CA Sri Lanka Curriculum 2020 Study Text PDF

STUDY TEXT CA SRI LANKA CURRICULUM 2020 Volume I  First edition 2020 ISBN 9781 5097 3124 4 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Med...

STUDY TEXT CA SRI LANKA CURRICULUM 2020 Volume I  First edition 2020 ISBN 9781 5097 3124 4 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place 142-144 Uxbridge Road London W12 8AA www.bpp.com/learningmedia The copyright in this publication is owned by BPP Learning Media Ltd. 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, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the copyright holder. The contents of this book are intended as a guide and not professional advice and every effort has been made to ensure that the contents of this book are correct at the time of going to press by CA Sri Lanka, BPP Learning Media, the Editor and the Author. Every effort has been made to contact the copyright holders of any material reproduced within this publication. If any have been inadvertently overlooked, CA Sri Lanka and BPP Learning Media will be pleased to make the appropriate credits in any subsequent reprints or editions. We are grateful to CA Sri Lanka for permission to reproduce the Learning Outcomes and past examination questions, the copyright of which is owned by CA Sri Lanka, and to the Association of Chartered Certified Accountants and Chartered Institute of Management Accountants for use of past examination questions in which they hold the copyright. © BPP Learning Media Ltd 2020 ii Contents Page Introduction iv Chapter features vi Learning outcomes vii Action verbs checklist xvi CL1 Advanced Audit and Assurance Part A Governance Internal Control Frameworks 1 Introduction to External Audit 3 2 Introduction to Internal Control 25 3 Internal Controls Over Specific Business Areas 69 Part B Audit Planning and Risk Assessment 4 Agreeing Terms and Risk Assessment 117 5 Audit Planning 165 6 The Auditor's Responsibilities in Relation to Fraud, Laws and Regulations 195 Part C Gathering Audit Evidence 7 Audit Evidence 233 8 Auditing Non-current Assets 259 9 Auditing Inventory 281 10 Audit of Revenue and Receivables 307 11 Auditing Cash and Bank Balances 329 12 Liabilities, Capital and Expenses 345 13 Sampling and Audit Procedures 381 14 Audit Review and Finalisation 397 Contents iii  Introduction CL1 Advanced Audit and Assurance At the Corporate Level knowledge on documenting and evaluating an organisation's internal control system is further looked at. The concept of assurance introduced at the first level is also explored in detail with a deep emphasis on auditing. A discussion on ethical issues is done in a broader manner incorporating regulatory aspects as well. Syllabus structure Main syllabus areas Weightings A. Governance and internal control frameworks 10% B. Audit planning and risk assessment 15% C. Gathering audit evidence 20% D. Auditing in a digital environment 10% E. Evaluating evidence and audit reporting 15% F. Assurance and related services 10% G. Audit quality and ethics 15% H. Professional practice of internal audit 5% One of the key elements in examination success is practice. It is important that not only you fully understand the topics by reading carefully the information contained in this Study Text, but it is also vital that you practise the techniques and apply the principles that you have learned. In order to do this, you should:  Work through all the examples provided within the chapters and review the solutions, ensuring that you understand them;  Complete the progress test for each chapter. In addition, you should use the Practice and Revision Kit. These questions will provide you with excellent examination practice when you are in the revision phase of your studies. iv Corporate Level Advanced Audit and Assurance Pillar structure The Chartered Accountant of Sri Lanka Curriculum 2020 is structured around four progressively ascending levels of competency, namely, Business I, Business II, Corporate and Strategic Levels The Corporate Level builds technical abilities whilst enhancing interpersonal and communication skills and problem resolution skills as required of a Certified Senior Business Accountant. The Curriculum is also subdivided into specific subject areas or knowledge pillars and learning material is delivered to meet the knowledge requirements. These Knowledge Pillars focus on imparting the technical knowledge required of a competent CA and comprise of five pillars that focus on the following subject areas: Knowledge Pillar 1: Audit, Assurance and Ethics (AA&E) Knowledge Pillar 2: Financial Accounting and Reporting (FA&R) Knowledge Pillar 3: Performance Measurement and Risk (PM&R) Knowledge Pillar 4: Taxation and Law (T&L) Knowledge Pillar 5: Business Management and Strategy (BM&S) Pillar structure v  Chapter features Each chapter contains a number of helpful features to guide you through each topic. Topic list This tells you what you will be studying in the chapter. The topic items form the numbered headings within the chapter. Chapter The introduction puts the chapter topic into perspective and explains why it is introduction important, both within your studies and within your practical working life. Learning The learning outcomes issued for the module by CA Sri Lanka are listed at the outcomes beginning of the chapter, with reference to the chapter section within which coverage will be found. Key terms These are definitions of important concepts that you really need to know and understand before the exam. Examples These are illustrations of particular techniques or concepts with a worked solution or explanation provided immediately afterwards. Case study Often based on real world scenarios and contemporary issues, these examples or illustrations are designed to enrich your understanding of a topic and add practical emphasis. Questions These are questions that enable you to practise a technique or test your understanding. You will find the answer underneath the question. Formula to These are the formula that you are required to learn for the exam. learn Section This summarises the key points to remember from each section. introduction Chapter This provides a recap of the key areas covered in the chapter. roundup Progress test Progress tests at the end of each chapter are designed to test your memory. Bold text Throughout the Study Text you will see that some of the text is in bold type. This is to add emphasis and to help you to grasp the key elements within a sentence or paragraph. vi Corporate Level Advanced Audit and Assurance  Learning outcomes CA Sri Lanka's Learning outcomes for the module are set out on the following pages. They are cross-referenced to the chapter in the Study Text where they are covered. A. Governance Internal Control Frameworks (Syllabus Weighting: 10%) Knowledge Learning Outcome Specific Knowledge Chapter Component 1.1 Corporate 1.1.1 Discuss the need for an audit of financial statements using Ability to connect stewardship, governance and agency theory. accountability and agency conflict with a 1 audit need to conduct an independent audit 1.2 Internal control 1.2.1 Evaluate components of an integrated internal control system. COSO-2014 Internal controls five 2, 3 framework components and 17 principles 1.2.2 Analyse design, implementation and operating effectiveness of SLAuS 315 2 identified controls. 