Principles of Auditing - An Introduction to International Standards

CHAPTER 14 CORPORATE GOVERNANCE

14.12 Questions, Exercises and Cases

QUESTIONS

14.3 The Nature of Corporate Governance

14.1 Explain the concept of Corporate Governance.
14.2 Describe the difference between shareholders and stakeholders and discuss why
differences play a central role in the corporate governance discussion.

14.4 Causes of Current Corporate Governance Discussions

14.3 Explain why the concept of corporate governance is being discussed all over the globe at
14.4 the beginning of the twenty-first century.
Talk about why IFRS and XBRL could contribute to good corporate governance.

14.5 Corporate Governance Structures

14.5 Describe the differences between a market-oriented versus a network-oriented corporate
14.6 governance structure.
What are advantages and disadvantages of a one-tier board structure.

14.6 Corporate Governance Committees and Reports

14.7 Should a corporate governance code be developed by governmental bodies and enforced
by law or should a code be developed by private institutions as companies, shareholder
representatives, lawyers and accountants and compliance be left to self-regulation?

14.7 Best Practice from a Global Perspective

14.8 Should auditors be appointed by management or the audit committee? Why?
14.9 According to Sarbanes-Oxley, at least one audit committee member should be a “financial

expert.” Discuss some criteria that should be met.
14.10 Should the audit committee review design and operating effectiveness of internal

controls? Do you think the audit committee is part of “internal control?”
14.11 Describe the steps of the audit of internal controls over financial reporting.
14.12 Transparency is an important element of good corporate governance. Do you think a

maximum level of transparency exists or should the company be able and willing to
communicate all information at the request of stakeholders?

14.8 Corporate Governance And The Role Of The Auditor

14.13 List major differences between the internal and external audit.
14.14 What is meant by the statement: “Corporate governance is not an end in itself?”
14.15 Describe the role of the external auditor in corporate governance.

PROBLEMS AND EXERCISES

14.3 The Nature of Corporate Governance
14.16 Using the example of basketball, explain the nature of corporate governance in terms of
a basketball team.

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QUESTIONS, EXERCISES AND CASES

14.4 Causes of Current Corporate Governance Discussions
14.17 Bakka Bee, a construction firm in Toronto Canada. They are a firm with 200 employees
in five countries. One of their divisions – in Peru – has encountered difficulties and may
have to be liquidated. The company uses computers for everything from design of
buildings to testing the quality of construction.

Required:
Discuss Bakka Bee in terms of the four causes of the current corporate governance
discussion:
1 Bankruptcies, fraud, and mismanagement.
2 The influence of public, customers and media.
3 Globalization of capital markets.
4 Developments in information technology (IT).

14.5 Corporate Governance Structures
14.18 Pick one US-based company and one European company and compare and contrast
their board of directors and other supervisory boards.

14.6 Corporate Governance Committees & Reports
14.19 According to the US Sarbanes-Oxley Act, auditors should audit the internal controls of
financial reporting (SOX 404). However, from prior research it can be concluded that
users of the auditor’s opinion on financial statements assume an unqualified opinion
implicates internal controls being adequately designed and operating. Explain why this
expectation cannot be met by an audit of financial statements. Describe major
differences in evaluating internal controls over financial reporting in a financial statements
audit and auditing internal controls over financial reporting as a separate engagement.

14.7 Best Practice from a Global Perspective
14.20 Discuss the duties of the PCAOB.
14.21 Royal Shell publishes a “Triple Bottom Line Report” in which it reports about economic,
social and environmental issues. This report (called The Shell Report) can be found on
the internet (www.shell.com). Review The Shell Report and summarize potential
stakeholders that could be interested in this report. For each potential stakeholder
formulate a financial or non-financial performance indicator.

14.8 Corporate Governance And The Role Of The Auditor
14.22 Why is self-regulation by the audit profession in the US no longer in place? Find some
arguments “pro and con” self-regulation?

CASES

14.23 Describe the system of oversight of the audit profession in your country. Compare this
system with the PCAOB standards. Discuss differences. US students should analyze the
oversight system in the UK and Europe as a whole, make a comparison and discuss
differences.

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Appendix A to Chapter 14

The Combined Code (UK), July 2003:
An Example of Auditors’ Review of
Corporate Governance Best Practice

■ Directors

Some key provisions
■ The chairman should ensure that new directors receive a full, formal and tailored intro-

duction on joining the board. (Code Provision A.5.1).
■ The board should identify in the annual report each non-executive director it considers to

be independent. The chairman should, on appointment, meet the independence criteria set
out in A.3.1 (A.2.2).
■ Except for smaller companies, at least half of the board, excluding the chairman, should
comprise non-executive directors determined by the board to be independent (A.3.2).
■ There should be a nomination committee which should lead the process for board
appointments and make recommendations to the board. A majority of the members of the
nomination committee should be independent non-executive directors (A.4.1).
■ Nomination committees should evaluate the balance of skills, knowledge and experience
on the board and, in the light of this evaluation prepare a description of the role and
capabilities required for a particular appointment (A.4.2).
■ All directors should be subject to election by shareholders at the first annual general
meeting after their appointment, and to re-election thereafter at intervals of no more than
three years. The names of directors submitted for election or re-election should be
accompanied by sufficient biographical details to enable shareholders to take an informed
decision on their election (A.7.1).
■ Non-executive directors should be appointed for specified terms subject to re-election and
to Companies Act provisions relating to the removal of a director, and re-appointment
should not be automatic (A.7.2).

Example of audit implications
■ The control environment could be considered weak if there are insufficient non-executive

directors.

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APPENDIX A

■ If directors are not properly trained can they make strategic decisions about the company’s
operations?

■ With more independent directors, the directors may not have the necessary understanding
of the company’s business and industry it operates in to make informed strategic decisions.

■ With directors being up for re-election every three years there may be less continuity on the
board.

According to the listing requirements of the London Stock Exchange, the company’s
auditors are required to review compliance statements relating to certain Code provisions
(illustrative):

■ The board should have a formal schedule of matters specifically reserved to it for decision
(Code Provision A.1.1).

■ The board should ensure that directors have access to independent professional advice at
the company’s expense where they judge it necessary to discharge their responsibilities as
directors (A.5.2).

■ Non-executive directors should be appointed for specified terms subject to re-election and
to Companies Act provisions relating to the removal of a director. The board should set out
to shareholders in the papers accompanying a resolution to elect a non-executive director
why they believe an individual should be elected (A.7.2).

■ All directors should be subject to election by shareholders at the first opportunity after their
appointment, and to re-election thereafter at intervals of no more than three years. The
names of directors submitted for election or re-election should be accompanied by
sufficient biographical details to enable shareholders to take an informed decision on their
election (A.7.1).

Audit procedures (illustrative)

■ The board should have a formal schedule of matters specifically reserved to it for decision
(Code Provision A.1.1).
– inspect the schedule of specific matters noting when this was last updated;
– inspect the board minutes recording adoption of the most recent schedule;
– consider whether the contents of the schedule are likely to be adequate for the business
taking into account its size, nature and complexity;
– consider whether the schedule of matters appears to be followed by reference to board
minutes throughout the period, and to any transactions, of which we are aware, that
would appear to require board approval.

■ The board should ensure that directors have access to independent professional advice at
the company’s expense where they judge it necessary to discharge their responsibilities as
directors (A.5.2).
– establish details of the agreed procedures;
– inspect the board minutes recording adoption of these procedures, if these have been
adopted this year;
– if procedures are not formally laid down in writing, confirm their existence with
directors and company secretary;
– consider, by discussion with the directors and from our knowledge of the business,
whether there was a need for independent advice during the period and, if so, whether
procedures have been followed in practice.

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CHAPTER 14 CORPORATE GOVERNANCE

■ Non-executive directors should be appointed for specified terms subject to re-election and
to Companies Act provisions relating to the removal of a director. The board should set out
to shareholders in the papers accompanying a resolution to elect a non-executive director
why they believe an individual should be elected (A.7.2).
– inspect the service contracts letter of appointment of all directors who were members of
the board at any time during the period under review (see A.7.1 below).
– check whether the non-executive directors’ contracts specify the terms of appointment;
– consider, for those non-executive directors who came to the end of their term during the
period, whether there is evidence that their re-appointment was formally considered by
the board and remuneration committee and in line with Companies Act provisions
relating to the removal of a director.

■ All directors should be subject to election by shareholders at the first opportunity after their
appointment, and to re-election thereafter at intervals of no more than three years. The
names of directors submitted for election or re-election should be accompanied by suffi-
cient biographical details to enable shareholders to take an informed decision on their
election (A.7.1).
– ensure that all directors appointed during the year have been elected or will be elected by
shareholders at the earliest opportunity;
– based on the inspection mentioned in A.7.2 above, determine whether any directors’
service contract exceeds three years. If so, establish why this is the case;
– ensure that all directors submitted for election or re-election are accompanied by suffi-
cient biographical details to enable shareholders to take an informed decision on their
election.

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QUESTIONS AND EXERCISES

14.A.1 Questions and Exercises

QUESTIONS

Appendix A to Chapter 14 – The Combined Code (UK) An Example of Auditors’ Review
of Corporate Governance Best Practice
14A.1 Choose one of the key provisions of the Combined Code and discuss what the impact of

that provision on the company should be.

PROBLEMS AND EXERCISES

Appendix A to Chapter 14 – The Combined Code (UK) An Example of Auditors’ Review
of Corporate Governance Best Practice
14A.2 Appendix A lists audit procedures that the auditor must undertake to ensure that the

board has a formal schedule of matters specifically reserved to it. For each audit
procedure:
A. List the source of the evidence;
B. Describe how the evidence will be examined (a) by whom and (b) using what type of

evidence gathering technique (inquiry, inspection, confirmation, etc.);
C. Give an example of the notation in the audit work papers; and
D. Describe the alternative procedures to be undertaken if a problem arises.

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Appendix B to Chapter 14

Governance and Auditing in a Public Interest
Context

■ The Example of Bank Auditing and its Relation to Banking
Supervision

In many commercial cases, the context of auditing is rather straightforward. Shareholders
have appointed a board of directors who govern a company on their behalf. The board
is responsible for arranging appropriate management of the company and faithfully reporting
the results to the shareholders. This model is described as a principal–agent relationship in
Chapter 2 The Audit Market.

Principal–Agent Relationship
Information asymmetry between principals and agents calls for the basic function of the
auditor. Auditors reduce such asymmetry by independently verifying management’s asser-
tions to the board, and the board’s assertions to the shareholders. Auditor independence,
integrity and expertise are essential conditions for the principal’s (shareholder) confidence in
the effectiveness of the audit-function. If this confidence is shocked by an auditor’s breach of
these conditions, the audit function loses its value. Several financial scandals have demon-
strated this, most notably in the complete disappearance of the Big Five firm Arthur Andersen
after the Enron collapse.

However, in a public interest context the principal–agent relationships are more complex.
We will use here the example of banks. Banks are commercial enterprises like many others,
and they have basically a similar governance structure, and shareholders, as well. But there is
another very important group of stakeholders, i.e. the creditors of the bank and more
generally, all those who have an interest in the stability of the financial system as a whole. In
essence, that includes every citizen, in other words, the public as a whole. This is meant by the
expression “public interest.”

Given the importance of the public interest in the better functioning of banks, the
principal–agent model is applicable only in a comprehensive way. If virtually everybody is a
principal to an interrelated complex of agents, it would overstretch the expectation that
auditors could reduce the information asymmetry sufficiently. Moreover, the importance of
stability of the financial system as a whole warrants the attention of public watchdogs on a
more permanent basis.

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APPENDIX B

Banking Supervision

Reducing information asymmetry with respect to financial reporting is not the only thing that
matters to banks’ principals. They need to be assured that they can rely on the financial system
on an ongoing basis. This has called for a more permanent regulatory and supervisory func-
tion, hereafter called banking supervision. (Note that such function exists in more contexts,
for example, insurance and securities supervision, and competition authorities). Banking
supervision, often referred to as prudential supervision, serves the public interest by licensing
banks; imposing on them regulations regarding corporate governance, capital adequacy, risk
management and internal controls, and customer due diligence; and by on- and off-site
supervision of banks’ compliance.

In many of these areas, the work of banking supervisors interferes with that of internal and
external auditors. Therefore, the Basel Committee on Banking Supervision1 (the Basel
Committee) and the International Auditing Practices Committee (IAPC) of the International
Federation of Accountants (IFAC) have issued in 2001 an International Auditing Practice
Statement (IAPS) 1004. (Note that the IAPC has been the predecessor of the International
Auditing and Assurance Standards Board (IAASB).)

International Auditing Practice Statement 1004
IAPS 10042 describes the roles and responsibilities of a bank’s board of directors and
management, the bank’s internal and external auditors, and the banking supervisors. It
intends to provide an understanding of these roles and how they relate to each other. This
should clarify each role, make the model as a whole more effective, and, as a result,
strengthen the contribution of each participant to the public interest in financial stability.

IAPS 1004 is organised as follows. First, it sets out the primary responsibility of the board of
directors and management. Then, it examines the essential features of the role of external
auditors and of the role of banking supervisors. Finally, it reviews the relationship between
the banking supervisor and the bank’s external auditor, and describes additional ways in
which external auditors and the accountancy profession can contribute to the supervisory
process.

■ The Responsibilities of Bank’s Board of Directors and
Management 3

From a corporate governance perspective, it is interesting to see that IAPS 1004 starts with the
responsibility of those who are charged with the governance of the bank, its board of directors
and its management. (This relates to the two decision-making functions within a bank and in
many other institutions. In a number of countries these functions are formally separated in
the previously described two tier-structure: a Supervisory Board and an Executive Board.)
Indeed, it is important to have these key functions right. As financial scandals have demon-
strated, without proper and fit directors to govern the control structures, the work of auditors
and of supervisors becomes less effective.

