Introduction to Assurance Master Class

What is assurance?

An assurance engagement is: 'An engagement in which a practitioner obtains sufficient appropriate evidence in order to express 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.' (International Framework for Assurance Engagements, 7)

Giving assurance means offering an opinion about specific information so the users of that information are able to make confident decisions knowing that the risk of the information being 'incorrect' is reduced.

Elements of an assurance engagement

There are five elements of an assurance engagement:

Three party involvement: Practitioner (the reviewer), Intended users (the people using the subject matter), and Responsible party (the party responsible for preparing the subject matter).
Appropriate subject matter: The information subject to examination by the practitioner.
Suitable criteria: The criteria against which the subject matter is evaluated, i.e. standards, guidance, laws and regulations.
Sufficient appropriate evidence: Evidence is needed to provide a basis for the opinion/conclusion.
Written assurance report in an appropriate form: The output of the assurance engagement expressing a conclusion/opinion about the subject matter.

Figure 1. The main types of assurance engagements.

Types of assurance engagement

Two types of assurance engagement are permitted: reasonable assurance and limited assurance. The key differences are in the level of confidence they provide.

Reasonable Assurance

Thorough procedures to obtain sufficient appropriate evidence.
Gives a high level of assurance (confidence).
A positively worded opinion (e.g., "In our opinion, the financial statements give a true and fair view...").

Limited Assurance

Fewer procedures, mainly enquiries and analytical procedures.
Gives a moderate or lower level of assurance.
A negatively worded conclusion (e.g., "Nothing has come to our attention that causes us to believe...").

External audit engagements

An external audit is an example of a reasonable assurance engagement. Its purpose is to 'enhance the degree of confidence of intended users in the financial statements' by expressing an opinion on whether they give a true and fair view.

True and Fair

True and fair are key concepts for an auditor's opinion.

Defining True and Fair

True: Factually correct information which conforms with accounting standards and relevant legislation, and agrees with the underlying records.
Fair: Clear, impartial and unbiased information which reflects the commercial substance of the transactions of the entity.

Benefits and Limitations of an Audit

Audits provide a number of benefits but also have inherent limitations. Understanding these is key to bridging the 'expectation gap'.

Benefits of an Audit

Higher quality, more reliable information.
Independent scrutiny and verification for management.
Reduces the risk of management bias and fraud/error.
Enhances the credibility of the financial statements.
Deficiencies in internal controls may be highlighted.

Limitations of an Audit

Audits do not provide absolute assurance due to:

Subjective estimates and judgmental matters.
Inherent limitations of internal controls.
Evidence is often persuasive, not conclusive.
Auditors test on a sample basis, not all transactions.
Timeliness of financial reporting.

The Expectation Gap

The expectation gap is the difference between what users incorrectly believe an audit provides and what it actually does. Examples of misconceptions include believing that auditors:

Test all transactions and balances.
Are required to detect all fraud.
Are responsible for preparing the financial statements.

Review engagements

A review engagement is an example of a limited assurance engagement. It is a voluntary procedure for companies not legally required to have an audit, providing some assurance at a lower cost and with less disruption.

Purpose and Objective

The objective is to state whether, on the basis of procedures (mainly analytical procedures and enquiries), anything has come to the auditor's attention that causes them to believe that the financial statements are not prepared in accordance with the applicable financial reporting framework.

Accountability, Agency and Stewardship

Incorporation creates a legal distinction between the owners (shareholders) and the business itself. This leads to a conflict of interest between directors (who manage the company) and shareholders (who own it).

Accountability: People in a position of power can be held to account for their actions.
Agency: One party, the principal (shareholder), employs another party, the agent (director), to perform a task on their behalf.
Stewardship: The responsibility to take good care of resources. Directors are the stewards of the company, and they are accountable to the shareholders for how they run it.

The Fiduciary Relationship

This is a relationship of 'good faith' such as that between the directors of a company and the shareholders of the company. The directors must make their decisions in the interests of the shareholders, not their own selfish personal interests.

