text
stringlengths 27
15.8k
| textbook_name
stringclasses 15
values |
|---|---|
other assets.
EXPLANATION
The major issues related to the possible impairment of the above-mentioned items can be
analyzed as follows:
Item #1
The recoverable amount is defined as the higher of an asset’s net selling price and its value
in use. No impairment loss is recognized because the recoverable amount of $121,000 is high-
er than the carrying amount of $119,000.
Items #2
Item #2 is impaired because its recoverable amount ($207,000) is lower than its carrying
amount ($237,000) giving rise to an impairment loss of $30,000. According to IAS 36 (par. 60),
the loss should be treated as a revaluation decrease. Therefore, $12,000 of the loss is debited
to revaluation surplus in equity and the balance of the loss ($18,000) is recognized in profit
or loss.
Items #3
Item #3 is not impaired.
Item #4
Item #4 is impaired because its recoverable amount ($79,000) is lower than its carrying
amount ($83,000), giving rise to an impairment loss of $4,000 which is recognized as an
expense in profit or loss.
Item #5
The recoverable amount of the bus cannot be determined because the asset’s value in use can-
not be estimated to be close to its net selling price and it does not generate cash inflows from
Chapter 22 Impairment of Assets (IAS 36)
191
continuing use that are largely independent of those from other assets. Therefore, manage-
ment must determine the cash-generating unit to which the bus belongs and estimate the
recoverable amount of this unit as a whole. If this unit consists of items #1 to #5, the carrying
amount of the cash-generating unit (after recognizing the impairment losses on items #2 and
#4) is $551,000. The fair value less costs to sell of the cash-generating unit is $546,000 (assum-
ing that the assets could not be sold for more than the aggregate of their individual fair val-
ues). The value in use of the cash-generating unit is $521,000 (assuming, again, that the assets
do not collectively produce cash flows that are higher than those used in the determination
of their individual values in use). Therefore, the recoverable amount of the cash-generating
unit is $546,000, giving rise to a further impairment loss of $5,000. The loss should be allo-
cated on a pro rata basis to items #1, #3, and #5 provided that the carrying amount of each
item is not reduced below the highest of its fair value less costs to sell and value in use. This
means, in practice, that the whole of the loss is allocated to item #5, the bus.
23 Provisions, Contingent Liabilities,
and Contingent Assets (IAS 37)
Note: IAS 37 is currently under review and an exposure draft of proposed amendments was issued in
June 2005. The exposure draft emphasized that an asset or liability cannot be contingent. The definition
for an asset or liability is either met, or not. Uncertainty is reflected in measurement, not in determin-
ing whether the asset or liability exists.
23.1 PROBLEMS ADDRESSED
Provisions and contingent liabilities have an increased level of inherent uncertainty. The
prime objective of the standard is to ensure that provisions are only recognized when estab-
lished criteria as to reliability of the obligation are met. In contrast, contingent liabilities
should not be recognized but should be disclosed so that such information is available in the
financial statements.
23.2
SCOPE OF THE STANDARD
This IAS prescribes the appropriate accounting treatment as well as the disclosure require-
ments for all provisions, contingent liabilities, and contingent assets to enable users to under-
stand their nature, timing, and amount.
It sets out the conditions that must be fulfilled for a provision to be recognized.
It guides the preparers of financial statements to decide when they should, in respect of a
specific obligation,
• provide for it (recognize),
• disclose information only, or
• disclose nothing.
IAS 37 is applicable to all entities when accounting for provisions and contingent liabilities
or assets, except those resulting from
| Hennie |
• financial instruments carried at fair value,
• executory contracts (for example, contracts under which both parties have partially
performed their obligations to an equal extent),
• insurance contracts with policyholders, and
• events or transactions covered by another IAS (for example, income taxes and lease
obligations).
192
Chapter 23 Provisions, Contingent Liabilities, and Contingent Assets (IAS 37)
193
23.3
KEY CONCEPTS
23.3.1 A provision is a liability of uncertain timing or amount. Provisions can be distin-
guished from other liabilities such as trade payables and accruals because there is uncertain-
ty about the timing or amount of the future expenditure required in settlement.
23.3.2 A liability is defined in the Framework as a present obligation of the entity arising
from past events, the settlement of which is expected to result in an outflow from the entity
of resources embodying economic benefits.
23.3.3 A contingent liability is either
• a possible obligation, because it has yet to be confirmed whether or not the entity has
a present obligation that could lead to an outflow of resources embodying economic
benefits, or
• a present obligation that does not meet the recognition criteria, either because it is not
probable that an outflow of resources embodying economic benefits will be required to
settle the obligation, or because a sufficiently reliable estimate of the amount of the
obligation cannot be made.
23.3.4 Contingent liabilities are not recognized because
• their existence will be confirmed by uncontrollable and uncertain future events (that is,
not liabilities), or
• they do not meet the recognition criteria.
23.3.5 A contingent asset is a possible asset that arises from past events and whose exis-
tence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain
future events not wholly within the control of the entity (for example, an insurance claim that
an entity is pursuing has an uncertain outcome).
23.4
ACCOUNTING TREATMENT
PROVISIONS
23.4.1 A provision should be recognized only when
• an entity has a present obligation (legal or constructive) as a result of a past event
(obligating event),
• it is probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, and
• a reliable estimate can be made of the amount of the obligation.
23.4.2 A past event is deemed to give rise to a present obligation if it is more likely than not
that a present obligation exists at balance sheet date.
23.4.3 A legal obligation normally arises from a contract or legislation. A constructive
obligation arises only when both of the following conditions are present:
• The entity has indicated to other parties, by an established pattern of past practice,
published policies, or a sufficiently specific current statement, that it will accept certain
responsibilities.
• As a result, the entity has created a valid expectation on the part of those other parties
that it will discharge those responsibilities.
194
Chapter 23 Provisions, Contingent Liabilities, and Contingent Assets (IAS 37)
23.4.4 The amount recognized as a provision should be the best estimate of the expendi-
ture required to settle the present obligation at the balance sheet date.
23.4.5 Some or all of the expenditure required to settle a provision might be expected to be
reimbursed by another party (for example, through insurance claims, indemnity clauses, or
suppliers’ warranties). These reimbursement are treated as follows:
• Recognize a reimbursement when it is virtually certain that reimbursement will be
received if the entity settles the obligation. The amount recognized for the reimburse-
ment should not exceed the amount of the provision.
• Treat the reimbursement as a separate asset.
• The expense relating to a provision can be presented net of the amount recognized for a
reimbursement in the income statement.
23.4.6 Provisions should be reviewed at each balance sheet date and adjusted to reflect the
current best estimate.
23.4.7 A provision should be used only for expenditures for which the provision was orig- | Hennie |
inally recognized.
23.4.8 Recognition and measurement principles for (1) future operating losses, (2) onerous
contracts, and (3) restructurings should be applied as follows:
1. Provisions should not be recognized for future operating losses. An expectation of
future operating losses is an indication that certain assets of the operation could be
impaired. IAS 36, Impairment of Assets, would then be applicable.
2. The present obligation under an onerous contract should be recognized and measured
as a provision. An onerous contract is one in which the unavoidable costs of meeting
the contract obligations exceed the economic benefits expected to be received under it.
3. A restructuring is a program planned and controlled by management that materially
changes either the scope of business or the manner in which that business is conducted.
A provision for restructuring costs is recognized when the normal recognition criteria for
provisions are met. A constructive obligation to restructure arises only when an entity
• has a detailed formal plan for the restructuring, and
• has raised a valid expectation in those affected that it will carry out the restructuring by
starting to implement that plan or announcing its main features to those affected by it.
Where a restructuring involves the sale of an operation, no obligation arises for the sale
until the entity is committed by a binding sale agreement.
CONTINGENT LIABILITIES
23.4.9 An entity should not recognize a contingent liability. An entity should disclose a
contingent liability unless the possibility of an outflow of resources embodying economic
benefits is remote.
23.4.10 Contingent liabilities are assessed continually to determine whether an outflow of
resources embodying economic benefits has become probable. When such an outflow becomes
probable for an item previously dealt with as a contingent liability a provision is recognized.
CONTINGENT ASSETS
23.4.11 An entity should not recognize a contingent asset.
23.4.12 A contingent asset should be disclosed where an inflow of economic benefits is
probable. When the realization of income is virtually certain, then the related asset is not a
contingent asset and its recognition is appropriate in terms of the Framework.
Chapter 23 Provisions, Contingent Liabilities, and Contingent Assets (IAS 37)
195
23.5
PRESENTATION AND DISCLOSURE
23.5.1 Provisions: disclose the following for each class separately:
• A detailed itemized reconciliation of the carrying amount at the beginning and end of
the accounting period; comparatives are not required
• A brief description of the nature of the obligation and the expected timing of any
resulting outflows of economic benefits
• An indication of the uncertainties about the amount or timing of those outflows
• The amount of any expected reimbursement, stating the amount of any asset that has
been recognized for that expected reimbursement.
23.5.2 Contingent liabilities: disclose the following for each class separately:
• Brief description of the nature
• Estimate of the financial effect
• Indication of uncertainties relating to the amount or timing of any outflow
• The possibility of any reimbursement
23.5.3 Contingent assets: disclose the following for each class separately:
• Brief description of the nature
• Estimate of the financial effect
23.5.4 Exceptions allowed are as follows:
• Where any information required for contingent liabilities or assets is not disclosed
because it is not practicable to do so, it should be so stated.
• In extremely rare cases, disclosure of some or all of the information required can be
expected to seriously prejudice the position of the entity in a dispute with other parties
regarding the provision, contingent liability, or contingent asset. In such cases, the
information need not be disclosed; however, the general nature of the dispute should
be disclosed, along with an explanation of why the information has not been disclosed.
196
Chapter 23 Provisions, Contingent Liabilities, and Contingent Assets (IAS 37)
| Hennie |
23.5.5 Figure 23.1 summarizes the main requirements of this Standard.
Figure 23.1 Decision Tree
Start
Present obligation
as a result of an
obliging event
NO
Possible obligation?
NO
YES
YES
Probable outflow?
NO
Remote?
YES
YES
NO
Reliable estimate?
NO (rare)
YES
Provide
Disclosure of
contingent liability
Do nothing
Chapter 23 Provisions, Contingent Liabilities, and Contingent Assets (IAS 37)
197
EXAMPLE: PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
EXAMPLE 23.1
The following scenarios relate to provisions and contingencies:
A. The Mighty Mouse Trap Company has just started to export mouse traps to the United
States. The advertising slogan for the mouse traps is: “A girl’s best friend.” The
Californian Liberation Movement is claiming $800,000 from the company because the
advertising slogan allegedly compromises the dignity of women. The company’s legal
representatives are of the opinion that the success of the claim will depend on the judge
who presides over the case. They estimate, however, that there is a 70 percent probability
that the claim will be thrown out and a 30 percent probability that it will succeed.
B. Boss Ltd. specializes in the design and manufacture of an exclusive sports car. During
the current financial year, 90 sports cars have been completed and sold. During the test-
ing of the sports car, a serious defect was found in its steering mechanism.
All 90 clients were informed by way of a letter of the defect and were required to
bring their cars back to have the defect repaired at no charge. All the clients have indi-
cated that this is the only arrangement that they require. The estimated cost of the recall
will amount to $900,000.
The manufacturer of the steering mechanism, a listed company with sufficient funds,
has accepted responsibility for the defect, and has undertaken to reimburse Boss Ltd. for
all costs that it might incur in this regard.
EXPLANATION
The matters above will be treated as follows for accounting purposes:
A. Present obligation as a result of a past event: The available evidence provided by the
experts indicates that it is more likely that no present obligation exists at balance sheet
date; there is a 70 percent probability that the claim will be thrown out. No obligating
event has taken place.
Conclusion: No provision is recognized. The matter is disclosed as a contingent liabili-
ty unless the 30 percent probability is regarded as being remote.
B. Present obligation as a result of a past event: The constructive obligation derives from
the sale of defective cars.
Conclusion: The outflow of economic benefits is beyond any reasonable doubt. A pro-
vision is therefore recognized. However, as it is virtually certain that all of the expendi-
tures will be reimbursed by the supplier of the steering mechanism, a separate asset is
recognized in the balance sheet. In the income statement, the expense relating to the pro-
vision can be shown net of the amount recognized for the reimbursement.
24 Intangible Assets (IAS 38)
24.1
PROBLEMS ADDRESSED
An intangible asset is one that has no physical form although it exists from contractual and
legal rights and has an economic value. The objective of the standard is to allow entities to
identify and recognize separately the value of intangible assets on the balance sheet provid-
ing certain conditions are satisfied. IAS 38 enables users to more accurately assess the value
as well as the makeup of assets of the entity.
24.2
SCOPE OF THE STANDARD
IAS 38 applies to all intangible assets that are not specifically dealt with in another IAS.
Examples include brand names, computer software, licenses, franchises, and intangibles
under development. This Standard prescribes the accounting treatment of intangible assets,
including:
• the definition of an intangible asset,
• recognition as an asset,
• determination of the carrying amount,
• determination and the treatment of impairment losses, and
• disclosure requirements.
24.3
KEY CONCEPTS
24.3.1 An intangible asset is an identifiable nonmonetary asset
• without physical substance, | Hennie |
• which is separable,
• which arises from contractual or other legal rights, regardless of whether those rights
are transferable or separable from the entity or other rights and obligations,
• that is capable of being separated from the entity and sold, transferred, licensed, rented, or
exchanged—either individually or together with a related contract, asset, or liability, and
• that is clearly distinguishable and controlled separately from an entity’s goodwill.
198
24.4
ACCOUNTING TREATMENT
Chapter 24 Intangible Assets (IAS 38)
199
24.4.1 An intangible asset is recognized as an asset (in terms of the Framework) if
• it is probable that the future economic benefits attributable to the asset will flow to the
entity, and
• the cost of the asset can be measured reliably.
24.4.2 All other expenses related to the following categories are expensed. They include:
• Internally generated brands, mastheads, publishing titles, customer lists, and so on
• Start-up costs
• Training costs
• Advertising and promotion
• Relocation and reorganization expenses
• Redundancy and other termination costs
24.4.3 On initial recognition, an intangible asset is measured at cost, whether it is acquired
externally or generated internally.
24.4.4 Subsequent to initial recognition, an entity should choose either the cost model or
the revaluation model as its accounting policy for intangible assets and should apply that
policy to an entire class of intangible assets:
• Cost model. The carrying amount of an intangible asset is its cost less accumulated
amortization. Assets classified as held for sale are shown at the lower of fair value less
costs to sell and carrying amount.
• Revaluation model. The carrying amount of an item of intangible asset is its fair value
less subsequent accumulated amortization and impairment losses. Assets classified as
held for sale are shown at the lower of fair value less costs to sell and carrying amount.
24.4.5 For any internal project to create an intangible asset, the research phase and devel-
opment phase should be distinguished from one another. Research expenditure is treated as
an expense. Development expenditure is recognized as an intangible asset if all of the fol-
lowing can be demonstrated:
• The technical feasibility of completing the intangible asset so that it will be available for
use or sale
• The availability of adequate technical, financial, and other resources to complete the
development and to use or sell the intangible asset
• The intention to complete the intangible asset and use or sell it
• The ability to use or sell the intangible asset
• How the intangible asset will generate probable future economic benefits
• The ability to measure the expenditure
24.4.6 An entity should assess whether the useful life of an intangible asset is finite or infi-
nite and, if finite, the length of its life, or number of production or similar units constituting
its useful life. Amortization and impairment principles apply as follows:
• An intangible asset with a finite useful life is amortized on a systematic basis over the
best estimate of its useful life.
• An intangible asset with an infinite useful life should be tested for impairment annual-
ly, but not amortized.
200
Chapter 24 Intangible Assets (IAS 38)
24.4.7 To assess whether an intangible asset might be impaired, an entity should apply
IAS 36, Impairment of Assets. Also, this Standard requires an entity to estimate, at least annu-
ally, the recoverable amount of an intangible asset that is not yet available for use.
24.4.8 In the case of a business combination, expenditure on an intangible item that does
not meet both the definition and recognition criteria for an intangible asset should form part
of the amount attributed to goodwill.
24.5
PRESENTATION AND DISCLOSURE
24.5.1 Each class of intangible assets should distinguish between internally generated and
other intangibles.
24.5.2 Accounting policies should specify
• measurement bases,
• amortization methods, and
• useful lives or amortization rates.
24.5.3 Income statement and notes should disclose
| Hennie |
• the amortization charge for each class of asset indicating the line item in which it is
included, and
• the total amount of research and development costs recognized as an expense.
24.5.4 Balance sheet and notes should disclose the following:
• Gross carrying amount (book value) less accumulated depreciation for each class of
asset at the beginning and the end of the period
• Detailed itemized reconciliation of movements in the carrying amount during the peri-
od; comparatives are not required
• If an intangible asset is amortized over more than 20 years, the evidence that rebuts the
presumption that the useful life will not exceed 20 years
• Carrying amount of intangibles pledged as security
• Carrying amount of intangibles whose title is restricted
• Capital commitments for the acquisition of intangibles
• A description, the carrying amount, and remaining amortization period of any intangi-
ble that is material to the financial statements of the entity as a whole
• For intangible assets acquired by way of a government grant and initially recognized at
fair value
• the fair value initially recognized for these assets,
• their carrying amount, and
• whether they are measured at the benchmark or allowed alternative treatment
24.5.5 Additional disclosures required for revalued amounts are as follows:
• Effective date of the revaluation
• Carrying amount of each class of intangibles had it been carried in the financial state-
ments on the historical cost basis
• Amount as well as a detailed reconciliation of the balance of the revaluation surplus
• Any restrictions on the distribution of the revaluation surplus
24.6
FINANCIAL ANALYSIS AND INTERPRETATION
Chapter 24 Intangible Assets (IAS 38)
201
24.6.1 This IFRS determines that the intangible assets reported on a balance sheet are only
those intangibles that have been purchased or manufactured (in limited instances). However,
companies have intangible assets that are not recorded on their balance sheets; these intan-
gible assets include management skill, valuable trademarks and name recognition, a good
reputation, proprietary products, and so forth. Such assets are valuable, and would fetch
their worth if a company were to be sold.
24.6.2 Analysts should try to assess the value of such assets based on a company’s ability
to earn economic profits or rents from them, even though it is difficult to do so.
24.6.3 Financial analysts have traditionally viewed the values assigned to intangible assets
with suspicion. Consequently, in adjusting financial statements they often exclude the book
value assigned to intangibles (reducing net equity by an equal amount and increasing pretax
income by the amortization expense associated with the intangibles).
24.6.4 This arbitrary assignment of zero value to intangibles might also be inadvisable. The
analyst should decide if there is any extra earning power attributable to goodwill, or any
other intangible asset. If there is, it is a valuable asset.
24.6.5 An issue to be considered when comparing the returns on equity or assets of various
companies is the degree of recognized intangible assets. An entity that has acquired many of
its intangible assets in mergers and acquisitions will typically have a significantly higher
amount of such assets in its balance sheet (and hence lower returns on equity and assets) than
an equivalent entity that has developed most of its intangible assets internally.
202
Chapter 24 Intangible Assets (IAS 38)
EXAMPLE: INTANGIBLE ASSETS
EXAMPLE 24.1
Alpha Inc., a motor vehicle manufacturer, has a research division that worked on the follow-
ing projects during the year:
Project 1
The design of a steering mechanism that does not operate like a conventional steering wheel,
but reacts to the impulses from a driver’s fingers.
Project 2
The design of a welding apparatus that is controlled electronically rather than mechanically.
The following is a summary of the expenses of the particular department:
General
$’000
Project 1
$’000
Project 2
$’000
| Hennie |
Material and Services
Labor
• Direct Labor
• Department Head Salary
• Administrative Personnel
Overhead
• Direct
• Indirect
128
–
400
725
–
270
935
620
–
–
340
110
620
320
–
–
410
60
The departmental head spent 15% of his time on Project 1 and 10% of his time on Project 2.
EXPLANATION
The capitalization of development costs for the year would be as follows:
Project 1. The activity is classified as research and all costs are recognized
as expenses.
Project 2. (620 + 320 + 10% ¥ 400 + 410 + 60)
$’000
–
1,450
1,450
25 Financial Instruments:
Recognition and
Measurement (IAS 39)
IAS 32 and 39 and IFRS 7 were issued as separate Standards but are applied in practice as a
unit because they deal with the same accounting and financial risk issues. IAS 39 deals with
the recognition and measurement issues of financial instruments. IAS 32 (Chapter 34) deals
with presentation issues and IFRS 7 deals with disclosure issues (Chapter 38).
25.1
PROBLEMS ADDRESSED
This Standard establishes principles for recognizing, measuring, and disclosing information
about financial instruments in the financial statements. IAS 39 significantly increases the use
of fair value in accounting for financial instruments, particularly on the asset side of the bal-
ance sheet.
25.2
SCOPE OF THE STANDARD
The standard distinguishes between four classes of financial assets, namely assets held at fair
value through profit and loss (for example, trading and other elected securities), assets avail-
able for sale, assets held to maturity, and loans and receivables. In addition it identifies two
classes of financial liabilities, those at fair value, and liabilities shown at amortized cost. It
outlines the accounting approach in each case. It also categorizes and sets out the accounting
treatment for three types of hedging: (i) fair value, (ii) cash flow and (iii) net investment in a
foreign subsidiary.
IAS 39 should be applied to all financial instruments identified in paragraph 25.4.6. The fol-
lowing elements are excluded from the requirements of IAS 39:
• Subsidiaries, associates, and joint ventures.
• Rights and obligations under leases.
• Employee benefit plan assets and liabilities.
• Rights and obligations under insurance contracts.
• Equity instruments issued by the reporting entity.
• Financial guarantee contracts related to failure by a debtor to make payments when
due
• Contracts for contingent consideration in a business combination.
• Contracts based on physical variables, for example climate.
203
204
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
25.3
KEY CONCEPTS
FINANCIAL INSTRUMENTS
25.3.1 Financial instruments are contracts that give rise to both
• a financial asset of one entity, and
• a financial liability of another entity.
25.3.2 A derivative is a financial instrument or other contract, for which
• the value changes in response to changes in an underlying interest rate, exchange rate,
commodity price, security price or credit rating, and so on,
• little or no initial investment is required, and
• settlement takes place at a future date.
25.3.3 An embedded derivative is a component of a hybrid instrument that also includes a non-
derivative host contract—with the effect that some of the cash flows of the combined instrument
vary in a way similar to a standalone derivative. A derivative that is attached to a financial instru-
ment but is contractually transferable independently of that instrument, or has a different coun-
terparty from that instrument, is not an embedded derivative, but a separate financial instrument.
VALUATION AND MARKET PRACTICE
25.3.4 Fair value is the amount at which an asset could be exchanged, or a liability settled,
between knowledgeable willing parties in an arm’s length transaction.
25.3.5 Mark-to-market (fair value adjustments to financial assets and liabilities) is the
process whereby the value of most trading assets (for example, those held for trading and
that are available-for-sale) and trading liabilities are adjusted to reflect current fair value.
Such adjustments are often made on a daily basis, and cumulative balances reversed on the | Hennie |
subsequent day, prior to recalculating a fresh cumulative mark-to-market adjustment.
25.3.6 Amortized cost is the amount at which the financial asset or financial liability is mea-
sured at initial recognition
• minus any principal repayments,
• plus or minus the cumulative amortization of the premiums or discounts an the instru-
ment, and
• minus any reduction for impairment or uncollectability.
The amortization calculation should use the effective interest rate (not the nominal rate of interest)
25.3.7 Trade or settlement date accounting arises when an entity chooses to recognize the pur-
chase of an instrument in its financial statements on the date when the commitment arises from
the transaction; or only on the date that the liability is settled. Most treasury accountants prefer
trade date accounting, because that is when the risks and rewards of ownership transfer.
25.3.8 Total return is the real return achieved on financial assets and the amount used to
assess the performance of a portfolio; an amount which includes income and expenses
recorded in the profit and loss account (for example, interest earned, realized gains and loss-
es) and unrealized gains and losses recorded in profit and loss or equity (for example, fair
value adjustments to available for-sale securities).
HEDGING
25.3.9 A fair value hedge hedges the exposure to changes in fair value of a recognized asset
or liability (for example, changes in the fair value of fixed rate bonds as a result of changes in
market interest rates).
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
205
25.3.10 A cash flow hedge hedges the exposure of cash flows related to a recognized asset or
liability (for example, future interest payments on a variable rate bond), a highly probable
transaction (for example, an anticipated purchase or sale of inventories), or the foreign curren-
cy risk effect of a firm commitment (for example, a contract entered into to buy or sell an asset
at a fixed price in the entity’s reporting currency).
25.3.11 The hedge of a net investment in a foreign entity hedges the exposure related to
changes in foreign exchange rates.
25.4
ACCOUNTING TREATMENT
INITIAL RECOGNITION
25.4.1 Management should establish policies for the classification of portfolios into various
asset and liability classes (see table 25.1 below).
25.4.2 Financial assets and financial liabilities are recognized initially at their cost—which
is the fair value of the consideration given or received. Transaction costs as well as certain
hedging gains or losses are also included.
25.4.3 All financial assets and financial liabilities (including derivatives) should be recog-
nized when the entity becomes a party to the contractual provisions of an instrument. For the
purchase or sale of financial assets where market convention determines a fixed period
between trade and settlement dates, the trade or settlement date can be used for recognition.
Interest is not normally accrued between trade and settlement dates, but mark-to-market
adjustments are made regardless of whether the entity uses trade date or settlement date
accounting. Although IAS 39 allows the use of either date, trade date accounting is preferred
by most treasury accountants.
SUBSEQUENT MEASUREMENT
25.4.4 Subsequent measurement of financial assets and liabilities on the balance sheet can
be summarized as follows per table 25.1:
Table 25.1 Financial Asset and Liability Categories
Category
Measurement
Financial Assets
Classes
Financial Liabilities
Classes
Comments
1
2
3
4
Fair value through
Profit & Loss
Trading assets
Trading liabilities
Derivatives
Derivatives
Other elected assets
Other elected liabilities
Short sales or issued debt with
intention to repurchase shortly
Unless designated as qualifying
hedging instruments
Fair value option (elected)—
allowed where inconsistencies
reduced; or where part of a docu-
mented group risk management
strategy; or liabilities contain
embedded derivatives
Amortized value
Held-to-maturity | Hennie |
securities
Accounts payable
Issued debt securities
Deposits from customers
Amortized value
Loans and receivables N/A
Fair value through
equity
Available for sale
securities
N/A
206
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
25.4.5 Gains or losses on remeasurement to fair value of financial assets and financial lia-
bilities are included in net profit or loss for the period. However there are two exceptions
to this rule:
• Unrealized gains or losses on an available-for-sale (nontrading) financial asset must be
recognized in equity until it is sold or impaired, at which time the cumulative amount
is transferred to net profit or loss for the period. (See also Chapter 20 and Example 25.1
at the end of this chapter.)
• When financial assets and financial liabilities (carried at amortized cost) are being
hedged by a hedging instrument, special hedging rules in IAS 39 apply.
Table 25.2 Financial Impact of Various Portfolio Classification Choices under IAS 39
IAS 39
Portfolio
Classification
Trading
Available for Sale (AFS)
Held to Maturity (HTM)
Realized and
Unrealized Coupon and
Gains and Losses
Realized and Unrealized
Discount/Premium
Amortization
Changes in Clean
Market Value
Income
Income
Income
Income
Income
Income
Income
Equity
—
Note: FX realized and unrealized through P&L per IAS 21 (except for MTM portion of AFS securities).
25.4.6 An entity should assess, at each balance sheet date, whether financial assets could be
impaired.
25.4.7 All impairment losses are included in net profit or loss for the period irrespective of
the category of financial assets. Therefore, when impairment losses occur for available-for-
sale financial assets (where fair value remeasurements are recognized in equity), an amount
should be transferred from equity to net profit or loss for the period.
25.4.8 An impairment loss could be reversed in future periods but the reversal may not
exceed the amortized cost for those assets that are not remeasured at fair value (for example,
held-to-maturity assets).
DERECOGNITION
25.4.9 A financial asset, or portion thereof, is derecognized when the entity loses control
of the contractual rights to the cash flows that compose the financial asset—through realiza-
tion, expiry, or surrender of those rights.
25.4.10 When a financial asset is derecognized, the difference between the proceeds and the
carrying amount is included in the profit or loss for the period. Any prior cumulative reval-
uation surplus or shortfall that had been recognized directly in equity is also included in the
profit or loss for the period. When a part of a financial asset is derecognized, the carrying
amount is allocated proportionally to the part sold using fair value at date of sale and the
resulting gain or loss is included in the profit or loss for the period.
25.4.11 A financial liability is derecognized when it is extinguished, that is, when the
obligation is discharged, or cancelled, or expires.
25.4.12 An entity may not classify any financial assets as held-to-maturity if during the
current year or preceding 2 years it sold or reclassified more than an insignificant amount of
held-to-maturity investments before maturity (or as a result of an unanticipated, nonrecur-
ring, isolated event beyond its control). Misuse of the category will result in nonavailability
of the category for a period of 3 years.
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
207
HEDGING
Table 25.3 Hedge Accounting Rules
Recognize in income
statement
All adjustments on hedging
instrument & hedged item
Recognize directly in equity measurement of asset/liability
Recognize in initial
Gain/loss on ineffective2
Gain/loss on the effective1
portion of hedging instrument
portion of hedging instrument
Fair value
hedge
Cash flow
hedge
Gain/loss previously recognized
in equity when hedge does not
result in asset/liability
Hedge of net Gain/loss on ineffective2
investment in
foreign entity
portion of hedging instrument
Gain/loss on the effective1
portion of hedging
instrument
Gain/loss previously recognized
in equity
| Hennie |
1. A hedge is normally regarded to be highly effective if, at inception and throughout the life of the hedge, the entity can expect changes
in the fair values or cash flows of the hedged item to be almost fully offset by the changes in the hedging instrument, and actual results are
in the range of 80 percent to 125 percent. For example, if the loss on a financial liability is 56 and the profit on the hedging instrument is
63, the hedge is regarded to be effective: 63 ÷ 56 =112.5 percent.
2. An ineffective hedge would be one where actual results of offset are outside the range mentioned above. Furthermore, a hedge would not
be fully effective if the hedging instrument and the hedged item are denominated in different currencies and the two do not move in tan-
dem. Also, a hedge of interest-rate risk using a derivative would not be fully effective if part of the change in the fair value of the derivative
is due to the counterparty’s credit risk.
25.4.13 Hedging contrasts with hedge accounting as follows:
• Hedging changes risks, whereas hedge accounting changes the accounting for gains
and losses.
• Hedging and hedge accounting are both optional activities (even when a position is
hedged, the entity does not have to use hedge accounting to account for the transaction).
• Hedging is a business decision—hedge accounting is an accounting decision.
• Hedging accounting is allowed only when hedging instrument is a
• derivative (other than a written option),
• written option when used to hedge a purchased option, or
• nonderivative financial asset or liability when used to hedge foreign currency risks.
• A hedging instrument might not be designated for only a portion of the time period
over which the instrument is outstanding.
25.4.14 Hedging means designating a derivative or nonderivative financial instrument as
an offset to the change in fair value or cash flows of a hedged item. A hedging relationship
qualifies for special hedge accounting if the following criteria apply (the hedge must be des-
ignated, documented, and tracked):
• At the inception of the hedge there is formal documentation setting out the hedge
details.
• The hedge is expected to be highly effective.
• In the case of a forecasted transaction, the transaction must be highly probable.
• The effectiveness of the hedge is reliably measured.
• The hedge was effective throughout the period.
208
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
25.4.15 Hedge accounting recognizes symmetrically the offsetting effects on net profit or
loss of changes in the fair values of the hedging instrument and the related item being
hedged. Hedging relationships are of three types:
1. Fair value hedge—hedges the exposure of a recognized asset or liability (for example,
changes in the fair value of fixed rate bonds as a result of changes in market interest rates).
2. Cash flow hedge—hedges the exposure to variability in cash flows related to
• a recognized asset or liability (for example future interest payments on a bond),
• a forecasted transaction (for example, an anticipated purchase or sale of inventories), or
• a firm commitment with foreign currency risk (for example, a contract entered into
to buy or sell an asset at a fixed price in the entity’s reporting currency).
3. Hedge of a net investment in a foreign entity—hedges the exposure related to
changes in foreign exchange rates.
25.4.16 Gains or losses on fair value hedges should be recognized in net profit or loss, and
the loss or the gain from adjusting the carrying amount of the hedged items should be rec-
ognized in net profit or loss. This applies even if the hedged item is accounted for at cost.
25.4.17 Profits and losses on cash flow hedges are treated as follows:
• The portion of the gain or loss on the hedging instrument deemed to be an effective
hedge is recognized directly in equity through the changes in equity statement. The
ineffective portion is reported in net profit or loss.
• If the hedged firm commitment or forecasted transaction results in the recognition of a | Hennie |
financial asset or liability, the associated gain or loss previously recognized in equity
should be removed and entered into the initial measurement of the acquisition cost of
the asset or liability.
• For cash flow hedges that do not result in an asset or liability, the gain or loss in equity
should be taken to profit or loss when the transaction occurs.
25.4.18 The portion of the profits and losses on hedges of a net investment in a foreign
entity, on the hedging instrument deemed to be an effective hedge, is recognized directly in
equity through the changes in equity statement. The ineffective portion is reported in net
profit or loss.
25.5
PRESENTATION AND DISCLOSURE
25.5.1 Presentation issues are dealt with in IAS 32 (Chapter 34).
25.5.2 Disclosure issues are dealt with in IFRS 7 (Chapter 38).
25.6
FINANCIAL ANALYSIS AND INTERPRETATION
25.6.1 The analyst should obtain an understanding of management’s policies for classify-
ing securities.
25.6.2 Securities held for trading and available for sale securities are both valued at fair
value. However, the unrealized profits and losses on available-for-sale securities do not flow
directly through the income statement. Therefore, total return calculations need to reflect
this.
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
209
25.6.3 Available-for-sale securities must also be marked-to-market and unrealized profits
and losses taken directly to equity (and not to the income statement). Securities that are not
held to maturity, but are also not held for trading, are classified as available-for-sale. These
securities are valued in a similar way as trading securities: They are carried at fair value.
However, only realized (actual sales) gains (losses) arising from the sale or reclassification of
investments are recorded on the income statement. Unrealized (not sold, but with a changed
value) gains and losses are shown as a separate component of stockholders’ equity on the
balance sheet.
25.6.4 If management decides to treat securities as available for sale and not as trading
securities, the decision could potentially have a negative impact on the transparency of total
return calculations and the potential for letting losses accumulate in equity (if information
technology systems are not sophisticated enough to link securities to their respective accu-
mulated profits and losses).
25.6.5 There are sound reasons why it might be preferable to take unrealized gains and
losses through the income statement. The total return on the portfolio includes both coupon
income and changes in price, and is an accurate reflection of the portfolio performance. When
there is an asymmetrical treatment of capital gains or losses and coupon income, it can lead
to unsophisticated observers regarding trading income in a manner incompatible with the
total return maximization objectives of modern portfolio management. By taking unrealized
gains and losses through the income statement, the portfolio management will correctly
focus on taking portfolio decisions to maximize returns based on anticipated future relative
returns, rather than on taking decisions for income manipulation.
25.6.6 Available for sale securities require sophisticated systems and accounting capacity.
As stated in Chapter 20.4.6, the treatment of foreign currency translation gains and losses
adds to this complexity.
25.6.7 Held-to-maturity securities are most often debt securities that management intends
and is able to hold to maturity. These securities are recorded initially at cost and are valued
on the balance sheet at amortized value. The book value of the marketable security is report-
ed on the balance sheet, and the interest income as well as any amortization profits or losses
and impairments losses are reported in the income statement. The coupon receipt is record-
ed as an operating cash flow.
25.6.8 A key purpose of derivatives is to modify future cash flows by minimizing the enti- | Hennie |
ty’s exposure to risks, by increasing risk exposure, or by deriving benefits from these instru-
ments. An entity can readily adjust its positions in financial instruments to align its financ-
ing activities with operating activities and, thereby, improve its allocation of capital to accom-
modate changes in the business environment. All such activities, or their possible occurrence,
should be transparent to financial statements’ users. For example, not reporting significant
interest rate or foreign currency swap transactions would be as inappropriate as not consol-
idating a significant subsidiary.
25.6.9 Sensitivity analysis is an essential element needed for estimating an entity’s future
expected cash flows; these estimates are needed in calculating the entity’s valuation.
Therefore, sensitivity analysis is an integral and essential component of fair value account-
ing and reporting. For example, many derivative instruments have significant statistical
deviation from the expected norm, which affect future cash flows. Unless those potential
effects are transparent in disclosures and analyses (for example, in sensitivity analyses or
stress tests), the balance sheet representation of fair values for financial instruments is
incomplete and cannot be used properly to assess risk-return relationships and to analyze
management’s performance.
210
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
EXAMPLES: FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT
EXAMPLE 25.1
An entity receives $100m equity in cash on 1 July 2005.
It invests in a bond of $100m par at a clean price of 97 with a 5% fixed coupon on 1 July 2005.
Coupons are paid annually and the bond has a maturity date of 30 June 2007.
The yield to maturity is calculated as 6.6513%.
On 30 June 2006 the entity receives the first coupon payment of $5m.
The clean market value of the security has increased to 99 at 30 June 2006.
The security has not been impaired and no principal has been repaid.
Using the effective interest method, the $3m discount is amortized 1.45 in year 1 and 1.55 in
year 2.
ISSUES
25.1.A Illustrate how this situation will be portrayed in the balance sheet assets and equity,
as well as the income statement of the entity concerned—under each of the following three
accounting policies for marketable securities:
• Assets held for trading purposes
• Assets available for sale
• Held-to-maturity assets
25.1.B Discuss the treatment of discounts or premiums on securities purchased in the finan-
cial statements of the entity.
25.1.C If these securities were denominated in a foreign currency, how would translation
gains and losses be treated in the financial statements of the entity?
Source: Hamish Flett—Treasury Operations, World Bank.
Continued on next page
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
211
Example 25.1 (continued)
EXPLANATIONS
25.1.A Financial Statements
Balance Sheet
As of 31 Dec. 2006
Held to Maturity
Portfolio
Trading Available for Sale
Portfolio
Portfolio
Assets
Cash
Securities
Analysis of “Securities”:
Cost of securities
Amortization of Discount/Premium
Unrealized Profit/Loss
Liabilities
Equity
Unrealized Profit/Loss on Securities
Net Income
Income Statement for year
to 31 Dec 2006:
Interest Income
Amortization of Discount/Premium
Unrealized Profit/Loss on Securities
Realized Profit/Loss Net Income
8.00
98.45
106.45
97.00
1.45
—
98.45
100.00
—
6.45
106.45
5.00
1.45
—
6.45
8.00
99.00
107.00
97.00
—
2.00
99.00
100.00
—
7.00
107.00
5.00
—
2.00
7.00
8.00
99.00
107.00
97.00
1.45
0.55
99.00
100.00
0.55
6.45
107.00
5.00
1.45
—
6.45
212
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
25.1.B
a. With the trading portfolio, the amoritzation of discount/premium is effectively account-
ed for in the mark to market adjustment. As the amortization of discount/premium,
realized P&L and unrealized P&L for a trading portfolio are all recorded in the income
statement, it is not necessary to separate the discount/premium amoritzation element
from the mark to market adjustment. However, it may be desirable to record any dis- | Hennie |
count/premium amortization separately, even for a trading portfolio, to provide addi-
tional management information on the performance of traders.
b. If the Trading security were subsequently sold, the clean sell proceeds would be com-
pared to its clean cost to determine the realized P&L.
c. If the AFS security were subsequently sold, the clean sell proceeds would be compared
to its amortized cost to determine the realized P&L, as amortization is already reflected.
d. Interest amortization table:
Amortized
Cost
Effective
Interest Rate
Effective
Interest
Coupon
Payment
End of Period
1
2
97.000
98.452
100.00
6.651%
6.651%
6.45
6.55
5.00
5.00
Amortization
Premium/
Discount
1.452
1.548
3.00
25.1.C All foreign currency translations adjustments on the securities (see IAS 21) should be
reflected in the income statement. In the case of available-for-sale securities, the mark-to-
market adjustment portion of the foreign currency translation should be reflected in equity—
in line with the normal treatment of fair value adjustments for available-for-sale securities. It
should be noted, however, that the foreign currency adjustment related to the principal
amount of an available-for-sale security is taken directly to the income statement.
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
213
EXAMPLE 25.2
The following example illustrates the accounting treatment of a hedge of the exposure to
variability in cash flows (cash flow hedge) that is attributable to a forecast transaction.
The Milling Co. is reviewing its maize purchases for the coming season. They anticipate pur-
chasing 1,000 tons of maize after 2 months. Currently, the 2-month maize futures are selling
at price of $600 per ton, and they will be satisfied with purchasing their maize inventory at
this price by the end of May.
As renewed drought is staring the farmers in the face, they are afraid that the maize price
might increase. They therefore hedge their anticipated purchase against this possible increase
in the maize price by going long (buying) on 2-month maize futures at $600 per ton for 1,000
tons. The transaction requires the Milling Co. to pay an initial margin of $30,000 into its mar-
gin account. Margin accounts are updated twice every month.
The following market prices are applicable:
Date
April 1
April 15
April 30
May 15
May 31
Futures Price (per Ton)
$600
$590
$585
$605
$620 (spot)
The maize price in fact did undergo an increase because of the drought, and the Milling Co. pur-
chases the projected 1,000 tons of maize at the market (spot) price of $620 per ton on May 31.
