ISA 510, Initial Audit Engagements Opening Balances

International Auditing and Assurance Standards Board Exposure Draft July 2007 Comments are requested by October 31, 2007 Proposed Redrafted International Standard on Auditing ISA 510, Initial Audit Engagements Opening Balances

REQUEST FOR COMMENTS The International Auditing and Assurance Standards Board (IAASB), an independent standardsetting body within the International Federation of Accountants (IFAC), approved the exposure draft, proposed International Standard on Auditing (ISA) 510 (Redrafted), Initial Audit Engagements Opening Balances, for publication in July 2007. The proposed ISA may be modified in light of comments received before being issued in final form. Please submit your comments, preferably by e-mail, so that they will be received by October 31, 2007. All comments will be considered a matter of public record. Comments should be addressed to: International Federation of Accountants 545 Fifth Avenue, 14 th Floor New York, New York 10017 USA Comments should be emailed to Edcomments@ifac.org. They may also be faxed to +1-212-286-9570 or mailed to the above address. Copies of the exposure drafts may be downloaded free-of-charge from the IFAC website at http://www.ifac.org. Copyright July 2007 by the International Federation of Accountants. All rights reserved. Permission is granted to make copies of this work to achieve maximum exposure and feedback provided that each copy bears the following credit line: Copyright July 2007 by the International Federation of Accountants. All rights reserved. Used with permission.

CONTENTS Page Explanatory Memorandum... 2 Introduction... 2 Background... 2 Effective Date... 2 Significant Matter... 2 Guide for Respondents... 3 Supplement to the Exposure Draft... 4 Proposed International Standard on Auditing (ISA) 510 (Redrafted), Initial Audit Engagements Opening Balances... 5 1

Introduction EXPLANATORY MEMORANDUM This memorandum provides background to proposed International Standard on Auditing (ISA) 510 (Redrafted), Initial Audit Engagements Opening Balances. The proposed ISA has been redrafted in accordance with conventions agreed by the International Auditing and Assurance Standards Board (IAASB) to be applied to all ISAs. The IAASB approved the proposed redrafted ISA for exposure in July 2007. Background As part of its project to improve the clarity of its International Standards, the IAASB has undertaken to redraft all of its ISAs in accordance with its new clarity drafting conventions. This approach responds to the desire for all ISAs to be consistently drafted, and subject to a single statement of their authority and effect. The IAASB has agreed, in response to the general call for the Clarity project to be completed within a reasonable time, that while a significant number of the ISAs are under substantive revision as well as redrafting to reflect the new conventions, others will be subject to a limited redrafting to reflect only the conventions and matters of clarity generally. Proposed ISA 510 (Redrafted) is in the latter category. The conventions used by the IAASB in redrafting extant ISA 510, Initial Engagements Opening Balances, and the authority and obligation attaching to those conventions, are established in the amended Preface to the International Standards on Quality Control, Auditing, Review, Other Assurance and Related Services 1 (Preface), approved by the IAASB in September 2006. Effective Date The current timetable envisages that all ISAs will have been revised and redrafted, or redrafted only, by late 2008 and the IAASB has provisionally agreed that the complete set of ISAs will be effective for audits of financial statements for periods beginning on or after December 15, 2008. This date will depend on satisfactory progress being made, and will be amended to a later date should that prove necessary. The IAASB believes that it is in the interest of auditors and others who use the ISAs that the ISAs should be released as soon as they are approved so as to facilitate their implementation. Significant Matter Split Opinion Extant ISA 510 restricts the circumstances when the auditor can express an unmodified opinion on the closing financial position of the entity and a qualified opinion or disclaimer of opinion on the results of operations and cash flows ( split opinion ) to jurisdictions permitting it. The IAASB believes that this restriction is unnecessary and may create inconsistency in reporting. Accordingly, the IAASB proposes to remove the restriction. This is consistent with the 1 The Preface can be accessed at http://web.ifac.org/download/iaasb_preface.pdf. 2