1.2.3 Outline deficiencies in control activities to be communicated SLAuS 265 2 to those charged with governance. 1.3 IT risk and controls 1.3.1 Demonstrate the importance of IT general controls and IT general controls and application controls 2 application controls in an audit of financial statements. Learning outcomes vii  viii Corporate Level Advanced Audit and Assurance B. Audit Planning and Risk Assessment (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 2.1 Terms of 2.1.1 Explain precondition required to perform an audit of financial SLAuS 210 4 engagement statements. 2.2 Overall audit 2.2.1 Demonstrate the importance of overall audit strategy as part Including non-complex group and SME 5 strategy of audit planning. audit scenarios covering the requirements 2.3 Risk of material 2.3.1 Assess risk of material misstatements including risk of frauds of SLAuS 300, 315, 240 and 600 4, 5 misstatement to be focused during the audit using risk assessment procedures. 2.4 Materiality 2.4.1 Apply the concept of materiality in planning and performing 4 the audit. 2.5 Responding to risk 2.5.1 Outline suitable overall response and further audit procedures Including non-complex group and SME 5 of material for identified risk at financial statement level and assertion audit scenarios covering the requirements misstatements level. of SLAuS 330  B. Audit Planning and Risk Assessment (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 2.6 Complex issues 2.6.1 Apply risk assessment procedures to identify risks relating to Requirements of SLAuS 540, 550 and 570 14 related party transactions , going concern and accounting in relation to risk assessment estimates including fair value and measurement. 2.7 Using the work of 2.7.1 Demonstrate the use of experts (both management and Requirements under SLAuS 610,SLAuS 620 6 others auditors experts), internal auditors and service organisation & SLAuS 402 auditors in an audit of financial statements. 2.8 Laws and 2.8.1 Explain auditors requirements consider compliance with laws Understanding the legal and regulatory 6 regulations and regulations during an audit of financial statement. framework, procedures when non-compliance is identified or suspected and reporting of identified or suspected non-compliance Learning outcomes ix  x Corporate Level Advanced Audit and Assurance C. Gathering Audit Evidence (Syllabus Weighting: 20%) Knowledge Learning Outcome Specific Knowledge Chapter Component 3.1 Test of details 3.1.1 Outline audit procedures to address assertion level risk for This should cover audit evidence over key 7, 8, 9, 10, 11, 12 non-complex key account balances and classes of transactions. account balances and classes of transactions 3.1.2 Apply specific considerations in obtaining sufficient SLAuS 501 9, 12 appropriate audit evidence with respect to inventory, litigation and claims involving the entity, and segment information. 3.2 External 3.2.1 Apply procedures to design and perform external SLAuS 505 10, 11 confirmation confirmation to obtain relevant and reliable audit evidence. 3.3 Opening balances 3.3.1 Discuss the requirements to be considered by an auditor in an SLAuS 510 and 710 13 and corresponding initial engagement and in relation to corresponding figures. figures 3.4 Selecting items for 3.4.1 Apply different methods of selecting items for audit testing SLAuS 530 13 testing and the use including audit sampling. of audit sampling 3.5 Analytical 3.5.1 Apply analytical procedures as substantive procedures and in Recognise the importance of analytical 7, 15 procedures the overall review of financial statements. software which has the ability to analyse 100% data to identify outliers 3.6 Complex account 3.6.1 Design audit procedures to address complex items including SLAuS 540, 550, 570 14 balances accounting estimates, fair valuation, related party transactions and going concern. 3.7 Subsequent events 3.7.1 Outline procedures required to deal with events occurring SLAuS 560 14 between the date of the financial statements and the date of the auditor's report and facts that become known to the auditor after the date of the auditor's report.  D. Auditing in a Digital Environment (Syllabus Weighting: 10%) Knowledge Learning Outcome Specific Knowledge Chapter Component 4.1 Digital business 4.1.1 Recognise trends in a digital business environments including Artificial intelligence (AI), robotic process 15 environment Artificial Intelligence (AI), Robotic Process Automation (RPA), automation (RPA), blockchain, digital Block chain, digital currencies and their impacts on internal currencies controls and audit. 4.1.2 Recognise the use of big data and analytics as business Big data and analytics 15 intelligence tools and potential risk associated with big data. 4.2 Audit automation 4.2.1 Demonstrates the use of cloud based audit working papers, Audit automation 15 audit automation tools and their limitations. 4.3 Data analytics 4.3.1 Discuss the use of data analytics software including CAATs in Data analytics 15 planning and gathering audit evidence. 4.4 Cyber security 4.4.1 Outline controls required to mitigate cyber security risk. Cyber security risk 15 E. Evaluating Audit Evidence and Audit Reporting (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 5.1 Audit report 5.1.1 Evaluate the effects of material misstatements on audit the SLAuS 450 16 audit opinion. Learning outcomes 5.1.2 Evaluate the effect of misstatements in opening balances and SLAuS 510 and SLAuS 710 13 corresponding figures on current year audit opinion. xi  xii Corporate Level Advanced Audit and Assurance E. Evaluating Audit Evidence and Audit Reporting (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 5.2 Key audit matters 5.2.1 Explain matters to be communicated with those charged with SLAUS 250 16 governance. 