Undergraduate study in Economics,
Management, Finance and the Social Sciences
Auditing and
assurance
R. Chandler
and S. Antrobus
AC3093
2022
AC3093
Auditing and assurance
R. Chandler and S. Antrobus
AC3093
2022
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social Sciences. This is
equivalent to Level 6 within the Framework for Higher Education Qualifications in England,
Wales and Northern Ireland (FHEQ).
For more information, see: london.ac.uk
This guide was prepared for the University of London by:
R. Chandler, Professor of Accountancy, Cardiff Business School.
S. Antrobus, Tutor at Accountancy Learning Ltd.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or
arising from, the guide. If you have any comments on this subject guide, please communicate
these through the discussion forum on the virtual learning environment.
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Contents
Contents
Chapter 1: Introduction........................................................................................... 1
1.1
1.2
1.3
1.4
1.5
1.6
Route map to the guide........................................................................................... 1
Introduction to the subject area............................................................................... 2
Syllabus.................................................................................................................. 3
Aims of the course................................................................................................... 4
Learning outcomes for the course............................................................................ 4
Overview of learning resources................................................................................ 5
Chapter 2: Reasons for auditing............................................................................ 11
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
Introduction.......................................................................................................... 11
Financial audits..................................................................................................... 13
Development of the company audit........................................................................ 13
Expectations versus auditing reality........................................................................ 16
The auditors’ role in the global financial crisis........................................................ 20
A reminder of your learning outcomes.................................................................... 21
Test your knowledge and understanding................................................................ 21
Hints..................................................................................................................... 21
Chapter 3: The theory of auditing......................................................................... 23
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Introduction.......................................................................................................... 23
The role of theory.................................................................................................. 24
Assumptions of auditing........................................................................................ 25
Auditing concepts.................................................................................................. 27
Recognition of theoretical issues in practice........................................................... 28
A reminder of your learning outcomes.................................................................... 29
Test your knowledge and understanding................................................................ 30
Hints..................................................................................................................... 30
Chapter 4: Independence...................................................................................... 33
4.1 Introduction.......................................................................................................... 33
4.2 Companies Act 2006, Part 42................................................................................ 35
4.3 Companies Act 2006, Part 16................................................................................ 35
4.4 International Ethics Standards Board for Accountants ............................................ 37
4.4 Other ethical concerns .......................................................................................... 42
4.5 Professional clearance........................................................................................... 43
4.6 Audit committees.................................................................................................. 44
4.7 The Sarbanes–Oxley Act......................................................................................... 45
4.8 More extreme suggestions..................................................................................... 45
4.9 A reminder of your learning outcomes.................................................................... 46
4.10 Test your knowledge and understanding.............................................................. 46
4.11 Hints................................................................................................................... 47
Chapter 5: Audit reporting.................................................................................... 49
5.1
5.2
5.3
5.4
5.5
5.6
Introduction.......................................................................................................... 49
Underlying sub-concepts........................................................................................ 51
Forming an audit opinion....................................................................................... 52
ISA 700 – contents of auditors’ reports.................................................................. 52
Example of an auditors’ report............................................................................... 54
Types of auditors’ opinions.................................................................................... 57
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AC3093 Auditing and assurance
5.7 ISA 260 Communication of audit matters to those charged with governance.......... 59
5.8 A reminder of your learning outcomes.................................................................... 59
5.9 Test your knowledge and understanding................................................................ 59
5.10 Hints................................................................................................................... 60
Chapter 6: Evidence............................................................................................... 63
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
Introduction.......................................................................................................... 63
Theoretical issues.................................................................................................. 64
The audit evidence process.................................................................................... 64
Types of audit evidence and techniques for collection............................................. 66
Which type(s) to use?............................................................................................ 66
Sufficiency of evidence........................................................................................... 68
A reminder of your learning outcomes.................................................................... 68
Test your knowledge and understanding................................................................ 68
Hints..................................................................................................................... 69
Chapter 7: The audit process................................................................................. 71
7.1 Introduction.......................................................................................................... 71
7.2 Audit risk and materiality....................................................................................... 72
7.3 Before accepting the audit engagement................................................................. 74
7.4 Engagement letters............................................................................................... 75
7.5 Planning the audit................................................................................................. 75
7.6 Analytical procedures............................................................................................. 76
7.7 Uses of analytics in planning.................................................................................. 77
7.8 Controls and assessing risk.................................................................................... 77
7.9 ISA 315................................................................................................................. 78
7.10 Substantive tests................................................................................................. 79
7.11 Tests of detail...................................................................................................... 81
7.12 Computer-based systems..................................................................................... 84
7.13 Completion......................................................................................................... 85
7.14 A reminder of your learning outcomes.................................................................. 86
7.15 Test your knowledge and understanding.............................................................. 86
7.16 Hints................................................................................................................... 86
Chapter 8: Responsibility (and legal liability)....................................................... 89
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
Introduction.......................................................................................................... 89
Duties under statute.............................................................................................. 90
Liability under case law (common law)................................................................... 91
What is reasonable skill and care?......................................................................... 92
Responsibility to whom?........................................................................................ 96
A reminder of your learning outcomes.................................................................. 105
Test your knowledge and understanding.............................................................. 105
Hints................................................................................................................... 106
Chapter 9: Audit regulation ................................................................................ 109
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
ii
Introduction........................................................................................................ 109
The roles of regulation......................................................................................... 109
The background to regulation in the UK............................................................... 110
Who sets the rules?............................................................................................. 110
The international scene........................................................................................ 111
Criticisms of the regulation of the profession........................................................ 113
Recent developments.......................................................................................... 113
A reminder of your learning outcomes.................................................................. 114
Test your knowledge and understanding.............................................................. 114
Contents
Chapter 10: Other forms of assurance service.................................................... 115
10.1 Introduction...................................................................................................... 115
10.2 Assurance engagements ................................................................................... 115
10.3 Internal audits................................................................................................... 116
10.4 Environmental audits......................................................................................... 117
10.5 Sustainability..................................................................................................... 117
10.6 Corporate responsibility assurance..................................................................... 118
10.7 The future.......................................................................................................... 119
10.8 A reminder of your learning outcomes................................................................ 119
10.9 Test your knowledge and understanding............................................................ 119
10.10 Hints............................................................................................................... 120
Chapter 11: Examination technique.................................................................... 121
11.1
11.2
11.3
11.4
Introduction...................................................................................................... 121
Before the examination..................................................................................... 121
In the examination............................................................................................ 122
After the examination........................................................................................ 123
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AC3093 Auditing and assurance
Notes
iv
Chapter 1: Introduction
Chapter 1: Introduction
You should find the study of auditing and assurance both challenging
and rewarding provided you apply yourself to the material set out in this
subject guide.
Auditing will be a new subject for most of you, although, you are likely to
have a general idea of what you think auditing is all about. Nevertheless,
there will be surprises as we go through the course. Whatever your
preconceived ideas, try to approach the subject with an open mind. If you
do so, we think you will find it an interesting and exciting area of study.
One reason that auditing has a dull reputation is that students are
sometimes presented with, and sometimes tempted to memorise, lists of
procedures. This sort of approach drives the life out of the subject and can
only be useful if you think that you will face exactly the same question
in some future test or examination. As with any subject, it is much better
to focus on understanding the topic so that you are better able to adapt
what you know to the particular situation facing you. The examination is
designed to test your understanding of the topic rather than your ability to
memorise lists of points, facts or cases.
1.1 Route map to the guide
The aim of this guide is to help direct you in your studies. If you are
currently studying as part of a course with lectures and seminars/tutorials,
then this guide will supplement your studies and coursework. The guide
will be especially useful if you are studying on your own. You may face the
difficulty of working out which of the many sources of information you
need to concentrate on – the guide will direct you to those areas that will
best repay your attention.
Every effort has been made to keep the text accessible, not overcomplicating the technical aspects and not contradicting the textbooks.
It should be stressed that the guide is not a substitute for the two key
textbooks, both of which are very comprehensive in their coverage of
numerous topics. There would be little point in trying to write yet another
textbook but what we have done is to select those issues which are really
worth concentrating on. The guide is not a substitute for diligent study
nor is it a shortcut for the lazy student. You still need to be motivated and
self-disciplined. You need to be diligent in the pursuit of your studies and
be prepared to put in the time and the effort. We have tried to make the
guide more engaging by inserting activities and ‘pause and think’-style
questions. Please do not skip over these exercises. They are designed to
grab your attention and get you working and, most of all, thinking.
The rest of this first chapter is a general introduction to the guide itself.
Chapter 2 looks at the basis of auditing and its development over the years
and ends with consideration of what has become known as the ‘expectations
gap’ – this still causes the profession problems many years after it was first
recognised that what the investing public thinks auditors do is very different
from what auditors actually do.
Chapter 3 is quite a challenge, looking as it does at the topic of theoretical
notions underpinning the concept of an audit. What makes this difficult is
that the discussion is mainly in the abstract rather than dealing with the
practical aspects of auditing, but do not let that put you off.
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AC3093 Auditing and assurance
Chapters 4 to 6 deal with three of the four main concepts in auditing theory
– independence, auditor reporting and audit evidence. Taking some of the
points from the theoretical basis, the discussion and evaluation begin to
focus on the practicalities of auditing.
Chapter 7 concerns the audit process and the approach of concentrating
audit resources on those areas most likely to be at risk of misstatement.
It is important to realise that the guide does not attempt to go into the
level of detail which you will find in the textbooks but this does not mean
that you can ignore the relevant chapters in those books. A thorough
understanding of auditing practices and procedures is necessary if you wish
to be best placed to tackle the scenario-based questions in Section A of the
examination paper.
Chapter 8 deals with the complex and difficult area of legal liability. Again,
no attempt has been made to better the textbooks’ coverage of the case law
but a different perspective is offered on how one may interpret the various
decisions of the courts.
Chapter 9 deals with the topics of regulation of auditing and the expansion
of auditing notions into other forms of professional service. In particular, we
highlight a few areas with which students should be familiar.
Chapter 10 acts as an overview and tries to bring together a number of
lessons and principles concerning examination technique – these have been
introduced throughout the guide but are worth repeating. It cannot be
overstated how important it is that you work on developing good style and
good technique. All too often examiners are dismayed by students’ poor
performance, not in terms of their lack of knowledge but in their lack of
ability to tailor their knowledge to answer the particular question set. Please
do not bypass this last chapter, it could seriously affect your final grade!
1.2 Introduction to the subject area
The word ‘audit’ is usually used to refer to the action of checking either
people or processes or documentation. In the accounting arena, it most
often refers to the process of providing an opinion on the accuracy or
validity of financial statements. In the context of company annual financial
statements, an ‘external’ audit provides assurance for users who are
outside the organisation’s management. The auditors’ opinion helps these
users to decide how much to rely on the financial statements when making
decisions. External financial audit has a long history and has become
highly organised and regulated. It therefore forms the main focus of this
subject guide. However, audit is only one form of assurance, and demand
for other forms, not limited to financial information, has greatly increased,
with accountants and others being engaged to offer assurance on all sorts
of information or processes. Some aspects of financial audits are very
much relevant to these other forms of assurance.
If you are not sure what other forms assurance can take, just look
around your home. In the kitchen, for instance, one may find some food
products labelled with the approval of an organisation such as the Soil
Association, a UK-based charity dedicated to promoting environmentally
safe methods of food production. The Association certifies that certain
food stuffs are being organically grown and this reassures consumers
who may be worried about mass-farming methods which may harm our
health and the planet. Other food is marked as ‘Freedom Food’ by the
Royal Society for the Prevention of Cruelty to Animals (a charity which
aims to promote good standards of animal welfare). Household goods
2
Chapter 1: Introduction
such as coffee and chocolate will bear the Fair Trade stamp if the suppliers
have demonstrated that they meet the Fair Trade criteria concerning
sustainability of production and fair treatment of those in the supply chain
in less developed countries; the prices paid should be ‘sustainable’ rather
than exploitative.
As consumers, we are reassured by the involvement of these credible
intermediaries, without whom we would only have the unsubstantiated
claims of the producers. These are examples of a type of ‘audit’ exercise
which may involve accounting firms even though the material or
processes being corroborated have little to do with accounting matters.
Accountants have established a reputation for honesty and fairness
which means that their clients and the public can generally trust them to
evaluate organisations in an objective way. The fact that the matter under
investigation is not accounting related means that these accounting firms
need to employ other specialists.
Companies are also increasingly reporting on their environmental and social
impacts – this is sometimes referred to as corporate social responsibility
(CSR) reporting – alongside their financial statements. Some companies
choose to have their environmental or sustainability reports audited and
this is a service that is often provided by the big accounting firms.
1.3 Syllabus
Reasons for auditing. The concept of accountability. Economic demand
for auditing. Auditing as a monitoring device.
Principles and postulates of auditing. Conditions for auditing to be
possible. The concept of independence.
The legal and professional environment. Approaches to the
regulation of auditing practice, in particular legal rules and professional
guidelines. International regulation of auditing. (Note: candidates will
be expected to be aware of the range of different approaches to auditor
regulation and the general content of such regulations but will not be
expected to know the detailed requirements of any specific country’s audit
regulations.)
The duties of auditors. The changing responsibilities of auditors for
fraud detection and financial statement attestation. The extent of auditors’
duties to primary clients and third parties. The ‘expectations gap’ between
what users of financial statements believe the audit provides and what the
audit is capable of offering. Auditor liability and the case for and against
limiting liability. Different levels of assurance that may be expressed.
Audit planning. Initial assessment of the client. The engagement letter.
Risk-based approaches. Identification of key areas of audits and assurance
services. Analytical procedures.
Conduct of audits and assurance services. The concept of
evidence. Compliance and substantive testing. The concept of internal
control. Identifying key controls and testing them. Statistical and other
sampling approaches to testing. Specific audit techniques, such as
observation, directional testing, cut-off tests, third-party confirmations.
The application of techniques in the context of the main revenue and cost
activities of the enterprise. Auditing the balance sheet. The significance
of management representations. Assessment of errors and weaknesses.
Documenting the audit or assurance service, preparation and review of
working papers.
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AC3093 Auditing and assurance
Computer-based systems. Auditing ‘round’ and ‘through’ the
computer. Internal control in a computer environment. Computerassisted audit techniques. The use of computers in conducting the audit
or assurance service, in particular spreadsheets, word-processing and
automated working papers.
The report of the auditors or assurance service providers. The
form and content of the auditors’ report. The qualified auditors’ report
(also referred to as the modified report or opinion). The hidden meanings
behind an auditors’ report. The report as an educational document.
Current developments in auditing and assurance services.
Audit committees. Internal audit. Management audit. The economic value
of auditing to society. The spread of auditing and other assurance services
into non-financial contexts: the ‘Audit Society’. The role of auditors in the
banking crisis and other scandals. Possible changes to enhance auditor
independence and competence.
1.4 Aims of the course
The course aims to:
•
introduce students who have passed AC1025 Principles of
accounting to the principles of external auditing and other assurance
services
•
provide students with an understanding of the nature of the function
of auditing and other assurance services and the principles of the
related processes.
We will be dealing with both theoretical and practical aspects of the audit
process, but you should always try to relate the two rather than treat them
as discrete parts.
1.5 Learning outcomes for the course
By the end of the course and having completed the Essential reading and
activities, you should be able to:
4
•
explain why external audits and other types of assurance services are
conducted
•
discuss the duties of auditors and other assurance providers and how
these have changed over time
•
explain the meaning of concepts that are fundamental to auditing and
assurance services, such as ‘independence’, ‘audit evidence’, ‘audit
risk’, ‘materiality’
•
describe, in general terms, the processes involved in auditing and
other assurance services
•
distinguish between compliance and substantive testing and describe
various audit tests
•
discuss the form, content and importance of auditors’ reports provided
at the end of the audit or assurance service
•
discuss the issue of legal liability arising from audits and other
assurance services
•
discuss current developments in auditing and other assurance services
– in order to do this you must be prepared to read widely in the
financial press and also in the academic journals.
Chapter 1: Introduction
1.5.1 Changes to the syllabus
The material contained in this subject guide reflects the syllabus for the
year 2022–2023.
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the virtual learning environment (VLE). It
is essential that you check the VLE at the beginning of each academic year
(September) for new material and changes to the syllabus. Any additional
material posted on the VLE will be examinable.
1.6 Overview of learning resources
If you are aiming to study for this subject over the course of one academic
year, you need to spend, as a minimum, six or seven hours per week on
these studies. This could include reading each chapter in this subject
guide, the related part or parts of the recommended texts and relevant
articles, making notes and practising writing short, and then longer,
answers to activities or questions in preparation for your examination. It
will be very clear to the examiners which candidates have prepared well
by reading around the subject as opposed to memorising a set of notes.
The more you know about your chosen subject, the better you are able to
relate your knowledge to any given examination question.
1.6.1 The subject guide
This subject guide has 10 main sections, covering the course syllabus and
examination techniques. Everyone has their own way of working, so the
following steps are only suggested as a guide. Work through each of the
remaining chapters (2 to 10) in the guide in the order in which they are
presented.
•
Read the notes in the chapter to gain an overview of the topic.
•
Read the notes in the chapter again. This time also read the relevant
material in the textbook(s), standards, regulations, or articles, making
your own notes as you do your reading. These notes will form the
basis of your learning.
•
Re-read the notes in the subject guide. Take time to pause and think
about the issues that have been raised (you will also be prompted to
do this at various stages). Reflecting on these issues will improve your
understanding of the material. Noting the key points presented in
the subject guide will help you to focus on the areas which are most
important. Add to or amend the notes you made on the reading as
you do this; for example, highlight the sections of your notes which
receive more emphasis in the subject guide. Pause and think hints are
provided at the end of each chapter.
•
Test yourself by attempting the activities as you work through each
chapter. Also have a go at the activities in the textbook(s) as well as
those in the subject guide. Keep your answers in a safe place so that
you can refer back to them in future.
If you cannot even begin an activity, go back and re-read the parts of the
chapter, and the relevant background reading, which cover the material in
that activity.
•
Check back to the learning objectives that are set out at the start of
the chapter you have read. Can you do all the tasks noted? If not, reread the relevant part(s) of the chapter and the relevant background
reading.
5
AC3093 Auditing and assurance
•
Complete the other study tasks provided in this subject guide, for
example, the sample examination questions at the end of each chapter.
It is essential that you try to gain a thorough understanding of each topic
rather than simply learning by rote. Do not accept what you read at face
value. Rather, try to distinguish between statements of fact and statements
of opinion, and ask yourself whether the opinions you read are reasonable
– do you agree, and why (or why not)?
Throughout the course you should also try to think about a wide range
of different organisations and the audit issues that are likely to arise. To
do this, draw upon your own knowledge from work experience or from
any other contact you may have – as a consumer or otherwise – with
businesses and other organisations. This will help you to provide answers
to examination questions that reflect current practice, rather than textbook
descriptions from the past.
1.6.2 Essential reading
You should obtain or have regular access to one or other of these two
textbooks:
Gray, I., S. Manson and L. Crawford The audit process: principles, practice and cases.
(London: Thomson, 2019) 7th edition [ISBN 9781473760189]. This text will
be referred to throughout as ‘Gray et al. (2019)’.
Porter, B., J. Simon and D. Hatherly Principles of external auditing. (Chichester:
John Wiley & Sons, 2014) 4th edition [ISBN 9780470974452]. This text will be
referred to throughout as ‘Porter et al. (2014)’.
Each of these texts contains references to articles and other sources, so there
is no shortage of direction to further reading. Both Gray et al. (2019) and
Porter et al. (2014) provide a good introduction to auditing, covering its
theoretical underpinning and some of its practical aspects. There is no need
to read both books since they cover essentially the same material in similar
depths. Each of these books has the benefit of being written specifically with
reference to the international auditing standards and each is written with
an undergraduate audience in mind.
You should always bear in mind that auditing is a dynamic subject;
it is always changing, with new rules, new legislation, new cases and
new scandals. So any book will quickly become outdated. However, the
principles of auditing have remained virtually unaltered. These principles
are also common across different countries and different legal frameworks.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
The United Kingdom regulatory system and international auditing
standards
It should be noted that the two essential texts, as well as this subject
guide, are based on the legal and regulatory system in the United
Kingdom, although they include references to international auditing
standards and other important international developments. The syllabus
for this course states that you are not expected to know the detailed
requirements of any specific country’s audit regulations, but the situation
in the UK tends to be similar in many respects to that in other parts of the
6
Chapter 1: Introduction
world. The situation in the UK is therefore presented by way of illustration
of the many issues surrounding auditing.
You should also obtain a set of International Standards on Auditing
(ISAs). You may also find it helpful to consult your own country’s Auditing
Standards (if you are not sure then check on the global impact map to find
the name of your local accounting body and follow the links from there).
In most countries, international and national standards are very similar,
and in some cases international standards have been adopted in place of
national standards.
1.6.3 Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
The large ‘Big Four’ accounting firms are involved in both audit and
assurance. Use these firms’ and others’ websites to gain an understanding
of the role of the firms and the different sorts of assurance services they
offer:
•
Deloitte
•
Ernst & Young
•
KPMG
•
PricewaterhouseCoopers
You are strongly encouraged to keep up to date by reading the professional
press in your country and internationally. In the UK, this includes
magazines such as Economia and newswires such as AccountingWeb as
well as other sources.
In addition, if you wish to delve more deeply into the subject, then the
following provides a critical review of the role of the auditor and the
explosion of audit/assurance into other areas:
Power, M. The audit society: rituals of verification. (Oxford: Oxford University Press,
1999) 2nd edition [ISBN 9780198289472].
A constant critic of the auditing profession in the UK has been Professor
Prem Sikka, who runs a website called AABA which contains material on
auditing ‘failures’. Use this sort of perspective to balance the views given in
the more conventional sources.
The internet is a useful, virtually free resource and you are encouraged
to use it to further your studies and to satisfy your curiosity. However, as
with any use of the internet, you need to pay particular attention to the
reliability of the source of the information; official websites are more likely
to give reliable information than amateur-hosted ones.
In Chapter 3 you are also recommended to read:
Flint, D. Philosophy and principles of auditing. (Basingstoke: Macmillan, 1988)
[ISBN 9780333311165].
1.6.4 Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
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AC3093 Auditing and assurance
You can access the VLE, the Online Library and your University of London
email account via the Student Portal.
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
•
Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
•
Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
•
Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
•
Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
•
External material: Links out to carefully selected third-party
resources.
•
Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
•
Collaborative activities: Work with fellow students to build a body
of knowledge.
•
Discussion forums: A space where you can share your thoughts
and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
•
Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide
guidance on how to approach the questions.
•
Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
8
Chapter 1: Introduction
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
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AC3093 Auditing and assurance
Notes
10
Chapter 2: Reasons for auditing
Chapter 2: Reasons for auditing
2.1 Introduction
An obvious starting point in the discussion of any topic is the definition of
the terms to be discussed or studied. So what do we mean by ‘auditing’?
Auditing has at its root a fundamental mistrust of other people. We cannot
be sure that passengers on a bus or a train have a valid ticket so we have
drivers or inspectors to check or automatic barriers to prevent passengers
passing except on the presentation of a valid ticket or travel card. This
is a form of check or control or ‘audit’. This sort of activity has a number
of benefits; it prevents or reduces fare-dodging (a preventative effect), it
means that more passengers will purchase a valid ticket since they may
fear being caught (a deterrent effect) and it lends a sense of credibility
and fairness to the whole system in the eyes of the public who one way or
another are financing the system.
This is a simple form of check or control. You can easily think of many
more examples from everyday life. A common feature will be mistrust,
even though we may not like to see things in that way. Audits therefore
have the ability to add trust to a situation and they come in many forms,
including:
•
financial audits
•
compliance audits
•
management efficiency audits
•
environmental audits
•
energy audits
•
social audits
•
academic audits
•
religious audits
•
software licence audits
•
circulation audits for newspapers.
Although the term ‘audit’ is used in conjunction with each of the above
items, it is probably more correct to consider most of them under the
general heading of ‘assurance’. The audit of financial statements is
one form of assurance service but, as can be seen from the above list,
assurance services are not limited to financial information.
These different types of assurance services have different objectives and
different contexts, but they generally share one common feature – they
involve some notion of an independent check by one person upon the
actions or activities of another.
Now read
Porter et al. (2014) pp.1–8.
Pause and think 1
Why do we need to check up on the activities of another person?
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AC3093 Auditing and assurance
Now read
Gray et al. (2019) pp.1–20.
Activity
Perform an internet search using the words ‘audit’ and ‘assurance’. Select a few of the
sites and read what they have to say about the different types of audit and assurance.
How well do they fit with the general idea of a check being made by one person upon
another?
2.1.1 Aims of the chapter
The aims of this chapter are to get you thinking about the subject of the
audit of financial statements specifically and of other assurance services
more generally. It is also intended to give you a better understanding of
the development of the discipline, with particular focus on the audit of
company financial statements.
2.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain what auditing and assurance services are
•
describe how different forms of check or audit occur in many aspects
of life
•
briefly outline the development of company auditing since the mid19th century
•
explain what we mean by the expectations gap
•
discuss some of the concerns about the role of auditors in the wake of
the financial crisis of 2007–2008 and what has been done to bridge
that expectations gap
•
critique recent examinations of the structure of the auditing profession
in the UK.
By reading around the subject and keeping an openly curious mind, you
will also see how the broad concept of audit is applied in many different
contexts.
2.1.3 Essential reading
Gray et al. (2019) Chapter 1 ‘Why are auditors needed?’, pp.1–27; Chapter 20 ‘The
audit expectations gap and audit quality’, pp.741–66; Chapter 22 ‘Issues in
auditing’, pp.804–42.
Porter et al. (2014) Chapter 1 ‘What is auditing?’, pp.1–21; Chapter 2 ‘The
development of auditing and audit objectives’, pp.23–56; Chapter 5 ‘Auditors’
legal, regulatory and professional responsibilities’, pp.161–216; Chapter 6
‘Auditors’ duties with respect to fraud and non-compliance with laws and
regulations’, pp.217–26.
2.1.4 Further reading
Chandler, R., J.R. Edwards and M. Anderson ‘Changing perceptions of the role of
the company auditor, 1840–1940’, Accounting and Business Research 23 1993,
pp.443–59.
Chandler, R.A. and J.R. Edwards ‘Recurring issues in auditing: back to the future?’,
Accounting, Auditing and Accountability Journal 9(2) 1996, p.429.
Lee, T.A. ‘A stakeholder approach to auditing’ Critical Perspectives on Accounting 9
1998, pp.217–26.
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Chapter 2: Reasons for auditing
Pasewark, W., R. Shockley and J. Wilkerson, Jr. ‘Legitimacy claims of the auditing
profession vis-à-vis the behaviour of its members: an empirical examination’,
Critical Perspectives on Accounting 6(1) 1995, pp.77–94.
Power, M. The audit society: rituals of verification. (Oxford: Oxford University Press,
1999) 2nd edition [ISBN 9780198289472].
2.2 Financial audits
Financial audits have a long history. From what we can decipher of the
remaining records, the need for this type of audit has been recognised
since the first civilisations. The Egyptians, the Greeks and the Romans all
had notions of accounting, accountability and audit because in organised
societies generally there were structures and organisations that placed
individuals in positions of power and authority over other people’s money
and resources. When money was received or spent on behalf of the
king, emperor or the people generally, there was a strong incentive for
the individual government official to keep records that showed that the
money had been properly and honestly handled. To add credibility to these
records, an independent check, or audit, was carried out. Without this sort
of check, no one could be sure that the officials had properly discharged
their responsibility.
Activity
Identify situations when one person has possession of resources belonging to other
people but no control or check is thought to be necessary. What is different? Why are no
checks or controls thought to be necessary?
Now read
Porter et al. (2014) pp.8–18.
The audit of company financial statements is the main focus of this course
because it is the oldest, most developed and regulated form of assurance.
Because all forms of assurance share the common characteristics of an
independent check by one person upon the information or activities
supplied or performed by another, lessons learned in financial audit may
be applied to other forms of assurance. Also, the ‘success’ of financial audit
may in part be the cause of the growth in other forms of assurance, in
what is sometimes referred to as the ‘audit society’ (Power, 1999).
Now read
Gray et al. (2019) pp.10–13.
Pause and think 2
What are auditing and assurance services and what role do they play in society?
2.3 Development of the company audit
A review of the development of UK company legislation, as it affects
auditors, will help consolidate your knowledge of the background to
the auditing of financial statements in the private sector. Obviously it
is specific to one country but the changes which have taken place there
have tended to reflect or be reflected in similar legislation elsewhere.
The development of company audits is discussed in detail in Chapter 2 of
Porter et al. (2014). The main points are highlighted here.
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1844 Joint Stock Companies Act
This early legislation was quite far-sighted since it recognised the need for
investors, who might not be involved in the running of their companies,
to receive reliable information from those who did play a part in company
management. The Act required all incorporated companies to produce
an audited balance sheet. The auditor was required to report on whether
the balance sheet showed a ‘full and fair view’ of the reporting company’s
position.
A major problem, however, was that there was nothing in the form of an
organised accountancy or auditing profession in existence at that time.
It was therefore hard for investors to tell whether the auditor was either
competent or independent of management.
1856 Companies Act
This Act withdrew the compulsory annual audit and instead gave the
Board of Trade, a government department, the right to investigate a
company upon the application by one-fifth of the shareholders. It is not
known how many investigations were carried out, but clearly this ad hoc
inspection system was less reliable than regular audits of companies.
The 1856 Act contained model articles of association (part of the
constitution of companies) which allowed for an audit along the lines of the
1844 Act. The difficulty was that these were not mandatory and companies
could choose to adopt alternative articles with no audit requirement.
During the middle of the 19th century there were financial scandals
involving the management of banks, railways, friendly societies, industrial
and provident societies. Parliament intervened to impose specific
legislation and regulations, including accounting and audit requirements,
on such industries.
1900 Companies Act
This Act introduced a compulsory audit for the generality of companies.
There was no requirement for auditors appointed to audit company accounts
to be professional. There was a bar, however, on directors and officers acting
as auditors, so some attempt was made to ensure auditors enjoyed a degree
of independence from management. In a similar vein, this Act gave auditors
a right of access to all accounting records and information.
Under the 1900 Act, auditors had to report on whether the accounts
showed a ‘true and correct view’.
1948 Companies Act
The scope of the audit was extended to include profit-and-loss accounts.
In addition, auditors had to be members of one of the professional bodies.
This was the first attempt to improve the competence of those who acted
as auditors to companies.
Auditors were to report on whether the accounts showed a ‘true and fair
view’; whether adequate books of account had been kept; whether the
accounts agreed with the books; and whether all the information and
explanations necessary for the audit had been received.
Pause and think 3
Why do you think the criterion for judging financial statements was changed from ‘true
and correct’ to ‘true and fair’?
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Chapter 2: Reasons for auditing
1967 Companies Act
This Act had the effect of reducing the length of standard ‘unqualified’
(unmodified) audit reports; from now on auditors would only refer to
the additional matters on which they had to form an opinion if they were
not satisfied; for example, if they considered that the financial statements
were not in agreement with the books of account. This meant that
auditors’ reports typically amounted to a single paragraph containing the
opinion on whether the accounts showed a true and fair view.
1976 Companies Act
The 1976 Act strengthened the position of auditors by requiring an auditor
who had been removed or had resigned to make a statement setting out
the circumstances of the termination of the position or a statement that
there were no circumstances which should be brought to the shareholders’
attention. This provision was aimed at ensuring that auditors who had had
serious disagreements with directors and no longer wished to remain as
auditor could not slip away quietly without making their concerns known
to those who were entitled to that information, the shareholders.
The Act also sought to enhance the quality of data that auditors checked
by imposing requirements to improve the adequacy of companies’
accounting records.
1981 Companies Act
This major piece of legislation brought UK company law into line with
that of other European countries. It increased the emphasis on the
need for financial statements to show a ‘true and fair view’ and in fact
made this an overriding requirement, meaning that companies could, in
some circumstances, depart from the detailed requirements of the Act if
compliance would have produced a result which was not true and fair.
The Act extended auditors’ work to require a review of the directors’ report
to ensure that it was not inconsistent with the financial statements which
it accompanied.
1985 Companies Act
The 1985 Act merely consolidated previous acts into one piece of
legislation. No new law was introduced.
1989 Companies Act
The 1989 Act was another Europe-inspired statute. It introduced
requirements for auditors to be more formally regulated than before. It
required disclosure of fees paid to auditors for non-audit services as well
as audit fees and allowed for the indemnity insurance premium of an
auditor to be paid by the audit client.
2004 Companies (Audit, Investigations and Community Enterprise) Act
This Act further enhanced the regulation of, and monitoring of compliance
with rules by, auditors.
2006 Companies Act
At the time, this was the biggest single piece of legislation to have been
passed by a UK Parliament. The Act allows companies and auditors to
agree to place a ‘cap’ on amounts that may be claimed against auditors.
It is not known how many such agreements have been made between
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audit firm and audit client. It also makes it a criminal offence for auditors
knowingly to issue a misleading audit report.
The point of this review of the development of the legislation is not to
provide yet another list of facts to be memorised; instead, it is to give
students a sense of how we have arrived at the position we are in today.
For example, the increasing power given to auditors in the form of more
extensive rights of access to evidence, the development of the wording of
the audit opinion (which is currently being debated once again) and the
elaboration of provisions aim to enhance the auditor’s independence. It is
unlikely that an examination question would expect complete knowledge
of all of these pieces of legislation, but it is entirely possible that a question
could be asked that tests your understanding of the evolution of the
auditors’ legal rights and duties.
Pause and think 4
How have changes in the statutory framework for auditing in the UK improved the
position of auditors over the years?
Activity
Imagine that you have been appointed to audit the financial statements of the college or
university where you are studying now or where you have studied in the past. What are
its main sources of income and types of expenditure? How would you set about checking
these items? What are its main assets and liabilities, and how would you check that these
have been properly accounted for?
Activity: practice questions
Attempt Questions 1.5 and 1.9 in Porter et al. (2014) p.19.
2.4 Expectations versus auditing reality
There is much confusion in the investing public’s mind about the true
nature of auditing and the assurance that auditors are expressing in their
reports. Major misconceptions about the role of auditors continue, the
most common being:
•
Auditors are ‘fraud detectives’.
•
Auditors prevent their clients committing illegal activities.
•
Auditors provide a guarantee of corporate solvency.
•
Auditors conduct a management efficiency review.
All professions suffer from some sort of expectations gap (e.g. lawyers,
doctors and surveyors), but the difference is that these groups tend to deal
on a one-to-one basis with their clients, whereas auditors have a mass
audience: the body of shareholders of their audit client, and others who
may rely on audited financial statements. One mistake by an auditor could
damage the financial fortunes of thousands of investors. Thus, there is a
greater public interest not only in the proper performance of an auditor’s
duties, but also in auditors meeting the expectations of the public. To some
extent this is never going to be achieved since public expectations may be
unreasonable, for example the expectation that an auditor is able to detect
and prevent every fraud no matter how trivial. There is a ‘reasonableness
gap’ – some of the public’s expectations are unreasonable because they are
impractical.
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Chapter 2: Reasons for auditing
There is also the performance gap which is composed of two elements,
a deficient standards gap and a deficient performance gap. The former
represents the possibility that the professional standards imposed on
auditors may be too lax. The latter represents the reality that in some cases
auditors have not performed up to the standards which the profession has
set.
Gray et al. (p. 49) present a diagram that neatly illustrates the elements
of the expectations gap. Students are often tempted to reproduce this
diagram or something like it in their examinations, but you would be wise
to resist this temptation. Diagrams are useful in visually getting across
often complex ideas; it can be very instructive to see such a representation
in a textbook or in lecture slides. However, Examiners do not need to be
instructed in this manner, so do not waste time in the examination by
drawing diagrams.
Pause and think 5
a. Why is it that lay (non-expert) people often expect professional people to be able to
do more in the practice of their profession than is actually feasible?
b. Does it matter that the public has a different view from that of practitioners?
Activity: practice questions
Porter et al. (2014) p.52, Question 2.2.
Porter et al. (2014) p.254, Question 6.2.
Porter et al. (2014) p.842, Questions 18.1 and 18.2.
2.4.1 Going concern and viability statements
You will remember from your Principles of Accounting studies that a
going concern is one of the fundamental assumptions underpinning the
preparation of financial statements. Accountants must consider whether
the organisation can continue in operation, paying its debts as they fall
due in the normal course of business. If for some reason there is significant
doubt about the validity of a going concern assumption then the basis of
the financial statements will have to be reconsidered. Assets may have to
be written down to a ‘fire sale’ basis – second-hand specialised equipment
will rarely be worth its book value (original cost less depreciation) in a
forced or liquidation sale. In addition, if the decision has been made to
close the business, there will be extra obligations − the costs involved in
winding up, the legal and other fees. So, the financial statements now
need to reflect those extra liabilities that would not be relevant if the
business were a going concern. Furthermore, in the event of liquidation,
the existing liabilities will have to be re-classified; what were previously
long-term debts will now become short-term.
Gray et al. (p.732) provide a helpful though not exhaustive list of warning
indicators that might suggest that there is doubt about a company’s
ability to continue as a going concern. For example, the company has lost
a number of major customers, there is a decline in demand for its main
products or services, or the limit on the company’s overdraft has been
reached or exceeded. You should be on the lookout for such warning signs
in the scenarios in Section A questions. It is surprising how many students
often overlook sometimes quite blatant indicators. If there were to be
a Section B essay question related to going concern, do not attempt to
reproduce this list or something similar; instead, select a few examples to
illustrate your awareness.
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Assessing the going concern question is primarily an issue for the directors
since it is they who have to prepare the financial statements. Directors of
companies covered by the UK Corporate Governance Code are required to
state in their annual and interim reports that they consider it appropriate
to apply the going concern concept, and they must identify any material
uncertainties which may impair that assumption over the 12 months from
the date on which the board approves the financial statements. This puts
the ball firmly in the directors’ court.
Now read
The UK Corporate Governance code.
In addition, these companies are also expected to provide a long-term
viability statement which should cover at least three years. The FRC
encourages companies to look even further into the future, while it
acknowledges that the longer the period, the less certainty there is. The
UK Government is currently considering a proposal to require a resilience
statement covering at least five years from the reporting date.
Now read
• Going concern and viability review:
• Restoring trust in audit and corporate governance (sections 3.1.9-3.1.20)
Question
When companies fail shortly after receiving an unmodified auditors’ report, there is nearly
always criticism of the auditors. To what extent do you think such criticism may be valid?
Now read
Porter et al. (2014) pp.783–98 and pp.217–41, and Gray et al. (2019) pp.48–50 and
pp.741–56.
Then locate and read the articles cited by Porter et al. on pp.53–56; Chandler et al., 1993;
Chandler and Edwards, 1996 (this is available in the Online Library).
Auditors are required to consider whether the directors’ use of the going
concern basis is appropriate and that the directors’ disclosures about
the going concern basis are adequate (ISA 570 Going Concern). Audit
work in this area would entail examining what the directors have done
in performing their review of the company’s prospects over the shortand medium-term. Auditors will need to assess whether the directors
have considered the most likely events, principal risks or threats to the
company’s continued existence. It would be a matter of some seriousness
if the directors had undertaken no review of the future because that would
suggest that they had no long-term plans and little ability to react to
possible future events or conditions.
All well-run organisations have short-, medium- and long-term plans, and
the directors will expect their internal accounting team to draw up regular
cash flow projections or forecasts. Auditors can review these documents
to see whether the company’s estimation of the future is consistent with
the going concern assumption. Auditors will have lengthy and detailed
consultations with management to test the robustness of their client’s
procedures in relation to the going concern question. They may refer to
minutes of board meetings to confirm management’s plans and strategic
decisions.
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Chapter 2: Reasons for auditing
Auditors must also be aware of other future events or conditions that
might impact their client’s business and which may not have been
considered by the directors. For example, new legislation or regulations
might severely curtail the client’s operations or incur significant
compliance costs that might make the business unviable.
Nevertheless, it has to be recognised that it is impossible to foretell the
future with complete accuracy. As recent experience of the covid pandemic
has shown us, events can catch us unawares. Natural disasters such as
earthquakes, droughts or floods can suddenly have a devastating impact
on businesses as well as people. Man-made catastrophes such as war or
terrorism may put pay to a once viable business with little or no warning.
Illegal acts and corruption
Auditors’ primary role is to form and report an opinion on a client’s
financial statements. In carrying out that role, auditors may come across
actions or evidence which may arouse suspicions of illegal activities such
as tax evasion, breaches of employment law, human trafficking, payments
of bribes or money-laundering. It should be stressed here that auditors do
not actively seek evidence of such activities because that would involve a
massive amount of effort, and a skillset that most auditors do not possess.
But it might reasonably be expected that auditors should at least be
aware of the possibility that a client may commit illegal acts. What to do
then if evidence of such acts surfaces? One natural reaction might be to
confront management immediately but in some situations that in itself
might be illegal. For example, under anti-money laundering regulations it
is an offence to ‘tip-off’ a suspected money-launderer because that would
give the individual an opportunity to cover their tracks or escape justice.
Depending on the nature of the suspected offence, it might be appropriate
to refer the matter to the authorities. It is likely that only in rare cases will
such illegal acts have a material impact on the financial statements. We
might think of cases where very heavy fines or penalties could be levied or
licenses withdrawn causing the client to cease trading. What this means is
that auditors should expend some effort to assess management’s integrity
because not only might company law or accounting rules be breached but
also other laws and regulations; but, in many cases, auditors may simply
not be aware of the illegal conduct of their clients.
2.4.2 What can be done to close the expectations gap?
Steps that can be taken to reduce the gap between public expectations and
audit performance include:
•
improve auditors’ performance
•
educate the public
•
do something else, for example, develop lower-level assurance services
such as the Independent Professional Review, which was tried in the
UK, although it was a short-lived experiment.
Others have argued that auditors should be prepared to expand their role
to cover corruption (see Jeppesen, K. ‘The role of auditing in the fight
against corruption’, British Accounting Review 51(5) 2019). Critics of the
auditing profession would surely counter this suggestion by claiming that
to talk of expanding the auditors’ role is premature when it appears that
they are unable to adequately perform their conventional role.
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2.5 The auditors’ role in the global financial crisis
In the UK, a Select Committee of the House of Lords has conducted an
investigation into market concentration within the role of auditors in the
financial crisis. See the Economic Affairs Committee – Second Report,
2011.
You should review Chapters 6 and 7 of the report (and more if you have
the time and the energy!). This is a hard-hitting report and it made the
profession sit up and take notice. In particular, the dominance of the Big
Four was a major source of concern not only because it appears to be an
oligopoly which raises the fear of collusive pricing but also because if one
of the Big Four were to fail (i.e. collapse) it would lead to a dangerously
high concentration in the market for bank audits. It is a fact that the Big
Four dominate the financial services industry as well as others and it is
difficult to defend the position.
When it comes to the question of the role of auditors having caused the
global financial crisis, or at least contributing to it, there is more scope for
debate. The banks were run by highly paid directors and managers. Some
of these people essentially took risks with shareholders’ and depositors’
money without fully understanding or caring about the consequences if
their bets did not pay off. Their objective was to create profits for their
banks so that they could enjoy bigger bonuses and bigger pay packets.
Shareholders themselves were happy provided the share price kept rising
and dividends continued to be paid. Ordinary, private individuals probably
are not sufficiently skilled to be able to understand the risks the banks
were running but the majority of shares are held by financial institutions
like pension funds. These institutions employ highly paid analysts and
fund managers who are expected to have the skills and training to assess
accurately the financial statement and other information coming on to the
market – yet these too failed to raise any concerns about the state of bank
finances or their banking strategies. Finally, government and regulators
whose jobs include monitoring the changing positions of major industries
should also accept some portion of the blame. While none of these parties
has completely escaped criticism, it is noticeable that it is the role of the
auditors in the financial crisis which has received so much attention.
For a balanced view of the situation, see both the ACCA’s and ICAEW’s
submissions to the House of Lords Committee as well as the evidence from
academics:
Auditors: Market concentration and their role – Minutes of Evidence taken
before The Economic Affairs Committee, 12 October 2010
Auditors: Market concentration and their role – Minutes of Evidence taken
19 October 2010
The point of recommending these reports to students is twofold: first
it makes you aware of the past concerns which have been voiced at the
highest levels in Parliament rather than simply presenting academic
arguments which can sometimes be rather removed from the real world;
and second, it alerts you to important challenges to the conventional role
of auditors.
Pause and think 6
To what extent do you think auditors of banks should bear some responsibility for the
global financial crisis of 2007–2008?
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Chapter 2: Reasons for auditing
2.6 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain what auditing and assurance services are
•
describe how different forms of check or audit occur in many aspects
of life
•
briefly outline the development of company auditing since the mid19th century
•
explain what we mean by the expectations gap
•
discuss some of the concerns about the role of auditors in the wake of
the financial crisis of 2007–2008 and what has been done to bridge
that expectations gap.
By reading around the subject and keeping an open and curious mind, you
will also see how the broad concept of audit is applied in many different
contexts.
2.7 Test your knowledge and understanding
2.7.1 Sample examination questions
1. Discuss how and why the primary objective of the company audit has
changed over time.
2. Evaluate the extent to which the performance of company auditing
meets public expectations and consider the implications of any
divergence between performance and expectations.
3. ‘The need for auditing is based on the assumption that no one can be
trusted to be honest.’ Discuss the extent to which you believe this to be true.
4. When companies fail shortly after receiving an unmodified auditors’
report, there is nearly always criticism of the auditors. To what extent
do you think such criticism is valid?
5. Critically evaluate the purpose of an audit of financial statements.
2.8 Hints
2.8.1 Pause and think questions
1. If we could trust other people to act as they should then there would
be little point in having a check up on them. But people make mistakes
sometimes and a few people are dishonest, so that we can never be
sure that they have done what they are supposed to. Having a check
upon other people means that we have added assurance that mistakes
and/or dishonesty are less likely – but we can never be totally sure.
2. Auditing and assurance services are part of the process of providing
assurance that activities have been properly conducted. They add
assurance because an independent, competent auditor/reviewer
has examined the process and/or output from the process and has
communicated a level of satisfaction. With more satisfaction, there is
more confidence in the system and therefore more people are likely to
engage with the process, whether that is investing in company shares
or buying goods which have been organically cultivated.
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3. It is difficult to see the difference between the words ‘true’ and
‘correct’. There is also the problem that the truth can be presented in a
misleading way. The word ‘fair’ means that financial statements should
be as objective as possible.
4. The powers and rights of auditors have been increased. There is now
less chance that they may have information withheld from them. On
the other hand, it is now a criminal offence to issue an audit report
without genuine belief in its accuracy, so the position of the careless
auditor has not improved.
5. a. Lay people clearly cannot fully understand the technical procedures that go into a process and they often find it difficult to
accept that judgements are required and that no one is perfect. There is also the hope that someone else can solve our problem.
b. If people’s expectations are routinely disappointed, it might
have a negative impact on the standing of that profession. Other
competing professions may seek to move into that area by offering
to provide a better service. So while it may be inevitable that all
professions suffer from the expectations gap to some extent, it is
important that they take steps to manage the gap.
6. The fault of course lies with the perpetrators of bad banking practice
– the bankers themselves. Supervisory authorities too must bear some
of the blame since their job was to monitor the banking sector. But
auditors have not escaped and while it has not been alleged that they
were irresponsible, the extent to which the large audit firms earned
substantial fees for non-audit work has called into question their
objectivity. The crisis has also aroused concern that there are too few
of these large firms, which exposes the system to the risk that should
something happen to one of the Big Four, the remaining three firms
would find it difficult to sustain the illusion that there is a fair market
for audit services.
2.8.2 Sample examination questions
1. You should reflect on the move from fraud detection to financial
statement verification. Consideration also needs to be given to the
difficulty of effectively detecting fraud.
2. You need to rehearse the various arguments based on the evidence
that suggest that the public expects more of auditors than auditors can
deliver (fraud, going concern and management efficiency are three of
the main areas). You also need to think about the consequences for the
profession if public expectations remain unsatisfied.
3. Sadly, this comment contains more than a grain of truth. If everyone
could be trusted then auditing would have little value. However, if ‘no
one’ could be trusted then there would be no point in having auditors
since they too could not be trusted.
4. Auditors cannot see into the future any better than anyone else.
However, the audit (or part of it) takes place after the year end when
more information is available. Auditors will have to look at cash flow
forecasts, order books and so on to judge the liquidity status of the
client but they can never be expected to guarantee solvency.
5. The phrase ‘critically evaluate’ carries the connotation that you have to
consider both sides of the argument. In this case, you would need to
expand on what the audit can and cannot achieve.
22
Chapter 3: The theory of auditing
Chapter 3: The theory of auditing
3.1 Introduction
For many years, the study and practice of auditing centred on the pure
mechanics of conducting an audit, concentrating on how to perform an
audit. However, as it became more of an established profession and, more
recently, accepted as an academic discipline, more attention has been
focused on the theoretical and conceptual underpinnings of the practice.
Thus, questions were explicitly raised about why certain procedures were
carried out.
The first coherent attempt to produce a theoretical discourse on company
auditing came from American academics, Mautz and Sharaf, who in 1961
published The philosophy of auditing. This was an important development
as it helped gain some measure of academic acceptance for auditing.
Mautz and Sharaf drew from established fields of study such as philosophy,
the sciences and law in producing a theory which helped to explain much
of the accepted practice in auditing. Their theory also helped to highlight
areas of practice that did not stand up to critical review, notwithstanding
that such areas were generally accepted. It is interesting now to reflect on
the fact that as long ago as 1961, these theoreticians were postulating that
for auditors to be independent they should only act as auditors for a client
– no other services could be countenanced. The profession in the UK and
elsewhere has been forced to face up to that truth.
A Scottish academic, Professor Tom Lee, built on and adapted the work
of Mautz and Sharaf to produce his own ‘theory’ in Company auditing.
This book was refined and polished into a third edition (last published in
1986). Sadly, Lee’s later book – Corporate audit theory (1993) – is aimed
at the US market and much of the easy accessibility of the earlier versions
has been lost.
Another Scot, Professor David Flint, has written Philosophy and principles
of auditing, building on Mautz and Sharaf and on Lee. The accounting
establishment has shown little interest in, or enthusiasm for, pursuing
theoretical lines of enquiry. This is in contrast to the financial reporting
field where, over the years, millions of dollars have been invested in
seeking what some have called the holy grail of accounting – a conceptual
framework – which currently takes the form of the Framework for the
preparation and presentation of financial statements published by the
International Accounting Standards Board (IASB). Similar statements
have been issued by national standard-setters, such as the Statement
of principles by the Accounting Standards Board (ASB) of the UK and
the Conceptual framework for financial reporting and the presentation of
financial statements by the Accounting Standards Council in Singapore. It
is interesting to debate why the effort has been made to formulate theories
about accounting but not about auditing, the process which renders
accounting statements valuable. However, that is beyond the range of our
studies at present.
Pause and think 1
a. What is a theory?
b. What purpose would be served by a theory of auditing?
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AC3093 Auditing and assurance
3.1.1 Aim of the chapter
The aim of this chapter is to provoke thoughts about the general principles
and concepts behind the practical procedures that we will study in depth
later on. You will also be able to discuss aspects of theory construction and
its relevance in the context of auditing.
3.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain what constitutes a theory
•
explain the difference between assumptions and concepts
•
discuss the role a theory of auditing could perform
•
list the main components of a possible theory of auditing.
3.1.3 Essential reading
Gray et al. (2019) Chapter 2 ‘An overview of the postulates and concepts of
auditing’, pp.29–60.
Porter et al. (2014) Chapter 3 ‘A framework of auditing concepts’, pp.57–98.
3.1.4 Further reading
Flint, D. Philosophy and principles of auditing. (Basingstoke: Macmillan, 1988)
[ISBN 9780333311165].
3.1.5 Works cited
Lee, T. Company auditing. (Wokingham: Van Nostrand Reinhold, 1986) 3rd edition
[ISBN 9780412437201].
Lee, T. Corporate audit theory. (London: Chapman and Hall, 1993)
[ISBN 9780412452200].
Mautz, R.K. and H.A. Sharaf The philosophy of auditing. (Sarasota, FL: American
Accounting Association, 1961) [ISBN 9780865390027].
Woolf, E. Auditing today. (London: Pearson Education, 1997) 6th edition
[ISBN 9780135894668].
3.2 The role of theory
The dictionary definition of a theory is:
a supposition put forward to explain something; an exposition
of the general principles of an art or a science as distinct from
the practice and execution of it.
So an auditing theory, if one could be developed, would explain practice
and put forward general principles. It has been argued that, if we had
general principles, we could use these to develop practices and to adapt
to new challenges and situations that might arise. Without principles,
procedures may evolve in an ad hoc manner, with no cohesion or internal
consistency.
In addition, if a theory could be developed, it could help to explain
practice, could highlight deficiencies and inconsistencies in existing
practice and could guide audit policy-makers and regulators in their
governing of the audit profession. It could also help teachers of auditing to
explain the practice of auditing to their students, who in turn could gain a
better understanding of their subject. Without a theoretical basis, auditing
is the application of a series of procedures, more akin to the practice of a
trade, rather than a profession.
24
Chapter 3: The theory of auditing
Now read
Porter et al. (2014) pp.57–60.
Gray et al. (2019) pp.29–35.
3.3 Assumptions of auditing
Assumptions (theoreticians sometimes call them postulates) are the
foundations of theory. Think back to your early studies of economic
theories which only ‘work’ if you make certain assumptions (for
example, the model for perfect competition assumes that consumers
aim to maximise utility and producers aim to maximise profits). If these
assumptions do not hold, the model fails. Let us now consider Flint’s seven
assumptions.
Assumption 1: There is a need for an audit based on a relationship of
accountability
The need could be based on a situation where one party owes a duty of
acceptable conduct to another or an audit has been imposed by one party
on another (for example, companies, government, charities).
In other situations, the need for an audit may come about because one
party wishes to establish the reliability and credibility of information for
which they are responsible and which will be used by another party; a
‘voluntary audit’ (for example, partnerships, companies which engage
environmental auditors, newspapers that have their circulation figures
audited).
In still other situations, the public interest in the proper and adequate
performance of some party may require an audit; this is sometimes
referred to as a ‘public interest audit’ (for example, academic audits
designed to test the robustness of the systems employed by educational
establishments in delivering services to their students).
Pause and think 2
Think of other examples of situations where an ‘audit’ may be necessary.
Assumption 2: The subject matter is too remote, too complex or too
important to accept without an audit
Remoteness: those relying on information may not physically be able to
check the validity of the information themselves, perhaps because they are
remote from the company.
Complexity: the nature of the subject is so complex that it requires
special expertise to investigate and check. For example, most ordinary
shareholders do not possess sufficient accounting knowledge and skills to
be able to conduct the audit themselves.
Significance: the matter under audit has such economic significance
that an audit is required to lend it credibility. Note in contrast that
unincorporated entities are often not required to have an audit, because
lenders have recourse to the assets of the owners in the event that the
business entity cannot meet its liabilities.
Pause and think 3
Do you think that it would be possible for ordinary shareholders with no accounting or
auditing qualifications to perform tests on the information in the financial statements
themselves?
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AC3093 Auditing and assurance
Assumption 3: An audit must be conducted with independence and
without constraints either over conduct or in reporting findings
If an audit is to add credibility then it must be done independently,
without bias or prejudice. A prime example is that of state auditors, who
since the time of Aristotle have had to be independent of the government
which they are auditing. In the words of Emile Woolf, for many years
a leading authority on auditing matters: ‘The auditor who has lost his
independence has lost his raison d’être; he has become “dependent”, and a
dependent auditor is a contradiction in terms’ (Woolf, 1997, p.349).
The independence of auditors has been called into question once again
following the banking crisis. Inquiries into the current state of auditing
have caused politicians in the UK and elsewhere to ask tough questions
of the auditing firms which not only audited the banks but also provided
them with other professional services which earned the firms large fees. In
addition, other links between clients and auditors have cast doubt on the
objectivity of the latter, for example, when senior staff leave an audit firm
and join an audit client.
Pause and think 4
What other sorts of situations might lead to a loss of auditor independence?
Assumption 4: The subject matter of an audit can be verified by
collection of evidence
Auditors report the results of their investigations. Without evidence
they have nothing on which to base their report, to make judgements or
criticisms. An audit is impossible if evidence is not available or cannot be
obtained. In practice, audit evidence comes from many sources. It varies in
its persuasiveness depending on quantity collected and quality (source).
Pause and think 5
What sorts of evidence might be available in the audit of a retail outlet for, say, sales
(revenue) and expenses?
Assumption 5: Standards of accountability, performance, etc., can be
set and actual performance can be measured against these standards
Parties to an accountability relationship must agree on what is acceptable
performance. Without this, auditors have nothing to go by. They cannot
set their own standards since these may be rejected by either party. In
company auditing some of these standards have been set down (by statute
or by professional guidance), but grey areas still remain. What constitutes
a ‘true and fair view’? What should auditors do when they discover a client
has committed an illegal act?
Pause and think 6
Is the giving of a bribe wrong when it is the only way for a company to get business in
some parts of the world?
Assumption 6: The purpose of the audit is sufficiently clear that its
results can be communicated clearly
The purpose of an audit is to add value to information. If the nature or
purpose of the information itself is not clear, it cannot be audited. If the
audit findings cannot be communicated effectively then inevitably the
value of the audit will be diminished.
26
Chapter 3: The theory of auditing
Over the years a lot of debate has taken place over the contents of the
auditors’ report. Starting in the late 1980s we began to see an expansion
of the auditors’ report which had been a simple statement of one or two
paragraphs into a document that covered two or more pages with many
more items being covered within. Since the global financial crisis of 2008,
the audit regulators around the world have been moving towards further
radical changes in order to grapple more successfully with the problem of
better communicating the messages which auditors are trying to convey to
interested parties (this topic will be covered in more detail later).
Pause and think 7
Do you think that the purpose of the company audit is well understood? What sort of
misunderstandings about the purpose of an audit have been shown to exist?
Assumption 7: An audit produces an economic or social benefit
Since audit is a social control mechanism it should only be undertaken
if the benefits outweigh the costs. Auditors are expected to provide the
benefit at minimum cost. In most audit situations the major part of the
work involves the collection of evidence. While a minimum level of
confidence must be achieved, absolute certainty is unattainable. There
is a point at which the cost of obtaining additional evidence exceeds the
marginal benefit. The direct costs of auditing are known but the benefits
are not so easily measured.
Pause and think 8
Auditing the financial statements of the largest companies costs industry huge sums of
money. Apart from the audit firms, who benefits from this auditing activity and how do
they benefit?
3.4 Auditing concepts
A concept is an abstract notion or idea. The role of concepts is to create
a better understanding of the subject. Concepts form the basis for
developing general working principles and practices by which theories are
articulated and put into operation.
These concepts, or general ideas, can be grouped into four categories,
according to whether they relate to the auditor’s credibility, the audit
process, the communication of the audit outcome (reporting), or the
performance of the auditor’s work. These general ideas form the basis of
the next few chapters. They are:
•
independence
•
reporting
•
evidence
•
responsibility.
Different authors have come up with different names for these concepts
and some have broken each one down into further sub-concepts but these
four will suffice for our purposes.
Now read
Porter et al. (2014) pp.60–94.
Gray et al. (2019) pp.35–48.
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AC3093 Auditing and assurance
3.5 Recognition of theoretical issues in practice
Despite the extensive academic effort expending in investigating
theoretical issues in auditing, there is no generally agreed theory or
conceptual framework for auditing in the UK or elsewhere for that matter.
The only authoritative reference to general ideas on the values behind the
audit process used to be found in the form of a one-page list of desirable
qualities, The Auditors’ Code. It sets out nine fundamental principles of
independent auditing, as follows.
Accountability
Auditors act in the interests of primary stakeholders, while having regard
to the wider public interest. The identity of primary stakeholders is
determined by reference to the statute or agreement requiring an audit:
in the case of companies, the primary stakeholder is the general body of
shareholders.
Integrity
Auditors act with integrity, fulfilling their responsibilities with honesty,
fairness and truthfulness. Confidential information obtained in the course
of the audit is disclosed only when required in the public interest, or by
operation of law.
Objectivity and independence
Auditors are objective. They express opinions independently of the entity
and its directors.
Competence
Auditors act with professional skill, derived from their qualification,
training and practical experience. This demands an understanding
of financial reporting and business issues, together with expertise in
accumulating and assessing the evidence necessary to form an opinion.
Rigour
Auditors approach their work with thoroughness and with an attitude
of professional scepticism. They assess critically the information and
explanations obtained in the course of their work and such additional
evidence as they consider necessary for the purposes of their audit.
Judgement
Auditors apply professional judgement, taking account of materiality in the
context of the matters on which they are reporting. (See Chapter 7 of this
guide for further discussion of materiality.)
Clear communication
Auditors’ reports contain clear expressions of opinion and set out
information necessary for a proper understanding of that opinion.
Association
Auditors allow their reports to be included in documents containing other
information only if they consider that the additional information is not in
conflict with the matters covered by their report and they have no cause to
believe it to be misleading.
28
Chapter 3: The theory of auditing
Providing value
Auditors add to the reliability and quality of financial reporting; they
provide to directors and officers constructive observations arising from
the audit process; and thereby contribute to the effective operation of
business, capital markets and the public sector.
Sadly even this brief statement of values has been omitted from recent
versions of the FRC’s statement, Scope and Authority of Audit and
Assurance Pronouncements. Nevertheless, the Code contains a long-lasting
set of principles, which are still relevant today.
You will note that the word ‘should’ does not appear at all in the Code.
This is because it is felt that instructions on what auditors ‘should’ and
‘should not do’ can only be given in auditing standards.
The Future
Despite years of neglect of auditing theory by regulatory and
representative bodies, there is now a prospect of change in the near future.
The Brydon Review suggested that a set of Principles of Corporate
Auditing be developed to help to create a new ethos in the auditing
profession and to stimulate a greater sense of scepticism, challenge
management and be more informative for readers of financial statements.
The Government seems to be very much in favour of this suggestion.
Although not quite the equivalent of financial reporting’s Conceptual
Framework, this is at least a nod in the right direction, suggesting that at
last the authorities realise the value of spelling out key principles rather
than adding to the list of detailed requirements in auditing standards.
It is worth pointing out that, as with any of the topics on the syllabus, you
would not be expected to memorise, let alone reproduce, the entire set of
ideas. If the topic of auditing theory were to appear on the examination
paper, it is likely to be an essay question worth 25 marks, and you
should spend no more than 45 minutes answering it. The knowledgeable
candidate is likely to be able to write on the topic for much longer but to
do so would not be an effective use of their time. The common error made
by candidates is to write all they know. This often takes the form of lists
of points, and while they may cover all the points, they do not constitute
a properly structured and well-argued essay. Consequently, such answers
are unlikely to obtain more than a pass mark. What the well-prepared
candidate always seeks to do is to answer the question within the allotted
time. If this means that some points cannot be covered then so be it. But
you must always attempt to address the question and not just reel off your
revision notes.
3.6 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain what constitutes a theory
•
explain the difference between assumptions and concepts
•
discuss the role a theory of auditing could perform
•
list the main components of a possible theory of auditing.
29
AC3093 Auditing and assurance
3.7 Test your knowledge and understanding
3.7.1 Sample examination questions
1. Explain what you would consider to be the main components that a
theory of auditing would include.
2. Consider the benefits of having a sound theoretical basis from which to
develop auditing standards.
3. The IASB has issued its Framework for the presentation of financial
statements and the ASB has issued a Statement of principles for financial
reporting. To what extent do you think it would be possible to produce
a ‘statement of principles’ for auditing?
3.8 Hints
3.8.1 Pause and think questions
1. a. A theory is an abstract set of ideas which helps us to understand the part of the world we are contemplating.
b. A theory of auditing would help us understand what an audit seeks
to achieve and more importantly how it can achieve the desired
end. Auditing standards are practical guides but they are not
theoretical.
2. There are so many different examples of situations where we need
some form of check but they will nearly all fit into one of these three
categories.
3. It would be difficult to see how it would be practical for a company
to open its books to all shareholders and since most investors lack
accounting skills, it would be a worthless exercise. So the answer to
the question is almost always going to be ‘No’.
4. There are a number of threats to audit independence: close personal
relationships, long working relationships or financial involvement
with an audit client are just some examples of situations which might
impair audit independence.
5. The evidence that auditors might look for to support sales revenue
would include the till receipts but of course this only reflects the
transactions which have been recorded and there is the possibility that
items have been sold and the proceeds have been stolen. So auditors
would look at things like turnover ratios and profit margins to see if
there were any distortions. For expenses, invoices and proof that the
goods had actually been received would provide evidence. For both
income and expense quite a lot of emphasis would be placed on the
auditors’ assessment of control systems.
6. This is a very sensitive area and one where answers can validly differ
depending on one’s ethical and cultural background. The furore that
has followed revelations in Westernised countries about bribery and
corruption committed by respected companies would suggest that
the public and political perception of this problem is that it is not
acceptable. In the UK, auditors who discover illegal acts committed by
clients are expected to report those acts to the appropriate authorities
which may include the police.
7. The evidence suggests that the audit of financial statements is almost
certainly not well understood. The public still associate the process of
30
Chapter 3: The theory of auditing
auditing with the detection of fraud. They also imagine that auditors
somehow are able to ‘guarantee’ that clients are financially sound.
8. It could be argued that we all benefit from having greater confidence
in the accuracy of the information being fed to the markets. A better
informed stock market is more stable and this will be more likely to
stimulate economic growth, creating more jobs and more wealth.
3.8.2 Sample examination questions
1. You would need to have a good grasp of the various theories of
auditing and be prepared to discuss the different assumptions and
concepts not as a list, but as a flowing explanation. It is unlikely
in the time available in the examination that you could produce a
comprehensive review so it would be important to make sure that you
touched on the main parts.
2. An accepted theory of auditing would help everyone from teachers to
students to practitioners and to standard-setters. It would provide a
sound basis for understanding what auditing is about and how it could
be better done.
3. This is quite a tricky question and one that you should not tackle by
simply repeating the lists of assumptions and concepts. There is no
obvious reason why a theory of auditing has not evolved. However,
it would not be a simple task because notions of auditing may vary,
albeit slightly, in different countries. In addition, it would take time
and money to get agreement. The fact that it has been achieved for
financial reporting suggests that, if there were the ‘political will’, it
should be possible to come up with a ‘statement of principles’ for
auditing.
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AC3093 Auditing and assurance
Notes
32
Chapter 4: Independence
Chapter 4: Independence
4.1 Introduction
There are a number of different perspectives from which one can view
audit independence. The conventional four main aspects of independence
that we will consider are:
•
programming independence
•
investigative independence
•
reporting independence
•
real and perceived independence.
The first three of these were identified by Mautz and Sharaf (1961) as
relating to individual auditors (or audit firms). Mautz and Sharaf also
discussed independence at the level of the audit profession itself.
Now read
Gray et al. (2019) pp.64–85.
Porter et al. (2014) pp.99–104.
Activity
Make a list of as many potential threats to independence as you can that may affect an
individual auditor. For each threat, note down what measures you think that the following
could take to address these threats:
• an individual auditor
• the profession as a whole.
Many attempts to address auditor independence have been made over
the years. In the USA, the Sarbanes–Oxley Act seriously curtailed the
provision of other services to audit clients (following Enron and other
scandals). More recently, searching questions have been asked of the role
of the big auditing firms in the banking crisis of 2007–2008 and following
the collapse of large companies in the UK such as Carillion. Much of that
concern centred on how the companies could fail, having received clean
audit reports. Doubts were raised over the independence of the auditors to
their audit clients.
So independence remains a contentious issue, long after the first
independence rules and ethical codes were established.
What follows are extracts from the current legislation in the UK, the
Companies Act 2006. Obviously the legislation in your own country may
be different but it is likely to contain similar provisions on most of the
important issues. Nevertheless, whether you are learning about your own
national laws and regulations or reviewing the position in the UK, great
care needs to be taken to ensure that you are not relying on material that
is out of date. Government websites usually allow easy access to the most
relevant legislation and you should always check your sources against them.
Very often major changes in legislation will be flagged up in the professional
press before they become effective, so you should try to keep up to date by
regularly reading the journals of the relevant accountancy bodies. Although
the legislation is of course only relevant in the UK, there are other countries
around the world which often implement similar legislation.
33
AC3093 Auditing and assurance
In the UK, the Companies Act 2006 has made changes to provisions
affecting auditors, but many of the principles from the previous Act remain
(the section numbers in the new Act are of course quite different to those
in the previous legislation).
Now read
Porter et al. (2014) pp.161–65 and pp.104–07.
Gray et al. (2019) pp.68–80.
Dunn, J., D. Hillier and A.P. Marshall ‘The market reaction to auditor resignations’,
Accounting and Business Research 29(2) 1999, pp.95–108.
4.1.1 Aim of the chapter
The aim of this chapter is to explain the essential quality of auditing –
auditor independence – and the threats which exist to undermine that
independence; as well as the safeguards which may be established to
counter such threats.
4.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you should be able to:
•
explain what audit independence entails
•
explain why audit independence is important
•
examine the current concerns relating to auditor independence
•
describe steps which have been taken to ensure that auditors retain
their independence
•
evaluate the effectiveness of these various measures
•
suggest other possible means of achieving auditor independence.
4.1.3 Essential reading
Barkess, L. and R. Simnett ‘The provision of other services by auditors:
independence and pricing issues’, Accounting and Business Research, 24(4)
1994, pp.99–108.
Beattie, V., S. Fearnley and R. Brandt ‘Perceptions of auditor independence: UK
evidence’, Journal of International Accounting, Auditing and Taxation 8(1)
1999, pp.67–107.
Beattie, V., S. Fearnley and T. Hines ‘Perceptions of factors affecting audit quality in
the post-SOX UK regulatory environment’, Accounting and Business Research
43(1) 2013, pp.56–81.
Dart, R. and E. Chandler ‘Client employment of previous auditors: shareholders’
views on auditor independence’, Accounting and Business Research 43(3)
2013, pp.205–24.
Dunn, J., D. Hillier and A.P. Marshall ‘The market reaction to auditor resignations’,
Accounting and Business Research 29(2) 1999, pp.95–108.
Gray et al. (2019) Chapter 3 ‘The meaning and importance of auditor
independence: factors affecting independence and measures to attain it’,
pp.64–108.
Holland, K. and J. Lane ‘Perceived auditor independence and audit firm fees’,
Accounting and Business Research 42(2) 2012, pp.115–41.
Patel, C. and J. Psaros ‘Perceptions of external auditors’ independence: some crosscultural evidence’, British Accounting Review 32 2000, pp.311–38.
Porter et al. (2014) Chapter 4 ‘Threats to, and preservation of, auditors’
performance’, pp.99–157.
International Federation of Accountants (IFAC)
34
Chapter 4: Independence
4.1.4 Work cited
Mautz, R.K. and H.A. Sharaf The philosophy of auditing. (Sarasota, FL: American
Accounting Association, 1961) [ISBN 0865390029].
4.2 Companies Act 2006, Part 42
The main purposes of this part of the Act are to ensure that only those who
are properly supervised and appropriately qualified are appointed auditors
and that audits are carried out properly, with integrity and a proper degree
of independence (s.1209).
Eligibility (s.1212)
An auditor must be a member of a Recognised Supervisory Body (RSB)
and must be entitled under the RSB’s rules to act as auditor (this
establishes the concept of a Registered Auditor).
Ineligibility (s.1213)
A person cannot act as auditor if they are ineligible. If someone is
appointed and then becomes ineligible, they must resign immediately and
give notice to the company.
Independence requirement (s.1214)
A person cannot act as auditor if they are an officer or employee of the
company to be audited, or if they are the partner or employee of an
officer or employee; or if they are an officer or employee of an associated
undertaking (parent company or subsidiary).
Effect of lack of independence (s.1215)
If during his term of office, an auditor becomes prohibited from acting
(under the independence requirement), he must resign immediately and
give notice to the company in writing. It is an offence if he does not comply.
Effect of appointing a partnership (s.1216)
If a partnership is appointed, the firm is the auditor not the individual
partner(s).
4.3 Companies Act 2006, Part 16
Appointment of auditors (s.475)
A company’s accounts must be audited unless it is exempt or dormant.
Members may require an exempt company to have its accounts audited.
Section 485 Private companies
The company’s directors may appoint its first auditor, or its first auditor
after it ceases to be exempt or to fill a casual vacancy. In all other cases, it
is the members who appoint the auditor.
Section 487
Auditors hold office until they are replaced or they resign.
Section 489 Public companies
Auditors must be appointed for each year by directors to begin with (as
with private companies), then by ordinary resolution of the members.
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AC3093 Auditing and assurance
Section 491
Auditors cease to hold office at the conclusion of the next accounts
meeting after their appointment unless they are re-appointed.
Remuneration (s.492)
The auditors’ remuneration is fixed by shareholders unless the auditor
was appointed by the directors or the secretary of state. The term
‘remuneration’ includes expenses and benefits in kind.
Disclosure of terms and remuneration (ss.493–4)
The secretary of state may make regulations requiring disclosure of terms
of auditors’ appointment and the nature of non-audit services provided by
the auditor.
Auditor’s duties (ss.495–8)
These sections of the Act are aimed at ensuring reporting independence.
Auditors must make a report to the company’s members on all annual
accounts sent to them. The auditors’ report must include an introduction
identifying the audited accounts and the reporting framework and a
description of the scope of the audit identifying the auditing standards.
Auditors must state clearly whether in their opinion the accounts give a
true and fair view, have been properly prepared in accordance with the
framework and prepared in accordance with the Act. The report must
be unqualified (unmodified) or qualified (modified) and must include a
reference to any matters to which the auditor wishes to draw attention
without a qualifying (modifying) report. Auditors report on whether
information in the directors’ report is consistent with the accounts. They
also report on the auditable part of the directors’ remuneration report.
Auditors must carry out investigations to determine and report (in the
negative) if adequate accounting records are not kept, if the accounts do
not agree with records or if they fail to obtain all the information and
explanations necessary for their audit.
Auditors must report if aspects of disclosure of directors’ remuneration do
not comply with the relevant regulations. They must report if the company
has prepared accounts under the small-company regime, but the auditors
consider that the company is not entitled to use this regime (for example,
because it is too large).
Auditors’ rights (ss.499–500)
These sections are to ensure investigative independence in that neither
directors nor anyone else can restrict the evidence which auditors may
require for the purposes of their audit.
•
Auditors have the ‘right of access at all times to the company’s
books, accounts and vouchers and may require such information and
explanations as are necessary’.
•
Auditors ‘may require a company to obtain from overseas
subsidiaries information and explanations. Company directors must
take all reasonable steps to obtain the requested information and
explanations’.
Offence (s.501)
It is a criminal offence to provide recklessly or knowingly information
which is misleading, false or deceptive in a material particular.
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Meetings (s.502)
Auditors have the right to be notified of any general meeting and to attend
that meeting and be heard on any matter concerning them as auditors.
Removal/resignation of auditor (ss.510–26)
Only shareholders can remove an existing auditor (by ordinary resolution)
in general meeting with special notice. Once the resolution is passed the
company must notify the Registrar of Companies within 14 days.
It is possible that auditors in some circumstances may wish to resign –
they are entitled to do this, but they must deposit a written notice with
the company. Audit firms may resign because they no longer have faith in
the accuracy of information provided to them by a client. A high-profile
example arose with the resignation of the auditors of one of the companies
run by former US President Trump. We may see other auditors decide to
distance themselves from clients based in countries that are seen in a bad
light such as Russia in the light of its internationally condemned invasion
of the Ukraine.
When auditors cease to continue in office, either because they have been
removed or have chosen to resign, they must make a statement containing
a description of the circumstances. The company concerned must circulate
this statement to members within 14 days (or it may apply to court for
an order to prevent the circulation on the grounds that the auditor is
using the report to secure needless publicity for a defamatory matter).
For a failed attempt to silence an auditor, see Jarvis v PwC 2000, outlined
in Gray et al. (2019), p.149. For evidence that the market takes notice
of auditor resignations and marks down share prices accordingly, even
when auditors claim that there are no circumstances to be brought to the
shareholders’ attention, see Dunn, Hillier and Marshall (1999).
The auditors must file a statement of circumstances at Companies House
and both the auditors and the company must notify the appropriate
authorities where the appointment which has ended relates to a major
audit (a listed company or a major public interest company).
4.4 International Ethics Standards Board for
Accountants
In the UK, the Auditing Practices Board (APB) was reorganised in 2012 as
part of the restructuring of the Financial Reporting Council. The FRC itself
has been in the process of being reformed for some time. The plan is to
replace the FRC with the Auditing, Reporting and Governance Authority
(ARGA), which is expected to be established in 2023/24. Progress has
been hindered by parliamentary time having to be devoted to urgent
matters such as dealing with the Covid pandemic and implementing
Brexit.
The need for reform of the way the accounting and auditing profession
is regulated was recognised by the Kingman Review − an investigation
set up by the UK government in the wake of high-profile scandals such
as Carillion, Patisserie Valerie and BHS. Kingman recommended that
ARGA be directly accountable to parliament, should work towards more
effective oversight of the profession and should take steps to address
the concentration in the audit of listed companies. The Big 4 accounting
firms audit nearly all of the top 250 listed companies, and it was this
concentration that was considered a weakness by reviews that followed
the global financial crisis in 2008.
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The UK’s Ethical Standards (ESs) issued in 2019 are authoritative
statements governing auditors. In substance, the ESs conform to the
revised International Code of Ethics for Professional Accountants
implemented by the International Ethics Standards Board for Accountants
of the International Federation of Accountants (IFAC). The aim of IFAC
is to develop standards which can be adopted by its member bodies in
order to promote ‘a level playing field’ around the world. The majority
of countries that have an IFAC member and subscribe to the IFAC aim
will have aligned their national rules to be consistent with the IFAC code
so the principles will be similar in content to many independence rules
around the world. These standards seek to deal with the various threats to
auditors’ objectivity. These are:
•
self-interest threat (e.g. investing in clients)
•
self-review threat (e.g. producing a valuation for inclusion in the
client’s financial statements)
•
management threat (e.g. taking a decision on behalf of management)
•
advocacy threat (e.g. supporting management in litigation)
•
familiarity threat (or trust) (e.g. close relationship with client
personnel)
•
intimidation threat (e.g. by dominant senior executive).
In addition, the UK standards recognise another type of threat −
management threat (for example, taking a decision on behalf of
management).
Section 1: General requirements and guidance
Firms should have policies and procedures in place to identify threats to
their actual and perceived objectivity and independence and to identify
and assess the effectiveness of any safeguards. The audit firm should
appoint an ethics partner who is responsible for ensuring the firm’s
compliance with the Ethical Standards.
Since December 2019 there has been a ban on auditors taking part in any
management decision making for public interest entities.
Section 2: Financial, business, employment and personal relationships
Financial relationships
Financial interests: An audit firm, a partner, or a person in an
influential position in the firm (or an immediate family member)
should not have a direct financial interest in a client. Neither should an
auditor have a material indirect interest or an indirect interest through
an intermediary where the auditor has the ability to influence the
intermediary or knows of the underlying investment in the client.
If, for example, an auditor inherits under a will shares in an audit client,
the shares must be disposed of immediately.
Interests held as trustee: Trustee holdings in an audit client are
acceptable where the auditor is not a beneficiary of the trust, or the
interest is immaterial to the trust, or the trust is not able to exercise
significant influence over the client, or the auditor does not have
significant influence over the trust.
Loans and guarantees: No loans should be made to – or received from
– a client except in the ordinary course of business on normal business
terms and where the loan is not material either to the firm or its client.
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Business relationships
General: Auditors should avoid doing business with audit clients unless
the transaction involves the purchase of goods or services in the ordinary
course of business on arm’s-length terms and for values which are not
material to either party. Firms should not provide audit services to any
party able to influence the affairs of the audit firm or conduct of its audit.
Employment relationships
Management role: Auditors should avoid situations where they are
employed by both the audit firm and the audit client. Such situations
might arise when an audit client is faced with a sudden vacancy caused
by the unexpected departure, illness or death of a key member of its staff.
The client may turn to its audit firm for help in an emergency. Audit firms
should not provide staff on secondment unless it is to a non-managerial
post and the client accepts responsibility for directing the work of that staff
member. On return to the audit firm, that individual should not be given
responsibility for auditing the work that they did for the client (since this
would ignore the self-review threat).
Auditor joining client: If a member of the audit firm leaves the firm
to join an audit client, that individual must sever all links with the firm.
Auditors should notify the audit firm’s management as soon as a move to
an audit client looks likely. The individual concerned should stand down
from the audit and their work on the current and last audit should be
reviewed.
If the individual moving to the client is the audit partner and they are
moving to take up a senior management post, then the audit firm should
resign from the audit and should not allow itself to be considered for
re-appointment for two years. If a more junior member of the audit team
makes the move to a key management post with the audit client, then the
audit firm should reconsider the composition of the team. It may be that
those who remain on the audit team had developed such close ties with
their former colleague that their objectivity, now that the colleague holds a
senior post with the client, cannot be guaranteed.
The evidence on this aspect of independence is not compelling. Dart and
Chandler (2013) find that institutional investors hardly seem concerned
at all that ex-auditors often find work in a former audit client. While there
is more concern among private individuals as shareholders, there is very
little desire on the part of shareholders generally for the professional
rules to be further tightened to prevent movement of personnel between
audit firm and audit client. However, financial journalists are not slow to
pick up on apparently cosy relationships as witnessed in the Independent
newspaper in June 2013 when it reported warnings to the board of the
Royal Bank of Scotland not to appoint any more former executives from its
auditors, KPMG.
Governance role: Auditors should avoid being appointed to the board
or a subcommittee of the board of an entity that holds more than 20 per
cent of the voting rights in one of their audit clients.
Employment with auditor: It sometimes happens that audit firms wish
to appoint to a staff position a former employee of an audit client. Where
that individual had some influence over the accounting function in the
client or the production of its financial statements, the audit firm should
take care to ensure that the new employee is not allocated to the audit team
responsible for the audit of their former employer for two years.
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Personal relationships
Firms should institute policies and procedures to alert them to family and
other relationships between audit team members and clients. For example,
audit firms should inform their employees on a regular basis of their client
portfolio and employees should be asked to make a declaration of their
relationships and financial interests in clients of the firm.
Section 3: Long association with the audit engagement
To ensure that the relationship between public interest companies and
their auditors does not become too familiar, the audit engagement partner
should be replaced after five years (other partners who have a role in the
audit should not serve the same public interest client for more than seven
years). For other companies, audit firms need to consider whether the
partner is or may be seen to be independent after 10 continuous years. If
an audit client becomes listed, then the five-year rule still applies, although
a special arrangement allows an audit partner who has served the client for
four years prior to listing to continue to serve for two years after listing.
In addition, the UK has adopted the EU Audit Regulation which requires
audit firms, not just the audit partner, to be rotated after 10 years with an
extension of another 10 years if the audit had been put out to public tender
or an extension of 14 years if the incumbent is a joint audit – where more
than one audit firm is involved in the audit. The UK has of course left the
EU, but it will be some time before the EU-influenced laws and regulations
can be unwound and there is at present no sign that this requirement
would be a likely priority for early reversal. So, it is most probable that the
mandatory rotation of audit firms will remain for the foreseeable future,
and there are strong arguments in support of that position. In the past, it
was not unusual for incumbent audit firms to remain in post for 20, 30 or
40 years or more, and while it could be suggested that in such a situation
the audit firm would have developed extensive knowledge and expertise
of that client and its industry, the problem is that such lengthy association
with the client does not make the audit firm look very independent.
Undoubtedly restricting the length of tenure of an audit appointment will
enhance the apparent independence of the auditors, but it must come at
a cost. A change of auditor every so often means that a new firm would
have to acquire the knowledge and understanding of the client, and this
will be expensive. In addition, more mistakes would likely be made (there
is evidence that audit ‘failures’ typically occurs in the early years of an
auditor’s appointment).
Section 4: Fees, remuneration, evaluation policies, litigation, gifts and
hospitality
Fees
Fees should not be charged on a contingent basis, for example as a
commission or as a percentage of some unknown amount, such as some
future financial saving made by the client.
Firms should be aware that unpaid audit fees may threaten their
independence (unless they are for trivial amounts). In effect, outstanding
fees owed by the client to the firm are a form of loan by the auditors and
may be used by the client as a lever to get the auditors to accept treatments
they would not otherwise accept. The client may threaten not to pay these
overdue amounts unless the auditors agree with the client.
A firm should not act where fees (audit and non-audit) from the client
exceed 10 per cent of the firm’s total income.
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Total fees paid by public interest entities to their audit firm for non-audit
services are limited to no more than 70 per cent of the average fees (audit
and non-audit) paid in the last consecutive three financial years.
Remuneration and evaluation policies
Firms should ensure that the objectives of the audit team do not include
selling non-audit services, nor are their appraisals or pay dependent on
persuading clients to engage the firm to perform such other services.
Litigation
When litigation in relation to an audit firm’s services, which is not
insignificant, has been or is about to be started, the audit firm should not
continue with or accept the engagement.
Gifts and hospitality
Auditors should not accept gifts from clients unless they are clearly of
insignificant value, nor should they accept hospitality unless it is reasonable
in terms of frequency, nature and cost. Audit firms should have policies to
ensure that staff understand these principles and comply with them.
Section 5: Non-audit services provided to audit clients
The audit partner must be informed of all non-audit services that the firm
renders to the audit client. Before accepting a non-audit engagement,
the audit engagement partner must consider the appearance of the
firm’s independence (or lack of it), identify possible threats and assess
effectiveness of the firm’s safeguards. Where there appears to be a conflict,
a firm should either not accept the non-audit engagement or decline/
withdraw from the audit.
The firm should inform those charged with governance (i.e. the audit
committee or its equivalent).
There are additional special considerations for the audit of public interest
entities. For firms carrying out audits of PIE’s there is a ‘black list’ of nonaudit services that this audit firm is banned from providing to its audit
client. When services are permitted they are usually subject to the 70% cap
referred to above in section 4.
Black listed non-audit services include the following:
•
Internal audit services are generally thought not to be compatible with
the external audit.
•
Information technology services, again, are not thought to be
compatible with the independent audit function.
•
Valuation services should not be provided where the matter is highly
subjective and material to the financial statements.
•
Actuarial services should not be provided unless all significant
judgements are taken by management or are immaterial.
•
Tax services should not be provided where the audit partner has
doubts about the appropriateness of any accounting treatments or the
tax services are to be remunerated on a contingent fee basis which is
material or is dependent on uncertain tax law.
•
Litigation support services should not be provided where they involve
giving an estimation of the likely outcome of a case, which is material
and very subjective.
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•
Legal services should not be provided if the matter is material.
•
Recruitment services should not be provided if they involve making
a decision to appoint personnel to the client’s staff. For listed clients,
no recruitment services should be provided in relation to key
management positions. Auditors should not undertake to advise on
remuneration packages of key management posts.
•
Corporate finance should not be offered if it amounts to dealing or
promoting shares, or if the firm has doubts as to the appropriateness of
any accounting treatment, or if the service is to be remunerated on a
contingent fee basis.
•
Accounting services should not be offered for listed companies (except
to cover emergency situations). Auditors may assist audit clients who
are not publicly listed, provided transactions are not initiated by the
audit firm employees, no decisions are taken by them and the firm
implements safeguards to maintain their independence.
Holland and Lane (2012) report evidence that only when the level of
non-audit fees becomes extremely high do shareholders get sufficiently
concerned about the threat which non-audit services pose to auditors’
independence that they sell their shares. They suggest that this behaviour
indicates that investors are relatively comfortable with moderate levels
of non-audit services even though in theory these might still compromise
auditor independence.
Now read
Porter et al. (2014) pp.107–39. Gray et al. (2019) pp.80–108.
Barkess, L. and R. Simnett ‘The provision of other services by auditors: independence and
pricing issues’, Accounting and Business Research 24(4) 1994, pp.99–108.
Dart, R. and E. Chandler ‘Client employment of previous auditors: shareholders’ views on
auditor independence’, Accounting and Business Research 43(3) 2013, pp.205–24.
Holland, K. and J. Lane ‘Perceived auditor independence and audit firm fees’, Accounting
and Business Research 42(2) 2012, pp.115–41.
A study by Barkess and Simnett (1994) of Australian companies’ use of
their auditors for non-audit services produced no evidence that there was
a link between non-audit services and either type of audit report or length
of tenure – which suggests that in Australia non-audit services pose no real
threat to auditor independence.
4.4 Other ethical concerns
The key qualities which professional accountants are expected to exhibit
are:
a. integrity
b. objectivity
c. professional competence and due care
d. confidentiality and
e. professional behavior.
Students should be able to discuss these qualities and explain why they are
important in building and maintaining trust in the accounting profession.
To some extent, the value of these qualities is obvious, but students need
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Chapter 4: Independence
to be able to articulate an argument about how each is an important
characteristic of those seeking to check and report upon the financial
statements of others.
4.5 Professional clearance
The proposed new auditor should contact the existing auditor to obtain
information about the circumstances of the proposed change in auditors.
The existing auditor is under a professional obligation to supply that
information. The new auditor needs to consider very carefully whether it
is wise to accept the engagement if the client refuses to give authority to
contact the outgoing auditor or if, having written to the existing auditor
asking for information, either no reply is received or the reply indicates
professional reasons for not accepting the appointment.
Now read
Porter et al. (2014) pp.140–57.
Beattie, V., S. Fearnley and R. Brandt ‘Perceptions of auditor independence: UK evidence’,
Journal of International Accounting, Auditing and Taxation 8(1) 1999, pp.67–107.
Patel, C. and J. Psaros ‘Perceptions of external auditors’ independence: some crosscultural evidence’, British Accounting Review 32 2000, pp.311–38.
Activity: practice questions
Porter et al. (2014) pp.152–53, Questions 4.1, 4.2 and 4.9.
4.5.1 Whistleblowing
Audit firms, like their large corporate clients, should have provision for
employees to sound the alarm when they become aware of practices
within the firm that are not appropriate. For example, where junior
members of staff are instructed to manufacture audit working papers to
support audit work that was not done or to destroy audit evidence that
might incriminate the partner or the firm.
The firm’s senior management must take whistleblowing seriously and be
prepared to take action to correct the situation. The risk of failing to act
or of acting incorrectly is shown in the case of Rihan v EY (High Court).
The plaintiff had worked as an audit partner on behalf of a member of the
EY global network. He discovered that an audit client based in Morocco
was circumventing the country’s currency controls by exporting gold bars
coated in silver. The coating was removed on arrival in Dubai and declared
gold. These shipments gave a false impression of the client’s profitability.
The plaintiff claimed that he had informed the authorities and senior EY
leadership, but he was put under pressure to overlook the matter. In the
end, he was forced to resign from his position within the EY network. The
judge upheld his claim for damages for loss of earnings and benefits such
as life insurance. He was awarded nearly US$11m.
The future
Following the Brydon Review, the UK Government proposes establishing a
new Code of Ethics based more closely on the IESBA’s code. So, you should
try to keep track of changes in this area as well as others.
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4.6 Audit committees
You should also be aware of the wider issues surrounding the concept of
auditor independence. For example, audit committees are seen as being an
essential part of a company’s corporate governance arrangements as they
help to enhance the auditors’ independent status.
The role of audit committees has been significantly developed in the UK
following the Cadbury Report on corporate governance in the early 1990s
and the later Smith Report on the role of audit committees. The most
recent version of the UK’s Corporate Governance Code was issued in 2018,
and the guidance on audit committees dates back to 2016.
The Code states that the committee should comprise at least three
independent non-executive directors (not including the company
chairman).
The role of audit committees is to:
•
review the company’s internal financial controls and, unless
expressly addressed by a separate board risk committee composed of
independent directors, or by the board itself, review the company’s
internal control and risk management systems
•
monitor and review the effectiveness of the company’s internal audit
function
•
make recommendations to the board to put to the shareholders for
their approval in general meeting, in relation to the appointment, reappointment and removal of the external auditor and to approve the
remuneration and terms of engagement of the external auditor
•
review and monitor the external auditor’s independence and
objectivity and the effectiveness of the audit process, taking into
consideration relevant UK professional and regulatory requirements
•
monitor the integrity of the financial statements of the company,
and any formal announcements relating to the company’s financial
performance, reviewing significant financial reporting judgements
contained in them
•
develop and implement policy on the engagement of the external
auditor to supply non-audit services, taking into account relevant
ethical guidance regarding the provision of non-audit services by the
external audit firm
•
report to the board, identifying any matters in respect of which
it considers that action or improvement is needed and making
recommendations as to the steps to be taken.