IAPS 1004 then describes comprehensively what this responsibility includes.4 It should
ensure that:

■ those entrusted with banking tasks have sufficient expertise and integrity and that there are
experienced staff in key positions;

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■ adequate policies, practices and procedures related to the different activities of the bank are
established and complied with, including:
– the promotion of high ethical and professional standards;
– systems that accurately identify and measure all material risks and adequately monitor
and control these risks;
– the evaluation of the quality of assets and their proper recognition and measurement;
– “know your customer” rules that prevent the bank being used, intentionally or
unintentionally, by criminal elements;
– the adoption of a suitable control environment, aimed at meeting the bank’s prescribed
performance, information and compliance objectives;
– the testing of compliance and the evaluation of the effectiveness of internal controls by
the internal audit function;

■ appropriate management information systems are established;
■ the bank has appropriate risk management policies and procedures;
■ statutory and regulatory directives, including directives regarding solvency and liquidity,

are observed;
■ the interests not only of the shareholders but also of the depositors and other creditors are

adequately protected.

If the whole of the long list is addressed appropriately, an important foundation of sound cor-
porate governance is laid down in the controlling structure of this institution. Logically, IAPS
1004 then continues to deal with the role of audit committees and their reinforcement of the
internal control system and the internal audit function. It, among other things, emphasizes
the importance of: “regular meetings of the audit committee with the internal and external
auditors. This should enhance the external auditors’ independence and the credibility of the
internal auditors, and assist the audit committee to perform its key role on strengthening
corporate governance.”

Regarding the establishment and effectiveness of the internal audit function, several best
practice statements are made. These deal with the independence and competence of internal
auditors, and the comprehensiveness of their function. Although this was written in a banking
context, well before Enron, etc., this best practice is relevant for many non-financial
institutions as well.

■ Role of the Bank’s External Auditor and of the Banking Supervisor

Then the role of the bank’s external auditor is described. So, in a nutshell, the full audit process
is exemplarily pictured. This follows closely what this book is all about. The objective of an
audit is to express an opinion on the financial statements. Consequently, it is important to
take into account the country-specific financial reporting framework. To arrive at this
opinion, the auditor designs audit procedures, assesses inherent and control risk and
considers fraud risk factors. Several relevant ISAs are quoted.

Characteristics That Distinguish Banks

Next is an interesting section: a description of 14 characteristics of banks that distinguish them
from most other commercial enterprises.5 This analysis is again a best practice example of the
need for auditors to carefully analyze and understand the audit object and its business
environment. Without that, a professionally appropriate audit is hard to achieve. This has

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APPENDIX B

always been true, but in today’s global and dynamic commercial context, it is imperative for
each audit. Therefore, both audit committees and audit firms should warrant that this is
adequately fulfilled.

The Statement continues with addressing issues such as testing of internal controls and
substantive procedures, using the work of the internal auditor, the importance of judgment
and materiality considerations, and communications with management.

Role of the Banking Supervisor

IAPS 1004 then deals with the role of the banking supervisor. It starts by explaining that
the “key objective or prudential supervision is to maintain stability and confidence in the
financial system, thereby reducing the risk of loss to depositors and other creditors.” It then
describes a key feature of banks, namely that “banking supervision is based on a system of
licensing, which allows supervisors to identify the population to be supervised and to control
entry into the banking system. In order to qualify for and retain a banking license, entities
must observe certain prudential requirements.”

Banking License

The following basic requirements for a banking license are ordinarily found in most systems
of supervision:

■ The bank must have suitable shareholders and members of the board (this notion includes
integrity and standing in the business community as well as the financial strength of all
major shareholders).

■ The bank’s management must be honest and trustworthy and must possess appropriate
skills and experience to operate the bank in a sound and prudent manner.

■ The bank’s organization and internal control must be consistent with its business plans and
strategies.

■ The bank should have a legal structure in line with its operational structure.
■ The bank must have adequate capital to withstand the risks inherent in the nature and size

of its business.
■ The bank must have sufficient liquidity to meet outflows of funds.

This licensing is a distinct feature of many financial institutions compared to commercial
enterprises, which has all to do with the great public interest of a financially stable system.
Therefore, although “ongoing banking supervision ordinarily is conducted on the basis of
recommendations and guidance, banking supervisors have at their disposal recourse to legal
powers to bring about timely corrective action when a bank fails to meet prudential require-
ments, when there are violations of laws or regulations, or when depositors are faced with a
substantial risk of loss. In extreme circumstances, the supervisor may have the authority to
revoke the bank’s license.”

Capital Base Accord

A key element for the solidity of banks is the requirement to maintain an adequate capital
base. The Basel Committee of Banking Supervisors has agreed in 1988 the “Basel Accord”
which defines the capital requirements for banks. A new and completely revised Accord is
expected to become applicable from 2007. This “New Accord” will not only have modernized
quantitative capital requirements (“Pillar I”), but will also explicitly state that supervisors have
to assess this for each bank and eventually should intervene with the above-mentioned

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minimum capital requirements (“Pillar II”). Finally, the “Pillar III” requires a number of
qualitative and quantitative disclosures in order to enhance market discipline.

Bank Risks

The Statement goes on to elaborate on a range of risks with which banks are faced, such as
credit risk, market risk, liquidity risk, operational risk, legal risk, and reputational risk. Banks
have to protect themselves against these risks by a sound risk management system and
comprehensive internal controls. A well-known example is the credit risk, i.e. the risk that
debtors do not repay their loans, resulting in loan losses.

There is an important lesson here for commercial enterprises as well. The above indicated
risk analysis should take place in every company, supervised or not, adapted of course to the
particular circumstances. Only on that basis can the directors and management establish solid
controls and have those appropriately audited.

Supervisors’ Efforts

Finally, this section of the Statement describes how supervisors make efforts to ensure
the quality of management; collect, analyze and validate information through on-site
inspections and the use of external auditors; and meet periodically with the audit committee
or directors to enhance their understanding of a bank’s corporate governance and system of
operation. As the work of the external auditors is highly relevant to the supervisors, they pay
full attention to the independence, competence, objectivity and quality assurance programs of
the auditors. Supervisors seldom have the power to get the auditor removed from a bank’s
statutory audit if he is not performing the audit function efficiently.

Lesson for the Business Environment

Also, here a lesson which can be drawn from this banking example to the business environment
at large. That is, business can learn how controls, audits and supervisory inspections come
together to enhance the bank’s corporate governance. Directors and management of non-
supervised entities, as well as their auditors, may consider to what extent they should
compensate for this non-supervision in order to achieve a high-level corporate governance
system. Although the public interest in financial institutions may be somewhat larger than for
commercial enterprises, the latter as well represents important investments from a rich variety
of stakeholders, including employees, municipalities and creditors.

■ Relationship Between Banking Supervisor and External Auditor

It is obvious from our discussion that a good relationship between the banking supervisor and
the external auditor effectively contributes to the corporate governance of a bank and to the
efficiency of supervisory and auditing processes. This subject is dealt with in the last part of
IAPS 1004. It states:6

In many respects the banking supervisor and the external auditor have complementary concerns
regarding the same matters though the focus of their concerns is different.

■ The banking supervisor is primarily concerned with maintaining the stability of the banking
system and fostering the safety and soundness of individual banks in order to protect the
interests of the depositors. Therefore, the supervisor monitors the present and future viability
of banks and uses their financial statements in assessing their condition and performance.

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APPENDIX B

The external auditor, on the other hand, is primarily concerned with reporting on the bank’s
financial statements ordinarily either to the bank’s shareholders or board of directors. In
doing so, the auditor considers the appropriateness of management’s use of the going
concern assumption. (...)
■ The banking supervisor is concerned with the maintenance of a sound system of internal
control as a basis for safe and prudent management of the bank’s business. The external
auditor, in most situations, is concerned with the assessment of internal control to determine
the degree of reliance to be placed on the system in planning and performing the audit.
■ The banking supervisor must be satisfied that each bank maintains adequate records
prepared in accordance with consistent accounting policies and practices that enable the
supervisor to appraise the financial conditions of the bank and the profitability of its business,
and that the bank publishes or makes available on a regular basis financial statements that
fairly reflect its condition. The external auditor is concerned with whether adequate and
sufficiently reliable accounting records are maintained in order to enable the entity to prepare
financial statements that do not contain material misstatements and thus enable the external
auditor to express an opinion on those statements.

The Statement then poses some caveats, as objectives and scope of the work of the auditors
and the supervisors, respectively, are not fully congruent or complementary to each other.
Nevertheless, “there are many areas where the work of the banking supervisor and of the
external auditor can be useful to each other. Communications from auditors to management
and other reports submitted by auditors can provide supervisors with valuable insight into
various aspects of the bank’s operations. It is the practice in many countries for such reports
to be made available to the supervisors.

Communications

“Similarly, external auditors may obtain helpful insights from information originating from the
banking supervisor. When a supervisory inspection or a management interview takes place, the
conclusions drawn from the inspection or interview are customarily communicated to the bank.
These communications can be useful to auditors inasmuch as they provide an independent
assessment in important areas such as the adequacy of the allowance for loan losses and focus
attention on specific areas of supervisory concern.”

But due care is important here; on one hand, to preserve the required professional confi-
dentiality on both sides, on the other, to warrant that information that is known by one party
and is vital to the other one, is communicated appropriately between them.

Governance Communications

This matter has been extensively discussed between IFAC and the Basel Committee. The
consensus achieved appears from paragraph 52 of IAPS 1004: ISA 260, “Communications of
Audit Matters With Those Charged With Governance,” identifies matters of governance
interest and requires auditors to communicate those matters on a timely basis to those
charged with governance. Audit matters of governance interest include only those matters that
have come to the attention of the auditor as a result of the performance of the audit. The
auditor is not required, in an audit in accordance with ISAs, to design procedures for the
specific purpose of identifying matters of governance interest.

Certain audit matters of governance interest are likely to be of interest to banking supervisors,
particularly where those matters may require urgent action by the supervisor. When required by
the supervisory, legal, or regulatory framework, or by a formal agreement or protocol, the

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auditor communicates such matters to the banking supervisor on a timely basis. In situations
where there are no such requirements, agreements or protocols, the auditor encourages the
bank’s management or those charged with governance to communicate on a timely basis
matters that, in the auditor’s judgment, may be of urgent interest to the banking supervisor.
Furthermore, even if there is no requirement to do so, the auditor considers communicating
such matters to the banking supervisor when management or those charged with governance do
not do so. In such circumstances, the auditor considers whether the law protects the auditor
when such communications are made.

So the Statement summarizes7 that “banking supervisors and internal and external auditors
co-operate with each other to make their contributions to the supervisory process more
efficient and effective. The co-operation optimizes supervision while allowing each party to
concentrate on its own responsibilities.”

Finally, IAPS 1004 deals with the possibility of additional requests for the external auditor
to contribute to the supervisory process. Criteria are suggested to avoid, among otherthing,
conflicts of interest and confusion about responsibilities and competence.

■ Summary

In this appendix the role of auditors has been discussed in the context of banks and in their
relationship to banking supervisors. It appears that corporate governance is enhanced by the
combined work of supervisors and auditors. The board of directors and management are the
central parties in an appropriate corporate governance model. The quality of this governance
should benefit from the professional contributions made by the internal and external auditors
and by the supervisors. IAPS 1004 describes how to make best use of each role. A lesson for
non-supervised entities may be that they should analyze what they miss as they are not
supervised, and how to compensate for that in order to achieve a high quality of corporate
governance. This is the more relevant as non-financial institutions are also seen as important
from a public interest perspective.

B.1 Notes

1 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that
was established by the central bank governors of the Group of Ten countries in 1975. It consists of
senior representatives of banking supervisory authorities and central banks from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK
and the USA. It usually meets at the Bank for International Settlements in Basel, where its permanent
Secretariat is located.

2 IFAC, 2004, Handbook of International Auditing, Assurance, and Ethics Pronouncements,
International Auditing Practice Statement 1004 (IAPS 1004), “The Relationship Between Banking
Supervisors and Banks’ External Auditors,” International Federation of Accountants, New York.

3 Ibid.
4 Ibid. Para. 8.
5 Ibid. Para. 18.
6 Ibid. Para. 46.
7 Ibid. Para. 55.

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QUESTIONS AND EXERCISES

B.2 Questions and Exercises

QUESTIONS

Appendix B to Chapter 14 – Governance and Auditing in a Public Interest Context
14B.1 Explain how information asymmetry between principals and agents calls for the basic

function of the auditor.
14B.2 What is the responsibility of a bank’s board of directors and management?

PROBLEMS AND EXERCISES

Appendix B to Chapter 14 – Governance and Auditing in a Public Interest Context
14B.3 Read the following cases and describe how IAPS 1004 would apply to each:

1 Lincoln Savings and Loan (Chapter 3, Concept and Company 3.2).
2 Resona Bank (Chapter 5, Concept and Company 5.1).
3 Penn Square Bank (Chapter 5, Concept and Company 5.2).
4 CitiBank (Chapter 7, Concept and Company 7.3).

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Glossary

Remember: If you see a term in this glossary, then that term and its related process are
discussed in the book. If you cannot find a term here, let the authors know at rhayes@
calstatela.edu.

Access controls – Procedures designed to restrict access to on-line terminal devices, programs
and data. Access controls consist of “user authentication” and “user authorization.” “User
authentication” typically attempts to identify a user through unique logon identifications,
passwords, access cards or biometric data. “User authorization” consists of access rules to
determine the computer resources each user may access. Specifically, such procedures are
designed to prevent or detect:
■ unauthorized access to on-line terminal devices, programs and data;
■ entry of unauthorized transactions;
■ unauthorized changes to data files;
■ the use of computer programs by unauthorized personnel; and
■ the use of computer programs that have not been authorized.