5.2.2 Apply Key Audit Matters (KAM) for a given scenario. SLAuS 701 16 5.3 Modified audit 5.3.1 Apply modified audit opinions and going concern reporting Reporting considerations relating to SLAuS 16 report requirements for a given scenario. 705, 701 and SLAuS 570 5.4 Emphasis of 5.4.1 Apply emphasis of matter and other matter for a given SLAuS 706 16 matters and other scenario of audit reporting. matters (SLAuS 706) 5.5 Special purpose 5.5.1 Apply special purpose audits including audit of single financial Includes both SLAuS 800 and 805 16 audit statements/elements to a given scenario. 5.6 Other information 5.6.1 Explain auditor's responsibility towards other information Fair understanding of the auditor's 16 included in documents containing audited financial responsibilities relating to other statements. information contained in an annual report (SLAuS 720) 5.7 Review 5.7.1 Explain procedures required in conducting review Fair understanding of application of review 17 engagements engagements. engagement and that the procedures used in a review engagement is limited compared to an audit of financial statements (SLSRE 2400,SLSRE 2410)  F. Assurance and Related Services (Syllabus Weighting: 10%) Knowledge Learning Outcome Specific Knowledge Chapter Component 6.1 Assurance 6.1.1 Apply framework for assurance engagements in identifying Understanding of the definition, elements, 17 framework and accepting assurance engagements. scope of and preconditions for an assurance engagement 6.2 Assurance 6.2.1 Apply Sri Lanka Standard on Assurance Engagement together Fair knowledge about application of SLSAE 17 engagements with subject matter specific assurance standards to provide 3000 for general subject matters and reasonable or limited assurance as required in the subject matter specific assurance standards engagement circumstances. including prospective financial statements 6.3 Related services 6.3.1 Apply Sri Lanka Standard on Related Services relating to Fair understanding of the SLSRE 4400 & 17 agreed up on procedures and compilation as required by SLSRE 4410 engagement circumstances. 6.4 Reporting 6.4.1 Outline key elements of reports used in assurance and related 17 services. G. Audit Quality and Ethics (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 7.1 Framework for 7.1.1 Demonstrate the elements of the framework for audit quality. Understanding of the definition and 18 Learning outcomes audit quality elements of the quality framework 7.2 System of quality 7.2.1 Demonstrate the elements of a system of quality controls of Fair understanding of the importance of 18 controls the firm. elements of quality controls of the firm based on SLQC 1 xiii  xiv Corporate Level Advanced Audit and Assurance G. Audit Quality and Ethics (Syllabus Weighting: 15%) Knowledge Learning Outcome Specific Knowledge Chapter Component 7.3 Audit quality 7.3.1 Explain the requirements to implement quality control Fair understanding of the importance of 18 procedures at the audit engagement level including the elements of quality controls of the firm engagement quality control review. based on SLAuS 220 7.4 Threats to 7.4.1 Analyse threats applicable to professional accountants in Part B of Code of Ethics (Section200 to 270) 19 compliance with public practice in complying with fundamental and ethical fundamental and principle. ethical principles 7.5 Auditors 7.5.1 Apply conceptual framework approach to analyse threats Fair understanding of the importance of 19 independence relating to auditors independence. auditors independence including the scope of applicability and specific issues dealt in Section 290-100 to 148) 7.5.2 Evaluate threats associated with provision of non-assurance Threats associated with provision of 19 service and methods of mitigating such threats. non-assurance service and methods of mitigating such threats 7.5.3 Apply conceptual framework approach to evaluate specific (Section 290-164- to 219) 19 non-assurance services.  H. Professional Practice of Internal Audit (Syllabus Weighting: 5%) Knowledge Learning Outcome Specific Knowledge Chapter Component 8.1 International 8.1.1 Recognise the importance of professional practice in internal Core principles for the professional practice 20 professional audit using the elements of the International Professional of internal auditing practice framework Practice Framework (IPPF) of the Institute of Internal Definition of internal auditing Auditors. Code of ethics International standards for the professional practice of internal auditing 8.2 Internal audit 8.2.1 Propose an internal audit charter to govern an internal audit Key elements and mandatory nature of the 20 charter function for a given entity considering entity specific Charter based on IIA standard circumstances. 8.3 Audit universe and 8.3.1 Develop an audit universe and a plan aligned to organisations 20 plan strategies, objectives and risks. 8.4 Risk role of internal 8.4.1 Advise the extent to which internal auditor can support risk IIA position paper-role of internal auditor 20 auditor management initiatives of an entity using assurance and in risk management (ERM FAN) advisory services. 8.5 Managing an 8.5.1 Outline key considerations in setting engagement objectives, Ability to apply IIA performance standards 20 internal audit engagement planning and conducting an internal audit applicable to engagement objectives, engagement for a given business scenario. planning and performance of an internal audit taking into account engagement specific issues eg fraud risk, IT controls, possibility of using data analytics etc 8.6 Governance and 8.6.1 Advise on the process of structuring a governance audit and a Understanding key elements of a 20 culture audit culture audit. governance and culture audit and approach Learning outcomes to be followed in the audit 8.7 Audit committee 8.7.1 Advise on the oversight role to be played by the audit Application of SLAuS 610 20 and internal audit committee in ensuring the independence and effectiveness of internal audit function. 