The committee should:
•
have meetings which are only open to committee members
•
be adequately resourced
•
include at least one member with experience as an auditor or finance
director
•
report unsatisfactory findings to the board.
You need to be able to comment on as many of these aspects as you can
rather than just reciting the list. Questions are likely to be in the form of
‘Critically evaluate the extent to which an audit committee can improve
effective corporate governance’ or ‘Consider the strengths and weaknesses
of the concept of the audit committee as an intermediary between audit
firm and audit client’.
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4.6.1 Possible problems
1. How are companies to ensure that only those with sufficient
competence are appointed to serve on audit committees?
2. How are companies to attract candidates with sufficient independence
from the company itself and from senior management (for example,
questions have been raised about the independence of individuals in
the Hollinger/Lord Black case in the USA and the Northern Rock affair
in the UK)?
3. There has also been concern that additional governance
structures such as audit committees will inhibit executive flair and
entrepreneurial risk-taking.
4. The cost of compliance with the governance rules may dissuade some
companies from seeking listings.
4.7 The Sarbanes–Oxley Act
Now read
Is the UK ready for Sarbanes-Oxley?
Beattie, V., S. Fearnley and T. Hines ‘Perceptions of factors affecting audit quality in the
post-SOX UK regulatory environment’, Accounting and Business Research 43(1) 2013,
pp.56–81.
The Sarbanes–Oxley Act has had a major impact on audit firms around the
globe, not just in the USA. Although you do not need to know the many
detailed requirements of the Act, you should have some knowledge of the
main requirements that seek to improve auditor independence.
In terms of perceptions, the work of Beattie, Fearnley and Hines (2013)
informs us that most chief financial officers, audit committee chairs and
audit partners seem to think that Sarbanes–Oxley has been a massive
compliance exercise, although there is a general feeling that audit
committees have had a positive effect on audit quality.
Pause and think 1
To what extent do you think that the Sarbanes–Oxley Act is likely to achieve its aims of
improving auditor independence? Does the Act go far enough, or too far?
4.8 More extreme suggestions
You should be generally aware that more extreme measures have been
suggested as a way of better ensuring that auditors possess the required
independence.
Suggestions for improving auditor independence include joint or shared
audits, audit-only firms and government appointment of auditors.
Joint or shared audits would require audit firms appointing a Big Four
auditor to also appoint a challenger firm to share the audit process.
The rationale is that this should improve audit quality, competition and
choice within the market. In Belgium, South Africa and some other
African jurisdictions, joint or shared audits are mandated for financial
services companies. In France, joint audits are mandated for larger listed
companies, banks and political parties. Joint audits were once common
practice for financial institutions in the UK.
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Those opposed to joint audits cite an increase in costs for audit firms as
their principal concern. Other concerns include whether challenger firms
have the competencies to be involved in large public interest audits, the
implications for legal liability and the implications for the provision of
non-audit services to these large companies if more firms become involved
in their audit work.
Other suggestions are that a government or quasi-governmental body
should take on the task of appointing and deciding the remuneration of
auditors. This would remove the temptation for auditors to be too familiar
with management or to be intimidated by them.
Another possibility is that government itself could employ auditors to
audit major companies. This sort of suggestion seems to buck the trend
of less government involvement in the regulation of business activities
but it is still worth considering as an option and you should be prepared
to consider these suggestions in answering general questions on ways of
making auditors independent of the companies they audit.
4.9 A reminder of your learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain what audit independence entails
•
explain why audit independence is important
•
examine the current concerns relating to auditor independence
•
describe steps which have been taken to ensure that auditors retain
their independence
•
evaluate the effectiveness of these various measures
•
suggest other possible means of achieving auditor independence.
4.10 Test your knowledge and understanding
4.10.1 Sample examination questions
1. a. Explain why auditor independence is an important quality for auditors to possess.
b. To what extent do you consider that legal rules and professional
regulations are able to ensure that auditors do possess this quality?
2. An audit committee is an indispensable aid to auditor independence.
Critically examine the role of audit committees and consider what
difficulties such committees face in aiding auditor independence.
3. Auditor independence is fundamental to the very concept of
accountability and audit. Examine the extent to which regulations
ensure that company auditors can be seen to be independent.
4. Identify cases which have come to light where auditors’ independence
has been called into question and evaluate the case against the
auditors and the audit profession.
5. Explain the extent to which you consider that it is important
for auditors not only to be independent but also to appear to be
independent; and critically evaluate the likely effectiveness of the
methods proposed by the profession’s critics for improving both real
and apparent independence.
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Chapter 4: Independence
4.11 Hints
4.11.1 Pause and think question
1. This is a difficult question to answer without getting into the detail
of the Act. However, restricting the sorts of other services auditors
can supply to their clients must reduce the risk of independence
being impaired and certainly increases the appearance of audit
independence.
4.11.2 Sample examination questions
1. You should at least attempt to explain why independence is important
even if you think it is obvious. You should mention actual and
apparent independence and you should have a sufficiently detailed
knowledge of the regulations in your country or internationally to be
able to assess both the strengths and weaknesses of the regulatory
regime. At the very least, you should refer to the fact that in most
countries the audit fees are paid by the company being audited and
that, to some, this does not look very independent.
2. You should understand and explain that the audit committee acts as
a buffer between management and auditor. The presence of an audit
committee is designed to project a greater element of independence.
Audit committee members are caught in the middle between
management and auditors and may have a difficult job to mediate
conflicting views. It is also notoriously difficult to get high quality,
objectively minded individuals to serve as audit committee members.
3. The word ‘ensure’ is always problematic. There can never be any
guarantee that auditors will always behave as they should nor that the
public will perceive them in the manner that is intended. In answering
this question you should be prepared to comment on both the
strengths and weaknesses of the regulations. For example, the ‘rule’
that one audit client should not provide more than 10 per cent of the
recurring income to the audit firm may seem to favour the firm since
10 per cent is quite a large percentage; critics have argued that this
threshold should be lowered to, say, 5 per cent.
4. This is a tricky question unless you have a very good knowledge of
the infringements of ethical rules. There have been cases but there
are not many. Key problem areas tend to be undue reliance on income
from a client, audit firm members investing in the shares of clients,
long association between audit firm and audit client and audit staff
being recruited as employees by audit clients. You should be prepared
to weigh up both sides. Consider, for example, the consequences of
banning auditors from choosing to work for an audit client as an
employee.
5. You should be able to argue that it is important for auditors to be
independent of their clients otherwise they cannot examine the
clients’ financial statements with an objective eye. But, equally, it is
vital that the investing public perceive the auditors to be independent
otherwise no value is added by having the audit. There are several
suggestions for improving independence; from banning other services
or the compulsory rotation of audit firms to having a government
department audit large companies. You should try to keep up to date
with developments since, in Europe at least, some of these suggestions
are now more mainstream than they once were.
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Notes
48
Chapter 5: Audit reporting
Chapter 5: Audit reporting
5.1 Introduction
The auditors’ report is the only visible sign that the check, which we
said at the outset of this subject guide was so important, has actually
been carried out. Without an audit, we said, the financial statements
constructed by the directors and presented to the shareholders could not
be relied upon. The mere fact that an audit has been conducted and the
results reported in the form of an opinion on the financial statements has
been shown by Dedman and Kausar (2012) to improve credit ratings even
though companies may be reporting lower profits than their unaudited
counterparts.
In the auditors’ report, the key message is whether the audited financial
statements show a ‘true and fair’ view of the financial position and
performance of the organisation. Such is the importance of this message
that the auditors’ report now usually starts with the opinion paragraph
whereas, in the past, the reader had to plough through a page or even
more of other material before getting to the opinion.
A first question is: What do we mean by the term ‘true and fair’? You will
find that there are no definitions of this term in any accounting or auditing
standards. There is a good reason for this – it is very hard to put in writing
exactly what accountants mean by this term.
‘True’ can mean ‘representing the thing as it is’. We could therefore try
to think of ‘true and fair’ as meaning, perhaps, ‘accurate and objective’.
However, this is misleading. Accounts are by their very nature subjective;
even historical-cost accounts require the use of estimates and judgement
(for example, in determining the likely useful economic life of a fixed asset
in order to charge depreciation).
We should bear in mind the view of an established expert that:
On most subjects, judgement is as important an element in truth
as incontrovertible fact. As a result, truth is challenging and
difficult [because] independent and objective judgement is rare.
(Swinson, 2003, p.26).
The term ‘fair’ means ‘unbiased’ and this seems consistent with the aim of
financial reporting. The IASB informs us that ‘to be reliable, information
must be neutral, i.e. free from bias’. Financial statements ‘are not neutral if
by the selection and presentation of information they influence the making
of a decision or judgement in order to achieve a predetermined result’.
However, the term ‘true and fair’ has a particular meaning for accountants,
and those reading financial statements are well advised to make
themselves aware of the basic principles involved in preparing financial
statements. This was put to the test in Re Press Caps (1949) Ch 434,
where it was claimed that the balance sheet did not show a true and fair
view because freehold property was shown at cost rather than at a more
realistic market value. The court held that the accounting convention of
historical cost was well known and those relying on financial statements
should have understood that the balance sheet could not be taken as a
valuation statement.
An enduring definition of true and fair was coined by the academic
G.A. Lee:
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True and fair has become a term of art. It is generally
understood to mean a presentation of accounts drawn up
according to accepted principles, using accurate figures as far
as possible and reasonable estimates otherwise; and arranging
them so as to show within the limits of current accounting
practice as objective a picture as possible, free from wilful bias,
distortion, manipulation or concealment of material facts (Lee,
1983, p.270).
If challenged, the courts are likely to determine whether or not a set
of financial statements shows a true and fair view with reference to
applicable accounting standards. However, even then it may be possible
to argue that, for a particular organisation in a given set of circumstances,
departure from those accounting standards is necessary in order to show a
true and fair view.
Now read
Porter et al. (2014) pp.543–49.
Activity: practice question
Porter et al. (2014) p.604, Question 14.2.
5.1.1 Aims of the chapter
The aims of this chapter are to introduce you to the outcome of the audit
process – the auditors’ report – and to examine the contents and messages
(both explicit and implicit) in such reports.
5.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
outline the various changes that have been made to the reporting
obligations over the years and why the format of the report remains a
topic for debate
•
describe the recent changes to the auditors’ report relating to
assessment of risks and materiality disclosures
•
explain the different matters that are stated in an auditors’ report
•
describe the process that auditors go through to arrive at their report
•
evaluate areas of possible confusion in the minds of the investing
public.
5.1.3 Essential reading
Gray et al. (2019) Chapter 18 ‘The auditors’ report’, pp.644–93.
Porter et al. (2014) Chapter 14 ‘Auditors’ reports to users of financial statements
and to management’, pp.543–610.
5.1.4 Further reading
Dedman, E. and A. Kausar ‘The impact of voluntary audit on credit ratings:
evidence from UK private firms’, Accounting and Business Research 42(4) 2012,
pp.397–418.
5.1.5 Works cited
Lee, G.A. Modern financial accounting. (Wokingham: Van Nostrand Reinhold, 1983)
3rd edition [ISBN 9780177710568], p.270.
Swinson, C. ‘Abuse of trust’, Accountancy, September 2003.
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Chapter 5: Audit reporting
5.2 Underlying sub-concepts
In order to determine whether the financial statements show a true and
fair view, the auditor will consider the following sub-concepts.
Substance over form
The ASB recognises that this is part of ‘faithful representation’. It is
necessary that transactions and events are accounted for and presented in
accordance with their substance and economic reality and not merely their
legal form.
Compliance with generally accepted accounting practice (GAAP)
The methods in compiling financial statements must have some basis of
authority or acceptance from the accounting profession.
Accounting standards are authoritative statements and compliance will
normally be necessary for financial statements to show a true and fair
view. However, in exceptional cases, accounting standards may not be
appropriate; they are not a rigid set of rules. There is a need to apply
informed and unbiased judgement to devise an appropriate alternative
treatment, which should be consistent with the economic and commercial
characteristics of the circumstances. But where a material departure is
necessary to show a true and fair view, that fact should be stated plus an
estimate of the effect of the departure from the normal basis (unless it is
impracticable or misleading to give such an estimate).
The auditor must be satisfied that the accounting policies and estimation
techniques are the most appropriate to the circumstances of the enterprise,
consistently applied (provided that they remain the most appropriate) and
adequately disclosed.
In selecting the most appropriate accounting policies, auditors should
consider also:
•
relevance
•
reliability
•
comparability
•
understandability
•
cost/benefit constraints.
Adequate disclosure
In order for financial statements to show a true and fair view, in addition
to appropriate accounting measurements (e.g. asset valuation and income
recognition policies), there must be sufficient detail and explanation given
so that the reader can understand how the accounting numbers have
been put together. However, disclosure cannot compensate for poor or
inappropriate policies.
Variations on true and fair
Of course, the formulation of a true and fair view is not the same in every
jurisdiction. Other countries often have a different way of signifying
the auditors’ general satisfaction with the financial statements after the
completion of the audit. It is likely that whatever country you are studying
in, there will be some form of wording which conveys a similar meaning.
Some countries follow the US model and refer to ‘fair presentation’
in compliance with GAAP. Auditors in other countries may only make
reference to compliance with accounting laws or rules. In an international
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study programme it is difficult to be prescriptive but you should have some
idea of the process of formulating an audit opinion.
Recent considerations
The Brydon Review suggested that the term ‘true and fair view’ be replaced
by ‘present fairly, in all material respects’ because ‘true and fair’ can be
confusing to some readers. Also, given the number of estimates and futurebased judgements, use of the word ‘true’ is hard to justify. The government
appears reluctant to move away from ‘true and fair’.
For examination purposes, you should be able to discuss generally the ideas
outlined above without necessarily being country-specific.
5.3 Forming an audit opinion
In terms of the amount of skill and care to be exercised when coming to
the precise form of words to report, an early legal judgement provides an
enduring lesson. One of the judges in the landmark case of London and
General Bank [1895] 2 Ch 673 said:
Such I take to be the duty of the auditor: he must be honest, that is, he
must not certify what he does not believe to be true, and he must take
reasonable care and skill before he believes that what he certifies is true.
In this case, the auditors had doubts about the recoverability of loans made
to the bank’s customers. Rather than state this clearly, they said that ‘the
valuation of assets is dependent on realisation’. The court considered that
this was a mere truism; of course values are dependent on realisation.
The auditors had intended shareholders to be sufficiently curious about this
strange wording that they would quiz the directors further and thus discover
the truth. However, the court held that providing the means of obtaining
information and providing information are not the same thing. This warns
us today that the words we use in the auditors’ report should be capable of
being understood by the average shareholder. Let us see how the modern
audit report compares to that legal benchmark.
5.4 ISA 700 – contents of auditors’ reports
The standard, unqualified (or unmodified) auditors’ report (i.e. one where
the auditors are satisfied that the financial statements show a true and fair
view) contains the following items of information:
52
•
Title.
•
Addressee.
•
Other paragraphs containing:
•
the name of the entity whose financial statements have been audited
•
a statement that the financial statements have been audited
•
a statement identifying the title of the financial statements that have
been audited
•
a reference to the notes to the financial statements, including the
summary of accounting policies
•
the date of, or period covered by, the financial statements.
•
a reference to the financial reporting framework used to prepare the
financial statements (including identifying the country of origin of
the financial reporting framework when the framework used is not
that of the IASB)
Chapter 5: Audit reporting
•
an expression of opinion on the financial statements. The basis of
opinion should include:
•
a statement that the audit was conducted in accordance with
ISAs
•
a reference to the section in the report that covers the auditors’
responsibilities
•
a statement that the auditor is independent and has complied
with the Code of Ethics for Professional Accountants issued by
the International Ethics Standards Board of IFAC (or similar
authoritative body of ethics principles)
•
a statement that the auditor believes that sufficient appropriate
evidence has been collected to form a basis of the audit
opinion.
•
A statement on going concern, as required by ISA 570, Going Concern,
if applicable.
•
A statement explaining the extent to which the audit is capable of
detecting fraud and irregularities.
•
Key audit matters (see ISA 701), which is covered in the guide, below.
•
Management responsibilities over matters such as internal control,
fraud and irregularities, going concern, etc.
•
Auditors’ responsibilities, including:
•
a statement that the objective of the audit is to provide reasonable
assurance (not absolute assurance) that the financial statements
are free from material misstatement, whether caused by fraud or
error, and to issue an auditors’ report containing an opinion
•
a statement that reasonable assurance is not a guarantee that no
material misstatement exists
•
a statement that a misstatement can arise through fraud or error,
and either a description of when misstatements are considered to
be material or a definition or description of materiality
•
a description of an audit which states that an auditor’s
responsibilities include:
•
identifying and assessing the risks of misstatements and
collecting sufficient evidence to provide a basis of opinion
•
obtaining an understanding of internal control in order
to design audit procedures that are appropriate to the
circumstances but without expressing an opinion on the
internal control system
•
evaluating the appropriateness of the accounting policies and
the reasonableness of the accounting estimates and related
disclosures
•
drawing a conclusion on the appropriateness of the use of
the going concern by management. If there is fundamental
uncertainty about the going concern, the auditors should draw
attention to any disclosures made by management. If auditors
consider that the disclosure is inadequate, they should modify
their opinion. They should also note that their opinion is based
on evidence collected at the time, but that future events may
occur that might cause the entity to cease to be a going concern
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•
a statement that the auditor communicates to those charged
with governance aspects of the audit planning and timing,
audit findings and issues of concern such as deficiencies in
internal control
•
for the audits of listed companies, a statement that the auditor
has complied with the ethical requirements on independence.
•
The name of the engagement partner.
•
The signature of the engagement partner.
•
The auditors’ address.
•
Date of the report.
Auditors may have additional reporting obligations which should be dealt
with in a separate section, for example, in the UK, auditors must confirm
that the financial statements have been compiled in accordance with
the Companies Act 2006. There may also be requirements for auditors
to report by exception (that is, to report certain matters only when the
auditors have found that regulations have not been complied with), for
example, where the entity has not kept proper accounting records.
For public interest entities, auditors in the UK have to state who appointed
them and when. They have to:
•
indicate the number of consecutive appointments
•
confirm that the auditors’ opinion is consistent with the report sent to
the audit committee
•
declare that non-audit services prohibited by ethical rules have not
been carried out
•
indicate other services that were provided in addition to the audit but
which have not been disclosed in the annual report.
Pause and think 1
Why do you think it is important for the audit report to contain these items? Are there
any other pieces of information that you think it should contain?
5.5 Example of an auditors’ report
The following is an illustration from the International Auditing and
Assurance Standards Board (IAASB) of an unqualified (unmodified) audit
report containing all the items of information listed above. For ease of
reference, this has been simplified from the original by omitting some of
the more technical details and references.
INDEPENDENT AUDITOR’S REPORT
To the Shareholders of ABC Company [or other appropriate
addressee]
Report on the Audit of the Financial Statements
Opinion
We have audited the financial statements of ABC Company (the
Company), which comprise the statement of financial position as
at 31December 20X1, the statement of comprehensive income,
statement of changes in equity and statement of cash flows for the
year then ended, and notes to the financial statements, including a
summary of significant accounting policies.
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Chapter 5: Audit reporting
In our opinion, the accompanying financial statements present
fairly, in all material respects, (or give a true and fair view of)
the financial position of the Company as at 31 December 20X1,
and (of) its financial performance and its cash flows for the year
then ended in accordance with International Financial Reporting
Standards (IFRSs).
Basis for Opinion
We conducted our audit in accordance with International
Standards on Auditing (ISAs). Our responsibilities under those
standards are further described in the Auditor’s Responsibilities
for the Audit of the Financial Statements section of our report.
We are independent of the Company in accordance with the
International Ethics Standards Board for Accountants’ Code of
Ethics for Professional Accountants (IESBA Code) together with the
ethical requirements that are relevant to our audit of the financial
statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the
IESBA Code. We believe that the audit evidence we have obtained is
sufficient and appropriate to provide a basis for our opinion.
Key Audit Matters
Key audit matters are those matters that, in our professional
judgement, were of most significance in our audit of the financial
statements of the current period. These matters were addressed in
the context of our audit of the financial statements as a whole, and
in forming our opinion thereon, and we do not provide a separate
opinion on these matters.
Other Information
…
Responsibilities of Management and Those Charged with Governance for the
Financial Statements
Management is responsible for the preparation and fair
presentation of the financial statements in accordance with
IFRSs, and for such internal control as management determines is
necessary to enable the preparation of financial statements that are
free from material misstatement, whether due to fraud or error.
In preparing the financial statements, management is responsible
for assessing the Company’s ability to continue as a going concern,
disclosing, as applicable, matters related to going concern and
using the going concern basis of accounting unless management
either intends to liquidate the Company or to cease operations, or
has no realistic alternative but to do so.
Those charged with governance are responsible for overseeing the
Company’s financial reporting process.
Auditor’s Responsibilities for the Audit of the Financial Statements
Our objectives are to obtain reasonable assurance about whether
the financial statements as a whole are free from material
misstatement, whether due to fraud or error, and to issue an
auditor’s report that includes our opinion. Reasonable assurance
is a high level of assurance, but is not a guarantee that an audit
conducted in accordance with ISAs will always detect a material
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misstatement when it exists. Misstatements can arise from fraud
or error and are considered material if, individually or in the
aggregate, they could reasonably be expected to influence the
economic decisions of users taken on the basis of these financial
statements.
Report on Other Legal and Regulatory Requirements
…
The engagement partner on the audit resulting in this independent
auditor’s report is [name].
Signature in the name of the audit firm, the personal name of the
auditor, or both, as appropriate for the particular jurisdiction
Auditor address
Date
As you can see, there is a lot of detail here, and students rightly worry that
unless they are able to repeat all of it, they will suffer in an examination
setting. This is simply not true. The examiners do not expect students
to be superhuman, but they do reasonably expect you to be able to
identify the key components. All too often examiners have expressed
their disappointment that students have been able only to identify two or
three elements. This has especially been the case since the extended audit
report was introduced several years ago. You really should know that a
major part of the modern audit report is concerned with the key audit
matters – those areas of a company’s business that are going to have the
greatest impact on its financial statements. Auditors need to describe these
areas and the actions that management have taken to mitigate any risks;
auditors also need to explain what they did in relation to each area and
what they found.
Activity
The most effective way for you to really get to grips with this topic is to look at a real-life
example of an auditors’ report.
From the website of a company with which you are familiar, find the auditors’ report on
the latest financial statements. Compare that report with the example above. Are there any
significant differences? Could the example you have found be improved by the inclusion of
the sort of information found in the report above? Or perhaps you think that your example
contains features that audit regulators at IFAC or in the UK could do well to copy.
The regulators and academic commentators in a number of countries
have been concerned for some time that the key messages in the standard
auditors’ report are difficult for non-auditors to decipher. This means that
there is still much confusion about the role of auditors and the nature of
auditing even after more than a century-and-a-half of auditing company
accounts on a fairly broad scale.
