307
Non-current liabilities
Bank loan 750 1,000
Lease obligations 473 –
1,223 1,000
Net assets 3,607 3,793
You have been informed by the managing director that the fall in revenue is due to the following
factors:
 The loss, in July, of a longstanding customer to a competitor
 A decline in trade in the repair of commercial vehicles
Due to the reduction in the repairs business, the company has decided to close the workshop
and sell the equipment and spares inventory. No entries resulting from this decision are
reflected in the draft accounts.
During the year, the company replaced a number of vehicles, funding them by a combination of
leasing and an increased overdraft facility. The facility is to be reviewed in January 20X6 after the
audited accounts are available.
The draft accounts show a loss for 20X5 but the forecasts indicate a return to profitability in
20X6, as the managing director is optimistic about generating additional revenue from new
contracts.

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Requirements
(a) State the circumstances particular to Truckers Ltd which may indicate that the company is
not a going concern. Explain why these circumstances give cause for concern.
(b) Describe the audit procedures to be performed in respect of going concern at Truckers Ltd.
4 Comparatives
Section overview
 ISA 710 provides guidance on corresponding figures and comparative financial
statements.
• The auditor should obtain sufficient, appropriate audit evidence that the corresponding
figures meet the requirements of the applicable financial reporting framework.
4.1 ISA 710, Comparative Information

ISA (UK) 710, Comparative Information – Corresponding Figures and Comparative Financial
Statements establishes standards and provides guidance on the auditor's responsibilities regarding C
comparatives. H
A
Comparatives are presented differently under different countries' financial reporting P
frameworks. Generally comparatives can be defined as corresponding amounts and other T
E
disclosures for the preceding financial reporting period(s), presented for comparative purposes. R
Because of these variations in countries' approach to comparatives, the ISA refers to the
following frameworks and methods of presentation. 8
Corresponding figures are amounts and other disclosures for the prior period included as an
integral part of the current period financial statements, and are intended to be read only in
relation to the amounts and other disclosures relating to the current period (referred to as
'current period figures'). The level of detail presented in the corresponding amounts and
disclosures is dictated primarily by its relevance to the current period figures. This is the usual
approach in the UK.
Comparative financial statements are amounts and other disclosures for the prior period
included for comparison with the financial statements of the current period but, if audited, are
referred to in the auditor's opinion. The level of information included in those comparative
financial statements is comparable with that of the financial statements of the current period.
Comparatives are presented in compliance with the relevant financial reporting framework. The
essential audit reporting differences are that:
 for corresponding figures, the auditor's report only refers to the financial statements of the
current period; and
 for comparative financial statements, the auditor's report refers to each period for which
financial statements are presented.
ISA 710 provides guidance on the auditor's responsibilities for comparatives (the audit
procedures are essentially the same for both approaches) and for reporting on them under the
two frameworks. We will concentrate on corresponding figures, as this is the approach usually
adopted in the UK.

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4.2 Audit procedures

The auditor must obtain sufficient, appropriate audit evidence that the comparative information
meets the requirements of the applicable financial reporting framework.
Audit procedures performed on the comparative information are usually limited to checking that
the comparative information has been correctly reported and is appropriately classified.
Auditors must assess whether the following are true:
 Accounting policies used for the comparative information are consistent with those of the
current period or whether appropriate adjustments and/or disclosures have been made.
 Comparative information agrees with the amounts and other disclosures presented in the
prior period or whether appropriate adjustments and/or disclosures have been made. In
the UK and Ireland this will include checking whether related opening balances in the
accounting records were brought forward correctly.
If the auditor becomes aware of a possible material misstatement in the comparative information
while performing the current period audit, then additional audit procedures should be
performed to obtain sufficient, appropriate audit evidence to determine whether a material
misstatement exists.
Written representations are required for all periods referred to in the auditor's opinion and
specific representations are also required regarding any restatement made to correct a material
misstatement in prior period financial statements that affect the comparative information. In the
case of corresponding figures representations are requested for the current period only
because the auditor's opinion is on those financial statements which include corresponding
figures.
When the financial statements of the prior period:
 have been audited by other auditors, or
 were not audited,
then the incoming auditors must assess whether the corresponding figures meet the conditions
specified above and also follow the guidance in ISA (UK) 510 (Revised June 2016), Initial Audit
Engagements – Opening Balances.
4.3 Reporting
When the comparatives are presented as corresponding figures, the auditor should issue an
auditor's report in which the comparatives are not specifically identified because the auditor's
opinion is on the current period financial statements as a whole, including the corresponding
figures.
The auditor's report will only make any specific reference to corresponding figures in the
circumstances described below.
(a) When the auditor's report on the prior period, as previously issued, included a qualified
opinion, disclaimer of opinion, or adverse opinion and the matter which gave rise to the
modification is unresolved:
(1) if the effects or possible effects of the matter on the current period's figures are
material, the auditor's opinion on the current period's financial statements should be
modified and the basis for modification paragraph of the report should refer to both
periods in the description of the matter; or
(2) in other cases the opinion on the current period's figures should be modified and the
basis for modification paragraph should explain that the modification is due to the
effects or possible effects of the unresolved matter on the comparability of the current
period's figures and the corresponding figures.

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(b) In performing the audit of the current period financial statements, the auditors, in certain
unusual circumstances, may become aware of a material misstatement that affects the prior
period financial statements on which an unmodified report has been previously issued. If
the prior period financial statements have not been revised and reissued, and the
corresponding figures have not been properly restated and/or appropriate disclosures
have not been made, the auditor shall express a qualified opinion or an adverse opinion in
the report on the current period financial statements, modified with respect to the
corresponding figures included therein.
4.4 Incoming auditors: additional requirements

When the prior period financial statements were audited by other auditors, in some countries
the incoming auditors can refer to the predecessor auditor's report on the corresponding
figures in the incoming auditor's report for the current period.
When the auditor decides to refer to another auditor, the incoming auditor's report should
indicate:
 that the financial statements of the prior period were audited by the predecessor auditor;
 the type of opinion expressed by the predecessor auditor and, if the opinion was modified,
the reasons therefore; and
 the date of that report.
In the UK, the existing auditor does not make reference to another auditor in their report. C
H
The situation is slightly different if the prior period financial statements were not audited. A
P
When the prior period financial statements are not audited, the incoming auditor must state in T
the auditor's report that the corresponding figures are unaudited. E
R
However, the inclusion of such a statement does not relieve the auditors of the requirement to
perform appropriate procedures regarding opening balances of the current period. If there is 8
insufficient evidence about corresponding figures or inadequate disclosures, the auditor should
consider the implications for their report.
In situations where the incoming auditor identifies that the corresponding figures are materially
misstated, the auditor should request management to revise the corresponding figures or, if
management refuses to do so, appropriately modify the report.
Point to note:
In the UK in accordance with Companies Act 2006 a predecessor auditor must allow the
successor auditor access to all relevant information in respect of the audit, including relevant
working papers.
5 Written representations
Section overview
 Written representations are normally obtained towards the end of the audit as a letter
written by management and addressed to the auditor.
• Where there is doubt as to the reliability of written representations or if management
refuse to provide representations, the auditor will need to reassess the level of assurance
obtained from this source of evidence.

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5.1 Representations
ISA (UK) 580, Written Representations covers this area and states that the objectives of the
auditor are as follows:
 To obtain written representations from management and, where appropriate, those
charged with governance that they believe that they have fulfilled their responsibility for the
preparation of the financial statements and for the completeness of the information
provided to the auditor.
 To support other audit evidence relevant to the financial statements or specific assertions in
the financial statements.
 To respond appropriately to the representations or if representations are not provided.
5.2 Management from whom written representations are requested

"The auditor shall request written representations from management with appropriate
responsibilities for the financial statements and knowledge of the matters concerned."
(ISA 580.9)
ISA 580 requires the auditor to determine the appropriate individuals from whom to seek written
representations. In most cases this is likely to be management, as they would be expected to
have sufficient knowledge of the way in which the entity's financial statements have been
prepared. However, the ISA goes on to point out that in circumstances where others are
responsible for the financial statements, for example those charged with governance, then they
should be requested to provide the representations.
In the UK, where written representations are critical to obtaining sufficient, appropriate evidence
they should be provided by those charged with governance rather than simply the entity's
management. (In the UK those charged with governance are responsible for the preparation of
the financial statements.)
The ISA emphasises the need for management to make informed representations. In some
cases the auditor may request that management confirms that it has made appropriate inquiries
to enable it to do so.
5.3 Written representations

5.3.1 Management's responsibilities
ISA 580 specifies a number of general representations which management must provide.
These are as follows:
 That management has fulfilled its responsibility for the preparation and presentation of the
financial statements as set out in the terms of the audit engagement.
 Whether the financial statements are prepared and presented in accordance with the
applicable financial reporting framework.
 That management has provided the auditor with all the relevant information.
 That all transactions have been recorded and are reflected in the financial statements.
 A description of management's responsibilities.

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Points to note:
1 In the UK management may include qualifying language to the effect that the
representations are made to the best of their knowledge and belief.
2 In the UK the representation that all transactions have been recorded and reflected in the
financial statements may be modified, for example to state that all transactions that may
have a material effect on the financial statements have been recorded.
5.3.2 Other written representations

Other written representations may be required regarding specific issues. These may be required
due to the provisions of other ISAs (a list is given in Appendix 1 of ISA 580) or to support other
audit evidence. In particular, written representations may be sought where sufficient,
appropriate evidence cannot be obtained independently. This might be the case where an
assertion is affected by judgement or management intent. For example, management intent
would be an important factor in the valuation basis used to value investments.
However, the ISA stresses that written representations do not provide sufficient, appropriate
audit evidence on their own. The fact that management has provided reliable written
representations does not affect the nature and extent of other audit evidence that the auditor
obtains.
The auditor may also consider it necessary to obtain other representations about the following.
 Whether the selection and application of accounting policies are appropriate
C
 Whether the following have been recognised, measured and presented (where relevant): H
A
– Plans or intentions that may affect the carrying value or classification of assets and P
liabilities T
E
– Liabilities, both actual and contingent R
– Title to, or control over, assets, the liens or encumbrances on assets, and assets
8
pledged as collateral
– Aspects of laws, regulations and contractual agreements that may affect the financial
statements
 That management has communicated to the auditor all deficiencies in internal control of
which management is aware
5.3.3 Threshold amount

The ISA allows for the possibility that the auditor may agree a 'threshold amount' above which
matters cannot be regarded as clearly trivial.
5.4 Date of written representations

"The date of the written representations shall be as near as practicable to, but not after, the date
of the auditor's report on the financial statements. The written representations shall be for all the
financial statements and periods referred to in the auditor's report." (ISA 580.14)
Because written representations are audit evidence, the auditor's report cannot be dated before
the date of the written representations.
Where a representation about a specific issue has been obtained during the course of the audit
the auditor may request an updated written representation.

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5.5 Form of written representations

"The written representation shall be in the form of a representation letter addressed to the
auditor. If law or regulation requires management to make written public statements about its
responsibilities and the auditor determines that such statements provide some or all of the
representations required by paragraphs 10 or 11 (covered in paragraph 5.3.1 above), the
relevant matters covered by such statements need not be included in the representation letter."
(ISA 580.15)
Appendix 2 of ISA 580 provides an illustrative example of a representation letter. It is not a
standard letter, and representations will vary from one period to the next and from one company
to another.
5.6 Doubts as to reliability

Where the auditor has concerns about the competence, integrity and ethical values of the
management, the auditor must consider the effect this will have on the reliability of both oral
and written representations.
In particular, if written representations are inconsistent with other audit evidence the auditor will
need to perform audit procedures in an attempt to resolve the matter. If the situation remains
unresolved, the auditor will need to consider the potential effect on the audit opinion.
Where the auditor concludes that representations about management's responsibilities
regarding the preparation and presentation of financial statements and information provided to
the auditor are not reliable, the audit opinion will be a disclaimer.
5.7 Written representations not provided

ISA 580 requires the following procedures to be followed where written representations are not
provided.
 Discuss the matter with management
 Re-evaluate the integrity of management and evaluate the effect that this may have on the
reliability of representations (oral and written) and evidence in general
 Take appropriate actions, including determining the possible effect on the audit opinion
Where management does not provide representations about management's responsibilities
regarding the preparation and presentation of financial statements and information provided to
the auditor, the audit opinion will be a disclaimer.
Interactive question 3: Written representations

You are an audit manager reviewing the completed audit file of Leaf Oil.
(a) There have been no events subsequent to the period end requiring adjustment in the
(b) The company has a policy of revaluing properties on an annual basis. A large revaluation
gain has been recorded for two properties in the year, on the basis that the directors
believe that the property market is going to boom next year. However, the directors have
not provided supporting evidence for the revaluation, and a survey of business property
values in the area does not show any increase.
(c) The directors confirm that the company owns 75% of the newly formed company,
Subsidiary, at the year end.
(d) The directors confirmed that the 500 gallons of oil in Warehouse B belong to Leaf Oil.

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Requirement
Comment on whether you would expect to see these matters referred to in the written
representation letter.
6 The auditor's report
Section overview
 Auditors must provide clear and understandable auditor's reports on the financial
statements audited.
• As well as the standard auditor's report, the wording of the report may be changed to
express a modified opinion, or an emphasis of matter or other matter paragraph may be
added to the report.
• Listed company auditor's reports include a description of key audit matters.
• Modifications result either from material misstatements (disagreements) in the financial
statements or from an inability to obtain sufficient, appropriate audit evidence (limitation
on scope).
C
• The auditor's report must include a separate section with a heading 'Other Information'. H
A
• Auditors must form, and then critically appraise, their audit opinion on the financial P
T
statements.
E
• Auditor's reports can be made available electronically; in this situation the auditor must R
ensure that their report is not misrepresented. 8
6.1 The standard report

In June 2016, the FRC issued ISA (UK) 700 (Revised June 2016), Forming an Opinion and
Reporting on Financial Statements. In doing so the FRC has adopted the current IAASB auditing
standard which was itself revised in 2015 as part of an IAASB project on auditor's reports. The
aim of the project was to:
 make the auditor's report more informative; and
 provide more relevant information about the entity and the audit.
Details of the format of the revised auditor's report in accordance with ISA (UK) 700 are given
below but the main changes you should be aware of are as follows:
 The audit opinion is placed at the start of the report.
 The auditor's reports of certain entities will include a description of key audit matters.
 There is a more detailed description of the auditor's responsibilities and the features of an
audit.
 Changes to reporting on going concern as required by revisions to ISA 570.
 Inclusion of an 'Other information' section as required by revisions to ISA 720.
 Changes to the requirements for enhanced audit reporting applicable to public interest
entities and/or listed companies.

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ISA (UK) 700 (Revised June 2016) states that the auditor's report must contain the following:
(a) Title
The term 'independent auditor' is usually used in the title to distinguish the auditor's report
from reports issued by others. (ISA 700.21)
(b) Addressee
In the UK the Companies Act 2006 requires the auditor to report to the company's
members. (ISA 700.22)
(c) Auditor's opinion
This is now required to be the first section of the auditor's report. It must have the heading
'Opinion' and in the UK when an unmodified opinion is expressed it must state clearly that
the financial statements give a true and fair view. (ISA 700.23 & .25)
This section must also:
 identify whose financial statements have been audited;
 state that the financial statements have been audited;
 identify the title of each statement comprising the financial statements;
 refer to the notes, including the summary of accounting policies; and
 specify the date of, or period covered by, each financial statement comprising the
financial statements. (ISA 700.24)
(d) Basis for opinion
This section must immediately follow the 'Opinion' section and must have the heading
'Basis for opinion'. It must include the following information:
 States that the audit was conducted in accordance with ISAs (UK) and applicable law
 Refers to the section of the auditor's report that describes the auditor's responsibilities
under the ISAs
 Includes a statement that the auditor is independent of the entity in accordance with
relevant ethical requirements including the FRC's Ethical Standard
 States whether the auditor believes that the audit evidence the auditor has obtained is
sufficient and appropriate to provide a basis for the auditor's opinion. (ISA 700.28)
(e) Going concern
Where applicable the auditor must report on going concern in accordance with ISA 570
(see section 3 of this chapter). (ISA 700.29)
(f) Key audit matters
In the UK, a key audit matters section must be included in accordance with ISA (UK) 701 for
audits of public interest entities and other entities that have applied the UK Corporate
Governance Code (see section 6.2 of this chapter). (ISA 700.30-.31)
(g) Other information
In the UK, the auditor's report must always include a separate section with a heading 'Other
information'. (ISA 700.32 and ISA 720.21)

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(h) Responsibilities for the financial statements

The auditor's report must include a section with the heading 'Responsibilities of those
charged with governance for the Financial Statements'. This includes a statement
describing the responsibility of those charged with governance for:
 preparing financial statements that give a true and fair view;
 such internal control as management determines is necessary to enable the
preparation of financial statements that are free from material misstatement; and
 assessing the ability of the entity to continue as a going concern, assessing whether the
use of the going concern basis of accounting is appropriate and disclosing matters
relating to going concern.
(i) Auditor's responsibilities for the audit of the financial statements
ISA 700's requirements regarding the description of the auditor's responsibilities is
extensive. These include statements:
 of the objectives of the auditor;
 that reasonable assurance is a high level of assurance but is not a guarantee that an
audit will always detect a material misstatement;
 that misstatements can arise from fraud or error; and
 that the auditor exercises professional judgment and maintains professional scepticism
C
throughout the audit.
H
This section also includes a description of an audit and includes the following points: A
P
 The auditor assesses risks of material misstatement, designs and performs audit T
E
procedures and obtains sufficient, appropriate evidence to provide a basis for the R
audit opinion.
8
 The auditor obtains an understanding of internal control relevant to the audit.
 The appropriateness of accounting policies is assessed.
 The auditor concludes on the appropriateness of management's use of the going
concern basis of accounting and whether a material uncertainty exists.
 The auditor communicates with those charged with governance regarding the planned
scope and timing of the audit and significant findings. (ISA 570.37– .40a)
For audits of listed entities the auditor's responsibilities section will also include the
following:
 Confirmation that the auditor has provided those charged with governance with a
statement that the auditor has complied with relevant ethical requirements regarding
independence
 Where key audit matters are communicated a statement that the auditor determines
these matters to be of the most significance in the audit. This applies to all entities for
which key audit matters are communicated (not just listed companies).
(ISA 570.40b & c)
In the UK the description of the auditor's responsibilities may be given in the body of the
auditor's report, within an appendix to the auditor's report or by cross reference to the
description maintained on a website by an appropriate authority eg, FRC. (ISA 700.41)
(j) Other reporting responsibilities
If the auditor addresses other reporting responsibilities in addition to those under ISAs (UK),
these must be addressed in a separate section of the auditor's report.

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If the auditor is required to report on certain matters by exception this section of the
auditor's report must describe the auditor's responsibilities and incorporate a suitable
conclusion. For example in the UK the Companies Act 2006 requires the auditor to report
when a company has not maintained adequate books and records. (ISA 700.43)
Additional requirements apply for audits of public interest entities. In this instance the
auditor must:
 state by whom the auditor was appointed;
 indicate the date of the appointment and the period of total uninterrupted
engagement;
 explain the extent to which the audit was capable of detecting irregularities, including
fraud ('Staff Guidance Note 02/2017' issued by the FRC provided further guidance on
the information that the auditor should include in the auditor's report, ensuring that so-
called 'boiler-plate' text is avoided in order to make such disclosure meaningful);
 confirm that the audit opinion is consistent with the additional report to the audit
committee;
 declare that non-audit services prohibited by the FRC's Ethical Standards were not
provided; and
 indicate any services in addition to the audit which were provided by the firm and
which have not been disclosed in the financial statements. (ISA 700.45R-1)
(k) Name of the engagement partner
The name of the engagement partner shall be included in the auditor's report on financial
statements of listed entities unless such disclosures would lead to a personal security threat.
(l) Auditor's signature
Where the auditor of a UK company is a firm, the report is signed by the senior statutory
auditor.
(m) Auditor's address
The report must name the location where the auditor is based.
(n) Date of the report
The date of the report is the date on which the auditor signs the report expressing an
opinion on the financial statements. It must be no earlier than the date on which the auditor
has obtained sufficient appropriate audit evidence.
Under Companies Act 2006, publicly traded companies are required to include a corporate
governance statement in their annual report. If this is not included the auditor must report by
exception.

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6.1.1 Auditor's report on individual company financial statements

The FRC issued Bulletin: Compendium of Illustrative Auditor's Reports on United Kingdom
Private Sector Financial Statements for periods commencing on or after 17 June 2016 in
October 2016. The auditor's report set out below is example 6 from the new Bulletin.
Independent auditor's report to the members of XYZ PLC
Appendix 6 – Publicly traded premium listed company preparing group and parent company
financial statements under IFRSs
• Company is a premium listed company, a quoted company and a public interest entity.
• Financial statements are prepared in accordance with IFRSs as adopted by the EU and are
also prepared in accordance with IFRSs as issued by the IAASB.
• Company prepares group financial statements.
• Section 408 exemption not taken in respect of parent company's own profit and loss
account.
• Corporate governance statement not incorporated into the strategic report or the directors'
report, either directly or by incorporation by cross-reference.
• Description of the auditor's responsibilities for the audit of the financial statements is
included within an appendix to the auditor's report.
Independent auditor's report to the members of [XYZ Plc]
C
Opinion H
A
We have audited the financial statements of [XYZ Plc] (the 'parent company') and its subsidiaries P
(the 'group') for the year ended [date] which comprise [specify the titles of the primary T
E
statements] and notes to the financial statements, including a summary of significant accounting R
policies. The financial reporting framework that has been applied in their preparation is
applicable law and International Financial Reporting Standards (IFRSs) as adopted by the 8
European Union.
In our opinion the financial statements:
• Give a true and fair view of the state of the group's and of the parent company's affairs as
at [date] and of the group's and the parent company's [profit/loss] for the year then ended;
• Have been properly prepared in accordance with [IFRSs as adopted by the European
Union]; and
• Have been prepared in accordance with the requirements of the Companies Act 2006 and,
as regards the group financial statements, Article 4 of the IAS Regulation.
Separate opinion in relation to IFRSs as issued by the IASB
As explained in note [X] to the group financial statements, the group in addition to complying
with its legal obligation to apply IFRSs as adopted by the European Union, has also applied
IFRSs as issued by the International Accounting Standards Board (IASB).
In our opinion the group financial statements give a true and fair view of the consolidated
financial position of the group as at [date] and of its consolidated financial performance and its
consolidated cash flows for the year then ended in accordance with IFRSs as issued by the IASB.
Basis for opinion
We conducted our audit in accordance with International Standards on Auditing (UK) (ISAs (UK))
and applicable law. Our responsibilities under those standards are further described in the
Auditor's responsibilities for the audit of the financial statements section of our report. We are
independent of the group in accordance with the ethical requirements that are relevant to our
audit of the financial statements in the UK, including the FRC's Ethical Standard as applied to

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listed public interest entities, and we have fulfilled our other ethical responsibilities in
accordance with these requirements. We believe that the audit evidence we have obtained is
sufficient and appropriate to provide a basis for our opinion.
Conclusions relating to principal risks, going concern and viability statement
We have nothing to report in respect of the following information in the annual report, in
relation to which the ISAs (UK) require us to report to you whether we have anything material to
add or draw attention to the following:
• The disclosures in the annual report [set out on page …] that describe the principal risks
and explain how they are being managed or mitigated;
• The directors' confirmation [set out on page …] in the annual report that they have carried
out a robust assessment of the principal risks facing the group, including those that would
threaten its business model, future performance, solvency or liquidity;
• The directors' statement [set out on page …] in the financial statements about whether the
directors considered it appropriate to adopt the going concern basis of accounting in
preparing the financial statements and the directors' identification of any material
uncertainties to the group and the parent company's ability to continue to do so over a
period of at least twelve months from the date of approval of the financial statements;
• Whether the directors' statement relating to going concern required under the Listing
Rules in accordance with Listing Rule 9.8.6R(3) is materially inconsistent with our
knowledge obtained in the audit; or
• The directors' explanation [set out on page …] in the annual report as to how they have
assessed the prospects of the group, over what period they have done so and why they
consider that period to be appropriate, and their statement as to whether they have a
reasonable expectation that the group will be able to continue in operation and meet its
liabilities as they fall due over the period of their assessment, including any related
disclosures drawing attention to any necessary qualifications or assumptions.
Key audit matters
Key audit matters are those matters that, in our professional judgment, were of most significance
in our audit of the financial statements of the current period and include the most significant
assessed risks of material misstatement (whether or not due to fraud) that we identified. These
matters included those which had the greatest effect on: the overall audit strategy, the allocation
of resources in the audit; and directing the efforts of the engagement team. These matters were
addressed in the context of our audit of the financial statements as a whole, and in forming our
opinion thereon, and we do not provide a separate opinion on these matters.
[Description of each key audit matter in accordance with ISA (UK) 701.]
Our application of materiality
[Explanation of how the auditor applied the concept of materiality in planning and performing
the group and parent company audit. This is required to include the threshold used by the
auditor as being materiality for the group and parent company financial statements as a whole
but may include other relevant disclosures.]
An overview of the scope of our audit
[Overview of the scope of the group and parent company audit, including an explanation of how
the scope addressed each key audit matter and was influenced by the auditor's application of
materiality.]
[Explanation as to what extent the audit was considered capable of detecting irregularities,
including fraud.]
Other information
The other information comprises the information included in the annual report [set out on
pages …][,including [specify the titles of the other information][set out on pages …]], other than

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the financial statements and our auditor's report thereon. The directors are responsible for the
other information. Our opinion on the financial statements does not cover the other information
and, except to the extent otherwise explicitly stated in our report, we do not express any form of
assurance conclusion thereon. In connection with our audit of the financial statements, our
responsibility is to read the other information and, in doing so, consider whether the other
information is materially inconsistent with the financial statements or our knowledge obtained in
the audit or otherwise appears to be materially misstated. If we identify such material
inconsistencies or apparent material misstatements, we are required to determine whether there
is a material misstatement in the financial statements or a material misstatement of the other
information. If, based on the work we have performed, we conclude that there is a material
misstatement of the other information, we are required to report that fact.
We have nothing to report in this regard.
In this context, we also have nothing to report in regard to our responsibility to specifically
address the following items in the other information and to report as uncorrected material
misstatements of the other information where we conclude that those items meet the following
conditions:
• Fair, balanced and understandable [set out on page …] – [the statement given / the
explanation as to why the annual report does not include a statement] by the directors that
they consider the annual report and financial statements taken as a whole is fair, balanced
and understandable and provides the information necessary for shareholders to assess
the group's performance, business model and strategy, is materially inconsistent with our
knowledge obtained in the audit; or
C
• Audit committee reporting [set out on page …] – [the section describing the work of the H
audit committee does not appropriately address matters communicated by us to the audit A
P
committee / the explanation as to why the annual report does not include a section T
describing the work of the audit committee is materially inconsistent with our knowledge E
obtained in the audit]; or R
• Directors' statement of compliance with the UK Corporate Governance Code [set out on 8
page …] – the parts of the directors' statement required under the Listing Rules relating to
the company's compliance with the UK Corporate Governance Code containing provisions
specified for review by the auditor in accordance with Listing Rule 9.8.10R(2) do not
properly disclose a departure from a relevant provision of the UK Corporate Governance
Code.
Opinions on other matters prescribed by the Companies Act 2006
In our opinion, the part of the directors' remuneration report to be audited has been properly
prepared in accordance with the Companies Act 2006.
In our opinion, based on the work undertaken in the course of the audit:
• The information given in the strategic report and the directors' report for the financial year
for which the financial statements are prepared is consistent with the financial statements
and those reports have been prepared in accordance with applicable legal requirements;
 The information about internal control and risk management systems in relation to financial
reporting processes and about share capital structures, given in compliance with rules 7.2.5
and 7.2.6 in the Disclosure Rules and Transparency Rules sourcebook made by the
Financial Conduct Authority (the FCA Rules), is consistent with the financial statements and
has been prepared in accordance with applicable legal requirements; and
• Information about the company's corporate governance code and practices and about its
administrative, management and supervisory bodies and their committees complies with
rules 7.2.2, 7.2.3 and 7.2.7 of the FCA Rules.

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Matters on which we are required to report by exception

In the light of the knowledge and understanding of the group and the parent company and its
environment obtained in the course of the audit, we have not identified material misstatements
in either of the following:
• The strategic report or the directors' report; or
• The information about internal control and risk management systems in relation to financial
reporting processes and about share capital structures, given in compliance with rules 7.2.5
and 7.2.6 of the FCA Rules.
We have nothing to report in respect of the following matters in relation to which the
Companies Act 2006 requires us to report to you if, in our opinion:
• Adequate accounting records have not been kept by the parent company, or returns
adequate for our audit have not been received from branches not visited by us; or
• The parent company financial statements and the part of the directors' remuneration report
to be audited are not in agreement with the accounting records and returns; or
• Certain disclosures of directors' remuneration specified by law are not made; or
• We have not received all the information and explanations we require for our audit; or
• A corporate governance statement has not been prepared by the parent company.
Responsibilities of directors
As explained more fully in the directors' responsibilities statement [set out on page …], the
directors are responsible for the preparation of the financial statements and for being satisfied
that they give a true and fair view, and for such internal control as the directors determine is
necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error.
In preparing the financial statements, the directors are responsible for assessing the group's and
the parent company's ability to continue as a going concern, disclosing, as applicable, matters
related to going concern and using the going concern basis of accounting unless the directors
either intend to liquidate the group or the parent company or to cease operations, or have no
realistic alternative but to do so.
Auditor's responsibilities for the audit of the financial statements
Our objectives are to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error, and to issue an
auditor's report that includes our opinion. Reasonable assurance is a high level of assurance, but
is not a guarantee that an audit conducted in accordance with ISAs (UK) will always detect a
material misstatement when it exists. Misstatements can arise from fraud or error and are
considered material if, individually or in the aggregate, they could reasonably be expected to
influence the economic decisions of users taken on the basis of these financial statements.
A further description of our responsibilities for the audit of the financial statements is included in
appendix [X] of this auditor's report. This description, which is located at [indicate page number
of other specific reference to the location of the description], forms part of our auditor's report.
Other matters which we are required to address
Following the recommendation of the audit committee, we were appointed by [state by whom
or which body the auditor was appointed] on [date] to audit the financial statements for the year
ending [date] and subsequent financial periods. The period of total uninterrupted engagement
is [X] years, covering the years ending [date] to [date].
The non-audit services prohibited by the FRC's Ethical Standard were not provided to the group
or the parent company and we remain independent of the group and the parent company in
conducting our audit.

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[Indicate any services, in addition to the audit, which were provided by the firm to the group that
have not been disclosed in the financial statements or elsewhere in the annual report.]
Our audit opinion is consistent with the additional report to the audit committee.
[Signature]
John Smith (Senior Statutory Auditor)
For and on behalf of ABC LLP, Statutory Auditor
[Address]
[Date]
Appendix: Auditor's responsibilities for the audit of the financial statements
As part of an audit in accordance with ISAs (UK), we exercise professional judgment and
maintain professional scepticism throughout the audit. We also:
• Identify and assess the risks of material misstatement of the financial statements, whether
due to fraud or error, design and perform audit procedures responsive to those risks, and
obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion.
The risk of not detecting a material misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery, intentional omissions,
misrepresentations, or the override of internal control.
• Obtain an understanding of internal control relevant to the audit in order to design audit
procedures that are appropriate in the circumstances, but not for the purpose of expressing C
H
an opinion on the effectiveness of the group's internal control. A
P
• Evaluate the appropriateness of accounting policies used and the reasonableness of T
accounting estimates and related disclosures made by the directors. E
R
• Conclude on the appropriateness of the directors' use of the going concern basis of
accounting and, based on the audit evidence obtained, whether a material uncertainty 8
exists related to events or conditions that may cast significant doubt on the group's or the
parent company's ability to continue as a going concern. If we conclude that a material
uncertainty exists, we are required to draw attention in our auditor's report to the related
disclosures in the financial statements or, if such disclosures are inadequate, to modify our
opinion. Our conclusions are based on the audit evidence obtained up to the date of our
auditor's report. However, future events or conditions may cause the group or the parent
company to cease to continue as a going concern.
• Evaluate the overall presentation, structure and content of the financial statements,
including the disclosures, and whether the financial statements represent the underlying
transactions and events in a manner that achieves fair presentation.
• Obtain sufficient appropriate audit evidence regarding the financial information of the
entities or business activities within the group to express an opinion on the group financial
statements. We are responsible for the direction, supervision and performance of the group
audit. We remain solely responsible for our audit opinion.
We communicate with those charged with governance regarding, among other matters, the
planned scope and timing of the audit and significant audit findings, including any significant
deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with
relevant ethical requirements regarding independence, and to communicate with them all
relationships and other matters that may reasonably be thought to bear on our independence,
and where applicable, related safeguards.
From the matters communicated with those charged with governance, we determine those
matters that were of most significance in the audit of the consolidated financial statements of the

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current period and are therefore the key audit matters. We describe these matters in our
auditor's report unless law or regulation precludes public disclosure about the matter or when, in
extremely rare circumstances, we determine that a matter should not be communicated in our
report because the adverse consequences of doing so would reasonably be expected to
outweigh the public interest benefits of such communication.
6.2 Key audit matters

The IAASB project on auditor's reports resulted in the issue of a new auditing standard. This
standard has now been adopted by the FRC as ISA (UK) 701, Communicating Key Audit Matters
in the Independent Auditor's Report. It applies to the audits of all listed entities but can be
applied to other audits when the auditor believes it to be necessary. In the UK, the standard also
applies to the audit of other public interest entities and entities that report on how they have
applied the UK Corporate Governance Code. The key points in this ISA are summarised below.
6.2.1 Determining key audit matters (KAMs)
Definition
Key audit matters (KAMs): Those matters, that in the auditor's professional judgment, were of
most significance in the audit of the financial statements of the current period. KAMs are
selected from matters communicated with those charged with governance. In the UK, these
include the most significant assessed risks of material misstatement (whether or not due to
fraud) identified by the auditor, including those that had the greatest effect on:
 the overall audit strategy;
 the allocation of resources in the audit; and
 directing the efforts of the engagement team. (ISA 701.8 &.A8-1)
ISA 701 identifies the purpose of including this information as being to:
 enhance the communicative value of the auditor's report;
 provide additional information to intended users; and
 assist users in understanding significant audit matters and the judgments involved.
(ISA 701.2)
Point to note:
The inclusion of a KAM section does not constitute a modification of the auditor's report and
cannot be used as a substitute for a modified opinion. In addition, the KAM section cannot be
used as a substitute for disclosures that should have been made.
ISA 701 suggests a three-step 'filtering' approach to determining what constitutes a KAM:
Step 1: The auditor starts by considering all the matters communicated with those charged with
governance
Step 2: From these the auditor will assess which of these matters required significant audit
attention. This process will involve taking into account areas of higher/significant risk,
significant auditor/management judgment and the effect of significant events or
transactions that occurred in the period
Step 3: The auditor will then select from those matters identified in Step 2 the matters which
were of most significance in the audit
Step 3 is clearly the most important step of the process in which the auditor is required to apply
judgment in evaluating the relative significance of different issues.

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In making this decision the auditor would consider the following:

 Matters which resulted in significant interaction with those charged with governance
 The importance of the matter to the intended users' understanding of the financial
statements as a whole
 The nature/complexity/subjectivity of selection of accounting policies
 The nature and materiality of misstatements (corrected and uncorrected)
 The nature and extent of audit effort needed to address the matter
 Whether there were issues in applying audit procedures
 Extent of related control deficiencies
 Whether the matter affected more than one area of the financial statements
(ISA 701.A27 & .A29)
6.2.2 Disclosure
Where relevant the auditor's report must include a separate section with the heading 'Key Audit
Matters'. This includes an introduction followed by information about each individual KAM. The
introductory material states that:
 the matters described are the matters of 'most significance'; and
 the auditor does not provide a separate opinion on these matters. (ISA 701.11)
The description of an individual KAM would include the following:
C
 Why the matter was considered to be one of the most significant in the audit H
A
 How the matter was addressed in the audit P
T
Reference should also be made to any related disclosures in the financial statements. E
R
In the UK the following information must also be provided:
8
 A description of the most significant assessed risks of material misstatement
 A summary of the auditor's responses to those risks
 Key observations arising in respect to those risks (ISA 701.13–.13-2)
The ICAEW Audit and Assurance Faculty published a report in 2017 titled 'The start of a
conversation – The extended audit report' to support all parties involved in this form of
communication. Clearly, this process is still in its infancy, but presenting it in terms of a dialogue
is intended to support the perception that it is a two-way process. The report also suggests
metrics that could be used to assess the quality of this dialogue in respect of KAMs: (i) the
average number of KAMs in a report; and (ii) most common topics making up KAMs.
Here is an example of how KAMs could appear, taken from the IAASB's guidance publication
Auditor Reporting – Illustrative Key Audit Matters:
Key Audit Matters

Key audit matters are those matters that, in our professional judgment, were of most significance
in our audit of the financial statements of the current period. These matters were addressed in
the context of our audit of the financial statements as a whole, and in forming our opinion
thereon, and we do not provide a separate opinion on these matters.
Goodwill
Under IFRSs, the Group is required to annually test the amount of goodwill for impairment. This
annual impairment test was significant to our audit because the balance of XX as of December 31,
20X1 is material to the financial statements. In addition, management's assessment process is
complex and highly judgmental and is based on assumptions, specifically [describe certain
assumptions], which are affected by expected future market or economic conditions, particularly
those in [name of country or geographic area].

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Our audit procedures included, among others, using a valuation expert to assist us in evaluating
the assumptions and methodologies used by the Group, in particular those relating to the
forecasted revenue growth and profit margins for [name of business line]. We also focused on
the adequacy of the Group's disclosures about those assumptions to which the outcome of the
impairment test is most sensitive, that is, those that have the most significant effect on the
determination of the recoverable amount of goodwill.
The Company's disclosures about goodwill are included in Note 3, which specifically explains that
small changes in the key assumptions used could give rise to an impairment of the goodwill
balance in the future.
Revenue Recognition
The amount of revenue and profit recognized in the year on the sale of [name of product] and
aftermarket services is dependent on the appropriate assessment of whether or not each long-
term aftermarket contract for services is linked to or separate from the contract for sale of [name
of product]. As the commercial arrangements can be complex, significant judgment is applied in
selecting the accounting basis in each case. In our view, revenue recognition is significant to our
audit as the Group might inappropriately account for sales of [name of product] and long-term
service agreements as a single arrangement for accounting purposes and this would usually
lead to revenue and profit being recognized too early because the margin in the long-term
service agreement is usually higher than the margin in the [name of product] sale agreement.
Our audit procedures to address the risk of material misstatement relating to revenue
recognition, which was considered to be a significant risk, included:
 Testing of controls, assisted by our own IT specialists, including, among others, those over:
input of individual advertising campaigns' terms and pricing; comparison of those terms
and pricing data against the related overarching contracts with advertising agencies; and
linkage to viewer data; and
 Detailed analysis of revenue and the timing of its recognition based on expectations
derived from our industry knowledge and external market data, following up variances from
our expectations.
(Source: IAASB guidance publication, Auditor Reporting – Illustrative Key Audit Matters, 2015)
In very limited circumstances it may be the case that KAMs exist but cannot or should not be
disclosed. These might include circumstances where law are regulation does not allow
disclosure or where the adverse consequences of disclosure would outweigh the public interest
benefit. (ISA 701.14)
It is also possible, although again very rare, that there may be no KAMs to disclose in the KAMs
section. Where this is the case a KAM section is still included in the auditor's report but a
statement is made that there are no KAMs to communicate. ISA 701.A58 provides the following
illustration of the appropriate wording in this situation:
'[Except for the matter described in the Basis for Qualified (Adverse) Opinion section or Material
Uncertainty Related to Going Concern section,] We have determined that there are no [other]
key audit matters to communicate in our report.'
6.2.3 Interaction between descriptions of key audit matters and other elements included in
the auditor's report
Where a matter results in a modified audit opinion, the matter by definition would be a KAM.
However modified audit opinions must be reported in accordance with ISA (UK) 705 (Revised
June 2016), Modifications to the Opinion in the Independent Auditor's Report and as a result a
description of the matter will be included in the 'Basis for modified opinion' paragraph and not
in the KAM section. The KAM section must however include a reference to the basis for
modified opinion paragraph.

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ISA 701 also makes particular reference to going concern issues. As we have seen in section 3 of
this chapter in accordance with ISA 570 if adequate disclosure is made in the financial
statements of a material uncertainty relating to going concern, the auditor expresses an
unmodified opinion but includes a separate section under the heading 'Material Uncertainty
Related to Going Concern'. The matter is not also described as a KAM, although the KAM
section should include a reference to the 'Material Uncertainty Related to Going Concern'
section.
6.2.4 Communicating other audit planning and scoping matters
In the UK, ISA 701 also requires the auditor's report to provide information about materiality
(including the threshold used for the financial statements as a whole) and an overview of the
scope of the audit. (ISA 701.16-1)
6.2.5 Communication with those charged with governance

The auditor is required to communicate to those charged with governance either the KAMs
included in the auditor's report or the fact that there are no KAMs. (ISA 701.17)
6.2.6 Documentation
Audit documentation must include the 'significant audit matters' from which the KAMs were then
selected and the rationale for determining whether each of these is a KAM or not. Where the
auditor has concluded that there are no KAMs, or that a KAM is not able to be disclosed the
reasons for this should be documented. (ISA 701.18)
C
H
6.3 Modified opinions, emphasis of matter and other matter paragraphs A
P
6.3.1 Modifications to the audit opinion T
E
Modifications to the audit opinion are covered by ISA (UK) 705 (Revised June 2016), R
Modifications to the Opinion in the Independent Auditor's Report.
8
ISA 705 requires a modified opinion when:
(a) the auditor concludes that, based on the evidence obtained, the financial statements as a
whole are not free from material misstatement; or
(b) the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the
financial statements as a whole are free from material misstatement.
and, in the auditor's judgement, the effect of the matter is or may be material to the financial
statements.
There are three types of modified opinion:
 Qualified opinion
 Disclaimer of opinion
 Adverse opinion
6.3.2 Determining the type of modification

In accordance with ISA 705 there are different types and degrees of modified opinion.
 A material misstatement (disagreement) may lead to a qualified opinion or an adverse
opinion.
 An inability to obtain sufficient, appropriate evidence (limitation on scope) may lead to a
qualified opinion or a disclaimer of opinion.
 The degree of modification depends on whether the auditor considers that the
misstatement, or possible misstatement, is pervasive to the financial statements.

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Definition
Pervasive effects on the financial statements are those that, in the auditor's judgement:
 are not confined to specific elements, accounts or items of the financial statements;
 if so confined, represent or could represent a substantial proportion of the financial
statements; or
 in relation to disclosures, are fundamental to users' understanding of the financial
statements. (ISA 705.5)
The following table based on the table from ISA 705.A1 summarises the different types of
modified opinion, and we will look at the detail of each of these in turn:
Nature of circumstances Material but not Material and pervasive

pervasive
Financial statements are Qualified opinion Adverse opinion

materially misstated
Except for … (Auditors state that the financial
(disagreement)
statements do not give a true and fair
view)
Inability to obtain Qualified opinion Disclaimer of opinion
sufficient, appropriate
Except for ... might (Auditors state they are unable to form
audit evidence (limitation
an opinion on the truth and fairness of
on scope)
the financial statements as a whole)
The ISA (ISA 705.7–.9) describes these different modified opinions and the circumstances
leading to them as follows.
(a) A qualified opinion must be expressed when the auditor concludes that an unmodified
opinion cannot be expressed but that the effect of any misstatement, or the possible effect
of undetected misstatements, is material but not pervasive. A qualified opinion should be
expressed as being "except for the effects of the matter to which the qualification relates".
(b) A disclaimer of opinion must be expressed when the auditor has not been able to obtain
sufficient appropriate audit evidence and accordingly is unable to express an opinion on
the financial statements. In rare circumstances involving multiple uncertainties the auditor
may issue a disclaimer even though sufficient appropriate evidence has been obtained
regarding each of the individual uncertainties, due to the potential interaction of these
uncertainties and their possible cumulative effect on the financial statements.
(c) An adverse opinion must be expressed when the auditor has obtained sufficient
appropriate audit evidence and concludes that misstatements, individually or in aggregate,
are both material and pervasive to the financial statements.
Basis for opinion paragraph
Where the auditor modifies the opinion on the financial statements the auditor must include a
paragraph immediately after the opinion paragraph (which is now the first paragraph in the
auditor's report in accordance with the revised ISA 700) to describe the matter giving rise to the
modification. It should be headed 'Basis for Qualified Opinion', 'Basis for Adverse Opinion' or
'Basis for Disclaimer of Opinion' as appropriate.

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Misstatement
The auditor may disagree with management about matters such as the acceptability of
accounting policies selected, the method of their application, or the adequacy of disclosures in
the financial statements. The ISA states that if such disagreements are material to the financial
statements, the auditor should express a qualified or an adverse opinion.
See Appendix Illustrations 1 and 2.
Inability to obtain evidence
The standard identifies three circumstances where there might be an inability to obtain sufficient
evidence:
(a) Circumstances beyond the entity's control (such as where the entity's accounting records
have been destroyed).
(b) Circumstances relating to the nature or timing of the auditor's work (for example, when the
timing of the auditor's appointment is such that the auditor is unable to observe the
counting of physical inventory). It may also arise when, in the opinion of the auditor, the
entity's accounting records are inadequate or when the auditor is unable to carry out an
audit procedure believed to be desirable. In these circumstances, the auditor would
attempt to carry out reasonable alternative procedures to obtain sufficient, appropriate
audit evidence to support an unqualified opinion.
(c) A limitation on the scope of the auditor's work may sometimes be imposed by
management (for example, when management prevents the auditor from observing the C
counting of physical inventory). This would constitute a limitation on scope if the auditor H
was unable to obtain sufficient, appropriate evidence by performing alternative A
P
procedures. T
E
If the auditor experiences a limitation on scope after they have accepted appointment which is R
both material and pervasive they should consider withdrawal from the audit where it is
practicable and possible under applicable law or regulation. Where this is not the case the 8
auditor must disclaim an opinion on the financial statements.
When the limitation in the terms of a proposed engagement is such that the auditor believes the
need to express a disclaimer of opinion exists before the appointment has been accepted, the
auditor would usually not accept such a limited audit engagement, unless required by statute.
Also, a statutory auditor would not accept such an audit engagement when the limitation
infringes on the auditor's statutory duties.
See Appendix Illustrations 3 and 4.
6.3.3 Emphasis of matter and other matters

ISA (UK) 706 (Revised June 2016), Emphasis of Matter Paragraphs and Other Matter Paragraphs
in the Independent Auditor's Report deals with circumstances where the auditor considers it
necessary to draw users' attention to important matters.
Definition
Emphasis of matter paragraph: A paragraph included in the auditor's report that refers to a
matter appropriately presented or disclosed in the financial statements that, in the auditor's
judgement, is of such importance that it is fundamental to users' understanding of the financial
statements. (ISA 706.5a)

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Examples
 An uncertainty relating to the future outcome of exceptional litigation or regulatory action
 Early application of a new accounting standard that has a pervasive effect on the financial
statement before its effective date
 A major catastrophe that has had, or continues to have, a significant effect on the entity's
financial position
Other ISAs specify circumstances in which it may be necessary to include an emphasis of matter
paragraph for example ISA (UK) 560, Subsequent Events which was covered earlier in this chapter.
This paragraph must be included in a separate section of the auditor's report with an
appropriate heading including the term 'Emphasis of Matter'. This section must also state that
the auditor's report is not modified in this respect. (ISA 706.9)
Point to note:
In some circumstances matters identified as KAMs may also be fundamental to users'
understanding of the financial statements. In this situation however, the matter is not disclosed
in an emphasis of matter paragraph as well as being disclosed as a KAM. Instead the auditor
must consider highlighting the importance of the matter, for example, by presenting it more
prominently in the KAM section. (ISA 706.A2)
Where a matter is not determined to be a KAM but is fundamental to users' understanding an
emphasis of matter paragraph would be included in the auditor's report. (ISA 706.A3)
Definition
Other matter paragraph: A paragraph included in the auditor's report that refers to a matter
other than those presented or disclosed in the financial statements that, in the auditor's
judgement, is relevant to users' understanding of the audit, the auditor's responsibilities or the
auditor's report. (ISA 706.5b)
This paragraph must also be included as a separate section in the auditor's report headed
'Other Matter' or another appropriate heading.
Point to note:
An 'Other Matter' paragraph would not be included where the matter has been determined to
be a KAM (ISA 706.10).
An example of an emphasis of matter paragraph is contained in the Appendix to this chapter.
See Illustration 5.
6.4 Current issues

6.4.1 The act of communication
In essence, the auditor's job is straightforward. They carry out tests and inquiries and evaluate
evidence received with the purpose of drawing an audit opinion. They then communicate that
opinion, in the form of an auditor's report, as we have been discussing. This can cause
problems.
The communication problem is caused by a number of different problems that can be identified
under three headings, although some of the problems are broadly linked between categories.
The three problematic areas are as follows:
 Understandability
 Responsibility
 Availability

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6.4.2 Understandability
Although the essence of the auditor's role is simple, in practice it is surrounded by auditing
standards and guidance, as it is a technical art. It also involves relevant language, or 'jargon',
that non-auditors may not understand.
Communicating the audit opinion in a way that people can understand is a challenge.
ISA (UK) 700 (Revised June 2016) together with ISA (UK) 701 go some way to addressing those
challenges (see section 6.1 and 6.2 above).
6.4.3 Responsibility
Connected with the problem of what the audit is and what the audit opinion means is the
question of what the auditors are responsible for. As far as the law is concerned, auditors have a
restricted number of duties. Professional standards and other bodies, such as the Financial
Conduct Authority, put other duties on auditors.
Users of financial statements, and the public, may not have a very clear perception of what the
auditors are responsible for and what the audit opinion relates to, or what context it is in.
The issue of auditor's liability ties in here. Auditor's reports are addressed to shareholders, to
whom auditors have their primary and legal responsibility. However, audited financial
statements are used by significantly more people than that. Should this fact be addressed in the
auditor's report?
6.4.4 Availability C
H
The fact that a significant number of people use audited financial statements has just been A
mentioned. Auditor's reports are publicly available, as they are often held on public record. This P
fact alone may add to any perception that exists that auditors address their report to more than T
E
just shareholders. R
The problem of availability is exacerbated by the fact that many companies publish their 8
financial statements on their website. This means that millions of people around the world have
access to the auditor's report.
This issue may cause misunderstanding:
 Language barriers may cause additional understandability problems.
 It may not be clear which financial information an auditor's report refers to.
 The auditor's report may be subject to malicious tampering by hackers or personnel.
If an auditor's report is published electronically, auditors lose control of the physical positioning
of the report; that is, what it is published with. This might significantly impact on
understandability and also perceived responsibility.
When financial information is available electronically, auditors must ensure that their report is
not misrepresented.
Interactive question 4: Forming an audit opinion

You are an audit senior. You are nearing the end of the audit of Russell Ltd for the year ended
30 June 20X7. The financial statements show a profit before tax of £14 million (20X6: £6 million)
and a statement of financial position total of £46 million (20X6: £30 million). The following points
have arisen on the audit:
(a) Russell Ltd owns a number of its retail premises, which it revalues annually. This year several
of its shops did rise sharply in value due to inflated property prices in their locality. Russell
Ltd also capitalises refits of its shops. Four shops were refitted in the year. The total increase
in assets due to refits and revaluations is £20 million. Russell Ltd does not revalue its factory
premises, which are recognised in the statement of financial position at £250,000.

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(b) Russell Ltd makes approximately 20% of its sales via an internet site from which it sells the
products of Cairns plc. Russell Ltd earns commission of 15% on these sales. Customers
place their order on the internet site and pay for goods by providing their credit card
details. Once Russell Ltd has received authorisation from the credit card company the order
is passed to Cairns plc. The product is then shipped directly to the customer and all product
returns and credit card related issues are dealt with by Cairns plc. The total product sales
achieved through the internet site and despatched to customers in the year were
£6,000,000. This amount has been recognised as revenue for the year ended 30 June 20X7.
Requirement
Comment on the matters you will consider in relation to the implications of the above points on
the auditor's report of Russell Ltd.
6.5 The Auditor's Responsibilities Relating to Other Information

The FRC has issued ISA (UK) 720 (Revised June 2016), The Auditor's Responsibilities Relating to
Other Information. This replaces ISA (UK and Ireland) 720 (Revised October 2012), Section A –
The Auditor's Responsibilities Relating to Other Information in Documents Containing Audited
Financial Statements and ISA (UK and Ireland) 720, Section B – The Auditor's Statutory Reporting
Responsibility in Relation to Directors' Reports. The key changes are as follows:
 ISA (UK and Ireland) 720 Section A and Section B are now covered by one standard.
 In the UK the auditor's report must include an 'Other Information' section.
 The revised ISA refers to misstatements of other information, rather than making a
distinction between misstatements of fact and inconsistencies.
6.5.1 What is other information?
Definitions
Other information is financial and non-financial information (other than financial statements and
the auditor's report) included in an entity's annual report.
Statutory other information in the UK includes the directors' report, the strategic report and the
separate corporate governance statement.
Misstatement of the other information: This exists when the other information is incorrectly
stated or otherwise misleading (including because it omits or obscures information necessary for
a proper understanding of a matter disclosed in the other information).
In the UK a misstatement of other information also exists when the statutory other information
has not been prepared in accordance with the legal and regulatory requirements applicable.
(ISA 720.12)
Appendix 1 of ISA 720 provides a comprehensive list of examples of amounts and other items
that may be included in the other information. This includes the following:
 Summaries of key financial results
 Selected operating data
 Financial measures or ratios
 Explanations of critical accounting estimates
 General descriptions of the business environment and outlook
 Overview of strategy

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Point to note:
In the UK statutory other information would also be relevant.
ISA 720.8 makes it clear that the auditor's responsibilities in relation to other information do not
constitute an assurance engagement or impose an obligation on the auditor to obtain assurance
about the other information. In other words the auditor does not express an opinion on the
other information. (The exception to this principle in the UK relates to the auditor's
responsibilities relating to the directors' report, the strategic report and the corporate
governance statement. We will look at this issue separately in section 6.5.5).
The auditor is required, however, to read the other information and do the following:
(a) Consider whether there is a material inconsistency between the other information and the
(b) Consider whether there is a material inconsistency between the other information and the
auditor's knowledge obtained in the audit
(c) Respond appropriately when the auditor identifies that such a material inconsistency
appears to exist, or when the auditor otherwise becomes aware that other information
appears to be materially misstated
(d) Report in accordance with ISA 720
6.5.2 Access to other information

In order for the auditor to satisfy their obligations under ISA 720, timely access to other C
H
information will be required. The auditors therefore must make arrangements with the client to A
obtain such information before the date of their report where possible. Where some or all of the P
documents will not be available until after the date of the auditor's report the auditor must T
E
request a written representation that the information will be provided as soon as it is available. R
(ISA 720.13)
8
6.5.3 Material inconsistency or material misstatement of other information
If, on reading the other information, the auditor identifies a material inconsistency or becomes
aware that the other information appears to be materially misstated, the auditor must
determine whether:
 The audited financial statements need to be amended
 The other information needs to be amended
 Or whether the auditor's understanding of the entity and its environment needs updating.
The auditor should seek to resolve the matter through discussion with those charged with
governance.
If an amendment is necessary in the audited financial statements and the entity refuses to make
the amendment, the auditor should express a qualified or adverse opinion.
If an amendment is necessary in the other information obtained before the date of the auditor's
report and the entity refuses to make the amendment, the auditor shall communicate this to
those charged with governance and:
(a) include in the 'Other information' section of the auditor's report a statement describing the
uncorrected material misstatement; or
(b) withdraw from the engagement. (ISA 720.18)
If a material misstatement exists in other information obtained after the date of the auditor's
report the actions taken by the auditor depend on whether a correction is made. If the other
information is corrected the auditors will perform additional procedures which will normally

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include checking that the correction has been made properly and reviewing the steps taken by
management to inform parties who have already received the information. (ISA 720.48)
If the other information is not corrected the specific action taken would depend on the auditor's
legal rights and obligations. As a result it is likely that the auditor will seek legal advice. In the UK,
the auditor may also consider using the right to be heard at the AGM.
6.5.4 Reporting
In the UK, all auditor's reports must include an 'Other Information' section. This must include the
following:
(a) A statement that management is responsible for other information
(b) Identification of:
 other information obtained before the date of the auditor's report; and
 for the audit of a listed entity, other information, if any expected to be obtained after
the date of the auditor's report.
(c) A statement that the auditor's opinion does not cover the other information and that the
auditor does not express an audit opinion or any form of assurance conclusion on this
(however see section 6.5.5)
(d) A description of the auditor's responsibilities relating to reading, considering and reporting
on other information
(e) When other information has been obtained before the date of the auditor's report, either
 a statement that the auditor has nothing to report; or
 where there is a material uncorrected misstatement a statement that describes this.
(ISA 720.22)
6.5.5 Statutory other information

In the UK, the auditor has a statutory duty to report on the directors' report, the strategic report
and the corporate governance statements where applicable. In order to do so the auditor is
required to read this information, and based on the audit work undertaken determine whether
this information appears to be materially misstated. (ISA 720.14.1)
In the auditor's report, the auditor is required to state whether:
 the information given in the statutory other information is consistent with the financial
statements and prepared in accordance with legal requirements;
 the auditor has identified any material misstatements in the statutory other information; and
 if applicable, give an indication of the nature of each misstatement.
(ISA 720.22D-1 – .22D-2)
For entities that report on how they have applied the UK Corporate Governance Code (or why
they have not) the auditor must review the statements made and report on them either stating
that they have nothing to report or by describing the uncorrected material misstatement.
(ISA 720.22-3)

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7 Other reporting responsibilities
Section overview
 Auditors may have to report on entire special purpose financial statements or simply one
element of those financial statements.
• Auditors may have to report on summary financial statements.
• The Companies Act 2006 allows limited liability agreements to be negotiated with the
audit client.
7.1 Special Considerations – Audits of Financial Statements Prepared in

Accordance with Special Purpose Frameworks
7.1.1 Introduction
ISA (UK) 800 (Revised), Special Considerations – Audits of Financial Statements Prepared in
Accordance with Special Purpose Frameworks was issued in October 2016 by the FRC and is
effective for periods commencing on or after 1 January 2016.
7.1.2 Overview
The ISA aims to address special considerations that are relevant to complete sets of financial
C
statements prepared in accordance with another comprehensive basis of accounting.
H
The aim of the ISA is simply to identify additional audit requirements relating to these areas. To A
P
be clear, all other ISAs still apply to the audit engagement. T
E
7.1.3 General considerations R
 Before undertaking a special purpose audit engagement, the auditor should ensure there is 8
agreement with the client as to the exact nature of the engagement and the form and
content of the report to be issued.
 To avoid the possibility of the auditor's report being used for purposes for which it was not
intended, the auditor may wish to indicate in the report the purpose for which it is
prepared and any restrictions on its distribution and use.
7.1.4 Special purpose frameworks

In the context of the ISA, special purpose frameworks refer to accounts which are prepared in
situations other than within a Companies Act statutory audit. Specific examples of special
purpose frameworks given in the ISA include the following:
 Tax basis of accounting for a set of financial statements that accompany an entity's tax
return
 Cash receipts and payments basis of accounting for cash flow information that an entity
may be requested to prepare for creditors
 The financial reporting provisions established by a regulator to meet that regulator's
requirements
 The financial reporting provisions of a contract, such as a bond, indenture, a loan
agreement and a project grant
The auditor's report in these circumstances should include an emphasis of matter that indicates
the basis of accounting used or should refer to the note to the financial statements giving that
information. The opinion should state whether the financial statements are prepared, in all
material respects, in accordance with the identified basis of accounting.

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In the UK the auditor must specifically describe the financial reporting framework as a special
purpose framework in the auditor's report. The auditor must also specifically state that the audit
has been carried out in accordance with ISAs, including ISA (UK) 800 and/or ISA (UK) 805).
7.1.5 Special Considerations – Audits of Single Financial Statements and Specific Elements,
Accounts or Items of a Financial Statement
ISA (UK) 805 (Revised), Special Considerations – Audits of Single Financial Statements and
Specific Elements, Accounts or Items of a Financial Statement relates to individual elements of
financial statements, such as the liability for accrued benefits of a pension plan and a schedule
of employee bonuses. This ISA was issued by the FRC in October 2016 and is effective for
periods commencing on or after 1 January 2017.
Many financial statement items are interrelated. Therefore, when reporting on a component the
auditor will not always be able to consider it in isolation and will need to examine other financial
information. This will need to be considered when assessing the scope of the engagement and
determining whether the audit of a single statement or single element is practicable.
The auditor's report should indicate the applicable financial reporting framework adopted or
the basis of accounting used, and should state whether the component is prepared in
accordance with this.
Reporting considerations
Engagements that involve  The auditor shall express a separate opinion for each.
reporting on a single statement or
 The auditor shall ensure that management presents the
specific element in conjunction
single financial statement or element in such a way that
with auditing the entity's complete
it is clearly differentiated from the complete set of
set of financial statements
The auditor's opinion on the  The auditor must determine whether this will affect the
entity's complete set of financial opinion on the single financial statement or element.
statements is modified or includes
an emphasis of matter or other
matter paragraph, a material
uncertainty related to going
concern, communication of key
audit matters or a statement
describing an uncorrected material
misstatement of other information
The auditor has expressed an  The auditor must not include an unmodified opinion on
adverse opinion or disclaimed an a single financial statement or element that forms part
opinion on the entity's complete of those financial statements in the same report (as this
set of financial statements would contradict the adverse opinion or disclaimer on
the complete set of financial statements).
 The auditor must not express an unmodified opinion
on a single financial statement of a complete set of
financial statements even if the report on the single
financial statement is not published with the auditor's
report containing the adverse opinion or disclaimer.
 The auditor may express an unmodified opinion on an
element of the financial statements if:
– not prohibited by law;
– the opinion is published separately; and
– the element does not form a major portion of the
entity's complete set of financial statements.

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7.1.6 Engagements to Report on Summary Financial Statements

ISA 810 (Revised), Engagements to Report on Summary Financial Statements was revised by the
IAASB in March 2016. It has not been adopted in the UK as an ISA (UK). The key point which this
ISA makes is that the auditor should not express an opinion on the summarised financial
statements unless they have expressed an audit opinion on the financial statements from which
they have been derived.
Reporting considerations: Form of report
Unmodified opinion on summary Unless law specifies otherwise, the wording should be:
financial statements  the accompanying summary financial statements
are consistent in all material respects with the
audited financial statements, in accordance with
(the applied criteria); or
 the accompanying summary financial statements
are a fair summary of the audited financial
statements, in accordance with (the applied
criteria).
When the auditor's report on the If the auditor is satisfied that an unmodified opinion, as
audited financial statements includes a above, is appropriate for the summary financial
qualified opinion, an emphasis of statements, the report must:
matter or an other matter paragraph, a  state that the auditor's report on the audited C
material uncertainty related to going financial statements includes a qualified opinion, an H
concern, a KAM section or a statement emphasis of matter or an other matter paragraph, a
A
describing an uncorrected material P
material uncertainty related to going concern, a T
misstatement of the other information KAM section or a statement describing an E
R
uncorrected material misstatement of the other
information; 8
 explain the basis for the above; and

 state the effect on the summary financial statements
if any.
When the auditor's report on the The auditor must:
audited financial statements contains
 state that the auditor's report on the audited
an adverse opinion, or a disclaimer
financial statements contains an adverse opinion or
disclaimer of opinion;
 explain the basis for the adverse opinion or
disclaimer; and
 state that it is inappropriate to express an opinion
on the summary financial statements.
Modified opinion on the summary If the summary financial statements are not consistent
financial statements in all material respects with the audited financial
statements (or not a fair summary of the audited
financial statements) and management does not agree
to make changes, the auditor shall express an adverse
opinion.

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7.2 XBRL tagging of information in audited financial statements

In September 2009, HMRC announced that the Company Tax Return, including the supporting
statutory accounts and tax computations, must be delivered electronically using the Inline XBRL
format. XBRL stands for eXtensible Business Reporting Language.
7.2.1 Audit
Guidance for auditors is contained in Bulletin 2010/1 XBRL Tagging of Information in Audited
Financial Statements – Guidance for Auditors.
Although HMRC is requiring financial statements supporting a company's tax return to be
transmitted using iXBRL, there is no requirement for an audit of data or of the XBRL tagging. The
Bulletin states that ISAs do not impose a general requirement on the auditor to check XBRL
tagging of financial statements as part of the audit. Furthermore, because the XBRL tagging is
simply a machine-readable rendering of the data within the financial statements, rather than a
discrete document, it does not constitute 'other information' either.
While the auditor does not provide assurance as to the accuracy of the tagging, audit clients
may request non-audit services, including the following:
 Performing the tagging exercise
 Undertaking an agreed-upon procedures engagement
 Providing advice on the selection of individual tags
 Supplying accounts preparation software that automates the tagging
 Training management in XBRL tagging
If this type of service is provided, ethical issues must be considered.
In December 2017, the FRC's Financial Reporting Lab published Deep-dive: Digital future of
corporate reporting suggesting that more still needs to be done to unlock the potential of XBRL.
7.3 Companies Act 2006

The Companies Act 2006 contains a number of audit-related provisions that affect audit
reporting.
7.3.1 Reckless auditing

The Act includes a criminal offence, punishable by an unlimited fine, for 'knowingly or recklessly'
to cause an auditor's report to include "any matter that is misleading, false, deceptive in a
material particular, or cause a report to omit a statement that is required under certain sections
of the Act" – s 507 CA 2006. The offence can be committed by a partner, director, employee or
agent of the audit firm if that person would be eligible for appointment as auditor of the
company. In other words, the offence is related not just to the partners of the firm but also to any
member of staff who has a practising certificate.
The Government's view is that 'recklessness' has a very high hurdle and would only catch an
auditor who is aware that an action or failure to act carried risks, that they personally knew that
the risks were not reasonable ones to take, and that, despite knowing that, they went ahead. The
real point is that this is a long way above negligence; one cannot be reckless inadvertently. In
other words, 'recklessly' is a subjective test because a risk taken must be unreasonable in the
mind of the person taking it.
The offence has yet to be tested in court. However, professional bodies continue to argue that
'honest mistakes' should not be punishable.

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7.3.2 Audit liability

Sections 534–538 of the Act allow members to pass an ordinary resolution to limit the liability of
their auditors for negligence, default, breach of duty or breach of trust occurring during the
course of an audit, by means of a limitation of liability agreement. Key points of this agreement
are as follows:
(a) Liability can only be limited where to do so would be 'fair and reasonable' in regard to all
circumstances. In other words, the agreement could be set aside by the court where the
auditor appeared to be contracting out of liability too much, or where a high standard of
work was expected and the auditor failed to provide this.
(b) Shareholder approval can be obtained either before or after the company enters into the
agreement with the auditor.
(c) The agreement must be disclosed in the directors' report.
(d) The agreement must be renewed annually.
(e) The members can terminate the agreement by ordinary resolution at any time.
The actual terms of the agreement therefore have to be decided between the auditor and the
client. However, the Act does not contain automatic proportional liability, which appeared to be
the objective of the audit profession.
7.3.3 Signature on auditor's reports

Where the auditor is a firm, the signature on the auditor's report will be that of the 'senior C
H
statutory auditor' signed in their own name, for and on behalf of the audit firm (s 504). This is a A
requirement of the EU Statutory Audit Directive. However, guidance on the Directive indicates P
that this does not place any additional liability on this person. Under ISAs, senior statutory T
E
auditor has the same meaning as the term 'engagement partner'. R
7.3.4 Right of members to raise audit concerns at general meeting 8
Members of quoted companies may require a company to publish a statement on its website on
any matter which it intends to raise at the shareholders' meeting where the annual accounts are
to be approved. The matters that can be raised are:
 relating to the audit of the accounts; and
 the circumstances connected to an auditor ceasing to hold office.
The request needs to be made by members holding 5% or more of the total voting rights or by
100 members holding fully paid-up shares which on average exceed £100 per member.

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Appendix
Point to note:
As per ISA (UK) 705, illustrations 1–4 in this Appendix have not been tailored for the UK but they
illustrate the requirements of the ISAs (UK).
Illustration 1
Qualified opinion – Material misstatement of the financial statements
Qualified opinion
We have audited the financial statements of ABC Company (the Company), which comprise the
statement of financial position as at December 31, 20X1, and the statement of comprehensive
income, statement of changes in equity and statement of cash flows for the year then ended,
and notes to the financial statements, including a summary of significant accounting policies. In
our opinion, except for the effects of the matter described in the Basis for Qualified Opinion
section of our report, the accompanying financial statements give a true and fair view of the
financial position of the Company as at December 31, 20X1, and of its financial performance and
its cash flows for the year then ended in accordance with International Financial Reporting
Standards (IFRSs).
Basis for qualified opinion
The company's inventories are carried in the statement of financial position at xxx. Management
has not stated the inventories at the lower of cost and net realisable value but has stated them
solely at cost, which constitutes a departure from IFRSs. The Company's records indicate that,
had management stated the inventories at the lower of cost and net realisable value, an amount
of xxx would have been required to write the inventories down to their net realisable value.
Accordingly cost of sales would have increased by xxx, and income tax, net income and
shareholders' equity would have been reduced by xxx, xxx and xxx, respectively.
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor's Responsibilities for
the Audit of the Financial Statements section of our report. We are independent of the Company
in accordance with the ethical requirements that are relevant to our audit of the financial
statements in [jurisdiction], and we have fulfilled our other ethical responsibilities in accordance
with these requirements. We believe that the audit evidence we have obtained is sufficient and
appropriate to provide a basis for our qualified opinion.
(Source: Illustration 1 (extract) ISA (UK) 705 (Revised June 2016), Modifications to the
Opinion in the Independent Auditor's Report)
Illustration 2
Adverse opinion. Material misstatement of the consolidated financial statements
Adverse opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries
(the Group), which comprise the consolidated statement of financial position as at
31 December 20X1, and the consolidated statement of comprehensive income, consolidated
statement of changes in equity and consolidated statement of cash flows for the year then
ended, and notes to the consolidated financial statements, including a summary of significant
accounting policies.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse
Opinion section of our report, the accompanying consolidated financial statements do not give
a true and fair view of the consolidated financial position of the Group as at December 31, 20X1,
and of its consolidated financial performance and its consolidated cash flows for the year then
ended in accordance with International Financial Reporting Standards (IFRSs).

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Basis for adverse opinion

As explained in Note X, the Group has not consolidated subsidiary XYZ Company that the
Group acquired during 20X1 because it has not yet been able to determine the fair values of
certain of the subsidiary's material assets and liabilities at the acquisition date. This investment is
therefore accounted for on a cost basis. Under IFRSs, the Company should have consolidated
this subsidiary and accounted for the acquisition based on provisional amounts. Had XYZ
Company been consolidated, many elements in the accompanying consolidated financial
statements would have been materially affected. The effects on the consolidated financial
statements of the failure to consolidate have not been determined.
the Audit of the Consolidated Financial Statements section of our report. We are independent of
the Group in accordance with the ethical requirements that are relevant to our audit of the
consolidated financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements. We believe that the audit evidence we
have obtained is sufficient and appropriate to provide a basis for our adverse opinion.
Illustration 3
Qualified opinion – Due to auditor's inability to obtain sufficient audit evidence regarding a
foreign associate
C
Qualified opinion H
A
We have audited the consolidated financial statements of ABC Company and its subsidiaries P
(the Group), which comprise the consolidated statement of financial position as at December 31, T
E
20X1, and the consolidated statement of comprehensive income, consolidated statement of R
changes in equity and consolidated statement of cash flows for the year then ended, and notes
to the consolidated financial statements, including a summary of significant accounting policies. 8
In our opinion, except for the possible effects of the matter described in the Basis for Qualified
Opinion section of our report, the accompanying consolidated financial statements give a true
and fair view of the financial position of the Group as at December 31, 20X1, and of its
consolidated financial performance and its consolidated cash flows for the year then ended in
accordance with International Financial Reporting Standards (IFRSs).
Basis for qualified opinion
The Group's investment in XYZ Company, a foreign associate acquired during the year and
accounted for by the equity method, is carried at xxx on the consolidated statement of financial
position at December 31, 20X1, and ABC's share of XYZ's net income of xxx is included in ABC's
income for the year then ended. We were unable to obtain sufficient appropriate audit evidence
about the carrying amount of ABC's investment in XYZ as at December 31, 20X1, and ABC's
share of XYZ's net income as we were denied access to the financial information, management,
and the auditors of XYZ. Consequently, we were unable to determine whether any adjustments
to these amounts were necessary.
the Audit of the Consolidated Financial Statements section of our report. We are independent of
the Group in accordance with the ethical requirements that are relevant to our audit of the
consolidated financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements. We believe that the audit evidence we
have obtained is sufficient and appropriate to provide a basis for our qualified opinion.

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Illustration 4
Disclaimer of opinion. Due to the auditor's inability to obtain sufficient appropriate audit
evidence about a single element of the consolidated financial statements
Disclaimer of opinion
We were engaged to audit the consolidated financial statements of ABC Company and its
subsidiaries (the Group), which comprise the consolidated statement of financial position as at
December 31, 20X1, and the consolidated statement of comprehensive income, consolidated
statement of changes in equity and consolidated statement of cash flows for the year then
ended, and notes to the consolidated financial statements, including a summary of significant
accounting policies.
We do not express an opinion on the accompanying consolidated financial statements of the
Group. Because of the significance of the matter described in the Basis for Disclaimer of Opinion
section of our report, we have not been able to obtain sufficient appropriate audit evidence to
provide a basis for an audit opinion on these consolidated financial statements.
Basis for Disclaimer of opinion
The Group's investment in its joint venture XYZ Company is carried at xxx on the Group's
consolidated statement of financial position, which represents over 90% of the Group's net
assets as at December 31, 20X1. We were not allowed access to the management and the
auditors of XYZ Company, including XYZ Company's auditor's audit documentation. As a result,
we were unable to determine whether any adjustments were necessary in respect of the Group's
proportional share of XYZ Company's assets that it controls jointly, its proportional share of XYZ
Company's liabilities for which it is jointly responsible, its proportional share of XYZ's income
and expenses for the year, and the elements making up the consolidated statement of changes
in equity and consolidated cash flow statement.
(Source: Illustration 4 (extract) ISA (UK) 705 (Revised June 2016), Modifications to the Opinion in
the Independent Auditor's Report)
Illustration 5
Emphasis of matter
We draw attention to note [X] of the financial statements, which describes [brief summary of the
matter]. Our opinion is not modified in this respect.
(Source: Appendix 3 (extract) Bulletin: Compendium of Illustrative Auditor's Reports on United
Kingdom Private Sector Financial Statements for Periods commencing on or after 17 June 2016)
Point to note:
This paragraph is inserted after the conclusions relating to going concern section.
Illustration 6
Unqualified opinion. Material uncertainty that may cast significant doubt about the company's
ability to continue as a going concern. Disclosure is adequate
Opinion
In our opinion the financial statements:
 Give a true and fair view of the state of the company's affairs as at 31 December 20X1 and
of its loss for the year then ended;
 Have been properly prepared in accordance with United Kingdom Generally Accepted
Accounting Practice; and
 Have been prepared in accordance with the requirements of the Companies Act 2006.

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Material uncertainty related to going concern

We draw attention to note [X] in the financial statements, which indicates that [brief description
of events or conditions identified that may cast significant doubt on the entity's ability to
continue as a going concern]. As stated in note [X], these events or conditions, along with the
other matters as set forth in note [X], indicate that a material uncertainty exists that may cast
significant doubt on the company's ability to continue as a going concern. Our opinion is not
modified in respect of this matter.
(Source: Appendix 4 (extract) FRC, Bulletin: Compendium of Illustrative Auditor's Reports on
United Kingdom Private Sector Financial Statements for Periods commencing on or after
17 June 2016)
C
H
A
P
T
E
R

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Summary
Governance issues
Audit
completion Review of financial Analytical procedures
statements
Responsibilities:
• Up to date of audit
report
• After date of audit
Subsequent
report but before
events
issued
• After financial
statements issued
Reporting implications
Going concern Management's responsibilities
Auditor's responsibilities
Corresponding figures
Comparatives
Comparative financial
statements Standard auditor's
report
Internal reporting
Key audit matters
Reporting External reporting
Modified reports
Other reporting
responsibilities Emphasis of matter
and other matters
Other
information

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Self-test
1 Branch plc
You are an audit partner. Your firm carries out the audit of Branch plc, a listed company.
Because the company is listed, you have been asked to perform a second partner review of
the audit file for the year ended 30 June 20X7 before the audit opinion is finalised.
Reported profit before tax is £1.65 million and the statement of financial position total is
£7.6 million.
You have read the following notes from the audit file:
"Earnings per share
The company has disclosed both basic and diluted earnings per share. The diluted
earnings per share has been incorrectly calculated because the share options held by a
director were not included in the calculations. Disclosed diluted earnings per share are
22.9p. Had the share options held by the director been included, this figure would have
been 22.4p. This difference is immaterial.
Financial performance statement
The directors have currently not amended certain financial performance ratios in this
statement to reflect the changes made to the financial statements as a result of the auditor's
work. The difference between the reported ratios and the correct ratios is minimal.
Opinion C
H
We recommend that an unmodified auditor's report be issued." A
P
You have noted that there is no evidence on the audit file that the corporate governance T
statement to be issued as part of the annual report has been reviewed by the audit team. E
You are aware that the company does not have an audit committee. R
You are also aware that the director exercised his share options last week. 8
Requirement
Comment on the suitability of the proposed audit opinion and other matters arising in the
light of your review. Your comments should include an indication of what form the auditor's
report should take.
2 SafeAsHouses plc
SafeAsHouses plc (SAH) was incorporated and commenced trading on 1 June 20X0 to retail
small household electronics products via free magazines inserted into newspapers. It has
established a presence in the market, but the early years of business have been a struggle
with low profitability as it has sought to create market share. On 1 June 20X2, it set up a
100% owned subsidiary, eSAH, with a view to redirecting the business to internet-based
sales in the hope of reducing printing and physical distribution costs of its free magazine.
SAH plans to obtain an AIM listing in the near future.
Your firm acts as auditors to both companies and you have recently been drafted into the
audit because the existing senior has been taken ill. Exhibit 1 comprises draft statements of
financial position and notes for both companies. Exhibit 2 comprises audit file notes
prepared by the previous audit senior.
The audit manager has asked you to take over the detailed audit work and to identify for
her in a briefing note those issues arising in the work to date that are likely to be
problematic. Given the late stage of the audit, and the consequent delays because of audit
staff sickness, only the major issues are to be highlighted in your briefing note to the
manager. The audit manager is concerned that, because the FD is new, the retention of the
audit is potentially at risk and that there should be no further delay in the audit. The FD is
pressing for these matters to be finalised and the accounts to be signed quickly.

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Requirement
Prepare the briefing note as requested.
Exhibit 1: Draft statements of financial position
The draft statements of financial position of SAH (parent company only) and eSAH at
31 May 20X3 are as follows.
SAH eSAH
£'000 £'000 £'000 £'000
Non-current assets at cost 1,895 408
Less depreciation (400) (25)
1,495 383
Current assets
Inventories 422 –
Receivables 550 225
Bank – 5
972 230
Current liabilities (662) (313)
Net current assets/(liabilities) 310 (83)
1,805 300
8% debentures (1,000) –
805 300
Financed by
Issued ordinary share capital 200 300
Share premium account 100 –
Retained earnings 505 –
805 300
Notes
1 Current liabilities
SAH eSAH
£'000 £'000
Bank overdraft 92 –
Trade payables 430 300
Other payables 40 –
Accruals 100 13
662 313
2 Property in SAH had been revalued during the year. The revaluation amounted to
£0.5 million.
3 Debentures were issued at par on 1 June 20X0 and are due for redemption at par on
31 December 20X4.
Exhibit 2: Audit file notes
(1) eSAH has received £120,000 as a payment on account from a customer on 27 May 20X3
for delivery of goods to the customer by SAH in the following months. eSAH has a
confirmed contract for this and has recorded the amount in revenue for the year.
(2) eSAH has capitalised software development costs to the amount of £408,000 during
the year. There are no specific details as yet, but it appears to relate almost entirely to
the development of new e-based sales systems. £186,000 of the capitalised amount
related to computers and consulting support staff time bought and brought in
specifically to help test the new system. eSAH is adopting its standard five-year,
straight-line depreciation policy with respect to the £408,000.

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(3) I have gathered together some data relating to SAH before performing analytical
procedures, but have yet to get around to doing it. The relevant data is:
Year end May 20X1 20X2 20X3
Revenue (£'000) 500 1,140 990
Gross profit margins (%) 22 19 17
Profit/(loss) retained in the year (£'000) 2 45 (42)
I understand eSAH's provisional revenue to the year end 31 May 20X3 to be about
£500,000, and gross profitability was at 10%. Inventory has remained constant during
the year ended 31 May 20X3 in SAH.
(4) SAH is planning to pay a dividend for the first time this year of about £50,000. This has
yet to be finalised and has not been provided for in the financial statements. The FD
said he would get back to me once the figure has been finalised.
(5) The FD has suggested that the format of the business of eSAH is completely different
from that of SAH and is insisting on not consolidating the results of eSAH on the
grounds that it would undermine a true and fair view of the financial statements.
(6) There are some debt covenants relating to the debenture (in SAH) of which we should
be aware. I have not done any work on these, as yet.
 Net current assets are to remain positive.
 Overdraft balances are to be no more than £150,000 at all times.
 Receivables days and payable days are not to exceed 180 days each. Calculations C
H
to be based on year-end figures. A
P
 Bank consent is required for any significant changes in the structure of the
T
business. E
R
 I understand that a breach of any of these conditions converts the debenture into
a loan repayable on demand. 8
When eSAH was incorporated, bank consent was obtained in accordance with the
covenants. Consent was obtained on the basis that the covenants would now apply on
a consolidated basis.