EXPLANATORY MEMORANDUM requirements and guidance of proposed ISA 705 (Revised and Redrafted), Modifications to the Opinion in the Independent Auditor s Report. Guide for Respondents The IAASB is seeking comments only on changes resulting from applying the clarity drafting conventions, including the matter discussed above, and their effect on the content of the extant ISA. Respondents are asked to respond in particular to the following questions: 1. Are the objectives to be achieved by the auditor, stated in the proposed redrafted ISA, appropriate? 2. Have the criteria identified by the IAASB for determining whether a requirement should be specified been applied appropriately and consistently, such that the resulting requirements promote consistency in performance and reporting, and the use of professional judgment by auditors? 2 Recognizing that the final ISA will apply to audits of all sizes and in all sectors of the economy, the IAASB is also interested in comments on matters set out below. Special Considerations in the Audit of Small Entities Respondents are asked to comment whether, in their opinion, considerations in the audit of small entities have been dealt with appropriately in the proposed redrafted ISA. Special Considerations in the Audit of Public Sector Entities Respondents are asked to comment whether, in their opinion, special considerations in the audit of public sector entities have been dealt with appropriately in the proposed redrafted ISA. Developing Nations Recognizing that many developing nations have adopted or are in the process of adopting the ISAs, the IAASB invites respondents from these nations to comment, in particular, on any foreseeable difficulties in applying the proposed redrafted ISA in a developing nation environment. Translations Recognizing that many respondents intend to translate the final ISA for adoption in their own environments, the IAASB welcomes comment on potential translation issues noted in reviewing the proposed redrafted ISA. Comments are most helpful when they refer to specific paragraphs, include the reasons for the comments and, where appropriate, make specific suggestions for any proposed changes to 2 The IAASB has identified the following criteria for determining the requirements of a Standard: The requirement is necessary to achieve the objective stated in the Standard; The requirement is expected to be applicable in virtually all engagements to which the Standard is relevant; and The objective stated in the Standard is unlikely to have been met by the requirements of other Standards. In determining the requirements of a Standard, the IAASB will consider whether the requirements are proportionate to the importance of the subject matter of the Standard in relation to the overall objective of the engagement. The criteria, which are intended only to assist the IAASB in appropriately and consistently determining requirements, may be refined as further experience is gained. 3

EXPLANATORY MEMORANDUM wording. When a respondent agrees with proposals in the exposure draft, it will be helpful for the IAASB to be made aware of this view. Respondents are also invited to comment on any undue costs, set against the benefits of more consistent auditor performance, arising from the fact that the proposed redrafted ISA includes requirements that would previously have been guidance under the old drafting conventions, as in the extant ISA (see below). In commenting on this matter, respondents should bear in mind the criteria that the IAASB has applied in redrafting the proposed ISA (see footnote 2) and the fact that the IAASB is seeking to clarify that there was some guidance in extant ISAs that was more in the nature of requirements and would already have been followed by many auditors. Supplement to the Exposure Draft To assist respondents in tracking changes, IAASB staff has prepared an analysis of the decisions that have been made by the IAASB with respect to the treatment of the present tense in the explanatory paragraphs of the extant ISA. This analysis also demonstrates how the material in the extant ISA has been reflected in the proposed redrafted ISA. In particular, the analysis: Identifies existing sentences in the present tense and whether they are now treated as a requirement or as application material; Maps the material of the extant ISA to the proposed redrafted ISA; and Identifies explanatory material that is proposed to be eliminated or repositioned as a result of redrafting. These staff-prepared mapping documents are available on the IAASB website at http://www.ifac.org/guidance/exd-details.php?edid=0088. They are for information purposes only and do not form part of the exposure draft. To be considered, responses should be emailed to Edcomments@ifac.org. They may also be faxed to +1-212-286-9570 or mailed to 545 Fifth Avenue, 14th Floor, New York, NY 10017, USA. They should be received by October 31, 2007. 4

