International Federation of Accountants

SUBMISSION

TO THE

INTERNATIONAL FEDERATION OF ACCOUNTANTS

ON EXPOSURE DRAFTS

• PROPOSED INTERNATIONAL STANDARDS ON AUDITING AND PROPOSED AMENDMENT TO ISA 200 “OBJECTIVE AND PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS”
• UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
• THE AUDITOR’S PROCEDURES IN RESPONSE TO ASSESSED RISKS
• AUDIT EVIDENCE

PREPARED BY THE

INSTITUTE OF CHARTERED ACCOUNTANTS

OF NEW ZEALAND

March 2003

SUBMISSION TO THE IFAC INTERNATIONAL AUDITNG AND ASSURANCE STANDARDS BOARD ON THE AUDIT RISK MODEL EXPOSURE DRAFTS

AINTRODUCTION

1.1The Professional Practices Board (PPB) of the Institute of Chartered Accountants of New Zealand (the Institute) has considered the exposure drafts “Proposed International Standards on Auditing and Proposed Amendment to ISA 200 Objective and Principles Governing an Audit of Financial Statements”, “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement”, “The Auditor’s Procedures in Response to Assessed Risks” and “Audit Evidence”. The PPB has overall responsibility for the development of Ethical and Professional Engagement Standards (including Auditing) for the Institute.

1.2Sections B – C of our submission raise general concerns regarding the rationale for the proposed new standards, certain definitional issues, and formatting and structural issues. Sections D – H provide detailed comments and suggested amendments in relation to each of the proposed standards.

1.3The PPB hopes that this submission will assist IFAC in its finalisation of the aforementioned exposure drafts on Audit Risk. Any queries on the content of this submission should be directed in the first instance to:

Simon Lee, Manager – Accounting & Professional Standards

Institute of Chartered Accountants of New Zealand

PO Box 11342

Wellington

(tel +64 4 917 5638, fax +64 4 472 6282)

or by email to:

or to:

Vanessa Sealy-Fisher, Manager – Accounting & Professional Standards

Institute of Chartered Accountants of New Zealand

PO Box 3334

Auckland

New Zealand

(tel +64 9 917 5923, fax +64 9 522 0820)

or by email to:

BGENERAL COMMENTS

2.1The PPB supports the international harmonisation of auditing standards and believes that the goal of the IAASB should be the development of a set of generic standards that apply to all assurance engagements to the maximum extent possible and to all sectors.

2.2The auditing standards in New Zealand apply to all sectors and as far as possible to all high-level assurance engagements. In New Zealand the Auditor-General uses the auditing standards promulgated by the Institute of Chartered Accountants of New Zealand as the basis for standards for the conduct of the audit of public sector entities.

2.3In addition, in New Zealand, the definition of audit[1] is not restricted to financial statements – it involves providing a high level of assurance regardless of the subject matter. In 1998 the PPB codified its audit standards in large part to harmonise with the ISAs issued by the then International Auditing Practices Committee. At that time a conscious effort was also made to develop standards that could be applied to all high-level assurance engagements, irrespective of the subject matter. In some cases the application of audit standards is limited to audits of financial statements, although in this case standards usually state that the principles may be applicable to all audits.

Reasons for changes from existing standards

2.4The PPB does not support the new documents because the changes proposed appear, in substance, to be relatively minor. The PPB believes that the same end could have been achieved by amending existing standards rather than a total reorganisation of current requirements and that the issue of new standards is not justified.

2.5When standards are changed there are significant costs in training and education and in reviewing and revising audit methodologies. Based on the background material in the Explanatory Memorandum, the PPB is not convinced that in this case the costs of the changes will exceed the benefits of the changes.

2.6The Explanatory Memorandum, states “Recent changes in the business environment…” as justification for reviewing the ISAs and exposing the proposed changes. However, it is not clear why the current ISAs are considered to be inappropriate as a result of these changes.

2.7The PPB recommends that an explanation of the changes and their impact on the current ISAs should be provided to enable constituents to properly understand the proposed changes.

2.8Appendix 1 to the Explanatory Memorandum states that “…the fundamental audit risk model was not broken, but certain changes were needed.” and “Where appropriate, the recommendations of the JWG and the POB have been adopted.” However, no further detail or explanation has been provided in the Explanatory Memorandum regarding the:

• reasons for the changes if the fundamental audit risk model was not broken; nor
• recommendations made by the JWG and POB.

2.9The PPB suggests that information regarding the reasons for the proposed changes and for adopting the recommendations of the JWG and the POB be provided to enable constituents to properly understand the proposed changes.

2.10The PPB did not find the Explanatory Memorandum very useful in understanding the changes from the existing standards.

2.11There are a number of actions the IAASB could consider in this regard that will assist its constituents when commenting on future exposure drafts. The PPB recommends for each proposed ISA that the IAASB:

• Clearly set out the background to the proposed revised/new standard, including specific issues that the proposed standard is intended to address, and a summary of the main changes from existing standards;
• Develop a detailed Basis for Conclusions to assist constituents understand the rationale for decisions; and
• Develop a discussion paper that includes key questions on which the IAASB seeks comment.