8.7.2 Advice on the extent to which external auditor can rely on the work of internal audit. xv  Action verbs checklist Knowledge Process Verb List Verb Definitions Tier - 1 Remember Define Describe exactly the nature, scope or meaning Recall important information Draw Produce (a picture or diagram) Identify Recognise, establish or select after consideration List Write the connected items one below the other Relate To establish logical or causal connections State Express something definitely or clearly Tier - 2 Calculate/Compute Make a mathematical computation Comprehension Explain important Discuss Examine in detail by argument showing information different aspects, for the purpose of arriving at a conclusion Explain Make a clear description in detail revealing relevant facts Interpret Present in understandable terms or to translate Recognise To show validity or otherwise, using knowledge or contextual experience Record Enter relevant entries in detail Summarise Give a brief statement of the main points (in facts or figures) Classify Allocate into categories Describe Communicate the key features Provide Give illustrations to support or illuminate a point or assertion Tier - 3 Application Apply Put to practical use Use knowledge in a Assess Determine the value, nature, ability setting other than the or quality one in which it was learned/solve close- Demonstrate Prove, especially with examples ended problems Graph Represent by means of a graph Prepare Make ready for a particular purpose Prioritise Arrange or do in order of importance Reconcile Make consistent with another Solve To find a solution through calculations and/ or explanations xvi Corporate Level Advanced Audit and Assurance Knowledge Process Verb List Verb Definitions Conduct Organize and carry out a task Communicate Transmit thoughts or knowledge Display Make evident or noticeable Perform Do or execute, usually in the sense of a complex procedure Reconcile Make or prove consistent or compatible or show differences Set Fix or establish Select Choose from a range of options or possibilities Support Assist to make decisions by providing appropriate information about respective concepts Use Apply in a practical way Undertake Commit to do or perform Tier - 4 Analysis Analyse Examine in detail in order to determine the solution or outcome Draw relations among Compare Examine for the purpose of ideas and to compare discovering similarities and Contrast Examine in order to show contrast/solve open- unlikeness or differences ended problems Construct Build or make a diagram, model or formula Differentiate Constitute a difference that distinguishes something Outline Make a summary of significant features Write Provide word descriptions to express an opinion or idea Tier - 5 Evaluate Advise Offer suggestions about the best course of Formation of action in a manner suited to the recipient judgments and Convince To persuade others to believe something decisions about the using evidence and/or argument value of methods, ideas, Criticise Form and express a judgment people or products Comment Provide written remarks expressing an opinion in both positive and negative perspectives Evaluate To determine the significance by careful appraisal Conclude Form a judgment about, or determine or resolve the outcome of, an issue through a process involving reasoning Determine Ascertain or conclude after analysis and consideration; judge Action verbs checklist xvii  Knowledge Process Verb List Verb Definitions Justify Give valid reasons or evidence for Review Study critically with a view to correction or improvement Recommend A suggestion or proposal as to the best course of action Resolve Settle or find a solution to a problem or contentious matter Validate Check or prove the accuracy Tier - 6 Synthesis Compile Produce by assembling information Solve unfamiliar problems by collected from various sources combining different aspects Design Devise the form or structure according to to form a unique or novel a plan solution Develop To disclose, discover, perfect or unfold a plan or idea Propose To form or declare a plan or intention for consideration or adoption Anticipate Foresee, or experience or realise beforehand Draft Write original material for the scrutiny of others Formulate Devise and put into words Plan Devise the plan for an assurance engagement Report Give the formal final conclusion for an assurance engagement Submit Send a completed document to a particular party Suggest Put forward an idea or give reasons Synthesize Make or propose a new concepts or ideas by combining existing knowledge in different aspects xviii Corporate Level Advanced Audit and Assurance Part A: Governance Internal Control Frameworks 2 CA Sri Lanka  CHAPTER INTRODUCTION In this introductory chapter we look first at what an assurance engagement is and the main elements of an assurance engagement. An audit is an assurance engagement in which an independent auditor expresses an opinion over the truth and fairness of a company's financial statements. We look at the objectives of the statutory audit and its benefits and limitations. We also cover in this chapter the regulation of auditors in Sri Lanka and introduce Sri Lanka Auditing Standards (SLAuS). Auditors must follow SLAuSs when carrying out an audit. Knowledge Component A Governance internal control frameworks 1.1 Corporate Governance and 1.1.1 Discuss the need for an audit of financial statements using agency theory Audit 3 AAA | Chapter 1: Introduction to External Audit LEARNING CHAPTER CONTENTS OUTCOME 1 Assurance engagements 1.1.1 2 Objective of statutory audits and the audit opinion 1.1.1 3 Regulation of auditors 1.1.1 4 Sri Lanka Auditing Standards (SLAuSs) 1.1.1 1 Assurance engagements An engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. 1.1 Introduction to assurance engagements In this chapter we revise the basic principles of audit engagements, and look at the regulation of auditors. Assurance engagements play an important role in giving users of financial information, such as company shareholders, confidence that the information is reasonably accurate and has been properly prepared and presented. This is because during an assurance engagement a review of that information is carried out by a practitioner who was not involved in its preparation. Therefore their conclusions are seen as independent and impartial. 1.2 Accountability, stewardship and agency The key reason for having a review as part of an assurance engagement can be seen by working through the following case study. 