Chapter 1 Notes: The Concept and Need for Assurance These notes simplify

the key concepts from the chapter and expand on them with practical, real-
world examples and additional details to deepen your understanding. 1. The
Meaning of an Audit At its core, an audit is about adding credibility. Think of
it as an independent expert check up on a company's financial health report.
Definition and Objective • Simple Definition: An audit is an independent
examination of an entity's financial statements1. • Main Objective: The
primary goal is for the auditor to give a professional opinion on whether the
financial statements have been prepared correctly according to the rules
(the "applicable financial reporting framework," like IFRS)2. Real-World
Example: Imagine you want to invest in a company. The company’s
management prepares financial statements showing it's very profitable. How
can you be sure they aren't exaggerating? An independent audit provides an
opinion that gives you confidence (or warns you) about whether those
financial statements are trustworthy. Key Concepts: Accountability,
Stewardship, and Agency These three concepts explain why audits are so
necessary, especially in large companies. • The Problem: In most companies,
the owners (shareholders) are not the people running the business day-to-
day (the directors or management)3. • Agency: This creates an "agency
relationship" where the directors act as agents for the shareholders (the
principals)4. • Stewardship: Directors have a stewardship role, meaning they
are entrusted to manage and protect the company's assets on behalf of the
owners5. • Accountability: Because they are acting on behalf of the owners,
directors are accountable to the shareholders6. They show this
accountability by preparing annual financial statements7. The audit is the
independent check that holds the directors accountable, adding credibility to
the financial statements they present to the shareholders8888. The Audit
Report: Core Features The audit report is the final product delivered to the
shareholders. Its value comes from three key features: 1. Independence: The
auditor must be completely independent from the company's management9.
If the auditor was an employee or had a close relationship with the directors,
their opinion wouldn't be objective and would have little value10. 2. True and
Fair View: The auditor gives an opinion on whether the financial statements
give a "true and fair view"11. a. This does not mean they are 100%
correct12. Financial statements involve many judgments and estimates (e.g.,
how long a machine will last)13. b. It means the statements are prepared
according to the rules (IFRS), are free from material errors, and can be relied
upon14. 3. Materiality: Auditors don't check every single transaction15. They
focus on information that is material, meaning it is significant enough to
influence the decisions of someone reading the financial statements16. a.
Real-World Example: An error of Rs. 100 in the petty cash of a multi-million
rupee company is immaterial and won't affect an investor's decision17.
However, failing to write off a Rs. 200,000 receivable that is definitely not
going to be paid is material, as it overstates the company's assets and
profit18. Who is Responsible for What? There's a common misconception
about the auditor's role. This is often called the "expectation gap"19. •
Management's Responsibility: o Preparing the financial statements20. o
Designing and implementing internal controls to prevent and detect
fraud21212121. o Providing the auditor with all necessary information and
access22. • Auditor's Responsibility: o To obtain reasonable assurance that
the financial statements are free from material misstatement23. o To
express an opinion on the financial statements based on their audit24. 2. The
Meaning of Assurance An audit is a specific type of assurance engagement.
"Assurance" is the broader concept. • Definition: An assurance engagement
is one where a professional (the "practitioner") gives an opinion on
information (the "subject matter") prepared by another party (the
"responsible party"), to increase the confidence of the intended
users25252525. Levels of Assurance Not all assurance is equal. The level
depends on the amount of work done26. 1. Reasonable Assurance (High
Level): a. This is the high level of assurance provided by a statutory
audit27272727. b. The opinion is expressed in a positive form: "In our
opinion, the financial statements give a true and fair view..."28. c. It's high,
but not absolute (100%), because of the inherent limitations of an audit (see
section 4 below)29. 2. Limited Assurance (Moderate Level): a. This is
provided by a review, which involves less work than an audit30. b. The
opinion is expressed in a negative form: "Based on our review, nothing has
come to our attention that causes us to believe that the financial statements
do not give a true and fair view..."31. c. Real-World Analogy: Think of a car
inspection. A full audit is like a mechanic stripping the car down and testing
every part (Reasonable Assurance). A review is like a mechanic doing a
visual inspection and a short test drive (Limited Assurance). The Five
Elements of an Assurance Engagement 32 Every assurance engagement,
including an audit, must have these five elements: 1. A Three-Party
Relationship: a. The Practitioner: The professional providing the assurance
(e.g., the audit firm)33. b. The Responsible Party: The person/group
responsible for the information (e.g., company directors)34. c. The Intended
Users: The people the report is for (e.g., the shareholders)35. 2. A Subject
Matter: The information being evaluated (e.g., the financial statements)36. 3.