2.12The recommendation in paragraph 2.11 above is based on the process undertaken by the International Accounting Standards Board (IASB) when it issues for comment an exposure draft or a revised standard.

2.13For example, ED 3 Business Combinations (issued for comment in December 2002) briefly explains a requirement of the proposed standard and then requests comment on a specific question in relation to that requirement. The reason for the requirement is then explained in the Basis for Conclusions that accompanies the exposure draft.

2.14This process identifies the major requirements of the proposed standard and enables constituents to provide a response that focuses on the requirements of the proposed standard and, particularly, the question/s that is/are posed in relation to each requirement.

CAREAS OF CONCERN

Applicability of the standards

3.1Although many of the New Zealand auditing standards have specific application (for example, the standard applies to all audits of financial reports), they also contain a statement to the effect that despite the scope of the standard being limited “much of the guidance in this Standard is applicable to any audit”.

3.2The PPB notes that the following statement to this effect is included beneath the “Contents” of ISA 200 “Objective and Principles Governing an Audit of Financial Statements”, the Audit Risk Exposure Drafts that are currently on issue for comment as well as many of the ISAs (for example, ISA 240, ISA 320 and ISA 580) currently on issue.

“International Standards on Auditing (ISAs) are to be applied in the audit of financial statements. ISAs are also to be applied, adapted as necessary, to the audit of other information and to related services.”

3.3The PPB recommends that this statement be included within all standards where such a statement is relevant.

3.4This would emphasise that while the standard is drafted for audits of financial statements, the general principles apply to all high-level assurance engagements and would make users aware of the wider applicability of the ISAs.

Audit risk model

3.5There is no definition or clear explanation of the proposed audit risk model.

3.6While the exposure drafts claim to be introducing a new or refined approach to audit risk, the proposed amendments to ISA 200, paragraphs 19 through 22, continue to identify the components of audit risk as Inherent Risk, Control Risk and Detection Risk – the current situation.

3.7The PPB recommends that the IAASB define and explain the proposed audit risk model and compare it to the current model in order that constituents may have a better understanding of the proposed changes.

Format and structuring

Black and grey lettering

3.8Throughout the proposed standards the PPB notes that many paragraphs mix “black letter” requirements and “grey letter” commentary. The PPB does not support the inclusion of black lettered principles and procedures in the same paragraphs as grey lettered explanatory and other material.

3.9The PPB considers that users will find the standards easier to follow if the “black letter” principles are set out in a separate paragraph supported by the explanatory and other material that explains the principles and procedures and provides examples and illustrations.

Structure of proposed ISAs

3.10The PPB also considers that a uniform “structure” should be applied consistently throughout all IAASB auditing standards that will assist users to understand the ISAs. Examples of inappropriate structure include:

• The inclusion of a bold letter standard in the Introduction section of the ISAs; and
• Explanatory material sometimes preceding rather than following the standard.

Bold letter standard in “Introduction”

3.11The Introduction section of these exposure drafts contains the purpose of the ISA and sometimes an overview of the ISA. The inclusion of a bold letter standard in an introduction is not appropriate. A standard contains a specific requirement therefore it should have its own heading and not be included within the Introduction.

3.12The PPB recommends that the ISAs contain separate headings “Purpose” and “Overview of the Requirements” above the relevant paragraphs. The use of more specific headings will enable users of the ISAs to find the information they are seeking.

3.13For example, ISA XX “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement” contains a standard in paragraph 4, and a heading above paragraph 7, an explanatory paragraph.

3.14The heading above paragraph 7 “Risk Assessment Procedures and Sources of Information About the Entity and its Environment, Including Its Internal Control” would be more appropriate prior to the standard in paragraph 4, “The auditor should obtain an understanding of the entity and its environment, including its internal control, that is sufficient to assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures”. This would then mean that the standard in paragraph 4 is no longer in the Introduction section of the ISA.

Explanatory material preceding a standard

3.15Explanatory material sometimes precedes a standard, for example ISA XX “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement”, paragraph 23 (explanatory) and paragraph 24 (standard). The explanatory and other material explains and expands on the requirements of the standard and often includes examples and illustrations.

3.16The PPB recommends, therefore, that explanatory material and guidance should follow the standard not precede it. This will make it easier for users to identify the standard and then read the additional guidance if they consider this to be necessary.

Definitions

3.17ISA XX “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement” introduces new terms, for example, “risk assessment procedures”, paragraph 8, and “significant risk”, paragraph 105. These terms are not defined in this exposure draft but the term “risk assessment procedures” is explained in ISA XX “Audit Evidence”, paragraph 15(a), as the procedures performed to obtain an understanding of the entity and its environment in order to assess the risks of material misstatement at the financial statement and assertion levels.