Activity
Have another look at the example audit report. Which terms used by auditors do you
think it might be difficult for the non-specialist investor to make some sense of?
56
Chapter 5: Audit reporting
5.6 Types of auditors’ opinions
Now read
Gray et al. (2019) pp.672−85.
Porter et al. (2014) pp.544–90..
The example given above is an unmodified (unqualified) opinion – that is,
the auditors have no reservations or disagreements to report. When auditors
have problems, this can lead to a modified or qualified opinion (often termed
a ‘modified’ or ‘qualified’ report). There are different reasons for giving a
qualification: the auditors have either been unable to satisfy themselves on
certain matters or they disagree with the accounting treatment or disclosure.
The different forms of qualification are: ‘except for’, ‘disclaimer’ and
‘adverse’. Where the matter about which there is doubt is material
(i.e. would affect the decisions of a person relying upon the financial
statements), but not so material that the financial statements as a whole
are affected, the auditors will caveat the opinion with the words ‘except
for’. The auditors will state ‘except for … [the issue about which we
have reservations; the matter will have been described in an additional
paragraph in the auditors’ report], in our opinion, the financial statements
show a true and fair view’. If, however, the matter is so serious that the
reliability of the whole set of financial statements is put in doubt, then the
auditors will either disclaim an opinion (‘Because of the matter referred
to, we are unable to form an opinion’) or issue an adverse opinion (‘In our
opinion, the financial statements do not show a true and fair view’).
In addition to the above unqualified and qualified forms of report, there
is another possibility: the auditors may want to draw attention to a
matter without qualifying their opinion because, for example, the matter
is adequately disclosed, it just needs further emphasis for the reader to
understand fully the impact on the financial statements. This type of
report is ‘Unqualified with emphasis of matter paragraph’. The following
is an example of an additional paragraph describing the consequences of
ongoing legal action.
Without qualifying our opinion we draw attention to Note X to the
financial statements. The Company is the defendant in a lawsuit
alleging infringement of certain patent rights and claiming royalties
and punitive damages. The Company has filed a counter action, and
preliminary hearings and discovery proceedings on both actions are
in progress. The ultimate outcome of the matter cannot presently be
determined, and no provision for any liability that may result has
been made in the financial statements.
It is worth stressing, however, that the auditors must be satisfied that the
financial statements or notes do fully explain the situation – if disclosure
of a matter were to be considered less than full, then the appropriate
report would be modified on the grounds of non-disclosure.
In most countries, the vast majority of auditors’ reports on large, listed
companies are of the unmodified type. It can be difficult to find examples
of modified or qualified auditors’ reports. However, an article in the
Business Times on 30 May 2019 highlights recent examples of modified
reports issued to South East Asian listed companies.
IHH Healthcare Bhd received a modified opinion – ‘except for’ – as a result
of a lack of evidence about particular matters involving the acquisition of a
subsidiary.
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AC3093 Auditing and assurance
A similar ‘except for’ modification can be found in the auditors’ report
on New Silkroutes: see p.31. This time the modification was caused by
the auditors’ inability to obtain sufficient evidence to substantiate the
recoverability of brought forward prepayments.
An example of an adverse opinion is found in the annual report of
iDimensions: see p.43. This was caused by the failure to properly account
for the results of a subsidiary. Here, the auditors explained that, because of
the significance of the matter, the financial statements as a whole do not
give a true and fair view.
An example of a disclaimer of opinion can be seen in the auditors’
report on Vibrant Group see, p.47. In this case, the auditors were unable
to obtain sufficient audit evidence because a fire had destroyed the
accounting records of a significant part of the group. This meant that they
could not express an opinion on the financial statements as a whole.
For examples of modified opinions given on the financial statements of
companies quoted on the Hong Kong Stock Exchange.
It will be very apparent to Examiners if a student has never read a real
auditors’ report because that student’s answers will tend to be limited
to the list of items in the auditing standard with no real appreciation of
real-world problems and circumstances. As always, you are encouraged
to read around the subject, and what better source of information than an
auditors’ report itself.
The topic of auditors’ reports is a frequently asked examination question,
so it is vital that you make yourself familiar with the various options
available. In the examination, you must be prepared to make decisions on
which type of opinion is most suited to a particular context. You should
avoid attempting to hedge your bets by suggesting ‘it could be this type of
report or perhaps an alternative type’. The question will contain sufficient
detail for a definite and clear decision to be made. Giving alternatives in
an answer only indicates that you are either not clear in your own mind or
are not brave enough to make a decision.
One final point on auditors’ reports: auditors will never modify an opinion
on financial statements if the amount in doubt or dispute is trivial.
Remember that auditors apply the concept of materiality – if an amount
is too small to sway the view of the reader, then there is little value in
modifying the opinion over such an issue.
Activities
1. Study the matrix of qualified (modified) reports in Gray et al. (2019) p.673. Make sure
that you fully understand the various outcomes before proceeding further.
2. Choose a large company which is likely to have a reliable website. Visit this website
and look at the company’s annual report, which is often to be found in the ‘investor
relations’ section. Find the auditors’ report in the annual report and compare
the contents of that report with the list of items given in ISA 700. Are there any
differences? If so, what does this tell you about the company or the reporting
environment in which the auditors are operating?
Activity: practice questions
Porter et al. (2014) p.605, Questions 14.3, 14.4, 14.5 and 14.10.
58
Chapter 6: Evidence
There has been much debate over the years about how the assurance
that the auditors are supposed to convey to the readers of the financial
statement can be clearly and succinctly captured in a report which forms
part of the annual package of information being presented by the directors
to the shareholders. If you go back far enough in the history of auditing,
you will find that one or two words were considered to be sufficient –
auditors in Victorian times often wrote simply ‘Audited’ or ‘Audited and
found correct’ at the foot of the balance sheet which they had investigated.
As time moved on, more items were added to the report. By the late 1960s
in the UK the standard report had reached about half a page in length and
the decision was made to shorten it by omitting the items that only needed
to be said if the outcome was negative (e.g. the balance sheet did not
agree with the underlying books. In consequence, the report was reduced
to a single short paragraph).
By the early 1990s, a feeling had arisen that auditors ought to be giving
investors more information and in particular the auditors ought to be
doing a better job explaining the audit process itself. The longer form of
audit report was introduced to meet this challenge.
5.7ISA 260 Communication of audit matters to those
charged with governance
Auditors are expected to communicate with the audit committee any
unadjusted errors in the financial statements and comment on the quality
of financial reporting, including the appropriateness of the policies
adopted and of the estimates and judgements made.
Now read
Porter et al. (2014) pp.590–600.
Gray et al. (2019) pp.415–20.
5.8 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
outline the various changes that have been made to the reporting
obligations over the years and why the format of the report remains a
topic for debate
•
describe the contents of the auditors’ report relating to assessment of
risks and materiality disclosuresexplain the different matters that are
stated in an auditors’ report
•
describe the process that auditors go through to arrive at their report
•
evaluate areas of possible confusion in the minds of the investing
public.
5.9 Test your knowledge and understanding
5.9.1 Sample examination questions
1. The auditors’ report is the only visible sign that an audit has been
performed. Analyse the messages in the unqualified auditors’ report
and consider those matters that are being implied rather than
explicitly stated in the report.
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AC3093 Auditing and assurance
2. ‘The standard auditors’ report under ISA 700 is essentially a defensive
document rather than one designed to inform the reader.’ Critically
assess this opinion.
3. Explain what you understand by the term ‘a true and fair view’.
4. Consider the various issues to be considered in formulating the
auditors’ report on financial statements and provide an analysis of the
key elements of the auditors’ unqualified report.
5. ‘True and fair’ has been described as ‘a term of art’. Critically examine
the implications of what this means for auditors and the effectiveness
of their communications with their audience, the readers of the
auditors’ report.
5.10 Hints
5.10.1 Pause and think question
1. The answer in relation to most of the items is quite obvious. The
other information which auditors’ reports might usefully contain
might include details of problems the auditors have encountered, the
errors they found, the assessment of the control, their evaluation of
the company’s performance and its likelihood of survival. Each one of
these possible items is fraught with legal risk and auditors are likely
to agree to include them only if they could be assured that they would
not be sued if they got it wrong.
This outline list of points to be covered looks reasonable enough but
wait until we get to the detail before deciding that the auditors’ report
is likely to be understood by the average investor.
5.10.2 Sample examination questions
1. You need to be able to pick through the contents of the report and
offer some sensible suggestions on the helpfulness or otherwise of the
item in question. It is no good simply reciting the contents without
offering a comment.
2. You should be able to offer a critical evaluation of the contents of the
auditors’ report. Which items look as though they have been inserted
to reduce the scope for auditors to be sued? There are several items
we can see immediately. Starting with the addressee – the report is
addressed to the members of the company not a potential investor and
not a bank. The scope paragraph identifies which pages have been
audited. The paragraphs on the respective responsibilities of auditors
and directors are clearly aimed at distinguishing exposure to potential
legal claims. And there are other items that the astute candidate can
easily comment on in a similar vein.
3. This is a technical question and you should have a good knowledge
of the various interpretations and the strengths and limitations of this
nebulous term. The flexibility in the term means that it can change
with changing times but it does make it difficult to define precisely.
You should make some reference to compliance with accounting
standards, the application of materiality and substance over form, as
well as other aspects.
4. You should be able to describe the main components of the auditors’
report. In addition, you should be able to describe the thought process:
has sufficient evidence been collected, does it support the supposition
that the accounts disclose all material matters in an unbiased manner,
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Chapter 5: Audit reporting
are there any substantial inaccuracies, do the accounts agree with the
underlying records, have proper records been kept and so on.
5. The fact that true and fair is a phrase with a particular technical
definition means that it is always likely to mean one thing to
practitioners and something else to the lay person. There is a risk
of miscommunication. You could introduce arguments from the
expectations gap debate here. You could also discuss the recent
changes to the contents of the auditors’ report.
6. You need to make sure that you keep up to date with your reading and
take an interest in the current developments within the profession.
The IAASB of the IFAC has been talking about making the auditors’
report more meaningful by reducing the technical aspects of the
report, by removing discussion of the responsibilities of management
and auditors and by getting auditors to add some commentary on
the picture shown by the accounts, thereby adding value to the audit
process.
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Notes
62
Chapter 6: Evidence
Chapter 6: Evidence
6.1 Introduction
In Chapter 5 we looked at how the auditor communicates the outcome of
the audit process (audit reporting). That is the end of the audit process. In
Chapter 7 we will go back to the beginning of the audit process and follow
it through to the point at which the auditor forms their opinion. But before
we proceed, it is important to spend some time considering the basis of the
auditor’s work – audit evidence.
In Chapter 3, we saw that one of the underlying assumptions (postulates)
of auditing is that the subject matter of audit can be verified by collection
of evidence. Auditors need evidence on which to base their report and
make judgements or criticisms. To audit something, that evidence must
exist and it must be possible for the auditors to find it.
ISA 500 Audit Evidence states: ‘The auditor should obtain sufficient
appropriate audit evidence to be able to draw reasonable conclusions on
which to base the audit opinion.’
What does this mean?
‘Sufficient’ refers to the amount of evidence gathered. It is important
to note from the outset that auditors do not examine every single piece
of data in an organisation – instead, they perform tests on samples.
‘Appropriate’ refers to the quality of the evidence – how reliable and
relevant is it?
The instruction from ISA 500 is based on certain key assumptions.
1. Sufficient evidence exists and can be collected by the auditor.
2. Evidence exists which is reliable and relevant.
3. Collecting evidence is not costless.
4. Audit time is not unlimited.
The last two assumptions explain why auditors are only required to obtain
‘sufficient’ evidence instead of ‘all’ the evidence.
Pause and think 1
How reasonable is it to assume that sufficient appropriate evidence always exists with
respect to determining the truth and fairness of financial statements? Can you think of
any examples where evidence might be very hard or impossible to obtain?
Now read
Gray et al. (2019) pp.257–79.
Activity: practice question
Porter et al. (2014) p.308, Question 7.3.
6.1.1 Aim of the chapter
The aim of this chapter is to explain the concept of audit evidence, the
different types of evidence that may be available and the factors that will
influence the auditors’ decisions in evaluating such evidence.
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6.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
describe the nature of the evidence-gathering process
•
discuss the types of evidence available
•
discuss the considerations which will affect how the auditors plan the
collection process
•
explain how auditors evaluate the evidence collected.
6.1.3 Essential reading
Gray et al. (2019) Chapter 7 ‘The search for evidence explained’, pp.257–79.
Porter et al. (2014) Chapter 7 ‘Overview of the audit process, audit evidence;
staffing and documenting an audit’, pp.261–77.
6.1.4 Further reading
ISA 315 Identifying and assessing the risks of material misstatement through
understanding the entity and its environment.
6.2 Theoretical issues
To understand better the evidence process, we can consider the use of
evidence in other disciplines such as philosophy and the law. Philosophy
instructs us that for a belief in any proposition to be rational, we require
evidence, and that different forms of evidence produce varying degrees of
assurance about the truth of the proposition. These seem relevant to the
auditing setting.
Similarly, the law has developed many rules for filtering evidence before it
can be used in a court of law. One rule which seems eminently valuable for
auditors is the ‘best evidence rule’, which instructs lawyers representing
clients to be prepared to present the best possible evidence, so that, for
example, it is unlikely that a court would be impressed by the production
of a photocopy of an important document when it would be reasonable for
the original document to be produced. By the same token, auditors should
insist on seeing original documents, because of the ease with which copies
can be manipulated.
6.3 The audit evidence process
The audit process is concerned with the collection and evaluation of
evidence but can be broken down into the following stages:
1. The auditors first obtain an understanding of the client. This may seem
a rather trite thing to say but many problems have arisen because
auditors were insufficiently versed in the client’s business model or
industry conditions. Auditors really need to be very careful about
taking on clients whose businesses involve a degree of complexity
that may be beyond the auditors’ competence. Without an indepth
knowledge of their client’s business, auditors will find it difficult if not
impossible to conduct risk analysis and analytical procedures. They will
also struggle to exercise a sufficient degree of professional scepticism.
2. Auditors then carry out overall analytical procedures to get ‘a feel’ for
the numbers in the financial statements they will have to audit.
3. Auditors next obtain an understanding of the accounting system and
they evaluate the likely strength or weakness of those controls in place
in the accounting system.
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Chapter 6: Evidence
4. Before the auditors can get any assurance that the data processed by
the accounting system are accurate, they must test the effectiveness of
the controls through compliance testing (tests of the controls).
5. Depending on the results of the tests of the controls, the auditors
determine the extent of their tests of the transactions and account
balances through substantive procedures, of which there are two
types:
i.
analytical procedures
ii. tests of detail.
6. The final stage of the audit is the completion and final review stage,
which allows auditors to consider all they have found out about the
client and whether the picture portrayed by the financial statements is
consistent with their findings.
At this point we need to be aware of the outline of the audit process, and
the role of audit evidence, but we have not yet looked at the details of the
audit procedures or how the auditor plans the audit work.
Analytical procedures involve the calculation of accounting ratios to
examine patterns and trends and ensure that these are in line with
expectations given the auditors’ knowledge of the organisation. Analytical
procedures can both identify areas which need further examination and
provide reassurance, in conjunction with other tests, that individual
account balances are ‘correct’.
Tests of controls determine whether the internal controls of the
organisation are operating as they are supposed to. Substantive tests
(which can include analytical procedures) are designed to test the
‘correctness’ of individual account balances by, for example, writing to (a
sample of) the company’s trade debtors and asking them to confirm the
outstanding balance of their account at the financial statement date.
You can see from Step 5 in the audit process above that the extent of
substantive audit testing depends upon the auditors’ opinion of the internal
controls of the organisation. This relationship is formalised by the audit
risk model (ARM). The important point to note is that auditors can rely
on the good operation of controls to reduce the extent of their substantive
procedures. This raises the possibility in very well-run organisations
of perhaps doing away with detailed tests altogether. Such a notion is
tempting because, typically, substantive procedures are more costly for
the auditor to perform than compliance tests. However, one can never
obtain all the assurance from the tests of control because of the inherent
limitations in any system of internal control, which include the following:
•
Most systematic internal controls tend to be directed at routine
transactions rather than non-routine transactions.
•
The potential for human error due to carelessness, distraction,
mistakes of judgement and the misunderstanding of instructions.
•
The possibility of circumvention of internal controls through collusion
with parties outside or inside the entity.
•
The possibility that a person responsible for exercising an internal
control could abuse that responsibility.
•
The possibility that controls and procedures may become inadequate
due to changes in conditions or that compliance with the laid-down
system may deteriorate over time.
It has been argued that because of these limitations, no system of internal
control can ever completely remove the possibility of fraud or error from
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the financial statements. Therefore, some substantive testing will always
be necessary.
Now read
Porter et al. (2014) p.400.
6.4Types of audit evidence and techniques for
collection
Now read
Porter et al. (2014) pp.261–77.
There are various types of evidence available to auditors.
1. Inspection of documents:
•
created and provided to auditors by third parties
•
created by third parties and held by the entity
•
created and held by the entity.
2. Observation.
3. Enquiry and confirmation.
4. Computation.
5. Analytical procedures.
6. Subsequent events.
6.5 Which type(s) to use?
This is an important question in practice and in the examination. The
case studies in Section A of the examination focus on the audit process
and the more practical side of the subject. It can be tempting simply
to try to memorise lists of audit procedures. However, it is much more
important that you remember the main types of evidence and understand
the characteristics of those types. You will have to apply this knowledge
to specific situations in the examination. It is never enough to list possible
audit procedures; you will need to justify your suggestions using the
specific information in the case. You need to be able to identify when a
particular type of evidence is most appropriate.
What type of evidence is most appropriate depends on:
•
relevance
•
reliability
•
availability
•
timeliness
•
cost.
The last four qualities depend on the source of the information.
Pause and think 2
Why does the timeliness of information matter? What effect could a tight audit deadline
(for example, only a few days after the financial statement date) have on the quality of
the audit work?
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Chapter 6: Evidence
With regard to relevance, it will help you to remember that for
substantive tests, the auditors are generally looking for evidence to
support the completeness, accuracy, validity and existence of the assets,
liabilities, income and expenses shown in the financial statements. You
can remember this using the mnemonic CAVE. Some types of evidence
can support more than one of these ‘financial statement assertions’. For
example, writing to a selection of a company’s trade receivables to ask
them to confirm the balance of their account (i.e. what they owe to the
company) at the financial statement date will provide evidence on the
accuracy, validity and existence of the total accounts receivable balance.
Pause and think 3
How could you try to examine the completeness of the accounts receivable balance?
Pause and think 4
A company’s debtors may be unable or unwilling to respond to your requests for balance
confirmation. What other evidence could help you to determine the accuracy, validity and
existence of the accounts receivable balance?
On reliability, we can make certain presumptions:
•
Documentary evidence is more reliable than oral evidence. For
example, receiving a written reply from a client’s customer to your
request for confirmation of an accounts receivable balance is more
reliable than obtaining a confirmation over the telephone.
Pause and think
Why?
•
Original documents are more reliable than photocopies or faxes.
Pause and think
Why?
•
Audit evidence from the accounting records is more reliable when the
accounting and internal controls are effective.
Pause and think
Why?
•
Evidence from external sources is more reliable than that obtained
from the entity. For example, replies from the company’s trade debtors
are more reliable than a statement from the organisation’s financial
director that the individual account balances are correct, or a printout
of the organisation’s sales ledger.
Pause and think
What makes an external source ‘external’? What steps could auditors take to be sure?
•
Evidence obtained directly by the auditor is more reliable than
evidence obtained by or from the entity. For example, writing to the
trade debtors yourself and having them reply directly to you, the
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auditor, is more reliable than the organisation doing so on your behalf
and giving the replies to you.
6.6 Sufficiency of evidence
In deciding the question of how much evidence is enough, auditors will
consider:
•
their assessment of the nature of and degree of risk of misstatement in
the item being investigated
•
the nature of the accounting and internal control system
•
the materiality of the item
•
their experience from previous audits and their knowledge of the
industry
•
their findings from this and other audit procedures
•
the source and reliability of evidence.
Part of this decision will involve selecting the sample size when performing
tests of detail. The basic idea is that the more sure you need to be about
the result of a test, the larger the sample size you need. But another part
of this decision involves the number of different types of evidence that the
auditors may need to gather about a particular account balance. The more
certain the auditor needs to be about a particular account balance, the
more the auditor will want to gather more different types of evidence or
more evidence from different sources.
When gathering evidence from a number of different sources, consistent
evidence is more persuasive than contradictory pieces of evidence. If the
evidence from different sources does not agree, then the auditor should
perform additional tests to determine which is most likely to be correct.
6.7 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
describe the nature of the evidence-gathering process
•
discuss the types of evidence available
•
discuss the considerations which will affect how the auditors plan the
collection process
•
explain how auditors evaluate the evidence collected.
6.8 Test your knowledge and understanding
6.8.1 Sample examination questions
1. Describe the different types of evidence which may be available and
give an example of the use of each type.
2. Explain in what respects theoretical notions of evidence have practical
relevance for the collection of audit evidence.
3. The auditor’s task is to sift the available evidence. Provide an analysis
of the factors which will generally determine the quality of various
forms of available evidence.
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Chapter 6: Evidence
6.9 Hints
6.9.1 Pause and think questions
1. Evidence may have been lost or destroyed or it may be held in
a very remote location. In other more subjective areas, such as
intangible asset values, it may prove difficult to produce evidence but
management cannot simply pluck numbers out of the air and they
must have based their valuations on some calculations.
2. The more recent the information the more useful and relevant it is
likely to be. Tight deadlines are a fact of professional life but that does
not mean that it is right to sacrifice audit quality just to keep an audit
client happy. Auditors must seek to organise themselves and their work
so that a complete audit can be done in the time available (e.g. by
doing an interim audit perhaps).
3. Completeness essentially refers to testing that there are no missing
figures so a review of the main customers during the year might
highlight customers whom we would expect to see on the list of
amounts due at the end of the year.
4. Think about the types of documentation available within the company;
also remember that at least some of the audit work will take place
after the financial statement date.
6.9.2 Sample examination questions
1. This sort of question should hold no traps for you if you have done the
reading. Remember, however, that you need to do more than list the
various methods – you have not only to describe the methods but also
to provide an example of each and the best answers would also be able
to fit that example to the best possible evidence rule. For example, the
best possible evidence of a building’s existence is for the auditors to
see it with their own eyes.
2. The theoretical notions will include aspects such as written versus oral
evidence, evidence from third parties being better than evidence from
the client, evidence created by the auditor being the best of all and so
on. You should be able to relate these notions (i.e. theoretical ideas) to
the practical procedures that you know auditors carry out.
3. There are several factors that will influence auditors and you need
to be able to discuss each. For example, ease and cost of collection of
the evidence, the availability of evidence, the source of the evidence,
the form which the evidence takes, past experience of reliability of
evidence from that source.
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Notes
70
Chapter 7: The audit process
Chapter 7: The audit process
7.1 Introduction
Whole books and auditing manuals have been written on what we are
attempting to cover in this one chapter, so that it will be impossible to
delve into this area in the same depth as some of the issues we have
explored in previous chapters. The reason for this approach is that the
recommended texts do a good job in leading you through the process
and so it seems to be unnecessary to repeat the matters of procedure at
length. This does not mean that you can skim over the practical aspects of
auditing, which are often not the most riveting chapters in the textbooks.
