Auditing

LEC 1

Definition and objective of audit

An audit is an official examination of the accounts (or accounting systems) of an entity (by
an auditor). When an auditor examines the accounts of an entity, what is he looking for?
The main objective of an audit is to enable an auditor to convey an opinion as to whether or
not the financial statements of an entity are prepared according to an applicable financial
framework. The applicable financial reporting framework is decided by:

Legislation within each individual country, and

Accounting standards (for example, International Accounting Standards/ International

Financial Reporting Standards).

The auditor seeks to express an opinion as the result of the audit work that he does. The
type of work carried out by an auditor in order to reach his opinion is described in later
chapters.

Concepts of accountability, stewardship and agency

An audit of a company’s accounts is needed because in companies, the owners of the

business are often not the same persons as the individuals who manage and control that
business.

 The shareholders own the company.

 The Company is managed and controlled by its directors.

The directors have a stewardship role. They look after the assets of the company and
manage them on behalf of the shareholders. In small companies the shareholders may be
the same people as the directors. However, in most large companies, the two groups are
different. The relationship between the shareholders of a company and the board of
directors is also an application of the general legal principle of agency.

The concept of agency applies whenever one person or group of individuals acts as an
agent on behalf of someone else (the principal). The agent has a legal duty to act in the best
interests of the principal, and should be accountable to the principal for everything that he
does as agent. As agents for the shareholders, the board of directors should be accountable
to the shareholders.
In order for the directors to show their accountability to the shareholders, it is a general
principle of company law that the directors are required to prepare annual financial
statements, which are presented to the shareholders for their approval.

The audit report: independence, materiality and true and fair

Audit has a very long history. The concept of an audit goes back to the times of the Egyptian
and Roman empires. In medieval times, independent auditors were employed by the feudal
barons to ensure that the returns from their stewards and their tenants were accurate.
Over time, the annual audit was developed as a way of adding credibility to the financial
statements produced by management. The statutory audit is now a key feature of company
law throughout the world. An auditor reports to the shareholders on the financial
statements produced by a company’s management

The key features of the audit report are as follows:

 The auditors producing the report are independent from the directors producing
the financial statements
 The report gives an opinion on whether the financial statements “give a true and fair
view”, or “present fairly” the position and results of the entity.
 The report considers whether the financial statements give a true and fair view in all
material respects. The concept of materiality is applied in reaching an audit opinion.

Independence of the auditor

The external auditor must be independent from the directors; otherwise his report will
have little value. If he is not independent, his opinion is likely to be influenced by the
directors. In contrast to external auditors, internal auditors may not be fully independent
from the directors, although they may be able to achieve a sufficient degree of
independence.
True and fair view (fair presentation)

The auditor reports on whether (or not) the financial statements give a true and fair view,
or present fairly, the position of the entity as at the end of the financial period and the
performance of the entity during the period. The auditor does not certify or guarantee that
the financial statements are correct. Although the phrase ‘true and fair view’ has no legal
definition, the term ‘true’ implies free from error, and ‘fair’ implies that there is no undue
bias in the financial statements or the way in which they have been presented. In preparing
the financial statements, a large amount of judgment is exercised by the directors.
Similarly, judgment is exercised by the auditor in reaching his opinion. The phrases ‘true
and fair view’ and ‘present fairly’ indicate that a judgement is being given that the financial
statements can be relied upon and have been properly prepared in accordance with an
appropriate financial reporting framework.

Materiality concept

The auditor reports in accordance with the concept of materiality. He gives an opinion on
whether the financial statements present fairly in all material respects the financial
position and performance of the entity. Information is material if, on the basis of the
financial statements, it could influence the economic decisions of users should it be omitted
or misstated.

For example, the shareholders of a company with assets of Rs.1 million will not be
interested if petty cash was miscounted with the result that the amount of petty cash is
overstated by Rs.100. This is immaterial. However, they will be interested if there are
receivables in the statement of financial position of Rs.200,000 which are not in fact
recoverable and which should therefore have been written off as a bad debt.

Applying the concept of materiality means that the auditor will not aim to examine every
number in the financial statements. He will concentrate his efforts on the more significant
items in the financial statements, either:

 Because of their (high) value, or

 Because there is a greater risk that they could be stated incorrectly.

