Practice Note. 11(Revised) March 2011 THE AUDIT OF CHARITIES IN THE UNITED KINGDOM

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1 March 2011 Practice Note 11(Revised) THE AUDIT OF CHARITIES IN THE UNITED KINGDOM

2 The Auditing Practices Board (APB) which is part of the Financial Reporting Council (FRC), prepares for use within the United Kingdom and Republic of Ireland: Standards and guidance for auditing; Standards and guidance for reviews of interim financial information performed by the auditor of the entity; Standards and guidance for the work of reporting accountants in connection with investment circulars; and Standards and guidance for auditors and reporting accountants integrity, objectivity and independence with the objective of enhancing public confidence in the audit process and the quality and relevance of audit services in the public interest. The APB comprises individuals who are not eligible for appointment as company auditor, as well as those who are so eligible. Those who are eligible for appointment as company auditor may not exceed 40% of the APB in number. Neither the APB nor the FRC accepts any liability to any party for any loss, damage or costs howsoever arising, whether directly or indirectly, whether in contract, tort or otherwise from any action or decision taken (or not taken) as a result of any person relying on or otherwise using this document or arising from any omission from it. The purpose of Practice Notes issued by the APB is to assist auditors in applying auditing standards of general application to particular circumstances and industries. Practice Notes are persuasive rather than prescriptive. However, they are indicative of good practice, even though they may be developed without the full process of consultation and exposure used for auditing standards. This Practice Note replaces Practice Note 11: The audit of charities in the United Kingdom (Revised) which was issued in December # Financial Reporting Council 2011 ISBN

3 PRACTICE NOTE 11 (REVISED) THE AUDIT OF CHARITIES IN THE UNITED KINGDOM Contents Page Preface 3 Introduction 5 Legislative and regulatory framework 6 Charity governing documents Accounting and auditing requirements Reports to third parties Reporting direct to the charity regulators Special features of charities 10 Governance Operating structures and branches Sources of income Restricted funds Charity tax and trading income The audit of financial statements ISAs (UK and Ireland) 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing (UK and Ireland) Agreeing the Terms of Audit Engagements Quality Control for an Audit of Financial Statements The Auditor s Responsibilities Relating to Fraud in an Audit of Financial Statements Section A Consideration of Laws and Regulations in an Audit of Financial Statements 29 Section B The Auditor s Right and Duty to Report to Regulators in the Financial Sector Communication with Those Charged with Governance Communicating Deficiencies in Internal Control to Those Charged with Governance and Management Planning an Audit of Financial Statements 47 1

4 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding of the Entity and Its Environment Materiality in Planning and Performing an Audit The Auditor s Responses to Assessed Risks Audit Considerations Relating to an Entity Using a Service Organisation External Confirmations Initial Engagements Opening Balances Analytical Procedures Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures Related Parties Subsequent Events Going Concern Written Representations Special considerations Audits of Group Financial Statements (Including the Work of Component Auditors) The Auditor s Report on Financial Statements Section A The Auditor s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements 99 Summary Financial Information and Summarised Financial Statements 102 Appendices 1. Charity accounting and audit regulations in the United Kingdom Publications Example paragraphs for insertion into an engagement letter Illustrative example statements of trustees responsibilities The duty of the auditor to report matters of material significance to CCEW and OSCR Legislative background to auditor s reports on charities financial statements Definitions Some significant topics relevant to audits of charities 148 2

5 PREFACE This Practice Note contains guidance on the application of auditing standards issued by the Auditing Practices Board (APB) to the audit of charities in the United Kingdom. The Practice Note is intended to assist auditors in applying the requirements of, and should be read in conjunction with, International Standards on Auditing (ISAs) (UK and Ireland), which apply to all audits undertaken in the United Kingdom in respect of accounting periods ending on or after 15 December This Practice Note sets out the special considerations relating to the audit of charities which arise from individual ISAs (UK and Ireland). The Practice Note does not, and is not intended to, provide detailed guidance on the audits of charities, so where no special considerations arise from a particular ISA (UK and Ireland), no material is included. This Practice Note supersedes the guidance included in Practice Note 11 The audit of charities in the United Kingdom (Revised) issued by the APB in December 2008, and takes account of significant regulatory and other developments affecting charities since that date, including: new ISAs (UK and Ireland) which were published in October 2009; the Charities Accounts (Scotland) Amendment Regulations 2010; the Charities Act (Northern Ireland) 2008, where references to specific requirements are given in anticipation of these being commenced. The legal framework for charities is complex and different requirements exist depending on the charity s constitution, the part of the UK in which it is established and the type of activity it undertakes. The Practice Note contains guidance for auditors; the APB s intention is not to provide a comprehensive commentary on all aspects of law that may apply to a charity s operations, and the Practice Note should not be used as a substitute for appropriate consultation with legal advisers. The Practice Note is based on the legislation and regulations that have been published at 28 February Further changes to the legislative framework are anticipated but are not addressed in this guidance including: the introduction of a new form of charity, a Charitable Incorporated Organisation (CIO); consolidation of charity legislation in England and Wales in a new Charities Act; changes to the regulation of charities in Northern Ireland; and changes to reporting thresholds. 3