It is vitally important for you to concentrate and study diligently because
the case studies in the first section of the examination paper, on which
at least 50 per cent of the marks are awarded, are primarily testing
your knowledge of the practical issues facing auditors in the day-today performance of their duties and the possible solutions available to
them. You will be expected to apply your knowledge to various difficult
situations.
Despite the focus on this area in the examination paper, remember not
to be tempted just to memorise lists of audit tests for reproduction in the
examination. You will need to demonstrate your understanding of the
appropriateness of different procedures in different situations by tailoring
your knowledge to the specific case in front of you. This will usually
include explaining the reasons behind your suggestions.
There is a lot of textbook material to cover in this chapter, so it is a good
idea to divide your study of it into several chunks. We start by looking at
the concept of audit risk and risk-based approaches to audit work, and
remind ourselves of the importance of judgement in the audit process.
Then we look at the audit process: from the decision of whether or not to
accept an engagement; through the audit work to assess the quality of the
internal controls and test the details of the information in the financial
statements; to the completion of the audit process.
You should begin by briefly reviewing Chapter 5 of this subject guide to
remind yourself of the end product of the audit process, the audit report.
Next, work through the first few sections of this chapter, dealing with audit
risk, accepting the audit engagement, engagement letters and planning the
audit.
At this point you should stop, complete all your notes, attempt all the
relevant activities, and consolidate your knowledge before continuing.
Now review Chapter 6 of this subject guide before working through the
sections of this chapter dealing with analytical procedures, the use of
analytical procedures in planning and controls and assessing risk. Again,
complete all your notes, attempt all relevant activities, and consolidate
your knowledge before continuing. Review the section on audit risk
again before working through the sections on substantive tests, the use of
analytical procedures in substantive testing, tests of detail and sampling.
Complete all your notes, attempt all relevant activities, and consolidate
your knowledge before continuing. Finally, work through the sections on
computer-based systems and completion of the audit process.
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7.1.1 Aim of the chapter
The aim of this chapter is to give a more detailed understanding of the
processes involved in conducting an audit.
7.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
identify the issues to be considered before accepting a proposed audit
engagement
•
outline the main considerations involved in planning an audit
•
explain the risk-based approach to auditing
•
describe how risk and materiality are considered by auditors
•
identify appropriate audit procedures to be adopted for various items
in the financial statements
•
describe and explain the role of computers in audit.
7.1.3 Essential reading
Gray et al. (2019) Chapter 6 ‘The risk-based approach to audit: audit judgement’,
pp.197–248; Chapter 9 ‘Systems work: basic ideas 2’, pp.326–64; Chapter
10 ‘Testing and evaluation of systems’, pp.368–92; Chapter 12 ‘Final work:
general principles, analytical review of financial statements, and management
assertions on financial statement headings’, pp.460–85; Chapter 14 ‘Final
work: non-current assets, trade receivables and financial assets’, pp.489–523;
Chapter 11 ‘Substantive testing, computer-assisted audit techniques and audit
programmes’, pp.396–422; Chapter 12 ‘Sampling and materiality’, pp.427–54;
Chapter 16 ‘Final review: post-balance sheet period, provisions, contingencies,
letter of representation’, pp.562–91.
Porter et al. (2014) Chapter 8 ‘Commencing an audit: engagement procedures,
understanding the client and identifying risks’, pp.311–43; Chapter 9 ‘Planning
the audit: materiality and audit risk’, pp.345–79; Chapter 10 ‘Internal control
and the auditor’, pp.381–424; Chapter 11 ‘Testing financial statement
assertions: substantive testing’, pp.425–66; Chapter 12 ‘Audit sampling and
computer-assisted auditing techniques’, pp.464–98; Chapter 13 ‘Completion
and review’, pp.499–542.
7.2 Audit risk and materiality
Now read
Porter et al. (2014) pp.350–76.
Gray et al. (2019) pp.197–248.
7.2.1 The audit risk model (ARM)
It is important that you understand the definitions of audit risk (AR),
inherent risk (IR), control risk (CR) and detection risk (DR) and the
relationships between them formalised by the audit risk model (ARM).
Some texts make a big play on the formulaic notation of ARM viz:
AR = IR × CR × DR
Some texts even go so far as to ‘prove’ the validity of the approach through
a numerical example, such as if the acceptable AR is 5 per cent and the
auditors assess IR as 100 per cent and CR as 70 per cent, then the DR has
to be 7 per cent – this means that the auditors need to be 93 per cent (100
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Chapter 7: The audit process
per cent – 7 per cent) confident that they have identified any material
misstatements in the accounts.
The problem with this approach is that it is an easy formula to remember
but a difficult one to explain. All too often candidates in the heat of the
examination room simply reproduce the formula without ever getting to
the substance of the question which is likely to be about particular risk
factors and how management or auditors might react to those factors.
What you should be able to do is to discuss what the risk approach means
for auditors.
The AR is the risk that the auditor expresses an inappropriate audit
opinion. This is usually taken as meaning that the auditor issues a ‘clean’
report when the report should have been qualified or modified (i.e. when
there is a material misstatement in the financial statements).
We cannot easily describe how the auditor chooses an acceptable level of
AR for each audit engagement but that is what must happen in practice.
In essence, the decision is based on knowledge of the client, knowledge of
the industry and the experience of the auditor.
The IR is the risk that the financial statements are materially misstated,
without taking into consideration the internal controls of the organisation.
The CR is the risk that the internal controls do not prevent or correct such
misstatement. The auditor cannot directly influence the IR or the CR, so
these must be assessed during the audit work or at the planning stage of
the audit process.
Finally, the DR is the risk that the auditor’s procedures do not identify any
material misstatements that exist in the financial statements. This is the
part which the auditor can control, by selecting audit procedures and by
looking at how well those procedures are performed.
You can think of the audit process as working through the ARM – first the
auditors assess the IR, then the CR by looking at the internal controls and
assessing whether there are any gaps or controls which are not working
properly, then finally they perform substantive procedures to achieve the
desired level of DR.
Pause and think 1
What are the advantages and disadvantages of using a formalised model like the ARM in
the auditor’s work?
Pause and think 2
How easy do you think it would be to quantify risk in an organisation? Consider the case
of your own organisation (this could be your college or university or an organisation
where you have been employed or have done work experience).
7.2.2 Business risk
Business risk (BR) approaches to audit are a more recent development.
BR is the risk that the entity fails to meet its objective. BR includes IR but
is much broader than IR alone. ISA 315 requires an auditor to obtain an
understanding of an organisation’s objectives and strategies, and related
business risks that may result in material misstatement of the financial
statements. Therefore, understanding BR may help auditors determine IR.
BR approaches to audit have often been criticised as making the auditors
think too much like management – this may have implications for auditor
independence.
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7.2.3 Materiality
Materiality is a central concept in auditing. Materiality is typically defined
by reference to the view of the financial statements formed by a reader.
Auditors need to consider whether an item is sufficiently important that
its inclusion or omission or misstatement might influence the view of the
reader of a set of financial statements. In auditing standards, it is dealt
with by ISA 320.
Now read
Gray et al. (2019) pp.442–54.
Just as the problem of dealing with audit risk invites the unwary student
to memorise a given formula, so it is tempting to want to reduce the
materiality decision to a simple rule such as using a fixed percentage of
a given benchmark, say 5 per cent of net profit. While it is true that in
practice this sort of approach is used as a general ‘rule of thumb’, it would
be inappropriate to use such a ‘rule’ mechanically. This is because:
•
There may be specific circumstances where, for example, the auditors
know that their work will be relied upon by a user who is likely to
have a lower threshold.
•
Within a set of financial statements there are some account balances in
which any error, no matter how small, can be deemed significant – for
example, share capital or directors’ remuneration.
•
Some smaller errors, if corrected, may turn a profit into a loss, an asset
into a liability, etc. – these changes are likely to be material no matter
how small the error.
It is also important that auditors consider the effects of both individual
errors and the cumulative effect of all identified errors. If the cumulative
effect is material even when the individual errors are not, then action
should be taken.
You may be asked to come up with an amount (in £ or $) that you would
consider to be an appropriate measure of materiality given the context and
conditions of a scenario in a Section A case study. Students are encouraged
to be brave here and rise to this challenge. Do not be afraid to commit.
Use one of the yardsticks that you are familiar with – 5% of net profit or
1% of turnover, for example – and provided you can justify your choice of
amount, you are likely to get some credit. The timid student either says
nothing or gives a range of possible numbers to hedge their bet – neither
approach is likely to impress the Examiners.
Pause and think 3
What are the advantages and disadvantages of fixed materiality guidelines being
established by the FRC (or a future ARGA) or IAASB?
Activity: practice questions
Porter et al. (2014) p.377, Questions 9.3 and 9.10.
7.3 Before accepting the audit engagement
Now read
Gray et al. (2019) pp.202–11.
Porter et al. (2014) pp.311–20.
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Chapter 7: The audit process
Activity: practice question
Porter et al. (2014) p.341, Question 8.2.
One of the biggest concerns that auditors have results from the amount
of litigation that they may face should things go wrong with an audit or
other reporting engagement. Prudent firms therefore take great care before
accepting a new client. Not only will they assess the potential client’s
business risk and management integrity but they will also be realistic about
their own competence in auditing that client. It would serve no purpose to
recruit audit clients only to find that the firm did not have the resources,
know-how or time to complete the audit on a timely basis. In addition,
the audit firm must take a critical look at its own independence issues: are
there any aspects of the new client that might compromise the auditors’
perceived or actual independence? If there are such aspects then it would
not seem appropriate to accept the new engagement, at least not without
first resolving the conflict of interest, for example by withdrawing from an
existing appointment. In addition, there is the need to make contact with
the previous auditors before an appointment can be accepted (we covered
this in Section 4.5 under the heading ‘Professional clearance’).
Pause and think 4
a. What sorts of warning signs exhibited by a potential audit client might alert auditors
to the increased risk of problems later on?
b. What are the likely consequences if auditors turn away potential clients?
7.4 Engagement letters
Now read
Gray et al. (2019) pp.236–40.
Porter et al. (2014) pp.320–25.
We have already stressed the importance for both auditor and client of
having a clear written agreement outlining the scope of the work and the
terms of the engagement. This is the engagement letter. The engagement
letter is also crucial for spelling out the respective responsibilities of
auditor and management and matters such as the basis of charging fees
for the audit and other services. You should spend time making sure you
are familiar with the contents of the engagement letter and what purposes
it serves in different contexts (e.g. a statutory company audit or the audit/
review of a set of financial statements of a partnership).
Activity: practice question
Porter et al. (2014) p.341, Question 8.5.
7.5 Planning the audit
Now read
Porter et al. (2014) pp.325–32 and 345–50.
Gray et al. (2019) pp.240–48.
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Activity: practice question
Porter et al. (2014) p.341, Question 8.6.
Auditors are required to plan their audits to enable them to complete
the engagement in an efficient and effective manner. It is, of course, also
necessary, if auditors are to run their own businesses at a profit, to plan
their personnel needs so that sufficient staff of the right grades are available
at the right times to deal expeditiously with the requirements of all their
clients. Efficient planning has become all the more important in an era
when audits are done for a fixed fee; auditors cannot afford to let expensive
staff members overrun on their time allocations. However, it would be
unwise if auditors were to place personal profit above the need to do an
adequate audit.
Pause and think 5
How do auditors manage to balance the conflicting demands of making a living for
themselves at the same time as rendering an adequate and valuable service to their
clients?
7.6 Analytical procedures
Now read
Porter et al. (2014) pp.336–40.
The Glossary of Terms produced by the FRC defines analytical procedures as:
The analysis of relationships:
a. between items of financial data, or between items of financial
and non-financial data, deriving from the same period; or
b. between comparable financial information deriving from
different periods, to identify consistencies and predicted
patterns or significant fluctuations and unexpected
relationships, and the results of investigations thereof.
The basis of analytical procedures is therefore comparison – comparing
accounting and other ratios with the auditors’ expectations based on
knowledge of the industry or on past experience of the client or similar
companies. The use of analytics may direct attention to potential problem
areas by highlighting unexpected changes or by indicating changes that
may be expected to occur but which do not materialise. Auditors work on
the basis that particular relationships between data will continue to exist
unless conditions change.
Changes in ratios may have a number of causes. For example, changes in
the gross profit margin may be caused by:
76
•
Management decisions – perhaps competitive pressures forced the
business to offer greater discounts.
•
Changes in the accounting methods used – perhaps the business
adopted a different basis of valuing closing inventory.
•
Unusual transactions – the business may have made a one-off purchase
at a special price.
Chapter 7: The audit process
•
Errors – for example, in counting or valuing the closing inventory.
•
Fraud or theft – for example, the theft or the deliberate overstatement
of inventory by employees.
Once something unusual has been identified, further investigations
are needed to determine the true cause. Remember, it will usually be
insufficient for the auditor to rely on management’s own explanations
for changes in ratios; evidence obtained by the auditor and/or from third
parties will be more reliable.
7.7 Uses of analytics in planning
In an audit engagement, analytics may be used at three main stages of
the audit: planning, evidence gathering (substantive testing) and the final
review of financial statements.
Auditors should apply analytical procedures at the planning stage to assist
in understanding the entity’s business, in identifying areas of potential
audit risk and in planning the nature, timing and extent of other audit
procedures (ISA 520).
Analytics may indicate aspects of the entity’s business of which the
auditors were previously unaware. These aspects can then be allowed for
in the planned audit work.
We will return to analytical procedures because ISA 520 indicates that
analytics must also be used at the final review stage of the audit. In
addition, we will come across analytics being used to gather substantive
evidence. Although this is not a requirement, it will often be more costeffective for the auditor to obtain evidence in this way rather than through
the more time-consuming tests of detail.
Pause and think 6
What are the possible problems with an over-reliance on analytical procedures at the
expense of tests of detail?
7.8 Controls and assessing risk
You should make sure you have a good grasp of the terms that are used in
the literature and the standards in relation to the ARM. Recall that audit
risk (AR) has the three components:
•
inherent risk (IR)
•
control risk (CR)
•
detection risk (DR).
You will remember from the section on the ARM that the auditor needs
to assess both IR and CR in order to know at what level to set DR. In
order to assess CR, the auditor must first gain an understanding of the
organisation’s internal controls, and then test whether those controls are
operating as they are supposed to.
Now read
Porter et al. (2014) pp.381–421.
Gray et al. (2019) pp.368–85, 390–92.
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7.9 ISA 315
ISA 315 contains the following instructions:
The auditor should obtain an understanding of the entity and its
environment, including its internal control, sufficient to identify
and assess the risks of material misstatement of the financial
statements whether due to fraud or error, and sufficient to
design and perform further audit procedures.
The auditor should perform the following risk assessment
procedures to obtain an understanding of the entity and its
environment, including its internal control:
a. Inquiries of management and others within the entity;
b. Analytical procedures; and
c. Observation and inspection.
When the auditor intends to use information about the entity
and its environment obtained in prior periods, the auditor
should determine whether changes have occurred that may
affect the relevance of such information in the current audit.
In addition to the ARM, you need to ensure you understand the following
terms.
Accounting system
This refers to the series of tasks and records to identify, assemble, analyse,
calculate, classify, record, summarise and report transactions and events.
Internal control system
This comprises the control environment and the control procedures. All
policies and procedures need to ensure:
•
efficient conduct of business
•
safeguarding of assets
•
prevention and detection of fraud
•
accuracy and completeness of accounting records
•
timely preparation of reliable financial information.
Control environment
This refers to the overall attitude, awareness and actions of directors,
including management style and corporate culture. Other factors include:
•
philosophy and operating style of management
•
organisational structure
•
methods of imposing control including internal audit and functions of
the board.
Control procedures
These are designed to achieve specific objectives, such as:
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•
approval and control of documents
•
computer controls
•
checking accuracy of records
•
control accounts and trial balances
Chapter 7: The audit process
•
reconciliations
•
comparison of physical counts with records
•
comparison of internal and external data
•
limiting physical access to assets and records.
It is important to understand that the so-called ‘walk-through test’ is one
means of gaining an understanding of the system. A single transaction is
‘walked through’ the system from start to finish, with the auditor noting the
checks and control procedures applied to it along the way. The aim is to see
if the system has been properly described and understood by the auditor.
Students sometimes wrongly think of the walk-through test as a test of
compliance but, as you will see when we look at sampling, a sample of one
transaction would never be considered an adequate basis on which to draw
conclusions about the operating effectiveness of the control system.
Activity: practice questions
Porter et al. (2014) pp.421–22, Questions 10.6 and 10.9.
We will meet the topic of internal controls again when we discuss internal
audit as part of the control environment in Chapter 9.
7.10 Substantive tests
The levels of inherent and control risks can never be low enough to
eliminate the need for auditors to perform any substantive procedures for
material account balances and transaction classes (because, for example,
of the inherent limitations in any system, which you will remember from
Chapter 6). Therefore, auditors will always perform some substantive tests
on the individual amounts in the financial statements. This work is what
the auditor can do to reduce detection risk, and therefore the risk of giving
the wrong audit opinion (audit risk).
ISA 500 Audit Evidence uses the term ‘substantive procedures’ to refer
to tests to obtain evidence to detect material misstatement in financial
statements. Substantive procedures are of two types, namely:
•
tests of details of transactions and balances
•
analytical procedures.
Now read
Porter et al. (2014) pp.425–36.
7.10.1 The use of analytics in substantive testing
Now read
Gray et al. (2019) pp.473–77..
ISA 500 suggests that substantive procedures may comprise only analytical
procedures where such procedures provide sufficient appropriate evidence.
The use of analytical procedures depends on auditors’ judgement about
the procedures’ expected effectiveness and efficiency. Auditors usually
enquire of management as to the availability and reliability of information
and the results of any of the entity’s own analytical procedures. Remember
it is not only the auditors who are concerned about controls, weaknesses
and problem areas: management too will be (or should be) on the lookout
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for difficulties so that they can take corrective action as quickly as possible.
This is why companies such as retailers routinely use measures like profit
margins, stock turnover ratios, or sales per square foot as key performance
indicators, since an unexpected variation can be a warning that something
is going wrong.
When deciding whether to use analytical procedures, auditors should
consider the:
•
plausibility and predictability of the relationships
•
objectives of the analytics and the reliability of results
•
degree of disaggregation of data (i.e. how much detail is available)
•
availability of information, both financial and non-financial
•
relevance of the information available
•
comparability of the information available
•
knowledge gained during previous audits: the effectiveness of the
accounting and internal control systems and the types of problems
encountered in the past.
Analytical procedures produce more reliable results if they are based on
data from sources independent of, rather than internal to, the entity. If
internal data are used, auditors should be aware that again the results are
more reliable if the data are produced independently of the accounting
system or if there are adequate controls over their preparation.
Reliability also depends on:
•
the results of other audit procedures directed towards the same
financial statement assertions
•
the accuracy of predicted results
•
the frequency with which a relationship is observed.
When significant fluctuations or unexpected relationships are
identified that are inconsistent with other relevant information
or that deviate from predicted patterns, auditors should
investigate and obtain adequate explanations and appropriate
corroborative evidence. (ISA 520)
Auditors carry out analytical procedures for the very purpose of seeing if
there are any unusual, unexpected or unexplained patterns in the financial
statements. These patterns must then be investigated further. Therefore,
even if the auditors had originally planned to do nothing except analytical
procedures for their substantive testing, they may have to perform other
audit procedures after all.
Perhaps the whole concept of analytical procedures will make more sense
if we put it in the context of a specific audit. Using the example of the
audit of a general insurance company, the following were considered to be
pertinent ratios for an auditor to examine:
80
•
The ratio of expenses to written premiums (the expense ratio).
Changes in this ratio might indicate manipulation of income or
difficult business conditions, depending on which direction the
variation takes.
•
The ratio of commissions incurred or paid to brokers to written
premiums. Variations may highlight changes in the commission
structure or business mix.
Chapter 7: The audit process
•
The ratio of claims outstanding to claims paid, where a change in
the ratio may indicate changing settlement patterns or a change in
business mix.
•
The ratio of claims outstanding to shareholders’ funds, which indicate
the strength of reserves available to cover adverse deviations on claims
provisions.
•
The solvency ratio: the ratio of net assets to annual written
premiums. This is an indicator of the margin available to meet various
contingencies, in particular adverse movements in investment values
and unexpectedly severe claims experience.
•
Investment yield. A significant increase in the investment yield may
indicate, for example, a shift in investment philosophy towards higherrisk investments.
Activity
You are the auditor of a taxi company and are looking at the income figure. What
relationships would you expect income to bear with other numbers in the financial
statements and with other data outside of the accounting numbers? For each relationship
or ratio that you propose, suggest what factors might cause significant variations.
Pause and think 7
In the above activity, how would you go on to confirm the cause of any variations?
7.10.2 Limitations of analytical procedures
There are three main factors which will determine the value of the results
of the analytics.
1. The reliability of the information being subjected to the analytics and
the quality of the system that produced it.
2. The quality of the analytics themselves; which in turn will be
determined by the degree of knowledge of the business and the
imagination and skill of the person conducting the analytics.
3. The thoroughness of the investigation of any differences revealed by
the analytics.
7.11 Tests of detail
Now read
Porter et al. (2014) pp.419–63.
Gray et al. (2019) pp.396–424.
We have not spent much time looking at tests of detail. The reasons for
this are that it is better to understand the principles than to memorise the
procedures; the procedures are in any case thoroughly dealt with in the
recommended textbooks and one can never be sure which areas may crop
up in the examination. Having said that, you should be familiar with tests
of the following areas, which are the most likely candidates to crop up in
Section A of the examination paper.
•
Non-current assets
•
intangibles
•
investments
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•
tangibles
•
inventories
•
accounts receivable
•
cash
•
accounts payable
•
sales
•
purchases
•
wages
•
questionable payments.
Examination answers can often be enriched if you can provide examples
of the kinds of tests and/or audit evidence which auditors may rely on.
For example, you can illustrate a point about evidence reliability by
contrasting two different types of evidence.
You should bear in mind the management assertions (and therefore audit
objectives) in each account balance case. Recall from Chapter 6 that these
will fall into the four main categories of completeness, accuracy, validity
and existence (CAVE). If you are asked to suggest appropriate audit tests
for a particular account balance, try to make sure that you propose at least
one test for each of these assertions. Remember to explain which of your
tests relates to which assertion.
7.11.1 Directional testing
Also remember that auditors are generally most concerned that the
financial statements do not overstate assets and income, and do not
understate liabilities and expenses. This is known as ‘directional testing’.
Therefore, auditors would most likely focus on examining the accuracy,
validity and existence of assets, and be less concerned about completeness.
In more practical terms, this would mean that the auditors would want
to determine that the assets exist (for example, in the case of fixed assets,
by looking at them), that the assets are valid – that is, that they have met
the definition of an asset at the financial statement date (e.g. in the case
of fixed assets, determining ownership by examining property deeds, car
registration documents, etc.) – and that the valuation of the assets in the
financial statements is appropriate (e.g. for fixed assets, by, among other
things, recalculating the depreciation charge).