4 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit CASE STUDY Amanthi decides to set up a business selling flowers. She gets up early in the morning, visits the market and then sets up a stall by the side of the road. For the first year, all goes well. She sells all the flowers she is able to buy and she derives some income from the business. However, Amanthi feels that she could sell more flowers if she was able to transport more to the place where she sells them, and she also knows that there are several other roads nearby where she could sell flowers, if she could be in two places at once. She could achieve these two things by buying a van and by employing people to sell flowers in other locations. Amanthi needs more money to achieve this expansion of her business. She decides to ask her wealthy friend Thilak to invest in the business. Thilak can see the potential of Amanthi's business and wants to invest, but he doesn't want to be involved in the management of the business. He also does not want to have ultimate liability for the debts of the business if it fails. He therefore suggests that they set up a company. He will own the majority of the shares and be entitled to dividends. Amanthi will be managing director and be paid a salary for her work. At the end of the first year of trading as a limited company, Thilak receives a copy of the financial statements. Profits are lower than expected, so his dividend will not be as large as he had hoped. He knows that Amanthi is paid a salary so she does not care as much as him that profits are low. Thilak is concerned by the level of profits and feels that he wants further assurance on the accounts. He doesn't know whether they give a true reflection on the last year's trading, particularly as the profits do not seem as high as those Amanthi had predicted when he agreed to invest. The solution is that the assurance Thilak is seeking can be given by an independent audit of the financial statements. The practitioner performing the review can provide the two things that Thilak requires:  A knowledgeable review of the company's business and of the accounts  An impartial view, since Amanthi's view might be biased Other people will also view the company's accounts with interest, for example:  Creditors (payables) of the company  Taxation authorities CA Sri Lanka 5 AAA | Chapter 1: Introduction to External Audit The various parties interested in the accounts of a company are sometimes referred to as stakeholders. Although they will each judge the accounts by different criteria, they will all gain assurance from learning that the accounts they are reading have been subject to an independent report. Figure 1.1: Typical stakeholders of an organisation Directors Shareholders Employees STAKEHOLDERS Creditors The public Taxation authorities The example above is a simple one. In practice, companies may have thousands of shareholders and may not know the management personally. It is therefore important that directors are accountable to shareholders. Directors act as stewards of the shareholders' investments. They are agents of the shareholders. Figure 1.2: Accountabilities Vera: Manager Agent Steward Directors: Management Accountable Accountable to to Peter (owner) Shareholders (owners) Accountability is the quality or state of being accountable, that is, being required or expected to justify actions and decisions. It suggests an obligation or willingness to accept responsibility for one's actions. Stewardship refers to the duties and obligations of a person who manages another person's property. Agents are people employed or used to provide a particular service. In the case of a company, the people being used to provide the service of managing the business also have the second role of trying to maximise their personal wealth in their own right. You may ask, 'what are the directors accountable for?' It is important to understand the answer to this question. The directors are accountable for the shareholders' investment. The shareholders have bought shares in that company (they have invested). They expect a return from their investment. As the directors manage the company, they are in a position to affect that return. 6 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit Figure 1.3: Shareholders' expectations Capital growth Shareholder buys shares expects Dividends The exact nature of the return expected by the shareholder will depend on the type of company he or she has chosen to invest in: that is part of his or her investment risk analysis. Certain issues are true of any such investment, however. For example, if the directors mismanage the company, and it goes bankrupt, it will neither provide a source of future dividends nor create capital growth in the investment – indeed, the opposite is true and the original investment may even be lost. Accountability therefore covers a range of issues, as shown in Figure 1.4. Figure 1.4: Aspects of accountability Financial ProitsĀ Going concern statements warnings disclosure Communication Directors' accountability Investment protection Internal controls Risk policies These issues are often discussed under the umbrella title 'corporate governance', where 'governance' indicates the management (governing) role of the directors, and 'corporate' indicates that the issue relates to companies (bodies corporate). This is illustrated by our scenario, where we saw Amanthi taking up a corporate governance position in relation to Thilak. 1.3 Assurance Provision Many of the requirements in relation to corporate governance necessitate communication between the directors and the shareholders. CA Sri Lanka 7 AAA | Chapter 1: Introduction to External Audit Directors of all companies are usually required to produce financial statements annually which give a true and fair view of the affairs of the company and its profit or loss for the period. They are also encouraged to communicate with shareholders on matters relating to directors' pay and benefits, going concern and management of risks. But how will the shareholders know whether the directors' communications are accurate, or present a fair picture? We are back to the problem that Thilak had in the scenario we presented earlier in this section. He knew that Amanthi's view might be biased in a different way to his own, and he sought assurance on the information he was presented with. The Sri Lanka Framework for Assurance Engagements provides a frame of reference for professional accountants when performing assurance engagements. It provides the following definition of an assurance engagement. An assurance engagement is an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than responsible party about the outcome of the evaluation or measurement of a subject matter against criteria. 