Account analysis schedule – Normally used for fixed assets, liabilities and equity accounts,
shows the activity in a general ledger account during the entire period under audit, tying
together the beginning and ending balances.

Accounting estimate – An approximation of the amount of an item in the absence of a precise
means of measurement.

Accounting system – The series of tasks and records of an entity by which transactions are
processed as a means of maintaining financial records. Such systems identify, assemble,
analyze, calculate, classify, record, summarize, and report transactions and other events.

Accounts receivable turnover – The ratio of operating revenues to accounts receivable; it
measures a company’s ability to convert revenues into cash.

Accuracy assertion – The assertion that amounts and other data relating to recorded trans-
actions and events have been recorded accurately.

Adjusting journal entry – The correcting entry required at the end of the reporting period due
to a mistake made in the accounting records; also called “correcting entry.”

Adverse opinion – see Modified auditor’s report and Opinion.

Advertising – The communication to the public of information as to the services or skills pro-
vided by professional accountants in public practice with a view to procuring professional
business.

Advocacy threat – Occurs when a member of the assurance team promotes, or seems to
promote, an assurance client’s position or opinion.

GLOSSARY

Affiliate – A party that, directly or indirectly, controls, is controlled by, or is under common
control with an enterprise.

Agency theory – A company is viewed as the result of more or less formal contracts, in which
several groups make some kind of contribution to the company, given a certain price.
A reputable auditor is appointed not only in the interest of third parties, but also in the
interest of management. (See Watts, R.L., Zimmerman J.L., 1978, “Towards a positive
theory of the determination of counting standards,” The Accounting Review, (January):
112–134; and Watts, R.L., Zimmerman J.L., 1979, “The demand for and supply of
accounting theories: The market for excuses,” The Accounting Review, (April): 273–305.)

Agree – An audit procedure whereby the auditor takes one document or set of documents and
compares it to another document or set which should contain the same information to
determine if the two match (agree with each other).

Agreed-upon procedures – see Agreed-upon procedures engagement.

Agreed-upon procedures engagement – In an engagement to perform agreed-upon pro-
cedures, an auditor is engaged to carry out those procedures of an audit nature to which the
auditor and the entity and any appropriate third parties have agreed and to report on
factual findings. The recipients of the report must form their own conclusions from the
report by the auditor. The report is restricted to those parties that have agreed to the
procedures being performed since others, unaware of the reasons for the procedures, may
misinterpret the results.

Analytical procedures – The analysis of significant ratios and trends including the resulting
investigation of fluctuations and relationships that are inconsistent with other relevant
information or deviate from predictable amounts.

Analytical review – The process of planning, executing, and drawing conclusions from analytical
procedures.

Annual report – An entity ordinarily issues on an annual basis a document which includes its
financial statements together with the audit report thereon. This document is frequently
referred to as the “annual report.”

Anomalous error – see Audit sampling.

Application controls in computer information systems – The specific controls over the relevant
accounting applications maintained by the computer. The purpose of application controls
is to establish specific control procedures over the accounting applications in order to
provide reasonable assurance that all transactions are authorized and recorded, and are
processed completely, accurately and on a timely basis.

Appropriateness – Appropriateness is the measure of the quality of audit evidence and its
relevance to a particular assertion and its reliability.

ASCII (American Standard Code for Information Interchange) – A standard translation scheme
used to translate computer bytes into readable characters; commonly used in micro-
computers, minicomputers, and non-IBM mainframes.

Asserted claims – Existing law suits.

645

GLOSSARY Assertions – Assertions are representations by management, explicit or otherwise, that are
embodied in the financial statements. Sometimes called “financial statements assertions,”
646 they can be categorized as follows: existence, rights and obligations, occurrence, completeness,
valuation, accuracy cutoff, classification, understandability, measurement, and presentation
and disclosure.

Asset Liability Management – A planning and control process, the key concept of which is
matching the mix and maturities of assets and liabilities.

Assistants – Assistants are personnel involved in an individual audit other than the audit
supervisor or manager.

Assurance – see Reasonable assurance.

Assurance client – An entity in respect of which a firm conducts an assurance engagement.

Assurance engagement – Means an engagement in which a practitioner expresses a con-
clusion that is designed to enhance the degree of confidence intended users can have about
the evaluation or measurement of a subject matter, that is the responsibility of a party other
than the intended users or the practitioner, against criteria.

Assurance team – (1) All professionals participating in the assurance engagement; (2) All
others within a firm who can directly influence the outcome of the assurance engagement,
including: (a) Those who recommend the compensation of, or who provide direct super-
visory, management or other oversight of the assurance engagement partner in connection
with the performance of the assurance engagement. (b) Those who provide consultation
regarding technical or industry specific issues, transactions or events for the assurance
engagement; and (c) Those who provide quality control for the assurance engagement; and
(3) For the purposes of an audit client, all those within a network firm who can directly
influence the outcome of the audit engagement.

Attendance – Attendance consists of being present during all or part of a process being
performed by others; for example, attending physical inventory taking will enable the
auditor to inspect inventory, to observe compliance of management’s procedures to count
quantities and record such counts and to test-count quantities.

Attestation – A professional opinion in report form on compliance of the responsible party
with some specific criteria.

Audit – The objective of an audit of financial statements is to enable the auditor to express an
opinion whether the financial statements are prepared, in all material respects, in accord-
ance with an identified financial reporting framework. The phrases used to express the
auditor’s opinion are “give a true and fair view” or “present fairly, in all material respects,”
which are equivalent terms. A similar objective applies to the audit of financial or other
information prepared in accordance with appropriate criteria.

Audit assurance – The expression of a conclusion by an auditor that is designed to enhance the
degree of confidence intended users can have about the evaluation or measurement of
historical financial statements that is the responsibility of the auditee against the criteria of
International Financial Reporting Standards or other national accounting standards.

Audit client – An entity in respect of which a firm conducts an audit engagement. When the
audit client is a listed entity, it will always include its related entities.

Audit committee – Selected members of a company’s outside directors, who take an active role
in overseeing the company’s accounting and financial reporting policies and practices.

GLOSSARY

Audit documentation – The principal record of the basis for the auditor’s conclusions and
provides the principal support for the representations in the auditor’s report.

Audit engagement – An assurance engagement to provide a high level of assurance that finan-
cial 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.

Audit evidence – The information obtained by the auditor in arriving at the conclusions on
which the audit opinion is based. Audit evidence will comprise source documents and
accounting records underlying the financial statements and corroborating information
from other sources.

Audit expectation gap – A gap that results from the fact that users of audit services have expect-
ations regarding the duties of auditors that exceed the current practice in the profession.

Audit firm – Audit firm is either a firm or entity providing audit services, including where
appropriate its partners, or a sole practitioner.

Audit matters of governance interest – Matters that arise from the audit of financial state-
ments and, in the opinion of the auditor, are both important and relevant to those charged
with governance in overseeing the financial reporting and disclosure process. Audit matters
of governance interest include only those matters that have come to the attention of the
auditor as a result of the performance of the audit.

Audit objective – The specific expression of a financial statement assertion or assertions for
which evidence needs to be obtained. For example, the objective “Investments exist and are
owned by the entity.”

Audit of financial statements – see Financial statement audit.

Audit opinion – see Opinion.

Audit plan – A work plan that reflects the design and performance of all audit procedures,
consisting of a detailed approach for the nature, timing and extent of audit procedures to
be performed (including the performance of risk assessment procedures) and the rationale
for their selection. The audit plan begins by planning risk assessment procedures and once
these procedures have been performed it is updated and changed to reflect the further audit
procedures needed to respond to the results of the risk assessments. Also called audit
program.

Audit planning memorandum – A document prepared by the auditor which gives an overview
of the client company, the industry environment, significant audit concerns, and areas of
interest to the audit team. Furthermore, it details the planned audit approach and budget.

Audit program – An audit program sets out the nature, timing, and extent of planned audit
procedures required to implement the overall audit plan. The audit program serves as a set
of instructions to assistants involved in the audit and as a means to control the proper
execution of the work. Also called audit plan.

Audit report – An Audit report in usually synonymous with an Audit opinion, but it may be a
more comprehensive report. The comprehensive audit report contains all important
administrative data related to the audit, including comments, results, and the corrective
preventive actions that have been determined. The Audit report is an official document
that is signed by the lead auditor and the head of the audited area.

647

GLOSSARY Audit risk – Audit risk is the risk that the auditor gives an inappropriate audit opinion when
the financial statements are materially misstated. Audit risk has three components:
648 inherent risk, control risk and detection risk.

■ Control risk – The risk that a misstatement that could occur in an account balance or
class of transactions and that could be material, individually or when aggregated with
misstatements in other balances or classes, will not be prevented or detected and
corrected on a timely basis by the accounting and internal control systems.

■ Detection risk – The risk that an auditor’s substantive procedures will not detect a
misstatement that exists in an account balance or class of transactions that could be
material, individually or when aggregated with misstatements in other balances or
classes.

■ Inherent risk – A component of audit risk. It is the susceptibility of an account balance
or class of transactions to misstatement that could be material, individually or when
aggregated with misstatements in other balances of classes, assuming that there were no
related internal controls.

Audit sampling – Audit sampling (sampling) involves the application of audit procedures to
less than 100 percent of items within an account balance or class of transactions such that
all sampling units have a chance of selection. This will enable the auditor to obtain and
evaluate audit evidence about some characteristic of the items selected in order to form or
assist in forming a conclusion concerning the population from which the sample is drawn.
Audit sampling can use either a statistical or a non-statistical approach.

■ Anomalous error – Anomalous error means an error that arises from an isolated event
that has not recurred other than on specifically identifiable occasions and is therefore
not representative of errors in the population.

■ Confidence level – As used in sampling, the probability of being correct in assessing the
level of control risk. The term is used interchangeably with reliability.

■ Error – Either control deviations, when performing tests of control, or misstatements,
when performing substantive procedures. Total error is either the rate of deviation or
total misstatement.

■ Expected error – The error that the auditor expects to be present in the population.
■ Homogeneity – All items in the population have similar characteristics.
■ Monetary unit sampling – A statistical sampling method that provides upper and lower

misstatment bounds expressed in monetary amounts; also referred to as dollar unit
sampling, cumulative monetary amount sampling, and sampling with probability
proportional to size.
■ Non-sampling risk – Non-sampling risk arises from factors that cause the auditor to
reach an erroneous conclusion for any reason not related to the size of the sample. For
example, most audit evidence is persuasive rather than conclusive, the auditor might
use inappropriate procedures, or the auditor might misinterpret evidence and fail to
recognize an error.
■ Population – Population means the entire set of data from which a sample is selected and
about which the auditor wishes to draw conclusions. A population may be divided into
strata, or sub-populations, with each stratum being examined separately. The term
population is used to include the term stratum.
■ Power of the test – It is a measure of how effective the test employed is in discriminating
between populations that contain material errors and populations that contain non-
material errors.

GLOSSARY

■ Representativeness – A sample having-essentially the same characteristis as the popu-
lation. Haphazard selection or a random-based selection method can be expected to
produce a sample that is representative of the population.

■ Sampling risk – Sampling risk arises from the possibility that the auditor’s conclusion,
based on a sample, may be different from the conclusion reached if the entire population
were subjected to the same audit procedure.

■ Sampling unit – Sampling unit means the individual items constituting a population, for
example, checks listed on deposit slips, credit entries on bank statements, sales invoices
or debtors’ balances, or a monetary unit.

■ Statistical sampling – Statistical sampling means any approach to sampling that has the
following characteristics:
(a) random selection of a sample;
(b) use of probability theory to evaluate sample results, including measurement of
sampling risk.
A sampling approach that does not have characteristics (a) and (b) is considered non-
statistical sampling.

■ Stratification – Stratification is the process of dividing a population into subpopulations,
each of which is a group of sampling units which have similar characteristics (often
monetary value).

■ Tolerable error – Tolerable error means the maximum error in a population that the
auditor is willing to accept.

■ Type I error – The auditor concludes, in the case of a test of control, that control risk is
lower than it actually is, or in the case of a substantive test, that a material error does not
exist when in fact it does. This type of risk affects audit effectiveness and is more likely to
lead to an inappropriate audit opinion.

■ Type II error – The auditor concludes, in the case of a test of control, that control risk is
higher than it actually is, or in the case of a substantive test, that a material error exists
when in fact it does not. This type of risk affects audit efficiency as it would usually lead
to additional work to establish that initial conclusions were incorrect.

Audit team – People who make up the group of auditors responsible for planning and
executing an audit.

Audit trail – The information that is used to trace the status and contents of an individual
transaction record backward or forward between output, processing, and source
document.

Auditee – The entity which is audited.

Auditor – The person with final responsibility for the audit. This term is also used to refer to an
audit firm. (For ease of reference, the term “auditor” is used throughout the ISAs when
describing both auditing and related services which may be performed. Such reference is
not intended to imply that a person performing related services need necessarily be the
auditor of the entity’s financial statements.)

■ Continuing auditor – The auditor who audited and reported on the prior period’s
financial statements and continues as the auditor for the current period.

■ External auditor – Where appropriate, the terms “external auditor” and “external audit”
are used to distinguish the external auditor from an internal auditor and to distinguish
the external audit from the activities of internal auditing.

649

GLOSSARY

■ Existing auditor – The auditor who is currently holding an audit or assurance services
appointment with the prospective client.