EXPLANATION
Calculation of variation margins
April 15 (600–590) ¥ 1,000 tons = $10,000 (payable)
April 30 (590–585) ¥ 1,000 tons = $5,000 (payable)
May 15 (605–585) ¥ 1,000 tons = $20,000 (receivable)
May 31 (620–605) ¥ 1,000 tons = $15,000 (receivable)
The accounting entries will be as follows:
Continued on next page
214
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
Example 25.2 (continued)
April 1
Initial Margin Account (B/S)
Cash
(Settlement of initial margin)
April 15
Hedging Reserve (Equity)
Cash Payable (variation margin)
(Account for the loss on the futures contract—cash flow hedge)
April 30
Hedging Reserve (Equity)
Cash Payable (variation margin)
(Account for the loss on the futures contract—cash flow hedge)
May 15
Cash Receivable (variation margin)
Hedging Reserve (Equity)
(Account for the profit on the futures contract—cash flow hedge)
May 31
Cash Receivable (variation margin)
Hedging Reserve (Equity)
(Account for the profit on the futures contract—cash flow hedge)
May 31
Inventory
Cash
(Purchase the inventory at spot—1,000 tons @ $620 per ton)
May 31
Cash
Margin Account
(Receive initial margin deposited)
May 31
Hedging Reserve (Equity)
Inventory
Dr ($)
30,000
10,000
5,000
20,000
15,000
Cr ($)
30,000
10,000
5,000
20,000
15,000
620,000
620,000
30,000
20,000
30,000
20,000
The gain or loss on the cash flow hedge should be removed from equity and the value of the
underlying asset recognized should be adjusted.
It is clear from this example that the value of the inventory is adjusted with the gain on the | Hennie |
hedging instrument, resulting in the inventory being accounted for at the hedged price or
futures price.
If the futures contract did not expire or was not closed out on May 31, the gains or losses cal-
culated on the futures contract thereafter would be accounted for in the income statement,
because the cash flow hedge relationship no longer exists.
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
215
EXAMPLE 25.3
This example concerns short-term money market instruments not marked-to-market (as held
in a Held-to-Maturity portfolio).
A company buys a 120-day Treasury bill whose face value is $1 million for $996,742. When
purchased, the recorded book value of the bill is this original cost.
EXPLANATION
These HTM instruments are normally recorded at cost and valued on the balance sheet at cost
adjusted for the effects of interest (or discount earned). The book value of the marketable security is
reported on the balance sheet and the interest income is reported in the income statement. The dis-
count earned is recorded as an operating cash flow. The entry to record the purchase of the bill is:
Short-term Investments
Cash
Dr ($)
996,742
Cr ($)
996,742
If 60 days later the company is constructing its financial statements, the bill must be marked
up to its amortized cost using the following adjusting entry:
Short-Term Investments
Interest Income
Dr ($)
1,629
Cr ($)
1,629(1)
(1)
Interest
Income
= (Pm – P0)( t )
tm
= ($1,000,000 – 996,742)( 60 ) = $1,629
120
where
Pm
P0
t
tm
is the value of the bill at maturity
is the value of the bill when purchased
is the number of days the bill has been held
is the number of days until the bill matures from when purchased.
The Treasury bill will be recorded on the balance sheet as a short-term investment valued at
its adjusted cost of $998,371 ($996,742 + $1,629), whereas the $1,629 discount earned will be
reported as interest income on the income statement.
When the Treasury bill matures, the entry is as follows:
Cash
Short-Term Investments
Interest Income (discount earned)
Dr ($)
1,000,000
Cr ($)
998,371
1,629*
* Assumes 60 days of interest on a straight-line basis as an approximation of effec-
tive interest rate.
216
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
EXAMPLE 25.4
Trading Securities—marked-to-market and “unrealized” profits taken through the income
statement.
On November 30, 20X3, a company buys 100 shares of Amazon for $90 per share and 100
shares of IBM for $75 per share.
The securities are classified as trading securities (current assets) and are valued at fair value
(market value).
EXPLANATION
Any increase or decrease in the value is included in net income in the year in which it occurs.
Also, any income received from the security is recorded in net income.
To record the initial purchases, the entry is:
Traded Equities
Cash
Dr ($)
16,500 (100 ¥ $90 + 100 ¥ $75)
Cr ($)
16,500
One month later, the company is preparing its year-end financial statements. On December
31, 20X3, Amazon’s closing trade was at $70 per share and IBM’s was at $80 per share. Thus,
the company’s investment in these two firms has fallen to $15,000 (100 ¥ $70 + 100 ¥ $80). The
short-term investments account is adjusted as follows:
Unrealized Gains/Loss on Investments
Traded Equities
Dr ($)
1,500
Cr ($)
1,500
Notice that the loss on Amazon and gain on IBM are netted. Thus, a net loss is recorded,
which reduces the firm’s income. This is an unrealized loss, as the shares have not been sold,
so the firm has not actually realized a loss, but this is still recorded in the income statement.
In mid-January 20X4, the firm receives a dividend of $0.16 per share on its IBM stock. The
entry is as follows:
Cash
Investment Income
Dr ($)
16 ($0.16 ¥ 100)
Cr ($)
16
Chapter 25 Financial Instruments: Recognition and Measurement (IAS 39)
217
Finally, on January 23, 20X4, the firm sells both stocks. They receive $80 per share for the
Amazon and $85 per share for the IBM. The entry is as follows:
Cash
Traded Equities
Unrealized Gains/Loss on Investments
Dr ($)
| Hennie |
16,500 (100 ¥ $80 + 100 ¥ $85)
Cr ($)
15,000
1,500
By consistently recording fair value adjustments to an unrealized gain/loss account, that
account is cleared when the security is sold.
26 Investment Property (IAS 40)
26.1
PROBLEMS ADDRESSED
The objective of this Standard is to prescribe the accounting treatment for investment prop-
erty and related disclosure requirements. The main issue arises when establishing whether
entities should adopt the fair value or the cost model for investment property for record-
keeping purposes. Regardless of the choice exercised, the standard specifies that the fair
value amount of its investment property should be disclosed.
26.2
SCOPE OF THE STANDARD
IAS 40 applies to all investment property. This Standard permits entities to choose either:
• A fair value model, under which an investment property is measured, after initial mea-
surement, at fair value, with changes in fair value recognized in profit or loss, or
• A cost model, under which investment property is measured, after initial measure-
ment, at depreciated cost (less any accumulated impairment losses).
The following major aspects of accounting for investment property are prescribed:
• Classification of a property as investment property.
• Recognition as an asset.
• Determination of the carrying amount at
• initial measurement, or
• subsequent measurement.
• Disclosure requirements.
26.3
KEY CONCEPTS
26.3.1 Investment property is property that is held by the owner or the lessee under a
finance lease to earn rentals, or for capital appreciation, or both. An investment property
should generate cash flows that are largely independent of the other assets held by the entity.
26.3.2 Investments property includes land and buildings or part of a building or both. It
excludes
• Owner-occupied property (PPE—IAS 16)
• Property held for sale (Inventory—IAS 2)
218
Chapter 26 Investment Property (IAS 40)
219
• Property being constructed or developed (Construction Contracts—IAS 11)
• Property held by a lessee under an operating lease (see Section 26.3.3)
• Biological assets (IAS 41)
• Mining rights and mineral resources (ED 6)
26.3.3 A property interest that is held by a lessee under an operating lease does not meet
the definition of an investment property, but could be classified and accounted for as invest-
ment property provided that
• the rest of the definition of investment property is met,
• the operating lease is accounted for as if it were a finance lease in accordance with IAS
17, and
• the lessee uses the fair value model set out in this Standard for the asset recognized.
26.4
ACCOUNTING TREATMENT
26.4.1 An investment property is recognized as an asset if
• it is probable that the future economic benefits attributable to the asset will flow to the
entity, and
• the cost of the asset can be reliably measured.
26.4.2 On initial measurement, investment property is recognized at its cost, comprising
the purchase price and directly attributable transaction costs (for example, legal services,
transfer taxes, and other transaction costs). However, general administrative expenses as well
as start-up costs are excluded. Cost is determined the same way as for other property (see
IAS 16, Chapter 15)
26.4.3 An entity might choose to subsequently measure all of its investment property,
using either of the following:
• Cost model. Measures investment property at cost less accumulated depreciation and
impairment losses
• Fair value model. Measures investment properties at fair value. Gains and losses from
changes in the fair value are recognized in the income statement as they arise. (Fair
value is the amount at which an asset could be exchanged between knowledgeable
willing parties in an arm’s length transaction)
26.4.4 The following principles are applied to determine the fair value for investment
property:
• Where an active market on similar property exists, this might be a reliable indicator of
fair value, provided the differences in the nature, condition, and location of the proper- | Hennie |
ties are considered and amended, where necessary.
• Other more pragmatic valuation approaches are also allowed when an active market is
not available (see also International Valuation Standards at www.ivsc.org).
• In exceptional circumstances, where it is clear when the investment property is first
acquired and that the entity will not be able to determine its fair value, such property is
measured using the benchmark treatment in IAS 16 until its disposal date. The entity
measures all of its other investment property at fair value.
26.4.5 Transfers to or from investment property should be made when there is a change in
use. Special provisions apply for determining the carrying value at date of such transfers.
220
Chapter 26 Investment Property (IAS 40)
26.4.6 Subsequent expenditures on investment property are recognized as expenses if they
restore the performance standard. These expenditures are capitalized when it is probable that
economic benefits in excess of the original standard of performance will flow to the entity.
26.5
PRESENTATION AND DISCLOSURE
26.5.1 Accounting policies should specify the following:
• Criteria to distinguish investment property from owner-occupied property
• Methods and significant assumptions applied in determining fair value
• Extent to which fair value has been determined by an external independent valuer
• Measurement bases, depreciation methods, and rates for investment property valued
according to the cost model
• The existence and amounts of restrictions on the investment property
• Material contractual obligations to purchase, construct, or develop investment property
or for repairs or enhancement to the property
26.5.2 Income statement and notes should include the following:
• Rental income
• Direct operating expenses arising from an investment property that generated rental
income
• Direct operating expenses from an investment property that did not generate rental
income
26.5.3 Balance sheet and notes should include the following:
• When an entity applies the fair value model:
• A detailed reconciliation of movements in the carrying amount during the period
should be provided.
• In exceptional cases when an investment property cannot be measured at fair value
(because of a lack of fair value), the reconciliation above should be separately dis-
closed from other investment property shown at fair value.
• When an entity applies the cost model:
• All the disclosure requirements of IAS 16 should be furnished.
• The fair value of investment property is disclosed by way of a note.
DECISION TREE
Figure 26.1 summarizes the classification, recognition, and measurement issues of an invest-
ment property. The diagram is based on a decision tree adapted from IAS 40.
Chapter 26 Investment Property (IAS 40)
221
Figure 26.1 Decision Tree
Start
Is the property held
for sale in the ordinary
course of business?
YES
Use IAS 2
NO
Is the property
owner-occupied?
YES
Use IAS 16
Use IAS 16
until completion
Completed
Defer recognition
NO
Is the property
being constructed
or developed?
YES
NO
The property is an
investment property
Does the
investment property
meet the
recognition
requirements?
NO
YES
Measure the
investment property
initially at cost
(use IAS 40)
YES
Cost model
IAS 40
Subsequently
measure the
investment property
choosing either:
Fair value model
IAS 40
222
Chapter 26 Investment Property (IAS 40)
EXAMPLE: INVESTMENT PROPERTY
EXAMPLE 26.1
Matchbox Inc. is a manufacturer of toys for boys. The following information relates to fixed
property owned by the company:
Land ERF 181 Hatfield
Buildings thereon (acquired June 30, 20X0)
Improvements to the building to extend rented floor capacity
Repairs and maintenance to investment property for the year
Rentals received for the year
$’000
800
2,100
400
50
160
The property is used as the administrative head office of the company (approximately 6 per-
cent of floor space). The property can only be sold as a complete unit. The remainder of the
building is leased out under operating leases. The company provides lessees with security
services.
The company values investment property using the fair value model. On December 31, 20X0, | Hennie |
the balance sheet date, Mr. Proper (an independent valuer) valued the property at $3.6 million.
EXPLANATION
To account for the property in the financial statements of Matchbox Inc. On December 31,
20X0, the property should first be classified as either investment property or owner-occupied
property. It is classified as an investment property and is accounted for in terms of the fair
value model in IAS 40. The motivation is that the portion occupied by the company for admin-
istrative purposes is deemed to be insignificant (6 percent) and the portions of the property
cannot be sold separately. In addition, the majority of the floor space of the property is used
to generate rental income and the security services rendered to lessee is insignificant.
The accounting treatment and disclosure of the property in the financial statements of
Matchbox Inc. are as follows:
Balance sheet at December 31, 20X0
Assets
Noncurrent Assets
Note
$’000
Property, Plant, and Equipment
Investment Property (Calculation A)
4
Xxx
3,600
Accounting Policies
Investment property is property held to earn rentals. Investment property is stated at fair
value, determined at balance sheet date by an independent valuer based on market evidence
of the most recent prices achieved in arms length transactions of similar properties in the
same area.
Chapter 26 Investment Property (IAS 40)
223
Notes to the Financial Statements
Investment Property
Opening balance
Additions
Improvements from subsequent expenditure
Net gain in fair value adjustments
Closing balance at fair value
Calculation
Carrying amount of investment property
Land
Building
Improvements to building
Fair value
Increase in value shown in income statement
—
$’000
2,900
400
300
3,600
$’000
800
2,100
400
3,300
(3,600)
(300)
27 Agriculture (IAS 41)
27.1
PROBLEMS ADDRESSED
IAS 41 prescribes the accounting treatment, financial statement presentation, and disclosures
related to biological assets and agricultural produce at the point of harvest insofar as they
relate to agricultural activity.
The accounting treatment of related government grants is also prescribed in IAS 41 (see also
Chapter 19, IAS 20).
27.2
SCOPE OF THE STANDARD
This Standard should be applied to account for the following when they relate to agricultur-
al activity:
• Biological assets.
• Agricultural produce at the point of harvest.
• Government grants.
This Standard does not apply to
• land related to agricultural activity (IAS 16), or
• intangible assets related to agricultural activity (IAS 38).
IAS 41 does not deal with processing of agricultural produce after harvest; for example, it
does not deal with processing grapes into wine or wool into yarn. Such processing is account-
ed for as inventory in accordance with IAS 2.
27.3
KEY CONCEPTS
27.3.1 Agricultural activity is the management by an entity of the biological transforma-
tion of biological assets for sale, into agricultural produce, or into additional biological assets.
27.3.2 Agricultural produce is the harvested product of the entity’s biological assets.
27.3.3 A biological asset is a living animal or plant.
27.3.4 Harvest is the detachment of produce from a biological asset or the cessation of a bio-
logical asset’s life processes.
224
Chapter 27 Agriculture (IAS 41)
225
27.3.5 An active market is a market where all the following conditions exist:
• The items traded within the market are homogeneous.
• Willing buyers and sellers can normally be found at any time.
• Prices are available to the public.
27.4
ACCOUNTING TREATMENT
27.4.1 An entity should recognize a biological asset or agricultural produce when, and only
when
• the entity controls the asset as a result of past events,
• it is probable that future economic benefits associated with the asset will flow to the
entity, and
• the fair value or cost of the asset can be measured reliably.
27.4.2 A biological asset should be measured on initial recognition and at each balance
sheet date at its fair value less estimated point-of-sale costs. However, if on initial recognition | Hennie |
it is determined that fair value cannot be measured reliably, a biological asset should be mea-
sured at cost less accumulated depreciation and any accumulated impairment losses. Once
the fair value of such an asset becomes reliably measureable, it should be measured at fair
value less estimated point of sale costs.
27.4.3 Agricultural produce harvested from an entity’s biological assets should be meas-
ured at its fair value less estimated point-of-sale costs at the point of harvest. Such measure-
ment is the cost at that date when applying IAS 2 or any other applicable IFRS.
27.4.4 If an active market exists for a biological asset or harvested produce, the quoted price
in that market is the appropriate basis for determining the fair value of that asset. If an active
market does not exist, an entity uses one or more of the following in determining fair value:
• The most recent market transaction price
• Market prices for similar assets
• Sector benchmarks such as the value of an orchard expressed per export tray, bushel, or
hectare, and the value of cattle expressed per kilogram of meat
27.4.3 A gain or loss on the initial recognition of a biological asset or agricultural produce
at fair value (less estimated point of sale costs) and from a change in fair value (less esti-
mated point of sale costs) of a biological asset should be included in net profit or loss for the
period in which the gain or loss arises.
27.4.4 An unconditional government grant related to a biological asset measured at its fair
value (less estimated point of sale costs) should be recognized as income only when the grant
becomes receivable.
27.5
PRESENTATION AND DISCLOSURE
27.5.1 An entity should present the carrying amount of its biological assets separately on
the face of its balance sheet.
27.5.2 An entity should disclose the aggregate gain or loss arising during the current peri-
od on initial recognition of biological assets and agricultural produce and from the change in
fair value less estimated point-of-sale costs of biological assets.
226
Chapter 27 Agriculture (IAS 41)
27.5.3 An entity should provide a description of each group of biological assets.
27.5.4 An entity should describe:
• The nature of its activities involving each group of biological assets
• Nonfinancial measures or estimates of the physical quantities of
• each group of biological assets at the end of the period, and
• output of agricultural produce during the period
27.5.5 An entity should disclose:
• The methods and significant assumptions applied in determining the fair value of each
group of agricultural produce and biological assets
• Fair value less estimated point-of sale costs of agricultural produce harvested during
the period, determined at the point of harvest
• The existence and carrying amounts of biological assets whose title is restricted, and
the carrying amounts of biological assets pledged as security for liabilities
• The amount of commitments for the development or acquisition of biological assets;
and financial risk management strategies related to its agricultural activity
• The nature and extent of government grants recognized in the financial statements
• Unfulfilled conditions and other contingencies attaching to government grants
• Significant decreases expected in the level of government grants
27.5.6 An entity should present a reconciliation of changes in the carrying amount of bio-
logical assets between the beginning and the end of the current period, including
• decreases due to sales,
• decreases due to harvest,
• increases resulting from business combinations,
• net exchange differences arising on the translation of financial statements of a foreign
entity, and
• other changes.
27.6
FINANCIAL ANALYSIS AND INTERPRETATION
27.6.1 As with any fair value standard, users should pay particular attention to the disclo-
sure of key assumptions used to determine fair value and the consistency of those assump-
tions from year to year.
27.6.2 In particular, the discount rate estimation and estimation techniques used to deter- | Hennie |
mine volumes of agricultural assets are likely to have a significant impact on the fair value
numbers.
Chapter 27 Agriculture (IAS 41)
227
EXAMPLES: AGRICULTURE
EXAMPLE 27.1
27.1.A Balance Sheet
XYZ Dairy Ltd. Balance Sheet
Notes
31 December
20X1
31 December
20X0
ASSETS
Noncurrent Assets
Dairy Livestock—Immature
Dairy Livestock—Mature
Subtotal Biological Assets
Property, Plant, and Equipment
Total Noncurrent Assets
Current Assets
Inventories
Trade and Other Receivables
Cash
Total Current Assets
3
52,060
372,990
425,050
1,462,650
1,887,700
82,950
88,000
10,000
180,950
47,730
411,840
459,570
1,409,800
1,869,370
70,650
65,000
10,000
145,650
TOTAL ASSETS
2,068,650
2,015,020
EQUITY AND LIABILITIES
Equity
Issued capital
Accumulated profits
Total equity
Current liabilities
Trade and other payables
Total Current Liabilities
1,000,000
902,828
1,902,828
1,000,000
865,000
1,865,000
165,822
165,822
150,020
150,020
TOTAL EQUITY AND LIABILITIES
2,068,650
2,015,020
An enterprise is encouraged but not required to provide a quantified description of each
group of biological assets, distinguishing between consumable and bearer biological assets
or between mature and immature biological assets as appropriate. An enterprise discloses
basis for making any such distinctions.
Source: International Accounting Standards Board, IAS 41: Agriculture, pp. 2071–2074. Used with per-
mission.
228
Chapter 27 Agriculture (IAS 41)
27.1.B Income Statement
XYZ Dairy Ltd. Income Statement
Notes
Fair value of milk produced
Gains arising from changes in fare value less
estimated point-of-sale costs of dairy livestock
3
Year Ended
31 December
20X1
518,240
39,930
558,170
(137,523)
(127,283)
(15,250)
(197,092)
(477,148)
81,022
(43,194)
37,828
Total Income
Inventories used
Staff costs
Depreciation expense
Other operating expenses
Profit from operations
Income Tax expense
Net Profit for the period
27.1.C Statement of Changes in Equity
XYZ Dairy Ltd.
Statement of Changes in Equity
Balance at 1 January 20X1
Net Profit for the Period
Balance at 31 December 20X1
27.1.D Cash Flow Statement
Year Ended
31 December 20X1
Accumulated
Profits
865,000
37,828
902,828
Share Capital
1,000,000
1,000,000
Total
1,865,000
37,828
1,902,828
XYZ Dairy Ltd. Cash Flow Statement
Notes
Cash Flows from Operating Activities
Cash Receipts from Sales of Milk
Cash Receipts from Sales of Livestock
Cash Paid For Supplies and to Employees
Cash Paid For Purchases of Livestock
Income Taxes Paid
Net Cash from Operating Activities
Cash Flows from Investing Activities
Purchase of Property, Plant and Equipment
Net Cash Used in Investing Activities
Net Increase in Cash
Cash at Beginning of Period
Cash at End of Period
Year Ended
31 December
20X1
498,027
97,913
(460,831)
(23,815)
111,294
(43,194)
68,100
(68,100)
(68,100)
0
10,000
10,000
Chapter 27 Agriculture (IAS 41)
229
27.1.E Notes to the Financial Statements
Note 1. Operations and Principal Activities
XYZ Dairy Ltd (“the Company”) is engaged in milk production for supply to various cus-
tomers. At 31 December 20X1, the Company held 419 cows able to produce milk (mature
assets) and 137 heifers being raised to produce milk in the future (immature assets). The
Company produced 157,584kg of milk with a fair value less estimated point-of-sale costs of
518,240 (that is determined at the time of milking) in the year ended 31 December 20X1.
Note 2. Accounting Policies
Livestock and milk
Livestock are measured at their fair value less estimated point-of-sale costs. The fair value of
livestock is determined based on market prices of livestock of similar age, breed, and genet-
ic merit. Milk is initially measured at its fair value less estimated point-of-sale costs at the
time of milking. The fair value of milk is determined based on market prices in the local area.
Note 3. Biological Assets
Reconciliation of Carrying Amounts of Dairy Livestock
Carrying Amount at 1 January 20X1
Increases Due to Purchases
Gain Arising from Changes in Fair Value Less Estimated
Point-Of-Sale Costs attributable to Physical Changes
Gain Arising from Changes in Fair Value Less Estimated
Point-Of-Sale Costs attributable to Price Changes
| Hennie |
Decreases Due to Sales
Carrying Amount at 31 December 20X1
20X1
459,570
26,250
15,350
24,580
(100,700)
425,050
Note 4. Financial Risk Management Strategies
The Company is exposed to financial risks arising from changes in milk prices. The Company
does not anticipate that milk prices will decline significantly in the foreseeable future and,
therefore, has not entered into derivative or other contracts to manage the risk of a decline in
milk prices. The Company reviews its outlook for milk prices regularly in considering the
need for active financial risk management.
230
Chapter 27 Agriculture (IAS 41)
EXAMPLE 27.2: PHYSICAL CHANGE AND PRICE CHANGE
The following example illustrates how to separate physical change and price change.
Separating the change in fair value less estimated point-of-sale costs between the portion
attributable to physical changes and the portion attributable to price changes is encouraged
but not required by this standard.
A herd of 10 2 year old animals was held at 1 January 20X1. One animal aged 2.5 years was
purchased on 1 July 20X1 for 108, and one animal was born on 1 July 20X1. No animals were
sold or disposed of during the period. Per-unit fair values less estimated point-of-sale costs
were as follows:
2 year old animal at 1 January 20X1
Newborn animal at 1 July 20X1
2.5 year old animal at 1 July 20X1
Newborn animal at 31 December 20X1
0.5 year old animal at 31 December 20X1
2 year old animal at 31 December 20X1
2.5 year old animal at 31 December 20X1
3 year old animal at 31 December 20X1
Fair value less estimate point-of-sale costs of herd on
1 January 20X1 (10 x 100)
Purchase on 1 July 20X1 (1 x 108)
Increase in fair value less estimated
point-of-sale costs due to price change:
10 x (105 – 100)
1 x (111 – 108)
1 x (72 – 70)
Increase in fair value less estimated
point-of-sale costs due to physical change:
10 x (120 – 105)
1 x (120 – 111)
1 x (80 – 72)
1 x 70
Fair value less estimated point- of sale
costs of herd on 31 December 20X1
11 x 120
1 x 80
100
70
108
72
80
105
111
120
108
50
3
2
150
9
70
1,000
55
8
237
1320
80
1,400
Source: International Accounting Standards Board, IAS 41: Agriculture, p. 2075. Used with permission.
Chapter 27 Agriculture (IAS 41)
231
EXAMPLE 27.3
In year 20X0 a farmer plants an apple orchard that costs him $250,000. At the end of year
20X1, the following facts regarding the orchard are available:
Disease. there has been widespread disease in the apple tree population. As a result there is
not an active market for the orchard, but the situation is expected to clear in 6 months. After
the 6 months, it should also be clear which types of trees are susceptible to infection and
which ones are not. Until that time, nobody is willing to risk an infected orchard.
Precedent. The last sale by the farmer of an orchard was 6 months ago at a price of $150,000.
He is not sure which way the market has gone since then.
Local values. The farmers in the region have an average value of $195,000 for their orchards
of a similar size.
National values. The farmer recently read in a local agricultural magazine that the average
price of an apple tree orchard is $225,000.
What is the correct valuation of the apple tree orchard ?
EXPLANATION
The valuation would be the fair value less estimated point-of-sales costs. Fair value is deter-
mined as follows:
• Use active market prices—there are none, due to the disease.
• Use other relevant information, such as:
• The most recent market transaction
• Market prices for similar assets
• Sector benchmarks
$150,000
$195,000
$225,000
If the fair value cannot be determined, then the valuation would be determined at cost, less
accumulated depreciation and accumulated impairment losses: $250,000.
However, there are other reliable sources available for the determination of fair value. Such
sources should be used – the mean value of all the available indicators above would be used
(in the range of $150,000 - $225,000).
In addition, the farmer would consider the reasons for the differences between the various | Hennie |
sources of other information, prior to arriving at the most reliable estimate of fair value.
In the absence of recent prices, sector benchmarks and other information, the farmer should
calculate the fair value as comprising the cost price, less impairments, less depreciation:
resulting in a valuation of $250,000.
Source: Deloitte Touche Tohmatsu.
PARTIV
Disclosure
28 Noncurrent Assets Held for
Sale and Discontinued
Operations (IFRS 5)
28.1
PROBLEMS ADDRESSED
The objective of this IFRS is to specify the accounting for assets held for sale, and the pre-
sentation and disclosure of discontinued operations. It is important to highlight the fact that
some assets of an entity are held for sale, or that operations are discontinued, in order for
investors to appreciate that these assets and earnings will no longer be available to the firm
in future periods.
28.2
SCOPE OF THE STANDARD
The IFRS and its measurement requirements apply to all recognized noncurrent assets and
disposal groups.
It requires that such assets and intended operations
• be measured at the lower of carrying amount and fair value less costs to sell,
• cease to be depreciated,
• be presented separately on the face of the balance sheet, and
• have their results disclosed separately in the income statement.
The measurement provisions of this IFRS do not apply to the following assets:
• Deferred tax assets (IAS 12).
• Assets arising from employee benefits (IAS 19).
• Financial assets within the scope of IAS 39.
• Noncurrent assets that are accounted for in accordance with the fair value model in
IAS 40.
• Noncurrent assets that are measured at fair value less estimated point-of-sale costs
(IAS 41).
• Contractual rights under insurance contracts as defined in IFRS 4.
28.3
KEY CONCEPTS
28.3.1 An operation is discontinued at the date the operation meets the criteria to be clas-
sified as held for sale or when the entity has disposed of the operation.
235
236
Chapter 28 Noncurrent Assets Held for Sale and Discontinued Operations (IFRS 5)
28.3.2 An entity should classify a noncurrent asset (or disposal group) as held for sale if its
carrying amount will be recovered principally through a sale transaction rather than through
continuing use. For this to be the case, the asset (or disposal group) must be available for
immediate sale in its present condition—subject only to terms that are usual and customary
for sales of such assets (or disposal groups)—and its sale must be highly probable.
28.3.3 For a sale to be highly probable, the appropriate level of management must be com-
mitted to a plan to sell the asset (or disposal group), and management must have initiated an
active program to locate a buyer and complete the plan.
28.3.4 A disposal group is a group of assets (and associated liabilities) to be disposed of, by
sale or otherwise, together as a group in a single transaction.
28.4
ACCOUNTING TREATMENT
28.4.1 Noncurrent assets held for sale
• should be measured at the lower of carrying amount or fair value, less cost to sell; and
• are not depreciated.
28.4.2 An asset or disposal group should be classified as held for sale in a period in which
all the following criteria are met:
• Management commits to a plan to sell.
• The component is available for immediate sale in its present condition.
• An active program and other actions exist to locate a buyer.
• A sale is highly probable and expected to be completed within 1 year.
• The asset or disposal group is actively marketed at a reasonable price and it is unlikely
that there will be significant changes to the plan or any plan will be considered to with-
draw the sale.
28.4.3 When an entity acquires a noncurrent asset (or disposal group) exclusively with a
view to its subsequent disposal, it should classify the noncurrent asset (or disposal group) as
held for sale at the acquisition date only if the 1-year requirement in this IFRS is met (except
in circumstances beyond its control) and it is highly probable that any other criteria that are
not met at that date will be met within a short period following the acquisition (usually with- | Hennie |
in 3 months). If its plans change, classification as a discontinued operation must cease imme-
diately.
28.4.4 An entity should not classify as held for sale a noncurrent asset (or disposal group)
that is to be abandoned. This is because its carrying amount will be recovered principally
through continuing use.
28.4.5 An entity should recognize an impairment loss for any initial or subsequent write-
down of the asset (or disposal group) to fair value less costs to sell.
28.4.6 An entity should recognize a gain for any subsequent increase in fair value less costs
to sell of an asset, but not in excess of the cumulative impairment loss that has been previ-
ously recognized.
28.4.7 When a sale is expected to occur beyond 1 year, the entity should measure the costs
to sell at their present value. Any increase in the present value of the costs to sell that arises
from the passage of time should be presented in profit or loss as a financing cost.
Chapter 28 Noncurrent Assets Held for Sale and Discontinued Operations (IFRS 5)
237
28.5
PRESENTATION AND DISCLOSURE
28.5.1 An entity should present and disclose information that enables users of the financial
statements to evaluate the financial effects of discontinued operations and disposals of non-
current assets (or disposal groups).
28.5.2 Noncurrent assets held for sale and assets and liabilities (held for sale) of a disposal
group should be presented separately from other assets and liabilities in the balance sheet.
28.5.3 Income statement or notes should disclose (after the net profit for the period)
• the amounts and analyses of revenue, expenses, and pretax profit or loss attributable to
the discontinued operation, and
• the amount of any gain or loss that is recognized on the disposal of assets or settlement
of liabilities attributable to the discontinued operation and the related income tax
expense.
28.5.4 The cash flow statement should disclose the net cash flows attributable to the oper-
ating, investing, and financing activities of the discontinued operation.
28.5.5 An entity should disclose the following information in the notes to the financial
statements in the period in which a noncurrent asset (or disposal group) has been either clas-
sified as held for sale or sold:
• A description of the noncurrent asset (or disposal group)
• A description of the facts and circumstances of the sale, or leading to the expected dis-
posal, and the expected manner and timing of that disposal
• The gain, loss, or impairment recognized and, if not separately presented on the face of
the income statement, the caption in the income statement that includes that gain or
loss
• The segment in which the noncurrent asset (or disposal group) is presented (IAS 14)
• In the period of the decision to change the plan to sell the noncurrent asset (or disposal
group), a description of the facts and circumstances leading to the decision and the
effect of the decision on the results of operations for the period and any prior periods
presented
28.6
FINANCIAL ANALYSIS AND INTERPRETATION
28.6.1 The requirements related to discontinued operations assist the analyst in distin-
guishing between ongoing or sustainable operations and future profitability, based on oper-
ations with which management plans to continue.
28.6.2 IFRS require that gains or losses on the disposal of depreciable assets be disclosed in
the income statement. If, however, the operations of a business are sold, abandoned, spun off,
or otherwise disposed of, then this IFRS requires that the results of continuing operations be
reported separately from discontinued operations to facilitate analysis of core business areas.
28.6.3 To facilitate analysis of profitability, any gain or loss from disposal of an entire busi-
ness or segment should also be reported with the related results of discontinued operations
as a separate item on the income statement below income from continuing operations.
238
Chapter 28 Noncurrent Assets Held for Sale and Discontinued Operations (IFRS 5)
| Hennie |
EXAMPLE: DISCONTINUED OPERATIONS
EXAMPLE 28.1
Outback Inc. specializes in camping and outdoor products and operates in three divisions,
namely, food, clothes, and equipment. Due to the high cost of local labor, the food division
has incurred significant operating losses. Management has decided to close down the divi-
sion and draw up a plan of discontinuance.
On May 1, 20X2, the board of directors approved and immediately announced the formal
plan. The following data were obtained from the accounting records for the current and prior
year ending June 30 (the numbers are shown in $’000):
20X2
20X1
Food
Clothes
Equip.
Food
Clothes
Equip.
Revenue
Cost of Sales
Distribution Costs
Administrative Expenses
Other operating Expenses
Taxation Expenses or (benefit)
470
350
40
70
30
(6)
1,600
500
195
325
130
137
1,540
510
178
297
119
124
500
400
20
50
20
3
1,270
400
185
310
125
80
1,230
500
130
200
80
90
The following additional costs, which are directly related to the decision to discontinue, are
not included in the table above.
Incurred between May 1, 20X2, and June 30, 20X2
• Severance pay provision $85,000 (These costs are not tax deductible)
Budgeted for the year ending June 30, 20X3
• Other direct costs
• Severance pay
• Bad debts
$73,000
$12,000
$4,000
A proper evaluation of the recoverability of the assets in the food division, in terms of IAS 36,
led to the recognition of an impairment loss of $19,000, which is included in the other oper-
ating expenses above and are fully tax deductible.
Chapter 28 Noncurrent Assets Held for Sale and Discontinued Operations (IFRS 5)
239
Apart from other information required to be disclosed elsewhere in the financial statements,
the income statement for the year ending June 30, 20X2, could be presented as follows:
Outback Inc.
Income Statement for the Year Ended June 30, 20x2
Continuing Operations (Clothes and Equipment)
Revenue
Cost of Sales
Gross Profit
Distribution Costs
Administrative Expenses
Other Operating Expenses
Profit before Tax
Income Tax Expense
Net Profit for the Period
Discontinued Operation (Food)
Total Entity Net Profit for the Period
Detail in the Notes to the Financial Statements
Discontinued Operations
Revenue
Cost of Sales
Gross Profit
Distribution Costs
Administrative Expenses
Other Operating Expenses (30—19)
Impairment Loss
Severance Pay
(Loss) or Profit before Tax
Income Tax Benefit or (Expense)
Net (Loss) or Profit for the Period
20X2
$’000
3,140
(1,010)
2,130
(373)
(622)
(249)
886
(261)
625
(99)
526
470
(350)
120
(40)
(70)
(11)
(19)
(85)
(105)
6
(99)
20X1
$’000
2,500
(900)
1,600
(315)
(510)
(205)
570
(170)
400
7
407
500
(400)
100
(20)
(50)
(20)
–
–
10
(3)
7
29 Events After the Balance
Sheet Date (IAS 10)
29.1
PROBLEMS ADDRESSED
Certain balance sheet events occur subsequent to the balance sheet date but before the date
that the financial statements are approved for issue. These events might indicate the need for
adjustments to the amounts recognized in the financial statements or require disclosure.
These events affect the information that is provided in the financial statements.
29.2
SCOPE OF THE STANDARD
This Standard should be applied in the accounting and disclosure of all postbalance sheet
events, both favorable and unfavorable, that occur before the date on which the financial
statements are authorized for issue. This Standard prescribes the appropriate accounting
treatment for such events and whether adjustments or simple disclosure is required.
This Standard also requires that an entity not prepare its financial statements on a going con-
cern basis if events after the balance sheet date indicate that the going concern assumption is
not appropriate.
29.3
KEY CONCEPTS
29.3.1 Events after the balance sheet date are those events that
• provide evidence of conditions that existed at the balance sheet date (adjusting events
after the balance sheet date), and
• are indicative of conditions that arose after the balance sheet date (nonadjusting events
after the balance sheet date).
29.3.2 Two types of events can be distinguished:
• Conditions existing at the balance sheet date: adjusting events providing additional | Hennie |
evidence of conditions existing at the balance sheet date (the origin of the event is in
the current reporting period)
• Nonadjusting events indicative of conditions arising after the balance sheet date
240
Chapter 29 Events after the Balance Sheet Date (IAS 10)
241
29.4
ACCOUNTING TREATMENT
29.4.1 Amounts recognized in the financial statements of an entity are adjusted for events
occurring after the balance sheet date that provide additional information about conditions
existing at the balance sheet date, and therefore allow these amounts to be estimated more
accurately (for example, adjustments could be required for a loss recognized on a trade
debtor that is confirmed by the bankruptcy of a customer after the balance sheet date).
29.4.2 If events occur after the balance sheet date that do not affect the condition of assets
and liabilities at the balance sheet date, no adjustment is required. However, disclosure
should be made of such events if they are of such importance that nondisclosure would affect
decisions made by users of the financial statements (for example, if an earthquake destroys a
major portion of the manufacturing plant of the entity after the balance sheet date or an event
were to alter the current or noncurrent classification of an asset at the balance sheet date, per
IAS 1).
29.4.3 Dividends stated should be in respect of the period covered by the financial state-
ments; those that are proposed or declared after the balance sheet date but before approval
of the financial statements should not be recognized as a liability at the balance sheet date.
29.4.4 An entity should not prepare financial statements on a going concern basis if man-
agement determines after the balance sheet date either that it intends to liquidate the entity
or to cease trading, or that it has no realistic alternative but to do the aforementioned.
29.4.5 The process of authorization for issue of financial statements will depend on the
form of the entity and its management structure. The date of authorization for issue would
normally be the date on which the financial statements are authorized for issue outside the
entity.
29.5
PRESENTATION AND DISCLOSURE
29.5.1 Disclosure requirements related to the date of authorization for issue are as follows:
• Date when financial statements were authorized for issue
• Name of the person who gave the authorization
• Name of the party (if any) with the power to amend the financial statements after
issuance
29.5.2 For nonadjusting events that would affect the ability of the users to make proper
evaluations and decisions, the following should be disclosed:
• Nature of the event
• Estimate of the financial effect
• A statement if such an estimate cannot be made
29.5.3 Disclosures that relate to conditions that existed at the balance sheet date should be
updated in light of any new information about those conditions that is received after the bal-
ance sheet date.
242
Chapter 29 Events after the Balance Sheet Date (IAS 10)
EXAMPLE: EVENTS AFTER THE BALANCE SHEET DATE
EXAMPLE 29.1
A corporation with a balance sheet date of December 31 has a foreign long-term liability that
is not covered by a foreign exchange contract. The foreign currency amount was converted
at the closing rate on December 31, 20X4, and is shown in the accounting records at the local
currency (LC) 2.0 million.
The local currency dropped significantly against the U.S. dollar on February 27, 20X5. On this
date, management decided to hedge further exposure by taking out a foreign currency for-
ward-exchange contract, which limited the eventual liability to LC6.0 million. If this situation
were to apply at the balance sheet date, it would result in the corporation’s liabilities exceed-
ing the fair value of its assets.
EXPLANATION
The situation under discussion falls within the definition of postbalance sheet events and
specifically those events that refer to conditions arising after the balance sheet date.
The loss of LC4.0 million that arises in 20X5 must be recognized in the 20X5 income state- | Hennie |
ment. No provision in respect of the loss can be made in the financial statements for the year
ending December 31, 20X4.
However, consideration should be given to whether it would be appropriate to apply the
going concern concept in the preparation of the financial statements. The date and frequen-
cy of repayment of the liability will have to be considered.
The following information should be disclosed in a note to the financial statements for the
year ending December 31, 20X4:
• The nature of the events
• An estimate of the financial effect, in this case LC 4.0 million
30 Segment Reporting (IAS 14)
Note: Exposure Draft 8 (ED 8 – Operating Segments) was issued in January 2006 for comment to be
received until May 2006. The basis for the ED is the US GAAP SFAS 131 and it will require identifica-
tion of operating segments on the basis of internal reports that are regularly reviewed by the entity’s
chief operating decision maker, when determining the allocation of resources to a segment and to assess
its performance.
30.1
PROBLEMS ADDRESSED
Principles are established for reporting information by segment; that is, information about
the different types of products and services of an entity and the different geographical areas
in which it operates. This is relevant to help users
• understand the entity’s past performance,
• assess the entity’s risks and returns, and
• make more informed judgments.
30.2
SCOPE OF THE STANDARD
This Standard applies to all entities whose equity or debt securities are traded in a public
securities market or those who are in the process of issuing such instruments. Disclosure on
a voluntary basis by other entities should nevertheless be in full compliance with this
Standard.
ED 8 extends the requirement to entities that hold assets in a fiduciary capacity for a broad
group of outsiders.
A parent entity is required to present segment information only on the basis of its consoli-
dated financial statements. If a subsidiary is itself an entity whose securities are publicly trad-
ed it will present segment information in its own separate financial report. (Financial state-
ment disclosure of equity information for associated investments would mirror this require-
ment.)