1.4 The objective of an assurance engagement The objective of an assurance engagement will depend on the level of assurance given. First we will consider a reasonable assurance engagement, where a high, but not absolute, level of assurance is given. Sri Lanka Framework for Assurance Engagements states that the objective of a reasonable assurance engagement is a reduction in assurance engagement risk to an acceptably low level in the circumstances of the engagement as the basis for a positive form of expression of the practitioner's conclusion. In order to give reasonable assurance, a significant amount of testing and evaluation is required to support the positive conclusion, such as the opinion given in the auditor's report on the financial statements. We look at reasonable assurance in the context of an audit in section 2. Limited assurance is a lower level of assurance. It allows for a lesser amount of testing and evaluation and results in a negative conclusion. Sri Lanka Framework for Assurance Engagements also states that the objective of a limited assurance engagement is a reduction in assurance engagement risk to a level that is acceptable in the circumstances of the engagement, but where that risk is greater than for a reasonable assurance engagement, as the basis for a negative form of expression of the practitioner's conclusion. 8 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit 1.5 The elements of an assurance engagement An assurance engagement performed by a practitioner will consist of the following elements: (a) A three-party relationship. The three parties are the intended user, the responsible party and the practitioner (each party is described in the key terms that follow). (b) A subject matter. This is the data to be evaluated that has been prepared by the responsible party. It can take many forms including financial performance (eg historical financial information), non-financial performance (eg key performance indicators), processes (eg internal control) and behaviour (eg compliance with laws and regulations). (c) Suitable criteria. The subject matter is evaluated or measured against criteria in order to reach an opinion. (d) Evidence. Sufficient appropriate evidence needs to be gathered to support the required level of assurance. (e) A written assurance report. A report containing the practitioner's opinion is issued to the intended user. Intended users are the person, persons or class of persons for whom the practitioner prepares the assurance report. The responsible person is the person (or persons) responsible for the subject matter (in a direct reporting engagement) or subject matter information of the assurance engagement. The practitioner is the individual providing professional services that will review the subject matter and provide the assurance. One way to remember these five elements of an assurance engagement is using the mnemonic CREST.  Criteria  Report  Evidence  Subject matter  Three-party relationship CA Sri Lanka 9 AAA | Chapter 1: Introduction to External Audit 1.6 Types of assurance services Assurance services include a wide range of activities such as external audits, internal audits, internal control, sustainability reviews, review engagements and forecasting. The degree of assurance given by the impartial professional will depend on the nature of the exercise being carried out. Directors prepare financial statements for the benefit of members. They declare that the financial statements give a true and fair view. As we will see in section 2, the auditors provide assurance on this declaration. To provide such assurance, the auditors must:  Assess risk  Plan audit procedures  Conduct audit procedures  Assess results  Express an opinion The degree of satisfaction achieved and, therefore, the level of assurance which may be provided, is determined by the nature of procedures performed and their results. Another type of assurance engagement, where a lower level of assurance is given, is a review engagement. A review engagement can be distinguished from an external audit engagement as follows. (a) External audit engagement: the auditor provides a high, but not absolute, level of assurance that the information audited is free of material misstatement. This is expressed positively in the audit report as reasonable assurance (see section 2). (b) Review engagement: the auditor provides a limited level of assurance that the information subject to review is free of material misstatement. The assurance report will contain a negative form of expression of the practitioner's conclusion. The following table summarises the different types of assurance engagements that can be carried out by practitioners. 10 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit Table 1.1: Different types of assurance engagements Engagement Type of Example Expression of assurance conclusion External audit Reasonable Statutory external Positive audit Review Limited Review of interim Negative financial statements In a limited assurance engagement, the practitioner expresses the conclusion in the negative form. An example might be: 'Based on our work as set out in this report, nothing has come to our attention that indicates the financial statements have not been prepared according to the financial reporting framework' 2 Objective of statutory audits and the audit opinion An external audit is a type of assurance engagement that is carried out by an auditor to give an independent opinion on a set of financial statements. 2.1 The objective of an external audit The objectives of an audit of financial statements are: 1. 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; and 2. To report on the financial statements, and communicate as required by the SLAuSs, in accordance with the auditor's findings. The purpose of an external audit is to enable auditors to enhance the degree of confidence of intended users (shareholders) in the financial statements by expressing an opinion on them. While an audit might produce by-products such as advice to the directors on how to run the business, its objective is solely to report to the shareholders. CA Sri Lanka 11 AAA | Chapter 1: Introduction to External Audit 2.2 The audit opinion in the auditor's report Within an auditor's report on the financial statements, the auditor will give an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. Following the audit of a company's financial statements, if the auditor finds no reason to modify the audit opinion (that is, a 'clean' report is issued), then the audit opinion in the auditor's report may state: 'In our opinion the financial statements present fairly, in all material respects, the financial position of the company...' An equivalent wording for 'present fairly in all material respects' is 'give a true and fair view of'. Therefore, under Sri Lanka Auditing Standards (SLAuSs) an alternative wording for an unmodified audit opinion is: 'In our opinion the financial statements give a true and fair view of the financial position of the company...' If the auditor concludes the financial statements are true and fair, this is generally taken to mean the financial statements:  Are factual  Are free from bias  Reflect the commercial substance of the business's transactions Below is an example of an auditor's report on an entity's financial statements. This is a report with an unmodified opinion (which means the financial statements are true and fair and properly prepared). It has been taken from SLAuS 700 Forming an opinion and reporting on financial statements. 