6 This Practice Note has been prepared with advice and assistance from staff of the Charity Commission for England and Wales (CCEW), the Office of the Scottish Charity Regulator (OSCR), and the Charity Commission for Northern Ireland (CCNI). 4

7 INTRODUCTION 1. The purpose of this Practice Note is to give guidance on the application of ISAs (UK and Ireland) to the audit of charities in the United Kingdom. The following paragraphs identify the special considerations arising from the application of the requirements of ISAs (UK and Ireland) to the audit of charities, and to suggest ways in which these can be addressed. Extracts from ISAs (UK and Ireland) are indicated by grey-shaded boxes below. This Practice Note does not contain commentary on all of the requirements included in the ISAs (UK and Ireland) and reading it should not be seen as an alternative to reading the relevant ISAs (UK and Ireland) in their entirety. In addition, where no special considerations arise from a particular ISA (UK and Ireland), no material is included. 2. Audits of charities required by legislation in the United Kingdom may only be carried out by a registered auditor, or other persons authorised by statute or to whom, in England and Wales, the Charity Commission (CCEW) may grant dispensation 1. Registered auditors are required to comply with ISAs (UK and Ireland) when conducting audits. This principle applies to charity audits, irrespective of their size, but the way in which the standards are applied needs to be adapted to suit the particular characteristics of the entity audited. 3. Where an audit is being performed on an entity within the Public Sector in the United Kingdom this Practice Note complements Practice Note 10: the Audit of Financial Statements of Public Sector Bodies in the United Kingdom (Revised). 4. Audit exemption thresholds are established in UK legislation and an independent examination will often be permitted instead of an audit. Guidance on the conduct of independent examinations in England and Wales has been published by CCEW 2 and best practice guidance on independent examination of Scottish Charities has been prepared by the Office of the Scottish Charity Regulator (OSCR) 3. An independent examination is significantly different from an audit: in particular the independent examiner must be an individual rather than a firm. Independent examiners of certain charities 4 must hold professional qualifications, as specified in the relevant legislation, but there is no requirement for the independent examiner to be a registered auditor. This Practice Note does not provide guidance on independent examinations. 1 The dispensation arises where a charity is audited under another statutory regime which is considered sufficiently similar to the audit requirements of the Charities Act 1993 or audited under arrangements which are sufficiently similar. CCEW can also give a dispensation from audit under the Charities Act 1993 in exceptional circumstances allowing an independent examination in place of an audit. 2 CC32 Independent Examination of Charity Accounts: Examiners Guide. 3 Independent Examination: Guidance for charities and independent examiners 4 Requirements for external scrutiny of financial statements are set out in Appendix 1. 5

8 LEGISLATIVE AND REGULATORY FRAMEWORK 5. The legal framework for charities is complex, and different requirements exist depending on the charity s constitution, the part of the United Kingdom in which the charity is established, or is active, and the type of activity which it undertakes. In addition, charities are affected by the whole range of national legislation applicable to business entities, such as employment, tax and pensions law and health and safety regulations. 6. The main laws that relate to a charity s financial statements and audit are: All company charities: the Companies Act 2006 (CA 2006) Charities in England and Wales; the Charities Act 1993 (as amended by the Charities Act 2006); All charities registered in Scotland with OSCR: the Charities and Trustee Investment (Scotland) Act 2005 (2005 Act (Scotland)); Non-company charities in Northern Ireland: the Charities Act (Northern Ireland) 1964; All charities registered in Northern Ireland with the The Charity Commission for Northern Ireland (CCNI): the Charities Act (Northern Ireland) 2008, as and when the relevant sections of the Act are commenced. 7. The legal requirements in relation to accounting and audit for charities in Scotland and Northern Ireland differ in some respects from those applicable in England and Wales, and it is important for auditors to understand what legislation applies. The legislation relating to accounting and audit applicable to each jurisdiction in the United Kingdom is summarised in Appendix 1 Charity accounting and audit regulations in the United Kingdom. 8. The regulatory framework is also complex. The primary regulators for charities (which are referred to as the charity regulators in this Practice Note) are: England and Wales: the Charity Commission (CCEW); Scotland: Office of the Scottish Charity Regulator (OSCR); Northern Ireland: The Charity Commission for Northern Ireland (CCNI). Appendix 1 to this Practice Note provides a summary of the regulatory framework for each of these jurisdictions. Additionally some charities may also be subject to other regulatory regimes, for example, housing associations 5 and higher and further education establishments. 5 Practice Note 14 deals with the audit of registered social landlords in the UK. 6

9 9. CCEW has powers under legislation to act for the protection of charity property where in the course of an inquiry it is satisfied that there has been misconduct or mismanagement in the administration of a charity, or that it is necessary to act for the purposes of protecting the property of a charity or to secure its proper application for the purposes of the charity. These powers include: issuing directions to the trustees; suspension of any trustee, officer, agent or employee; appointment of additional trustees; removal of a trustee, officer, agent or employee; freezing of property, restrictions on transactions or payments; and appointment of an interim manager. In Scotland, OSCR has similar powers under sections 28, 31 and 34 of the 2005 Act (Scotland). In Northern Ireland, CCNI will have similar powers under section 33 of the Charities Act (Northern Ireland) 2008, once that section has been commenced. 10. Charities with significant operations in Scotland but established in another jurisdiction are required to register separately with OSCR and to comply with the 2005 Act (Scotland) and regulations made thereunder. OSCR has prepared guidance on registration entitled Seeking charitable status in Scotland 6. The guidance includes a number of selfassessment questions to assist in determining whether registration with OSCR is required and, although it refers to English and Welsh charities, the principles apply to Northern Irish charities with operations in Scotland. OSCR introduced a bespoke monitoring programme for English and Welsh charities that are entered on the Scottish Charity Register in May In addition to relevant charities legislation and regulations, charities may be subject to other regulatory regimes. Examples of bodies which, when constituted as charities, may be subject to additional and/or different accounting and audit requirements include companies, registered social landlords, friendly societies, non-departmental public bodies (NDPBs), universities and further education colleges. Statements of Recommended Practice (SORPs) are issued in relation to a number of such sectors, and need to be taken into account in preparing charities financial statements. Charity governing documents 12. The governing documents of charities establish the purpose and constitution of each charity. They may also require an audit to be undertaken (which may supplement, but not 6 The full title is Seeking charitable status in Scotland: Guidance for England and Wales charities on registration with the Office of the Scottish Charity Regulator. 7

10 derogate from, a statutory requirement for an audit). There is no such thing as a standard charity; the governing documents of each charity are individual and will need careful consideration to identify matters relevant to the audit such as particular charitable objects and any special powers conferred on the trustees. 13. The terms of charities governing documents tend to be narrower than those for commercial entities, the objects of which are usually very generally phrased. This means that the auditor is much more likely to be faced with a situation where a charity has acted ultra vires or in breach of trust than would be the case with an entity in the commercial sector. 14. Any transaction by a charity that is undertaken outside its objects and powers is potentially a breach of trust. Such transactions require particular consideration. Noncompliance with the governing document is also likely to have financial implications for the charity, and thus needs to be taken into account in determining whether the financial statements give a true and fair view. Charities are broadly exempt from direct tax on their income where expenditure is applied for a charitable purpose and therefore if transactions are outside the objects, or they involve significant benefit to the donor (i.e. tainted donations), there may also be tax implications. In addition such transactions may give rise to a need to report the matter to the charity regulator. Accounting and auditing requirements 15. The financial statements of a charity which are prepared to give a true and fair view under the requirements of the Charities Act 1993, the 2005 Act (Scotland), or the Charities Act (Northern Ireland) 2008 (when the relevant sections are commenced) are required to be prepared in accordance with UK Generally Accepted Accounting Practice (UK GAAP) 7. Additionally, charitable companies comply with company legislation which requires accounts to be prepared in accordance with applicable law and regulations, and UK accounting standards. 16. UK GAAP comprises law and accounting standards issued by the Accounting Standards Board, including where applicable the FRSSE. Charities cannot currently apply International Financial Reporting Standards. 17. The Statement of Recommended Practice Accounting and Reporting by Charities (the Charities SORP) is an interpretation of UK accounting standards for the charity sector and is intended to apply to the accounts of all charities in the United Kingdom required to give 7 Trustees of small non-company charities in England and Wales and Scotland which are within the income thresholds defined by legislation may elect to prepare financial statements on a receipts and payments basis. Financial statements prepared on a receipts and payments basis are not required to give a true and fair view, but to be properly presented. 8