3.18The PPB recommends that a definition section for key terms be included in all ISAs. The definitions will clarify the meaning of the terms used in the document, thus reducing confusion regarding the meaning of the terms, and will assist users to understand the standard.

Explanatory Memorandum – Changes to Existing Requirements

3.19Although the PPB agrees with the requirements for the auditor to obtain an understanding of the business to be included in the proposed standard, the PPB considers that the purpose of obtaining this understanding has been restricted in the proposed standard.

3.20ISA 310 “Knowledge of the Business”, paragraph 9, identifies the following areas in which an understanding of the entity and its environment can be used to assist the auditor:

• Assessing risks and identifying problems.
• Planning and performing the audit effectively and efficiently.
• Evaluating audit evidence.
• Providing better service to the client.

3.21ISA XX “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement”, paragraph 4, emphasises an understanding of the entity and its environment for the purposes of assessing the risks of material misstatement of the financial statements. This means that the purpose of gaining an understanding of the entity and its environment in order to plan and perform the audit effectively and efficiently and to provide a better service to the client is not adequately considered.

3.22The PPB considers that the proposed standard should be cross-referenced to ISA 310 “Knowledge of the Business” in order that users of the standard are aware that obtaining an understanding of the entity and its environment is undertaken for reasons other than the assessment of the risk of material misstatement of the financial statements.

DRESPONSE TO SPECIFIC ISSUES ON WHICH COMMENT IS SOUGHT IN APPENDIX 3

GENERAL

ISAs are drafted to contain basic principles and essential procedures together with related guidance that apply to the auditor of financial statements of any entity, irrespective of its size. However, the IAASB recognises that the audit of small entities may give rise to certain special audit considerations.

Are there such special audit considerations in applying the standards and guidance contained in proposed ISA XX “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement” and proposed ISA XX “The Auditor’s Procedures in Response to Assessed Risks”? If so, include details of such considerations.

(The IAASB will take any comments made in response to this request when taking forward its project to consider the effect of the proposed ISAs on IAPS 1005, “The Special Considerations in the Audit of Small Entities”, and to make proposals about whether to incorporate relevant guidance in the ISAs or revision of IAPS 1005.)

4.1The PPB considers that there are no special audit considerations in applying the standards and guidance in the exposure drafts to small entities.

4.2For this reason the PPB considers that paragraphs relating to small entities should be removed from the proposed ISAs.

ISA XX “UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT”

Paragraphs 50 through 94 deals with internal control including the requirement to obtain an understanding of the components of internal control and guidance on obtaining the understanding. Appendix 2 contains further guidance to assist the auditor in understanding the components of internal control, including their application to small entities.

Is this additional guidance helpful, or is there sufficient material in the ISA itself? In considering this question, commentators should assume that the paragraphs relating to small entities will be retained, whether in the Appendix or elsewhere.

4.3The PPB considers that the guidance in Appendix 2 is helpful..

4.4However, the PPB considers that there are no special audit considerations in applying the standards and guidance in the exposure draft to small entities, therefore, the guidance in Appendix 2 specifically relating to small entities should be removed for the following reasons:

• The requirement is for the auditor to assess the risk of material misstatement, irrespective of the size of the entity;
• The inclusion of examples specific to small entities may limit the use of professional judgement by auditors; and
• There is no definition of what comprises a “small” entity.

ISA XX “THE AUDITOR’S PROCEDURES IN RESPONSE TO ASSESSED RISKS”

Where the auditor plans to rely on controls that have not changed since they were last tested, paragraph 38 requires the auditor to test the operating effectiveness of such controls at least every third audit. The IAASB discussed whether it was appropriate to impose such a limit on the ability of the auditor to use audit evidence obtained in a prior audit. The alternative view is that the period for such reliance should be left to the auditor’s judgement.

Is it appropriate for the ISA to specify a time period, and if so, is every third audit an appropriate limit? If not, please indicate what time period, if any, is considered more appropriate?

4.5The PPB does not agree that every third audit is an appropriate limit where the auditor plans to rely on controls that have not changed since they were last tested. The controls would need to be tested at least annually in order to determine whether or not they have in fact changed. Refer to paragraphs 7.7 – 7.8 of our submission.

DOCUMENTATION

Proposed ISAs XX, “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement”, and ISA XX, “The Auditor’s Procedures in Response to Assessed Risks”, include detailed documentation requirements. The IAASB considers that documentation requirements are important as a means of ensuring that auditors comply with significant requirements of the standards. The requirements are more extensive than previously.

Do commentators agree that it is appropriate for the IAASB to establish detailed documentation requirements? Are the proposals practical? If not, what suggestions do you have for documentation that achieves the objective of improving compliance with standards?

4.6The PPB does not agree with the inclusion of the specific topic material included on the grounds that this sort of information should be detailed in the planning memorandum. Refer to paragraphs 6.12 and 7.13 of our submission.

RESPONSES TO SPECIFIC EXPOSURE DRAFTS

EPROPOSED AMENDMENT TO ISA 200, “OBJECTIVES AND PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS”