Chapter 13Financial Audit
This chapter introduces the legal requirements concerning presentation and maintenance of financial accounts.
RELEVANT PAST EXAM QUESTIONS
■ 2016, Autumn, Question 5(b)
■ 2017, Autumn, Question 3(c)
■ 2018, Summer, Question 2(c)
■ 2018, Summer, Question 4(d)
13.1.Understanding of the legal requirements concerning the presentation and maintenance of financial accounts
One of the principal techniques used by the Companies Acts to safeguard investors and persons who deal with companies is the compulsory disclosure of information. In exchange for the privilege of separate legal personality and limited liability status, companies are required to disclose certain facts about themselves to the general public, usually via the Companies Registration Office (‘CRO’). Further, a number of fundamental rules of company law, such as the maintenance of capital in the calculation of profits available for distribution could not be enforced effectively without the proper regulation of company accounts.
13.1.2.The requirements surrounding the directors’ reports
Under sections 325-332 of the Companies Act 2014 the directors must prepare a report on the state of the company’s affairs and those of any subsidiaries. This report must contain a fair review of the business of the company, and a description of the principal risks and uncertainties facing the company. This report must be laid before the company at its AGM and should be circulated to every member and debenture holder who is entitled to attend such a meeting. Where the company has two or more directors, two directors of the company must sign the report on behalf of all of the directors.
Company performance and overview
Section 327 of the Companies Act 2014 requires that the report must be a balanced and comprehensive analysis of the development and performance of the business of the company during the financial year, and of the assets, liabilities and financial position of the company at the end of the financial year.
The report must state what dividend is to be paid to the shareholders and how much is proposed to be carried to reserves.
Any change in the business
The report must also indicate any changes in the nature of the company’s business or the class of business in which the company has an interest that occurred during the year. It must also contain an explanation of the change and the effect of the change on the company’s subsidiaries.
The report must also contain a list of the company’s subsidiaries outlining the names, places of incorporation and nature of their businesses.
Any important event
The report must set out a fair view as to how the business developed in the year. If any particular event or events occurred during the year which affected the company or any of its subsidiaries in any significant manner, then these particulars should also be included in the report.
Future development and research & development
The report must contain comments about the likely future developments in the business and a statement on the research and development that the company was carrying out or has carried out during the current year.
The report must contain particulars of all donations for political purposes exceeding €5,079 in value made by the company in the year to which the report relates and details of the person to whom the donation was made.
Safety, health and welfare
The report must also contain a statement on the safety, health and welfare of the company and its employees. This statement has to evaluate the extent to which the policy of the company in relation to safety has been carried out during the year covered by the report.
Other information relating to the Directors
The Companies Act 2014 also requires that certain transactions between the company and the directors be disclosed in the accounts (not in the Directors’ Report).
Directors’ salaries, pensions, payments, compensations, benefits
Section 305 of the Companies Act 2014 requires that there be a note and explanation of the directors’ salaries and other payments made to them during the year. Particulars of the amount of the directors’ emoluments, pensions (including past directors’ pensions), and any compensation to directors or past directors for loss of office must also be included.
Benefits received by the directors in a form otherwise than in cash must be contained in the particulars. As you have seen, there are stringent requirements regarding loans that are made to directors.
Where loans or other transactions or arrangements are entered into with directors such transactions must be disclosed by way of notes to the accounts. There are exemptions where the amounts are not significant. These provisions also apply to shadow directors and/or persons connected with directors.
There is a duty on directors to give notice in writing to the company of any such matters which are required for the purposes of the company to prepare accounts. Every Statement of Financial Position and Statement of Comprehensive Income of the company must be signed on behalf of the directors by two of the directors of the company (bar sole-director companies).
13.1.3.The purpose of a financial audit
The purpose of a financial audit is to form a professional, independent opinion as to whether the accounts give a fair presentation of the financial position of the company at the period end and the performance of the company during the period. Financial audits are important because they provide the users of the Financial Statements with a level of assurance that the accounts are materially correct and can be trusted. Many companies will opt to have their accounts audited even if they fall within the exemption for small companies because it provides assurance to investors, lenders etc.
Financial audits may also be performed by internal auditors (employees of the company) to ensure that the internal controls the company has put in place over their accounting systems are effective and to substantiate the amounts included in the accounting records and financial accounts.
13.1.4.The auditors rights
External auditors of a company have a right to access (at all reasonable times) the books, accounts and vouchers of the company. They can also require any information and explanations necessary to fulfil the duties of auditor from the officers of the company.
The auditors of a company are entitled to attend any general meeting of the company and to be heard at any general meeting which they attend on any part of the business of the meeting which concerns them as auditors.
Company law (Section 333 CA 2014) requires that public companies and most limited companies appoint an external auditor. In the case of a private limited company (and certain unlimited companies who must file accounts with the CRO) the requirement to appoint an auditor and to have the annual accounts audited may be set aside provided that certain conditions are met (‘audit exemption’).
Under section 350 CA 2014 certain small businesses that meet specified criteria can avail of an exemption from the obligation to appoint an auditor and have their accounts audited. The exemption is not a general exemption but applies in any year in which the necessary criteria are met. The company qualifies for audit exemption if 2 or more of the following criteria are met for the financial year in question and the immediately preceding year:
1) the annual turnover of the company did not exceed €12,000,000,
2) its total assets did not exceed €6,000,000
3) it did not employ more than 50 people.
Moreover, the exemption is only available to a company that has submitted its annual return on time in the current and the preceding year.
Where an exemption ceases to have effect in relation to a company, the directors must appoint an auditor as soon as possible after the circumstances have arisen which lead to the exemption ceasing to have effect.
The obligation to file accounts with its annual return does not apply to an unlimited company other than:
(a) an unlimited company, all of whose members are limited liability entities; and
(b) an unlimited company, where the shareholders of the unlimited liability members of the unlimited company are all limited liability entities.
If a company is an unlimited company which is not required to file accounts with its annual return, it is not entitled to the audit exemption.
However, unlimited companies falling within (a) or (b) above must attach accounts to their annual return as if they were a limited company. Such companies may qualify for the audit exemption, provided that they meet the other qualifying conditions as set out above.
13.1.6.Work needed to establish whether accounts are true & fair
Auditors will set a materiality level for the audit and in general, they will not look at balances below the materiality threshold (other than cash balances) unless there is a particular risk that the balance may have been misstated. The materiality level will usually be calculated as a percentage of profit before tax (although different methods will the used where the company is in a loss making position or is dormant).
Auditors will perform detailed testing (known as substantive testing) on high risk accounts and all balances that are above the materiality limit set at the beginning of the audit.
When the auditors have completed their audit procedures, they will review the combined errors they have identified during their testing. If the combined errors are material, the auditors may request that the company adjusts their accounts to ensure that the final Financial Statements give a fair presentation of the financial position of the company at the period end and the performance of the company during the period.
Section 392 of the Companies Act 2014 requires that if auditors form the opinion that a company has not kept proper books of account they must serve a notice on the company as soon as possible and notify the registrar of companies within seven days. Where the auditors feel that proper books of account were not maintained but that the directors have since taken the necessary steps to rectify the situation, the requirement to notify the registrar of companies does not apply.
If there are inconsistencies between directors’ report and Financial Statements then the auditor is required to resolve them. If the matters cannot be resolved then the Auditor has to report this in his audit report and may result in a ‘qualified’ opinion on the Financial Statements.
A qualified audit report provides an opinion subject to an issue/issues of concern to the auditor. These concerns (or qualifications) are detailed in the auditor’s report.
An unqualified audit report states the auditors’ opinion that the Financial Statements give a fair presentation without any issues of concern being noted between the auditor and the directors. This is sometimes referred to as a ‘clean audit report’.
The role of the auditor is to form an opinion as to whether the Financial Statements prepared by the directors give a fair presentation of the company’s affairs. Consequently, the audit report does not (and could not) provide absolute assurance that every entry in the Financial Statements is 100% accurate. Neither does it guarantee that the company is free from fraud.
Some stakeholders are of the view that an unqualified (favourable) audit report provides the guaranteed assurances described above. The variation between what these stakeholders erroneously believe and the actuality of what the auditor provides is known as “the expectation gap”.
Auditors are required to be independent of the company, and to bring independent judgement to bear on the Financial Statements. They are not precluded, however, from providing other services to the company provided satisfactory assurance can be provided that this independence is not compromised.
How this is assured is beyond the scope of this course. However, students should be aware that, in addition to the disclosure of the audit fee, the company must disclose the total amount payable to it auditor under the following headings:
■ Audit of company accounts
■ Other assurance services
■ Tax advisory services
■ Other non-audit services
13.2.Outline and apply how tax balances are audited for purposes of the audit report in Irish financial statements and how the audit work is evidenced
The role of the auditor is to audit the books and Financial Statements to ascertain that they are in accordance with the Companies Act 2014 and give an audit opinion in the audit report as to whether they give a true and fair view/fair presentation.
The auditor will prepare an audit plan in line with International Standards on Auditing (ISA) as published by the International Auditing and Assurances Standards Board (IAASB), the auditing equivalent of the IFRS standards for accountants. As with the accounting standards there is a UK and Ireland equivalent called the UK and Ireland ISA’s and these are published by the Audit and Assurance Council of the Financial Reporting Council. The UK and Ireland standards are quite similar to the international versions.
Remember that auditors work within the concept of materiality. This is in contrast to preparing the tax return, where there is no such level of materiality and the return must be 100% correct or if not, that fact must be disclosed to the tax authorities and reasons given.
In forming an opinion in relation to the Financial Statements the auditor must carry out tests concerning the accuracy of the figures and information contained in the Financial Statements. In relation to corporation tax the objective is to gather sufficient audit evidence:
1. to ensure that the tax charge in the accounts is materially correct and in compliance with legislation; and
2. to ensure that the tax charge and deferred tax are prepared and disclosed in accordance with the relevant accounting standards.
13.2.2.Audit tests on corporation tax in accounts
The following are some of the main tests that would be performed in the audit of the corporation tax balances. It is not an exhaustive list as each company’s audit plan is tailored to the type of activity and location the company operates from. For example, the audit of a bank would be very different from the audit of a construction company.
1. The auditor will ensure that the corporation tax disclosures are in line with the relevant accounting standards. This would involve, for example, checking that any losses being carried forward were included if applicable as a deferred asset under IAS 12 or checking that the comparison between net book values and tax written down values were correct for the purposes of FRS 102.
2. They will check that the prior year corporation tax amounts were correctly brought into the current years accounts and that all current year movements can be traced from the Financial Statements to working papers prepared by the accountants. These working papers would be then reviewed for accuracy, for example, the wear and tear computation or the close-company surcharge calculation and charge to the Financial Statements.
3. They will check that the liability and return for the previous year have been agreed with the company’s Inspector of Taxes and fully paid. They will also check whether there are any accounting periods currently being audited by the tax authorities which may lead to an increase in tax liabilities.
4. During the review of the Statement of Comprehensive Income, they will cross check to the tax computation any unusual transactions/costs, for example sales of capital assets, as well as review for reasonableness of cost headings such as travel and entertainment expenses.
5. The auditor should meet with the company’s directors and tax advisers to ascertain if the company undertook any aggressive tax planning during the period which may be questioned at a later date by the tax authorities. The auditor will need to decide if any adjustments are required to the corporation tax liability following on from the meeting.
6. The information contained in the corporation tax return in relation to directors emoluments and loan accounts should be compared to the Financial Statements where similar information needs to be disclosed.
7. The auditor will review closing accruals and provisions to ensure that charges in the Statement of Comprehensive Income which are not tax allowable, for example, unpaid pension contributions, have been added back.
13.3.Outline and apply when audit adjustments are required in tax balances for financial statements
If during the course of the audit errors or items which require adjustment are found, the auditor will request that the Financial Statements and tax returns are amended accordingly. Typical items which would require adjustment would be:
1. An accounting error is discovered in the Financial Statements, for example, an item which is actually an asset has been mistakenly charged to the Statement of Comprehensive Income.
2. A provision or other similar charge to the Statement of Comprehensive Income is not in agreement with the appropriate accounting standard and should be cancelled. For example, a general provision for repairs not in accordance with IAS37 would have to be cancelled.
3. Any information which comes to light since the preparation of the Financial Statements and the performance of the audit may lead to audit adjustments, for example the agreed extra liabilities due following a revenue audit which were not originally included in the accounts when first drafted.
The auditors of Murrisk Ltd have discovered the following entries during their audit of the year ended 31 December 2018 which require correction:
A new machine which cost €100,000 was charged to the Statement of Comprehensive Income as repairs. The auditor requires it to be capitalised as a new machine and not as repairs and estimates it has a five year working life with a nil residual value.
A provision for slow-moving inventory of €50,000 is adjudged to not be in compliance with IAS 2 and must be cancelled.
The corporation tax rate is 12.50% and the accounting entries are as follows:
Being the audit adjustments for the year ended 31 December 2018
Being the current tax audit adjustment for the year ended 31 December 2018
The audit adjustment for tax is arrived at as follows:
The depreciation charge of €20,000 is ignored as it has no tax effect.
If the company disagrees over the accounting adjustments the auditor can mention in the audit report that certain items were not adjusted in the Financial Statements. If the adjustments are not carried out are fundamental in ensuring that the accounts provide a true and fair view the auditor will qualify the audit report in this respect. Students should always bear in mind that the directors are responsible for the Financial Statements. The auditor has no authority to amend them.
13.4.An awareness of how uncertain tax positions arise in Irish financial statements and the appropriate provisioning
13.4.1.Definition and examples of uncertain tax positions
In most cases the preparation of a corporation tax return is based on the facts as per the company’s Financial Statements together with any other information the tax adviser has to hand and the tax charge is calculated on that basis and provided for in the accounts. However, situations can arise when the taxation treatment is not clear or is ambiguous.
