Auditing – Study Notes Chapter 1 Introduction to Assurance Services

CHAPTER ONE
INTRODUCTION TO ASSURANCE SERVICES

ICAP'S STUDY TEXT

L O #* LEARNING OBJCTIVE
REFERENCE**

LO 1
1.1.2, 1.1.3 (excluding
ORIGIN, ADVANTAGES AND DISADVANTAGES OF
True & Fair view),
✯ ASSURANCE SERVICE
1.1.4, 1.5.1
LO 2 DEFINITION AND ELEMENTS OF ASSURANCE
1.2.3
✯✯ ENGAGEMENT
1.2.1, 1.2.2 (excluding
LO 3 TYPES OF ASSURANCE AND WHY ABSOLUTE
Assurance provided by
✯✯✯ ASSURANCE CANNOT BE PROVIDED
audit and review), 1.5.2

*Explanation of Symbol:
Symbol ✯ shows important of the concept from exam point of view.
 If a concept is tagged with three stars i.e. ✯✯✯, it is very very important concept. Such concepts should be focused
most during preparation, should be revised atleast 10 times in the last month before exam, and should be revised
first on last day before exam.
 If a concept is tagged with two stars i.e. ✯✯, it is very important concept. Such concepts should be focused highly
during preparation, should be revised atleast 6 times in the last month before exam, and should be revised after
three-star concepts on last day before exam.
 If a concept is tagged with single star i.e. ✯, it is important concept. Such concepts should be focused moderately
during preparation, should be revised atleast 3 times in the last month before exam, and should be revised after
two-star concepts on last day before exam.
(Note that none of the concept is unimportant, therefore none should be skipped)

**Explanation of Reference:
First digit in Study Text’s Reference represents chapter number, second and third digits represents
section and sub-section number. Contents in brackets (if any) represent part of the sub-section
which is covered by the learning objective.

Coverage from Question Bank

After completion of this chapter, you will be able to attempt following questions in ICAP's Question
Bank:

Question # in ICAP’s Question Bank Type of Question

Q. # 2 (Levels of assurance) Concept Review Question

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Auditing – Study Notes Chapter 1 Introduction to Assurance Services

LO 1: ORIGIN, ADVANTAGES AND DISADVANTAGES OF ASSURANCE SERVICES: ✯

Origin of Assurance Services:
Since the Industrial Revolution in 18th century, businessmen started forming Joint Stock Companies
to do business. In most situations, people who managed the company (called management and
directors) were separate from those who owned the company (called shareholders). Management
and Directors had role of stewardship (i.e. management wisely look after the assets of the company
on behalf of shareholders) and role of agent (i.e. management act in accordance with instructions
of shareholders). To judge the performance of management and directors, shareholders asked them
to prepare and present them financial statements.

Soon after, it was recognized that financial statements prepared by management/directors

presented “best-view” of business instead of “true-and-fair-view” due to some Incentive (e.g.
bonus) or Pressure (e.g. fear of removal) faced by management. Thus credibility of financial
statements was questioned.

To enhance the credibility/confidence/assurance on these financial statements, an expert person

(called assurance provider or auditor) was hired by shareholders to verify financial statements.
This person is independent of both management and shareholders.

Advantages of Assurance Services:

An assurance engagement may be performed not only to meet statutory requirements, but there
are also some other value-added advantages.

For Shareholders:
1. Financial statements are more reliable for decision making because most of the
misstatements will be detected during audit.
2. Minority shareholders (or sleeping partners) will have assurance that their interest is
protected.

For Directors/Management:
An audit improves a company’s governance i.e.
1. Audit identifies deficiencies in entity’s internal control system and assurance providers
suggest recommendations for improvement through Management Letter.
2. Audit acts as a check on employees; thereby positive behavior increases and risk of fraud is
reduced.
3. Audit assures that management is performing its statutory duties.

For Third Parties:

An audit also provides facilities to third parties in their dealings with company e.g.
1. To prospective investors in purchase of Business or Shares.
2. To banks in granting loan.
3. To tax authorities in ascertaining tax liability.
4. To insurance companies in settlement of insurance claims

Disadvantages of Assurance Services:

1) Audit takes cost and time of client.
2) Entity has to share its confidential information with auditor.
3) Management/Directors often think audit as a “disturbing activity” instead of a “value added
activity”.

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Auditing – Study Notes Chapter 1 Introduction to Assurance Services

4) Audit does not provide 100% (i.e. absolute) assurance, therefore, there is still some risk that
errors or fraud may exist.
5) Terminology used in audit report is not usually understood by non-accountants which
causes misunderstanding among stakeholders (e.g. terms of “reasonable assurance”,
“material”, “misstatement”, “true and fair”, “test basis”, “accounting principles”)
6) Audit is of little value if shareholders are actively involved in management.

Services of auditors were appreciated greatly. Now a days, assurance engagements are performed
either because:
 they are required by law (called statutory assurance engagements e.g. all companies in
Pakistan are required by law to get their annual financial statements audited before they
are given to shareholders)
 they are not required by law but are voluntarily performed (called non-statutory
assurance engagements e.g. sole-proprietorships, partnerships and NGOs etc. conducting
an audit)

CONCEPT REVIEW QUESTION

What are the advantages of an audit to an organization? (05 marks)
(CA Inter – Spring 2004)
List six benefits to organizations, which are exempt from the statutory audit, of voluntarily
undergoing an external audit.
(ICAEW – December 2007)

LO 2: DEFINITION AND ELEMENTS OF ASSURANCE ENGAGEMENT: ✯✯

Assurance Engagement:
“Assurance engagement” means an engagement in which a practitioner obtains evidence about
evaluation of a subject matter against suitable criteria, and expresses his conclusion to enhance the
confidence of the intended users (other than the responsible party).