11 a true and fair view (unless a separate SORP exists for a particular class of charities 8 ). The Charities SORP issued in March 2005 by CCEW and other SORPs relevant to particular categories of charities are likely to be revised once the ASB proposals for the future of UK GAAP including the adoption of IFRS for SMEs are implemented and the proposed Public Benefit Entities standard is published. Since the publication of the Charities SORP, FRS 30: Heritage Assets, which has particular relevance to the recognition of some charity assets, has also been published and applies to accounting periods beginning on or after 1 April FRS 18 Accounting Policies requires an entity to adopt the most appropriate accounting policies to its particular circumstances for the purpose of giving a true and fair view in preparing financial statements. For charities it is normally necessary to follow the guidance set out in the Charities SORP in order to give a true and fair view, as required by legislation. A statement that the financial statements have been prepared in accordance with the relevant SORP, and details of any departures from the recommended practice and disclosures is also required. 19. Apart from any requirement for audit in the governing document, the statutory requirement for audit depends on the size of the charity, as defined in relevant legislation or regulations. Audit exemption thresholds are described in Appendix 1. For company charities the interaction between the thresholds established in CA 2006, the Charities Act 1993, the regulations made under the 2005 Act (Scotland) and the 2008 Northern Ireland Act need to be considered. Charities registered in both England and Wales and Scotland will report under both the English and Welsh legislation and the Scottish legislation. 20. A number of non-departmental public bodies are charities. The auditors of such bodies are responsible for expressing an opinion on both the view given by the body s financial statements and on whether the expenditure of the body is in accordance with the purposes intended by Parliament 9. Furthermore, for some bodies where the auditor is appointed by the Secretary of State, there may be a requirement in the auditor s terms of engagement for it to report to the sponsor department any significant matters arising out of the audit work, including losses incurred owing to failures of internal control, misconduct, fraud or other irregularity. Reports to third parties 21. In addition to the auditor s report on the financial statements, auditors of charities may be requested to provide additional reports in relation to grant-funded projects, giving 8 Where sector specific SORPs exist e.g. for Registered Social Landlords, and Further and Higher Educational Institutions, the specialist SORP takes precedence. 9 Practice Note 10 (Revised) provides guidance for auditors of public bodies on reporting on the regularity of expenditure. 9

12 assurance on matters such as the proper use of money and costs to completion. This Practice Note does not cover such additional engagements 10. Reporting direct to the charity regulators 22. In addition to the primary objective of reporting on financial statements, auditors of charities may have an additional statutory duty to report in certain circumstances to the relevant charity regulator. This duty is discussed in the section giving guidance on ISA (UK and Ireland) 250 section B: The Auditor s Right and Duty to Report to Regulators in the Financial Sector. SPECIAL FEATURES OF CHARITIES 23. There is a great diversity of charities in terms of constitution, activity and size. The smallest are local, single activity operations sometimes run by trustees with limited financial expertise, whereas the largest are international organisations with multiple activities, employing many full-time professional staff and operating sophisticated accounting systems. Despite this diversity there are special features of charities which will influence the planning and performance of all charity audits. Governance 24. Although the detail of regulation differs between different parts of the United Kingdom, the general principles governing the duties of trustees are the same regardless of what they are called in the charity s governing document 11. Trustees: have the general duty of protecting all the charity s property; ensure that all the charity s funds are properly applied; are responsible for the solvency and continuing effectiveness of the charity and the preservation of any permanent endowments; and must exercise control over the charity s financial affairs. Principles and guidance for governance in the charity sector is contained in a document Good Governance: a Code for the Voluntary and Community Sector which was published in October Trustee duties and responsibilities 12 include, but are not limited to: 10 Guidance has been provided by ICAEW in AAF 1/10 Framework document for accountants reports on grant claims. 11 Charity trustees are defined in legislation as the persons having the general control and management of the administration of a charity. 12 Comprehensive information regarding trustees duties and responsibilities is set out in guidance issued by the charity regulators. 10

13 where a particular function is delegated to staff or third parties, monitoring the performance of the delegated function and clearly setting out the scope and limits of the delegated authority; acting in accordance with the charity s governing document, in particular, the income and property of the charity must be applied for the purposes set out in the governing document and, in the case of any restricted fund, within the particular trusts attaching to that fund, and for no other purpose; acting reasonably and prudently in the charity s interests only and without regard to their own private interests; not deriving remuneration or benefit personally from the charity unless legally permitted to do so; maintaining proper accounting records and preparation of accounts required by the regulatory regime under which they operate; being able and willing to give time to the efficient administration of the charity and the fulfillment of its trusts. In addition, trustees are required to have regard to the regulators guidance on how charities meet the public benefit requirement. 26. Trustees may not profit out of transactions with the charity or receive any remuneration or benefit from it unless there is provision for this in the charity s governing document 13, or the transaction is authorised by the relevant public authority, (in England and Wales usually CCEW), or the statutory conditions relating to the supply of services by trustees, set out in paragraph 210 below are met. 27. It is possible for employees to be appointed as trustees if this is provided for in a charity s governing document or, in England and Wales, is otherwise authorised. Typically, the authority will draw a clear distinction between their functions as employees, conducting the operations of the charity in accordance with the trustees policy, for which they may be paid, and time spent acting as trustees, to which the remuneration authority would not usually extend 14. Similarly, professionally qualified trustees may only charge the charity for their firm s or their own professional services if the conditions set out above are applicable. 28. The Charities SORP and the Regulations in both England and Wales and Scotland require the accounts of a charity to disclose most transactions between the trustees and the charity, and trustee remuneration or benefits from the charity, whether authorised or 13 For charities registered in Scotland, the authorising provision would have to have been in force on 15 November In Scotland the authority applies to all services as there is no distinction drawn. 11