■ Incoming auditor – The incoming auditor is a current period’s auditor who did not audit
the prior period’s financial statements.

■ Other auditor – An independent auditor other than the group auditor or a related
auditor.

■ Personnel – Personnel includes all partners and professional staff engaged in the audit
practice of the firm.

■ Predecessor auditor – The auditor who was previously the auditor of an entity and who
has been replaced by an incoming auditor.

■ Proposed professional accountant – A professional accountant in public practice who
will act as the current financial statement period’s auditor who did not audit the prior
period’s financial statements.

■ Principal auditor – The principal auditor is the auditor with responsibility for reporting
on the financial statements of an entity when those financial statements include
financial information of one or more components audited by another auditor.

■ Related auditor – An independent auditor from the group auditor’s office, other office
of the group auditor’s firm, a network firm or another firm operating under common
quality control policies and procedures as described in International Standard on
Quality Control (ISQC) 1, “Quality Control for Audit, Assurance and Related Services
Practices.”

Auditor’s association – An auditor is associated with financial information when the auditor
attaches a report to that information or consents to the use of the auditor’s name in a
professional connection.

Authorization – The delegation of initiation of transactions and obligations on the company’s
behalf.

Bank reconciliation – A test of the agreement between a balance on the bank statement and the
same balance on the company’s books.

Basel Committee on Banking Supervision – A committee of banking supervisory authorities
that was established by the central bank Governors of the Group of Ten countries in 1975.
It consists of senior representatives of banking supervisory authorities and central banks
from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, the UK and the USA. It usually meets at the Bank for
International Settlements in Basel, where its permanent Secretariat is located.

Basis – The difference between the price of the hedged item and the price of the related
hedging instrument.

Basis Risk – The risk that the basis will change while the hedging contract is open and, thus,
the price correlation between the hedged item and hedging instrument will not be perfect.

Bearer securities – A document of title to stocks, bonds, shares, debentures, etc. transferable
by hand, being made out to bearer (any person who has it in hand) and not a named
person.

Benchmarking – The comparison of actual performance to a standard of typical competence
developed by testing or a published standard.

650

GLOSSARY

Benford’s Law – Provides the expected frequencies of the digits and digit combinations in
tabulated data.

Board of Directors – Individuals responsible for overseeing the affairs of an entity, including
the election of its officers. The board of a corporation that issues stock is elected by
stockholders.

Bookkeeping services – Services including payroll services and the preparation of financial
statements or financial information which forms the basis of the financial statements on
which the audit report is provided for audit clients that are listed entities.

Boundary testing – Audit testing of documentation at the lowest level of the information
stream; for example, testing the first document (i.e. purchase order) that initiates an
exchange.

Breach of contract – A failure of one or both parties in a contract to fulfill the requirements of
the contract.

Business operations – The ongoing activities of the business.

Business risks – Risks that result from significant conditions, events, circumstances, or
actions that could adversely affect the entity’s ability to achieve its objectives and execute its
strategies.

Bylaws – Includes rules and procedures of the corporation including fiscal year, frequency of
stockholder meetings, method of voting for board of directors, and the duties and powers
of the corporate officer.

Cap – A series of call options based on a notional amount. The strike price of these options
defines an upper limit to interest rates.

Capital structure – The proportions of capital of an entity that are derived from each source of
financing, i.e. the proportion of debt versus equity.

Checklists – A list of considerations or procedures which are followed by the auditor.

Circumstantial evidence – Evidence based on facts and circumstances from which a court may
infer that a factual matter has been proved.

Classes of transactions – Groups of accounting entries in an accounting cycle of transactions
such as the revenue cycle, expenditure cycle, production cycle, or personnel cycle, or any
sub-categories of those cycles.

Classification – The process of finding models, also known as classifiers, or functions that map
records into one of several discrete prescribed classes.

Clear and convincing evidence – A proof that is stronger than a mere preponderance of
evidence, but not convincing beyond a reasonable doubt.

Client account – Any bank account, which is used solely for the banking of clients’ monies.

Clients’ monies – Any monies, including documents of title to money (e.g. bills of exchange,
promissory notes and documents of title) which can be converted into money (e.g. bearer
bonds received by a professional accountant in public practice to be held or paid out on the
instruction of the person from whom or on whose behalf they are received).

Close family – A parent, non-dependent child or sibling.

651

GLOSSARY

Close out – The consummation or settlement of a financial transaction.

Cluster Analysis – A technique that aggregates data based on certain specified common
characteristics.

Collateral – Assets pledged by a borrower to secure a loan or other credit; these are subject to
seizure in the event of default.

Collusion – The act of two or more employees to steal assets or misstate records.

Combined Code (of the Committee on Corporate Governance) – Represents the Code of Best
Practice of the London Stock Exchange. (See the Committee on Corporate Governance.
1998, The Combined Code, London Stock Exchange, London, January; or KPMG Review,
1999, The Combined Code: A Practical Guide, KPMG, United Kingdom, January.)

Commitments – Agreements that the entity will hold to a fixed set of conditions, such as the
purchase or sale of merchandise at a stated price, at a future date, regardless of what
happens to profits or to the economy as a whole.

Commodity – A physical substance, such as food, grains, and metals that is interchangeable
with other product of the same type.

Company bylaws – The rules and procedures adopted by a company’s stockholders, including
the company’s fiscal year as well as duties and powers of the officers.

Comparatives – Comparatives in financial statements, may present amounts (such as financial
position, results of operations, cash flows) and appropriate disclosures of an entity for
more that one period, depending on the framework. The frameworks and methods of
presentation are as follows:

■ Corresponding figures where amounts and other disclosures for the preceding period
are included as part of the current period financial statements, and are intended to be
read in relation to the amounts and other disclosures relating to the current period
(referred to as “current period figures”). These corresponding figures are not presented
as complete financial statements capable of standing alone, but are an integral part of the
current period financial statements intended to be read only in relationship to the
current period figures.

■ Comparative financial statements where amounts and other disclosures for the pre-
ceding period are included for comparison with the financial statements of the current
period, but do not form part of the current period financial statements.

Competence – The knowledge and skills necessary to accomplish tasks that define the
individual’s job.

Compilation – see Compilation engagement.

Compilation engagement – In a compilation engagement, the accountant is engaged to use
accounting expertise as opposed to auditing expertise to collect, classify and summarize
financial information.

Completeness assertion – see Financial statement assertions.

Completion memorandum – A report on auditing findings at the completion of the audit that
ordinarily describes critical and significant audit areas, accounting issues, and any matters
that need to be highlighted.

652

GLOSSARY

Compliance auditing – Is a review of an organization’s procedures to determine whether the
organization is following a specific set of criteria (e.g. government regulation, commercial
contract, lease).

Component – Component is a division, branch, subsidiary, joint venture, associated company,
or other entity whose financial information is included in financial statements audited by
the principal auditor.

Components of audit risk – There are three components of audit risk: inherent risk, control
risk, and detection risk.

Components of financial statements – The auditor may be requested to express an opinion on
one or more components of a financial statement, for example, accounts receivable, inven-
tory, an employee’s bonus calculation, or a provision for income taxes. This is described in
ISA 800.

Components of internal control – There are five components of internal control: control
environment, risk assessment, control procedures (activities), information and communi-
cation system, and monitoring.

Component management – Management responsible for the preparation and presentation of
a component’s financial information.

Comprehensive basis of accounting – A comprehensive basis of accounting comprises a set of
criteria used in preparing financial statements which applies to all material items and which
has substantial support.

Computation – Computation consists of checking the arithmetical accuracy of source
documents and accounting records or of performing independent calculations.

Computer assisted audit techniques – Applications of auditing procedures using the
computer as an audit tool are known as Computer Assisted Audit Techniques (CAATs).

Computer information systems – A computer information systems (CIS) environment exists
when a computer of any type or size is involved in the processing by the entity of financial
information of significance to the audit, whether that computer is operated by the entity or
by a third party.

Confidence level – see Audit sampling.

Confirmation – Consists of the response to an inquiry of a third party to corroborate infor-
mation contained in the accounting records – see External confirmation.

Confirmation letter – A letter sent to a third party to request information about, confirm, or
corroborate a particular item affecting assertions made by management in the financial
statements.

Consignment – A specialized way of marketing certain types of goods. The consignor delivers
goods to the consignee who acts as the consignor’s agent in selling the merchandise to a
third party. The consignee accepts the goods without any liability except to reasonably
protect them from damage. The consignee receives a commission when the merchandise is
sold. Goods on consignment are included in the consignor’s inventory and excluded from
the consignee’s inventory since the consignor has legal title.

Consulting services – Services that are designed to improve the effectiveness and efficiency of
clients’ operations, broadly defined as any services other than attestation and related
services. Examples are executive search, legal services, financial services, strategic planning,
and development of management information systems.

653

GLOSSARY Contingency fee – An arrangement whereby no fee will be charged unless a specified finding
or result is obtained or when the fee is otherwise contingent on the findings or results of
654 these services.

Contingent fees – Fees calculated on a predetermined basis relating to the outcome or result
of a transaction or the result of the work performed.

Contingent liability – A potential future obligation to an outside part for an unknown amount
resulting from the outcome of a past event.

Continuing auditor – see Auditor.

Continuous reporting – The real-time disclosure of transaction data.

Contracts – Include long-term notes and payables, stock options, pension plans, contracts
with vendors, government contracts, royalty agreements, union contracts, and leases.

Control environment – Comprises the overall attitude, awareness and actions of directors and
management regarding the internal control system and its importance in the entity.

Control procedures – Those policies and procedures in addition to the control environment
which management has established to achieve the entity’s specific objectives.

Control risk – see Audit risk.

Controls – All the organizational activities aimed at having organizational members co-
operate to reach the organizational goals.

Corporate bylaws – The rules and procedures adopted by a company’s stockholders, including
the company’s fiscal year, as well as duties and powers of the officers.

Corporate charter – A legal document granted by the country, state or province in which a
company is incorporated and recognizes a company as a separate legal entity. Included in
the charter is the name of the company, date of incorporation, capital stock authorized, and
the types of business activities the company may undertake.

Corporate finance and similar activities – Promoting, dealing in, or underwriting a client’s
share; committing the client to the terms of the transaction; and consummating a trans-
action on behalf of the client.

Corporate governance – see Governance.

Corporate minutes – Official record of the meetings of the board of directors and stock-
holders. Include authorization of compensation of officers, new contracts, acquisition of
fixed assets, loans, and dividends payments.

Correcting entry – see Adjusting journal entry.

Correlation – The degree to which contract prices of hedging instruments reflect price
movements in the cash-market position. The correlation factor represents the potential
effectiveness of hedging a cash-market instrument with a contract where the deliverable
financial instrument differs from the cash-market instrument. Generally, the correlation
factor is determined by regression analysis or some other method of technical analysis of
market behavior.

Corroborate – To attest the truth or accuracy of an inquiry.

Counterparty – The other party to a derivative transaction.

GLOSSARY

Credit risk – The risk that a customer or counterparty will not settle an obligation for full
value, either when due or at any time thereafter.

Currency risk – The risk of loss arising from future movements in the exchange rates applicable
to foreign currency assets, liabilities, rights, and obligations.

Custody – Physical control over assets or records.

Customer relationship management (CRM) – A software package that helps organize detailed
data about customers so that the data can be used to facilitate better customer service.

Cutoff – Transactions and events have been recorded in the correct accounting period.

Cutoff procedures – Refers to recognizing assets and liabilities as of a proper date and
accounting for revenue, expense and other transactions in the proper period.

Data description – A technique that provides an overall description of data, either in itself or
in each class or concept, typically in summarized, concise, and precise form. It summarizes
general characteristics of data and compares characteristics of data between contrasting
groups or classes.

Data mining – A set of computer-assisted techniques that use sophisticated statistical analysis,
including artificial intelligence techniques, to examine large volumes of data with the
objective of indicating hidden or unexpected information or patterns.

Database – A collection of data that is shared and used by a number of different users for
different purposes.

Dealer (for the purposes of IAPS 1012) – The person who commits the entity to a derivative
transaction.

Defalcation – Theft of an entity’s assets, also referred to as misappropriation of assets.

Dependency analysis – A technique that searches data for the most significant relationship
across large number of variables or attributes. One use is to describe data items or events
that frequently occur together or in sequence.

Derivative – A generic term used to categorize a wide variety of financial instruments whose
value “depends on” or is “derived from” an underlying rate or price, such as interest rates,
exchange rates, equity prices, or commodity prices. Many national financial reporting
frameworks and the International Accounting Standards contain definitions of derivatives.
For example, International Accounting Standard (IAS) 39, “Financial Instruments:
Recognition and Measurement,” defines a derivative as a financial instrument:
■ whose value changes in response to the change in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit
index, or similar variable (sometimes called the “underlying”);
■ that requires no initial net investment or little initial net investment relative to other
types of contracts that have a similar response to changes in market conditions; and
■ that is settled at a future date.

Detection risk – see Audit risk.

Direct evidence – Comes from personal knowledge of the witnesses under oath as to specific
facts.

655

GLOSSARY Direct financial interest – A financial interest: (1) Owned directly by and under the control of
an individual or entity (including those managed on a discretionary basis by others); or (2)
656 Beneficially owned through a collective investment vehicle, estate, trust or other inter-
mediary over which the individual or entity has control.

Directors and officers – Those charged with the governance of an entity, regardless of their
title, which may vary from country to country.

Disclaimer of opinion – see Modified auditor’s report and Opinion.

Disclosure – Typically required when accounts of interest (revenue, joint venture accounts)
exceed certain amounts or have certain characteristics. (Revenue segments amounts are
disclosed if they exceed 10 percent of total revenue and joint venture amounts, and
consolidated if the company has effective control.)