243
244
Chapter 30 Segment Reporting (IAS 14)
30.3
KEY CONCEPTS
30.3.1 A reportable segment is either a business or a geographical segment where both of
the following apply:
• The majority (greater than 50 percent) of its sales is earned externally.
• Its revenue from sales, segment result, or assets is greater than or equal to 10 percent of
the appropriate total amount of all segments.
30.3.2 A business segment is a distinguishable component of an entity that is engaged in
providing an individual product or service or a group of related products or services and that
is subject to risks and returns that are different from those of other business segments.
30.3.3 A geographical segment is a distinguishable component of an entity that is engaged in pro-
viding products or services within a particular economic environment and that is subject to risks
and returns that are different from those of components operating in other economic environments.
30.3.4 Segment result is a measure of operating profit before corporate head office expens-
es, interest income or expense (except for financial segments), income taxes, investment gains
and losses (again, except for financial segments), and minority interest deduction. It includes
proportionately consolidated revenue and expenses from joint ventures and all equity-
accounted profits or losses.
30.3.5 Operating activities are the principal revenue-producing activities of an entity and
other activities that are not investing or financing activities.
30.4
ACCOUNTING TREATMENT
30.4.1 The dominant source and nature of risks and returns governs whether an entity’s
primary segment reporting format will be its business segments or its geographical seg-
ments. The entity’s internal organization and management structure, and its system of inter- | Hennie |
nal financial reporting to the board of directors and the chief executive officer, are normally
the basis for identifying the predominant source and nature of risks and differing rates of
return facing the entity.
30.4.2 Different business and geographical segments should be identified. An entity’s busi-
ness and geographical segments for external reporting purposes should be those organization-
al units for which information is reported to the board of directors and to the chief executive
officer. If an entity’s internal organizational and management structure and its system of inter-
nal financial reporting to the board of directors and the chief executive officer are not based on
individual products, services, groups of related products or services, nor on geography, the
directors and management of the entity should choose either business segments or geographi-
cal segments as the entity’s primary segment reporting format, based on their assessment of
which reflects the primary source of the entity’s risks and returns. Under this Standard, most
entities would identify their business and geographical segments as the organizational units for
which information is reported to the nonexecutive board of directors and senior management.
30.4.3 Decide whether segments are reportable segments. If the total revenue from external
customers for all reportable segments combined is less than 75 percent of the total entity rev-
enue, additional reportable segments should be identified until the 75 percent level is reached.
30.4.4 Small segments might be combined as one if they share a substantial number of fac-
tors that define a business or geographical segment, or they might be combined with a sim-
ilar significant reportable segment. If they are not separately reported or combined, they are
included as an unallocated reconciling item.
Chapter 30 Segment Reporting (IAS 14)
245
30.4.5 A segment that is not judged to be a reportable segment in the current period should
continue to be reportable if judged to be of significance for decisionmaking purposes (for
example, future market strategy).
30.4.6 Segment assets and liabilities are identified as follows:
• It includes all operating assets and liabilities that are used by or result from a segment’s
operating activities and that are directly attributable to the segment or can be allocated
to the segment on a reasonable basis.
• Symmetry is required for the inclusion of items in the segment result and in segment assets
or liabilities. If, for example, the segment result reflects depreciation expense, the deprecia-
ble asset must be included in segment assets. Similarly, if the segment result includes inter-
est expense, the interest-bearing liabilities should be included in segment liabilities.
• Income tax assets or liabilities are excluded.
• Assets that are jointly used by two or more segments should be allocated to segments
only if their related revenues and expenses also are allocated to those segments.
30.4.7 Segment information should conform to the accounting policies adopted for prepar-
ing and presenting the consolidated financial statements.
30.5
PRESENTATION AND DISCLOSURE
30.5.1 For each primary segment, the following should be disclosed:
• Segment revenue distinguishing between sales to external customers and revenue from
other segments
• Segment result
• Carrying amount of segment assets
• Segment liabilities
• Cost of property, plant, and equipment, and intangible assets acquired
• Depreciation and amortization expense
• Other noncash expenses
• Share of the net profit or loss of an investment accounted for under the equity method
• A reconciliation between the information of reportable segments and the consolidated
financial statements in terms of segment revenue, result, assets, and liabilities
30.5.2 For each secondary segment, the following should be disclosed:
• Revenue from external customers
• Carrying amount of segment assets
• Cost of property, plant, and equipment, and intangible assets acquired
| Hennie |
30.5.3 Other required disclosures are as follows:
• Revenue of any segment whereby the external revenue of the segment is greater than
or equal to 10 percent of entity revenue but that is not a reportable segment (because a
majority of its revenue is from internal transfers)
• Basis of pricing intersegment transfers
• Changes in segment accounting policies
• Types of products and services in each business segment
• Composition of each geographical segment
246
Chapter 30 Segment Reporting (IAS 14)
EXAMPLES: SEGMENT REPORTING
EXAMPLE 30.1
Hollier Inc. is a diversified entity that operates in five business segments and four geo-
graphical segments. The following financial information relates to the year ending June 30,
20X5.
Business Segment Data (in $’000)
Total Revenue from Sales
To External Customers
To Other Segments
Segment Result
Assets
Beer
2,249
809
1,440
631
4,977
Beverages
Hotels
1,244
543
701
(131)
3,475
4,894
4,029
865
714
5,253
Retail
3,815
3,021
794
(401)
1,072
Packaging
7,552
5,211
2,341
1,510
8,258
Geographical Segment Data (in $’000)
Finland
France
United Kingdom
Australia
Total Revenue from Sales
To External Customers
To Other Segments
Segment Result
Assets
7,111
6,841
270
1,536
9,231
1,371
1,000
371
(478)
5,001
3,451
2,164
1,287
494
3,667
7,821
3,608
4,213
771
5,136
Total
19,754
13,613
6,141
2,323
23,035
Total
19,754
13,613
6,141
2,323
23,035
EXPLANATION
The first step in identifying the reportable business and geographical segments of the entity
is to identify those who earn the majority of its revenue from sales to external customers.
Segments
Percent Sales External
Qualify?
Business
Beer
Beverages
Hotels
Retail
Packaging
Geographical
Finland
France
United Kingdom
Australia
809/2,249 = 36%
543/1,244 = 44%
4,029/4,894 = 82%
3,021/3,815 = 79%
5,211/7,552 = 69%
6,841/7,111 = 96%
1,000/1,371 = 73%
2,164/3,451 = 63%
3,608/7,821 = 46%
No
No
Yes
Yes
Yes
Yes
Yes
Yes
No
Chapter 30 Segment Reporting (IAS 14)
247
The second step would be to ensure that the 10 percent thresholds for revenue from either
sales, segment result, or assets are being met by those segments that qualified under step one.
The thresholds are calculated as follows.
• Sales (10 percent x 19,754)
• Segment result
• Business: [10 percent of the greater of (631 + 714 + 1,510) or (131 + 401)]
• Geographical: [10 percent of the greater of (1,536 + 494 + 771) or 478]
• Assets (10 percent x 23,035)
$
1,976
286
280
2,304
Segments
Business
Hotels
Retail
Packaging
Geographical
Finland
France
United Kingdom
Thresholds that qualified
Reportable?
Sales, Result, Assets
Sales, Result
Sales, Result, Assets
Sales, Result, Assets
Result, Assets
Sales, Result, Assets
Yes
Yes
Yes
Yes
Yes
Yes
The third step would be to check if total external revenue attributable to reportable segments
constitutes at least 75 percent of the total consolidated or entity revenue of $13,613,000.
• Reportable business segments’ external revenue is $12,261,000 (4,029 + 3,021 + 5,211),
which is 90 percent of total sales revenue.
• Reportable geographical segments’ external revenue is $10,005,000 (6,841 + 1,000 +
2,164), which is 73.5 percent of total sales revenue and less than 75 percent.
In terms of IAS 14, additional geographical segments should now be identified as reportable
even if they do not meet the 10 percent thresholds in step two. This would mean that
Australia would, under this requirement, also qualify to be a reportable geographical seg-
ment (see paragraph 10.3.2).
The reportable segments would be as follows:
• Business. Hotels, Retail, and Packaging
• Geographical. Finland, France, United Kingdom, and Australia
31 Related-Party Disclosures (IAS 24)
31.1
PROBLEMS ADDRESSED
A related-party relationship between entities or individuals is one where the arrangement is
not of the normal independent business type. A related-party relationship can have an effect
on the financial position and operating results of the reporting entity. The objective of this
IAS is to define related-party relationships and transactions and to enhance their disclosure.
31.2
SCOPE OF THE STANDARD
An entity’s financial statements should contain the disclosures necessary to draw attention | Hennie |
to the possibility that the financial position and profit or loss could have been affected by the
existence of related parties and by transactions and outstanding balances with them.
This IAS should be applied when identifying related-party relationships and related-party
transactions, such as outstanding balances or the circumstances under which these aspects
should be reported.
31.3
KEY CONCEPTS
31.3.1 Parties are considered to be related if one party has the ability to control, jointly con-
trol, or exercise significant influence over the other party.
31.3.2 A related-party transaction is a transfer of resources, services, or obligations
between related parties, regardless of whether a price is charged.
31.3.3 Related-party relationships include
• entities that directly control, are controlled by, or are under common control with the
reporting entity (for example, a group of companies),
• associates,
• individuals, including close family members, owning, directly or indirectly, interest in
the voting power in the reporting entity that gives them significant influence,
• key management personnel (including directors, officers, and close family members)
responsible for planning, directing, and controlling the activities,
248
Chapter 31 Related-Party Disclosures (IAS 24)
249
• entities in which a substantial interest in the voting power is held, either directly or
indirectly, by individuals (key personnel and close family members), or entities over
which these people can exercise significant influence,
• parties with joint control over the entity,
• joint ventures in which the entity is a venturer, and
• postemployment benefit plans for the benefit of employees of an entity, or of any entity
that is a related party to that entity.
31.3.4 Close members of the family of an individual are those family members who might
be expected to influence, or be influenced by, that individual in their dealings with the enti-
ty. They could include
• the individual’s domestic partner and children,
• children of the individual’s domestic partner, and
• dependants of the individual or the individual’s domestic partner.
31.3.5 Compensation includes all employee benefits (see also IAS 19 and IFRS 2) and all
forms of such consideration paid, payable, or provided by the entity, or on behalf of the enti-
ty, in exchange for services rendered to the entity. It also includes such consideration paid on
behalf of a parent of the entity in respect of the entity. Compensation includes
• short-term employee benefits and nonmonetary benefits for current employees,
• postemployment benefits,
• other long-term employee benefits,
• termination benefits, and
• share-based payment.
31.4
ACCOUNTING TREATMENT
31.4.1 A related-party transaction comprises a transfer of resources or obligations between relat-
ed parties, regardless of whether or not a price is charged; this transfer of resources includes trans-
actions concluded on an arm’s length basis. The following are examples of these transactions:
• Purchase or sale of goods
• Purchase or sale of property or other assets
• Rendering or receipt of services
• Agency arrangements
• Lease agreements
• Transfer of research and development
• License agreements
• Finance, including loans and equity contributions
• Guarantees and collaterals
• Management contracts
31.4.2 Related-party relationships are normal features in commerce. Many entities carry on
separate parts of their activities through subsidiaries, associates, joint ventures, and so on.
These parties sometimes enter into transactions through atypical business terms and prices.
31.4.3 Related parties have a degree of flexibility in the price-setting process that is not pre-
sent in transactions between nonrelated parties. For example, they can use a
• comparable uncontrolled price method,
• resale price method, or
• cost-plus method.
250
Chapter 31 Related-Party Disclosures (IAS 24)
31.5
PRESENTATION AND DISCLOSURE
31.5.1 Relationships between parent and subsidiaries should be disclosed, irrespective of
whether or not there have been transactions between the parties. The name of the parent and, | Hennie |
if different, the name of the ultimate controlling party, should be disclosed.
31.5.2 Compensation of key management personnel should be disclosed in total and for
each of the following categories of compensation:
• Short-term employee benefits
• Post-employment benefits
• Other long-term benefits
• Termination benefits
• Equity compensation benefits
31.5.3 If related-party transactions occur, the following should be disclosed:
• Nature of related-party relationships
• Nature of the transactions
• Transactions and outstanding balances, including:
• Amount of transactions and outstanding balances
• Terms and conditions
• Guarantees given or received
• Provisions for doubtful debts and bad and doubtful debt expense
31.5.4 The matters in 31.5.3 should be separately disclosed for
• the parent,
• entities with joint control or significant influence over the entity,
• subsidiaries,
• associates,
• joint ventures in which the entity is a venturer,
• key management personnel of the entity or its parent, and
• other related parties.
31.6
FINANCIAL ANALYSIS AND INTERPRETATION
31.6.1 Transactions with related parties often raise questions of governance, especially
when the impact is not clear from the amounts disclosed.
31.6.2 These types of transactions and the related approval processes can give rise to neg-
ative publicity. For example, amounts paid to management and directors have been the focus
of significant attention in terms of governance processes in recent years.
31.6.3 The disclosure of pricing policies and approval processes for related-party transac-
tions should for this reason be taken into account when considering the impact of those trans-
actions on the business.
31.6.4 The potential disempowerment of groups such as minority shareholders should be
considered particularly where payments are made to other group companies.
EXAMPLE: RELATED-PARTY DISCLOSURES
Chapter 31 Related-Party Disclosures (IAS 24)
251
EXAMPLE 31.1
Habitat Inc. is a subsidiary in a group structure, which is indicated by the diagram in this
chart.
Habitat Inc.
Yuka
Habitat
Fall
Associate
Solid lines indicate control, whereas dotted lines indicate the exercise of significant influ-
ence.
During the year Habitat acquired plant and equipment from Associate at an amount of $23
million on which Associate earned a profit of $4 million.
EXPLANATION
Habitat and Associate are deemed to be related parties in terms of IAS 24. The full details of
the transaction should therefore be disclosed in the financial statement of both entities as
required by IAS 24, namely
• nature of the related-party relationship,
• the nature of the transaction,
• amount involved, and
• any amount still due by Habitat to Associate.
32
Accounting and Reporting by
Retirement Benefit Plans (IAS 26)
32.1
PROBLEMS ADDRESSED
This IAS prescribes the information that should be reported in the financial statements of a
retirement benefit plan to all its participants when such statements are prepared. It specifi-
cally distinguishes between the information that needs to be provided by defined benefit and
defined contribution plans.
32.2
SCOPE OF THE STANDARD
This Standard should be applied in the financial statements of retirement benefit plans that
are directed to all participants, irrespective of whether a plan is
• not a separate fund,
• either a defined contribution or a defined benefit plan,
• managed by an insurance company,
• sponsored by other parties than employees, or
• either a formal or informal agreement.
32.3
KEY CONCEPTS
32.3.1 Retirement benefit plans are either defined contribution plans or defined benefit
plans.
32.3.2 Defined contribution plans are retirement benefit plans under which amounts to be
paid as retirement benefits are determined by contributions to a fund together with invest-
ment earnings thereon. An employer’s obligation is usually discharged by its contributions.
An actuary’s advice is therefore not normally required.
32.3.3 Defined benefit plans are retirement benefit plans under which amounts to be paid | Hennie |
as retirement benefits are determined by reference to a formula which is usually based on
employees’ earnings or years of service, or both. Periodic advice of an actuary is required to
assess the financial condition of the plan, review the assumptions, and recommend future
contribution levels. An employer is responsible for restoring the level of a benefit plan when
deficits occur in order to provide the agreed benefits to current and former employees.
Occasionally, plans exist that contain characteristics of both defined contribution plans and
252
Chapter 32 Accounting and Reporting by Retirement Benefit Plans (IAS 26)
253
defined benefit plans. Such hybrid plans are considered to be defined benefit plans for the
purposes of IAS 26.
32.3.4 Participants are the members of a retirement benefit plan and others who are enti-
tled to benefits under the plan’s distinctive characteristics. The participants are interested in
the activities of the plan because those activities directly affect the level of their future bene-
fits. Participants are interested in knowing whether contributions have been received and
whether proper control has been exercised to protect the rights of beneficiaries.
32.3.5 Net assets available for benefits are the assets of a plan less liabilities other than the
actuarial present value of promised retirement benefits.
32.3.6 Actuarial present value of promised retirement benefits is the present value of the
expected payments by a retirement benefit plan to existing and past employees, attributable
to the service already rendered.
32.3.7 Vested benefits are benefits the rights to which—under the conditions of a retire-
ment benefit plan—are not conditional on continued employment.
32.4
ACCOUNTING TREATMENT
DEFINED CONTRIBUTIONS PLANS
32.4.1 The financial statements of a defined contribution plan should contain a statement
of net assets available for benefits and a description of the funding policy.
32.4.2 The following principles apply to the valuation of assets owned by the plan:
• Investments should be carried at fair value.
• If carried at other than fair value, the investments’ fair value should be disclosed.
DEFINED BENEFIT PLANS
32.4.3 The financial statement of a defined benefit plan should contain either
• a statement that shows the net assets available for benefits, the actuarial present value
of retirement benefits (distinguishing between vested and nonvested benefits), and the
resulting excess or deficit, or
• a statement of net assets available for benefits including either a note disclosing the
actuarial present value of retirement benefits (distinguishing between vested and non-
vested benefits) or a reference to this information in an accompanying report.
32.4.4 Actuarial valuations are normally obtained every 3 years. The present value of the
expected payments by a defined benefit plan can be calculated and reported using either cur-
rent salary levels or projected salary levels up to the time of the participants’ retirement.
32.4.5 Retirement benefit plan investments should be carried at fair value. In the case of
marketable securities fair value is market value. Where plan investments are held for which
an estimate of fair value is not possible disclosure should be made of the reason why fair
value is not used.
32.4.6 The financial statements should explain the relationship between the actuarial pre-
sent value of the promised retirement benefits and the net assets available for benefits, as well
as the policy for the funding of the promised benefits.
254
Chapter 32 Accounting and Reporting by Retirement Benefit Plans (IAS 26)
32.5
PRESENTATION AND DISCLOSURE
32.5.1 A description of the plan requires information such as the names of the employers
and the employee groups covered, number of participants receiving benefits, type of plan,
and other details.
32.5.2 Policies include:
• A statement of changes in net assets available for benefits
• Significant accounting policies | Hennie |
• Description of the investment policies
• Description of the funding policy
32.5.3 The statement of net assets available for benefits shows the amount of assets avail-
able to pay retirement benefits that are expected to become payable in future. It includes:
• Assets at year-end, suitably classified
• Basis of valuation of assets
• Note stating that an estimate of the fair value of plan investments is not possible, when
plan investments are being held for that reason
• Details of any single investment exceeding either 5 percent of net assets available for
benefits or 5 percent of any class or type of security
• Details of any investment in the employer
• Liabilities other than the actuarial present value of promised retirement benefits
32.5.4 The statement of changes in net assets available for benefits includes:
• Investment income
• Employer contributions
• Employee contributions
• Other income
• Benefits paid or payable (analyzed per category of benefit)
• Administrative expenses
• Other expenses
• Taxes on income
• Profits and losses on disposal of investments and changes in value of investments
• Transfers from and to other plans
32.5.5 Actuarial information (for benefit plans only) includes:
• The actuarial present value of promised retirement benefits, based on the benefits
promised under the terms of the plan, on service rendered to date, and on using either
current salary levels or projected salary levels
• Description of main actuarial assumptions
• Method used to calculate the actuarial present value of promised retirement benefits
• Date of most recent actuarial valuation
32.6
FINANCIAL ANALYSIS AND INTERPRETATION
See Chapter 18 for a discussion of analytical issues related to retirement benefit funds.
Chapter 32 Accounting and Reporting by Retirement Benefit Plans (IAS 26)
255
EXAMPLE: ACCOUNTING AND REPORTING BY RETIREMENT BENEFIT PLANS
EXAMPLE 32.1
The financial statements of a retirement benefit plan should inter alia contain a statement of
changes in net assets available for benefits.
EXPLANATION
The following extract was taken from the World Bank Group: Staff Retirement Plan–2004 Annual
Report. It contains statements that comply with the IAS 26 requirements in all material
respects.
Statements of Changes in Net Assets Available for Benefits (in thousands)
Year Ended December 31
2004
2003
Investment income (loss)
Net appreciation in fair value of Investments (Note F)
Interest and dividends
Less: investment management fees
Net investment income
881,325
262,406
(45,193)
1,098,538
1,348,382
265,212
(43,618)
1,569,976
Contributions (Note C)
Contributions by participants
Contributions by employer
Total contributions
Total additions
Benefit payments
Pensions
Commutation payments
Contributions, withdrawal benefits, and interest
paid to former participants on withdrawal
Lump sum death benefits
Termination grants
Total benefit payments
Administrative expenses
Custody and consulting fees
Others
Total administrative expenses
Net increase
Net assets available for benefits
Beginning-of-year
End-of-year
77,224
184,228
261,452
1,359,990
76,280
85,027
161,307
1,731,283
(293,908)
(41,218)
(271,399)
(32,099)
(28,312)
(622)
(2,375)
(366,435)
(23,586)
(1,671)
(3,048)
(331,803)
(4,516)
(8,083)
(12,599)
980,956
(4,985)
(5,902)
(10,887)
1,388,593
10,276,705
11,257,661
8,888,112
10,276,705
33 Financial Reporting
in Hyperinflationary
Economies (IAS 29)
33.1
PROBLEMS ADDRESSED
In a hyperinflationary economy, reporting of operating results and financial position without
restatement is not useful. Money loses purchasing power at such a rapid rate that compari-
son of amounts from transactions and other events that have occurred, even within the same
accounting period, is misleading.
33.2
SCOPE OF THE STANDARD
This IAS should be applied by entities that report in the currency of a hyperinflationary econ-
omy. Characteristics of a hyperinflationary economy include:
• The general population prefers to keep its wealth in nonmonetary assets or in a rela-
tively stable foreign currency.
• Prices are normally quoted in a stable foreign currency.
• Credit transactions take place at prices that compensate for the expected loss of pur-
| Hennie |
chasing power.
• Interest, wages, and prices are linked to price indices.
• The cumulative inflation rate over 3 years is approaching or is greater than 100 percent
(that is, an average of more than 26 percent per annum).
This IAS requires that the financial statements of an entity operating in a hyperinflationary
economy be restated in the measuring unit current at the reporting date.
IAS 21 requires that if the functional currency of a subsidiary is the currency of a hyperinfla-
tionary economy, transactions and events of the subsidiary should first be measured in the sub-
sidiary’s functional currency; the subsidiary’s financial statements are then restated for price
changes in accordance with IAS 29. Thereafter, the subsidiary’s financial statements are trans-
lated, if necessary, into the presentation currency using closing rates. IAS 21 does not permit
such an entity to use another currency, for example a stable currency, as its functional currency.
33.3
KEY CONCEPTS
33.3.1 A general price index should be used that reflects changes in general purchasing
power.
256
Chapter 33 Financial Reporting in Hyperinflationary Economies (IAS 29)
257
33.3.2 Restatement starts from the beginning of the period in which hyperinflation is
identified.
33.3.3 When hyperinflation ceases, restatement is discontinued.
33.4
ACCOUNTING TREATMENT
33.4.1 The financial statements of an entity that reports in the currency of a hyperinflation-
ary economy should be restated in the measuring unit current at the balance sheet date; that
is, the entity should restate the amounts in the financial statements from the currency units
in which they occurred into the currency units on the balance sheet date.
33.4.2 The restated financial statements replace the financial statements and do not serve
as a supplement of the financial statements. Separate presentation of the nonadjusted finan-
cial statements is not permitted.
RESTATEMENT OF HISTORICAL COST FINANCIAL STATEMENTS
33.4.3 Rules applicable to the restatement of the balance sheet are as follows:
• Monetary items are not restated.
• Index-linked assets and liabilities are restated in accordance with the agreement.
• Nonmonetary items are restated in terms of the current measuring unit by applying the
changes in the index or currency unit to the carrying values since the date of acquisi-
tion (or the first period of restatement) or fair values on dates of valuation.
• Nonmonetary assets are not restated if they are shown at net realizable value, fair
value, or recoverable amount at balance sheet date.
• At the beginning of the first period in which the principles of IAS 29 are applied, com-
ponents of owners’ equity, except accumulated profits and any revaluation surplus are
restated from the dates the components were contributed.
• At the end of the first period and subsequently all components of owners’ equity are
restated from the date of contribution.
• The movements in owners’ equity are included in equity.
33.4.4 All items in the income statement are restated by applying the change in the gener-
al price index from the dates when the items were initially recorded.
33.4.5 A gain or loss on the net monetary position is included in net income. This amount
can be estimated by applying the change in the general price index to the weighted average
of net monetary assets or liabilities.
RESTATEMENT OF CURRENT COST FINANCIAL STATEMENTS
33.4.6 Rules applicable to the restatement of the balance sheet are:
• Items shown at current cost are not restated.
• Other items are restated in terms of the rules above.
33.4.7 All amounts included in the income statement are restated into the measuring unit
at balance sheet date by applying the general price index.
33.4.8 If a gain or loss on the net monetary position is calculated, such an adjustment
forms part of the gain or loss on the net monetary position calculated in terms of IAS 29.
258
Chapter 33 Financial Reporting in Hyperinflationary Economies (IAS 29)
33.4.9 All cash flows are expressed in terms of the measuring unit at balance sheet date.
| Hennie |
33.4.10 When a foreign subsidiary, associate, or joint venture of a parent company reports
in a hyperinflationary economy, the financial statements of such entities should first be
restated in accordance with IAS 29 and then translated at closing rate as if the entities were
foreign entities per IAS 21
33.5
PRESENTATION AND DISCLOSURE
The following aspects should be disclosed:
• The fact of restatement
• The fact that comparatives are restated
• Whether the financial statements are based on the historical cost approach or the cur-
rent cost approach
• The identity and the level of the price index or stable currency at balance sheet date
• The movement in price index or stable currency during the current and previous finan-
cial years
33.6
FINANCIAL ANALYSIS AND INTERPRETATION
33.6.1 The interpretation of hyperinflated results is difficult if one is not familiar with the
mathematical processes that give rise to the hyperinflated numbers.
33.6.2 Where the financial statements of an entity in a hyperinflationary economy are trans-
lated and consolidated into a group which does not report in the currency of a hyperinfla-
tionary economy, analysis becomes extremely difficult.
33.6.3 Users should consider the disclosures of the level of price indices used to compile the
financial statements and, where provided, should consider the levels of foreign exchange
rates applied to the translation of financial statements.
33.6.4 When inflation rates and exchange rates do not correlate well, the carrying amounts
of nonmonetary assets in the financial statements will have to be analyzed to consider how
much of the change is attributable to structural issues such as hyperinflation and how much
is attributable to, for example, temporary exchange rate fluctuations.
33.6.5 As accounting standards increasingly require use of fair value measurement, users
of the financial statements of entities that operate in hyperinflationary economies must con-
sider the reliability of fair value measurements in those financial statements.
33.6.6 Hyperinflationary economies often do not have active financial markets and could
be subject to high degrees of regulation, such as price control. In such circumstances, the
determination of fair values, as well as discount rates for defined benefit obligations and
impairment tests, is very difficult.
Chapter 33 Financial Reporting in Hyperinflationary Economies (IAS 29)
259
EXAMPLE: FINANCIAL REPORTING IN HYPERINFLATIONARY ECONOMIES
EXAMPLE 33.1
Darbrow Inc. was incorporated on January 1, 20X2, with an equity capital of $40 million. The
balance sheets of the entity at the beginning and end of the first financial year were as fol-
lows:
Assets
Property, Plant, and Equipment
Inventory
Receivables
Equity and Liabilities
Share Capital
Accumulated Profit
Borrowings
Beginning
$’000
60,000
30,000
50,000
140,000
40,000
–
100,000
140,000
End
$’000
50,000
40,000
60,000
150,000
40,000
10,000
100,000
150,000
The income statement for the first year reflected the following amounts:
Revenue
Operating Expenses
Depreciation of Plant and Equipment
Operating Profit
Interest Paid
Profit before Tax
Income Tax Expense
Profit after Tax
$’000
800,000
(750,000)
(10,000)
40,000
(20,000)
20,000
(10,000)
10,000
Additional Information
1. The rate of inflation was 120 percent for the year.
The inventory represents 2 months’ purchases, and all income statement items accrued even-
ly during the year.
Continued on next page
260
Chapter 33 Financial Reporting in Hyperinflationary Economies (IAS 29)
Example 33.1 (continued)
EXPLANATION
The financial statements can be restated to the measuring unit at balance sheet date using a
reliable price index, as follows:
Balance Sheet
Assets
Property, Plant, and Equipment
Inventory (Calculation a)
Receivables
Equity and Liabilities
Share Capital
Accumulated Profits
Borrowings
Recorded
$’000
Restated
$’000
Calculations
50,000
40,000
60,000
150,000
40,000
10,000
100,000
150,000
110,000
41,905
60,000
211,905
88,000
23,905
100,000
211,905
Income Statement
$’000
$’000
Revenue (Calculation b)
Operating Expenses | Hennie |
Depreciation (Calculation c)
Interest Paid
Income Tax Expense
Net Profit before Restatement Gain
Gain arising from
Inflationary Adjustment
Net Profit after Restatement Gain
800,000
(750,000)
(10,000)
(20,000)
(10,000)
10,000
1,100,000
(1,031,250)
(22,000)
(27,500)
(13,750)
5,500
18,405
23,905
Calculations
a. Index for inventory
Inventory purchased on average at 30 November
Index at that date = 1.00 + (1.20 ¥ 11/12) = 2.10
b. Index for income and expenses
Average for the year = 1.00 + (1.20 ÷ 2) = 1.60
c. Index for depreciation
Linked to the index of property, plant and equipment = 1.00
2.20/1.00
2.20/2.10
2.20/1.00
Balancing
2.20/1.60
2.20/1.60
2.20/1.00
2.20/1.60
2.20/1.60
Balancing
Figure
34 Financial Instruments:
Presentation (IAS 32)
Note: IAS 32, IAS 39, and IFRS 7 were issued as separate Standards but are applied in practice as a unit
because they deal with the same accounting phenomenon.
34.1
PROBLEMS ADDRESSED
Users need information that will enhance their understanding of the significance of on-balance-
sheet and off-balance-sheet financial instruments regarding an entity’s existing financial posi-
tion, performance, cash flows as well as the amounts, timing, and certainty of future cash flows
associated with those instruments.
This IAS prescribes requirements for the presentation of on-balance-sheet financial instru-
ments.
34.2
SCOPE OF THE STANDARD
The IAS deals with all types of financial instruments, both recognized and unrecognized,
and should be applied to contracts to buy or sell a nonfinancial item that can be settled net
• in cash,
• by another financial instrument, or
• by exchanging financial instruments, as if the contracts were financial instruments.
Presentation issues addressed by IAS 32 relate to
• distinguishing liabilities from equity
• classification of compound instruments
• reporting of interest, dividends, losses and gains
• offsetting of financial assets and liabilities
IAS 32 applies to all risks arising from all financial instruments, except:
• interests in subsidiaries, associates and joint ventures IAS 27, 28 and 31)
• employers’ rights and obligations arising from employee benefit plans (IAS 19)
• financial instruments within the scope of IFRS 2
• contracts for contingent consideration in a business combination (IFRS 3)
261
262
Chapter 34 Financial Instruments: Presentation (IAS 32)
• insurance contracts and financial instruments within the scope of IFRS 4 Insurance
Contracts. (except for derivatives that are embedded in insurance contracts if IAS 39
requires the entity to account for them separately).
34.3
KEY CONCEPTS
34.3.1 A financial instrument is any contract that gives rise to both a financial asset of one
entity and a financial liability or equity instrument of another.
34.3.2 A financial asset is any asset that is
• cash (for example, cash deposited at a bank);
• a contractual right to receive cash or a financial asset (for example, the right of a debtor
and derivative instrument);
• a contractual right to exchange financial instruments under potentially favorable condi-
tions;
• a contract that will or may be settled in an entity’s own equity instruments; or
• an equity instrument of another entity (for example, investment in shares).
Physical assets (for example, inventories and patents) are not financial assets, because they
do not give rise to a present contractual right to receive cash or other financial assets.
34.3.3 A financial liability is a contractual obligation to
• deliver any financial asset;
• exchange financial instruments under potentially unfavorable conditions; or
• be settled in the entity’s own equity instruments.
Liabilities imposed by statutory requirements (for example, income taxes) are not financial
liabilities because they are not contractual.
34.3.4 An equity instrument is any contract that evidences a residual interest in the assets
of an entity after deducting all of its liabilities. An obligation to issue an equity instrument is
not a financial liability because it results in an increase in equity and cannot result in a loss
to the entity.
| Hennie |
34.3.5 Fair value is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
34.4
PRESENTATION
34.4.1 The issuer of a financial instrument should classify the instrument, or its component
parts, on initial recognition as a financial liability, a financial asset, or an equity instrument
in accordance with the substance of the contractual arrangement and the definitions of a
financial liability, a financial asset, and an equity instrument.
34.4.2 The issuer of a compound financial instrument that contains both a liability and
equity element (for example, convertible bonds), should classify the instrument’s component
parts separately, for example: total amount – liability portion = equity portion. Once so clas-
sified, the classification is not changed, even if economic circumstances change. No gain or
loss arises from recognizing and presenting the parts separately.
34.4.3 Interest, dividends, losses, and gains relating to a financial liability should be
reported in the income statement as expense or income. Distributions to holders of an equi-
Chapter 35 Financial Instruments: Disclosure and Presentation (IAS 32)
263
ty instrument should be debited directly to equity. The classification of the financial instru-
ment therefore determines its accounting treatment:
• Dividends on shares classified as liabilities would thus be classified as an expense in
the same way that interest payments on a loan are classified as an expense.
Furthermore, such dividends would have to be accrued over time.
• Gains and losses (premiums and discounts) on redemption or refinancing of instru-
ments classified as liabilities are reported in the income statement, whereas gains and
losses on instruments classified as equity of the issuer are reported as movements in
equity.
34.4.4 A financial asset and a financial liability should be offset only when
• a legal enforceable right to set off exists, and
• there is an intention either to settle on a net basis, or to realize the asset and settle the
related liability simultaneously.
34.5
DISCLOSURE
Disclosure is dealt with in IFRS 7 (see Chapter 38).
35
Earnings per Share (IAS 33)
35.1
PROBLEMS ADDRESSED
Earning per share is a prime variable used for evaluating the performance of an entity. This
Standard prescribes principles for the determination and presentation of earnings per share,
and focuses on the denominator (per share amount) of the calculation. The Standard distin-
guishes between the notions of basic as well as diluted earnings per share.
35.2
SCOPE OF THE STANDARD
This Standard applies to entities whose shares are publicly traded or in the process of being
issued in public securities markets, and other entities that choose to disclose earnings per
share. It is applicable to consolidated information only if the parent prepares consolidated
financial statements.
The Standard requires and prescribes the form of calculation and disclosure of basic as well
as diluted earnings per share.
35.3
KEY CONCEPTS
35.3.1 An ordinary share is an equity instrument that is subordinate to all other classes of
equity instruments. More than one class of ordinary shares can be issued by an entity.
35.3.2 Dilution is a reduction in earnings per share or an increase in loss per share result-
ing from the assumption that convertible instruments are converted, that options or warrants
are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions.
35.3.3 A potential ordinary share is a financial instrument or other contract that can enti-
tle its holder to ordinary shares (for example, debt or equity instruments that are convertible
into ordinary shares, and share warrants and options that give the holder the right to pur-
chase ordinary shares).
35.3.4 Options, warrants, and their equivalents are financial instruments that give the
holder the right to purchase ordinary shares.
35.3.5 Put options on ordinary shares are contracts that give the holder the right to sell | Hennie |
ordinary shares at a specified price for a given period.
264
35.4
ACCOUNTING TREATMENT
Chapter 35 Earnings per Share (IAS 33)
265
35.4.1 Basic earnings per share (BEPS) are calculated by dividing the profit or loss for the
period attributable to ordinary equity holders of the parent entity by the weighted average
number of ordinary shares outstanding during the period.
35.4.2 Basic earnings are
• Profit or loss attributable to ordinary equity holders and (if presented) profit or loss
from continuing operations attributable to those equity holders
• Profit or loss is adjusted for the following amounts related to preference dividends:
• Differences arising on the settlement of the preference shares
• Other similar effects of preference shares classified as equity
• Qualifying preference dividends are
• the amount declared for the period on noncumulative preference shares, and
• the full amount of cumulative preference dividends for the period, whether or not
declared.
35.4.3 When calculating the weighted number of shares, the following aspects must be
considered:
• The weighted number of shares comprises the weighted average number of shares
outstanding during the period (that is, the number of ordinary shares outstanding at
the beginning of the period, adjusted by those bought back or issued during the period
multiplied by a time-weighting factor).
• Contingency issuable shares are included in the computation of basic earnings per
share, only from the date when all necessary conditions have been satisfied.
• The number of shares for current and all previous periods presented should be adjust-
ed for changes in shares without a corresponding change in resources (for example,
bonus issue and share split).
• The number of ordinary shares should be adjusted for all periods prior to a rights
issue (which includes a bonus element), multiplied by the following factor:
Fair value per share immediately prior to the exercise of rights
Theoretical ex-rights fair value per share
35.4.4 Diluted earnings comprise the profit or loss attributable to ordinary equity holders
of the parent entity and (if presented) profit or loss from continuing operations attributable
to those equity holders, adjusted for the effects of all dilutive potential ordinary shares.
35.4.5 Diluted earnings consist of the basic earnings adjusted for after-tax effects of the fol-
lowing items associated with dilutive potential ordinary shares:
• Dividends or other items
• Interest for the period
• Other changes in income or expense that would result from a conversion of shares (for
example, the savings on interest related to these shares can lead to an increase in the
expense relating to a nondiscretionary employee profit-sharing plan)
35.4.6 The following adjustments are made to the weighted number of shares:
• The weighted average number of shares for basic earnings per share (EPS), plus those
to be issued on conversion of all dilutive potential ordinary shares. Potential ordinary
shares are treated as dilutive when their conversion would decrease net profit per share
from continuing ordinary operations.
266
Chapter 35 Earnings per Share (IAS 33)
• These shares are deemed to have been converted into ordinary shares at the beginning
of the period or, if later, at the date of the issue of the shares.
• Options, warrants (and their equivalents), convertible instruments, contingently
issuable shares, contracts that can be settled in ordinary shares or cash, purchased
options, and written put options should be considered.
35.4.7 Earnings per share amounts should be restated in the following circumstances:
• If the number of shares outstanding is affected as a result of a capitalization, bonus
issue, share split, or a reverse share split, the calculation of basic EPS and diluted EPS
should be adjusted retrospectively
• If these changes occur after balance sheet date but before issue of financial statements,
the per share calculations are based on the new number of shares
35.4.8 Basic EPS and diluted EPS for all periods presented are adjusted for the effect of
| Hennie |
• prior period errors, or
• changes in accounting policies.
35.5
PRESENTATION AND DISCLOSURE
35.5.1 Basic EPS and diluted EPS are shown with equal prominence on the face of the
income statement for each class of ordinary share with different rights for:
• Profit or loss from continuing operations attributable to ordinary equity holders of the
parent entity
• Profit or loss attributable to ordinary equity holders of the parent entity
• Any reported discontinued operation
35.5.2 Basic and diluted losses per share are disclosed when they occur.
35.5.3 Amounts used as numerators for basic EPS and diluted EPS and a reconciliation of
those amounts to the net profit or loss for the period must be disclosed.
35.5.4 If an earnings-per-share figure is disclosed, in addition to one required by IAS 33:
• Basic and diluted amounts per share should be disclosed with equal prominence.
• That figure should be disclosed in notes, not on face of income statement.
• The basis on which the numerator is determined should be indicated, including
whether amounts are before or after tax.
• Reconciliation of the numerator and reported line item should be provided in the
income statement of the denominator.
• The same denominator should be used as for basic EPS or dilutive EPS (as appropriate).
35.5.5 The weighted average number of ordinary shares used as the denominator in calcu-
lating basic EPS and diluted EPS, and a reconciliation of these denominators to each other,
must be disclosed.
35.6
FINANCIAL ANALYSIS AND INTERPRETATION
35.6.1 When discussing companies, investors and others commonly refer to earnings per
share. If a company has a simple capital structure—which is one that contains no convertible
Chapter 35 Earnings per Share (IAS 33)
267
bonds or preferred shares, no warrants or options, and no contingent shares—it will only pre-
sent its basic earnings per share.
35.6.2 For complex capital structures, both basic earnings per share and diluted earnings
per share are generally reported. A complex capital structure is one where the company does
have one or more of the following types of securities: convertible bonds, preferred shares,
warrants, options, and contingent shares.
268
Chapter 35 Earnings per Share (IAS 33)
EXAMPLES: EARNINGS PER SHARE
EXAMPLE 35.1
The issued and fully paid share capital of Angli Inc. remained unchanged at the following
amounts since the date of incorporation until the financial year ended March 31, 20X4:
• 1,200,000 ordinary shares with no par value
• 300,000 6% participating preference shares of $1 each
The corporation has been operating at a profit for a number of years. As a result of a very
conservative dividend policy followed by the directors during previous years, there is a large
accumulated profit balance on the balance sheet. On July 1, 20X4, the directors decided to
issue to all ordinary shareholders, two capitalization shares for every one previously held.
The following abstract was taken from the (noncompliant) consolidated income statement for
the year ending March 31, 20X5:
Profit after Tax
Minority Interest (not IFRS compliant)
Net Profit from Ordinary Activities
Extraordinary Item (not IFRS compliant)
Profit for the Year
20X5
$
400,000
(30,000)
370,000
–
370,000
20X4
$
290,000
(20,000)
270,000
(10,000)
260,000
The following dividends have been paid or declared at the end of the reported periods:
Ordinary
Preference
20X5
$
165,000
34,500
20X4
$
120,000
30,000
The participating preference shareholders are entitled to share profits in the same ratio in
which they share dividends, after payment of the fixed preference dividend. The sharehold-
ers will enjoy the same benefits during liquidation of the company.
Continued on next page
Chapter 35 Earnings per Share (IAS 33)
269
Example 35.1 (continued)
EXPLANATION
The earnings per share (required by IAS 33) and the dividends per share (required by IAS 1)
to be presented in the group financial statements for the year ending March 31, 20X5, is cal-
culated as follows:
EARNINGS PER SHARE
Attributable earnings (Calculation b) divided by | Hennie |
weighted number of shares (Calculation c)
• Ordinary Shares
• Participating Preference Shares
DIVIDENDS PER SHARE
Dividends divided by actual number of shares in issue
• Ordinary Shares
20X4 adjusted for the capitalization issue for the
purposes of comparability
• Preference Shares
20X5
20X4
320,000
3,600,000
= $0.089
50,000
300,000
= $0.167
220,000
3,600,000
= $0.061
40,000
300,000
= $0.133
20X5
20X4
165,000
3,600,000
120,000
3,600,000
= $0.046
34,500
300,000
= $0.115
= $0.033
30,000
300,000
= $0.10
CALCULATIONS
a. Percentage of Profits Attributable to Classes of Equity Shares
Total preference dividend
Fixed portion (6% x $300,000)
20X5
$
34,500
(18,000)
16,500
20X4
$
30,000
(18,000)
12,000
Dividend paid to ordinary shareholders
165,000
120,000
Therefore: The participating preference shareholders share profits in the ratio 1:10 with the
ordinary shareholders after payment of the fixed preference dividend out of profits.
270
Chapter 35 Earnings per Share (IAS 33)
b. Earnings per Class of Share
Net profit for the period
Fixed preference dividend
20X5
$
370,000
(18,000)
352,000
20X4
$
260,000
(18,000)
242,000
Attributable to ordinary shareholders 10/11
320,000
220,000
Attributable to participating preference
shareholders 1/11
Fixed dividend
c. Weighted Number of Ordinary Shares in Issue
Balance, 1 April 20X3
Capitalization issue
2,000
18,000
50,000
22,000
18,000
40,000
20X5
Shares
1,200,000
2,400,000
3,600,000
20X4
Shares
1,200,000
2,400,000
3,600,000
Chapter 35 Earnings per Share (IAS 33)
271
EXAMPLE 35.2
L. J. Pathmark reported net earnings of $250,000 for the year ending 20X1. The company had
125,000 shares of $1 par value common stock and 30,000 shares of $40 par value convertible
preference shares outstanding during the year. The dividend rate on the preference shares is
$2 per share. Each share of the convertible preference shares can be converted into two shares
of L. J. Pathmark Class A common shares. During the year no convertible preference shares
were converted.
What is L. J. Pathmark’s basic earnings per share?
a. $0.89 per share
b. $1.52 per share
c. $1.76 per share
d. $2.00 per share
EXPLANATION 2
Choice b. is correct. The answer was derived based on the following formula calculation:
Basic earnings
per share
=
–
Net
Preference
( income
dividends )
( common shares )
Weighted average
=
=
($250,000 – ($2 ¥ 30,000 shares))
125,000 shares
$190,000
125,000
= $1.52 per share
Choice a. is incorrect. This answer does not correctly apply the formula above.
Choice c. is incorrect. The preference dividends were improperly determined by using the
shares (only), and not deriving a dollar dividend.
Choice d. is incorrect. When determining basic EPS, preference dividends were not
subtracted.
272
Chapter 35 Earnings per Share (IAS 33)
EXAMPLE 35.3
L.J. Pathmark reported net earnings of $250,000 for the year ending 20X1. The company had
125,000 shares of $1 par value common stock and 30,000 shares of $40 par value convertible
preference shares outstanding during the year. The dividend rate on the preference shares is
$2 per share. Each share of the convertible preference shares can be converted into two shares
of L.J. Pathmark Class A common shares. During the year no convertible preference shares
were converted.
What is L.J. Pathmark’s diluted earnings per share?
a. $0.70 per share.
b. $1.35 per share.
c. $1.68 per share.
d. $2.00 per share.
EXPLANATION 3
Choice b. is correct. The answer was derived based on the following formula calculation:
Diluted
earnings per share
=
=
Net
( income
–
Preference
dividends
+
Dividends on
converted securities)
Shares
outstanding
+
Additional shares if
securities were converted
($250,000 – $60,000 + $60,000)
125,000 + (30,000 ¥ 2)
= $250,000
185,000
= $1.35 per share
Choice a. is incorrect. Dividends on converted securities were incorrectly subtracted in the
numerator.
Choice c. is incorrect. Preference dividends were ignored in the numerator of the calculation.
Choice d. is incorrect. This represents an incorrect application of both fully diluted and basic
EPS, as net income is divided by shares outstanding.
36
Interim Financial
Reporting (IAS 34)
36.1
| Hennie |
PROBLEMS ADDRESSED
Interim financial information enhances the accuracy of forecasting earnings and share prices.
IAS 34 is concerned with the following for interim financial reports:
• Minimum content
• Principles for recognition and measurement
36.2
SCOPE OF THE STANDARD
This Standard applies to all entities that are required by law or regulatory bodies, or that vol-
untarily elect to publish interim financial reports covering a period shorter than a full finan-
cial year (for example, a period of a half-year or a quarter).
It defines and prescribes the minimum content of an interim financial report, including dis-
closures; and identifies the accounting recognition and measurement principles that should
be applied in an interim financial report.
36.3
KEY CONCEPTS
36.3.1 An interim financial report is a financial report that contains either a complete or
condensed set of financial statements for a period shorter than an entity’s full financial year.
36.3.2 A condensed balance sheet is produced at the end of an interim period with com-
parative balances provided for the end of the prior full financial year.
36.3.3 A condensed income statement is produced for the current interim period and
cumulative for the current financial year to date, with comparatives for the comparable inter-
im periods of the prior financial year. An entity that publishes interim financial reports quar-
terly would, for example, prepare four income statements in its third quarter, that is, one for
the 9 months cumulatively since the beginning of the year, one for the third quarter only, and
comparative income statements for the exact comparable periods of the prior financial year.
273
274
Chapter 36 Interim Financial Reporting (IAS 34)
36.3.4 A condensed cash flow statement is a cumulative statement for the current financial
year to date, and a comparative statement for the comparable interim period of the prior
financial year.
36.3.5 Condensed changes in equity statements are cumulative for the current financial
year to date and comparative for the comparable interim period of the prior financial year.
36.4
ACCOUNTING TREATMENT
36.4.1 An interim financial report includes the following:
• Condensed balance sheet
• Condensed income statement(s)
• Condensed cash flow statement
• Condensed changes in equity
• Selected explanatory notes
36.4.2 The form and content of an interim financial report is prescribed as follows:
• Include at a minimum
• each of the headings and subtotals that were included in the most recent annual
financial statements, and
• selected explanatory notes required by this IAS.
• Basic and diluted earnings per share to be presented on the face of the income
statement.
• A parent should prepare the report on a consolidated basis.
36.4.3 An entity should apply the same accounting policies in its interim financial state-
ments as in its latest annual financial statements, except for accounting policy changes made
subsequently.
36.4.4 The frequency of interim reporting (for example, semiannually or quarterly) does
not affect the measurement of an entity’s annual results. Measurements for interim reporting
purposes are therefore made on a year-to-date basis, the so-called discrete method.
36.4.5 Revenues received seasonally, cyclically, or occasionally should not be recognized or
deferred as of an interim date if recognition or deferral would not be appropriate at the end
of the entity’s financial year. For example, an entity that earns all its revenue in the first half
of a year does not defer any of that revenue until the second half of the year.
36.4.6 Costs incurred unevenly during the financial year should not be recognized or
deferred as of the interim date if recognition or deferral would not be appropriate at the end
of the financial year. To illustrate, the cost of a planned major periodic maintenance that is
expected to occur late in the year is not anticipated for interim reporting purposes unless the
entity has a legal or constructive obligation. Similarly, development costs incurred are not | Hennie |
deferred in an earlier period in the hope that they will meet the asset recognition criteria in
a later period.
36.4.7 Whereas measurements in both annual and interim financial reports are often based
on reasonable estimates, the preparation of interim financial reports generally will require a
greater use of estimation methods than annual financial reports. For example, full stock-tak-
ing and valuation procedures cannot be realistically carried out for inventories at interim
dates.
Chapter 36 Interim Financial Reporting (IAS 34)
275
36.4.8 A change in accounting policy should be reflected by restating the financial state-
ments of prior interim periods of the current financial year and the comparable interim peri-
ods of prior years in terms of IAS 8 (if practicable).
36.5
PRESENTATION AND DISCLOSURE
36.5.1 Selected explanatory notes in interim financial reports are intended to provide an
update since the last annual financial statements. The following should be included as a
minimum:
• A statement that accounting policies have been applied consistently or a description of
any subsequent changes
• Explanatory comments about seasonality or cyclicality of operations
• Nature and amount of items affecting assets, liabilities, equity, net income, or cash
flows that are unusual because of their nature, size, or incidence
• Changes in estimates of amounts reported in prior interim periods of the current year
or amounts reported in prior years
• Changes in outstanding debt or equity, including uncorrected defaults or breaches of a
debt covenant
• Dividends paid
• Revenue and result of business segments or geographical segments, whichever is the
primary format of segment reporting
• Events occurring after the balance sheet date
• Purchases or disposals of subsidiaries and long-term investments, restructurings, and
discontinued operations
• Changes in contingent liabilities or assets
• The fact that the interim financial report complies with the IAS
36.5.2 If an estimate of an amount reported in an interim period is changed significantly
during the final interim period of the financial year but a separate financial report is not
published for that final interim period, the nature and amount should be disclosed in a note
to the annual financial statements.
36.6
FINANCIAL ANALYSIS AND INTERPRETATION
36.6.1 Because of the requirement that the tax expense in interim financial statements
should be based on the expected effective tax rate for the entity for the entire financial year,
the disclosed tax expense might provide interesting clues as to management’s assessment of
prospects for the remainder of the financial year.
• For example, if the effective tax rate is low, this could indicate an expectation of a
greater proportion of profits originating in low tax rate jurisdictions.
• Alternatively, if capital gains are taxed at lower rates than other gains, it might indicate
an anticipated higher level of fixed asset disposals.
276
Chapter 36 Interim Financial Reporting (IAS 34)
EXAMPLE: INTERIM FINANCIAL REPORTING
EXAMPLE 36.1
The following three basic recognition and measurement principles are stated in IAS 34:
A. An entity should apply the same accounting policies in its interim financial statements
as it applies in its annual financial statements, except for accounting policy changes
made after the date of the most recent annual financial statements that are to be reflected
in the next annual financial statements. However, the frequency of an entity’s reporting
(annually, semiannually, or quarterly) should not affect the measurement of its annual
results. To achieve that objective, measurements for interim reporting purposes should
be made on a year-to-date basis.
B. Revenues that are received seasonally, cyclically, or occasionally within a financial year
should not be anticipated or deferred as of an interim date if anticipation or deferral
would not be appropriate at the end of the entity’s financial year.
C. Costs that are incurred unevenly during an entity’s financial year should be anticipated | Hennie |
or deferred for interim reporting purposes if, and only if, it is also appropriate to antici-
pate or defer that type of cost at the end of the financial year.
EXPLANATION
The following table illustrates the practical application of the above-mentioned recognition
and measurement principles:
Principles and Issues
Practical Application
A. Same accounting policies as for annual financial
statements
A devaluation in the functional currency against other currencies
occurred just before the end of the first quarter of the year. This
necessitated the recognition of foreign exchange losses on the
restatement of unhedged liabilities, which are repayable in
foreign currencies.
Indications are that the functional currency will regain its
position against the other currencies by the end of the second
quarter of the year. Management is reluctant to recognize these
losses as expenses in the interim financial report and wants to
defer recognition, based on the expectation of the functional
currency. They hope that the losses will be neutralized by the
end of the next quarter, in order to smooth the earnings rather
than recognizing losses in one quarter and profits in the next.
In the interim financial statements, these losses
are recognized as expenses in the first quarter
in accordance with IAS 21.
The losses are recognized as expenses on a
year-to-date basis to achieve the objective of
applying the same accounting policies for both
the interim and annual financial statements.
Continued on next page
Chapter 36 Interim Financial Reporting (IAS 34)
277
Example 36.1 (continued)
Principles and Issues
Practical Application
B. Deferral of revenues
An ice cream manufacturing corporation recently had its shares
listed on the local stock exchange. Management is worried
about publishing the first quarter’s interim results because the
entity normally earns most of its profits in the third and fourth
quarters (during the summer months).
Statistics show that the revenue pattern is more or less as follows:
First quarter
= 10 percent of total annual revenue
Second quarter = 15 percent of total annual revenue
Third quarter = 40 percent of total annual revenue
Fourth quarter = 35 percent of total annual revenue
During the first quarter of the current year total revenue
amounted to $254,000. However, management plans to
report 1/4 of the projected annual revenue in its interim
financial report, calculated as follows:
$254,000 ÷ 0,10 x 1/4 = $635,000
C. Deferral of expenses
An entity that reports quarterly has an operating loss
carryforward of $10,000 for income tax purposes at the start of
the current financial year, for which a deferred tax asset has not
been recognized.
The entity earns $10,000 in the first quarter of the current
year and expects to earn $10,000 in each of the three
remaining quarters. Excluding the carryforward, the estimated
average annual income tax rate is expected to be 40 percent.
Tax expense for the year would be calculated as follows:
40 percent x (40,000 – 10,000 tax loss) = $12,000
The effective tax rate based on the annual earnings would then
be 30 percent (12,000 ÷ 40,000).
The question is whether the tax charge for interim financial
reporting should be based on actual or effective annual rates,
which are illustrated below:
It is a phenomenon in the business world that
some entities consistently earn more revenues in
certain interim periods of a financial year than in
other interim periods, for example, seasonal rev-
enues of retailers.
IAS 34 requires that such revenues are recog-
nized when they occur, because anticipation or
deferral would not be appropriate at the bal-
ance sheet date. Revenue of $254,000 is there-
fore reported in the first quarter.
According to IAS 34, §30(c), the interim period
income tax expense is accrued using the tax
rate that would be applicable to expected total
annual earnings, that is, the weighted average
annual effective income tax rate applied to the
pretax income of the interim period.
This is consistent with the basic concept set out
in IAS 34, §28 that the same accounting recog- | Hennie |
nition and measurement principles should be
applied in an interim financial report as are
applied in annual financial statements. Income
taxes are assessed on an annual basis. Interim
period income tax expense is calculated by
applying to an interim period’s pretax income
the tax rate that would be applicable to expect-
ed total annual earnings, that is, the weighted
average annual effective income tax rate.
This rate would reflect a blend of the progres-
sive tax rate structure expected to be applicable
to the full year’s earnings.
Income tax payable
Quarter
Actual rate
Effective rate
This particular issue is dealt with in IAS 34,
Appendix B, para. 22.
First
Second
Third
Fourth
nil*
4,000
4,000
4,000
$12,000
3,000
3,000
3,000
3,000
$12,000
* The full benefit of the tax loss carried forward is used in the first quarter.
37
Exploration for and Evaluation
of Mineral Resources (IFRS 6)
37.1
PROBLEMS ADDRESSED
This IFRS is concerned with those entities that recognize assets used in the exploration for
and evaluation of mineral resources. The key issues are the initial recognition criteria and
basis for these assets and subsequent to recognition, and the tests for impairment of such
assets in accord with IAS 36.
37.2
SCOPE OF THE STANDARD
An entity should apply this IFRS to exploration and evaluation expenditures that it incurs.
IFRS 6 is specifically concerned with the initial recognition criteria for exploration and eval-
uation expenditure, the measurement basis thereafter (cost or revaluation model) and testing
for any subsequent impairment of asset value. This Standard does not address other aspects
of accounting by entities engaged in the exploration for and evaluation of mineral resources.
An entity that has exploration and evaluation assets can test such assets for impairment on
the basis of a cash-generating unit for exploration and evaluation assets, rather than on the
basis of the cash-generating unit that might otherwise be required by IAS 36.
Entities with exploration and evaluation assets should disclose information about those
assets, the level at which such assets are assessed for impairment, and any impairment loss-
es recognized.
37.3
KEY CONCEPTS
37.3.1 A cash-generating unit is the smallest identifiable group of assets that generates
cash inflows from continuing use, and that are largely independent of the cash inflows from
other assets or groups of assets.
37.3.2 Cash-generating units for exploration and evaluation assets are the smallest iden-
tifiable group of assets that generates cash inflows from continuing use. Impairment tests
should be performed by an entity under the accounting policies applied in its most recent
annual financial statements. A cash-generating unit for exploration and evaluation assets
should be no larger than a business segment
278
Chapter 37 Exploration for and Evaluation of Mineral Resources (IFRS 6)
279
37.3.3 Exploration and evaluation assets are expenditures for exploration and evaluation
of mineral resources that are recognized as assets.
37.3.4 Exploration and evaluation expenditures are expenditures incurred by an entity in
connection with the exploration for and evaluation of mineral resources.
37.3.5 Exploration for and evaluation of mineral resources is the search for mineral
resources as well as the determination of the technical feasibility and commercial viability of
extracting the mineral resource before the decision is made to develop the mineral resource.
37.4
ACCOUNTING TREATMENT
37.4.1 Exploration and evaluation assets should be measured at cost.
37.4.2 Expenditures related to the following activities which could be included in the ini-
tial measurement of exploration and evaluation assets are
• acquisition of rights to explore;
• topographical, geological, geochemical, and geophysical studies;
• exploratory drilling;
• trenching;
• sampling; and
• activities in relation to evaluating technical feasibility and commercial viability of
extracting a mineral resource.
37.4.3 Expenditures not to be included in the initial measurement of exploration and eval- | Hennie |
uation assets are
• the development of a mineral resource once technical feasibility and commercial viabil-
ity of extracting a mineral resource have been established, and
• administration and other general overhead costs.
37.4.4 Any obligations for removal and restoration that are incurred during a particular
period as a consequence of having undertaken the exploration for and evaluation of mineral
resources is recognized in terms of IAS 37.
37.4.5 After recognition, an entity should apply either the cost model or the revaluation
model to its exploration and evaluation assets (IAS 16 and IAS 38 contain the key concepts
that relate to cost, fair value, carrying value, and the impairment of assets).
37.4.6 An entity that has recognized exploration and evaluation assets should assess those
assets for impairment annually, and should recognize any resulting impairment loss in
accordance with IAS 36 (conditional exemption available at first application). Impairment
might be indicated by the following:
• The period for which the entity has the right to explore in the specific area has expired
during the period or will expire in the near future, and is not expected to be renewed.
• Further exploration for and evaluation of mineral resources in the specific area are nei-
ther budgeted nor planned for in the near future.
• Significant changes with an adverse effect on the main assumptions, including prices
and foreign exchange rates, underlying approved budgets, or plans for further explo-
ration for and evaluation of mineral resources in the specific area.
• The decision not to develop the mineral resource in the specific area has been made.
279
280
Chapter 37 Exploration for and Evaluation of Mineral Resources (IFRS 6)
• The entity plans to dispose of the asset at an unfavorable price.
• The entity does not expect the recognized exploration and evaluation assets to be rea-
sonably capable of being recoverable from a successful development of the specific
area, or by its sale.
37.5
PRESENTATION AND DISCLOSURE
37.5.1 An entity should disclose information that identifies and explains the amounts rec-
ognized in its financial statements that arise from the exploration for and evaluation of min-
eral resources.
37.5.2 An entity should also disclose
• its accounting policies for exploration and evaluation expenditures;
• its accounting policies for the recognition of exploration and evaluation assets;
• the amounts of assets, liabilities, income, and expense (and, if it presents its cash flow
statement using the direct method), cash flows arising from the exploration for and
evaluation of mineral resources; and
• the level at which the entity assesses exploration and evaluation assets for impairment.
37.6
FINANCIAL ANALYSIS AND INTERPRETATION
37.6.1 The allocation of the original cost of acquiring and developing natural resources
over time is called depletion (and is similar to depreciation).
37.6.2 Depletion is the means of expensing the costs incurred in acquiring and developing
natural resources. When depletion is accounted for using the units of production method, the
formula would appear as follows:
Depletion Rate =
Capitalized Cost of the Natural Resource Asset
Estimated Number of Extractable Units
37.6.3 If, for example, a company buys oil and mineral rights for $5 million on a property
that is believed to contain 2 million barrels of extractable oil, every barrel of oil extracted from
the property causes $2.50 of depletion to be recorded as an expense on the income statement,
until the $5 million is written off. The depletion rate is therefore:
Depletion Rate =
$5,000,000
2,000,000 bbls.
= $2.50/bbl.
37.6.4 Companies in some accounting jurisdictions might choose to capitalize only those
costs that are associated with a successful discovery of a natural resource. Costs associated
with unsuccessful efforts (that is, when the natural resources sought are not found) are
expensed against income. This could be in line with §37.4.2 above, with the exception that an | Hennie |
impairment test should determine which costs are not recoverable through depletion (depre-
ciation). This is the more conservative method of accounting for acquisition and develop-
ment costs, because it usually results in higher expenses and lower profits.
37.6.5 A company might buy, for example, oil and mineral rights on two properties for $6 mil-
lion and $4 million, respectively. Ultimately, the company finds no oil on the first property, and
finds that the second property contains an estimated 2 million barrels of oil. Under the suc-
cessful efforts method, the accounting is as follows:
Chapter 37 Exploration for and Evaluation of Mineral Resources (IFRS 6)
281
• At the time property rights are purchased:
Oil & Mineral Rights (Balance Sheet Asset)
Cash
10,000,000
10,000,000
Dr
Cr
• At the time when the first property is found to contain no oil, its cost is written off and
the loss is taken immediately:
Loss on Oil & Mineral Rights (Income Statement)
Oil & Mineral Rights (Balance Sheet)
Dr
6,000,000
Cr
6,000,000
37.6.6 Suppose, during the next year, 300,000 barrels of oil are extracted from the second
property. This process is repeated every year until the balance sheet natural resource asset,
Oil & Mineral Rights, is written down to zero:
Depletion Expense (Income Statement)
Oil & Mineral Rights (Balance Sheet)
Dr*
600,000
Cr
600,000
*Depletion
Expense
$4,000,000
= (2,000,000 bbls) (300,000 bbls) = $600,000
37.6.7 Larger firms are more likely to expense as many costs as possible because:
• They tend to hold reported earnings down, thereby making the firm less vulnerable to
taxes and to political charges of earning windfall profits.
• The earnings volatility associated with this method is less harmful to large firms that
engage in many more activities than just exploration.
• The negative impact on earnings is not severe for integrated oil companies that make
substantial profits from marketing and refining activities, rather than just exploration
activities.
282
Chapter 37 Exploration for and Evaluation of Mineral Resources (IFRS 6)
EXAMPLES: MINERAL RESOURCES
EXAMPLE 37.1
Rybak Petroleum purchases an oil well for $100 million. It estimates that the well contains
250 million barrels of oil. The oil well has no salvage value. If the company extracts and sells
10,000 barrels of oil during the first year, how much depletion expense should be recorded?
a. $4,000
b. $10,000
c. $25,000
d. $250,000
EXPLANATION
Choice a. is correct. Depletion expense is:
Depletion Rate =
Current period production
Total barrels of production
=
10,000
250,000,000
= .00004
Depletion expense = Purchase price ¥ Depletion rate
= 100,000,000 ¥ .00004
= $4,000
Choice b. is incorrect. The choice incorrectly uses the depletion rate multiplied by the total
barrels of oil in the well rather than the depletion rate multiplied by purchase price.
Choice c. is incorrect. The choice incorrectly divides current production of 10,000 barrels
divided by the purchase price, then multiplies this incorrect depletion rate by the total num-
ber of barrels of oil in the well.
Choice d. is incorrect. The choice incorrectly assumes a 0.001 depletion rate multiplied by the
total number of barrels of oil in the well.
Chapter 37 Exploration for and Evaluation of Mineral Resources (IFRS 6)
283
EXAMPLE 37.2
SunClair Exploration, Inc has just purchased new offshore oil drilling equipment for $35 mil-
lion. The company’s engineers estimate that the new equipment will produce 400 million
barrels of oil over its estimated 15-year life, and have an estimated parts salvage value of
$500,000. Assuming that the oil drilling equipment produced 22 million barrels of oil during
its first year of production, what amount will the company record as depreciation expense
for this equipment in the initial year using the units-of-production method of depreciation?
a. $2,300,000
b. $1,897,500
c. $1,925,000
d. $2,333,333
EXPLANATION 2
Choice b. is correct. Depreciation expense using units-of-production method is:
Depreciation rate
per unit
=
=
| Hennie |
(Original Cost – Salvage value)
Est. production over useful life
($35,000,000 – $500,000)
400,000,000 barrels
= .0863
Depreciation
Expense
= Depreciation rate ¥ Units produced
= .0863 ¥ 22,000,000
= $1,897,500
Choice a. is incorrect. Units produced were multiplied by a useful life of 15 years, and incor-
rectly used as the denominator of the depreciation rate calculation, rather than using the esti-
mated 400 million-barrel estimated production over the useful life.
Choice c. is incorrect. This choice fails to subtract salvage value from original cost in the
depreciation rate per unit calculation.
Choice d. is incorrect. This choice fails to subtract salvage value from the original cost in the
depreciation rate per unit calculation, and incorrectly multiplies units produced by a useful
life of 15 years as the denominator of the depreciation rate calculation.
38
Financial Instruments:
Disclosures (IFRS 7)
38.1
PROBLEMS ADDRESSED
Users of financial statements need information about an entity’s exposure to risks and how
those risks are managed. Such information can influence a user’s assessment of the financial
position and financial performance of an entity or of the amount, timing and uncertainty of
its future cash flows. Greater transparency regarding those risks allows users to make more
informed judgements about risk and return.
The objective of IFRS 7 is to require entities to provide disclosures in their financial state-
ments that enable users to evaluate the significance of financial instruments for the entity’s
financial position and performance. Entities should describe the nature and extent of risks
arising from financial instruments to which they are exposed during the period under review
and at the reporting date, and how they manage those risks.
38.2
SCOPE OF THE STANDARD
IFRS 7 applies to all entities and for all risks arising from all financial instruments, whether
recognized or unrecognized (for example, instruments falling outside the direct scope of IAS
39, such as some loan commitments), except:
• interests in subsidiaries, associates and joint ventures (IAS 27, 28 and 31)
• employers’ rights and obligations arising from employee benefit plans (IAS 19)
• contracts for contingent consideration in a business combination (IFRS 3)
• insurance contracts as defined in IFRS 4 Insurance Contracts (except for derivatives that
are embedded in insurance contracts if IAS 39 requires the entity to account for them
separately).
The IFRS requires disclosure of the:
• significance of financial instruments for an entity’s financial position and performance
(four classes of financial assets —namely assets held at fair value through profit and
loss, assets available for sale, assets held to maturity, and loans and receivables; and
two classes of financial liabilities—those at fair value and liabilities shown at amortized
cost);
• carrying values of financial assets and financial liabilities;
• nature and extent of the risks exposures arising from financial instruments used by the
entity;
284
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
285
• qualitative and quantitative information about exposure to risks arising from financial
instruments (credit risk, liquidity risk and market risk);
• management’s objectives, policies and processes for managing those risks.
38.3
KEY CONCEPTS
38.3.1 Four classes of financial assets. Assets carried at fair value through profit and loss;
held-to-maturity securities; available for sale securities; and loans and receivables.
38.3.2 Two classes of financial liabilities. Liabilities carried at fair value through profit
and loss, and liabilities measured at amortized cost (see also Chapter 25).
38.3.3 Classes of financial instruments. Financial instruments must be grouped into class-
es that:
• are appropriate to the nature of the information disclosed
• take into account the characteristics of those financial instruments
38.3.4 Reconciliations. Sufficient information must be provided to enable reconciliations | Hennie |
with items presented in the balance sheet.
38.4
ACCOUNTING TREATMENT / DISCLOSURE OVERVIEW
38.4.1 Macro view of disclosure requirements (table 38.1). IFRS 7 requires a determination
of the significance of key disclosures, as well as the financial instruments affected, for the
financial position and performance of an entity. In addition, the nature and extent of risks
arising from financial instruments is required, both from a qualitative and a quantitative
viewpoint.
Table 38.1 Information to be Disclosed and Financial Instruments Affected
A. Determination of Significance for Financial Position and Performance
A1. Balance Sheet
A2. Income Statement and Equity
A3. Other Disclosures – accounting policies, hedge accounting and fair value
B. Nature and Extent of Risks Arising from Financial Instruments
B1. Qualitative disclosures (nature and how arising)—not necessarily by instrument
B2. Quantitative disclosures
286
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
38.4.2 Overview of balance sheet disclosure (see table 38.2). The carrying values of all
financial assets and liabilities must be disclosed. The broad categories of balance sheet dis-
closures relate to credit risk and related collateral issues, recognition and reclassification
issues, liabilities with embedded options; and loans payable, but in default.
Table 38.2 Overview of Balance Sheet Disclosures
Information to be Disclosed
Financial Instruments Affected
Carrying Values
Credit Risk
Reclassification
Derecognition—Transfers of Assets not
Qualifying
Collateral given or held
Allowance for credit losses—impairments in
a separate account
Structured liabilities with equity components—
using interdependent multiple embedded
derivatives
Loans payable—defaults and breaches
All financial assets and financial liabilities
Loans and Receivables at Fair Value—
Liabilities at Fair Value
All financial assets
All financial assets
Financial assets pledged and Pledged
assets received
Financial assets impaired—per class
Financial liabilities with multiple
embedded derivatives
Loans payable—currently in default
38.4.3 Overview of income statement disclosure. Income statement disclosures focus on
net gains and losses on financial assets and liabilities, with a split between the different class-
es of assets and liabilities—to enable the reader to distinguish between designated fair value
financial instruments, amortized instruments and traded fair value instruments.
Table 38.3 Overview of Income Statement Disclosure
Information to be Disclosed
Financial Instruments Affected
Net gains and losses
Net gains and losses
Trading financial assets
and liabilities held at fair
value through profit or loss
Designated financial assets
and liabilities held at fair value
through profit or loss
All other financial assets not measured at fair value and
financial liabilities measured at amortized cost (neither at fair
value through profit and loss)
Net gains and losses—amounts
recognized and amounts
removed from equity to be
separated
Total interest income and total
interest expense—using
effective interest rate method
Available for sale financial assets
Financial assets not measured at fair value and financial
liabilities measured at amortized cost (neither at fair value
through profit and loss)
38.4.4 Overview of other disclosure types. IFRS 7 also requires that the annual financial
statements provide information regarding the accounting policies and measurement bases
used when preparing those financial statements, in addition to detailed disclosure regarding
hedge accounting for all hedge types; and fair value information in respect of all classes of
financial assets and financial liabilities.
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
287
38.4.5 Overview of disclosure of nature and extent of risks arising from financial instru-
ments. Once the preparer of financial statements has complied with balance sheet and
income statement disclosures, the user has to be provided with qualitative and quantitative | Hennie |
information regarding the different types of risks arising from all financial instruments, as
well as specific quantitative information with regard to credit, liquidity and market risks.
Table 38.4 Nature and Extent of Risks Arising from Financial Instruments
Information to be Disclosed
Financial Instruments Affected
Qualitative disclosures (nature and how
arising)—not necessarily by instrument
Quantitative disclosures
Credit Risk
Liquidity risk
Market Risk
Each type of risk arising from all financial
assets and financial liabilities
Each type of risk arising from all financial
assets and financial liabilities
Financial assets and financial liabilities—
per class
All financial liabilities
Each type of market risk arising from all
financial assets and financial liabilities
38.5
DISCLOSURE—DETAILED/MICRO VIEW
38.5.1 Credit risk on the balance sheet. The credit risk related to loans and receivables as
well as liabilities, both measured at fair value, must be disclosed.
For loans and receivables designated at fair value through profit and loss, disclose:
• Maximum exposure to credit risk
• Mitigation by using credit derivatives
• The change in fair value attributable to credit risk (not market risk events) as well as
the methods used to achieve this specific credit risk disclosure
• The change in the fair value of credit derivatives – for the current period and cumula-
tively since loan was designated at fair value.
For liabilities at fair value, disclose:
• The change in fair value attributable to credit risk (not market risk events) as well as
the methods used to achieve this specific credit risk disclosure
• The difference between the current carrying amount and the required contractual pay-
ment when the liability matures.
38.5.2 Reclassification of balance sheet items. Reclassification of balance sheet items must
be disclosed for all financial assets when items are reclassified
• between cost, amortized cost or fair value
• out of fair value and the reason therefore
• into fair value and the reason therefore.
288
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
38.5.3 Derecognition of balance sheet items. All transfers of assets not qualifying must be
identified as follows:
• The nature of assets transferred which do not qualify for derecognition (for example,
certain special-purpose vehicles for asset-backed securities)
• The nature of the risks/rewards still exposed
• The carrying amount of assets still recognized; disclose the original total and associated
liabilities
38.5.4 Collateral related to items on the balance sheet. The following has to be disclosed:
• Collateral given or held for financial assets pledged and pledged assets received
• For financial assets pledged, the
• carrying amount of assets pledged
• terms and conditions of assets pledged
• For financial assets received as a pledge and available to be sold, the
• fair value of collateral held if available to be sold or repledged (even if owner does
not default)
• fair value of collateral sold or repledged and whether there is any obligation to
return the collateral at the contract maturity
• terms and conditions for the use of collateral
38.5.5 Allowance for credit losses on the balance sheet. Reconciliation of changes during
period should be provided for all financial assets impaired per class of asset.
38.5.6 Embedded options in the balance sheet (Structured liabilities with equity compo-
nents - using interdependent multiple embedded derivatives). Disclose the existence of fea-
tures and interdependencies for all financial liabilities with multiple embedded derivatives.
38.5.7 Loans payable in default. For loans payable, where loans are in default or condi-
tions have been breached, disclose:
• The carrying amount of such liabilities
• Details related to the principal, interest, sinking fund or redemption terms
• Any remedy of default or renegotiation of loan terms which had taken place prior to
the issue of the financial statements.
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
289
38.5.8 Hedge accounting in the financial statements. The types of hedges and risks relat- | Hennie |
ed to hedging activities must be disclosed as follows per table 38.5:
Table 38.5 Disclosure of Hedging Activities
Information to be Disclosed
Financial Instruments Affected
Description of each type of hedge
Description of financial instruments designated
as hedging instruments
Fair value of financial instruments designated as
hedging instruments
Periods when cash flows will occur—when
impact on profit and loss is expected
Description of forecast transactions where hedge
accounting previously used—no longer expected
to occur
Amount recognized in equity during the period
Amount removed from equity into profit and
loss—per income statement line item
Amount removed from equity into intial cost/
carrying amount of forecast hedged
non-financial instrument
Ineffectiveness recognized in profit and loss
Gains or losses on hedging instrument
Gains or losses on hedged item attributable
to the hedged risk
Ineffectiveness recognized in profit and loss
All hedge types
Financial instruments used as hedging
instruments
Cash flow hedges
Fair value hedges
Hedges of net investments in foreign
operations
38.5.9 Fair value disclosure in the financial statements. For all classes of financial assets
and financial liabilities, the following fair value financial information has to be disclosed:
• Information that is reconcilable with corresponding amounts in the balance sheet
• Methods and valuation techniques used - market price reference if used
• Valuation techniques using assumptions not supported by observable/quoted market
prices as well as the change in fair value recognized in profit and loss, using this technique
• Effects of reasonable/possible alternatives for assumptions used in valuation tech-
niques
• Carrying amounts and descriptions where fair value not used, including the reasons
why not used, the market for such instruments and how disposals might occur
• Carrying amount and profit and loss on derecognition of instruments whose fair value
could not be measured reliably
Fair value need not be disclosed where the carrying value is a reasonable approximation of
fair value (eg short-term trade receivables/payables, equities shown at cost per IAS 39, cer-
tain IFRS 4 discretionary participation contracts). However, sufficient information for users
to make their own judgements, should be disclosed.
38.5.10 Nature and extent of risks arising from financial instruments – qualitative dis-
closures. Qualitative disclosures (nature and how arising) does not necessarily have to be
provided by instrument. However, each type of risk arising from all financial assets and
financial liabilities, must be discussed as follows:
290
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
• The exposure to risk and how risks arise
• The objectives, policies and processes to manage risk as well as any changes in risk
management processes from the previous period.
• The methods used to measure risk as well as any changes in risk measurement processes
from the previous period.
38.5.11 Quantitative disclosures. For each type of risk arising from all financial assets and
financial liabilities, provide:
• Summary quantitative data as supplied internally to key management personnel
• Detail of all risk concentrations
• Further information if data provided is not representative of the risk during period
• Credit , liquidity and market risk information (specified below), where material.
38.5.12 Credit risk—quantitative disclosures. The maximum exposure (ignore collateral
or netting outside IAS 32—credit enhancements) to credit risk must be provided for each
class of financial asset and financial liability. In addition, the following information must be
provided for each class of financial asset:
• A description of any collateral held
• Information regarding the credit quality of financial assets which are neither past due
nor impaired
• The carrying value of assets renegotiated
• An age analysis of past due (but not impaired) items. Include the fair value of any col-
lateral held
• Analysis of impaired items - including any factors considered in determining the
| Hennie |
impairment as well as the fair value of collateral
• A discussion of the nature and carrying value of collateral acquired and recognized
(able). Include the policies for disposal or usage of collateral.
38.5.13 Liquidity risk—quantitative disclosures. For all financial liabilities, the following
must be provided:
• An analysis of remaining contractual maturities
• A description of the management of inherent liquidity risk.
38.5.14 Market risk—quantitative disclosures. For each type of market risk arising from all
financial assets and financial liabilities, disclose:
• Sensitivity analysis, including the impact on income and equity. Value-at-risk (VAR)
may be used, as long as objectives and key parameters are disclosed.
• Methods and assumptions used for sensitivity analysis—as well as changes from the
previous period.
• Further information if data provided is not representative of risk during the period.
38.6
FINANCIAL ANALYSIS AND INTERPRETATION
38.6.1 Historically, generally accepted accounting practices (GAAP) did not place heavy
burdens of disclosure of financial risk management practices. This situation changed in the
1990s with the introduction of IAS 30 (scrapped with introduction of IFRS 7) and IAS 32 (dis-
closure requirements transferred to IFRS 7). These Standards, which are now largely super-
seded by IFRS 7, resulted in the requirement on the part of many financial regulators to adopt
a “full disclosure” approach. IAS 30 encouraged management to comment on financial state-
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
291
ments describing the way liquidity, solvency, and other risks associated with the operations
of a bank were managed and controlled.
38.6.2 Users need information to assist them with their evaluation of an entity’s financial
position, financial performance, and risk management, so that they are in a position to make
economic decisions (based on their evaluation). Of key importance are a realistic valuation of
assets, including sensitivities to future events and adverse developments, and the proper
recognition of income and expenses. Equally important is the evaluation of the entire risk
profile, including on- and off-balance-sheet items, capital adequacy, the capacity to withstand
short-term problems, and the ability to generate additional capital.
38.6.3 Market participants also need information that enhances their understanding of the
significance of on- and off-balance-sheet financial instruments to an entity’s financial posi-
tion, performance, and cash flows. This information is necessary to assess the amounts, tim-
ing, and certainty of future cash flows associated with such instruments. For several years,
but especially in the wake of the East Asia financial crises of the late 1990s, criticism has been
voiced regarding deficiencies in accounting practices that have resulted in the incomplete
and inadequate presentation of risk-based financial information in annual financial reports.
Market participants perceived the opacity of financial information as not only an official
oversight, but also as the Achilles heel of effective corporate governance and market disci-
pline.
38.6.4 Disclosure is an effective mechanism to expose financial risk management practices
to market discipline and should be sufficiently comprehensive to meet the needs of users
within the constraints of what can reasonably be required. Improved transparency through
better disclosure can reduce (but does not necessarily reduce) the chances of a systemic finan-
cial crisis or the effects of contagion, because creditors and other market participants will be
better able to distinguish between the financial circumstances that face different institutions
or countries.
38.6.5 Lastly, disclosure requirements should be accompanied by active regulatory enforce-
ment—and perhaps even fraud laws—to ensure that the information disclosed is complete,
timely, and not deliberately misleading. Regulatory institutions should also have adequate | Hennie |
enforcement capacities. IFRS 7 aims to rectify some of the remaining gaps in financial risk
disclosure by adding the following requirements to the existing accounting standards:
• New disclosure requirements in respect of loans and receivables designated as fair
value through profit or loss.
• Disclosure the amount of the change in the financial liability’s fair value that is not
attributable to changes in market conditions
• The method used to determine the effects of the changes from a benchmark interest
rate.
• Where an impairment of a financial asset is recorded through an allowance account (for
example, a provision for doubtful debts as opposed to a direct reduction to the carrying
amount of the receivable), a reconciliation of changes in carrying amounts in that
account during the period, for each class of financial asset, should be disclosed.
• The amount of ineffectiveness recognized in profit or loss on cash flow hedges and
hedges of net investments.
• Gains or losses in fair value hedges arising from remeasuring the hedging instrument
and on the hedged item attributable to the hedged risk.
• The net gain or loss on ‘held-to-maturity investments’, ‘loans and receivables’ and
‘financial liabilities measured at amortized cost’.
292
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
38.6.6 Summary of the information to be disclosed and the financial instruments affected
by such disclosure, is included in table 38.6 below.
Table 38.6 IFRS 7—Information to be Disclosed and Financial Instruments Affected
A. Determination of Significance for Financial Position and Performance
Carrying Values
Credit Risk
Maximum exposure to credit risk
Mitigation by using credit derivatives
Balance Sheet
All financial assets and financial liabilities
Loans and receivables
designated at fair value
through profit and loss
Change in fair value attributable to credit risk (not market
risk events). Methods used to achieve this specific credit
risk disclosure
Fair value change of credit derivatives—current period and
cumulatively since loan was designated
Difference—carrying amount and required contractual
payment at maturity
Reclassification
Reclassification between cost; amortized cost and fair value
Reclassified out of fair value and the reason therefore
Reclassified into fair value and the reason therefore
Derecognition—Transfers of Assets not Qualifying
Nature of assets transferred which do not qualify for
derecognition (certain special-purpose vehicles for
asset-backed securities)
Nature—risks/rewards still exposed
Carrying amount of assets still recognized; disclose
as original total and associated liabilities
Collateral given of held
Carrying amount of assets pledged
Terms and conditions of assets pledged
Fair value of collateral held if available to be sold or repledged
(even if owner does not default)
Fair value of collateral sold or repledged—obligation to return?
Terms and conditions for use of collateral
Allowance for credit losses—impairments in a
separate account
Liabilities at fair value
Liabilities at fair value
All financial assets
All financial assets
Financial assets pledged
Financial assets received as a pledge and available to be
sold
Reconciliation of changes during period
Financial assets impaired—per class
Structured liabilities with equity components—using
interdependent multiple embedded derivatives
Disclose existence of features and interdependencies
Loans payable—defaults and breaches
Carrying amount
Details of principal, interest, sinking fund or
redemption terms
Any remedy of default, renegotiation of loan terms
prior to issue of financial statements
Financial liabilities with multiple embedded derivatives
Loans payable in default
Continued on next page
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
293
Income Statement and Equity
Net gains and losses
Net gains and losses—amounts recognized and amounts
removed from equity to be shown separately
Net gains and losses
Total interest income and total interest expense—using
effective interest rate method
Trading financial assets
through profit or loss / | Hennie |
fair value through profit or loss
Designated financial assets
and liabilities held at fair
Available for sale financial assets
All other financial assets not measured at fair value and
financial liabilities measured at amortized cost (neither
at fair value through profit and loss)
Financial assets not measured at fair value and financial
liabilities measured at amortized cost (neither at fair
value through profit and loss)
1. Accounting policies—measurement basis used in
preparing financial statements
2. Hedge accounting (types of hedges and risks)
Other Disclosures—3 types
Annual Financial Statements
All hedge types
Description of each type of hedge
Description of financial instruments designated as
hedging instruments
Fair value of financial instruments designated
as hedging instruments
Periods when cash flows will occur—when impact
on profit and loss is expected
Description of forecast transactions where hedge
accounting previously used—no longer expected to occur
Amount recognized in equity during the period
Amount removed from equity into profit and loss—
per income statement line item
Amount removed from equity into intial cost/carrying
amount of forecast hedged non-financial instrument
Ineffectiveness recognized in profit and loss
Gains or losses on hedging instrument
Gains or losses on hedged item attributable to the
hedged risk
Ineffectiveness recognized in profit and loss
3. Fair value
Disclosure reconcilable with corresponding amount
in the balance sheet
Methods and valuation techniques used—market price
reference if used
Valuation techniques using assumptions not supported
by observable/quoted market prices—change in fair
value recognized in profit and loss using this technique
Effects of reasonable/possible alternatives for assumptions
used in valuation techniques
Carrying amounts and descriptions where fair value
not used—include reasons why not used, the market
for such instruments and how disposals might occur
Financial instruments used as hedging instruments
Cash flow hedges
Fair value hedges
Hedges of net investments in foreign operations
All financial assets and financial liabilities—per class
Continued on next page
294
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
Carrying amount and profit and loss on derecognition
of instruments whose fair value could not be
measured reliably
Fair value need not be disclosed where carrying value
is reasonable approximation of fair value (e.g., short-term
trade receivables/payables, equities shown at cost
per IAS 39, certain IFRS 4 discretionary participation
contracts)—disclose sufficient information for users to
make own judgments
B. Nature and Extent of Risks Arising from Financial Instruments
Qualitative disclosures (nature and how arising)—not
necessarily by instrument
Exposure to risk and how risks arise
Objectives, policies, processes to manage risk—changes
from previous period
Each type of risk arising from all financial assets and
financial liabilities
Methods used to measure risk—changes from
previous period
Quantitative disclosures
Summary quantitative data as supplied internally to
key management personnel
Risk concentrations
Further information if data provided is not representative
of risk during period
Credit, liquidity and market risk information as below,
where material
Credit Risk
Maximum exposure (ignore collateral or netting
outside IAS 32—credit enhancements)
Description of collateral held
Information regarding credit quality of financial assets—
not past due nor impaired
Carrying value of assets renegotiated
Age analysis of past due (but not impaired) items—
fair value of collateral
Analysis of impaired items—including factors considered
in determining impairment—fair value of collateral
Nature and carrying value of collateral acquired and
recognized (able)—policies for disposal or usage
Liquidity risk
Analysis of remaining contractual maturities
Description of management of inherent liquidity risk
Market Risk
Sensitivity analysis including the impact on income and
equity (may use value-at-risk: VAR, disclose objectives and | Hennie |
key parameters)
Each type of risk arising from all financial assets and
financial liabilities
All financial assets and financial liabilities—per class
All financial assets—per class
All financial liabilities
Methods and assumptions used for sensitivity
analysis—changes from previous period
Each type of market risk arising from all financial assets
and financial liabilities
Further information if data provided is not representative
of risk during period
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
295
EXAMPLES: FINANCIAL INSTRUMENTS: DISCLOSURE AND PRESENTATION
The following extracts were taken from The World Bank Annual Report 2003.
EXAMPLE 38.1
LIQUIDITY MANAGEMENT
IBRD’s liquid assets are held principally in obligations of governments and other official entities, time
deposits and other unconditional obligations of banks and financial institutions, currency and interest
rate swaps, asset-backed securities, and futures and options contracts pertaining to such obligations.
Liquidity risk arises in the general funding of IBRD’s activities and in the management of its financial
positions. It includes the risk of being unable to fund its portfolio of assets at appropriate maturities
and rates and the risk of being unable to liquidate a position in a timely manner at a reasonable price.
The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of
IBRD’s financial commitments.
Under IBRD’s liquidity management policy, aggregate liquid asset holdings should be kept at or
above a specified prudential minimum. That minimum is equal to the highest consecutive six months
of expected debt service obligations for the fiscal year, plus one-half of net approved loan disburse-
ments as projected for the fiscal year. The FY 2004 prudential minimum liquidity level has been set at
$18 billion, unchanged from that set for FY 2003. IBRD also holds liquid assets over the specified min-
imum to provide flexibility in timing its borrowing transactions and to meet working capital needs.
• Liquid assets may be held in three distinct subportfolios: stable; operational; and discretionary,
each with different risk profiles and performance benchmarks.
• The stable portfolio is principally an investment portfolio holding the prudential minimum level of
liquidity, which is set at the beginning of each fiscal year.
• The operational portfolio provides working capital for IBRD’s day-to-day cash flow requirements.
FINANCIAL RISK MANAGEMENT
IBRD assumes various kinds of risk in the process of providing development banking services. Its activ-
ities can give rise to four major types of financial risk: credit risk; market risk (interest rate and exchange
rate); liquidity risk; and operational risk. The major inherent risk to IBRD is country credit risk, or loan
portfolio risk.
Governance Structure
The risk management governance structure includes a Risk Management Secretariat supporting the
Management Committee in its oversight function. The Risk Management Secretariat was established in
FY 2002 to support the Management Committee, particularly in the coordination of different aspects
of risk management, and in connection with risks that cut across functional areas.
For financial risk management, there is an Asset/Liability Management Committee chaired by the
Chief Financial Officer. The Asset/Liability Management Committee makes recommendations in the
areas of financial policy, the adequacy and allocation of risk capital, and oversight of financial report-
ing. Two subcommittees that report to the Asset/Liability Management Committee are the Market Risk
and Currency Management Subcommittee and the Credit Risk Subcommittee.
The Market Risk and Currency Management Subcommittee develops and monitors the policies
under which market and commercial credit risks faced by IBRD are measured, reported and managed.
The subcommittee also monitors compliance with policies governing commercial credit exposure and | Hennie |
currency management. Specific areas of activity include establishing guidelines for limiting balance
sheet and market risks, the use of derivative instruments, setting investment guidelines, and monitor-
ing matches between assets and their funding. The Credit Risk Subcommittee monitors the measure-
ment and reporting of country credit risk and reviews the impact on the provision for losses on loans
and guarantees of any changes in risk ratings of borrowing member countries or movements between
the accrual and nonaccrual portfolios.
Country credit risk, the primary risk faced by IBRD, is identified, measured and monitored by the
Country Credit Risk Department, led by the Chief Credit Officer. This unit is independent from IBRD's
Continued on next page
296
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
business units. In addition to continuously reviewing the creditworthiness of IBRD borrowers, this
department is responsible for assessing loan portfolio risk, determining the adequacy of provisions for
losses on loans and guarantees, and monitoring borrowers that are vulnerable to crises in the near term.
Market risks, liquidity risks and counterparty credit risks in IBRD's financial operations are identified,
measured and monitored by the Corporate Finance Department, which is independent from IBRD's
business units. The Corporate Finance Department works with IBRD's financial managers, who are
responsible for the day-to-day management of these risks, to establish and document processes that
facilitate, control and monitor risk. These processes are built on a foundation of initial identification and
measurement of risks by each of the business units.
The processes and procedures by which IBRD manages its risk profile continually evolve as its activ-
ities change in response to market, credit, product, and other developments. The Executive Directors,
particularly the Audit Committee members, periodically review trends in IBRD's risk profiles and per-
formance, as well as any significant developments in risk management policies and controls.
Market Risk
IBRD faces risks which result from market movements, primarily interest and exchange rates. In com-
parison to country credit risk, IBRD’s exposure to market risks is small. IBRD has an integrated asset/lia-
bility management framework to flexibly assess and hedge market risks associated with the character-
istics of the products in IBRD’s portfolios.
Asset/Liability Management
The objective of asset/liability management for IBRD is to ensure adequate funding for each product at
the most attractive available cost, and to manage the currency composition, maturity profile and inter-
est rate sensitivity characteristics of the portfolio of liabilities supporting each lending product in accor-
dance with the particular requirements for that product and within prescribed risk parameters. The cur-
rent value information is used in the asset/liability management process.
Use of Derivatives
As part of its asset/liability management process, IBRD employs derivatives to manage and align the
characteristics of its assets and liabilities. IBRD uses derivative instruments to adjust the interest rate
repricing characteristics of specific balance sheet assets and liabilities, or groups of assets and liabilities
with similar repricing characteristics, and to modify the currency composition of net assets and liabili-
ties. Table 14 details the current value information of each loan product, the liquid asset portfolio, and
the debt allocated to fund these assets.
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
297
Table 14: Financial Instrument Portfolios
In millions of U.S. dollars
At June 30, 2003
At June 30, 2002
Carrying
Value
Contractual
Yield
Current
Value
Mark
Carrying
Value
Contractual
Yield
$116,240
4.09%
$6,353
$121,589
5.06%
22,728
20,490
36,424
4.62
6.95
1.62
2,447
1,682
44
28,076
25,585
33,031
5.03
8.12
2.44
15,315
6.45
1,756
15,873
6.59
8,454
12,414
415
3.33
3.18
7.92
8
401
15
11,505
7,017
502
4.22
4.00
7.86
Current
Value
Mark
$4,865
1,766
1,987
54
969
15
57
17
Loansª | Hennie |
Variable-Rate Multicurrency
Pool Loans
Single Currency Pool Loans
Variable-Spread Loans
Fixed Rate Single Currency
Loans
Special Structural and Sector
Adjustment Loans
Fixed-Spread Loans
Other Fixed Rate Loans
Liquid Asset Portfolioe,f
$26,423
1.35%
$24,886
2.11%
Borrowings (including
swaps)e
Variable-Rate Multicurrency
Pools
Single Currency Pools
Variable-Spread
Fixed-Rate Single Currency
Special Structural and Sector
Adjustment
Fixed-Spread
Other Debt
$107,845
2.75%
$4,946
$114,261
3.61%
$3,499
13,615
12,857
25,151
12,400
8,012
7,146
28,664
3.96
5.68
1.05
6.13
1.04
2.61
1.42
2,624
1,046
(186)
1,451
(22)
133
(100)
17,875
16,996
22,106
13,727
11,916
5,055
26,586
4.09
7.03
1.96
5.83
1.79
3.13
2.27
1,780
1,260
(229)
774
(74)
(85)
73
a. Contractual yield is presented before the application of interest waivers.
b. Excludes fixed-rate single currency pool loans, which have been classified in other fixed-rate loans.
c. Includes fixed-rate single currency loans for which the rate had not yet been fixed at fiscal year-end.
d. Includes loans with non-standard terms.
e. Carrying amounts and contractual yields are on a basis which includes accrued interest and any unamortized
amounts, but does not include the effects of applying FAS 133.
f. The liquid asset portfolio is carried and reported at market value and excludes investment assets associated with
certain other postemployment benefits.
g. Includes amounts not yet allocated at June 30, 2003 and June 30, 2002.
Interest Rate Risk
There are two main sources of potential interest rate risk to IBRD. The first is the interest rate sensitivi-
ty associated with the net spread between the rate IBRD earns on its assets and the cost of borrowings,
which fund those assets. The second is the interest rate sensitivity of the income earned from funding
a portion of IBRD assets with equity. In general, lower nominal interest rates result in lower lending rates
which, in turn, reduce the nominal earnings on IBRD’s equity. In addition, as the loan portfolio shifts
from pool loans to LIBOR based loans, the sensitivity of IBRD's income to changes in market interest
rates will increase.
298
Chapter 38 Financial Instruments: Disclosures (IFRS 7)
Exchange Rate Risk
In order to minimize exchange rate risk in a multicurrency environment, IBRD matches its borrowing
obligations in any one currency (after swap activities) with assets in the same currency, as prescribed
by the Articles. In addition, IBRD’s policy is to minimize the exchange rate sensitivity of its equity-to-
loans ratio. It carries out this policy by undertaking currency conversions periodically to align the cur-
rency composition of its equity to that of its outstanding loans. This policy is designed to minimize the
impact of market rate fluctuations on the equity-to-loans ratio, thereby preserving IBRD’s ability to
better absorb potential losses from arrears regardless of the market environment.
Operational Risk
Operational risk is the potential for loss resulting from inadequate or failed internal processes or sys-
tems, human factors, or external events, and includes business disruption and system failure, transac-
tion processing failures and failures in execution of legal, fiduciary and agency responsibilities. IBRD,
like all financial institutions, is exposed to many types of operational risks. IBRD attempts to mitigate
operational risk by maintaining a system of internal controls that is designed to keep that risk at appro-
priate levels in view of the financial strength of IBRD and the characteristics of the activities and mar-
kets in which IBRD operates.
Fair Value of Financial Instruments
Under the current value basis of reporting, IBRD carries all of its financial assets and liabilities at esti-
mated values. Under the reported basis, IBRD carries its investments and derivatives, as defined by FAS
133, on a fair value basis. These derivatives include certain features in debt instruments that, for
accounting purposes, are separately valued and accounted for as either assets or liabilities. When pos-
sible, fair value is determined by quoted market prices. If quoted market prices are not available, then | Hennie |
fair value is based on discounted cash flow models using market estimates of cash flows and discount
rates.
All the financial models used for input to IBRD's financial statements are subject to both internal and
external verification and review by qualified personnel. These models use market sourced inputs, such
as interest rate yield curves, exchange rates, and option volatilities. Selection of these inputs may
involve some judgment. Imprecision in estimating these factors, and changes in assumptions, can
impact net income and IBRD's financial position as reported in the balance sheet.
In millions of U.S. dollars
INVESTMENTS – TRADING PORTFOLIO
Options and futures
• Long position
• Short position
• Credit exposure due to potential nonperformance by counterparties
Currency swapsª
• Credit exposure due to potential nonperformance by counterparties
Interest rate swaps
• Notional principal
• Credit exposure due to potential nonperformance by counterparties
BORROWING PORTFOLIO
Currency swaps
• Credit exposure due to potential nonperformance by counterparties
Interest rate swaps
• Notional principal
• Credit exposure due to potential nonperformance by counterparties
2003
2002
$9,590
222
*
92
4,575
50
6,949
82,112
5,079
$6,300
976
1
51
10,705
8
2,092
82,533
3,084
About the Author
Hennie van Greuning is currently a senior advisor in the World Bank’s Treasury and has
previously worked as a sector manager for financial sector operations in the Bank. He has
had a career as a partner in a major international accounting firm and as controller in a cen-
tral bank, in addition to heading bank supervision in his home country. He is a CFA
Charterholder and qualified as a Chartered Accountant. He holds doctorate degrees in both
accounting and economics.
299
“Overall, this book gets very high marks for its comprehensive
yet understandable and easy-to-read coverage of the field of
international accounting and financial reporting. It should prove
very useful to anyone seeking an understanding of International
Financial Reporting Standards, their requirements, and their
application.”
—Global Business and Economics Review, April 2005
ting Standards (IFRS) in a
Applying International Financial Repor
business situation can have a significant effect on the financial results
and position of a division or an entire business enterprise. International
Financial Reporting Standards: A Practical Guide gives private
or public sector executives, managers, and financial analysts without a
strong background in accounting the tools they need to participate in
discussions and decisions on the appropriateness or application
of IFRS.
Each chapter summarizes an International Financial Reporting
Standard, following a consistent structure:
• Problems addressed
• Scope of the Standard
• Key concepts
• Accounting treatment
• Presentation and disclosure
• Financial analysis and interpretation
Many chapters of the book also contain examples that illustrate
the practical application of key concepts in a particular standard.
The publication includes all of the standards issued by the
International Accounting Standards Board (IASB) through
May 31, 2006.
For more information, visit our Treasury Client Services at:
http://treasury.worldbank.org
THE WORLD BANK
ISBN 0-8213-6768-4
| Hennie |
Apago PDF Enhancer
Summary of the Audit Process
PHASE I
Plan and design an
audit approach
Accept client and perform
initial planning
Understand the client’s
business and industry
Assess client business risk
Perform preliminary
analytical procedures
Set materiality and assess
acceptable audit risk and
inherent risk
Understand internal control
and assess control risk
Gather information
to assess fraud risks
Develop overall audit plan
and audit program
PHASE II
Perform tests of
controls and
substantive tests
of transactions
Plan
to reduce
assessed level of
control
risk?
No
Apago PDF Enhancer
Yes
Perform tests of controls*
PHASE III
Perform analytical
procedures and
tests of details
of balances
PHASE IV
Complete the
audit and
issue an
audit report
Perform substantive tests
of transactions
Assess likelihood of misstatements
in financial statements
Low
Medium
High or
unknown
Perform analytical procedures
Perform tests of key items
Perform additional tests
of details of balances
Perform additional tests for
presentation and disclosure
Accumulate final evidence
Evaluate results
Issue audit report
Communicate with audit
committee and management
*The extent of testing of controls is determined by planned reliance on controls. For public companies required
to have an audit of internal control, testing must be sufficient to issue an opinion on internal control over
financial reporting.
F O U R T E E N T H E D I T I O N
AUDITING AND
ASSURANCE
SERVICES
AN INTEGRATED APPROACH
Includes coverage of international standards and global auditing issues, in addition to coverage of
PCAOB Auditing Standards, the risk assessment SASs, the Sarbanes–Oxley Act, and Section 404 audits.
Apago PDF Enhancer
ALVIN A. ARENS
PricewaterhouseCoopers
Emeritus Professor
Michigan State University
RANDAL J. ELDER
Syracuse University
MARK S. BEASLEY
North Carolina State University
Deloitte Professor of Enterprise Risk Management
Prentice Hall
Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto
Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo
Library of Congress Cataloging-in-Publication Information is available.
Arens, Alvin A.
Auditing and assurance services: an integrated approach/
Alvin A. Arens, Randal J. Elder, Mark S. Beasley.—14th ed.
p. cm.
Includes index.
ISBN-13: 978-0-13-257595-9
ISBN-10: 0-13-257595-7
1. Auditing. I. Elder, Randal J. II. Beasley, Mark S. III. Title.
VP/Editorial Director: Sally Yagan
Editor in Chief: Donna Battista
Executive Editor: Stephanie Wall
Product Development Manager: Ashley Santora
Editorial Project Manager: Christina Rumbaugh
Editorial Assistant: Brian Reilly
Director of Marketing: Patrice Lumumba Jones
Marketing Assistant: Ian Gold
Senior Managing Editor: Cynthia Zonneveld
Production Project Manager: Carol O’Rourke
Senior Operations Manager: Diane Peirano
Art Director: Anthony Gemmellaro
Interior Design: Lisa Delgado & Co.
Cover Design: Anthony Gemmellaro
Composition: Lynne Wood
Printer/Binder: Quebecor World Color/Versailles
Typeface: 11/12.5 Minion Regular
Apago PDF Enhancer
Credits and acknowledgments borrowed from other sources and reproduced, with
permission, in this textbook appear on appropriate page within text.
__________________________________________________________________________________
Copyright © 2012, 2010, 2008, 2006, 2005 by Pearson Education, Inc., Upper Saddle River,
New Jersey, 07458. Pearson Prentice Hall. All rights reserved. Printed in the United States of
America. This publication is protected by Copyright and permission should be obtained from
the publisher prior to any prohibited reproduction, storage in a retrieval system, or
transmission in any form or by any means, electronic, mechanical, photocopying, recording,
or likewise. For information regarding permission(s), write to: Rights and Permissions
Department.
Pearson Prentice Hall™ is a trademark of Pearson Education, Inc.
Pearson® is a registered trademark of Pearson plc
Prentice Hall® is a registered trademark of Pearson Education, Inc.
| Alvin |
Pearson Education Ltd., London
Pearson Education Singapore, Pte. Ltd
Pearson Education, Canada, Inc.
Pearson Education–Japan
Pearson Education Australia PTY, Limited
Pearson Education North Asia Ltd., Hong Kong
Pearson Educación de Mexico, S.A. de C.V.
Pearson Education Malaysia, Pte. Ltd
Pearson Education Upper Saddle River, New Jersey
10 9 8 7 6 5 4 3 2 1
ISBN-13: 978-0-13-257595-9
ISBN-10: 0-13-257595-7
A TRIBUTE TO
ALVIN A. ARENS
The auditing profession and audit education lost a great friend,
mentor, and leader with the passing of Alvin A. Arens in December
2010. Al’s leadership at national and international levels and his
commitment to expanding knowledge through the development of
educational materials, resources, articles, and cases profoundly
impacted students and professionals in auditing.
As founding author of Auditing and Assurance Services: An Integrated
Approach, he has shaped classroom instruction and student learning
about auditing concepts and their practical implementation around
the world. Since the first edition was published in 1976, his textbook
has impacted audit education for over 30 years in the U.S. and
globally, including six different language translations of the most
recent edition.
November 24, 1935 – December 6, 2010
Al was the PricewaterhouseCoopers Auditing Professor and member of
the Accounting & Information Systems faculty in the Eli Broad College
Apago PDF Enhancer
of Business at Michigan State University from 1968 through 2007.
Among his many honors, Al was selected as one of five national auditing educators to hold the first Price
Waterhouse Auditing professorships, was honored as AICPA Educator of the Year, served on the AICPA’s
Auditing Standards Board, and was President of the American Accounting Association. Al taught accounting,
mainly auditing, with a passion that is legendary. He had a heart for sharing his knowledge of auditing with the
next generation of professionals. He will be missed.
This 14th edition is dedicated in memory of Al Arens — author, leader, mentor, friend.
iii
This page intentionally left blank
Apago PDF Enhancer
CONTENTS
PREFACE xv
THE AUDITING PROFESSION
THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
Learning Objectives 3
Nature of Auditing 4
Distinction Between Auditing and Accounting 6
Economic Demand for Auditing 6
Assurance Services 8
Types of Audits 12
Types of Auditors 15
Certified Public Accountant 17
Summary 18
Essential Terms 18
Review Questions 19
Multiple Choice Questions from CPA Examinations 20
Discussion Questions and Problems 21
Internet Problem 1-1: CPA Requirements 24
Apago PDF Enhancer
T 1
R
A
P
C H A P T E R
1
Learning Objectives 25
Certified Public Accounting Firms 26
Activities of CPA Firms 27
Structure of CPA Firms 28
Sarbanes–Oxley Act and
THE CPA PROFESSION
C H A P T E R
2
Public Company Accounting Oversight Board 30
Securities and Exchange Commission 30
American Institute of Certified Public Accountants (AICPA) 31
International and U.S. Auditing Standards 32
Generally Accepted Auditing Standards 34
Statements on Auditing Standards 36
Quality Control 37
Summary 39
Essential Terms 39
Review Questions 40
Multiple Choice Questions from CPA Examinations 41
Discussion Questions and Problems 42
Internet Problem 2-1: International Auditing and
Assurance Standards Board 44
CONTENTS
v
C H A P T E R
3
C H A P T E R
4
C H A P T E R
5
AUDIT REPORTS
Learning Objectives 45
Standard Unqualified Audit Report 46
Report on Internal Control Over Financial Reporting Under Section 404
of the Sarbanes–Oxley Act 49
Unqualified Audit Report with Explanatory Paragraph or Modified Wording 51
Departures from an Unqualified Audit Report 55
Materiality 56
Discussion of Conditions Requiring a Departure 59
Auditor’s Decision Process for Audit Reports 62
International Accounting and Auditing Standards 65
Summary 65
Essential Terms 66
Review Questions 66
Multiple Choice Questions from CPA Examinations 68
Discussion Questions and Problems 69
Internet Problem 3-1: Research Annual Reports 74
PROFESSIONAL ETHICS
Learning Objectives 77 | Alvin |
What Are Ethics? 78
Ethical Dilemmas 79
Special Need for Ethical Conduct in Professions 82
Code of Professional Conduct 84
Independence 87
Apago PDF Enhancer
Independence Rule of Conduct and Interpretations 90
Other Rules of Conduct 95
Enforcement 103
Summary 103
Essential Terms 104
Review Questions 104
Multiple Choice Questions from CPA Examinations 105
Discussion Questions and Problems 106
Cases 109
Internet Problem 4-1: IESBA Code of Ethics 112
LEGAL LIABILITY
Learning Objectives 113
Changed Legal Environment 114
Distinguishing Business Failure, Audit Failure, and Audit Risk 115
Legal Concepts Affecting Liability 116
Liability to Clients 118
Liability to Third Parties Under Common Law 121
Civil Liability Under the Federal Securities Laws 123
Criminal Liability 127
The Profession’s Response to Legal Liability 130
Protecting Individual CPAs from Legal Liability 130
Summary 131
Essential Terms 132
Review Questions 133
Multiple Choice Questions from CPA Examinations 133
vi
CONTENTS
Discussion Questions and Problems 135
Case 139
Internet Problem 5-1: SEC Enforcement 139
THE AUDIT PROCESS
AUDIT RESPONSIBILITIES AND OBJECTIVES
Learning Objectives 141
Objective of Conducting an Audit of Financial Statements 142
Management’s Responsibilities 143
Auditor’s Responsibilities 144
Financial Statement Cycles 148
Setting Audit Objectives 152
Management Assertions 153
Transaction-Related Audit Objectives 156
Balance-Related Audit Objectives 158
Presentation and Disclosure-Related Audit Objectives 161
How Audit Objectives Are Met 161
Summary 163
Essential Terms 164
Review Questions 165
Multiple Choice Questions from CPA Examinations 166
Discussion Questions and Problems 167
Case 171
Internet Problem 6-1: International and PCAOB Audit Objectives 172
Apago PDF Enhancer
AUDIT EVIDENCE
Learning Objectives 173
Nature of Evidence 174
Audit Evidence Decisions 175
Persuasiveness of Evidence 176
Types of Audit Evidence 179
Audit Documentation 188
Summary 196
Essential Terms 196
Review Questions 197
Multiple Choice Questions from CPA Examinations 198
Discussion Questions and Problems 199
Cases 204
ACL Problem 206
Internet Problem 7-1: Use of Audit Software for Fraud Detection
206
and Continuous Auditing
T 2
R
A
P
C H A P T E R
6
C H A P T E R
7
AUDIT PLANNING AND ANALYTICAL PROCEDURES
Learning Objectives 209
Planning 210
Accept Client and Perform Initial Audit Planning 211
Understand the Client’s Business and Industry 215
C H A P T E R
8
CONTENTS
vii
C H A P T E R
9
Assess Client Business Risk 220
Perform Preliminary Analytical Procedures 222
Summary of the Parts of Audit Planning 223
Analytical Procedures 223
Five Types of Analytical Procedures 226
Common Financial Ratios 230
Summary 233
Essential Terms 234
Review Questions 234
Multiple Choice Questions from CPA Examinations 236
Discussion Questions and Problems 237
Cases 243
Integrated Case Application — Pinnacle Manufacturing: Part I 245
ACL Problem 247
Internet Problem 8-1: Obtain Client Background Information 248
MATERIALITY AND RISK
Learning Objectives 249
Materiality 250
Set Preliminary Judgment about Materiality 251
Allocate Preliminary Judgment about Materiality to Segments
(Tolerable Misstatement) 254
Apago PDF Enhancer
Estimate Misstatement and Compare with Preliminary Judgment 257
Audit Risk 258
Audit Risk Model Components 261
Assessing Acceptable Audit Risk 263
Assessing Inherent Risk 266
Relationship of Risks to Evidence and Factors Influencing Risks 268
Summary 274
Essential Terms 274
Review Questions 275
Multiple Choice Questions from CPA Examinations 276
Discussion Questions and Problems 278
Cases 284
Integrated Case Application — Pinnacle Manufacturing: Part II 287
Internet Problem 9-1: Materiality and Tolerable Misstatement 288
C H A P T E R
10
SECTION 404 AUDITS OF
INTERNAL CONTROL AND CONTROL RISK
Learning Objectives 289
Internal Control Objectives 290
Management and Auditor Responsibilities for Internal Control 291
COSO Components of Internal Control 294
Obtain and Document Understanding of Internal Control 302
Assess Control Risk 307
Tests of Controls 312
Decide Planned Detection Risk and Design Substantive Tests 315 | Alvin |
Section 404 Reporting on Internal Control 315
Evaluating, Reporting, and Testing Internal Control for Nonpublic Companies 317
Summary 319
Essential Terms 320
Review Questions 322
Multiple Choice Questions from CPA Examinations 324
viii
CONTENTS
Discussion Questions and Problems 326
Case 331
Integrated Case Application — Pinnacle Manufacturing: Part III 332
Internet Problem 10-1: Disclosure of Material Weaknesses in
Internal Control Over Financial Reporting 333
FRAUD AUDITING
Learning Objectives 335
Types of Fraud 336
Conditions for Fraud 337
Assessing the Risk of Fraud 341
Corporate Governance Oversight to Reduce Fraud Risks 345
Responding to the Risk of Fraud 349
Specific Fraud Risk Areas 351
Responsibilities When Fraud is Suspected 356
Summary 360
Essential Terms 361
Review Questions 361
Multiple Choice Questions from CPA Examinations 362
Discussion Questions and Problems 363
Case 368
Integrated Case Application — Pinnacle Manufacturing: Part IV 369
ACL Problem 369
Internet Problem 11-1: Brainstorming About Fraud Risks 370
C H A P T E R
11
THE IMPACT OF INFORMATION TECHNOLOGY
ON THE AUDIT PROCESS
Apago PDF Enhancer
C H A P T E R
12
Learning Objectives 371
How Information Technologies Improve Internal Control 372
Assessing Risks of Information Technology 372
Internal Controls Specific to Information Technology 374
Impact of Information Technology on the Audit Process 380
Issues for Different IT Environments 386
Summary 390
Essential Terms 390
Review Questions 392
Multiple Choice Questions from CPA Examinations 392
Discussion Questions and Problems 394
Case 399
ACL Problem 401
Internet Problem 12-1: Assessing IT Governance 402
OVERALL AUDIT PLAN AND AUDIT PROGRAM
Learning Objectives 403
Types of Tests 404
Selecting Which Types of Tests to Perform 409
Impact of Information Technology on Audit Testing 412
Evidence Mix 413
Design of the Audit Program 414
Summary of Key Evidence-Related Terms 423
Summary of the Audit Process 424
Essential Terms 428
C H A P T E R
13
CONTENTS
ix
Review Questions 429
Multiple Choice Questions from CPA Examinations 430
Discussion Questions and Problems 431
Cases 436
Internet Problem 13-1: Assessing Effects of Evidence Mix 439
T 3
R
A
P
APPLICATION OF THE AUDIT PROCESS TO
THE SALES AND COLLECTION CYCLE
C H A P T E R
14
AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF
CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS
Learning Objectives 441
Accounts and Classes of Transactions in the Sales and Collection Cycle 442
Business Functions in the Cycle and Related Documents and Records 443
Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales 447
Sales Returns and Allowances 458
Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Cash Receipts 459
Audit Tests for the Write-off of Uncollectible Accounts 463
Additional Internal Controls over Account Balances and
Presentation and Disclosure 464
Apago PDF Enhancer
Effect of Results of Tests of Controls and Substantive Tests of Transactions 464
Summary 465
Essential Terms 466
Review Questions 466
Multiple Choice Questions from CPA Examinations 467
Discussion Questions and Problems 469
Case 474
Integrated Case Application — Pinnacle Manufacturing: Part V 475
ACL Problem 476
Internet Problem 14-1: Revenue Recognition Fraud 476
C H A P T E R
15
AUDIT SAMPLING FOR TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS
Learning Objectives 477
Representative Samples 478
Statistical Versus Nonstatistical Sampling and
Probabilistic Versus Nonprobabilistic Sample Selection 479
Nonprobabilistic Sample Selection Methods 480
Probabilistic Sample Selection Methods 482
Sampling for Exception Rates 484
Application of Nonstatistical Audit Sampling 485
Statistical Audit Sampling 501
Sampling Distribution 501
Application of Attributes Sampling 502
Summary 507
Essential Terms 508
Review Questions 509
x
CONTENTS
Multiple Choice Questions from CPA Examinations 510
Discussion Questions and Problems 512
Case 516
Integrated Case Application — Pinnacle Manufacturing: Part VI 516
Internet Problem 15-1: Applying Statistical Sampling 518
| Alvin |
COMPLETING THE TESTS IN THE SALES AND
COLLECTION CYCLE: ACCOUNTS RECEIVABLE
C H A P T E R
16
Learning Objectives 519
Methodology for Designing Tests of Details of Balances 520
Designing Tests of Details of Balances 526
Confirmation of Accounts Receivable 532
Developing Tests of Details Audit Program 538
Essential Terms 541
Review Questions 542
Multiple Choice Questions from CPA Examinations 543
Discussion Questions and Problems 544
Case 550
Integrated Case Application — Pinnacle Manufacturing: Part VII 551
ACL Problem 556
Internet Problem 16-1: Revenue Recognition 556
AUDIT SAMPLING FOR TESTS OF DETAILS OF BALANCES
Learning Objectives 557
Comparisons of Audit Sampling for Tests of Details of Balances
and for Tests of Controls and Substantive Tests of Transactions 558
Apago PDF Enhancer
Nonstatistical Sampling 559
Monetary Unit Sampling 567
Variables Sampling 578
Illustration Using Difference Estimation 583
Summary 589
Essential Terms 590
Review Questions 590
Multiple Choice Questions from CPA Examinations 592
Discussion Questions and Problems 593
Cases 598
ACL Problem 599
Internet Problem 17-1: Monetary Unit Sampling Considerations 599
C H A P T E R
17
APPLICATION OF THE
AUDIT PROCESS TO OTHER CYCLES
T 4
R
A
P
AUDIT OF THE ACQUISITION AND PAYMENT CYCLE:
TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS, AND ACCOUNTS PAYABLE
C H A P T E R
18
Learning Objectives 601
Accounts and Classes of Transactions in the Acquisition and Payment Cycle 602
Business Functions in the Cycle and Related Documents and Records 603
CONTENTS
xi
Methodology for Designing Tests of Controls and Substantive Tests of Transactions 606
Methodology for Designing Tests of Details of Balances for Accounts Payable 612
Summary 620
Essential Terms 621
Review Questions 621
Multiple Choice Questions from CPA Examinations 623
Discussion Questions and Problems 624
Case 630
Internet Problem 18-1: Identifying Accounts Payable Fraud 632
C H A P T E R
19
COMPLETING THE TESTS IN THE ACQUISITION AND
PAYMENT CYCLE: VERIFICATION OF SELECTED ACCOUNTS
Learning Objectives 633
Types of Other Accounts in the Acquisition and Payment Cycle 634
Audit of Property, Plant, and Equipment 634
Audit of Prepaid Expenses 641
Audit of Accrued Liabilities 644
Audit of Income and Expense Accounts 646
Summary 649
Essential Terms 650
Review Questions 650
Multiple Choice Questions from CPA Examinations 651
Discussion Questions and Problems 653
Cases 655
Internet Problem 19-1: Centerpulse Ltd. Fraud 657
AUDIT OF THE PAYROLL AND PERSONNEL CYCLE
Apago PDF Enhancer
Learning Objectives 659
Accounts and Transactions in the Payroll and Personnel Cycle 660
Business Functions in the Cycle and Related Documents and Records 660
Methodology for Designing Tests of Controls and Substantive Tests of Transactions 664
Methodology for Designing Tests of Details of Balances 668
Summary 672
Essential Terms 673
Review Questions 673
Multiple Choice Questions from CPA Examinations 674
Discussion Questions and Problems 675
Case 679
Internet Problem 20-1: Risks of Outsourcing the Payroll Function 680
AUDIT OF THE INVENTORY AND WAREHOUSING CYCLE
Learning Objectives 681
Business Functions in the Cycle and Related Documents and Records 682
Parts of the Audit of Inventory 684
Audit of Cost Accounting 686
Analytical Procedures 689
Physical Observation of Inventory 689
Audit of Pricing and Compilation 693
Integration of the Tests 697
Summary 699
Essential Terms 699
C H A P T E R
2 0
C H A P T E R
2 1
xii
CONTENTS
Review Questions 700
Multiple Choice Questions from CPA Examinations 701
Discussion Questions and Problems 702
Case 708
Internet Problem 21-1: Using Inventory Count Specialists 710
AUDIT OF THE CAPITAL ACQUISITION AND REPAYMENT CYCLE
Learning Objectives 711
Accounts in the Cycle 712
Notes Payable 713
Owners’ Equity 716
Summary 723
Essential Terms 723
Review Questions 724
Multiple Choice Questions from CPA Examinations 725
Discussion Questions and Problems 726
Internet Problem 22-1: Overview of the NYSE 730
AUDIT OF CASH BALANCES
Learning Objectives 731
Cash in the Bank and Transaction Cycles 732
Types of Cash Accounts 734 | Alvin |
Audit of the General Cash Account 735
Fraud-Oriented Procedures 742
Audit of the Imprest Payroll Bank Account 746
Audit of Imprest Petty Cash 747
Summary 747
Essential Terms 748
Review Questions 748
Multiple Choice Questions from CPA Examinations 749
Discussion Questions and Problems 750
Internet Problem 23-1: Check Clearing for the 21st Century Act 755
Apago PDF Enhancer
COMPLETING THE AUDIT
COMPLETING THE AUDIT
Learning Objectives 757
Perform Additional Tests for Presentation and Disclosure 758
Review for Contingent Liabilities and Commitments 759
Review for Subsequent Events 764
Final Evidence Accumulation 767
Evaluate Results 771
Issue the Audit Report 776
Communicate with the Audit Committee and Management 776
Subsequent Discovery of Facts 778
Summary 779
C H A P T E R
2 2
C H A P T E R
2 3
T 5
R
A
P
C H A P T E R
2 4
CONTENTS
xiii
Essential Terms 779
Review Questions 780
Multiple Choice Questions from CPA Examinations 781
Discussion Questions and Problems 783
Case 787
Internet Problem 24-1: Audit Committee Responsibilities 787
OTHER ASSURANCE
AND NONASSURANCE SERVICES
OTHER ASSURANCE SERVICES
Learning Objectives 789
Review and Compilation Services 790
Review of Interim Financial Information for Public Companies 795
Attestation Engagements 796
WebTrust and SysTrust Services 799
Reports on Controls at Service Organizations 800
Prospective Financial Statements 801
Agreed-Upon Procedures Engagements 803
Other Audits or Limited Assurance Engagements 804
Summary 806
Essential Terms 807
Review Questions 808
Apago PDF Enhancer
Multiple Choice Questions from CPA Examinations 809
Discussion Questions and Problems 810
Internet Problem 25-1: Accounting and Review Services Committee 814
INTERNAL AND GOVERNMENTAL
FINANCIAL AUDITING AND OPERATIONAL AUDITING
Learning Objectives 815
Internal Financial Auditing 816
Governmental Financial Auditing 819
Operational Auditing 821
Summary 829
Essential Terms 829
Review Questions 830
Multiple Choice Questions from CPA, CIA, and CMA Examinations 831
Cases 833
Internet Problem 26-1: Institute of Internal Auditors 837
APPENDIX: ACL INSTALLATION AND INSTRUCTIONS 838
INDEX 843
T 6
R
A
P
C H A P T E R
2 5
C H A P T E R
2 6
xiv
CONTENTS
PREFACE
INTEGRATED APPROACH FOR RISK ASSESSMENT
AND AUDIT DECISION-MAKING
Auditing and Assurance Services: An Integrated Approach is an introduction to auditing and
other assurance services. It is intended for either a one-quarter or one-semester course at the
undergraduate or graduate level. This book is also appropriate for introductory professional
development courses for CPA firms, internal auditors, and government auditors.
