«1666 K Street, NW Washington, D.C. 20006 Telephone: (202) 207-9100 Facsimile: (202)862-8430 STANDING ADVISORY GROUP MEETING ...»
1666 K Street, NW
Washington, D.C. 20006
Telephone: (202) 207-9100
STANDING ADVISORY GROUP MEETING
OCTOBER 5-6, 2005
The Board's interim auditing standards1/ require auditors to obtain reasonable
assurance that the financial statements are free of material misstatements to support
their unqualified opinion on the financial statements. This briefing paper discusses the concept of reasonable assurance and provides information to consider in deciding whether that concept is articulated with sufficient clarity and whether the standard of reasonable assurance is an appropriate level of auditor responsibility for the detection of material misstatements and for evaluating other areas of auditor performance.
The Concept of Reasonable Assurance The assurance the auditor obtains from performing procedures and the assurance the auditor expresses in the report on the financial statements vary based on the type of service the auditor provides. An audit is the highest level of service an auditor can provide. An audit allows the auditor to express an opinion about whether 1/ On April 16, 2003, the Board adopted certain pre-existing auditing standards as its interim auditing standards to be used on an initial, transitional basis.
PCAOB Rule 3200T describes the auditing standards that the Board adopted and requires registered public accounting firms and their associated persons to comply with these interim auditing standards to the extent not superseded or amended by the Board.
See the interim auditing standards at www.pcaob.org/standards.
This paper was developed by the staff of the Office of the Chief Auditor to foster discussion among the members of the SAG. It is not a statement of the Board; nor does it necessarily reflect the views of the Board or PCAOB staff.
Reasonable Assurance October 5-6, 2005 Page 2
STANDING ADVISORY GROUP MEETINGthe financial statements are free of material misstatement. In contrast, the objective of a review of interim financial information is to provide the auditor with a basis for communicating whether, as a result of the procedures performed, the auditor became aware of any modificationsthat should be made to the interim financial information for it to conform with generally accepted accounting principles ("GAAP"). The procedures performed in a review do not provide the auditor with a basis for expressing an opinion on the financial statements. Thus, the assurance the auditor provides to financial statement users based on a review is more limited than the assurance that can be provided as a result of an audit.
The term "reasonable assurance," as used in the interim auditing standards, describes the level of assurance auditors are required to obtain by performing audit procedures and evaluating the resulting audit evidence when expressing an opinion that the financial statements are fairly presented in conformity with GAAP. Reasonable assurance refers to the auditor's degree of satisfaction that the evidence obtained during the performance of the audit supports the assertions embodied in the financial statements. The auditor's standard report on the audit of financial statements explicitly asserts in the scope paragraph that the audit was conducted in accordance with professional standards and states that "those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement."
Defining Reasonable Assurance Paragraph 17 of PCAOB Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial
Statements, describes reasonable assurance as follows:
Management's assessment of the effectiveness of internal control over financial reporting is expressed at the level of reasonable assurance...
Reasonable assurance includes the understanding that there is a remote likelihood that material misstatements will not be prevented or detected on a timely basis. Although not absolute assurance, reasonable assurance is, nevertheless, a high level of assurance.
STANDING ADVISORY GROUP MEETINGreasonable assurance is a high level of assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes.
However, in the context of a financial statement audit, the term "reasonable assurance" is not explicitly defined. Rather than defining what reasonable assurance is, the interim auditing standards explain reasonable assurance by contrasting it with absolute assurance. For example – The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected. (AU sec. 110.02) The exercise of due professional care allows the auditor to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud. Absolute assurance is not attainable because of the nature of the audit evidence and the characteristics of fraud. Therefore, an audit conducted in accordance with generally accepted auditing standards may not detect a material misstatement. (AU sec. 230.10) Thus, the interim auditing standards convey the idea that reasonable assurance is less than absolute assurance, but they do not explicitly define reasonable assurance;
rather, they state what reasonable assurance is not.
STANDING ADVISORY GROUP MEETINGachieve reasonable assurance as they have in the past, especially in areas in which they believe that risk is low.2/ What Level of Assurance Is Reasonable Assurance?
Because reasonable assurance is less than absolute assurance, the interim auditing standards are clear that it is less than certainty or, in quantitative terms, less than 100 percent. But how much less is not stated.