Uncertain tax position is the term used when a transaction has been undertaken by a company for which the taxation implications are unclear and subject to doubt or when the company is in dispute with its Inspector of Taxes and the liability or refund due is not clarified. When the Financial Statements are being prepared provision must be made in the accounts for the corporation tax expense or income on these uncertain tax positions.
The most common examples of uncertain tax positions would be:
1. Deductions against taxable profits made by the company, for example large capital repairs which the company is maintaining are replacements, which may be disputed by the Inspector of Taxes.
2. Refunds or offset claims by the company, for example under the research and development tax credit scheme under s. 766 TCA 1997 where the Inspector of Taxes may not agree that the company is involved in R&D to that extent that it is claiming.
3. Issues relating to transactions with other entities, the ownership of whom may not be fully disclosed to the auditor, for example close company implications under s. 436 – 439 TCA 1997, interest charges anti-avoidance under s. 249 TCA 1997 etc.
4. A Revenue audit is currently in progress at the same time that the financial audit is being finalised and the outcome will not be known for some time, perhaps due to delays over appeals etc.
This will be covered in Part 3.
13.4.2.Providing for uncertain tax positions
Neither IFRS nor FRS 102 accounting standards provide any formal guidance to the treatment of uncertain tax positions, though the European Securities and Markets Authority (‘ESMA’) issued a Public Statement on the matter in October 2014 stating its expectation that such positions would be clearly identified in Financial Statements.
IAS 12 provides that all taxes (therefore by definition including uncertain taxes) should be provided at the amount expected to be paid. While this ensures that straightforward tax computations and liabilities are included in the tax charge, it does not assist in determining the amount of tax to recognise when the tax treatment is uncertain.
In the absence of formal guidance two approaches are commonly adopted:
1. One step approach - each separate uncertain tax position is calculated but is not recognised in the accounts as a liability (or asset) unless it is likely that the position will crystallise, based on the “probability weighted average of all possible outcomes”, this definition is contained in an Exposure Draft (a form of standard issued in advance of the final version, for which comments are invited) on a new IAS 12 which issued in 2009. The draft has not been converted into a new IAS. In the absence of any formal guidance, this approach is commonly used.
2. Two step approach - a minimum recognition threshold is set, where it is more likely than not that the position will crystallise, for example a threshold of 50% and from that the exposure is measured for the tax position. This approach is similar to the approach adopted under US (see discussion on FIN 48 in 13.5). It is also in line in IAS 37 which states that assets and liabilities should be recognised when it is more likely than not that they will crystallise. This approach is also quite common, even though IAS 37 specifically states that it does not apply to income taxes.
13.5.An awareness of the main requirements for disclosing uncertainties in income tax provisions (FIN 48)
The US standards governing the preparation of Financial Statements are issued by the Financial Accounting Standards Board (FASB). Enterprises registered with the Securities and Exchange Commission (SEC) are required to follow these standards.
Accounting Statement No. 109 governs the taxation treatment of taxes on profits in the Financial Statements. Concerns had arisen that differing companies were accounting for tax items in ways that lead to difficulties in comparing the taxation charges in their accounts.
FASB Interpretation Number 48 – Accounting for Uncertainty in Income Taxes (FIN 48) was brought in to clarify the position and provide guidance on accounting for uncertainties in a company’s tax position. It has been in effect since December 2006.
For example, a company might take a particular view on an aggressive taxation planning measure which may result in a reduced taxation charge but there is a high chance that the revenue authorities may challenge the measure. As a result, the taxation charge eventually levied on the company might be higher than that disclosed in the accounts.
In this case, FIN 48 gives a two step approach to deciding on whether there is an adequate provision in the accounts for taxation:
The first step, “recognition”, states that the company must assume that the relevant tax authority has all the information in relation to the transaction/plan in question that is relevant. The company must then decide whether it is “more likely-than-not” that the tax position taken by the company would stand after a review.
Following on from this, the second step, “measurement”, deals with the amount to be included in the accounts of “more likely-than-not” tax positions. It states that the amount to be recognised is the largest amount of “benefit” that has a greater than 50% likelihood of being realised after examination.
FIN 48 states that, where a benefit has been claimed in a tax return but has not been recognised in the Financial Statements, interest and (if appropriate) penalties should be accrued on this element of the amount. So if you are not confident enough of the outcome of a given tax - planning measure to include the tax saving in the Financial Statements, you provide for interest and penalties.
In addition to US domestic taxes, FIN 48 must be applied to the foreign “income taxes” suffered by US enterprises, such as Irish corporation tax. In your career as a Chartered Tax Adviser (CTA) you may have to learn more about and actually apply the requirements of FIN 48 to Irish business taxes.