Documentary evidence – Evidence gathered from written, printed or electronic sources.

Documentation – Documentation is the material (working papers) prepared by and for, or
obtained and retained by the auditor in connection with the performance of, the audit.

Due diligence report – A report based on the analysis by an acquiring company’s auditing firm
of a company to be acquired.

Due professional care – The activities of a professional fulfilling his duties diligently and
carefully. Due care for an auditor includes the completeness of the working papers, the
sufficiency of the audit evidence, and the appropriateness of the audit report.

Edit check – An accuracy check performed by a computer accounting system edit program.

Electronic data interchange (EDI) – The electronic transmission of documents between
organizations in a machine-readable form. EDI allows output of one system to be
electronically transmitted and input into another system.

Electronic funds transfer (EFT) – A transfer of funds between two or more organizations or
individuals using computer and network technology.

Embedded audit modules (EAM) – Database software routines that are placed at pre-
determined points to gather information about transactions or events within the system
that auditors deem to be material. EAMs allow auditors to proactively monitor auditable
conditions.

Embedded derivative instruments – Implicit or explicit terms in a contract or agreement that
affect some or all of the cash flows or the value of other exchanges required by the contract
in a manner similar to a derivative.

Emphasis of matter paragraph – The explanatory paragraph placed after the opinion para-
graph in an unqualified auditor’s opinion which emphasizes a matter related to the entity
or its financial statements.

Employed professional accountant – A professional accountant employed in industry, com-
merce, the public sector, or education.

Encryption (cryptography) – The process of transforming programs and information into a
form that cannot be understood without access to specific decoding algorithms (crypto-
graphic keys). For example, the confidential personal data in a payroll system may be
encrypted against unauthorized disclosure or modification. Encryption can provide an

GLOSSARY

effective control for protecting confidential or sensitive programs and information from
unauthorized access or modification. However, effective security depends upon proper
controls over access to the cryptographic keys.

End user – An entity that enters into a financial transaction, either through an organized
exchange or a broker, for the purpose of hedging, asset liability management or specu-
lating. End users consist primarily of corporations, government entities, institutional
investors and financial institutions. The derivative activities of end users are often related
the production or use of a commodity by the entity.

Engagement circumstances – The terms of the engagement, the characteristics of subject
matter, the criteria to be used, the needs of the intended users, relevant characteristics of
the responsible party, and its environment and other matters (e.g. events, transactions,
conditions and practices) that may have a significant effect on the subject matter and the
engagement.

Engagement letter – An engagement letter documents and confirms the auditor’s acceptance
of the appointment, the objective and scope of the audit, the extent of the auditor’s
responsibilities to the client and the form of any reports.

Engagement partner – The partner or other person with sufficient and appropriate experience
and authority in the firm who has responsibility for the engagement and its performance,
for issuing the report on the subject matter on behalf of the firm, and who is permitted by
law, regulation or a professional body to act in the role in the relevant jurisdiction.

Engagement proposal – A written proposal from the auditor or audit firm to the proposed or
existing client proposing that an audit or assurance engagement be undertaken.

Engagement quality control review – A process designed to provide an objective evaluation,
before the report is issued, of the significant judgments the engagement team made and the
conclusions they reached in formulating the report.

Engagement quality control reviewer – A partner, other person in the firm, suitably qualified
external person, or a team made up of such individuals, with sufficient and appropriate
experience and authority to objectively evaluate, before the report is issued, the significant
judgments the engagement team made and the conclusions they reached in formulating the
report.

Engagement team – The individuals involved in performing an engagement, including any
experts employed or engaged by the firm in connection with that engagement.

Entity – A separate or self-contained existence that provides goods or services. For example, a
company, organization, or agency.

Enterprise resource planning (ERP) – A system that integrates all aspects of an organization’s
activities (such as recording accounting transactions, database maintenance, financial
reporting, operations and compliance) into one accounting information system.

Environmental matters – Environmental matters are defined as:
■ initiatives to prevent, abate, or remedy damage to the environment, or to deal with
conservation of renewable and non-renewable resources (such initiatives may be
required by environmental laws and regulations or by contract, or they may be under-
taken voluntarily);

657

GLOSSARY ■ consequences of violating environmental laws and regulations;
■ consequences of environmental damage done to others or to natural resources;
658 ■ consequences of vicarious liability imposed by law (e.g. liability for damages caused by

previous owners).

Environmental performance report – An environmental performance report is a report,
separate from the financial statements, in which an entity provides third parties with
qualitative information on the entity’s commitments towards the environmental aspects of
the business, its policies and targets in that field, its achievement in managing the relation-
ship between its business processes and environmental risk, and quantitative information
on its environmental performance.

Environmental risk – In certain circumstances, factors relevant to the assessment of inherent
risk for the development of the overall audit plan may include the risk of material
misstatement of the financial statements due to environmental matters.

Error – An error is an unintentional mistake in financial statements. See also Audit sampling.

Evaluation assertion – Not an assertion given in the IFAC definitions (see Financial statement
assertions). It is particular to specific firms. It means that the account balance has been
evaluated for consistency.

Evidence – Anything that can make a person believe that a fact, proposition, or assertion is
true or false.

Evidence-gathering techniques – Those techniques employed by an auditor to obtain
evidence. There are six types of evidence-gathering techniques including inquiry, obser-
vation, inspection (physical evidence and examination of documents), computation
(reperformance or mechanical accuracy), confirmation, and analytical procedures.

Evolution analysis – A technique that determines the most significant changes in data sets over
time. It includes other types of algorithm methods (i.e. data description, dependency
analysis, classification or clustering) plus time-related and sequence-related characteristics.

Exchange-traded derivatives – Derivatives traded under uniform rules through an organized
exchange.

Existence – see Financial statement assertion.

Existing accountant – A professional accountant in public practice currently holding an audit
appointment or carrying out accounting, taxation, consulting, or similar professional
services for a client.

Existing auditor – The auditor who is currently holding an audit or assurance services
appointment with the prospective client.

Expected error – see Audit sampling.

Expert – A person or firm possessing special skill, knowledge, and experience in a particular
field other than accounting and auditing.

Extent of audit procedures – The size of the evidence sample audited.

External audit auditor – see Auditor.

External confirmation – External confirmation is the process of obtaining and evaluating audit
evidence through a direct communication from a third party in response to a request for

GLOSSARY

information about a particular item affecting assertions made by management in the
financial statements.

Fair value – The amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction.

Familiarity threat – Occurs when, by virtue of a close relationship with an assurance client, its
directors, officers or employees, an auditor becomes to sympathetic to the client’s interests.

Fiduciary risk – The risk of loss arising from factors such as failure to maintain safe custody or
negligence in the management of assets on behalf of other parties.

Fields – A group of bytes that make up a meaningful unit of information (e.g. account
number, account balance, or account name).

File – Set of related data records.

File interrogation – A technique that performs automated routines on computer data.

File interrogation specifications – A document prepared by the engagement team that
describes the file interrogation tests to be performed, documents any selection or calcu-
lation criteria, and documents control totals of one or more key fields.

File interrogation specialist – A professional in the firm who has appropriate training and
experience in identifying, designing, and running file interrogation applications.

Financial instruments – Common stock, preferred stock, bonds, and other contracts or rights
to assets, liabilities, or equity which convey financial interest to the holder.

Financial interest – An interest in an equity or other security, debenture, loan or other debt
instrument of an entity, including rights and obligations to acquire such an interest and
derivatives directly related to such interest.

Financial reporting policies – Company policies and accounting methods related to the
reporting of accounting information.

Financial statement assertions – Financial statement assertions are assertions by manage-
ment, explicit or otherwise, that are embodied in the financial statements and can be
categorized as follows:
■ Accuracy – Amounts and other data relating to recorded transactions and events have
been recorded appropriately.
■ Classification – Transactions and events have been recorded in the proper accounts.
■ Completeness – All transactions, events, assets, liabilities, and equity interests that
should have been recorded have been recorded.
■ Cutoff – Transactions and events have been recorded in the correct accounting period.
■ Existence – Assets, liabilities and equity interests exist.
■ Measurement – A transaction or event is recorded at the proper amount and revenue or
expense is allocated to the proper period.
■ Occurrence – An assertion that a transaction or event took place which pertains to the
entity during the period.
■ Presentation and disclosure – An item is disclosed, classified, and described in
accordance with the applicable financial reporting framework.
■ Rights and obligations – An entity holds or controls the rights to assets, and liabilities are
the obligations of the entity.

659

GLOSSARY ■ Transparency – Financial information is appropriately classified and disclosures are
understandable.
660
■ Valuation and allocation – Assets, liabilities, and equity interests are included in the
financial statements at appropriate amounts and any resulting valuation or allocation
adjustments are appropriately recorded.

Financial statement audit – An audit of financial statements guided by ISAs 100–799 and
IAPSs 1000–1100.

Financial statements – The balance sheets, income statements or profit and loss accounts,
statements of changes in financial position (which may be presented in a variety of ways,
for example, as a statement of cash flows or a statement of fund flows), notes, and other
statements and explanatory material which are identified as being part of the financial
statements.

Firewall – A combination of hardware and software that protects a WAN, LAN or PC from
unauthorized access through the internet and from the introduction of unauthorized or
harmful software, data or other material in electronic form.

Firm – (a) A sole practitioner, partnership or corporation of professional accountants; (b) An
entity that controls such parties; and (c) An entity controlled by such parties.

Floor – A series of put options based on a notional amount. The strike price of these options
defines a lower limit to the interest rate.

Forecast – A forecast is prospective financial information prepared on the basis of assumptions
as to future events which management expects to take place and the actions management
expects to take as of the date the information is prepared (best-estimate assumptions).

Foreign Exchange Contracts – Contracts that provide an option for, or require a future
exchange of foreign currency assets or liabilities.

Foreign Exchange Risk – The risk of losses arising through repricing of foreign currency
instruments because of exchange rate fluctuations.

Forensic accounting – The application of accounting methods and financial techniques to
collect civil and criminal legal evidence.

Forward Contracts – A contract negotiated between two parties to purchase and sell a specified
quantity of a financial instrument, foreign currency, or commodity at a price specified at
the origination of the contract, with delivery and settlement at a specified future date.

Forward Rate Agreements – An agreement between two parties to exchange an amount deter-
mined by an interest rate differential at a given future date based on the difference between
an agreed interest rate and a reference rate (LIBOR, Treasury bills, etc.) on a notional
principal amount.

Fraud – Refers to an intentional act by one or more individuals among management,
employees, or third parties, which results in a misrepresentation of financial statements.

Functional audit quality – The degree to which the process of carrying out the audit and
communicating its results meets a consumer’s expectations.

Futures contracts – Exchange-traded contracts to buy or sell a specified financial instrument,
foreign currency or commodity at a specified future date or during a specified period at a
specified price or yield.

GLOSSARY

General controls in computer information systems – The establishment of a framework of
overall control over the computer information systems activities to provide a reasonable
level of assurance that the overall objectives of internal control are achieved.

Generalized audit software (GAS) – A computer software package (e.g., ACL, Idea) that
performs automated routines on electronic data files based on auditor expectations. GAS
functions generally include reformatting, file manipulation, calculation, data selection,
data analysis, file processing, statistics and reporting on the data. It may also include
statistical sampling for detailed tests, generating confirmation letters.

Generally Accepted Auditing Standards (GAAS) – A set of auditing standards accepted by
professional accountants.

Going concern assumption – Under the going concern assumption, an entity is ordinarily
viewed as continuing in business for the foreseeable future with neither the intention nor
the necessity of liquidation, ceasing trading, or seeking protection from creditors pursuant
to laws or regulations. Accordingly, assets and liabilities are recorded on the basis that the
entity will be able to realize its assets and discharge its liabilities in the normal course of
business.

Governance – The term “governance” describes the role of persons entrusted with the super-
vision, control and direction of an entity. Those charged with governance ordinarily are
accountable for ensuring that the entity achieves its objectives, financial reporting, and
reporting to interested parties. Those charged with governance include management only
when it performs such functions.

Government business enterprises – Government business enterprises are businesses which
operate within the public sector ordinarily to meet a political or social interest objective.
They are ordinarily required to operate commercially, that is, to make profits or to recoup,
through user charges, a substantial proportion of their operating costs.

Group audit instructions – A communication from a group auditor to the related auditors and
other auditors to provide them with the group auditor’s requirements.

Group auditor – The independent auditor who signs the auditor’s report on the group financial
statements.

Group financial statements – Financial statements that include or should include financial
information of more than one component by means of consolidation procedures or equity
accounting methods. It may also mean a combination of components’ financial infor-
mation or an equivalent presentation.

Group management – Management responsible for the preparation and presentation of the
group financial statements.

Gross negligence – see Negligence of auditor.

Hedge – A strategy that protects an entity against the risk of adverse price or interest rate
movements on certain of its assets, liabilities or anticipated transactions. A hedge is used to
avoid or reduce risks by creating a relationship by which losses on certain positions are
expected to be counterbalanced, in whole or in part, by gains on separate positions in
another market.

Hedge effectiveness – The degree to which offsetting changes in fair value or cash flows
attributable to a hedged risk are achieved by the hedging instrument.

661

GLOSSARY

Hedged item – An asset, liability, firm commitment, or forecasted future transaction that

■ exposes an entity to risk of changes in fair value or changes in future cash flows;
■ for hedge accounting purposes, is designated as being hedged.

Hedging (for accounting purposes) – Designating one or more hedging instruments so that
their change in fair value is an offset, completely or in part, to the change in fair value or
cash flows of a hedged item.