12 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit Figure 1.5: Example audit report, unmodified INDEPENDENT AUDITOR'S REPORT To the Shareholders of ABC Company [or Other Appropriate Addressee] Report on the Audit of the Financial Statements 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, the accompanying financial statements present fairly, in all material respects, (or 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 Sri Lanka Accounting Standards. Basis for Opinion We conducted our audit in accordance with Sri Lankan Standards on Auditing (SLAuSs). 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 with the Code of Ethics issued by CA Sri Lanka (Code of Ethics) and we have fulfilled our other ethical responsibilities in accordance with these requirements and the Code of Ethics. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. 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. [Description of each key audit matter in accordance with SLAuS 701, which applies to audits of the financial statements of listed entities.] CA Sri Lanka 13 AAA | Chapter 1: Introduction to External Audit Other Information Management is responsible for the other information. The other information comprises the information included in the X report, but does not include the financial statements and our auditor's report thereon. Our opinion on the financial statements does not cover the other information and 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, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Responsibilities of Management and Those Charged with Governance for the Financial Statements Management is responsible for the preparation and fair presentation of the financial statements in accordance with Sri Lanka Accounting Standards, and for such internal control as management determines 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, management is responsible for assessing the 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 management either intends to liquidate the Company or to cease operations, or has no realistic alternative but to do so. Those charged with governance are responsible for overseeing the Company's financial reporting process. 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 SLAuSs 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. 14 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit As part of an audit in accordance with SLAuSs, 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 an opinion on the effectiveness of the Company's internal control.  Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by management.  Conclude on the appropriateness of management's use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the 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 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. 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. CA Sri Lanka 15 AAA | Chapter 1: Introduction to External 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 financial statements of the 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. Report on Other Legal and Regulatory Requirements [The form and content of this section of the auditor's report would vary depending on the nature of the auditor's other reporting responsibilities prescribed by local law, regulation, or national auditing standards. The matters addressed by other law, regulation or national auditing standards (referred to as 'other reporting responsibilities') shall be addressed within this section unless the other reporting responsibilities address the same topics as those presented under the reporting responsibilities required by the SLAuSs as part of the Report on the Audit of the Financial Statements section. The reporting of other reporting responsibilities that address the same topics as those required by the SLAuSs may be combined (ie, included in the Report on the Audit of the Financial Statements section under the appropriate subheadings) provided that the wording in the auditor's report clearly differentiates the other reporting responsibilities from the reporting that is required by the SLAuSs where such a difference exists.] The engagement partner on the audit resulting in this independent auditor's report is [name]. [Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the particular jurisdiction] [Auditor Address] [Date] Auditor's reports with modified opinions may arise because of a number of different reasons and are discussed in depth in Chapter 16. 16 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit External auditors give an opinion on the truth and fairness of financial statements. This is not an opinion of absolute correctness. 'True' and 'fair' are not defined in law or audit guidance, but the following definitions are generally accepted. True information is factual and conforms with reality. In addition the information conforms with required standards and law. The financial statements have been correctly extracted from the books and records. Fair information is free from discrimination and bias and in compliance with expected standards and rules. The accounts should reflect the commercial substance of the company's underlying transactions. The auditor's report refers to the fact that the audit is planned and performed to obtain 'reasonable assurance' whether the financial statements are free from material misstatement. This is because the auditor cannot check everything and therefore can only provide 'reasonable', not 'absolute', assurance. Reasonable assurance is a high, but not absolute, level of assurance. The auditor's report does not guarantee that the financial statements are correct, but that they are true and fair within a reasonable margin of error. One of the reasons that an auditor does not give absolute assurance is because of the inherent limitations of audit. We discuss these limitations below. 