Auditing - Lecture notes - Auditing - Lecture notes, lectures 1 - 10 PDF

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MGT 304 – Auditing Introduction, scope and purposes of auditing An auditor is only undertaken on a sample of the full account so a guarantee cannot be made that the accounts are free from fraud or error. In recent years, audit reports now include the signature of the auditor so show responsibility for the audit. Most of the time the audit report says the same thing, as long as the company met the standards. However, more recently the audit reports are much longer and more detailed such as potential risks and outline what the auditor did. There is more criteria to be met by the auditor since the collapse of banks following an accepted audit. Note Re audit exemption  

Some small and medium sized companies may be exempt from an audit (although one can be requested by shareholders)

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New limits from 1 Oct 2012 – companies are eligible for exemption if meet 2 from 3 of the following 

Turnover less than £6.5million 

No more than 50 employees 

No more than £3.26million on balance sheet

Public companies and banks and insurance companies cannot be exempt no matter what size

Potential changes to audit exemption limits 

As a result of EU directive 

Limits potentially to be raised 

Watch out for updates in the press

What is an audit? A systematic process of objectively gathering and evaluating evidence in order to ascertain whether assertions about economic actions and events made by individuals or organisations correspond with established criteria and communicating the results of the examination to users of the reports in which the assertions are made An audit in respect of the financial statements for a company Distinction between accounting and auditing  

Accounting – identifies, organises, classifies, summarises and communicates information about economic events. it is a creative process Auditing – gathers and evaluates evidence with respect to these events. It is an evaluative process.

Relationship of managers, shareholders and auditors  

Managers manage a company on behalf of owners (shareholders) Owners (shareholders) may/may not work for the company

Do the accounts of the company, prepared by the managers, show a true and fair view? How do the

owners know? The company is independently audited and the auditors’ report on the accounts. The report is addressed to the owners. Why is an audit needed?  

Split of ownership and management (accountability?). Auditor will ensure that the company is acting within the best interest of the shareholders. Regulations and laws. Companies Act 2006, Financial Reporting Council and International Auditing Standards

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Impractical (complexity/remoteness) and not possible (no legal access) for owners to review accounts 

Auditor reports on whether proper books and records kept, any weaknesses in accounting systems – to do this, auditor reviews accounting records, controls, ask for explanations, confirmation from third parties.

Understanding audit – a control system Gives credibility to financial information so are 3 types of control: 

Preventative control: encouraged to do accounts to a better standard to start with

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Detective control: looks for human error 

Reporting control: any material errors identified will be told to the manager to change. If they do not change them, it will have to be outlined in the audit report.

The market value of an external audit 

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“To foster effective audits that improve the reliability of financial statements, enhance their credibility, contribute to investors confidence in the profession, and improve the efficiency of the capital markets”. Panel on Audit Effectiveness (2000) “Without accountants to ensure the quality and integrity of financial information, the markets for capital would be higher and our standard of living would be lower” Wallman, ex SEC Commissioner

Types of audit 

Depends on who the audit is for (beneficiary)

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Depends on the reason for the audit (objective) 

Needs to consider the context

Classification of audits by their beneficiary 

External : undertaken by professionally qualified and externally accredited auditors who are external to the audited business. These are to benefit the shareholders and market efficiency 

Internal: traditionally undertaken by the company’s own staff or an auditing firm different from main auditor. These are to benefit the management. Large companies have their own audit department who ensure accounts are good

Classification by their objective

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Financial statement (certification) audits: involve the examination of an entities F/S which have been prepared by managers and directors for the benefit of shareholders Compliance audits: aim to determine

whether an individual or an entity has acted in accordance with procedures/regulations set by an authority 

Operational audits: involve the systematic examination and evaluation of an entities operations for the purpose of improving the efficiency and/or effectiveness of the entity. Known as ‘value for money’ audits. Expansion of thought of auditing and wider society.

Brief history of the development of auditing objectives Purpose of review? To consider shifts in focus…….close link between: 

changes in socio-economic environment (in particular changes in characteristics and accountability expected of enterprises) and

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changes in audit objectives and techniques.

Development of corporate auditing (Porter et al 2014 pg 24) 

Pre-1844 – detection of fraud (BS only audited) 

1844-1920s – detection of fraud, errors; determination of insolvency (BS dominant); 

1920s-1960s - lending credibility to financial statements provided by management, move away from fraud detection, etc. (P&L a/c emphasised more).

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1960s-1990s, as 1920s-1960s, but also provision of management advisory services.

1990 – present 

Lending credibility to financial and non-financial information provided by management in annual reports.

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Provision of management advisory services. 

Increased responsibility for detecting fraud and reporting doubts about “going concern”.

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Helping to secure responsible corporate governance. 

Reporting to regulatory authorities on (a) fraud detected during an audit; and (b) doubts about auditees’ solvency.

How is auditing done? 