Elements of Assurance Engagement:

Every assurance engagement consists of following 5 elements:

Element Explanation (with respect to assurance on financial statements)

1. Intended users (the parties who require subject matter and assurance
report e.g. shareholders, bankers)
A three party 2. A responsible party (the party which is responsible for preparation of
relationship subject matter i.e. management) and
3. A practitioner (the professional who verifies subject matter and provides
assurance on it i.e. auditor)
Subject matter is the data which responsible party prepares and is to be
A subject matter
verified e.g. Financial Statements
Criteria means Framework (i.e. standard rules and regulations) which is used
A Suitable Criteria to prepare and evaluate financial statements e.g. IFRS or Tax Laws.
Suitable means it should be selected appropriately.
Evidence means information on which practitioner’s conclusion is based.
Evidence
Evidence should be sufficient and appropriate.

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Auditing – Study Notes Chapter 1 Introduction to Assurance Services

It is a page written in standard format which includes conclusion of

Written Assurance
practitioner. It is provided by practitioner to intended users e.g. Report on
Report
audit of financial statements, or Report on review of financial statements.

CONCEPT REVIEW QUESTION

Explain the five elements of an assurance engagement (05 marks)
(ACCA F8 – June 2013)

LO 3: LEVELS OF ASSURANCE AND WHY ABSOLUTE ASSURANCE CANNOT BE

PROVIDED: ✯✯✯
“Assurance” means confidence with which a practitioner expresses his conclusion. Assurance adds
credibility in financial statements, however level of credibility depends on type of assurance
provided.

Levels/Types of Assurance:
There are two levels of assurance that can be provided to assurance client i.e. Reasonable
Assurance and Limited Assurance.

Reasonable Assurance (also called High Level or Positive Assurance)

It is a high but not absolute level of assurance which is expressed in positive form of conclusion i.e.
“in our opinion, financial statements give true and fair view”.

This is usually given in an audit of financial statements.

Concept of reasonable assurance acknowledges that there is still some risk that audit opinion can
be wrong because of inherent limitations of audit.

Limited Assurance (also called Moderate Level or Negative Assurance)

It is a moderate level of assurance which is expressed in negative form of conclusion i.e. “Based on
our review, nothing has come to our attention that causes us to believe that financial statements do
not give true and fair view”.

This is usually given in a review of financial statements.

Why absolute assurance cannot be provided to an assurance client:

Auditor cannot provide absolute assurance because of inherent limitations of assurance/audit.
These limitations are discussed below:
1. Some accounts in financial statements involve estimates / judgments/ uncertainties which
are difficult to calculate and verify (e.g. Provision for bad debts, Depreciation, Outcomes of
legal cases, Warranty expenses, Intangible assets.)
2. There are always some limitations/weaknesses in internal control system of client.
3. Many of the audit procedures based on auditor’s judgment which can be faulty.
4. Because of time and cost limitation, auditor checks only a sample of transactions.
5. Fraud involving collusion and complex techniques are harder to detect.
6. Management may not provide complete information to auditor.
7. Auditor does not have specific legal powers e.g. power to search.
8. Most of the evidence is persuasive rather than conclusive.

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Auditing – Study Notes Chapter 1 Introduction to Assurance Services

CONCEPT REVIEW QUESTION

(a) What is meant by reasonable assurance? (02 marks)
(b) Why an auditor cannot provide an absolute assurance as a result of audit? Explain. (03 marks)
(CA Inter -Autumn 2004)

Distinguish between absolute and reasonable assurance. Identify the type of assurance that is
expected in an audit of the financial statements, clearly outlining the reasons to justify your point of
view. (08 marks)
(CA Inter -Spring 2009)

“An unmodified audit report is not a guarantee that the financial statements are free from material
misstatements”. Discuss the rationale of this statement. (06 marks)
(CA Inter -Spring 2007)

Explain why audit risk cannot be reduced to zero. (02 marks)

(ICAEW - December 2008)

Is an auditor responsible for the detection and disclosure of every error and fraud? Discuss.
(06 marks)
(CA Inter -Autumn 2003)

5 By Muhammad Asif, ACA

Auditing – Case Studies Chapter 1 Introduction to Assurance Services

CHAPTER ONE (Attempting Case Studies)

INTRODUCTION TO ASSURANCE SERVICES

APX 1: CASE STUDY RELATING TO NECESSAITY, ADVANTAGES AND DISADVANTAGES OF

ASSURANCE SERVICE:
Structure of the Case:
In exam, you may be required to comment on necessity, advantages or disadvantages of performing
assurance service in a given situation.

Suggested Approach to Answer:

Before attempting question, carefully note:
 From whose perspective you are required to comment (whether shareholders, directors or
bankers etc.)
 What you are required to comment (whether necessity, advantages or disadvantages).

Model Case Study From Examination Questions:

Case Study:
You are the auditor of Royale Limited, a manufacturer of fireworks. Following a disappointing last
three months of trading, the company has requested an extension to its overdraft facility from its
bankers. The bank has in turn asked your firm to carry out an assurance engagement on financial
statements of company.

Explain the benefits and limitations to both the bank and Royale Limited of obtaining the assurance
report. (04 marks)
(ICAEW Professional Stage – March 2006)

Suggested Solution:
Benefits to Bank:
 Independent assurance report increases credibility of financial statements. Bank can better
analyze liquidity and solvency position of company as well as appropriateness of value of
securities.

Limitation for Bank:

 Assurance is not absolute. There is still some risk of misstatement in financial statements.

Benefits to Royale Limited:

 Help in approval and quick processing of loan.

Limitation for Royale Limited:

 Assurance will take cost and time of Royal Limited.

1 By Muhammad Asif, ACA