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Technical reference
1 ISA 260
 Auditor's objectives ISA 260.9
 Who auditor should communicate to ISA 260.11–.13
 Matters to be communicated to those charged with governance ISA 260.14-.17R-1
 Timing of communications ISA 260.21
 Form of communications ISA 260.19–.20
2 ISA 265
 Identifying significant deficiencies ISA 265.A5–.A7
 Written communication ISA 265.11
3 ISA 450
 Evaluating the effects of misstatements ISA 450.10–.11
4 ISA 520
ISA 520.6,.A17–
 Analytical procedures at the end of the audit
.A19
 Investigating unusual items ISA 520.7
5 ISA 560
 Auditor's duty ISA 560.6
 Audit procedures for obtaining audit evidence ISA 560.7–.9
 Events after date of auditor's report but before date financial ISA 560.10–.13
statements issued
 Events after date financial statements have been issued ISA 560.14–.17
6 ISA 570
 Auditor's responsibility ISA 570.6–.7
 Auditor's objectives ISA 570.9
 Indicators of going concern problems ISA 570.A3
 Audit procedures ISA 570.16, A16
 Evaluating management assessment of going concern ISA 570.12–.14
 Audit procedures – period beyond management's assessment ISA 570.15
 Audit conclusions and reporting ISA 570.17–.24
7 A 580
 Acknowledgement of management responsibility ISA 580.10–.12
 Representations by management as audit evidence ISA 580.13
 Documentation of representations ISA 580.15

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 Elements of a representation letter ISA 580 Appendix 2

 Actions if management refuse to provide written representations ISA 580.19
8 ISA 700
 Auditor's objective ISA 700.6
 Elements of a standard auditor's report ISA 700.21–.49
9 ISA 701
 Determining key audit matters ISA 701.9–10
 Communicating key audit matters ISA 701.11–16
10 ISA 705
 Circumstances when modifications are required ISA 705.6
 Types of modification ISA 705.7–10, A1
11 ISA 706
 Emphasis of matter paragraphs ISA 706.8–.9
 Other matter paragraphs ISA 706.10–.11
C
H
12 ISA 710 A
P
 Reporting responsibilities ISA 710.3 T
E
 Overview of audit procedures ISA 710.7–.9 R
 Corresponding figures – reporting ISA 710.10–.14
8
 Comparative financial statements – reporting ISA 710.15–.16
13 ISA 720
 Action when a material misstatement of the other information exists ISA 720.17–.19
 Action on identifying a material misstatement in the financial ISA 720.20
statements
 Reporting ISA 720.21–.24
14 ISA 800
 Reports on financial statements prepared in accordance with a special ISA 800.11–.14 &
purpose framework Appendix
15 ISA 805
 Reports on a single financial statement or specific element of a ISA 805.11–.17 &
financial statement Appendix
16 ISA 810
 Reports on summary financial statements ISA 810.16–.17 &
Appendix

lOMoARcPSD|5054551

Implications
(1) Accounting treatment
 The accounting treatment of the oil spill depends on when the event (ie, the oil spill)
took place.
 If the oil spill took place before the financial statements were authorised for issue the
spill is an event after the reporting period. The key question then is whether it should
be treated as an adjusting or non-adjusting event in accordance with IAS 10.
 Although the spill has only come to light on 1 April, it is possible that the leak was
present at the reporting date but was not detected at this time. If this were the case,
then the event would be an adjusting event and the financial statements should include
a provision for the costs of rectifying the damage, including that caused to the
environment. If it can be demonstrated that the leak occurred after the year end and
that the effects are material, which is probable in this case, the nature of the event and
an estimate of the financial effect should be disclosed.
 If the leak took place after 28 March ie, when the financial statements were authorised
for issue, the event would not be recognised in the financial statements for 20X7 but
would be recognised in 20X8.
 It is likely that expert evidence would need to be sought to determine how the leak has
occurred and therefore to estimate when the leak might have started.
(2) Auditor's responsibility
 Once the auditor's report has been signed, the auditor does not have any
responsibility to perform audit procedures regarding subsequent events. However, the
fact that the oil spill is revealed so soon after the signing of the auditor's report may call
into question whether the directors were attempting to conceal information and avoid
a provision being made in the current year financial statements. It also calls into
question whether all other relevant information has been given to the auditors up to
this date.
 As the financial statements have not been issued, the auditor should consider the need
to amend the financial statements. This will depend on the application of IAS 10 as
described above. If the financial statements are amended to provide for an adjusting
event or disclose a non-adjusting event, additional audit procedures will be required
and a new auditor's report would be issued.

(a)
Circumstances Why cause for concern?
Fall in gross profit % achieved While the fall in absolute revenue has been explained
the fall in gross profit margin is more serious.
This will continue to be a problem, as expenses seem
constant and interest costs are growing.
This will make a future return to profitability difficult.

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Circumstances Why cause for concern?
Losses £249,000 Such levels of losses by comparison to 20X4 profits will

make negotiations with the bank difficult, especially with
the loss of a major customer.
Increased receivables balance Worsening debt collection is bad news when the
and increased ageing company is making losses and has a deteriorating
liquidity position.
20X4 74.8 days
The increase in average debt collection period may be
20X5 96.7 days
due to an irrecoverable receivable on the account of the
major customer lost in the year.
An irrecoverable receivable write-off would cause much
increased losses.
Worsening liquidity ratio This is a significant fall which will worsen further if an
allowance for irrecoverable receivables is required.
20X4 1.03
20X5 0.87 The company has loan and lease commitments which
possibly may not be met.
Increasing reliance on short- This does not secure the future.
term finance
C
Summary – If the company is not a going concern the financial statements would be truer H
and fairer if prepared on a break-up basis. Material adjustments may then be required to A
the financial statements. P
T
(b)  Analyse post-reporting date sale proceeds for non-current assets, inventory, cash E
R
received from customers.
8
 Review the debt ageing and cash recovery lists. Ask directors if outstanding amounts
from lost customer are recoverable.
 Discuss the optimistic view of likely future contracts with the MD. Orders in the post-
reporting date period should be reviewed to see if they substantiate his opinion.
 Obtain his opinion about future contracts in a written representation letter.
 Review bank/loan records to assess the extent to which the company has met its loan
and lease commitments in the post-reporting date period.
 Review sales orders/sales ledger for evidence of additional lost custom in post-
reporting date period.
 Obtain cash flow and profit forecasts:
– Discuss assumptions with the directors
– Perform sensitivity analysis flexing the key assumptions ie, interest rates, date of
payment of payables and receipts from customers
 Check all commitments have been cleared in accordance with legal agreements:
– Agree budgets to any actual results achieved in the post-reporting date period
– Assess reasonableness of assumptions in the light of the success of the
achievement of the company's budgets set for 20X5. Discuss with the directors
any targets not achieved
– Reperform calculations
– Ensure future budgeted profits are expected to meet likely interest charges

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 Review bank records to ensure that the company is operating within its overdraft
facility in the post-reporting date period. Review bank certificate for terms and
conditions of the facility. Review bank correspondence for any suggestion the bank is
concerned about its current position.
 Ask management whether the new vehicle fleet is attracting new contracts as
anticipated. Scrutinise any new contracts obtained and check improved gross profit
margins will be achieved.
 Obtain written representation as to the likelihood of the company operating for
12 months from the date of approval of the financial statements.

(a) I would expect to see this referred to in a written representation letter. Appendix 1 to
ISA 580 cross refers to the requirement in ISA (UK) 560, Subsequent Events that
management should inform auditors of relevant subsequent events.
(b) This should not appear on a written representation letter, even though management
opinion is involved. This indicates an incorrect accounting treatment which the auditors
should be in disagreement with the directors over.
(c) This should not appear on a written representation letter, as there should be sufficient
alternative evidence for this matter. The auditor should be able to obtain registered
information about Subsidiary from the companies' registrar.
(d) This should not appear on a written representation letter. The auditors should be able to
obtain evidence from Leaf Oil that the inventory belongs to them.

(a) Non-current assets
There are two issues here. The first is whether Russell Ltd's policy of revaluations is correct
and the second is whether Russell Ltd should capitalise refit costs.
The most important thing to consider is materiality, as only material items will affect the
audit opinion. The revaluations and refit total is material to the statement of financial
position. It is possible that any revaluation of the factory premises would also be material.
(1) Revaluation policy
Per IAS 16, non-current assets may be held at cost or valuation. Where a company
applies a revaluation policy, IAS 16 requires that all revaluations are made with
sufficient regularity that the carrying amount does not vary materially from that which
would be determined if fair value were used. Russell Ltd revalues annually, so meets
the latter requirement.
Russell Ltd revalues property and IAS 16 requires that all items in the same class of
assets be revalued, so the question arises as to whether it should also revalue the
factory. This might have a material effect on the statement of financial position.
IAS 16 states that a 'class' of property, plant and equipment is a grouping of assets of a
similar nature and use in an entity's operations. Although the IAS implies that buildings
comprise one class, in this case the nature and use of the two kinds of building are
quite distinct. Therefore creating two classes (retail premises and manufacturing
premises) would appear reasonable.

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(2) Refits
Assets should be held at cost or valuation as discussed above. However, in some cases,
IAS 16 allows the cost of refits to be added to the original cost of the asset. This is when
it is probable that future economic benefits in excess of the originally assessed
standard of performance of the existing asset will flow to the entity. A retail shop will be
subject to refitting and this refitting may enhance its value. However, it is possible in a
shop that such refitting might be better classified as expenditure on fixtures and
fittings. Russell Ltd's policy should be consistent and comparable so, if they have
followed a policy of capitalising refits into the cost of the shop in the past, this seems
reasonable.
Conclusion
The issues relating to non-current assets were material and could have affected the
auditor's report. However, having considered the issues, it appears that there are no
material misstatements relating to these issues. As there appears to have been no problem
in obtaining sufficient appropriate evidence in relation to non-current assets, the audit
opinion would be unmodified in relation to these issues.
(b) Revenue recognition
The key question is the nature of the revenue earned by Russell Ltd on the internet sales.
Russell Ltd is acting as an agent for Cairns plc. At no point do the risks and rewards of
ownership of the goods sold on the internet pass to Russell Ltd. This is evidenced by the
fact that goods are sent directly to the customer by Cairns plc and they are responsible for C
all after-sales issues. The revenue earned by Russell Ltd is therefore the commission on H
A
sales generated rather than the sales price of the goods sold. Equally there will be no
P
recognition of cost of sales or inventory in respect of these items. Therefore the current T
treatment in the financial statements is incorrect. E
R
In accordance with IFRS 15, Revenue from Contracts with Customers commission received
by a party acting as an agent should be recognised as earned. As Russell Ltd has no further 8
obligations once the initial transaction has been undertaken the commission should be
recognised at this time. Commission of approximately £900,000 should be recognised
(£6,000,000  15%). An additional adjustment may be required in respect of sales made not
despatched. The £6,000,000 trading revenue should be eliminated with any associated
costs of sale and inventory. These amounts are likely to be material to the financial
statements.
Conclusion
The financial statements should be revised, as they do not comply with IFRS 15. If
management refuse to adjust the financial statements the auditor will need to qualify the
audit opinion on the grounds of a misstatement (disagreement) which is material but not
pervasive.

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1 Branch plc
Earnings per share
The problem in the EPS calculation relates to share options held by a director. As they are
held by a director, it is unlikely that they are immaterial, as matters relating to directors are
generally considered to be material by their nature. The fact that EPS is a key shareholder
ratio which is therefore likely to be material in nature to the shareholders should also be
considered.
As the incorrect EPS calculation is therefore material to the financial statements, the
auditor's report should be modified in this respect, unless the directors agree to amend the
EPS figure. This would be an 'except for' modification, on the grounds of material
misstatement (disagreement).
Share options
The share options have not been included in the EPS calculations. The auditors must ensure
that the share options have been correctly disclosed in information relating to the director
in both the financial statements and the other information, and that these disclosures are
consistent with each other. If proper disclosures have not been made, the auditor will have
to modify the auditor's report due to lack of disclosure in this area.
Exercise of share options
The fact that the director has exercised his share options after the year end does not require
disclosure in the financial statements. However, it is likely that he has exercised them as part
of a new share issue by the company and, if so, the share issue would be a non-adjusting
event after the reporting period that would require disclosure in the financial statements.
We should check if this is the case and, if so, whether it has been disclosed. Non-disclosure
would be further grounds for modification.
Financial performance statement
The financial performance statement forms part of the other information that the auditor is
required to review under ISA 720. The auditor's report would include an 'Other Information'
section in accordance with this standard. The ISA states that the auditors should seek to
rectify any apparent misstatements in this information. The ratio figures are misstated, and
the auditor should encourage the directors to correct them, regardless of the negligible
difference.
The ISA refers to material items. The ratios will be of interest to shareholders, being investor
information, and this fact may make them material by their nature. However, as the
difference is negligible in terms of value, on balance, the difference is probably not
sufficiently material for the auditors to make any specific reference to this in their auditor's
report.
Corporate governance statement
For the company to meet stock exchange requirements, the auditors must review the
corporate governance statement. For our own purposes, we should document that we have
done so. As having an audit committee is a requirement of the UK Corporate Governance
Code and the company does not have one, the corporate governance statement should
explain why the company does not comply with the Code in this respect.
We would not modify our audit opinion over the corporate governance statement, although
we would make reference to it in the 'Other Information' section, if we do not feel the

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disclosure is sufficient in respect of the non-compliance with the requirement to have an

audit committee.
The audit opinion would not be modified in this respect. We are also required to report by
exception if we have identified information that is:
 inconsistent with the information in the audited financial statements; or
 materially misstated based on the knowledge acquired by the auditor in the course of
the audit.
Overall conclusion
None of the matters discussed above, either singly or seen together, are pervasive to the
financial statements. The auditor's report should be modified on the material matter of the
incorrect EPS calculation. We should ensure that all the other disclosures are in order and
also review the corporate governance statement. If the corporate governance statement
does not adequately address the issue of the company not having an audit committee, we
will need to address this in the 'Other Information' of our report. Our audit opinion will not
be modified in this respect.
2 SafeAsHouses plc
BRIEFING NOTES TO MANAGER
To: Audit Manager
From: Audit Senior
C
Date: July 20X3
H
Client: SafeAsHouses (hereafter SAH) and eSAH A
Subject: Major issues arising in audit work performed to date P
T
There are a host of issues that need to be addressed. Some are important, and these are E
those I have highlighted for your attention. R
While there may now be some urgency with respect to completing the audit it is not 8
acceptable for us to be rushed in forming our judgement. This creates a threat to our
objectivity through possible intimidation.
Incorrect financial statements
The financial statements are incorrectly stated for SAH. There is no revaluation reserve and
it seems, after looking at the retained earnings in the analytical procedures, that the
revaluation has been credited to profit or loss. Retained earnings should therefore be
£5,000 and the revaluation reserve balance should be £500,000. (The revaluation would
also be recognised as other comprehensive income in the statement of profit or loss and
other comprehensive income.) The implication of this is that the company has insufficient
distributable reserves to pay the proposed dividend. There also appears to be little cash to
pay any dividend given the overdraft in SAH.
The intention not to consolidate the 100% subsidiary is unlikely to be allowed. IFRS 10,
Consolidated Financial Statements does not allow exclusion of a subsidiary from
consolidation on the basis of differing activities.
The company does not appear to have established a sinking fund for the redemption of the
debenture. There is not enough cash in the financial statements to approach the figure
required and the profitability of SAH is not sufficient to generate the amount required in the
months remaining. eSAH does not appear to be generating any cash at all. Nevertheless,
the company appears to have had or raised £300,000 to launch eSAH.
Moreover, in SAH, revenue and profit margins have been falling since 20X1. We will need
to ascertain why this has happened and consider any explanations received in conjunction
with available forecast figures.

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I am seriously concerned at the levels of receivables and payables in both companies. Not
enough cash is coming into the businesses and not enough, it appears, is being used to pay
the payables. There is a solvency issue pending which may well be crystallised when one
considers the debt covenants.
Net current assets
These stand at £310,000 for SAH and are clearly positive, which satisfies the constraint in
place from the debt covenant. However, there are some issues in eSAH that indicate that its
net current assets figures (already negative) may have to be further adjusted downward.
(1) The treatment of the payment on account of £120,000 is incorrect and does not accord
with prudent revenue recognition rules. The payment should not have been taken to
revenue, but credited to an account in short-term payables. This adjustment will
reduce net current assets to (£203,000).
(2) This means that the provisional revenue figure for eSAH of £500,000 should be
reduced by £120,000 to £380,000. There is also an intra-group element that requires
adjustment in that SAH still presumably holds the inventory to which the amount of
£120,000 relates.
(3) In general, the inventory figure in SAH looks large and we will have to prepare an audit
programme that challenges this figure in order to establish its accuracy. Given its
central role in relation to the covenants, this will be important.
Other issues
(1) The development costs of the software seem to be correctly treated under IAS 38,
Intangible Assets in that an intangible asset may be recognised as arising from
development (or from the development phase of an internal project) if the following
can be demonstrated.
(a) The technical feasibility of completing the intangible asset so that it will be
available for use or sale.
(b) The entity's intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.
This would also appear to relate to the testing costs since they meet the criteria of
development activities under the standard ('the design, construction and testing of a
chosen alternative for new or improved materials, devices, products, processes,
systems or services', para 59).
More generally, the testing costs of £186,000 look substantial in relation to the overall
£408,000 spent. This may have indicated some problems with the software. We should
establish why the testing costs were so high and, if there were problems, obtain
assurance of their resolution.
(2) The depreciation provision in eSAH's accounts does not seem to accord with its stated
policy. They have charged only £25,000 out of a maximum of £81,600 (£408,000 ÷ 5).
This would imply a charge only relating to 3.6 months of the year. We will need to
ascertain what the depreciation policy is and exactly what capitalised costs have been
incurred.
(3) I am suspicious that eSAH has made a nil profit in the year. It looks too coincidental and
may have been the result of an arbitrary calculation on, say, depreciation with which I
have some doubts anyway.
(4) The investment in the subsidiary eSAH has not been separately presented in SAH's
accounts. £300,000 will need to be recorded as a non-current asset investment once it
has been identified where the incorrect debit has been recorded (possibly in the 'non-
current assets' total figure).

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(5) Overdraft. Unless we see a cash flow forecast demonstrating a dramatic improvement I
cannot see how breaching the overdraft condition can be avoided. Two forces are at
work in relation to this. First, the debenture interest at 8% suggests a repayment
schedule of £130,000 per annum. Allied to significant investment in the subsidiary,
cash flow may well be strained in the forthcoming year. Second, unless a refinancing
package is agreed, I cannot see how the company can redeem its debenture. I cannot
see any course of action at this stage other than to require disclosures on the grounds
of going concern.
Receivable and payable days
I have calculated these on a consolidated basis. The relevant figures are
550 + 225
Receivables:  365 = 206 days (assuming revenues are all on credit)
990 + (500 – 120)
With inventory remaining constant in SAH (and no inventory values in eSAH), then cost of
sales is equivalent to purchases. Assuming these are all on credit then
430 + 300
Trade payables:  365 = 229 days
(990 × 83%) + ((500 – 120) × 90%)
The covenant is exceeded. Once this is reported, the debenture holders will be able to
enforce the conversion of the debenture into a loan repayable on demand.
I consider it highly likely that the company SAH will become insolvent. It will then be up to
the debenture holders to assess if a reorganisation plan is viable. In particular we will need C
H
to do the following: A
P
 See and investigate what projections are available for SAH with a view to considering T
the viability of the business. E
R
These projections will have implications for the plans for a listing in the near future
which look too ambitious as there is likely to be too much uncertainty for the business 8
to be floated successfully.
 Assess if there are any refinancing arrangements in place or proposed that would
underpin the survival of the company.
 Look to correspondence with financiers to ascertain evidence of refinancing or a
relaxation of the covenants.

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CHAPTER 9
Reporting financial
performance
Introduction
TOPIC LIST
1 IAS 1, Presentation of Financial Statements
2 IFRS 8, Operating Segments
3 IFRS 5, Non-current Assets Held for Sale and Discontinued Operations
4 IAS 24, Related Party Disclosures
5 IFRS 1, First-time Adoption of International Financial Reporting Standards
6 IAS 34, Interim Financial Reporting
7 IFRS 14, Regulatory Deferral Accounts
8 Audit focus – General issues with reporting performance
9 Audit focus – Specific issues
Technical reference

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Introduction
can affect reported financial performance
 Explain and appraise accounting standards that relate to reporting performance: in
respect of presentation of financial statements; revenue; operating segments;
continuing and discontinued operations; EPS; construction contracts; interim
reporting
 Formulate and evaluate accounting and reporting policies for single entities and
groups of varying sizes and in a variety of industries
 Calculate and disclose, from financial and other qualitative data, the amounts to be
included in an entity's financial statements according to legal requirements,
applicable financial reporting standards and accounting and reporting policies
 Appraise the significance of inconsistencies and omissions in reported information
in evaluating performance
 Compare the performance and position of different entities allowing for
inconsistencies in the recognition and measurement criteria in the financial
statement information provided
 Make adjustments to reported earnings in order to determine underlying earnings
and compare the performance of an entity over time
 Demonstrate and explain, in the application of audit procedures, how relevant ISAs
affect audit risk and the evaluation of audit evidence
Specific syllabus references for this chapter are: 2(a)–(d), 9(f)–(h), 14(f)

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Section overview
IAS 1, Presentation of Financial Statements sets down the format of financial statements,
containing requirements as to their presentation, structure and content.
1.1 Main features

1.1.1 Titles of financial statements
The three main financial statements under IAS 1 are as follows:
 Statement of financial position
 Statement of profit or loss and other comprehensive income
 Statement of cash flows
You may still see the old names (balance sheet, etc), as these new titles are not mandatory.
1.1.2 Reporting owner changes in equity and comprehensive income
IAS 1 classifies changes in equity in a period as either:
 owner changes in equity; or
 non-owner changes in equity.
Owner changes in equity arise from transactions with owners in their capacity as owners, eg,
dividends paid and issues of share capital. These are presented in the statement of changes in
equity.
Non-owner changes in equity (known as 'comprehensive income') include:
 the profit or loss for the period; and
 income or expenditure recognised directly in equity (known as 'other comprehensive
income').
These are presented in the statement of profit or loss and other comprehensive income.
C
Summary H
A
P
IAS 1 T
E
Profit or loss for period R
Statement of profit or loss and
Non-owner transactions recognised directly in other comprehensive income 9
equity
Owner transactions Statement of changes in equity
1.1.3 Presentation of comparatives

IAS 1 requires disclosure of comparative information in respect of the previous period. It also
requires inclusion of a statement of financial position as at the beginning of the earliest
comparative period when an entity:
 retrospectively applies an accounting policy;
 retrospectively restates items in the financial statements; or
 reclassifies items in the financial statements.
In effect this will result in the presentation of three statements of financial position when there is
a prior period adjustment.
ICAEW 2019 Reporting financial performance 491

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1.2 Statement of financial position

Note that reserves other than share capital and retained earnings may be grouped as 'other
components of equity'.
Statement of financial position as at 31 December 20X7
31 Dec 20X7 31 Dec 20X6
$m $m
ASSETS
Non-current assets
Property, plant and equipment X X
Goodwill X X
Other intangible assets X X
Investments in associates X X
Investments in equity instruments X X
X X
Current assets
Inventories X X
Trade receivables X X
Other current assets X X
Cash and cash equivalents X X
X X
Total assets X X
EQUITY AND LIABILITIES
Equity attributable to owners of the parent
Share capital X X
Retained earnings X X
Other components of equity X X
X X
Non-controlling interests X X
Total equity X X
Long-term borrowings X X
Deferred tax X X
Long-term provisions X X
Total non-current liabilities X X
Current liabilities
Trade and other payables X X
Short-term borrowings X X
Current portion of long-term borrowings X X
Current tax payable X X
Short-term provisions X X
Total current liabilities X X
Total liabilities X X
Total equity and liabilities X X
1.3 Statement of profit or loss and other comprehensive income

The statement of profit or loss and other comprehensive income presents the total
comprehensive income of an entity for a period.
Total comprehensive income is the change in equity during a period resulting from transactions
and other events, other than those changes resulting from transactions with owners in their
capacity as owners. It includes all components of profit or loss and of 'other comprehensive
income'.

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Other comprehensive income includes income and expenses that are not recognised in profit or
loss, but instead recognised directly in equity. It includes:
 changes in the revaluation surplus;
 remeasurements (actuarial gains and losses on defined benefit plans recognised in
accordance with IAS 19, Employee Benefits (revised 2011)) (Chapter 18);
 gains and losses arising from translating the financial statements of a foreign operation
(Chapter 21);
 gains and losses on remeasuring investments in equity instruments where an irrevocable
election has been made to record changes in OCI (Chapter 16); and
 the effective portion of gains and losses on hedging instruments in a cash flow hedge
(Chapter 17).
1.3.1 Presentation of other comprehensive income

The issue
The blurring of distinctions between different items in OCI is the result of an underlying general
lack of agreement among users and preparers about which items should be presented in OCI
and which should be part of the profit or loss section. For instance, a common misunderstanding
is that the split between profit or loss and OCI is on the basis of realised versus unrealised gains.
This is not, and has never been, the case.
This lack of a consistent basis for determining how items should be presented can lead to the
somewhat inconsistent use of OCI in financial statements.
IAS 1 approach
Entities are required to group items presented in OCI on the basis of whether they would be
reclassified to (recycled through) profit or loss at a later date, when specified conditions are met.
The amendment does not address which items are presented in OCI or which items need to be
reclassified.
Income tax
IAS 1 requires an entity to disclose income tax relating to each component of OCI. This is C
H
because these items often have tax rates different from those applied to profit or loss. A
P
This may be achieved by either: T
E
 presenting individual components of OCI net of the related tax; or R
 presenting individual components of OCI before tax, with one amount shown for the
9
aggregate amount of income tax relating to those components.
Presentation
IAS 1 allows comprehensive income to be presented in two ways:
(1) A single statement of profit or loss and other comprehensive income; or
(2) A statement displaying components of profit or loss plus a second statement beginning
with profit or loss and displaying components of OCI (statement of profit or loss and other
comprehensive income).

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The recommended format of a single statement of profit or loss and other comprehensive
income is as follows:
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X7
20X7 20X6
$m $m
Revenue X X
Cost of sales (X) (X)
Gross profit X X
Other income X X
Distribution costs (X) (X)
Administrative expenses (X) (X)
Other expenses (X) (X)
Finance costs (X) (X)
Share of profit of associates X X
Profit before tax X X
Income tax expense (X) (X)
Profit for the year from continuing operations X X
Loss for the year from discontinued operations (X)
PROFIT FOR THE YEAR X X
Other comprehensive income:
Items that will not be reclassified to profit or loss:
Gains on property revaluation X X
Investment in equity instruments (X) X
Actuarial gains (losses) on defined benefit pension plans (X) X
Share of gain (loss) on property revaluation of associates X (X)
Income tax relating to items that will not be reclassified X (X)
(X) X
Items that may be reclassified subsequently to profit or loss:
Exchange differences on translating foreign operations X X
Cash flow hedges (X) (X)
Income tax relating to items that may be reclassified (X) (X)
X X
Other comprehensive income for the year, net of tax (X) X
TOTAL COMPREHENSIVE INCOME FOR THE YEAR X X
Profit attributable to:
Owners of the parent X X
X X
Total comprehensive income attributable to:
Owners of the parent X X
X X
Earnings per share ($)

Basic and diluted X X
Alternatively, components of OCI could be presented in the statement of profit or loss and other
comprehensive income net of tax.

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Tutorial note
Throughout this Manual, income and expense items which are included in the 'top half' of the
statement of profit or loss and other comprehensive income are referred to as recognised in
profit or loss, or recognised in the income statement.
Income and expense items included in the 'bottom half' of the statement of profit or loss and
other comprehensive income are referred to as recognised in other comprehensive income.
For exam purposes, you must ensure that you clarify where in the statement of profit or loss and
other comprehensive income an item is recorded, by referring to recognition:
 in profit or loss; or
 in other comprehensive income.
1.4 Statement of changes in equity

All changes in equity arising from transactions with owners in their capacity as owners are shown
in the statement of changes in equity.
Non-owner transactions are not permitted to be shown in the statement of changes in equity
other than in aggregate.
Statement of changes in equity for the year ended 31 December 20X7
Translation Investments Non-
Share Retained of foreign in equity Cash flow Revaluation controlling Total
capital earnings operations instruments hedges surplus Total interest equity
Balance at £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000 £'000
1 Jan 20X7 X X (X) X X – X X X
Changes in
accounting
policy – X – – – – X – X
Restated
balance X X (X) X X – X X X
Changes
in equity
during 20X7
Issue of share
capital X – – – – – X – X
Dividends – (X) – – – – (X) (X) (X)
C
Total
comprehensive H
income for the A
year – X X X X X X X X P
Transfer to T
retained E
earnings – X – – – (X) – – – R
Balance at
31 Dec 20X7 X X X X X X X X X 9

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A comparative statement for the prior period is also required.

Here is an example of a statement of changes in equity with some real figures in, to give you a
better idea of what it looks like:
Olive Group: statement of changes in equity for the year ended 30 June 20X9
Inv. in Non-
Share Retained equity Revaluation controlling Total
capital earnings instruments surplus Total interest equity
£m £m £m £m £m £m £m
Balance at
1 July 20X8 14,280 10,896 384 96 25,656 1,272 26,928
Share capital issued 1,320 1,320 1,320
Dividends (216) (216) (120) (336)
Total comprehensive
income for the year (1,296) 72 48 (1,176) 528 (648)
Balance at
30 June 20X9 15,600 9,384 456 144 25,584 1,680 27,264
1.5 Disclosure initiative: Amendments to IAS 1

The IASB's disclosure initiative is a broad-based undertaking exploring how disclosures in IFRS
financial reporting can be improved. It is made up of a number of projects, the third of which
was completed in September 2017.
The amendment to IAS 1 is a narrow scope project which aims to ensure that entities are able to
use judgement when presenting their financial reports as the wording of some of the
requirements in IAS 1 had in some cases been read to prevent the use of judgement. The final
Standard Disclosure Initiative (Amendments to IAS 1) was published in 2014, and is effective for
annual periods beginning on or after 1 January 2016 with earlier application permitted.
The following amendments are made.
(a) Materiality. Information should not be obscured by aggregating or by providing immaterial
information. Materiality considerations apply to the parts of the financial statements.
Materiality considerations still apply, even when a standard requires a specific disclosure.
(b) Statement of financial position and statement of profit or loss and other comprehensive
income. The list of line items to be presented in these statements can be disaggregated
and aggregated as relevant and additional guidance is given on subtotals in these
statements. An entity's share of other comprehensive income of equity-accounted
associates and joint ventures should be presented in aggregate as single line items based
on whether or not it will subsequently be reclassified to profit or loss.
Note: Additional examples have been added of possible ways of ordering the notes to clarify
that understandability and comparability should be considered when determining the order of
the notes and to demonstrate that the notes need not be presented in the order listed in
paragraph 114 of IAS 1. The IASB also removed guidance and examples with regard to the
identification of significant accounting policies that were perceived as being potentially
unhelpful.
1.5.1 Practice Statement 2: Making Materiality Judgements

The IASB issued Practice Statement 2: Making Materiality Judgements in September 2017. This
is a tool to aid management in using judgement to decide what information is material and what
is not; it is a non-mandatory document and does not have the status of an IFRS.

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The Practice Statement was discussed as a current issue in Chapter 2. The key point is a
four-step process for making materiality judgements:
Step 1
Identify information that has the potential to be material. This step requires consideration of IFRS
requirements and the common information needs of primary users.
Step 2
Assess whether the information identified is material. Both quantitative and qualitative factors
should be considered.
Step 3
Organise the information within the draft financial statements so that it supports clear and
concise communication.
Step 4
Review the information provided as a whole, considering whether it is material individually and
in combination with other information. At this stage information may need to be added or
removed.
Section overview
An important aspect of reporting financial performance is segment reporting. This is covered
by IFRS 8, Operating Segments.
IFRS 8 is a disclosure standard.
• Segment reporting is necessary for a better understanding and assessment of:
– past performance;
– risks and returns; and
– informed judgements.
 IFRS 8 adopts the managerial approach to identifying segments.
C
 The standard gives guidance on how segments should be identified and what information H
A
should be disclosed for each. P
T
It also sets out requirements for related disclosures about products and services, geographical E
areas and major customers. R
9
2.1 Introduction
Large entities produce a wide range of products and services, often in several different
countries. Further information on how the overall results of entities are made up from each of
these product or geographical areas will help the users of the financial statements. This is the
reason for segment reporting.
 The entity's past performance will be better understood.
 The entity's risks and returns may be better assessed.
 More informed judgements may be made about the entity as a whole.
Risks and returns of a diversified, multinational company can be better assessed by looking at
the individual risks and rewards attached to groups of products or services or in different
geographical areas. These are subject to differing rates of profitability, opportunities for growth,
future prospects and risks.

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2.2 Objective and scope

An entity must disclose information to enable users of its financial statements to evaluate the
nature and financial effects of the business activities in which it engages and the economic
environments in which it operates.
Only entities whose equity or debt securities are publicly traded (ie, on a stock exchange) need
disclose segment information. In group accounts, only consolidated segmental information
needs to be shown. (The statement also applies to entities filing or in the process of filing
financial statements for the purpose of issuing instruments.)
2.3 Definition of operating segment
Definition
Operating segment: This 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 regularly reviewed by the entity's chief operating decision
maker to make decisions about resources to be allocated to the segment and assess its
performance; and
 for which discrete financial information is available.
The term 'chief operating decision maker' identifies a function, not necessarily a manager with a
specific title. That function is to allocate resources and to assess the performance of the entity's
operating segments.
2.4 Aggregation
Two or more operating segments may be aggregated if the segments have similar economic
characteristics, and the segments are similar in all of the following respects:
 The nature of the products or services
 The nature of the production process
 The type or class of customer for their products or services
 The methods used to distribute their products or provide their services
 If applicable, the nature of the regulatory environment
2.5 Determining reportable segments

An operating segment is reportable where:
 It meets the definition of an operating segment; and
 Any of the following size criteria are met:
– Segment revenue ≥ 10% of total (internal and external) revenue
– Segment profit or loss ≥ 10% of the profit of all segments in profit (or loss of all
segments making a loss if greater)
– Segment assets ≥ 10% of total assets
At least 75% of total external revenue must be reported by operating segments. Where this is
not the case, additional segments must be identified (even if they do not meet the 10%
thresholds).

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2.5.1 Aggregating segments

Two or more operating segments below the thresholds may be aggregated to produce a
reportable segment if the segments have similar economic characteristics, and the segments are
similar in a majority of the aggregation criteria above.
Evidence of similar economic characteristics is given by similar long-term financial performance.
For example, similar long-term average gross margins for two operating segments would be
expected if their economic characteristics were similar.
2.5.2 Non-reportable segments

Operating segments that do not meet any of the quantitative thresholds may be reported
separately if management believes that information about the segment would be useful to users
of the financial statements.
Non-reportable segments are required by IFRS 8 to be combined and disclosed in an 'all other
segments' category separate from other reconciling items in the reconciliations required by
IFRS 8. Entities must disclose the sources of revenue in the 'all other segments' category.
2.6 Disclosures
2.6.1 Segment disclosures
Disclosures required by the IFRS are extensive and best learned by looking at the example and
pro forma, which follow the list. Disclosure is required of:
 Factors used to identify the entity's reportable segments
 Types of products and services from which each reportable segment derives its revenues
 For each reportable segment:
– Operating segment profit or loss
– Segment assets
– Segment liabilities
– Certain income and expense items
External
Revenue
Inter segment
Interest revenue
C
H
Interest expense A
P
Depreciation and amortisation T
E
R
Other material non-cash items
9
Material income/expense (IAS 1)
Profit, assets Share of profit of associates/jointly controlled entities equity accounted

and liabilities
Profit or loss (as reported to chief operating decision maker)
Income tax expense
Non-current assets
Investments in associates/jointly controlled entities
Expenditures for reportable assets
Segment liabilities
Figure 9.1: IFRS 8 Disclosures

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A reconciliation of each of the above material items to the entity's reported figures is required.
Reporting of a measure of profit or loss by segment is compulsory. Other items are disclosed if
included in the figures reviewed by or regularly provided to the chief operating decision maker.
2.6.2 Entity-wide disclosures

The following disclosures are required for the whole entity:
 External revenue by each product and service (if reported basis is not products and
services)
 Geographical information:
by:
External revenue
Geographical • entity's country of domicile, and
areas Non-current assets • all foreign countries (subdivided if material)
Notes
1 External revenue is allocated based on the customer's location.
2 Non-current assets exclude financial instruments, deferred tax assets, post-
employment benefit assets, and rights under insurance contracts.
 Information about reliance on major customers (ie, those who represent more than 10% of
external revenue)
2.6.3 Disclosure example from IFRS 8
The following example is adapted from the IFRS 8, Implementation Guidance, which emphasises
that this is for illustrative purposes only and that the information must be presented in the most
understandable manner in the specific circumstances.
The hypothetical company does not allocate tax expense (tax income) or non-recurring gains
and losses to reportable segments. In addition, not all reportable segments have material
non-cash items other than depreciation and amortisation in profit or loss. The amounts in this
illustration, denominated as dollars, are assumed to be the amounts in reports used by the chief
operating decision maker.
Car Motor All
parts vessel Software Electronics Finance other Totals
$ $ $ $ $ $ $
Revenues from external
customers 3,000 5,000 9,500 12,000 5,000 1,000 35,500
Inter-segment revenues – – 3,000 1,500 – – 4,500
Interest revenue 450 800 1,000 1,500 – – 3,750
Interest expense 350 600 700 1,100 – – 2,750
Net interest revenue – – – – 1,000 – 1,000
Depreciation and
amortisation 200 100 50 1,500 1,100 – 2,950
Reportable segment profit 200 70 900 2,300 500 100 4,070
Other material non-cash
items:
Impairment of assets – 200 – – – – 200
Reportable segment 2,000 5,000 3,000 12,000 57,000 2,000 81,000
assets
Expenditure for reportable
segment non-current 300 700 500 800 600 – 2,900
assets
Reportable segment 1,050 3,000 1,800 8,000 30,000 – 43,850
liabilities

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 'All other' segment results are attributable to four operating segments of the company
which do not meet the quantitative thresholds. Those segments include a small property
business, an electronics equipment rental business, a software consulting practice and a
warehouse leasing operation. None of those segments has ever met any of the quantitative
thresholds for determining reportable segments.
 The finance segment derives a majority of its revenue from interest. Management primarily
relies on net interest revenue, not the gross revenue and expense amounts, in managing
that segment. Therefore, as permitted by IFRS 8, only the net amount is disclosed.
2.6.4 Suggested pro forma

Information about profit or loss, assets and liabilities
Segment Segment Segment All other Inter Entity
A B C segments segment total
Revenue – external customers X X X X – X
Revenue – inter segment X X X X (X) –
X X X X (X) X
Interest revenue X X X X (X) X
Interest expense (X) (X) (X) (X) X (X)
Depreciation and
amortisation (X) (X) (X) (X) – (X)
Other material non-cash
items X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Material income/expense
(IAS 1) X/(X) X/(X) X/(X) X/(X) X/(X) X/(X)
Share of profit of
associate/JVs X X X X – X
Segment profit before tax X X X X (X) X
Income tax expense (X) (X) (X) (X) – (X)
Unallocated items X/(X)
Profit for the period X
Segment assets X X X X (X) X
Investments in
associate/JVs X X X X – X C
H
Unallocated assets X
A
Entity's assets X P
T
Expenditures for reportable E
R
assets X X X X (X) X
Segment liabilities X X X X (X) X 9
Unallocated liabilities X
Entity's liabilities X
Information about geographical areas

Country of Foreign
domicile countries Total
Revenue – external customers X X X
Non-current assets X X X
Interactive question 1: Segments

Endeavour, a public limited company, trades in six business areas which are reported separately
in its internal accounts provided to the chief operating decision maker. The results of these
segments for the year ended 31 December 20X5 are as follows.

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Operating segment information as at 31 December 20X5

Revenue Segment Segment Segment
External Internal Total profit/(loss) assets liabilities
£m £m £m £m £m £m
Chemicals: Europe 14 7 21 1 31 14
Rest of world 56 3 59 13 778 34
Pharmaceuticals wholesale 59 8 67 9 104 35
Pharmaceuticals retail 22 0 22 (2) 30 12
Cosmetics 12 3 15 2 18 10
Hair care 11 1 12 4 21 8
Body care 18 24 42 (6) 54 19
192 46 238 21 336 132
Requirement
Which of the operating segments of Endeavour constitute a 'reportable' operating segment
under IFRS 8, Operating Segments for the year ending 31 December 20X5?
3 IFRS 5, Non-current Assets Held for Sale and Discontinued

Operations
Section overview
IFRS 5 requires assets and groups of assets that are 'held for sale' to be presented separately
on the face of the statement of financial position and the results of discontinued operations to
be presented separately in the statement of profit or loss and other comprehensive income.
This is required so that users of financial statements will be better able to make projections
about the financial position, profits and cash flows of the entity based on continuing operations
only.
Definition
Disposal group: A group of assets to be disposed of, by sale or otherwise, together as a group
in a single transaction, and liabilities directly associated with those assets that will be transferred
in the transaction. (In practice a disposal group could be a subsidiary, a cash-generating unit or
a single operation within an entity.) (IFRS 5)
A disposal group could form a group of cash-generating units, a single cash-generating unit or
be part of a cash-generating unit.
The disposal group should include goodwill if it is a cash-generating unit (or group of cash-
generating units to which goodwill has been allocated under IAS 36). Only goodwill recognised
in the statement of financial position can be included in the disposal group. If a previous
generally accepted accounting practice (GAAP) allowed goodwill to be recorded directly in
reserves, this goodwill does not form part of a disposal group.
A disposal group may include current and non-current assets and current and non-current
liabilities. However, only liabilities that will be transferred as part of the transaction are classified
as part of the disposal group. If any liabilities remain with the vendor, these are not included in
the scope of IFRS 5.

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IFRS 5 does not apply to certain assets covered by other accounting standards:
 Deferred tax assets (IAS 12)
 Assets arising from employee benefits (IAS 19)
 Financial assets (IFRS 9)
 Investment properties accounted for in accordance with the fair value model (IAS 40)
 Agricultural and biological assets that are measured at fair value less estimated point of sale
costs (IAS 41)
 Insurance contracts (IFRS 4)
3.1 Classification of assets held for sale

A non-current asset (or disposal group) should be classified as held for sale if its carrying
amount will be recovered principally through a sale transaction 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.
 Its sale must be highly probable (ie, significantly more likely than not).
For the 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 programme to locate a buyer.
 The asset must be marketed for sale 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.
An asset (or disposal group) can still be classified as held for sale, even if the sale has not
actually taken place within one year. However, the delay must have been caused by events or
circumstances beyond the entity's control and there must be sufficient evidence that the entity
is still committed to sell the asset or disposal group. Otherwise the entity must cease to classify C
H
the asset as held for sale. A
P
Subsidiaries acquired exclusively with a view to resale T
E
If an entity acquires a disposal group (eg, a subsidiary) exclusively with a view to its subsequent R
disposal it can classify the asset as held for sale only if the sale is expected to take place within
one year and it is highly probable that all the other criteria will be met within a short time 9
(normally three months).
Abandoned assets
An asset that is to be abandoned should not be classified as held for sale. This is because its
carrying amount will be recovered principally through continuing use. However, a disposal
group that is to be abandoned may meet the definition of a discontinued operation and
therefore separate disclosure may be required (see below).
Interactive question 2: Held for sale

On 1 December 20X3, a company became committed to a plan to sell a manufacturing facility
and has already found a potential buyer. The company does not intend to discontinue the
operations currently carried out in the facility. At 31 December 20X3 there is a backlog of
uncompleted customer orders. The subsidiary will not be able to transfer the facility to the buyer

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until after it ceases to operate the facility and has eliminated the backlog of uncompleted
customer orders. This is not expected to occur until Spring 20X4.
Requirement
How should the manufacturing facility be accounted for as at 31 December 20X3?
3.2 Measurement of assets held for sale

A non-current asset (or disposal group) that is held for sale should be measured at the lower of
its carrying amount and fair value less costs to sell (net realisable value).
An impairment loss should be recognised where fair value less costs to sell is lower than carrying
amount. Note that this is an exception to the normal rule. IAS 36, Impairment of Assets requires
an entity to recognise an impairment loss only where an asset's recoverable amount is lower
than its carrying value. Recoverable amount is defined as the higher of net realisable value and
value in use. IAS 36 does not apply to assets held for sale.
Non-current assets held for sale should not be depreciated, even if they are still being used by
the entity.
A non-current asset (or disposal group) that is no longer classified as held for sale (for example,
because the sale has not taken place within one year) is measured at the lower of the following:
 Its carrying amount before it was classified as held for sale, adjusted for any depreciation
that would have been charged had the asset not been held for sale
 Its recoverable amount at the date of the decision not to sell
3.3 Presenting discontinued operations

Definitions
Discontinued operation: A component of an entity that has either been disposed of, or is
classified as held for sale, and:
 represents a separate major line of business or geographical area of operations;
 is part of a single co-ordinated plan to dispose of a separate major line of business or
geographical area of operations; or
 is a subsidiary acquired exclusively with a view to resale.
Component of an entity: Operations and cash flows that can be clearly distinguished,
operationally and for financial reporting purposes, from the rest of the entity.
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.
An entity should disclose a single amount on the face of the statement of profit or loss and
other comprehensive income (or statement of profit or loss where presented separately)
comprising the total of:
 the post-tax profit or loss of discontinued operations; and
 the post-tax gain or loss recognised on the measurement to fair value less costs to sell or
on the disposal of the assets or disposal group(s) constituting the discontinued operation.

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An entity should also disclose an analysis of the above single amount into:
 the revenue, expenses and pre-tax profit or loss of discontinued operations;
 the related income tax expense;
 the gain or loss recognised on the measurement to fair value less costs to sell or on the
disposal of the assets or the discontinued operation; and
 the related income tax expense.
This may be presented either on the face of the statement of profit or loss and other
comprehensive income or in the notes. If it is presented on the face of the statement of profit or
loss and other comprehensive income it should be presented in a section identified as relating
to discontinued operations, ie, separately from continuing operations. This analysis is not
required where the discontinued operation is a newly acquired subsidiary that has been
classified as held for sale.
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.
Gains and losses on the remeasurement of a disposal group that is not a discontinued operation
but is held for sale should be included in profit or loss from continuing operations.
Interactive question 3: Closure
On 20 October 20X3 the directors of a parent company made a public announcement of plans
to close a steel works. The closure means that the group will no longer carry out this type of
operation, which until recently has represented about 10% of its total revenue. The works will be
gradually shut down over a period of several months, with complete closure expected in July
20X4. At 31 December 20X3 output had been significantly reduced and some redundancies
had already taken place. The cash flows, revenues and expenses relating to the steel works can
be clearly distinguished from those of the subsidiary's other operations.
Requirement
How should the closure be treated in the financial statements for the year ended
31 December 20X3?
See Answer at the end of this chapter. C
H
A
P
T
E
3.4 Presentation of a non-current asset or disposal group classified as R
held for sale
9
Non-current assets and disposal groups classified as held for sale should be presented
separately from other assets in the statement of financial position. The liabilities of a disposal
group should be presented separately from other liabilities in the statement of financial position.
 Assets and liabilities held for sale should not be offset.
 The major classes of assets and liabilities held for sale should be separately disclosed either
on the face of the statement of financial position or in the notes.
3.5 IFRS 5 and impairment

There are particular rules on impairment in the context of IFRS 5. These are covered in
Chapter 12, section 1.4 of this Study Manual.

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3.6 Additional disclosures

In the period in which a non-current asset (or disposal group) has been either classified as held
for sale or sold, the following should be disclosed.
(a) A description of the non-current asset (or disposal group)
(b) A description of the facts and circumstances of the disposal
(c) Any gain or loss recognised when the item was classified as held for sale
(d) If applicable, the segment in which the non-current asset (or disposal group) is presented in
accordance with IFRS 8, Operating Segments
Where an asset previously classified as held for sale is no longer held for sale, the entity should
disclose a description of the facts and circumstances leading to the decision and its effect on
results.
Section overview
The objective of IAS 24 is to ensure that an entity's financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position and/or profit or loss may
have been affected by the existence of related parties or by related party transactions.
4.1 Overview of material from earlier studies

Scope
IAS 24 requires disclosure of related party transactions, and outstanding balances, in the
separate financial statements of:
 a parent;
 a venturer; or
 an investor.
What constitutes a related party?
A related party is a person or entity that is related to the entity that is preparing its financial
statements.
(a) A person or a close member of that person's family is related to a reporting entity if that
person:
(1) has control or joint control over the reporting entity;
(2) has significant influence over the reporting entity; or
(3) is a member of the key management personnel of the reporting entity or of a parent of
the reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions apply:
(1) The entity and the reporting entity are members of the same group (which means that
each parent, subsidiary and fellow subsidiary is related to the others).
(2) One entity is an associate or joint venture of the other entity (or an associate or joint
venture of a member of a group of which the other entity is a member).
(3) Both entities are joint ventures of the same third party.

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(4) One entity is a joint venture of a third entity and the other entity is an associate of the
third entity.
(5) The entity is a post-employment defined benefit plan for the benefit of employees of
either the reporting entity or an entity related to the reporting entity. If the reporting
entity is itself such a plan, the sponsoring employers are also related to the reporting
entity.
(6) The entity is controlled or jointly controlled by a person identified in (a).
(7) A person identified in (a)(1) has significant influence over the entity or is a member of
the key management personnel of the entity (or of a parent of the entity).
(8) The entity, or any member of a group of which it is a part, provides key management
personnel services to the reporting entity or the parent of the reporting entity.
Exclusions
 Two entities simply because they have a director or other key management in common
(notwithstanding the definition of related party above, although it is necessary to consider
how that director would affect both entities)
 Two venturers, simply because they share joint control over a joint venture
 Certain other bodies, simply as a result of their role in normal business dealings with the
entity:
– Providers of finance
– Trade unions
– Public utilities
– Government departments and agencies
 Any single customer, supplier, franchisor, distributor or general agent with whom the entity
transacts a significant amount of business, simply by virtue of the resulting economic
dependence
What constitutes a related party transaction?
Definition
C
Related party transaction: A transfer of resources, services or obligations between related H
parties, regardless of whether a price is charged. A
P
T
E
What must be disclosed? R
 A related party relationship between parent and subsidiaries 9
 Compensation, being the consideration in exchange for their services, received by key
management personnel
 Disclosures required about related parties only if transactions have taken place between
them during the period:
– The nature of the relationship (but remember this must always be disclosed in respect
of a parent)
– The amount of the transactions
– The amount of any balance outstanding at the year end
– The terms and conditions attaching to any outstanding balance (for example, whether
security or guarantees have been provided and what form the payment will take)
– If an amount has been provided against or written off any outstanding balance due

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 Disclosure of the fact that transactions are on an arm's length basis (The term 'arm's length'
continues to be used in the context of IAS 24, even though it has been removed from the
definition of fair value in IFRS 13 (see Chapter 2, section 4))
Interactive question 4: Related party transactions

P owns S and a number of other subsidiaries. The following details relate to amounts due to the
key management personnel (KMP) of P and of S for the year ended 31 December 20X5.
£
Salaries and related taxes payable by S to its KMP for services rendered to S 500,000
Salaries and related taxes payable by P to S's KMP for services rendered to S 60,000
Salaries and related taxes payable by S to its KMP for services rendered to P 20,000
Pension benefits accruing within the group-wide pension scheme to S's KMP 50,000
for services rendered to S
Share options granted under the group-wide share option scheme to S's 28,000
KMP for services rendered to S
658,000
Requirement
What transactions should be disclosed as key management personnel compensation in the
financial statements of S?
4.2 Application of substance over form

Under IAS 24 attention should be directed to the substance of the relationship rather than
focusing on its legal form. For example, the following are not related parties:
 Two entities simply because they have a director (or other member of key management
personnel) in common, or because a member of key management personnel of one entity
has significant influence over the other entity
 Two venturers simply because they share joint control over a joint venture
 Providers of finance, trade unions, public utilities and government departments and
agencies of a government that does not control, jointly control or significantly influence the
reporting entity simply by virtue of their normal dealings with an entity
 A customer, supplier, franchisor, distributor or general agent, with whom an entity transacts
a significant volume of business, simply by virtue of the resulting economic dependence
Worked example: Related parties

The following examples illustrate the application of the definition of a related party to practical
situations:
(a) Alan Jones owns 30% of Benson Co and Clark Co owns 40% of Benson Co. The remaining
30% is held by many unconnected shareholders.
Benson Co is the reporting entity:
Alan Jones is a related party under definition (a)(2) and Clark Co is a related party
under definition (b)(2)
Clark Co is the reporting entity:
Benson Co is a related party under definition (b)(2)

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(b) Alan Jones and Benson Co have joint control over Clark Co
Clark Co is a related party under definition (b)(2)
Alan Jones is a related party under definition (a)(1) and Benson Co is a related party
(c) Alan Jones is a non-executive director of Benson Co
Alan Jones falls within the definition of Benson Co's key management personnel and is
a related party under definition (a)(3)
(d) Alan Jones owns 70% of Benson Co and is a director of Clark Co
Alan Jones is a related party under definition (a)(1) and Clark Co is a related party
Alan Jones falls within the definition of Clark Co's key management personnel and is a
related party under definition (b)(3)
Benson Co is a related party under definition (b)(6)
5 IFRS 1, First-time Adoption of International Financial

Reporting Standards
Section overview
IFRS 1 gives guidance to entities applying IFRSs for the first time. C
H
A
The adoption of a new body of accounting standards will inevitably have a significant effect on P
T
the accounting treatments used by an entity and on the related systems and procedures. In E
2005 many countries adopted IFRS for the first time and over the next few years other countries R
are likely to do the same.
9
In addition, many Alternative Investment Market (AIM) companies and public sector companies
adopted IFRSs for the first time for accounting periods ending in 2009 and 2010. US companies
are likely to move increasingly to IFRS, although the US Securities and Exchange Commission
did not give any definite timeline for this in its 2012 work plan.
As discussed in Chapter 2 of this Manual, the regulatory shift away from UK GAAP means that all
entities except those small enough to qualify as micro-entities will be required to report in
accordance with FRS 102, with an option to use IFRS.
IFRS 1, First-time Adoption of International Financial Reporting Standards was issued to ensure
that an entity's first IFRS financial statements contain high quality information that fulfill the
following criteria:
 It is transparent for users and comparable over all periods presented.
 It provides a suitable starting point for accounting under IFRSs.
 It can be generated at a cost that does not exceed the benefits to users.

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5.1 General principles

An entity applies IFRS 1 in its first IFRS financial statements.
An entity's first IFRS financial statements are the first annual financial statements in which the
entity adopts IFRSs by an explicit and unreserved statement of compliance with IFRSs.
Any other financial statements (including fully compliant financial statements that did not state
so) are not the first set of financial statements under IFRSs.
An entity may apply IFRS 1 more than once, for example if a UK company adopted IFRSs, then
reverted to UK GAAP, then moved to IFRSs again.
5.2 Opening IFRS statement of financial position

An entity prepares and presents an opening IFRS statement of financial position at the date of
transition to IFRSs as a starting point for IFRS accounting.
Generally, this will be the beginning of the earliest comparative period shown (ie, full
retrospective application). Given that the entity is applying a change in accounting policy on
adoption of IFRS 1, IAS 1, Presentation of Financial Statements requires the presentation of at
least three statements of financial position (and two of each of the other statements).
Worked example: Opening IFRS SOFP

Comparative year First year of adoption
1.1.20X8 31.12.20X8 31.12.20X9
Transition
date
Preparation of an opening IFRS statement of financial position typically involves adjusting the
amounts reported at the same date under previous GAAP.
All adjustments are recognised directly in retained earnings (or, if appropriate, another category
of equity) not in profit or loss.
5.3 Estimates
Estimates in the opening IFRS statement of financial position must be consistent with estimates
made at the same date under previous GAAP even if further information is now available (in
order to comply with IAS 10).
5.4 Transition process

(a) Accounting policies
The entity should select accounting policies that comply with IFRSs effective at the end of
the first IFRS reporting period.
These accounting policies are used in the opening IFRS statement of financial position and
throughout all periods presented. The entity does not apply different versions of IFRSs
effective at earlier dates.

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(b) Derecognition of assets and liabilities

A previous GAAP statement of financial position may contain items that do not qualify for
recognition under IFRS.
Eg, IFRSs do not permit capitalisation of research, staff training and relocation costs.
(c) Recognition of new assets and liabilities
New assets and liabilities may need to be recognised.
Eg, deferred tax balances and certain provisions such as environmental and
decommissioning costs.
(d) Reclassification of assets and liabilities
Eg, compound financial instruments need to be split into their liability and equity
components.
(e) Measurement
Value at which asset or liability is measured may differ under IFRSs.
Eg, discounting of deferred tax assets/liabilities not allowed under IFRSs.
5.5 Main exemptions from applying IFRSs in the opening IFRS statement of
financial position
(a) Property, plant and equipment, investment properties and intangible assets
 Fair value/previous GAAP revaluation may be used as a substitute for cost at date of
transition to IFRSs.
(b) Business combinations
For business combinations before the date of transition to IFRSs:
 The same classification (acquisition or uniting of interests) is retained as under previous
GAAP.
 For items requiring a cost measure for IFRSs, the carrying value at the date of the
business combination is treated as deemed cost and IFRS rules are applied from C
H
thereon. A
P
 Items requiring a fair value measure for IFRSs are revalued at the date of transition to T
IFRSs. E
R
 The carrying value of goodwill at the date of transition to IFRSs is the amount as
reported under previous GAAP. 9
(c) Employee benefits

 Unrecognised actuarial gains and losses can be deemed zero at the date of transition
to IFRSs. IAS 19 is applied from then on.
(d) Cumulative translation differences on foreign operations
 Translation differences (which must be disclosed in a separate translation reserve
under IFRSs) may be deemed zero at the date of transition to IFRSs. IAS 21 is applied
from then on.
(e) Adoption of IFRSs by subsidiaries, associates and joint ventures
If a subsidiary, associate or joint venture adopts IFRSs later than its parent, it measures its
assets and liabilities either:

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 at the amount that would be included in the parent's financial statements, based on the
parent's date of transition; or
 at the amount based on the subsidiary (associate or joint venture)'s date of transition.
Disclosure
 A reconciliation of previous GAAP equity to IFRSs is required at the date of transition to
IFRSs and for the most recent financial statements presented under previous GAAP.
 A reconciliation of profit for the most recent financial statements presented under previous
GAAP.
5.6 Organisational and procedural changes

The technical changes involved in adopting a new body of standards will provide a challenge to
company management and their advisers. These are some of the key issues:
 Accurate assessment of the task involved. Underestimation or wishful thinking may hamper
the effectiveness of the conversion and may ultimately prove inefficient.
 Proper planning. This should take place at the overall project level, but a detailed task
analysis could be drawn up to control work performed.
 Human resource management. The project must be properly structured and staffed.
 Training. Where there are skills gaps, remedial training should be provided.
 Monitoring and accountability. A relaxed 'it will be all right on the night' attitude could spell
danger. Implementation progress should be monitored and regular meetings set up so that
participants can personally account for what they are doing as well as flag up any problems
as early as possible. Project drift should be avoided.
 Achieving milestones. Successful completion of key steps and tasks should be
appropriately acknowledged, ie, what managers call 'celebrating success', so as to sustain
motivation and performance.
 Physical resources. The need for IT equipment and office space should be properly
assessed.
 Process review. Care should be taken not to perceive the conversion as a one-off quick fix.
Any change in future systems and processes should be assessed and properly
implemented.
 Follow-up procedures. Good management practice dictates that follow-up procedures
should be planned and in place to ensure that the transfer is effectively implemented and
that any necessary changes are identified and implemented on a timely basis.
 Contractual terms. These may be affected, such as covenants related to borrowing facilities
based on statement of financial position ratios. The potential effect of the new standards on
these measurements should be assessed and discussed with the lenders at an early stage.
Interactive question 5: IFRS 1

Europa is a listed company incorporated in Molvania. It will adopt International Financial Reporting
Standards (IFRSs) for the first time in its financial statements for the year ended 31 December 20X8.
The directors of Europa are unclear as to the impact of IFRS 1, First-time Adoption of International
Financial Reporting Standards.

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Requirement
Advise the directors of Europa on the following.
(a) The procedure for preparing IFRS financial statements for the first time (as required by
IFRS 1).
(b) The practical steps that the company should take in order to ensure an efficient transfer to
accounting under IFRS.
(c) In its previous financial statements for 31 December 20X6 and 20X7, which were prepared
under local GAAP, the company:
(1) made a number of routine accounting estimates, including accrued expenses and
provisions; and
(2) did not recognise a provision for a court case arising from events that occurred in
September 20X7. When the court case was concluded on 30 June 20X8, Europa was
required to pay $10 million and paid this on 10 July 20X8, after the 20X7 financial
statements were authorised for issue.
In the opinion of the directors, the company's estimates of accrued expenses and
provisions under local GAAP were made on a basis consistent with IFRSs.
Requirement
Discuss how the matters above should be dealt with in the financial statements of Europa for the
year ended 31 December 20X8.
Section overview
IAS 34 recommends that publicly traded entities should produce interim financial reports and,
for entities that do publish such reports, it lays down principles and guidelines for their
production. C
H
A
The following definitions are used in IAS 34. P
T
Definitions E
R
Interim period: A financial reporting period shorter than a full financial year.
9
Interim financial report: A financial report containing either a complete set of financial
statements (as described in IAS 1) or a set of condensed financial statements (as described in
this standard) for an interim period.
6.1 Scope of IAS 34

IAS 34 does not make the preparation of interim financial reports mandatory, taking the view
that this is a matter for governments, securities regulators, stock exchanges or professional
accountancy bodies to decide within each country. The IASB does, however, strongly
recommend to governments and regulators that interim financial reporting should be a
requirement for companies whose equity or debt securities are publicly traded.

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IAS 34 encourages publicly traded entities:

 to provide an interim financial report for at least the first six months of their financial year
(ie, a half year financial report); and
 to make the report available no later than 60 days after the end of the interim period.
Thus, a company with a year ending 31 December would be required as a minimum to prepare
an interim report for the half year to 30 June and this report should be available before the end
of August.
6.2 Minimum components

IAS 34 specifies the minimum component elements of an interim financial report as follows:
 Condensed statement of financial position
 Condensed statement of profit or loss and other comprehensive income, presented either
as a single condensed statement or a statement of profit or loss and a statement showing
other comprehensive income
 Condensed statement of changes in equity
 Condensed statement of cash flows
 Selected note disclosures
IAS 34 applies where an entity is required to or chooses to publish an interim financial report in
accordance with IFRSs.
An interim report complying with IFRSs may be:
 a complete set of financial statements at the interim reporting date complying in full with
IFRSs; or
 a condensed interim financial report prepared in compliance with IAS 34.
The rationale for allowing only condensed statements and selected note disclosures is that
entities need not duplicate information in their interim report that is contained in their report for
the previous financial year. Interim statements should focus more on new events, activities and
circumstances.
6.3 Form and content

Where full financial statements are given as interim financial statements, IAS 1 should be used
as a guide, otherwise IAS 34 specifies minimum contents.
The condensed statement of financial position should include, as a minimum, each of the major
components of assets, liabilities and equity as were in the statement of financial position at the
end of the previous financial year, thus providing a summary of the economic resources of the
entity and its financial structure.
The condensed statement of profit or loss and other comprehensive income should include, as
a minimum, each of the component items of total comprehensive income as were shown in the
statement of profit or loss and other comprehensive income for the previous financial year,
together with the earnings per share and diluted earnings per share.
The condensed statement of cash flows should show, as a minimum, the three major subtotals
of cash flow as required in statements of cash flows by IAS 7, namely: cash flows from operating
activities, cash flows from investing activities and cash flows from financing activities.
The condensed statement of changes in equity should include, as a minimum, each of the major
components of equity as were contained in the statement of changes in equity for the previous
financial year of the entity.

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6.3.1 Selected explanatory notes

IAS 34 states that relatively minor changes from the most recent annual financial statements
need not be included in an interim report. However, the notes to an interim report should
include the following (unless the information is contained elsewhere in the report).
 A statement that the same accounting policies and methods of computation have been
used for the interim statements as were used for the most recent annual financial
statements. If not, the nature of the differences and their effect should be described. (The
accounting policies for preparing the interim report should only differ from those used for
the previous annual accounts in a situation where there has been a change in accounting
policy since the end of the previous financial year, and the new policy will be applied for the
annual accounts of the current financial period.)
 Explanatory comments on the seasonality or 'cyclicality' of operations in the interim period.
For example, if a company earns most of its annual profits in the first half of the year,
because sales are much higher in the first six months, the interim report for the first half of
the year should explain this fact
 The nature and amount of items during the interim period affecting assets, liabilities,
capital, net income or cash flows, that are unusual, due to their nature, incidence or size
 The issue or repurchase of equity or debt securities
 Nature and amount of any changes in estimates of amounts reported in an earlier interim report
during the financial year, or in prior financial years if these affect the current interim period
 Dividends paid on ordinary shares and the dividends paid on other shares
 Segmental results for entities that are required by IFRS 8, Operating Segments to disclose
segment information in their annual financial statements
 Any significant events since the end of the interim period
 Effect of changes in the composition of the entity during the interim period including the
acquisition or disposal of subsidiaries and long-term investments, restructurings and
discontinued operations
 Any significant change in a contingent liability or a contingent asset since the date of the
last annual statement of financial position
C
Changes in the business environment such as changes in price, costs, demand, market share H
and prospects for the full year should be discussed in the management discussion and analysis A
of the financial review. P
T
The entity should also disclose the fact that the interim report has been produced in compliance E
R
with IAS 34 on interim financial reporting.
9
Worked example: Disclosure
Give some examples of the type of disclosures required according to the above list of
explanatory notes.
Solution
The following are examples:
 Write down of inventories to net realisable value and the reversal of such a write down
 Recognition of a loss from the impairment of property, plant and equipment, intangible
assets, or other assets, and the reversal of such an impairment loss
 Reversal of any provisions for the costs of restructuring
 Acquisitions and disposals of items of property, plant and equipment
 Commitments for the purchase of property, plant and equipment

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 Litigation settlements
 Corrections of fundamental errors in previously reported financial data
 Any debt default or any breach of a debt covenant that has not been corrected
subsequently
 Related party transactions
6.4 Periods covered

The standard requires that interim financial reports should provide financial information for the
following periods or as at the following dates.
 Statement of financial position data as at the end of the current interim period, and
comparative data as at the end of the most recent financial year
 Statement of profit or loss and other comprehensive income data for the current interim
period and cumulative data for the current year to date, together with comparative data for
the corresponding interim period and cumulative figures for the previous financial year
 Statement of cash flows data should be cumulative for the current year to date, with
comparative cumulative data for the corresponding interim period in the previous financial
year
 Data for the statement of changes in equity should be for both the current interim period
and for the year to date, together with comparative data for the corresponding interim
period, and cumulative figures, for the previous financial year
6.5 Materiality
Materiality should be assessed in relation to the interim period financial data. It should be
recognised that interim measurements rely to a greater extent on estimates than annual
financial data.
6.6 Recognition and measurement principles

A large part of IAS 34 deals with recognition and measurement principles, and guidelines as to
their practical application. The guiding principle is that an entity should use the same
recognition and measurement principles in its interim statements as it does in its annual
This means, for example, that a cost that would not be regarded as an asset in the year-end
statement of financial position should not be regarded as an asset in the statement of financial
position for an interim period. Similarly, an accrual for an item of income or expense for a
transaction that has not yet occurred (or a deferral of an item of income or expense for a
transaction that has already occurred) is inappropriate for interim reporting, just as it is for year-
end reporting.
Applying this principle of recognition and measurement may result, in a subsequent interim
period or at the year end, in a remeasurement of amounts that were reported in a financial
statement for a previous interim period. The nature and amount of any significant
remeasurements should be disclosed.
6.6.1 Revenues received occasionally, seasonally or cyclically

Revenue that is received as an occasional item, or within a seasonal or cyclical pattern, should
not be anticipated or deferred in interim financial statements, if it would be inappropriate to

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anticipate or defer the revenue for the annual financial statements. In other words, the principles
of revenue recognition should be applied consistently to the interim reports and year-end
reports.
6.6.2 Costs incurred unevenly during the financial year

These should only be anticipated or deferred (ie, treated as accruals or prepayments) if it would
be appropriate to anticipate or defer the expense in the annual financial statements. For
example, it would be appropriate to anticipate a cost for property rental where the rental is paid
in arrears, but it would be inappropriate to anticipate part of the cost of a major advertising
campaign later in the year, for which no expenses have yet been incurred.
The standard goes on, in an appendix, to deal with specific applications of the recognition and
measurement principles. Some of these examples are explained below, by way of explanation
and illustration.
6.6.3 Payroll taxes or insurance contributions paid by employers

In some countries these are assessed on an annual basis, but paid at an uneven rate during the
course of the year, with a large proportion of the taxes being paid in the early part of the year,
and a much smaller proportion paid later on in the year. In this situation, it would be appropriate
to use an estimated average annual tax rate for the year in an interim statement, not the actual
tax paid. This treatment is appropriate because it reflects the fact that the taxes are assessed on
an annual basis, even though the payment pattern is uneven.
6.6.4 Cost of a planned major periodic maintenance or overhaul

The cost of such an event later in the year must not be anticipated in an interim financial
statement unless there is a legal or constructive obligation to carry out this work. The fact that a
maintenance or overhaul is planned and is carried out annually is not of itself sufficient to justify
anticipating the cost in an interim financial report.
6.6.5 Other planned but irregularly occurring costs

Similarly, these costs, such as charitable donations and employee training costs, should not be
accrued in an interim report. These costs, even if they occur regularly and are planned, are
nevertheless discretionary. C
H
A
6.6.6 Year-end bonus P
A year-end bonus should not be provided for in an interim financial statement unless there is a T
E
constructive obligation to pay a year-end bonus (eg, a contractual obligation, or a regular past R
practice) and the size of the bonus can be reliably measured.
9
Worked example: Bonus

An entity's accounting year ends on 31 December each year and it is currently preparing interim
financial statements for the half year to 30 June 20X4. It has a contractual agreement with its staff
that it will pay them an annual bonus equal to 10% of their annual salary if the full year's output
exceeds one million units. Budgeted output is 1.4 million units and the entity has achieved
budgeted output during the first six months of the year. Annual salaries are estimated to be
£100 million, with the cost in the first half year to 30 June being £45 million.
Requirement
How should the bonus be reflected in the interim financial statements?

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Solution
It is probable that the bonus will be paid, given that the actual output already achieved in the
year is in line with budgeted figures, which exceed the required level of output. So a bonus of
£4.5 million should be recognised in the interim financial statements at 30 June 20X4.
6.6.7 Holiday pay

The same principle applies here. If holiday pay is an enforceable obligation on the employer,
then any unpaid accumulated holiday pay may be accrued in the interim financial report.
6.6.8 Non-monetary intangible assets

The entity might incur expenses during an interim period on items that might or will generate
non-monetary intangible assets. IAS 38, Intangible Assets requires that costs to generate non-
monetary intangible assets (eg, development expenses) should be recognised as an expense
when incurred unless the costs form part of an identifiable intangible asset. Costs that were
initially recognised as an expense cannot subsequently be treated as part of the cost of an
intangible asset instead. IAS 34 states that interim financial statements should adopt the same
approach. This means that it would be inappropriate in an interim financial statement to 'defer' a
cost in the expectation that it will eventually be part of a non-monetary intangible asset that has
not yet been recognised: such costs should be treated as an expense in the interim statement.
6.6.9 Depreciation
Depreciation should only be charged in an interim statement on non-current assets that have
been acquired, not on non-current assets that will be acquired later in the financial year.
6.6.10 Foreign currency translation gains and losses

These should be calculated by the same principles as at the financial year end, in accordance with
IAS 21.
6.6.11 Tax on income

An entity will include an expense for income tax (tax on profits) in its interim statements. The tax
rate to use should be the estimated average annual tax rate for the year. For example, suppose
that in a particular jurisdiction, the rate of tax on company profits is 30% on the first £200,000 of
profit and 40% on profits above £200,000. Now suppose that a company makes a profit of
£200,000 in its first half year, and expects to make £200,000 in the second half year. The rate of
tax to be applied in the interim financial report should be 35%, not 30%, ie, the expected
average rate of tax for the year as a whole. This approach is appropriate because income tax on
company profits is charged on an annual basis, and an effective annual rate should therefore be
applied to each interim period.
As another illustration, suppose a company earns pre-tax income in the first quarter of the year
of £30,000, but expects to make a loss of £10,000 in each of the next three quarters, so that net
income before tax for the year is zero. Suppose also that the rate of tax is 30%. In this case, it
would be inappropriate to anticipate the losses, and the tax charge should be £9,000 for the first
quarter of the year (30% of £30,000) and a negative tax charge of £3,000 for each of the next
three quarters, if actual losses are the same as anticipated.
Where the tax year for a company does not coincide with its financial year, a separate estimated
weighted average tax rate should be applied for each tax year, to the interim periods that fall
within that tax year.

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Some countries give entities tax credits against the tax payable, based on amounts of capital
expenditure or research and development, etc. Under most tax regimes, these credits are
calculated and granted on an annual basis; therefore it is appropriate to include anticipated tax
credits within the calculation of the estimated average tax rate for the year, and apply this rate to
calculate the tax on income for the interim period.
Worked example: Taxation charge

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim
financial statements for the half year to 30 June 20X4. Its profit before tax for the six month
period to 30 June 20X4 is £6 million. The business is seasonal and the profit before tax for the
six months to 31 December 20X4 is almost certain to be £10 million. Income tax is calculated as
25% of reported annual profit before tax if it does not exceed £10 million. If annual profit before
tax exceeds £10 million the tax rate on the whole amount is 30%.
Requirement
Under IAS 34 what should the taxation charge be in the interim financial statements?
Solution
The taxation charge in the interim financial statements is based upon the weighted average rate
for the year. In this case the entity's tax rate for the year is expected to be 30%. The taxation
charge in the interim financial statements will be £1.8 million.
Interactive question 6: Interim financial statements

The Alshain Company's profit before tax for the six months to 30 September 20X6 was £4 million.
However, the business is seasonal and profit before tax for the six months to 31 March 20X7 is
almost certain to be £8 million. Profit before tax equals taxable profit for this company.
Alshain operates in a country where income tax on companies is at a rate of 25% if annual profits
are below £11 million and a rate of 30% where annual profits exceed £11 million. These tax rates
apply to the entire profit for the year.
Requirement C
H
Under IAS 34, Interim Financial Reporting, what should be the income tax expense in Alshain's A
interim financial statements for the half year to 30 September 20X6? P
T
See Answer at the end of this chapter. E
R
6.6.12 Inventory valuations

Within interim reports, inventories should be valued in the same way as year-end accounts. It is
recognised, however, that it will be necessary to rely more heavily on estimates for interim
reporting than for year-end reporting.
In addition, it will normally be the case that the net realisable value of inventories should be
estimated from selling prices and related costs to complete and dispose at interim dates.
Worked example: Inventory valuations

An entity's accounting year ends on 31 December 20X4, and it is currently preparing interim
financial statements for the half year to 30 June 20X4. The price of its products tends to vary. At
30 June 20X4, it has inventories of 100,000 units, at a cost per unit of £1.40. The net realisable
value of the inventories is £1.20 per unit at 30 June 20X4. The expected net realisable value of
the inventories at 31 December 20X4 is £1.55 per unit.

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Requirement
How should the value of the inventories be reflected in the interim financial statements?
Solution
The value of the inventories in the interim financial statements at 30 June 20X4 is the lower of
cost and NRV at 30 June 20X4. This is:
100,000  £1.20 = £120,000
6.7 Use of estimates

Although accounting information must be reliable and free from material error, it may be
necessary to sacrifice some accuracy and reliability for the sake of timeliness and cost benefits.
This is particularly the case with interim financial reporting, where there will be much less time to
produce reports than at the financial year end. The standard therefore recognises that estimates
will have to be used to a greater extent in interim reporting, to assess values or even some costs,
than in year-end reporting.
An appendix to IAS 34 gives some examples of the use of estimates.
 Inventories. An entity might not need to carry out a full inventory count at the end of each
interim period. Instead, it may be sufficient to estimate inventory values using sales margins.
 Provisions. An entity might employ outside experts or consultants to advise on the
appropriate amount of a provision, as at the year end. It will probably be inappropriate to
employ an expert to make a similar assessment at each interim date. Similarly, an entity
might employ a professional valuer to revalue non-current assets at the year end, whereas
at the interim date(s) the entity will not rely on such experts.
 Income taxes. The rate of income tax (tax on profits) will be calculated at the year end by
applying the tax rate in each country/jurisdiction to the profits earned there. At the interim
stage, it may be sufficient to estimate the rate of income tax by applying the same 'blended'
estimated weighted average tax rate to the income earned in all countries/jurisdictions.
 Classification of current and non-current assets and liabilities. The investigation for
classifying assets and liabilities as current and non-current may be more thorough at annual
reporting dates than at interim ones.
 Pensions. IAS 19, Employee Benefits encourages the use of a professionally qualified
actuary in the measurement of the plan's defined benefit obligations. For interim reporting
purposes reliable estimates may be obtained by extrapolation of the latest actuarial
valuation.
 Contingencies. Normally the measurement of contingencies may involve formal reports
giving the opinions of experts. Expert opinions about contingencies and uncertainties
relating to litigation or assessments may or may not be needed at interim dates.
 Revaluations and fair value accounting. Where an entity carries assets at fair value such as
non-current assets in accordance with IAS 16, Property, Plant and Equipment or investment
properties in accordance with IAS 40, Investment Property, it may rely on independent
professional valuations at annual reporting dates, though not at interim reporting dates.
 Intercompany reconciliations. Intercompany balances that are reconciled at a detailed level
at the year end may be reconciled at a less detailed level at the interim reporting date.
 Specialised industries. Interim period measurement in specialised industries may be less
precise than at year end due to their complexity, and the cost and time investment that is
required.

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The principle of materiality applies to interim financial reporting, as it does to year-end

reporting. In assessing materiality, it needs to be recognised that interim financial reports will
rely more heavily on estimates than year-end reports. Materiality should be assessed in relation
to the interim financial statements themselves, and should be independent of 'annual
materiality' considerations.
6.8 IFRIC 10, Interim Financial Reporting and Impairment

This IFRIC, issued in 2006, addresses the apparent conflict between IAS 34 and the requirement
in other standards on the recognition and reversal in financial statements of impairment losses
on goodwill and certain financial assets.
IFRIC 10 states that any such impairment losses recognised in an interim financial statement
must not be reversed in subsequent interim or annual financial statements.
6.9 IFRS 13, amendments

IFRS 13, Fair Value Measurement amended IAS 34, requiring interim reports to make the
disclosures required by paragraphs 91–93(h), 94–96, 98 and 99 of IFRS 13, Fair Value
Measurement and paragraphs 25, 26 and 28–30 of IFRS 7, Financial Instruments: Disclosures.
Section overview
• IFRS 14, Regulatory Deferral Accounts permits entities adopting IFRS for the first time to
continue to account, with some limited changes, for 'regulatory deferral account balances'
in accordance with their previous GAAP, both on initial adoption of IFRS and in
subsequent financial statements.
• Regulatory deferral account balances, and movements in them, are presented separately
in the statement of financial position and statement of profit or loss and other
comprehensive income. Specific disclosures are required.
C
IFRS 14, Regulatory Deferral Accounts was issued in January 2014 and is effective for an entity's H
first annual IFRS financial statements for a period beginning on or after 1 January 2016. IFRS 14 A
is an interim standard, applicable to first-time adopters of IFRS that provide goods or services to P
T
customers at a price or rate that is subject to rate regulation by the Government eg, the supply
E
of gas or electricity. R
The following definitions are used in IFRS 14. 9
Definitions
Rate regulation: A framework for establishing the prices that can be charged to customers for
goods and services and that framework is subject to oversight and/or approval by a rate
regulator.
Rate regulator: An authorised body that is empowered by statute or regulation to establish the
rate or range of rates that bind an entity.
Regulatory deferral account balance: The balance of any expense (or income) account that
would not be recognised as an asset or a liability in accordance with other Standards, but that
qualifies for deferral because it is included, or is expected to be included, by the rate regulator
in establishing the rate(s) that can be charged to customers.

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7.1 Objective
The objective of IFRS 14 is to specify the financial reporting requirements for 'regulatory deferral
account balances' that arise when an entity provides goods or services to customers at a price or
rate that is subject to rate regulation.
7.2 Scope of IFRS 14

IFRS 14 is permitted, but not required, to be applied where an entity conducts rate-regulated
activities and has recognised amounts in its previous GAAP financial statements that meet the
definition of 'regulatory deferral account balances' (sometimes referred to as 'regulatory assets'
and 'regulatory liabilities').
7.3 Main issues

Rate regulation is a means of ensuring that specified costs are recovered by the supplier, and
that prices charged to customers are fair. These twin objectives mean that prices charged to
customers at a particular time do not necessarily cover the costs incurred by the supplier at that
time. In this case, the recovery of such costs is deferred and they are recognised through future
sales.
This leads to a mismatch. IFRS does not have specific requirements in respect of accounting for
this mismatch. However, established practice is that amounts are recognised in profit or loss as
they arise.
In some jurisdictions, however, local GAAP allows or requires a supplier of rate-regulated
activities to recognise costs to be recovered either as a separate regulatory deferral account or
as part of the cost of a related asset.
The IASB is currently working on a comprehensive project to address this issue, but the project
is not complete. In the meantime, IFRS 14 permits first-time adopters of IFRS to continue to
recognise amounts related to rate regulation in accordance with their previous GAAP when
they adopt IFRS. This is effected through an exemption from paragraph 11 of IAS 8, Accounting
Policies, Changes in Accounting Estimates and Errors, which generally requires an entity to
consider the requirements of IFRSs dealing with similar matters and the requirements of
the Conceptual Framework when setting its accounting policies.
An entity may change its policy for regulatory deferral accounts in accordance with IAS 8, but
only if the change makes the financial statements more relevant and reliable to users.
7.4 Presentation
The amounts of regulatory deferral account balances are separately presented in an entity's
7.5 Disclosures
Specific disclosures are required in order to enable users to assess:
 the nature of, and risks associated with, the rate regulation that establishes the price(s) the
entity can charge customers for the goods or services it provides; and
 the effects of rate regulation on the entity's financial statements.

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8 Audit focus – General issues with reporting performance
Section overview
The auditor must consider the risk of fraud in general, and the risk of creative accounting in
particular, when auditing financial performance.
ISA (UK) 200 (Revised June 2016), Overall Objectives of the Independent Auditor and the
Conduct of an Audit in Accordance with the International Standards on Auditing (UK) states the
auditor's overall objectives as follows:
 To obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are prepared, in all material
respects, in accordance with an applicable financial reporting framework
 To report on the financial statements, and communicate as required by the ISAs (UK), in
accordance with the auditor's findings (ISA 200.11)
Note that the auditor is concerned with material misstatements arising both as a result of error,
and as a result of fraud.
We looked at creative accounting, a form of fraudulent financial reporting, in Chapter 5. We will
look at the audit approach to fraud and creative accounting in more detail in Chapter 24.
Another point which is worth drawing out is the need for the auditor to report and communicate
as required by the ISAs. As ISA 200 makes clear, the auditor must fully understand and comply
with all the ISAs relevant to the audit.
9 Audit focus – specific issues
Section overview
This section looks at some of the audit issues related to certain financial reporting treatments
covered earlier in this chapter.
C
H
9.1 Presentation and disclosure of segment information A
P
ISA (UK) 501, Audit evidence – Specific Considerations for Selected Items governs the auditor's T
approach to auditing segment information. E
R
Auditors are required to obtain sufficient, appropriate audit evidence regarding the
presentation and disclosure of segment information by: 9
(a) obtaining an understanding of the methods used by management in determining segment

information:
(i) evaluating whether such methods are likely to result in disclosure in accordance with
the applicable financial reporting framework,
(ii) where appropriate, testing the application of such methods; and
(b) performing analytical procedures or other audit procedures appropriate in the
circumstances. (ISA 501.13)
When the ISA talks about obtaining an understanding of management's methods, the following
may be relevant:
 Sales, transfers and charges between segments, elimination of inter-segment amounts
 Comparisons with budgets and other expected results; for example, operating profits as a
percentage of sales

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 Allocations of assets and costs

 Consistency with prior periods, and the adequacy of the disclosures with respect to
inconsistencies
It is important to stress that auditors only have a responsibility in relation to the financial
statements taken as a whole. Auditors are not required to express an opinion on the segment
information presented on a standalone basis.
9.2 Held for sale assets

As we have seen above, 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, that held for sale assets
are classified separately on the statement of financial position and the results of discontinued
operations are presented separately on the statement of profit or loss and other comprehensive
income.
Audit procedures to ensure assets meet the criteria include the following:
 Inquiries/written representations from management concerning intentions
 Reviewing minutes of management for evidence of firm plan to sell
 Ascertaining whether appropriate estate agent appointed (by reviewing contract between the
parties)
 Reviewing sale particulars
 Comparison of sale price per sale particulars to fair value
 Asking estate agent of likelihood of completion within a year
Interactive question 7: Audit procedures – held for sale assets

Robinson Ltd has a balance of £250,000 in respect of assets classified as held for sale in the
financial statements for the year ended 31 December 20X7. This is in respect of two assets as
follows:
 £70,000 relates to production machinery used for a product which is to be withdrawn.
Production will be run down until the end of January 20X8 so that outstanding orders can
be completed. The plant will then be serviced and uninstalled in early February.
 £180,000 relates to a piece of land which was classified as held for sale on 1 October. (You
should assume that the IFRS 5 criteria are satisfied.) On this date the land's fair value was
estimated to be £210,000 with costs to advertise the asset as being available for sale
estimated at £6,000. The £180,000 represents the carrying value of the land on the basis
that it is lower than fair value less costs to sell. Robinson Ltd has adopted a revaluation
policy for land.
Requirements
Do the following for each of the above assets:
(a) Identify the key audit issue
(b) State the audit procedures which would be performed to address this issue
9.3 Related parties

Related parties are often involved in cases of fraudulent financial reporting, as highlighted in many
major corporate scandals. Transactions with related parties provide scope for distorting financial
information in financial statements and hiding the economic substance of transactions or fraud in
companies.

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The overall aim of ISA (UK) 550, Related Parties is to enhance the auditor's consideration of related
parties and related party transactions with a focus on risk assessment, including the recognition of
fraud risk factors. The auditor must establish an approach that requires the auditor to assess the risks
of misstatement and design audit procedures to address these. In particular, the ISA includes the
following:
 Clearer responsibilities for the auditor, with a distinction being made between
circumstances where the accounting framework includes disclosure and other reporting
requirements for related parties, and circumstances where either there are no such
requirements or they are inadequate
 Clearer distinction between the risk assessment procedures and the further audit
procedures
 A definition of a related party, which is to be used as a minimum level for audit purposes
where the applicable financial reporting framework establishes minimal or no related party
requirements
9.4 Related parties: key issues

Readers of financial statements normally assume that transactions reflected in financial
statements are made with independent parties unless told otherwise.
Readers will also normally assume that a company is owned by a number of shareholders and is
not subject to control or significant influence by any one person or company unless told
otherwise, eg, through disclosure of the identity of the parent company and significant
shareholdings disclosure.
Where a company does business with 'related parties', for instance with shareholders or
directors, these assumptions may not be valid.
9.5 The audit of related parties

9.5.1 Scope
ISA 550 provides guidance on the auditor's responsibilities, and audit procedures regarding
related parties and transactions with such parties. C
H
ISA 550 is applicable whether or not IAS 24, Related Party Disclosures is a requirement of the A
reporting framework for the entity concerned. ISA 550, therefore, applies to private companies P
T
in the UK as well as listed companies. ISA 550 provides the following definition. E
R
Definition 9
Related party: A party that is either:

(a) a related party as defined in the applicable financial reporting framework; or
(b) where the applicable financial reporting framework establishes minimal or no related party
requirements:
(1) a person or other entity that has control or significant influence, directly or indirectly
through one or more intermediaries, over the reporting entity;
(2) another entity over which the reporting entity has control or significant influence,
directly or indirectly through one or more intermediaries; or
(3) another entity that is under common control with the reporting entity through having:
 common controlling ownership;
 owners who are close family members; or
 common key management.

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However, entities that are under common control by a state (ie, a national, regional or local
government) are not considered related unless they engage in significant transactions or share
resources to a significant extent with one another.
9.5.2 Responsibilities
Management is responsible for the identification of related parties and the disclosure of
transactions with such parties. Management should set up appropriate internal controls to
ensure that related parties are identified and disclosed along with any related party transactions.
It may not be self-evident to management whether a party is related. Furthermore, many
accounting systems are not designed to either distinguish or summarise related party
transactions, so management will have to carry out additional analysis of accounting information.
The auditor has a responsibility to perform audit procedures to identify, assess and respond to
the risks of material misstatement arising from the entity's failure to appropriately account for or
disclose related party relationships, transactions or balances.
9.5.3 Risks
The following audit risks may arise from a failure to identify a related party.
 Failure of the financial statements to comply with IAS 24.
 There may be a misstatement in the financial statements – transactions may be on a non
arm's length basis and thus may result in assets, liabilities, profit or loss being overstated or
understated. For example, special tax rates may apply to profits reported on sales to related
parties.
 The reliance on a source of audit evidence may be misjudged. An auditor may rely on what
is perceived to be third-party evidence when in fact it is from a related party. More
generally, reliance on management assurances may be affected if the auditor were made
aware of non-disclosure of a related party.
 The motivations of related parties may be outside normal business motivations and thus
may be misunderstood by the auditor if there is non-disclosure. In the extreme, this may
amount to fraud.
The inherent risk linked to related party transactions (RPT) can be high, especially where
management is unaware of the existence of all the related party relationships or transactions, or
where there is an opportunity for collusion, concealment or manipulation by management.
There is an increased risk that the auditor may fail to detect a RPT, where:
 there has been no charge made for a RPT (ie, a zero cost transaction);
 disclosure would be sensitive for directors or have adverse consequences for the company;
 the company has no formal system for detecting RPTs;
 RPTs are with a party that the auditor could not reasonably expect to know is a related
party;
 RPTs from an earlier period have remained as an unsettled balance;
 management have concealed, or failed to disclose fully, related parties or transactions with
such parties; and
 the corporate structure is complex.
Point to note:
The term 'arm's length' continues to be used in the context of IAS 24 even though it has been
removed from the definition of fair value in IFRS 13.

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9.5.4 Risk assessment procedures

In planning the audit, the auditor needs to consider the risk of undisclosed related party
transactions. This is a difficult area because IAS 24 does not have consideration for materiality.
Thus, even small RPTs should be disclosed by a company. Indeed, related party relationships
where there is control (eg, a subsidiary) need to be disclosed even where there are no
transactions with this party.
The auditor needs to perform the following procedures:
(a) The engagement team shall discuss the risks of fraud-related misstatements.
Matters to be addressed would include the importance of maintaining professional
scepticism and circumstances which may indicate the existence of related party
relationships or transactions that management has not identified.
(b) Make inquiries of management about the identities of related parties and any RPTs.
This includes:
(1) the identity of related parties, including changes from prior period;
(2) the nature of the relationships between the entity and its related parties;
(3) whether any transactions occurred between the parties and, if so;
(4) what controls the entity has to identify, account for and disclose related party
relationships and transactions;
(5) what controls the entity has to authorise and approve significant transactions and
arrangements with related parties; and
(6) what controls the entity has to authorise and approve significant transactions and
arrangements outside the normal course of business.
(c) Obtain an understanding of controls established to identify, account for and disclose RPTs
and to authorise and approve significant transactions with related parties / outside the
normal course of business.
C
Where controls are ineffective or non-existent, the auditor may be unable to obtain H
sufficient, appropriate audit evidence and will need to consider the impact of this on the A
audit opinion. P
T
The auditor is also required to be alert for related party information when reviewing records or E
R
documents. In particular, the auditor must inspect bank and legal confirmations and minutes of
meetings of the shareholders and those charged with governance. Where these procedures 9
reveal significant transactions outside the entity's normal course of business, the auditor must
inquire of management about the nature of these transactions and whether a related party could
be involved.
9.5.5 Responses to the risks of material misstatement

In accordance with ISA 330, the auditor must design and perform further audit procedures
to obtain sufficient, appropriate evidence about the assessed risks of material misstatement.
These may include:
 confirming or discussing the transactions with intermediaries eg, banks, lawyers or agents;
 confirming the purposes, specific terms or amounts of the transaction with the related
party; and
 reading the financial statements of the related party for evidence of the transaction in the
related party's accounting records.

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Where the risk of misstatement may be due to fraud additional procedures may apply:
 Inquiries of and discussion with management and those charged with governance
 Inquiries of the related party
 Inspection of significant contracts with the related party
 Background research eg, internet
 Review of employee whistleblowing reports
Identification of previously unidentified or undisclosed related parties or significant related
party transactions
If the auditor identifies related parties or significant related party transactions that management
has not previously identified or disclosed to the auditor, the auditor must do the following:
 Promptly communicate the relevant information to the other members of the engagement
team
 Where the applicable reporting framework establishes related party requirements request
management to identify all transactions with the newly identified related parties and inquire
as to why the entity's controls have failed to identify and disclose the transaction
 Perform appropriate substantive audit procedures
These might include making inquiries regarding the nature of the entity's relationships with
the newly identified related party, conducting an analysis of accounting records for
transactions with the newly identified related party and verifying the terms and conditions
of the newly identified related party transaction
 Reconsider the risk that other unidentified related parties or significant related party
transactions may exist
 If the non-disclosure by management appears intentional and therefore indicates possible
fraud evaluate the implications for the rest of the audit
Identified significant related party transactions outside the entity's normal course of business
Where significant related party transactions outside the entity's normal course of business are
identified, the auditor must do the following:
 Inspect the underlying contracts and agreements and evaluate whether:
– the business rationale or lack of suggests fraud;
– the terms are consistent with the management's explanations; and
– the transaction has been appropriately accounted for and disclosed.
 Obtain audit evidence that transactions have been appropriately authorised and approved
Management assertions
If management has made assertions in the financial statements to the effect that a related party
transaction was conducted on terms equivalent to those prevailing in an arm's length
transaction, the auditor must obtain evidence to support this. The nature of the evidence
obtained will depend on the support management has obtained to substantiate their claim but
may involve:
 considering the appropriateness of management's process for supporting the assertion;
 verifying the source of internal and external data supporting the assertion and testing it for
accuracy, completeness and relevance; and
 evaluating the reasonableness of any significant assumptions on which the assertion is
based.

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9.5.6 Evaluation of accounting and disclosure

The auditor is required to evaluate whether related parties and related party transactions have
been properly accounted for and disclosed and do not prevent the financial statements from
achieving fair presentation.
9.5.7 Written representations

The auditor is required to obtain written representations from management and, where
appropriate, those charged with governance that all related parties and related party
transactions have been disclosed to the auditor and that these have been appropriately
accounted for and disclosed.
In the UK, an entity may require its management and those charged with governance to sign
individual declarations in relation to related party matters. It may be helpful if any such
declarations are addressed jointly to a designated official of the entity and also to the auditor.
9.5.8 Documentation
The auditor is required to include in the audit documentation the identity of related parties and
the nature of related party relationships.
Note: The law regarding transactions with directors was covered in Chapter 1 of this Study Manual.
9.6 Related parties: practical application

The ICAEW Audit faculty has produced guidance in its publication The Audit of Related Parties in
Practice. This proposes a five point action plan as follows:
 Plan your work on the audit of related party relationships and transactions thoroughly.
 Focus on the risk of material misstatement that might arise from related party transactions.
 Understand the internal controls at the company to identify related parties and to record
related party transactions.
 Design procedures to respond to risks identified.
 Perform completion procedures.
C
9.6.1 Identifying undisclosed related parties H
A
It is often difficult to identify related party relationships and transactions which should have been P
T
disclosed, but are not. E
R
ISA 550 points out that the existence of the following relationships may indicate the presence of
control or significant influence: 9
(a) Direct or indirect equity holdings or other financial interests in the entity
(b) The entity's holdings of direct or indirect equity or other financial interests in other entities
(c) Being part of those charged with governance or key management (that is, those members
of management who have the authority and responsibility for planning, directing and
controlling the activities of the entity)
(d) Being a close family member of any person referred to in subparagraph (c)
(e) Having a significant business relationship with any person referred to in subparagraph (c)
The related parties described in subparagraph (c) above, and by extension those described in
(d) and (e), are often the hardest to identify. While entities related through equity interest should
be fairly clearly documented, auditors frequently struggle to identify related party transactions
established through connected persons.

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The following risk assessment procedures are relevant when testing for the existence of
undisclosed related parties:
 Enquire of management and the directors as to whether transactions have taken place with
related parties that are required to be disclosed by the disclosure requirements that are
applicable to the entity
 Review prior year working papers for names of known related parties
 Review minutes of meetings of shareholders and directors and other relevant statutory
records, such as the register of directors' interests
 Review accounting records for large or unusual transactions or balances, in particular
transactions recognised at or near the end of the financial period
 Review confirmations of loans receivable and payable and confirmations from banks. Such
a review may indicate the relationship, if any, of guarantors to the entity
 Review investment transactions, for example purchase or sale of an interest in a joint
venture or other entity
 Enquire as to the names of all pension and other trusts established for the benefit of
employees and the names of their management and trustees
 Enquire as to the affiliation of directors and officers with other entities
 Review the register of interests in shares to determine the names of principal shareholders
 Enquire of other auditors currently involved in the audit, or predecessor auditors, as to their
knowledge of additional related parties
 Review the entity's tax returns, returns made under statute and other information supplied
to regulatory agencies for evidence of the existence of related parties
 Review invoices and correspondence from lawyers for indications of the existence of
related parties or related party transactions
9.7 First-time adoption of IFRS

Companies adopting IFRS for the first time are required to produce comparative financial
statements, restating prior period figures in accordance with IFRS.
Auditing the financial statements of a company adopting IFRS for the first time poses a special
challenge to the auditor, as set out in ISA (UK) 710, Comparative Information: Corresponding
Figures and Comparative Financial Statements. We have discussed the auditing of comparatives
in detail in Chapter 8.
9.7.1 Scope of the audit

Comparative financial statements refer to a full set of financial statements for the prior period,
included in the current period's annual report. This differs from corresponding figures, where
prior period figures are set out next to current period figures in a set of financial statements for
comparison.
While the auditor does not express an opinion on corresponding figures, where comparative
financial statements are issued, the auditor is required to express an opinion on both the
restated prior period and the current period.

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9.7.2 Audit procedures

ISA 710 requires the auditor to evaluate:
 Whether the comparative information agrees with the amounts and other disclosures
presented in the prior period or, when appropriate, have been restated; and
 Whether the accounting policies reflected in the comparative information are consistent
with those applied in the current period or, if there have been changes in accounting
policies, whether those changes have been properly accounted for and adequately
presented and disclosed.
If the auditor identifies any possible misstatement, they should carry out additional audit
procedures to obtain sufficient, appropriate audit evidence about whether a material
misstatement actually exists.
In addition, auditors must obtain written representations for all the periods referred to in the
auditor's report. This means that written representations must be obtained for the restated
period, as well as the current period.
9.7.3 Audit reporting

ISA 710 states that 'the auditor's opinion shall refer to each period for which the financial
statements are presented'.
It is possible for different audit opinions to be expressed for each period. Where a modified
audit opinion is given for the restated period, an Other Matter paragraph should be included,
explaining the reason for the modification.
C
H
A
P
T
E
R

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Summary
IAS 1, Presentation
of Financial
Statements
Statement of Present SFP at start of previous period

financial position where prior period adjustment
Statement of profit Profit for period

or loss and other
comprehensive income Other comprehensive income
Statement of
cash flows
Statement of
Transactions with owners
changes in equity

ICAEW 2019
• Change in accounting Corporate
policies (retrospective) governance
• Change in estimate Accounting
policies, estimates Reporting performance Other
(prospective) and errors (IAS 8) Directors'
• Prior period errors report
(retrospective)
IFRS 5 Non-current Segment reporting Related parties IFRS for

assets held for sale (IFRS 8) (IAS 24) SMEs
and discontinued
operations
Related party Related party
Operating segments relationship transactions
Non-current assets Discontinued
held for sale operations
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Reportable Aggregated Substance Zero Artificial Arm's

segments segments over form price price length
Classification • Statement of
profit and loss Control Influence Management Other
Profits, assets
• Statement of
Measurement and liabilities
cash flows
• Statement of UK: Only material
Disclosure related party
financial position transactions disclosed
• External revenue

• Geographical
information
Reconciliation
Disclosure
Reporting financial performance

533
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9
E
P
R
C
A
H
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Interim Financial Reporting

IAS 34
Minimum Minimum
requirements disclosure
Condensed Where relevant Impact of any

statement of how performance is changes in
financial position affected by seasonality accounting policies
Condensed Changes in debt or Statement that

statement of profit or equity from new accounting policies
loss and other issues, repurchases or followed are
comprehensive income repayments consistent with
latest full financial
statements
Nature and effect
Condensed statement
of any material
of changes in equity
changes in estimates
Changes in contingent
liabilities or contingent
Condensed An update of segmental assets since last
statement information reporting date
of cash flows
Any changes in the

composition of the Dividends paid
entity for each class of share
Material events after

the reporting period Any unusual items

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Self-test
IAS 1, Presentation of Financial Statements
1 AZ
AZ is a quoted manufacturing company. Its finished products are stored in a nearby
warehouse until ordered by customers. AZ has performed very well in the past, but has
been in financial difficulties in recent months and has been reorganising the business to
improve performance.
The trial balance for AZ at 31 March 20X3 was as follows:
$'000 $'000
Sales 124,900
Cost of goods manufactured in the year to
31 March 20X3 (excluding depreciation) 94,000
Distribution costs 9,060
Administrative expenses 16,020
Restructuring costs 121
Interest received 1,200
Loan note interest paid 639
Land and buildings (including land $20,000,000) 50,300
Plant and equipment 3,720
Accumulated depreciation at 31 March 20X2:
Buildings 6,060
Plant and equipment 1,670
Investment properties (at market value) 24,000
Inventories at 31 March 20X2 4,852
Trade receivables 9,330
Bank and cash 1,190
Ordinary shares of $1 each, fully paid 20,000
Share premium 430
Revaluation surplus 3,125
Retained earnings at 31 March 20X2 28,077
Ordinary dividends paid 1,000
7% loan notes 20X7 18,250 C
Trade payables 8,120 H
A
Proceeds of share issue 2,400 P
214,232 214,232 T
Additional information provided: E
R
(1) The property, plant and equipment are being depreciated as follows:
9
Buildings 5% per annum straight line.
Plant and equipment 25% per annum reducing balance.
Depreciation of buildings is considered an administrative cost while depreciation of
plant and equipment should be treated as a cost of sale.
(2) On 31 March 20X3 the land was revalued to $24,000,000.
(3) Income tax for the year to 31 March 20X3 is estimated at $976,000. Ignore deferred
tax.
(4) The closing inventories at 31 March 20X3 were $5,180,000. An inspection of finished
goods found that a production machine had been set up incorrectly and that several
production batches, which had cost $50,000 to manufacture, had the wrong
packaging. The goods cannot be sold in this condition but could be repacked at an
additional cost of $20,000. They could then be sold for $55,000. The wrongly
packaged goods were included in closing inventories at their cost of $50,000.

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(5) The 7% loan notes are 10-year loans due for repayment by 31 March 20X7. Interest on
these loan notes needs to be accrued for the six months to 31 March 20X3.
(6) The restructuring costs in the trial balance represent the cost of a major restructuring of
the company to improve competitiveness and future profitability.
(7) No fair value adjustments were necessary to the investment properties during the
period.
(8) During the year the company issued 2 million new ordinary shares for cash at $1.20 per
share. The proceeds have been recorded as 'Proceeds of share issue'.
Requirement
Prepare the statement of profit or loss and other comprehensive income and statement of
changes in equity for AZ for the year to 31 March 20X3 and a statement of financial position
at that date.
Notes to the financial statements are not required, but all workings must be clearly shown.
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations
2 Viscum
The Viscum Company accounts for non-current assets using the cost model.
On 25 April 20X6 Viscum classified a non-current asset as held for sale in accordance with
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations. At that date the
asset's carrying amount was £30,000, its fair value was estimated at £22,000 and the costs
to sell at £3,000.
On 15 May 20X6 the asset was sold for net proceeds of £18,400.
Requirement
In accordance with IFRS 5, what amount should be included as an impairment loss in
Viscum's financial statements for the year ended 30 June 20X6?
3 Reavley
The Reavley Company accounts for non-current assets using the cost model.
On 20 July 20X6 Reavley classified a non-current asset as held for sale in accordance with
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations. At that date the
asset's carrying amount was £19,500, its fair value was estimated at £26,500 and the costs
to sell at £1,950.
The asset was sold on 18 October 20X6 for £26,000.
Requirement
In accordance with IFRS 5, at what amount should the asset be stated in Reavley's statement
of financial position at 30 September 20X6?
4 Smicek
The Smicek Company classified an asset as being held for sale on 31 December 20X6. The
asset had been purchased for a cost of £1.2 million on 1 January 20X4, and then had a
12-year useful life. On 31 December 20X6 its carrying amount was £900,000, its fair value
was £860,000 and the expected sale costs were £20,000.
On 31 December 20X7 the board of Smicek, having failed to sell the asset during 20X7,
decided to reverse their original decision and therefore use the asset in the business. At
31 December 20X7 the asset had a fair value of £810,000 and expected sale costs of
£20,000. The directors estimate that annual cash flows relating to the asset would be
£200,000 per year for the next 6 years. The effect of discounting is not material.

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Requirement
What is the effect on profit or loss of Smicek's ceasing to classify the asset as held for sale,
according to IFRS 5, Non-current Assets Held for Sale and Discontinued Operations?
5 Ndombe
The Ndombe Company classified a group of assets as held for sale on 31 December 20X6.
Their fair value less costs to sell was £1,180,000.
During 20X7 the company decided that one of the assets, a polishing machine, should no
longer be treated as an asset held for sale. The sale of the other assets was delayed due to
events beyond the control of Ndombe and the company remains committed to their sale,
which is highly probable in 20X8.
Asset values and dates are as follows:
Polishing
machine Other assets
£ £
Cost at 1 January 20X5 400,000 1,500,000
Accumulated depreciation to 31 December 20X6 (160,000) (600,000)
Carrying amount on 31 December 20X6 240,000 900,000
Useful life 5 years 5 years
Fair value less costs to sell 31 December 20X6 210,000 970,000
Fair value less costs to sell 31 December 20X7 190,000 880,000
Value in use at 31 December 20X7 170,000 810,000
Requirement
Under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations what are the
amounts that should be shown under assets on the statement of financial position at
31 December 20X6 and 31 December 20X7?
6 Sapajou
The Sapajou Company bought a property with a useful life of 10 years for £1,200,000 on
1 January 20X4.
On 1 July 20X6 the board of Sapajou made a decision to sell the property, and immediately C
vacated it and advertised it for sale. At this date fair value less costs to sell was estimated at H
£880,000. Negotiations with a buyer appeared successful, and a sale was provisionally A
P
agreed for 1 August 20X7 for £880,000. At the last minute the buyer withdrew and Sapajou
T
had to readvertise the property. E
R
A new buyer was found in November 20X7 and a new price was agreed at fair value less
costs to sell of £995,000. The sale is scheduled to take place in February 20X8. 9
Requirement
What are the amounts that should be included in profit or loss for the years ending
31 December 20X6 and 31 December 20X7?
IAS 24, Related Party Disclosures
7 Sulafat
The Sulafat Company has a 70% subsidiary Vurta and is a venturer in Piton, a joint venture
company. During the financial year to 31 December 20X6, Sulafat sold goods to both
companies.
Consolidated financial statements are prepared combining the financial statements of
Sulafat and Vurta.

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Requirement
Which transactions should be disclosed under IAS 24, Related Party Disclosures, in the
separate financial statements of Sulafat for 20X6?
8 Phlegra
In the year ended 31 December 20X7, the Phlegra Company undertook transactions with
the following entities to the value stated.
(a) The Nereidum Company, one of whose non-executive directors is an executive director
of Phlegra: £300,000.
(b) The Chub Company, which sources 100% of its raw materials requirements from
Phlegra: £190,000.
Requirement
Under IAS 24, Related Party Disclosures, what is the total amount to be disclosed in respect
of transactions with related parties in Phlegra's financial statements for the year ended
31 December 20X7?
9 Mareotis
The Mareotis Company is a partly owned subsidiary of the Bourne Company. In the year
ended 31 December 20X7 Mareotis undertook transactions with the following entities to
the value stated.
(a) The Hayles Company, in which the Wrasse Company holds 55% of the equity. Bourne
holds 40% of the equity of Wrasse and has the power to appoint 3 out of the 5 members
of Wrasse's board of directors: £300,000.
(b) The Galaxius Company, which is controlled by Danielle (the aunt of Agnes, a member
of Mareotis's board of directors): £500,000.
Requirement
Under IAS 24, Related Party Disclosures, what is the total amount of transactions with
related parties to be disclosed in Mareotis's financial statements for the year ended 31
December 20X7?
IAS 34, Interim Financial Reporting

10 Anteater
The Anteater Company operates a saleroom in a city centre from premises which it leases
from the Moreno Company under an operating lease according to IAS 17, Leases.
Anteater's accounting year end is 31 December each year and it is currently preparing half-
yearly interim financial statements for the six months to 30 June 20X7.
The lease agreement on the store premises contains a clause for contingent lease payments
as follows:
"If the revenue of Anteater in any year to 31 December exceeds £123 million then an
additional lease rental of £4.2 million becomes payable in respect of that year to Moreno on
31 March of the following year."
Anteater's business is seasonal due to high sales around the Christmas period. Only about
one-third of annual sales are normally earned in the first six months of the year. In January
20X7 a refurbishment of the premises was carried out and this is attracting more customers
than had been budgeted for.

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Relevant information is as follows:

£m
Budgeted sales for the six months to 30 June 20X7 39
Budgeted sales for the year to 31 December 20X7 117
Actual sales for the six months to 30 June 20X7 49
The budgets were set in December 20X6 and have not been changed.
Requirement
According to IAS 34, Interim Financial Reporting, what amount should be recognised in
profit or loss for Anteater for the six months to 30 June 20X7 in respect of the contingent
lease payment clause?
11 Marmoset
The Marmoset Company offers the service of transport consultations. Its accounting year
ends on 31 December each year and it is currently preparing half-yearly interim financial
statements for the six months to 30 June 20X7.
During 20X7 the directors drew up a plan to introduce a new bonus scheme for all junior
consultants in order to provide incentives and improve retention. The details of the scheme
were announced to employees the day before the interim financial statements were
released on 15 August 20X7. Under the planned scheme any bonus would be paid on
31 March 20X8.
The bonus will be equal to 1% of profit before tax (calculated before recognising the bonus)
of the year ended 31 December 20X7.
The business is seasonal such that 60% of the annual profit before tax is earned in the first
six months of the year. The profit before tax in the interim financial statements for the six
months to 30 June 20X7 is £6 million.
Requirement
What amount should be recognised in profit or loss for Marmoset for the six months to
30 June 20X7 in respect of the bonus, according to IAS 34, Interim Financial Reporting?
12 Aconcagua
C
The Aconcagua Company sells fashion shoes, the price of which varies during the year. Its H
accounting year ends on 31 December and it prepares half-yearly interim financial A
statements. P
T
At 30 June 20X7 it has inventories of 2,000 units which cost £30 each. The net realisable E
R
value of the inventories at 30 June, when the shoes are out of season, is £20 each. No sales
are expected in the period to 31 December 20X7, but the expected net realisable value of 9
the shoes at that date (when they are about to come back into season) is £28 each.
Requirement
Should any changes in inventory values be reflected in the interim financial statements of
Aconcagua for the six months ending 30 June 20X7 and for the six months ending
31 December 20X7, according to IAS 34, Interim Financial Reporting?

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Technical reference
 Applies to all general purpose financial statements
 Links back to much in the IASB Framework
 Presentation and disclosure rules apply only to material items IAS 1.31 and IAS 1.7
 Statement of financial position IAS 1.54, 56, 60, 66,
69, 79

 Requires an entity to report its operating segments based on the IFRS 8 Paragraph
data reported internally to management. Geographical disclosures 20–22
of external revenue and non-current assets are also required.
 The minimum disclosure is of profit/loss by segment.
 Geographical disclosures of external revenue and non-current
assets are also required.
3 IFRS 5, Non-current Assets Held for Sale and Discontinued

Operations
4 Discontinued operations
 Definition IFRS 5.31–32
 Disclosures on the face of the statement of profit or loss and other IFRS 5.33(a)
comprehensive income:
– A single amount comprising the total of:
– The post-tax profit or loss of discontinued operations, and
– The post-tax gain or loss recognised on related assets
 Disclosures on the face or in the notes IFRS 5.33(b) (c)
– An analysis of the single amount on the face
 Comparative figures must be restated IFRS 5.34
 Narrative disclosures are also required IFRS 5.41

 Definition of a related party and related party transaction IAS 24.9
 Exclusions from definition of related party IAS 24.11
 Disclosures IAS 24.12,16,17,18
6 IFRS 1, First-time Adoption of International Financial Reporting

Standards
 Opening IFRS SOFP IFRS 1.6
 Accounting policies IFRS 1.7–12
 Estimates IFRS 1.23-33
 Transition process IFRS 1 App C,D
 Exemptions IFRS 1.20–33
 Disclosure

lOMoARcPSD|5054551

 Minimum components of an interim financial report IAS 34.8
 Form and content of interim financial statements IAS 34.9–11
 Selected explanatory notes IAS 34.16
 Disclosure of compliance with IFRSs IAS 34.19
 Periods for which interim financial statements are required to be IAS 34.20
presented
 Materiality IAS 34.23
8 Disclosure in annual financial statements

 If an estimate of an amount reported in an interim period is changed IAS 34.26
significantly during the final interim period of the financial year but a
separate financial report is not published for that final interim
period, the nature and amount of that change in estimate shall be
disclosed in a note to the annual financial statements for that
financial year.
9 Recognition and measurement

 An entity should apply the same accounting policies in its interim IAS 34.28
financial statements as are applied in its annual financial statements,
except for accounting policy changes made after the date of the
most recent annual financial statements that are to be reflected in
the next annual financial statements. However, the frequency of an
entity's reporting (annual, half-yearly, or quarterly) should not affect
the measurement of its annual results. To achieve that objective,
measurements for interim reporting purposes should be made on a
year-to-date basis.
10 Revenues received seasonally, cyclically, or occasionally

 Revenues that are received seasonally, cyclically, or occasionally IAS 34.37
C
within a financial year shall not be anticipated or deferred as of an
H
interim date if anticipation or deferral would not be appropriate at A
the end of the entity's financial year. P
T
11 Costs incurred unevenly during the financial year E
R
 Costs that are incurred unevenly during an entity's financial year IAS 34.39
9
shall be anticipated or deferred for interim reporting purposes if,
and only if, it is also appropriate to anticipate or defer that type of
cost at the end of the financial year.
 Applying the recognition and measurement principles IAS 34.40
 Use of estimates IAS 34.41
 Restatement of previously reported interim periods IAS 34.43

lOMoARcPSD|5054551

 Specifies the financial reporting requirements for 'regulatory IFRS 14.1
deferral account balances' that arise when an entity provides goods
or services to customers at a price or rate that is subject to rate
regulation.
 Eligible entities can continue to apply the accounting policies used IFRS 14.11
for regulatory deferral account balances under the basis of
accounting used immediately before adopting IFRS ('previous
GAAP') when applying IFRSs, subject to the presentation
requirements of IFRS 14.
 The impact must be presented separately. IFRS 14.20
 Specific disclosures are required. IFRS 14.27
13 ISA 501
 Audit of segment information ISA 501.13
14 ISA 550
 Definition of related parties ISA 550.10
 Auditor's responsibilities in relation to related parties ISA 550.3–7
 Audit procedures in respect of related parties ISA 550.11–28
15 ISA 710
 Audit procedures in respect of comparative financial statements ISA 710.7–9
 Audit reporting in respect of comparative financial statements ISA 710.10–19

lOMoARcPSD|5054551

IFRS 8, Operating Segments states that an operating segment is separately reportable if it has
been identified as a separate operating segment meeting the operating segment definition,
and:
 its reported revenue is 10% or more of the combined revenue (external and internal) of all
operating segments, or
 the absolute amount of its reported profit or loss is 10% or more of the greater of the
combined profit of all operating segments that did not report a loss and the combined
reported loss of all operating segments that reported a loss, or
 its assets are 10% or more of the combined assets of all operating segments.
Revenue as % of Profit or loss as % of
total revenue profit of all segments Assets as % of total
(£238m) in profit (£29m) assets (£336m)
Chemicals * 33.6% 48.3% 32.4%
Pharmaceuticals
wholesale 28.2% 31.0% 31.0%
Pharmaceuticals retail 9.2% 6.9% 8.9%
Cosmetics 6.3% 6.9% 5.4%
Hair care 5.0% 13.8% 6.3%
Body care 17.6% 20.7% 16.1%
* The chemicals segments are aggregated due to their similar economic characteristics
At 31 December 20X5 four of the six operating segments are reportable operating segments:
Chemicals
All size criteria are met.
C
Pharmaceuticals wholesale
H
All size criteria are met. A
P
Pharmaceuticals retail T
E
The Pharmaceuticals retail segment is not separately reportable, as it does not meet the R
quantitative thresholds. It can, however, still be reported as a separate operating segment if 9
management believes that information about the segment would be useful to users of the
financial statements. Alternatively, the group could consider amalgamating it with the
Pharmaceuticals wholesale segment, providing the two operating segments have similar
economic characteristics and share a majority of the 'aggregation' criteria which, excluding the
type of customer, may be the case. Otherwise it would be disclosed in an 'All other segments'
column.
Cosmetics
The Cosmetics segment does not meet the quantitative thresholds and therefore is not
separately reportable. It can also be reported separately if management believes the
information would be useful to users. Alternatively the group may be able to amalgamate it with
the Body care segment, providing the operating segments have similar economic characteristics
and share a majority of the 'aggregation' criteria. Otherwise it would also be disclosed in an 'All
other segments' column.

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Hair care
The Hair care segment is separately reported due to its profitability being greater than 10% of
total segments in profit.
Body care
All size criteria are met.
Note: IFRS 8.15 states that at least 75% of total external revenue must be reported by operating
segments. This condition has been met, as the reportable segments account for 82% of total
external revenue (158/192).

The facility will not be transferred until the backlog of orders is completed; this demonstrates
that the facility is not available for immediate sale in its present condition. The facility cannot be
classified as 'held for sale' at 31 December 20X3. It must be treated in the same way as other
items of property, plant and equipment: it should continue to be depreciated and should not be
separately disclosed.

Because the steel works is being closed, rather than sold, it cannot be classified as 'held for sale'.
In addition, the steel works is not a discontinued operation. Although at 31 December 20X3 the
group was firmly committed to the closure, this has not yet taken place and therefore the steel
works must be included in continuing operations. Information about the planned closure could
be disclosed in the notes to the financial statements.

In its financial statements S must disclose all benefits provided in exchange for services
rendered to S (but not those rendered to P), whether they are provided by S, by P, or on behalf
of S (as are the pension benefits and the share options). All the amounts listed should be
disclosed by S, with the exception of the £20,000 payable in respect of services rendered to P.

(a) Europa's first IFRS financial statements will be for the year ended 31 December 20X8. IFRS 1
requires that at least one year's comparative figures are presented and therefore the date
of transition to IFRSs is the beginning of business on 1 January 20X7 (or close of business
on 31 December 20X6).
Therefore the procedure for adopting IFRSs is:
 Identify accounting policies that comply with IFRSs effective at 31 December 20X8 (the
reporting date for the first IFRS financial statements).
 Restate the opening statement of financial position at 1 January 20X7 (the date of
transition) using these IFRSs retrospectively, by:
– Recognising all assets and liabilities whose recognition is required by IFRSs
– Not recognising items as assets or liabilities if IFRSs do not permit such
recognition
– Reclassifying items that were recognised under previous GAAP as one type of
asset, liability or component of equity, but are a different type of asset, liability or
component of equity under IFRSs
– Measuring all recognised assets and liabilities in accordance with IFRSs

lOMoARcPSD|5054551
The company will almost certainly need to change some of its accounting policies and
to adjust some of the amounts that it reported previously at the same dates using
previous GAAP. It should recognise these adjustments directly in retained earnings (ie,
in equity).
 Explain the effect of the transition from previous GAAP to IFRSs, by presenting:
– A reconciliation of equity reported under previous GAAP to equity under IFRSs at
the date of transition and at the latest previous GAAP reporting date
– A reconciliation of the profit or loss reported under previous GAAP to profit or loss
reported under IFRSs for the last period presented under previous GAAP
If Europa presented a statement of cash flows under previous GAAP, it should also explain
any material adjustments to the statement of cash flows.
Although the general rule is that all IFRSs should be applied retrospectively, a number of
exemptions are available. These are intended to cover cases in which the cost of complying
fully with a particular requirement would outweigh the benefits to users of the financial
statements. Europa may choose to take advantage of any or all of the exemptions.
(b) Changing from previous GAAP to IFRSs is likely to be a complex process and should be
carefully planned. Although previous GAAP and IAS/IFRS may follow broadly the same
principles, there are still likely to be many important differences in the detailed
requirements of individual standards.
If Europa has foreign subsidiaries outside Molvania it will need to ensure that they comply
with any previous reporting requirements. This may mean that subsidiaries have to prepare
two sets of financial statements: one using their previous GAAP; and one using IFRSs (for
the consolidation).
The process will be affected by the following:
 The differences between previous GAAP and IFRSs as they affect the group financial
statements in practice. The company will need to carry out a detailed review of current
accounting policies, paying particular attention to areas where there are significant
differences between previous GAAP and IFRSs. These will probably include deferred
tax, business combinations, employee benefits and foreign currency translation. It
should be possible to estimate the effect of the change by preparing pro forma C
H
financial statements using IFRSs. A
P
 The level of knowledge of IFRSs of current finance staff (including internal auditors). It T
will probably be necessary to organise training and the company may need to recruit E
additional personnel. R
 The group's accounting systems. Management will need to assess whether 9

computerised accounting systems can produce the information required to report
under IFRSs. They will also need to produce new consolidation packages and
accounting manuals.
Lastly, the company should consider the impact of the change to IFRSs on investors and
their advisers. For this reason management should try to quantify the effect of IFRSs on
results and other key performance indicators as early as possible.
(c) (1) Accounting estimates
Estimates under IFRSs at the date of transition must be consistent with those made at
the same date under previous GAAP (after adjustments to reflect any difference in
accounting policies). The only exception to this is if the company has subsequently
discovered that these estimates were in error. This is not the case here and therefore
the estimates are not adjusted in the first IFRS financial statements.

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(2) Court case

The treatment of this depends on the reason why Europa did not recognise a provision
under previous GAAP at 31 December 20X7.
If the requirements of previous GAAP were consistent with IAS 37, Provisions,
Contingent Liabilities and Contingent Assets, presumably the directors concluded that
an outflow of economic benefit was not probable and that the recognition criteria were
not met. In this case, Europa's assumptions under IFRSs are consistent with its previous
assumptions under previous GAAP. Europa does not recognise a provision at
31 December 20X7 and accounts for the payment in the year ended 31 December 20X8.
If the requirements of previous GAAP were not consistent with IAS 37, Europa must
determine whether it had a present obligation at 31 December 20X7. The directors
should take account of all available evidence, including any additional evidence
provided by events after the reporting period up to the date the 20X7 financial
statements were authorised for issue in accordance with IAS 10, Events After the
Reporting Period.
The outcome of the court case confirms that Europa had a liability in September 20X7
(when the events that resulted in the case occurred), but this event occurred after the
20X7 financial statements were authorised for issue. Based on this alone, the company
would not recognise a provision at 31 December 20X7 and the $10 million cost of the
court case would be recognised in the 20X8 financial statements. If the company's
lawyers had advised Europa that it was probable that they would be found guilty and
suggested the expected settlement amount before the financial statements were
authorised for issue, the provision would be recognised in the 20X7 financial
statements reporting under IFRSs for that amount.

30%  £4m = £1.2m
The tax rate for the entire year is applied to the profits for the interim period.

Production machinery
(a) In this case the key issue is whether or not the asset should be classified as held for sale. In
accordance with IFRS 5 a held for sale asset must be available for immediate sale. In this
instance this does not appear to be the case, as the asset is still required for production
purposes until after the year end. It should only be classified as held for sale at the end of
January 20X8 when it has been serviced and uninstalled. Relevant audit evidence would
include orders to be fulfilled compared to goods made by this machine compared to
available inventory, budgets and inquiries of production staff.
(b) Audit procedures would be as follows:
 Discuss with management intentions to run down production and the timescales
involved.
 Review minutes of management/board meetings to confirm management's intentions.
 If material, agree with the management the reclassification of the asset as part of plant
and machinery.
 Consider whether an impairment adjustment is required as the asset will no longer be
used for its current purpose.

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Land
(a) The key issue is the valuation of the land. As the entity has adopted the revaluation model
the land should have been revalued to fair value (£210,000) immediately before being
reclassified as held for sale. Any gain would be recognised in the revaluation surplus and
disclosed as other comprehensive income in the statement of profit or loss and other
comprehensive income. On reclassification the £6,000 costs to sell would be recognised in
profit or loss as an impairment loss resulting in a carrying value of the asset of £204,000
(£210,000 – £6,000).
(b) Audit procedures would be as follows:
 Review the process of estimating the fair value of the land on 1 October and the
necessary advertising costs.
 Discuss with management why the land was not revalued on classification as held for
sale.
C
H
A
P
T
E
R

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IAS 1, Presentation of Financial Statements
1 AZ
AZ statement of profit or loss and other comprehensive income
for the year ended 31 March 20X3
$'000
Revenue 124,900
Cost of sales (W1) (94,200)
Gross profit 30,700
Distribution costs (W1) (9,060)
Administrative expenses (W1) (17,535)
Other expenses (W1) (121)
Finance income 1,200
Finance costs (18,250  7%) (1,278)
Profit before tax 3,906
Income tax expense (976)
PROFIT FOR THE YEAR 2,930
Other comprehensive income:
Gain on land revaluation 4,000
Total comprehensive income for the year 6,930
AZ statement of financial position

as at 31 March 20X3
$'000
Non-current assets
Property, plant and equipment (W2) 48,262
Investment properties 24,000
72,262
Current assets
Inventories (5,180 – (W3) 15) 5,165
Trade receivables 9,330
Cash and cash equivalents 1,190
15,685
87,947
Equity
Share capital (20,000 + (W4) 2,000) 22,000
Share premium (430 + (W4) 400) 830
Retained earnings (28,077 – 1,000 + 2,930) 30,007
Revaluation surplus (3,125 + 4,000) 7,125
59,962
7% loan notes 20X7 18,250
Current liabilities
Trade payables 8,120
Income tax payable 976
Interest payable (1,278 – 639) 639
9,735
87,947

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AZ statement of changes in equity

for the year ended 31 March 20X3
Share Share Retained Revaluation
capital premium earnings surplus Total
$'000 $'000 $'000 $'000 $'000
Balance at 1 April 20X2 20,000 430 28,077 3,125 51,632
Issue of share capital 2,000 400 2,400
Dividends (1,000) (1,000)
Total comprehensive income 2,930 4,000 6,930
for the year
Balance at 31 March 20X3 22,000 830 30,007 7,125 59,962
WORKINGS
(1) Expenses
Cost of
sales Distribution Admin Other
$'000 $'000 $'000 $'000
Per TB 94,000 9,060 16,020 121
Opening inventories 4,852
Depreciation on buildings (W2) 1,515
Depreciation on P&E (W2) 513
Closing inventories (5,180 – (W3) 15) (5,165)
94,200 9,060 17,535 121
(2) Property, plant and equipment

Land Buildings P&E Total
$'000 $'000 $'000 $'000
Cost b/d 20,000 30,300 3,720 54,020
Acc'd depreciation b/d – (6,060) (1,670) (7,730)
20,000 24,240 2,050 46,290
Depreciation charge for year:
 $30,300  5% – (1,515) (1,515)
 ($3,720 – $1,670)  25% (513) (513) C
20,000 22,725 1,537 44,262 H
Revaluation (balancing figure) 4,000 – – 4,000 A
P
Carrying amount c/d 24,000 22,725 1,537 48,262
T
E
(3) Inventories R
$'000
9
Defective batch:
Selling price 55
Cost to complete: repackaging required (20)
NRV 35
Cost (50)
Write-off required (15)
(4) Share issue

The proceeds have been recorded separately in the trial balance. This requires a
transfer to the appropriate accounts:
$'000 $'000
DEBIT Proceeds of share issue 2,400
CREDIT Share capital (2,000  $1) 2,000
CREDIT Share premium (2,000  $0.20) 400

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IFRS 5, Non-current Assets Held for Sale and Discontinued Operations

2 Viscum
£11,000
IFRS 5.15 requires assets classified as held for sale to be measured at the time of
classification at the lower of (1) the carrying value (£30,000) and (2) the fair value less costs
to sell (£19,000).
IFRS 5.20 requires recognition of the resulting impairment loss (£30,000 – £19,000). The
gain or loss on disposal is treated separately per IFRS 5.24.
3 Reavley
£19,500
IFRS 5.15 requires that a non-current asset held for sale should be stated at the lower of (1)
the carrying amount (£19,500) and (2) the fair value less costs to sell (£24,550).
4 Smicek
£40,000
At the end of the current year, a non-current asset that has ceased to be classified as held
for sale should be valued at the lower of:
(a) The carrying amount had it not been recognised as held for sale, ie, to charge a full
year's depreciation of £100,000 for 20X7 and reduce the carrying amount from
£900,000 at 31 December 20X6 to £800,000.
(b) The recoverable amount, which is the higher of the £790,000 fair value less costs to sell
(£810,000 less £20,000) and value in use (the cash flows generated from using the
asset) of £1,200,000.
Therefore the asset should be carried at £800,000 in the statement of financial position at
31 December 20X7.
At the end of the prior year, when the asset was classified as held for sale, the asset would
have been carried at the lower of carrying amount (£900,000) and fair value less costs to sell
of £840,000 (£860,000 less £20,000). Therefore the asset has fallen in value from £840,000
to £800,000 in the current year, giving a charge to profits of £40,000.
5 Ndombe
31 December 20X6: the assets should be shown in the statement of financial position at a
value of £1,140,000.
31 December 20X7: the assets should be shown in the statement of financial position at a
value of £1,040,000.
At the end of 20X6 the assets are classified as held for sale. The assets should be measured
at the lower of carrying amount and fair value less costs to sell (IFRS 5.15). The carrying
amount was £1,140,000 and the fair value less costs to sell was £1,180,000 so they were
measured at £1,140,000.
No depreciation is charged on these assets in 20X7 (IFRS 5.25).
At the end of 20X7, it is still possible to classify the 'other' assets as held for sale as the
company is still committed to the sale (IFRS 5.29). These assets would be measured at fair
value less costs to sell of £880,000, as this is lower than the carrying amount of £900,000.
However, the polishing machine should be valued at the lower of £160,000 carrying
amount had classification as held for sale not occurred (£400,000  2/5) and the higher of
fair value less costs to sell (£190,000) and value in use (£170,000) (IFRS 5.27). This gives a
value of £160,000.

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This gives a total value of £1,040,000 at 31 December 20X7.

6 Sapajou
An expense of £20,000 is shown in the profit or loss part of the statement of profit or loss
and other comprehensive income for the year ended 31 December 20X6.
Income of £20,000 is shown in the profit or loss part of the statement of profit or loss and
other comprehensive income for the year ended 31 December 20X7.
Under IFRS 5.15 an asset classified as held for sale is measured at the lower of carrying
amount immediately before the reclassification of £900,000 (£1,200,000 – 2.5  £120,000),
and fair value less costs to sell of £880,000. The £20,000 impairment loss is charged to
profits (IFRS 5.20).
In the following year, the increase in fair value less costs to sell is £115,000, but only
£20,000 of this can be recognised in profit (IFRS 5.21) as this is the reversal of the previous
impairment loss.
IAS 24, Related Party Disclosures
7 Sulafat
Disclosure is required of transactions with both Vurta and Piton. See IAS 24.3, which states
that entities under both direct and common control are related parties.
8 Phlegra
Nil under IAS 24.11 (a) two entities are not related parties simply because they have a
director in common, nor per IAS 24.11 (b) simply because the volume of transactions
between them results in economic dependence.
So neither Nereidum nor Chub is a related party of Phlegra.
9 Mareotis
£300,000. Under IAS 24.9, Hayles is a related party of Mareotis. Bourne 'controls' Wrasse
(by virtue of the power to appoint the majority of directors) and Wrasse 'controls' Hayles (by
virtue of holding the majority of the equity). So Bourne 'controls' both Mareotis and Hayles,
which are therefore related parties as a result of being under common control.
Being an aunt does not make Danielle a close member of Agnes's family so, although C
Galaxius is controlled by a relative of Agnes, the relationship is not close enough to make H
Galaxius a related party of Mareotis. So only transactions with Hayles have to be disclosed. A
P
IAS 34, Interim Financial Reporting T
E
10 Anteater R
£2.1 million 9
Interim reports should apply the normal recognition and measurement criteria, using
appropriate estimates under IAS 34.41.
There is a constructive obligation in relation to the contingent lease payments, which
should be measured by reference to all the evidence available. As the trigger level of sales
is expected to be achieved, then under IAS 34 App.B B7 the amount to be recognised is
£4.2m  6/12.

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11 Marmoset
Nil
appropriate estimates under IAS 34.41.
There is no legal or constructive obligation at the interim reporting date to pay the bonus,
as no announcement had been made at this date. Under IAS 34 App B B6 no expense is
required.
12 Aconcagua
Six months ending 30 June 20X7 £20,000 profit decrease
Six months ending 31 December 20X7 £16,000 profit increase
appropriate estimates under IAS 34.41. IAS 34 App B B25–B26 links these general
principles to inventories by requiring them to be written down to net realisable value at the
interim date; the write down is then reversed at the year end, if appropriate.
So the profit decrease in the six months to 30 June 20X7 is 2,000  (£30 – £20) = £20,000,
while the profit increase in the six months to 31 December 20X7 is 2,000  (£28 – £20) =
£16,000.

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CHAPTER 10
Reporting revenue
Introduction
TOPIC LIST
1 Context
2 IFRS 15, Revenue from Contracts with Customers
3 Applications of IFRS 15
4 Audit focus
Technical reference

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Introduction
Tick
Learning outcomes off

can affect reported financial performance
respect of financial statements; revenue; operating segments; continuing and
discontinued operations; EPS; construction contracts; interim reporting
 Calculate and disclose, from financial and other qualitative data, the amounts to be
included in an entity's financial statements according to legal requirements,
applicable financial reporting standards and accounting and reporting policies
evidence
 Design and determine audit procedures in a range of circumstances and scenarios,
for example identifying an appropriate mix of tests of controls, analytical procedures
and tests of details
Specific syllabus references for this chapter are: 1(e), 2(a), 2(b), 2(d), 14(c), 14(d), 14(f)

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1 Context
Section overview
• Income, as defined by the IASB's Conceptual Framework, includes both revenues and
gains. Revenue is income arising in the ordinary course of an entity's activities and it may
be called different names, such as sales, fees, interest, dividends or royalties.
• IFRS 15, Revenue from Contracts with Customers establishes a single comprehensive
framework for accounting for the majority of contracts that result in revenue.
• Revenue recognition is straightforward in most business transactions, but can be
complicated in some situations.
1.1 Accrual accounting

Financial statements are prepared on the underlying assumption of the accrual basis of
accounting, whereby effects of transactions are recognised when they occur and not when the
cash associated with them is received or paid.
But this raises questions about when a transaction 'occurs':
 Is it when the buyer takes possession of the goods, in circumstances where the contract for
sale contains clauses that seek to ensure that ownership does not pass to the customer until
the seller has been paid in full?
 Is it when services are provided, in circumstances where the seller undertakes to come back
to do additional work without charge if needed, eg, remedial work carried out by a building
contractor?
 When does the profit arise on a contract for the provision of services to a customer over
time, such as under a maintenance contract of two years' duration? Only at the start, only in
the middle, only at the end, or over the period of two years?
IFRS 15, Revenue from Contracts with Customers was brought in to address this.
1.2 Significance of revenue

Revenue is often the largest single item in the financial statements. US studies have shown that
over half of all financial statement frauds and requirements for restatements of previously
published financial information involved revenue manipulation.
The most blatant example was the Satyam Computer Services fraud in 2009, in which false
invoices were used to record fictitious revenue amounting to £1.5 billion. Revenue recognition
fraud also featured in the Enron and WorldCom cases.
The directors of Enron inflated the value of 'agency' services by reporting the entire value of
each of its trades as revenue, rather than just the agency commission on the sale. Other energy
C
companies then adopted this 'model' in a bid to keep up with Enron's results.
H
In the UK, an example showing the weaknesses of IFRS 15's predecessor IAS 18, Revenue is A
P
supermarket giant, Tesco. T
E
R
10
ICAEW 2019 Reporting revenue 555

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Case study: Tesco

In 2014, supermarket giant Tesco made headline news amid claims that it had overstated its
first-half profits by some £250 million. It is possible that the issue of incorrect timing of revenue
recognition could have played a part. IAS 18's vagueness and inconsistency will not have helped
in this respect, and has allowed scope for aggressive earnings management, although this has
not yet been demonstrated in the case of Tesco. In particular, the timing of revenue has been a
cause for criticism because of the lack of clear and comprehensive guidance.
On the website Wiley Global Insight, Steve Collings wrote:
It appears that Tesco may have accelerated the recognition of revenue relating to suppliers'
rebates (hence recognising revenue too early) and at the same time delayed the
recognition of costs. The result of this accounting treatment is that accounting profits are
brought into the first half of the year, with costs pushed into the second half of the year so
that the profits look disproportionately healthy in the first-half of the year.
[…]
Whether this new standard [IFRS 15] will lessen the potential for companies to adopt
aggressive earnings management in their revenue recognition policies remains to be seen.
The steps in IFRS 15 do offer more clarity than IAS 18.
IFRS 15 only came into force in January 2018. However, early adoption was permitted. In a
paper given at the Annual Paris Business Research Conference in July 2016 titled IFRS 15 Early
Adoption and Accounting Quality: The Evidence from Real Estate Companies, Nadia Sbei
Trabelsi concluded:
Results indicate that early adoption of IFRS 15 by REC has a significant positive effect on
earnings and stockholders' equity for all firms analyzed in the paper. The new standard has
a double favorable effect: revenue could be recognized over time and not at a point of time
in almost all contracts with customers and contract costs are more likely capitalized rather
than expensed. The application of IFRS 15 leads to providing accounting information which
is in harmony with qualitative characteristics of the Conceptual Framework.
2 IFRS 15, Revenue from Contracts with Customers
Section overview
 Revenue is income arising in the course of an entity's ordinary activities.
• Revenue should be recognised to depict the transfer of goods or services to a customer in
an amount that reflects the consideration to which the entity expects to be entitled.
• Generally revenue is recognised when the entity has transferred to the buyer control of the
asset.
 IFRS 15 sets out a five-stage process for this.
2.1 Objective and scope

The objective of IFRS 15 is to establish the principles that should be applied to report on the
nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a
customer. (IFRS 15.1)
IFRS 15 applies to all contracts with customers except:
 leases within the scope of IFRS 16, Leases
 insurance contracts within the scope of IFRS 4, Insurance Contracts
 non-monetary exchanges between entities in the same line of business

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2.2 Revenue
Income is defined in the IASB's Conceptual Framework as "increases in economic benefits in the
form of inflows or enhancements of assets or decreases of liabilities that result in increases in
equity." Revenue is simply income arising in the course of an entity's ordinary activities
(IFRS 15: Appendix A) and it may be called different names such as:
 Sales
 Turnover
 Interest
 Dividends
 Royalties
2.3 Core principle

The core principle of IFRS 15, Revenue from Contracts with Customers is that an entity
recognises revenue to depict the transfer of promised goods or services to customers in an
amount that reflects the consideration to which the entity expects to be entitled in exchange for
those goods or services (IFRS 15. IN7).
The transfer of goods and services is evidenced by the transfer of control.
Revenue is recognised in accordance with this core principle by applying a five-step model.
2.4 Five-step model

IFRS 15 takes a five-step approach to recognising revenue:
Step 1 Identify the contract(s) with a customer


Step 2 Identify separate performance obligations


Step 3 Determine the transaction price


Step 4 Allocate transaction price to performance obligations


Step 5 Recognise revenue as or when each performance

obligation is satisfied
Figure 10.1: Five-step model
Revenue is therefore recognised when control over goods or services is transferred to the
customer.
2.5 Identify the contract with the customer C

H
The contract can be written, verbal or implied. For instance, in retail sales the contract is implied. A
P
The criteria to be met are as follows:
T
(a) All parties have approved the contract. E
R
(b) The entity can identify each party's rights regarding the goods or services to be transferred.
10
(c) The payment terms can be identified.
(d) The contract has commercial substance.
(e) It is probable that the entity will collect the consideration to which it will be entitled in
exchange for the goods or services. (IFRS 15.9)

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2.6 Identify the performance obligations in the contract

A performance obligation is a promise to transfer to the customer either:
(a) a distinct good or service (or bundle of goods or services); or
(b) a series of distinct goods or services. (IFRS 15.22)
A good or service is distinct if it can be sold separately and has a distinct function. If this does
not apply, it will form part of a distinct bundle.
The definition of distinct is therefore key when identifying separate performance obligations. A
good or service (or a bundle of goods or services) is distinct if the customer can benefit from the
good or service on its own or together with other readily available resources and the entity's
promise is separately identifiable from other promises in the contract).
If goods or services are not distinct, the reporting company must combine them with other
promised goods or services until a bundle of goods or services that is distinct can be identified.
Worked example: Performance obligations (1)

Colossal Construction plc has recently signed a contract to build a warehouse for SupaSave Ltd.
Colossal Construction is responsible for designing the building, preparing the site, purchasing
raw materials, construction, plumbing, wiring and finishing.
Requirement
Identify the performance obligation(s) in the contract.
Solution
In the context of this contract, Colossal Construction is contracted to provide a significant service
of integrating the inputs in order to produce a single output; this being the warehouse.
Therefore the provision of each good or service is not separately identifiable.
The promises are not distinct and therefore there is only a single performance obligation, being
the development of the property.
Worked example: Performance obligations (2)

MetaConnect Software Services plc (MetaConnect) supplies computer aided design packages to
customers. It has recently signed a contract with EverTel Design Ltd to provide a licence to use a
software package, installation service (which does not involve customising the software
package) and technical support for four years. MetaConnect is not the only company that could
install the software and provide technical support.
Requirement
Identify the performance obligation(s) in the contract.
Solution
Each good or service provided (the provision of the licence, the installation service and the
technical support) is capable of being distinct because a customer could gain benefit from each
either on its own or by obtaining the other goods/services from another supplier. The good or
service could therefore benefit the customer either on its own or together with other resources
that are readily available.
In the context of this contract, MetaConnect is not integrating the goods or services, none of the
goods or services modifies another and the goods/services are not highly interrelated.

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Therefore each promise is separately identifiable. Therefore the promise to transfer the good or
service to the customer is separately identifiable from other promises in the contract
In conclusion, there are three distinct performance obligations in the contract, being:
(1) Installation of the software
(2) Provision of the licence
(3) Provision of technical support
2.7 Determine the transaction price

This is the amount of consideration in a contract to which an entity expects to be entitled for
transferring promised goods or services to a customer (IFRS 15.47).
This may include both fixed and variable elements but not amounts collected on behalf of third
parties. Variable amounts could be discounts, refunds, price concessions, incentives, bonuses or
other items.
Variable consideration is included in the transaction price based on either:
 its expected value (the sum of probability weighted amounts in a range of possible
outcomes); or
 the single most likely amount (the single most likely amount in a range of possible
consideration amounts).
The expected value approach is generally appropriate if the vendor has a large number of
contracts with similar characteristics.
The single most likely outcome may be appropriate if a contract has only two possible outcomes
(eg, an entity achieves a performance bonus or does not).
The chosen approach should be that which is expected to provide a better prediction of
consideration.
Variable consideration is included in the transaction price only to the extent that it is highly
probable that a significant amount will not be reversed when the uncertainty associated with the
variable consideration is resolved. When assessing whether it is highly probable that a
significant reversal will occur, an entity should consider both the likelihood and magnitude of
the revenue reversal. Factors that may increase the likelihood or magnitude of reversal include
any of the following:
(a) The amount of consideration is very susceptible to factors outside the entity's influence eg,
weather conditions or market volatility.
(b) The uncertainty about consideration is not expected to be resolved for a long period of
time.
(c) The entity's experience with similar types of contracts is limited or has limited predictive
value. C
H
(d) The entity has a practice of offering a wide range of price concessions or changing the A
payment terms and conditions of similar contracts in similar circumstances. P
T
(e) The contract has a large number and broad range of possible consideration amounts. E
R
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Worked example: Variable consideration

On 1 July 20X8, Danmar Construction plc (Danmar) signs a contract to build an extension to a
retail outlet. The total price agreed is £80 million. The contract terms require completion by
31 March 20X9. The price will decrease by £200,000 for every day after this date that the project
remains incomplete. At the year end of 31 December 20X8, Danmar expects that there is an
80% chance of the project being completed on time, a 10% chance of it being completed a day
late, a 7% chance of it being completed two days late and a 3% chance of it being completed
three days late.
Requirement
What is the transaction price?
Solution
The consideration is variable due to the fact that Danmar will accept an amount that is less than
the price stated in the contract if the project overruns (the price concession).
Here the calculation of transaction price is based on expected values.
£
80%  £80,000,000 64,000,000
10%  £79,800,000 7,980,000
7%  £79,600,000 5,572,000
3%  £79,400,000 2,382,000
Transaction price 79,934,000
2.8 Allocate the transaction price to the performance obligations in the contract
The transaction price is allocated to each performance obligation on the basis of the stand-alone
selling price of each distinct good or service in the contract. If the good or service does not have
a stand-alone selling price, it will need to be estimated (IFRS 15.IN7).
This applies particularly where a bundle of goods is sold which the entity also supplies
unbundled. An example of this is a mobile phone service contract which includes a free handset.
In accordance with IFRS 15, the entity will have to allocate some of the revenue to the handset,
based on its stand-alone selling price.
Worked example: Allocation of transaction price

The contract between MetaConnect and EverTel Design (see Worked example: Performance
obligations 2) is priced at £6,000. The stand-alone selling prices of each element are as follows:
£
Provision of a licence 5,000
Installation service 1,500
Provision of technical support 3,000
9,500
Requirement
Allocate the transaction price to the performance obligations in the contract.

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Solution
Licence provision £5,000/£9,500  £6,000 = £3,158
Installation service £1,500/£9,500  £6,000 = £947
Technical support service £3,000/£9,500  £6,000 = £1,895
Worked example: Unbundling

A mobile phone company gives customers a free handset when they sign a two-year contract for
provision of network services. The handset has a stand-alone price of £52 and the contract is for
£20 per month.
Under IFRS 15, revenue must be allocated to the handset because delivery of the handset
constitutes a performance obligation. This will be calculated as follows:
£ %
Handset 52 10
Contract – two years 480 90
Total value 532 100
As the transaction price is the total receipts of £480, this is the amount which must be allocated
to the separate performance obligations. Revenue will be recognised as follows:
£
Year 1
Handset (480  10%) 48
Contract (480 – 48)/2 216
264
Year 2
Contract as above 216
2.9 Recognise revenue when (or as) a performance obligation is satisfied

A performance obligation is satisfied when control of the good or service specified in the
contract is transferred to the customer (IFRS 15.31).
A performance obligation can be satisfied at a point in time, such as in retail sales, or over time,
such as a construction contract taking place over weeks, months or even years.
Where a performance obligation is satisfied at a point in time, that point will occur when control
is transferred. At that point the customer is able to direct the use of the asset and obtain
substantially all the remaining benefits from it (IFRS 15.33).
The following events can indicate that control has been transferred (IFRS 15.38):
 The entity has a present right to payment for the asset
 The customer has legal title to the asset C
 The entity has transferred physical possession of the asset H
A
 The significant risks and rewards of ownership have been transferred to the customer P
 The customer has accepted the asset T
E
A performance obligation satisfied over time will meet one of the following criteria: R
 The customer simultaneously receives and consumes the benefits as the performance
10
obligation is satisfied.
 The entity's performance creates or enhances an asset that the customer controls as the
asset is created or enhanced.

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 The entity's performance does not create an asset with an alternative use to the entity and
the entity has an enforceable right to payment for performance completed to date.
(IFRS 15.35)
Where performance obligations are satisfied over time, the entity recognises revenue by
measuring progress towards complete satisfaction of the performance obligation. Progress can
be measured using output methods (measuring the value to the customer of goods or services
transferred to date) or input methods (measuring the cost to the entity of goods or services
transferred to date) (IFRS 15.B14).
In the early stages of a contract it may not be possible to reasonably measure the outcome of a
performance obligation, but the entity is entitled to recover costs incurred. In this case, revenue
can be measured to the extent of costs incurred.
A contract where performance obligations are recognised over time may give rise to asset or
liability amounts at the end of the reporting period.
Contracts with customers will be presented in an entity's statement of financial position as a
contract liability, a contract asset or a receivable, depending on the relationship between the
entity's performance and the customer's payment. (IFRS 15.105)
A contract liability is recognised and presented in the statement of financial position where a
customer has paid an amount of consideration prior to the entity performing by transferring
control of the related good or service to the customer. (IFRS 15.106)
When the entity has performed but the customer has not yet paid the related consideration, this
will give rise to either a contract asset or a receivable. A contract asset is recognised when the
entity's right to consideration is conditional on something other than the passage of time, for
instance future performance. A receivable is recognised when the entity's right to consideration
is unconditional except for the passage of time. (IFRS 15.107)
Where revenue has been invoiced a receivable is recognised. Where revenue has been earned
but not invoiced, it is recognised as a contract asset.
Worked example: Performance obligation satisfied over time

Associated Solutions Ltd is building a bespoke software system for an insurance company. The
contract started on 1 January 20X7 with an estimated completion date of 31 December 20X9.
The contract price is £2 million. As at 31 December 20X7:
(a) costs incurred amounted to £800,000;
(b) half the work on the contract was completed;
(c) certificates of work completed have been issued by the insurance company, to the value of
£1,000,000; and
(d) it is estimated with reasonable certainty that further costs to completion will be £800,000.
Requirement
What is the contract profit in 20X7, and what entries would be made for the contract at
31 December 20X7?
Solution
This is a contract in which the performance obligation is satisfied over time. The entity is carrying
out the work for the benefit of the customer rather than creating an asset for its own use and in
this case it has an enforceable right to payment for work completed to date. We can see this
from the fact that certificates of work completed have been issued.

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IFRS 15 states that the amount of payment that the entity is entitled to corresponds to the
amount of performance completed to date (ie, goods and/or services transferred). This
approximates to the costs incurred in satisfying the performance obligation plus a reasonable
profit margin.
In this case, the contract is certified as 50% complete, measuring progress under the output
method. At 31 December 20X7, the entity will recognise revenue of £1,000,000 and cost of sales
of £800,000, leaving profit of £200,000. The contract asset will be the costs to date plus the
profit – that is £1,000,000. We are not told that any of this amount has yet been invoiced, so
none of this amount is classified as receivables.
Interactive question 1: Publishing revenue

A magazine publisher launched a new monthly magazine on 1 January 20X7. During January it
received £48,000 in annual subscriptions in advance. It has despatched four issues by the year
end 31 March 20X7.
Requirement
What revenue should be recognised for the year ended 31 March 20X7?
Interactive question 2: Advance sales

A DIY store is about to sell a new type of drill. Customer demand is high and the store has taken
advance orders for the drill. The selling price of the drill will be £50 and so far 200 customers
have paid an initial 10% deposit on the selling price of the drill. No drills are yet held in
inventory.
Requirement
What amount should be recognised as revenue?
Interactive question 3: Rendering of services

A £210,000 fixed-price contract is entered into for the provision of services. At the end of 20X7,
the first accounting period, the contract is thought to be 33% complete and costs of £45,000
have been incurred in performing that 33% of the work.
Requirements
Calculate the revenue to be recognised in 20X7 on the alternative assumptions that: C
H
(a) the costs to complete are reliably estimated at £90,000; and
A
(b) the costs to complete cannot be reliably estimated, and it is thought that £40,000 of the P
T
costs incurred are recoverable from the customer. E
See Answer at the end of this chapter. R
10

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Interactive question 4: Service contract

An entity entered into a contract for the provision of services over a two year period. The total
contract price was £150,000 and the entity initially expected to earn a profit of £20,000 on the
contract. In the first year, costs of £60,000 were incurred and 50% of the work was completed.
The contract did not progress as expected and management was not sure of the ultimate
outcome but believed that the costs incurred to date would be recovered from the customer.
Requirement
What revenue should be recognised for the first year of the contract?
2.10 Performance obligations satisfied over time: 'construction contracts'

Before IFRS 15 came into force 'construction contracts', sometimes called 'long-term contracts'
had their own IAS, and you may still come across these terms. However, IFRS 15 does not
specifically use these terms, but refers to them as contracts in which performance obligations are
satisfied over time. Such contracts often include contracts for large construction projects falling
into more than one accounting period. As mentioned in section 2.9 above, the entity recognises
revenue by measuring progress towards complete satisfaction of the performance obligation.
Progress can be measured using output methods (measuring the value to the customer of
goods or services transferred to date) or input methods (measuring the cost to the entity of
goods or services transferred to date) (IFRS 15.B14).
Worked example: Contract to construct a conference centre

During the year ended 31 July 20X9, Frizco Construction plc (Frizco) began the construction of a
leisure centre on behalf of a local authority. The agreed contract price was £70 million. However
this will be reduced by £6 million if Frizco completes the centre a month or more behind
schedule. During the year ended 31 July 20X9, costs incurred amounted to £18.6 million,
including £1,000,000 material that could not be used in the project as it was of the incorrect
grade to meet regulations. The total cost of the project (excluding the £1,000,000 in wasted
material) is estimated to be £44 million. Work certified at the year-end was £24.5 million.
The construction is currently progressing in accordance with the agreed schedule.
Requirements
(a) What amount of revenue is recognised in profit or loss in the year ended 31 July 20X9 if an
output method is used to assess progress?
(b) What amount of revenue is recognised in profit or loss in the year ended 31 July 20X9 if an
input method is used to assess progress?
Solution
The transaction price is £70 million. £64 million is fixed consideration and £6 million is variable
consideration. The transaction price is £70 million as the project is currently expected to be
completed on time and therefore the single most likely outcome is the receipt of £70 million.
(a) Output method
Using the output method the project is 35% complete:
Work certified
= 24,500 ÷ 70,000= 35%
Transaction price
Therefore 35%  £70m = £24.5 million is recognised as revenue in the year.

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(b) Input method

Using the input method the project is 40% complete:
Costs incurred to date
= (18,600 – 1,000) ÷ 44,000 = 40%
Total expected costs
Therefore 40%  £70m = £28 million is recognised as revenue in the year.

Note that the £1 million wasted material is not relevant to the assessment of progress,
however, it must be recognised in profit or loss as a wastage expense.
Contract costs are considered in further detail in section 2.12.
2.11 Deferred consideration

In some sectors of the retail industry it is common practice to provide interest-free credit to
customers in order to encourage sales of, for example, furniture and new cars.
IFRS 15 refers to this as a 'financing component' in the contract. When the contract contains a
significant financing component, such as a period of interest-free credit exceeding one year, the
amount of consideration should be adjusted for the time value of money (IFRS 15.60, .63).
Where an extended period of credit is offered, the revenue receivable has two separate
elements:
 The value of the goods on the date of sale
 Financing income
In order to separate these two elements the future receipts are discounted to present value at an
imputed interest rate, identified as either:
 the prevailing rate for lending to a customer with a credit rating similar to that of the
customer; or
 the rate of interest which discounts the receivable back to the current cash selling price.
The effect on the timing of the revenue recognition is that:
 the fair value of the goods is recognised on delivery of the goods
 the finance element is recognised over the period that the financing is provided
Worked example: Deferred consideration 1

A car retailer sells its new cars by requiring a 20% deposit followed by no further payments until
the full balance is due after two years. The price of the cars is calculated using a 10% per annum
finance charge.
On 1 January 20X7 a car was sold to a customer for £20,000.
Requirement
C
How should the revenue be recognised in the year ended 31 December 20X7 and what should H
the carrying amount of the customer receivable be on that date? A
P
T
Solution E
R
Revenue to be recognised
£ 10
Sale of goods (£4,000 + £13,223 (W)) 17,223
Financing income (£13,223 (W)  10%) 1,322
Carrying amount of receivable (£13,223 (W)  1.10) 14,545

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WORKING
The deposit is £4,000 (£20,000  20%), so the amount receivable in two years is £16,000.
2
This is discounted at 10% for two years to £13,223 (£16,000  1/1.10 ).
Worked example: Deferred consideration 2

Comfy Couches Ltd sells an item of furniture to a customer on 1 September 20X7 for £2,500
with a one-year interest-free credit period. The fair value of the consideration receivable is
£2,294. (In other words, if the company tried to sell this debt, this is the amount it would expect
to receive now.)
In this case the transaction would be split into two components:
(1) Interest revenue of £206 (2,500 – 2,294), which would be recognised over the period of
credit
(2) Sales revenue of £2,294, which would be recognised on 1 September 20X7
2.12 Contract costs

IFRS 15 deals with the costs of obtaining a contract and the costs of fulfilling a contract.
2.12.1 Costs of obtaining a contract

The incremental costs of obtaining a contract (such as sales commission) are recognised as an
asset if the entity expects to recover those costs.
Costs that would have been incurred regardless of whether the contract was obtained are
recognised as an expense as incurred.
Costs incurred in fulfilling a contract, unless within the scope of another standard, (such as IAS 2,
Inventories, IAS 16, Property, Plant and Equipment or IAS 38, Intangible Assets) are recognised
as an asset if they meet the following criteria (IFRS 15.95):
(a) The costs relate directly to an identifiable contract (costs such as labour, materials,
management costs)
(b) The costs generate or enhance resources of the entity that will be used in satisfying (or
continuing to satisfy) performance obligations in the future
(c) The costs are expected to be recovered
Costs recognised as assets are amortised on a systematic basis consistent with the transfer to the
customer of the goods or services to which the asset relates.
Worked example: Costs of obtaining a contract

Copyquick Ltd enters into contracts for five-year terms to service and repair a customer's
photocopiers. The contracts may be subsequently renewed on a one-year rolling basis and the
average customer term is seven years. Copyquick pays its sales staff a commission of £35,000
when a new customer signs an initial contract.
On 1 January 20X8, the Copyquick sales staff secured a new customer contract.
Requirement
How is the cost of commission of £35,000 accounted for?

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Solution
The £35,000 is an incremental cost of obtaining a new contract, and Copyquick expects to
recover the cost by charging the customer for servicing and repairing their photocopiers.
Copyquick should capitalise the £35,000 and amortise it over a period to reflect the transfer of
services to the customer. Although the original contract is for five years, this is usually extended
for a further two years and so the amortisation period is seven years.
Therefore the annual amortisation charge is £5,000 (£35,000/7 years).
2.13 Presentation and disclosure

2.13.1 Presentation
Contracts with customers will be presented in an entity's statement of financial position as a
contract liability, a contract asset, or a receivable depending on the relationship between the
entity's performance and the customer's payment.
A contract liability is recognised and presented in the statement of financial position where a
customer has paid an amount of consideration before the entity has transferred control of the
related good or service to the customer.
When the entity has performed but the customer has not yet paid the related consideration, this
will give rise to either a contract asset or a receivable. A contract asset is recognised when the
entity's right to consideration is conditional on something other than the passage of time, for
instance future performance. A receivable is recognised when the entity's right to consideration
is unconditional except for the passage of time.
Where revenue has been invoiced, a receivable is recognised. Where revenue has been earned
but not invoiced, it is recognised as a contract asset.
2.13.2 Disclosure
Disclosure of the following is required:
(a) Revenue from contracts with customers (separately from other sources of revenue) in
categories that depict how the nature, timing, amount and uncertainty of revenue and cash
flows are affected by economic factors (eg, by type of goods or geographical area).
Sufficient information should be disclosed to enable users to understand the relationship
between the disclosure of disaggregated revenue and revenue information that is disclosed
for each reportable segment (where IFRS 8 is applied).
(b) Impairment losses recognised on receivables, or contract assets arising from contracts with
customers (by category, as above).
(c) The opening and closing balances of receivables, contract assets and contract liabilities and
explanation of significant changes in contract assets and liabilities, including both
qualitative and quantitative information. C
H
(d) Revenue recognised in the reporting period that was included in the contract liability A
balance at the start of the period and revenue recognised in the period from performance P
obligations satisfied in previous periods (eg, due to changes in transaction price). T
E
(e) A description of performance obligations including the following: R
– When they are typically satisfied 10
– Significant payment terms

– The nature of goods or services that an entity has promised to transfer, highlighting
obligations to arrange for another party to transfer goods or services

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– Obligations for returns, refunds or similar

– Types of warranties and related obligations
(f) The transaction price allocated to performance obligations that are unsatisfied at the end of
the reporting period, and an explanation of when related revenue is expected to be
recognised. This information need not be disclosed if the performance obligation is part of
a contract lasting 12 months or less, or the entity recognises revenue from the satisfaction of
the performance obligation in the amount that it has a right to invoice (because the amount
directly corresponds with the value to the customer of the entity's performance completed
to date).
Worked example: Applying the IFRS 15 five-step model

On 1 January 20X4, Peterloo enters into a 12-month 'pay monthly' contract for a mobile phone.
The contract is with Westerfield, and terms of the plan are as follows:
 Peterloo receives a free handset on 1 January 20X4.
 Peterloo pays a monthly fee of £200, which includes unlimited free minutes. Peterloo is
billed on the last day of the month.
Customers may purchase the same handset from Westerfield for £500 without the payment
plan. They may also enter into the payment plan without the handset, in which case the plan
costs them £175 per month.
The company's year-end is 31 July 20X4.
Requirement
Show how Westerfield should recognise revenue from this plan in accordance with IFRS 15,
Revenue from Contracts with Customers. Your answer should give journal entries:
(a) On 1 January 20X4
(b) On 31 January 20X4
Solution
IFRS 15 requires application of its five-step process:
(1) Identify the contract with a customer. A contract can be written, oral or implied by
customary business practices.
(2) Identify the separate performance obligations in the contract. If a promised good or
service is not distinct, it can be combined with others.
(3) Determine the transaction price. This is the amount to which the entity expects to be
'entitled'. For variable consideration, the probability-weighted expected amount is used.
(4) Allocate the transaction price to the separate performance obligations in the contract. For
multiple deliverables, the transaction price is allocated to each separate performance
obligation in proportion to the stand-alone selling price at contract inception of each
performance obligation.
(5) Recognise revenue when (or as) the entity satisfies a performance obligation. That is when
the entity transfers a promised good or service to a customer. The good or service is only
considered as transferred when the customer obtains control of it.