2.3 Limitations of audit and materiality External audits give reasonable assurance that the financial statements are free from material misstatement. The assurance given by auditors is governed by the fact that auditors use judgement in deciding what audit procedures to use and what conclusions to draw, and also by the limitations of every audit. These are illustrated in the following diagram. CA Sri Lanka 17 AAA | Chapter 1: Introduction to External Audit Figure 1.6: Audit limitations Risk Audit opinion Standard format assessment can be limiting Auditing is not Audit report What to test objective. has inherent Judgements have to limitations Layman may not How much be made LIMITATIONS OF understand 'audit jargon'. to test AUDITING Whether errors are representative T Up-to-date position H Audit report is and historic position What to Not all items issued a long time may be different sample in the FS are E after the period end Sampling tested R risk E F O Estimates Non-routine R Audit evidence transactions Limitations in E accounting and sometimes indicates control systems what is probable, not certain Human Judgements error Possibility of Possibility of controls Intentions collusion in override Auditors can never fraud certify that the Cost/beneit trade off accounts are correct. They can only ever express an opinion Misstatements which are significant to readers may exist in financial statements and auditors will plan their work on this basis, that is, with professional scepticism. The concept of 'significance to readers' is the concept of materiality (which will be discussed in more detail later in this Text). Materiality is an expression of the relative significance or importance of a particular matter in the context of the financial statements as a whole. A matter is material if its omission or misstatement would reasonably influence the economic decisions of users, taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. The auditor's task is to decide whether the financial statements show a true and fair view. The auditors are not responsible for establishing whether the financial statements are correct in every particular. This is because it can take a great deal of time and trouble to check the accuracy of even a very small transaction and the resulting benefit may not justify the effort. Also, financial accounting inevitably involves a degree of estimation which means that financial statements can never be completely precise. Although the definition of materiality refers to the decisions of the addressees of the audit report (the company's members), their decisions may well be influenced by other entities that use the financial statements, for example, the bank. 18 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit 3 Regulation of auditors Auditors in Sri Lanka must follow Sri Lanka Auditing Standards (SLAuSs). SLAuSs are published by the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka). Auditors are monitored by the Sri Lanka Accounting & Auditing Standards Monitoring Board (SLAASMB). 3.1 Regulation of auditors in Sri Lanka Under the Sri Lanka Accounting and Auditing Standards Act, No 15 of 1995, the Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka) is the formulating body for Sri Lanka Accounting Standards (SLFRS/LKAS) and Sri Lanka Auditing Standards (SLAuSs). Auditors in Sri Lanka must follow SLAuSs. Regulation of the auditing profession and monitoring of compliance with SLASs and SLAuSs by Specified Business Enterprises is carried out by the Sri Lanka Accounting & Auditing Standards Monitoring Board (SLAASMB). Auditors carrying out an audit in accordance with the Accounting and Auditing Standards Act, No 15 of 1995 are required to certify in their auditor's report that the audit has been conducted in accordance with Sri Lanka Auditing Standards and that the financial statements have been prepared and presented in accordance with Sri Lanka Accounting Standards. 3.2 Entities subject to audit Specified Business Enterprises (SBEs) must have their financial statements audited by members of the Institute of Chartered Accountants of Sri Lanka, holding a certificate to practice issued by the Institute. SBEs are:  Companies licensed under the Banking Act, No. 30 of 1988  Companies authorised, under the Control of Insurance Act, No. 25 of 1962, to carry on insurance business  Companies carrying on leasing business  Factoring companies  Companies registered under the Finance Companies Act, No. 78 of 1988  Companies licensed under the Securities and Exchange Commission Act, No. 36 of 1987, to operate unit trust  Fund Management Companies CA Sri Lanka 19 AAA | Chapter 1: Introduction to External Audit  Companies licensed under the Securities and Exchange Commission Act, No.36 of 1987, to carry on business as stockbrokers or stock dealers  Companies licensed under the Securities and Exchange Commission Act, No. 36 of 1987, to operate a Stock Exchange  Companies listed in a Stock Exchange licensed under the Securities and Exchange Commission Act, No.36 of 1987  Other companies which: – Have a turnover in excess of s 500 million Rupees; – At the end of the previous financial year, had shareholder equity in excess of 100 million Rupees; – At the end of the previous financial year, had gross assets in excess of 300 million Rupees; – At the end of the previous year had liabilities to banks and other financial institutions in excess of 100 million Rupees; – Have a staff in excess of 1,000 employees. 20 CA Sri Lanka  AAA | Chapter 1: Introduction to External Audit 4 Sri Lanka Auditing Standards (SLAuSs) Sri Lanka Auditing Standards (SLAuSs) are based on the Sri Lanka Standards on Auditing published by the Sri Lanka Auditing and Assurance Standards Board (IAASB). The Sri Lanka Auditing Standards are based on the Sri Lanka Standards on Auditing (SLAuS) published by the Sri Lanka Auditing and Assurance Standards Board (IAASB) of the Sri Lanka Federation of Accountants (IFAC). The Sri Lanka Standards have been adapted where necessary to comply with Sri Lanka legislation. However, compliance with the SLAuSs ensures compliance in all material respects with the Sri Lanka Standards on Auditing. The most recently published set of SLAuSs are applicable for audits of financial statements for periods beginning on or after 31 March 2018. A list of these standards and the SLAuSs themselves can be found on the