14 not. The disclosure requirements are widely drawn to include a person connected with a charity trustee and companies or institutions connected with the charity. 29. Charity trustees are usually unpaid and part-time, and governance structures can be very varied. In planning the audit, the auditor needs to understand the nature of the charity s governance and the influence that this has on the control environment of the charity (see ISA (UK and Ireland) 315) and on reporting to those charged with governance (see ISA (UK and Ireland) 260). 30. Charity trustees need to meet a fit and proper persons test in order to ensure that the charity is able to take advantage of charity tax reliefs. Consequently charities will take steps to ensure that their trustees meet this test and comply with the guidelines set out by HMRC. Operating structures and branches 31. Charities can adopt a variety of organisational structures including: a single centrally administered organisation; a centrally administered organisation with branches both in the UK and overseas; and a parent charity with a group structure including subsidiaries, joint ventures and associates. A charity may operate through branches to raise funds or carry out particular aspects of its charitable activities. The principles as to whether branches in the charity s wider structure are accounted for as part of the charity are set out in the Charities SORP and these apply whether operations are carried out in the UK or overseas. In England and Wales separate charities may in certain circumstances account as one entity where a uniting direction has been issued by CCEW. Such entities will normally be listed as subsidiary registrations by CCEW. 32. Some charities will use the term branches outside of its Charities SORP meaning to describe a network of charities which are administratively autonomous and as such are separate accounting entities. The constitutional provisions in such cases may require careful consideration. Audits of independent (or autonomous) branches are regarded as separate engagements where a separate opinion is required. 33. Sometimes charities enter into joint venture situations whereby two or more charities jointly control an entity, or undertake joint arrangements in partnership to carry out an activity. The structure adopted in such arrangements may be differentiated from participating interests in associates. The Charities SORP provides guidance on this issue and the accounting methods to be adopted. 12

15 34. The terms on which branches raise funds will also be relevant to determining the accounting policies of a charity. Local appeals may be for specific purposes, and where this is the case such funds will be restricted in the accounts of the main charity. The Charities SORP requires non-autonomous branches (see definition in Appendix 7 of this Practice Note) to be accounted for in the entity s financial statements and for consolidated financial statements to be prepared in group situations. Sources of income 35. Sources of income (other than trading income) giving rise to particular audit issues include: cash donations; legacies; gifts in kind and donated services; contractual income; and grants, for example from public authorities or other charities. Donations may be made tax-effectively, through gift aid, payroll giving, and gifts of land and shares. For most tax effective schemes, and especially for gift aid, there are detailed requirements relating to the procedures to be followed by donors and recipient charities, as well as detailed rules designed to prevent abuse (for instance the reciprocal benefit limits). The auditor considers the implications of the significance of these income streams and adapts the audit procedures accordingly. 36. The completeness of recorded donation income can be difficult to substantiate as such income will not always be supported by invoices or equivalent documentation. Where cash donations are received, the trustees need to make arrangements to institute appropriate controls, to the extent practicable, to ensure that all income is properly accounted for. Evidence concerning the effectiveness of such controls can be used in assessing the sufficiency of evidence about the completeness of the income shown in the charity s financial statements. 37. The use of autonomous branches, agents or loosely affiliated volunteer groups for fundraising needs to be considered when determining the appropriate method of income recognition for donations The Charities SORP states that income recognition is dependent on entitlement, certainty of receipt and the monetary value being measurable with sufficient reliability. 13