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Application of the five-step process to Westerfield

(1) Identify the contract with a customer. This is clear. Westerfield has a 12-month contract with
Peterloo.
(2) Identify the separate performance obligations in the contract. In this case there are two
distinct performance obligations:
– The obligation to deliver a handset
– The obligation to provide network services for 12 months
(The obligation to deliver a handset would not be a distinct performance obligation if the
handset could not be sold separately, but it is in this case because the handsets are sold
separately.)
(3) Determine the transaction price. This is straightforward: it is £2,400, that is 12 months  the
monthly fee of £200.
(4) Allocate the transaction price to the separate performance obligations in the contract. The
transaction price is allocated to each separate performance obligation in proportion to the
stand-alone selling price at contract inception of each performance obligation, that is the
stand-alone price of the handset (£500) and the stand-alone price of the network services
(£175  12 = £2,100):
Performance Stand-alone % Revenue (= relative selling
obligation selling price of total price = £2,400  %)
£ £
Handset 500.00 19.2 460.80
Network services 2,100.00 80.8 1,939.20
Total 2,600.00 100 2,400.00
(5) Recognise revenue when (or as) the entity satisfies a performance obligation. That is when
the entity transfers a promised good or service to a customer. This applies to each of the
performance obligations:
– When Westerfield gives a handset to Peterloo, it needs to recognise the revenue of
£460.80.
– When Westerfield provides network services to Peterloo, it needs to recognise the total
revenue of £1,939.20. It's practical to do it once per month as the billing happens.
Journal entries
(a) On 1 January 20X4
The entries in the books of Westerfield will be:
DEBIT Receivable (unbilled revenue) £460.80
CREDIT Revenue £460.80
Being recognition of revenue from the sale of the handset
(b) On 31 January 20X4 C
H
The monthly payment from Peterloo is split between amounts owing for network services
A
and amounts owing for the handset: P
T
DEBIT Bank/Receivable (Peterloo) £200 E
CREDIT Revenue (1,939.20/12) £161.60 R
CREDIT Receivable (unbilled revenue) (460.80/12) £38.40
10
Being recognition of revenue from monthly provision of network services and 'repayment'
of handset

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Interactive question 5: Caravan

Caravans Deluxe is a retailer of caravans, dormer vans and mobile homes, with a year end of
30 June. It is having trouble selling one model – the £30,000 Mini-Lux, and so is offering
incentives for customers who buy this model before 31 May 20X7.
(a) Customers buying this model before 31 May 20X7 will receive a period of interest free
credit, provided they pay a non-refundable deposit of £3,000, an instalment of £15,000 on
1 August 20X7 and the balance of £12,000 on 1 August 20X9.
(b) Equipment for the caravan, normally worth £1,500, is included free in the price of the
caravan.
On 1 May 20X7, a customer agrees to buy a Mini-Lux caravan, paying the deposit of £3,000.
Delivery is arranged for 1 August 20X7.
As the sale has now been made, the sales director of Caravans Deluxe wishes to recognise the
full sale price of the caravan, £30,000, in the accounts for the year ended 30 June 20X7.
Requirement
Show how the IFRS 15 five-step plan is applied to this sale. Assume a 10% discount rate. Show
the journal entries for this treatment.
3 Applications of IFRS 15
Section overview
 IFRS 15 includes Application Guidance, which explains how the provisions of the standard
should be applied to a number of situations.
 These include:
– Sales with a right of return
– Extended warranties
– Transactions involving an agent
– Licensing
– Royalties
– Repurchase agreements
– Consignment arrangements
– Bill and hold arrangements
– Non-refundable upfront fees
3.1 Sales with a right of return

Some contracts give the customer the right to return the product and receive a refund, a credit
or a replacement.
The entity should recognise (IFRS 15.B21):
 revenue for the transferred products
 a refund liability
 an asset in respect of products to be returned

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The asset is:

 measured at the former carrying amount of the products less any expected decreases in
value and other costs to recover the products;
 presented separately from the refund liability; and
 remeasured to reflect changes in expectations about the products to be returned at each
reporting date.
Interactive question 6: Sale or return

Bags Galore Ltd operates a number of high-end handbag outlets. On 28 January 20X9, it sells
50 identical bags to different customers for £850 each. The bags cost £400 each. The customers
have 28 days in which they can return purchases in exchange for a full refund and, based on past
experience, Bags Galore Ltd expects a returns level of 6%. Bags Galore Ltd's 'Fabulous
February' sale starts on 1 February and the selling price of the bags will be reduced to 50% of
the original price from that date.
Requirements
(a) How should Bags Galore account for the sale of the bags?
(b) How would the accounting treatment change if the selling price of the bags was to be
reduced to 40% of the original price in the Fabulous February sale?
3.2 Warranties
It is necessary to distinguish between warranties which give the customer assurance that the
product complies with agreed upon specifications, and warranties which provide the customer
with a distinct service (such as free repairs over a specified period).
A warranty which the customer purchases separately will always be a service warranty.
A service warranty is accounted for as a separate performance obligation and a portion of the
transaction price is allocated to it.
A warranty which does not promise a service is simply accounted for in accordance with IAS 37,
Provisions, Contingent Liabilities and Contingent Assets (IFRS 15.B28–30).
When considering whether a warranty is standard or extended, IFRS 15 requires that the
following factors are considered:
(1) Whether the provision of the warranty is a legal requirement; this would indicate that it is a
standard warranty
(2) The length of the warranty period – the longer the period, the more likely it is to be an
additional or extended warranty
C
(3) The nature of the tasks promised within the warranty and whether they relate to providing H
assurance that a product will function as intended A
P
T
E
3.3 Principal versus agent R
IFRS 15 specifically excludes amounts collected on behalf of third parties from the transaction
10
price attached to a contract (IFRS 15.47).

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Individually or in combination, the following criteria indicate that the entity is acting as an agent
(IFRS 15.B37):
 Another party has the primary responsibility for providing the goods or services to the
customer, or for fulfilling the order.
 The entity does not have the inventory risk before or after the customer order, during
shipping or on return.
 The entity does not have discretion in establishing prices for the goods or services.
 The entity's consideration is in the form of commission.
 The entity is not exposed to credit risk on the amount due from the customer.
An entity is a principal if it controls the promised good or service before it is transferred to the
customer. In this case, when the performance obligation is satisfied the entity recognises the
revenue.
An entity is an agent if its performance obligation is to arrange for the provision of goods or
services by another party. When this performance obligation is satisfied, it recognises revenue
only for the fee or commission to which it is entitled (IFRS 15.B36).
Worked example: Agent or principal?

An entity runs a website which enables customers to buy goods from a range of suppliers. Prices
are set by suppliers, and payments are processed through the entity's website. Customers pay in
advance and goods are delivered directly from the supplier to the customer.
The entity receives a commission of 10% of the sales price and has no further obligation to the
customer after arranging for the products to be shipped.
Requirement
Is the entity an agent or the principal?
Solution
The entity is acting as an agent based on the following points:
 Goods travel directly from the supplier to the customer, so the entity never has physical
custody of them and does not bear the associated risk.
 The supplier, not the entity, has the obligation to the customer.
 The entity does not set prices or bear credit risk.
 The payment received by the entity is in the form of commission.
So the entity should only recognise the commission received from suppliers as revenue.
3.4 Goods and services provided in one contract

One marketing approach frequently used is to bundle together both goods and services into
one transaction. For example, a car dealer may sell new cars with one year's free servicing and
insurance.
In such cases:
 the components of the package which could be sold separately should be identified; and
 each should be measured and recognised as if sold separately.

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IFRS 15 does not specifically state how each component should be measured but general
principles require that each component should be:
 measured at its fair value; and
 recognised as revenue only when it meets the recognition criteria.
If the total of the fair values exceeds the overall price of the contract, an appropriate approach
would be to apply the same discount percentage to each separate component.
Worked example: Goods and services

A car dealer sells a new car, together with 50 litres of fuel per month for a year and one year's
servicing, for £27,000. The fair values of these components are: car £28,000, fuel £1,200 and
servicing £800.
Requirement
How should the £27,000 be recognised as revenue?
Solution
The total fair value of the package is £30,000 (28,000 + 1,200 + 800) but is being sold for
£27,000, a discount of £3,000 or 10%.
The discounted fair value of the car should be recognised as revenue upon delivery:
£28,000  90% = £25,200
The discounted fair value of the fuel should be recognised as revenue on a straight line basis
over the next 12 months:
£1,200  90% = £1,080
The discounted fair value of the servicing should be recognised as revenue at the earlier of
when the servicing is provided and the end of the year:
£800  90% = £720
Interactive question 7: Goods and services

An entity sells an item of equipment to a customer on 1 January 20X7 for £1.5 million. Due to
the specialised nature of the equipment, the entity has agreed to provide free support services
for the next two years, despite the cost to the entity of that support being estimated at £120,000
in total. The entity usually earns a gross margin of 20% on such support service contracts.
Requirement
How much revenue should the entity recognise for the year ended 30 April 20X7?
Fill in the proforma below.
C
£ H
Revenue A
P
T
E
WORKING R
10

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Interactive question 8: Servicing fees

On the last day of its current accounting period, Computer Ltd completes the handover of a new
system to a client and raises an invoice for £800,000. This price includes after-sales support for
the next two years, which is estimated to cost £35,000 each year. Computer Ltd normally earns a
gross profit margin of 17.5% on such support activity.
Requirement
Calculate the revenue to be included in Computer Ltd's current year statement of profit or loss
in respect of this sale.
Fill in the proforma below.
£
After-sales support
Remainder
Total selling price
So the revenue from the sale in the current year is
3.5 Licences
A licence allows a customer to access intellectual property such as software, patents,
trademarks, franchises, copyrights and media (eg, films).
The grant of a licence may be accompanied by the promise to transfer other goods or services
in the following circumstances:
(a) Where the promise to grant a licence is distinct, it forms a separate performance obligation
from that for goods and services.
(b) Where the promise to grant a licence is a separate performance obligation, revenue is
either recognised at a point in time or over time depending on the nature of the contract.
(c) Where the promise to grant a licence is not distinct from the promised goods and services,
the goods, services and licence are combined as one single performance obligation (eg,
software that requires ongoing upgrade services in order to function or a software hosting
agreement on an internet site). This performance obligation may be satisfied at a point in
time or over time and this should be determined in accordance with IFRS guidance (see
section 2.9).
(d) Where the licence allows the customer access to the vendor's intellectual property as it
exists at any given time in the licence period (ie, the vendor continues to support and
update the intellectual property), this is a performance obligation satisfied over time.
(e) Where the licence allows the customer access to the vendor's intellectual property as it
exists at the date the licence is granted, this is a performance obligation satisfied at a point
in time.
Worked example: Licensing

A fast food company 'PizzaTheAction' grants a franchise licence to a customer, allowing the
customer to use the PizzaTheAction brand and sell company products for a 10-year period.
During the 10-year period, management at PizzaTheAction will perform customer analysis,
continuously improve the product and advertise the brand, all of which will affect the franchise
licence.
Requirement
Explain how the revenue arising from this transaction is recognised.

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Solution
PizzaTheAction is providing access to its intellectual property as it exists throughout the licence
period (ie, the customer will benefit from continuous improvements and marketing etc).
Therefore the performance obligation is satisfied over time and PizzaTheAction recognises
revenue over the licence period.
3.6 Royalties
A contract to licence intellectual property may require as consideration a royalty that is
measured by reference to sales or usage. In such cases, the seller recognises revenue when the
later of the following events occurs:
 The subsequent sale or usage arises.
 The performance obligation to which some or all of the sales- or usage-based royalty has
been allocated is satisfied (or partially satisfied).
3.7 Repurchase agreements

Under a repurchase agreement an entity sells an asset and has the option to repurchase it. This
can come in one of three forms (IFRS 15.B64):
(a) An obligation to repurchase (a forward contract)
(b) A right to repurchase (a call option)
(c) An obligation to repurchase at the customer's request (a put option)
Under a forward contract or a call option the customer does not obtain control of the asset
because that control is limited by the repurchase option. The contract is accounted for as a lease
if the repurchase price is below the original selling price, or a financing arrangement if the
repurchase price is equal to or above the original selling price (IFRS 15.B66).
Under a put option, if the customer does not have sufficient economic incentive to exercise the
right to request repurchase, the agreement should be treated as if it were a sale with a right of
return. If the customer does have sufficient economic incentive, for instance if the repurchase
price is above the original selling price and above market value, the contract is treated as a
financing arrangement (IFRS 15.B73).
Worked example: Repurchase agreement

An entity sold an investment property to a financial institution for £4 million when the fair value
of the property was £5 million. Further investigation uncovered an agreement whereby the
entity could repurchase the property after one year for £4.32 million.
Requirement
How should this transaction be accounted for? C
H
A
Solution
P
The entity has a right to repurchase the property – a call option. The repurchase price is above T
E
the original selling price, so this is, in effect, a financing arrangement. R
The sale of the property at 20% below fair value is sufficient to cast doubt on whether a real sale 10
has been made. Also, the repurchase price is below fair value at the date of sale and represents
a return to the financial institution of 8% ((£4.32m – £4m) as a percentage of £4 million) on the
amount paid out.

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The substance of the arrangement appears to be that the financial institution has granted the
entity a one-year loan secured on the property, charging interest at 8%.
The transaction should be accounted for by:
 continuing to recognise the property as an asset;
 crediting the £4 million received to a liability account;
 recognising £0.32 million as a finance cost in profit or loss and crediting it to the liability
account; and
 derecognising the liability when the £4.32 million cash is paid out.
Interactive question 9: Sale and repurchase

Builder Ltd specialises in building high quality executive flats in city centres. On 1 March 20X6 it
sells a plot of building land to Finance plc, an unconnected company, for £1.5 million.
Builder Ltd retains rights of access and supervision over the plot, the right to build on this land
until 28 February 20X9 and the right to buy the plot back again on that date for £1.9 million. On
1 March 20X6 the plot is valued at £2.5 million.
Requirement
Explain how this sale transaction would be dealt with in Builder Ltd's financial statements for the
year ended 28 February 20X7.
2
3.8 Consignment arrangements

In a consignment arrangement, a dealer does not obtain control of an asset. Such arrangements
are common in the motor industry. Often a car manufacturer will enter into an arrangement with
a car dealer such that the dealer takes and displays vehicles with a view to selling them to a
customer. In such situations, the manufacturer cannot recognise any revenue because the dealer
does not obtain control of the cars at the point of delivery.
The following are indicators that an arrangement is a consignment arrangement:
 The product is controlled by the seller (manufacturer) until a specified event occurs (eg, the
product is sold onwards or a specified period of time expires).
 The seller (manufacturer) can require the return of the product or transfer it to another
party.
 The customer (dealer) does not have an unconditional obligation to pay for the product.
3.9 Bill and hold arrangements

Under these arrangements, an entity bills the customer for the product but delivery is delayed
with the agreement of the customer, perhaps because the customer is short of space. In this
case, the entity must determine the point in time at which it has satisfied its performance
obligation by transferring control of the product to the customer. It may be that the customer is
still able to exercise control without having physical possession of the product. (IFRS 15 .B79)
Control may pass at the point of delivery or when the product is shipped or at an earlier date ie,
the customer may obtain control even though the seller has physical possession of the product.

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All the following IFRS 15 criteria must have been met in a bill and hold arrangement, in order for
control to be said to have passed:
(1) There must be a substantive reason for the bill and hold must be substantive, for example,
the customer has requested it.
(2) The product must be identified as belonging to the customer.
(3) The product must be ready for physical transfer to the customer.
(4) The seller must not be able to use the product or transfer it to another customer.
If these criteria are met, enabling revenue to be recognised on a bill and hold basis, the seller
should consider whether to allocate a proportion of the transaction price to the provision of a
storage service.
Interactive question 10: Bill and hold

Walbrooke Engineering plc enters into a contract with Southfield Beverages Ltd on
1 January 20X8 for the sale of a bottling machine and spare parts. It takes two years to
manufacture these and on 31 December 20X9 the customer pays for both the machine and the
spare parts, but only takes physical possession of the machine. The customer inspects and
accepts the spare parts, but requests that Walbrooke Engineering continues to store them at its
warehouse.
Requirement
Explain when Walbrooke Engineering should recognise revenue in respect of this transaction.
2
3.10 Options for additional goods and services

An option in a sales contract may grant the customer the right to acquire additional goods or
services for free or at a discount. In some cases this may take the form of 'loyalty points'. For
example, airlines often give passengers loyalty points when they buy a flight. When enough
loyalty points are acquired, they can be redeemed for a free flight.
The option to acquire additional goods or services forms a separate performance obligation if
the option can only be obtained by entering into the initial sales contract.
In this case, part of the transaction price is allocated to the option to acquire additional goods or
services, and part is allocated to the goods or services that are the subject of the sales contract.
Revenue is recognised in respect of the option to acquire additional goods or services at the
earlier of:
 the date on which the additional goods or services are provided;
 the date on which the option to acquire the additional goods or services expires.
C
The allocation of transaction price to the option is based on the stand-alone selling price of the H
additional goods or services, taking account of the discount and adjusted for the likelihood that A
P
the option will be exercised. T
E
If the option granted to the customer does not offer a discount, it is treated as a marketing offer
R
and no contract exists until the customer exercises the option to purchase.
10

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Worked example: Customer loyalty scheme

GymGo Ltd, a 'pay as you go' gym operates a customer loyalty scheme whereby if a customer
pays for nine visits and has a loyalty card stamped, the tenth visit is provided free of charge.
During 20X7, customers visit the gym a total of 94,995 times, paying £10 per visit, so earning the
right to a maximum of 10,555 (94,995/9) free visits, each of which has an average stand-alone
price of £10. The gym expects 7,400 of the free visits to be claimed and by 31 December 20X7,
4,350 have been claimed.
Requirement
Explain how revenue is recognised by GymGo Ltd.
Solution
The promise to provide a free tenth visit is a performance obligation, and total revenue of
£949,950 (94,995  £10) is allocated between visits to the gym by customers and the loyalty
scheme.
Revenue is allocated to the provision of 'stamps' based on the expected take up rate and the
stand-alone selling price basis ie, based on a total stand-alone selling price of £74,000
(7,400  £10):
£
Gym visits £949,950  (949,950/(949,950 + 74,000)) 881,298
Loyalty stamps £949,950  (74,000/(949,950 + 74,000)) 68,652
949,950
At 31 December 20X7, 4,350 of the expected 7,400 free visits have been claimed, therefore of
the £68,652 transaction price allocated to loyalty stamps:
 £40,356 (4,350/7,400  £68,652) is recognised as revenue; and
 £28,296 is recognised as a contract liability for the unredeemed loyalty stamps.
Therefore total revenue recognised in 20X7 is £921,654 (881,298 + 40,356).
3.11 Non-refundable upfront fees

A non-refundable upfront fee is often charged at the beginning of a contract, such as joining
fees in health club membership contracts.
In many cases upfront fees do not relate to the transfer of any promised good or service, but are
simply advance payments for future goods or services. In this case revenue is recognised when
the future goods or services are provided.
If the fee relates to a good or service the entity should evaluate whether or not it amounts to a
separate performance obligation. This depends on whether it results in the transfer of an asset
to the customer. The fee may relate to costs incurred in setting up a contract, but these setup
activities may not result in the transfer of services to the customer.
3.12 Key effects of IFRS 15

 Revenue is recognised only in the transfer of goods or services to a customer. This will
affect some long-term contracts previously accounted for using a percentage of completion
method when the customer does not receive goods or services continuously (eg, some
construction and some software development contracts). Under the new standard, a
company would apply the percentage of completion method of revenue recognition only if
the company transfers services to the customer throughout the contract – ie, if the customer
owns the work in progress as it is built or developed.

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 Separate performance obligations are recognised for distinct goods or services. This could
result in some revenue being attributed to goods or services that were previously
considered incidental to the contract – for instance, to mobile phones that are provided free
of charge with airtime contracts and to some post-delivery services, such as maintenance
and installation.
 Probability-weighted estimates are required of the consideration to be received. This
could result in a company recognising some revenue on the transfer of a good or service,
even if the consideration amount is contingent on a future event – for example, an agent
that provides brokerage services in one period in exchange for an amount of consideration
to be determined in future periods, depending on the customer's behaviour.
 A customer's credit risk is reflected in the measurement of revenue. This could result in a
company recognising some revenue when it transfers a good or service to a customer even
if there is uncertainty about the collectability of the consideration, rather than deferring
revenue recognition until the consideration is collected.
 The transaction price is allocated in proportion to the standalone selling price. This will
affect some previous practices, particularly in the software sector, that resulted in the
deferral of revenue if a company did not have objective evidence of the selling price of a
good or service to be provided.
 Contract acquisition costs are expensed. This will affect companies that have previously
capitalised such costs – for example, commissions and other directly incremental costs – and
amortised them over the contract period.
3.13 Timing of revenue

By far the most significant change in IFRS 15 is to the pattern of revenue reporting. Even if the
total revenue reported does not change, the timing will change in many cases.
The example of Westerfield, our fictitious company in the worked example above (Applying the
IFRS 15 five-step model), illustrates this point. Under IAS 18, Revenue, the old standard,
Westerfield would not recognise any revenue from the sale of the handset, on the grounds that
Westerfield has given it to Peterloo for free. Westerfield would view the free handset as a cost of
acquiring a new customer, and the cost would be recognised in profit or loss immediately.
Revenue from the provision of network services would be recognised on a monthly basis as
follows:
DEBIT Receivable/Cash £200
CREDIT Revenue £200
Westerfield's year-end is 31 July 20X4, which means that the contract falls into more than one
accounting period. The impact of changing from IAS 18 to IFRS 15 for Westerfield, for the year
ended 31 July 20X4 is as follows:
Performance obligation Under IAS 18 Under IFRS 15
£ £
C
Handset 00.00 460.80
H
Network services: (200  7)/(161.60  7) 1,400.00 1,131.20 A
Total 1,400.00 1,592.00 P
T
The variation in timing has tax implications, and if the tax rate changes, this may have an overall E
effect on profit. R
10

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4 Audit focus
Section overview
This section looks at audit procedures relevant when considering the appropriateness of the
accounting treatment adopted for construction contracts.
4.1 Audit procedures for testing IFRS 15

Stage of IFRS 15 Suggested audit procedures
Step 1  Obtain copies of contracts between entities and customers
Identify the  Inspect contracts to confirm they are legally binding and effective for
contract(s) with a the year of audit
customer.  For implied contracts (such as retail contracts) clarify the likely
contractual terms to establish rights and responsibilities in each case
Step 2  Confirm the goods or services to be transferred, either individually or

as part of a series, by reference to the contracts in place
Identify separate
performance  Confirm whether any of the goods or service are not distinct by
obligations. reference to the contracts in place and if separate bundles
Step 3  Identify the amount of consideration by reference to the contract
Determine the  Where appropriate, confirm the split between variable and fixed
transaction price. elements and re-calculate any variable amounts by reference to the
contract terms
 Test the hypothesis that variable consideration is highly probable by
reviewing the reasonableness of the underlying assumptions used in
the entity's calculations
Step 4  Confirm stand-alone prices to individual elements of the contract as

performance obligations are settled
Allocate transaction
price to  In the case of estimated stand-alone prices, test the assumptions
performance underpinning the calculations used by the entity for reasonableness
obligations.
Step 5  For performance obligations satisfied at a point in time (such as retail

sales) confirm the occurrence of the event required (such as the sale
Recognise revenue
itself) by reference to supporting documentation
as or when each
performance (For performance obligations satisfied over time refer to section 4.2
obligation is below.)
satisfied.
Other tests  For deferred consideration, confirm the proportion split between the
value of the goods on the date of sale and the financing income by
reference to the contract and testing the reasonableness of the
entity's calculations for recognising revenue (such as interest rates for
estimating fair value)

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Consignment  Consider the existence of any indicators of consignment

arrangements arrangements, such as:
– Confirming who controls the product and what (if any)
conditions need to have occurred for control to be passed on
– Clarifying who can require the return of a product or transfer it
to a third party
Bill and hold  Consider the existence of such arrangements and if present, review
arrangements the conditions required by IFRS 15 have been met:
– Confirm that the customer owns the products stored by the seller by
reference to the contract terms, and obtain confirmation from the
customer that they are happy for the seller to hold them
– Inspect the agreement between the seller and customer to confirm
the products can be accessed at any time and not transferred to
another customer
4.2 Audit procedures for contracts in which performance obligations are

satisfied over time ('construction contracts')
Remember, under IFRS 15, the entity recognises revenue in such cases by measuring progress
towards complete satisfaction of the performance obligation. Progress can be measured using
output methods (measuring the value to the customer of goods or services transferred to date)
or input methods (measuring the cost to the entity of goods or services transferred to date).
(IFRS 15.B14)
The following audit procedures will be relevant:
 Confirm contract price to contract agreed between client and customer
 Determine any amounts of conditional revenue/costs including the associated conditions
 Confirm the progress to date of the work completed, including any potential delays or
problems
 Confirm costs incurred to date (inputs) by reference to management accounts, invoices,
budgets and other relevant documentation
 Identify any expenditure not supporting fulfilment of the contract by inspecting board
minutes, management accounts or other documentation (such as legal correspondence)
 Confirm total costs estimated for contract to ensure no planned overspends have been
identified (again, budgets, board minutes or management accounts can be inspected)
 Confirm the amounts of contract work certified as complete (outputs) at the year end by
reference to relevant documentation (such as surveyors' reports or client estimates)
C
Interactive question 11: Construction contracts H
A
Construction Co has entered into a fixed price contract to construct an office block. Construction P
commenced on 1 March 20X6 and is expected to take 36 months. You are auditing the financial T
E
statements for the year ended 31 December 20X6. R
The contract price is made up as follows:
10
£'000
Contract price 600
Incentive payment if completed on time 40
640

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Total contract costs were originally estimated to be £470,000. At the end of 20X6 this estimate
has increased to £570,000 due to extra costs incurred to rectify a number of construction faults.
At the end of 20X6 the contract was assessed as being 30% complete. The draft financial
statements show that revenue of £192,000 has been recognised in respect of this contract.
Requirements
For the year ended 31 December 20X6:
(a) identify the audit issues you would need to consider
(b) list the audit procedures you would perform
Worked example: Carillion

In July 2017, UK construction firm Carillion collapsed leaving over £1 billion in debts and a
number of unfulfilled contracts, as well as a significant unfunded pension scheme. A UK
parliamentary committee interviewed the company's directors, internal auditors Deloitte, and
external auditors KPMG and asked why this could not have been foreseen in March 2017, only 4
months earlier, when the 2016 financial statements were signed off, despite a number of so-
called 'red flags' which had been identified by investors.
These 'red flags' included poor corporate governance, uncertainty over complex accounting
practices for goodwill and revenue (including the cash-flows on individual contracts) and
inadequate site visits as part of managing high-profile construction contracts clients.
(Source: www.accountancyage.com/2018/02/26/carillion-inquiry-missed-red-lights-aggressive-
accounting-pension-deficit/)

lOMoARcPSD|5054551
Summary
IFRS 15, Revenue from

Contracts with Customers
Five-step approach
Step 1 – Identify the contract(s)

with the customer
Are the goods Promise to

or services Step 2 – Identify separate provide goods
distinct? performance obligations or services
Step 3 – Determine the

transaction price
Step 4 – Allocate the Per

transaction price to stand-alone
performance obligations selling prices
Step 5 – Recognise revenue as

At a point or when performance Over time
in time obligations are satisfied
C
H
A
P
T
E
R
10

lOMoARcPSD|5054551
Self-test
IFRS 15, Revenue from Contracts with Customers
1 Webber
Webber sells two types of product, the Sleigh and the Sled. Webber sells the sleigh as an
agent of Caplin receiving commission of 15% on selling price. Webber sells the sled as
principal at a gross margin of 30%.
The following information relates to the year ended 30 September 20X8.
Sleighs Sleds
£ £
Total sales 200,000 75,000
Requirement
According to IFRS 15, Revenue from Contracts with Customers what revenue should
Webber recognise in total for Sleighs and Sleds for the year ended 30 September 20X8?
2 Alexander
On 1 January 20X0, Alexander Ltd supplied goods to David Ltd for an agreed sum of
£600,000. This amount becomes payable on 31 December 20X2. David Ltd could have
bought the goods for cash of £450,000 on 1 January 20X0. The imputed rate of interest to
discount the receivable to the cash sales price is 10%.
Requirement
In accordance with IFRS 15, Revenue from Contracts with Customers what amounts for
revenue and interest income should Alexander Ltd record in profit or loss relating to this
transaction for the year ended 31 December 20X0?
3 Southwell
Southwell Ltd, a manufacturing company, sold a property with a carrying amount of
£4.5 million for £5 million to Financier Ltd on 1 January 20X4. Southwell Ltd retains the right
to occupy the property and has an option to repurchase the property after two years for
£6 million. Property prices are expected to rise and the current market value is £8 million.
The annual rate for 20% over two years is 9.5%.
Requirement
In accordance with IFRS, 15 Revenue from Contracts with Customers what should be
recognised in the financial statements relating to this transaction for the year ended
31 December 20X4?
4 White Goods
White Goods Ltd sells an electrical appliance for £2,400 on 1 October 20X7 making a mark
up on cost of 20%. The customer is given a one-year interest-free credit period. White
Goods Ltd has a cost of capital of 9%.
Requirement
In accordance with IFRS 15, Revenue from Contracts with Customers, what amount should
the company recognise as revenue from the sale of the appliance in profit or loss for the
year ended 31 December 20X7?

lOMoARcPSD|5054551
5 Tree
You are the accountant of Tree, a listed limited liability company that prepares consolidated
financial statements. Your Managing Director, who is not an accountant, has recently
attended a seminar at which key financial reporting issues were discussed. She remembers
being told the following.
 Financial statements of an entity should reflect the substance of its transactions.
 Revenue from the contracts with customers should only be recognised when certain
conditions have been satisfied. Transfer of legal title to the goods is not necessarily
sufficient for an entity to recognise revenue from their 'sale'.
The year end of Tree is 31 August. In the year to 31 August 20X1, the company entered into
the following transactions.
Transaction 1
On 1 March 20X1, Tree sold a property to a bank for £5 million. The market value of the
property at the date of the sale was £10 million. Tree continues to occupy the property rent-
free. Tree has the option to buy the property back from the bank at the end of every month
from 31 March 20X1 until 28 February 20X6. Tree has not yet exercised this option. The
repurchase price will be £5 million plus £50,000 for every complete month that has elapsed
from the date of sale to the date of repurchase. The bank cannot require Tree to repurchase
the property and the facility lapses after 28 February 20X6. The directors of Tree expect
property prices to rise at around 5% each year for the foreseeable future.
Transaction 2
On 1 September 20X0, Tree sold one of its branches to Vehicle for £8 million. The net
assets of the branch in the financial statements of Tree immediately before the sale were
£7 million. Vehicle is a subsidiary of a bank and was specifically incorporated to carry out
the purchase – it has no other business operations. Vehicle received the £8 million to
finance this project from its parent in the form of a loan.
Tree continues to control the operations of the branch and receives an annual operating fee
from Vehicle. The annual fee is the operating profit of the branch for the 12 months to the
previous 31 August less the interest payable on the loan taken out by Vehicle for the
12 months to the previous 31 August. If this amount is negative, then Tree must pay the
negative amount to Vehicle.
Any payments to or by Tree must be made by 30 September following the end of the
relevant period. In the year to 31 August 20X1, the branch made an operating profit of
£2,000,000. Interest payable by Vehicle on the loan for this period was £800,000.
Requirements
(a) Explain the conditions that need to be satisfied before revenue can be recognised. You
should support your answer with reference to IFRS 15.
(b) Explain how the transactions described above will be dealt with in the consolidated
financial statements (statement of financial position and statement of profit or loss and C
H
other comprehensive income) of Tree for the year ended 31 August 20X1 in A
accordance with IFRS 15. P
T
6 Taplop E
R
Taplop supplies laptop computers to large businesses. On 1 July 20X5, Taplop entered into
a contract with TrillCo, under which TrillCo was to purchase laptops at £500 per unit. The 10
contract states that if TrillCo purchases more than 500 laptops in a year, the price per unit is
reduced retrospectively to £450 per unit. Taplop's year end is 30 June.

lOMoARcPSD|5054551
 As at 30 September 20X5, TrillCo had bought 70 laptops from Taplop. Taplop

therefore estimated that TrillCo's purchases would not exceed 500 in the year to
30 June 20X6, and would therefore not be entitled to the volume discount.
 During the quarter ended 31 December 20X5, TrillCo expanded rapidly as a result of a
substantial acquisition, and purchased an additional 250 laptops from Taplop. Taplop
then estimated that TrillCo's purchases would exceed the threshold for the volume
discount in the year to 30 June 20X6.
Requirements
Calculate the revenue Taplop would recognise in:
(a) the quarter ended 30 September 20X5
(b) the quarter ended 31 December 20X5
Your answer should apply the principles of IFRS 15, Revenue from Contracts with
Customers.
7 Clavering
Clavering Leisure Co owns and operates a number of hotels. The company is preparing its
financial statements for the year ended 31 May 20X3, and has come across the following
issues.
(a) One of the hotels owned by Clavering Leisure is a complex which includes a theme
park and a casino as well as a hotel. The theme park, casino and hotel were sold in the
year ended 31 May 20X3 to Manningtree Co, a public limited company, for
£200 million but the sale agreement stated that Clavering Leisure would continue to
operate and manage the three businesses for their remaining useful life of 15 years.
The residual interest in the business reverts back to Clavering Leisure after the 15-year
period. Clavering Leisure would receive 75% of the net profit of the businesses as
operator fees, and Manningtree would receive the remaining 25%. Clavering Leisure
has guaranteed to Manningtree that the net minimum profit paid to Manningtree
would not be less than £15 million per year.
(b) Clavering Leisure has recently started issuing vouchers to customers when they stay in
its hotels. The vouchers entitle the customers to a £30 discount on a subsequent room
booking within three months of their stay. Historical experience has shown that only
one in five vouchers are redeemed by the customer. At the company's year end of
31 May 20X3, it is estimated that there are vouchers worth £20 million which are
eligible for discount. The income from room sales for the year is £300 million and
Clavering Leisure is unsure how to report the income from room sales in the financial
statements.
Requirement
Advise Clavering Leisure on how the above accounting issues should be dealt with in its
financial statements in accordance with IFRS 15, Revenue from Contracts with Customers.
8 Rockwye
Rockwye is a manufacturer of luxury watches which it sells to customers via a number of
independent retailers. Rockwye recognises revenue and derecognises inventory when it
supplies each retailer with deliveries of watches for display. Watches are then displayed by
retailers at a price set by the manufacturer – once a watch is sold to a customer, the retailer
passes the revenue back to Rockwye. Any unsold watches are returned to Rockwye after a
period of 11 months.
Requirement
Comment on the accounting treatment in operation at Rockwye and recommend suitable
audit procedures that you should undertake.

lOMoARcPSD|5054551
Scenario question
9 Eco-Ergonom
Eco-Ergonom plc is an AIM quoted company which manufactures ergonomic equipment
and furniture, and environmentally friendly household products. You are the Financial
Controller, and the accounting year end is 31 December 20X7.
It is now 15 March 20X8, and the company's auditors are currently engaged in their work.
Deborah Carroll, the Finance Director, is shortly to go into a meeting with the Audit
Engagement Partner, Brian Nicholls, to discuss some unresolved issues relating to company
assets. To save her time, she wants you to prepare a memorandum detailing the correct
accounting treatment. She has sent you the following email, in which she explains the
issues:
To: Financial Controller
From: Deborah Carroll
Date: 15 March 20X8
Subject: Assets
As a matter of urgency, I need you to prepare a memorandum on the correct accounting
treatment of the items below, so that I can discuss this with the auditors.
Stolen lorries
As you know, we acquired a wholly owned subsidiary, a small road-haulage company, on
1 January 20X7 to handle major deliveries once we start producing larger items. So far, it
has proved more profitable to hire out its services to other companies, so the company is a
cash-generating unit.
We paid £460,000 for the business, and the values of the assets, based on fair value less
costs to sell, at the date of acquisition were as follows:
£'000
Vehicles (lorries) 240
Intangible assets (licences) 60
Trade receivables 20
Cash 100
Trade payables (40)
380
Unfortunately, three of the lorries were stolen on 1 February 20X7. The lorries were not
insured, because the road haulage company manager had failed to complete the
paperwork in time. The lorries had a net book value of £60,000, and we estimate that
£60,000 was also their fair value less costs to sell.
I believe that, as a result of the theft of the uninsured lorries, the value in use of the cash-
generating unit has fallen. We should recognise an impairment loss of £90,000, inclusive of
the loss of the stolen lorries.
We have another problem with this business. A competitor has come into operation,
covering similar routes and customers. Our revenue will be reduced by one-quarter, which C
will in turn reduce the fair value less costs to sell and the value in use of our haulage H
A
business to £310,000 and £300,000 respectively. Part of this decline is attributable to the P
competitor's actions causing the net selling value of the licences to fall to £50,000. There T
has been no change in the fair value less costs to sell of the other assets, which is the same E
R
as on the date of acquisition.
10
The company will continue to rent out the lorries for the foreseeable future.
How should we show this impairment in the financial statements?

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Fall in value of machines

The goods produced by some of our machines have been sold below their cost. This has
affected the value of the machines in question, which has suffered an impairment. The
carrying amount of the machines at depreciated historical cost is £580,000 and their fair
value less costs to sell is estimated to be £240,000. We anticipate that cash inflows from the
machines will be £200,000 per annum for the next three years. The annual market discount
rate, as you know, is 10%.
How should we determine the impairment in value of the machines in the financial
statements and how should this be recognised?
Own brand
This year, Eco-Ergonom has been developing a new product, Envirotop. Envirotop is a new
range of environmentally friendly kitchen products and an ergonomic kitchen design
service. The expenditure in the year to 31 December 20X7 was as follows:
Period from Expenditure type £m
1 Jan 20X7 – 31 March 20X7 Research on size of potential market 6
1 April 20X7 – 30 June 20X7 Prototype kitchen equipment and
product design 8
1 July 20X7 – 31 August 20X7 Wage costs in refinement of products 4
1 September 20X7 – 30 November 20X7 Development work undertaken to
finalise design of kitchen equipment 10
1 December 20X7 – 31 December 20X7 Production and launch of equipment
and products 12
40
Currently an intangible asset of £40 million is shown in the financial statements for the year
ended 31 December 20X7.
Included in the costs of the production and launch of the products are the cost of
upgrading the existing machinery (£6 million), market research costs (£4 million) and staff
training costs (£2 million).
Please explain the correct treatment of all these costs.
Purchase of Homecare
You will also know that, on 1 January 20X7, Eco-Ergonom acquired 100% of Homecare, a
private limited company manufacturing household products. Eco-Ergonom intends to
develop its own brand of environmentally friendly cleaning products. The shareholders of
Homecare valued the company at £25 million based upon profit forecasts which assumed
significant growth in the demand for the 'Homecare' brand name. We took a more
conservative view of the value of the company and estimated the fair value to be in the
region of £21 million to £23 million, of which £4 million relates to the brand name
'Homecare'. Eco-Ergonom is only prepared to pay the full purchase price if profits from the
sale of 'Homecare' goods reach the forecast levels. The agreed purchase price was
£20 million plus a further payment of £5 million in two years on 31 December 20X8. This
further payment will comprise a guaranteed payment of £2 million with no performance
conditions and a further payment of £3 million if the actual profits during this two-year
period from the sale of Homecare goods exceed the forecast profit. The forecast profit on
Homecare goods over the two-year period is £3 million and the actual profits in the year to
31 December 20X7 were £0.8 million. Eco-Ergonom did not feel at any time since
acquisition that the actual profits would meet the forecast profit levels. Assume an annual
discount rate of 5.5%.
Requirement
Prepare the memorandum asked for by the Finance Director.

lOMoARcPSD|5054551
Technical reference
Revenue is income arising in the course of an entity's ordinary activities. IFRS 15 Appendix A
Five-step approach is used: IFRS 15 (IN7)
 Identifying the contract IFRS 15 (9)
 Identifying the performance obligations IFRS 15 (22)
– Satisfaction of performance obligations IFRS 15 (31)
– Performance obligations satisfied over time IFRS 15 (35)
– Performance obligations satisfied at a point in time IFRS 15 (38)
 Determining the transaction price IFRS 15 (47)
 Allocating the transaction price to the performance obligations IFRS 15 (73)
 Recognising revenue as/when obligations are satisfied IFRS 15 (31)
Incremental costs of a contract are recognised. IFRS 15 (91–94)
Costs incurred to fulfil a contract are recognised as an asset if and only if IFRS 15 (95)
all of certain criteria are met:
– The costs relate directly to a contract (or a specific anticipated
contract);
– The costs generate or enhance resources of the entity that will be
used in satisfying performance obligations in the future; and
– The costs are expected to be recovered.
Costs include direct labour, direct materials, and the allocation of IFRS 15 (97)
overheads that relate directly to the contract.
The asset recognised in respect of the costs to obtain or fulfil a contract is IFRS 15 (99)
amortised on a systematic basis that is consistent with the pattern of
transfer of the goods or services to which the asset relates.
IFRS 15 gives further guidance on: IFRS 15 (App B)
 Performance obligations satisfied over time
 Methods for measuring progress towards complete satisfaction of a
performance obligation
 Sale with a right of return
 Warranties
 Principal versus agent considerations
 Customer options for additional goods or services
 Customers' unexercised rights C
H
 Non-refundable upfront fees
A
 Licensing P
T
 Repurchase agreements E
R
 Consignment arrangements
 Bill-and-hold arrangements 10
 Customer acceptance
 Disclosures of disaggregation of revenue

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Magazine revenue £16,000
Explanation
Revenue for the magazines should be recognised in the periods in which they are despatched,
assuming the items are of similar value in each period. Despatch of the magazine constitutes
satisfaction of the performance obligation. Thus the revenue to be recognised in the year ended
31 March 20X7 is £48,000  4/12 = £16,000.

Revenue £nil
Explanation
Revenue should be recognised when the drills are delivered to the customer. This is the point at
which the performance obligation is satisfied. Until then no revenue should be recognised and
the deposits should be carried forward as deferred income.

(a) Costs to complete are £90,000
This is a contract with performance obligations satisfied over time and 33% of the
performance has been completed to date.
Revenue can be recognised on the output basis by the percentage of completion method,
so 33% of £210,000 = £69,300.
Note: The project is profitable overall (total revenue £210,000, total costs £135,000), so no
provision for a contract loss need be made.
(b) Costs to complete cannot be estimated reliably
As the outcome of the overall contract cannot be estimated reliably, revenue is recognised
to the extent of the costs incurred which are recoverable ie, £40,000. The current period
therefore recognises the contract loss to date of £5,000.

Contract revenue £60,000
Explanation
If the outcome of a services transaction cannot be estimated reliably, revenue should only be
recognised to the extent that expenses incurred are recoverable from the customer.

The Sales Director wishes to recognise the sale as early as possible. However, following IFRS 15,
Revenue from Contracts with Customers, revenue from the sale should only be recognised when
the performance obligations in the contract have been satisfied.

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Performance obligations in the contract

The contract contains a promise to deliver the caravan and a promise to deliver additional
goods free of charge. These are distinct promises and therefore the contract contains two
performance obligations.
Transaction price
The transaction price is made up of three elements.
A significant financing component must be considered where consideration is received more
than 12 months before or after the date on which revenue is recognised (being the delivery
date, 1 August 20X7). Therefore the payment on 1 August 20X9 must be discounted to present
value at 1 August 20X7.
£
Deposit 3,000
Payment on 1.8.X7 (the delivery date) 15,000
Payment on 1.8.X9 (£12,000/1.12) 9,917
27,917
Allocation to performance obligations

The transaction price is allocated based on standalone selling prices:
Caravan 30,000/31,500  £27,917 = £26,588
Free equipment 1,500/31,500  £27,917 = £1,329
Recognition of revenue
The two performance obligations are satisfied simultaneously on 1 August 20X7, and therefore
all revenue is recognised on this date.
Journal entries are as follows:
1 May 20X7
The receipt of cash in the form of the £3,000 deposit is recognised on receipt as a contract
liability (deferred income) in the statement of financial position by:
DEBIT Bank £3,000
CREDIT Contract liability (deferred income) £3,000
1 August 20X7
Revenue is recognised together with payment of the first £15,000. The contract liability is
transferred to be revenue:
DEBIT Bank £15,000
DEBIT Contract liability £3,000
DEBIT Receivable £9,917
CREDIT Revenue £27,917
Note: This question is rather fiddly, so do not worry too much if you didn't get all of it right. Read
through our solution carefully, going back to first principles where required. C
H
A
P
T
E
R
10

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(a)  Bags Galore Ltd expects 3 bags (6%  50) to be returned.
 Therefore on 28 January 20X9 revenue is recognised in relation to 47 bags, giving a
total of £39,950 (47  £850).
 A refund liability of £2,550 (3  £850) is recognised.
 The cost of 47 bags of £18,800 (47  £400) is transferred to cost of sales. The
remaining 3 bags are recognised as an asset (the right to recover the bags) at cost of
£1,200 (3  £400). The 'right to recover' asset is measured at the original cost of the
bags that are expected to be returned because, even in the 'Fabulous February' sale,
they are capable of being sold for £425 (50%  £850) ie, more than cost.
The required accounting entries are:
DEBIT Bank (50  £850) £42,500
CREDIT Revenue £39,950
CREDIT Refund liability £2,550
To recognise the sale of bags and expectation that 6% will be returned.
DEBIT Asset (right to recover

inventory) £1,200
DEBIT Cost of sales (47  £400) £18,800
CREDIT Asset (inventory) £20,000
To recognise the transfer of items of inventory that are not expected to be returned to
become cost of sales and that are expected to be returned to become assets (the right to
recover the 3 bags).
(b) If the selling price of the bags were reduced to £340 (40%  £850):
 The revenue and refund liability would be recorded as before.
 The retained asset would be measured at £1,020 (3  £340), so resulting in a write
down of the carrying amount of inventory in profit or loss.

£
Revenue – Sale of goods (W) 1,350,000
– Sale of services (W) 25,000
Total 1,375,000
WORKING
£
After-sale support (120,000/(100% – 20%)) 150,000
Remainder = sale of goods (bal fig) 1,350,000
Total revenue 1,500,000
Revenue for sale of services recognised in the four months to 30 April 20X7 should be
£150,000/2 years  4/12 = £25,000

£
After-sales support (2  (35,000/82.5%)) 84,848
Remainder 715,152
Total selling price 800,000
So the revenue from the sale in the current year is: 715,152

lOMoARcPSD|5054551

 As there is an option to repurchase, this is a call option with a repurchase price above the
original selling price, so it is treated as a financing arrangement.
 Through the rights of access and supervision, together with the right to build on the land,
Builder Ltd has retained the risks and rewards of ownership over the building plot, so
should continue to show it as an asset in its statement of financial position.
 The fact that the consideration for the sale on 1 March 20X6 is so far below the valuation is
further evidence that the transaction is in substance a three-year loan, with the £400,000
difference between the selling and repurchase prices being interest on the loan.
 The right to repurchase in the future for much less than the current valuation (making the
exercise of the repurchase right almost a certainty) is further evidence that this is not a real
sale.
 So Builder Ltd will show the building plot in its 28 February 20X7 statement of financial
position as a current asset (as it will be realised in the normal course of its operating cycle)
at its original acquisition cost (not given in the Interactive question).
 In the same statement of financial position it will show the £1.5 million received on
1 March 20X6 as a liability, together with any unpaid part of the £400,000 interest which is
attributable to the first year of the loan.
 The appropriate part of the total interest will be charged to profit or loss for the year ended
28 February 20X7.

The contract contains three performance obligations – transfer of the machine, transfer of the
spare parts and the custodial services. The transaction price is allocated to the three
performance obligations and revenue is recognised when (or as) control passes to the customer.
The machine and the spare parts are both performance obligations satisfied at a point in time,
this being 31 December 20X9. In the case of the spare parts, the customer has paid for them,
the customer has legal title to them and the customer has control of them as they can remove
them from storage at any time.
The custodial services are a performance obligation satisfied over time, so revenue will be
recognised over the period during which the spare parts are stored.

(a) Audit issues
 Whether revenue recognised to date includes a proportion of the incentive payment.
This would only be appropriate if it is probable that this income will be received.
 Total costs to complete have been increased during the year due to rectification costs.
C
There is a risk that there may be other rectification costs which have yet to be H
identified. A
P
 Whether the accounting treatment of the revenue recognised is in accordance with T
IFRS 15. The current figure of £192,000 appears to be based on 30% of the expected E
R
total revenue (640  30%) but it is unclear where this 30% has come from. If revenue is
being measured on costs incurred to date (input basis) the additional £100,000 of 10
contract costs may not be allowable as part of this calculation. Similarly, if certified as
complete (output basis) on a pro-rated time basis, the contract is only 10 months old –
this would give a percentage of 10/36 = 27.8% which could lead to overstated
revenue.

lOMoARcPSD|5054551
(b) Audit procedures

 Agree the contract price and incentive payment to the sales contract.
 Discuss with management the basis on which they have recognised the incentive
payment and review their performance on other similar contracts to determine the
likelihood of the contract being completed on time.
 Establish the basis on which the percentage completion of 30% has been determined.
If a surveyor has been used to make this estimate assess the extent to which this
evidence can be relied on.
 Discuss with management the nature of the rectification costs and assess the likelihood
of other similar additional costs being incurred. Obtain a schedule of these and agree
to supporting documentation.
 Review management calculations regarding costs to complete and seek corroboration
for any assumptions made.
 Discuss with management the revenue recognition policy adopted. If material to the
financial statements the figures should be revised in accordance with IFRS 15.

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1 Webber
£
Revenue recognised as agent (£200,000  15%) 30,000
Revenue recognised as principal 75,000
Total revenue 105,000
2 Alexander
At the time of supply, revenue is recognised for the cash sale price of £450,000. Interest will
then be accrued until payment is made. For the year ended 31 December 20X0 the interest
charge is £450,000  10% = £45,000.
3 Southwell
As there is an option to repurchase, this is a call option with a repurchase price above the
original selling price, so it is treated as a financing arrangement.
Initial loan: DR Cash £5m
CR Loan £5m
Interest: DR Interest (Profit or loss) (5m  9.5%) £0.475m
CR Loan £0.475m
Total loan liability is £5.475 million.
4 White Goods
The amount receivable discounted to present value = £2,400  1/1.09 = £2,202
This is recognised as income on 1 October 20X7. The difference between this and the sale
proceeds (2,400 – 2,202 = 198) is treated as interest and will be recognised over the
12-month interest-free credit period.
5 Tree
(a) IFRS 15, Revenue from Contracts with Customers states the following (IFRS 15.35):
Revenue is recognised when (or as) a performance obligation is satisfied. The entity
satisfies a performance obligation by transferring control of a promised good or
service to the customer. A performance obligation can be satisfied at a point in time,
such as when goods are delivered to the customer, or over time. An obligation
satisfied over time will meet one of the following criteria:
 The customer simultaneously receives and consumes the benefits as the
performance takes place.
 The entity's performance creates or enhances an asset that the customer controls
as the asset is created or enhanced.
C
 The entity's performance does not create an asset with an alternative use to the H
entity and the entity has an enforceable right to payment for performance A
completed to date. P
T
The amount of revenue recognised is the amount allocated to that performance E
R
obligation. An entity must be able to reasonably measure the outcome of a
performance obligation before the related revenue can be recognised. In some 10
circumstances, such as in the early stages of a contract, it may not be possible to
reasonably measure the outcome of a performance obligation, but the entity expects
to recover the costs incurred. In these circumstances, revenue is recognised only to the
extent of costs incurred.

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(b) Transaction 1
Tree has the option to repurchase the property but cannot be required to do so. This is
a call option in which the repurchase price is equal to or above the original selling
price, so it should be accounted for as a financing arrangement.
Tree has not transferred control of the property to the bank as it still has the right to
exercise this option, so no performance obligation has been satisfied that could justify
the recognition of revenue.
The transaction is essentially a loan secured on the property, rather than an outright
sale. The £50,000 payable for each month that the bank holds the property is interest
on the loan.
The property remains in the consolidated statement of financial position at its cost or
market value (depending on the accounting policy adopted by Tree). The loan of
£5 million and accrued interest of £300,000 (6  50,000) are reported under non-
current liabilities. Interest of £300,000 is recognised in consolidated profit or loss.
Transaction 2
The key issue is whether Tree has transferred control of the branch.
Tree continues to control the operations of the branch and the amount that it receives
from Vehicle is the operating profit of the branch less the interest payable on the loan.
Tree also suffers the effect of any operating losses made by the branch. Therefore, the
position is essentially the same as before the 'sale' and Tree has not satisfied any
performance obligation in return for the consideration of £8 million.
Although Vehicle is not a subsidiary of Tree as defined by IFRS 10, Consolidated
Financial Statements, it is a special purpose entity (quasi-subsidiary). It gives rise to
benefits for Tree that are in substance no different from those that would arise if it were
a subsidiary. Its assets, liabilities, income and expenses must be included in the
consolidated financial statements.
The assets and liabilities of Vehicle are included in the consolidated statement of
financial position at £7 million (their original value to the group). The loan of £8 million
is recognised as a non-current liability. The profit on disposal of £1 million and the
operating fee of £1,200,000 are cancelled as intra-group transactions. The operating
profit of £2 millon is included in consolidated profit or loss, as is the loan interest of
£800,000.
6 Taplop
(a) Applying the requirements of IFRS 15 to TrillCo's purchasing pattern at 30 September
20X5, Taplop should conclude that it was highly probable that a significant reversal in
the cumulative amount of revenue recognised (£500 per laptop) would not occur when
the uncertainty was resolved, that is when the total amount of purchases was known.
Consequently, Taplop should recognise revenue of 70  £500 = £35,000 for the first
quarter ended 30 September 20X5.
(b) In the quarter ended 31 December 20X5, TrillCo's purchasing pattern changed such
that it would be legitimate for Taplop to conclude that TrillCo's purchases would
exceed the threshold for the volume discount in the year to 30 June 20X6, and
therefore that it was appropriate to reduce the price to £450 per laptop. Taplop should
therefore recognise revenue of £109,000 for the quarter ended 31 December 20X5.
The amount is calculated as from £112,500 (250 laptops  £450) less the change in
transaction price of £3,500 (70 laptops × £50 price reduction) for the reduction of the
price of the laptops sold in the quarter ended 30 September 20X5.

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7 Clavering
(a) Sale of hotel complex
The issue here is one of revenue recognition, and the accounting treatment is
governed by IFRS 15, Revenue from Contracts with Customers. Step (5) of the
standard's revenue recognition process requires that revenue is recognised when (or
as) a performance obligation is satisfied. The entity satisfies a performance obligation
by transferring control of a promised good or service to the customer. A performance
obligation can be satisfied at a point in time, such as when goods are delivered to the
customer, or over time. In the case of the hotel transfer, the issue is that of a
performance obligation satisfied at a point in time. One of the indicators of control is
that significant risks and rewards of ownership have been transferred to the customer.
It can be argued in some cases where property is sold that the seller, by continuing to
be involved, has not satisfied the performance obligation by transferring control,
partly because the seller has not transferred the risks and rewards of ownership. In
such cases, the sale is not genuine, but is often in substance a financing arrangement.
IFRS 15 requires that the substance of a transaction is determined by looking at the
transaction as a whole. If two or more transactions are linked, they should be treated as
one transaction to better reflect the commercial substance.
Clavering Leisure continues to operate and manage the hotel complex, receiving the
bulk (75%) of the profits, and the residual interest reverts back to Clavering Leisure;
effectively, Clavering Leisure retains control by retaining the risks and rewards of
ownership. Manningtree does not bear substantial risk: its minimum annual income is
guaranteed at £15 million. The sale should not be recognised. In substance it is a
financing transaction. The proceeds should be treated as a loan, and the payment of
profits as interest.
(b) Discount vouchers
The treatment of the vouchers is governed by IFRS 15, Revenue from Contracts with
Customers. The principles of the standard require the following:
(1) The voucher should be accounted for as a separate component of the sale.
(2) The promise to provide the discount is a performance obligation.
(3) The entity must estimate the stand-alone selling price of the discount voucher in
accordance with paragraph B42 of IFRS 15. That estimate must reflect the discount
that the customer would obtain when exercising the option, adjusted for both of
the following:
 Any discount that the customer could receive without exercising the option
 The likelihood that the option will be exercised.
The vouchers are issued as part of the sale of the room and redeemable against
future bookings. The substance of the transaction is that the customer is
purchasing both a room and a voucher.
C
Vouchers worth £20 million are eligible for discount as at 31 May 20X3. However, H
A
based on past experience, it is likely that only one in five vouchers will be P
redeemed, that is vouchers worth £4 million. Room sales are £300 million, so T
effectively, the company has made sales worth £(300m + 4m) = £304 million in E
R
exchange for £300 million. The stand-alone price would give a total of
£300 million for the rooms and £4 million for the vouchers. 10
To allocate the transaction price, following step (4) of IFRS 15's five-step process
for revenue recognition, the proceeds need to be split proportionally pro rata the

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stand-alone prices, that is the discount of £4 million needs to be allocated

between the room sales and the vouchers, as follows:
300
Room sales:  £300m = £296.1m
304
Vouchers (balance) = £3.9m
The £3.9 million attributable to the vouchers is only recognised when the
performance obligations are fulfilled, that is when the vouchers are redeemed.
8 Rockwye
Matters to consider
The accounting treatment adopted by Rockwye does not appear to comply with IFRS 15 as
it appears to be a consignment arrangement in place with retailers. This means that
Rockwye cannot recognise any revenue or derecognise inventory when the watches are
delivered to retailers because control has not passed from Rockwye to the retailer due to
control being retained (the right to fix the price and receive the watches back after
11 months).
Revenue should only be recognised when the retailer makes a sale to a customer. This
means that revenue in Rockwye's financial statements is likely to be overstated. In addition,
if watches are returned unsold, there may also be a risk that inventory is overstated if any of
the watches have suffered any impairment.
Audit procedures
 The auditor should obtain copies of the contracts in place between Rockwye and
individual retailers to confirm the supplier arrangements in place and which party
retains controls of the watches
 The auditor should establish the proportion of watches that are returned unsold to
determine if there are any indicators of impairment in the inventory held
 The auditor should re-calculate revenue for a sample of months using the consignment
approach and compare to actual revenue recorded to establish if there is any material
misstatement
Scenario question
9 Eco-Ergonom
Memorandum
To: Deborah Carroll, Finance Director
From: Financial Controller
Date: 15 March 20X8
Subject: Accounting treatment of non-current assets
As requested, this memorandum sets out the appropriate accounting treatment for the non-
current assets detailed in today's email.
The three lorries that were stolen should be written off at their NBV first and then the
impairment test should be performed.
Recoverable
NBV Impairment amount
£'000 £'000 £'000
Goodwill 80 (80.0) –
Intangibles 60 (2.5) 57.5
Vehicles (240 – 60) 180 (7.5) 172.5
Sundry net assets 80 – 80.0
Total 400 (90) 310.0 Higher of VIU and NFV

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£80,000 is set against goodwill and the remaining £10,000 is split pro rata between the
other two relevant assets: £2,500 against intangibles (£10,000  60,000/(60,000 + 180,000))
and £7,500 against vehicles (£10,000  180,000/(60,000 + 180,000)). There is no need here
to restrict the impairment of the intangibles.
Tutorial note
The calculation of the impairment loss is based on the carrying amount of the business
including the trade payables. Recoverable amount is the fair value less costs to sell of the
business as a whole, with any buyer assuming the liabilities. Otherwise, the impairment test
would be based on the carrying amount of the gross assets (IAS 36.76).
Fall in value of machines

An impairment review will be carried out because of the losses and the haulage business
problems.
For the productive machinery
£
Carrying amount 580,000
Fair value less costs to sell 240,000
Value in use (200,000  3, discounted at 10%) 497,200
An impairment loss of £82,800 (580,000 – 497,200) will be recognised in profit or loss.

Development of new product
IAS 38, Intangible Assets divides a development project into a research phase and a
development phase. In the research phase of a project, an entity cannot yet demonstrate
that the expenditure will generate probable future economic benefits. Therefore
expenditure on research must be recognised as an expense when it occurs.
Development expenditure is capitalised when an entity demonstrates all the following.
(a) The technical feasibility of completing the project
(b) Its intention to complete the asset and use or sell it
(c) Its ability to use or sell the asset
(d) That the asset will generate probable future economic benefits
(e) The availability of adequate technical, financial and other resources to complete the
development and to use or sell it
(f) Its ability to reliably measure the expenditure attributable to the asset
C
H
A
P
T
E
R
10

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Assuming that all these criteria are met, the cost of the development should comprise all
directly attributable costs necessary to create the asset and to make it capable of operating
in the manner intended by management. Directly attributable costs do not include selling
or administrative costs, or training costs or market research. The cost of upgrading existing
machinery can be recognised as property, plant and equipment. Therefore the expenditure
on the project should be treated as follows:
Recognised in statement of financial
position
Expense Property,
(income Intangible plant and
statement) assets equipment
£m £m £m
Research 6
Prototype design 8
Wage costs 4
Development work 10
Upgrading machinery 6
Market research 4
Training 2
12 22 6
Eco-Ergonom should recognise £22 million as an intangible asset.
Purchase of Homecare
IFRS 3, Business Combinations states that the cost of a business combination is the
aggregate of the fair values of the consideration given. Fair value is measured at the date of
exchange. Where any of the consideration is deferred, the amount should be discounted to
its present value. Where there may be an adjustment to the final cost of the combination
contingent on one or more future events, the amount of the adjustment is included in the
cost of the combination at the acquisition date only if the fair value of the contingent
consideration can be measured reliably.
The purchase consideration consists of £20 million paid on the acquisition date plus a
further £5 million payable on 31 December 20X8 including £3 million payable only if profits
exceed forecasts. At the acquisition date it appeared that profit forecasts would not be met.
However, under IFRS 3, contingent consideration must be recognised and measured at fair
value at the acquisition date. Therefore the cost of combination at 1 January 20X7 is
£24.49 million (£20m + (£5m  0.898)).
A further issue concerns the valuation and treatment of the 'Homecare' brand name. The
brand name is an internally generated intangible asset of Homecare, and therefore it will
not be recognised in the statement of financial position of Homecare. However, IFRS 3
requires intangible assets of an acquiree to be recognised if they meet the identifiability
criteria in IAS 38, Intangible Assets and their fair value can be measured reliably. For an
intangible asset to be identifiable the asset must be separable or it must arise from
contractual or other legal rights. It appears that these criteria have been met (a brand is
separable) and the brand has also been valued at £4 million for the purpose of the sale to
Eco-Ergonom. Therefore the 'Homecare' brand will be separately recognised in the
consolidated statement of financial position.

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CHAPTER 11
Earnings per share
Introduction
TOPIC LIST
1 EPS: overview of material covered in earlier studies
2 Basic EPS: weighted average number of shares
3 Basic EPS: profits attributable to ordinary equity holders
4 Diluted earnings per share
5 Diluted EPS: convertible instruments
6 Diluted EPS: options
7 Diluted EPS: contingently issuable shares
8 Retrospective adjustments, presentation and disclosure
Technical reference

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Introduction

respect of presentation of financial statements; revenue; operating segments;
continuing and discontinued operations; EPS; construction contracts; interim
reporting
evidence
for example identifying an appropriate mix of tests of controls, analytical
Specific syllabus references for this chapter are: 2(b), 14(c), 14(d), 14(f)

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1 EPS: overview of material covered in earlier studies C

H
A
Section overview P
T
This section reviews the material on basic and diluted earnings per share covered at E
Professional Level. R
11
1.1 Scope
IAS 33, Earnings per Share applies to entities whose ordinary shares are publicly traded or are in
the process of being issued in public markets.
1.2 Basic earnings per share (EPS)

 Basic earnings per share (EPS) is calculated as:
Profit / (loss) attributable to ordinary equity holders of the parent
Weighted average number of ordinary shares outstanding during the period
 Profit attributable to the ordinary equity holders is based on profit after tax after the
deduction of preference dividends and other financing costs in relation to preference
shares classified as equity under IAS 32. Whether an adjustment is needed depends on the
type of preference share:
Redeemable No adjustment is required as these shares are classified as

preference shares liabilities and the finance charge relating to them will already have
been charged to profit or loss as part of finance charges.
Irredeemable These shares are classified as equity and the dividend relating to
preference shares them is disclosed in the statement of changes in equity. This
dividend must be deducted from profit for the year to arrive at
profit attributable to the ordinary shareholders.
 The weighted average number of shares should be adjusted for changes in the number of
shares without a corresponding change in resources, for example a bonus issue, by
assuming that the new number of shares had always been in issue.
Shares should generally be included in the weighted average number of shares from the
date the consideration for their issue is receivable.
 An entity is required to calculate and present a basic EPS amount based on the profit or loss
for the period attributable to the ordinary equity holders of the parent entity. If results from
'continuing operations' and 'discontinued operations' are reported separately, EPS on
these results should also be separately reported.
1.3 Diluted earnings per share

 A diluted EPS figure should also be reported by an entity. A dilution is a reduction in the
EPS figure (or increase in a loss per share) that will result from the issue of more equity
shares on the conversion of convertible instruments already issued.
 For the purpose of calculating diluted earnings per share, an entity shall adjust profit or loss
attributable to ordinary equity holders of the parent entity, and the weighted average
number of shares outstanding for the effects of all dilutive potential ordinary shares.
ICAEW 2019 Earnings per share 603

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1.4 Presentation
 Basic and diluted EPS figures (and from continuing operations if reported separately)
should be presented on the face of the statement of comprehensive income with equal
prominence.
 Where changes in ordinary shares occur during the accounting period, an amendment is
necessary to the number of shares used in the EPS calculations. In some situations, the EPS
in prior periods will also have to be adjusted.
 Treasury shares are accounted for as a deduction from shareholders' funds. Since such
shares are no longer available in the market, they are excluded from the weighted average
number of ordinary shares for the purpose of calculating EPS.
Interactive question 1: Adjustment for preference shares

A company has issued £100,000 4% redeemable non-cumulative preference shares. Should the
dividend be subtracted from the reported profit after tax figure for the calculation of EPS?
2 Basic EPS: weighted average number of shares
Section overview
This section deals with certain adjustments to the number of shares used for the calculation of
basic earnings per share.
IAS 33 requires that a time-weighted average number of shares should be used in the
denominator of the earnings per share calculation. The basic idea of how to calculate such a
weighted average has been covered at Professional Level. In this section we deal with issues
relating to the treatment of share repurchases, partly paid shares, bonus and rights issues and
the impact of consolidation.
2.1 Calculation of the weighted average number of shares

The use of the weighted average number of ordinary shares outstanding during the period
reflects the possibility that the amount of shareholders' capital varied during the period.
The weighted average number of ordinary shares outstanding during the period is the number
of ordinary shares outstanding at the beginning of the period, adjusted by the number of
ordinary shares bought back or issued during the period multiplied by a time-weighting factor.
2.2 Time weights determination

Shares are usually included in the weighted average number of shares from the date
consideration is receivable (which is generally the date of their issue), for example:
 Ordinary shares issued in exchange for cash are included when cash is receivable.
 Ordinary shares issued on the voluntary reinvestment of dividends on ordinary or
preference shares are included when dividends are reinvested.
 Ordinary shares issued as a result of the conversion of a debt instrument to ordinary shares
are included from the date that interest ceases to accrue.

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 Ordinary shares issued in place of interest or principal on other financial instruments are
included from the date that interest ceases to accrue. C
H
 Ordinary shares issued in exchange for the settlement of a liability of the entity are included A
P
from the settlement date. T
E
 Ordinary shares issued as consideration for the acquisition of an asset other than cash are
R
included as of the date on which the acquisition is recognised.
11
 Ordinary shares issued for the rendering of services to the entity are included as the
services are rendered.
 Ordinary shares issued as part of the cost of a business combination are included in the
weighted average number of shares from the acquisition date. This is because the acquirer
incorporates into its results the acquiree's profits and losses from that date.
 Ordinary shares that will be issued upon the conversion of a mandatorily convertible
instrument are included in the calculation of basic earnings per share from the date the
contract is entered into.
 Contingently issuable shares are included in the calculation of basic earnings per share only
from the date when all necessary conditions for their issue are satisfied. Shares that are
issuable solely after the passage of time are not contingently issuable shares, because the
passage of time is a certainty.
 Outstanding ordinary shares that are contingently returnable (ie, subject to recall) are
excluded from the calculation of basic earnings per share until the date the shares are no
longer subject to recall.
Worked example: Weighted average number of ordinary shares

The following information is provided for an entity.
Shares Treasury Shares
issued shares outstanding
1 January 20X1 Balance at beginning of year 2,000 300 1,700
31 May 20X1 Issue of new shares for cash 800 – 2,500
1 December 20X1 Purchase of treasury shares for cash – 250 2,250
31 December 20X1 Balance at year end 2,800 550 2,250
Requirement
Calculate the weighted average number of shares in issue during the year.
Solution
The calculation can be performed on a cumulative basis:
Weighted
average
1 Jan X1 – 30 May X1 1,700  5/12 708
Share issue 800
31 May X1 – 30 Nov X1 2,500  6/12 1,250
Share purchase (250)
1 Dec X1 – 31 Dec X1 2,250  1/12 188
2,146

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or alternatively each issue or recall treated separately:

Weighted
average
1 Jan X1 – 31 Dec X1 1,700  12/12 1,700
31 May X1 – 31 Dec X1 800  7/12 467
1 Dec X1 – 31 Dec X1 (250)  1/12 (21)
2,146
2.3 Partly paid shares

Where ordinary shares are issued but not fully paid, they are treated in the calculation of basic
earnings per share as a fraction of an ordinary share to the extent that they were entitled to
participate in dividends during the period relative to a fully paid ordinary share.
To the extent that partly paid shares are not entitled to participate in dividends during the
period they are treated as the equivalent of warrants or options in the calculation of diluted
earnings per share. The unpaid balance is assumed to represent proceeds used to purchase
ordinary shares. The number of shares included in diluted earnings per share is the difference
between the number of shares subscribed and the number of shares assumed to be purchased.
Worked example: Partly paid shares

At 1 January 20X5 an entity had 900 ordinary shares in issue. It issued 600 new shares at
1 September 20X5, at a subscription price of £4 per share. At the date of issue each shareholder
paid £2. The balance of £2 per share will be paid during 20X6. Each part-paid share will be
entitled to dividends in proportion to the percentage of the issue price paid up on the share.
The entity has a year end of 31 December.
Requirement
Calculate the weighted average number of shares for the year ended 31 December 20X5.
Solution
The new shares issued should be included in the calculation of the weighted average number of
shares in proportion to the percentage of the issue price received from the shareholding during
the period.
Weighted
Shares Fraction average
issued of period shares
1 January 20X5 – 31 August 20X5 900 8/12 600
Issue of new shares for cash, part paid (2/4  600) 300
1 September 20X5 – 31 December 20X5 1,200 4/12 400
Weighted average number of shares 1,000
2.4 The impact of bonus issues and share consolidations on the number of
shares
The weighted average number of ordinary shares outstanding during the period must be
adjusted for events that have changed the number of ordinary shares outstanding without a
corresponding change in resources. These include the following:
 Bonus issues (capitalisation issues)
 Share consolidation

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2.4.1 Bonus issue

C
In a bonus or capitalisation issue, or a share split, ordinary shares are issued to existing H
shareholders for no additional consideration. Therefore, the number of ordinary shares A
P
outstanding is increased without a corresponding increase in resources. T
E
The number of ordinary shares outstanding before the event is adjusted for the proportionate
R
change in the number of ordinary shares outstanding as if the event had occurred at the
beginning of the earliest period presented. For example, on a 2 for 1 bonus issue, the number of 11
ordinary shares outstanding before the issue is multiplied by three to obtain the new total
number of ordinary shares, or by two to obtain the number of additional ordinary shares.
Bonus issue after the reporting date
Where a bonus issue takes place after the reporting date but before the financial statements are
authorised for issue, the number of shares in the EPS calculation is adjusted for the current and
prior periods as though the bonus issue took place during the current year.
Worked example: Bonus issue

The following information is given for an entity.
Profit attributable to ordinary equity holders for y/e 30 September 20X6 £300
Profit attributable to ordinary equity holders for y/e 30 September 20X7 £900
Ordinary shares outstanding until 30 September 20X7 200
Bonus issue 1 October 20X7 two ordinary shares for each ordinary share
outstanding at 30 September 20X7
Requirement
Calculate the basic earnings per share for 20X6 and 20X7.
Solution
The bonus issue arose in the period after the reporting date. It should be treated as if the bonus
issue arose during 20X7, and EPS calculated accordingly:
Additional shares issued 200  2 = 400
Basic EPS 20X7
£900
= £1.50
(200 + 400)
Basic EPS 20X6

£300
= £0.50
(200 + 400)
2.4.2 Share consolidation

A consolidation of ordinary shares generally reduces the number of ordinary shares outstanding
without a corresponding reduction in resources.
Sometimes, however, shares are repurchased at fair value, and in this instance, there is a
corresponding reduction in resources. An example is a share consolidation combined with a
special dividend. In this case, the weighted average number of ordinary shares outstanding for
the period is adjusted for the reduction in the number of ordinary shares from the date the
special dividend is recognised.

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Worked example: Share consolidation

At the start of its financial year ended 31 December 20X5, an entity had 10 million ordinary
shares in issue. On 30 April 20X5 it issued three million shares in consideration for the
acquisition of a majority holding in another entity. On 31 August 20X5 it went through a share
reconstruction by consolidating the shares in issue, on the basis of one new share for two old
shares.
Requirement
Calculate the weighted number of shares in issue for the year to 31 December 20X5.
Solution
The three million new shares issued at the time of the acquisition should be weighted from the
date of issue, but the consolidation should be related back to the start of the financial year (and
to the start of any previous years presented as comparative figures).
The calculation of the weighted number of shares in issue is as follows:
Adjusted
Number Weighting number
At 1 January 20X5 10,000,000
Effect of consolidation is to halve the number of shares
(since one new share was issued for every two old
shares held) (5,000,000)
5,000,000 12/12 5,000,000
30 April 20X5 issue 3,000,000

Effect of consolidation is to halve the number of shares (1,500,000)
1,500,000 8/12 1,000,000
Weighted average shares in issue 6,000,000
Worked example: Special dividend and share consolidation

A company has issued 20,000 shares with a nominal value of 20p each. At the beginning of
20X7 it considers whether to launch a share repurchase of 2,000 shares at the current market
price of £2 per share, or pay a special dividend of 20p per share to be followed by a share
consolidation of 9 new shares for 10 old shares. The profit after tax for 20X6 and 20X7 is
expected to be £4,000 for each year. Interest rates stand at 5% and the company tax rate is 20%.
Requirement
Calculate the basic EPS for the two alternatives.
Solution
(a) Share repurchase at fair value
20X7 20X6
£ £
Loss of interest as cash
paid out £4,000  0.05  0.80* (160)
Earnings 3,840 4,000
Number of shares outstanding 18,000 20,000
Earnings per share 21.33p 20.00p

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(b) Special dividend followed by share consolidation

20X7 20X6 C
£ £ H
A
Profit for the year 4,000 4,000 P
Loss of interest on cash paid out as dividend T
£4,000  0.05  0.80* (160) E
Earnings 3,840 4,000 R
The effect of share consolidation is to leave the total nominal value of outstanding shares the 11
same, but to reduce the number of shares from 20,000 to 18,000, and raising the market price of
a share from £2 to £2.22.
20X7 20X6
Number of shares 18,000 20,000
Earnings per share 21.33p 20.00p
No adjustment to prior year's EPS is made for the share consolidation.
* 0.80 = (1 – tax rate)
2.5 Rights issue

A rights issue is an issue of shares for cash to the existing ordinary equity holders in proportion
to their current shareholdings, at a discount to the current market price.
Because the issue price is below the market price, a rights issue is in effect a combination of an
issue at fair value and a bonus issue.
In order to calculate the weighted average number of shares when there has been a rights issue,
an adjustment factor is required:
Pre - rights issue price of shares
Adjustment factor =
Theoretical ex-rights price (TERP)
The TERP is the theoretical price at which the shares would trade after the rights issue and takes
into account the diluting effect of the bonus element in the rights issue. It is calculated as:
Total market value of original shares pre rights issue + Proceeds of rights issue
TERP =
Number of shares post rights issue
The adjustment factor is used to increase the number of shares in issue before the rights issue
for the bonus element.
Where the rights are to be publicly traded separately from the shares before the exercise date,
fair value for the purposes of this calculation is established at the close of the last day on which
the shares are traded together with the rights.
Worked example: Rights issue

The following information is provided for an entity which is making a rights issue.
20X4 20X5 20X6
Profit attributable to ordinary equity holders of the parent entity £1,100 £1,500 £1,800
Shares outstanding before rights issue: 500 shares

Rights issue: One new share for each five outstanding shares (100 new shares total)
Exercise price: £5.00
Date of rights issue: 1 January 20X5

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Last date to exercise rights: 1 March 20X5

Market price of one ordinary share immediately before exercise on 1 March 20X5: £11.00
Reporting date 31 December
Requirement
Calculate the theoretical ex-rights value per share and the basic EPS for each of the years 20X4,
20X5 and 20X6.
Solution
Calculation of theoretical ex-rights value per share
No. Price Total
Pre-rights issue holding 5 £11 £55
Rights share 1 £5 £5
6 £60
Therefore TERP = £60/6 = £10

(The TERP may also be calculated on the basis of all shares in issue ie, £6,000/600 shares.)
Calculation of adjustment factor
Fair value per share before exercise of rights £11
Adjustment factor = = = 1.10
Theoretical ex- rights value per share £10
Calculation of basic earnings per share

20X4
20X4 basic EPS as originally £1,100
= £2.20
reported: 500 shares
20X4 basic EPS restated for £1,100
= £2.00
rights issue in 20X5 accounts: (500 shares)  (adjustment factor)
Alternatively the restated EPS may be calculated by applying the reciprocal of the adjustment
factor to the basic EPS as originally reported:
£2.20  10/11 = £2.00
20X5
Weighted average number of shares:
1 January – 28 February 500  11/10  2/12 92
Rights issue 100
1 March – 31 December 600  10/12 500
592
£1,500
Basic EPS including effects of rights issue: = £2.53
592 shares
20X6
£1,800
Basic EPS: = £3.00
600 shares

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Worked example: Cash and rights issue

C
An entity had 14 million ordinary shares in issue on 1 January 20X4 and 20X5. In its financial year H
ended 31 December 20X5 it issued further shares, as follows: A
P
 On 1 April 20X5, 4 million shares in consideration for the majority holding in another entity. T
E
 On 1 July 20X5 a rights issue of 1 for 6 at £15 when the market price of the existing shares R
was £20. There were 18 million shares in issue at this date, another 3 million shares were
11
therefore issued.
A profit of £17 million attributable to the ordinary equity holders was reported for 20X5 and
£14 million for 20X4.
Requirement
Calculate the earnings per share for 20X5 and restate the comparative for 20X4.
Solution
As the shares issued on the acquisition were issued at full fair value, a time apportionment
adjustment over the period they are in issue is required.
The rights issue shares require a time apportionment adjustment and an adjustment for the
bonus element in the rights. The latter adjustment should be applied to the shares issued on
1 April as well as to those issued earlier.
To adjust for the bonus element the theoretical ex-rights fair value per share is required:
Computation of theoretical ex-rights price (TERP):
No. Price Total
Pre-rights issue holding 6 £20 £120
Rights share 1 £15 £15
7 £135
Therefore TERP = £135/7 = £19.29
The adjustment factor is therefore £20/£19.29

20X4 and earlier EPS figures would be adjusted by dividing the corresponding earnings figure
by 1.037.
The weighted number of shares in issue in 20X5 is calculated as:
Adjusted
Number Weighting number
1 January to 31 March 14,000,000  20/19.29 3/12 3,628,823
Issue 1 April 4,000,000
1 April to 30 June 18,000,000  20/19.29 3/12 4,665,630
Rights issue 1 July 3,000,000
1 July to 31 December 21,000,000 6/12 10,500,000
20X5 EPS:
£17m/18,794,453 shares = £0.90
20X4 restatement – original EPS: £14m ÷ 14m shares = £1.00
£1.00  19.29/20.00 = £0.96

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3 Basic EPS: profits attributable to ordinary equity holders
Section overview
In this section we discuss the adjustments that are required to earnings as a result of
preference shares, in order to calculate profits attributable to ordinary shareholders (equity
holders).
As we have seen in earlier studies, for the purpose of calculating basic earnings per share, we
must calculate the amounts attributable to ordinary equity holders of the parent entity in respect
of profit or loss.
This is done in two steps:
 First the profit or loss which includes all items of income and expense that are recognised in
a period, including tax expense, dividends on preference shares classified as liabilities or
non-controlling interest is calculated according to IAS 1, Presentation of Financial
Statements.
 In the second step the calculated profit or loss is adjusted for the after-tax amounts of
preference dividends, differences arising on the settlement of preference shares, and other
similar effects of preference shares classified as equity under IAS 32, Financial Instruments:
Presentation.
3.1 Adjusting earnings for the impact of preference shares

Where an entity has preference shares in issue depending on their terms these will be classified
under IAS 32 as either:
 financial liabilities; or
 equity.
3.1.1 Preference shares classified as equity
Any dividends and other appropriations (for example, amortised premium or discount) is
debited directly to equity, in the statement of changes in equity. Therefore an adjustment is
required to deduct these amounts from the profit for the period in order to derive the profit
attributable to ordinary shareholders (equity holders).
3.1.2 Preference shares classified as liabilities
Any dividends or other appropriations are treated as finance costs in arriving at profit for the
period and no adjustment is required.
In both the above cases the treatment is the same, as in both cases the amounts are deducted
from profit attributable to ordinary shareholders. In the latter case the deduction will already
have been made in arriving at reported profit and loss, however in the former case an
adjustment to reported profits is required.
3.1.3 Cumulative preference shares
Where preference shares are cumulative, the dividends for the period need to be taken into
account irrespective of whether these have been declared or not.
3.1.4 Non-cumulative preference shares
For non-cumulative preference dividends only the amount of dividend declared for the period
should be deducted in arriving at profit or loss attributed to ordinary equity holders.

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Interactive question 2: Redeemable preference shares

C
Turaco is a company listed on a recognised stock exchange. Given below is an extract from its H
statement of comprehensive income for the year ended 31 December 20X6. A
P
£ T
Profit before tax 500,000 E
R
Tax 150,000
Profit after tax 350,000 11
The company paid an ordinary dividend of £20,000 and a dividend on its redeemable
preference shares of £70,000.
The company had £100,000 of £0.50 ordinary shares in issue throughout the year and
authorised share capital of 1,000,000 ordinary shares.
Requirement
What is the basic earnings per share figure for the year according to IAS 33, Earnings per Share?
3.1.5 Other adjustments in respect of preference shares

Increasing rate preference shares
These are preference shares that provide for a low initial dividend to compensate an entity for
selling the preference shares at a discount, or an above-market dividend in later periods to
compensate investors for purchasing preference shares at a premium.
Under IAS 32, Financial Instruments: Presentation and IFRS 9, Financial Instruments any original
issue discount or premium on increasing rate preference shares is amortised using the effective
interest method and treated as a preference dividend for the purposes of calculating earnings
per share.
In addition, there may be other elements amortised such as transaction costs.
All these elements should be deducted in arriving at the earnings attributed to ordinary equity
holders.
Note: the sale of shares at a discount is not allowed by UK Company Law, however it may be
permitted in certain jurisdictions, and is therefore examinable.
Worked example: Increasing rate preference shares

Dennison Co issued issued non-convertible, non-redeemable class A cumulative preference
shares of £100 par value on 1 January 20X1. The class A preference shares are entitled to a
cumulative annual dividend of £7 per share starting in 20X4.
At the time of issue, the market rate dividend yield on the class A preference shares was 7% a
year. Thus, Dennison Co could have expected to receive proceeds of approximately £100 per
class A preference share if the dividend rate of £7 per share had been in effect at the date of issue.
There was, however, to be no dividend paid for the first three years after issue. In consideration
of these dividend payment terms, the class A preference shares were issued at £81.63 per share
ie, at a discount of £18.37 per share. The issue price can be calculated by taking the present
value of £100, discounted at 7% over a three-year period.
Requirement
Calculate the imputed dividends attributable to preference shares that need to be deducted
from earnings to determine the profit or loss attributable to ordinary equity holders.