The primary emphasis in this text is on the auditor’s decision-making process in a finan-
cial statement audit, as well as an integrated audit of both financial statements and internal
control over financial reporting required for accelerated filer public companies. We believe
that the most fundamental concepts in auditing concern deter mining the nature and amount
of evidence the auditor should gather after considering the unique circumstances of each engage -
ment. If students of auditing understand the objectives to be accomplished in a given audit
area, the risks related to the engagement, and the decisions to be made, they should be able
to determine the appropriate evidence to gather and how to evaluate the evidence obtained.
Our objective is to provide up-to-date coverage of globally recognized auditing concepts
with practical examples of the implementation of those concepts in real-world settings. The
collective experience of the author team in the practice of auditing is extensive. All three
authors have worked in the auditing profession involving both large inter national audit firms
and regional firms. All three authors have taught extensively in continuing education for
either large international or small CPA firms and they have been involved in standards setting
activities of the Auditing Standards Board and the PCAOB. One author currently serves as
one of the board members of the Committee of Sponsoring Organizations of the Treadway | Alvin |
Commis sion (COSO). These experiences provide unique perspectives about the integration
of auditing concepts in real-world settings.
Apago PDF Enhancer
As the title of this book reflects, our purpose is to integrate the most important interna-
tionally recognized concepts of auditing in a logical manner to assist students in understand-
ing audit decision making and evidence accumulation in today’s complex, global auditing
environment. For example, developments related to international auditing and issues affect-
ing auditing in a global and economically volatile environment are described throughout the
book and emphasized in selected mid-chapter vignettes and homework problems. Key con-
cepts related to risk assessment as emphasized in standards issued by the Auditing Standards
Board (ASB) and the International Auditing and Assurance Standards Board (IAASB) are
integrated into all of the planning chapters, as well as each chapter dealing with a particular
transaction cycle and related accounts. Internal control is related to tests of controls and sub-
stantive tests of transactions that are performed in a financial statement audit and an inte-
grated audit of financial statements and internal control over financial reporting, with an
emphasis on the requirements of PCAOB Auditing Standards. Tests of controls and substan-
tive tests of transactions are, in turn, related to the tests of details of financial statement bal-
ances for the area. Audit sampling is applied to the evaluation of audit evidence rather than
treated as a separate topic. Risk assessment, technology, fraud, and auditing of internal con-
trol issues are integrated throughout the chapters.
KEY FEATURES IN THE FOURTEENTH EDITION
New auditing standards are released without regard to textbook revision cycles. As auditing
instructors, we appreciate how critical it is to have the most current content available. This
edition includes coverage of PCAOB Auditing Standard No. 7, Engagement Quality Review,
Current Coverage
xv
and new standards covering auditor responsibilities related to supplementary information
included in financial statements (SAS Nos. 119 and 120). We are committed to con tinually
providing you with up-to-date content in this dynamic global auditing environment and
will keep you updated with high lights posted on our Web site of major changes in new
standards as they are issued.
Consistent with the convergence toward international accounting and auditing standards,
this edition contains integrated coverage of developments related to inter national auditing
standards and emphasizes issues affecting audits of multi-national entities. Chapter 1
introduces the importance of considering international auditing standards developments,
followed by discussion in Chapter 2 about the role of the International Auditing and
Assurance Standards Board (IAASB) in the issuance of international auditing standards
and the Auditing Standards Board’s efforts to converge U.S. standards to international
standards. Chapter 3 highlights implications for auditor reports on companies reporting
under International Financial Reporting Standards (IFRS) and describes the SEC’s current
roadmap proposal for embracing the use of IFRS for financial reporting by U.S. public
companies. Several chapters throughout the book include text or mid-chapter vignette
coverage of international issues, and international issues are also addressed in homework
problems, including Internet problems.
Apago PDF Enhancer
The requirements of the Sarbanes-Oxley Act of 2002 and the PCAOB’s Auditing Standard 5
(AS 5) that impact accelerated filer public companies, and the risk assessment standards
issued by the Auditing Standards Board are integrated throughout the text. Chapter 2
emphasizes the importance of understanding the client’s business and its environment,
including internal control. We also introduce the PCAOB’s new risk assessment standards.
Chapter 3 highlights reporting on internal controls over financial reporting for auditors of
accelerated filer public companies and describes the permanent exemption of that reporting | Alvin |
requirement for non-accelerated filers that resulted from the passage of the 2010 federal
financial reform legislation. We have always emphasized under standing the client’s business
and industry in planning, and we incorporate the risk assessment procedures required by the
risk assessment standards in our coverage of planning in Chapter 8 and throughout the text.
Chapter 10 emphasizes the importance of considering internal control as part of the risk
assess ment process and the chapter also highlights important concepts in AS 5 affecting the
audit of internal control over financial reporting for large public companies. Subsequent
chapters that focus on the transaction cycles include extensive coverage of internal controls
to help students understand how the auditor’s consideration of internal controls is inte -
grated for audits of the financial statements and internal controls over financial reporting.
The risk assessment standards include three categories of assertions related to transac-
tions and events, account balances, and presentation and disclosures. These are described
in Chapter 6, related to the phases of the audit in Chapter 13, and applied to transaction
cycles and tests of account balances throughout the text. Additional tests the auditor per-
forms to address presentation and disclosure objectives are discussed in Chapter 24 on
completing the audit.
CPA firms are increasingly using audit software to perform audit testing including tests for
fraud. We have included selected problems using ACL in several chapters in the text. Many
CPA firms use audit software to perform audit sampling, and we have included an ACL
problem on audit sampling in Chapter 17. These problems are related to the topic of the
chapter so that students can see how audit software is used to perform specific types of
audit tests. Additional guidance for students on the use of ACL is included both on the text
Web site and as an appendix to the text. The educational version of ACL software is
included with every new copy of this edition.
The annual report for the Hillsburg Hardware Company is included as a four-color insert
to the text. Financial statements and other information included in the annual report are
used in examples throughout the text to illustrate chapter concepts. The annual report also
includes management’s report on internal control required by Section 404a and the auditor’s
report required by Section 404b consistent with PCAOB Auditing Standard No. 5.
Emphasis on
International Issues
Coverage of
AS 5 and the Risk
Assessment Standards
ACL Problems
Hillsburg Hardware
Annual Report
xvi
PREFACE
The Pinnacle Manufacturing integrated case is based on a large, multi-division company.
The case has been revised and expanded to now consist of seven parts included at the end
of the chapter to which that part relates. Each part of the case is designed to give students
hands-on experience, and the parts of the case are connected so that students will gain a
better understanding of how the parts of the audit are integrated by the audit process.
Pinnacle
Manufacturing
Integrated Case
All chapters include an Internet-based case/homework assignment that requires students
to use the Internet to research relevant auditing issues. All chapters include several new or
revised problems. The use of bullets and numbering and a large font size enhance the
readability of the text and help students retain key concepts.
New and Revised
Homework Problems
ORGANIZATION
Apago PDF Enhancer
The text is divided into six parts. The chapters are relatively brief and designed to be easily
read and comprehended by students.
Part 1, The Auditing Profession (Chapters 1–5) The book begins with an opening
vignette, featuring the WorldCom fraud, to help students begin to see the connection
between recent frauds and the responsibilities for auditing internal control and other
requirements of the Sarbanes–Oxley Act. Chapter 1 introduces key provisions of the Act,
including the creation of the PCAOB and Section 404 internal control reporting | Alvin |
requirements. Chapter 2 covers the CPA profession, with particular emphasis on the standards
setting responsibilities of the International Auditing and Assurance Standards Board
(IAASB) and the PCAOB and how those responsibilities differ from those of the Auditing
Standards Board (ASB) of the AICPA. Chapter 3 provides a detailed discussion of audit
reports, including a separate section on the report on internal control over financial
reporting for an accelerated filer public company. The chapter also emphasizes conditions
affecting the type of report the auditor must issue and the type of audit report applicable to
each condition under varying levels of materiality. Chapter 4 explains ethical dilemmas,
professional ethics, independence, and the AICPA Code of Professional Conduct. Chapter 5
ends this part with an investigation of auditors’ legal liability.
Part 2, The Audit Process (Chapters 6–13) The first two of these chapters deal with
auditor and management responsibilities, audit objectives, general concepts of evidence
accumulation, and audit documentation, including the management assertions and evidence
concepts in the risk assessment standards. Chapter 8 deals with planning the engage ment,
including understanding the company’s business and its industry as part of risk assessment
procedures, and using analytical procedures as an audit tool. Chapter 9 introduces materiality
and risk and how the auditor responds to risks of significant misstatement with further audit
procedures. Chapter 10 shows how effective internal controls can reduce planned audit
evidence in the audit of financial statements. Most of the chapter describes how auditors of
accelerated filer public companies integrate evidence to provide a basis for their report on the
effectiveness of internal control over financial reporting with the assessment of control risk in
the financial statement audit. Fraud auditing is the focus of Chapter 11 and describes the
auditor’s responsibility for assessing fraud risk and detecting fraud. The chapter also includes
specific examples of fraud and discusses warning signs and procedures to detect fraud.
Chapter 12 addresses the most important effects of information technology on internal
controls in businesses, risks the auditor must consider, and audit evidence changes. Chapter 13
summarizes Chapters 6 through 12 and integrates them with the remainder of the text.
Part 3, Application of the Audit Process to the Sales and Collection Cycle
(Chapters 14–17) These chapters apply the concepts from Part 2 to the audit of sales, cash
receipts, and the related income statement and balance sheet accounts. The appropriate
audit procedures for accounts in the sales and collection cycle are related to internal control
and audit objectives for tests of controls, substantive tests of transactions, and tests of
details of balances in the context of both the audit of financial statements and audit of
internal control over financial reporting.
PREFACE
xvii
Students also learn to apply audit sampling to the audit of sales, cash receipts, and
accounts receivable. Chapter 15 begins with a general discussion of audit sampling for tests
of controls and substantive tests of transactions. Similarly, Chapter 17 begins with general
sampling concepts for tests of details of balances. The next topic in each chapter is extensive
coverage of nonstatistical sampling. The last part of each chapter covers statistical sampling
techniques.
Part 4, Application of the Audit Process to Other Cycles (Chapters 18–23) Each of
these chapters deals with a specific transaction cycle or part of a transaction cycle in much
the same manner as Chapters 14 through 17 cover the sales and collection cycle. Each
chapter in Part IV demonstrates the relationship of internal controls, tests of controls, and
substantive tests of transactions for each broad category of transactions to the related
balance sheet and income statement accounts. We integrate discussion of implications
related to the audit of internal control throughout all these transaction cycle chapters. Cash | Alvin |
in the bank is studied late in the text to demonstrate how the audit of cash balances is
related to most other audit areas.
Part 5, Completing the Audit (Chapter 24) This part includes only one chapter,
which deals with performing additional tests to address presentation and disclosure
objectives, summarizing all audit tests, reviewing audit documentation, obtaining manage -
ment repre sentations in an integrated audit of financial statements and internal control,
communi cating with those charged with governance, and all other aspects of completing
an audit.
Part 6, Other Assurance and Nonassurance Services (Chapters 25 and 26) The
last two chapters deal with various types of engagements and reports, other than the audit
of financial statements using generally accepted accounting principles. Topics covered
include assurance services, review and compilation services, agreed-upon procedures
engagements, attestation engagements, other audit engagements, internal financial
auditing, governmental financial auditing, and operational auditing.
Apago PDF Enhancer
Instructor’s Resource Center www.pearsonhighered.com/arens This password-
protected site is accessible from the catalog page for Auditing and Assurance Services, 14th
ed. and hosts the following resources:
Image Library The Image Library allows access to most of the images and illus trations
featured in the text.
Instructor’s Resource Manual Suggestions for each chapter include: Homework
problems, how learning objectives correlate with chapter problem material, and trans -
parency masters. Chapters have been designed so that their arrangement and selection
provides maximum flexibility in course design. Sample syllabi and suggested term projects
are provided.
Solutions Manual Included are detailed solutions to all the end-of-chapter exercises,
problems, and cases. Guidelines for responses to review questions and discussion questions
are offered.
Test Item File & TestGen The printed Test Item File includes multiple choice exercises,
true/false responses, essay questions, and questions related to the chapter vignettes. To
assist the instructor in selecting questions for use in examinations and quizzes, each
question has been assigned one of three difficulty ratings—easy, medium, or challenging.
In addition, questions that uniquely relate to the integrated audits of large public
companies or to the provisions of the Sarbanes–Oxley Act and Section 404 have been
separately labeled for easy identification by the professor. TestGen testing software is an
easy-to-use computerized testing program. It can create exams, evaluate, and track student
results. All Test Item File questions are available in the TestGen format.
SUPPLEMENTS
xviii
PREFACE
PowerPoint Slides PowerPoint presentations are available for each chapter of the text.
Instructors have the flexibility to add slides and/or modify the existing slides to meet
course needs.
Enhanced Companion Website Prentice Hall’s Learning on the Internet Partner ship
offers the most expansive Internet-based support available. Our Website provides a wealth
of resources for students and faculty. Resources include:
• Periodically, faculty will be able to access electronic summaries and PowerPoint
slides of the most recent changes to professional standards and summaries of major
issues affecting the auditing profession. This will help instructors to stay informed
of emerging issues.
• “Internet Problems,” end-of-chapter assignments available for most chapters, require
students to utilize the Internet to conduct research in order to develop a solution.
• “Faculty Web Links” provided for most chapters take interested instructors to
related Internet sites.
• Online “Study Guide” provides students with immediate feedback on quizzes,
including total score, an explanation provided for each incorrect answer, and the
ability to e-mail the results to a faculty member. All questions are created specifically
for this Study Guide, and there is no duplication of questions taken from the text or | Alvin |
test bank. This is included with the price of the text.
CAST: Comprehensive Assurance and Systems Tool by Buckless/Ingraham/
Jenkins This integrated practice set enables students to complete accounting transactions
based on the day-to-day operations of a real winery. Three modules are available—
assurance, manual AIS, and computerized AIS. Appropriate for use in auditing as well as in
AIS or intermediate courses.
The Lakeside Company: Cases in Auditing, 11th ed. by Trussel & Frazer This
practice set guides the student through the life cycle of an audit from beginning to end. The
cases are designed to create a realistic view of how an auditor organizes and carries out an
audit.
Auditing Cases, 4th ed., by Beasley/Buckless/Glover/Prawitt This collection of 44
auditing cases addresses most major activities performed during the conduct of an audit,
from client acceptance to issuance of an audit report. Several cases ask students to work
with realistic audit evidence to prepare and evaluate audit schedules. The cases are available
as a collection or as part of the Pearson Custom Publishing Resources Program. For details,
go to www.pearsoncustom.com.
Apago PDF Enhancer
ACKNOWLEDGMENTS
We acknowledge the American Institute of Certified Public Accountants for per mission to
quote extensively from Statements on Auditing Standards, the Code of Professional Conduct,
Uniform CPA Examinations, and other publications. The willingness of this major account -
ing organization to permit the use of its materials is a significant contribu tion to the book.
The continuing generous support of the PricewaterhouseCoopers Foundation is acknow -
ledged, particularly in regard to the word processing, editing, and moral support of this text.
We gratefully acknowledge the contributions of the following reviewers for their
suggestions and support in the 14th edition as well as previous publications:
Sherri Anderson, Sonoma State University
Stephen K. Asare, University of Florida
David Baglia, Grove City College
Brian Ballou, Miami University
William E. Bealing, Jr., Bloomsburg University
Stanley F. Biggs, University of Connecticut
Joe Brazel, North Carolina State University
PREFACE
xix
Frank Buckless, North Carolina State University
Joseph V. Calmie, Thomas Nelson Community College
Eric Carlsen, Kean College of New Jersey
Freddie Choo, San Francisco State University
Karl Dahlberg, Rutgers University
Frank Daroca, Loyola Marymount University
Stephen Del Vecchio, University of Central Missouri
Todd DeZoort, University of Alabama – Tuscaloosa
William L. Felix, University of Arizona
Magdy Farag, California State Polytechnic University – Pomona
Michele Flint, Daemen College
David S. Gelb, Seton Hall University
David Gilbertson, Western Washington University
John Giles, North Carolina State University
Lori Grady, Bucks County Community College
Charles L. Holley, Virginia Commonwealth University
Steve Hunt, Western Illinois University
Greg Jenkins, Virginia Tech University
James Jiambalvo, University of Washington
David S. Kerr, University of North Carolina at Charlotte
William R. Kinney, Jr., University of Texas at Austin
W. Robert Knechel, University of Florida
John Mason, University of Alabama – Tuscaloosa
Heidi H. Meier, Cleveland State University
Alfred R. Michenzi, Loyola College in Maryland
Charles R. (Tad) Miller, California Polytechnic State University
Lawrence C. Mohrweis, Northern Arizona University
Patricia M. Myers, Brock University
Kathy O’Donnell, SUNY Buffalo
Kristine N. Palmer, Longwood College
Vicki S. Peden, Cal Poly – Pomona
Ron Reed, University of Northern Colorado
Pankaj Saksena, Indiana University South Bend
Cindy Seipel, New Mexico State University
Philip H. Siegel, Troy University
Scott Showalter, North Carolina State University
Robert R. Tucker, Fordham University
Barb Waddington, Eastern Michigan University
D. Dewey Ward, Michigan State University
Jeanne H. Yamamura, University of Nevada, Reno
Doug Ziegenfuss, Old Dominion University
Apago PDF Enhancer
A special recognition goes to Carol Borsum for her editorial, production, and moral | Alvin |
support throughout the last several editions. Her concern for quality is beyond the ordinary.
We also thank Lynne Wood for her leadership, dedication and assistance in production. She
is an extremely important part of the text team.
We especially thank the Prentice Hall book team for their hard work and dedica tion,
including Cynthia Zonneveld, Senior Managing Editor; Stephanie Wall, Acquisitions Editor;
Christina Rumbaugh, Editorial Project Manager; Brian Reilly, Editorial Assistant; Sally Yagan,
VP/Editorial Director; Donna Battista, Editor in Chief; Patrice Lumumba Jones, Director of
Marketing; Ian Gold, Marketing Assistant; and Ashley Santora, Manager of Product
Development.
A. A. A.
R. J. E.
M. S. B.
xx
PREFACE
ABOUT THE AUTHORS
Al Arens, founding author of this textbook, was the PricewaterhouseCoopers Professor of
Accounting Emeritus at Michigan State University. In addition to writing books on auditing, he
was a coauthor of computerized accounting supplements and he was actively involved in the
continuing education of practitioners with local and regional CPA firms. Al was a past president
of the American Accounting Association and a former member of the AICPA Auditing Standards
Board. He practiced public accounting with both a local CPA firm and the predecessor firm to
Ernst & Young. He received many awards including the AAA Auditing Section Outstanding
Educator award, the AICPA Out standing Educator award, the national Beta Alpha Psi
Professor of the Year award and many teaching and other awards at Michigan State.
Randy Elder, who has served as a co-author of this textbook since the 8th edition, is a
Professor of Accounting at Syracuse University. He teaches undergraduate and graduate auditing
courses, and has received several teaching awards. His research focuses on audit quality and
current audit firm practices. He has extensive public accounting experience with a large
regional CPA firm, frequently teaches continuing education for a large international CPA firm,
and is a member of the AICPA and Michigan Association of CPAs.
Apago PDF Enhancer
Mark Beasley, who has served as a co-author of this textbook since the 8th edition, is the
Deloitte Professor of Enterprise Risk Management and Professor of Accounting at North
Carolina State University. He teaches undergraduate and graduate auditing courses, and has
received several teaching awards including membership in NC State’s Academy of Outstanding
Teachers. He has extensive professional audit experience with the predecessor firm to Ernst &
Young and has extensive standards-setting experience working with the Auditing Standards
Board as a Technical Manager in the Audit and Assurance Division of the AICPA. He served on
the ASB’s Fraud Standard Task Force responsible for developing SAS 99, the ASB’s Antifraud
Programs and Controls Task Force, and the Advisory Council overseeing COSO’s Enterprise
Risk Management Framework project. He is now a member of the COSO Board, representing
the AAA.
1
C H A P T E R S
1 – 5
T
R
A
P
1
THE AUDITING PROFESSION
These first five chapters in Part I provide background for performing financial
audits, which is our primary focus. This background will help you understand
why auditors perform audits the way they do.
• Chapters 1 and 2 describe assurance services, including auditing, and the
role of certified public accounting (CPA) firms and other organizations in
performing audits.
products of audits.
• Chapter 3 provides a detailed discussion of audit reports, which are the final
Apago PDF Enhancer
• Chapters 4 and 5 emphasize the regulation and control of CPA firms
through ethical standards and the legal responsibilities of auditors.
C H A P T E R 1
THE DEMAND FOR
AUDIT AND OTHER
ASSURANCE SERVICES
Auditors Have A Great Responsibility
“Oh my! ” Gene Morse was stunned. He stared at the computer screen in
his cubicle, unable to believe that he had found an unsupported entry for
$500 million in computer acquisitions. He immediately took his discovery
to his supervisor, Cynthia Cooper, vice president for internal audit at | Alvin |
WorldCom. “Keep going,” directed Cooper. Her team of internal auditors
kept digging. They worked late into the night to avoid detection, concerned
that they would be fired if superiors found out what they were doing. They
burned data onto CDs because they feared the data might be destroyed.
Major frauds often begin at the top, and such was the case at WorldCom.
Bernie Ebbers, WorldCom’s founder and CEO, had told Cooper not to use
the term “ internal controls ” claiming that he did not understand it.
However, Cooper fought for respect and more resources for the internal
audit department. She told Ebbers that her division could save millions
of dollars of wasteful operations with internal controls. In the years that
followed, “ we paid for ourselves many times over ” said Cooper.
Apago PDF Enhancer
L E A R N I N G O B J E C T I V E S
After studying this chapter,
you should be able to
1-1 Describe auditing.
1-2 Distinguish between auditing
and accounting.
1-3
1-4
Explain the importance of
auditing in reducing information
risk.
List the causes of information
risk, and explain how this risk
can be reduced.
1-5 Describe assurance services
and distinguish audit services
from other assurance and
nonassurance services provided
by CPAs.
1-6 Differentiate the three main
types of audits.
1-7
Identify the primary types of
auditors.
1-8 Describe the requirements for
As she pursued the trail of fraud, Cooper was obstructed at every turn.
In late May 2002, Cooper’s team found a gaping hole in the books. The
company had recorded billions of dollars of regular fees paid to local
telephone companies as capital assets. This accounting trick allowed the company to turn a $662 million loss into a
$2.4 billion profit in 2001. The company’s CFO, Scott Sullivan, called her to his office and asked her what they were up
to. He then asked her to delay her investigation to the following quarter, but she refused. In June 2002, the company
announced that it had inflated assets by $3.8 billion, the largest accounting fraud in history. When the investigation
was complete, the total amount of the fraud had grown to an astonishing $11 billion.
becoming a CPA .
Sources: Adapted from 1. Amanda Ripley, “The Night Detective,” Time (December 30, 2002); 2. Susan Pulliam and Deborah Solomon,
“Uncooking the Books: How Three Unlikely Sleuths Discovered Fraud at WorldCom,” The Wall Street Journal (October 30, 2002) p. A1.
Each chapter’s opening story illustrates important auditing principles based on realistic situations. Some of these stories are
based on public information about the audits of real companies, whereas others are fictitious. Any resemblance in the latter
stories to real firms, companies, or individuals is unintended and purely coincidental.
The opening story involving Cynthia Cooper and WorldCom illustrates the importance of company controls and
the role of auditors in detecting fraud. In the aftermath of WorldCom and other major financial reporting
frauds, Congress passed the Sarbanes–Oxley Act, called by many the most significant securities legislation since the
1933 and 1934 Securities Acts. The provisions of the Act apply to publicly held companies and their audit firms.
Section 404 of the Act expanded the audit of public companies to include reporting on the effectiveness of the
company’s internal control over financial reporting.
This chapter introduces auditing and other assurance services provided by auditors, as well as auditors’ role in
society. These services provide value by offering assurance on financial statements, the effectiveness of internal
control, and other information. There is also a discussion of the types of audits and auditors, including the
requirements for becoming a certified public accountant (CPA).
NATURE OF AUDITING
OBJECTIVE 1-1
Describe auditing.
We have introduced the role of auditors in society, and how auditors’ responsibilities
have increased to include reporting on the effectiveness of internal control over
financial reporting for public companies. We now examine auditing more specifically | Alvin |
using the following definition:
Information and
Established Criteria
Auditing is the accumulation and evaluation of evidence about information to determine and report
on the degree of correspondence between the information and established criteria. Auditing should
be done by a competent, independent person.
The definition includes several key words and phrases. For ease of understanding,
we’ll discuss the terms in a different order than they occur in the description.
Apago PDF Enhancer
To do an audit, there must be information in a verifiable form and some standards
(criteria) by which the auditor can evaluate the information. Information can and does
take many forms. Auditors routinely perform audits of quantifiable information,
including companies’ financial statements and individuals’ federal income tax returns.
Auditors also audit more subjective information, such as the effectiveness of computer
systems and the efficiency of manufacturing operations.
The criteria for evaluating information also vary depending on the information
being audited. In the audit of historical financial statements by CPA firms, the
criteria may be U.S. generally accepted accounting principles (GAAP) or Inter -
national Financial Reporting Standards (IFRS). This means that in an audit of
Boeing’s financial statements, the CPA firm will determine whether Boeing’s financial
statements have been prepared in accordance with GAAP. For an audit of internal
control over financial reporting, the criteria will be a recognized framework for
establishing internal control, such as Internal Control—Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (widely
known as COSO).
For the audit of tax returns by the Internal Revenue Service (IRS), the criteria are
found in the Internal Revenue Code. In an IRS audit of Boeing’s corporate tax return,
the internal revenue agent uses the Internal Revenue Code as the criteria for correctness,
rather than GAAP.
For more subjective information, it is more difficult to establish criteria. Typically,
auditors and the entities being audited agree on the criteria well before the audit
starts. For example, in an audit of the effectiveness of specific aspects of computer
operations, the criteria might include the allowable level of input or output errors.
Accumulating and
Evaluating Evidence
Evidence is any information used by the auditor to determine whether the information
being audited is stated in accordance with the established criteria. Evidence takes many
different forms, including:
4
Part 1 / THE AUDITING PROFESSION
• Electronic and documentary data about transactions
• Written and electronic communication with outsiders
• Observations by the auditor
• Oral testimony of the auditee (client)
To satisfy the purpose of the audit, auditors must obtain a sufficient quality and
volume of evidence. Auditors must determine the types and amount of evidence
necessary and evaluate whether the information corresponds to the established
criteria. This is a critical part of every audit and the primary subject of this book.
The auditor must be qualified to understand the criteria used and must be competent to
know the types and amount of evidence to accumulate to reach the proper conclusion
after examining the evidence. The auditor must also have an independent mental
attitude. The competence of those performing the audit is of little value if they are
biased in the accumulation and evaluation of evidence.
Auditors strive to maintain a high level of independence to keep the confidence of
users relying on their reports. Auditors reporting on company financial statements are
often called independent auditors. Even though such auditors are paid fees by the
company, they are normally sufficiently independent to conduct audits that can be
relied on by users. Even internal auditors—those employed by the companies they
audit—usually report directly to top management and the board of directors, keeping
the auditors independent of the operating units they audit.
| Alvin |
The final stage in the auditing process is preparing the audit report, which com -
municates the auditor’s findings to users. Reports differ in nature, but all must inform
readers of the degree of correspondence between the information audited and
established criteria. Reports also differ in form and can vary from the highly technical
type usually associated with financial statement audits to a simple oral report in the
case of an operational audit of a small department’s effectiveness.
Apago PDF Enhancer
The key parts in the description of auditing are illustrated in Figure 1-1 using an
IRS agent’s audit of an individual’s tax return as an example. To determine whether the
tax return was prepared in a manner consistent with the requirements of the federal
Internal Revenue Code, the agent examines supporting records provided by the
taxpayer and from other sources, such as the taxpayer’s employer. After completing the
Competent ,
Independent Person
Reporting
FIGURE 1-1
Audit of a Tax Return
Competent,
independent
person
Internal
revenue
agent
Accumulates and
evaluates evidence
Examines cancelled
checks and other
supporting records
Information
Federal
tax returns
filed by
taxpayer
Determines
correspondence
Established criteria
Internal Revenue
Code and
all interpretations
Report on results
Report on tax
deficiencies
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
5
audit, the internal revenue agent issues a report to the taxpayer assessing additional
taxes, advising that a refund is due, or stating that there is no change in the status of the
tax return.
DISTINCTION BETWEEN AUDITING AND ACCOUNTING
OBJECTIVE 1-2
Distinguish between
auditing and accounting.
Many financial statement users and the general public confuse auditing with accounting.
The confusion results because most auditing is usually concerned with accounting
information, and many auditors have considerable expertise in accounting matters.
The confusion is increased by giving the title “certified public accountant” to many
individuals who perform audits.
Accounting is the recording, classifying, and summarizing of economic events in a
logical manner for the purpose of providing financial information for decision making.
To provide relevant information, accountants must have a thorough understanding of
the principles and rules that provide the basis for preparing the accounting information.
In addition, accountants must develop a system to make sure that the entity’s economic
events are properly recorded on a timely basis and at a reasonable cost.
When auditing accounting data, auditors focus on determining whether recorded
information properly reflects the economic events that occurred during the accounting
period. Because U.S. or international accounting standards provide the criteria for
evaluating whether the accounting information is properly recorded, auditors must
thoroughly understand those accounting standards.
In addition to understanding accounting, the auditor must possess expertise in the
accumulation and interpretation of audit evidence. It is this expertise that distinguishes
auditors from accountants. Determining the proper audit procedures, deciding the
number and types of items to test, and evaluating the results are unique to the auditor.
Apago PDF Enhancer
ECONOMIC DEMAND FOR AUDITING
OBJECTIVE 1-3
Explain the importance
of auditing in reducing
information risk.
To illustrate the need for auditing, consider the decision of a bank officer in making a
loan to a business. This decision will be based on such factors as previous financial
relationships with the business and the financial condition of the business as reflected
by its financial statements. If the bank makes the loan, it will charge a rate of interest
determined primarily by three factors:
1. Risk-free interest rate. This is approximately the rate the bank could earn by
investing in U.S. treasury notes for the same length of time as the business
loan.
2. Business risk for the customer. This risk reflects the possibility that the business
will not be able to repay its loan because of economic or business conditions, | Alvin |
such as a recession, poor management decisions, or unexpected competition in
the industry.
Information risk. Information risk reflects the possibility that the information
upon which the business risk decision was made was inaccurate. A likely cause
of the information risk is the possibility of inaccurate financial statements.
3.
Auditing has no effect on either the risk-free interest rate or business risk, but it
can have a significant effect on information risk. If the bank officer is satisfied that
there is minimal information risk because a borrower’s financial statements are
audited, the bank’s risk is substantially reduced and the overall interest rate to the
borrower can be reduced. The reduction of information risk can have a significant
effect on the borrower’s ability to obtain capital at a reasonable cost. For example,
6
Part 1 / THE AUDITING PROFESSION
Causes of
Information Risk
OBJECTIVE 1-4
List the causes of
information risk, and
explain how this risk can
be reduced.
Reducing
Information Risk
assume a large company has total interest-bearing debt of approximately $10 billion. If
the interest rate on that debt is reduced by only 1 percent, the annual savings in interest
is $100 million.
As society becomes more complex, decision makers are more likely to receive unreliable
information. There are several reasons for this: remoteness of information, biases and
motives of the provider, voluminous data, and the existence of complex exchange
transactions.
Remoteness of Information In a global economy, it is nearly impossible for a
decision maker to have much firsthand knowledge about the organization with which
they do business. Information provided by others must be relied upon. When informa -
tion is obtained from others, the likelihood of it being intentionally or unintentionally
misstated increases.
Biases and Motives of the Provider If information is provided by someone whose
goals are inconsistent with those of the decision maker, the information may be biased
in favor of the provider. The reason can be honest optimism about future events or an
intentional emphasis designed to influence users. In either case, the result is a misstate -
ment of information. For example, when a borrower provides financial statements to a
lender, there is considerable likelihood that the borrower will bias the statements to
increase the chance of obtaining a loan. The misstatement could be incorrect dollar
amounts or inadequate or incomplete disclosures of information.
Voluminous Data As organizations become larger, so does the volume of their
exchange transactions. This increases the likelihood that improperly recorded informa -
tion is included in the records—perhaps buried in a large amount of other information.
For example, if a large government agency overpays a vendor’s invoice by $2,000, it is
unlikely to be uncovered unless the agency has instituted reasonably complex procedures
to find this type of misstatement. If many minor misstatements remain undiscovered,
the combined total can be significant.
Apago PDF Enhancer
Complex Exchange Transactions In the past few decades, exchange transactions
between organizations have become increasingly complex and therefore more difficult
to record properly. For example, the correct accounting treatment of the acquisition of
one entity by another poses relatively difficult accounting problems. Other examples
include properly combining and disclosing the results of operations of subsidiaries in
different industries and properly disclosing derivative financial instruments.
After comparing costs and benefits, business managers and financial statement users
may conclude that the best way to deal with information risk is simply to have it remain
reasonably high. A small company may find it less expensive to pay higher interest costs
than to increase the costs of reducing information risk.
For larger businesses, it is usually practical to incur costs to reduce information
risk. There are three main ways to do so.
User Verifies Information The user may go to the business premises to examine | Alvin |
records and obtain information about the reliability of the statements. Normally, this is
impractical because of cost. In addition, it is economically inefficient for all users to
verify the information individually. Nevertheless, some users perform their own
verification. For example, the IRS does considerable verification of business and
individual tax returns to determine whether the tax returns filed reflect the actual tax
due the federal government. Similarly, if a business intends to purchase another
business, it is common for the purchaser to use a special audit team to independently
verify and evaluate key information of the prospective business.
User Shares Information Risk with Management There is considerable
legal precedent indicating that management is responsible for providing reliable
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
7
FIGURE 1-2
Relationships Among Auditor, Client, and External Users
Client or audit
committee hires
auditor
Client
Auditor
Provides capital
Client provides
financial statements
to users
Auditor issues
report relied upon
by users to reduce
information risk
External
Users
information to users. If users rely on inaccurate financial statements and as a result
incur a financial loss, they may have a basis for a lawsuit against management. A
difficulty with sharing information risk with management is that users may not be able
to collect on losses. If a company is unable to repay a loan because of bankruptcy, it is
unlikely that management will have sufficient funds to repay users.
Audited Financial Statements Are Provided The most common way for users to
obtain reliable information is to have an independent audit. Typically, management of
a private company or the audit committee for a public company engages the auditor to
provide assurances to users that the financial statements are reliable.
External users such as stockholders and lenders who rely on those financial state -
Apago PDF Enhancer
ments to make business decisions look to the auditor’s report as an indication of the
statements’ reliability. Decision makers can then use the audited information on the
assumption that it is reasonably complete, accurate, and unbiased. They value the
auditor’s assurance because of the auditor’s independence from the client and
knowledge of financial statement reporting matters. Figure 1-2 illustrates the rela -
tionships among the auditor, client, and financial statement users.
ASSURANCE SERVICES
OBJECTIVE 1-5
Describe assurance
services and distinguish
audit services from other
assurance and nonassurance
services provided by CPAs.
An assurance service is an independent professional service that improves the quality
of information for decision makers. Such services are valued because the assurance
provider is independent and perceived as being unbiased with respect to the infor -
mation examined. Individuals who are responsible for making business decisions seek
assurance services to help improve the reliability and relevance of the information used
as the basis for their decisions.
Assurance services can be done by CPAs or by a variety of other professionals. For
example, Consumers Union, a nonprofit organization, tests a wide variety of products
used by consumers and reports their evaluations of the quality of the products tested in
Consumer Reports. The organization provides the information to help consumers make
intelligent decisions about the products they buy. Many consumers consider the
information in Consumer Reports more reliable than information provided by the
product manufacturers because Consumers Union is independent of the manu -
facturers. Similarly, the Better Business Bureau (BBB) online reliability program, the
BBB Accredited Business Seal, allows Web shoppers to check BBB information about a
company and be assured the company will stand behind its service. Other assurance
8
Part 1 / THE AUDITING PROFESSION
Attestation Services
services provided by firms other than CPAs include the Nielsen television and Internet | Alvin |
ratings and Arbitron radio ratings.
The need for assurance is not new. CPAs have provided many assurance services
for years, particularly assurances about historical financial statement information. CPA
firms have also performed assurance services related to lotteries and contests to
provide assurance that winners were determined in an unbiased fashion in accordance
with contest rules. More recently, CPAs have expanded the types of assurance services
they perform to include forward-looking and other types of information, such as
company financial forecasts and Web site controls. For example, businesses and
consumers using the Internet to conduct business need independent assurances about
the reliability and security of electronic information. The demand for assurance
services continues to grow as the demand increases for real-time electronic information.
One category of assurance services provided by CPAs is attestation services. An
attestation service is a type of assurance service in which the CPA firm issues a report
about the reliability of an assertion that is made by another party. Attestation services
fall into five categories:
1. Audit of historical financial statements
2. Audit of internal control over financial reporting
3. Review of historical financial statements
4. Attestation services on information technology
5. Other attestation services that may be applied to a broad range of subject matter
Audit of Historical Financial Statements In an audit of historical financial state -
ments, management asserts that the statements are fairly stated in accordance with
applicable U.S. or international accounting standards. An audit of these statements is a
form of attestation service in which the auditor issues a written report expressing an
opinion about whether the financial statements are fairly stated in accordance with the
applicable accounting standards. These audits are the most common assurance service
provided by CPA firms.
Apago PDF Enhancer
Publicly traded companies in the United States are required to have audits under
the federal securities acts. Auditor reports can be found in all public companies’ annual
financial reports. Most public companies’ audited financial statements can be accessed
over the Internet from the Securities and Exchange Commission (SEC) EDGAR
database or directly from each company’s Web site. Many privately held companies also
have their annual financial statement audited to obtain financing from banks and other
financial institutions. Government and not-for-profit entities often have audits to meet
the requirements of lenders or funding sources.
Audit of Internal Control over Financial Reporting For an audit of internal
control over financial reporting, management asserts that internal controls have been
developed and implemented following well established criteria. Section 404 of the
Sarbanes–Oxley Act requires public companies to report management’s assessment of
the effectiveness of internal control. The Act also requires auditors to attest to the
effectiveness of internal control over financial reporting. This evaluation, which is
integrated with the audit of the financial statements, increases user confidence about
“AND THE OSCAR GOES TO . . .”
“THERE SHE IS, MISS AMERICA . . .”
“WELCOME TO THE NEW YORK
STATE LOTTERY . . .”
You probably recognize these statements from the Academy Awards,
the Miss America Pageant, and the New York State Lottery drawing. What you
may not recognize is what these well-known events have to do with assurance
services. Each event is observed by CPAs from a major accounting firm to
assure viewers that the contests were fairly conducted. So when you become
a member of a CPA firm, you might not win an Oscar—but you could be on the
Oscars!
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
9
future financial reporting, because effective internal controls reduce the likelihood of
future misstatements in the financial statements.
Review of Historical Financial Statements For a review of historical financial | Alvin |
statements, management asserts that the statements are fairly stated in accordance
with accounting standards, the same as for audits. The CPA provides a lower level of
assurance for reviews of financial statements compared to a high level for audits,
therefore less evidence is needed. A review is often adequate to meet financial state -
ment users’ needs. It can be provided by the CPA firm at a much lower fee than an audit
because less evidence is needed. Many nonpublic companies use this attestation option
to provide limited assurance on their financial statements without incurring the cost of
an audit.
Attestation Services on Information Technology For attestations on information
technology, management makes various assertions about the reliability and security of
electronic information. Many business functions, such as ordering and making pay -
ments, are conducted over the Internet or directly between computers using electronic
data interchange (EDI). As transactions and information are shared online and in real
time, businesspeople demand even greater assurances about information, transactions,
and the security protecting them. WebTrust and SysTrust are examples of attestation
services developed to address these assurance needs.
• WebTrust services. The AICPA and the Canadian Institute of Chartered Accountants
(CICA) jointly created the WebTrust attestation service. CPA firms that are licensed
by the AICPA to perform this service provide assurance to users of Web sites
through the CPA’s electronic WebTrust seal displayed on the Web site. This seal
assures the user that the Web site owner has met established criteria related to
business practices, transaction integrity, and information processes.
• SysTrust services. The AICPA and CICA jointly created the SysTrust attestation
Apago PDF Enhancer
service to evaluate and test system reliability in areas such as security and data
integrity. Whereas the WebTrust assurance service is primarily designed to provide
assurance to third-party users of a Web site, SysTrust services might be done by CPAs
to provide assurance to management, the board of directors, or third parties about
the reliability of information systems used to generate real-time information.
The AICPA and CICA have developed five principles related to online privacy,
security, processing integrity, availability, and confidentiality to be used in performing
services such as WebTrust and SysTrust. These services and principles are discussed
further in Chapter 25.
Other Attestation Services CPAs provide numerous other attestation services.
Many of these services are natural extensions of the audit of historical financial
statements, as users seek independent assurances about other types of information. In
each case, the organization being audited must provide an assertion before the CPA can
provide the attestation. For example, when a bank loans money to a company, the loan
agreement may require the company to engage a CPA to provide assurance about the
company’s compliance with the financial provisions of the loan. The company
requesting the loan must assert the loan provisions to be attested to before the CPA can
accumulate the evidence needed to issue the attestation report. CPAs can also, for
example, attest to the information in a client’s forecasted financial statements, which
are often used to obtain financing. We discuss attestation services further in Chapter 25.