Basics – gathering evidence – could be checking, sampling, verifying that assets and stock exist, checking and relying on internal controls of company, confirm balances with third parties – eg bank, debtors, creditors etc. 

But also consideration of the “business risk”? Move away from detailed checking? A shift in the way an audit is conducted?....see next slide

1990’s – 2002: characterisation of audit techniques 

Emergence of audit methodologies focusing on clients’ business risk (risk of auditees not meeting their objectives) 

Audit based on:   

a thorough understanding of the client, its business, its industry and (especially) its risks; and identification of audit risk through analytical review.

Adaptation of auditing to the e-commerce, e-business environment.

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i.e there was a move away from detailed checking 

But, as a result of corporate failure - since 2002, a shift away again?

Audit expectation gap

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“A gap between what the public expects or needs and what the auditors can and should reasonably expect to accomplish”.

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Role-perception gap, ignorance gap, information gap, performance gap, reasonableness gap and other “components” of the gap 

Often in the spot light – try searching for “The Future of Audit”, and “Audit Expectations Gap” on www.icaew.co.uk – various documents and podcasts.

Been a raging debate for years……eg: 

USA (1974) - the Commission on Auditors’ Responsibilities. 

UK - Institute of Chartered Accountants in England & Wales (ICAEW) – work been on-going for a number of years – see link above 

International Auditing and Assurance Standards Board (IAASB) – considering usefulness (or not) of the existing audit report

Content of the audit expectations gap (Humphreys 1997) The Provision of Audit Assurance 

-’Probabilistic statement’ vs ‘Guarantee of Accuracy’ 

-Changing nature of auditor’s responsibility for detection of fraud 

Suggests meaning of audit changes over time (Scandal, period of change, next scandal, period of change and so on)

Audit Reporting 

-Perception of unqualified (clean) audit opinion 

-Going concern debate?

Who can be an auditor? Appointment 

Under company law (CA 2006) auditors must be approved by a Recognised Supervisory Body (RSB) – ACCA, ICAEW, ICAS, CA Ireland, AAPA 

The auditor must be a member of the RSB and auditors must be qualified (individuals) or be controlled by qualified persons (firms).

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Qualifications are offered by Recognised Qualifying Bodies (RQBs), approved by secretary of state – ACCA, ICAEW, ICAS, CA Ireland, AIA, CIPFA 

CA requires both public and private companies to appoint auditor for each financial year

Who appoints the auditor?

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Directors or shareholders 

Usually directos appoint the auditor and the decision is ratified by the shareholders ACCA F8 book – Chapter 2 section 2

Removal/resignation of auditors 

May resign or be replaced 

Statement of circumstances (or statement of no circumstances) to be deposited at registered office

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‘Signals’ that are given to the market, media and stakeholders, both about 

what does a new appointment show? 

what does an unexpected ‘exit’ show?

If a company has the same audit firm for a long period of time it doesn’t look good as probably getting too close. New rules say they have to swap more. Auditors’ rights 

Access to the company’s books and accounts 

Explanations from the company’s management/subsidiary 

Right to attend and speak at general meetings 

Right to receive copies of written resolutions

Auditors’ duties 1) Statutory Companies Act 2006, sections 495-498 The Auditors are to prepare their Report to the Company’s shareholders on the company’s financial statements, including 1. identifying the FS that are the subject of the audit and the financial reporting framework used 2. a description of the scope of the audit and the auditing standards adopted 3. a clear statement as to whether the company’s FS “give a true and fair view” of its state of affairs at the end of the year and its profit or loss for the year - have been properly prepared in accordance with the relevant financial reporting framework (ie. IAS or UK GAAP) - Comply with the Companies Act 2006 4. a statement, whether in auditor’s opinion, the strategic and directors reports are consistent with the FS 5. a statement, whether the corporate governance statement is consistent with the FS 6. For quoted cos, a report on the auditable part of the directors’ remuneration report and whether it has been properly prepared per CA 2006. 2) Under Common Law Courts explain what is actually expected from auditors, through cases such as Kingston Cotton Mill (1896): 

Reasonable skill 

Care 

Caution in the circumstances

3) Under professional auditing standards and guidelines Originally set up by the auditing profession, the Auditing Practices Board (now incorporated into the reformed FRC – the Audit and Assurance council) adopted International Standards on Auditing (ISAs) from 2004 with the purposes of:  

informing/increasing the quality of audit work protecting the reputation of auditors and increasing public confidence in the profession.

Also Ethical Standards and Guidance

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4) Under regulatory requirements 

Requirements for listed (publicly quoted) companies 

Compliance with corporate governance requirements (i.e., the UK Corporate Governance Code (formerly the Combined Code – see FRC website)

So what about the Auditors’ responsibility to detect and report fraud? See ISA 240 – www.frc.org.uk .. Whose responsibility is it? ..Role of the auditor? Have a read……..part of the “expectations gap”? Auditing theory and concepts Need for theory? 