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Solution
Because the shares are classified as equity, the original issue discount is amortised to retained
earnings using the effective interest method and treated as a preference dividend for earnings
per share purposes. To calculate basic earnings per share, the following imputed dividend per
class A preference share is deducted to determine the profit or loss attributable to ordinary
equity holders of the parent entity.
Carrying amount of class A Imputed Carrying amount of class A Dividend

Year preference shares 1 January dividend preference shares 31 December paid
£ £ £ £
20X1 81.63 5.71 87.34 –
20X2 87.34 6.12 93.46 –
20X3 93.46 6.54 100.00 –
Thereafter: 100.00 7.00 107.00 (7.00)
Convertible preference shares

An entity may achieve early conversion of convertible preference shares by improving the
original conversion terms or paying additional consideration.
Where this is the case, then the excess amount transferred as a result of the improvement of
conversion terms is treated as a return to the preference shareholders and so should be
deducted in arriving at earnings attributable to ordinary equity holders.
Deduction = Fair value of ordinary shares – Fair value of ordinary shares
issued/consideration paid issuable under original terms
Worked example: Cumulative convertible preference shares

An entity issued £100,000 2% cumulative convertible preference shares in 20X4 and the shares
were due to be converted in the current year, 20X6.
The convertible shares were converted at the beginning of 20X6 and no dividend was accrued
in respect of the year, although the previous year's dividend was paid immediately before
conversion. The terms of conversion were also amended and the revised terms entitled the
preference shareholders to a total additional 100 ordinary shares on conversion with a fair value
of £300.
Requirement
If the profit attributable to ordinary equity holders for the year is £150,000 what adjustments
need to be made for the purpose of calculating EPS in 20X6?
Solution
The excess of the fair value of additional ordinary shares issued on conversion of the convertible
preference shares over fair values of the ordinary shares to which they would have been entitled
under the original conversion terms is deducted from profit as it is an additional return to the
convertible preference shareholders.
£
Profits attributable to the ordinary equity holders 150,000
Fair value of additional ordinary shares
issued on conversion of convertible preference shares (300)
149,700

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There is no adjustment in respect of the preference shares as no dividend accrual was made in
respect of the year. The payment of the previous year's cumulative dividend is ignored for EPS C
H
purposes as it will have been adjusted for in the prior year. A
P
T
E
R
Repurchase of preference shares
11
 Where the fair value of consideration paid to preference shareholders exceeds the carrying
value of the preference shares repurchased, the excess is a return to the preference
shareholders and must be deducted in calculating profits attributable to ordinary equity
holders.
 Where the carrying value of preference shares repurchased exceeds the fair value of
consideration paid, the excess is added in calculating profit attributable to ordinary equity
holders.
In respect of preference shares that are classified as liabilities, the above adjustments, where
these are relevant, would have already been made in arriving at the profit or loss for the period.
Worked example: Repurchase of preference shares

An entity has issued £100,000 8% non-redeemable non-cumulative preference shares. Half way
through the year, the entity repurchased half of the preference shares at a discount of £1,000.
No dividends were paid on these shares in respect of the amounts repurchased or outstanding
at the end of the year.
Requirement
If the profit attributable to ordinary equity holders for the year is £150,000, what adjustments
should be made for the purpose of calculating EPS?
Solution
£
Profit for the year attributed to ordinary equity holders 150,000
Plus discount on repurchasing of preference shares 1,000
151,000
The discount on repurchase of the preference shares has been credited to equity and it must
therefore be adjusted against profit.
Had there been a premium payable on repurchase, the loss on repurchase would have been
subtracted from profit.
No accrual for the dividend on the 8% preference shares is required as these are non-
cumulative. Had a dividend been paid for the year it would have been deducted from profit for
the purpose of calculating basic EPS as the shares are treated as equity and the dividend would
have been charged to equity in the financial statements.
3.2 Participating securities and two-class ordinary shares

The equity of some entities includes:
 instruments that participate in dividends with ordinary shares according to a predetermined
formula (for example, 2 for 1) with an upper limit on the extent of participation (for example,
up to, but not beyond, a specified amount per share); or
 a class of ordinary shares with a different dividend rate from that of another class of ordinary
shares.

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Profit or loss for the period is allocated to the different classes of shares and participating equity
instruments in accordance with their dividend rights or other rights to participate in
undistributed earnings.
To calculate basic earnings per share:
 Profit or loss attributable to ordinary equity holders of the parent entity is adjusted as
previously discussed.
 The remaining profit or loss is allocated to ordinary shares and participating equity
instruments to the extent that each instrument shares in earnings as if all of the profit or loss
for the period had been distributed. The total profit or loss allocated to each class of equity
instrument is determined by adding together the amount allocated for dividends and the
amount allocated for a participation feature.
 The total amount of profit or loss allocated to each class of equity instrument is divided by
the number of outstanding instruments to which the earnings are allocated to determine
the earnings per share for the instrument.
Worked example: Participating equity instruments

The following information is provided for an entity.
Profit attributable to equity holders of the parent entity £100,000
Ordinary shares outstanding 10,000
Non-convertible preference shares 6,000
Non-cumulative annual dividend on preference shares
(before any dividend is paid on ordinary shares) £5.50 per share
After ordinary shares have been paid at a dividend of £2.10 per share, the preference shares
participate in any additional dividends on a 20:80 ratio with ordinary shares.
Dividends on preference shares paid £33,000 (£5.50 per share  6,000 shares)
Dividends on ordinary shares paid £21,000 (£2.10 per share  10,000 shares)
Requirement
Calculate the earnings attributable to ordinary shares.
Solution
Basic earnings per share is calculated as follows.
£ £
Profit attributable to equity holders of the parent entity 100,000
Less dividends paid:
Preference 33,000
Ordinary 21,000
(54,000)
Undistributed earnings 46,000
Allocation of undistributed earnings

Let A be the allocation of undistributed earnings per ordinary share and B the allocation per
preference share. That is:
(A  10,000) + (B  6,000) = £46,000
As B's entitlement is one quarter that of A's, we can eliminate B from the equation as follows:
(A  10,000) + (1/4  A  6,000) = £46,000
10,000A + 1,500A = £46,000
11,500A = £46,000

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A = £46,000/11,500
C
A = £4.00 H
A
Therefore B = £1.00 P
T
Basic per share amounts E
Per preference Per ordinary R
share share
Distributed earnings £5.50 £2.10 11
Undistributed earnings £1.00 £4.00
Totals £6.50 £6.10
4 Diluted earnings per share
Section overview
This section deals with the adjustments required to earnings in order to take into account the
dilutive impact of potential ordinary shares.
The objective of diluted earnings per share is consistent with that of basic earnings per share;
that is, to provide a measure of the interest of each ordinary share in the performance of an
entity taking into account dilutive potential ordinary shares outstanding during the period.
4.1 Potential ordinary shares

Potential ordinary shares are financial instruments or other contracts that may entitle their
holders to ordinary shares. Potential ordinary shares are as follows:
 Various financial liabilities or equity instruments, including preference shares that are
convertible into ordinary shares
 Options
 Warrants
 Shares that would be issued on satisfaction of certain conditions that result from contractual
arrangements, such as the purchase of a business or other assets
The conversion of potential ordinary shares will lead in the future to an increase in the weighted
average number of ordinary shares outstanding by the weighted average number of additional
ordinary shares that would have been outstanding assuming the conversion of all dilutive
potential ordinary shares.
Conversion may also lead to consequential changes in income or expenses. For example, the
reduction of interest expense related to convertible debt and the resulting increase in profit or
reduction in loss may lead to an increase in the expense related to a non-discretionary
employee profit-sharing plan.
For the purpose of calculating diluted earnings per share, profit or loss attributable to ordinary
equity holders of the parent entity is adjusted for any such consequential changes in income or
expense.

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4.2 Dilutive and antidilutive potential ordinary shares

Potential ordinary shares are dilutive when their conversion to ordinary shares would decrease
earnings per share or increase loss per share from continuing operations.
Potential ordinary shares are antidilutive when their conversion to ordinary shares would
increase earnings per share or decrease loss per share from continuing operations. Antidilution
is therefore the situation where the 'diluted' EPS is greater than the basic EPS (or where there is
a lower loss per share). IAS 33 defines antidilution as follows.
Definition
Antidilution: An increase in earnings per share or a reduction in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised,
or that ordinary shares are issued upon the satisfaction of specified conditions.
In computing diluted EPS only potential ordinary shares that are dilutive are considered in the
calculations. The calculation ignores the effects of potential ordinary shares that would have an
antidilutive effect on earnings per share.
Determining whether potential ordinary shares are dilutive or antidilutive
In determining whether potential ordinary shares are dilutive or antidilutive, each issue or series
of potential ordinary shares is considered separately rather than in aggregate.
A separate EPS calculation is performed for each potential share issue.
(a) Those individual EPS which exceed the entity's basic EPS are disregarded as they are
antidilutive.
(b) Those individual EPS which are less than the entity's basic EPS are dilutive and are ranked
from most to least dilutive. Options and warrants are generally included first because they
do not affect the numerator of the calculation. These dilutive factors are added one by one
into the DEPS calculation in order to identify the maximum dilution.
The calculation showing each issue or series of potential ordinary shares being considered
separately is shown in the worked example Convertible loan stock 2.
4.3 Computation of diluted earnings

For the purpose of calculating diluted earnings per share, the profit or loss attributable to
ordinary equity holders of the parent entity should be adjusted for the after-tax effect of:
 any dividends or other items related to dilutive potential ordinary shares deducted in
arriving at profit or loss attributable to ordinary equity holders;
 any interest recognised in the period related to dilutive potential ordinary shares; and
 any other changes in income or expense that would result from the conversion of the
dilutive potential ordinary shares.
After the potential ordinary shares are converted into ordinary shares, the dividends, interest
and any other expenses associated with the potential ordinary shares will no longer arise.
Instead, the new ordinary shares are entitled to participate in profit or loss attributable to
ordinary equity holders of the parent entity. The expenses associated with potential ordinary
shares include transaction costs and discounts accounted for in accordance with the effective
interest method.

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4.4 Calculation of the number of shares

C
In the calculation of diluted earnings per share, the number of ordinary shares in the H
A
denominator is the weighted average number of ordinary shares calculated for the basic
P
earnings per share plus the weighted average number of ordinary shares that would be issued T
on the conversion of all the dilutive potential ordinary shares into ordinary shares. That is: E
R
Number of shares in = Number of shares in basic + Dilutive potential ordinary
diluted earnings per share earnings per share shares 11
 Dilutive potential ordinary shares shall be deemed to have been converted into ordinary
shares at the beginning of the period or, if later, the date of the issue of the potential
ordinary shares (ie, where the convertible instruments or options are issued during the
current period).
 Potential ordinary shares are weighted for the period they are outstanding.
 Potential ordinary shares that are cancelled or allowed to lapse during the period are
included in the calculation of diluted earnings per share only for the portion of the period
during which they are outstanding.
 Potential ordinary shares that are converted into ordinary shares during the period are
included in the calculation of diluted earnings per share from the beginning of the period
to the date of conversion. From the date of conversion, the resulting ordinary shares are
included in both basic and diluted earnings per share.
 The number of ordinary shares that would be issued on conversion of dilutive potential
ordinary shares is determined from the terms of the potential ordinary shares. When more
than one basis of conversion exists, the calculation assumes the most advantageous
conversion rate or exercise price from the standpoint of the holder of the potential ordinary
shares.
5 Diluted EPS: convertible instruments
Section overview
This section deals with the impact of convertible instruments on the diluted earnings per share.
5.1 Convertible instruments

Convertible instruments, such as convertible loan stock or convertible preference shares impact
both the profit or loss attributed to ordinary equity holders, and the number of ordinary shares,
on conversion.
Where this has a dilutive effect, the instrument should be taken into account when calculating
diluted earnings per share (DEPS).
Indicators that convertible instruments are antidilutive
Convertible preference shares are antidilutive whenever the amount of the dividend on such
shares declared in, or accumulated for, the current period per ordinary share obtainable on
conversion exceeds basic earnings per share.
Similarly, convertible debt is antidilutive whenever its interest (net of tax and other changes in
income or expense) per ordinary share obtainable on conversion exceeds basic earnings per
share.

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Worked example: Convertible loan stock 1

On 1 January 20X5 entity A had in issue:
 24 million ordinary shares of £1 nominal value each; and
 £8 million of 8% convertible loan stock. These were issued on 1 January 20X5 and are
convertible at any time from 1 January 20X8. The conversion terms are one ordinary share
for each £2 nominal of loan stock.
The split accounting required for compound financial instruments per IAS 32 resulted in a
liability element for the loan stock of £7 million and an effective interest rate of 10%.
After charging income tax at 20%, the entity reported profit attributable to the ordinary equity
holders of £15 million for its year ended 31 December 20X5.
Requirement
Calculate the basic and diluted earnings per share for 20X5.
Solution
Basic EPS
£15m/24m shares = £0.63
Diluted EPS
To calculate the diluted earnings per share we need to consider the impact on both earnings
and number of shares.
Impact on earnings: On conversion, after tax earnings attributed to ordinary shareholders

should be increased by the reduction in the interest charge payable to
loan holders.
Taking tax into account, the interest saved will be:
£7m  0.1  (1 – 0.2) = £0.56m
Therefore diluted earnings = £15m + £0.56m = £15.56m
Impact on number of On conversion the number of ordinary shares will increase by £8m/2 =
shares: 4 million shares, raising the number of ordinary shares after
conversion to 28 million ordinary shares.
Therefore DEPS = £15.56m/28 million shares = £0.56
Interactive question 3: Test of dilution

The issued share capital of Entity A at 31 December 20X5 was 2,000,000 ordinary shares of
£1 each. On 1 January 20X6, Entity A issued £1,500,000 of 7% convertible loan stock for cash at
par. (Ignore the requirement to split the value of a compound financial instrument.) Each
£100 nominal of the loan stock may be converted into 140 ordinary shares at any time after
1 January 20X9.
The profit before interest and taxation for the year ended 31 December 20X6 amounted to
£1,050,000 and arose exclusively from continuing operations. The rate of tax is 30%.
Requirement
Test whether the potential shares are dilutive.

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Worked example: Convertible loan stock 2

C
On 1 January 20X5 Entity A had in issue: H
A
(a) 20 million ordinary shares; P
T
(b) £11 million of 6.5% convertible loan stock, convertible at any time from 1 January 20X7. The E
conversion terms are one ordinary share for each £2 nominal of loan stock, the 1 January R
carrying amount of the liability component is £10 million and the effective interest rate is
11
9%;
(c) £9 million of 6.75% convertible loan stock, convertible at any time from 1 January 20X8. The
conversion terms are one ordinary share for each £2 nominal of loan stock, the 1 January
carrying amount of the liability component is £8 million and the effective interest rate is 8%;
and
(d) £12.6 million of 9% convertible loan stock, convertible at any time from 1 January 20X9. The
conversion terms are one ordinary share for each £6 nominal of loan stock, the 1 January
carrying amount of the liability component is £12 million and the effective interest rate is
12%.
The entity reported profit attributable to the ordinary equity holders of £4 million for its year
Requirement
Ignoring taxes, calculate the diluted earnings per share.
Solution
The incremental earnings per share for each type of potential ordinary shares is shown below.
Increase in
earnings Increase in Earnings per
(interest number of additional
saved) shares share
£ £
£11 million of 6.5% convertible loan stock
£10m  9% convertible loan stock 900,000
1 ordinary share for £2 nominal of loan stock 5,500,000 0.16
£9 million of 6.75% convertible loan stock
£8m  8% convertible loan stock 640,000
£12.6 million of 9% convertible loan stock
£12m  12% convertible loan stock 1,440,000
The earnings per share can be calculated adjusting both the earnings and the number of shares
for each type of potential shares, and the results are shown below. Each issue of potential
ordinary shares is added to the calculation at a time, taking the most dilutive factor first.
Number of Earnings per
Earnings shares share
£ £
Shares already in issue 4,000,000 20,000,000 0.20
Including 6.75% convertible loan stock 4,640,000 24,500,000 0.189
Including 6.5% convertible loan stock 5,540,000 30,000,000 0.185
Including 9% convertible loan stock 6,980,000 32,100,000 0.217

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The diluted earnings per share will be £0.185. The 9% convertible loan stock is antidilutive since it
increases earnings per share, and it will not be taken into account in calculating diluted earnings per
share.
5.2 Testing for dilution

In some cases some convertible preference shares are redeemed or converted in a period, and
others remain outstanding.
Where this occurs, any excess consideration paid on redemption or conversion is attributed to
those shares which have been redeemed or converted.
Outstanding convertible preference shares are therefore tested for dilution as normal and
without regard to this excess.
6 Diluted EPS: options
Section overview
This section deals with the impact of options on diluted earnings per share.
Definition
Options and warrants: Financial instruments that give the holder the right to purchase ordinary
shares.
6.1 Options, warrants and their equivalents

Options and warrants are dilutive when they would result in the issue of ordinary shares for less
than the average market price of ordinary shares during the period (ie, when they are 'in the
money').
To calculate diluted EPS where there are options or warrants, the potential ordinary shares at
less than average market price are treated as consisting of two elements:
 A contract to issue some shares at average market price. These shares are assumed to be
fairly priced and to be neither dilutive nor antidilutive. They are ignored in the calculation of
diluted EPS.
 A contract to issue the remaining ordinary shares for no consideration. These shares are
dilutive and are added to the number of ordinary shares outstanding in the calculation of
diluted EPS.
Average market price of ordinary shares
 Theoretically every market transaction for an entity's ordinary shares could be included in
the determination of the average market price. It is however adequate to use a simple
average of weekly or monthly prices.
 Generally, closing market prices are adequate for calculating the average market price.
When prices fluctuate widely, however, an average of the high and low prices usually
produces a more representative price.
 The method used to calculate the average market price must be used consistently unless it
is no longer representative because of changed conditions. For example, an entity that uses

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closing market prices to calculate the average market price for several years of relatively
stable prices might change to an average of high and low prices if prices start fluctuating C
H
greatly and the closing market prices no longer produce a representative average price. A
P
Interactive question 4: Diluted earnings per share T
E
At 31 December 20X6, the issued share capital of Entity A consisted of 3,000,000 ordinary R
shares of 20p each. Entity A has granted options that give holders the right to subscribe for
11
ordinary shares between 20X8 and 20X9 at 50p each. Options outstanding at 31 December
20X7 were 600,000. There were no grants, exercises or lapses of options during the year. The
profit after tax attributable to ordinary equity holders for the year ended 31 December 20X7
amounted to £900,000 arising from continuing operations. The average market price of one
ordinary share during year 20X7 was £1.50.
Requirement
Calculate the diluted earnings per share for 20X7.
6.2 Employee share options

The most common type of option that leads to earnings dilution is an employee share option
granted by a company to its employees.
Employee share options give the right to the holder to acquire shares in the company at a price
that is fixed when the options are issued.
Employee share options can normally be exercised after a certain time eg, once the employee
has completed a period of service and within a certain period eg, over a period of five years
after they become exercisable.
Employee share options that can be exercised are vested options, whereas options that cannot
yet be exercised are unvested options.
Worked example: Vested options

The profit attributable to the ordinary equity holders of an entity for the year ended
31 December 20X5 was £30 million and the weighted average number of its ordinary shares in
issue was 60 million. Its basic earnings per share was £0.50.
In addition, there was a weighted average of five million shares under options which had vested
(ie, were able to be exercised). The exercise price for the options was £21 and the average
market price per share over the year was £30.
Requirement
Calculate the diluted EPS.
Solution
The amount to be received on exercise is £21  5m = £105m
The number of shares issued at average market price is: £105m / £30 = 3.5m
The number of 'free' shares is: 5 million issued – 3.5 million issued at average market price =
1.5 million
Diluted earnings per share:
£30m/(60m + 1.5m) = £0.49

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Where shares are unvested, the amount still to be recognised in profit or loss before the vesting
date must be taken into account when calculating the number of 'free' shares.
Worked example: Unvested options

Assume the same information as in above example, except that:
 the options have not yet vested; and
 the amount to be recognised in relation to these options in the entity's profit or loss over
future accounting periods up to date of vesting, as calculated according to IFRS 2, is
£15 million.
Requirement
Calculate the diluted EPS.
Solution
The amount to be recognised in profit or loss is reduced to a per share amount: £15m/5m = £3
This is added to the exercise price: £21 + £3 = £24
The amount to be received on exercise: £24  5m = £120m
The number of shares issued at average market price: £120m/£30 = 4m
The number of 'free' shares: 5m – 4m = 1m
Diluted earnings per share: £30m/(60m + 1m) = £0.49
7 Diluted EPS: contingently issuable shares
Section overview
This section deals with the impact of contingently issuable shares on the number of ordinary
shares used in the calculation of diluted earnings per share.
7.1 Contingently issuable shares

The consideration for acquisitions of other entities may partly be in the form of shares which will
only be issued if certain targets are met in the future. The additional consideration is contingent
consideration and the additional shares are described as contingently issuable.
Contingently issuable shares may also arise where senior staff members are issued shares as a
performance reward.
 Until the shares are issued (if indeed they ever are), they should not be taken into account
when calculating basic EPS.
 They should be taken into account when calculating diluted EPS if and only if the conditions
leading to their issue have been satisfied. For these purposes the end of the accounting
period is treated as the end of the contingency period.
 Contingently issuable shares are included from the beginning of the period (or from the
date of the contingent share agreement, if later).

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Worked example: Contingently issuable shares

C
The profit attributable to the ordinary equity holders of an entity for the year ended H
31 December 20X5 was £20 million and the weighted average number of its ordinary shares in A
P
issue was 16 million. Basic earnings per share was therefore £1.25. T
E
Under an agreement relating to a business combination, two million additional shares were to
R
be issued if the share price on 30 June 20X6 was £8 or above. On 31 December 20X5 the share
price was £9. Assuming the end of the reporting period was the end of the contingency period, 11
the condition would have been met.
Requirement
Determine the diluted EPS.
Solution
As the two million additional shares do not result in additional resources for the entity, they are
brought into the diluted earnings per share calculation from the start of the 20X5 reporting
period. The diluted earnings per share is therefore:
Diluted earnings per share = £20m/(16m + 2m) = £1.11
7.2 Conditions for issue

Contingently issuable shares are included within the calculation of diluted EPS where:
 the shares have not yet been issued
 the relevant performance criteria have been met
Future earnings
Achieving or maintaining a specified level of earnings for a particular period may be the
condition for contingent issue.
In this case, if the effect is dilutive, the calculation of diluted EPS is based on the number of
ordinary shares that would be issued if the amount of earnings at the end of the reporting
period were the amount of earnings at the end of the contingency period.
Market price of shares
The number of ordinary shares contingently issuable may depend on the future market price of
the ordinary shares.
In this case, if the effect is dilutive, the calculation of diluted EPS is based on the number of
ordinary shares that would be issued if the market price at the end of the reporting period were
the market price at the end of the contingency period.
If the condition is based on an average of market prices over a period of time that extends
beyond the end of the reporting period, the average for the period of time that has lapsed is
used.
Future earnings and market price of shares
The number of ordinary shares contingently issuable may depend on future earnings and future
prices of the ordinary shares.
In such cases, the number of ordinary shares included in the diluted EPS calculation is based on
both conditions (ie, earnings to date and the current market price at the end of the reporting
period).
Contingently issuable ordinary shares are not included in the diluted earnings per share
calculation unless both conditions are met.

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Other conditions
In other cases, the number of ordinary shares contingently issuable may depend on a condition
other than earnings or market price (for example, the opening of a specific number of retail
stores).
In this case, the contingently issuable ordinary shares are included in the calculation of diluted
earnings per share according to the status at the end of the reporting period.
Cumulative targets
Note that where performance criteria involve a cumulative target, no dilution is accounted for
until the cumulative target has been met. For example, where the issue of shares is dependent
upon average profits of £300,000 over four years, the cumulative target is £1,200,000. No
dilution is accounted for until this cumulative target is met.
Worked example: Cumulative targets

A manufacturer has in issue 3,000,000 ordinary shares at 1 January 20X7. It agreed to issue
500,000 shares to its staff if factory output averages 100,000 units per annum over the period from
1 January 20X7 to 31 December 20X9. The shares are to be issued on 1 January 20Y0.
Results for the three periods are:
Units produced Profits
20X7 120,000 £780,000
20X8 99,000 £655,000
20X9 105,000 £745,000
Requirement
What are basic and diluted EPS in each of the years 20X7–20X9?
Solution
The cumulative target of 3 years  100,000 units is not met in 20X7 and 20X8, therefore no
dilution is accounted for.
In 20X9, the cumulative target is met as is the average target, therefore a diluted EPS is
disclosed:
Basic EPS Diluted EPS
20X7 £780,000
=
3,000,000 shares £0.26 Not relevant
20X8 £655,000
=
3,000,000 shares £0.22 Not relevant
20X9 £745,000 £745,000
= =
3,000,000 shares £0.25 3,500,000 shares £0.21
7.3 Issue of contingently issuable shares

Where contingently issuable shares are issued at the end of a contingency period, they must be
included within the calculation of basic EPS. Any outstanding contingently issuable shares are
included in diluted EPS as discussed above.
Worked example: Contingently issuable shares

The profit attributable to the ordinary equity holders of an entity for the year ended
31 December 20X5 was £200 million and the number of its ordinary shares in issue at
1 January 20X5 was 80 million.

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Under an agreement relating to a business combination, 12 million additional shares were to be

issued each time the entity's products were ranked in the top three places in a consumer C
H
satisfaction survey conducted by a well-known magazine. A maximum of 36 million shares was A
issuable under this agreement and the products appeared in the top three places in surveys P
dated 28 February and 30 September 20X5. T
E
There were no other issues of ordinary shares. R
Requirement 11
Determine the basic and diluted EPS.
Solution
Basic earnings per share
The 24 million additional shares are weighted by the period they have been in issue:
Adjusted
Issued Weighting number
1 January 20X5 – 28 February 80,000,000 2/12 13,333,333
Issued 28 February 12,000,000
1 March – 30 Sept 92,000,000 7/12 53,666,667
Issued 30 September 12,000,000
30 September – 31 December 104,000,000 3/12 26,000,000
Basic earnings per share = £200m/93m = £2.15

Diluted earnings per share
As the 24 million additional shares do not result in any additional resources for the entity, the
diluted calculation assumes all the new shares were issued at the start of the year (see section
2.4).
Diluted earnings per share = £200m/(80m + 12m + 12m) = £1.92
8 Retrospective adjustments, presentation and disclosure
Section overview
This section deals with retrospective adjustments to EPS and the provisions of IAS 33
concerning presentation and disclosure.
8.1 Retrospective adjustment

Bonus issues, share splits and share consolidations
If the number of ordinary or potential ordinary shares outstanding increases as a result of a
capitalisation, bonus issue or share split, or decreases as a result of a share consolidation, the
calculation of basic and diluted earnings per share for all periods presented must be adjusted
retrospectively.
If these changes occur after the year end but before the financial statements are authorised for
issue, EPS calculations for all periods presented must be based on the new number of shares.
The fact that EPS calculations reflect such changes must be disclosed.

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Prior period adjustments and errors

Basic and diluted earnings per share of all periods presented must be adjusted for the effects of
errors (IAS 8) and adjustments resulting from changes in accounting policies accounted for
retrospectively.
DEPS
An entity does not restate diluted earnings per share of any prior period presented for changes
in the assumptions used in earnings per share calculations or for the conversion of potential
ordinary shares into ordinary shares.
8.2 Presentation
Please note the following key points regarding presentation.
 Basic and diluted EPS for the year (and from continuing operations if reported separately)
must be presented on the face of the statement of profit or loss and other comprehensive
income with equal prominence for all periods presented.
 Where a separate statement of profit or loss is presented, basic and diluted EPS should be
presented on the face of this statement.
 Earnings per share is presented for every period for which a statement of comprehensive
income is presented.
 If diluted earnings per share is reported for at least one period, it shall be reported for all
periods presented, even if it equals basic earnings per share.
 If basic and diluted earnings per share are equal, dual presentation can be accomplished in
one line on the statement of comprehensive income.
 An entity that reports a discontinued operation shall disclose the basic and diluted amounts
per share for the discontinued operation either on the face of the statement of
comprehensive income or in the notes.
 An entity shall present basic and diluted earnings per share, even if the amounts are
negative (ie, a loss per share).
8.3 Disclosure
An entity shall disclose the following:
 The amounts used as the numerators in calculating basic and diluted earnings per share,
and a reconciliation of those amounts to profit or loss attributable to the parent entity for
the period. The reconciliation shall include the individual effect of each class of instruments
that affects earnings per share.
 The weighted average number of ordinary shares used as the denominator in calculating
basic and diluted earnings per share, and a reconciliation of these denominators to each
other. The reconciliation shall include the individual effect of each class of instruments that
affects earnings per share.
 Instruments (including contingently issuable shares) that could potentially dilute basic
earnings per share in the future, but were not included in the calculation of diluted earnings
per share because they are antidilutive for the period(s) presented.
 A description of ordinary share transactions or potential ordinary share transactions, other
than retrospective adjustments, that occur after the reporting date and that would have
changed significantly the number of ordinary shares or potential ordinary shares
outstanding at the end of the period if those transactions had occurred before the end of
the reporting period.

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Examples of transactions referred to in the paragraph above include the following:

C
 An issue of shares for cash H
A
 An issue of shares when the proceeds are used to repay debt or preference shares P
outstanding at the reporting date T
E
 The redemption of ordinary shares outstanding R
 The conversion or exercise of potential ordinary shares outstanding at the reporting date 11
into ordinary shares
 An issue of options, warrants, or convertible instruments
 The achievement of conditions that would result in the issue of contingently issuable shares
Earnings per share amounts are not adjusted for such transactions occurring after the reporting
date because such transactions do not affect the amount of capital used to produce profit or loss
for the period.
Financial instruments and other contracts generating potential ordinary shares may incorporate
terms and conditions that affect the measurement of basic and diluted earnings per share. These
terms and conditions may determine whether any potential ordinary shares are dilutive and, if
so, the effect on the weighted average number of shares outstanding and any consequential
adjustments to profit or loss attributable to ordinary equity holders. The disclosure of the terms
and conditions of such financial instruments and other contracts is encouraged, if not otherwise
required (refer also to IFRS 7, Financial Instruments: Disclosures in Chapter 15).
8.4 Additional EPS

If an entity discloses, in addition to basic and diluted earnings per share, amounts per share
using a reported component of profit other than one required by IAS 33, such amounts shall be
calculated using the weighted average number of ordinary shares determined in accordance
with this Standard.
Basic and diluted amounts per share relating to such a component shall be disclosed with equal
prominence and presented in the notes.
An entity shall indicate the basis on which the numerator(s) is (are) determined, including
whether amounts per share are before tax or after tax.
If a component of profit is used that is not reported as a line item in the statement of profit or
loss and other comprehensive income, a reconciliation shall be provided between the
component used and a line item that is reported in the statement of profit or loss and other
Worked example: Allied Irish Bank plc

In addition to the required EPS under IAS 33, Allied Irish Bank plc reports an adjusted EPS
measure excluding hedge volatility, profit on disposal of property and business and construction
contract income. A comment to the disclosure states that the adjusted measure is presented to
help better understand underlying business performance.

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Allied Irish Bank plc 31 December 2006

Extract from Notes to the accounts:
Profit attributable Earnings per share
2006 2005 2006 2005
19 Adjusted earnings per share €m €m € €
(a) Basic earnings per share
As reported (Note 18(a)) 2,147 1,305 246.8 151.0
Adjustments:
Construction contract income (82) (38) (9.4) (4.4)
Hedge volatility 4 (6) 0.5 (0.7)
Profit on disposal of property (290) – (33.4) –
Profit on disposal of business (189) – (21.7) –
1,590 1,261 182.8 145.9
Although not required under IFRS, adjusted earnings per share is presented to help understand
the underlying performance of the Group. The adjustments in 2006 and 2005 are items that
management believe do not reflect the underlying business performance. The adjustment in
respect of profit on sale of property relates only to the profit on sale of properties that are
subject to sale and leaseback arrangements (Note 12). The adjustments listed above are shown
net of taxation.

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Summary and Self-test C

H
A
P
T
Summary E
R
IAS 33, Earnings 11
per Share
Earnings Number of shares
Minus Plus rights

earnings attributable issues and bonus
to preference shareholders issues
Earnings attributable Total number

to ordinary shareholders of shares
Basic EPS
Adjust for potential shares

Adjust earnings resulting
due to
from change in convertible • Convertible debt
debt • Options
• Contingently issuable
shares
Diluted
EPS

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Self-test
1 Puffbird
Puffbird is a company listed on a recognised stock exchange. Its financial statements for the
year ended 31 December 20X6 showed earnings per share of £0.95.
On 1 July 20X7 Puffbird made a 3 for 1 bonus issue.
Requirement
According to IAS 33, Earnings per Share, what figure for the 20X6 earnings per share will be
shown as comparative information in the financial statements for the year ended
31 December 20X7?
2 Urtica
The Urtica Company is listed on a recognised stock exchange.
During the year ended 31 December 20X6, the company had 5 million ordinary shares of
£1 and 500,000 6% irredeemable preference shares of £1 in issue.
Profit before tax for the year was £300,000 and the tax charge was £75,000.
Requirement
According to IAS 33, Earnings per Share, what is Urtica's basic earnings per share for the
year?
3 Issky
The following extracts relate to the Issky Company for the year ended 31 December 20X7.
£'000
Statement of comprehensive income
Profit after tax 5,400
Statement of financial position

Ordinary shares of £1 8,400
In addition, the company had in issue throughout the year 1,800,000 share options granted
to directors at an exercise price of £15. These were fully vested (ie, conditions required
before these could be exercised were fulfilled and the options were exercisable) but had
not yet been exercised. The market price for Issky's shares was £24 at 1 January 20X7, £30
at 31 December 20X7, and the average for 20X7 was £27.
Requirement
What is the diluted earnings per share for 20X7 according to IAS 33, Earnings per Share?
4 Whiting
The Whiting Company has the following financial statement extracts in the year ended
31 December 20X7.
Profit after tax £
Continuing operations 1,600,000
Discontinued operations (400,000)
Total attributable to ordinary equity holders 1,200,000

Ordinary shares of £1 9,600,000

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On 1 January 20X7, Whiting issued £1.2 million of 7% redeemable convertible bonds,

interest being payable annually in arrears on 31 December. The split accounting required C
H
of compound financial instruments resulted in the following classification. A
£ P
T
Equity component 100,000 E
Liability component 1,100,000 R
1,200,000
11
The effective interest rate on the liability component is 10%. The bonds are convertible on
specified dates in the future at the rate of one ordinary share for every £2 bond.
The tax regime under which Whiting operates gives relief for the whole of the charge based
on the effective interest rate and applies a tax rate of 20%.
Requirement
Based upon the profit from continuing operations attributable to ordinary equity holders,
what amount, if any, for diluted earnings per share should be presented by Whiting in its
financial statements for the year ended 31 December 20X7 according to IAS 33, Earnings
per Share?
5 Garfish
The Garfish Company had profits after tax of £3.0 million in the year ended 31 December
20X7.
On 1 January 20X7, Garfish had 2.4 million ordinary shares in issue. On 1 April 20X7 Garfish
made a 1 for 2 rights issue at a price of £1.40 when the market price of Garfish's shares was
£2.00.
Requirement
What is Garfish's basic earnings per share figure for the year ended 31 December 20X7,
according to IAS 33, Earnings per Share?
6 Sakho
The Sakho Company has 850,000 ordinary shares in issue on 1 January 20X7 and had the
following share transactions in the year ended 31 December 20X7.
(1) A 1 for 5 bonus issue on 1 May 20X7
(2) A 2 for 5 rights issue on 1 September 20X7 at £0.45 when the market price was £1.50
Requirement
Indicate whether the following statements are true or false according to IAS 33, Earnings
per Share.
(a) The basic earnings per share for the year ended 31 December 20X6 has to be adjusted
by a fraction of 5/6.
(b) For the calculation of 20X7 basic earnings per share, the number of shares in issue
before the rights issue has to be adjusted by a rights fraction of 1.50/1.20.
7 Sardine
The Sardine Company operates in Moldania, a jurisdiction in which shares may be issued at
a discount. It has profit after tax and before preference dividends of £200,000 in the year
On 1 January 20X7 Sardine has in issue 500,000 ordinary shares, and on 1 January 20X7
issues £300,000 of £100 non-convertible, non-redeemable preference shares. Cash
dividends of 8% per annum will only start to be paid on the preference shares from

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1 January 20X9, so the shares are issued at a discount. The effective interest rate of the
discount is 8%.
Requirement
According to IAS 33, Earnings per Share, what is the basic earnings per share for Sardine in
the year ended 31 December 20X7?
8 Citric
The following information relates to The Citric Company for the year ended
31 December 20X7.
Profit after tax £100,000
Ordinary shares of £1 1,000,000
There are warrants outstanding in respect of 1.7 million new shares in Citric at a
subscription price of £18.00. Citric's share price was £22.00 on 1 January 20X7, £24.00 on
30 June 20X7, £30.00 on 31 December 20X7 and averaged £25.00 over the year.
On 1 January 20X7 Citric issued £2 million of 6% redeemable convertible bonds, interest
being payable annually in arrears on 31 December. The split accounting required of
compound financial instruments resulted in a liability component of £1.75 million and
effective interest rate of 7%. The bonds are convertible on specified dates many years into
the future at the rate of two ordinary shares for every £5 bonds.
The tax regime under which Citric operates gives relief for the whole of the effective interest
rate charge on the bonds and applies a tax rate of 25%.
Requirement
Determine the following amounts in respect of Citric's diluted earnings per share for the
year ending 31 December 20X7 according to IAS 33, Earnings per Share:
(a) The number of shares to be treated as issued for no consideration (ie, 'free' shares) on
the subscription of the warrants
(b) The earnings per incremental share on conversion of the bonds, expressed in pence
(to one decimal place)
(c) The diluted earnings per share, expressed in pence (to one decimal place)

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Technical reference C
H
A
P
IAS 33, Earnings per Share T
E
Earnings R
 Amounts attributable to ordinary equity holders in respect of profit or loss IAS 33.12 11
for the period (and from continuing operations where reported
separately) adjusted for the after tax amounts of preference dividends.
Shares
 For the calculation of basic EPS the number of ordinary shares should be IAS 33.26
the weighted average number of shares outstanding during the period
adjusted where appropriate for events, other than the conversion of
shares, that have changed the number of ordinary shares outstanding
without a corresponding change in resources.
Diluted earnings per share

 For the purposes of calculating diluted earnings per share an entity shall IAS 33.30
adjust profit or loss attributable to ordinary equity holders and the
IAS 33.31
weighted number of shares outstanding for the effects of dilutive
potential ordinary shares.
Dilutive potential ordinary shares

 Potential ordinary shares shall be treated as dilutive when, and only when,
IAS 33.41
their conversion to ordinary shares could decrease earnings per share or
increase loss per share from continuing operations.
Options, warrants and their equivalents IAS 33.45
Convertible instruments IAS 33.49
Contingently issuable shares IAS 33.52
Retrospective adjustments
 Basic and diluted EPS should be adjusted retrospectively for all IAS 33.64
capitalisations, bonus issues or share splits or reverse share splits that
affect the number of shares in issue without affecting resources.
Presentation IAS 33.66
Disclosure IAS 33.70

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No, the 4% preference shares are classed as liabilities under IAS 32. The dividend has been
charged to profits as part of the finance cost and no adjustment is necessary.

£1.75
Being the total earnings £350,000 divided by the number of shares in issue (200,000).
The redeemable preference share dividend is included as a finance cost and deducted in
arriving at profit before tax.

Basic EPS
20X6
£
Trading results
Profit before interest and tax 1,050,000
Interest on 7% convertible loan stock (105,000)
Taxation (283,500)
Number of shares outstanding 2,000,000
Basic EPS (£661,500/2,000,000 shares) £0.33
Testing for dilutive impact

Increase in earnings = interest saved (£1,500,000  7%  (1 – 30%)) £73,500
Increase in number of shares (£1,500,000/£100  140) 2,100,000
EPS (£73,500/2,100,000) 3.5p
This is less than basic EPS and therefore the convertible loan stock is dilutive.

20X7
£
Trading results
Number of shares outstanding 3,000,000
Basic EPS £0.30
Number of shares under option
Issued at full market price (600,000  50p)/£1.50 200,000
Issued at nil consideration 600,000 – 200,000 400,000
Total number of shares under option 600,000
Number of equity shares for basic EPS 3,000,000
Number of dilutive shares under option 400,000
Adjusted number of shares 3,400,000
Diluted EPS (£900,000/3,400,000) £0.26

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Answers to Self-test C
H
A
1 Puffbird P
T
23.75 pence E
R
Last year's EPS figure is adjusted by the reciprocal of the bonus fraction:
11
Number of shares post issue 4
Bonus fraction = =
Number of shares pre issue 1
Therefore revised EPS = 95p  ¼ = 23.75p

2 Urtica
3.9 pence
IAS 33 12 – 13 define earnings for basic EPS as after tax and after dividends on
irredeemable preference shares.
£
Tax (75,000)
Preference dividend (£500,000  6%) (30,000)
Profit attributable to ordinary equity holders 195,000
Therefore BEPS = £195,000/5,000,000 shares = 3.9p

3 Issky
58.7 pence
Number of shares under option
Issued at average market price (£15  1,800,000)/£27 1,000,000
Issued at nil consideration (1,800,000 – 1,000,000) 800,000
Number of equity shares for basic EPS 8,400,000

Number of dilutive shares under option 800,000
Adjusted number of shares 9,200,000
Diluted EPS (£5,400,000/9,200,000 shares) 58.7p
According to IAS 33.46, the proceeds of the options should be calculated using the
average market price during the year. The difference between the number of ordinary
shares issued and the number that would have been issued at the average market price are
the 'free' shares that create the dilutive effect.

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4 Whiting
12.6 pence
Basic EPS £1,600,000
Based on continuing operations = 16.7 p
9,600,000
Incremental Increment to profits after conversion of bonds:

EPS £1,100,000  10%  (1 – 20%) = £88,000
Increase to number of shares:
£1,200,000/£2 = 600,000
£88,000
Therefore: = 14.7 p
600,000
Diluted EPS Based on continuing operations

£(1,600,000 + 88,000) 16.6 p
=
9,600,000 + 600,000 shares
The shares issuable on conversion of the bonds are potentially dilutive, but IAS 33.41 only
requires them to be taken into account if they dilute the basic EPS figure based on
continuing operations.
5 Garfish
89.1 pence
Weighted average number of shares:
TERP: 2 shares @ £2.00 = £4.00
1 share @ £1.40 = £1.40
3 £5.40 therefore £5.40/3 = £1.80
Market value of share £2.00

Adjustment factor: =
TERP £1.80
1 Jan X7 – 31 March X7 2,400,000  2.00  3/12 666,667

1.80
Rights issue 1,200,000
1 April X7 – 31 Dec X7 3,600,000  9/12 2,700,000
3,366,667
Basic EPS:
£3,000,000
= 89.1p
3,366,667 shares
6 Sakho
(a) False
(b) True
Number of shares post issue 6
Bonus fraction = =
Number of shares pre issue 5
MV of share 1.50
Rights adjustment factor = =
TERP 1.20
TERP: 5 shares @ £1.50 = £7.50
2 shares @ £0.45 = £0.90
7 £8.40 therefore TERP = £8.40/7 shares = £1.20
The basic EPS for the prior year is multiplied by the inverse of the rights factor and the
bonus factor, so 1.20/1.50  5/6 = 2/3.

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7 Sardine
C
35.9 pence H
2 A
Issue price of preference shares = £300,000/1.08 = £257,202 P
T
Profit attributable to ordinary equity holders = £200,000 – (8%  £257,202) = £179,424 E
R
£179,424
Basic EPS = = 35.9p
500,000 shares 11
As no dividend is payable on the preference shares in 20X7, the discount on issue is

amortised using the effective interest method and treated as preference dividend when
calculating earnings for EPS purposes (IAS 33.15).
The £300,000 preference shares must be discounted at 8% for the two years between issue
and the date when dividends commence. A dividend is then calculated at 8% per annum
compound on that value.
8 Citric
(a) 476,000
(b) 11.5 pence
(c) 6.78 pence
(a) Shares issued at average market price (1,700,000  £18)/£251,224,000
Shares issued at nil consideration (1,700,000 – 1,224,000) 476,000
(b) Incremental profits (£1,750,000  7%  (1 – 25%)) £91,875
Increase in number of shares (£2,000,000/£5  2) 800,000
Therefore incremental EPS (£91,875/800,000 shares) 11.5p
(c) Profits Number of shares EPS
Basic EPS £100,000 1,000,000 10p
Add in options £100,000 1,476,000 6.78p
The warrants (treated as issued for nil consideration) are more dilutive than the bonds, so are
dealt with first under IAS 33.44. As the 11.5 pence earnings per incremental share on conversion
of the bonds is antidilutive, under IAS 33.36 the conversion is left out of the calculation of diluted
EPS.

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CHAPTER 12
Reporting of assets
Introduction
TOPIC LIST
1 Review of material from earlier studies
2 IAS 40, Investment Property
3 IAS 41, Agriculture
4 IFRS 6, Exploration for and Evaluation of Mineral Resources
5 IFRS 4, Insurance Contracts
6 Audit focus points
Technical reference

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Introduction
Tick off
Learning outcomes
can affect reported financial position and explain the role of data analytics in
 Explain and appraise accounting standards that relate to assets and non-financial
liabilities for example: property, plant and equipment; intangible assets, held-for-
sale assets; inventories; investment properties; provisions and contingencies
evidence
Specific syllabus references for this chapter are: 3(a), 3(b), 14(c), 14(d), 14(f)

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1 Review of material from earlier studies
Section overview
You should already be familiar with the standards relating to current and non-current assets
from earlier studies. If not, go back to your earlier study material.
• IAS 2, Inventories
• IAS 16, Property, Plant and Equipment
• IAS 38, Intangible Assets
• IAS 36, Impairment of Assets
Read the summary of knowledge brought forward and try the relevant questions. If you have any C
H
difficulty, go back to your earlier study material and revise it. A
P
Assets have been defined in many different ways and for many purposes. The definition of an T
asset is important because it directly affects the treatment of such items. A good definition will E
prevent abuse or error in the accounting treatment: otherwise some assets might be treated as R
expenses, and some expenses might be treated as assets.
12
In the current accounting climate, where complex transactions are carried out daily a definition
that covers ownership and value is not sufficient, leaving key questions unanswered.
 What determines ownership?
 What determines value?
The definition of an asset in the IASB's Framework for the Preparation and Presentation of
Financial Statements (Framework) from earlier studies is given below.
Definition
Asset: A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity. (Framework)
This definition ties in closely with the definitions produced by other standard-setters, particularly
the FASB (USA) and the ASB (UK).
A general consensus seems to exist in the standard setting bodies as to the definition of an asset
which encompasses three important characteristics.
 Future economic benefit
 Control
 The transaction to acquire control has already taken place
1.1 Property, plant and equipment

The following concepts will be familiar to you from your earlier studies.
 Cost is the amount of cash or cash equivalents paid or the fair value of the other
consideration given to acquire an asset at the time of its acquisition or construction.
 Residual value is the estimated amount that an entity would currently obtain from disposal
of the asset, after deducting the estimated costs of disposal, if the asset were already of the
age and in the condition expected at the end of its useful life.
 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. (Note that this
definition changed when IFRS 13, Fair Value Measurement came into force in January 2013
– see Chapter 2, section 4.)
ICAEW 2019 Reporting of assets 643

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 Carrying amount is the amount at which an asset is recognised after deducting any
accumulated depreciation and accumulated impairment losses.
Accounting treatment
 As with all assets, recognition depends on two criteria:
– It is probable that future economic benefits associated with the item will flow to the
entity.
– The cost of the item can be measured reliably.
 These recognition criteria apply to subsequent expenditure as well as costs incurred initially
(ie, there are no longer separate criteria for recognising subsequent expenditure).
 Once recognised as an asset, items should initially be measured at cost.
 Cost is the purchase price, less trade discount/rebate plus:
– directly attributable costs of bringing the asset to working condition for intended use;
and
– initial estimate of the unavoidable cost of dismantling and removing the item and
restoring the site on which it is located.
IAS 16, Property, Plant and Equipment also does the following:
 Provides additional guidance on directly attributable costs, including the cost of an item of
property, plant and equipment
 States that income and related expenses of operations that are incidental to the
construction or development of an item of property, plant and equipment should be
recognised in profit or loss for the period
 Specifies that exchanges of items of property, plant and equipment, regardless of whether
the assets are similar, are measured at fair value, unless the exchange transaction lacks
commercial substance or the fair value of neither of the assets exchanged can be measured
reliably. If the acquired item is not measured at fair value, its cost is measured at the
carrying amount of the asset given up
 Permits a choice of measurement models subsequent to initial recognition
– Cost model: carrying asset at cost less depreciation and any accumulated impairment
losses
– Revaluation model: carrying asset at revalued amount, ie, fair value less subsequent
accumulated depreciation and any accumulated impairment losses. (IAS 16 makes
clear that the revaluation model is available only if the fair value of the item can be
measured reliably.)

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Asset is
revalued
upw ards dow nw ards
Has the asset Has the asset

previously suffered previously had
a downward an upward
valuation? valuation? C
H
NO NO
A
P
T
E
R
Recognise the increase Recognise the
as a revaluation surplus. decrease 12
(Other comprehensive directly in profit
YES or loss. YES
income)
Recognise the increase in

profit or loss up to the Recognise the decrease
value of the downward against the revaluation
valuation. Any excess should surplus up to the value of
be recognised as a revaluation the upward valuation. Any
surplus. (Other comprehensive excess should be recognised
income) directly in profit or loss.
Figure 12.1: Revaluations
Interactive question 1: Revaluations

Binkie Co has an item of land carried in its books at £13,000. Two years ago a slump in land
values led the company to reduce the carrying amount from £15,000. This was recorded as an
expense. There has been a surge in land prices in the current year, however, and the land is now
worth £20,000.
In the example given above assume that the original cost was £15,000, revalued upwards to
£20,000 two years ago. The value has now fallen to £13,000.
Crinkle Co bought an asset for £10,000 at the beginning of 20X6. It had a useful life of five years.
On 1 January 20X8 the asset was revalued to £12,000. The expected useful life has remained
unchanged (ie, three years remain).
Requirements
(a) Account for the revaluation in the current year
(b) Account for the decrease in value
(c) Account for the revaluation and state the treatment for depreciation from 20X8 onwards

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1.2 Inventories
Valuation
Lower of:
 Cost
 Net realisable value
Each item/group/category considered separately
Allowable costs
Include:
 Cost of purchase
Exclude:
 Cost of storage
 Cost of selling
Determining cost
 First in, first out (FIFO)
 Weighted average cost
Net realisable value
 Estimated cost of completion
 Estimated costs necessary to make the sale (eg, marketing, selling and distribution)
Interactive question 2: Attributable cost

A production line results in two outputs, Product 1 and Product 2. Parts of the production
process give rise to indirect costs specifically identifiable with only one of these products,
although other costs are not separately identifiable.
Budgeted cost information for the most recent month is as follows.
Total Product 1 Product 2
£ £ £
Direct cost 300,000 140,000 160,000
Indirect production overheads
Identifiable 82,000 37,000 45,000
Other 50,000
432,000
Budgeted output – units 690 900
The entity has a policy which allocates indirect costs which are not specifically identifiable to an
individual product by reference to relative selling prices. This results in 60% being allocated to
Product 1 and 40% to Product 2.
During the month, costs were incurred in line with the budget but, due to a failure of calibration
to a vital part of the process, only 675 units of Product 2 could be taken into inventory. The
remainder produced had to be scrapped, for zero proceeds.
Requirement
Calculate the cost attributable to Products 1 and 2.

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Interactive question 3: Reclassification of asset

An entity manufactures a particular type of machine tool, each of which costs £36,000 to
produce and has a net realisable value of £45,000.
The entity takes one of the tools out of inventories to use for demonstration purposes over the
next three years. This item will be reclassified as a non-current asset and recognised in
accordance with IAS 16, Property, Plant and Equipment.
Requirement
Assuming the tool has a nil residual value at the end of the three years, find its carrying amount
to be recognised as part of non-current assets one year later.
C
H
A
P
T
1.3 IAS 38, Intangible Assets E
R
 An intangible asset is an identifiable non-monetary asset without physical substance, such
as a licence, patent or trademark. 12
 An intangible asset is identifiable if it is separable (ie, it can be sold, transferred,

exchanged, licensed or rented to another party on its own rather than as part of a business)
or it arises from contractual or other legal rights.
 An intangible asset should be recognised if it is probable that future economic benefits
attributable to the asset will flow to the entity and the cost of the asset can be measured
reliably.
 At recognition the intangible should be recognised at cost (purchase price plus directly
attributable costs). After initial recognition an entity can choose between the cost model
and the revaluation model. The revaluation model can only be adopted if an active market
(as defined) exists for that type of asset.
 An intangible asset (other than goodwill recognised in the acquiree's financial statements)
acquired as part of a business combination should initially be recognised at fair value.
 Internally generated goodwill should not be recognised.
 Expenditure incurred in the research phase of an internally generated intangible asset
should be expensed as incurred.
 Expenditure incurred in the development phase of an internally generated intangible asset
must be capitalised provided certain tightly defined criteria are met.
– Expenditure incurred before the criteria being met may not be capitalised
retrospectively.
 An intangible asset with a finite useful life should be amortised over its expected useful life,
commencing when the asset is available for use in the manner intended by management.
 Residual values should be assumed to be nil, except in the rare circumstances when an
active market exists or there is a commitment by a third party to purchase the asset at the
end of its useful life.
 An intangible asset with an indefinite life should not be amortised, but should be reviewed
for impairment on an annual basis.
– There must also be an annual review of whether the indefinite life assessment is still
appropriate.
 On disposal of an intangible asset the gain or loss is recognised in profit or loss.

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Interactive question 4: Intangible assets

(a) Give some common examples of intangible assets.
(b) Can employees be recognised as intangible assets?
1.4 IAS 36, Impairment of Assets

1.4.1 Scope
IAS 36 applies to impairment of all assets other than the following:
 Inventories
 Deferred tax assets
 Employee benefit assets
 Financial assets
 Investment property held under the fair value model
 Biological assets held at fair value less estimated point-of-sale costs
 Non-current assets held for sale
IAS 36 most commonly applies to the following:
 Property, plant and equipment accounted for in accordance with IAS 16, Property, Plant
and Equipment
 Intangible assets accounted for in accordance with IAS 38, Intangible Assets
 Some financial assets, namely subsidiaries, associates and joint ventures. Impairments of all
other financial assets are accounted for in accordance with IFRS 9, Financial Instruments
1.4.2 Issue
Assets should be carried at no more than their recoverable amount.
Recoverable Amount
= Higher of
Fair value less Value in use

costs to sell
Figure 16.2: Recoverable amount

1.4.3 Fair value less costs to sell
Fair value less costs to sell is the price that would be received to sell the asset in an orderly
transaction between market participants at the measurement date (IFRS 13 definition of fair
value, see Chapter 2, section 4), less the direct incremental costs attributable to the disposal of
the asset.
Examples of costs of disposal are legal costs, stamp duty and similar transaction taxes, costs of
removing the asset, and direct incremental costs to bring an asset into condition for its sale.
They exclude finance costs and income tax expense.
1.4.4 Value in use
Cash flow projections are based on the most recent management-approved budgets/forecasts.
They should cover a maximum period of five years, unless a longer period can be justified.

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The cash flows should include the following:

 Projections of cash inflows from continuing use of the asset
 Projections of cash outflows necessarily incurred to generate the cash inflows from
continuing use of the asset
 Net cash flows, if any, for the disposal of the asset at the end of its useful life
 Future overheads that can be directly attributed, or allocated on a reasonable and
consistent basis
They should exclude the following:
 Cash outflows relating to obligations already recognised as liabilities (to avoid double
counting) C
 The effects of any future restructuring to which the entity is not yet committed H
A
 Cash flows from financing activities or income tax receipts and payments P
T
1.4.5 Discount rate E
R
The discount rate (or rates) should be a pre-tax rate (or rates) that reflect(s) current market
assessments of: 12
 the time value of money; and

 the risks specific to the asset for which future cash flow estimates have not been adjusted.
Interactive question 5: Impairment loss

An entity has a single manufacturing plant which has a carrying value of £749,000. A new
government elected in the country passes legislation significantly restricting exports of the
product produced by the plant. As a result, and for the foreseeable future, the entity's
production will be cut by 40%. Cash flow forecasts have been prepared derived from the most
recent financial budgets/forecasts for the next five years approved by management (excluding
the effects of general price inflation).
Year 1 2 3 4 5
£'000 £'000 £'000 £'000 £'000
Future cash flows 230 211 157 104 233
(including
disposal
proceeds)
If the plant was sold now it would realise £550,000, net of selling costs.
The entity estimates the pre-tax discount rate specific to the plant to be 15%, after taking into
account the effects of general price inflation.
Requirement
Calculate the recoverable amount of the plant and any impairment loss.
Note: PV factors at 15% are as follows.
Year PV factor @15%
1 0.86957
2 0.75614
3 0.65752
4 0.57175
5 0.49718

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1.4.6 Impairment indicators

The entity should look for evidence of impairment at the end of each period and conduct an
impairment review on any asset where there is evidence of impairment. The following are
indicators of impairment.
External
 Significant decline in market value of the asset below that expected due to normal passage
of time or normal use
 Significant changes with an adverse effect on the entity in the:
– technological or market environment; and
– economic or legal environment.
 Increased market interest rates or other market rates of return affecting discount rates and
thus reducing value in use
 Carrying amount of net assets of the entity exceeds market capitalisation
Internal
 Evidence of obsolescence or physical damage
 Significant changes with an adverse effect on the entity*:
– The asset becomes idle
– Plans to discontinue/restructure the operation to which the asset belongs
– Plans to dispose of an asset before the previously expected date
– Reassessing an asset's useful life as finite rather than indefinite
 Internal evidence available that asset performance will be worse than expected.
* Once the asset meets the criteria to be classified as 'held for sale', it is excluded from the
scope of IAS 36 and accounted for under IFRS 5, Non-current Assets Held for Sale and
Discontinued Operations.
Annual impairment tests, irrespective of whether there are indications of impairment, are
required for:
 intangible assets with an indefinite useful life/not yet available for use; and
 goodwill acquired in a business combination.
1.4.7 Cash-generating units (CGUs)
Where it is not possible to estimate the recoverable amount of an individual asset, the entity
estimates the recoverable amount of the cash-generating unit (CGU) to which it belongs.
Definition
Cash-generating unit: A cash-generating unit is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or
groups of assets.
If an active market exists for the output produced by an asset or a group of assets, this group of
assets should be identified as a CGU even if some or all of the output is used internally. If the
cash inflows are affected by internal transfer pricing, management's best estimates of future
prices that could be achieved in an orderly transaction between market participants at the
measurement date are used in estimating the CGU's value in use.

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Interactive question 6: Cash-generating units

Discuss whether the following items would be cash-generating units in their own right, or part of
a larger cash-generating unit.
(a) A pizza oven in a pizza restaurant
(b) A branch of a pizza restaurant in Warsaw
(c) A monorail that takes fee paying visitors to a theme park from its car park
(d) A monorail that transports fee paying commuters from a suburban part of town to the centre of
town
(e) The internal large telephone network of a country's railway system, although its use is
currently not permitted to anybody other than railway workers C
H
A
P
T
E
R
1.4.8 Corporate assets
12
 Corporate assets are treated in a similar way to goodwill.
The CGU includes corporate assets (or a portion of them) that can be allocated to it on a
'reasonable and consistent basis'. Where not possible, the assets (or unallocated portion)
are tested for impairment as part of the group of CGUs to which they can be allocated on a
reasonable and consistent basis.
1.4.9 Recognition of impairment losses in financial statements
 Assets carried at historical cost – in profit or loss
 Revalued assets
The impairment loss should be treated under the appropriate rules of the applicable IFRS.
For example, property, plant and equipment first against any revaluation surplus relating to the
asset and then in profit or loss in accordance with IAS 16.
1.4.10 Allocation of impairment losses in a CGU
General rule
The impairment should be allocated in the following order:
 Goodwill allocated to the CGU
 Other assets on a pro rata basis based on carrying value
The carrying amount of an asset should not be reduced below the higher of its recoverable
amount (if determinable) and zero.
The amount of the impairment loss that would otherwise have been allocated to the asset
should be allocated to the other assets on a pro rata basis.
Allocation of loss with unallocated corporate assets or goodwill
Where not all assets or goodwill have been allocated to an individual CGU then different levels
of impairment tests are performed to ensure the unallocated assets are tested.
Test of individual CGUs
 Test the individual CGUs (including allocated goodwill and any portion of the carrying
amount of corporate assets that can be allocated on a reasonable and consistent basis)

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Test of group of CGUs

 Test the smallest group of CGUs that includes the CGU under review and to which the
goodwill can be allocated/a portion of the carrying amount of corporate assets can be
allocated on a reasonable and consistent basis
1.4.11 After the impairment review
The depreciation/amortisation should be adjusted in future periods to allocate the asset's
revised carrying amount less its residual value on a systematic basis over its remaining useful life.
1.4.12 Treatment of the non-controlling interest element of goodwill
The revision to IFRS 3 allows two methods of initially valuing the non-controlling (minority)
interest in an entity:
 As a share of the net assets of the entity at the acquisition date; or
 at fair value.
The non-controlling interest is then taken into account in the goodwill calculation per the revised
standard:
Purchase consideration X
Non-controlling interest X
X
Total fair value of net assets of acquiree (X)
Goodwill X
This means that the resulting goodwill will represent:

 only the parent's share of total goodwill when valuing the non-controlling interest using the
proportion of net assets method; and
 full goodwill (ie, the parent's share plus the non-controlling interest share) when using the
fair value method.
Where the share of net assets method is used to value the non-controlling interest, the carrying
amount of a CGU therefore comprises:
 the parent and non-controlling share of the identifiable net assets of the unit; and
 only the parent's share of the goodwill.
Part of the calculation of the recoverable amount of the CGU relates to the unrecognised share
in the goodwill.
For the purpose of calculating the impairment loss, the carrying amount of the CGU is therefore
notionally adjusted to include the non-controlling share in the goodwill by grossing it up.
The consequent impairment loss calculated is only recognised to the extent of the parent's
share.
Where the fair value method is used to value the non-controlling interest, no adjustment is
required.
Interactive question 7: Allocation of impairment loss

Peter acquired 60% of Stewart on 1 January 20X1 for £450 million recognising net assets of
£600 million, a non-controlling interest (valued as a proportion of total net assets) of £240 million
and goodwill of £90 million. Stewart consists of a single cash-generating unit.
Due to adverse publicity, the recoverable amount of Stewart had fallen by 31 December 20X1.
The depreciated value of the net assets at that date was £550 million (excluding goodwill). No
impairment losses have yet been recognised relating to the goodwill.

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Requirement
Show the allocation of the impairment losses:
(a) if the recoverable amount was £510 million at 31 December 20X1
(b) if the recoverable amount was £570 million at 31 December 20X1
1.4.13 Reversal of past impairments

A reversal for a CGU is allocated to the assets of the CGU, except for goodwill, pro rata with the
carrying amounts of those assets. C
H
However, the carrying amount of an asset is not increased above the lower of: A
P
 its recoverable amount (if determinable); and T
 its depreciated carrying amount had no impairment loss originally been recognised. E
R
Any amounts left unallocated are allocated to the other assets (except goodwill) pro rata.
12
The reversal is recognised in profit or loss, except where reversing a loss recognised on assets
carried at revalued amounts, which are treated in accordance with the applicable IFRS.
For example, an impairment loss reversal on property, plant and equipment first reverses the
loss recorded in profit or loss and any remainder is credited to the revaluation surplus (IAS 16).
Goodwill
Once recognised, impairment losses on goodwill are not reversed.
1.4.14 Impairment and IFRS 5
IFRS 5 is covered in detail in Chapter 9. Regarding impairment, note the following:
 Immediately before initial classification as held for sale, the asset (or disposal group) is
measured in accordance with the applicable IFRS (eg, property, plant and equipment held
under the IAS 16 revaluation model is revalued).
 On classification of the non-current asset (or disposal group) as held for sale, it is written
down to fair value less costs to sell (if less than carrying amount).
 Any impairment loss arising under IFRS 5 is charged to profit or loss (and the credit
allocated to assets of a disposal group using the IAS 36 rules, ie, first to goodwill then to
other assets pro rata based on carrying value).
 Non-current assets/disposal groups classified as held for sale are not
depreciated/amortised.
 Any subsequent changes in fair value less costs to sell are recognised as a further
impairment loss (or reversal of an impairment loss).
 However, gains recognised cannot exceed cumulative impairment losses to date (whether
under IAS 36 or IFRS 5).

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2 IAS 40, Investment Property
Section overview
• An investment property is land or buildings or both that is held by an entity to earn rentals
and/or for its capital appreciation potential.
• Following initial measurement, investment property may be measured using the cost
model or the fair value model.
One of the distinguishing characteristics of investment property is that it generates cash flows
largely independent of the other assets held by an entity.
Owner-occupied property is not investment property and is accounted for under IAS 16,
Property, Plant and Equipment.
2.1 Recognition
Investment property should be recognised as an asset when two conditions are met.
 It is probable that the future economic benefits that are associated with the investment
property will flow to the entity.
 The cost of the investment property can be measured reliably.
2.2 Initial measurement and further aspects of recognition

An investment property should initially be measured at its cost, including transaction costs.
Further aspects of recognition
Transaction costs Expenses that are directly attributable to the investment property, for
example professional fees and property transfer taxes. Cost does not
include activities that, while related to the investment property, are not
directly attributable to it. For example, start- up costs, abnormal
amounts of wasted resources in constructing the property, relocation
costs, losses incurred before full occupancy and the normal servicing of
the property are not directly attributable.
Self-constructed Property being self-constructed or under development for future use as
investment an investment property qualifies itself as an investment property.
properties
Leases A property interest held under a lease and classified as an investment
property shall be accounted for as if it were a finance lease. The asset is
recognised at the lower of the fair value of the property and the present
value of the minimum lease payments. An equivalent amount is
recognised as a liability.
Entity occupies part If the two portions can be sold separately or leased separately under a
of property and finance lease, each is accounted for as appropriate. If not, entire
leases out balance property is an investment property only if insignificant portion is owner
occupied.

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Further aspects of recognition
Entity supplies An investment property only if the services are insignificant to the
services to the lessee arrangement as a whole.
of the property
Property leased to An investment property in entity's own accounts but owner occupied
and occupied by from group perspective.
parent, subsidiary or
other group company
Interactive question 8: Identification of investment property

C
(a) An entity has a factory that has been shut down due to chemical contamination, worker H
unrest and strike. The entity plans to sell this factory. A
P
(b) An entity has purchased a building that it intends to lease out under an operating lease. T
E
(c) An entity has acquired a large-scale office building, with the intention of enjoying its capital R
appreciation. Rather than holding it empty, the entity has decided to try to recover its
12
running costs by renting the space out for periods which run from one week to one year. To
make the building attractive to potential customers, the entity has fitted the space out as
small office units, complete with full-scale telecommunications facilities, and offers
reception, cleaning, a loud speaker system and secretarial services. The expenditure
incurred in fitting out the offices has been a substantial proportion of the value of the
building.
(d) An entity acquired a site on 30 April 20X4 with the intention of building office blocks to let.
After receiving planning permission, construction started on 1 September 20X4 and was
completed at a cost of £10 million on 30 March 20X5 at which point the building was ready
for occupation.
The building remained vacant for several months and the entity incurred significant
operating losses during this period.
The first leases were signed in July 20X5 and the building was not fully let until
1 September 20X6.
Requirement
Do the buildings referred to in (a)–(d) above meet the definition of investment property?
2.3 Measurement subsequent to initial recognition

Following initial measurement, investment properties are held either:
 at cost less accumulated depreciation (the cost model); or
 measured at fair value (the fair value model).
2.3.1 Cost model
Where the cost model is adopted, the property should be accounted for in accordance with
IAS 16, Property, Plant and Equipment.
2.3.2 Fair value model
 After initial recognition, an entity that chooses the fair value model should measure all of its
investment property at fair value, except in the extremely rare cases where this cannot be
measured reliably. In such cases it should apply the IAS 16 cost model.

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 A gain or loss arising from a change in the fair value of an investment property should be
recognised in net profit or loss for the period in which it arises.
 The fair value of investment property should reflect market conditions at the reporting date.
 A change in use of an investment property may lead to a change in classification.
Whatever policy the entity chooses should be applied to all of its investment property.
Interactive question 9: Estimating fair value

An entity with a 31 December year end owns the freehold of an office block standing on a city
centre site on which there are four other similar buildings, none of which are owned by the
entity. All the office buildings were constructed at the same time as the entity's building and the
floors in all five buildings are let out on standard 25-year leases.
Requirement
Which of the following values could be used by the entity as a basis for estimating the fair value
of its office building at 31 December 20X5, according to IAS 40?
(a) The first of the other office buildings changed hands early in 20X5 for £5 million as a result
of an auction which was widely publicised in the professional property press.
(b) The second of the other office buildings changed hands late in 20X5 for £6 million as a
result of a sale to an entity, 55% of whose shares were owned by the seller.
(c) The third of the other office buildings changed hands late in 20X5 for £4.5 million as a
result of sale to a financial institution to which the seller owed £3.5 million. It is understood
that the seller had breached its banking covenants and had to raise cash by the end of
20X5.
(d) The fourth of the other office buildings changed hands late in 20X5 for £5.5 million as a
result of a sale to an overseas institution which was seeking to establish its first foothold in
the country's property market. The offer of the office building was widely publicised in the
professional property press although it is understood that local institutions were only
prepared to offer in the region of £4.9 million.
2.4 Derecognition
When an investment property is derecognised, a gain or loss on disposal should be recognised
in profit or loss. The gain or loss should normally be determined as the difference between the
net disposal proceeds and the carrying amount of the asset.
Interactive question 10: Disposal of investment property

An entity purchased an investment property on 1 January 20X3, for a cost of £5.5 million. The
property has a useful life of 50 years, with no residual value and at 31 December 20X5 had a fair
value of £6.2 million. On 1 January 20X6 the property was sold for net proceeds of £6 million.
Requirement
Calculate the profit or loss on disposal under both the cost and fair value model.

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2.5 Transfers following a change in use

A change in use may lead to recognition or de-recognition of an investment property. The
following is a summary of such instances.
Evidence of change in use Accounting treatment
Commencement of owner  Owner-occupied property recognised under IAS 16.

occupation  If fair value model was used, treat fair value as deemed
cost.
Commencement of  Reclassify as inventory under IAS 2.
development with a view to  If fair value model was used, treat fair value as deemed
sale C
cost. H
A
Development with view to  Continue to hold as an investment property. P
continue letting T
E
End of owner occupation with  Transfer to investment properties under IAS 40. R
view to let to third parties  If fair value model to be used, revalue at date of change 12
and recognise difference as revaluation under IAS 16.
Property held as inventory now  Transfer to investment properties under IAS 40.
let to a third party
 If fair value model to be used, revalue at date of change
and recognise difference in profit or loss.
Commencement of operating  Transfer from property, plant and equipment to
lease to another party investment property under IAS 40.
Interactive question 11: Change of use

An entity with a 31 December year end purchased an office building, with a useful life of
50 years, for £5.5 million on 1 January 20X1. The amount attributable to the land was negligible.
The entity used the building as its head office for five years until 31 December 20X5 when the
entity moved its head office to larger premises. The building was reclassified as an investment
property and leased out under a five-year lease.
Owing to a change in circumstances the entity took possession of the building five years later on
31 December 20Y0, to use it as its head office once more. At that date the remaining useful life
of the building was confirmed as 40 years.
The fair value of the head office was as follows.
At 31 December 20X5 £6 million
At 31 December 20Y0 £7.5 million
Requirements
How should the changes of use be reflected in the financial statements on the assumption that:
(a) the entity uses the cost model for investment properties?
(b) the entity uses the fair value model for investment properties?

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2.6 Summary of disclosure requirements

An entity shall disclose the following:
 Whether it has followed the fair value model or cost model
 Whether property interests held as operating leases are included in investment property
 Criteria for classification as investment property
 Assumptions in determining fair value
 Use of independent professional valuer (encouraged but not required)
 Rental income and expenses
 Any restrictions or obligations
2.6.1 Fair value model – additional disclosures
An entity that adopts this must also disclose a reconciliation of the carrying amount of the
investment property at the beginning and end of the period.
2.6.2 Cost model – additional disclosures
These relate mainly to the depreciation method, rates and useful lives used as well as a
reconciliation of the carrying amount at the beginning and end of the period. In addition, an
entity which adopts the cost model must disclose the fair value of the investment property.
Interactive question 12: Installation of new equipment 1

An entity owns the freehold of an office building which was acquired on 31 December 20X0 for
£17 million, £2 million of which was attributable to the land. The freehold is an investment
property measured under the cost model with the building's useful life estimated at 30 years.
The building was fully equipped with an air-conditioning system. No separate value was placed
on the air conditioning unit as this was not something that was required by accounting standards
at the time of acquisition.
On 31 December 20X5 the entity replaced the air-conditioning system for £1.2 million, which
has an estimated useful life of 10 years. As no more reliable information was available, it used
this cost as an indication of the cost of the old system.
Requirement
How should the replacement of the air-conditioning be accounted for?
Interactive question 13: Installation of new equipment 2

An entity with a 31 December year end owns an office building which is recognised as an
investment property. The lift system is an integral part of the office building. The entity uses the
fair value model for measurement of investment properties.
The lift system was purchased on 1 January 20X0 for £400,000 and is being depreciated at
12.5% per annum on cost. Its carrying amount has been accepted as a reasonable value at which
to include it within the fair value of the office building as a whole.
Early in December 20X5 a professional valuer determined the fair value of the office building,
including the lift system, to be £3 million. The lift system failed on 28 December 20X5 and was
immediately replaced on 31 December 20X5 with a new system costing £600,000.
Requirement
How should the lift system be recognised?

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Interactive question 14: Replacement property

An entity with a 31 December year end owns an investment property which it measures using
the fair value model. At 31 December 20X4, the property's carrying amount is £4 million. On
30 June 20X5, an explosion close to the property causes major damage to the property. In
July 20X5, the entity makes a number of insurance claims as a result, one of which is for the
rebuilding cost, estimated at £3.7 million.
Although the property is repairable, the entity decides to sell it in its present state and buy a
replacement property. This decision is made on 30 September 20X5, on which date the
damaged property meets the criteria for classification as held for sale. Its fair value on that date
is £350,000 and the costs to sell are £35,000. The fair value does not change between
30 September 20X5 and 31 December 20X5. The sale is completed in the middle of 20X6 for
£375,000, with selling costs of £40,000. C
H
On 1 March 20X6, the entity acquires a replacement property for £3.8 million. A
P
The entity's insurers contest the claim relating to the building on the basis of an exclusion clause. T
The entity disagrees with the insurers' interpretation and in February 20X6 initiates legal E
R
proceedings. Negotiations are protracted and it is not until the end of 20X7 that the insurers
agree to settle for £3.9 million. 12
Requirement
How should the entity recognise these transactions?
3 IAS 41, Agriculture
Section overview
IAS 41 sets out the accounting treatment, including presentation and disclosure requirements,
for agricultural activity.
3.1 Definitions
Definitions
Agricultural activity: Agricultural activity is defined as the management of the biological
transformation of biological assets for sale, into agricultural produce, or into additional
biological assets.
Agricultural activities include, for example, raising livestock, forestry and cultivating orchards
and plantations.
Biological transformation: A biological transformation comprises the processes of growth,
degeneration, production and procreation that cause qualitative or quantitative changes in a
biological asset.
In its simplest form a biological transformation is the process of growing something such as a
crop, although it also incorporates the production of agricultural produce such as wool and milk.
Biological asset: A biological asset is a living plant or animal.
Agricultural produce: Agricultural produce is the harvested produce of an entity's biological
assets.

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IAS 41 considers the classification of biological assets and how their characteristics, and hence
value, change over time. The standard applies to agricultural produce up to the point of harvest,
after which IAS 2, Inventories is applicable. A distinction is made between the two because IAS 41
applies to biological assets throughout their lives but to agricultural produce only at the point of
harvest.
IAS 41 includes a table of examples which clearly sets out three distinct stages involved in the
production of biological assets. For example, we can identify dairy cattle as the biological asset,
milk as the agricultural produce and cheese as the product that is processed after the point of
harvest.
Calves and cows are biological assets as they are living animals whereas beef and milk are
agricultural produce.
Agricultural activities may be quite diverse, but all such activities have similar characteristics as
described below.
Common characteristics of agricultural activities
 Capacity to change – living animals and plants are capable of changing. For example, a
sapling grows into a fruit tree which will bear fruit and a sheep can give birth to a lamb;
 Management of change – the biological transformation relies on some form of
management input, ensuring, for example, the right nutrient levels for plants, providing the
right amount of light or assisting fertilisation; and
 Measurement of change – the changes as a result of the biological transformation are
measured and monitored. Measurement is in relation to both quality and quantity.
Worked example: Agricultural activities

An entity is involved in the production and sale of raw materials for food products, in the sale of
fish reared at its own 'fish farms' and in the sale of fish caught in the Northern seas by ocean-
going trawlers. An analysis of the processes involved is as follows.
Food products raw materials
The entity owns farmland on which it grows annual crops of corn for sale to food manufacturers.
The growing process is aided by the careful application of a range of nutrients, while additives
are administered to the underlying land immediately after harvesting has ended. This is an
agricultural activity; the corn growing each year is the biological transformation; growth is
encouraged by management's activities and the change is monitored, to identify the time at
which harvest should commence.
Fish farming
The entity leases a number of privately-owned lakes into which it puts underwater tanks for the
rearing of fish. This is an agricultural activity, because the fish are grown to the size suitable for
sale and their feed must be provided for them since the amount available naturally in the tanks
will be insufficient.
Ocean fishing
The entity owns a number of trawlers. The trawlers go to sea in search of suitable fish. This is not
an agricultural activity. Although there is biological transformation on the part of the fish, there is
no management intervention in the process; neither is there any routine measurement of the
amount of any change which has taken place. The trawlers harvest what the seas yield naturally.

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3.1.1 Bearer biological assets

An amendment was issued to IAS 41 in 2014 regarding plant-based bearer biological assets,
which would include trees grown in plantations, such as grape vines, rubber trees and oil palms.
These plants are used solely to grow crops over several periods and are not in themselves
consumed. When no longer productive they are usually scrapped.
It was decided that fair value was not an appropriate measurement for these assets as, once they
reach maturity, the only economic benefit they produce comes from the agricultural produce
they create. In this respect, they are similar to assets in a manufacturing activity.
Consequently, these assets have been removed from the scope of IAS 41 and should be
accounted for under IAS 16, Property, Plant and Equipment. They are measured at accumulated
cost until maturity and are then subject to depreciation and impairment charges. The IAS 16 C
revaluation model could also be applied. Agricultural produce from these plants continues to be H
A
recognised under IAS 41.
P
T
E
Interactive question 15: Classification R
Into which category would the following items be classified according to IAS 41, Agriculture?
12
(a) Wool
(b) Vines
(c) Sugar
3.2 Recognition and measurement

3.2.1 Recognition criteria
A biological asset or agricultural produce should only be recognised when:
 the entity controls the asset as a result of past events, for example the acquisition of dairy
cattle. The past event is the purchase, and control is obtained as the entity is now the legal
owner;
 it is probable that future economic benefits will flow to the entity, for example because the
dairy cattle will produce milk which can be sold or processed into cheese and sold; and
 fair value, or cost, of the asset can be measured reliably.
3.2.2 Measurement of biological assets

A biological asset should initially be measured at its fair value less estimated costs to sell, such
as duty and commission to brokers or dealers.
Costs to sell
Costs to sell do not include any costs that are necessary to get the asset to a market, for example
transport. These should, however, be deducted in determining fair value.
Fair value
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' – see Chapter 2,
section 4.
Where an active market exists for a biological asset the quoted price in the market is the
appropriate fair value.

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Where an active market does not exist, then fair value may be derived by using:
 the most recent transaction in the market, assuming that similar economic conditions exist
at the time of the transaction and at the reporting date;
 market prices for similar assets with appropriate adjustments to reflect differences; and
 sector-based benchmarks, for example the value of meat per kilogram.
IAS 41 includes the presumption that it will be possible to fair value a biological asset. But if fair
value cannot be measured reliably at the time of initial recognition then the biological asset
should be recognised at cost less accumulated depreciation and impairment cost (ie, the
decrease in the recoverable amount of an asset). Fair value should then be used as soon as a
reliable measurement can be made.
At subsequent reporting dates a biological asset should continue to be measured at its fair
value. Once a biological asset has been measured at fair value it is not possible to revert to cost.
3.2.3 Measurement of agricultural produce

Agricultural produce should be measured at its fair value, less estimated costs to sell at the point
of harvest. Subsequent measurement is by reference to IAS 2. It will always be possible to fair
value the agricultural produce since, by its very nature, there must be a market for it.
Interactive question 16: Costs to sell

Which of the following expenses would be classified as costs to sell when valuing biological
assets and agricultural produce?
(a) Commission to brokers
(b) Transfer taxes and duties
(c) Transport costs
(d) Advertising costs
Worked example: Fair value

An entity rears animals to be sold in a local market. The market is 50 km away, and transport to
market costs £1 per animal. At the measurement date the open market value is £60. The
auctioneers charge a sales commission of 2% of market value and there is a government levy,
based on market value, of 1% on purchases and 3% on sales.
Requirement
How should the fair value less cost to sell be calculated?
Solution
The fair value less costs to sell is calculated as:
£
Market value 60.00
Transport to market costs (1.00)
Fair value 59.00
Costs to sell
Auctioneers' commission – 2% of £60 (1.20)
Government levy – 3% of £60 (1.80)
Fair value less costs to sell 56.00

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3.2.4 Grouping assets

Grouping biological assets, or agricultural produce, according to significant attributes, such as
age or quality, may help to establish fair value. Such groupings should be consistent with
attribute groupings that are used in the market as a basis for pricing, for example, by wine
vintage.
Some biological assets are physically attached to land, for example tree plantations, and it is
necessary to value the land and biological assets together as one asset, even though agricultural
land is not within the scope of IAS 41. To obtain the fair value of the biological assets, the fair
value of the land element should be deducted from the combined fair value.
Land is dealt with under IAS 16 or IAS 40.
C
3.3 Gains and losses H
A
Gains or losses arising on the initial recognition at fair value of a biological asset and agricultural P
produce should be reported directly in profit or loss for the period to which they relate, for T
E
example a gain may arise on the birth of a calf. Subsequent changes in the fair value will also be R
reported directly in profit or loss.
12
Gains or losses on the initial recognition of agricultural produce should also be included in profit
or loss in the period in which they arise. Such gains or losses may arise as a result of harvesting,
because the harvested crop may be worth more than the unharvested crop. In this case a gain
would arise.
Worked example: Changes in fair value

A herd of five four-year old animals was held on 1 January 20X3. On 1 July 20X3, a 4.5-year old
animal was purchased. The fair values less estimated costs to sell were as follows.
4-year-old animal at 1 January 20X3 £200
4.5-year-old animal at 1 July 20X3 £212
5-year-old animal at 31 December 20X3 £230
Requirement
Show the reconciliation of the changes in fair value.
Solution
The movement in the fair value less estimated costs to sell of the herd can be reconciled as
follows.
£
At 1 January 20X3 (5  £200) 1,000
Purchased 212
Change in fair value (the balancing figure) 168
At 31 December 20X3 (6  £230) 1,380
The entity is encouraged to disclose separately the amount of the change in fair value less
estimated costs to sell arising from physical changes and price changes.
If it is not possible to measure biological assets reliably and they are instead recognised at their
cost less depreciation and impairment an explanation should be provided of why it was not
possible to establish fair value. A full reconciliation of movements in the net cost should be
presented with an explanation of the depreciation rate and method used.