Chapter Test Your Understanding Questions and Solutions

Test your understanding 1: List and explain the elements of an assurance engagement. (5 marks)

Solution:

An assurance engagement will involve three separate parties: intended user, responsible party, and the practitioner.
A suitable subject matter. The subject matter is the data that the responsible party has prepared and which requires verification.
Suitable criteria. The subject matter is compared to the criteria in order for it to be assessed and an opinion/conclusion provided.
Sufficient appropriate evidence has to be obtained by the practitioner in order to give the required level of assurance.
An assurance report contains the opinion/conclusion that is given by the practitioner to the intended user.

Test your understanding 2: Explain the term 'limited assurance' in the context of an examination of a company's cash flow forecast and explain how this differs from the assurance provided by an external audit.

Solution:

Limited assurance in the context of a cash flow forecast

Limited assurance is a moderate level of assurance.
The objective is to obtain sufficient appropriate evidence that the forecast is plausible in the circumstances, i.e., prepared on the basis of reasonable assumptions.
A limited assurance report provides a negative conclusion. The practitioner will state that nothing has come to their attention which indicates that the assumptions used to prepare the cash flow forecast are not reasonable.
With limited assurance, limited procedures are performed. A forecast relates to the future, which is inherently uncertain, and it would therefore not be possible to obtain assurance that it is free from material misstatement.

Assurance provided by an external audit

An audit provides reasonable assurance, which is a high level.
The objective is to obtain sufficient appropriate evidence that the financial statements conform in all material respects with the relevant financial reporting framework.
An auditor's report provides a positive opinion as to whether or not the financial statements give a true and fair view.
More evidence will need to be obtained to provide reasonable assurance, and a wider range of procedures performed, including tests of controls. Financial statements relate to the past, and so the auditor should be able to obtain sufficient appropriate evidence.

Test your understanding 3: Your firm has been approached to perform the external audit of Perth Co. Perth Co has grown over the last two years and has now reached the audit threshold. As this is the first year the company has required an audit, the directors are unsure about the purpose of the audit. They have been informed that an audit need not be as inconvenient or intrusive as they expect it to be as there are additional benefits that may arise from having an audit. The directors have indicated that they expect your firm to detect every fraud and error in the accounting records so that when they need to apply for finance to help them grow further, they can use the audited financial statements to support the loan application and this should make it easier to obtain the loan.

Question 1: What level of assurance will be provided by the independent auditor's report?
A. Absolute
B. Reasonable
C. Moderate
D. Limited

Solution:
B. Reasonable assurance is given in an independent auditor's report.

Question 2: Which of the following is NOT one of the five elements of an assurance engagement?
A. Subject matter
B. Suitable criteria
C. Assurance file
D. Written report

Solution:
C. Assurance file.

Question 3: Which of the following is NOT a benefit of an audit?
A. Increased credibility of the financial statements
B. Deficiencies in controls may be identified during testing
C. Fraud may be detected during the audit
D. Sampling is used

Solution:
D. Sampling provides a limitation of the audit process, not a benefit.

Question 4: Which of the following statements is false?
A. The auditor will express an opinion as to whether the financial statements give a true and fair view
B. The auditor must obtain sufficient appropriate evidence to be able to form an audit opinion
C. If the financial statements are found to contain material misstatements a negative audit opinion will be given
D. An audit may not detect all fraud and error in the financial statements

Solution:
C. A negative conclusion is used for limited assurance engagements.

Question 5: Which of the following are examples of the expectation gap?
(i) The independent auditor's report confirms the financial statements are accurate.
(ii) An unmodified opinion means the company is a going concern.
(iii) The auditor tests all transactions.
(iv) The auditor can be sued for negligence if they issue an inappropriate opinion.
A. (i), (ii) and (iii)
B. (i), (ii) and (iv)
C. (i) and (ii) only
D. (ii) and (iii) only

Solution:
A. The auditor cannot confirm the accuracy of the financial statements as they contain estimates and judgments of management. The company may not be a going concern and the financial statements may correctly reflect this, resulting in an unmodified audit opinion. The auditor does not test all transactions.