16 38. Trustees need to understand the terms attaching to legacies in order to consider the application of the charity s income recognition policies. The valuation of donations in kind also needs consideration. 39. An understanding of the conditions underlying contractual or grant income is necessary to determine the proper accounting treatment. As well as distinguishing whether the income is restricted or not, the nature of the terms and conditions may affect taxation considerations (for example, the Value Added Tax (VAT) treatment). 40. Income received under contract is unrestricted income while grants for the provision of a specific service normally represent restricted income. However the terminology used to describe funding arrangements can differ, particularly in relation to international charities, and an understanding of the nature of all significant funding arrangements is necessary to determine the proper accounting treatment. 41. Grants are often made for specific purposes and are subject to conditions, breach of which can have serious implications for the charity. Developments in the public sector mean that the auditor of a public authority donor may have, or seek, the right of access to the charity s records to follow through and verify the use made of the grant. In addition grants from public bodies are increasingly subject to claw back provisions requiring repayment if a charity breaches specified conditions. Restricted funds 42. Restricted funds are subject to specific trusts, which may be declared by the donor or created through legal process. They may be restricted income funds (which are expendable at the discretion of the trustees in furtherance of some particular aspect of the objects of the charity) or they may be endowments (where the assets are required or permitted to be invested or retained for future use see Charities SORP definition of restricted funds in Appendix 7). If restricted funds are used other than in the way specified, the trustees of the charity will have breached their duty. 43. The Charities SORP indicates that restricted funds are to be separately disclosed in the charity s financial statements. Consequently, the auditor considers whether restrictions are likely to exist as part of the planning process and when assessing the presentation of funds in a charity s balance sheet. The auditor also establishes whether it may be requested to issue a special donor report in respect of grants or restricted funds. Charity tax and trading income 44. Whilst charities do not enjoy a general exemption from direct taxation, there are significant tax exemptions available to charities both in relation to income and chargeable gains, as well as certain indirect taxes. The auditor needs to have an understanding of these statutory exemptions and extra-statutory concessions in order to identify activities that may fall outside their scope. Especially where income is receivable that does not fall within such reliefs, a charity can be exposed to significant tax liabilities. 14

17 45. Gift aid is an important source of income for many charities, and trustees need to ensure that the charity is complying with the strict rules set out by HMRC for its proper operation. In particular, the completeness of documentation and audit trails, and any transactions with, or benefits passing to, the donor or connected persons will need careful consideration. HMRC may consider the implications for operating gift aid where a charity s activities are not fulfilling the public benefit test, or where the trustees do not meet the fit and proper persons test The existence of trading activities can affect the charity s compliance with laws and regulations, potential tax liabilities and, in some cases, can give rise to matters to be reported to the relevant charity regulator as a result of the auditor s statutory duty to report. Trading by charities falls into two main categories primary purpose trading (also known as charitable trading) which is generally exempt from direct taxation; and trading to raise funds for charitable purposes, which is generally not exempt from direct taxation unless the trade falls within the exemptions available for small trades or the concessions made for charity fundraising events. 47. Primary purpose trading is the exercise of a trade in the course of the actual carrying out of a primary purpose of a charity, for example the charging of fees by a school which is established as a charity for the advancement of education. The tax exemption available on primary purpose trading also extends to trades where the work is mainly carried out by the beneficiaries of the charity and the remedial or educational value of the work to the beneficiaries can be demonstrated. 48. Charitable trading may also extend beyond primary purpose activities to incorporate ancillary trading. Ancillary trading, which contributes indirectly to the successful furtherance of the purposes of the charity, is treated as part of primary purpose trading for both charity law and tax purposes. An example of ancillary trading is the sale of food and drink in a restaurant or bar by a theatre charity to members of an audience. 49. Trading for fundraising purposes and other non-charitable trading activities, where undertaken directly by a charity on a substantial or regular basis, may be contrary to charity law and the profits may be liable to income or corporation tax. If a relevant power exists a charity may trade on a small scale for fundraising purposes. 50. Substantial permanent trading for fundraising purposes would also be incompatible with charitable status, and generally such trades would be hived off to a wholly-owned subsidiary company. Similarly, a failure to apply such income or gains for charitable 16 This requirement was introduced by Section 30 and Schedule 6 of Finance Act HMRC have issued detailed guidance on how HMRC applies this test. 15

18 purposes only can result in loss of tax relief. The impact of a tax assessment, perhaps going back a number of years, may affect a charity s ability to conduct its business. 51. Charities enjoy no general exemption from VAT, which can apply to a range of goods and services supplied in the course of business. Certain primary purpose trading activities as well as trading for fundraising purposes can fall within the meaning of business activity for VAT purposes. Many areas in which charities operate, such as the supply of certain educational, health and welfare services, may be exempt from VAT, and a number of special reliefs also apply specifically to charities 17. Non-compliance or errors could have adverse financial consequences for the charity. 17 A number of specific exemptions and zero-rating treatments may be available in relation to supplies by and to a charity. 16