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) INITIAL AUDIT ENGAGEMENTS OPENING BALANCES (Effective for audits of financial statements for periods beginning on or after [date]) * CONTENTS Paragraph Introduction Scope of this ISA... 1 Effective Date... 2 Objective... 3 Definitions... 4 Requirements Audit Procedures... 5-8 Audit Conclusions and Reporting... 9-12 Application and Other Explanatory Material Audit Procedures... A1-A6 Audit Conclusions and Reporting... A7-A8 Appendix: Illustration of Auditor s Report with a Qualified Opinion International Standard on Auditing (ISA) 510 (Redrafted), Initial Audit Engagements Opening Balances should be read in the context of the Preface to the International Standards on Quality Control, Auditing, Review, Other Assurance and Related Services, which sets out the authority of ISAs. * See footnote 1. 5

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Introduction Scope of this ISA 1. This International Standard on Auditing (ISA) deals with the auditor s responsibilities relating to opening balances when conducting an initial audit engagement. In addition to financial statement amounts, opening balances include matters requiring disclosure that existed at the beginning of the period, such as contingencies and commitments. ISA 710, Comparatives deals with the auditor s responsibilities regarding comparatives and for reporting on them. Effective Date 2. This ISA is effective for audits of financial statements for periods beginning on or after [date]. 1 Objective 3. The objective of the auditor is, in conducting an initial audit engagement, to obtain sufficient appropriate audit evidence about whether: (a) (b) Misstatements that materially affect the current period s financial statements arising from the opening balances exist; and Appropriate accounting policies have been consistently applied or changes thereto are accounted for properly. Definitions 4. For the purposes of the ISAs the following terms have the meanings attributed below: (a) Initial audit engagement An engagement in which either: (i) The financial statements for the prior period were not audited; or (ii) The financial statements for the prior period were audited by a predecessor auditor. (b) Opening balances Those account balances that exist at the beginning of the period. Opening balances are based upon the closing balances of the prior period and reflect the effects of transactions of prior periods and accounting policies applied in the prior period. Opening balances also include matters requiring disclosure that existed at the beginning of the period, such as contingencies and commitments. (c) Predecessor auditor The auditor from a different audit firm, who was previously the auditor of an entity and who has been replaced by an incoming auditor. 1 This date will not be earlier than December 15, 2008. 6

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Requirements Audit Procedures Opening Balances 5. The auditor shall obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements that materially affect the current period s financial statements by: (a) Determining whether the prior period s closing balances have been correctly brought forward to the current period or, when appropriate, have been restated; (b) Determining that the opening balances reflect the application of appropriate accounting policies; and (c) Performing one or more of the following, as is necessary in the circumstances: (i) Review of the predecessor auditor s working papers; (ii) Evaluation of whether audit procedures performed in the current period provide evidence relevant to the opening balances; or (iii) Specific audit procedures to obtain evidence regarding the opening balances. (Ref: Para. A1 A5) 6. If the auditor obtains audit evidence that the opening balances contain misstatements which could materially affect the current period s financial statements, the auditor shall perform such additional audit procedures as are appropriate in the circumstances. If the auditor concludes that such a misstatement exists, the auditor shall communicate the misstatement to the appropriate level of management and those charged with governance in accordance with [proposed] ISA 450 (Revised and Redrafted), Evaluation of Misstatements Identified during the Audit, and subject to obtaining management s authorization, inform the predecessor auditor, if any. Consistency of Accounting Policies 7. The auditor shall obtain sufficient appropriate audit evidence whether the accounting policies reflected in the opening balances have been consistently applied in the current period s financial statements, and whether changes in the accounting policies have been properly accounted for and adequately presented and disclosed. Modification to the Opinion in the Predecessor Auditor s Report 8. If the prior period s financial statements were audited by a predecessor auditor and there was a modification to the opinion in the predecessor auditor s report, the auditor shall consider the effect of the matter giving rise to the modification as part of the auditor s risk assessment in the current period. (Ref: Para. A6) 7