Suitable Criteria: The rules or standards used to evaluate the subject matter
(e.g., IFRS and the Companies Act)37. 4. Sufficient Appropriate Evidence:
The practitioner must gather enough high-quality evidence to support their
conclusion38. 5. A Written Assurance Report: The report containing the
practitioner's opinion for the intended users39. 3. The Statutory Audit
Framework in Pakistan (Companies Act, 2017) This section outlines the key
legal rules for auditors in Pakistan. Appointment, Removal, and Pay of
Auditors (s246 CA17) • First Auditor: Appointed by the board of directors
within 90 days of the company's incorporation40. Holds office until the first
Annual General Meeting (AGM)41. • Subsequent Auditors: Appointed at each
AGM to hold office until the next one42. • Filling a Vacancy: If a vacancy
arises (e.g., an auditor resigns), the board can fill it within 30 days43. •
Remuneration (Pay): Fixed by whoever appoints the auditor (the company in
a general meeting, the board, or the Commission)44. • Removal: An auditor
can be removed during their term through a special resolution by the
members45. Qualifications and Disqualifications of Auditors (s247 CA17) •
Who can be an auditor? For public companies and large private companies,
the auditor must be a practicing Chartered Accountant from ICAP46. • Who
CANNOT be an auditor? An individual or firm is disqualified if they: o Are a
director or employee of the company (or were in the last 3 years)47. o Are a
partner or employee of a director/officer of the company48. o Are the spouse
of a director49. o Are significantly indebted to the company (exceptions exist
for small credit card balances or utility bills)50505050. o Have provided a
guarantee for a third person's debt to the company51. o Have a business
relationship with the company (outside the ordinary course of business)52. o
Hold any shares in the audit client or its associated companies53. (If shares
are held before appointment, they must be sold within 90 days 54). Rights
and Duties of Auditors (s248 & s249 CA17) • Rights: o A right of access at all
times to the company's books, accounts, and vouchers55. o A right to
require information and explanations from directors, officers, and
employees56565656. o A right to attend general meetings and be heard on
matters concerning them as an auditor57. • Duties: o Must conduct the audit
in accordance with International Standards on Auditing (ISAs) as adopted by
ICAP58. o Must report to the members on whether they have obtained all
necessary information 59, proper books of account have been kept 60, and
the financial statements give a true and fair view61. o Must also report on
specific matters like whether investments were for the company's business
purpose and if Zakat was properly deducted and deposited62. 4.
International Standards on Auditing (ISAs) ISAs provide consistent, high-
quality rules that ensure an audit performed in one country is comparable to
an audit performed in another. • IFAC (International Federation of
Accountants): The global organization for the accountancy profession63.
ICAP is a member64. • IAASB (International Auditing and Assurance
Standards Board): An independent board within IFAC that sets the ISAs65. •
ISA 200 - Overall Objectives of the Auditor: This is a cornerstone standard. It
requires the auditor to: o Obtain reasonable assurance that financial
statements are free from material misstatement66. o Comply with relevant
ethical requirements67. o Plan and perform the audit with professional
skepticism68. This means having a questioning mind and critically assessing
audit evidence, not just accepting what management says69. o Exercise
professional judgment70. This is the application of relevant training,
knowledge, and experience in making informed decisions71. o Obtain
sufficient appropriate audit evidence72. Inherent Limitations of an Audit An
auditor can only ever provide reasonable, not absolute, assurance. This is
because every audit has inherent limitations that cannot be overcome73. •
The Nature of Financial Reporting: Many financial statement items involve
management judgment and estimates (e.g., estimating bad debts), which
are uncertain74. • The Nature of Audit Procedures: Auditors use sampling,
not 100% testing. There is always a risk that the sample chosen is not
representative of the whole population of transactions75. Also, fraud can be
deliberately and sophisticatedly concealed, making it difficult to detect76. •
Timeliness and Cost: Users expect an audit report within a reasonable time
and at a reasonable cost. This creates a balance between the depth of
testing and the practical constraints of the engagement77. 5. Advantages
and Limitations of Statutory Audits Advantages (The "Pros") • Increased
Credibility: An audit makes financial statements more reliable for
shareholders, banks, and potential investors78787878. • Improved Internal
Controls: Auditors often identify weaknesses in a company's systems and
provide recommendations for improvement in a "management letter"79. •
Assurance for Management: Confirms to management that they are fulfilling
their statutory duties correctly80. • Dispute Settlement: Audited accounts
can be a reliable basis for settling disputes, such as those related to profit-
sharing or tax liabilities. Limitations (The "Cons") • Cost: Audits can be
expensive, especially for smaller companies81. • Disruption: The audit
process requires time and effort from the company's staff, who need to
answer questions and provide documents82. • Subjectivity: The financial
statements (and the audit itself) are based on judgment and estimates, not
absolute certainties83. • Sampling Risk: As auditors test on a sample basis,
there is always a risk that material errors in the untested items will be
missed84. • Persuasive, Not Conclusive Evidence: Most audit evidence
persuades the auditor that something is correct, rather than offering
absolute proof85.