19 THE AUDIT OF FINANCIAL STATEMENTS ISAs (UK and Ireland) apply to the conduct of all audits. This includes audits of the financial statements of charities. The purpose of the following paragraphs is to identify the special considerations arising from the application of certain requirements to the audit of charities, and to suggest ways in which these can be addressed (extracts from ISAs (UK and Ireland) are indicated by grey-shaded boxes below). This Practice Note does not contain commentary on all of the requirements included in the ISAs (UK and Ireland) and reading it should not be seen as an alternative to reading the relevant ISAs (UK and Ireland) in their entirety. Where no special considerations arise from a particular ISA (UK and Ireland), no material is included. ISA (UK AND IRELAND) 200: OVERALL OBJECTIVES OF THE INDEPENDENT AUDITOR AND THE CONDUCT OF AN AUDIT IN ACCORDANCE WITH INTERNATIONAL STANDARDS ON AUDITING (UK AND IRELAND) This International Standard on Auditing (UK and Ireland) (ISA (UK and Ireland)) deals with the independent auditor s overall responsibilities when conducting an audit of financial statements in accordance with ISAs (UK and Ireland). Specifically, it sets out the overall objectives of the independent auditor, and explains the nature and scope of an audit designed to enable the independent auditor to meet those objectives. It also explains the scope, authority and structure of the ISAs (UK and Ireland), and includes requirements establishing the general responsibilities of the independent auditor applicable in all audits, including the obligation to comply with the ISAs (UK and Ireland). The independent auditor is referred to as the auditor hereafter. (paragraph 1) In conducting an audit of financial statements, the overall objectives of the auditor are: (a) (b) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and To report on the financial statements, and communicate as required by the ISAs (UK and Ireland), in accordance with the auditor s findings. (paragraph 11) 17

20 In all cases when reasonable assurance cannot be obtained and a qualified opinion in the auditor s report is insufficient in the circumstances for purposes of reporting to the intended users of the financial statements, the ISAs (UK and Ireland) require that the auditor disclaim an opinion or withdraw (or resign) 18 from the engagement, where withdrawal is possible under applicable law or regulation. (paragraph 12) The auditor shall plan and perform an audit with professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. (paragraph 15) 52. A fundamental principle is that practitioners shall not accept or perform work which they are not competent to undertake. The importance of technical competence is also underlined in the Auditor s Code, issued by the APB, which states that the necessary degree of professional skill demands an understanding of financial reporting and business. Practitioners do not undertake the audit of a charity unless they are satisfied that they have, or can obtain, the necessary level of competence. The auditor s responsibilities in this respect are not related to the level of fee charged for the audit. For example, the same levels of rigour are required in respect of audits carried out on an honorary basis as for audits carried out for a commercial fee and the engagement partner has a responsibility for being satisfied and able to demonstrate that the audit engagement has assigned to it sufficient partners and staff with appropriate time and skill to perform the audit in accordance with all applicable Auditing and Ethical Standards ISAs (UK and Ireland) include a requirement for auditors to comply with relevant ethical requirements relating to audit engagements. In the United Kingdom, the auditor complies with the APB s Ethical Standards (ESs) and relevant ethical guidance relating to the work of auditors issued by the auditor s professional body. 54. Particular issues that the audit engagement partner of a charity has regard to when assessing possible threats to the independence and objectivity and the nature and extent of the safeguards to be applied include: self interest in addition to financial interests, the auditor needs to be aware of other interests in a charity which may affect the conduct or outcome of the audit. The auditor therefore ensures that none of the audit team is in any way dependent upon the charity or are involved in providing significant support to the charity. 18 In the ISAs (UK and Ireland), only the term withdrawal is used. 19 ES 4 (Revised), paragraph 5. 18

21 self-review auditors will often be asked to provide additional help and advice, often on a pro bono basis. The provision of this service is regarded in the same way as other non-audit services in assessing whether there is a threat to objectivity. The ESs include a small number of additional requirements that apply to the audits of listed companies 20. ES 1 establishes that an audit firm s policies and procedures will set out the circumstances in which these additional requirements apply to the audits of nonlisted clients (which may include some charities), taking into consideration the nature of the entity s business, its size, the number of its employees and the range of its stakeholders. 55. Where safeguards include the review by an engagement quality control reviewer, that reviewer will have sufficient knowledge of the charity regulatory framework to enable a meaningful review to be completed. 20 These are set out in paragraph 46 of ES 1 (Revised). 19

22 ISA (UK AND IRELAND) 210: AGREEING THE TERMS OF AUDIT ENGAGEMENTS Objective The objective of the auditor is to accept or continue an audit engagement only when the basis upon which it is to be performed has been agreed, through: (a) (b) Establishing whether the preconditions for an audit are present; and Confirming that there is a common understanding between the auditor and management and, where appropriate, those charged with governance of the terms of the audit engagement. (paragraph 3) The auditor shall agree the terms of the audit engagement with management or those charged with governance, as appropriate. (paragraph 9) Subject to paragraph 11, the agreed terms of the audit engagement shall be recorded in an audit engagement letter or other suitable form of written agreement and shall include: (a) The objectives and scope of the audit of the financial statements; (b) The responsibilities of the auditor; (c) The responsibilities of management 2b ; (d) Identification of the applicable financial reporting framework for the preparation of the financial statements; and (e) Reference to the expected form and content of any reports to be issued by the auditor and a statement that there may be circumstances in which a report may differ from its expected form and content. (paragraph 10) If law or regulation prescribes in sufficient detail the terms of the audit engagement referred to in paragraph 10, the auditor need not record them in a written agreement, except for the fact that such law or regulation applies and that management acknowledges and understands its responsibilities as set out in paragraph 6(b). (paragraph 11) 2b In the UK and Ireland, the engagement letter sets out the responsibilities of those charged with governance. 20

