1. Introduction to Audit and Assurance (F8) paper of ACCA

Paper Structure

Welcome to the Audit and Assurance classes at Global Fin-X. Before we begin discussing audit and assurance topics, we need to understand what audit and assurance mean, as well as the question paper pattern so that we can schedule our classes in accordance with the exam requirements. Audit and Assurance was previously called F8 and is now referred to as AA.

For other fundamental applied skills papers, such as Financial Reporting and Financial Management, the exam pattern consists of:

• Section A: 15 multiple choice questions of 2 marks each, totaling 30 marks.
• Section B: 3 scenarios, each containing 5 questions of 2 marks each, totaling 30 marks.
• Section C: 2 constructive response questions of 20 marks each, totaling 40 marks.

This gives a total of 100 marks across three sections.

In Audit and Assurance, the question paper structure has only two sections:

• Section A: 3 scenario-based questions, each containing 5 multiple choice questions of 2 marks each, totaling 30 marks.
• Section B: Constructive response questions divided into two questions of 20 marks each, giving 40 marks, and one question of 30 marks.

Section B totals 70 marks, which combined with Section A gives 100 marks. Overall, there are six questions in the examination. Three are scenario-based objective test cases containing five multiple choice questions each, and three are constructive response questions.

Agency Theory and Company Structure

To understand audit and assurance, we first need to understand agency theory. A company possesses a separate legal identity. A company is distinct from its founders, the people who control it, and the people who manage it. It can sue and be sued in a court of law. For example, if a lawsuit is filed against Reliance Jio, it does not mean the case is filed personally against the Ambani family. There is a distinction between the company, its owners, and its managers.

Consider an example where twenty individuals establish a company, ABC Company, to run a business. The company purchases raw materials, manufactures goods, sells to customers, and handles receivables and payables. If the company is unable to pay its debts, those twenty members are not personally liable. They do not have to sell their personal assets or contribute personal funds beyond the capital already invested. The individuals behind the formation of the company are not personally liable for company debts.

Now consider a company with 50,000 shareholders. The shareholders provide capital and are the true owners of the company. However, it is practically impossible for 50,000 people spread across various regions to assemble under one roof to make day-to-day business decisions.

To resolve this practical challenge, shareholders appoint representatives to act on their behalf. These representatives are the directors of the company. Directors may be selected from among the shareholders or may be outside professionals. Shareholders delegate authority to directors to manage day-to-day operational decisions, such as credit policies, discount structures, marketing strategies, or operational timing like just-in-time implementation.

Major or strategic decisions are reserved for the shareholders. These include decisions regarding amalgamations, mergers, acquisitions, demergers, spin-offs, borrowings that exceed share capital, and the appointment of auditors. Directors manage operations, while shareholders retain control over fundamental corporate decisions.

Financial Statements and Reporting Framework

Because directors manage the business and receive fixed salaries or fees, their personal financial interests may diverge from those of the shareholders. Directors might make reckless decisions or fail to maximize shareholder wealth.

To protect shareholder interests, directors are held accountable and must provide information regarding their stewardship of the company. This information is provided through financial statements.

According to IAS 1, Presentation of Financial Statements, a complete set of financial statements comprises five components:

• Statement of financial position, commonly known as the balance sheet
• Statement of profit or loss and other comprehensive income
• Statement of changes in equity
• Statement of cash flows, prepared under IAS 7
• Notes to the financial statements, including significant accounting policies and disclosures

Directors cannot prepare these statements arbitrarily. They must prepare them in accordance with an applicable financial reporting framework. The framework provides the principles, rules, measurement bases, and disclosure requirements for preparing financial statements.

In the ACCA syllabus, the primary financial reporting frameworks are International Accounting Standards and International Financial Reporting Standards. Alternatively, entities in specific jurisdictions may apply national standards, such as Indian Accounting Standards in India, Financial Reporting Standards in the UK, or US GAAP in the United States. Directors are responsible for preparing the financial statements in compliance with the relevant framework.

Role of the Auditor

Shareholders receive financial statements from the directors, but most shareholders lack detailed accounting and finance knowledge. They cannot evaluate complex standards such as IAS 33 on earnings per share or determine whether the figures are accurate.

An independent, knowledgeable third party is needed between the shareholders and the directors. This independent professional is the auditor.

The auditor's primary responsibilities are:

• To express an independent opinion on the financial statements.
• To evaluate whether the financial statements have been prepared in accordance with the applicable financial reporting framework.
• To state whether the financial statements present a true and fair view.

The auditor does not evaluate the commercial wisdom of management decisions, nor do they determine whether the directors ran the business successfully. The auditor's role is strictly to determine whether the financial information presented in the financial statements complies with the reporting framework and is free from material misstatement.

The auditor cannot provide absolute certainty that the statements are completely correct. Due to inherent limitations of an audit, an auditor cannot offer a guarantee of complete accuracy.

Levels of Assurance

Assurance represents the level of confidence that an auditor provides to users of financial statements. There are three recognized levels of assurance:

• Absolute assurance: A 100 percent guarantee that the financial statements are entirely correct, which would require checking every transaction and balance. This is not practically possible due to inherent limitations in auditing.
• Reasonable assurance: A high, but not absolute, level of assurance, typically around 90 to 95 percent confidence. The auditor concludes that the financial statements as a whole are free from material misstatement and present a true and fair view. This is the level provided in a statutory audit of financial statements.
• Limited assurance: A lower level of assurance, where the auditor performs more restricted procedures, such as inquiries and analytical reviews. The conclusion is expressed in a negative form, stating that nothing has come to the auditor's attention to suggest that the information is materially misstated. This is common in review engagements or specific investigations.

In an audit, the auditor gathers sufficient appropriate evidence to provide reasonable assurance. This assurance gives shareholders the confidence to rely on the financial statements when making economic decisions.