Hedging instrument (for hedge accounting purposes) – A designated derivative or (in limited
circumstances) another financial asset or liability whose value or cash flows are expected to
offset changes in the fair value or cash flows of a designated hedged item.

Hidden reserves – Some financial reporting frameworks allow banks to manipulate their
reported income by transferring amounts to non-disclosed reserves in years when they
make large profits and transferring amounts from those reserves when they make losses or
small profits. The reported income is the amount after such transfers. The practice served
to make the entity appear more stable by reducing the volatility of its earnings, and would
help to prevent a loss of confidence in the bank by reducing the occasions on which it
would report low earnings.

Homogenity – see Audit sampling.

HTML (Hypertext Markup Language) – The language used to format web pages. Web browsers
like Internet Explorer transmit information using the hypertext transport protocol
(HTTP).

Illegal act – An act or omission that violates any law or any rule having the force of law.

Immediate family – A spouse (or equivalent) or dependant.

Incoming auditor – see Auditor.

Independence – (a) Independence of mind – the state of mind that permits the provision of an
opinion without being affected by influences that compromise professional judgment,
allowing an individual to act with integrity, and exercise objectivity and professional
skepticism; and (b) Independence in appearance – the avoidance of facts and circum-
stances that are so significant a reasonable and informed third party, having knowledge of
all relevant information, including any safeguards applied, would reasonably conclude a
firm’s, or a member of the assurance team’s, integrity, objectivity or professional
skepticism had been compromised.

Independent director – A director is independent when he has no relationship of any kind
whatsoever with the corporation, its group, or the management of either that is such as to
color his judgment. (Bouton, 2002)

Indirect financial interest – A financial interest beneficially owned through a collective invest-
ment vehicle, estate, trust or other intermediary over which the individual or entity has no
control.

Information asymmetry – A condition in which at least some relevant information is known to
some but not all parties involved. Information asymmetry causes markets to become
inefficient, since all the market participants do not have access to the information they need
for their decision making processes.

662

GLOSSARY

Information technology – The computing, communications and management information
systems technology. This technology includes computer hardware and software systems
such as operating systems, networks, databases and operating applications (word
processing, presentation, monitoring and design systems), as well as communications.

Inherent limitations in an audit – Limitations that result from such factors as the use of testing,
the inherent limitations of any accounting and internal control system, and the fact that
most audit evidence is persuasive rather than conclusive. Furthermore, the work
performed by an auditor to form an opinion is permeated by judgment.

Inherent risk – see Audit risk.

Inquiry – Consists of seeking information of knowledgeable persons inside or outside the
entity.

Inspection – Inspection consists of examining records, documents, or tangible assets.

Inspection – In relation to completed engagements, procedures designed to provide evidence
of compliance by engagement teams with the firm’s quality control policies and
procedures.

Inspired confidence, theory of – The demand for audit services is the direct consequence of the
participation of outside stakeholders (third parties) in the company. These stakeholders
demand accountability from the management, in return for their contribution to the
company. Since information provided by management might be biased, because of a
possible divergence between the interests of management and outside stakeholders, an
audit of this information is required. (See Limperg, T.H., 1932, Theory of Inspired
Confidence, University of Amsterdam, Amsterdam, 1932 1933.)

Intended users (for assurance services) – The class or classes of persons for whom the prac-
titioner prepares the assurance report. It includes cases when there is only one intended
user. The responsible party can be one of the intended users, but not the only one.

Interest rate risk – The risk that a movement in interest rates would have an adverse effect on
the value of assets and liabilities or would affect interest cash flows.

Interest rate swap – A contract between two parties to exchange periodic interest payments on
a notional amount (referred to as the notional principal) for a specified period. In the most
common instance, an interest rate swap involves the exchange of streams of variable and
fixed-rate interest payments.

Interim financial information or statements – Financial information (which may be less than
full financial statements as defined above) issued at interim dates (usually half-yearly or
quarterly) in respect of a financial period.

Internal auditing – An appraisal activity established within an entity as a service to the entity.
Its functions include, amongst other things, examining, evaluating and monitoring the
adequacy and effectiveness of the accounting and internal control systems.

Internal control – A process, effected by an entity’s board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories: effectiveness and efficiency of operations, reliability
of financial reporting, and compliance with applicable laws and regulations. – Committee
of Sponsoring Organizations of the Treadway Commission.

663

GLOSSARY Internal control flow chart – A symbolic, diagrammatic representation of the client’s
documents and their sequential flow in the organization.
664
Internal control questionnaire – A series of questions about the controls in each audit area as a
means of indicating to the auditor aspects of the internal control structure that may be
inadequate.

Internal control narrative – A written description of a client’s internal control structure.

Internal control structure – The set of policies and procedures designed to provide manage-
ment with reasonable assurance that the goals and objectives it believes are important will
be met.

Internal control system – An internal control system consists of all the policies and procedures
(internal controls) adopted by the management of an entity to assist in achieving manage-
ment’s objective of ensuring, as far as practicable, the orderly and efficient conduct of its
business, including adherence to management policies, the safeguarding of assets, the
prevention and detection of fraud and error, the accuracy and completeness of the
accounting records, and the timely preparation of reliable financial information. The
internal control system extends beyond these matters which relate directly to the functions
of the accounting system.

International Financial Reporting Standards (IFRS) – The international standards for financial
statements developed by the International Accounting Standards Board (IASB). IFRS set
out recognition, measurement, presentation and disclosure requirements dealing with
transactions and events that are important in general purpose financial statements.

International Standards on Assurance Engagements (ISAEs) – Standards applied in assurance
engagements dealing with subject matters other than historical financial information.
Developed by IAASB.

International Standards on Auditing (ISAs) – Standards applied, as appropriate, in the audit or
review of historical financial information. Developed by IAASB.

International Standards on Quality Control (ISQCs) – The standards relating to quality of audit
applied to all services falling under the standards of the IAASB.

International Standards on Related Services (ISRSs) – Standards applied to compilation
engagements, engagements to apply agreed upon procedures to information and other
related services engagements as specified by the IAASB.

International Standards on Review Engagements (ISREs) – Standards applied to the review of
historical financial information. Developed by IAASB.

Intimidation Threat – Occurs when a member of the assurance team may be deterred from
acting objectively and exercising professional skepticism by threats, actual or perceived,
from the directors, officers, or employees of an assurance client.

IT environment – The policies and procedures that the entity implements and the IT infra-
structure (hardware, operating systems, etc.) and application software that it uses to
support business operations and achieve business strategies.

Joint and several liability – All parties involved are liable for losses.

Key performance indicators (KPIs) – Quantitative measurements, both financial and non-
financial, of the process’s ability to meet its objectives and of the process performance. They

GLOSSARY

are usually analyzed through trend analyses within a company, or benchmarking against a
peer of the company or its industry. The KPIs that should be listed must be relevant to the
critical success factors and or the process objectives. The KPIs listed must have relevance to
the organization. Taken together they should provide a key set of measures for measuring
process performance and achieving process objectives.

Knowledge of the business – The auditor’s general knowledge of the economy and the indus-
try within which the entity operates and a more particular knowledge of how the entity
operates.

Lead engagement partner – In connection with an audit, the partner responsible for signing
the report on the consolidated financial statements of the audit client and, where relevant,
the partner responsible for signing the report in respect of any entity whose financial
statements form part of the consolidated financial statements and on which a separate
stand-alone report is issued. When no consolidated financial statements are prepared, the
lead engagement partner would be the partner responsible for signing the report on the
financial statements.

Lead schedule – A listing of the detailed accounts which make up the line item total on a
general ledger trial balance.

Legal letter (or inquiry of client’s attorneys) – A letter from the client’s legal counsel informing
the auditor of pending litigation or other information involving legal counsel that is
relevant to financial statement disclosure.

Legal and documentary risk – The risk that contracts are documented incorrectly or are not
legally enforceable in the relevant jurisdiction in which the contracts are to be enforced or
where the counterparties operate. This can include the risk that assets will turn out to be
worthless or liabilities will turn out to be greater than expected because of inadequate or
incorrect legal advice or documentation. In addition, existing laws may fail to resolve legal
issues involving a bank; a court case involving a particular bank may have wider impli-
cations for the banking business and involve costs to it and many or all other banks; and
laws affecting banks or other commercial enterprises may change. Banks are particularly
susceptible to legal risks when entering into new types of transactions and when the legal
right of a counterparty to enter into a transaction is not established.

Legal Risk – The risk that a legal or regulatory action could invalidate or otherwise preclude
performance by the end user or its counterparty under the terms of the contract.

Lending Credibility Theory – Audited financial statements are used by management to enhance
the stakeholders’ faith in management’s stewardship.

LIBOR (London Interbank Offered Rate) – An international interest rate benchmark. It is
commonly used as a reprising benchmark for financial instruments such as adjustable rate
mortgages, collateralized mortgage obligations, and interest rate swaps.

Limitation on scope – A limitation on the scope of the auditor’s work may sometimes be
imposed by the entity (e.g. when the terms of the engagement specify that the auditor will
not carry out an audit procedure that the auditor believes is necessary). A scope limitation
may be imposed by circumstances (e.g. when the timing of the auditor’s appointment is
such that the auditor is unable to observe the counting of physical inventories). It may also
arise when, in the opinion of the auditor, the entity’s accounting records are inadequate or
when the auditor is unable to carry out an audit procedure believed desirable.

665

GLOSSARY Linear contracts – Contracts that involve obligatory cash flows at a future date.

666 Liquidity – The capability of a financial instrument to be readily convertible into cash.

Liquidity risk – Changes in the ability to sell or dispose of the derivative. Derivatives bear the
additional risk that a lack of sufficient contracts or willing counterparties may make it
difficult to close out the derivative or enter into an offsetting contract.

List schedule – Shows the detail of those items that make up an end-of-period balance in a
general ledger account.

Listed entity – An entity whose shares, stock or debt are quoted or listed on a recognized stock
exchange, or are marketed under the regulations of a recognized stock exchange or other
equivalent body.

Litigation support – The making of managerial decisions on behalf of an audit client or acting
for an audit client in the resolution of a dispute or litigation when the amounts involved are
material to the financial statements of the audit client.

Local area network (LAN) – A communications network that serves users within a confined
geographical area. LANs were developed to facilitate the exchange and sharing of resources
within an organization, including data, software, storage, printers, and telecommuni-
cations equipment. They allow for decentralized computing. The basic components of a
LAN are transmission media and software, user terminals, and shared peripherals.

Management – Management comprises officers and others who also perform senior manage-
rial functions. Management includes directors and the audit committee only in those
instances when they perform such functions.

Management assertion – see Financial statement assertions.

Management letter – The auditor’s written communications to management to point out
weaknesses in the internal control, other reportable conditions, and possibilities for
operational improvements.

Management report – A report that is needed for publicly traded companies in the US.

Management representations – Representations made by management to the auditor during
the course of an audit, either unsolicited or in response to specific inquiries.

Management representations letter – A written communication from the client to the auditor
formalizing representations made by management to the auditor about matters pertinent
to the audit.

Margin – (1) The amount of deposit money a securities broker requires from an investor to
purchase securities on behalf of the investor on credit. (2) An amount of money or
securities deposited by both buyers and sellers of futures contracts and short options to
ensure performance of the terms of the contract, i.e. the delivery or taking of delivery of the
commodity, or the cancellation of the position by a subsequent offsetting trade. Margin in
commodities is not a payment of equity or down payment on the commodity itself, but
rather a performance bond or security deposit.

Margin call – A call from a broker to a customer (called a maintenance margin call) or from a
clearinghouse to a clearing member (called a variation margin call) demanding the deposit
of cash or marketable securities to maintain a requirement for the purchase or short sale of
securities or to cover an adverse price movement.

GLOSSARY

Market risk – The risk of losses arising because of adverse changes in the value of derivatives
due to changes in equity prices, interest rates, foreign exchange rates, commodity prices or
other market factors. Interest rate risk and foreign exchange risk are sub-sets of market risk.

Material inconsistency – A material inconsistency exists when other information contradicts
information contained in the audited financial statements. A material inconsistency may
raise doubt about the audit conclusions drawn from audit evidence previously obtained
and, possibly, about the basis for the auditor’s opinion on the financial statements.

Material misstatement – A significant mistake in financial information which would arise
from errors and fraud if it could influence the economic decisions of users taken on the
basis of the financial statements.

Material misstatement of fact – A material misstatement of fact in other information exists
when such information, not related to matters appearing in the audited financial state-
ments, is incorrectly stated or presented.

Material weaknesses – The weaknesses in internal control that could have a material effect on
the financial statements.

Materiality – Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements. Materiality
depends on the size of the item or error judged in the particular circumstances of its
omission or misstatement. Thus, materiality provides a threshold or cutoff point rather
than being a primary qualitative characteristic which information must have if it is to be
useful.

Materiality threshold – In substantive testing, the amount of audited difference between the
book value of an account and the tested value that an auditor will accept before he
determines that an account is misstated.

Matters for Attention of Partners (MAP) – A report by audit managers to be reviewed by a
partner or director detailing the audit decisions reached by managers or partners and the
reasons for those decisions.

Measurement – see Financial statement assertions.

Minutes of the board of directors – The written notes of a meeting of the board of directors
which lists the names of the attendees, summarizes the key topics discussed, and reports the
results of any votes of the board.

Misappropriation – Employee theft of assets. Especially susceptible accounts are inventory and
cash.

Misstatement – Incorrect information as a result of error, inappropriate application of
standards, or fraud.

Modeling risk – The risk associated with the imperfections and subjectivity of valuation
models used to determine the values of assets or liabilities.

Modified auditor’s report – An auditor’s report is considered to be modified if either an
emphasis of matter paragraph(s) is added to the report or if the opinion is other than
unqualified.