23 56. The same basic principles used in drafting engagement letters apply in relation to the audit of charities as to the audit of any entity. Practical considerations arising from the particular characteristics of charities are considered below. 57. The terms of the engagement are to be agreed with management or those charged with governance. In the case of a charity the auditor agrees the terms of the audit engagement with the trustees of the charity and address the letter of engagement to the trustees. 58. The auditor may consider checking that all the trustees receive a copy of the letter. If the trustees are not engaged in the day-to-day running of the charity, the auditor may wish to send a copy of the engagement letter to the chief executive or the persons responsible for its day-to-day management, together with a more detailed description of the audit work to be undertaken and any client assistance to be given. 59. Matters that will normally be included in an engagement letter for a charity are: the legislative framework under which the financial statements are prepared and the audit is conducted 21 ; the statutory duty to report to the charity regulators any matters of which the auditor becomes aware that may be of material significance to the respective regulators; access to information, recognising that not all charities are constituted as limited companies (for which the auditor s rights of access are enshrined in company law). 60. Trustees may issue other reports to stakeholders in addition to the annual report required by statute. For example, they may provide summary reports and financial statements, and periodic newsletters. Where this is the case, the engagement letter also sets out the auditor s responsibilities, if any, in respect of such other reports. 61. It is the responsibility of the trustees to identify the need for any additional reports required by funders and to instruct the auditor accordingly: it will not be practicable for the auditor to check the documentation relating to all funds received by the charity to identify any conditions requiring special reports. However, the auditor may consider it appropriate to enquire of the trustees whether any reports are required in addition to the auditor s report on the charity s financial statements. Separate engagement letters will be obtained for non-audit work undertaken on behalf of the charity or its trustees. 21 Scottish charity law requires the auditor or independent examiner to consider the Trustees Annual Report and to state whether or not the report meets the requirements of the regulations and an opinion, where they have formed one, that there is a material inconsistency between the annual report and the rest of the statement of account. Although there is some legal uncertainty, the Scottish Government has given a provisional view that the Annual Report is outside the scope of the true and fair view, and have said that they will clarify the legislation on this point when a suitable legislative vehicle is available. 21

24 On recurring audits, the auditor shall assess whether circumstances require the terms of the audit engagement to be revised and whether there is a need to remind the entity of the existing terms of the audit engagement. (paragraph 13) 62. ISA (UK and Ireland) 210 sets out a number of reasons as to why an engagement letter will be revised on a recurring audit 22. In the case of charities, these reasons are also applicable including changes in the legal and regulatory framework or a new SORP. Appendix 3 sets out example paragraphs for an engagement letter for the audit of: England and Wales: non-company (accruals basis); England and Wales: non-company (receipts and payments basis); England and Wales: company; Scotland: non-company (accruals basis); Scotland: non-company (receipts and payments basis); Scotland: company; Cross-border charity. 22 Paragraph A28 of ISA (UK and Ireland)

25 ISA (UK AND IRELAND) 220: QUALITY CONTROL FOR AN AUDIT OF FINANCIAL STATEMENTS Objective The objective of the auditor is to implement quality control procedures at the engagement level that provide the auditor with reasonable assurance that: (a) The audit complies with professional standards and applicable legal and regulatory requirements; and (b) The auditor s report issued is appropriate in the circumstances. (paragraph 6) The engagement partner shall be satisfied that the engagement team, and any auditor s experts who are not part of the engagement team, collectively have the appropriate competence and capabilities to: (a) (b) Perform the audit engagement in accordance with professional standards and applicable legal and regulatory requirements; and Enable an auditor s report that is appropriate in the circumstances to be issued. (paragraph 14). Staff capabilities, competence 63. Competence is emphasised in the Auditor s Code. As well as ensuring that the engagement team has an appropriate level of knowledge and experience of the charity sector (including the legislation, which is increasingly complex), the engagement partner also satisfies himself that the members of the engagement team have sufficient knowledge, commensurate with their roles in the engagement, of: (a) the Charities SORP; (b) the governing document of the charity; (c) the legal responsibilities and duties of charity trustees; (d) the regulatory framework within which charities operate to identify situations which may give them reasonable cause to believe that a matter must be reported to a charity regulator. Engagement Quality Control Reviews 64. International Standard on Quality Control (UK and Ireland) 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and 23

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