Most of the other assurance services that CPAs provide do not meet the definition of
attestation services, but the CPA must still be independent and must provide assurance
about information used by decision makers. These assurance services differ from
attestation services in that the CPA is not required to issue a written report, and the
assurance does not have to be about the reliability of another party’s assertion about
Other
Assurance Services
10
Part 1 / THE AUDITING PROFESSION
GREEN
INITIATIVES
BRING
ASSURANCE
OPPORTUNITIES,
COMPETITION
Global interest in sustainability and corporate | Alvin |
responsibility has triggered a surge in corporate
reports that address these topics. In a 2008 KPMG
survey, 80 percent of the Global Fortune 250
released environmental, social, and governance
data in standalone reports or integrated into
annual financial reports, up from 50 percent in
the last survey three years earlier. Over half of
these reports included some form of commentary
or formal assurance on the reports. Reports with
formal assurance increased from 30 percent to
40 percent over the three year period. Major
accounting firms were the most common choice
of assurance provider. Other assurance providers
included certification bodies and technical expert
firms.
Source: Adapted from KPMG International Survey
of Corporate Responsibility Reporting 2008, KPMG
Sustainability Services, KPMG LLP.
compliance with specified criteria. These other assurance service engagements focus on
improving the quality of information for decision makers, just like attestation services.
For example, a CPA might provide assurances on a company’s use of personal data
provided by customers.
CPA firms face a larger field of competitors in the market for other assurance
services. Audits and some types of attestation services are limited by regulation to
licensed CPAs, but the market for other forms of assurance is open to non-CPA
competitors. For example, CPAs must compete with market research firms to assist
clients in the preparation of customer surveys and in the evaluation of the reliability
and relevance of survey information. However, CPA firms have the competitive
advantage of their reputation for competence and independence.
The types of assurance services that CPAs can provide are almost limitless. A survey
of large CPA firms identified more than 200 assurance services that are currently being
provided. Table 1-1 lists some of the other assurance service opportunities for CPAs.
Additional information on the performance of assurance services is included in
Chapter 25.
Apago PDF Enhancer
TABLE 1-1
Other Assurance Services Examples
Other Assurance Services
Service Activities
Controls over and risks related to investments,
Assess the processes in a company’s investment practices to identify risks
including policies related to derivatives
and to determine the effectiveness of those processes
Mystery shopping
Perform anonymous shopping to assess sales personnel dealings with
customers and procedures they follow
Assess risks of accumulation, distribution,
and storage of digital information
Assess security risks and related controls over electronic data, including
the adequacy of backup and off-site storage
Fraud and illegal acts risk assessment
Develop fraud risk profiles, and assess the adequacy of company systems
and policies in preventing and detecting fraud and illegal acts
Compliance with trading policies and
Examine transactions between trading partners to ensure that transactions
procedures
comply with agreements; identify risks in the agreements
Compliance with entertainment royalty
Assess whether royalties paid to artists, authors, and others comply with
agreements
ISO 9000 certifications
royalty agreements
Certify a company’s compliance with ISO 9000 quality control standards,
which help ensure company products are of high quality
Corporate responsibility and sustainability
Report on whether the information in a company’s corporate
responsibility report is consistent with company information and
established reporting criteria
Source: Adapted from AICPA Special Committee on Assurance Services.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
11
FIGURE 1-3
Relationships Among Assurance Services, Attestation Services, and Nonassurance Services
ASSURANCE SERVICES
ASSURANCE SERVICES
NONASSURANCE SERVICES
NONASSURANCE SERVICES
ATTESTATION SERVICES
ATTESTATION SERVICES
Audits
Reviews
Internal Control
over Financial Reporting
Attestation Services on
Information Technology and
Other Attestation Services
Other Assurance Services
Other Management
Consulting
Certain
Management
Consulting
| Alvin |
Accounting and
Bookkeeping
Tax
Services
Nonassurance
Services Provided
by CPAs
CPA firms perform numerous other services that generally fall outside the scope of
assurance services. Three specific examples are:
1. Accounting and bookkeeping services
2. Tax services
3. Management consulting services
Apago PDF Enhancer
Most accounting and bookkeeping services, tax services, and management con sult -
ing services fall outside the scope of assurance services, although there is some
common area of overlap between consulting and assurance services. While the primary
purpose of an assurance service is to improve the quality of information, the primary
purpose of a management consulting engagement is to generate a recom mendation to
management.
Although the quality of information is often an important criterion in manage ment
consulting, this goal is normally not the primary purpose. For example, a CPA may be
engaged to design and install a new information technology system for a client as a
consulting engagement. The purpose of that engagement is to install the new system,
with the goal of improved information being a by-product of that engagement.
Figure 1-3 reflects the relationship between assurance and nonassurance services.
Audits, reviews, reports on the effectiveness of internal control over financial report ing,
attestation services on information technology, and other attestation services are all
examples of attestation services, which fall under the scope of assurance services. Some
assurance services, such as WebTrust and SysTrust, also meet the criteria of attestation
services.
TYPES OF AUDITS
OBJECTIVE 1-6
CPAs perform three primary types of audits, as illustrated with examples in Table 1-2:
Differentiate the three main
types of audits.
1. Operational audit
2. Compliance audit
3. Financial statement audit
12
Part 1 / THE AUDITING PROFESSION
TABLE 1-2
Examples of the Three Types of Audits
Type of Audit
Example
Information
Established Criteria
Available Evidence
Operational
Evaluate whether
Number of payroll
audit
the computerized
payroll processing for
a Chinese subsidiary
is operating efficiently
and effectively
records processed in
in a month, costs of
the department, and
number of errors
made
Compliance
Determine whether
Company records
Company standards
for efficiency and
effectiveness in
payroll department
Error reports, payroll
records, and payroll
processing costs
Loan agreement
provisions
bank requirements
for loan continuation
have been met
audit
Financial
statement
audit
Annual audit of Boeing’s
financial statements
Boeing’s financial
statements
Generally accepted
accounting principles
Financial statements
and calculations by
the auditor
Documents, records,
and outside sources
of evidence
Operational Audits
An operational audit evaluates the efficiency and effectiveness of any part of an
organization’s operating procedures and methods. At the completion of an operational
audit, management normally expects recommendations for improving operations. For
example, auditors might evaluate the efficiency and accuracy of processing payroll
transactions in a newly installed computer system. Another example, where most
accountants feel less qualified, is evaluating the efficiency, accuracy, and customer
satisfaction in processing the distribution of letters and packages by a company such as
Federal Express.
Apago PDF Enhancer
In operational auditing, the reviews are not limited to accounting. They can
include the evaluation of organi zational structure, computer operations, production
methods, marketing, and any other area in which the auditor is qualified. Because of
the many different areas in which operational effectiveness can be evaluated, it is
impossible to characterize the conduct of a typical operational audit. In one organi -
zation, the auditor might evaluate the relevancy and sufficiency of the information
used by management in making decisions to acquire new fixed assets. In a different
organization, the auditor might evaluate the efficiency of the information flow in | Alvin |
processing sales.
It is more difficult to objectively evaluate whether the efficiency and effectiveness
of operations meets established criteria than it is for compliance and financial statement
audits. Also, establishing criteria for evaluating the information in an operational audit
is extremely subjective. In this sense, operational auditing is more like management
consulting than what is usually considered auditing. Operational auditing is discussed
in greater depth in Chapter 26.
XBRL
ELECTRONIC DATA
TO IMPROVE
FINANCIAL
REPORTING
Extensible Business Reporting Language (XBRL)
is a language for the electronic communication
of business and financial data developed by a
non-profit consortium of companies and
government agencies to enhance the usability
of financial information. XBRL is used to encode
financial statements using data tags so that the
financial information can be read automatically
by XBRL-enabled software and more easily
sorted and compared.
In 2009 the SEC adopted rules requiring public
companies to provide interactive financial state -
ment data in XBRL format. Although auditors may
attest to this data under attestation standards,
companies are not required to obtain assurance
from auditors or other parties on the interactive
data.
Sources: 1. “Interactive Data to Improve Financial
Reporting,” SEC Final Rules (sec.gov/rules/final/2009/
33-9002.pdf); 2. XBRL International (www.xbrl.org).
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
13
Compliance Audits
Financial
Statement Audits
FRAUD FIGHTERS:
DEMAND FOR
FORENSIC
ACCOUNTANTS
REMAINS STRONG
THROUGH
ECONOMIC
DOWNTURN
A compliance audit is conducted to determine whether the auditee is following specific
procedures, rules, or regulations set by some higher authority. Following are examples
of compliance audits for a private business.
• Determine whether accounting personnel are following the procedures pre -
scribed by the company controller.
• Review wage rates for compliance with minimum wage laws.
• Examine contractual agreements with bankers and other lenders to be sure the
company is complying with legal requirements.
Governmental units, such as school districts, are subject to considerable compliance
auditing because of extensive government regulation. Many private and not-for-profit
organizations have prescribed policies, contractual agreements, and legal requirements
that may require compliance auditing. Compliance audits for federally funded grant
programs are often done by CPAs and are discussed in detail in Chapter 26.
Results of compliance audits are typically reported to management, rather than
outside users, because management is the primary group concerned with the extent
of compliance with prescribed procedures and regulations. Therefore, a significant
portion of work of this type is often done by auditors employed by the organizational
units. When an organization such as the IRS wants to determine whether individuals or
organizations are complying with its requirements, the auditor is employed by the
organization issuing the requirements.
A financial statement audit is conducted to determine whether the financial statements
(the information being verified) are stated in accordance with specified criteria.
Normally, the criteria are U.S. or international accounting standards, although auditors
may conduct audits of financial statements prepared using the cash basis or some other
basis of accounting appropriate for the organization. In determining whether financial
statements are fairly stated in accordance with accounting standards, the auditor gathers
Apago PDF Enhancer
When Ron Forster conducts interviews, he
watches his subjects as much as he listens to
them. Even a seemingly innocuous gesture — an
interviewee moving his hand away from his face
before answering a sensitive question — could be
a sign the subject is lying. Mr. Forster is a forensic
accountant, a growing subset of the accounting
field focused on uncovering financial fraud.
And while forensic accountants do their share
of number crunching and computer analysis, they | Alvin |
also do work that resembles television crime
show investigations. “Forensic accountants are
really financial detectives,” says Alex Brown of
the United Kingdom Institute of Chartered
Accountants’ forensic group. Brown has worked
on cases involving Caribbean money laundering,
Eastern European smuggling, and major
commercial disputes. Forensic accountants use
rigorous accounting skills and a flair for
investigation to sniff out fraud, uncover money-
laundering and trace missing assets.
The day-to-day work of a forensic accountant
involves interviewing key people, studying
accounts and, increasingly, examining electronic
documents. The ever-growing volume of such
documentation means that there is now a new
branch of forensic accounting. Specialist
computing forensic experts usually have a
background in IT and receive accounting training
on the job.
Forensic accounting is booming, and
continues to expand through the recent global
recession. Over a five year period, the number
of fraud examiners certified by the Association
of Certified Fraud examiners increased from
just over 15,000 to nearly 25,000. “During a
declining economy, fraud activity often comes
to light ” says Marc Brdar, a forensic accountant
in Pittsburgh. “Prosperity can hide a multitude
of sins.”
“I was attracted to forensic accountancy
because, like science, you need to have investi -
gative skills,” says forensic trainee Amy Hawkins.
“I really like the sleuthing side of the job, where
you’re finding out whodunit and where the
money went.” Forensic accountant Simon Bevan
adds, “ When you find that killer document it ’s a
real reward for all your hard work.”
Sources: Adapted from 1. Anya Sostek, “Fraud
Fighters: Forensic Accountants on Front Line in
Fight Against Fraud,” Pittsburgh Post Gazette
(March 29, 2009); 2. Amy McClellan, “Forensic
Accountancy: Hot on the Trail of the Fraudsters,”
The Independent (April 26, 2006).
14
Part 1 / THE AUDITING PROFESSION
evidence to determine whether the statements contain material errors or other
misstatements. The primary focus of this book is on financial statement audits.
As businesses increase in complexity, it is no longer sufficient for auditors to focus
only on accounting transactions. An integrated approach to auditing considers both the
risk of misstatements and operating controls intended to prevent misstatements. The
auditor must also have a thorough understanding of the entity and its environment.
This understanding includes knowledge of the client’s industry and its regulatory and
operating environment, including external relationships, such as with suppliers,
customers, and creditors. The auditor also considers the client’s business strategies and
processes and critical success factors related to those strategies. This analysis helps the
auditor identify business risks associated with the client’s strategies that may affect
whether the financial statements are fairly stated.
Several types of auditors are in practice today. The most common are certified public
accounting firms, government accountability office auditors, internal revenue agents,
and internal auditors.
OBJECTIVE 1-7
Identify the primary types
of auditors.
TYPES OF AUDITORS
Certified Public
Accounting Firms
Government
Accountability
Office Auditors
Certified public accounting firms are responsible for auditing the published historical
financial statements of all publicly traded companies, most other reasonably large
companies, and many smaller companies and noncommercial organizations. Because
of the widespread use of audited financial statements in the U.S. economy, as well as
businesspersons’ and other users’ familiarity with these statements, it is common to use
the terms auditor and CPA firm synonymously, even though several different types of
auditors exist. The title certified public accounting firm reflects the fact that auditors
who express audit opinions on financial statements must be licensed as CPAs. CPA
firms are often called external auditors or independent auditors to distinguish them
from internal auditors.
| Alvin |
Apago PDF Enhancer
A government accountability office auditor is an auditor working for the U.S. Govern -
ment Accountability Office (GAO), a nonpartisan agency in the legislative branch of
the federal government. Headed by the Comptroller General, the GAO reports to and is
responsible solely to Congress.
The GAO’s primary responsibility is to perform the audit function for Congress,
and it has many of the same audit responsibilities as a CPA firm. The GAO audits much
of the financial information prepared by various federal government agencies before it
is submitted to Congress. Because the authority for expenditures and receipts of
governmental agencies is defined by law, there is considerable emphasis on compliance
in these audits.
An increasing portion of the GAO’s audit efforts are devoted to evaluating the
operational efficiency and effectiveness of various federal programs. Also, because of
the immense size of many federal agencies and the similarity of their operations, the
GAO has made significant advances in developing better methods of auditing through
the widespread use of highly sophisticated statistical sampling and computer risk
assessment techniques.
In many states, experience as a GAO auditor fulfills the experience requirement for
becoming a CPA. In those states, if an individual passes the CPA examination and
fulfills the experience stipulations by becoming a GAO auditor, he or she may then
obtain a CPA certificate.
As a result of their great responsibility for auditing the expenditures of the federal
government, their use of advanced auditing concepts, their eligibility to be CPAs, and
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
15
Internal Revenue
Agents
Internal Auditors
their opportunities for performing operational audits, GAO auditors are highly
regarded in the auditing profession.
The IRS, under the direction of the Commissioner of Internal Revenue, is responsible
for enforcing the federal tax laws as they have been defined by Congress and inter -
preted by the courts. A major responsibility of the IRS is to audit taxpayers’ returns to
determine whether they have complied with the tax laws. These audits are solely
compliance audits. The auditors who perform these examinations are called internal
revenue agents.
It might seem that the audit of returns for compliance with the federal tax laws is a
simple and straightforward problem, but nothing is farther from the truth. Tax laws are
highly complicated, and there are hundreds of volumes of interpretations. The tax
returns being audited vary from the simple returns of individuals who work for only
one employer and take the standard tax deduction to the highly complex returns of
multinational corporations. Taxation problems may involve individual income taxes,
gift taxes, estate taxes, corporate taxes, trusts, and so on. An auditor involved in any of
these areas must have considerable tax knowledge and auditing skills to conduct effec -
tive audits.
Internal auditors are employed by all types of organizations to audit for management,
much as the GAO does for Congress. Internal auditors’ responsibilities vary considerably,
depending on the employer. Some internal audit staffs consist of only one or two
employees doing routine compliance auditing. Other internal audit staffs may have
more than 100 employees who have diverse responsibilities, including many outside the
accounting area. Many internal auditors are involved in operational auditing or have
expertise in evaluating computer systems.
To maintain independence from other business functions, the internal audit group
typically reports directly to the president, another high executive officer, or the audit
Apago PDF Enhancer
committee of the board of directors. However, internal auditors cannot be entirely
independent of the entity as long as an employer–employee relationship exists. Users
from outside the entity are unlikely to want to rely on information verified solely
by internal auditors because of their lack of independence. This lack of independence is | Alvin |
the major difference between internal auditors and CPA firms.
In many states, internal audit experience can be used to fulfill the experience
requirement for becoming a CPA. Many internal auditors pursue certification as a
certified internal auditor (CIA), and some internal auditors pursue both the CPA and
CIA designations.
CBT-e:
THE CPA EXAM
GETS A
MAKEOVER
The CPA examination changed to computer-based
testing (CBT) in 2004. The next generation of the
exam, known as CBT-e (the “e” is for evolution),
became effective January 1, 2011. The revision
includes new content and skill specifi cation
outline revisions, changes in the structure of the
exam and weighting of individual exam com -
ponents, coverage of international auditing and
financial reporting standards, and new task-
|based simulations. Although the overall length
of the exam did not change, the testing times
for individual sections were adjusted to reflect
the new content specifications.
“CBT-e – the next generation of the
CPA Examination – represents a significant
advancement,” says Colleen Conrad, Chair of the
AICPA Board of Examiners. “More than a series of
examination improvements, CBT-e is a leap into
a more advanced technological environment –
an environ ment that is necessary in order to
enhance the operational and psychometric
quality of the CPA Examination, improve the
candidate experience, and provide a platform
for further innovation.”
Sources: Adapted from 1. The Uniform CPA
Examination Alert (Spring 2009); 2. The Uniform
CPA Examination Alert (Fall 2009) (www.cpa.org).
16
Part 1 / THE AUDITING PROFESSION
CERTIFIED PUBLIC ACCOUNTANT
OBJECTIVE 1-8
Describe the requirements
for becoming a CPA .
Use of the title certified public accountant (CPA) is regulated by state law through the
licensing departments of each state. Within any state, the regulations usually differ for
becoming a CPA and retaining a license to practice after the designation has been
initially achieved. To become a CPA, three requirements must be met. These are
summarized in Figure 1-4.
For a person planning to become a CPA, it is essential to know the requirements in
the state where he or she plans to obtain and maintain the CPA designation. The best
source of that information is the State Board of Accountancy for the state in which the
person plans to be certified. The National Association of State Boards of Accountancy
(NASBA) Web site (www.nasba.org) provides information on licensure requirements
and links to the Web site of each state board. It is possible to transfer the CPA desig -
nation from one state to another, but additional requirements often must be met for
formal education, practice experience, or continuing education.
Most young professionals who want to become CPAs start their careers working
for a CPA firm. After they become CPAs, many leave the firm to work in industry,
govern ment, or education. These people may continue to be CPAs but often give up
their right to practice as independent auditors. To maintain the right to practice as
independent auditors in most states, CPAs must meet defined continuing education
and licensing requirements. Therefore, it is common for accountants to be CPAs who
do not practice as independent auditors.
Information about the CPA examination can be found in The Uniform CPA
Exami nation Candidate Bulletin and the Content and Skill Specifications for the Uniform
CPA Examination, both of which can be downloaded from the CPA Examination site
found on the AICPA Web site (www.aicpa.org). The AICPA also publishes selected
examination questions with unofficial answers indexed to the content specification
outlines of the examination.
Apago PDF Enhancer
Some of the questions and problems at the end of the chapters in this book have
been taken from past CPA examinations. They are designated “AICPA” or “AICPA
adapted.”
FIGURE 1-4
Three Requirements for Becoming a CPA
Educational
Requirement
Uniform CPA
Examination Requirement
Experience
Requirement
Normally, an undergraduate or
graduate degree with a major
in accounting, including a | Alvin |
minimum number of
accounting credits. Most states
now require 150 semester
credit hours (225 quarter
credits) for licensure as a CPA.
Some states require fewer
credits before taking the
examination but require 150
semester credits before
receiving the CPA certificate.
Computer-based examination
offered at various testing centers.
Examination sections are as follows:
• Auditing and Attestation
— 4 hours
• Financial Accounting and Reporting
— 4 hours
• Regulation
— 3 hours
• Business Environment and Concepts
— 3 hours
Some states also require a separate
ethics examination.
Varies widely from no
experience to 2 years,
including auditing.
Some states include
experience working for
governmental units or in
internal auditing.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
17
SUMMARY
This chapter defined auditing and distinguished auditing from accounting. Audits are
valuable because they reduce information risk, which lowers the cost of obtaining capital.
The chapter also described attestation and assurance services, including reports on the
effectiveness of internal control over financial reporting, and described the relationships
among audits, attestation services, and assurance services. The chapter also described
different types of audits and auditors and requirements for becoming a CPA.
ESSENTIAL TERMS
Accounting—the recording, classifying,
and summarizing of economic events in a
logical manner for the purpose of pro -
viding financial information for decision
making
Assurance service—an independent pro -
fessional service that improves the quality
of information for decision makers
Attestation service—a type of assurance
service in which the CPA firm issues a
report about the reliability of an assertion
that is the responsibility of another party
Apago PDF Enhancer
Audit of historical financial statements—
a form of attestation service in which the
auditor issues a written report stating
whether the financial statements are in
material conformity with accounting
standards
Audit report—the communication of
audit findings to users
Auditing—the accumulation and evalu -
ation of evidence about information to
determine and report on the degree of
correspondence between the information
and established criteria
Certified public accountant—a person
who has met state regulatory requirements,
including passing the Uniform CPA
Examination, and has thus been certified;
a CPA may have as his or her primary
responsibility the performance of the
audit function on published historical
financial statements of commercial and
noncommercial financial entities
Compliance audit—(1) a review of an
organization’s financial records performed
to determine whether the organization is
following specific procedures, rules, or
18
Part 1 / THE AUDITING PROFESSION
regulations set by some higher authority;
(2) an audit performed to determine
whether an entity that receives financial
assistance from the federal government
has complied with specific laws and
regulations
Evidence—any information used by the
auditor to determine whether the infor -
mation being audited is stated in accord -
ance with established criteria
Financial statement audit—an audit
con ducted to determine whether the
overall financial statements of an entity
are stated in accordance with specified
criteria (usually U.S. or international
accounting standards)
Government accountability office audi -
tor—an auditor working for the U.S.
Government Accountability Office (GAO);
the GAO reports to and is responsible
solely to Congress
Independent auditors—certified public
accountants or accounting firms that
perform audits of commercial and non -
commercial financial entities
Information risk—the risk that informa -
tion upon which a business decision is
made is inaccurate
Internal auditors—auditors employed by
a company to audit for the company’s
board of directors and management
Internal control over financial reporting—
an engagement in which the auditor reports | Alvin |
on the effectiveness of internal control
over financial reporting; such reports are
required for accelerated filer public
companies under Section 404 of the
Sarbanes–Oxley Act
Internal revenue agents—auditors who
work for the Internal Revenue Service
(IRS) and conduct examinations of tax -
payers’ returns
provides less assurance than an audit as
to whether the financial statements are
in material conformity with accounting
standards
Operational audit—a review of any part
of an organization’s operating procedures
and methods for the purpose of evalu -
ating efficiency and effectiveness
Review of historical financial state -
ments—a form of attestation in which a
CPA firm issues a written report that
Sarbanes–Oxley Act—a federal securities
law passed in 2002 that provides for
additional regulation of public companies
and their auditors; the Act established the
Public Company Accounting Oversight
Board and also requires auditors to audit
the effective ness of internal control over
financial reporting
REVIEW QUESTIONS
1-1 (Objective 1-5) Explain the relationships among audit services, attestation services, and
assurance services, and give examples of each.
1-2 (Objective 1-3) Discuss the major factors in today’s society that have made the need for
independent audits much greater than it was 50 years ago.
1-3 (Objective 1-3) Distinguish among the following three risks: risk-free interest rate,
business risk, and information risk. Which one or ones does the auditor reduce by per -
forming an audit?
1-4 (Objective 1-4) Identify the major causes of information risk and identify the three
main ways information risk can be reduced. What are the advantages and disadvantages of
each?
Apago PDF Enhancer
1-5 (Objective 1-1) Explain what is meant by determining the degree of correspondence
between information and established criteria. What are the information and established
criteria for the audit of Jones Company’s tax return by an internal revenue agent? What
are they for the audit of Jones Company’s financial statements by a CPA firm?
1-6 (Objectives 1-1, 1-7) Describe the nature of the evidence the internal revenue agent
will use in the audit of Jones Company’s tax return.
1-7 (Objective 1-2) In the conduct of audits of financial statements, it would be a serious
breach of responsibility if the auditor did not thoroughly understand accounting.
However, many competent accountants do not have an understanding of the auditing
process. What causes this difference?
1-8 (Objective 1-6) What are the differences and similarities in audits of financial state -
ments, compliance audits, and operational audits?
1-9 (Objectives 1-6, 1-7) List five examples of specific operational audits that can be
conducted by an internal auditor in a manufacturing company.
1-10 (Objectives 1-5, 1-6) What knowledge does the auditor need about the client’s
business in an audit of historical financial statements? Explain how this knowledge may be
useful in performing other assurance or consulting services for the client.
1-11 (Objective 1-7) What are the major differences in the scope of the audit respon -
sibilities for CPAs, GAO auditors, IRS agents, and internal auditors?
1-12 (Objective 1-8) Identify the four parts of the Uniform CPA Examination.
1-13 (Objective 1-5) Explain why CPAs need to be knowledgeable about information
technology, including e-commerce technologies.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
19
MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS
1-14 (Objectives 1-1, 1-3, 1-5) The following questions deal with audits by CPA firms.
Choose the best response.
a. Which of the following best describes why an independent auditor is asked to express
an opinion on the fair presentation of financial statements?
(1) It is difficult to prepare financial statements that fairly present a company’s
financial position, operations, and cash flows without the expertise of an inde -
pendent auditor.
(2) It is management’s responsibility to seek available independent aid in the appraisal
| Alvin |
of the financial information shown in its financial statements.
(3) The opinion of an independent party is needed because a company may not be
objective with respect to its own financial statements.
(4) It is a customary courtesy that all stockholders of a company receive an independent
report on management’s stewardship of the affairs of the business.
b. Independent auditing can best be described as
(1) a branch of accounting.
(2) a discipline that attests to the results of accounting and other functional operations
and data.
(3) a professional activity that measures and communicates financial and business
data.
(4) a regulatory function that prevents the issuance of improper financial informa -
tion.
c. Which of the following professional services is an attestation engagement?
(1) A consulting service engagement to provide computer-processing advice to a
client.
(2) An engagement to report on compliance with statutory requirements.
Apago PDF Enhancer
(3) An income tax engagement to prepare federal and state tax returns.
(4) The compilation of financial statements from a client’s financial records.
d. Which of the following attributes is likely to be unique to the audit work of CPAs as
compared to the work performed by practitioners of other professions?
(1) Due professional care.
(2) Competence.
(3) Independence.
(4) Complex body of knowledge.
1-15 (Objectives 1-6, 1-7) The following questions deal with types of audits and auditors.
Choose the best response.
a. Operational audits generally have been conducted by internal auditors and govern -
mental audit agencies but may be performed by certified public accountants. A
primary purpose of an operational audit is to provide
(1) a means of assurance that internal accounting controls are functioning as
planned.
(2) a measure of management performance in meeting organizational goals.
(3) the results of internal examinations of financial and accounting matters to a
company’s top-level management.
(4) aid to the independent auditor, who is conducting the audit of the financial
statements.
b. In comparison to the external auditor, an internal auditor is more likely to be con -
cerned with
(1) internal administrative control.
(2) cost accounting procedures.
(3) operational auditing.
(4) internal control.
20
Part 1 / THE AUDITING PROFESSION
c. Which of the following best describes the operational audit?
(1) It requires the constant review by internal auditors of the administrative controls
as they relate to the operations of the company.
(2) It concentrates on implementing financial and accounting control in a newly
organized company.
(3) It attempts and is designed to verify the fair presentation of a company’s results of
operations.
(4) It concentrates on seeking aspects of operations in which waste could be reduced
by the introduction of controls.
d. Compliance auditing often extends beyond audits leading to the expression of
opinions on the fairness of financial presentation and includes audits of efficiency,
economy, effectiveness, as well as
(1) accuracy.
(2) evaluation.
(3) adherence to specific rules or procedures.
(4) internal control.
DISCUSSION QUESTIONS AND PROBLEMS
1-16 (Objective 1-5) The list below indicates various audit, attestation, and assurance
engagements involving auditors.
1. A report on the effectiveness of internal control over financial reporting as required
by Section 404 of the Sarbanes–Oxley Act.
2. An auditor’s report on whether the financial statements are fairly presented in
accordance with International Financial Reporting Standards.
3. A report stating whether the company has complied with restrictive covenants
related to officer compensation and payment of dividends contained in a bank loan
agreement.
Apago PDF Enhancer
4. An electronic seal indicating that an electronic seller observes certain practices.
5. A report indicating whether a governmental entity has complied with certain
government regulations.
6. A report on the examination of a financial forecast. | Alvin |
7. A review report that provides limited assurance about whether financial statements
are fairly stated in accordance with U.S. GAAP.
8. A report on management’s assertion on the company’s level of carbon emissions.
9. A report about management’s assertion on the effectiveness of controls over the
availability, reliability, integrity, and maintainability of its accounting information
system.
10. An evaluation of the effectiveness of key measures used to assess an entity’s success
in achieving specific targets linked to an entity’s strategic plan and vision.
a. Explain or use a diagram to indicate the relationships among audit services, attesta -
Required
tion services, and assurance services.
b. For each of the services listed above, indicate the type of service from the list that
follows.
(1) An audit of historical financial statements.
(2) An attestation service other than an audit service.
(3) An assurance service that is not an attestation service.
1-17 (Objective 1-3) Busch Corporation has an existing loan in the amount of $4.5 million
with an annual interest rate of 5.5%. The company provides an internal company-prepared
financial statement to the bank under the loan agreement. Two competing banks have
offered to replace Busch Corporation’s existing loan agreement with a new one. United
National Bank has offered to loan Busch $4.5 million at a rate of 4.5% but requires Busch
to provide financial statements that have been reviewed by a CPA firm. First City Bank has
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
21
Required
Required
offered to loan Busch $4.5 million at a rate of 3.5% but requires Busch to provide financial
statements that have been audited by a CPA firm. Busch Corporation’s controller
approached a CPA firm and was given an estimated cost of $20,000 to perform a review and
$45,000 to perform an audit.
a. Explain why the interest rate for the loan that requires a review report is lower than
that for the loan that did not require a review. Explain why the interest rate for the
loan that requires an audit report is lower than the interest rate for the other two
loans.
b. Calculate Busch Corporation’s annual costs under each loan agreement, including
interest and costs for the CPA firm’s services. Indicate whether Busch should keep its
existing loan, accept the offer from United National Bank, or accept the offer from
First City Bank.
c. Assume that United National Bank has offered the loan at a rate of 4.0% with a review,
and the cost of the audit has increased to $55,000 due to new auditing standards
requirements. Indicate whether Busch should keep its existing loan, accept the offer
from United National Bank, or accept the offer from First City Bank.
d. Discuss why Busch may desire to have an audit, ignoring the potential reduction in
interest costs.
e. Explain how a strategic understanding of the client’s business may increase the value
of the audit service.
1-18 (Objectives 1-3, 1-4, 1-5) Consumers Union is a nonprofit organization that provides
information and counsel on consumer goods and services. A major part of its function is
the testing of different brands of consumer products that are purchased on the open
market and then the reporting of the results of the tests in Consumer Reports, a monthly
publication. Examples of the types of products it tests are middle-sized automobiles,
residential dehumidifiers, flat-screen TVs, and boys’ jeans.
Apago PDF Enhancer
services provided by CPA firms?
a. In what ways are the services provided by Consumers Union similar to assurance
b. Compare the concept of information risk introduced in this chapter with the infor -
mation risk problem faced by a buyer of an automobile.
c. Compare the four causes of information risk faced by users of financial statements as
discussed in this chapter with those faced by a buyer of an automobile.
d. Compare the three ways users of financial statements can reduce information risk
with those available to a buyer of an automobile.
1-19 (Objective 1-1) James Burrow is the loan officer for the National Bank of Dallas. | Alvin |
National has a loan of $325,000 outstanding to Regional Delivery Service, a company
specializing in delivering products of all types on behalf of smaller companies. National’s
collateral on the loan consists of 25 small delivery trucks with an average original cost of
$24,000.
Burrow is concerned about the collectibility of the outstanding loan and whether the
trucks still exist. He therefore engages Samantha Altman, CPA, to count the trucks, using
registration information held by Burrow. She was engaged because she spends most of her
time auditing used automobile and truck dealerships and has extensive specialized
knowledge about used trucks. Burrow requests that Altman issue a report stating the
following:
1. Which of the 25 trucks is parked in Regional’s parking lot on the night of June 30,
2011.
2. Whether all of the trucks are owned by Regional Delivery Service.
3. The condition of each truck, using the guidelines of poor, good, and excellent.
4. The fair market value of each truck, using the current “blue book” for trucks, which
states the approximate wholesale prices of all used truck models, and also using the
poor, good, and excellent condition guidelines.
22
Part 1 / THE AUDITING PROFESSION
a. For each of the following parts of the definition of auditing, state which part of the
Required
preceding narrative fits the definition:
(1) Information
(2) Established criteria
(3) Accumulating and evaluating evidence
(4) Competent, independent person
(5) Reporting results
b. Identify the greatest difficulties Virms is likely to have doing this audit.
1-20 (Objective 1-7) Five college seniors with majors in accounting are discussing alter -
native career plans. The first senior plans to become an internal revenue agent because his
primary interest is income taxes. He believes the background in tax auditing will provide
him with better exposure to income taxes than will any other available career choice. The
second senior has decided to go to work for a CPA firm for at least 5 years, possibly as a
permanent career. She believes the variety of experience in auditing and related fields offers
a better alternative than any other available choice. The third senior has decided on a career
in internal auditing with a large industrial company because of the many different aspects
of the organization with which internal auditors become involved. The fourth senior plans
to become an auditor for the GAO because she believes that this career will provide
excellent experience in computer risk assessment techniques. The fifth senior plans to
pursue some aspect of auditing as a career but has not decided on the type of organization
to enter. He is especially interested in an opportunity to continue to grow professionally,
but meaningful and interesting employment is also a consideration.
a. What are the major advantages and disadvantages of each of the four types of auditing
Required
careers?
b. What other types of auditing careers are available to those who are qualified?
1-21 (Objectives 1-6, 1-7) In the normal course of performing their responsibilities,
auditors often conduct audits or reviews of the following:
Apago PDF Enhancer
1. Federal income tax returns of an officer of the corporation to determine whether he
or she has included all taxable income in his or her return.
2. Disbursements of a branch of the federal government for a special research project
to determine whether it would have been possible to accomplish the same research
results at a lower cost to the taxpayers.
3. Computer operations of a corporation to evaluate whether the computer center is
being operated as efficiently as possible.
4. Annual statements for the use of management.
5. Operations of the IRS to determine whether the internal revenue agents are using
their time efficiently in conducting audits.
6. Statements for bankers and other creditors when the client is too small to have an
audit staff.
7. Financial statements of a branch of the federal government to make sure that the
statements present fairly the actual disbursements made during a period of time. | Alvin |
8. Federal income tax returns of a corporation to determine whether the tax laws have
been followed.
9. Financial statements for use by stockholders when there is an internal audit staff.
10. A bond indenture agreement to make sure a company is following all requirements
of the contract.
11. The computer operations of a large corporation to evaluate whether the internal
controls are likely to prevent misstatements in accounting and operating data.
12. Disbursements of a branch of the federal government for a special research project
to determine whether the expenditures were consistent with the legislative bill that
authorized the project.
a. For these 12 examples, state the most likely type of auditor (CPA, GAO, IRS, or
Required
internal) to perform each.
Chapter 1 / THE DEMAND FOR AUDIT AND OTHER ASSURANCE SERVICES
23
b. In each example, state the type of audit (financial statement audit, operational audit,
or compliance audit).
1-22 (Objectives 1-3, 1-5) Dave Czarnecki is the managing partner of Czarnecki and
Hogan, a medium-sized local CPA firm located outside of Chicago. Over lunch, he is
surprised when his friend James Foley asks him, “Doesn’t it bother you that your clients
don’t look forward to seeing their auditors each year? Dave responded, “Well, auditing is
only one of several services we provide. Most of our work for clients does not involve
financial statement audits, and our audit clients seem to like interacting with us.”
Required
a. Identify ways in which a financial statement audit adds value for clients.
b. List other services other than audits that Czarnecki and Hogan likely provides.
c. Assume Czarnecki and Hogan has hired you as a consultant to identify ways in which
they can expand their practice. Identify at least one additional service that you believe
the firm should provide and explain why you believe this represents a growth
opportunity for CPA firms.
INTERNET PROBLEM 1-1: CPA REQUIREMENTS
Individuals are licensed as CPAs by individual states. Information on the requirements for
each state can be found on the National Association of State Boards of Accountancy
(NASBA) web site (www.nasba.org). The Uniform CPA Examination is administered by
the American Institute of Certified Public Accountants (AICPA), and information on CPA
examination requirements can be found on the AICPA web site (www.aicpa.org).
Required
a. Identify the education requirements to be eligible to sit for the CPA exam in your
state. Include any specific educational content requirements.
b. List any frequently asked questions (FAQ) for your state, if there are any.
Apago PDF Enhancer
c. What are the Elijah Watts Sells awards?
d. What was the passing rate for each exam section in the most recent quarter?
24
Part 1 / THE AUDITING PROFESSION
C H A P T E R 2
THE CPA PROFESSION
Good Auditing Includes Good Client Service
‘‘It had been a good week,” thought Jeanine Wilson, as she drove out of the
parking lot of Solberg Paints on Friday afternoon. Just a few months earlier,
she graduated from State University and sat for the CPA examina tion. Still,
Jeanine did not think her transition to profes sional life had been all that
smooth, and she was surprised at how much there still was to learn. But
she had made great progress on the Solberg job.
John Hernandez was the audit senior on the Solberg Paints audit, and
he had a reputation as a patient teacher and supervisor. Jeanine was not
disappointed. At the start of the engage ment, John told her, “Don’t be afraid
to ask questions. If you see anything that seems unusual, let’s discuss it.
And most importantly, if you have any ideas that will help the client, bring
them up. The client expects us to deliver more than an audit report.’’
‘‘I’d say I delivered,” thought Jeanine. She found an error in the way the
company had calculated LIFO inventory that was going to save the client
a significant amount of taxes. But her biggest contribution almost did not
happen. Jeanine read as much as she could about paint manufac turers and
learned about some new production control methods that seemed like | Alvin |
they could apply to Solberg. She was afraid to bring it up, thinking that she
couldn’t possibly know any thing that the client didn’t already know, but
John encouraged her to discuss it with the client. The result was that the
client wanted to meet further with Jeanine’s firm to better understand how
they could improve their production processes.
Apago PDF Enhancer
L E A R N I N G O B J E C T I V E S
After studying this chapter,
you should be able to
2-1 Describe the nature of CPA firms,
what they do, and their structure.
2-2 Understand the role of
the Public Company Accounting
Oversight Board and the effects
of the Sarbanes–Oxley Act
on the CPA profession.
2-3 Summarize the role of the
Securities and Exchange
Commission in accounting and
auditing.
2-4 Describe the key functions
performed by the AICPA.
2-5 Understand the role of
international auditing standards
and their relation to U.S. auditing
standards.
2-6 Use U.S. auditing standards as
a basis for further study.
2-7 Identify quality control standards
and practices within the
accounting profession.
Friday was the last day of field work on the audit, and the partner, Bill
Marlow, was at the client’s office to complete his review of the audit files.
Jeanine was surprised to hear him say to her, “What are you doing on the 15th? We’re going to meet with the client
to discuss our audit findings. You’ve made a real contribution on this audit, and I’d like you to be there.” Jeanine tried
not to show her excitement too much, but she couldn’t hide the smile on her face. “Yes, it had been a good week.’’
We learned in the first chapter that auditing plays an important role in society by reducing information risk and
facilitating access to capital and that audit firms provide additional, value-added service to their clients. As
the opening story to this chapter demonstrates, audit professionals at all experience levels serve as valued advisors
to their clients. This chapter describes the organization of CPA firms and the types of services they provide. We also
discuss the effects on auditing of the Sarbanes–Oxley Act and the Public Company Accounting Oversight Board
(PCAOB), as well as other standards and regulatory agencies that influence auditor performance.
CERTIFIED PUBLIC ACCOUNTING FIRMS
OBJECTIVE 2-1
Describe the nature of
CPA firms, what they do,
and their structure.
Except for certain governmental organizations, the audits of all general use financial
statements in the United States are done by CPA firms. The legal right to perform
audits is granted to CPA firms by regulation of each state. CPA firms also provide
many other services to their clients, such as tax and advisory services.
It is estimated that more than 45,000 CPA firms exist in the United States. These
firms range in size from 1 person to 20,000 partners and staff. Table 2-1 provides
revenue and other data for some of the largest accounting firms in the United States.
Four size categories are used to describe CPA firms: Big Four international firms,
national firms, regional and large local firms, and small local firms.
• Big Four international firms. The four largest CPA firms in the United States are
called the “Big Four” international CPA firms. They are the first four firms listed
TABLE 2-1
Revenue and Other Data for the Largest CPA Firms in the United States
Apago PDF Enhancer
Net Revenue—
U.S. Only
(in $ millions)
Partners
Professionals
U.S.