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4 IFRS 6, Exploration for and Evaluation of Mineral Resources
Section overview
IFRS 6, Exploration for and Evaluation of Mineral Resources has been effective since
1 January 2006 and essentially deals with two matters.
• Allows entities to use existing accounting policies for exploration and evaluation assets.
• Requires entities to assess exploration and evaluation assets for impairment. The
recognition criteria for impairment are different from IAS 36 but, once impairment is
recognised, the measurement criteria are the same as for IAS 36.
4.1 Scope
The standard deals with the accounting of expenditures on the exploration for and evaluation of
mineral resources (that is, minerals such as gold, copper, etc, oil, natural gas and similar
resources), except:
 expenditures incurred before the acquisition of legal rights to explore; and
 expenditures incurred following the assessment of technical and commercial feasibility.
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors still applies to such
industries in helping them determine appropriate accounting policies. Thus, accounting policies
must present information that is relevant to the economic decision needs of users. Entities may
change their policies under IFRS 6 as long as the new information comes closer to meeting the
IAS 8 criterion.
4.2 Measurement at recognition

At recognition, exploration and evaluation assets must be measured at cost.
Entities must determine which expenditures to recognise and apply their policy consistently.
Such expenditure may include acquisition of rights to explore, exploratory drilling, sampling,
studies and activities relating to commercial evaluation.
Expenditure related to the development of mineral resources is outside the scope of IFRS 6.
This comes under IAS 38.
4.3 Measurement after recognition

Entities must apply either the cost model or the revaluation model in IAS 16.
4.4 Changes in accounting policies

These may be made if the change makes the financial statements more relevant to users. IAS 8
criteria need to be applied.
4.5 Classification and reclassification

Exploration and evaluation assets are classified as tangible or intangible according to the nature
of the assets acquired. The classification must be applied consistently. They should no longer be
classified as such when the technical feasibility and commercial viability of extracting a mineral
resource are demonstrable.

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4.6 Impairment
The difficulty with respect to exploratory activities is that future economic benefits are generally
very uncertain and hence forecasting future cash flows, for example, is difficult. IFRS 6 modifies
IAS 36 to state that impairment tests are required:
 When the technical and commercial viability of extraction is demonstrable, at which point
IFRS 6 is no longer relevant to the asset.
 When other facts indicate that the carrying amount exceeds recoverable amounts, such as:
– exploration rights have expired;
– substantive expenditure on further exploration for and evaluation of mineral resources
in the specific area is neither budgeted nor planned; C
H
– there has been no success in finding commercially viable mineral resources and the A
entity has decided to discontinue exploratory activities within a specific area; and P
T
– estimates suggest that the carrying amounts of assets are unlikely to be recovered in E
full following successful development of the mineral resource. R
In such circumstances, impairment is undertaken in accordance with IAS 36. 12
4.7 Presentation and disclosure

Exploration and evaluation assets are recorded as tangible or intangible assets, as appropriate.
Once benefits are demonstrable, assets dealt with under IFRS 6 are superseded by other
appropriate standards and are reclassified accordingly.
Disclosure relates to the following:
 A description of the accounting policies applied
 The amounts relating to assets, liabilities, income and expense, and operating and investing
cash flows arising from exploration for and evaluation of mineral resources
5 IFRS 4, Insurance Contracts
Section overview
IFRS 4 represents interim guidance, as the first phase of a bigger project on insurance
contracts. The objective of IFRS 4 is to make limited improvements to accounting practices for
insurance contracts and to require an issuer of insurance contracts to disclose information that
identifies and explains amounts arising from such contracts.
5.1 Background
IFRS 4 specifies the financial reporting for insurance contracts by any entity that issues such
contracts, or holds reinsurance contracts. It does not apply to other assets and liabilities held by
insurers.
In the past there was a wide range of accounting practices used for insurance contracts and the
practices adopted often differ from those used in other sectors. As a result the IASB embarked
on a substantial project to address the issues surrounding the accounting for insurance
contracts. Rather than issuing one standard that covered all areas, the IASB decided to tackle the
project in two phases.

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Interim guidance has been issued in phase one of the project in the form of IFRS 4; it is a
stepping stone to the second phase of the project. IFRS 4 largely focuses on improving the
disclosure requirements in relation to insurance contracts; however, it also includes a number of
limited improvements to existing accounting requirements.
Although IFRS 4 sets out a number of accounting principles as essentially best practice, it does
not require an entity to use these if it currently adopts different accounting practices. An
insurance entity is however prohibited from changing its current accounting policies to a
number of specifically identified practices.
5.2 What is an insurance contract?
Definition
Insurance contracts: A contract between two parties, where one party, the insurer, agrees to
compensate the other party, the policyholder, if it is adversely affected by an uncertain future
event.
An uncertain future event exists where at least one of the following is uncertain at the inception
of an insurance contract:
 the occurrence of an insured event;
 the timing of the event; or
 the level of compensation that will be paid by the insurer if the event occurs (IFRS 4
Appendix B).
Some insurance contracts may offer payments-in-kind rather than compensation payable to the
policyholder directly. For example, an insurance repair contract may pay for a washing machine
to be repaired if it breaks down; the contract will not necessarily pay monetary compensation.
In identifying an insurance contract it is important to make the distinction between financial risk
and insurance risk. A contract that exposes the issuer to financial risk without significant
insurance risk does not meet the definition of an insurance contract.
Definitions
Financial risk: Where there is a possible change in a financial or non-financial variable, for
example a specified interest rate, commodity prices, an entity's credit rating or foreign exchange
rates.
Insurance risk: A risk that is not a financial risk. The risk in an insurance contract is whether an
event will occur (rather than arising from a change in something), for example a theft, damage
against property, or product or professional liability.
Examples of insurance contracts

Appendix B to IFRS 4, which forms an integral part of the standard, includes an extensive list of
examples of insurance contracts including:
 life insurance and prepaid funeral plans. It is the timing of the event that is uncertain here,
for example certain life cover plans only pay out if death occurs within a specified period of
time;
 disability and medical cover;
 credit insurance, covering the policyholder for non-recoverable receivables; and
 travel cover to provide against any loss suffered while travelling.

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Examples of an insurer taking on insurance risk are as follows:

 An insurance contract issued to a policyholder against the escalation of claims from faulty
motorcycles. The fault was discovered a year ago and the extent of total claims is yet to be
established. This is an insurance contract since the insured event is the discovery of the
ultimate cost of the claims.
 A gas boiler repair service available from a supplier who, for the payment of a fixed fee, will
fix the malfunctioning boiler. This is an insurance contract as it is a payment-in-kind contract,
with the uncertain event being whether the boiler will break down and the policyholder will
be adversely affected.
Examples which are not insurance contracts
It is important to distinguish between insurance contracts and other contracts that are not C
H
covered by IFRS 4 but which might look like insurance contracts. To provide clarification IFRS 4
A
specifically identifies a number of areas where its provisions do not apply, for example: P
T
 the provision of product warranties given directly by the manufacturer, dealer or retailer; E
R
 employers' assets and liabilities in relation to employee benefit plans and obligations under
a defined benefit plan; 12
 a contractual right, or obligation, that is contingent on the right to use a non-financial item,
for example some licences;
 a finance lease that contains a residual value guaranteed by the lessee, ie, a specified value
for the asset at the end of the lease is guaranteed by the lessee;
 financial guarantees within the scope of IAS 39, Financial Instruments: Recognition and
Measurement;
 contingent consideration that has arisen as a result of a business combination; and
 insurance contracts that the entity holds as policyholder.
5.3 Recognition and measurement

IFRS 4 exempts an insurer temporarily (during phase one of the IASB's insurance project) from
the need to consider the IASB Framework in selecting accounting policies for insurance
contracts where there is no specific accounting requirement set out in another international
Standard (IFRS 4.13, through its reference to IAS 8, Accounting Policies, Changes in Accounting
Estimates and Errors).
However, IFRS 4 expressly:
 requires a test for the adequacy of recognised insurance liabilities – referred to as the
liability adequacy test;
 prohibits provisions for possible claims under contracts that are not in existence at the
reporting date (referred to as catastrophe or equalisation provisions);
 requires an impairment test for reinsurance assets. An impairment is only recognised where
after the commencement of a reinsurance contract, an event has occurred that will lead to
amounts due under the contract not being recovered in full, and a reliable estimate of the
shortfall can be assessed; and
 requires an insurer to continue to recognise insurance liabilities in its financial statements
until they are discharged, cancelled or expire, and to present such liabilities without
offsetting them against related reinsurance assets.

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Liability adequacy test

An insurer recognises its insurance liabilities at each reporting date based on the current
estimate of future contractual cash flows, and related items such as handling costs, arising under
the insurance contracts.
This provision should be reassessed at each reporting date and any identified shortfall should
be recognised immediately as part of profit or loss for the period. This is the so called liability
adequacy test.
The assessment should be based on current estimates for future cash flows under the insurance
contracts issued. If the recognised insurance liability is assessed as being adequate, then IFRS 4
does not require any further action by the insurer. However, if the liability is found to be
inadequate, then the entire shortfall should be recognised in profit or loss.
The liability adequacy test considers all contractual cash flows under current insurance contracts,
and related costs, such as claims handling costs. Where there are embedded options or
guarantees within a contract, any cash flows arising should also be included in the assessment.
Where an entity has deferred acquisition costs and related intangible assets, such as those
arising from an insurance based business combination these should be deducted from the
insurance liabilities.
If the accounting policies of an insurer do not demand that a liability adequacy test should be
carried out, as described above, then an assessment is still required of the potential net liability
(ie, the relevant insurance liabilities less any related deferred acquisition costs). In these
circumstances the insurer is required to recognise at least the amount that would be required to
be recognised as a provision under the application of IAS 37, Provisions, Contingent Liabilities
and Contingent Assets.
That is, if the carrying amount of the IAS 37 calculated provision is greater than that recognised,
then the insurer should increase the liabilities as appropriate.
Worked example: Liability adequacy test

An insurance entity writes one-year policies for one of its classes of general insurance business
and is carrying the following amounts for that class in its draft statement of financial position at
31 December 20X5.
Liabilities £m
Provision for claims – discounted value of likely claims for insured
losses occurring up to 31 December 20X5 75
Liability for unearned premiums – proportion of premiums for policies
already written which relates to cover in 20X6 30
Assets
Deferred acquisition costs – proportion of commission and other
business acquisition costs for policies already written which relate
to the unearned premiums 10
The effect of reinsurance is immaterial.
The entity's procedure for calculating the provision for claims is as follows.
(a) To use past experience to make a range of estimates of amounts ultimately payable to
insured persons in respect of claims for losses occurring by the reporting date and of the
timing of the payments
(b) To select the most likely amount and timing as its central estimate
(c) To discount the amount by reference to a risk-free rate

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(d) To use past experience to increase the discounted amount by a risk margin to reflect the
inherent uncertainty in this discounted estimate
(e) To increase the adjusted amount by an estimate, based on past experience and discounted,
of the internal costs (such as employee benefits and accommodation costs) which will be
incurred in handling the loss claims over the period up to their settlement
The cost of the provision is recognised in profit or loss. As this procedure meets the
requirements of IFRS 4 no further action is necessary.
The entity also estimates on a similar basis the discounted total amount, including claims
handling costs, which will be payable in respect of insured losses arising after the reporting date
over the period of cover which generates the unearned premiums. The estimated amount is
£25 million.
C
As all the policies extend for one year, in 20X6 the whole of the £30 million unearned premiums H
will become earned. But in 20X6 the deferred acquisition costs of £10 million will be charged A
against those premiums. Against this net income of £20 million, the estimated cost of claims is P
T
£25 million. Hence, there is a premium deficiency of £5 million in 20X6, which should be E
recognised in profit or loss in 20X5. R
12
5.4 Disclosures
IFRS 4 sets out an overriding requirement that the information to be disclosed in the financial
statements of an insurer "helps users understand the amounts in the insurer's financial
statements that arise from insurance contracts" (IFRS 4: para 4.36).
This information should include the accounting policies adopted and the identification of
recognised assets, liabilities, income and expense arising from insurance contracts.
More generally, the risk management objectives and policies of an entity should be disclosed,
since this will explain how an insurer deals with the uncertainty it is exposed to.
An entity is not generally required to comply with the disclosure requirements in IFRS 4 for
comparative information that relates to annual periods beginning before 1 January 2005.
However, comparative disclosure is required in relation to accounting policies adopted and the
identification of recognised assets, liabilities, income and expense arising from insurance
contracts.
5.5 Current developments: IFRS 17

5.5.1 Background
IFRS 4 has been criticised for allowing a large number of different accounting policies, resulting
in a lack of comparability, even within insurance groups. To address this the IASB has developed
a new standard, IFRS 17, Insurance Contracts.
Adoption of IFRS 17 is mandatory for reporting periods beginning on or after 1 January 2021.
Early adoption is permitted. In addition insurance companies are permitted to delay initial
adoption of IFRS 9 (see Chapter 16) until IFRS 17 is applied.
Tutorial note
IFRS 4 is still the examinable standard, so an overview of the main features of IFRS 17 is required,
bearing in mind that companies may early adopt.
IFRS 17 was published in 2017 and introduces a comprehensive financial reporting framework
for insurance contracts which aims to achieve greater comparability and consistency in financial
reporting by insurers.

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5.5.2 Scope
The scope of IFRS 17 is similar to IFRS 4 and encompasses insurance contracts issued,
reinsurance contracts both issued and held and investment contracts with discretionary
participation features if issued by insurers.
5.5.3 Simplified measurement model
A simplified measurement model referred to as the premium allocation approach can be used
for short term insurance contracts and is similar to the use of an unearned premium reserve
under IFRS 4.
5.5.4 General measurement model
The general measurement method is more complex and will be applied to long-term insurance
contracts. It uses a building block approach to establish the value of insurance contracts on
initial recognition.
This general method discounts future cash flows related to the contract and adjusts for non-
financial risk to arrive at the value of fulfilment cash flows. To these is added an equal and
opposite amount representing the unearned profit over the contract life, referred to as
contractual service margin.
Insurance contracts are remeasured at each subsequent year end and a proportion of
contractual service margin is released to profit or loss as part of the insurance service result.
Contracts for which the value of fulfilment cash flows is negative (liability) are referred to as
onerous contracts. This amount is not mirrored in the creation of a contractual service margin,
but rather is recognised immediately in profit or loss.
In practice the measurement models of IFRS 17 will generally be applied to groups of contracts
with similar characteristics aggregated together rather than on an individual contract basis.
5.5.5 Reinsurance contracts
The measurement of reinsurance contracts follows the same measurement principles and
mirrors that of the primary insurance contract(s) to which it is related.
5.5.6 Implementation challenges
The implementation of such a significant change to the financial reporting of insurance contract
is likely to represent a significant systems challenge to insurers and auditors will need to perform
additional work in relation to these systems and the related internal controls. Implementing
IFRS 17 is likely to be a complex, lengthy process, with the following implications:
(a) Changes to profit recognition patterns
(b) Increased volatility of profit and equity
(c) Increased options and requirement for judgement
Set against this, it can be argued that the changes will bring greater transparency through
disclosure.
6 Audit focus points
Section overview
The audit of investment properties should focus on:
• whether the property has been correctly classified;
• whether the valuation is materially correct (either under the cost model or the FV model);
and
• whether the disclosure complies with IAS 40/IFRS 13.

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6.1 General approach to auditing assets

You should be familiar with the auditing of tangible and intangible assets from the Certificate
Level Assurance paper. If you do not feel confident in this area, we would recommend that you
revise it.
Your earlier studies should give you a good understanding of the audit techniques, and the
sources of audit evidence, that an auditor can use in a range of different scenarios. Your
knowledge of the financial reporting standards will inform your specific approach in the exam.
6.2 Auditing investment properties
Definition C
H
Investment property: Property (land or a building – or part of a building – or both) held (by the A
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, P
rather than for: T
E
 use in the production or supply of goods or services or for administrative purposes; or R
 sale in the ordinary course of business. 12
The following would be non-investment properties:

 Property held for sale in the ordinary course of business
 Property being constructed or developed on behalf of third parties
 Owner-occupied property
Investment property is initially measured at its cost (including transaction costs and directly
attributable expenditure). After recognition it is measured at either depreciated cost or fair
value.
Audit evidence
Issue Evidence
Classification as an Confirm that all investment properties are classified in accordance

investment property with the IAS 40 definition. This will include:
 a building owned by the entity and leased out under one or more
operating leases; and
 a building that is vacant but is held to be leased under one or
more operating leases.
Verify rental agreements, ensuring that the occupier is not a
connected company and that the rent has been negotiated at arm's
length
If the building has recently been built, check the architect's certificates
to ensure that cost/fair value is reasonable

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Issue Evidence
Valuation If cost model adopted, check compliance with IAS 16.

If fair value model adopted:
 Check that fair value has been measured in accordance with
IFRS 13
 Where current prices in an active market are not available confirm
that alternative valuation basis is reasonable and in accordance
with IFRS 13, and document the relevant audit evidence
 Agree valuation to valuer's certificate
 Recalculate gain or loss on change in fair value and agree to
amount in statement of profit or loss and other comprehensive
income
 If fair value cannot be measured reliably confirm use of cost
model
 Consider the use of an auditor's expert to review the
appropriateness of the underlying market assumptions and
valuation methodology used
Disclosure Confirm compliance with IAS 40/IFRS 13, for example:
 Disclosure of policy adopted
 If fair value model adopted disclosure of a reconciliation of
carrying amounts of investment property at the beginning and
end of the period
 Disclosure of the inputs used to measure fair value based on the
fair value hierarchy (Level 1, Level 2 or Level 3)
 Where Level 2 or Level 3 inputs are used, a description of the
valuation techniques and inputs used (interest rates, net
reversionary yield, stabilised net rental value, costs to complete
and developer's profit)
 For fair value measurements using significant unobservable
inputs (Level 3), the effect of the measurements on profit or loss
and other comprehensive income for the period
Note: IAS 40 states that fair value should be measured in accordance with IFRS 13.

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Interactive question 17: Investment property and fair value

Propertyco, an investment property company, has a portfolio of properties, including the
following:
Property A This is used as the company head office.

Property B This is held under a finance lease and is currently rented out to a
non-group company under an operating lease.
Property C This was acquired in the year at a cost of £3 million including
legal fees. It is currently vacant but a tenant is being actively
sought.
Property D This has been owned by Propertyco for a number of years and is C
H
currently rented out to a non-group company. A
P
Propertyco uses the fair value model in accordance with IAS 40. Currently all the above T
properties are recorded in the financial statements at fair value. E
R
Requirements
12
Based on the information above:
(a) identify the audit issues which the auditor would need to consider
(b) list the audit procedures you would perform regarding fair values
Case study: Big Yellow Group plc

Deloitte, the statutory auditor of the Big Yellow Group plc – the self-storage solutions business
listed on the FTSE 250 – noted in the auditor's report in the group's financial statements for the
year ended 31 March 2015 that investment properties constituted an area of particular audit risk.
The nature of the risk and the auditor's responses to the risk were described in the following
excerpt from the auditor's report. The full annual report can be found at the following URL:
http://html.investis.com/B/Big-yellow-plc/reports/ar2015/pdfs/Big_Yellow_AR2015.pdf
Risk
At 31 March 2015, the Group held wholly owned investment properties and investment
properties under construction valued at £1,022.8 million.
Investment properties are held at fair value on the balance sheet. The net valuation gain, relating
to Group held properties was £64.5 million, which was recognised through the Consolidated
Income Statement during the year. The fair values at 31 March 2015 are calculated using actual
and forecast inputs, such as occupancy, capitalisation rates, an assessment of cost to complete
for investment properties under construction and net rent per square foot by property. In
addition, the valuers apply professional judgement concerning market conditions and factors
impacting individual properties.
The valuation process is inherently judgemental, which is why we consider this to be a risk of
material misstatement. In particular, changes in assumptions such as the capitalisation rates,
forecast rent per square foot, forecast occupancy levels and, in the case of investment property
under construction, cost to complete can lead to significant movements in the value of the
property, as can changes in the underlying market conditions.

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How the scope of our audit responded to the risk

(a) We assessed the design and implementation of controls around the property valuations by
considering the level of management oversight and review of the valuations prepared by
the external valuation specialists engaged by management, who have been named in note
14;
(b) We tested the integrity of the information provided by management to the valuers by
agreeing key inputs such as actual occupancy and net rent per square foot to underlying
records and source evidence;
(c) We modelled eight years of valuations and key valuation inputs to the investment property
portfolio, to understand the historical trends of key inputs and compared these against the
key forecast assumptions included in the property valuation;
(d) We met with the valuers. We assessed their independence, the scope of the work they were
requested to perform by management, and the valuation methodology applied. For each
property we identified as having significant or unusual valuation movements (compared to
market data or previous periods), we challenged the valuers on the key assumptions
applied. Our challenge was informed by input from our internal valuation specialists,
utilising their knowledge and expertise in the market at a macro level and the relevant
geographies to challenge the key judgemental inputs noted adjacent. We also researched
comparable transactions and understood trends in analogous industries. We understood
the rationale for outlying valuations or movements and obtained corroborative evidence.
We also assessed the valuations for a sample of other properties; and
(e) We visited a sample of properties to assess the condition of the buildings.

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Summary
IAS 16, Property, Plant and Equipment
Definition Recognition Depreciation

C
H
A
P
Measurement at recognition Measurement T
• Purchase price after recognition E
R
• Directly attributable costs
• Finance costs 12
Cost Revaluation
model model
IAS 38, Intangible Assets
Amortisation/
Definition Recognition
impairment test
Finite useful Indefinite useful

life life
Measurement at Measurement after

recognition recognition
Cost Revaluation
model model
Acquired in Acquisition by Exchanges Internally Internally

Separate
business way of a of generated generated
acquisition
combination government grant assets goodwill intangibles

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IAS 2, Inventories
Value at FIFO
lower of Weighted average
Cost including Net

all costs of realisable
purchase/production value
IAS 36, Impairments
Impairment CGUs
Indicators
= Notional goodwill for NCI
carrying value – recoverable amount Allocate any loss to goodwill
then other assets on pro rata basis

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IAS 40,
Investment Property
Recognition as
investment property?
No Yes
C
H
A
P
T
E
Treat according to Recognise according R
IAS 16 to IAS 40 12
Subsequent
measurement
Initial recognition
– accounting policy
choice
Cost Fair value
model model
At cost – At cost less

Fair value
including • depreciation
IAS 40
transaction costs impairment
paras 33 – 35
IAS 40 para 20 • IAS 40 para 56

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Other Standards
IAS 41, Agriculture
Biological assets Agricultural produce

initial recognition at the point of
subsequent harvest
measurement fair value less
at fair value point of sale
less point of sale costs
costs
IFRS 6, Exploration for and

IFRS 4, Insurance Contracts
Evaluation of Mineral Resources
Recognition of exploration
Unbundle and evaluation assets
contracts into Liability
insurance adequacy test
After recognition, apply
component recognise
either the cost model
(apply IFRS 4) deficiency
in profit or or the revaluation model
deposit
component loss
(apply IFRS 9)

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Self-test
IAS 2, Inventories
1 Reapehu
The Reapehu Company manufactures a single type of concrete mixing machine, which it
sells to building companies. Reapehu is currently considering the value of its inventories at
31 December 20X7. The following data are relevant at this date:
Cost per item £
Variable production costs 200,000
Fixed production costs 40,000
C
240,000 H
A
There are 85 mixing machines held in inventory. P
T
The company has a contract to sell 15 concrete mixing machines at £225,000 each to a E
major local building company in January 20X8. The normal selling price is £260,000 per R
machine. Selling costs are minimal.
12
Requirement
What is the value of Reapehu's inventory at 31 December 20X7, according to IAS 2,
Inventories?
2 Utah
The Utah Company manufactures motors for domestic refrigerators. A major customer is
The Bushbaby Company, which is a major international electrical company making
refrigerators as one of its products.
Utah is currently preparing its financial statements for the year to 31 December 20X7 and it
expects to authorise them for issue on 3 March 20X8.
Utah holds significant inventories of motors (which are unique to the Bushbaby contract) as
Bushbaby requires them to be supplied on a just-in-time basis and has variable production
schedules.
On 3 January 20X8, Bushbaby announced that it was fundamentally changing the design of
its refrigerators and that, while this had been planned for some time, it had not been
possible to warn Utah for reasons of commercial confidentiality. As a consequence, it would
cease to use Utah's motors from 30 April 20X8 and would reduce production before that
date. Details for Utah are as follows:
Number of motors held in inventory at 31 December 4,000 motors
Expected sales in the four months to 30 April 20X8 1,600 motors
Net selling price per motor sold to Bushbaby £50
Net selling price per motor unsold at 30 April 20X8 £10
Cost per motor £25
Requirement
At what value should the inventories of motors be stated by Utah in its statement of financial
position at 31 December 20X7 according to IAS 2, Inventories, and IAS 10, Events after the
Reporting Period?
3 Niobium
The Niobium Company operates in the petrol refining industry. A fire at a competitor using
similar plant has revealed a safety problem and the Government has introduced new
regulations requiring the installation of new safety equipment in the industry. The refinery

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had a carrying amount of £30 million before the installation of the safety equipment. The
new safety equipment cost £5 million and was fully operational at 31 December 20X7, but it
does not generate any future economic benefits. The refinery would, however, be closed
down without such equipment being installed.
At 31 December 20X7 the net selling price of the refinery was estimated at £33 million. In
determining its value in use, the directors have determined that the refinery would generate
annual cash flows of £3.2 million from next year in perpetuity, to be discounted at 10% per
annum.
Requirement
According to IAS 16, Property, Plant and Equipment, what is the carrying amount of the
refinery in Niobium's statement of financial position at 31 December 20X7?
4 Oruatua
The Oruatua Company acquired a piece of machinery for £800,000 on 1 January 20X6. It
identified that the asset had three major components as follows:
Component Useful life Cost
£'000
Pump 5 years 110
Filter 4 years 240
Engines 15 years 450
Under the terms of the 15-year licence agreement for the use of the machinery, the engines
(but not the other components) were to be dismantled at the end of the licence period. The
machinery contained three engines, and dismantling costs for all three engines were
initially estimated at a total cost of £480,000 (ie, £160,000 per engine) payable in 15 years'
time. Oruatua's discount rate appropriate to the risk specific to this liability is 7% per
annum.
One of the three engines developed a fault on 1 January 20X7 and had to be sold for scrap
for £40,000. A replacement engine was purchased at a cost of £168,000 on 1 January 20X7,
for use until the end of the licence period, when dismantling costs on this engine estimated
at £150,000 would be payable.
At a rate of 7% per annum the present value of £1 payable in 15 years' time is 0.3624 and of
£1 payable in 14 years' time is 0.3878.
Requirement
Calculate the following figures for inclusion in Oruatua's financial statements for the year
ended 31 December 20X7 according to IAS 16, Property, Plant and Equipment, and
IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
(a) The carrying amount of the machinery at 31 December 20X6
(b) The profit/loss on the disposal of the faulty engine
(c) The carrying amount of the machinery at 31 December 20X7
IAS 36, Impairment of Assets
5 Antimony
The Antimony Company acquired its head office on 1 January 20W8 at a cost of £5.0 million
(excluding land). Antimony's policy is to depreciate property on a straight-line basis over 50
years with a zero residual value.
On 31 December 20X2 (after five years of ownership) Antinomy revalued the non-land
element of its head office to £8.0 million. Antinomy does not transfer annual amounts out of
revaluation reserves as assets are used: this is in accordance with the permitted treatment in
IAS 16, Property, Plant and Equipment.

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In January 20X8, localised flooding occurred and the recoverable amount of the non-land
element of the head office property fell to £2.9 million.
Requirement
What impairment charge should be recognised in the profit or loss of Antimony arising
from the impairment review in January 20X8 according to IAS 36, Impairment of Assets?
6 Sundew
The Sundew Company is a vertically integrated manufacturer of chainsaws. It has two
divisions. Division X manufactures engines, all of which are identical. Division Y assembles
complete chainsaws and sells them to third party dealers.
Division X, a cash-generating unit, sells to Division Y at cost price but sells to other chainsaw
C
manufacturers at cost plus 50%. Details of Division X's budgeted revenues for the year H
ending 31 December 20X7 are as follows: A
Engines Price per engine P
T
Sales to Division Y 2,500 £1,000 E
Third party sales 1,500 £1,500 R
Requirement 12
What are the 20X7 cash inflows which should be used in determining the value in use of
Division X according to IAS 36, Impairment of Assets?
7 Cowbird
The Cowbird Company operates in the television industry. It acquired a licence to operate
in a particular region for 20 years at a cost of £10 million on 31 December 20X3. Cowbird's
policy was to amortise the fee paid for the licence on a straight-line basis.
By 31 December 20X5 it had become apparent that Cowbird had overpaid for the licence
and, measuring recoverable amount by reference to value in use, it recognised an
impairment charge of £4.05 million, leaving a carrying amount of £4.95 million.
At 31 December 20X7 the market place had improved, such that the conditions giving rise
to the original impairment no longer existed. The recoverable amount of the licence by
reference to value in use was now £11 million.
Requirement
What should be the carrying amount of the licence in the statement of financial position of
Cowbird at 31 December 20X7, according to IAS 36, Impairment of Assets?
8 Acetone
The Acetone Company is testing for impairment two subsidiaries which have been
identified as separate cash-generating units.
Some years ago, Acetone acquired 80% of The Dushanbe Company for £600,000 when the
fair value of Dushanbe's identifiable assets was £400,000. As Dushanbe's policy is to
distribute all profits by way of dividend, the fair value of its identifiable net assets remained
at £400,000 on 31 December 20X7. The impairment review indicated Dushanbe's
recoverable amount at 31 December 20X7 to be £520,000.
Some years ago Acetone acquired 85% of The Maclulich Company for £800,000 when the
fair value of Maclulich's identifiable net assets was £700,000. Goodwill of £205,000
(£800,000 – (£700,000  85%)) was recognised. As Maclulich's policy is to distribute all
profits by way of dividend, the fair value of its identifiable net assets remained at £700,000
on 31 December 20X7. The impairment review indicated Maclulich's recoverable amount at
31 December 20X7 to be £660,000.

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It is Acetone group policy to value the non-controlling interest using the proportion of net
assets method.
Requirement
Determine the following amounts in respect of Acetone's consolidated financial statements
at 31 December 20X7 according to IAS 36, Impairment of Assets.
(a) The carrying amount of Dushanbe's assets to be compared with its recoverable
amount for impairment testing purposes
(b) The carrying amount of goodwill in respect of Dushanbe after the recognition of any
impairment loss
(c) The carrying amount of the non-controlling interest in Maclulich after recognition of
any impairment loss
9 Titanium
On 1 January 20X7 The Titanium Company acquired the copyright to four similar
magazines, each with a remaining legal copyright period for 10 years. At the end of the
legal copyright period, other publishing companies will be allowed to tender for the
copyright renewal rights.
At 31 December 20X7 the following information was available in respect of the assets:
Remaining period over
which publication is Value in active
Copyright cost at expected to generate cash market at
Publication name 1 January 20X7 flows at 1 January 20X7 31 December 20X7
Dominoes £900,000 6 years £700,000
Billiards £1,200,000 16 years £1,150,000
Skittles £1,700,000 8 years Unknown
Darts £1,400,000 Indefinite £2,100,000
Titanium uses the revaluation model as its accounting policy in relation to intangible assets.
Requirement
What is the total charge to profit or loss for the year ended 31 December 20X7 in respect of
these intangible assets per IAS 38, Intangible Assets?
10 Lewis
The following issues have arisen in relation to business combinations undertaken by the
Lewis Company.
(a) Lewis acquired the trademark of a type of wine when it acquired 80% of the ordinary
share capital of The Calcium Company on 1 April 20X7. This wine is produced from a
vineyard that is exclusively used by Calcium.
(b) When Lewis bought a football club on 1 May 20X7, it acquired the registrations of a
group of football players.
(c) Lewis acquired a 75% share in the Stilt Company during 20X7. At the acquisition date
Stilt was researching a new pharmaceutical product which is expected to produce
future economic benefits.
The cost of these assets can be measured reliably.

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Requirement
Indicate which of the above items should or should not be recognised as assets separable
from goodwill in Lewis's statement of financial position at 31 December 20X7, according to
IAS 38, Intangible Assets.
11 Diversified group
The following issues have arisen within a diversified group of businesses.
(a) The Thrasher Company has signed a three-year contract with a team of experts to write
questions for a computer based examination on International Financial Reporting
Standards. The contract states that the experts cannot work on similar projects for rival
entities. Thrasher incurred costs of £5,000 in training the experts to use the software,
and believes that the product developed by the team will be a market leader. C
H
(b) The Curium Company has a loyalty card scheme for customers. Every customer A
purchase is recorded in such a way that Curium is able to create a profile of spending P
T
amounts and habits of customers, and uses this to target them with special offers and E
discounts to encourage repeat business. The database has cost £60,000 to create and R
Curium has been approached by another company wishing to buy the contents of the
12
database.
Requirement
Which of the above items should be classified as intangible assets per IAS 38, Intangible
Assets?
12 Cadmium
The Cadmium Company produces a globally recognised dog food that is a market leader.
The trademark was established over 50 years ago and is renewable every eight years. The
last renewal was effective from 1 January 20X2 and cost £65,000. Cadmium intends to
continue to renew the trademark in future years.
Cadmium uses the revaluation model where allowed for measuring intangible assets, in
accordance with IAS 38, Intangible Assets. A valuation of £50 million was made by an
independent valuation expert on 31 December 20X7, who charged £650,000 for the
valuation report.
Requirement
What is the carrying amount of the trademark in Cadmium's statement of financial position
at 31 December 20X7 per IAS 38, Intangible Assets?
13 Piperazine
The Piperazine Company's financial reporting year ends on 31 December. It has adopted
the revaluation model for intangible assets and revalues them on a regular three-year cycle.
For intangibles with a finite life Piperazine transfers the relevant amount from revaluation
reserve to retained earnings each year.
During 20X4 Piperazine incurred £70,000 on the process of preparing an application for
licences for 15 taxis to operate in a holiday resort where, in order to prevent excessive
traffic pollution, the licensing authority only allowed a small number of taxis to operate. The
outcome of its application was uncertain up to 30 November 20X4 when the local authority
accepted its application. In December 20X4 Piperazine incurred a total cost of £9,000 in
registering its licences. The licences were for a period of nine years from 1 January 20X5.
The licences are freely transferable and an active market in them exists. The fair value of the
licences at 31 December 20X4 was £9,450 per taxi and Piperazine carried them at fair value
in its statement of financial position at 31 December 20X4.

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At 31 December 20X7, Piperazine undertook its regular revaluation. On that date the
licensing authority announced that it would triple the number of licences offered to taxi
operators and there were transactions in the active market for licences with six years to run
at £4,500.
Requirement
Determine the following amounts in respect of the revaluation reserve in respect of these
taxi licences in Piperazine's financial statements according to IAS 38, Intangible Assets.
(a) The balance at 31 December 20X4
(b) The balance at 31 December 20X7 before the regular revaluation
(c) The balance at 31 December 20X7 after the regular revaluation
IAS 40, Investment Property
14 Which of the following properties fall under the definition of investment property and
therefore within the scope of IAS 40, Investment Property?
(a) Property occupied by an employee paying market rent
(b) A building owned by an entity and leased out under an operating lease
(c) Property being constructed on behalf of third parties
(d) Land held for long-term capital appreciation
15 Boron
The Boron Company is an investment property company. On 31 December 20X6, it
purchased a retirement home as an investment at a cost of £600,000. Legal costs associated
with the acquisition of this property were a further £50,000.
At 31 December 20X7 Boron adopted the fair value model. The fair value of the retirement
home at this date was £700,000 and costs to sell were estimated at £40,000.
Requirement
What amount should appear in the statement of profit or loss and other comprehensive
income of Boron in the year ending 31 December 20X7 in respect of the retirement home
under IAS 40, Investment Property?
16 Acimovic
The Acimovic Company is an investment property company. It acquired an industrial
investment property on 31 December 20X6 from The Tyrant Company, a finance house, on
a long lease which is a finance lease in accordance with IAS 17, Leases. The following
information is available.
At 31 December 20X6 20X7
£ £
Present value of minimum payments under the lease 740,000 720,000
Fair value of the property interest 840,000 875,000
Fair value of the property 790,000 890,000
The property has a useful life of 40 years from 31 December 20X6.

Requirement
What amount should appear in the statement of profit or loss and other comprehensive
income of Acimovic in the year ending 31 December 20X7 in respect of the property under
IAS 40, Investment Property?

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17 Laburnum
The Laburnum Company is an investment property company. One of its properties is a
warehouse which has the specialist use of storing tropical plants at high temperatures. As a
result, the central heating system is an important and integral part of the warehouse
building. Laburnum uses the fair value model for investment properties.
The central heating system was purchased on 1 January 20X2 for £80,000. It is being
depreciated at 10% per annum on cost and it has been agreed by the valuer that the
carrying amount of the central heating system is a reasonable value at which to include it in
the fair value of the entire warehouse.
In December 20X7, the valuer initially determined the fair value of the warehouse, including
the central heating system, to be £1,250,000. Unfortunately, the central heating system
C
completely failed on 25 December 20X7 and was immediately scrapped and replaced with H
a new heating system costing £140,000 on 31 December 20X7. A
P
Requirement T
E
According to IAS 40, Investment Property, at what value should the warehouse, including R
the heating system, be recognised in the financial statements of Laburnum in the year
12
ending 31 December 20X7?
18 Ramshead
On 1 January 20X6, The Ramshead Company acquired an investment property for which it
paid £3.1 million and incurred £100,000 agency and legal costs. The property's useful life
was estimated at 20 years, with no residual value; its fair value at 31 December 20X6 was
estimated at £3.45 million and agency and legal costs to dispose of the property at that
date were estimated at £167,500.
On 1 July 20X7, Ramshead decided to dispose of the property. The criteria for being
classified as held for sale were met on that date, when the property's fair value was
£3.5 million. Agency and legal costs to dispose of the property were estimated at £160,000.
On 1 October 20X7, the property was sold for a gross price of £3.7 million, with agency and
legal costs of £165,000 being incurred.
Requirement
Calculate the following amounts in respect of Ramshead's financial statements for the year
ended 31 December 20X7 in accordance with IAS 40, Investment Property and
IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
(a) The gain or loss arising in 20X6 from the change in carrying amount if the fair value
model is used to account for the property
(b) The gain or loss on disposal arising in 20X7 if the cost model is used
(c) The increase or decrease, compared with the cost model, in the gain or loss on
disposal arising in 20X7 if the fair value model is used
IAS 41, Agriculture
19 Arapawanui
The Arapawanui Company keeps a flock of sheep on its land, selling the milk outputs. The
day after its production, the milk is collected on behalf of the purchasers and revenue from
its sale is recognised.
On 30 June 20X7 300 animals were born, all of which survived and were still owned by
Arapawanui at 31 December 20X7. 10,000 litres of milk were produced in the year to
31 December 20X7.

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The following market data is available in respect of the sheep.

At 30 June 20X7 At 31 December 20X7
Type of animal Fair value per animal Fair value per animal
£ £
Newborn 22 23
6 months old 25 26
The animal fair values are based on transactions prices in the local markets. Auctioneers'
commission is 1.5% of the transaction price and the government sales levy is 0.5% of that
price.
The production cost, including overheads, of the milk was £0.08 per litre and the fair values
were £0.13 per litre throughout 20X7 and £0.14 per litre throughout 20X8. Costs to sell
were estimated at 4%.
Requirement
What gain should be recognised in respect of the newborn sheep and the milk in
Arapawanui's financial statements for the year to 31 December 20X7, according to
IAS 41, Agriculture?
20 Tepev
The Tepev Company bought a flock of 400 sheep on 1 December 20X7. The cost of each
sheep was £80, which represented fair value at that date. Auctioneers' fees on sale are 5%
of fair value, and the cost of transporting each sheep to market is £4.00. An agricultural levy
of £2.00 is payable on each sheep sold.
At 31 December 20X7 all of the sheep are still held and fair value has increased to £90 per
sheep. No other costs have changed. Tepev has a contract to sell the sheep on
31 March 20X8 for £100 each.
Requirement
What is the carrying amount of the flock in the statement of financial position at
31 December 20X7, according to IAS 41, Agriculture?
21 Saving
The Saving Company bought a flock of 500 sheep on 1 December 20X7. The cost of each
sheep was £95, which represented fair value at that date. Auctioneers' fees on sale are 5%
of fair value, and the cost of transporting each sheep to market is £3.00. An agricultural levy
of £2.00 is payable on each sheep sold.
At 31 December 20X7 all of the sheep are still held and fair value has increased to £107 per
sheep. No other costs have changed. Saving has a contract to sell the sheep on
31 March 20X8 for £119 each.
Requirement
What is the gain arising in relation to the flock between the date of initial recognition as an
asset and 31 December 20X7, according to IAS 41, Agriculture?

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22 Monkey
The Monkey Company has the following information in relation to a cattle herd in the year
£'000
Cost of herd acquired on 1 January 20X7 (which equates to fair value) 1,800
Auctioneers' sales fees 2% of sale price
Loan obtained at 8% to finance acquisition of herd 1,500
Fair value of herd at 31 December 20X7 2,500
Transport cost to market 35
Government transfer fee on sales – no fee on purchases 50
Requirement
What is the loss arising on initial recognition of the herd as biological assets and the gain C
H
arising on its subsequent remeasurement under IAS 41, Agriculture, in the year ended A
31 December 20X7? P
T
IFRS 4, Insurance Contracts E
R
23 Blackbuck
12
The Blackbuck Company has in issue unit-linked contracts which pay benefits measured by
reference to the fair value of the pool of investments supporting the contracts. The terms of
the contracts include the following.
(1) On surrender by the holder or on maturity, the benefits shall be the full fair value of the
relevant proportion of the investment.
(2) In the event of the holder's death before surrender or maturity, the benefits shall be
120% of the full value of the relevant proportion of the investments.
Blackbuck's accounting policies do not otherwise require it to recognise all the obligations
under any deposit component within these contracts.
Blackbuck's financial controller is unclear whether these contracts should be accounted for
under IFRS 4, Insurance Contracts, or under IFRS 9, Financial Instruments.
Requirement
Explain how these contracts should be accounted for.
24 Traore
The Traore Company is organised into a number of divisions operating in different sectors.
The accounting policies applied in two of its divisions before the introduction of IFRS 4,
Insurance Contracts are as follows.
Accounting policy (1) In its car breakdown division, Traore offers unlimited amounts of
roadside assistance in exchange for an annual subscription.
Although it has always accepted that this activity is in the nature of
offering insurance against breakdown, it accounts for these
subscriptions by using the stage of completion method under
IAS 18, Revenue, and making relevant provisions for fulfilment
costs under IAS 37, Provisions, Contingent Liabilities and
Contingent Assets.
Accounting policy (2) In its property structures insurance division, Traore makes a
detailed estimate for the cost of each outstanding claim but
adopts the practice of adding another 20% to the total on a 'just
in case' basis.

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Requirement
Which of these accounting policies is Traore permitted to continue to use under
IFRS 4, Insurance Contracts?
IFRS 6, Exploration for and Evaluation of Mineral Resources
25 Give examples of circumstances that would trigger a need to test an evaluation and
exploration asset for impairment.

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Technical reference
 Recognition IAS 16.7
 Initial costs IAS 16.11
 Subsequent costs IAS 16.12
 Measurement at recognition IAS 16.15
 Measurement after recognition IAS 16.29
 Derecognition IAS 16.67–72
 Disclosure IAS 16.73–79
C
IAS 38, Intangible Assets H
A
 Scope IAS 38.2 P
T
 Definitions IAS 38.8 E
 Intangible assets IAS 38.9–10 R
 Identifiability IAS 38.11–12
 Control IAS 38.13 12
 Future economic benefits IAS 38.17
 Recognition and measurement IAS 38.18–67
 Recognition of an expense IAS 38.68
 Measurement after recognition IAS 38.72
 Cost model IAS 38.74
 Revaluation model IAS 38.75–87
 Useful life IAS 38.88–96
 Intangible assets with finite useful lives IAS 38.97–106
 Intangible assets with indefinite useful lives IAS 38.107–110
 Recoverability of the carrying amount – impairment losses IAS 38.111
 Retirements and disposals IAS 38.112
 Disclosure IAS 38.118
IAS 2, Inventories
 Measurement and disclosure but not recognition IAS 2.1
 Measured at lower of cost and net realisable value IAS 2.9
 Cost = expenditure incurred, in bringing the items to their present IAS 2.10
location and condition, so the cost of purchase and the cost of
conversion
– Fixed costs included by reference to normal levels of activity IAS 2.13
 Cost formula: FIFO or Weighted average IAS 2.25
 NRV includes costs to complete and selling costs IAS 2.6
 Disclosures include accounting policies, carrying amounts and IAS 2.36–38
amounts recognised as an expense

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1 Indications
 At each reporting date assess whether indication of impairment: IAS 36.9
– If so, estimate recoverable amount (RA)
– RA is higher of fair value less costs to sell and value in use IAS 36.6
(present value of future cash flows in use and on disposal)
– Review both external and internal information for evidence of IAS 36.12
impairment
 Impairment loss where carrying amount exceeds RA IAS 36.59
2 Fair value less costs to sell

 The way in which fair value is determined depends on whether IAS 36.25–27
there is a binding sale agreement and/or an active market
 Examples of disposal costs IAS 36.28
3 Value in use
 Calculation involves the estimation of future cash flows as follows: IAS 36.39
– Cash flows from continuing use
– Cash flows necessarily incurred to generate cash inflows from
continuing use
– Net cash flows receivable/payable on disposal
 These should reflect the current condition of the asset IAS 36.44
 The discount rate should reflect:
– The time value of money IAS 36.55

– Risks specific to the asset for which the future cash flow
estimates have not been adjusted
4 Cash-generating units
 Estimate recoverable amount of CGU if not possible to assess for IAS 36.66
an individual asset
 Identification of an asset's CGU involves judgement IAS 36.68
 Goodwill should be allocated to each of the acquirer's CGUs that IAS 36.80
are expected to benefit
 Goodwill that cannot be allocated to a CGU on a non-arbitrary IAS 36.81
basis is allocated to the group of CGUs to which it relates
 Annual impairment review required for any CGU which includes IAS 36.90
goodwill
 Corporate assets should be allocated on a reasonable and IAS 36.102
consistent basis

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5 Impairment losses
 If the asset is held under the cost model the impairment should be IAS 36.60
recognised in profit or loss
 If the asset has been revalued the impairment loss is treated as a IAS 36.60
revaluation decrease
 An impairment loss for a CGU should be allocated: IAS 36.104
– To goodwill then
– To all other assets on a pro rata basis
 When a CGU is a non-wholly owned subsidiary and non-controlling IAS 36 (Appendix C)
interest is measured at acquisition date at share of net assets, C
notionally gross up goodwill for that part attributable to the non- H
controlling interest A
P
T
6 Reversals E
R
 An impairment loss recognised for goodwill should not be IAS 36.124
reversed 12
7 Disclosures
 All impairments IAS 36.126
 For a material impairment on an individual asset IAS 36.130
 For a material impairment on a CGU IAS 36.130

 Definition of investment property IAS 40.5
 Definition of fair value IFRS 13.9
 Property held by lessee under operating lease may be investment IAS 40.6
property
IAS 40.33–35,
 Fair value model
IAS 40.38
 Cost model IAS 40.56
IAS 41, Agriculture

 Scope IAS 41.1
 Agricultural activity IAS 41.5, 8
– Biological assets
– Agricultural produce at the point of harvest
– Government grants
 Recognition and measurement IAS 41.10, 12–13
 Gains and losses IAS 41.26, 28
 Government grants IAS 41.34–35
 Disclosure IAS 41.40, 41, 46-50,
54–57

 Scope IFRS 6.3–5
 Measurement at recognition IFRS 6.8–11
 Measurement after recognition IFRS 6.12
 Changes in accounting policies IFRS 6.13
 Impairment IFRS 6.18

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 Objective IFRS 4.1
 Scope IFRS 4.2–6
 Embedded derivatives IFRS 4.7–9
 Liability adequacy test IFRS 4.15

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(a) The double entry is:
DEBIT Asset value (statement of financial position) £7,000
CREDIT Profit or loss £2,000
CREDIT Revaluation surplus (other comprehensive income) £5,000
The case is similar for a decrease in value on revaluation. Any decrease should be
recognised as an expense, except where it offsets a previous increase taken as a revaluation
surplus in other comprehensive income. Any decrease greater than the previous upwards C
increase in value must be recorded as an expense in profit or loss. H
A
(b) The double entry is: P
T
DEBIT Revaluation surplus (other comprehensive income) £5,000 E
DEBIT Profit or loss £2,000 R
CREDIT Asset value (statement of financial position) £7,000
12
There is a further complication when a revalued asset is being depreciated. An upward
revaluation means that the depreciation charge will increase. Normally, a revaluation
surplus is only realised when the asset is sold, but when it is being depreciated, part of that
surplus is being realised as the asset is used. The amount of the surplus realised is the
difference between depreciation charged on the revalued amount and the (lower)
depreciation which would have been charged on the asset's original cost. This amount can
be transferred to retained (ie, realised) earnings but not through profit or loss.
(c) On 1 January 20X8 the carrying value of the asset is £10,000 – (2  £10,000 ÷ 5) = £6,000.
For the revaluation:
DEBIT Asset value (statement of financial position) £6,000
CREDIT Revaluation surplus (other comprehensive income) £6,000
The depreciation for the next three years will be £12,000 ÷ 3 = £4,000 compared to
depreciation on cost of £10,000 ÷ 5 = £2,000. Each year the extra £2,000 is treated as
realised and transferred to retained earnings:
DEBIT Revaluation surplus £2,000
CREDIT Retained earnings £2,000
This is a movement within reserves, not an item in profit or loss.

The total cost attributable to Product 1 is calculated as:
£140,000 + £37,000 + (60%  £50,000) = £207,000
The cost per unit therefore being £207,000/690 = £300 each.
The total cost attributable to Product 2 is:
£160,000 + £45,000 + (40%  £50,000) = £225,000
The cost per unit therefore being £225,000/900 = £250 each.
The allocation of the cost for Product 2 is therefore:
£250  675 = £168,750 as inventories
£250  225 = £56,250 as an expense
The indirect costs not specifically identifiable with either product which are allocated to the
scrapped Product 2 cannot be recovered into the cost of Product 1.

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£
Cost (being lower than NRV) 36,000
Depreciation (£36,000/3 years) (12,000)
24,000

(a) Common examples of intangible assets are as follows:
 Computer software (other than operating systems which are accounted for under
IAS 16)
 Patents and copyrights
 Motion picture films
 Customer lists, customer loyalty, customer/supplier relationships
 Airline landing slots
 Fishing licences
 Import quotas
 Franchises
(b) Employees can never be recognised as an asset; they are not under the control of the
employer, are not separable and do not arise from legal rights.

The fair value less costs to sell of the plant is below its carrying value so it may be impaired. It is
now necessary to find the value in use in order to determine whether an impairment has
occurred and to quantify any impairment loss.
Discounted future
Year Future cash flows PV factor at 15% cash flows
£'000 £'000
1 230 0.86957 200
2 211 0.75614 160
3 157 0.65752 103
4 104 0.57175 59
5 233 0.49718 116
638
To calculate the impairment loss, compare the carrying value of £749,000 with the higher of
value in use (£638,000) and fair value less costs to sell (£550,000). The impairment loss is
therefore £749,000 – £638,000 = £111,000.

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The key issue is whether the cash-generating unit produces cash flows which are independent of
other assets or not.
The CGUs which appear to have cash flows independent of the other assets (and can therefore
be subject to reliable assessment of their recoverable value) are:
(b) a branch of a pizza restaurant in Warsaw; and
(d) a commuter monorail.
(a) and (c) are not generators of independent cash flows and are therefore too small to be CGUs
in their own right. In the case of (c) the CGU is the theme park as one entity.
Additionally (e) is a CGU in its own right as there is an external active market for its services, even
C
though these are not openly available (IAS 36.71). H
A
P
Answer to Interactive question 7 T
(a) (b) E
£m £m R
Recognised goodwill 90 90 12
Notional goodwill (£90m  40/60) 60 60
Carrying amount of net assets 550 550
700 700
Recoverable amount 510 570
Impairment loss 190 130
Allocation of impairment loss:

£m £m
Recognised goodwill 90 90
Notional goodwill 60 40
Other assets pro rata 40 –
190 130
Carrying value after impairment:

£m £m
Goodwill (90 – (150  60%))/(90 – (130  60%)) – 12
Other net assets (550 – 40) 510 550
510 562

(a) The factory is not an investment property. It should be classified as property held for sale
and accounted for under IFRS 5.
(b) The building would qualify as an investment property under IAS 40, as the entity intends to
earn rentals from it under an operating lease.
(c) The provisions offered over and above the office space itself fall within what IAS 40
describes as 'ancillary services'. Considering the nature and extent of these services, it
would be unlikely that they could be described as 'insignificant' in relation to the
arrangements as a whole. The building is, in essence, being used for the provision of
serviced offices and therefore does not meet the definition of an investment property.
Although the entity's main objective in acquiring the building is its potential capital
appreciation, the building should be recognised and measured in accordance with IAS 16
rather than IAS 40.
(d) The property should be recognised as an investment property on 30 March 20X5 when the
offices were ready to be occupied. Costs incurred, and consequently operating losses, after
this date should be expensed even though the entity did not start to receive rentals until

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later in 20X5. Losses incurred during this 'empty' period are part of the entity's normal
business operations and do not form part of the cost of the investment property.

(a) The £5 million value could be used as a basis of fair value, because the price was agreed
between market participants.
(b) The £6 million value could not be used as a basis of fair value, because the sale transaction
cannot be presumed to be between market participants in an orderly transaction.
(c) The £4.5 million value could not be used as a basis of fair value, because the sale
transaction would appear to have been made by a forced, not willing, seller, and therefore
not an orderly transaction.
(d) The £5.5 million value could not be used as a basis of fair value, because the sale
transaction would appear to have been made to a buyer who was not knowledgeable of
local market conditions, and therefore not a market participant in an orderly transaction.

The cost model £m
Net proceeds 6.00
Carrying amount £5,500,000  47/50 (5.17)
Profit on sale 0.83
The fair value model £m

Net proceeds 6.0
Fair value (6.2)
Loss on sale (0.2)

The changes of use will be reflected in the financial statements based on whether the entity uses
the cost model or the fair value model for investment properties as follows.
(a) The cost model for investment properties
At 31 December 20X5, the building has a carrying amount of:
£5.5m  45/50 years = £4.95 million in accordance with IAS 16.
On 1 January 20X6 the property will be recognised as an investment property at its IAS 16
carrying amount of £4.95 million and will continue to be depreciated over its remaining
45-year life.
At 31 December 20Y0, the building has a carrying amount of:
£4.95m  40/45 years = £4.4 million in accordance with IAS 40.
On 1 January 20Y1 the property will be recognised as property, plant and equipment at its
IAS 40 carrying amount of £4.4 million and will continue to be depreciated over its
remaining 40-year life.
(b) The fair value model for investment properties
At 31 December 20X5, the building has a carrying amount of £4.95 million in accordance
with IAS 16 (as set out above).
On 1 January 20X6, the property will be recognised as an investment property. However,
the property should be revalued to fair value at 31 December 20X5, and any change in
value should be recognised in accordance with IAS 16.

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The property will therefore be recognised at a carrying amount of £6 million and the
difference of £1.05 million should be recognised as a revaluation surplus (other
comprehensive income).
During the period between 1 January 20X6 and 31 December 20Y0 the building is
measured at fair value with any gain or loss recognised directly in profit or loss. At the end
of 20Y0 the cumulative gain is £1.5 million.
At 31 December 20Y0, the building has a carrying amount of £7.5 million being its fair value
and this is the amount that should be recognised as its carrying amount under IAS 16. The
carrying amount will be depreciated over the building's remaining 40-year useful life.
Answer to Interactive question 12 C

£1 million is derecognised being the depreciated cost of the replaced system: H
A
£1.2 million  (25/30 years) P
T
£1.2 million is capitalised as the cost of the new system and will be depreciated over its E
estimated useful life of 10 years. R
Answer to Interactive question 13 12
The carrying amount of the failed system should be derecognised:

Carrying amount is £100,000 (£400,000 less six years' depreciation at 12.5%)
The replacement system should be recognised:
Total carrying amount of the office building is £3,500,000
(£3m – £100,000 + £600,000)

The entity recognises these transactions and events as follows.
20X5
The property continues to be measured under the fair value model on classification as held for
sale on 30 September. An impairment of £3.65 million is recognised (£4 million less £350,000).
At 31 December the property is presented as held for sale within current assets at £350,000.
20X6
The replacement property is recognised at a cost of £3.8 million and a loss on disposal is
recognised of £15,000 being (proceeds of £375,000 less selling costs of £40,000 less carrying
amount of property of £350,000).
20X7
The insurance proceeds of £3.9 million are recognised in profit or loss.
Note: The requirement to measure an asset 'held for sale' and the lower of carrying amount and
fair value less costs to sell does not apply to investment properties measured at fair value
(IFRS 5.5). IAS 40.37 states that costs to sell should not be deducted from fair value.

(a) Wool: Agricultural produce
(b) Vines: Biological assets
(c) Sugar: Products that are the result of processing after harvest

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(a) Commission to brokers
(b) Transfer taxes and duties
Commissions to brokers and transfer taxes and duties are recognised costs to sell in the
standard.

(a) Audit issues
(1) Classification as an investment property
Property A: As this property is owner occupied it does not fall within the definition of
an investment property in accordance with IAS 40 (IAS 40(9)).
Property B: While this property is not legally owned it is held under a finance lease
and therefore can be treated as an investment property (IAS 40(5)).
Property C: Although this property is currently vacant, on the basis that it is being held
for investment purposes it can be classified as an investment property (IAS
40(8d)).
Property D: This is an investment property as it is legally owned by Propertyco and is
let out to a non-group company (IAS 40(5)).
(2) Valuation
Property A: Should be valued in accordance with IAS 16 ie, cost less accumulated
depreciation unless the revaluation model is to be adopted.
Property B: Would have been recognised at the inception of the lease at the lower of
fair value and the present value of the minimum lease payments. After
initial recognition it would be valued at fair value in accordance with
company policy in respect of investment properties.
Property C: Should initially be recognised at cost including transaction costs. In this
case the asset should initially be recognised at £3 million. As the fair value
model is adopted by Propertyco the value will then be revised to fair
value.
Property D: Should be recognised at fair value in accordance with IAS 40 and the
accounting policy adopted by Propertyco. Changes in fair value should be
recognised in profit or loss for the period.
(b) Audit procedures
 Evaluate the control environment and the process by which Propertyco establishes fair
values.
 Determine the basis on which fair values have been calculated. (In accordance with
IAS 40/IFRS 13 this should be the price that would be received to sell an asset in an
orderly transaction between market participants at the measurement date.) Current
prices per square metre in an active market for similar property in the same location
and condition are likely to provide the best evidence or observable market rents.
(IAS 40.40 states that the fair value must reflect rental income from current leases and
other assumptions that participants would use when pricing investment property under
current market conditions).
 Where external valuers have been used assess the extent to which they can be relied
on in accordance with the principles of using the work of a management's expert in
ISA (UK) 500, Audit Evidence.

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 If fair values have been based on discounted cash flows ie, discounted future rental
incomes compare predicted cash flows to current rental agreements and assess
whether this is the most appropriate basis for estimating fair value in accordance with
IFRS 13. Review the basis on which the interest rate applied has been selected and any
other assumptions built into this calculation eg, consider management's history of
carrying out its intentions.
 Review any documentation to support assumptions.
 Agree level of disclosure is in accordance with IAS 40/IFRS 13.
C
H
A
P
T
E
R
12

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IAS 2, Inventories
1 Reapehu
£20,175,000
IAS 2.31 requires that NRV should take into account the purpose for which inventory is held.
The NRV for the contract is therefore determined separately from the general sales, thus:
£
Contract: NRV is lower than cost thus use NRV, so (£225,000  15) = 3,375,000
General: Use cost as this is less than NRV, so (£240,000  (85 – 15)) = 16,800,000
20,175,000
2 Utah
£64,000
IAS 2.30 requires the NRV of inventories to be calculated on the basis of all relevant
information, including events after the reporting period. This is supported by the example
in IAS 10.9(b).
Thus:
£
£25  1,600 expected to be sold to Bushbaby: 40,000
£10  2,400 remainder 24,000
Total 64,000
3 Niobium
£33 million
IAS 16.11 requires the capitalisation of essential safety equipment even if there are no
future economic benefits flowing directly from its operation.
It does however subject the total value of all the related assets to an impairment test. In this
case the recoverable amount is £33 million, as the net selling price £33 million is greater
than the value in use £32 million (ie, £3.2m/0.1). As this is less than the total carrying
amount of £35 million (£30m + 5m), the assets are written down to £33 million.
4 Oruatua
(a) £850,355
(b) £(154,118)
(c) £756,521
(a) The initial cost of the asset must include the dismantling cost at its present value, where
the time value of the money is material (IAS 16.16(c) and IAS 37.45). The present value
of these costs at 1 January 20X6 is £173,952 (£480,000  0.3624), making the total cost
of the engines £623,952. Each part of the asset that has a cost which is significant in
relation to the total asset cost should be depreciated separately (IAS 16.43). Therefore,
at the end of 20X6 the carrying amount of the asset is £850,355 (£110,000  4/5) +
(£240,000  3/4) + (£623,952  14/15).
(b) The loss on disposal is (per IAS 16.71) the difference between the carrying amount of
an individual engine at 1 January 20X7 of £194,118 (£623,952/3  14/15)) and the
scrap sale proceeds of £40,000, to give a loss of £154,118.

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(c) The replacement engine is capitalised at cost of £226,170 (£168,000 + £150,000 

0.3878), and then depreciated over the remaining length of the licence of 14 years.
The carrying amount of the asset at 31 December 20X7 is therefore £756,521
(£110,000  3/5) + (£240,000  2/4) + (£623,952  2/3  13/15) + (£226,170  13/14).
5 Antimony
£0.7 million
IAS 36.60 and 61 (also IAS 16.40) require that an impairment that reverses a previous
revaluation should be recognised through the revaluation reserve to the extent of that
reserve. Any remaining amount is recognised through profit or loss. Thus:
C
 The carrying amount at 31 December 20X2 is 45/50  £5.0m = £4.5 million. H
A
 The revaluation reserve created is £3.5 million (ie, £8.0m – £4.5m). P
T
 The carrying amount at 31 December 20X7 is 40/45  £8.0m = £7.1 million. E
R
 The recoverable amount at 31 December 20X7 is £2.9 million.
12
 The total impairment charge is £4.2 million (ie, £7.1m – £2.9m).
 Of this, £3.5 million is a reversal of the revaluation reserve, so only £0.7 million is
recognised through profit or loss.
6 Sundew
£6,000,000
IAS 36.70 requires that in determining value in use where internal transfers are made, then
a best estimate should be made of prices that would be paid in an orderly transaction
between market participants at the measurement date.
Thus revenues are 4,000  £1,500 = £6,000,000
7 Cowbird
£8.0 million
IAS 36.110 requires consideration of whether an impairment loss recognised in previous
years has reversed or decreased.
IAS 36.117 and 118 restrict the recognition of any such reversal to the value of the carrying
amount at the current reporting date had the original impairment not taken place. Thus:
Carrying amount under original conditions = £10m  16/20 years = £8.0m.
8 Acetone
(a) £750,000
(b) £96,000
(c) £99,000
£
(a) Book value of Dushanbe's net assets 400,000
Goodwill recognised on acquisition
£600,000 – (80%  £400,000) 280,000
Notional goodwill (£280,000  20/80) 70,000
750,000

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(b) The impairment loss is the total £750,000 less the recoverable amount of £520,000 =
£230,000. Under IAS 36.104 this is firstly allocated against the £350,000 goodwill. (As
the impairment loss is less than the goodwill, none is allocated against identifiable net
assets.) As only the goodwill relating to Acetone is recognised, only its 80% share of
the impairment loss is recognised:
£
Carrying value of goodwill 280,000
Impairment (80%  230,000) (184,000)
Revised carrying amount of goodwill 96,000
(c)
Carrying amount of Maclulich's net assets 700,000
Recognised goodwill 205,000
Notional goodwill (15/85  £205,000) 36,176
941,176
Recoverable amount (660,000)
Impairment loss 281,176
Allocated to:
Recognised and notional goodwill 241,176
Other net assets 40,000
Therefore the non-controlling interest is (£700,000 – £40,000)  15% = £99,000.

9 Titanium
£672,500
IAS 38.94 deals with the identification of the useful life of an intangible asset arising from
legal rights.
The Dominoes publication has a useful life of six years, and so should be amortised over
this period. At the year end the carrying amount of £750,000, (900,000  5/6), exceeds the
active market value, so an impairment of £50,000 is required. This gives a total charge of
£200,000 (£150,000 amortisation plus £50,000 impairment charge)
The Billiards publication is initially amortised over the period of 10 years to the end of the
copyright arrangement, as there is no certainty that the company can publish the magazine
after this date. This gives a charge of £120,000.
The Skittles publication is amortised over the period it is expected to generate cash flows of
eight years, giving a charge of £212,500.
The Darts publication has an indefinite period over which it is expected to generate cash
flows. Under normal circumstances it would be automatically subject to an annual
impairment review. However, because the copyright arrangement does have a finite period,
amortisation should take place over 10 years, and so a charge of £140,000 is required.
The total charge is £672,500.
10 Lewis
(a) Recognised
(b) Recognised
(c) Recognised
(a) The vineyard trademark is not separable because it could only be sold with the
vineyard itself. But under IAS 38.36, the combination of the vineyard and the trademark
should be recognised.

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(b) The footballers' registrations represent a legal right which meets the identifiability
criterion in IAS 38.12.
(c) The research project should be treated as a separate asset, as on a business
combination it meets the definition of an asset and is identifiable (IAS 38.34).
11 Diversified group
(a) Not an intangible
(b) An intangible
(a) The training costs would not satisfy the definition of an intangible asset. This is because
Thrasher has insufficient control over the expected future benefits of the team of
experts (IAS 38.15).
C
(b) The database would be classified as an intangible asset because the willingness of H
another party to buy the contents provides evidence of a potential exchange A
transaction for the relationship with customers and that the asset is separable P
T
(IAS 38.16). E
R
12 Cadmium
12
£16,250
The revaluation model cannot be used for this trademark, because for a unique item there
cannot be the active market required by IAS 38.75. (A professional valuation does not rank
as a value by reference to an active market.) IAS 38.81 requires the cost model to be
applied to such an item, even if it is in a class for which the revaluation model is used.
The cost of renewal should be treated as part of the cost of an intangible, under
IAS 38.28(b), but the valuation expenses should be charged directly to profit or loss, as
administration overheads (IAS 38.29(c)).
The trademark is therefore carried at the cost of renewal, depreciated for six of the eight
years' life since last renewal, so £65,000  2/8 = £16,250.
13 Piperazine
(a) £132,750
(b) £88,500
(c) £61,500
(a) Under IAS 38.21 the £70,000 spent in 20X4 in applying for the licences must be
recognised in profit or loss, because the generation of future economic benefits is not
yet probable. The £9,000 incurred in December 20X4 in registering the licences is
treated as the cost of the licences because the economic benefits are then probable.
The carrying amount of the licences under the revaluation model at 31 December
20X4 is £141,750 (£9,450  15), so the balance on the revaluation reserve is the
£132,750 uplift (IAS 38.75 & 85).
(b) After three years the accumulated amortisation based on the revalued amount is
£47,250 (£141,750  3/9), whereas the accumulated amortisation based on the cost
would have been £3,000 (£9,000  3/9). So £44,250 will have been transferred from
the revaluation reserve to retained earnings (IAS 38.87). The remaining balance before
the regular revaluation is £88,500 (£132,750 – £44,250).
(c) The carrying amount of the licences immediately before the revaluation is £94,500
(£141,750 – £47,250). The revalued carrying amount is £67,500 (£4,500  15). The
deficit of £27,000 is recognised in the revaluation reserve, reducing the balance to
£61,500 (IAS 38.86).

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14 (b) and (d) fall under the definition of investment property
(b) A building owned by an entity and leased out under an operating lease
(d) Land held for long-term capital appreciation
IAS 40.8 and 9 give examples of types of investment property.
15 Boron
£50,000
Under the fair value model IAS 40.33 requires investment properties to be measured at fair
value, while IAS 40.37 requires fair value to be determined excluding transaction costs that
may be incurred on sale or other disposal. IAS 40.35 requires changes in fair value to be
recognised in profit or loss.
IAS 40.20 requires transaction costs, such as legal costs, to be included in the initial
measurement.
So the change in fair value is £700,000 – (£600,000 + £50,000) = £50,000.
16 Acimovic
£135,000 income
IAS 40.25 requires that an investment property held under a finance lease should initially be
recognised according to IAS 17, Leases, which is at the lower of (1) fair value and (2) present
value of minimum lease payments, so £740,000.
Subsequent measurement is at fair value, per IAS 40.33. IAS 40.26 requires the subsequent
fair value to relate to the property interest, not to the underlying property. So the £875,000
fair value of the property interest should be used.
The result is income of £135,000 (ie, £875,000 – £740,000).
17 Laburnum
£1,358,000
IAS 40.19 and 68 require derecognition of the carrying amount of the failed system &
inclusion of the replacement.
Thus £1,250,000 – (£80,000  4/10) + £140,000 = £1,358,000
18 Ramshead
(a) £250,000 gain
(b) £575,000 gain
(c) £540,000 decrease
(a) Transaction costs should be included in the initial measurement of investment
properties (IAS 40.20). Under the fair value model an investment property is
subsequently carried at fair value without any deduction for costs to sell (IAS 40.33 &
5). The gain recognised in profit or loss is £250,000 (£3.45m – (£3.1m + £0.1m)).
(b) Any asset classified as held for sale is measured in accordance with applicable IFRS
immediately before classification. So if the cost model is used, the carrying amount
before initial classification is cost less depreciation to the date of classification, so
£2.96 million (£3.2m less 18 months' depreciation at 5% per annum). On initial
classification, the property is measured at the lower of this carrying amount and the
£3.34 million (£3.5m – £160,000) fair value less costs to sell (IFRS 5.15) so £2.96 million.
There is no subsequent depreciation (IFRS 5.25), so the carrying amount will be the
same at the date of disposal. The profit on disposal is net disposal proceeds less the
carrying amount (IAS 40.69), so net sales proceeds of £3.535 million (£3.7m –
£165,000) less £2.960 million gives a profit on disposal of £575,000.

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(c) If the fair value model is used, then the carrying amount immediately before initial
classification will be the £3.5 million fair value. The requirement to measure an asset
'held for sale' at the lower of carrying amount at fair value less costs to sell does not
apply to investment properties measured at fair value (IFRS 5.5) and so the property
continues to be measured at fair value. IAS 40.37 states that costs to sell should not be
deducted from fair value, so the property continues to be measured at £3.5 million.
Profit on disposal will be net sales proceeds of £3.535m less £3.5m = £35,000. This is a
reduction of £540,000 on the cost model gain.
IAS 41, Agriculture
19 Arapawanui
The newborn sheep are biological assets and should be measured at fair value less costs to
C
sell, both on initial recognition and at each reporting date (IAS 41.12). The gains on initial H
recognition and from a change in this value should be recognised in profit or loss A
(IAS 41.26). As the animals are six months old at the year end, the total gain in the year P
T
(being the initial gain based on a newborn fair value of £22 plus the year-end change in E
value by £4 to £26) is £7,644 (300  £26  (100% – 1.5% – 0.5%)). R
The milk is agricultural produce and should be recognised initially under IAS 41 at fair value 12
less costs to sell (IAS 41.13). (At this point it is taken into inventories and dealt with under
IAS 2.) The gain on initial recognition should be recognised in profit or loss (IAS 41.28). The
gain is £1,248 (10,000 litres  £0.13  (100% – 4)).
Total gain is £8,892.
20 Tepev
£33,400
Biological assets should be measured at fair value less costs to sell (IAS 41.12). Costs to sell
include sales commission and regulatory levies but exclude transport to market (IAS 41.14).
Transport costs are in fact deducted from market value in order to reach fair value. In this
question fair value of £90 is provided; it is assumed that this is calculated as a market value
of £94 less the quoted transport costs of £4. Contracts to sell agricultural assets at a future
date should be ignored (IAS 41.16).
The statement of financial position carrying amount per sheep is:
£
Fair value 90.00
Costs to sell (£90  5%) + £2.00 (6.50)
Value per sheep 83.50
For the flock of 400 sheep, the amount is £33,400.

21 Saving
£5,700
Biological assets should be measured at fair value less costs to sell, both on initial
recognition and at each reporting date (IAS 41.12). Costs to sell include sale commission
and regulatory levies but exclude transport to market (IAS 41.14). Transport costs are in fact
deducted from market value in order to reach fair value. Contracts to sell agricultural assets
at a future date should be ignored (IAS 41.16).
£
FV at reporting date (£107 – commission (£107  5%) – levy £2.00) 99.65
Initial FV per sheep (£95 – commission (£95  5%) – levy £2.00) (88.25)
Gain per sheep 11.40
There is, therefore, a gain on the flock of 500 sheep of £5,700.

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22 Monkey
£86,000 loss on initial recognition
£686,000 gain on subsequent measurement
£'000
Cost of herd 1,800
Recognised at FV – costs to sell (£1.8m – fees (£1.8m  2%) – gvnmt fee £50,000) (1,714)
Initial loss on recognition 86
On acquisition of the herd, the cattle are initially recognised as biological assets at fair value
less costs to sell (IAS 41.27), which in this case is less than cost by the costs to sell which are
immediately deducted (IAS 41.27). Acceptable costs to sell include auctioneers' fees and
government transfer fees (IAS 41.14) but exclude transport to market costs (IAS 41.14). The
interest on the loan taken out to finance the acquisition is not a cost to sell (IAS 41.22).
The value is then restated to fair value less costs to sell at each reporting date
(IAS 41.12)
£'000
Fair value at 31 December 20X7 2,500
Costs to sell: auctioneers fees (£2.5m  2%) (50)
Government fees (50)
Carrying value 2,400
Less initial recognition value (1,714)
Gain 686

23 Blackbuck
The extra payable on death before surrender/maturity should be accounted for under
IFRS 4 and the remainder under IAS 39.
Given the entity's accounting policies in relation to the recognition of obligations under the
deposit components, IFRS 4.10 requires the insurance component and the deposit
component to be unbundled; IFRS 4.12 requires the insurance component to be accounted
for under IFRS 4 and the deposit component under IAS 39.
24 Traore
The entity is permitted to continue with both policies.
IFRS 4.13 disapplies the provisions of IAS 8, Accounting Policies, Changes in Accounting
Estimates and Errors, in relation to selection of accounting policies where there is no IFRS.
Entities are therefore only required to change existing policies in the circumstances listed in
IFRS 4.14. Accounting policy (1) is not caught by this paragraph, so its continued use is
permitted.
The application of Accounting policy (2) involves the use of excessive prudence. The
continued use of excessive prudence is permitted by IFRS 4.26.

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25  The expiration or anticipated expiration in the near future of the period for which the
entity has the right to explore the relevant area, unless the right is expected to be
renewed.
 The lack of available planned or budgeted expenditure for further exploration and
evaluation of the specific area.
 A decision to discontinue evaluation activities in the exploration and specific area when
commercially viable resources have not been identified.
C
H
A
P
T
E
R
12

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CHAPTER 13
Reporting of
non-financial
liabilities
Introduction
TOPIC LIST
1 IAS 10, Events After the Reporting Period
2 IAS 37, Provisions, Contingent Liabilities and Contingent Assets
3 Audit focus
Technical reference

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Introduction
can affect reported financial position, and explain the role of data analytics in
 Explain and appraise accounting standards that relate to assets and non-financial
liabilities for example: property, plant and equipment; intangible assets, held-for-
sale assets; inventories; investment properties; provisions and contingencies
evidence
Specific syllabus references for this chapter are: 1(e), 3(a), 3(b), 14(c), 14(d), 14(f)

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1 IAS 10, Events After the Reporting Period
Section overview
 Events after the reporting period are split into adjusting and non-adjusting events. Those
events that may affect the going concern assumption underlying the preparation of the
financial statements must be considered further.
 The following is a summary of the material covered in earlier studies.
1.1 Overview of earlier studies

Events after the reporting period are split into adjusting and non-adjusting events.
1.1.1 Adjusting events after the reporting period
Adjusting events are events that provide evidence of conditions that existed at the reporting
date, and the financial statements should be adjusted to reflect them. Examples include the
following:
 Settlement of a court case that confirms that the entity had an obligation at the reporting
date
 Evidence that an asset was impaired at the reporting date eg,:
– Bankruptcy of a customer C
H
– Selling prices achieved for inventory A
P
 Determination of profit-sharing or bonus payments relating to the year
T
E
 Finalisation of prices for assets sold or purchased before year end
R
 The discovery of fraud or errors (where material) that show that the financial statements are
13
misstated
 An adjustment to the disclosed earnings per share (EPS) for transactions such as bonus
issues, share splits or share consolidations where the number of shares altered without an
increase in resources. The additional shares are thus treated as having been in issue for the
whole period
1.1.2 Non-adjusting events after the reporting period
Non-adjusting events are events that are indicative of conditions that arose after the reporting
date. Disclosure should be made in the financial statements where the outcome of a non-
adjusting event would influence the economic decisions made by users of the financial
statements. Examples are as follows:
 A major business combination after the reporting date (IFRS 3 or the disposing of a major
subsidiary)
 Announcement of plan to discontinue an operation
 Major purchases and disposals of assets
 Classification of assets as held for sale
 Expropriation of assets by government
 Destruction of assets, for example by fire or flood
 Announcing or commencing the implementation of a major restructuring
 Major ordinary share transactions (unless these involve transactions such as capitalisation
and bonus issues where there is a change in the number of shares without an inflow or
ICAEW 2019 Reporting of non-financial liabilities 711

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outflow of resources, see adjusting events above. Such transactions require EPS to be
restated as if the new number of shares was in issue for the whole year)
 Decline in the market value of investments including investment properties after the
reporting date. These should reflect the fair value at the reporting date and should not be
affected by hindsight
1.1.3 Going concern basis
Financial statements are prepared on the 'going concern' basis. Where an entity goes into
liquidation after the reporting date, it is no longer considered to be a going concern and the
financial statements should not be prepared on this basis.
Where the going concern basis is clearly not appropriate, a basis other than the going concern
basis should be adopted, for example the 'break-up basis'. The break-up basis measures the
assets at their recoverable amount in a non-trading environment, and a provision is recognised
for future costs that will be incurred to 'break-up' the business.
Where the financial statements are not prepared on a going concern basis, this should be fully
disclosed, along with the actual basis of preparation used.
Management is required to make an explicit assessment of the entity's ability to continue as a
going concern by considering a number of financial, operating and other indicators. Indicative
of inability to continue as a going concern would be major restructuring of debt, adverse key
financial ratios, substantial sale of non-current assets not intended to be replaced, loss of key
staff or major markets.
1.1.4 The period of review
The cut-off date for the consideration of events after the reporting period is the date on which
the financial statements are authorised for issue. Events that occur after the reporting date but
before the financial statements are authorised for issue need to be considered, regardless of
what financial information has been made publicly available during this period.
Normally the financial statements are authorised by the directors before being issued to the
shareholders for approval; the authorisation date is the date these are authorised for issue to the
shareholders, and not the date they are approved by the shareholders.
Where a supervisory board is made up wholly of non-executive directors, the financial
statements will first be authorised by the executive directors for issue to that supervisory board
for its approval. The relevant cut-off date for the review of events that have occurred after the
reporting date is the date on which the financial statements are authorised for issue to the
supervisory board.
The date on which the financial statements were authorised for issue should be disclosed, since
events occurring after that date will not be reflected in the financial statements.
1.1.5 Treatment of errors
Errors identified before the authorisation date will be adjusted in the current financial
statements. Those identified after the financial statements have been published should be dealt
with in a subsequent period under IAS 8, Accounting Policies, Changes in Accounting Estimates
and Errors. IAS 8 requires an error relating to a prior period to be treated as an adjustment to
the comparative information presented in the subsequent financial statements.
If a significant event occurs after the authorisation of the financial statements but before the
annual report is published, the entity is not required to apply the requirements of IAS 10.
However, if the event was so material that it affects the entity's business and operations in the
future, the entity may wish to discuss the event in the narrative section at the front of the Annual
Review but outside the financial statements themselves.