A practical subject ‘wholly utilitarian’ 

Practice has developed without theory 

Public conception has evolved without theory 

Applied theories of agency, information and insurance

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Attempts at auditing theory by Mautz & Sharaf (1961,1975) and Flint (1988) in terms of auditing postulates and concepts

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Helps identify which basic assumptions underpin auditing as a practice 

Helps organise knowledge of auditing so that it is useful 

Helps us understand the social role and context of the audit function

Driven by demand for audit services Policeman theory – auditor’s job is to focus on arithmetical accuracy and on prevention and detection of fraud, ties into preventative and detective controls. Lending credibility theory (LCT) – audited financial statements used by management to enhance stakeholder faith in management’ stewardship. Trust issues so audit report with increase faith Theory of inspired confidence (TIC) – outside stakeholders involved with the company demand accountability from management in return for their contribution. Audit addresses issue of possible bias in management information and divergence of interest. Eg Worldcom manipulated figures. Agency theory – company considered as contractual relationships in which several groups make different contributions, given a price. Audit required in the interest of all parties. Information hypothesis

overlap with LCT

Insurance hypothesis

and TIC

Can theory explain the existence of f/s audits? Agency Theory Agency relationships: a contract under which one or more persons (principal) engage another person (agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent. Assumptions:  

Rational utility maximisers (greatest amount of value for least possible money) Asymmetry of information

These two assumptions may lead to: Adverse selection: refers to the tendency of individuals with private information (that benefits them)

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to undertake action detrimental to the other party Moral hazard: the agent will not always act in the best interests of the principal: 

Shirking (why bother to maximise the value of the firm?)

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Spend a lot on non-pecuniary benefits (perks, such as corporate jets) 

Steal (defrauding the company)

How principals may protect their interests Jensen and Meckling 1976 resolve these problem by contracting between principals and agents: Bonding activities: agents deposit amounts with a third party Monitoring activities: establishment of control systems, budget restrictions and incentive compensation schemes Auditing – auditors are now considered to be agents, this emphasises the agency problem more and the need for a mechanism to accurately align all their interests. Soo… 

Financial statements main mechanism to monitor performance of directors

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Serve economic purpose/used for decision making 

Separation of ownership and control = imbalance of information/different motives/limited access to information/ lack of trust

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Need = accountability/reinforce trust/ promote stability/ inspire confidence

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BUT? Maybe agency theory is too simple

Can theory explain the existence of f/s audits? Information hypothesis 

Investors demand financial information to assess returns and risks of their investment

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There is an overlap with the propositions of agency theory, LCT and TIC. Information that is useful for monitoring the agent is also useful for investors decisions

Can theory explain the existence of f/s audits? Insurance hypothesis 

Audit serves as an insurance for managers. Managers shift responsibility for reported data to auditors and thus they lower the expected loss from ligitation 

Politicians also demand audits for similar reasons eg to escape criticism in cases of corporate failures

Social role of auditing 

To add credibility to financial statements Mauts 1975 

Necessary that all relevant findings are communicated clearly 

Necessary for public to understand exactly what an audit can reasonably expect to achieve

Concepts and postulates approach: “there has to be an explanation of why auditors do what they do, what they believe they achieve and what the public believes they achieve” Flint 1988 Concepts and postulates (assumptions) approach  

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Essentially intended to develop a conceptual framework for audit practice It is a very normative approach (more emphasis on what should be rather than what is) Ignores alternative perspective on the significance of locating auditing in a social context 7

(ie the managerial, commercial orientation of audit practice) 

Provides ideas to guide the performance of the audit function rather than a theory of its existence

Postulates are…. “assumptions that do not lend themselves to direct verification. The propositions deducted from the postulates…. However, can be directly verified and such verification bears evidence of the truth of the postulates themselves” Maut and Sharaf 1961 “fundamental principles, assumed to be truths” Porter et al 7 postulates:

A focus on the key concept of independence and objectivity 

The cornerstone of auditing 

A postulate and a concept 

Is there a link between scepticism, judgement and independence

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Consider: independence vs need to trust and rely on directors for information

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Fine balance: scepticism the buffer between independence and the trust No independence – audit is worthless?

Ethical standard – integrity, objectivity and independence INDEPENDENCE: the cornerstone of auditing, an attitude of mind not a set of rules 

Auditors need to be independent (independent in fact) 

possess an objective unbiased attitude of mind, evaluate evidence and express an opinion impartially without being influenced by personal bias 

and must also be seen to be independent (independent in appearance), not to give the impression to others that the auditor is not independent

Dart’s article (2011, p.174) refers to the definition of independence, as described by DeAngelo (1981:116) (see the article for reference), suggesting that an auditor is independent, if, on discovering a breach in accounting regulation, the auditor would “report the breach” Threats to auditors’ independence 
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