Offices
Percentage of Total
Revenue from
Accounting and
Auditing/Taxes/
Management
Consulting and Other
2010
Size by
Revenue
BIG FOUR
Firm
1
2
3
4
Deloitte & Touche
Ernst & Young
PricewaterhouseCoopers
KPMG
NATIONAL
$ 10,722.0
$ 7,620.0
$ 7,369.4
$ 5,076.0
2,968
2,500
2,235
1,847
5
6
7
8
RSM McGladrey/McGladrey & Pullen(1)
Grant Thornton
BDO Seidman
CBIZ/Mayer Hoffman McCann(2)
$ 1,460.7
$ 1,147.8
620.0
$
600.7
$
REGIONAL(3)
9
10
11
12
Crowe Horwath
BKD
Moss Adams
Plante & Moran
LARGE LOCAL
50
75
Holthouse Carlin & Van Trigt
LeMaster & Daniels
$
$
$
$
$
$
508.0
393.0
323.0
301.2
58.0
41.7
751
535
273
465
240
258
240
221
27
27
30,637
17,500
22,729
15,803
5,331
3,700
1,849
2,085
1,636
1,256
1,130
1,108
164
193
102
80
76
88
93
52
37
180
25
31
18
18
7
12
37/24/39
41/33/26
54/31/15
48/27/25
44/35/21
47/26/27
60/25/15
23/27/50
65/22/13
52/30/18
49/34/17
50/32/18
22/67/11
28/51/21
| Alvin |
(1) RSM McGladrey and McGladrey & Pullen have an alternative practice structure in which each is a separate and independent legal entity. The firm now operates
under the single name McGladrey.
(2) CBIZ and Mayer Hoffman and McCann are affiliated through an alternative practice structure.
(3) Only the four largest regional firms are listed.
Source: Accounting Today (www.webcpa.com).
26
Part 1 / THE AUDITING PROFESSION
in Table 2-1. These four firms have offices throughout the United States and
throughout the world. The Big Four firms audit nearly all of the largest companies
both in the United States and worldwide and many smaller companies as well.
• National firms. Four CPA firms in the United States are called national firms
because they have offices in most major cities. These are firms 5 through 8 in Table
2-1. These firms are large but considerably smaller than the Big Four. The national
firms perform the same services as the Big Four firms and compete directly with
them for clients. Each national firm is affiliated with firms in other countries and
therefore has an international capability.
• Regional and large local firms. There are less than 200 CPA firms with professional
staffs of more than 100 people. Some have only one office and serve clients
primarily within commuting distances. Others have several offices in a state or
region and serve a larger radius of clients. For example, Table 2-1 shows that the
largest regional firms are not dramatically smaller than the four national firms.
Regional and large local firms compete for clients with other CPA firms, including
national and Big Four firms. Many of the regional and large local firms are
affiliated with associations of CPA firms to share resources for such things as
technical information and continuing education. Many of these firms also have
international affiliations.
• Small local firms. More than 95 percent of all CPA firms have fewer than 25
professionals in a single-office firm. They perform audits and related services
primarily for smaller businesses and not-for-profit entities, although some have
one or two clients with public ownership. Many small local firms do not perform
audits and primarily provide accounting and tax services to their clients.
Apago PDF Enhancer
As discussed in Chapter 1, CPA firms provide audit services, as well as other attestation
and assurance services. Additional services commonly provided by CPA firms include
accounting and bookkeeping services, tax services, and management consulting
services. CPA firms continue to develop new products and services, such as financial
planning, business valuation, forensic accounting, and information technology
advisory services.
ACTIVITIES OF CPA FIRMS
• Accounting and bookkeeping services. Many small clients with limited accounting
staff rely on CPA firms to prepare their financial statements. Some small clients lack
the personnel or expertise to use accounting software to maintain their own
accounting records. Thus, CPA firms perform a variety of accounting and book -
keeping services to meet the needs of these clients. In many cases in which the
financial statements are to be given to a third party, a review or even an audit is also
performed. When neither of these is done, the financial statements are accom panied
by a type of report by the CPA firm called a compilation report, which provides no
assurance to third parties. As Table 2-1 shows, attestation services and accounting
and bookkeeping services are the major source of revenue for most large CPA firms.
• Tax services. CPA firms prepare corporate and individual tax returns for both audit
and nonaudit clients. Almost every CPA firm performs tax services, which may
include estate tax, gift tax, tax planning, and other aspects of tax services. For many
small firms, such services are far more important to their practice than auditing, as
most of their revenue may be generated from tax services.
• Management consulting services. Most CPA firms provide certain services that | Alvin |
enable their clients to operate their businesses more effectively. These services are
called management consulting or management advisory services. These services
range from simple suggestions for improving the client’s accounting system to
advice in risk management, information technology and e-commerce system design,
Chapter 2 / THE CPA PROFESSION
27
PEER REVIEW
EXPANDS AFTER
MADOFF SCANDAL
The AICPA created a voluntary uniform peer
review program in 1977 with the establishment
of the Division for CPA Firms. Firms were required
to be peer reviewed every three years to make
certain all firms conducting attest functions
adhered to generally accepted auditing standards.
In 1988, AICPA members approved mandatory
peer reviews for all members. However, since
membership in the AICPA is voluntary, firms that
were not members were not subject to peer
review unless required by the state in which the
firm practiced.
Interest in peer review seemed to diminish
when PCAOB quality inspections replaced peer
review for auditors of public companies.
However, the Ponzi scheme involving Bernie
Madoff refocused attention on peer review when
it was revealed that his sole practitioner auditor
was not peer reviewed. In response, New York
passed a peer review requirement for all CPA
firms in New York State, increasing to 45 the
number of states with a peer review requirement.
When the New York requirement is implemented
in 2012, the number of CPA firms in New York
subject to peer review will nearly double, from
approximately 1,800 to about 3,000. Ironically,
Madoff’s auditor would not have been required to
have a peer review under the new requirements,
as firms with one or two practitioners are exempt
from the requirement.
Sources: Adapted from 1. Richard Stolz, “Peer Review in
Need of Review?” (April 20, 2009) (www.webcpa.com);
2. Robert Bunting, “Transparency, the New Peer Review
Watchword,” The CPA Journal (October 2004) p. 6.
mergers and acquisitions due diligence, business valuations, and actuarial benefit
consulting. Many large CPA firms have departments involved exclusively in
management consulting services with little interaction with the audit or tax staff.
Although the Sarbanes–Oxley Act and Securities and Exchange Commission
(SEC) restrict auditors from providing many consulting services to public company
audit clients, some services are allowed, and audit firms are not restricted from
providing consulting to private companies and public companies that are not audit
clients. Table 2-1 (p. 26) shows that management consulting and other services are
a significant source of revenue for most accounting firms.
Apago PDF Enhancer
STRUCTURE OF CPA FIRMS
Organizational
Structures
CPA firms vary in the nature and range of services offered, which affects the organi -
zation and structure of the firms. Three main factors influence the organizational
structure of all firms:
1. The need for independence from clients. Independence permits auditors to
remain unbiased in drawing conclusions about the financial statements.
2. The importance of a structure to encourage competence. Competence permits
auditors to conduct audits and perform other services efficiently and effectively.
3. The increased litigation risk faced by auditors. Audit firms continue to experience
increases in litigation-related costs. Some organizational structures afford a
degree of protection to individual firm members.
Six organizational structures are available to CPA firms. Except for the proprietorship,
each structure results in an entity separate from the CPA personally, which helps
promote auditor independence. The last four organizational structures provide some
protection from litigation loss.
Proprietorship Only firms with one owner can operate in this form. Traditionally, all
one-owner firms were organized as proprietorships, but most have changed to organi -
zational forms with more limited liability because of litigation risks.
General Partnership This form of organization is the same as a proprietorship,
except that it applies to multiple owners. This organizational structure has also become | Alvin |
less popular as other forms of ownership that offer some legal liability protection
became authorized under state laws.
28
Part 1 / THE AUDITING PROFESSION
General Corporation The advantage of a corporation is that shareholders are liable
only to the extent of their investment in the corporation. Most CPA firms do not organize
as general corporations because they are prohibited by law from doing so in most states.
Professional Corporation A professional corporation (PC) provides professional
services and is owned by one or more shareholders. PC laws in some states offer
personal liability protection similar to that of general corporations, whereas the
protection in other states is minimal. This variation makes it difficult for a CPA firm
with clients in different states to operate as a PC.
Limited Liability Company A limited liability company (LLC) combines the most
favorable attributes of a general corporation and a general partnership. An LLC is
typically structured and taxed like a general partnership, but its owners have limited
personal liability similar to that of a general corporation. All of the states have LLC
laws, and most also allow accounting firms to operate as LLCs.
Limited Liability Partnership A limited liability partnership (LLP) is owned by
one or more partners. It is structured and taxed like a general partnership, but the
personal liability protection of an LLP is less than that of a general corporation or an
LLC. Partners of an LLP are personally liable for the partnership’s debts and obliga -
tions, their own acts, and acts of others under their supervision. Partners are not
personally liable for liabilities arising from negligent acts of other partners and
employees not under their supervision. It is not surprising that all of the Big Four firms
and many smaller firms now operate as LLPs.
The organizational hierarchy in a typical CPA firm includes partners or shareholders,
managers, supervisors, seniors or in-charge auditors, and assistants. A new employee
usually starts as an assistant and spends 2 or 3 years in each classification before
achieving partner status. The titles of the positions vary from firm to firm, but the
structure is similar in all. When we refer in this text to the auditor, we mean the person
performing some aspect of an audit. It is common to have one or more auditors from
each level on larger engagements.
Apago PDF Enhancer
Table 2-2 summarizes the experience and responsibilities of each classi fication level
within CPA firms. Advancement in CPA firms is fairly rapid, with evolving duties and
responsibilities. In addition, audit staff members usually gain diversity of experience
across client engagements. Because of advances in computer and audit technology,
beginning assistants on the audit are rapidly given greater responsibility and challenges.
The hierarchical nature of CPA firms helps promote competence. Individuals at
each level of the audit supervise and review the work of others at the level just below
them in the organizational structure. A new staff assistant is supervised directly by the
senior or in-charge auditor. The staff assistant’s work is then reviewed by the in-charge
as well as by the manager and partner.
Hierarchy of a
Typical CPA Firm
TABLE 2-2
Staff Levels and Responsibilities
Staff Level
Average
Experience
Typical Responsibilities
Staff Assistant
0–2 years
Performs most of the detailed audit work.
Senior or
in-charge auditor
2–5 years
Coordinates and is responsible for the audit field work, including supervising and reviewing staff
work.
Manager
5–10 years
Helps the in-charge plan and manage the audit, reviews the in-charge’s work, and manages relations
with the client. A manager may be responsible for more than one engagement at the same time.
Partner
10+ years
Reviews the overall audit work and is involved in significant audit decisions. A partner is an owner of
the firm and therefore has the ultimate responsibility for conducting the audit and serving the client.
Chapter 2 / THE CPA PROFESSION
29
SARBANES–OXLEY ACT AND | Alvin |
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD
OBJECTIVE 2-2
Understand the role of
the Public Company
Accounting Oversight Board
and the effects of the
Sarbanes–Oxley Act on
the CPA profession.
Triggered by the bankruptcies and alleged audit failures involving such companies as
Enron and WorldCom, the Sarbanes–Oxley Act is considered by many to be the most
important legislation affecting the auditing profession since the 1933 and 1934
Securities Acts. The provisions of the Act dramatically changed the relationship
between publicly held companies and their audit firms.
The Sarbanes–Oxley Act established the Public Company Accounting Oversight
Board (PCAOB), appointed and overseen by the SEC. The PCAOB provides oversight
for auditors of public companies, establishes auditing and quality control standards for
public company audits, and performs inspections of the quality controls at audit firms
performing those audits.
The PCAOB conducts inspections of registered accounting firms to assess their
compliance with the rules of the PCAOB and SEC, professional standards, and each
firm’s own quality control policies. The PCAOB requires annual inspections of
accounting firms that audit more than 100 issuers and inspections of other registered
firms at least once every three years. Any violations could result in disciplinary action
by the PCAOB and be reported to the SEC and state accountancy boards.
SECURITIES AND EXCHANGE COMMISSION
OBJECTIVE 2-3
Summarize the role of the
Securities and Exchange
Commission in accounting
and auditing.
Apago PDF Enhancer
The Securities and Exchange Commission (SEC), an agency of the federal govern -
ment, assists in providing investors with reliable information upon which to make
invest ment decisions. The Securities Act of 1933 requires most companies planning to
issue new securities to the public to submit a registration statement to the SEC for
approval. The Securities Exchange Act of 1934 provides additional protection by
requiring public companies and others to file detailed annual reports with the com -
mission. The commission examines these statements for completeness and adequacy
before per mitting the company to sell its securities through the securities exchanges.
Although the SEC requires considerable information that is not of direct interest to
CPAs, the securities acts of 1933 and 1934 require financial statements, accompanied
by the opinion of an independent public accountant, as part of a registration statement
and subsequent reports.
Of special interest to auditors are several specific reports that are subject to the
reporting provisions of the securities acts. The most important of these are as
follows:
• Form S-1. “S” forms apply to the Securities Act of 1933 and must be completed
and registered with the SEC when a company plans to issue new securities to the
public. The S-1 form is the general form used when there is no specifically
prescribed form. The others are specialized forms. For example, S-11 is for regis -
tration of securities of certain real estate companies.
• Form 8-K. This report is filed to report significant events that are of interest to
public investors. Such events include the acquisition or sale of a subsidiary, a change
in officers or directors, an addition of a new product line, or a change in auditors.
• Form 10-K. This report must be filed annually within 60 to 90 days after the close of
each fiscal year, depending on the size of the company. Extensive detailed finan cial
information, including audited financial statements, is contained in this report.
• Form 10-Q. This report must be filed quarterly for all publicly held companies. It
contains certain financial information and requires auditor reviews of the financial
statements before filing with the commission.
30
Part 1 / THE AUDITING PROFESSION
Because large CPA firms usually have clients that must file one or more of these
reports each year, and the rules and regulations affecting filings with the SEC are
extremely complex, most CPA firms have specialists who spend a large portion of their | Alvin |
time ensuring that their clients satisfy all SEC requirements.
The SEC has considerable influence in setting generally accepted accounting
principles (GAAP) and disclosure requirements for financial statements as a result of
its authority for specifying reporting requirements considered necessary for fair
disclosure to investors, such as the recent requirement to begin filing financial statement
data in XBRL format. The SEC has power to establish rules for any CPA associated with
audited financial statements submitted to the commission. The SEC’s attitude is
generally con sidered in any major change proposed by the Financial Accounting
Standards Board (FASB), the independent organization that establishes U.S. GAAP.
The SEC requirements of greatest interest to CPAs are set forth in the commission’s
Regulation S-X, Accounting Series Releases, and Accounting and Auditing Enforcement
Releases. These publications constitute important regulations, as well as decisions and
opinions on accounting and auditing issues affecting any CPA dealing with publicly
held companies.
AMERICAN INSTITUTE OF
CERTIFIED PUBLIC ACCOUNTANTS (AICPA)
OBJECTIVE 2-4
Describe the key functions
performed by the AICPA.
CPAs are licensed by the state in which they practice, but a significant influence on
CPAs is exerted by their national professional organization, the American Institute of
Certified Public Accountants (AICPA). Membership in the AICPA is restricted to
CPAs, but not all members are practicing as independent auditors. Many members
formerly worked for CPA firms but are currently working in government, industry, and
education. AICPA membership is voluntary, so not all CPAs join. With over 360,000
CPAs, the AICPA is the largest professional association for CPAs in the United States.
Apago PDF Enhancer
The AICPA sets professional requirements for CPAs, conducts research, and pub -
lishes materials on many different subjects related to accounting, auditing, attestation
and assurance services, management consulting services, and taxes. The AICPA also
promotes the accounting profession through organizing national adver tising campaigns,
promoting new assurance services, and developing specialist certi fications to help
market and ensure the quality of services in specialized practice areas. For example, the
association currently offers specialty designations in business valuation, financial
planning, information technology, and financial forensics.
The AICPA sets standards and rules that all members and other practicing CPAs must
follow. Four major areas in which the AICPA has authority to set standards and make
rules are as follows:
Establishing
Standards and Rules
1. Auditing standards. The Auditing Standards Board (ASB) is responsible for issuing
pronouncements on auditing matters for all entities other than publicly traded
companies. ASB pronouncements are called Statements on Auditing Standards
(SASs). They are further discussed later in this chapter and through out the text.
2. Compilation and review standards. The Accounting and Review Services Com -
mittee is responsible for issuing pronouncements of the CPA’s responsibilities
when a CPA is associated with financial statements of privately owned companies
that are not audited. They are called Statements on Standards for Accounting
and Review Services (SSARS), and they provide guidance for performing com -
pilation and review services. In a compilation service, the accountant helps the
client prepare financial statements without providing any assurance. In a review
service, the accountant performs inquiry and analytical procedures that provide
a reasonable basis for expressing limited assurance on the financial statements.
Chapter 2 / THE CPA PROFESSION
31
Other
AICPA Functions
3. Other attestation standards. Statements on Standards for Attestation Engage -
ments provide a framework for the development of standards for attestation
engagements. Detailed standards have been developed for specific types of
attestation services, such as reports on prospective financial information in | Alvin |
forecasts and projections. Attestation standards are studied in Chapter 25.
4. Code of Professional Conduct. The AICPA Professional Ethics Executive
Committee sets rules of conduct that CPAs are required to meet. The rules and
their relationships to ethical conduct are the subject of Chapter 4.
In addition to writing and grading the CPA examination, the AICPA performs many
educational and other functions for CPAs. The association supports research by its own
research staff and provides grants to others. It also publishes a variety of materials,
including journals such as the Journal of Accountancy, industry audit guides for several
industries, periodic updates of the Codification of Statements on Auditing Standards,
and the Code of Professional Conduct.
CPAs must meet continuing education requirements to maintain their licenses
to practice and to stay current on the extensive and ever-changing body of knowledge
in accounting, auditing, attestation and assurance services, management consulting
services, and taxes. The AICPA provides a considerable number of seminars and
educational aids in a variety of subjects, such as online continuing education oppor -
tunities and reference materials in its CPExpress online learning library and its daily
email alert about emerging professional issues through its CPA Letter Daily.
INTERNATIONAL AND U.S. AUDITING STANDARDS
OBJECTIVE 2-5
Understand the role of
international auditing
standards and their relation
to U.S. auditing standards.
Apago PDF Enhancer
Auditing standards are general guidelines to aid auditors in fulfilling their profes sional
responsibilities in the audit of historical financial statements. They include considera -
tion of professional qualities such as competence and independence, reporting
requirements, and evidence. The three main sets of auditing standards are International
Standards on Auditing, U.S. Generally Accepted Auditing Standards for entities other
than public companies, and PCAOB Auditing Standards.
International
Standards on Auditing
International Standards on Auditing (ISAs) are issued by the International Auditing
and Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC). IFAC is the worldwide organization for the accountancy profession, with 159
CLARITY AND
CONVERGENCE
PROJECT
COMPLETION
IMPACTS AUDITING
STANDARDS
The AICPA Auditing Standards Board has
undertaken a significant effort to make U.S.
generally accepted auditing standards (GAAS)
easier to read, understand and apply. The project
originated with the ASB plan to converge U.S.
GAAS with the ISAs and align its agenda with the
IAASB.
The foundation of the clarity project is the
establishment of an objective for each auditing
standard to reflect a principles-based approach to
standard-setting. Conventions applied by the ASB
in drafting standards include:
◆ Establishing objectives for each standard
◆ Including a definitions section, where
relevant, in each standard
◆ Separating requirements from application
and other explanatory material
◆ Using bulleted lists and other formatting
techniques to enhance readability
When all of the sections of auditing standards
have been clarified, they will be issued as one
SAS. When the new standard becomes effective,
SASs issued prior to SAS 117 will be super seded
and new AU Sections will be created. Additionally,
when the clarified standards become effective,
the 10 GAAS standards will be moved to the
Preface of the AU Sections as principles governing
the conduct of an audit. The principles will be
organized consistent with the current structure,
but the GAAS headings of “General” and
“Fieldwork” will be changed to “Responsibilities”
and “Performance,” respectively, to better reflect
the content. The Reporting principles will be less
detailed than the current reporting standards.
Sources: 1. “Clarity Project: Update and Final
Product, May 2010” (www.aicpa.org);
2. AICPA Auditing Standards Board Clarity and
Convergence Explanatory Memorandum (July 2008).
32
Part 1 / THE AUDITING PROFESSION
| Alvin |
member organizations in 124 countries, representing more than 2.5 million accountants
throughout the world. The IAASB works to improve the uniformity of auditing practices
and related services throughout the world by issuing pronouncements on a variety of
audit and attest functions and by promoting their acceptance worldwide.
ISAs do not override a country’s regulations governing the audit of financial or
other information, as each country’s own regulations generally govern audit practices.
These regulations may be either government statutes or statements issued by regu -
latory or professional bodies, such as the Australian Auditing & Assurance Standards
Board or Spain’s Instituto de Contabilidad y Auditoría de Cuentas. Most countries,
including the United States, base their auditing standards on ISAs, modified as
appropriate for each country’s regulatory environment and statutory requirements.
The Auditing Standards Board in the U.S. has revised most of its standards to
converge with the international standards. In addition, the PCAOB considers existing
international standards in developing its standards. As a result, U.S. standards are
mostly consistent with international standards, except for certain requirements that
reflect unique characteristics of the U.S. environment, such as legal and regulatory
requirements. For example, PCAOB Standard 5 (AS 5) addresses audits of internal
control over financial reporting required by the Sarbanes –Oxley Act.
Auditing standards for private companies and other entities in the United States are
established by the Auditing Standards Board (ASB) of the AICPA. These standards are
referred to as Statements on Auditing Standards (SASs). These Generally Accepted
Auditing Standards (GAAS) are similar to the ISAs, although there are some differences.
If an auditor in the United States is auditing historical financial statements in accordance
with ISAs, the auditor must meet any ISA requirements that extend beyond GAAS.
Prior to passage of the Sarbanes–Oxley Act, the ASB established auditing standards
for private and public companies. The PCAOB now has responsibility for auditing
standards for public companies, while the ASB continues to provide auditing standards
for private companies and other entities.
Apago PDF Enhancer
The PCAOB initially adopted existing auditing standards established by the ASB as
interim audit standards. In addition, the PCAOB considers international auditing
standards when developing new standards. As a result, auditing standards for U.S.
public and private companies are mostly similar. Standards issued by the PCAOB are
referred to as PCAOB Auditing Standards in the audit reports of public companies and
when referenced in the text, and apply only to the audits of public companies.
Figure 2-1 summarizes the relations among international auditing standards,
generally accepted auditing standards, and PCAOB auditing standards. International
FIGURE 2-1
Relation of U.S. and International Auditing Standards
International
Standards on
Auditing
U.S. Generally
Accepted Auditing
Standards (GAAS)
PCAOB
Auditing Standards
Applicable to entities
outside the United States
Applicable to private
entities in the United States
Applicable to U.S. Public
Companies and other SEC
registrants
U.S. Generally Accepted
Auditing Standards
PCAOB
Auditing Standards
Chapter 2 / THE CPA PROFESSION
33
auditing standards as adopted by standard-setting bodies in individual countries
apply to audits of entities outside the United States. Generally accepted auditing
standards are similar to international auditing standards and apply to the audits of
private companies and other entities in the United States. PCAOB auditing standards
apply to audits of U.S public companies and other SEC registrants.
The overlapping ovals illustrate that there are more similarities than differences in
the three sets of standards. The auditing concepts illustrated throughout this book are
generally applicable to all audits. When we refer to “auditing standards,” the term | Alvin |
applies to all audits unless otherwise noted.
GENERALLY ACCEPTED AUDITING STANDARDS
OBJECTIVE 2-6
Use U.S. auditing standards
as a basis for further study.
The broadest guidelines available to auditors in the U.S. are the 10 generally accepted
auditing standards (GAAS), which were developed by the AICPA. As illustrated in
Figure 2-2, the 10 generally accepted auditing standards fall into three categories:
General Standards
• General standards
• Standards of field work
• Reporting standards
The individual standards in each category are included in Table 2-3. These standards
are not sufficiently specific to provide any meaningful guide to practitioners, but they
do represent a framework upon which the AICPA can provide interpretations.
The general standards stress the important personal qualities that the auditor should
possess.
Adequate Technical Training and Proficiency The first general standard is
normally interpreted as requiring the auditor to have formal education in auditing
and accounting, adequate practical experience for the work being performed, and
Apago PDF Enhancer
FIGURE 2-2
Summary of Generally Accepted Auditing Standards
Generally Accepted
Auditing Standards
General
qualifications
and conduct
Field work
performance of
the audit
Reporting
results
Adequate training
and proficiency
Independence in
mental attitude
Due professional care
Proper planning and
supervision
Sufficient understanding
of the entity, its
environment, and its
internal control
Whether statements were
prepared in accordance
with GAAP
Circumstances when
GAAP not consistently
followed
Sufficient appropriate
evidence
Adequacy of informative
disclosures
Expression of opinion
on financial statements
34
Part 1 / THE AUDITING PROFESSION
TABLE 2-3
Generally Accepted Auditing Standards
General Standards
1. The auditor must have adequate technical training and proficiency to perform the audit.
2. The auditor must maintain independence in mental attitude in all matters relating to the audit.
3. The auditor must exercise due professional care in the performance of the audit and the preparation of the report.
Standards of Field Work
1. The auditor must adequately plan the work and must properly supervise any assistants.
2. The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of
material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further
audit procedures.
3. The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion
regarding the financial statements under audit.
Standards of Reporting
1. The auditor must state in the auditor’s report whether the financial statements are presented in accordance with generally accepted
accounting principles (GAAP).
2. The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the
current period in relation to the preceding period.
3. When the auditor determines that informative disclosures are not reasonably adequate, the auditor must so state in the auditor’s report.
4. The auditor must either express an opinion regarding the financial statements, taken as a whole, or state that an opinion cannot be
expressed, in the auditor’s report. When the auditor cannot express an overall opinion, the auditor should state the reasons therefor in the
auditor’s report. In all cases where an auditor’s name is associated with financial statements, the auditor should clearly indicate the
character of the auditor’s work, if any, and the degree of responsibility the auditor is taking, in the auditor’s report.
con tinuing professional education. Recent court cases clearly demonstrate that auditors
must be technically qualified and experienced in those industries in which their audit
clients are engaged.
Apago PDF Enhancer
In any case in which the CPA or the CPA’s assistants are not qualified to perform
the work, a professional obligation exists to acquire the requisite knowledge and skills, | Alvin |
suggest someone else who is qualified to perform the work, or decline the engagement.
Independence in Mental Attitude The importance of independence was emphasized
in Chapter 1 under the definition of auditing. The Code of Professional Conduct and
SASs stress the need for independence. CPA firms are required to follow several
practices to increase the likelihood of independence of all personnel. For example,
there are established procedures on larger audits when there is a dispute between
management and the auditors. Specific methods to ensure that auditors maintain their
independence are studied in Chapter 4.
Due Professional Care The third general standard involves due care in the perfor -
mance of all aspects of auditing. Simply stated, this means that auditors are professionals
responsible for fulfilling their duties diligently and carefully. Due care includes con -
sideration of the completeness of the audit documentation, the sufficiency of the audit
evidence, and the appropriateness of the audit report. As professionals, auditors must
not act negligently or in bad faith, but they are not expected to be infallible.
The standards of field work concern evidence accumulation and other activities during
the actual conduct of the audit.
Adequate Planning and Supervision The first standard requires that the audit be
sufficiently planned to ensure an adequate audit and proper supervision of assistants.
Supervision is essential in auditing because a considerable portion of the field work is
done by less experienced staff members.
Understand the Entity and its Environment, Including Internal Control To
adequately perform an audit, the auditor must have an understanding of the client’s
business and industry. This understanding helps the auditor identify significant client
Standards
of Field Work
Chapter 2 / THE CPA PROFESSION
35
business risks and the risk of significant misstatements in the financial statements. For
example, to audit a bank, an auditor must understand the nature of the bank’s
operations, federal and state regulations applicable to banks, and risks affecting signifi -
cant accounts such as loan loss reserves.
One of the most widely accepted concepts in the theory and practice of auditing is
the importance of the client’s system of internal control for mitigating client business
risks, safeguarding assets and records, and generating reliable financial information.
If the auditor is convinced that the client has an excellent system of internal control, one
that includes adequate internal controls for providing reliable data, the amount of audit
evidence to be accumulated can be significantly less than when controls are not
adequate. In some instances, internal control may be so inadequate as to preclude
conducting an effective audit.
Sufficient Appropriate Evidence Decisions about how much and what types of
evidence to accumulate for a given set of circumstances require professional judgment.
A major portion of this book is concerned with the study of evidence accumulation
and the circumstances affecting the amount and types needed.
The four reporting standards require the auditor to prepare a report on the financial
statements taken as a whole, including informative disclosures. The reporting
standards also require that the report state whether the statements are presented in
accordance with GAAP and also identify any circumstances in which GAAP have not
been consistently applied in the current year compared with the previous one.
Standards
of Reporting
STATEMENTS ON AUDITING STANDARDS
Apago PDF Enhancer
The 10 generally accepted auditing standards are too general to provide meaningful
guidance, so auditors turn to the SASs issued by the ASB for more specific guidance.
These statements interpret the 10 generally accepted auditing standards and have the
status of GAAS and are often referred to as auditing standards or GAAS, even though
they are not part of the 10 generally accepted auditing standards. This book follows
common practice and refers to these interpretations as auditing standards or SASs. | Alvin |
Generally accepted auditing standards and SASs are regarded as authoritative literature,
and every member who performs audits of historical financial statements is required to
follow them under the AICPA Code of Professional Conduct. The ASB issues new
statements when an auditing problem arises of sufficient importance to warrant an
official interpretation. At this writing, SAS 120 was the last one issued and incor porated
into the text materials, but readers should be alert to subsequent standards that
influence auditing requirements.
All SASs are given two classification numbers: an SAS and an AU number that indicates
location in the Codification of Auditing Standards. Both classification systems are used
in practice. For example, the Statement on Auditing Standards, The Relationship of
Generally Accepted Auditing Standards to Quality Control Standards, is SAS 25 and AU
161. The SAS number identifies the order in which it was issued in relation to other
SASs; the AU number identifies its location in the AICPA codification of all SASs. AUs
beginning with a “2” are always interpretations of the general standards. Those
beginning with a “3” are related to field work standards, and those beginning with a “4,”
“5,” or “6” deal with reporting standards.
Although GAAS and the SASs are the authoritative auditing guidelines for members of
the profession, they provide less direction to auditors than might be assumed. A limited
number of specific audit procedures are required by the standards, and there are no
specific requirements for auditors’ decisions, such as determining sample size, selecting
sample items from the population for testing, or evaluating results. Many practitioners
Classification of
Statements on
Auditing Standards
GAAS and Standards
of Performance
36
Part 1 / THE AUDITING PROFESSION
believe that the standards should provide more clearly defined guidelines for determining
the extent of evidence to be accumulated. Such specificity would eliminate some difficult
audit decisions and provide a line of defense for a CPA firm charged with conducting an
inadequate audit. However, highly specific requirements could turn auditing into
mechanistic evidence gathering, devoid of professional judgment. From the point of
view of both the profession and the users of auditing services, there is probably greater
harm in defining authoritative guidelines too specifically than too broadly.
GAAS and the SASs should be looked on by practitioners as minimum standards of
performance rather than as maximum standards or ideals. At the same time, the
existence of auditing standards does not mean the auditor must always follow them
blindly. If an auditor believes that the requirement of a standard is impractical or
impossible to perform, the auditor is justified in following an alternative course of
action. Similarly, if the issue in question is immaterial in amount, it is also unnecessary
to follow the standard. However, the burden of justifying departures from the standards
falls on the auditor.
When auditors desire more specific guidelines, they must turn to less authoritative
sources, including textbooks, journals, and technical publications. Materials published
by the AICPA, such as the Journal of Accountancy and industry audit guides, furnish
assistance on specific questions. We provide further study of the standards and make
frequent reference to specific standards throughout the text.
QUALITY CONTROL
For a CPA firm, quality control comprises the methods used to ensure that the firm
meets its professional responsibilities to clients and others. These methods include the
organizational structure of the CPA firm and the procedures the firm establishes. For
example, a CPA firm might have an organizational structure that ensures the technical
review of every engagement by a partner who has expertise in the client’s industry.
Auditing standards require each CPA firm to establish quality control policies and
procedures. The standards recognize that a quality control system can provide only | Alvin |
reasonable assurance, not a guarantee, that auditing standards are followed.
Apago PDF Enhancer
Quality control is closely related to but distinct from GAAS. To ensure that
generally accepted auditing standards are followed on every audit, a CPA firm follows
specific quality control procedures that help it meet those standards consistently on
every engagement. Quality controls are therefore established for the entire CPA firm,
whereas GAAS are applicable to individual engagements.
Each firm should document its quality control policies and procedures. Procedures
should depend on such things as the size of the firm, the number of practice offices, and
the nature of the practice. The quality control procedures of a 150-office international
firm with many complex multinational clients should differ considerably from those of
a five-person firm specializing in small audits in one or two industries.
The system of quality control should include policies and procedures that address
six elements. These are listed in Table 2-4 (p. 38) with brief descriptions and pro -
cedural examples that firms might use to satisfy the requirement.
Public accounting firms must be enrolled in an AICPA approved practice-monitoring
program for members in the firm to be eligible for membership in the AICPA. Practice-
monitoring, also known as peer review, is the review, by CPAs, of a CPA firm’s
compli ance with its quality control system. The purpose of a peer review is to deter -
mine and report whether the CPA firm being reviewed has developed adequate quality
control policies and procedures and follows them in practice. Unless a firm has a peer
review, all members of the CPA firm lose their eligibility for AICPA membership.
OBJECTIVE 2-7
Identify quality control
standards and practices
within the accounting
profession.
Elements of
Quality Control
Peer Review
Chapter 2 / THE CPA PROFESSION
37
TABLE 2-4
Elements of Quality Control
Element
Summary of Requirements
Example of a Procedure
Leadership responsibilities
for quality within the firm
(“tone at the top”)
Relevant ethical
requirements
Acceptance and
continuation of clients
and engagements
Human resources
The firm should promote a culture that quality is
essential in performing engagements and
should establish policies and procedures that
support that culture.
All personnel on engagements should maintain
independence in fact and in appearance,
perform all professional responsibilities with
integrity, and maintain objectivity in performing
their professional responsibilities.
Policies and procedures should be established for
deciding whether to accept or continue a client
relationship. These policies and procedures
should minimize the risk of associating with a
client whose management lacks integrity. The
firm should also only undertake engagements
that can be completed with professional
competence.
Policies and procedures should be established to
provide the firm with reasonable assurance that
• All new personnel should be qualified to
perform their work competently.
• Work is assigned to personnel who have
adequate technical training and proficiency.
• All personnel should participate in continuing
The firm’s training programs emphasize
the importance of quality work, and this
is reinforced in performance evaluation
and compensation decisions.
Each partner and employee must answer
an “independence questionnaire”
annually, dealing with such things
as stock ownership and membership
on boards of directors.
A client evaluation form, dealing with
such matters as predecessor auditor
comments and evaluation of manage-
ment, must be prepared for every
new client before acceptance.
Each professional must be evaluated on
every engagement using the firm’s
individual engagement evaluation
report.
professional education and professional
development activities that enable them to
fulfill their assigned responsibilities.
• Personnel selected for advancement have
Apago PDF Enhancer
the qualifications necessary for the fulfillment
of their assigned responsibilities.
Engagement
| Alvin |
performance
Monitoring
Policies and procedures should exist to ensure
that the work performed by engagement
personnel meets applicable professional
standards, regulatory requirements, and
the firm’s standards of quality
Policies and procedures should exist to ensure
that the other quality control elements are
being effectively applied.
The firm’s director of accounting and
auditing is available for consultation
and must approve all engagements
before their completion.
The quality control partner must test the
quality control procedures at least
annually to ensure the firm is in
compliance.
The AICPA Peer Review Program is administered by the state CPA societies under
the overall direction of the AICPA peer review board. Reviews are conducted every
three years, and are normally performed by a CPA firm selected by the firm being
reviewed, although the firm can request that it be assigned a reviewer through the
administering state society. Firms required to be registered with and inspected by the
PCAOB must be reviewed by the AICPA National Peer Review Committee to evaluate
the non-SEC por tion of the firm’s accounting and auditing practice that is not
inspected by the PCAOB. After the review is completed, the reviewers issue a report
stating their conclusions and recommendations. Results of the peer review are included
in a public file by the AICPA.
Peer review benefits individual firms by helping them meet quality control
standards, which, in turn, benefits the profession through improved practitioner per -
formance and higher-quality audits. A firm having a peer review can further benefit if
the review improves the firm’s practice, thereby enhances its reputation and effective ness,
38
Part 1 / THE AUDITING PROFESSION
FIGURE 2-3
Relationships Among GAAS, Quality Control, AICPA Practice
Centers, and Peer Review
Quality control
standards
Standards applicable to a
CPA firm to aid in satisfying
generally accepted auditing
standards
Audit practice
and quality centers
Organizations intended to
help firms meet quality
control standards and audit
standards
Generally accepted
auditing standards
Standards applicable to
each audit
Peer review
Method to determine
whether a CPA firm meets
quality control standards
and reduces the likelihood of lawsuits. Of course, peer reviews are expensive to con -
duct, so the benefits come at a cost.
The AICPA has established audit practice and quality centers as resource centers to
improve audit practice quality. The Center for Audit Quality (CAQ) is an autonomous
public policy organization affiliated with the AICPA serving investors, public company
auditors and the capital markets. The Center’s mission is to foster confidence in the
audit process and to make public company audits even more reliable and relevant for
investors. The Private Companies Practice Section (PCPS) provides practice manage -
ment information to firms of all sizes.
Apago PDF Enhancer
In addition to these firm resources, the AICPA has established audit quality centers
for governmental audits and employee benefit plan audits. Figure 2-3 summarizes the
relationships among GAAS, quality control, the audit practice and quality centers, and
peer review in ensuring audit quality.
Audit Practice
and Quality Centers
SUMMARY
This chapter discussed the nature of the CPA profession and the activities of CPA firms.
Because CPA firms play an important social role, several organizations, including the
PCAOB, SEC, and AICPA provide oversight to increase the likelihood of appropriate audit
quality and professional conduct. These are summarized in Figure 2-4 (p. 40). Shaded
circles in the figure indicate items discussed in this or the last chapter. The AICPA Code of
Professional Conduct provides a standard of conduct for practitioners and is discussed in
Chapter 4. The potential for legal liability is also a significant influence on auditor conduct
and is discussed in Chapter 5.
ESSENTIAL TERMS
AICPA—American Institute of Certified
Public Accountants, a voluntary organiza -
tion of CPAs that sets professional require - | Alvin |
ments, conducts research, and pub lishes
materials relevant to accounting, auditing,
management consulting services, and taxes
Center for Audit Quality (CAQ)—An
autonomous public policy organization
with a mission to foster confidence in the
audit process and to make public company
audits even more reliable and relevant
for investors
Chapter 2 / THE CPA PROFESSION
39
FIGURE 2-4
Ways the Profession and Society Encourage CPAs to Conduct
Themselves at a High Level
CPA
examination
GAAS and
interpretations
Quality
control
Peer review
Conduct
of
CPA firm
personnel
PCAOB and SEC
Code of
Professional
Conduct
Continuing
education
requirements
AICPA
practice and
quality centers
Legal
liability
Generally accepted auditing standards
(GAAS)—10 auditing standards, developed
by the AICPA, consisting of general
standards, standards of field work, and
standards of reporting, along with inter -
pretations; often called auditing standards
International Standards on Auditing
(ISAs)—statements issued by the Inter -
national Auditing and Assurance Standards
Board of the International Federation of
Accountants to promote international
acceptance of auditing standards
Apago PDF Enhancer
public companies, including establishing
auditing and quality control standards
and performing inspections of registered
accounting firms
Quality control—methods used by a CPA
firm to ensure that the firm meets its
profes sional responsibilities to clients and
others
Securities and Exchange Commission
(SEC)—a federal agency that oversees
the orderly conduct of the securities markets;
the SEC assists in providing investors
in public corporations with reliable infor -
mation upon which to make invest ment
decisions
Statements on Auditing Standards
(SASs)—pronouncements issued by the
AICPA to interpret generally accepted
auditing standards
Peer review—the review by CPAs of a
CPA firm’s compliance with its quality
control system
Public Company Accounting Oversight
Board (PCAOB)—Board created by the
Sarbanes–Oxley Act to oversee auditors of
REVIEW QUESTIONS
2-1 (Objective 2-1) State the four major types of services CPAs perform, and explain each.
2-2 (Objectives 2-1, 2-7) What major characteristics of the organization and conduct of
CPA firms permit them to fulfill their social function competently and independently?
2-3 (Objective 2-2) What is the role of the Public Company Accounting Oversight Board?
2-4 (Objective 2-3) Describe the role of the SEC in society and discuss its relationship with
and influence on the practice of auditing.
2-5 (Objective 2-4) What roles are played by the American Institute of Certified Public
Accountants for its members?
40
Part 1 / THE AUDITING PROFESSION
2-6 (Objective 2-4) What are the purposes of the AICPA Statements on Standards for
Attestation Engagements?
2-7 (Objectives 2-2, 2-4, 2-5) Who is responsible for establishing auditing standards for
audits of U.S. public companies? Who is responsible for establishing auditing standards for
U.S. private companies? Explain.
2-8 (Objective 2-6) Distinguish between generally accepted auditing standards and gen -
erally accepted accounting principles, and give two examples of each.
2-9 (Objective 2-6) The first standard of field work requires the performance of the audit
by a person or persons having adequate technical training and proficiency as an auditor.
What are the various ways in which auditors can fulfill the requirement of the standard?
2-10 (Objective 2-6) Generally accepted auditing standards have been criticized by
different sources for failing to provide useful guidelines for conducting an audit. The critics
believe the standards should be more specific to enable practitioners to improve the quality
of their performance. As the standards are now stated, some critics believe that they
provide little more than an excuse to conduct inadequate audits. Evaluate this criticism of
the 10 generally accepted auditing standards.
2-11 (Objective 2-5) Describe the role of International Standards on Auditing. What is the
relationship between International Standards on Auditing and U.S. Generally Accepted | Alvin |