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Audit Conclusions and Reporting Opening Balances 9. If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances, the auditor shall consider the effect thereof on the opinion in the auditor s report. (Ref: Para. A7) 10. If the auditor concludes that the opening balances contain misstatements that materially affect the current period s financial statements, and the effect of the misstatement is not properly accounted for or adequately presented and disclosed, the auditor shall express a qualified opinion or an adverse opinion, as appropriate, in accordance with [proposed] ISA 705 (Revised and Redrafted), Modifications to the Opinion in the Independent Auditor s Report. Consistency of Accounting Policies 11. If: (a) the current period s accounting policies have not been consistently applied in relation to opening balances in accordance with the applicable financial reporting framework; or (b) a change in accounting policies has not been properly accounted for or adequately presented and disclosed the auditor shall express a qualified opinion or an adverse opinion as appropriate in accordance with [proposed] ISA 705 (Revised and Redrafted). Modification to the Opinion in the Predecessor Auditor s Report 12. If a modification to the predecessor auditor s opinion regarding the prior period s financial statements remains relevant and material to the current period s financial statements, the auditor shall modify the auditor s report accordingly. (Ref: Para. A8) *** Application and Other Explanatory Material Audit Procedures Opening Balances (Ref: Para. 5) A1. The nature and extent of audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances depends on such matters as: The accounting policies followed by the entity. The nature of the accounts and the risks of material misstatement in the current period s financial statements. The materiality of the opening balances relative to the current period s financial statements. 8

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Whether the prior period s financial statements were audited, and if so whether the predecessor auditor s report was modified. A2. If the prior period s financial statements were audited by a predecessor auditor, the auditor may be able to obtain sufficient appropriate audit evidence regarding the opening balances by reviewing the predecessor auditor s working papers. Whether such a review provides sufficient appropriate audit evidence is influenced by the professional competence and independence of the predecessor auditor. A3. Relevant ethical and professional requirements guide the auditor s communications with the predecessor auditor. A4. For current assets and liabilities some audit evidence may be obtained as part of the current period s audit procedures. For example, the collection (payment) of opening accounts receivable (accounts payable) during the current period will provide some audit evidence of their existence, rights and obligations, completeness and valuation at the beginning of the period. In the case of inventories, however, it is more difficult for the auditor to be satisfied as to inventory on hand at the beginning of the period. Therefore, additional audit procedures may be necessary, such as: Observing a current physical inventory taking and reconciling it back to the opening inventory quantities. Performing audit procedures on the valuation of the opening inventory items. Performing audit procedures on gross profit and cutoff. A combination of these audit procedures may provide sufficient appropriate audit evidence. A5. For non current assets and liabilities, such as fixed assets, investments and long-term debt, some audit evidence may be obtained by examining the accounting records and other information underlying the opening balances. In certain cases, the auditor may be able to obtain confirmation of opening balances with third parties, for example, for longterm debt and investments. In other cases, the auditor may need to carry out additional audit procedures. Modification to the Opinion in the Predecessor Auditor s Report (Ref: Par. 8) A6. If the predecessor auditor s report was modified, the matter which resulted in the modification is relevant to the auditor s risk assessment in the current period s audit carried out in accordance with ISA 315 (Redrafted), Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment. Audit Conclusions and Reporting Opening Balances (Ref: Para. 9) A7. [Proposed] ISA 705 (Revised and Redrafted) establishes requirements and provides guidance on circumstances that may result in a modification to the auditor s opinion on the financial statements, the type of opinion appropriate in the circumstances, and the content of the auditor s report when the auditor s opinion is modified. The inability of the 9

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) auditor to obtain sufficient appropriate audit evidence regarding opening balances may result in one of the following modifications to the opinion in the auditor s report: (a) A qualified opinion; or (b) A disclaimer of opinion; or (c) An opinion which is qualified or disclaimed regarding the financial performance and cash flows and unqualified regarding financial position. (Refer to the Appendix.) Modification to the Opinion in the Predecessor Auditor s Report (Ref: Para. 12) A8. In some situations a modification to the predecessor auditor s opinion may not be relevant and material to the opinion on the current period s financial statements. This may be the case where, for example, there was a scope limitation in the prior period, but the matter giving rise to the scope limitation has been resolved in the current period. 10