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1.1.6 Equity dividends

These should only be recognised as a liability where they have been declared before the
reporting date, as this is the date on which the entity has an obligation. Where equity dividends
are declared after the reporting date, this fact should be disclosed but no liability recognised at
the reporting date.
1.1.7 Further points to note
Information on customers and suppliers
 Information after the reporting date on either a customer or supplier may not only affect
amounts that have been recorded in the financial statements but also impact on the future
trading of the entity.
 This should be assessed and disclosure made if the liquidation of a major customer or
supplier is likely to influence the economic decisions of users of the financial statements.
 Significant customer and supplier relationships are fundamental where an entity relies on
one major supplier. An example of a significant supplier/customer relationship is Intel
Corporation and Dell Inc, where until recently Dell computers have used only Intel
microprocessors. Dell relies almost totally on the ongoing supplier/customer relationship
with Intel, and the success of Intel is vitally important to the future trade of Dell itself.
1.1.8 Contingent liabilities
Evidence may come to light regarding a contingent liability or provision that an entity was
C
unaware of at the reporting date. The distinction between a contingent liability and a provision is H
discussed in IAS 37, Provisions, Contingent Liabilities and Contingent Assets. An example of an A
unknown provision is where, because of a major fault with goods which were purchased before P
T
the reporting date, an electrical retail chain has had the goods returned after the reporting date. E
The fault may raise safety issues and the retailer may have to recall all such items sold within a R
period of time in order to repair the fault. In such circumstances, a provision should be
13
recognised for the repair of all items that have been sold before the reporting date. The entity
may not have been aware of the problem at the reporting date but, as it existed at that date, a
provision should be recognised in light of the new information.
Interactive question 1: Various events

The Roach Company is completing the preparation of its draft financial statements for the year
ended 31 May 20X6.
On 24 July 20X6, an equity dividend of £200,000 was declared and a contractual profit share
payment of £35,000 was made, both based on the profits for the year to 31 May 20X6.
On 20 June 20X6, a customer went into liquidation having owed the company £31,000 for the
past six months. No provision had been made against this debt.
On 17 July 20X6, a manufacturing plant was destroyed by fire resulting in a financial loss of
£200,000.
Requirement
According to IAS 10, Events After the Reporting Period, which amounts should be recognised in
Roach's financial statements for the year to 31 May 20X6 to reflect adjusting events after the
reporting period?

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Interactive question 2: Significant events

An entity's draft financial statements for the year ended 31 December 20X3 were completed on
30 May 20X4, approved by the finance director on 7 June 20X4, authorised for issue on
20 June 20X4 and approved by the shareholders on 5 July 20X4.
The following events occurred after the reporting date (assume all amounts are significant to the
entity):
(a) Notification on 18 February 20X4 that a customer owing £100,000 as at 31 December 20X3
has gone into liquidation. The financial statements already include a specific provision of
£20,000 for this customer and the entity does not make general provisions.
(b) A rights issue on 6 April 20X4 to raise £1,500,000 for an acquisition.
(c) Confirmation on 28 May 20X4 from the entity's insurer that they will pay £500,000 for
inventories that were destroyed in a fire on 24 December 20X3. The entity had claimed
£650,000 and included this as a receivable in the financial statements.
Requirement
How should the entity treat these events in its financial statements?
Interactive question 3: Dividends proposed and declared

The recent financial calendar of an entity with a 31 December year end has included the
following:
Authorised by directors Approved in annual
for issue general meeting
Financial statements for 20X2 28 February 20X3 3 May 20X3
Financial statements for 20X3 28 February 20X4 4 May 20X4
Dividends on ordinary Proposed by Declared by Approved in annual general

shares directors directors meeting
20X2 final 28 Feb 20X3 no yes
20X3 interim 31 Aug 20X3 yes no
20X3 final 28 Feb 20X4 no yes
Requirement
How will the dividends be dealt with in the entity's financial statements?
2 IAS 37, Provisions, Contingent Liabilities and Contingent

Assets
Section overview
The following is a summary of the material covered in earlier studies.

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2.1 Overview of earlier studies
Definition
Provision: A liability where there is uncertainty over its timing or the amount at which it will be
settled.
2.1.1 Recognition
 A provision should be recognised when:
– an entity has a present obligation (legal or constructive) as a result of a past event;
– it is probable that there will be an outflow of resources in the form of cash or other
assets; and
– a reliable estimate can be made of the amount.
 A provision should not be recognised in respect of future operating losses since there is no
present obligation arising from a past event.
2.1.2 Onerous contracts
 If future benefits under a contract are expected to be less than the unavoidable costs under
it, the contract is described as onerous. The excess unavoidable costs should be provided
for at the time a contract becomes onerous.
C
2.1.3 Restructuring costs H
A
 A constructive obligation, requiring a provision, only arises in respect of restructuring costs P
where the following criteria are met: T
E
– A detailed formal plan has been made, identifying the areas of the business and R
number of employees affected with an estimate of likely costs and timescales
13
– An announcement has been made to those who will be affected by the restructuring
2.1.4 Contingent liability
 A contingent liability arises where a past event may lead to an entity having a liability in the
future but the financial impact of the event will only be confirmed by the outcome of some
future event not wholly within the entity's control.
 A contingent liability should be disclosed in the financial statements unless the possible
outflow of resources is thought to be remote.
2.1.5 Contingent asset
 A contingent asset is a potential asset that arises from past events but whose existence can
only be confirmed by the outcome of future events not wholly within an entity's control.
 A contingent asset should be disclosed in the financial statements only when the expected
inflow of economic benefits is probable.
2.1.6 Reimbursement
 An entity may be entitled to reimbursement from a third party for all or part of the
expenditure required to settle a provision. In these circumstances, an entity generally
retains the contractual obligation to settle the expenditure. A provision and reimbursement
are therefore recognised separately in the statement of financial position. A reimbursement
should be recognised only when it is virtually certain that an amount will be received.
2.1.7 Recognition and disclosure
 A full reconciliation of movements in provisions should be presented in the financial
statements. Detailed narrative explanations should also be provided in relation to

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provisions, contingent liabilities and contingent assets. The narrative should include an
estimate of the financial amount in relation to contingent liabilities and assets as well as
indications of uncertainties.
 The required disclosures have already been covered at Professional Level. In particular, in
relation to discounting, any increase in the value of the discounted amount arising from the
passage of time or the effect of any change in the discount rate need to be disclosed.
2.1.8 Disclosure let out
 IAS 37 permits reporting entities to avoid disclosure requirements relating to provisions,
contingent liabilities and contingent assets if they would be expected to be seriously
prejudicial to the position of the entity in dispute with other parties. However, this should
only be employed in extremely rare cases. Details of the general nature of the
provision/contingency must still be provided, together with an explanation of why it has not
been disclosed.
2.1.9 Discounting to present value
 Where the time value of money is material, the amount of provision should be the present
value of the expenditures required to settle the obligation. The main types of provision
where the impact of discounting may be significant are those relating to decommissioning
and other environmental restoration liabilities. For most other provisions, no discounting
will be required, as the cash flows are not sufficiently far into the future.
 The discount rate to be used should reflect current market assessments of the time value of
money and the risks specific to the liability (ie, it would be a risk-adjusted rate). In practice it
may be more appropriate to use a risk-free rate and adjust the cash flows for risk. For
further guidance on the risk-free rate you may refer to your Strategic Business Management
Study Manual. Whichever method is adopted, it is important not to double count risk.
2.1.10 Unwinding the discount
 Where discounting is used, the carrying amount of the provision increases each period to
reflect the passage of time and this is recognised as a finance cost in profit or loss.
Interactive question 4: Constructive obligation

On 25 September 20X7, further to a decision made earlier in the year by the board of directors,
Industrial plc publicly announced a decision to reduce the level of harmful emissions from its
manufacturing plants.
The directors had reached their decision to proceed with the project after appraising the
investment using discounted cash flow techniques and an annual discount rate of 8%.
The directors estimated that the future cash payments required to meet their stated objective
would be as follows:
 £20 million on 30 September 20X8
 £25 million on 30 September 20X9
 £30 million on 30 September 20Y0
No contracts were entered into until after the start of the new accounting year on
1 October 20X7; however, the entity has a reputation of fulfilling its financial commitments after
it has publicly announced them. Industrial included a provision for the expected costs of its
proposal in its financial statements for the year ended 30 September 20X7. The actual
expenditure in September 20X8 was £20 million as expected.
The average remaining useful lives of the factories on 30 September 20X7 (the reporting date)
was 30 years and depreciation is computed on a straight-line basis and charged to cost of sales.

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Requirements
(a) Compute the appropriate provision in the statements of financial position in respect of the
proposed expenditure at 30 September 20X7 and 30 September 20X8, and explain why
the directors decided to recognise the provision.
(b) Compute the two components of the charge to profit in respect of the proposal for the year
ended 30 September 20X8. You should explain how each component arises and identify
where in the statement of profit or loss and other comprehensive income each component
is reported.
Interactive question 5: Unwinding the discount

A company has a present obligation at 31 December 20X0, which it expects to settle in four
years' time for £200,000. It calculates that the present value of the obligation is £136,603,
discounted at 10%.
The unwinding of the discount in 20X1, 20X2, 20X3 and 20X4 is shown in the table below.
Provision
Cr
Cr Unwinding Cr
Balance discount Balance
b/f @ 10% c/f C
1 Jan 31 Dec 31 Dec H
A
£ £ £ P
20X1 136,603 13,660 150,263 T
20X2 150,263 15,026 165,289 E
20X3 165,289 16,529 181,818 R
20X4 181,818 18,182 200,000 13
Requirement
What are the accounting entries for the above for 20X1?
Interactive question 6: Restructuring

(a) An entity has a 31 December year end. The directors approved a major restructuring
programme on 1 December 20X5 and announced the details on the entity's intranet and to
the media on 2 December 20X5. The programme involves two stages.
Stage 1 Closure of three production lines during 20X6, the redundancy of 3,000
employees on 31 March 20X6, and the transfer during 20X6 of 500 employees to
continuing parts of the business. All associated costs would be settled during
20X6.
Stage 2 Probable closure of four more production lines during 20X7, with probable
redundancies of 3,500 employees during 20X7. Other staff will be transferred to
continuing businesses. All associated costs would be settled during 20X7.
Assume that the details of Stage 2 were formally confirmed on 1 November 20X6.
(b) The entity had some years ago signed a 'take or pay' contract with a supplier, in order to
ensure the reliable supply each year of 100,000 tonnes of critical raw materials to each of
the seven production lines affected by the restructuring programme. Under the contract,
the entity must pay for the 700,000 tonnes each year, even if it decides not to take delivery.
This contract falls due for renewal on 1 January 20X8.

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Requirement
How should these matters be recognised in the statement of profit or loss and other
comprehensive income?
Interactive question 7: Obligation to dismantle

A company is awarded a contract to build and operate a nuclear power station on
1 January 20X1. The power station comes into operation on 31 December 20X3 and the
operating licence is for 30 years from that date.
The construction cost of the power station was £450 million. Part of the agreement for the
contract was that, in addition to building and operating the power station, the company is
obliged to dismantle it at the end of its 30-year life and make the site safe for alternative use. At
31 December 20X3, the estimated cost of the obligation was £50 million.
An appropriate discount rate reflecting market assessments of the time value of money and risks
specific to the power station is 8%.
Requirement
Explain the treatment of the cost of the power station and obligation to dismantle it as at
31 December 20X3 and for the year ended 31 December 20X4.
Work to the nearest £0.1 million.
3 Audit focus
Section overview
Auditors will carry out specific procedures on provisions and contingencies.
3.1 Auditing provisions and contingencies

Much of the audit work here is focused on ensuring that the recognition and treatment of these
items is in accordance with IAS 37, which we looked at in section 2 of this chapter.
The audit procedures that should be carried out on provisions and contingent assets and
liabilities are as follows.
 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; and
– discussing with the directors. Have they created a valid expectation in other parties
that they will discharge the obligation?

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 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 end of the reporting period
in respect of the item;
– reviewing correspondences with solicitors, banks, customers, insurance company and
suppliers both pre and post year end;
– sending a letter to the solicitor to obtain their views (where relevant);
– discussing the position of similar past provisions with the directors. Were these
provisions eventually settled?; and
– 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 this
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.
C
3.2 Procedures regarding litigation and claims H
A
3.2.1 Introduction P
T
ISA (UK) 501, Audit Evidence – Specific Considerations for Selected Items provides guidance on E
procedures regarding litigation and claims. R
A summary of the procedures regarding litigation and claims is provided below. 13
3.2.2 Litigation and claims

Litigation and claims involving the entity may have a material effect on the financial statements,
and so will require adjustment to or disclosure in those financial statements.
The auditor shall design and perform procedures in order to identify any litigation and claims
involving the entity which may give rise to a risk of material misstatement. (ISA 501.9)
Such procedures would include the following:
 Make appropriate inquiries of management and those charged with governance 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.
When litigation or claims have been identified or when the auditor believes they may exist, the
auditor must seek direct communication with the entity's lawyers. (ISA 501.10)
This will help to obtain sufficient, appropriate audit evidence as to whether potential material
litigation and claims are known and management's estimates of the financial implications,
including costs, are reliable.

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Form of the letter of inquiry

The letter, which should be prepared by management and sent by the auditor, should request
the lawyer to communicate directly with the auditor.
If it is thought unlikely that the lawyer will respond to a general inquiry, the letter should specify
the following.
 A list of litigation and claims
 Management's assessment of the outcome of the litigation or claim and its estimate of the
financial implications, including costs involved
 A request that the lawyer confirm the reasonableness of management's assessments and
provide the auditor with further information if the list is considered by the lawyer to be
incomplete or incorrect
The auditors must consider these matters up to the date of their report and so a further,
updating letter may be necessary.
A meeting between the auditors and the lawyer may be required, for example where a complex
matter arises, or where there is a disagreement between management and the lawyer. Such
meetings should take place only with the permission of management, and preferably with a
management representative present.
If management refuses to give the auditor permission to communicate with the entity's lawyers
or if the lawyer refuses to respond as required and the auditor can find no alternative sufficient
evidence, this would mean that the auditor is unable to obtain sufficient, appropriate evidence
and should ordinarily lead to a qualified opinion or a disclaimer of opinion. (ISA 501.11)
Interactive question 8: Contingencies

In February 20X7 the directors of Newthorpe Engineering suspended the managing director. At
a disciplinary hearing held by the company on 17 March 20X7 the managing director was
dismissed for gross misconduct, and it was decided the managing director's salary should stop
from that date and no redundancy or compensation payments should be made.
The managing director has claimed unfair dismissal and is taking legal action against the
company to obtain compensation for loss of his employment. The managing director says he
has a service contract with the company which would entitle him to two years' salary at the date
of dismissal.
The financial statements for the year ended 30 April 20X7 record the resignation of the director.
However, they do not mention his dismissal and no provision for any damages has been
included in the financial statements.
Requirements
(a) State how contingent liabilities should be disclosed in financial statements according to
IAS 37, Provisions, Contingent Liabilities and Contingent Assets.
(b) Describe the audit procedures you will carry out to determine whether the company will
have to pay damages to the director for unfair dismissal, and the amount of damages and
costs which should be included in the financial statements.
Note: Assume the amounts you are auditing are material.
3.3 Procedures regarding events after the reporting period

ISA (UK) 560, Subsequent Events sets out the audit requirements in relation to events occurring
after the reporting period. Please refer to Chapter 8 for a more detailed discussion.

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Summary
Events after the reporting period,
provisions and contingencies
IAS 10, IAS 37,

Events after the Provisions and
Reporting Period Contingencies
Did the event

occur between Is there a present No No
Possible
the reporting date obligation as a result
obligation?
and the date of an obligating event?
on which the Yes Yes
No Yes
were authorised Probable outflow? Remote?
for issue?
Yes No
Yes No No (rare) C
Reliable estimate? H
A
Does the
Yes P
event relate Outside T
to a condition the Provide Disclose contingent liability Do nothing E
that existed scope R
as at the of IAS 10
reporting date? 13
Yes No
This is Does the

an adjusting event mean that
event and management
financial statements will have to
should be liquidate the
adjusted as entity or cease
appropriate trading?
Yes No
Going concern This is a

basis not appropriate. non-adjusting
Disclosure event and the
of the change of basis numbers in the
to be made in financial statements
accordance with should not be
IAS 1, Presentation of changed. However,
Financial Statements disclosure should
generally be provided

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Self-test
IAS 10, Events After the Reporting Period
1 ABC International
ABC International Inc is a company that deals extensively with overseas entities and its
financial statements include a substantial number of foreign currency transactions. The
entity also holds a portfolio of investment properties.
Requirement
Discuss the treatment of the following events after the reporting date.
(a) Between the reporting date of 31 December 20X6 and the authorisation date of
20 March 20X7, there were significant fluctuations in foreign exchange rates that were
outside those normally expected.
(b) The entity obtained independent valuations of its investment properties at the
reporting date based on current prices for similar properties. On 15 March 20X7,
market conditions which included an unexpected rise in interest rates and the
expectation of further rises resulted in a fall in the market value of the investment
properties.
(c) A competitor introduced an improved product on 1 February 20X7 that caused a
significant price reduction in the entity's own products.
2 Saimaa
The Saimaa Company operates in the banking industry. It is attempting to sell one of its
major administrative office buildings and relocate its employees.
Saimaa has found a potential buyer, The Nipigon Company, which operates a chain of retail
stores. Nipigon would like to convert the building into a new retail store but would require
planning permission for this change of use. Nipigon may, however, still consider purchasing
the building and using it for its own administrative offices if planning permission is declined.
It is estimated that there is approximately a 50% probability of planning permission being
granted.
A contract for sale of the building is to be drawn up in November 20X7 and two alternatives
are available:
Contract 1 This sale contract would be made conditional on planning permission being
granted. Thus the contract would be void if planning permission is not
granted but it would otherwise be binding.
Contract 2 This contract would be unconditional and binding, except that the price
would vary according to whether or not planning permission is granted.
The financial statements of Saimaa for the year to 31 December 20X7 are authorised for
issue on 28 March 20X8. A decision on planning permission will be made in February 20X8.
Requirement
With respect to the financial statements of Saimaa for the year to 31 December 20X7, and
according to IAS 10, Events After the Reporting Period, indicate whether the granting of
planning permission on each of the contracts is an adjusting event.
3 Quokka
The Quokka Company manufactures balers for agricultural use. The selling price per baler,
net of selling expenses, at 31 December 20X7 is £38,000. Due to increasing competition,
however, Quokka decides to reduce the selling price by £5,000 on 3 January 20X8.

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On 4 January 20X8 a health and safety report was delivered to Quokka by the Government,
showing that some of its balers were toppling over on moderate gradients. £9,000 per
baler would need to be incurred by Quokka to correct the fault. No further sales could be
made without the correction. Quokka had been unaware of any problem or health and
safety investigation until the report was delivered.
The financial statements of Quokka for the year to 31 December 20X7 are to be authorised
for issue on 23 March 20X8.
The cost of manufacture for each baler was £36,000 and there were 80 balers in inventory at
31 December 20X7.
Requirement
After adjustment (if any) for the above events, what should be the carrying amount of the
inventory in the financial statements of Quokka at 31 December 20X7, in accordance with
IAS 10, Events After the Reporting Period and IAS 2, Inventories?
4 Labeatis
The financial statements of the Labeatis Company for the year to 31 December 20X7 were
approved and issued with the authority of the board of directors on 6 March 20X8. However,
the financial statements were not presented to the shareholders' meeting until
27 March 20X8.
The following events took place:
Event 1 On 18 February 20X8 the Government announced a retrospective increase in the C
tax rate applicable to Labeatis's year ending 31 December 20X7. H
A
Event 2 On 19 March 20X8 a fraud was discovered which had had a material effect on the P
financial statements of Labeatis for the year ending 31 December 20X7. T
E
Requirement R
State which event (if any) is an adjusting event according to IAS 10, Events After the 13
Reporting Period.
5 Scioto
The Scioto Company's financial statements for the year ended 30 April 20X7 were
approved by its finance director on 7 July 20X7 and a public announcement of its profits for
the year was made on 10 July 20X7.
The board of directors authorised the financial statements for issue on 15 July 20X7 and
they were approved by the shareholders on 20 July 20X7.
Requirement
Under IAS 10, Events After the Reporting Period, after which date should consideration no
longer be given as to whether the financial statements to 30 April 20X7 need to reflect
adjusting and non-adjusting events?
IAS 37, Provisions, Contingent Liabilities and Contingent Assets
6 Fushia
The Fushia Company sells electrical goods covered by a one-year warranty for any defects.
Of sales of £60 million for the year, the company estimates that 3% will have major defects,
6% will have minor defects and 91% will have no defects.
The cost of repairs would be £5 million if all the products sold had major defects and
£3 million if all had minor defects.
Requirement
What amount should Fushia provide as a warranty provision?

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7 Wilcox
The Wilcox Company has been lead mining in Valovia for many years. To clean the lead,
Wilcox uses toxic chemicals which are then deposited back into the mines. Historically there
has not been any legislation requiring environmental damage to be cleaned up. The
company has a policy of only observing its environmental responsibilities when legally
obliged.
In December 20X7, the Government of Valovia introduced legislation on a retrospective
basis, forcing mining companies to rectify environmental damage that they have caused.
Wilcox estimates that the damage already caused will cost £27 million to rectify, but the
work would not be paid for until December 20X9. It also estimates that damage caused by
its operations each year for the remaining four years of the mines' lifespan will be
£3 million, payable at the end of the relevant year.
17% is the pre-tax rate that reflects the time value of money and the risk specific to these
liabilities.
Requirement
To the nearest £1 million, what provision should be shown in the statement of financial
position of Wilcox at 31 December 20X7 under IAS 37, Provisions, Contingent Liabilities and
Contingent Assets?
8 Yau Enterprise
The Yau Enterprise Company signed a non-cancellable lease for a property, Hyde Court, on
1 January 20X4. The lease was for a period of 10 years, at an annual rental of £480,000
payable in arrears.
On 31 December 20X7, Yau Enterprise vacated Hyde Court to move to larger premises.
Yau Enterprise has the choice of signing a contract to sub-lease Hyde Court at an annual
rental of £120,000 for the remaining six years of the lease, payable in arrears, or
immediately to pay compensation of £2.2 million to Hyde Court's landlord.
5% is the pre-tax rate that reflects the time value of money and the risk specific to these
liabilities. The cumulative present value of £1 for six years at an interest rate of 5% is £5.076.
Requirement
What provision should appear in the statement of financial position of Yau Enterprise at
31 December 20X7 under IAS 37, Provisions, Contingent Liabilities and Contingent Assets?
9 Noble
The Noble Company operates a fleet of commercial aircraft. On 1 April 20X7, a new law was
introduced requiring all operators to use aircraft fitted with fuel-efficient engines only.
At 31 December 20X7 Noble had not fitted any fuel-efficient engines and the total cost of
fitting them throughout the fleet was estimated at £4.2 million.
Under the terms of the legislation, the company is liable for a fine of £1 million for non-
compliance with legislation for any calendar year, or part of a year, in which the law has
been broken. The Government rigorously prosecutes all violations of the new law.
The effect of the time value of money is immaterial.
Requirement
State the provision required in Noble's financial statements for the year ended
31 December 20X7 under IAS 37, Provisions, Contingent Liabilities and Contingent Assets.

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10 Noname
The Noname Company decided to carry out a fundamental restructuring of its papermaking
division which operates in Hyberia. The effect was that most activities carried out in this
location would cease with a number of employees being made redundant, whereas other
activities and employees would relocate to Sidonia where there was unused capacity.
Negotiations with landlords and employee representatives were concluded on
30 December 20X7 and a formal announcement was made to all employees on
31 December 20X7.
The restructuring budget approved by the board of directors in November 20X7 included
the following amounts:
£
Payments to employees:
Termination payments to those taking voluntary redundancy 90,000
Termination payments to those being made compulsorily redundant 180,000
One-off payments to employees agreeing to move to Sidonia 37,000
Employment cost for closing down activities in Hyberia in
preparation for the move to Sidonia 50,000
Lease costs:
5 years remaining of a lease which can immediately be sublet for
£70,000 per annum 45,000 per annum
7 years remaining of a lease which can immediately be sublet for
£35,000 per annum 90,000 per annum
Cost of moving plant and equipment from Hyberia to Sidonia 26,000 C
Impairment losses on non-current assets under IAS 36, Impairment H
of Assets 110,000 A
P
Trading transactions in Hyberia up to date of closure, other than T
those itemised above: E
Revenue 850,000 R
Expenses 1,150,000
13
None of these amounts has yet been recognised in Noname's financial statements. The
effect of the time value of money is immaterial.
Requirement
Determine the amounts to be included in the financial statements for the Noname
Company for the year ending 31 December 20X7 according to IAS 37, Provisions,
Contingent Liabilities and Contingent Assets.

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Technical reference
1 Authorisation
 Process of authorisation of financial statements IAS 10.4
 Authorisation date is the date on which financial statements are IAS 10.5, 10.6
authorised for issue to shareholders
 The relevant cut-off date for consideration of events after the reporting IAS 10.7
period is the authorisation date
2 Adjusting events
 Amounts recognised in financial statements should be adjusted to reflect IAS 10.8, 10.9
adjusting events after the reporting date
 Examples of adjusting events include
– Outcome of court case that confirms obligation at reporting date
– Receipt of information on recoverability or value of assets
– Finalisation of profit sharing or bonus payments
– Discovery of fraud or errors
3 Non-adjusting events
 An entity should not adjust amounts recognised in financial statements for IAS 10.10
non-adjusting events after the reporting period
 An example is the subsequent decline of market value of investments
 Non-adjusting events may need to be disclosed IAS 10.10
 Dividends proposed or declared on equity instruments after the reporting IAS 10.12
date cannot be recognised as a liability at the reporting date
 Dividends proposed or declared after the reporting date should be IAS 10.13
disclosed
4 Going concern basis

 Financial statements are not to be prepared on going concern basis if IAS 10.14
management intends to liquidate entity or cease trading
 If going concern assumption no longer appropriate, disclosures required IAS 10.16
in accordance with IAS 1
5 Disclosure
 Date of authorisation to be disclosed IAS 10.17
 Disclosures relating to information after the reporting date to be updated IAS 10.19
in the light of new information
 For material non-adjusting events after the reporting period an entity IAS 10.21
shall disclose
– Nature of event
– Estimate of financial effect

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 Scope IAS 37.1
 Definitions IAS 37.10
 Recognition of provisions IAS 37.14–15
 Contingent liabilities IAS 37.27
 Contingent assets IAS 37.31
 Measurement best estimate IAS 37.36
 Risks and uncertainties IAS 37.42
 Present value IAS 37.45–47
 Future events IAS 37.48
 Onerous contracts IAS 37.66
 Restructuring IAS 37.70–72
IAS 37.78–80
ISA 501
 Audit procedures in respect of litigation and claims ISA 501.9–12
C
H
A
P
T
E
R
13

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The £35,000 profit share payment and the £31,000 bad debt expense are adjusting events and
should be recognised in the financial statements.
See IAS 10.9, 10.12 and 10.22.

(a) This is an adjusting event, as it provides more up to date information about a provision that
was recognised at the reporting date. The £100,000 receivable should be written off.
(b) This is a disclosable non-adjusting event. The rights issue occurred after the reporting date,
but is considered to be of significant importance and should be disclosed in the financial
statements.
(c) This is an adjusting event since it is in relation to an asset that was recognised at the
reporting date. The receivable should be reduced to £500,000.

These dividends will be dealt with in the entity's financial statements for 20X2, 20X3 and 20X4 as
follows:
Financial statements for: 20X2 20X3 20X4
20X2 final dividend Disclosed in the Charged to –
notes statement of
changes in equity
20X3 interim dividend – Charged to –
statement of
changes in equity
20X3 final dividend – Disclosed in the Charged to
notes statement of
changes in equity

(a) Provision at 30 September 20X7
£'000
Expenditure on:
30 September 20X8 20,000  0.926 18,520
30 September 20X9 25,000  0.857 21,425
30 September 20Y0 30,000  0.794 23,820
63,765
Provision at 30 September 20X8

£'000
Expenditure on:
30 September 20X9 25,000  0.926 23,150
30 September 20Y0 30,000  0.857 25,710
48,860

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A provision should be recognised where:

(1) there is a present obligation as a result of a past event;
(2) there is a probable outflow of economic benefits; and
(3) the amount can be measured reliably.
(2) and (3) are clearly met, as Industrial will incur expenditure and the detailed estimates of
the amounts have been prepared.
By announcing the plan to reduce emissions publicly, Industrial has created a constructive
obligation to carry out the project. Therefore, although there is no legal obligation,
Industrial should record a provision for the estimated (and discounted) costs of the project.
(b) The charge to profit or loss for the year ended 30 September 20X8 consists of:
(1) Depreciation (£63,765,000  30) £2,125,500
This is reported in cost of sales.

The provision of £63,765,000 also represents an asset, as it gives rise to future
economic benefits (it enhances the performance of the factories). This is capitalised
and depreciated over 30 years (the average useful life of the factories).
(2) Unwinding of the discount (see working) £5,095,000
This is reported as a finance cost.

WORKING
£'000 C
Provision at 1 October 20X7 63,765 H
A
Expenditure on 30 September 20X8 (20,000) P
Unwinding of discount (balancing figure) 5,095 T
Provision at 30 September 20X8 48,860 E
R
Answer to Interactive question 5 13
The accounting entry to record the unwinding of the discount in 20X1 will be:
DEBIT Finance costs £13,660
CREDIT Provisions £13,660

(a) Detailed information was made available about who would be affected by Stage 1 and
when the various steps in the first stage of the closure programme would take place.
The announcement about Stage 2 was more of an overview. It was not until
1 November 20X6 that information was announced in respect of Stage 2 in as much detail
as that provided in December 20X5 about Stage 1. There is a constructive obligation in
respect of Stage 1 on 2 December 20X5; no such obligation in respect of Stage 2 is made
until 1 November 20X6. Although the announcement is made as a single restructuring
programme, there will be two entirely separate restructuring provisions.

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The costs of this major programme will be recognised in profit or loss for the years ending
31 December 20X5–20X7 as follows:
Reason Stage 1 Stage 2
Termination payments to those taking Restructuring 20X5 20X6
voluntary redundancy provision
Termination payments to those being made Restructuring 20X5 20X6
compulsorily redundant provision
Employment costs during closing down Restructuring 20X5 20X6
activities and selling off inventory provision
One-off payments to employees agreeing to Continuing 20X6 20X7
move to continuing parts of the business activities
Cost of moving plant and equipment to Continuing 20X6 20X7
continuing parts of the business activities
Cost of moving saleable inventory to Continuing 20X6 20X7
continuing parts of the business activities
Impairment losses on non-current assets See Note 20X5 & 20X5 to
20X6 20X7
Losses on disposal of non-current assets Year when loss 20X6 20X7
on disposal
incurred
Revenue less expenses up to date of closure, Year when 20X6 20X7
other than itemised expenses operating
losses incurred
Note: The announcement of a restructuring programme is an indicator of impairment under

IAS 36, so an impairment test should be carried out at the time of the first announcement
for all relevant non-current assets. Despite Stage 2 only being 'probable', its assets should
still be tested for impairment in 20X5.
(b) A provision should be recognised in respect of all contracts when they become onerous,
regardless of whether this is associated with a restructuring programme. If the entity's
production lines were loss-making before the restructuring announcement, then this
contract may already have been classified as onerous.
If it had not already been identified as being onerous then, at a minimum, a provision
should be made for the 300,000 tonnes per annum for the three Stage 1 production lines,
for the period from when they cannot take any further supplies through to the end of the
contract on 31 December 20X7.
A provision should be made for the remaining 400,000 tonnes per annum for the four Stage
2 production lines for the period from when they cannot take any further supplies through
to the end of the contract on 31 December 20X7.
Note: This answer includes a comprehensive list of issues to be considered under
restructuring programmes, included for learning purposes.

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At 31 December 20X3
The discounted amount of the provision would be included in the initial measurement of the
cost of the power station as at 31 December 20X3:
£m
Cost 450.0
Provision (£50m  1/1.0830) 5.0
455.0
Year ended 31 December 20X4

The power plant would be depreciated over its 30-year life resulting in a charge of
£455.0m/30 = £15.2m to profit or loss and a carrying amount of £455m – £15.2m = £439.8m.
The provision would begin to be compounded resulting in an interest charge of
£5.0  8% = £0.4m and an outstanding provision of £5.0 + £0.4 = £5.4m in the statement of
financial position.
Any change in the expected present value of the provision would be made as an adjustment to
the provision and to the asset value (affecting future depreciation charges).

(a) IAS 37 states that a provision should be recognised in the accounts if:
C
 an entity has a present obligation (legal or constructive) as a result of a past event; H
A
 a transfer of economic benefits will probably be required to settle the obligation; and P
 a reliable estimate can be made of the amount of the obligation. T
E
Under IAS 37 contingent liabilities should not be recognised. However, they should be R
disclosed unless the prospect of settlement is remote. The entity should disclose:
13
 the nature of the liability;
 an estimate of its financial effect;
 the uncertainties relating to any possible payments; and
 the likelihood of any reimbursement.
(b) The following procedures should be carried out to determine whether the company will
have to pay damages and the amount to be included in the financial statements.
 Review the director's service contract and ascertain the maximum amount to which he
would be entitled and the provisions in the service contract that would prevent him
making a claim, in particular those relating to grounds for justifiable dismissal.
 Review the results of the disciplinary hearing. Consider whether the company has
acted in accordance with employment legislation and its internal rules, the evidence
presented by the company and the defence made by the director.
 Review correspondence relating to the case and determine whether the company has
acknowledged any liability to the director that would mean that an amount for
compensation should be accrued in accordance with IAS 37.
 Review correspondence with the company's solicitors and obtain legal advice, either
from the company's solicitors or another firm, about the likelihood of the claim
succeeding.
 Review correspondence and contact the company's solicitors about the likely costs of
the case.

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 Consider the likelihood of costs and compensation being reimbursed by reviewing

the company's insurance arrangements and contacting the insurance company.
 Consider the amounts that should be accrued and the disclosures that should be made
in the accounts. Legal costs should be accrued, but compensation payments should
only be accrued if the company has admitted liability or legal advice indicates that the
company's chances of success are very poor. However, the claim should be disclosed
unless legal advice indicates that the director's chance of success appears to be
remote.

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1 ABC International
(a) Details of the abnormal fluctuations in exchange rates should be disclosed as a
non-adjusting event after the reporting period.
(b) The decline in the value of investment properties is a non-adjusting event, as it does
not reflect the state of the market at the reporting date. The valuation should reflect the
state of the market at the reporting date and should not be affected by hindsight or
events at a later date.
(c) The improved product issued by the competitor is likely to have been developed over
a period of time. The value of inventories should be reviewed and adjusted to their net
realisable value where appropriate. Non-current assets may need to be reviewed for
possible impairment. This is an adjusting event, as it reflects increased competitive
conditions which existed at the reporting date even if the entity was not fully aware of
them.
2 Saimaa
Contract 1 is a non-adjusting event. Contract 2 is an adjusting event.
Under IAS 10.3, events after the reporting period are those which occur after the reporting C
period but before the financial statements are authorised for issue. The planning H
A
permission decision is such an event, because it is to be made before the financial P
statements are to be authorised for issue on 28 March 20X8. Adjusting events are those T
providing evidence of conditions that existed at the reporting date and non-adjusting E
R
events are those indicative of conditions that arose after that date.
13
Under Contract 1, the uncertainty surrounding the contract at the reporting date would be
such that no sale could be recognised as at that date. So there is no transaction for which
the planning permission decision could provide evidence and there would not be an
adjusting event.
Under Contract 2, there would be an unconditional sale recognised at the reporting date,
with only the consideration needing to be confirmed after the reporting date. According to
IAS 10.9(c) the planning permission decision would provide additional evidence of the
proceeds and would be an adjusting event.
3 Quokka
£1,920,000
IAS 2.9 states that inventories should be stated at the lower of cost and NRV, and under
IAS 10.9(b)(ii) the sale of inventories after the reporting date may give evidence of NRV at
the reporting date.
The 3 January price reduction is a response to competitive conditions which would have
existed at the reporting date. So even though it comes after the year end, it is an adjusting
event. Similarly, the safety report received after the year end relates to conditions at the
year end (as the balers in inventories were defective at this date) and is an adjusting event.
The carrying amount is 80 balers at the lower of cost (£36,000) and NRV £(38,000 – 5,000 –
9,000).
So 80  £24,000 = £1,920,000

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4 Labeatis
Event 1 is a non-adjusting event. Event 2 happened after the statements were authorised,
so does not constitute an event after the reporting period.
Applying IAS 10.3, events after the reporting period are those which occur after the
31 December 20X7 reporting date but before the financial statements are authorised for
issue on 6 March 20X8.
Event 1 occurs before 6 March 20X8 but is a non-adjusting event, because in accordance
with IAS 10.22(h) this change was not enacted before the reporting date. This is the case
even though the announcement has a retrospective effect on the financial statements still
being prepared.
Event 2, the discovery of fraud, would have been an adjusting event per IAS 10.9(e), had it
occurred before the date of authorisation for issue. As it was not discovered until
19 March 20X8, it is not even an event after the reporting period, let alone an adjusting
event.
5 Scioto
15 July is the correct answer.
IAS 10.7 states that the authorisation date is the date on which the financial statements are
authorised for issue, even if this is after a public announcement of profit. IAS 10.5 confirms
that it is not the date on which the shareholders approve the financial statements.
6 Fushia
£330,000
Provision must be made for estimated future claims by customers for goods already sold.
The expected value (£5m  3%) + (£3m  6%) is the best estimate of this amount
(IAS 37.39).
7 Wilcox
£20 million
At the year end a legal obligation exists – through the retrospective legislation – as a result
of a past event (the environmental damage caused in the past) (IAS 37.14). The company
should therefore create a provision for the damage that has already been caused.
It should not now set up a provision for the future damage, because that will be caused by a
future event (the company could close down the mines and therefore not cause further
damage to the environment).
Because the effect of discounting at 17% over two years is material, the cost should be
discounted to present value (IAS 37.45).
2
So, the provision is £27m/1.17 = £20 million (to the nearest £m)
8 Yau Enterprise
£1,827,360
The signing of the lease is a past event that creates a legal obligation to pay for the
property under the terms of the contract and is an obligating event (IAS 37.14). The
company should therefore create a provision for the onerous contract that arises on leaving
the premises (IAS 37.66). This is calculated as the excess of unavoidable costs of the
contract over the economic benefits to be received from it. The unavoidable cost is the
lower of the cost of fulfilling the contract and the penalty that arises from failing to fulfil it
(IAS 37.68).

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The effect of the time value of money over six years is material, so the provision should be
discounted to its present value (IAS 37.45).
The present value of the sub-lease arrangement is £1,827,360 ((£480,000 – £120,000) 
5.076). As this is less than the £2.2 million compensation payable, it should be used to
measure the provision.
9 Noble
No provision is required for the fitting of the engines. This is because the present obligation
as a result of the past event required by IAS 37.14 does not exist. The company can choose
not to fit the engines and then not to operate the aircraft.
However, a provision of £1.0 million is required in relation to the fines, because at the
reporting date there is a present obligation in respect of a past event (the non-compliance
with legislation).
10 Noname
The total amount recognised in profit or loss is the £385,000 lease provision for the onerous
lease + the £270,000 restructuring provision + the £110,000 impairment losses = £765,000.
The five-year lease is not an onerous contract in terms of IAS 37.10 because the premises
can be sublet at profit. The seven-year lease is an onerous contract and under IAS 37.66 the
provision should be measured at (£90,000 – 35,000)  7 years = £385,000.
Under IAS 37.80 all the payments to employees should be included in the restructuring
C
provision, with the exception of the employment costs of £50,000 in preparation for the
H
move to Sidonia and £37,000 payable to those moving to Sidonia – this relates to the A
ongoing activities of the business, so is disallowed by IAS 37.80(b). For the same reason the P
costs of moving plant and equipment is disallowed. Impairment losses reduce the carrying T
E
amount of the relevant assets rather than increasing the restructuring provision and revenue R
less expenses are trading losses which are disallowed by IAS 37.63. So provision, excluding
the onerous lease, is £90,000 + 180,000 = £270,000. 13

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CHAPTER 14
Leases, government
grants and borrowing
costs
Introduction
TOPIC LIST
IAS 17, Leases
1 Overview of material covered in earlier studies
2 Evaluating the Substance of Transactions Involving the Legal Form of a
Lease – SIC 27 and Operating Lease Incentives – SIC 15
3 Determining Whether an Arrangement Contains a Lease – IFRIC 4
4 Current developments
Other standards
5 IAS 20, Accounting for Government Grants and Disclosure of
Government Assistance
6 IAS 23, Borrowing Costs
7 Statements of cash flows
8 Audit focus
Technical reference

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Introduction
 Determine and calculate how different bases for recognising, measuring and
classifying financial assets and financial liabilities can impact upon reported
performance and position
 Appraise and evaluate cash flow measures and disclosures in single entities and
groups
 Explain and appraise accounting standards that relate to an entity's financing
activities which include: financial instruments; leasing; cash flows; borrowing costs;
and government grants
evidence
Specific syllabus references for this chapter are: 1(e), 4(a), 4(b), 4(d), 14(c), 14(d), 14(f)

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1 Overview of material covered in earlier studies
Section overview
 IAS 17, Leases was the first standard to address the problem of substance over form.
 The correct treatment of the transaction in the financial statements of both the lessee and
the lessor is determined by the commercial substance of the lease. The legal form of any
lease is that the title to the asset remains with the lessor.
 The approach to lessor accounting is very similar to that for lessee accounting, the key
difference being the inclusion of 'unguaranteed residual value'.
1.1 Lessee accounting

Lessee accounting
Finance lease Operating lease
 A lease that transfers substantially all the  A lease other than a finance lease.
risks and rewards incidental to ownership
of an asset to the lessee. Title may or may
not eventually be transferred.
 Capitalise asset and recognise liability at  Rentals are charged to profit or loss on a
fair value of leased property or, if lower, straight-line basis over the lease term
present value of minimum lease payments. unless another systematic basis is
representative of the user's benefit.
 Add initial direct costs (incremental costs  Incentives to sign operating leases (and
directly attributable to negotiating and initial reverse premiums or rent-free
arranging a lease) to amount recognised as periods) are spread over the life of the
an asset. operating lease reducing the overall
payments on the lease charged to profit or C
H
loss (SIC 15).
A
(see also section 2) P
T
E
 Depreciate asset over the shorter of the
R
useful life and the lease term including any
secondary period (useful life if reasonable 14
certainty the lessee will obtain ownership).
 Apply finance charge so as to give a

constant rate on the outstanding liability
(using the interest rate implicit in the
lease).
 Rental payments are split between the

finance charge element and the repayment
of capital.
ICAEW 2019 Leases, government grants and borrowing costs 739

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1.2 Finance lease classification

IAS 17, Leases identifies five situations which would normally lead to a lease being classified as a
finance lease.
 The lease transfers ownership of the asset to the lessee at the end of the lease term.
 The lessee has the option to purchase the asset at a price sufficiently below fair value at the
option exercise date, that it is reasonably certain the option will be exercised.
 The lease term is for a major part of the asset's economic life even if title is not transferred.
 Present value of minimum lease payments amounts to substantially all of the asset's fair
value at inception.
 The leased asset is so specialised that it could only be used by the lessee without major
modifications being made.
Definitions
Lease term: The non-cancellable period for which the lessee has contracted to lease the asset
together with any further terms for which the lessee has the option to continue to lease the asset,
with or without further payment, when at the inception of the lease it is reasonably certain that
the lessee will exercise the option.
Minimum lease payments: The payments over the lease term that the lessee is, or can be
required, to make (excluding contingent rent, costs for services and taxes to be paid by and
reimbursed to the lessor) plus any amounts guaranteed by the lessee or by a party related to the
lessee.
1.3 Summary of disclosures

1.3.1 Leased assets
For each class of asset, the net carrying amount at the reporting date.
1.3.2 Finance lease liabilities

 Give maturity analysis:
– Not later than one year
– Later than one year and not later than five years
– Later than five years
 Reconciliation of minimum lease payments and present value:
– Within one year
– Less future finance charges
– Present value of finance lease liabilities
 Present value of finance lease liabilities:
– Within one year

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1.3.3 Operating leases

Disclose the future minimum lease payments under non-cancellable operating leases analysed
as follows.
 Operating lease payments
– Within one year
Interactive question 1: Lessee

A company leases an asset (as lessee) on 1 January 20X1. The terms of the lease are to pay:
 a non-refundable deposit of £5,800 on inception; and
 six annual instalments of £16,000 payable in arrears.
The fair value of the asset (equivalent to the present value of minimum lease payments) on
1 January 20X1 is £80,000. Its useful life to the company is five years.
As part of the lease agreement the company guaranteed the lessor that the asset could be sold
for £8,000 at the end of the lease term. It also incurred £2,000 of costs in setting up the lease
agreement.
The interest rate implicit in the lease has been calculated as 10.0%.
Requirements
(a) Prepare the relevant extracts from the financial statements (excluding notes) in respect of
the above lease for the year ended 31 December 20X1.
(b) Explain what would happen at the end of the lease if the asset could be sold by the lessor:
(1) for £10,000
(2) for only £6,000
C
H
1.4 Lessor accounting A
P
Lessor accounting T
E
Finance lease Operating lease R
14
Substance
 Risks and rewards with the lessee (or other  Risks and rewards with the lessor.
third parties).
 Recognise a receivable equal to 'net  Asset retained in the books of the lessor
investment in the lease'. This is the gross and is depreciated over its useful life.
investment (minimum lease payments plus any
unguaranteed residual value (see below)
accruing to the lessor) discounted at the
interest rate implicit in the lease.

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Lessor accounting
Finance lease Operating lease
 Initial direct costs incurred by the lessor are  Rentals are credited to profit or loss on
not added separately to the net investment, as a straight-line basis over the lease term
they are already included in the discounted unless another systematic basis is more
figures since they are included in the representative.
calculation of the interest rate implicit in the
lease (reducing the return).
 Finance income is recognised reflecting

constant periodic rate of return on the lessor's
net investment outstanding.
1.4.1 Unguaranteed residual value

The unguaranteed residual value is that portion of the residual value of the leased asset which is
not assured or is guaranteed solely by a party related to the lessor.
As we have already seen, to qualify as a finance lease the risks and rewards of ownership must
be transferred to the lessee. One reward of ownership is any residual value in the asset at the
end of the primary period. If the asset is returned to the lessor then it is he who receives this
reward of ownership, not the lessee. This might prevent the lease from being a finance lease if
this reward is significant (IAS 17 allows insubstantial ownership risks and rewards not to pass).
IAS 17 does not state at what point it should normally be presumed that a transfer of
substantially all the risks and rewards of ownership has occurred. To judge the issue it is
necessary to compare the present value of the minimum lease payments against the fair value of
the leased assets. This is an application of discounting principles to financial statements. The
discounting equation is:
Present value of Present value of Fair value of
minimum lease + unguaranteed = leased asset
payments residual amount
accruing to lessor
Note: Any guaranteed residual amount accruing to the lessor will be included in the minimum
lease payments.
You should now be able to see the scope for manipulation involving lease classification.
Whether or not a lease is classified as a finance lease can hinge on the size of the unguaranteed
residual amount due to the lessor, and that figure will only be an estimate. A lessor might be
persuaded to estimate a larger residual amount than he would otherwise have done and cause
the lease to fail the test on present value of lease payments approximating to the asset's fair
value, rather than lose the business.
Interactive question 2: Unguaranteed residual value

A company leased an asset to another company on 1 January 20X1 on the following terms.
Lease term 4 years
Inception of lease 1.1.X1
Annual instalments in advance £22,000
Residual value of asset as guaranteed by lessee £10,000
Expected residual value at end of lease £12,000
Fair value of the asset £82,966
Initial direct costs incurred by the lessor £700
Interest rate implicit in the lease 11%

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Requirements
(a) Calculate the unguaranteed residual value and the net investment in the lease as at
1 January 20X1.
(b) Prepare extracts from the financial statements of the lessor for the year ended
31 December 20X1 (excluding notes).
1.4.2 Finance income

A lessor should recognise finance income based on the pattern which reflects a constant
periodic rate of return on the net investment recognised. A systematic and rational basis for
allocation should be applied. Use of the actuarial method for determining finance costs will
generally be appropriate, as this accurately reflects the constant rate of return on the net
investment. IAS 17 does not state that the use of approximations is allowed by a lessor in the
way it is to a lessee, and therefore such approximations are not appropriate.
1.4.3 Non-current assets held for sale
An asset which is provided by a lessor under a finance lease arrangement but is classified as
held for sale in accordance with IFRS 5, Non-current Assets Held for Sale and Discontinued
Operations should be treated in accordance with IFRS 5 rather than IAS 17.
Interactive question 3: Lessor

For many years an entity has owned a freehold building which it has recognised as an
investment property under the fair value model of IAS 40. This requires that the property is
revalued to fair value at each reporting date with any gains or losses recognised in profit or loss.
At 31 December 20X4, the carrying amount of the building was £5 million.
On 1 January 20X5, the entity leased it out under a 40-year finance lease. The lease included a
clause transferring title to the lessee at the end of the lease; the lease was therefore recognised
as a single finance lease comprising both the land and building elements.
The annual rental is £400,000 payable in advance and the interest rate implicit in the lease has
been calculated as 8.3%. C
H
Requirement A
P
How should the transaction be recognised on 1 January 20X5 and in the year ending 31 T
E
December 20X5?
R
14
1.5 Manufacturer or dealer lessors

Context
 Special consideration is needed in the case of:
– manufacturers, who lease out assets they have made; and
– dealers, who acquire assets to lease to third parties.
 The cost of the leased asset to its manufacturer is its manufactured cost, while a dealer
would expect to acquire the leased asset at a substantial discount to its retail price. In
neither case will cost reflect the asset's fair value.
 Such entities generally offer assets either for outright purchase or for use under
arrangements whereby the entities themselves provide a form of financing.

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(a) Manufacturers and dealers offering finance leases should recognise separately:
(1) A normal selling profit as if from an outright sale, based on the normal selling price
adjusted for normal volume or trade discounts
(2) Finance income over the lease term
(b) The revenue to be recognised at the lease commencement should be measured as the
lower of the fair value of the asset and the present value of the minimum lease payments
computed at a market interest rate.
(1) The cost of sale to be recognised at the lease commencement should be measured as
the lower of cost of the asset, or its carrying amount if different, less the present value
of any unguaranteed residual value. This will be relevant where the dealer or
manufacturer has ownership of the asset at the end of the lease term and a residual
value can be realised.
(2) The profit or loss should be recognised in accordance with the entity's normal
accounting policy for sales transactions.
(3) A market rate of interest is applied to the minimum lease payments to ensure that
where a dealer or manufacturer quotes an artificially low rate of interest this does not
result in an artificially high profit being recognised immediately on the outright sale
component.
Interactive question 4: Dealer lessor

A motor dealer acquires vehicles of a particular model from the manufacturer for £21,000, a 20%
discount on the recommended retail price of £26,250. It offers them for sale at the
recommended retail price with 0% finance over three years, provided three annual payments of
£8,750 are made in advance. The market rate of interest is 8%.
A sale transaction made on 1 January 20X5 is recognised as a combination of an outright sale
and a finance lease. The present value of the minimum lease payments is treated as the
consideration for the outright sale and at 8% is calculated as follows:
Year Cash flow Discount factor at 8% Present value
£ £
20X5 8,750 1.000 8,750
20X6 8,750 1
= 0.926 8,102
(1.08)
1
20X7 8,750 = 0.857 7,499
(1.08)2
24,351
Requirement
How should the transaction be recognised by the dealer in the year ending 31 December 20X5?
The initial costs incurred by the dealer or manufacturer in negotiating and arranging the lease
should not be recognised as part of the initial finance receivable in the way that they are by
other types of lessor. Such costs are instead expensed at the start of the lease arrangement,
because they are 'mainly related to earning the manufacturer's or dealer's selling profit'.

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1.6 Sale and leaseback transactions

Entities sometimes enter into sale and leaseback transactions. These involve the original owner
of the asset selling it, typically to a finance house or bank, and immediately leasing it back,
thereby raising cash and retaining the use of the asset.
 The accounting for a sale and finance leaseback results in any profit being recognised over
the lease term, not immediately.
 The accounting for a sale and operating leaseback depends on the relationship between
the sale price and fair value.
1.7 Sale and leaseback as a finance lease

This transaction is essentially a financing arrangement. The seller (who is subsequently the
lessee) does not dispose of the risks and rewards of ownership (because the leaseback is
through a finance lease) and no profit should be recognised immediately on disposal.
The accounting entries are as follows:
 Derecognise the carrying amount of the asset now sold
 Recognise the sales proceeds
 Calculate the profit on sale and recognise it as deferred income
 Recognise the finance lease as asset and the associated liability in the normal way (at fair
value or the present value of the minimum lease payments, if lower)
 Recognise the profit on sale as income over the lease term
The effect is to adjust the expense in profit or loss to an amount equal to the depreciation
expense before the leaseback transaction.
Interactive question 5: Sale and leaseback as finance lease

An entity recognises its ownership of a freehold building under the IAS 16 cost model. The
annual buildings depreciation charge is £100,000, and at 31 December 20X4 the carrying
amount is £3.5 million. C
H
On 1 January 20X5, the entity sells the building to an institution for £5 million, the present value A
of the minimum lease payments, and leases it back under a 40-year finance lease. P
T
The lease includes a clause transferring title back to the entity at the end of the lease; the lease is E
recognised as a single finance lease comprising both land and building elements. The annual R
rental is £400,000 payable in advance and the interest rate implicit in the lease has been 14
calculated as 8.3%.
Requirement
How should the transaction be accounted for in the financial statements on 1 January 20X5 and
in the year ending 31 December 20X5?
Because of IAS 36's provisions in respect of impairment testing any excess of an asset's carrying
amount over recoverable amount should be recognised as an impairment loss before the sale
and finance leaseback transaction is recognised.

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1.8 Sale and leaseback as an operating lease

Some businesses arrange sales and operating leasebacks to give them the capital to build a
replacement asset while occupying the original one for a short period of time. For example, a
football club might sell its stadium, and then lease it back for a year, while using the sale
proceeds to fund the construction of a new stadium.
The substance of the transaction is that a sale has taken place both in terms of the legal transfer
of ownership and because the risks and rewards of ownership are not subsequently substantially
reacquired when the leaseback is an operating lease. There is a genuine profit or loss to be
recognised.
The rules about how this profit or loss should be recognised depend on the relationship
between the sale price and fair value.
 If the sale price is established at fair value, any profit or loss should be recognised
immediately.
 If the sale price is below fair value and future lease payments are at market levels, any profit
or loss shall be recognised immediately.
The sale price might be below fair value because the entity is desperate for cash, and so
accepts a low sale price to alleviate its liquidity problems. Under these circumstances it is
appropriate that the whole loss on disposal should be immediately recognised.
 If the sale price is below fair value and the loss is compensated for by future lease payments
at below market price, the loss shall be deferred and amortised in proportion to the lease
payments over the period for which the asset is expected to be used.
 If the sale price is above fair value, the excess over fair value shall be deferred and
amortised over the period for which the asset is expected to be used.
Considering now the relationship between carrying amount and fair value, if the fair value at the
time of a sale and leaseback transaction is less than the carrying amount of the asset, a loss
equal to the amount of the difference should be recognised immediately.
The following table summarises these rules.
Sale price at fair value
Carrying amount Carrying amount less Carrying amount

equal to fair value than fair value above fair value
Profit No profit Recognise profit N/A

immediately
Loss No loss N/A Recognise loss
immediately

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Sale price below fair value

Profit No profit Recognise profit No profit (Note 1)

immediately
Loss not Recognise loss Recognise loss Note 1
compensated immediately immediately
immediately for by
future lease rentals
below market rate
Loss compensated for Defer and amortise Defer and amortise Note 1
by future lease rentals loss loss
below market rate
Sale price above fair value

Profit Defer and amortise Defer and amortise Defer and amortise
profit (sale price less fair profit (Note 2)
value)
Recognise
immediately (fair
value less carrying
amount)
Loss No loss No loss Note 1
Notes
1 IAS 17 requires the carrying amount of an asset to be written down to fair value where it is
subject to a sale and leaseback.
C
2 Profit is the difference between fair value and sale price because the carrying amount would H
A
have been written down to fair value in accordance with IAS 17. P
T
E
2 Evaluating the Substance of Transactions Involving the R
Legal Form of a Lease – SIC 27 and Operating Lease 14
Incentives – SIC 15
Section overview
 Entities sometimes enter into a series of structured transactions that involve the legal form
of a lease. These are addressed by SIC 27.
 In negotiating a new operating lease, the lessor may provide incentives to the lessee.
These are dealt with by SIC 15.
2.1 Lease and leaseback arrangements (SIC 27)

SIC 27, Evaluating the Substance of Transactions Involving the Legal Form of a Lease relates to
the situation where an entity may enter into a series of structured transactions (an arrangement)
with an unrelated party (an investor) that involves the legal form of a lease.

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One example of this is a lease and leaseback arrangement where an entity leases an asset to an
investor and then leases the same asset back in order to continue using it.
In these circumstances, if the two leases are similar, then the economic substance is unchanged
and the entity should continue to recognise the leased asset as previously. Thus, the general
rule is that accounting treatment should reflect the economic substance of the arrangement.
Where there are a series of transactions that involve the legal form of a lease and they are linked
they should be accounted for as one transaction when the overall economic effect cannot be
understood without reference to the series of transactions as a whole.
Companies enter into such arrangements in order to gain tax advantages or cheaper financing,
but these considerations should not determine the financial reporting treatment.
2.2 Operating lease incentives (SIC 15)

In negotiating a new or renewed operating lease, the lessor may provide incentives for the
lessee to enter into the agreement. Examples of such incentives are:
 an upfront cash payment to the lessee;
 the reimbursement of costs of the lessee; and
 initial rent-free or reduced rent periods.
All incentives for the agreement of a new or renewed operating lease should be recognised as
an integral part of the net amount agreed for the use of the leased asset, irrespective of the
incentive's nature or form or the timing of payments.
The lessor
The lessor should normally recognise the aggregate cost of incentives as a reduction of rental
income over the lease term, on a straight-line basis.
The lessee
The lessee should normally recognise the aggregate benefit of incentives as a reduction of
rental expense over the lease term, on a straight-line basis.
Interactive question 6: Operating lease incentive

On 1 January 20X5, a lessor entered into a 21-year operating lease in respect of a retail unit.
Leasing payments were £30,000 quarterly in advance. It had proved difficult to find a tenant, so
the lessor had to accept an initial rent-free period of 18 months.
Requirement
How should the transaction be recognised in the lessor's financial statements?
3 Determining Whether an Arrangement Contains a Lease –

IFRIC 4
Section overview
Sometimes entities enter into transactions that may contain a lease even though they do not
take the legal form of a lease. These are addressed by IFRIC 4.

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Background
An entity may enter into an arrangement, comprising a transaction or a series of related
transactions, that does not take the legal form of a lease, but conveys a right to use an asset in
return for a payment or series of payments.
Examples of arrangements in which one entity (the supplier) may convey such a right to use an
asset to another entity (the purchaser), often together with related services, include the
following:
 Outsourcing arrangements (eg, the outsourcing of the data processing functions of an
entity)
 Arrangements in the telecommunications industry, in which suppliers of network capacity
enter into contracts to provide purchasers with rights to capacity
 Take or pay and similar contracts, in which purchasers must make specified payments
regardless of whether they take delivery of the contracted products or services (eg, a take
or pay contract to acquire substantially all of the output of a supplier's power generator)
IFRIC 4 provides guidance for determining whether such arrangements are, or contain, leases
that should be accounted for in accordance with IAS 17. It does not provide guidance for
determining how such a lease should be classified under IAS 17.
The key features of IFRIC 4 in determining whether an arrangement is, or contains, a lease are as
follows.
Determining whether an arrangement is, or contains, a lease
Determining whether an arrangement is, or contains, a lease is based on the substance of the
arrangement and requires an assessment of whether:
 fulfilment of the arrangement is dependent on the use of a specific asset or assets (the
asset); and
 the arrangement conveys a right to use the asset.
Fulfilment of the arrangement is dependent on the use of a specific asset
Although a specific asset may be explicitly identified in an arrangement, it is not the subject of a
lease if fulfilment of the arrangement is not dependent on the use of the specified asset. C
H
For example, if the supplier is obliged to perform building work and has the right and ability to A
carry out the task using other assets not specified in the arrangement, then fulfilment of the P
T
arrangement is not dependent on the specified asset and the arrangement does not contain a E
lease. R
Arrangement conveys a right to use the asset 14
An arrangement conveys the right to use the asset if the arrangement conveys to the purchaser
(lessee) the right to control the use of the underlying asset.
 The purchaser, while obtaining or controlling more than an insignificant amount of the
asset's output:
– has the ability to operate the asset or direct others to operate the asset; or
– has the ability or right to control physical access to the asset.
 There is only a remote possibility that parties other than the purchaser will take more than
an insignificant amount of the asset's output and the price the purchaser will pay is neither
fixed per unit of output nor equal to the current market price at the time of delivery.

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The IFRIC's view is that where a purchaser is taking substantially all of the output from an asset it
has the ability to restrict the access of others to the output of that asset. In these circumstances,
the purchaser is seen as controlling access to the economic benefits of the asset even if it does
not physically control the asset.
Is the arrangement a No
contractual relationship?
Yes
Is arrangement dependent
on use of a specific asset? No
May be Not a
Implicitly specified Lease
Explicitly identified
Yes
Does the purchaser (lessee)

No
have the right to control
the asset’s use?
(See conditions to be met)
Yes
Arrangement
contains a lease
Figure 14.1: Is it a lease?
Worked example: Arrangement that contains a lease

An entity (the supplier) enters into an arrangement to supply electricity for the building for a new
airport. To be able to fulfil this obligation, the supplier builds a power station next to the new
airport site.
The supplier has no access to any other electricity generating stations and maintains ownership
and control of the power station.
The contractual agreement provides for the following.
 The power generating station is specifically identified in the agreement. The supplier has
the right to provide electricity from other sources although doing so is not feasible.
 The supplier has the right to provide electricity to other customers. However, this is not
economically feasible, as the power station is designed to meet only the purchaser's needs.
 The purchaser pays a fixed capacity charge and a variable charge based on electricity
power taken. The variable charge is based on normal energy costs.
Requirement
Does the arrangement contain a lease within the scope of IAS 17, Leases?

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Solution
Yes. The arrangement contains a lease within the scope of IAS 17, Leases.
The first condition ie, the existence of an asset (which in this case is specifically identified) is
fulfilled.
The second condition is also fulfilled, as it is remote that one or more parties other than the
purchaser will take more than an insignificant amount of the facility's output and the price the
purchaser will pay is neither contractually fixed per unit of output nor equal to the market price
at the time of delivery.
4 Current developments
Section overview
The IASB has completed a leasing project with the objective of developing a single method of
accounting for leases that does not rely on the distinction between operating and finance
leases. The result of this project is a new standard, IFRS 16, Leases.
4.1 Background
The distinction between classification of a lease as an operating or finance lease has a
considerable impact on the financial statements, most notably on indebtedness, gearing ratios,
ROCE and interest cover. It is argued that the current accounting treatment of operating leases
is inconsistent with the definition of assets and liabilities in the IASB's Conceptual Framework.
The different accounting treatment of finance and operating leases has been criticised for a
number of reasons.
 Many users of financial statements believe that all lease contracts give rise to assets and
liabilities that should be recognised in the financial statements of lessees. Therefore these
users routinely adjust the recognised amounts in the statement of financial position in an
attempt to assess the effect of the assets and liabilities resulting from operating lease
contracts. C
H
 The split between finance leases and operating leases can result in similar transactions A
being accounted for very differently, reducing comparability for users of financial P
T
statements. E
R
 The difference in the accounting treatment of finance leases and operating leases also
provides opportunities to structure transactions so as to achieve a particular lease 14
classification.
It is also argued that the current accounting treatment of operating leases is inconsistent with
the definition of assets and liabilities in the IASB's Conceptual Framework. An operating lease
contract confers a valuable right to use a leased item. This right meets the Conceptual
Framework's definition of an asset, and the liability of the lessee to pay rentals meets the
Conceptual Framework's definition of a liability. However, the right and obligation are not
recognised for operating leases.
Lease accounting is scoped out of IAS 32 and IFRS 9, which means that there are considerable
differences in the treatment of leases and other contractual arrangements.
There have therefore been calls for the capitalisation of non-cancellable operating leases in the
statement of financial position on the grounds that, if non-cancellable, they meet the definitions
of assets and liabilities, giving similar rights and obligations as finance leases over the period of
the lease.

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4.2 IFRS 16, Leases

IFRS 16, Leases was published in January 2016 and replaces IAS 17 with effect from
1 January 2019. Candidates need to be aware of it as a current issue and when considering how
future accounting periods may be affected. It may be examined in this context.
4.2.1 IFRS 16 model

The new standard adopts a single accounting model applicable to all leases by lessees,
substantially retains the requirements of IAS 17 for lessors (requiring classification of a lease as
finance or operating) and refers to IFRS 15 guidelines with respect to sale and leaseback
transactions.
Definitions
Lease: A contract, or part of a contract, that conveys the right to use an asset, the underlying
asset, for a period of time in exchange for consideration.
Underlying asset: An asset that is the subject of a lease, for which the right to use that asset has
been provided by a lessor to a lessee.
4.2.2 Control
The key is the right to control the use of the asset. The right to control the use of an identified
asset depends on the lessee having:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset;
and
(b) the right to direct the use of the identified asset. This arises if either:
(1) the customer has the right to direct how and for what purpose the asset is used during
the whole of its period of use; or
(2) the relevant decisions about use are pre-determined and the customer can operate the
asset without the supplier having the right to change those operating instructions, or
the customer designed the asset in a way that predetermines how and for what
purpose the asset will be used throughout the period of use.
A lessee does not control the use of an identified asset if the lessor can substitute the underlying
asset for another asset during the lease term and would benefit economically from doing so.
4.2.3 Non-lease components

Some contracts may contain elements that are not leases, such as service contracts. These must
be separated out from the lease and accounted for separately.
Worked example: Is this a lease?

Outandabout Co provides tours round places of interest in the tourist city of Sightsee. While
these tours are mainly within the city, it does the occasional day trip to visit tourist sites further
away. Outandabout Co has entered into a three-year contract with Fastcoach Co for the use of
one of its coaches for this purpose. The coach must seat fifty people, but Fastcoach Co can use
any of its fifty-seater coaches when required.
Requirement
Is this arrangement a lease within the scope of IFRS 16, Leases?

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Solution
No. This is not a lease. There is no identifiable asset. Fastcoach can substitute one coach for
another, and would derive economic benefits from doing so in terms of convenience. Therefore
Outandabout should account for the rental payments as an expense in profit or loss.
4.2.4 Lessee accounting

A single lease model is applied by all lessees, with no requirement to distinguish between
operating and finance leases. At the commencement of the lease, the lessee recognises:
(a) a right of use asset, which represents the right to use the underlying asset; and
(b) a lease liability which represents the obligation to make lease payments.
4.2.5 Lease asset

The right of use asset is initially measured at cost, which is:
 the initial measurement of the lease liability;
 plus any lease payments made before the commencement date;
 less lease incentives received;
 plus initial direct costs incurred by the lessee; and
 plus estimated dismantling and restoration costs that a lessee is obliged to pay at the end
of the lease term.
The asset is subsequently measured at cost less accumulated depreciation and impairment
losses unless the right of use asset is:
 a class of PPE that is measured using the revaluation model; or
 an investment property and the lessee applies the fair value model.
Where relevant, the asset is depreciated over the shorter of the useful life of the underlying asset
and the lease term. Useful life is always the depreciation period when ownership of the
underlying asset is transferred at the end of the lease term.
C
4.2.6 Lease liability H
A
At the commencement date the lease liability is measured at the present value of future lease P
payments, including any expected payments at the end of the lease, discounted at the interest T
E
rate implicit in the lease. If that rate cannot be readily determined, the lessee's incremental R
borrowing rate should be used.
14
After the commencement date the carrying amount of the lease liability is increased by interest
charges on the outstanding liability and reduced by lease payments made.
4.2.7 Apportionment of rental payments

When the lessee makes a rental payment it will comprise two elements.
(1) An interest charge on the finance provided by the lessor. This proportion of each payment
is interest payable in the statement of profit or loss of the lessee.
(2) A repayment of part of the capital cost of the asset. In the lessee's books this proportion of
each rental payment must be debited to the lessor's account to reduce the outstanding
liability.
The accounting problem is to decide what proportion of each instalment paid by the lessee
represents interest, and what proportion represents a repayment of the capital advanced by the
lessor. This is done by the actuarial method, using the interest rate implicit in the lease.

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Worked example: Apportionment of rental payments

[This is based on IFRS 16 Illustrative example 13.]
A lessee enters into a five-year lease of a building which has a remaining useful life of 10 years.
Lease payments are $50,000 per annum, payable at the beginning of each year.
The lessee incurs initial direct costs of $20,000 and receives lease incentives of $5,000. There is
no transfer of the asset at the end of the lease and no purchase option.
The interest rate implicit in the lease is not immediately determinable but the lessee's
incremental borrowing rate is 5%.
Requirement
How will the right-of-use asset and the lease liability be measured at the commencement date,
and at the end of year 1?
Solution
At the commencement date the lessee pays the initial $50,000, incurs the direct costs and
receives the lease incentives.
The lease liability is measured at the present value of the remaining four payments:
$
$50,000/1.05 47,619
$50,000/1.052 45,351
$50,000/1.053 43,192
$50,000/1.054 41,135
177,297
Assets and liabilities will initially be recognised as follows:

Debit Credit
$ $
Right-of-use asset:
Initial payment 50,000
Discounted liability 177,297
Initial direct costs 20,000
Incentives received (5,000)
242,297
Lease liability 177,297
Cash (50,000 + 20,000 – 5,000) 65,000
242,297 242,297
At the end of year 1 the liability will be measured as:
$
Opening balance 177,297
Interest 5% 8,865
186,162
Current liability 50,000

Non-current liability 136,162
186,162
The right of use asset will be depreciated over five years, being the shorter of the lease term and
the useful life of the underlying asset.

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4.2.8 Simplified accounting

A lessee can elect to apply simplified accounting to a lease with a term of twelve months or less,
or a lease for a low value asset. The election is made on a lease by lease basis for leases for low
value assets, and by class of underlying asset for short-term leases.
In this case, the lessee recognises lease payments on a straight line basis over the lease term.
Interactive question 7: Short lease

Oscar Co is preparing its financial statements for the year ended 30 June 20X6. On 1 May 20X6,
Oscar made a payment of £32,000 for an eight-month lease of a milling machine.
Requirement
How should the transaction be recognised in the financial statements?
4.2.9 Sale and leaseback transactions

Guidance in IFRS 15, Revenue from Contracts with Customers (see Chapter 10) is applied in
order to determine whether a sale has taken place.
Transfer is a sale
The seller (lessee) measures the lease asset at an amount equal to the right of use retained, ie, a
proportion of the previous carrying amount.
A gain or loss on disposal is therefore calculated based only on the rights transferred to the
buyer (lessor).
The buyer (lessor) accounts for the purchase of the asset by applying relevant IFRS and accounts
for the lease by applying IFRS 16 guidance on accounting by lessors.
If transfer proceeds do not equal the fair value of the transferred asset or lease payments are not
at market rate, the following accounting adjustments are made:
 Below market terms are a prepayment of lease payments C
H
 Above market terms are additional financing provided by the buyer (lessor) to the seller A
(lessee) P
T
Transfer is not a sale E
R
The seller (lessee) should not derecognise the asset and instead recognises proceeds as a
14
financial liability, accounting for it in line with IFRS 9.
The buyer (lessor) should not recognise the asset and instead recognises a financial asset,
accounting for it in line with IFRS 9.
Technique for sale and leaseback
Measure the right-of-use asset arising from the leaseback at the proportion of the previous
carrying amount of the asset that relates to the right of use retained by the seller/lessee. This is
calculated as:
Carrying amount × discounted lease payments
fair value
The discounted lease payments are calculated as for any other lease.
Recognise only the amount of any gain or loss on the sale that relates to the rights transferred
to the buyer/lessor. Calculate in three stages:

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Stage 1: Calculate gain = fair value (usually = proceeds) less carrying amount
Stage 2: Calculate gain that relates to rights retained:
Gain × discounted lease payments
= Gain relating to rights retained
fair value
Stage 3: Gain relating to rights transferred is the balancing figure:
Gain on rights transferred = total gain (Stage 1) less gain on rights retained (Stage 2)
Worked example: Sale and leaseback

On 1 January 20X6, Sidcup Co sold its head office building to Eltham Co for £3 million and
immediately leased it back on a 10-year lease. On that date, the carrying value of the building
was £2.6 million and its fair value was £3 million. The present value of the lease payments was
calculated as £2.1 million. The remaining useful life of the building at 1 January 20X6 was
15 years. The transaction constituted a sale in accordance with IFRS 15.
Requirement
(a) A right-of-use asset must be recognised in respect of the leased building. At what value
should this right-of-use asset be recognised on 1 January 20X6 in the financial statements
of Sidcup Co?
(b) What is the gain on the sale that may be recognised on 1 January 20X6 in the financial
statements of Sidcup Co?
Solution
(a) £1,820,000
IFRS 16 requires that, at the start of the lease, Sidcup should measure the right-of-use asset
arising from the leaseback of the building at the proportion of the previous carrying amount of
the building that relates to the right of use retained. This is calculated as carrying amount 
discounted lease payments/fair value. The discounted lease payments were given in the
question as £2.1million.
The right-of-use asset is therefore: £2.6m  £2.1m/£3m = £1,820,000.
(b) £120,000
Sidcup only recognises the amount of gain that relates to the rights transferred.
Stage 1: Gain is £3,000,000 – £2,600,000 = £400,000
Stage 2: Gain relating to rights retained £(400,000  2,100,000/3,000,000) = £280,000
Stage 3: Gain relating to rights transferred £(400,000 – 280,000) = £120,000
4.2.10 Transition
A lessee may apply IFRS 16 with full retrospective effect. Alternatively the lessee is permitted not
to restate comparative information but recognise the cumulative effect of initially applying
IFRS 16 as an adjustment to opening equity at the date of initial application.
Interactive question 8: Sale and leaseback

On 1 April 20X2, Wigton Co bought an injection moulding machine for £600,000. The carrying
amount of the machine as at 31 March 20X3 was £500,000. On 1 April 20X3, Wigton Co sold it
to Whitehaven Co for £740,000, its fair value. Wigton Co immediately leased the machine back
for five years, the remainder of its useful life, at £160,000 per annum payable in arrears. The
present value of the annual lease payments is £700,000 and the transaction satisfies the IFRS 15
criteria to be recognised as a sale.

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Requirement
What gain should Wigton Co recognise for the year ended 31 March 20X4 as a result of the sale
and leaseback?
4.2.11 Lessor accounting

Lessor accounting is largely unchanged under IFRS 16. IFRS 16 retains the IAS 17 distinction
between finance leases and operating leases.
5 IAS 20, Accounting for Government Grants and Disclosure

of Government Assistance
Section overview
This section gives a very brief overview of the material covered in earlier studies.
Definitions
Government assistance: Action by government designed to provide an economic benefit
specific to an entity or range of entities qualifying under certain criteria.
Government grants: Assistance by government in the form of transfers of resources to an entity
in return for past or future compliance with certain conditions relating to the operating activities
of the entity. They exclude those forms of government assistance which cannot reasonably have
a value placed upon them and transactions with government which cannot be distinguished
from the normal trading transactions of the entity.
Grants related to assets: Government grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire long-term assets. Subsidiary
conditions may also be attached restricting the type or location of the assets or the periods
during which they are to be acquired or held. C
H
Grants related to income: Government grants other than those related to assets. A
P
Forgivable loans: Loans which the lender undertakes to waive repayment of under certain T
prescribed conditions. E
R
14
 Recognise government grants and forgivable loans once conditions complied with and
receipt/waiver is assured.
 Grants are recognised under the income approach: recognise grants as income to match
them with related costs that they have been received to compensate.
 Use a systematic basis of matching over the relevant periods.
 Grants for depreciable assets should be recognised as income on the same basis as the
asset is depreciated.
 Grants for non-depreciable assets should be recognised as income over the periods in
which the cost of meeting the obligation is incurred.
 A grant may be split into parts and allocated on different bases where there are a series of
conditions attached.

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 Where related costs have already been incurred, the grant may be recognised as income in
full immediately.
 A grant in the form of a non-monetary asset may be valued at fair value or a nominal value.
 Grants related to assets may be presented in the statement of financial position either as
deferred income or deducted in arriving at the carrying value of the asset.
 Grants related to income may be presented in the statement of profit or loss and other
comprehensive income (in profit or loss) either as a separate credit or deducted from the
related expense.
 Repayment of government grants should be accounted for as a revision of an accounting
estimate.
Disclosure
 Accounting policy note
 Nature and extent of government grants and other forms of assistance received
 Unfulfilled conditions and other contingencies attached to recognised government
assistance
Interactive question 9: Government grants

IAS 20 suggests that there are two approaches to recognising government grants: a capital
approach (credit directly to shareholders' interests) and an income approach. IAS 20 requires
the use of the income approach.
Requirement
What are the arguments in support of each method?
6 IAS 23, Borrowing Costs

Section overview
 This section gives a very brief overview of the material covered in earlier studies.
 IAS 23 deals with the treatment of borrowing costs, often associated with the construction
of self-constructed assets, but which can also be applied to an asset purchased that takes
time to get ready for use/sale.
Definitions
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.
Until the IASB issued a revised IAS 23 in 2007, entities had the choice of whether to account for
'directly attributable' borrowing costs as part of the cost of the asset or as an expense in profit or
loss. The revised IAS 23 removes the option of recognising them as an expense. It is mandatory
for accounting periods beginning on or after 1 January 2009.

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The revised standard is now consistent with US generally accepted accounting practice (GAAP)
and was developed as part of the convergence project being undertaken with the US FASB. The
IASB believes that the new standard will improve financial reporting in three ways:
 The cost of an asset will in future include all costs incurred in getting it ready for use or sale.
 Comparability is enhanced because the choice in previous accounting treatments is
removed.
 The revision to IAS 23 achieves convergence in practice with US GAAP.
6.1 Accounting treatment

Note the following key points, which should be familiar from your earlier studies.
 Borrowing costs must be capitalised as part of the cost of the asset if they are directly
attributable to acquisition/construction/production. Other borrowing costs must be expensed.
 Borrowing costs eligible for capitalisation are those that would have been avoided
otherwise. Use judgement where a range of debt instruments is held for general finance.
 Amount of borrowing costs available for capitalisation is actual borrowing costs incurred
less any investment income from temporary investment of those borrowings.
 For borrowings obtained generally, apply the capitalisation rate to the expenditure on the
asset (weighted average borrowing cost). It must not exceed actual borrowing costs.
 Capitalisation is suspended if active development is interrupted for extended periods.
(Temporary delays or technical/administrative work will not cause suspension.)
 Capitalisation ceases (normally) when physical construction of the asset is completed.
When an asset is comprised of separate stages, capitalisation should cease when each
stage or part is completed.
 Where the recoverable amount of the asset falls below carrying amount, it must be written
down/off.
6.2 Disclosure
 Amount of borrowing costs capitalised during the period
 Capitalisation rate used to determine borrowing costs eligible for capitalisation
C
H
Interactive question 10: Borrowing costs 1 A
P
On 1 January 20X8, Rechno Co borrowed £15 million to finance the production of two assets, T
both of which were expected to take a year to build. Production started during 20X8. The loan E
facility was drawn down on 1 January 20X8 and was used as follows, with the remaining funds R
invested temporarily. 14
Asset X Asset Y
£m £m
1 January 20X8 2.5 5.0
1 July 20X8 2.5 5.0
The loan rate was 10% and Rechno Co can invest surplus funds at 8%.
Requirement
Ignoring compound interest, calculate the borrowing costs which must be capitalised for each of
the assets and consequently the cost of each asset as at 31 December 20X8.

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Interactive question 11: Borrowing costs 2

Zenzi Co had the following loans in place at the beginning and end of 20X8.
1 January 31 December
20X8 20X8
£m £m
10.0% bank loan repayable 20Y3 120 120
9.5% bank loan repayable 20Y1 80 80
8.9% debenture repayable 20Y8 – 150
The 8.9% debenture was issued to fund the construction of a qualifying asset (a piece of mining
equipment), construction of which began on 1 July 20X8.
On 1 January 20X8, Zenzi Co began construction of a qualifying asset, a piece of machinery for a
hydroelectric plant, using existing borrowings. Expenditure drawn down for the construction
was: £30 million on 1 January 20X8, £20 million on 1 October 20X8.
Requirement
Calculate the borrowing costs to be capitalised for the hydroelectric plant machine.
7 Statements of cash flows
Section overview
This section briefly revises single company statements of cash flows, which was covered at
Professional Level. Try the interactive questions here to make sure you are comfortable with
this topic before revising consolidated statements of cash flows in Chapter 20.
7.1 Basic statements of cash flows – revision

(a) A statement of cash flows prepared in accordance with IAS 7, Statement of Cash Flows
provides information about the historical changes in an entity's cash and cash equivalents.
This information is presented in a statement that classifies cash flows between operating
activities, investing activities and financing activities.
(b) Cash, as defined in IAS 7, includes not only cash itself but also any instrument that can be
converted into cash so quickly that it is in effect equivalent to cash.
(c) 'Operating activities' are the principal revenue-generating activities of an entity, together
with any other activities which are not identified as being investing or financing in nature.
(d) The cash flows from an entity's operating activities can be presented using two methods:
(1) The direct method, which discloses the major classes of gross cash receipts and
payments; or
(2) The indirect method, where the entity starts with the net profit or loss for the period
and adjusts it for non-cash transactions, deferrals or accruals of income and
expenditure and items that will form part of the entity's investing and financing
activities.
(e) 'Investing activities' are acquisitions and disposals of long-term assets and investments,
other than cash and cash equivalents. Examples include: cash paid or received to acquire or
sell an item of property, plant or equipment, a receipt of cash from the sale of a business,
and cash advanced as a loan to another entity.