Monetary unit sampling – see Audit sampling.

667

GLOSSARY

Monitoring – For an audit firm a process comprising an ongoing consideration and evaluation
of the firm’s system of quality control, including a periodic inspection of a selection of
completed engagements, designed to enable the firm to obtain reasonable assurance that its
system of quality control is operating effectively.

National practices (auditing) – A set of auditing guidelines not having the authority of
standards defined by an authoritative body at a country level and commonly applied by
auditors in the conduct of an audit or related services.

National standards (auditing) – A set of auditing standards defined by law or regulations or an
authoritative body at a country level, the application of which is mandatory in conducting
an audit or related services and which should be complied with in the conduct of an audit
or related services.

Nature of audit procedures – Primarily substantive (tests of transactions and tests of balances)
tests, tests of controls, and analytical procedures.

Negative confirmation – A letter, addressed to the debtor, creditor, or third party, requesting a
response only if the recipient disagrees with the amount of the stated account balance.

Negligence of auditor – An auditor in the performance of his duty may not use an appropriate
level of care and therefore be legally liable.
■ Ordinary negligence – The absence of reasonable care that can be expected in similar
circumstances.
■ Gross negligence is reckless behavior with not even slight care.

Network – A group of interconnected computers and terminals; a series of locations tied
together by communications channels.

Network firm – An entity under common control, ownership, or management with the firm
or any entity that a reasonable and informed third party having knowledge of all
relevant information would reasonably conclude as being part of the firm nationally or
internationally.

Neural network – A computer model based on the architecture of the brain. It first detects a
pattern from data sets then predicts the best classifiers of that pattern, and finally learns
from the mistakes.

Non-compliance – Used to refer to acts of omission or commission by the entity being audited,
either intentional or unintentional, which are contrary to the prevailing laws or regulations.

Non-executive directors – A member of the board of directors who is not an executive of the
entity supervised.

Non-linear contracts – Contracts that have option features where one party has the right, but
not the obligation to demand that another party deliver the underlying item to it.

Non-sampling risk – see Audit sampling.

Nostros – Accounts held in the bank’s name with a correspondent bank.

Notional amount – A number of currency units, shares, bushels, pounds or other units
specified in a derivative instrument.

Object of an audit – see Audit objective.

668

GLOSSARY

Objectivity – A combination of impartiality, intellectual honesty and a freedom from conflicts
of interest.

Observation – Observation consists of looking at a process or procedure being performed by
others, for example, the observation by the auditor of the counting of inventories by the
entity’s personnel or the performance of internal control procedures that leave no audit
trail.

Occurrence assertion – see Financial statement assertions.

Off-balance-sheet instrument – A derivative financial instrument that is not recorded on the
balance sheet, although it may be disclosed.

Off-balance-sheet risk – The risk of loss to the entity in excess of the amount, if any, of the
asset or liability that is recognized on the balance sheet.

Office – A distinct sub-group, whether organized on geographical or practice lines.

Opening balances – Opening balances are those account balances which 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.

Operational auditing – A study of a specific unit of an organization for the purpose of
measuring its performance.

Operational risk – The risk of direct or indirect loss resulting from inadequate or failed internal
processes, people and systems, or from external events.

Opinion – The auditor’s report contains a clear written expression of opinion on the financial
statements as a whole.
■ Adverse opinion – An adverse opinion is expressed when the effect of a disagreement is
so material and pervasive to the financial statements that the auditor concludes that a
qualification of the report is not adequate to disclose the misleading or incomplete
nature of the financial statements.
■ Disclaimer of opinion – A disclaimer of opinion is expressed when the possible effect of
a limitation on scope is so material and pervasive that the auditor has not been able to
obtain sufficient appropriate audit evidence and accordingly is unable to express an
opinion on the financial statements.
■ Qualified opinion – A qualified opinion is expressed when the auditor concludes that an
unqualified opinion cannot be expressed but that the effect of any disagreement with
management, or limitation on scope, is not so material and pervasive as to require an
adverse opinion or a disclaimer of opinion.
■ Unqualified opinion – An audit opinion expressed when the auditor concludes that the
financial statements give a true and fair view (or are presented fairly, in all material
respects) in accordance with the identified financial reporting framework. (See also
Modified auditor’s report.)

Option – A contract that gives the holder (or purchaser) the right, but not the obligation to buy
(call) or sell (put) a specific or standard commodity, or financial instrument, at a specified
price during a specified period (the American option) or at a specified date (the European
option).

Ordinary negligence – see Negligence of auditor.

669

GLOSSARY Other auditor – see Auditor.

670 Organization chart – A visual diagram of an organization’s structure that depicts formal lines
of reporting, communication, and responsibility among managers.

Organisation for Economic Co-operation and Development (OECD) – The OECD groups 30
member countries sharing a commitment to democratic government and market economy
in a unique forum to discuss, develop and, refine economic and social policies. Countries
compare experiences, seek answers to common problems and work to co-ordinate
domestic and international policies to help members and non-members deal with an
increasingly globalized world. Their exchanges may lead to agreements to act in a formal
way, for example by establishing legally binding agreements to crack down on bribery, or
codes for free flow of capital and services. Together, they produce around two-thirds of the
world’s goods and services.

Outcome of the audit process – The end results after planning and performing procedures on
financial statements.

Outlier analysis – Analysis of data items (outliers) that are distinctly dissimilar to others, fall
outside the standard distribution of data, and ordinarily are viewed as noises or errors in
the data sets.

Outside directors – Directors on an entity’s board of directors who are neither officers nor
employees of the entity.

Parent – The entity in respect of which group financial statements are or should be prepared.

Parent company – The owner of a subsidiary company and this could be a holding company
not engaged in a trade or business.

Partner – Any individual with authority, whether through office or otherwise, to bind the firm.

PCs or personal computers (also referred to as microcomputers) – Economical yet powerful self-
contained general purpose computers consisting typically of a monitor (visual display unit),
a case containing the computer electronics, and a keyboard (and mouse). These features may
be combined in portable computers (laptops). Programs and data may be stored internally
on a hard disk or on removable storage media such as CDs or floppy disks. PCs may be
connected to online networks, printers and other devices such as scanners and modems.

Performance reviews – Independent checks on performance by a third party not directly
involved in the activity.

Permanent audit file – A file of audit work papers containing all the data that is of continuing
interest from year to year.

Personnel – Partners and staff (see Auditor).

Physical controls – Procedures to ensure the physical security of assets.

Planning – Planning involves developing a general strategy and a detailed approach for the
expected nature, timing, and extent of the audit.

Planning memorandum – A written discussion of the audit strategy and audit plan which
incorporates most of the important ideas of the audit.

Policy – Management’s dictate of what should be done to effect control. A policy serves as the
basis for procedures and their implementation.

GLOSSARY

Policeman theory – An auditor’s job was to focus on arithmetical accuracy and on prevention
and detection of fraud.

Population – see Audit sampling.

Position – The status of the net of claims and obligations in financial instruments of an entity.

Positive confirmation – The process of obtaining and evaluating audit evidence through a
direct communication from a third party in response to a request for information about a
particular item affecting assertions made by management in the financial statements. The
request for positive confirmation asks the recipient (debtor, creditor, or other third party) to
confirm agreement or by asking the respondent to fill in information.

Post balance sheet events – see Subsequent events.

Power of the test – see Audit sampling.

Practice – A sole practitioner, a partnership or a corporation of professional accountants
which offers professional services to the public.

Practitioner – A professional accountant in public practice.

Predecessor auditor – The auditor who was previously the auditor of an entity and who has
been replaced by an incoming auditor. (See also Auditor.)

Preformatting – An online data entry control in which the computer displays a form on the
screen and the user fills in the blanks on the form.

Preponderance of evidence – Upon listening to both sides, the weight of the evidence inclines
a person with an impartial mind to one side rather than the other.

Presentation and disclosure assertion – see Financial statement assertions.

Price risk – The risk of changes in the level of prices due to changes in interest rates, foreign
exchange rates, or other factors that relate to market volatility of the underlying rate, index,
or price.

Principal auditor – see Auditor.

Privity – A relationship that is established by contract between entities. There can be privity of
contract without a written agreement under common law.

Probable cause – Serves as the basis for arrest and search warrants.

Procedures to obtain an understanding – Procedures used by the auditor to gather evidence
about the design and placement in operation of specific control policies and procedures.

Professional accountant – That person, whether in public practice (including a sole practi-
tioner, partnership or corporate body), industry, commerce, the public sector or education
who is a member of an IFAC member body.

Professional accountant in public practice – Each partner or person occupying a position
similar to that of a partner, and each employee in a practice providing professional services
to a client irrespective of their functional classification (e.g. audit, tax, or consulting) and
professional accountants in a practice having managerial responsibilities. This term is also
used to refer to a firm of professional accountants in public practice.

671

GLOSSARY Professional service – Any service requiring accountancy or related skills performed by a
professional accountant including accounting, auditing, taxation, management consulting,
672 and financial management services.

Professional skepticism – Having a questioning mind and performing a critical assessment of
audit evidence through the audit process.

Professional standards – IAASB engagement standards and relevant ethical requirements,
which ordinarily comprise Parts A and B of the IFAC Code of Ethics for Professional
Accountants and national ethical requirements.

Programming controls – Procedures designed to prevent or detect improper changes to
computer programs that are accessed through on-line terminal devices. Access may be
restricted by controls such as the use of separate operational and program development
libraries, and the use of specialized program library software. It is important for online
changes to programs to be adequately documented, controlled and monitored.

Projection – A projection is prospective financial information prepared on the basis of: (a)
Hypothetical assumptions about future events and management actions which are not
necessarily expected to take place, such as when some entities are in a start-up phase or are
considering a major change in the nature of operations; or (b) A mixture of best-estimate
and hypothetical assumptions.

Proportionate liability – A defendant is not liable for the entire liability or loss incurred by
plaintiffs, but only to the extent to which the loss is attributable to the defendant.

Proposed professional accountant – A professional accountant in public practice who will act
as the current financial period’s auditor (and who did not audit the prior period’s financial
statements).

Prospective financial information – Prospective financial information is financial information
based on assumptions about events that may occur in the future and possible actions by an
entity. Prospective financial information can be in the form of a forecast, a projection or a
combination of both. (See also Forecast and Projection).

Provision – An adjustment to the carrying value of an asset to take account of factors that
might reduce the asset’s worth to the entity. Sometimes called an allowance.

Prudential ratios – Ratios used by regulators to determine the types and amounts of lending a
bank can undertake.

Public Company Accounting Oversight Board (PCAOB) – An independent board established
under the US Sarbanes-Oxley Act of 2002 to oversee the audit of public companies that are
subject to the securities laws of the USA in order to protect the interests of investors and the
public in the preparation of informative, accurate, and independent audit reports.

Public interest companies – Broadly defined by the EU 2004 proposal for statutory audits as
listed (publicly-traded) companies, banks, or insurance companies.

Public sector – Refers to national governments, regional (e.g. state, provincial, territorial)
governments, local (e.g. city, town) governments and related governmental entities (e.g.
agencies, boards, commissions and enterprises).

Publicity – The communication to the public of facts about a professional accountant which
are not designed for the deliberate promotion of that professional accountant.

GLOSSARY

Qualified opinion – see Modified auditor’s report and Opinion.

Quality controls – The policies and procedures adopted by a firm to provide reasonable
assurance that all audits done by the firm are being carried out in accordance with the
Objective and General Principles Governing an Audit of Financial Statements, as set out in
International Standard on Auditing 220 “Quality Control for Audit Work” and
International Standard on Quality Control (ISQC).

Ratio analysis – The comparison of relationships between financial statement accounts, the
comparison of an account with non-financial data, or the comparison of relationships
between firms in an industry.

Reasonable assurance – In an audit engagement, the auditor provides a high, but not
absolute, level of assurance, expressed positively in the audit report as reasonable
assurance, that the information subject to audit is free of material misstatement.

Reasonable doubt – The degree of certainty a person has in accomplishing or transacting the
more important concerns in everyday life.

Reasonableness testing – The analysis of account balances or changes in account balances
within an accounting period in terms of their “reasonableness” in light of expected
relationships between accounts.

Recalculation – Checking the arithmetical accuracy of source documents and accounting
records or performing independent calculations.

Receiving accountant – A professional accountant in public practice to whom the existing
accountant or client of the existing accountant has referred audit, accounting, taxation,
consulting or similar appointments, or who is consulted in order to meet the needs of the
client.

Reconciliation – Relates a specific amount in the accounting records to another source of
information (e.g. a reconciliation of accounts payable balances with vendor’s statements).

Recording – The creation of documentary evidence of a transaction and its entry into the
accounting records.

Regression analysis – The use of statistical models to quantify the auditor’s expectation in
dollar terms, with measurable risk and precision levels.

Regulatory risk – The risk of loss arising from failure to comply with regulatory or legal
requirements in the relevant jurisdiction in which the bank operates. It also includes any
loss that could arise from changes in regulatory requirements.

Related auditor – An independent auditor from the group auditor’s office, other office of the
group auditor’s firm, a network firm or another firm operating under common quality
control policies and procedures as described in International Standard on Quality Control
(ISQC) 1, “Quality Control for Audit, Assurance and Related Services Practices.”

Related entity – An entity that has any of the following relationships with the client: (a) An
entity that has direct or indirect control over the client provided the client is material to
such entity; (b) An entity with a direct financial interest in the client provided that such
entity has significant influence over the client and the interest in the client is material to
such entity; (c) An entity over which the client has direct or indirect control; (d) An entity
in which the client, or an entity related to the client under (c) above, has a direct financial

673

GLOSSARY interest that gives it significant influence over such entity and the interest is material to the
client and its related entity in (c); and (e) An entity which is under common control with
674 the client (hereinafter a “sister entity”) provided the sister entity and the client are both
material to the entity that controls both the client and sister entity.