The statutory requirement for audit

Most countries impose a statutory requirement for an annual (external) audit to be carried
out on the financial statements of most companies. However, in many countries, smaller
companies are exempt from this requirement for an audit. Other entities, such as sole
traders, partnerships, clubs and societies are usually not subject to a statutory audit
requirement. Small companies and these other entities may decide to have a voluntary
audit, even though this is not required by law
Assurance:

‘Assurance’ means confidence. In an assurance engagement, an ‘assurance firm’ is engaged

by one party to give an opinion on a piece of information that has been prepared by
another party. The opinion is an expression of assurance about the information that has
been reviewed. It gives assurance to the party that hired the assurance firm that the
information can be relied on.

Assurance can be provided by:

 Audit: this may be external audit, internal audit or a combination of the two
 Review.

A statutory audit is one form of assurance. Without assurance from the auditors, the
shareholders may not accept that the information provided by the financial statements is
sufficiently accurate and reliable. The statutory audit provides assurance as to the quality
of the information. The provision of this assurance should add credibility to the
information in the financial statements, making the information more reliable and
therefore more useful to the user. However, there are differing levels or degrees of
assurance. Some assurances are more reliable than others.

Levels of assurance

The degree of assurance that can be provided about the reliability of the financial
statements of a company will depend on:

The amount of work performed in carrying out the assurance process, and

The results of that work.

The resulting assurance falls into one of two categories:

Reasonable Assurance – A high (but not absolute) level of assurance provided by the
practitioner’s conclusion expressed in a positive form. E.g. “In our opinion the accounts are
true and fair”. The objective of a statutory audit is to provide reasonable assurance.

Limited Assurance – A moderate level of assurance provided by the practitioner’s

conclusion expressed in a negative form. E.g. “Based on our review, nothing has come to
our attention that causes us to believe that the accompanying financial statements do not
give a true and fair view”. The objective of a review engagement is often to provide limited
assurance.
Assurance provided by audit

An audit provides a high, but not absolute, level of assurance that the audited information
is free from any material misstatement. This is often referred to as reasonable assurance.
The assurance of an audit may be provided by external auditors or internal auditors.

An external audit is performed by an appropriately qualified auditor, appointed by the

shareholders and independent of the company.

Internal audit is a function or department set up within an entity to provide an appraisal

or monitoring process, as a service to other functions or to senior management within the
entity. Typically, internal auditors are employees of the entity. However, it is also common
for entities to ‘outsource’ their internal audit function, and internal audit work is
sometimes carried out by firms of external auditors. Many of the practical auditing
procedures that will be described in later chapters are the same for both internal and
external audit work.

Assurance provided by review

A review is a ‘voluntary’ investigation. In contrast to ‘reasonable’ level of assurance

provided by an audit, a review into an aspect of the financial statements would provide
only a moderate level of assurance that the information under review is free of material
misstatement. A review does not provide the same amount of assurance as an audit. An
external audit provides positive assurance that, in the opinion of the auditors, the financial
statements do present fairly the financial position and performance of the company.

The higher level of assurance provided by an audit will enhance the credibility provided by
the assurance process, but the audit work is likely to be:

more time-consuming than a review, and so

more costly than a review.

Elements of an assurance engagement

An engagement in which a practitioner expresses a conclusion designed to enhance the

degree of confidence of the intended users other than the responsible party about the
outcome of the evaluation or measurement of a subject matter against criteria. The
outcome of the evaluation or measurement of a subject matter is the information that
results from applying the criteria. Under the International Framework for Assurance
Engagements there are two types of assurance engagement a practitioner is permitted to
perform: a reasonable assurance engagement a limited assurance engagement

(IAASB Handbook 2012)

An assurance engagement performed by a practitioner will consist of the following five
elements:

1) A three party relationship:

Practitioner – the individual providing professional services that will review the subject
matter and provide the assurance. E.g. the audit firm in a statutory audit

Responsible party – the person(s) responsible for the subject matter. E.g. the Directors
are responsible for preparing the financial statements to be audited

Intended users – the person(s) or class of persons for whom the practitioner prepares
the assurance report. E.g. the shareholders in a statutory audit

2) Subject matter: This is the data such as the financial statements that have been prepared
by the responsible party for the practitioner to evaluate. Another example might be a cash
flow forecast to be reviewed by the practitioner.

3) Suitable criteria: This can be thought of as ‘the rules’ against which the subject matter is
evaluated in order to reach an opinion. In a statutory audit this would be the applicable
reporting framework (e.g. IFRS and company law).

4) Evidence: Information used by the practitioner in arriving at the conclusion on which

their opinion is based. This must be sufficient (enough) and appropriate (relevant).

5) Assurance Report: The report (normally written) containing the practitioner’s opinion.
This is issued to the intended user following the collection of evidence.