Case Study & Need for Assurance
Scenario: Ahmed starts a business, Mohamed invests as a shareholder, Ahmed manages. Lower profits raise Mohamed's concern about financial statement accuracy, creating a need for independent assurance.
- Separation of Ownership & Management: In a limited company, shareholders (owners) are distinct from directors (managers).
- Conflict of Interest: Shareholders seek profit maximization; directors may prioritize personal rewards (salary, bonuses), potentially manipulating financial statements.
- Purpose of Assurance: To add credibility to financial statements prepared by management for shareholders.
Accountability: Those in power being answerable for their actions.
Stewardship: Managing another person's property.
Agency: Principal (shareholder) employs agent (director) to act on their behalf.
- Fiduciary Relationship: Relationship of 'good faith' between directors and shareholders.
- Directors are stewards accountable to shareholders.
- Directors' stewardship duties include: keeping proper records, safeguarding assets, implementing controls, producing true & fair financial statements, and preparing directors' reports.
Auditor's Role: The auditor is accountable to shareholders, acts in their interest and the public interest, but is not an agent for other stakeholders. The audit report is addressed to shareholders.
Assurance Engagement: A practitioner obtains sufficient appropriate evidence to express a conclusion designed to enhance the confidence of intended users about a subject matter evaluated against criteria.
Five Key Elements (CREST):
- Criteria (Suitable framework, e.g., IFRS)
- Responsible Party (Management)
- Evidence (Sufficient & Appropriate)
- Subject Matter (e.g., Financial Statements)
- Three Parties (Intended User, Responsible Party, Practitioner)
Increasing Demand: Driven by information expansion, technology, changing stakeholder expectations, and corporate accountability needs (governance, environmental/social reporting).
| Category | Examples |
|---|---|
| Financial | Audit of historic financial statements, Review of historic FS, Review of prospective financial information (e.g., cash flows). |
| Non-Financial | Verification of social/environmental info, Review of internal controls, Corporate governance review, Risk assessments, Performance measurement. |
| Type | Level | Conclusion Wording | Procedures | Example |
|---|---|---|---|---|
| Reasonable Assurance | High | Positive ("In our opinion") | Thorough: Tests of controls & substantive procedures | Audit of Financial Statements |
| Limited Assurance | Moderate/Lower | Negative ("Nothing has come to our attention") | Limited: Mainly enquiries & analytical procedures | Review of Financial Statements |
Reasonable assurance requires more regulations, more thorough procedures, and higher quality evidence than limited assurance.
- Purpose: Enhance user confidence in financial statements.
- Objective: Express an opinion on whether FS give a true and fair view / "present fairly" and comply with an applicable financial reporting framework (e.g., IFRS).
- Auditor's Objective: Obtain reasonable assurance that FS are free from material misstatement (error/fraud).
- Benefits: Enhances credibility, provides independent scrutiny, reduces risk of management bias/fraud/error, may highlight internal control deficiencies.
The phrases “present fairly, in all material respects” and “give a true and fair view” are equivalent.
- Financial statements include subjective estimates/judgments.
- Internal controls have inherent limitations (human error, management override, collusion).
- Some evidence is only persuasive, not conclusive (e.g., management representations).
- Auditors test on a sample basis, not all transactions.
- Therefore, an audit provides reasonable, not absolute, assurance (no 100% guarantee).
The Expectation Gap: The difference between what users believe auditors do and what they actually do.
Users may incorrectly believe:
1. Auditors detect all fraud. (Reality: Provide reasonable assurance FS are free from material misstatement from fraud.)
2. Auditors prepare the financial statements. (Reality: Management's responsibility.)
3. Auditors test all transactions. (Reality: Sample-based testing.)
- Purpose: Voluntary engagement for companies not legally requiring an audit. Provides some assurance at lower cost/less disruption than an audit.
- Objective: State whether anything has come to the auditor's attention causing them to believe the FS are not prepared in accordance with the framework.
- Procedures: Primarily analytical procedures and enquiries of management.
- Report: Contains a negatively worded conclusion ("Based on our review, nothing has come to our attention..."). Explicitly states it is not an audit and does not express an audit opinion.
- Reason: The separation of ownership and management leads to conflicts of interest → need for independent assurance.
- Concepts: Accountability, Agency, Stewardship, Fiduciary Relationship.
- Assurance Engagement: Gathering evidence to express an opinion that enhances confidence.
- CREST Elements: Criteria, Responsible Party, Evidence, Subject Matter, Three Parties.
- Two Levels: Reasonable Assurance (High), Limited Assurance (Low).
- Audit: Detailed examination → positive opinion → high confidence.
- Limitations: No absolute guarantee, sampling, subjective estimates.
- Expectation Gap: Users' misunderstanding of the auditor's scope.
- Review Engagement: Limited procedures → negative opinion → moderate confidence.