Related party – Parties are considered to be related if one party has the ability to control the
other party or exercise significant influence over the other party in making financial and
operating decisions.

Related party transaction – A transfer of resources or obligations between related parties,
regardless of whether a price is charged.

Related services – Related services comprise reviews, agreed-upon procedures and compilations.

Relational database – A database in which all data elements are logically viewed as being
stored in the form of two-dimensional tables called “relations.” Each column represents a
field where the record’s attributes are stored.

Relevance of evidence – The appropriateness (pertinence) of the evidence to the audit
objective being tested.

Reliability – The quality of information when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it either purports to represent or
could reasonably be expected to represent.

Reperformance – Performance of an auditor of a task done by an employee to verify the result
of the transaction.

Replacement risk – (Sometimes called performance risk) the risk of failure of a customer or
counterparty to perform the terms of a contract. This failure creates the need to replace the
failed transaction with another at the current market price. This may result in a loss to the
bank equivalent to the difference between the contract price and the current market price.

Reportable conditions – Significant deficiencies in the design or operation of the internal
control structure which could adversely affect the organization’s ability to record, process,
summarize, and report financial data consistent with the assertions of management in the
financial statements. (AICPA SAS 60 (AU 325).)

Representativeness – see Audit sampling.

Reputational risk – The risk of losing business because of negative public opinion and con-
sequential damage to the entity’s reputation arising from failure to properly manage some
significant risks, or from involvement in improper or illegal activities by the entity or its
senior management, such as money laundering or attempts to cover up losses.

Responsible party – Someone other than the intended user or the practitioner who is
responsible for the subject matter (e.g. board of directors, management).

Revenue cycle – The recurring set of business activities and information-processing oper-
ations associated with providing goods and services to customers and collecting cash in
payment for those sales.

Review – see Review of financial statements.

Review of financial statements – The objective of a review of financial statements engagement
is to enable an auditor to state whether, on the basis of procedures which do not provide all

GLOSSARY

the evidence that would be required in an audit, anything has come to the auditor’s atten-
tion that causes the auditor to believe that the financial statements are not prepared, in all
material respects, in accordance with an identified financial reporting framework.

Rights and obligations assertions – see Financial statement assertions.

Risk management – Using derivatives and other financial instruments to increase or decrease
risks associated with existing or anticipated transactions.

Roll forward – An audit procedure whereby a month-end closing (handclose) is audited and
then transactions in the intervening months, before the fiscal year-end closing (balance
sheet date) are audited and combined with the results of the hand close.

Sales cycle – see Revenue cycle.

Sampling risk – see Audit sampling.

Sampling unit – see Audit sampling.

Sarbanes-Oxley Act of 2002 – This Act was passed by US Congress and signed into law by
President W. Bush on July 30, 2002. The Act is intended to establish investor confidence by
improving the quality of corporate disclosure and financial reporting, strengthen the
independence of accounting firms, and increase the role and responsibility of corporate
officers and directors in financial statements and corporate disclosures. It required the US
Securities and Exchange Commission (SEC) to create a Public Company Accounting
Oversight Board (PCAOB). The most famous sections are on internal control reporting in
Section 404, “Management Assessment of Internal Controls.” (107th US Congress, 2002,
Sarbanes-Oxley Act of 2002, Public Law 107–204, Senate and House of Representatives of
the United States of America in Congress assembled. Washington, DC, July 30.)

Scope limitation – see Limitation on scope.

Scope of an audit – The term “scope of an audit” refers to the audit procedures deemed
necessary in the circumstances to achieve the objective of the audit.

Scope of a review – The term “scope of a review” refers to the review procedures deemed
necessary in the circumstances to achieve the objective of the review.

Scope paragraph – The paragraph in an audit opinion that describes the nature of the audit
and the standards by which it was carried out. It is the second paragraph in an unqualified
and qualified audit opinion.

Scope sample – A sample of data from a subsidiary ledger or account classification (customer
invoices, shipping documents) based on auditor judgment that represents a variety of types
of information from that classification.

Second tier audit firm – An audit firm that is not one of the Big Four (first tier firms), but is
one level below them in terms of revenue, assets, etc.

Segment information – Information in the financial statements regarding distinguishable
components or industry and geographical aspects of an entity.

Segregation of duties – A segregation of the following activities in an organization: custody of
assets, accounting (or recording), and authorization.

Self-interest threat – Occurs when an auditor could benefit from the financial interest in, or
other self-interests conflict with, an assurance client.

675

GLOSSARY Self-review threat – Occurs when (a) when any product or judgment of a previous assurance
engagement or non-assurance engagement needs to be re-evaluated in reaching con-
676 clusions on the assurance engagement; or (b) when a member of the assurance team was
previously a director or officer of the assurance client or was an employee in a position to
exert direct and significant influence over the subject matter of the assurance engagement.

Sensitivity Analysis – A general class of models designed to assess the risk of loss in market-
risk-sensitive instruments based upon hypothetical changes in market rates or prices.

Sequence check – An edit check that determines if a batch of input data is in the proper
numerical or alphabetical sequence.

Service organization – A client may use a service organization such as one that executes
transactions and maintains related accountability or records transactions and processes
related data (e.g. a computer information systems service organization).

Settlement date – The date on which derivative transactions are to be settled by delivery or
receipt of the underlying product or instrument in return for payment of cash.

Settlement risk – The risk that one side of a transaction will be settled without value being
received from the customer or counterparty. This will generally result in the loss to the
bank of the full principal amount.

Side agreements – see Side letters.

Side letters – Agreements made outside the standard company contracts. These otherwise
undisclosed agreements may be signed by senior officers, but not approved by the board of
directors.

Significance – Significance is related to materiality of the financial statement assertion
affected.

Significant risk – A type of business risk that generally relates to judgmental matters and
significant non-routine transactions requiring special audit consideration.

Small entity – A small entity is any entity in which:
(a) There is concentration of ownership and management in a small number of indi-
viduals (often a single individual); and
(b) One or more of the following are also found:
(i) few sources of income;
(ii) unsophisticated record-keeping;
(iii) limited internal controls together with the potential for management override of
controls.

Small entities will ordinarily display characteristic (a), and one or more of the
characteristics included under (b).

Solicitation – An approach to a potential client for the purpose of offering professional services.

Solvency risk – The risk of loss arising from the possibility of the bank not having sufficient
funds to meet its obligations, or from the bank’s inability to access capital markets to raise
required funds.

Special purpose auditor’s report – A report issued in connection with the independent audit
of financial information other than an auditor’s report on financial statements, including:

GLOSSARY

(a) Financial statements prepared in accordance with a comprehensive basis of
accounting other than International Accounting Standards or national standards;

(b) Specified accounts, elements of accounts, or items in a financial statement;
(c) Compliance with contractual agreements;
(d) Summarized financial statements.

Special purpose engagement – An independent audit of financial information other than
financial statements in accordance with IFRS or the national financial reporting standards,
including:
(a) Financial statements prepared in accordance with a comprehensive basis of
accounting other than International Accounting Standards or national standards;
(b) Specified accounts, elements of accounts, or items in a financial statement;
(c) Compliance with contractual agreements;
(d) Summarized financial statements.

Special purpose entity (SPE) – Defined as an entity (e.g. corporation, partnership, trust, joint
venture) created for a specific purpose or activity. SPEs may be used to transfer assets and
liabilities from an entity; accounted for as a gain for that entity. Between 1993 and 2001,
Enron created over 3,000 SPEs.

Speculation – Entering into an exposed position to maximize profits, that is, assuming risk in
exchange for the opportunity to profit on anticipated market movements.

Staff – Individuals, other than the engagement partner, involved in performing engagements,
including any experts employed or engaged by the firm in connection with that
engagement.

Stakeholders – Individuals and entities who have a stake (claim, share, involvement, interest)
in a company. Stakeholders may include shareholders, employees, government, banks, etc.

Standards of proof – Concepts that describe the quality of evidence for most legal systems.
There are four standards of proof: (1) beyond a reasonable doubt, (2) preponderance of
evidence, (3) clear and convincing evidence, and (4) probable cause.

Statistical sampling – see Audit sampling.

Statutory audit – Audits established by law.

Stratification – see Audit sampling.

Stress testing – Testing a valuation model by using assumptions and initial data outside
normal market circumstances and assessing whether the model’s predictions are still
reliable.

Subject matter – In an assurance engagement, the topic about which the assurance is con-
ducted. Subject matter could be financial statements, statistical information, non-financial
performance indicators, capacity of a facility, etc.

Subsequent events – International Accounting Standard 10 identifies two types of events both
favorable and unfavorable occurring after period end:
(a) Those that provide further evidence of conditions that existed at period end;
(b) Those that are indicative of conditions that arose subsequent to period end.

Subsidiary company – A firm in which a controlling interest is owned by another company,
called a parent company.

677

GLOSSARY Substantive procedures – Substantive procedures are tests performed to obtain audit evidence
to detect material misstatements in the financial statements, and are of two types: (a) tests
678 of details of transactions and balances; and (b) analytical procedures.

Substantive testing – see Substantive procedures.

Sufficiency – The measure of the quantity of audit evidence.

Sufficient appropriate audit evidence – Sufficiency is the measure of the quantity (amount) of
audit evidence. Appropriateness is the measure of the quality of audit evidence and its
relevance to a particular assertion and its reliability.

Suitably qualified external person – An individual outside the audit firm with the capabilities
and competence to act as an engagement partner, for example, a partner of another firm or
an employee (with appropriate experience) of either a professional accountancy body
whose members may perform audits and reviews of historical financial information, or
other assurance or related services engagements, or of an organization that provides
relevant quality control services.

Summarized financial statements – An entity may prepare financial statements summarizing
its annual audited financial statements for the purpose of informing user groups interested
in the highlights only of the entity’s financial performance and position.

Summary of procedures description schedule – A schedule which summarizes the result of
audit procedures performed.

Supreme Audit Institution – The public body of a state which, however designated, constituted,
or organized, exercises by virtue of law, the highest public auditing function of that state.

Suspense file – An account used to balance transactions when there is an error, the resolution
of which is not possible at that time.

Sustainability – The set of perceptual and analytic abilities, ecological wisdom, and practical
wherewithal essential to the meshing of human purposes with the larger patterns and flows
of the natural world, and careful study of those patterns and flows to inform human
purposes. As a value, it refers to giving equal weight in your decisions to the future as well
as the present. Actions are sustainable if:

(a) There is a balance between resources used and resources regenerated.
(b) Resources are as clean or cleaner at end use as at beginning.
(c) The viability, integrity, and diversity of natural systems are restored and maintained.
(d) They lead to enhanced local and regional self-reliance.
(e) They help create and maintain community and a culture of place.
(f) Each generation preserves the legacies of future generations.

Swaption – A combination of a swap and an option.

Technical audit quality – The degree to which an audit meets a consumer’s expectations with
regard to the detection and reporting of errors and irregularities regarding the audited
company and its financial statements.

Term structure of interest rates – The relationship between interest rates of different terms.
When interest rates of bonds are plotted graphically according to their interest rate terms,
this is called the “yield curve.” Economists and investors believe that the shape of the yield
curve reflects the market’s future expectation for interest rates and thereby provide
predictive information concerning the conditions for monetary policy.

GLOSSARY

Terms of the engagement – Agreed to conditions or terms to the employment of an auditing
firm by a client to provide a specific service for a given period of time which is generally
recorded in an engagement letter or other suitable form, such as a contract.

Test of reasonableness schedule – A schedule containing information that enables the
auditor to evaluate whether the client’s balance appears to include a misstatement
considering the circumstances.

Tests of control – Tests of control are performed to obtain audit evidence about the
effectiveness of the:
(a) Design of the accounting and internal control systems, that is, whether they are
suitably designed to prevent or detect and correct material misstatements;
(b) Operation of the internal controls throughout the period.

Tests of details of balances – Audit tests that substantiate the ending balance of a general
ledger or line item in a financial statement.

Tests of details of transactions – Audit procedures related to examining the processing of
particular classes of transactions through the accounting system. Tests of transactions are
usually performed for major classes of transactions.

Theory of Inspired Confidence – see Inspired Confidence, theory of.

Third parties – Someone other than the principals directly involved in a transaction or
agreement.

Tick marks – Symbols used by the auditor to indicate the nature and extent of procedures applied
in specific circumstances. Tick marks are notations directly on the working paper schedules.
Tick marks are generally done by hand with a pen or pencil alongside a specific item.

Timing of audit procedures – Timing concerns the day on which audit proceedures occur and
in what sequence. For example, are procedures planned at the end of the period or at an
earlier (interim) date.

Tolerable error – see Audit sampling.

Tort – A wrongful act, damage or injury done willfully, negligently or in circumstances where
liability is strictly applied.

Tracing – An audit procedure whereby the auditor selects sample items from basic source
documents and proceeds forward through the accounting system to find the final record-
ing of the transaction (e.g. in the ledger).

Trading – The buying and selling of financial instruments for short-term profit.

Transaction logs – Reports that are designed to create an audit trail for each on-line trans-
action. Such reports often document the source of a transaction (terminal, time and user)
as well as the transaction’s details.

Transfer risk – The risk of loss arising when counterparty’s obligation is not denominated in
the counterparty’s home currency. The counterparty may be unable to obtain the currency
of the obligation irrespective of the counterparty’s particular financial condition.

Transparency – For corporations, practices that make rules, regulations, and accounting
methods open and accessible to the public. Transparency includes concepts like openness,
reporting and disclosure.

679