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(f) 'Financing activities' are activities that change the amount and composition of an entity's
equity capital and borrowings. Examples include: cash proceeds from issuing shares, cash
paid to repay debt instruments, and the capital element in a finance lease payment.
(g) Investing and financing activities that do not impact on cash, for example the conversion of
debt to equity, should not be included in the statement of cash flows.
Interactive question 12: Operating and financing activities

On 1 January 20X5, an entity entered into a 20-year lease for land and buildings. The lease
payments are £910,000 annually in advance, of which £546,000 relates to the land which is
classified as being held under an operating lease and £364,000 to the buildings held under a
finance lease.
The 20X5 income statement showed a finance charge in respect of the finance lease of £50,000.
The entity treats interest paid as relating to its operating activities.
Requirement
Show the amounts appearing in the statements of cash flows for 20X5 and 20X6.
Interactive question 13: Single company statement of cash flows

Elida is a publicly listed company. The following financial statements of Elida are available:
Statement of profit or loss and other comprehensive income for year ended 31 March 20X8
£'000
Revenue 5,740
Cost of sales (4,840)
Gross profit 900
Income from and gains on investment property 60
Distribution costs (120)
Administrative expenses (Note (ii)) (350)
Finance costs (50) C
Profit before tax 440 H
A
Income tax expense (160)
P
Profit for the year 280 T
Other comprehensive income E
Gains on property revaluation 100 R
Total comprehensive income 380
14
Statements of financial position as at:
31 March 20X8 31 March 20X7
£'000 £'000 £'000 £'000
ASSETS
Non-current assets (Note (1))
Property, plant and equipment 2,880 1,860
Investment property 420 400
3,300 2,260
Current assets
Inventory 1,210 810
Trade receivables 480 540
Income tax asset nil 50
Bank 10 1,700 nil 1,400

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£'000 £'000 £'000 £'000
Equity
Equity shares of 20p each (Note (3)) 1,000 600
Share premium 600 nil
Revaluation reserve 150 50
Retained earnings 1,440 2,190 1,310 1,360
3,190 1,960
6% loan notes (Note (2)) nil 400
Deferred tax 50 50 30 430
Current liabilities
Trade payables 1,410 1,050
Bank overdraft nil 120
Warranty provision (Note (4)) 200 100
Current tax payable 150 1,760 nil 1,270
Total equity and liabilities 5,000 3,660
The following supporting information is available:
(1) An item of plant with a carrying amount of £240,000 was sold at a loss of £90,000 during
the year. Depreciation of £280,000 was charged (to cost of sales) for property, plant and
equipment in the year ended 31 March 20X8.
Elida uses the fair value model in IAS 40, Investment Property. There were no purchases or
sales of investment property during the year.
(2) The 6% loan notes were redeemed early incurring a penalty payment of £20,000 which has
been charged as an administrative expense in the statement of profit or loss.
(3) There was an issue of shares for cash on 1 October 20X7. There were no bonus issues of
shares during the year.
(4) Elida gives a 12-month warranty on some of the products it sells. The amounts shown in
current liabilities as warranty provision are an accurate assessment, based on past experience,
of the amount of claims likely to be made in respect of warranties outstanding at each year
end. Warranty costs are included in cost of sales.
(5) A dividend of 3p per share was paid on 1 January 20X8.
Requirement
Prepare a statement of cash flows for Elida for the year to 31 March 20X8 in accordance with
IAS 7, Statement of Cash Flows.
8 Audit focus
Section overview
Matters that the auditor should consider when auditing leases include:
 whether the lease is classified according to the substance of the transaction (operating
lease/finance lease);
 whether the lease/depreciation/finance expense charged to profit or loss, and amounts
recognised in the statement of financial position (in the case of finance leases), are in line
with accounting standards and based on reasonable assumptions; and
 whether the disclosure is in line with applicable accounting standards.
Auditors should also be aware of the transitional issues presented by the adoption of IFRS 16
instead of IAS 17 in order to continue to understand and support their clients.

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8.1 Auditing leases

In auditing leases recognised at fair value, the auditor must evaluate whether the fair value is
appropriate. We will cover the auditing of fair value in further detail in the Audit Focus Sections
(10 to 12) in Chapter 17.
The table below summarises the areas of audit focus when auditing leases in accordance with
IAS 17, and provides some examples of audit evidence required.
Issue Evidence
Ascertaining that the Obtain schedules of finance leases and operating leases, including any
leases recorded in the leases that existed at the end of the prior period, and any new leases.
financial statements are
Determine that any leased property is still in use.
complete
Obtain assurance about the completeness of the schedule by making
inquiries of informed management, and consider any evidence of
additional leases by examining other documents such as board
meeting minutes, significant contracts and property additions.
The classification of the Review lease agreements for indicators that the risks and rewards of
leases reflects the ownership have been transferred to the entity, such as:
substance of the  responsibility for repairs and maintenance;
transaction
 transfer of legal title at the end of the lease term;
 the lease is for most of the assets' useful life; and
 the present value of the minimum lease payments is substantially
all of the assets' fair value.
Ascertaining that the Select a sample of entries in the lease expense account, and verify that
operating lease they relate to operating leases.
expenses have been
Recalculate operating lease expenses, on a straight-line basis over the
correctly recorded in
lease term.
profit or loss
Ascertaining that the Recalculate the finance charges charged against profit and loss. C
finance leases have H
Agree interest rates used in calculations to lease agreements. A
been correctly P
recorded in the Agree the calculation of the leased assets' fair value to external T
statements of financial evidence, such as market prices or surveyors' reports. E
R
position and profit or
Recalculate the depreciation charges applied to non-current assets.
loss 14
Review the assumptions made in respect of the useful life of each
finance lease asset, and agree the useful life/lease term to the
depreciation workings to ensure that the assets are depreciated over
an appropriate period.
Review rentals paid during the year to verify that rental payments are
split between the finance charge element and the repayment of
capital in accordance with IAS 17.
Ascertaining that the Review the disclosures in the financial statements to determine
lease liability has been whether the disclosures are consistent and complete.
disclosed in the
financial statements in
accordance with IFRSs

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8.2 Transitional issues from adopting IFRS 16

Once IFRS 16 has replaced IAS 17, financial statements for entities with leased assets will look
quite different: consequently, auditors will need to understand the differences in terminology
and approach presented by this update, as well as the impact it will have on the audits they
conduct.
 Clients may not understand how IFRS 16 should be adopted, so may ask for assistance from
their auditor.
 Financial statements may be deliberately misstated to present short term or low value
assets inappropriately to avoid the need to show lease liabilities.
 Clients with assets previously classified as operating leases may misstate the new lease
asset and liability, either deliberately or by mistake.
 Sale and leaseback arrangements will now require accounting treatment that supports
IFRS 15 and auditors will need to ensure their clients have followed this treatment in such
cases.

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Summary
Leases
Finance Operating
leases leases
Lessee Lessor Lessee Lessor

Accounting Accounting Accounting Accounting
Capitalise asset Derecognise asset Charge rentals on Recognise income

(lower of fair value (in substance risks a systematic basis on a systematic
and present value and rewards over lease period basis over lease
of minimum lease transferred to period
payments) lessee)
Set up finance Set up a receivable Recognise operating

lease liability balance at the net incentives on a
investment in the straight-line basis
lease over lease term
Repayments:
Receipts:
• Split between
finance charge and • Split between
capital finance income C
and capital H
• Allocate using A
actuarial method • Allocate using
P
or sum of digits actuarial method T
method only E
R
14

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Government
grants
Recognition Presentation Repayment Government

assistance
Grants related Accounted for as a

Only when there Grants related
to assets change in an
is reasonable to income
accounting estimate
assurance that
entity will:
• Comply with Deferred Credit to Excluded from
conditions of income method income definition of
grant or netting off or government
• Receive grant method Deduct from grants:
related expense • Free technical/
marketing
advice
Should be
recognised under • Provision of
the income guarantees
approach • Transactions
with
government
that cannot be
Should not be distinguished
accounted for on from normal
a cash basis trading
transactions
Non-monetary
grants measured
at fair value or
nominal amount
Borrowing
costs
Capitalise
Directly attributable
Qualifying asset
borrowing costs
Period of
capitalisation

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Statement of cash flows
Consolidated
Single entity statement of cash
flows (see Chapter 20)
Split finance lease Acquisition/

Dividends Dividends Acquisition of
instalments disposal of
paid to NCI received associate
Interest = operating subsidiary
from associates
activities
Capital = financing
activities Classify as cash Classify as cash Show payments
Show net cash
flows from flows from effect as part under cash
financing investing of cash flows flows from
activities from investing investing
activities activities
Disclosure in
notes to the
statement
C
H
A
P
T
E
R
14

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Self-test
IAS 17, Leases
1 Hypericum
On 31 December 20X7 The Hypericum Company leased from a bank three different
machines, X, Y and Z. Each lease is for three years.
£100,000 is payable annually in advance for each machine on 1 January 20X8, 20X9 and
20Y0. Hypericum uses its annual incremental borrowing rate of 10% to determine the
present value of the minimum lease payments.
Under the contract for machine Z, Hypericum is also required to pay a lease premium of
£50,000 on 31 December 20X7.
Other details are as follows.
Machine X Machine Y Machine Z
£ £ £
Fair value 280,000 265,000 300,000
Residual value at 31 December 20Y0 1,000 100,000 3,000
All the machines are to be returned to the lessor at the end of the lease period. The useful
life of Machine Y is six years. The useful life of the other machines is three years.
Requirement
Which of the machines should be recognised at its fair value in the statement of financial
position of Hypericum at 31 December 20X7, according to IAS 17, Leases?
2 Sauvetage
The Sauvetage Company enters into a sale and leaseback arrangement which results in an
operating lease for five years from 1 January 20X7. The agreement is with its bank in
respect of a major piece of equipment that Sauvetage currently owns. The details at
1 January 20X7 are as follows.
£m
Carrying amount of equipment 6.0
Proceeds generated from sale and
leaseback 8.0
Fair value of equipment 7.2
The lease rentals are £4.0 million per year.
Requirement
By how much should the pre-tax profit of Sauvetage be reduced in respect of the sale and
leaseback arrangement for the year to 31 December 20X7, according to IAS 17, Leases?
3 Mocken
The Mocken Company enters into a sale and leaseback arrangement which results in a
finance lease for five years from 1 January 20X7. The agreement is with its bank in respect
of a major piece of equipment that Mocken currently owns. The residual value of the
equipment after five years is zero.
The carrying amount of equipment at 1 January 20X7 is £140,000. The sale proceeds are at
fair value at 1 January 20X7 of £240,000. There are five annual rentals each of £56,000
payable annually in advance.
Mocken recognises depreciation on all non-current assets on a straight-line basis. Finance
charges on a finance lease are recognised on a sum of digits basis.

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Requirement
What total amount should be recognised in the profit or loss of Mocken in respect of the
sale and leaseback arrangement for the year to 31 December 20X7 according to IAS 17,
Leases?
4 Szczytno
At 31 December 20X6 the carrying amount of a freehold property in The Szczytno
Company's financial statements was £436,000, of which £366,000 was attributable to the
building which had a remaining useful life of 36 years.
On 1 January 20X7 Szczytno sold the property to a financial institution for £697,000 and
immediately leased it back under a 35-year lease at an annual rental of £43,600 payable in
advance.
Other information available is as follows.
Land Building
Fair value of a 35-year interest £90,000 £607,000
The interest rate implicit in the lease is 6% per annum and the present value factor for a
constant amount annually in advance over 35 years is 15.368.
Requirements
Determine the following amounts for inclusion in Szczytno's financial statements for the year
ended 31 December 20X7 in accordance with IAS 17, Leases.
(a) The profit on sale recognised in the year
(b) Excluding any profit on sale, the total effect on profit or loss for the year of the building
element of the lease
(c) The total liability to the financial institution at 31 December 20X7
5 Bodgit
Bodgit Ltd started trading 16 years ago manufacturing traditional toys. On that date it
acquired a freehold factory (and land) in Warwick for £200,000.
Bodgit Ltd has seen a significant decline in profitability due to falling demand for traditional C
toys as a result of competition from more modern electronic toys and games. H
A
Following a series of board meetings the management has decided to change its focus of P
T
production to game consoles and computer games. This will require significant investment.
E
R
In order to finance this investment the management is planning to enter into a sale and
leaseback arrangement in respect of the Warwick property. It is expected that the property 14
will fetch £750,000 in sale proceeds and would be sold on 1 January 20X7.
The property would then be leased back on a 20-year lease at an initial rental of £95,000.
Both the sale and the rental are at market value, and the land element of the property
represents one-fifth of these amounts.
Bodgit's incremental borrowing rate is 12%.
Requirement
Explain the accounting implications of the sale and leaseback arrangement.

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6 Tonto
The following information relates to the draft financial statements of Tonto.
Summarised statements of financial position as at:
£'000 £'000 £'000 £'000
ASSETS
Non-current assets
Property, plant and equipment (Note (1)) 19,000 25,500
Current assets
Inventory 12,500 4,600
Trade receivables 4,500 2,000
Tax refund due 500 nil
Bank nil 1,500
Equity
Equity shares of £1 each (Note (2)) 10,000 8,000
Share premium (Note (2)) 3,200 4,000
Retained earnings 4,500 7,700 6,300 10,300
17,700 18,300
10% loan note (Note (3)) nil 5,000
Finance lease obligations 4,800 2,000
Deferred tax 1,200 6,000 800 7,800
Current liabilities
10% loan note (Note (3)) 5,000 nil
Tax nil 2,500
Bank overdraft 1,400 nil
Finance lease obligations 1,700 800
Trade payables 4,700 12,800 4,200 7,500
Total equity and liabilities 36,500 33,600
Summarised statements of profit or loss for the years ended:

£'000 £'000
Revenue 55,000 40,000
Cost of sales (43,800) (25,000)
Operating expenses (12,000) (6,000)
Finance costs (Note (iv)) (1,000) (600)
Profit (loss) before tax (1,800) 8,400
Income tax relief (expense) 700 (2,800)
Profit (loss) for the year (1,100) 5,600
The following additional information is available:

(1) Property, plant and equipment is made up of:
As at: 31 March 20X1 31 March 20X0
£'000 £'000
Leasehold property nil 8,800
Owned plant 12,500 14,200
Leased plant 6,500 2,500
19,000 25,500

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During the year Tonto sold its leasehold property for £8.5 million and entered into an
arrangement to rent it back from the purchaser. There were no additions to or
disposals of owned plant during the year. The depreciation charges (to cost of sales)
for the year ended 31 March 20X1 were:
£'000
Leasehold property 200
Owned plant 1,700
Leased plant 1,800
3,700
(2) On 1 July 20X0 there was a bonus issue of shares from share premium of one new
share for every 10 held. On 1 October 20X0 there was a fully subscribed cash issue of
shares at par.
(3) The 10% loan note is due for repayment on 30 June 20X1. Tonto is in negotiations with
the loan provider to refinance the same amount for another five years.
(4) The finance costs are made up of:
For year ended: 31 March 20X1 31 March 20X0
£'000 £'000
Finance lease charges 300 100
Overdraft interest 200 nil
Loan note interest 500 500
1,000 600
Requirement
Prepare a statement of cash flows for Tonto for the year ended 31 March 20X1 in
accordance with IAS 7, Statement of Cash Flows, using the indirect method.
7 Livery
Livery Co leases a delivery van from Bettalease Co for three years at £12,000 per year. This
payment includes servicing costs.
Livery could lease the same make and model of van for £11,000 per year and would need
to pay £2,000 a year for servicing. C
H
Requirement A
P
Explain how this arrangement would be accounted for under IFRS 16, Leases.
T
E
R
14

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Technical reference
IAS 17, Leases
1 Lease classification
 If substantially all of the risks and rewards of ownership are transferred to IAS 17.4
the lessee, then a lease is a finance lease (Note: 90% rule for UK GAAP).
Factors:
– Ownership passing at end of term IAS 17.10–11
– Bargain purchase option
– Lease term the major part of asset's life
– Very substantial charges for early cancellation
– Peppercorn rent in secondary period
– PV of minimum lease payments substantially all of asset's fair value IAS 17.10(d)
 Otherwise, an operating lease IAS 17.4
 Classify at inception IAS 17.13
 Land and buildings elements within a single lease are classified IAS 17.15
separately
(Note: Together, usually as operating lease, for UK GAAP)
 Can be a lease even if lessor obliged to provide substantial services IAS 17.3
2 Finance lease
 Non-current asset and liability for the asset's fair value (or PV of minimum
lease payments, if lower): IAS 17.20
– Measured at inception of lease IAS 17.4
– Recognised at commencement of lease term IAS 17.4
 Depreciate asset over its useful life, or the lease term if shorter and no IAS 17.27
reasonable certainty that lessee will obtain ownership at end of lease
 Consider whether IAS 36 impairment procedures needed IAS 17.30
 Debit lease payments to liability, without separating into capital and
interest
 Charge lease interest to profit or loss and credit lease liability
 Charge interest so as to produce constant periodic rate of charge on IAS 17.25
reducing liability – approximations allowed
 Disclosures:
– Show carrying value of each class of leased assets IAS 17.31
– In the statement of financial position split the liability between IAS 17.23
current and non-current
– In a note, show analysis of total liability over amounts payable in 1, 2 IAS 17.31(b)
to 5 and over 5 years, both gross and net of finance charges
allocated to future periods
– General description of material leasing arrangements IAS 17.31(e)
– Other IAS 16 disclosures re leased PPE assets IAS 17.32

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3 Operating lease
 Charge lease payments to profit or loss on straight-line basis, unless IAS 17.33
some other systematic basis is more representative of users' benefit
 Disclosures:
– Lease payments charged as expense in the period IAS 17.35(c)
– In a 'commitment' note, show analysis of amounts payable in 1, 2 to IAS 17.35(a)
5 and over 5 years, even though not recognised in statement of
financial position
– General description of significant leasing arrangements IAS 17.35(d)
4 Lessor accounting
Finance lease:
 Recognise a receivable measured at an amount equal to the net IAS 17.36
investment in the lease
 Net investment in the lease is the gross investment in the lease IAS 17.4
discounted at the interest rate implicit in the lease
 Include initial direct costs incurred but exclude general overheads IAS 17.38
 Recognition of finance income should be based on a pattern reflecting a IAS 17.39
constant periodic rate of return on the lessor's net investment
 Finance income should be allocated on a systematic and rational basis IAS 17.40
 Special rules for manufacturer/dealer lessors IAS 17.42
 Disclosures IAS 17.47
Operating lease:
 The asset should be recorded in the statement of financial position IAS 17.49
according to its nature
 Operating lease income should be recognised on a straight-line basis IAS 17.50
over the lease term, unless another basis is more appropriate
 Asset should be depreciated as per other similar assets IAS 17.53 C
H
 IAS 36 should be applied to determine whether the asset is impaired IAS 17.54 A
P
 Disclosures IAS 17.56 T
E
R
5 Sale and finance leaseback
14
 Recognise excess sale proceeds as deferred income and amortise over IAS 17.59–60
the lease term
 Alternative: treat as a secured loan
6 Sale and operating leaseback

 Treatment depends on relationship between sale price and fair value: IAS 17.61
– Sale price at fair value
– Sale price below fair value
– Sale price above fair value
 If the fair value at the time of the sale and leaseback is less than the IAS 17.63
carrying amount of the asset, the loss (carrying amount minus fair value)
is recognised immediately
 Lease and leaseback arrangements SIC 15 & 27

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IAS 20, Accounting for Government Grants and Disclosure of Government

Assistance
1 Treatment
 Should only be recognised if reasonable assurance that: IAS 20.7
– Entity will comply with conditions
– Grant will be received
 Manner in which received does not affect accounting method adopted IAS 20.9
 Should be recognised as income over periods necessary to match with IAS 20.12
related costs
 Income approach, where grant is taken to income over one or more IAS 20.13
periods should be adopted
 Grants should not be accounted for on a cash basis IAS 20.16
 Grants in recognition of specific expenses are recognised as income in IAS 20.17
same period as expense
 Grants related to depreciable assets usually recognised in proportion to IAS 20.17
depreciation
 Grants related to non-depreciable assets requiring fulfilment of certain IAS 20.18
obligations should be recognised as income over periods which bear the
cost of meeting obligations
 Grant received as compensation for expenses already incurred IAS 20.20
recognised in period in which receivable
 Non-monetary grants should be measured at fair value or a nominal IAS 20.23
amount
2 Presentation of grants related to assets

 Can be presented in the statement of financial position by: IAS 20.24
– Setting up the grant as deferred income or
– Netting it off against the carrying amount of the asset
IAS 20.29
3 Presentation of grants related to income
 Either:
– Recognised in profit or loss as income separately or under a general
heading or
– Deducted in arriving at the amount of the related expense
recognised in profit or loss
4 Repayment of government grants
 Accounted for as a revision to an accounting estimate IAS 20.32
5 Government assistance
 The following forms of government assistance are excluded from the IAS 20.34–35
definition of government grants:
– Assistance which cannot reasonably have a value placed on it
– Transactions with government which cannot be distinguished from
the normal trading transactions of the entity

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6 Disclosures
 Required disclosures IAS 20.39
IAS 23, Borrowing Costs

 Core principle IAS 23.1 and 8
 Qualifying asset IAS 23.5 and 7
 Directly attributable borrowing costs IAS 23.10–11
 Eligible borrowing costs IAS 23.12–15
 Excess of carrying amount over recoverable amount of asset IAS 23.16
 Commencement of capitalisation IAS 23.17–19
 Suspension of capitalisation IAS 23.20–21
 Cessation of capitalisation IAS 23.22–25
 Disclosure IAS 23.26
IAS 7, Statement of Cash Flows

 Objective of the statement of cash flows
– The statement of cash flows should show the historical changes in
cash and cash equivalents
– Cash comprises cash on hand and demand deposits IAS 7.6
– Cash equivalents are short-term, highly liquid investments that are IAS 7.6
readily convertible to known amounts of cash and which are subject
to an insignificant risk of changes in value
 Presentation of a statement of cash flows Appendix A
– Cash flows should be classified by operating, investing and financing IAS 7.10
activities
– Cash flows from operating activities are primarily derived from the IAS 7.13–14
principal revenue-producing activities of the entity
– Cash flows from investing activities are those related to the IAS 7.16
acquisition or disposal of any non-current assets, or trade
investments together with returns received in cash from investments
C
(ie, dividends and interest) H
A
 Financing activities include: IAS 7.17
P
– Cash proceeds from issuing shares T
E
– Cash proceeds from issuing debentures, loans, notes, bonds, R
mortgages and other short- or long-term borrowings
14
– Cash repayments of amounts borrowed
– Dividends paid to shareholders / the non-controlling interest
– Principal repayments of amounts borrowed under finance leases
 Cash flows from operating activities
– There are two methods of presentation allowed:
 Direct method IAS 7.19
 Indirect method IAS 7.20

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(a) Financial statement extracts
Statement of profit or loss and other comprehensive income
for the year ended 31 December 20X1 (extract)
£
Depreciation [(80,000 + 2,000 – 8,000)/5)] 14,800
Finance costs (Working) 7,420
Statement of financial position as at 31 December 20X1 (extract)
£
Non-current assets
Leased asset [(80,000 + 2,000) – ((80,000 + 2,000 – 8,000)/5)] 67,200
Finance lease liability (Working) 56,182
Current liabilities
Finance lease liability (Working) (65,620 – 56,182) 9,438
WORKING
Bal b/f Interest accrued at 10% Payment 31 Dec Bal c/f 31 Dec
£ £ £ £
80,000
(5,800)
20X1 74,200 7,420 (16,000) 65,620
20X2 65,620 6,562 (16,000) 56,182
(b) Treatment of guaranteed residual value

At the end of the lease, the lessee will have an asset at residual value of £8,000 in its
statement of financial position and a finance lease liability of £8,000 representing the
residual value guaranteed to the lessor.
(1) If the lessor is able to sell the asset for more than the value guaranteed by the lessee,
the lessee has no further liability and derecognises the asset and lease liability:
DEBIT Finance lease liability £8,000
CREDIT Asset carrying amount £8,000
(2) If the lessor is unable to sell the asset for the value guaranteed by the lessee, the lessee
has a liability to make up the difference of £8,000 – £6,000 = £2,000:
Recognise impairment loss on asset (as soon as known during the lease term):
DEBIT Profit or loss £2,000
Make guaranteed payment to lessor and derecognise the asset and lease liability:
DEBIT Finance lease liability £8,000
CREDIT Cash £2,000

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(a) Unguaranteed residual value and net investment in the lease at 1 January 20X1
Discount
Gross factor Net
Date investment (11%) investment
£ £
1.1.X1 Instalment 22,000 1 22,000
1.1.X2 Instalment 22,000 0.901 19,822
1.1.X3 Instalment 22,000 0.812 17,864
1.1.X4 Instalment 22,000 0.731 16,082
31.12.X4 Guaranteed residual value 10,000 0.659 6,590
Lessee's
Minimum lease payments 98,000 82,358
liability
31.12.X4 Unguaranteed residual value 0.659
2,000 1,318
Lessor's
Investment in the lease 100,000 83,676
asset
Note: The net investment in the lease is equal to the fair value of the asset of £82,966 plus
the lessor's costs of £700. In this instance there is a rounding difference of £10.
(b) Financial statement extracts
Statement of comprehensive income for the year ended 31 December 20X1 (extract)
£
Finance income (Working) 6,784
Statement of financial position as at 31 December 20X1 (extract)
£
Non-current assets
Net investment in finance lease (Working) 46,460
Current assets
Net investment in finance lease (Working) (68,460 – 46,460) 22,000
WORKING
Net investment in finance lease
Interest
Instalments in income at
C
Bal b/f advance c/f 11% Bal c/f 31 Dec H
£ £ £ £ £ A
20X1 83,676 (22,000) 61,676 6,784 68,460 P
T
20X2 68,460 (22,000) 46,460 E
R
14
The transaction will be recognised by the entity as follows.
1 January 20X5 Derecognise £5 million investment property asset
Recognise £5 million finance lease receivable
Recognise £400,000 cash received as a reduction in the receivable
Note that the net investment in the lease is equal to the fair value of the asset plus any costs
incurred by the lessor. In this case there were no such costs and therefore the fair value of the
asset is the net investment in the lease.
31 December 20X5 Increase the receivable by £381,800 (8.3%  (£5,000,000 – £400,000))
Recognise finance income of £381,800 in profit or loss

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£
Revenue (lower of FV £26,250 and PV of MLPs £24,351) 24,351
Cost of sales (lower of cost and CV – PV of unguaranteed residual value) (21,000)
Profit 3,351
Finance income: (Working) 1,248
Receivable (Working) 16,849
WORKING
Instalments Interest Bal c/f
Bal b/f in advance c/f income at 8% 31 Dec
£ £ £ £ £
20X5 24,351 (8,750) 15,601 1,248 16,849

On 1 January 20X5, the transaction will be recorded by the entity as follows:
 Recognise cash proceeds received of £5,000,000
 Derecognise the asset of £3,500,000
 Recognise deferred income of £1,500,000 and release the profit over the lease term
(£37,500 per annum)
 Recognise the building at £5,000,000
 Recognise a finance lease liability at £5,000,000
 Recognise £400,000 cash paid
For the year ended 31 December 20X5, the entity will recognise the following:
 Income of £37,500 out of the deferred profit, being £1.5m/40 years
 Depreciation of £125,000 (£5m/40 years)
 Finance charge of £381,800 being 8.3% of (£5m – £0.4m)

The amount lost as a result of agreeing to the rent-free period is treated as a reduction in the net
consideration receivable by the lessor, which has the effect of spreading it over the lease term.
The total consideration receivable over the 21-year lease is:
19.5 years  4 quarterly payments  £30,000 = £2,340,000.
This results in an annual income of £2,340,000/21 years = £111,429.
At 31 December 20X5, no cash will have been received from the lessee, so the lessor recognises
a receivable £111,429 – the first year's rent.

The lease is for eight months, which counts as a short-term lease, and so it does not need to be
recognised in the statement of financial position. The amount charged to profit or loss for the
year ended 30 June 20X6 is therefore £32,000  2/8 = £8,000.

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The answer is £12,973
Stage 1: Gain on sale: £740,000 – £500,000 = £240,000
Stage 2: Gain relating to rights retained = £(240,000  700,000/740,000) = £227,027
Stage 3: Gain relating to rights transferred = £240,000 – £227,027 = £12,973

IAS 20 gives the following arguments in support of each method.
Capital approach
(a) The grants are a financing device, so should go through the statement of financial position.
In the statement of profit or loss and other comprehensive income they would simply offset
the expenses which they are financing. No repayment is expected by the Government, so
the grants should be credited directly to shareholders' interests.
(b) Grants are not earned, they are incentives without related costs, so it would be wrong to
record them in profit or loss.
Income approach
(a) The grants are not received from shareholders so should not be credited directly to
shareholders' interests.
(b) Grants are not given or received for nothing. They are earned by compliance with
conditions and by meeting obligations. There are therefore associated costs with which the
grant can be matched in the statement of profit or loss and other comprehensive income,
as these costs are being compensated by the grant.
(c) Grants are an extension of fiscal policies and so, as income and other taxes are charged
against income, grants should be credited to income.
Asset X Asset Y
£'000 £'000
Borrowing costs C
H
£5.0m/£10m  10% 500 1,000 A
P
Less investment income
T
To 30 June 20X8 £2.5m/£5.0m  8%  6/12 (100) (200) E
400 800 R
£'000 £'000 14
Cost of assets
Expenditure incurred 5,000 10,000
Borrowing costs 400 800
5,400 10,800

120 80
Capitalisation rate = weighted average rate = (10%  ) + (9.5%  ) = 9.8%
120 + 80 120 + 80
Borrowing costs = (£30m  9.8%) + (£20m  9.8%  3/12)

= £3.43m

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The amounts appearing in the statement of cash flows for operating and financing activities
include:
20X5 20X6
£ £
Operating activities
Operating lease payments 546,000 546,000
Interest paid (payments are made in advance, so there is no interest in
the January 20X5 payment) 50,000
Financing activities
Payments under finance leases 364,000 314,000

Elida – statement of cash flows for the year to 31 March 20X8
£'000 £'000
Cash flows from operating activities
Profit before tax 440
Loss on sale of plant 90
Depreciation 280
Early redemption penalty 20
Finance costs 50
Investment income (60)
Increase in warranty provision (200 – 100) 100
920
Increase in inventory (1,210 – 810) (400)
Decrease in receivables (480 – 540) 60
Increase in trade payables (1,410 – 1,050) 360
Cash generated from operations 940
Interest paid (50)
Tax refund received (W1) 60
Net cash from operating activities 950
Cash flows from investing activities
Proceeds of sale of plant (240 – 90) 150
Purchase of plant (W2) (1,440)
Income from investment property (60 – 20) 40
Net cash used in investing activities (1,250)
Cash flows from financing activities
Share issue ((1,000 – 600) + 600) 1,000
Loan notes repaid (400)
Early redemption penalty (20)
Dividend paid (1,000  5  0.03) (150)
Net cash from financing activities 430
Net increase in cash and cash equivalents 130
Cash and cash equivalents at beginning of period (120)
Cash and cash equivalents at end of period 10

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WORKINGS
(1) INCOME TAX PAYABLE
£'000 £'000
Bal b/d (current tax) 50 Bal b/d (deferred tax) 30
Bal c/d (current tax) 150 Profit or loss charge 160
Bal c/d (current tax) 50 Cash received (balancing figure) 60
250 250
(2) PROPERTY, PLANT AND EQUIPMENT
£'000 £'000
Bal b/d 1,860 Disposal 240
Revaluation (150 – 50) 100 Depreciation 280
Additions (balancing figure) 1,440 Bal c/d 2,880
3,400 3,400
C
H
A
P
T
E
R
14

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IAS 17, Leases
1 Hypericum
Machine Z
IAS 17.20 requires that assets under finance leases should be stated at the lower of the fair
value and the present value of the minimum lease payments. The latter amount is calculated
as:
Cash flows 10% discount factor PV
£ £
100,000 1.0 100,000
100,000 1/1.1 90,909
100,000 1/(1.1  1.1) 82,645
273,554
For Machine Z, this is increased by the £50,000 premium to £323,554.

As Machine Z has a lower fair value, it should be recognised at fair value.
Machine X has a higher fair value, while Machine Y will be held under an operating lease –
the residual value indicates that plenty of reward has been retained by the lessor, so it
cannot be classified as a finance lease. This is confirmed by the useful life being
substantially longer than the lease period.
2 Sauvetage
£2,640,000
The arrangement results in a profit of £2.0 million (proceeds £8.0 million less carrying
amount £6.0 million) of which £0.8 million relates to the difference between proceeds and
fair value and £1.2 million to that between fair value and carrying amount.
IAS 17.61 requires that where the proceeds of a sale and leaseback re an operating lease
are above fair value, then the excess shall be deferred and matched over the period that
the asset is to be used. But any excess of the fair value over the carrying amount should be
recognised immediately, per IAS 17, Implementation Guidance Footnote 3.
Thus the charge to profit or loss is: £'000
Rental 4,000
Immediate profit (1,200)
Release of deferred profit (£0.8m/5 years) (160)
2,640
3 Mocken
£44,000 expense
IAS 17.59 and .60 require that where a sale and finance leaseback takes place and the sale
proceeds exceed the carrying amount then it shall not be recognised as profit but shall be
deferred and recognised over the lease term.
£
Depreciation (£240,000/5) 48,000
Release of deferred profit [(£240,000 – £140,000)/5] (20,000)
Finance charge 4/10  [(£56,000  5) – £240,000] 16,000
Total 44,000

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4 Szczytno
(a) £26,886
(b) £49,405
(c) £578,286
(a) The leaseback of the land element results in an operating lease because land normally
has an infinite life (IAS 17.14). The leaseback of the building element results in a
finance lease because in leasing it back for 35 of its 36 years Szczytno has access to
substantially all the risks and rewards of ownership (IAS 17.4). The sale and leaseback is
at fair value, because the sales proceeds are substantially equal to the sum of the fair
values of the 35-year interest.
The portion of the total profit on the sale of £261,000 (£697,000 – £436,000) to be
recognised depends on the type of lease involved in the leaseback (IAS 17.58). The
profit attributable to the land operating lease is recognised immediately (IAS 17.61),
but the profit attributable to the building finance lease is spread over the lease term
(IAS 17.59).
Land profit: proceeds £90,000 – carrying amount (£436,000 – £366,000) = £20,000
Building profit: proceeds £607,000 – carrying amount £366,000 = £241,000
Profit on sale recognised in year:
£
Full land profit 20,000
Proportion of building profit (£241,000/35 years) 6,886
26,886
(b) The annual rental is allocated between the two elements in proportion to the relative
fair values of the leasehold interest (IAS 17.16), so the amount allocated to the building
element is:
£43,600  607,000/(607,000 + 90,000) = £37,970.
The present value over 35 years is £37,970  15.368 = £583,523.
This amount is recognised as a non-current asset and a liability.
The 20X7 depreciation charge on the asset is £583,523/35 = £16,672
C
while, since the lease payments are in advance, the finance charge is £(583,523 – H
A
37,970)  6% = £32,733. P
T
The total effect on profit or loss is £16,672 + £32,733 = £49,405.
E
(c) The liability at the year end is £583,523 – £37,970 + £32,733 interest = £578,286. R
5 Bodgit 14
Accounting
Type of sale and leaseback
The transaction includes two elements:
 Sale and leaseback of the property itself
 Sale and leaseback of the land on which the property stands
In the case of the leaseback of the land on which the property stands, IAS 17 requires the
lease to be classified as an operating lease.

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As regards the property, from the information provided, it would appear that Bodgit Ltd has
entered into a sale and finance leaseback.
The key factors which indicate this are as follows.
 The lease term of 20 years. This is not a long period of time for property, so does not
clarify the situation.
 Rentals. The present value of discounted future rentals relating to the property is (4/5 
£95,000)  20-year annuity discount factor @ 12% ie, £76,000  7.469 = £567,644. This
is approximately 95% of fair market value of 4/5  £750,000 = £600,000.
The land and building should be derecognised in Bodgit's accounts and a profit or loss
calculated based on the difference between the proportion of the proceeds allocated to
each element (land being 1/5  £750,000 = £150,000 and the building being the remaining
£600,000) and their carrying value.
Based on the original cost to Bodgit of the factory (including land) of £200,000, this is likely
to result in a profit in both cases.
Sale and leaseback as an operating lease
The sale is at fair value and IAS 17 therefore requires that the land is derecognised and the
profit made on the sale is recognised immediately.
The operating lease is then recorded in the normal way by spreading the annual rental
amounts over the lease term and recording them as an expense. The annual rental expense
is therefore 1/5  £95,000 = £19,000.
Sale and leaseback as a finance lease
If the leaseback is a finance lease, the transaction is a means whereby the lessor provides
finance to the lessee, with the asset as security. For this reason it is not appropriate to
regard any excess of sales proceeds over the carrying amount as income. The profit arising
should therefore be deferred and amortised over the term of the lease.
The finance lease is then recorded in the normal way, with the building asset and
corresponding liability both initially recognised at £567,644, being the lower of the fair
value (4/5 x £750,000 = £600,000) and present value of minimum lease payments.

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6 Tonto
Tonto statement of cash flows for the year ended 31.3.20X1
£'000 £'000
Cash flows from operating activities
Loss before tax (1,800)
Depreciation (W1) 3,700
Interest expense 1,000
Loss on disposal of leasehold property (8,500 – (8,800 – 200)) 100
Increase in inventories (12,500 – 4,600) (7,900)
Increase in receivables (4,500 – 2,000) (2,500)
Increase in payables (4,700 – 4,200) 500
Cash used in operations (6,900)
Interest paid (1,000)
Tax paid (W2) (1,900)
Net cash used in operating activities (9,800)
Cash flows from investing activities
Cash from sale of leasehold property 8,500
Net cash from investing activities 8,500
Cash flows from financing activities
Dividends paid (6,300 – 4,500 – 1,100) (700)
Payments made under finance leases (W3) (2,100)
Share issue (10,000 + 3,200) – (8,000 + 4,000) 1,200
Net cash used in financing activities (1,600)
Net decrease in cash and cash equivalents (2,900)
Cash and cash equivalents at 31.3.20X0 1,500
Cash and cash equivalents at 31.3.20X1 (1,400)
WORKINGS
(1) PPE – CARRYING AMOUNT
£'000 £'000
B/d 25,500 Disposal (8,800 – 200) 8,600
Lease plant additions Depreciation (β) 3,700
(6,500 – 2,500 + 1,800) 5,800 C/d 19,000
31,300 31,300 C
H
(2) INCOME TAX A
P
£'000 £'000 T
E
Profit or loss 700 31.3.X0 – Current tax 2,500 R
31.3.X1 – Deferred tax 1,200 31.3.X0 – Deferred tax 800
Tax paid β 1,900 Refund due 500 14
3,800 3,800
(3) FINANCE LEASE LIABILITY
£'000 £'000
Payments made β 2,100 Balance b/f (2,000 + 800) 2,800
Additions (W1) 5,800
Balance c/f (4,800 + 1,700) 6,500
8,600 8,600
7 Livery
Livery Co would allocate £10,154 (£12,000  £11,000 ÷ £(11,000 + 2,000) to the lease
component and account for that as a lease under IFRS 16.
Livery Co would allocate £1,846 (£12,000  £2,000 ÷ £(11,000 + 2,000) to the servicing.

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CHAPTER 15
Financial
instruments:
presentation and
disclosure
Introduction
TOPIC LIST
IAS 32, Financial Instruments: Presentation
1 Overview of material from earlier studies
IFRS 7, Financial Instruments: Disclosures
2 Objective and scope
3 Disclosures in financial statements
4 Other disclosures
5 Financial instruments risk disclosure
Technical reference

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Introduction
 Determine and calculate how different bases for recognising, measuring and
classifying financial assets and financial liabilities can impact upon reported
performance and position
 Explain and appraise accounting standards that relate to an entity's financing
activities which include: financial instruments; leasing; cash flows; borrowing costs;
and government grants
Specific syllabus references for this chapter are: 1(e), 4(a), 4(d)

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1 Overview of material from earlier studies

Section overview
 IAS 32 applies to all entities and all types of financial instruments except where explicitly
covered by another standard, such as IFRS 10 for subsidiaries and IAS 28 for associates
and joint ventures.
 A financial instrument should be classified as either equity, financial liability or financial
asset. This classification is made at the time the financial instrument is issued and not
changed subsequently.
 Compound financial instruments, ie, instruments that contain both a liability and an equity
component, should be split into their component parts at the date they are issued.
 Interest, dividends, losses and gains arising from financial instruments classified as
financial liabilities are recognised in the profit or loss for the year. Dividends paid to
holders of a financial instrument classified as equity are charged directly against equity.
 Financial assets and financial liabilities are presented as separate items in the statement of
financial position with offset being allowed only in limited cases.
 Treasury shares are deducted from equity with the consideration paid or received
recognised directly in equity. Gains or losses on the purchase, sale, issue or cancellation of
equity instruments are not recognised in profit or loss.
1.1 Test your memory

Try these questions to see how well you remember the material covered in your earlier studies.
Interactive question 1: Financial instruments

Why do you think that physical assets and prepaid expenses do not qualify as financial
instruments?
Interactive question 2: Liability or equity?

During the financial year ended 31 December 20X5, Kim issued the financial instrument
described below. Identify whether it should be classified as liability or equity, giving reasons for
your choice.
Redeemable preference shares with a coupon rate 5%. The shares are redeemable on
31 December 20X9 at premium of 20%.
C
H
A
P
Interactive question 3: Convertible bond 1 T
E
An entity issues a convertible bond for £1,000. The bond is convertible into equity shares of the R
issuer at the discretion of the holder at any time in the next 10 years. The bond converts into a
variable number of shares equal to the value of the liability. 15
The entity also issues £7,000 of 8% convertible redeemable preference shares. In 5 years' time
the preference shares will either be redeemed or converted into 5,000 equity shares of the
issuer, at the option of either the holder or issuer.
ICAEW 2019 Financial instruments: presentation and disclosure 789

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Requirement
How should the entity account for the instruments according to IAS 32?
Interactive question 4: Convertible bond 2

An entity issued 5,000 8% convertible bonds at par value of £10 on 1 January 20X5. Each bond
is convertible into 3 ordinary shares on 31 December 20X6. Interest is payable annually in
arrears. The entity incurred transaction costs of £1,000. On the date of issue the market interest
rate for similar debt without the conversion option was 10%.
Requirement
Calculate the liability and equity component of the convertible bond on issue.
Interactive question 5: Options contract

An entity enters into an options contract to acquire 100 ounces of platinum in 90 days' time. The
entity will settle the contract by delivering as many of its own shares as are equal to the cash
value of £1,000 on the purchase date.
Requirement
Explain whether the options contract should be classified as a financial asset, financial liability or
equity.
Interactive question 6: Offsetting

An entity issues debt with a variable rate of interest linked to LIBOR. It enters into a
corresponding, receive floating, pay fixed interest rate swap for the period of the debt. The
effect of the two instruments is to synthesise a fixed-rate long-term loan.
Requirement
Explain whether the two instruments should be presented separately or whether they should be
offset.
1.2 More complex issues

1.2.1 Debt/equity distinction
The separation of debt and equity components of a financial instrument should be familiar to
you from your Professional Level studies, and you should not have had any serious difficulty with
the convertible bond question above (Interactive question 4). However, at Advanced Level you
will need to consider more complex, 'real world' issues. In practice, the debt/equity distinction
may not be not clear cut. Classification of financial instruments as debt or equity can have a
significant effect on the financial statements. Guidance is provided in IAS 32, Financial
Instruments: Presentation (and other standards for items outside IAS 32's scope), but there are
sometimes areas where it is difficult to determine whether a transaction is debt or equity.

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A contract is not an equity instrument solely because it may result in the receipt or delivery of the
entity's own equity instruments. It is necessary to consider whether the settlement results in
receipt or delivery of variable or fixed number of the entity's own equity instruments.
If the contract results in delivery of variable number of equity instruments, the fair value of the
equity instruments equals to the amount of the fixed contractual right or obligation. Such a
contract does not evidence a residual interest in the entity's assets after deducting all of its
liabilities.
The following contracts require delivery of the entity's own equity instruments but are classified
as financial liability:
 A contract to deliver as many of the entity's own equity instruments as are equal in value to
£6,000
 A contract to deliver as many of the entity's own equity instruments as are equal in value to
200 ounces of gold
Contingent settlement provisions
A financial instrument may require the entity to deliver cash or another financial asset in the
event of occurrence or non-occurrence of uncertain future events that are beyond the control of
both the issuer and holder of the instrument. These are known as contingent settlement
provisions and could relate to changes in stock market index, consumer price index, interest
rate, issuer's future profits or revenues. Such instruments are classified as financial liability. This is
because the issuer does not have an unconditional right to avoid delivering cash or another
financial asset.
The financial instrument would be an equity instrument if it has equity-like features, for example,
obligation arises only in the event of liquidation of the issuer.
Worked example: Redemption of preference shares

High Growth Bank issues 7% fixed preference shares. The dividends on the preference shares
are cumulative. The terms and conditions of the issue of preference shares indicate that they will
be redeemed if the net profit of the bank increases by more than 50% in the next three years.
In this case, the contingent event is outside the control of both the bank and the holder. If the
net profit of the bank increases by more than 50% in the next three years, it does not have the
unconditional right to avoid delivering cash. The preference shares also pay a fixed cumulative
dividend and hence are classified as financial liability.
Worked example: Contingent convertible bonds (CoCos)

Contingent convertible bonds issued by Stable Bank give it the right to convert the debt to
equity in the event of its capital ratio falling below a pre-set level. To offset the risk the holder is
undertaking, the yields that Stable Bank offers on its CoCos are 6.6% compared to an average
yield to maturity on other medium-term bonds of 3.5%. C
H
Stable Bank must classify the bonds as a hybrid instrument with both debt and equity features. A
P
T
E
1.2.2 Practical implications R
The classification of financial instruments as debt versus equity is particularly important with
15
items that are financial liabilities or equity as the presentation of the two items and associated
financial effects are very different.
If a financial instrument is classified as a financial liability (debt) it will be reported within current
or non-current liabilities. Non-current liabilities are relevant in determining an entity's leverage,

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or gearing ie, the proportion of debt finance versus equity finance of a business, and therefore
risk to ordinary equity holders.
Distributions relating to instruments classified as financial liabilities are classified as finance cost,
having an impact on reported profitability.
If a financial instrument is classified as equity, reported gearing will be lower than if it were
classified as a financial liability. However, classification as equity is sometimes viewed negatively
as it can be viewed as a dilution of existing equity interests.
Distributions on instruments classified as equity are charged to equity and therefore do not
affect reported profit.
It is important to note that it is not just the presentation of an arrangement that determines the
underlying gearing of a business that an analyst will use to assess the business's risk, but the
substance of the arrangement. Analysts often make their own adjustments to financial
statements where they believe that the information reported under IFRSs does not show the
underlying economic reality. IAS 32, Financial Instruments: Presentation strives to follow a
substance-based approach to give the most realistic presentation of items that are in substance
debt or equity, avoiding the need for analysts to make adjustments.
Classification of instruments can also have financial implications for businesses. For example,
debt covenants on loans from financial institutions often contain clauses that reported gearing
cannot exceed a stated figure, with penalties or call-in clauses if it does.
Companies with high gearing may also find it harder to get financing or financing may be at a
higher interest rate.
High gearing is particularly unpopular in the current economic climate and there have been high
profile cases of companies that have been pressed to sell off parts of their business to reduce
their 'debt mountains' eg, Telefónica SA, the Spanish telecoms provider, selling O2 Ireland to
Hutchison Whampoa (the owner of the '3' telephone network).
Consider the following examples.
Worked example: Debt or equity?

(a) Acquittie issued 40 million non-redeemable £1 preference shares at par value. Under the
terms attaching to the preference shares, a dividend is payable on the preference shares
only if Acquittie also pays a dividend on its ordinary shares relating to the same period.
(b) Acquittie entered into a contract with a supplier to buy a significant item of equipment.
Under the terms of the agreement the supplier will receive ordinary shares with an
equivalent value of £5 million one year after the equipment is delivered.
(c) The directors of Acquittie, on becoming directors, are required to invest a fixed agreed sum
of money in a special class of £1 ordinary shares that only directors hold. Dividend
payments on the shares are discretionary and are ratified at the annual general meeting
(AGM) of the company. When a director's service contract expires, Acquittie is required to
repurchase the shares at their nominal value.
Solution
(a) IAS 32 requires a financial instrument to be classified as a liability if there is a contractual
obligation to deliver cash or another financial asset to another entity.
In the case of the preference shares, as they are non-redeemable, there is no obligation to
repay the principal.
In the case of the dividends, because of the condition that preference dividends will only be
paid if ordinary dividends are paid in relation to the same period, the preference
shareholder has no contractual right to a dividend. Instead, the distributions to holders of

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the preference shares are at the discretion of the issuer as Acquittie can choose whether or
not to pay an ordinary dividend and therefore a preference dividend. Therefore, there is no
contractual obligation in relation to the dividend.
As there is no contractual obligation in relation to either the dividends or principal, the
definition of a financial liability has not been met and the preference shares should be
treated as equity and initially recorded at fair value ie, their par value of £40 million.
The treatment of dividends should be consistent with the classification of the shares and
should therefore be charged directly to retained earnings.
(b) The price of the equipment is fixed at £5 million one year after delivery. In terms of
recognition and measurement of the equipment, the £5 million price would be discounted
back one year to its present value.
The company is paying for the equipment by issuing shares. However, this is outside the
scope of IFRS 2, Share-based Payment because the payment is not dependent on the value
of the shares, it is fixed at £5 million.
This is an example of a contract that "will or may be settled in an entity's own equity
instruments and is a non-derivative for which the entity is or may be obliged to deliver a
variable number of the entity's own equity instruments" (IAS 32.11) ie, a financial liability.
It is the number of shares rather than the amount paid that will vary, depending on share
price. Therefore it should be classed as a financial liability and initially measured at the
present value of the £5 million.
Subsequently, as it is not measured at fair value through profit or loss (as it is not held for
short-term profit-taking or a derivative), it should be measured at amortised cost.
As a result, interest will be applied to the discounted amount over the period until payment
and recognised in profit or loss with a corresponding increase in the financial liability.
(c) Most ordinary shares are treated as equity as they do not contain a contractual obligation to
deliver cash.
However, in the case of the directors' shares, a contractual obligation to deliver cash exists
on a specific date as the shares are redeemable at the end of the service contract.
The redemption is not discretionary, and Acquittie has no right to avoid it. The mandatory
nature of the repayment makes this capital a financial liability. The financial liability will
initially be recognised at its fair value ie, the present value of the payment at the end of the
service contract. It will be subsequently measured at amortised cost and effective interest
will be applied over the period of the service contract.
Dividend payments on the shares are discretionary as they must be ratified at the AGM.
Therefore, no liability should be recognised for any dividend until it is ratified. When
recognised, the classification of the dividend should be consistent with the classification of
the shares and therefore any dividends are classified as a finance cost rather than as a
deduction from retained earnings.
C
H
A
Interactive question 7: Purchase of own equity instruments P
Emporium is a listed retail group, and has a year end of 31 October. On 21 October 20X8, T
E
Emporium carried out a bonus issue where the shareholders of Emporium received certain R
rights. The shareholders are able to choose between the following:
15
(a) receiving newly issued shares of Emporium, which could be traded on 30 November 20X8;
or
(b) transferring their rights back to Emporium by 10 November 20X8 for a fixed cash price
which would be paid on 20 November 20X8.

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While preparing the financial statements at 31 October 20X8, the finance director of Emporium
argued that the criteria for the recognition of a financial liability as regards the second option
were not met at 31 October 20X8 because it was impossible to reliably determine the full
amount to be paid until 10 November 20X8.
Requirement
Discuss whether the finance director is correct regarding the recognition of a financial liability.
2 Objective and scope
Section overview
This section discusses the objectives and sets out the scope of IFRS 7, Financial Instruments:
Disclosures.
2.1 Objective
The principles of IFRS 7 complement the principles for recognising, measuring and presenting
financial assets and financial liabilities in IAS 32, Financial Instruments: Presentation and IFRS 9,
Financial Instruments.
IFRS 7 requires entities to provide disclosures in their financial statements that enable users to
evaluate:
 the significance of financial instruments for the entity's financial position and performance;
and
 the nature and extent of risks arising from financial instruments to which the entity is
exposed during the period and at the reporting date, and how the entity manages those
risks.
The main presentation and disclosure requirements as detailed in IFRS 7 and IAS 32 together
with certain aspects of recognition and measurement of IFRS 9 have already been covered at
Professional Level. This chapter extends the coverage of the disclosure requirements of IFRS 7
and the presentation requirements.
2.2 Scope
IFRS 7 applies to all entities and to all types of financial instruments, except instruments that are
specifically covered by other standards. Examples of financial instruments not covered by IFRS 7
 Interests in subsidiaries, associates and joint ventures that are accounted for in accordance
with IFRS 10, Consolidated Financial Statements or IAS 28, Investments in Associates and
Joint Ventures
 Employers' rights and obligations arising from employee benefit plans, to which IAS 19,
Employee Benefits applies
 Insurance contracts as defined in IFRS 4, Insurance Contracts
 Financial instruments, contracts and obligations under share-based payment transactions to
which IFRS 2, Share-based Payment applies
IFRS 7 applies to recognised and unrecognised financial instruments. Recognised financial
instruments include financial assets and financial liabilities that are within the scope of IFRS 9.

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Unrecognised financial instruments include some financial instruments that, although outside
the scope of IFRS 9, are within the scope of IFRS 7 (such as some loan commitments).
IFRS 7 also applies to contracts to buy or sell a non-financial item that are within the scope of
IFRS 9 because they can be settled net and there is not the expectation of delivery, receipt or
use in the ordinary course of business.
2.3 General considerations

2.3.1 Classes of financial instruments and level of disclosures
IFRS 7 requires that certain disclosures should be given by class of financial instruments. The
classes of financial instruments that will be disclosed should be appropriate to the nature of the
information disclosed and should take into account the characteristics of those financial
instruments. An entity should provide sufficient information to permit reconciliation to the line
items presented in the statement of financial position.
In deciding how to disclose the classes of financial instruments, an entity should not necessarily
adopt the classification of IFRS 9. The classes should be determined by the entity, but at the
minimum it should:
 provide distinctive classes for financial instruments at amortised cost and financial
instruments at fair value; and
 provide a separate class or classes for financial instruments outside the scope of IFRS 7.
Note: A 'class' is not the same as a classification under IFRS 9 (investment in equity instruments,
financial assets held at amortised cost, financial assets at fair value through profit or loss and
financial assets at fair value through other comprehensive income).
2.3.2 Significance of financial instruments for financial position and performance

An entity must disclose information that enables users of its financial statements to evaluate the
significance of financial instruments for its financial position and performance.
2.3.3 Risks from financial instruments

IFRS 7 requires qualitative and quantitative disclosure about the following risks associated with
financial instruments:
 Market risk. This is the risk of changes in the market value of a financial instrument. When
changes in the market value can be attributed to changes in interest rates then the market
risk is normally called interest rate risk, and when it can be attributed to changes in
exchange rates, market risk is called currency risk.
 Credit risk. This is the risk that one party to a financial instrument will fail to fulfil the
obligations that arise for the financial instrument causing loss to the other party.
 Liquidity risk. This is the risk that an entity will encounter difficulty in meeting obligations
associated with financial liabilities.
C
H
A
P
T
E
R
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3 Disclosures in financial statements
Section overview
This section discusses the basic disclosures required by IFRS 7 in the financial statements.
3.1 Statement of financial position

3.1.1 Categories of financial assets and financial liabilities
The carrying amounts of each of the following categories, as defined in IFRS 9, must be
disclosed either in the statement of financial position or in the notes:
 Financial assets at fair value through profit or loss, showing separately:
– those designated as such on initial recognition; and
– those classified as held for trading in accordance with IFRS 9.
 Financial assets at fair value through other comprehensive income
 Financial assets held at amortised cost
 Investments in equity instruments
 Financial liabilities at fair value through profit or loss, showing separately:
– those designated as such on initial recognition; and
– those classified as held for trading in accordance with IFRS 9.
 Financial liabilities measured at amortised cost
3.1.2 Loans and receivables at fair value through profit or loss

(a) Disclosures
If the entity has designated a loan or receivable (or group of loans or receivables) as at fair
value through profit or loss, it should disclose the following:
(1) The maximum exposure to credit risk of the loan or receivable (or group of loans or
receivables) at the reporting date
(2) The amount by which any related credit derivatives or similar instruments mitigate that
maximum exposure to credit risk
(3) The amount of change, during the period and cumulatively, in the fair value of the loan
or receivable (or group of loans or receivables) that is attributable to changes in the
credit risk of the financial asset
(4) The amount of the change in the fair value of any related credit derivatives or similar
instruments that has occurred during the period and cumulatively since the loan or
receivable was designated
(b) Calculation
The amount of any change in the fair value attributable to credit risk can be calculated as
the amount of the change not attributed to market risk. That is
 Amount of change in fair value   Total amount of   Amount of change in fair value 
 =  
attributed to credit risk  change in fair value attributed to market risk 
(c) Alternative method

The standard allows the employment of an alternative method to calculate the amount of
change in the fair value attributed to credit risk if the entity believes that such a method

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more faithfully represents the amount of change in its fair value that is attributable to
changes in the credit risk of the asset.
(d) Market risk
Changes in market conditions that give rise to market risk include changes in an observed
(benchmark) interest rate, commodity price, foreign exchange rate or index of prices or
rates.
3.1.3 Financial liabilities at fair value through profit or loss

(a) Disclosures
If the entity has designated a financial liability as at fair value through profit or loss it should
disclose the following:
(1) The amount of change, during the period and cumulatively, in the fair value of the
financial liability that is attributable to changes in the credit risk of that liability
(2) The difference between the financial liability's carrying amount and the amount the
entity would be contractually required to pay at maturity to the holder of the obligation
(b) Calculation
The amount of any change in the fair value attributable to credit risk can be calculated as
the amount of the change not attributed to market risk. That is
 Amount of change in fair value   Total amount of   Amount of change in fair value 
 =  
attributed to credit risk  change in fair value attributed to market risk 
(c) Alternative method

The standard allows the employment of an alternative method to calculate the amount of
change in the fair value attributed to credit risk if the entity believes that such a method is
more accurate.
(d) Market risk
Changes in market conditions that give rise to market risk include changes in a benchmark
interest rate, the price of another entity's financial instrument, a commodity price, a foreign
exchange rate or an index of prices or rates. For contracts that include a unit-linking feature,
changes in market conditions include changes in the performance of the related internal or
external investment fund.
The example below illustrates how an entity can arrive at the change in fair value
attributable to credit risk by estimating the amount of change in fair value attributable to
risks other than credit risk.
Worked example: Credit risk and change in value

On 1 January 20X6, an entity issues a five-year bond with a par value of £200,000, and an annual
fixed coupon rate of 7%. The coupon rate reflects the market LIBOR rate and the credit spread C
H
associated with the bond at the time of the issue. At the time of the issue LIBOR was 5%, A
implying a credit spread of 2%. P
T
The price of the bond will subsequently change either due to change in LIBOR (market risk) or E
due to a change in the credit spread (credit risk). R
Thus a change in the fair value of the bond attributed to credit risk can be calculated by 15
subtracting from the total change in the fair value the changes due to market risk (ie, due to
changes in LIBOR).

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Suppose that on 31 December 20X6, the value of the bond has decreased to £196,651, as the
LIBOR has increased to 5.25%. The yield to maturity for the bond has now risen to 7.50%. The
credit spread has now increased to 2.25% implying deterioration in the credit quality of the
bond.
In order to calculate the change in the value of the bond due to changes in LIBOR alone, we
shall calculate the fair value of the bond, at the new LIBOR of 5.25% assuming that the credit
spread has remained at 2%. This means that we need to discount the remaining four payments
using a discount rate of 7.25%.
Using this discount factor produces
14,000 14,000 14,000 14,000 + 200,000
+ + + = £198,316
1.0725 1.0725 1.07253
2
1.07254
Total change in market value (£200,000 – £196,651) £3,349
Change in market value due to market risk (£200,000 – £198,316) £1,684
Difference in value due to credit risk (£198,316 – £196,651) £1,665
3.1.4 Reclassification
If an entity has reclassified a financial asset, previously measured at fair value as measured at
cost or amortised cost or vice versa, it should disclose the amount reclassified into and out of
each category and the reason for that reclassification.
3.1.5 Derecognition
An entity may have transferred financial assets in such a way that part or all of the financial
assets do not qualify for derecognition. In such a case, the entity should disclose the following
for each class of financial assets:
 The nature of the assets
 The nature of the risks and rewards of ownership to which the entity remains exposed
 When the entity continues to recognise all of the assets, the carrying amounts of the assets
and of the associated liabilities
 When the entity continues to recognise the assets to the extent of its continuing
involvement, the total carrying amount of the original assets, the amount of the assets that
the entity continues to recognise, and the carrying amount of the associated liabilities
3.1.6 Collateral
An entity should disclose the following:
 The carrying amount of financial assets it has pledged as collateral for liabilities or
contingent liabilities, including amounts that have been reclassified
 The terms and conditions relating to its pledge
When an entity holds collateral (of financial or non-financial assets) and is permitted to sell or re-
pledge the collateral in the absence of default by the owner of the collateral, it shall disclose the
following:
 The fair value of the collateral held
 The fair value of any such collateral sold or re-pledged, and whether the entity has an
obligation to return it
 The terms and conditions associated with its use of the collateral

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3.2 Profit or loss for the year

Items of income, expense, gains or losses
An entity should disclose the following items of income, expense, gains or losses either in the
statement of profit or loss and other comprehensive income or in the notes:
(a) Net gains or net losses on:
(1) Financial assets or financial liabilities at fair value through profit or loss, showing
separately those on financial assets or financial liabilities designated as such on initial
recognition, and those on financial assets or financial liabilities that are classified as
held for trading in accordance with IFRS 9
(2) Investments in equity instruments where gains are recognised in profit or loss for the
period
(3) Held-to-maturity investments
(4) Loans and receivables
(5) Financial liabilities measured at amortised cost
(b) Total interest income and total interest expense (calculated using the effective interest
method) for financial assets or financial liabilities that are not at fair value through profit or
loss
(c) Fee income and expense (other than amounts included in determining the effective interest
rate) arising from:
 financial assets or financial liabilities that are not at fair value through profit or loss; and
 trust and other fiduciary activities that result in the holding or investing of assets on
behalf of individuals, trusts, retirement benefit plans and other institutions.
(d) Interest income on impaired financial assets
(e) The amount of any impairment loss for each class of financial asset
4 Other disclosures
Section overview
This section discusses additional quantitative and qualitative disclosures in the financial
statements.
4.1 Accounting policies

An entity should disclose, in the summary of significant accounting policies, the measurement
basis (or bases) used in preparing the financial statements and the other accounting policies C
used that are relevant to an understanding of the financial statements. H
A
P
4.2 Hedge accounting T
E
Hedge accounting is covered in Chapter 17. The disclosures are dealt with in that chapter. R
15

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4.3 Fair value

IFRS 7 retains the following general requirements in relation to the disclosure of fair value for
those financial instruments measured at amortised cost:
 For each class of financial assets and financial liabilities an entity should disclose the fair
value of that class of assets and liabilities in a way that permits it to be compared with its
carrying amount.
 In disclosing fair values, an entity should group financial assets and financial liabilities into
classes, but should offset them only to the extent that their carrying amounts are offset in
the statement of financial position.
It also states that disclosure of fair value is not required:
 where carrying amount is a reasonable approximation of fair value; and
 for investments in equity instruments that do not have a quoted market price in an active
market for an identical instrument, or derivatives linked to such equity instruments.
IFRS 13 (see Chapter 2, section 4) provides disclosure requirements in respect of the fair value
of financial instruments measured at fair values. It requires that information is disclosed to help
users assess:
 For assets and liabilities measured at fair value after initial recognition, the valuation
techniques and inputs used to develop those measurements
 For recurring fair value measurements (ie, those measured at each period end) using
significant unobservable (Level 3) inputs, the effect of the measurements on profit or loss
or other comprehensive income for the period
In order to achieve this, the following should be disclosed as a minimum for each class of
financial assets and liabilities measured at fair value:
 The fair value measurement at the end of the period
 The level of the fair value hierarchy within which the fair value measurements are
categorised in their entirety
 For assets and liabilities measured at fair value at each reporting date (recurring fair value
measurements), the amounts of any transfers between Level 1 and Level 2 of the fair value
hierarchy and reasons for the transfers
 For fair value measurements categorised within Levels 2 and 3 of the hierarchy, a
description of the valuation techniques and inputs used in the fair value measurement, plus
details of any changes in valuation techniques
 For recurring fair value measurements categorised within Level 3 of the fair value hierarchy:
– A reconciliation from the opening to closing balances
– The amount of unrealised gains or losses recognised in profit or loss in the period and
the line item in which they are recognised
– A narrative description of the sensitivity of the fair value measurement to changes in
unobservable inputs
 For recurring and non-recurring fair value measurements categorised within Level 3 of the
fair value hierarchy, a description of the valuation processes used by the entity
An entity should also disclose its policy for determining when transfers between levels of the fair
value hierarchy are deemed to have occurred.

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Worked example: Fair value disclosures

For financial assets and liabilities measured at fair value at the end of the reporting period, IFRS
13 requires quantitative disclosures about the fair value measurements for each class of financial
assets and liabilities.
An entity might disclose the following for financial assets and financial liabilities (excludes
comparatives and further quantitative disclosures in relation to fair value hierarchy):
Fair value measurements at the end of the
reporting period using
Description 31.12.X5 Level 1 inputs Level 2 inputs Level 3 inputs
£'000
Trading portfolio assets 95 95
Non-trading equity securities 73 73
Corporate bonds 175 25 150
Designated at fair value 33 31 2
Investments in equity
instruments 41 11 25 5
Derivatives – interest rate
swaps 55 55
Financial assets at fair value 472 131 261 80
Trading portfolio liabilities 60 40 20
Designated at fair value 12 9 3
Derivatives – interest rate
swaps 55 55
Financial liabilities at fair value 127 40 84 3
5 Financial instruments risk disclosure
Section overview
An entity should disclose information that enables users of its financial statements to evaluate
the nature and extent of risks arising from financial instruments to which the entity is exposed at
the reporting date. These risks include, but are not limited to, credit risk, liquidity risk and
market risk.
5.1 Types of risk

In undertaking transactions in financial instruments, an entity may assume or transfer to another
party one or more different types of financial risk as defined below. The disclosures required by
the standard show the extent to which an entity is exposed to these different types of risk,
relating to both recognised and unrecognised financial instruments.
Credit risk The risk that one party to a financial instrument will cause a financial loss for C
the other party by failing to discharge an obligation. H
A
Currency risk The risk that the fair value or future cash flows of a financial instrument will P
fluctuate because of changes in foreign exchange rates. T
E
Interest rate risk The risk that the fair value or future cash flows of a financial instrument will R
fluctuate because of changes in market interest rates.
15
Liquidity risk The risk that an entity will encounter difficulty in meeting obligations
associated with financial liabilities.
Loans payable Loans payable are financial liabilities, other than short-term trade payables
on normal credit terms.

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Market risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises three
types of risk: currency risk, interest rate risk and other price risk.
Other price risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices (other than those arising from
interest rate risk or currency risk), whether those changes are caused by
factors specific to the individual financial instrument or its issuer, or factors
affecting all similar financial instruments traded in the market.
Past due A financial asset is past due when a counterparty has failed to make a
payment when contractually due.
5.2 Qualitative disclosures

For each type of risk arising from financial instruments, an entity must disclose the following:
(a) The exposures to risk and how they arise
(b) Its objectives, policies and processes for managing the risk and the methods used to
measure the risk
(c) Any changes in (a) or (b) from the previous period
5.3 Quantitative disclosures

For each financial instrument risk, summary quantitative data about risk exposure must be
disclosed. This should be based on the information provided internally to key management
personnel. More information should be provided if this is unrepresentative.
Information about credit risk must be disclosed by class of financial instrument:
(a) Maximum exposure at the year end
(b) Any collateral pledged as security
(c) In respect of the amount disclosed in (b), a description of collateral held as security and
other credit enhancements
(d) Information about the credit quality of financial assets that are neither past due nor
impaired
(e) Financial assets that are past due or impaired, giving an age analysis and a description of
collateral held by the entity as security
(f) Collateral and other credit enhancements obtained, including the nature and carrying
amount of the assets and policy for disposing of assets not readily convertible into cash
For liquidity risk, entities must disclose the following:
 A maturity analysis of financial liabilities
 A description of the way risk is managed
Disclosures required in connection with market risk:
 Sensitivity analysis, showing the effects on profit or loss of changes in each market risk
 If the sensitivity analysis reflects interdependencies between risk variables, such as interest
rates and exchange rates, the method, assumptions and limitations must be disclosed

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5.3.1 Credit risk disclosures in more detail

Information about credit risk must be disclosed by class of financial instrument:
(a) Maximum exposure at the year end, which for a financial asset is the gross carrying amount,
net of:
 any amounts offset in accordance with IAS 32; and
 any impairment losses recognised in accordance with IFRS 9.
The maximum exposure to credit risk at the reporting date should be without taking
account of any collateral held or other credit enhancements (eg, netting agreements that
do not qualify for offset in accordance with IAS 32).
(b) In respect of the amount disclosed in (a), a description of collateral held as security and
other credit enhancements.
(c) Information about the credit quality of financial assets that are neither past due nor
impaired.
(d) Financial assets that are past due or impaired, giving an age analysis and a description of
collateral held by the entity as security.
(e) Collateral and other credit enhancements obtained, including the nature and carrying
amount of the assets and policy for disposing of assets not readily convertible into cash.
(f) Analysis of financial assets that are individually determined to be impaired as at the
reporting date, including the factors the entity considered in determining that they are
impaired.
The activities that give rise to credit risk and the associated maximum exposure to credit risk
include, but are not limited to the following:
 Grant of loans to customers and placing deposits with other entities: Maximum exposure to
credit risk is the carrying amount of related financial assets.
 Derivative contracts: When the resulting financial asset is measured at fair value, the
maximum exposure to credit risk at the end of the reporting period will equal the carrying
amount.
 Grant of financial guarantees: Maximum exposure to credit risk is the maximum amount the
entity could have to pay if the guarantee is called on, which may be significantly greater
than the amount recognised as a liability.
 Making a loan commitment that is irrevocable over the life of the facility or is revocable only
in response to a material adverse change: If the issuer cannot settle the loan commitment
net in cash or another financial instrument, the maximum credit exposure is the full amount
of the commitment.
Additional disclosures
These include disclosures such as the following:
C
 Reconciliation of loss allowances H
A
 Explanation of how significant changes in the gross carrying amount of financial instruments
P
during the period contributed to changes in loss allowance T
E
 Inputs, assumptions and techniques in estimating 12-month and lifetime expected credit R
losses including how forward looking information has been incorporated into the
determination of expected credit losses 15
 Separate disaggregation by credit risk rating grades of the gross carrying amount
 Information about collateral, modified financial assets and write offs still subject to
enforcement activity

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5.4 Sensitivity analysis: more detail

The standard requires that an entity should disclose a sensitivity analysis for each type of market
risk to which the entity is exposed.
The standard gives two options regarding disclosure of the sensitivity analysis.
Option 1
An entity should disclose the following:
(a) Sensitivity analysis for each type of market risk to which the entity is exposed at the
reporting date, showing how profit or loss and equity would have been affected by changes
in the relevant risk variable that were reasonably possible at that date. Risk variables that are
relevant to disclosing market risk include, but are not limited to:
 the yield curve of market interest rates, for example the LIBOR rate. It may be necessary
to consider both parallel and non-parallel shifts in the yield curve;
 foreign exchange rates;
 prices of equity instruments; and
 market prices of commodities.
(b) The methods and assumptions used in preparing the sensitivity analysis
(c) Changes from the previous period in the methods and assumptions used, and the reasons
for such changes
The effect on profit or loss and equity of reasonably possible changes in the relevant risk
variables may include changes in the prevailing interest rates for interest-sensitive instruments,
and/or changes in currency rates for foreign currency financial instruments.
For interest rate risk, the sensitivity analysis might show separately the effect of a change in
market interest rates on interest income and expenditure, on other items of profits and on
equity.
Option 2
Alternatively, if an entity prepares a sensitivity analysis, such as value at risk, that reflects
interdependencies between risk variables (eg, interest rates and exchange rates) and uses it to
manage financial risks, it may use that sensitivity analysis in place of the analysis specified in the
previous paragraph. In this case the entity should also disclose:
 an explanation of the method used in preparing such a sensitivity analysis, and of the main
parameters and assumptions underlying the data provided; and
 an explanation of the objective of the method used and of limitations that may result in the
information not fully reflecting the fair value of the assets and liabilities involved.
It is important for auditors to test this sensitivity analysis and document this on their files. For
example, they should document how they gained comfort over the underlying assumptions and
sensitivity analysis methodology. Auditing financial instruments is covered in Chapter 17,
section 11.
5.5 Other market risk disclosures

Other market risk is any market risk which is not currency or interest rate risk. When the
disclosure of sensitivity analyses discussed above are unrepresentative of a risk inherent in a
financial instrument (for example because the year-end exposure does not reflect the exposure
during the year), the entity shall disclose that fact and the reason it believes the sensitivity
analyses are unrepresentative.

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Summary
Statement of Profit or loss Other disclosures

financial position and equity
Categories of Other disclosures Income, expenses, Accounting policies

assets/liabilities gains and losses
at carrying
value
Reclassification Hedge accounting
Net gains/losses
Further detailed on all asset/liability
disclosures categories
relating to Derecognition Fair value
risk for financial
assets/liabilities
at fair value Total interest
Collateral income Credit risk
through profit
or loss
Allowances accounted Fee income Liquidity risk

for credit loss and expenditure
• Financial assets/
liabilities not
Compound financial through Market risk
instrument with • Trust and other
multiple embedded fiduciary activities
derivatives
Interest income
on impaired
Defaults and breaches financial assets
Amount of
impairment loss
for each class of C
financial asset H
A
P
T
E
R
15

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Presentation in financial
statements
Treasury shares (own shares)

acquired by entity
• To be deducted from equity
• Consideration paid/received
recognised directly in equity
Liability or equity
Compound financial instruments,

Equity Liability Offsetting eg, convertible instruments
• Ordinary shares • Redeemable • Legally enforceable
• Irredeemable preference shares rights of set-off
preference shares not • Entity intends to
requiring payment of settle net or
an annual fixed dividend simultaneously Liability element
Interest, dividends, gains Equity element
and losses relating to a (valued as fair value (valued as total value
financial liability are of similar liability – liability element)
• Transaction costs of
recognised in profit without equity
an equity transaction
or loss component)
are accounted for as
a deduction from equity
• Distributions to holders
of an equity instrument
are debited to equity

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Self-test
1 What is the main objective of the disclosure requirements of IFRS 7?
2 How does IFRS 7 define the following?
(a) Liquidity risk
(b) Market risk
3 Why does IFRS 7 require entities to disclose sensitivity analysis to market risk?
4 Warburton
The Warburton Company issued £10 million of convertible bonds at par on
31 December 20X7. Interest is payable annually in arrears at a rate of 7%. The bonds are
redeemable on 31 December 20X9. The bonds can be converted at any time up to maturity
into 12.5 million ordinary shares.
At the time of issue, the market interest rate on debt with a similar credit status and the
same cash flows, but without conversion rights, was 10% per annum.
Requirement
What carrying amount should be recognised for the liability in the statement of financial
position of Warburton at 31 December 20X7 in respect of the convertible bond, in
accordance with IAS 32, Financial Instruments: Presentation?
5 Erubus
The Erubus Company issued £15 million of 6% convertible bonds at par on
31 December 20X7. The bonds are redeemable at 31 December 20Y1. The bonds can be
converted by their holders any time up to maturity into ordinary shares of Erubus.
At 31 December 20X7 the present value of the future capital and interest payments
discounted at the prevailing market interest rate for similar bonds without the conversion
rights is £13 million.
The transaction costs directly attributable to the issue of the convertible bonds were
£400,000. These costs are deductible against Erubus's taxable profits. Erubus's tax rate
is 25%.
Requirement
What increase in equity should be recognised in the statement of financial position of
Erubus at 31 December 20X7 as a result of the issue of the convertible bonds, in
accordance with IAS 32, Financial Instruments: Presentation?
Note: Some of the requirements of IAS 32 relate to derivatives and embedded derivatives.
C
These will be tested after you have covered those topics in Chapter 16. H
A
P
achieved these objectives, please tick them off. T
E
R
15

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Technical reference

1 Presentation of equity and liabilities
 Classification as financial asset, financial liability or equity instrument IAS 32.15–16
 Definitions IAS 32.11
 Contractual obligation and substance of instrument IAS 32.17–18
 Settlement options IAS 32.26–27
 Treasury shares IAS 32.33–34
 Interest, dividends, losses and gains IAS 32.35–36
 Offsetting IAS 32.42
2 Compound instruments
 Recognising liability and equity elements IAS 32.28
 Example of convertible bonds IAS 32.29–30
 Calculation of liability and equity elements IAS 32.31–32

IFRS 7.8–19
1 Statement of financial position disclosures
IFRS 7.20
2 Statement of profit or loss and other comprehensive income and
statement of changes in equity disclosures
3 Nature and extent of risks arising from financial instruments

 Purpose of disclosures IFRS 7.31–32
 Qualitative disclosures IFRS 7.33
 Quantitative disclosures IFRS 7.34–35

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Refer to the definitions of financial assets and liabilities.
 Physical assets: Control of these creates an opportunity to generate an inflow of cash or
other assets, but it does not give rise to a present right to receive cash or other financial
assets.
 Prepaid expenses, etc: The future economic benefit is the receipt of goods/services rather
than the right to receive cash or other financial assets.

Liability. The preference shares require regular distributions to the holders but more importantly
have the debt characteristic of being redeemable. Therefore, according to IAS 32, Financial
Instruments: Presentation they must be classified as liability.

The convertible bond is not a compound financial instrument, as it is not settled in a fixed
amount of shares. It should instead be wholly classified as a liability.
The convertible redeemable preference shares are compound instruments. They have a
financial liability component, as there is an obligation to deliver cash through dividends and on
redemption in five years' time to deliver either cash or equity instruments (through the holder's
right to convert into equity).

The liability component is computed as the present value of the maximum potential cash flows
discounted at 10%.
Discount
Time Cash flow factor @ PV
10%
£ £
1 4,000 0.909 3,636
2 54,000 0.826 44,604
48,240
The equity component of the gross proceeds is therefore (£50,000 – £48,240) £1,760.
The issue costs of £1,000 are split in the ratio 48,240:1,760 ie, £965 is netted against the liability
and £35 is netted against the equity.
C
The entries are therefore: H
A
£ £
P
DEBIT Cash 50,000 T
CREDIT Liability 48,240 E
CREDIT Equity 1,760 R
and 15
CREDIT Cash 1,000

DEBIT Liability 965
DEBIT Equity 35

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The net liability initially recognised is £47,275. This is then amortised to £50,000 over the next
2 years at an effective interest rate of 11.19% (the IRR of the cash flows of £47,275, –£4,000 and
–£54,000) as follows:
Interest
expense at
Year B/fwd 11.19% Cash flow C/fwd
£ £ £ £
1 47,275 5,290 (4,000) 48,565
2 48,565 5,435 (4,000) 50,000

The contract is a financial asset or financial liability, even though the entity must settle it by
issuing its own equity. It is not an equity instrument, as it is settled using a variable number of the
entity's own equity instruments.

Offsetting is not appropriate.
Each of the financial instruments has its own terms and conditions and may be transferred or
settled separately. The risks of the financial instruments are different.
They should not be offset unless they meet the criteria in IAS 32 (legal right of set-off and
intention to settle net), which is unlikely. However, disclosure of the relationship between the
two financial instruments would provide useful information to users of the financial statements.

Emporium's finance director is incorrect. A financial liability for the present value of the
maximum amount payable to shareholders should be recognised in the financial statements as
of 31 October 20X8. At 31 October 20X8, the rights are equivalent to a written put option
because they represent for Emporium a purchase obligation which gives shareholders the right
to sell the entity's own equity instruments for a fixed price. The fundamental principle of IAS 32
Financial Instruments: Presentation is that a financial instrument should be classified as either a
financial liability or an equity instrument according to the substance of the contract, not its legal
form, and the definitions of financial liability and equity instrument. IAS 32 states that a contract
which contains an entity's obligation to purchase its own equity instruments gives rise to a
financial liability, which should be recognised at the present value of its redemption amount.
IAS 32 also states that a contractual obligation for an entity to purchase its own equity
instruments gives rise to a financial liability for the present value of the redemption amount even
if the obligation is conditional on the counterparty exercising a right to redeem, as is the case
with the bonus issue of Emporium.

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1 The main objective of the disclosure requirements of IFRS 7 is to show the significance of
financial instruments for an entity's financial position and financial performance and
qualitative and quantitative information about exposure to risks arising from financial
instruments.
2 (a) Liquidity risk is defined as the risk that an entity will encounter difficulty in meeting the
obligations associated with its financial liabilities.
(b) Market risk is the risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices.
3 Sensitivity analysis helps users of financial statements to evaluate the effect of possible
changes in the entity's financial position and financial performance due to changes in
market risk factors.
4 Warburton
£9,479,339
IAS 32.28 requires the separation of the compound instrument into its liability and equity
elements. IAS 32.31 and .32 explain how this separation should be made. IAS 32.AG30 –
AG35 explain the application of this principle.
2
Thus the liability is (£0.7m/1.10) + (£10.7m/1.10 ) = £9,479,339.
5 Erubus
£1,960,000
IAS 32.28 requires the separation of a compound instrument into liability and equity
elements where this is appropriate.
IAS 32.35 and 32.37 require that transaction costs of an equity transaction shall be
deducted from equity net of tax.
IAS 32.38 requires that transaction costs directly attributable to a compound financial
instrument should be allocated to the liability and equity components in proportion to the
allocation of the proceeds.
Liability component of gross proceeds: £13m
Equity component of gross proceeds: £2m
Issue costs are £400,000, allocated:
Liability component (13/15) £346,667
Equity component (2/15) £53,333
C
The initial liability recognised is therefore (£13m – £346,667) £12,653,333. H
A
The equity component is (£2m – (£53,333 – 25% tax relief on £53,333) £1,960,000 P
T
Note that tax relief on the issue costs allocated to the liability component will be given, as E
they are amortised against profit or loss. Initially they attract no relief and so there is no tax R
adjustment for them in the original allocation of the issue costs. 15

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Financial Reporting (Institute of Chartered Accountants of Pakistan)

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Financial Statement Analysis

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Professional Level exams Permitted text

Audit and Assurance 

Financial Accounting and Reporting 

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Skills within the ACA

Assimilating and using information

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 Structure and analyse financial and non-financial data to enhance understanding of

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1 Using this Study Manual

2 The importance of corporate reporting

3 The role and context of modern auditing