Some insight into what reasonable assurance means to the auditor may be gained by recognizing that it is the complement of audit risk. Audit risk is defined in AU sec. 312, Audit Risk and Materiality in Conducting an Audit, as "the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated." The interim auditing standards describe the relationship between audit risk and assurance as follows – The existence of audit risk is recognized in the description of the responsibilities and functions of the independent auditor that states, 'Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected.' (AU sec. 312.02) The interim auditing standards also state the following about the risk/assurance relationship –
• The auditor should plan the audit so that audit risk will be limited to a low level that is, in his or her professional judgment, appropriate for expressing an opinion on the financial statements. (AU sec. 312.13)
• The auditor should seek to restrict audit risk at the individual accountbalance or class-of-transactions level in such a way that will enable him or her, at the completion of the audit, to express an opinion on the financial
Because the auditor must limit overall audit risk to a low level, reasonable assurance must be at a high level. Stated in mathematical terms, if audit risk is 5 percent, then the level of assurance is 95 percent. The relationship is not normally quantified at the financial statement level, but the relationship between risk and assurance is incontrovertible, and the interim auditing standards explicitly make the connection.
Other professional standards also articulate the concept of reasonable assurance as a high level of assurance. For example, the glossary of terms that accompanies the pronouncements of the International Auditing and Assurance Standards Board defines reasonable assurance, both in the context of an audit engagement and quality control, as a high, but not absolute, level of assurance.3/ In addition, IFAC's Code of Ethics for Professional Accountants defines an audit engagement as – An assurance engagement to provide a high level of assurance that financial statements are free of material misstatement, such as an engagement in accordance with International Standards on Auditing. This includes a statutory audit which is an audit required by national legislation or other regulation.
Comments made by some members of the Standing Advisory Group at the September 8-9, 2004, SAG meeting provide anecdotal indications that at least some investors and other financial statement users are uncertain about the level of assurance described by the term "reasonable assurance." For example, one member expressed the view that the language in the interim auditing standards describing the inherent limitations of an audit may create the impression that reasonable assurance is not a high level of assurance. Furthermore, this member suggested that auditors should be required to apply procedures such as maintaining a heightened skepticism about the possibility of fraud throughout the audit and focusing specific audit procedures on highrisk areas that would allow the auditor to express a high level of assurance on the financial statements, rather than reasonable assurance. Another member expressed
STANDING ADVISORY GROUP MEETINGthe view that the term "reasonable assurance" conveyed a low level of assurance when compared to the clear expression of "high but not absolute" assurance used in the international auditing standards.
Using Different Terms to Define Reasonable Assurance Because both auditors and financial statement users have preconceptions about the meaning of the term "reasonable assurance," it may be helpful to articulate the auditor's responsibility to obtain satisfaction about the reliability of the assertions embodied in the financial statements using terms other than reasonable assurance. For example, using words with which auditors are familiar because they are defined in Financial Accounting Standards Board ("FASB") Statements of Financial Accounting Standards ("FASB Statement"), the auditor's responsibility could be articulated as "planning and performing the audit in a manner that makes it probable, though not a certainty, that the financial statements are free of material misstatement." The term "probable" is defined in FASB Statement No. 5, Accounting for Contingencies, as "likely" and also conveys a high level of assurance.
Discussion Questions –
2. Should the term "reasonable assurance," as used in the interim auditing standards, be described as a high level of assurance? Or, is there another definition or description that is more appropriate?
3. Should the assurance that the auditor obtains be expressed using terms other than reasonable assurance? If so, what terms better articulate the auditor's assurance level?
Is Reasonable Assurance an Appropriate Level of Responsibility?
STANDING ADVISORY GROUP MEETINGNature of Audit Evidence The limitation on the level of assurance that can be obtained by the auditor due to the nature of audit evidence generally results from two matters: (1) the concept of selective testing and (2) the fact that accounting presentations include accounting estimates that are inherently uncertain. AU sec. 230.11 states – The nature of most evidence derives, in part, from the concept of selective testing of the data being audited, which involves judgment regarding both the areas to be tested and the nature, timing, and extent of the tests to be performed. In addition, judgment is required in interpreting the results of audit testing and evaluating audit evidence. Even with good faith and integrity, mistakes and errors in judgment can be made. Furthermore, accounting presentations contain accounting estimates, the measurement of which is inherently uncertain and depends on the outcome of future events. The auditor exercises professional judgment in evaluating the reasonableness of accounting estimates based on information that could reasonably be expected to be available prior to the completion of field work. As a result of these factors, in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing.
Selective testing is necessary to perform an audit within reasonable time and cost constraints, but audit sampling techniques, if properly applied, can help the auditor control the level of assurance achieved through selective testing.
Accounting estimates are an integral part of financial statements. Management's judgment in making estimates is normally based on its knowledge and experience about past and current events and its assumptions about conditions it expects to exist and courses of action it expects to take. Because estimates are approximations of financial statement amounts based on subjective as well as objective factors, they are less precise than other financial statement amounts. Further, some accounting estimates have a higher degree of uncertainty than others. For example, environmental loss reserves are generally more uncertain than the collectibility of a receivable from a customer. These differences in uncertainty can be adequately disclosed4/ in the financial statement presentation and understood by a user.