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Appendix (Ref: Para. A7) Illustration of Auditor s Report with a Qualified Opinion Circumstances include the following: Auditor did not observe the counting of the physical inventory at the beginning of the current period and was unable to obtain sufficient other audit evidence regarding the opening balances of inventory. The inability to obtain sufficient appropriate audit evidence regarding opening balances of inventory, the possible effects of which, in the auditor s judgment, are material but not pervasive to the entity s financial performance and cash flows. 2 The financial position at the year end is fairly presented. An opinion which is qualified regarding the financial performance and cash flows and unqualified regarding financial position is considered appropriate in the circumstances. INDEPENDENT AUDITOR S REPORT [Appropriate Addressee] Report on the Financial Statements 3 We have audited the accompanying financial statements of ABC Company, which comprise the balance sheet as at December 31, 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory notes. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation 4 of these financial statements in accordance with International Financial Reporting Standards. This responsibility includes: designing, implementing and maintaining internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; selecting and applying appropriate accounting policies; and making accounting estimates that are reasonable in the circumstances. 2 If the possible effects, in the auditor s judgment, are considered to be material and pervasive to the entity s financial performance and cash flows, the auditor would disclaim the opinion on the financial performance and cash flows. 3 The subheading Report on the Financial Statements is unnecessary in circumstances when the second subheading Report on Other Legal and Regulatory Requirements is not applicable. 4 Depending on the circumstances, this sentence may read: Management is responsible for the preparation and presentation of financial statements that give a true and fair view in accordance with International Financial Reporting Standards. 11

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation 5 of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. 6 An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified audit opinion. Basis for Qualified Opinion on the Financial Performance and Cash Flows We did not observe the counting of the physical inventory stated at xxx as at December 31, 20X0, since that date was prior to our appointment as auditors. We were unable to satisfy ourselves as to the inventory quantities at that date by other audit procedures. Since opening inventories enter into the determination of the financial performance and cash flows, we were unable to determine whether adjustments to profit for the year and net cash flows from operating activities might be necessary. Qualified Opinion on the Financial Performance and Cash Flows In our opinion, except for the effects of adjustments, if any, which we might have determined to be necessary had we been able to audit the opening inventory quantities as described in the Basis for Qualified Opinion paragraph, the income statement and cash flow statement present fairly, in all material respects, (or give a true and fair view of ) the financial performance and cash flows 5 Depending on the circumstances, this sentence may read: In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and presentation of financial statements that give a true and fair view in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. 6 In circumstances when the auditor also has responsibility to express an opinion on the effectiveness of internal control in conjunction with the audit of the financial statements, this sentence would be worded as follows: In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances. In the case of footnote 5, this sentence may read: In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and presentation of financial statements that give a true and fair view in order to design audit procedures that are appropriate in the circumstances. 12

PROPOSED INTERNATIONAL STANDARD ON AUDITING 510 (REDRAFTED) of ABC Company for the year ended December 31, 20X1, in accordance with International Financial Reporting Standards. Opinion on the Financial Position However, in our opinion, the balance sheet presents fairly, in all material respects, (or gives a true and fair view of ) the financial position of ABC Company as at December 31, 20X1, in accordance with International Financial Reporting Standards. Report on Other Legal and Regulatory Requirements [Form and content of this section of the auditor s report will vary depending on the nature of the auditor s other reporting responsibilities.] [Auditor s signature] [Date of the auditor s report] [Auditor s address] 13

International Federation of Accountants 545 Fifth Avenue, 14 th Floor, New York, NY 10017 USA Tel +1 (212) 286-9344 Fax +1(212) 286-9570 www.ifac.org