Implicit in the approach (although it is never openly acknowledged) is the
concern with fraud. If management or employees have the intention either
to overstate performance or misappropriate assets, the typical consequence
is that either assets or expenses will be overstated and/or income or
liabilities will be understated. An example of management manipulation
of financial statements is the UK café chain, Patisserie Valerie, which
collapsed in 2018. Subsequent investigations found that its cash position
was overstated by £30m, and it had undisclosed overdrafts of nearly
£10m i.e assets were overstated and liabilities understated. An example of
employee fraud is that committed by a Singapore Airlines supervisor who
was responsible for granting flight crew expense allowances. Over thirteen
years, he stole as much as SG$35m: he simply inflated the number of
crew members on particular flights and paid himself an allowance as well
as those crew members who did attend those flights i.e expenses were
overstated.
Directional testing, with some relevant examples of audit tests, is discussed
in Gray et al. (2019) pp.410–12.
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Activity: practice questions
Porter et al. (2014) p.463, Questions 11.4 and 11.6.
7.11.2 Sampling
When auditors perform their tests, they do not test every single individual
balance or transaction. This would not be practical. Instead, they test
samples of the data. In order to be able to draw conclusions about the
population as a whole based on these samples, they need to ensure that
the samples are representative of the population and sufficiently large.
The size of the sample will largely depend upon how confident the auditors
need to be that their tests will detect any material misstatements – the
lower the required level of detection risk, the larger the sample required.
Now read
Porter et al. (2014) pp.467–91.
Gray et al. (2019) pp.427–54.
The material on sampling in the texts can be quite complex, so it is as
well to spend time focusing on this area. The idea behind sampling is
straightforward enough: auditors cannot possibly look at every item in
the population being examined. Even small companies may be involved in
hundreds of transactions per day. And even if auditors were able to look
at every item, the extra assurance they would obtain from doing so would
hardly be worth the effort of looking at all rather than some of the items.
The principle of sampling has been long accepted but it has grown in
complexity over the last 40 years or so. It is unlikely that you would
be called upon by the examiners to produce a sampling plan. You
should, however, have a grasp of the different sampling approaches, the
similarities and differences between judgemental and statistical sampling,
and the limitations of any sampling plan. You should understand that
both compliance and substantive tests are based on samples of items
and that, while technically a sample size of one is still a sample, it is too
small a sample on which to base any meaningful conclusions. The ability
to generalise the results of the tests to the entire population being tested
is also dependent on the randomness of the sample selection and the
homogeneity (‘sameness’) of the population. Where populations comprise
several different subgroups with different characteristics, it is usually
better to divide up the population into those different groups before
selecting samples – for example, national and foreign customers may have
different payment terms, and accounts receivable should therefore be
separated along those lines before testing.
You should also understand the consequences of the results of the sample
tests. For example, if the auditors are performing a compliance test and
one item appears not to have been subject to the appropriate control, or
the control has not been properly applied, then they will need to assess
whether the one discovered incidence of non-compliance is an isolated
event or whether more transactions have slipped through the system. It
would be quite wrong to consider the amount involved and then perhaps
to dismiss the non-compliance as being immaterial, since this was not
the purpose of the test. When auditors are carrying out substantive tests,
materiality will be a consideration in assessing the results.
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Activity: practice questions
Porter et al. (2014) p.496, Questions 12.1, 12.2 and 12.3.
7.12 Computer-based systems
In your own lifetime you will have seen how advances in technology have
changed the world around us. Computers are now an integral part of
the operation of most businesses and they are equally important to the
operation of audit firms. Computers have also changed the way that the
audit firms’ clients create and maintain their accounting records, and this
has had a major impact on the way in which auditors conduct their audits.
You need to consider two main areas in which computer advances have
affected the work of the auditor, namely:
•
a move from auditing ‘round’ the computer to auditing ‘through’ the
computer to auditing ‘with’ the computer.
Auditing ‘round’ or ‘through’ the computer is dependent on the nature
of the client’s own systems and the ability of the auditor to examine the
workings of the client’s computer software or to obtain and manipulate
the outputs of that software. In contrast, auditing ‘with’ the computer is
about the auditor’s own use of computers to manage the audit process, for
example by using spreadsheets to monitor staff allocation.
Now read
Gray et al. (2019) pp.368–71.
Activity
Using the audit of accounts receivable as a specific example, distinguish between auditing
‘round’ the computer and auditing ‘through’ the computer.
Pause and think 8
Gray et al. (2019, p.385) remind us that in the early days of computers auditors would
audit round the computer (i.e. they would take little interest in what processes went
on within the computer). Think about what problems that approach might create for
the auditor.
Now read
Porter et al. (2014) pp.491–96.
Gray et al. (2019) pp.385–87 and 396–410.
The discussion in Gray et al. (2019) is more comprehensive than that in Porter et al.
(2014). It is unlikely in the examination that you will have to remember all the details of
specific computer-assisted audit techniques (CAAT), but you should be able to describe
briefly the main types of CAAT and outline the advantages and disadvantages/limitations
of different techniques.
You should also be able to contrast the audit of a manual system with that of a
computerised system. You should be able to describe the advantages but also the possible
disadvantages to the auditor and the client that come from having a computerised
accounting system. You should therefore review your understanding of internal
accounting controls and identify how such controls might differ in a computerised
environment.
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Chapter 7: The audit process
Another area to consider is:
•
the effect of computerised audit techniques on the sampling and audit
evidence.
With manual testing techniques, sampling must be used to gather audit
evidence as 100 per cent testing is impractical and costly. CAAT, however,
open up the possibility of being able to test 100 per cent of a balance
quickly and efficiently. What impact might this have on the audit process
and the purpose of the audit?
Pause and think 9
a. Are there any ways in which a computerised accounting system is more susceptible to
fraud or error than a manual system?
b. Are errors in a computerised system harder to spot because there is an assumption
that the ‘computer must be right’?
Now read
Gray et al. (2019) pp.420–23.
Try to draw upon your own experiences of the use of computers when
writing about this subject, but without going into so much detail that you
lose focus on the question you have been asked. Textbooks and regulators
struggle to keep up with the pace of technology. It takes such a long
time to write a book or to produce an auditing standard that by the time
the work is finished and the item is published, advances in technology
have rendered the material very nearly obsolete. This is the reason why
most of the standards that touch on computer technology do so in very
broad terms rather than in specific details. You are encouraged to provide
answers to examination questions that reflect the current practice of
organisations, rather than textbook descriptions from the past.
7.13 Completion
Once the main body of the audit work has been completed, the auditors
need to review their results in order to form their audit opinion. There are
also several important items that need to be checked at the latest possible
date before issuing the audit report, allowing the auditor access to as
much post-balance sheet date information as possible. These items include
the appropriateness of the going-concern assumption, arguably one of the
most important aspects of the financial statements for users.
Now read
Porter et al. (2014) pp.499–542.
Gray et al. (2019) pp.562–91.
7.13.1 A note on the use of analytical procedures in completion
In conducting their final review of the financial statements, auditors will
again make use of analytical procedures. The ISAs instruct us that:
When completing the audit, auditors should apply analytical
procedures in forming an overall conclusion as to whether
the financial statements as a whole are consistent with their
knowledge of the entity’s business. (ISA 520).
Analytical procedures must be performed as part of the overall review on
completion of the audit. Such procedures may corroborate conclusions
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formed during the audit and may also assist in concluding that the
financial statements are consistent with the auditors’ knowledge. However,
as when applied earlier in the audit process, analytical procedures may
also identify areas requiring further investigation.
Activity: practice questions
Porter et al. (2014) p.538, Questions 13.6 and 13.8.
7.14 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
identify the issues to be considered before accepting a proposed audit
engagement
•
outline the main considerations involved in planning an audit
•
explain the risk-based approach to auditing
•
describe how risk and materiality are considered by auditors
•
identify appropriate audit procedures to be adopted for various items
in the financial statements
•
describe and explain the role of computers in audit.
7.15 Test your knowledge and understanding
You should pay particular attention to the case study questions in Section
A of past examination papers and the Examiners’ commentaries on those
sections of the paper.
7.16 Hints
7.16.1 Pause and think questions
1. The advantage is that it forces auditors to consider the audit approach
in a methodical way and concentrates audit resources in areas where
the risk of misstatement is highest. The disadvantage is that it is not
possible to quantify risk in precise terms.
You should consider cost savings and efficiency for the auditor, whether
these cost savings will be passed on to the clients or whether the
approach might be used to justify fee increases, and whether the model
might result in dangerous oversimplifications. For example, auditors
may be tempted to interpret DR as being limited to not including errors
in samples (sampling risk), (i.e. ignoring the possibility of including
errors in a sample but failing to identify them).
2. No hint provided.
3. Setting materiality as a fixed percentage of profit or sales makes
life easy for auditors but it is not always appropriate so individual
professional judgement will be needed.
4. a.Known problems in the past. Bad publicity in the financial press.
Directors who have been known to be prepared to bend the rules
or who are known to be high risk takers.
b. the firm will lose potential revenue and the difficult client will
have to end up somewhere – perhaps with a less ethical, less
competent audit firm.
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5. This is an almost impossible question to answer. Professional bodies
routinely make claims that their members serve the public interest
in order to attract credibility and respectability. The reality is that
practitioners must also make money otherwise they could not survive
in practice. Putting one aim before another will be problematic in
one way or another. But how to get the balance right is a constant
challenge.
When we considered the ARM we saw that planning will involve
assessments of risk. Planning will also involve the use of analytical
procedures to enable the auditors to start to get an understanding
of the business, and to start to identify areas that need further
investigation and explanation (i.e. areas of potential misstatement).
Analytical procedures are also important in the auditors’ substantive
testing work, which we return to later in this chapter.
6. Analytical procedures are only as good as the data used and the person
performing the procedures. There is always the risk that weaknesses
in one or the other will mean that analytical procedures will produce
misleading results. There is a risk that unwarranted weight will be
given to analytical procedures because they are relatively cheaper to
perform.
7. Making enquiries will often be necessary to back up the findings from
analytical procedures. For example, if the ratio of fuel consumed
per mile travelled has gone up, we would need to establish whether
this is due to a rise in fuel prices, less efficient cars being used or
the possibility of under-recording of miles travelled – or some other
reason.
8. Ideally, we would need to know exactly how the information is being
processed within the computer. Treating it as a black-box and only
looking in detail at a sample of output relies on the entirety of the
processing being done with integrity. There is the possibility that
particular transactions may be processed differently and the auditor
may fail to spot these if they attempt to audit round the computer.
Auditing ‘through’ the computer involves the use of computer-assisted
audit techniques (CAAT). CAAT can be used for both tests of control
and substantive tests of detail.
9. a.The fact that it requires specialist skills to ‘see’ inside the computer
system may mean that a weakness is more difficult to spot. The
mass-processing of transactions and information by a computer
may mean that a simple error or manipulation may be made many
times before it is identified so the potential amount at risk could be
larger than in a manual system.
b. Wise auditors always check a sample of calculations performed by
the computer just to make sure. But there is a natural tendency
to believe what the system produces. This can only be rational
if detailed work has been done testing the accuracy of the
programming.
Just as computers have changed the way that businesses operate,
they have also changed the way that audit firms conduct their
audits in terms of planning and documentation. This is known as
audit ‘with’ the computer, using computers to manage the audit
process itself.
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Notes
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Chapter 8: Responsibility (and legal liability)
Chapter 8: Responsibility (and legal
liability)
8.1 Introduction
In broad terms, we can say that there are three grounds on which auditors
owe some responsibility.
Moral: The idea here is that, notwithstanding their legal and professional
duties, auditors ought to have some moral responsibility to provide audit
or assurance services fully and effectively. However, the bounds of this idea
are vague and it would involve a complex and lengthy debate to explore
aspects such as personal, ethical values. An auditing course is probably
not the right environment for such an exploration, especially as there is
sufficient material to cover when we come to the legal aspects.
Professional: Auditors are members of an elite professional group
within society. They are held in high regard because their technical and
ethical values are supposed to be higher than those of a lay person.
As such, auditors are expected to comply with the norms of their own
professional group. In practice, this means complying with the relevant
auditing standards, for example, the International Statements on Auditing
and other guidance. Apparent failure to do so could result in disciplinary
action.
Legal: The legal obligations of auditors are contained in the Companies
Act and other statutory provisions and in the principles established by the
courts in decided cases, namely case law.
8.1.1 Aim of the chapter
The aim of this chapter is to provide you with an understanding of the
importance of various aspects of responsibility, with particular emphasis on
the legal aspects.
8.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
outline the various bases of auditors’ responsibility – professional, legal
and moral
•
explain the effect of major cases involving the question of
responsibility – for what?
•
explain the effect of major cases involving the question of
responsibility – to whom?
•
assess the significance of the ‘deep pocket’ syndrome and insurance
implications
•
evaluate the effect of litigation on audit practice
•
describe other consequences of the litigation crisis.
8.1.3 Essential reading
Gray et al. (2019) Chapter 21 ‘The auditor and liability under the law’, pp.770–97.
Porter et al. (2014) Chapter 5 ‘Auditors’ legal, regulatory and professional
responsibilities’, pp.161–216; Chapter 15 ‘Legal liability of auditors’, pp.611–
69; Chapter 16 ‘Avoiding and limiting auditors’ liability’, pp.673–722.
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8.2 Duties under statute
The most obvious source for statutory duties in the UK is the Companies
Act 2006.
Section 495
Auditors are to report to the members whether in their opinion:
•
The balance sheet gives a true and fair view of the company’s state of
affairs.
•
The profit and loss account gives a true and fair view of the period’s
profit or loss.
•
The financials have been properly prepared in accordance with the
Companies Act.
Section 498
Auditors are to report by exception where they consider:
•
Proper accounting records have not been kept.
•
The financial statements are not in agreement with the accounting
records.
•
They have not received all the required information and explanations.
•
The financial statements do not make certain statutory disclosures
regarding directors (e.g. emoluments, loans and transactions).
Section 507
It is a criminal offence for auditors knowingly or recklessly to issue a
report which includes a matter that is misleading, false or deceptive in a
material particular.
Section 532
Any provision which exempts auditors from liability for negligence, default
or breach of duty is void. However, a company can indemnify its auditors
for the costs of defending an action (s.533); and auditors and clients can
now make agreements which limit the liability of the auditors (s.534);
provided the agreement is authorised by the company’s members (s.536).
Other statutes
Other pieces of legislation which may be relevant to practising auditors
in the UK are the Proceeds of Crime Act 2002 and Money Laundering
Regulations. Auditors are unlikely inadvertently to become involved in
money laundering (although the definition is wider than many people
may think). However, auditors who fail to report to the authorities their
reasonable suspicions about a client may face a fine and up to five years in
prison.
The Fraud Act 2006 may also represent a trap for the unwary auditor.
The definition of fraud in the Act includes false representation, failure
to disclose information and abuse of position. In other countries there
could be similar legislation or even more serious rules and penalties. For
the purposes of the examination, you should not worry too much about
memorising many small details from the various pieces of legislation. It is
far more important that you have a working grasp of the principles of the
law. When it comes to particular legal cases which have involved auditors,
then you will need to spend more time reading and making notes on the
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facts and the decisions of the cases. However, it is important to appreciate
that answering an examination question simply by reciting a mass of detail
about individual cases is unlikely to satisfy the examiners.
Pause and think 1
Are there any other statutes which auditors might be in breach of if they are not careful
in carrying out their audits? Consider the situation in your country.
8.3 Liability under case law (common law)
Actions can and have been brought against auditors in contract and in
tort. It is important to understand these issues, and a number of cases
are covered in the following pages as well as in the textbooks. You should
concern yourself not so much with memorising all the names, dates and
‘stories’ behind the cases but with trying to understand the principles
involved.
Now read
Gray et al. (2019) pp.773–88.
Porter et al. (2014) pp.194–98.
Activity: practice question
Porter et al. (2014) p.205, Question 5.7.
8.3.1 In contract
Auditors are in contract with their clients: the companies they audit (and,
through the company, its members). So the company (or its shareholders
on behalf of the company) can bring an action against the auditors for
failing to comply with their contractual duties, one of which is to act with
reasonable skill and care.
It is in this context that the importance of engagement letters cannot be
overemphasised (we met the topic of engagement letters in Chapter 7 of
this subject guide). In non-statutory situations, the engagement letter will
be the contract and a court will look to the evidence of the agreement
between the parties in deciding on the performance of one or both parties.
Cases have occurred where the accounting firm believed it was engaged to
do basic accounting work, whereas the client believed that a higher service
was being paid for. The absence of a written agreement may make matters
unnecessarily difficult for accountants (see the cases of Apfel v Annan
Dexter (1926) and 1136 Tenants, Corporation v Max Rothenberg [1971]
319 NYS2d 1007). Even in the case of a statutory audit, it is advisable to
have an engagement letter, since this will help to clarify matters in the
mind particularly of those engaging the auditors, who may suffer from any
number of delusions about what an audit is and what auditors are legally
required to do as part of a statutory audit.
8.3.2 In tort
Auditors face liability suits not only from their disappointed clients but
also from third parties who may or may not have been known to the
auditors at the time the audit was performed. Tort is the name given to
law which deals with cases where people suffer a wrong outside the terms
of a contract. In the case of the financial auditor, the contract is between
the auditor and the client company and its body of shareholders. This
means that, for example, potential shareholders, and lenders such as
banks, do not have a contract with the auditors. But these third parties are
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likely to rely on the auditors’ financial statements and may suffer a loss as
a result. Tort is the law which will deal with these cases. It is this seam of
case law which makes for fascinating reading for the enthusiastic student,
for a wealth of material for the legal-minded examiners and for a source of
constant anxiety for those in practice.
One tort action which is possible but rare against auditors is the tort of
deceit. A third party who has been knowingly misled by an auditor may
bring such an action.
The most common type of third-party action against auditors is in the tort
of negligence, and this will now be covered in detail.
Pause and think 2
What are the best defences against (a) an action in contract, and (b) an action in tort?
There have been many cases involving lawsuits against auditors. To try to
organise the material in a logical and manageable way, we will look at two
separate strands of litigation dealing with the following issues:
•
What is reasonable skill and care (i.e. what to auditors have to do)?
•
Who can hold them to it (i.e. responsibility to whom)?
8.4 What is reasonable skill and care?
Now read
Porter et al. (2014) pp.586–625.
Ignorance of the company’s constitution and of the duties of auditors
there-under is likely to cause problems for auditors. In Leeds Estate,
Building and Investment Co v Shepherd (1887) 36 Ch D 787, dividends had
been paid contrary to the company’s articles of association. In addition,
both the balance sheet and the auditors’ report failed to comply with
the forms specified in the articles. The auditors, one of whom was a
bank manager, were unaware of the articles so had no knowledge that a
particular form of report was required. The court held that the auditors
were negligent because they had performed merely a mechanical audit.
They had not checked the articles of association, although they must have
known of their existence because every company was required to have
articles.
This leads us on to consider the question of how much checking is
required by the auditor and how much the auditor can rely simply on
management’s word. In Kingston Cotton Mill [1896] 2 Ch 279, the
manager of the mill falsified the inventory figure but certified to the
auditor that the figure was correct. The auditor accepted the manager’s
word without checking further. The court held in favour of the auditors;
auditors could not be held liable for failing to track down ingenious
schemes of fraud. The case is still cited in legal arguments before the
courts today, although the passage of time and the development of more
rigorous standards makes it a less weighty judgment than it once was.
It has since been suggested that the Kingston Cotton Mill decision hindered
the progress of the accountancy profession. It was too defensive of
auditors who, after all, are paid to check on the accounts prepared by the
company’s servants – the managers.
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Pause and think 3
To what extent do you think that the court in the Kingston Cotton Mill case took a fair
view of the work of the auditor who, in that case, was a qualified accountant?
A more modern approach comes through in the judgment in Re
Westminster Road Construction (1932) 76 Acct LR 38, where the auditors
had relied on management representations rather than on an examination
of the company’s own internal inventory records. The inventory in the
balance sheet was overstated, and the auditors were sued. The court
held that the auditors had been negligent; they should not have merely
relied on the word of management. The internal records of the company
varied from the figure in the balance sheet and the auditors would have
discovered that had they looked at the stock records. The principle is:
where evidence exists, it should be checked.
Another more recent case is that of Re Thomas Gerrard [1968] Ch 455,
where a managing director (who was also a major shareholder) inflated
reported profits by manipulating cutoff procedures around the year end,
bringing into the present accounting period sales made in the next period
and delaying recognition of current period expenditure until the next
period. The same sort of manipulation happened over five accounting
periods. The auditors became suspicious and questioned the director but
were rather too easily satisfied with his explanation that these were ‘yearend adjustments’. They were held to have been negligent: they should
have checked that the explanations made sense and corresponded with the
underlying business reality.
Pause and think 4
What could the auditors have done in the Thomas Gerrard case that would have revealed
that the year-end adjustments were not right?
8.4.1Can the auditors hide behind the negligence of the
directors?
In London Oil Storage v Seear, Hasluck & Co [1904] 31 Acct LR1, the
company secretary, an officer of the company – not a mere clerk – stole
money from the petty-cash float. The float was there and could have been
counted by the auditors. Remember, the best evidence of the existence of
assets is to see or to count them. The auditors did neither and as a result
were held to have been negligent. Auditors should look to gather evidence.
Although the company’s directors had been negligent in not having
instituted proper controls over the company secretary, the auditors could
not use the directors’ negligence as a defence.
8.4.2Can auditors be expected to have the benefit of hindsight
when they conduct audits?
The answer is obviously ‘no’. Auditors cannot know in advance how things
will turn out. In Henry Squire v Ball, Baker & Co [1911] 44 Acct LR 25, stock
sheets had been altered to hide a fraud. The fraud came to light later but
there were no suspicious circumstances at the time which would have alerted
the auditors. The court held that in the absence of suspicious circumstances,
auditors could not be made liable for failing to detect a fraud or errors.
8.4.3 When should auditors become suspicious?
This is a difficult question and one for which there is no definitive or
exhaustive answer. That will be frustrating for the diligent student, but a
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few cases illustrate some of the factors that will likely influence a court.
In Arthur E Green v Central Advance & Discount Co [1920] 63 Acct, a
company manager was paid a commission based on a percentage of
profits. It was clearly in his interest to report as high a profit as possible.
In drawing up the accounts, he had made no allowance for bad debts, but
he certified to the auditors that the debtors were correct. It was held that
the auditors were negligent. If they had enquired more closely, they would
have discovered the lack of a bad debt provision. The circumstances were
such that this level of enquiry was called for.
In Re City Equitable Fire Insurance [1924] 71 Acct LR 81, the audited
balance sheets included investments. The auditors sought evidence for
the existence of the investment but were told that the share certificates
representing the investments were in the hands of the company’s
stockbrokers. The auditors wrote to the stockbrokers asking for
confirmation that they held the share certificates and later received a
confirmation letter. On the stockbrokers’ letterhead appeared the name of
the company chairman, who was also a partner in the stockbrokers’ firm.
The letter turned out to have been forged by the chairman. The shares
were not in the hands of the stockbrokers, they had been sold by the
chairman. The court held against the auditors: judges questioned but left
undecided whether auditors should look to independent evidence (here
confirmation was not from an independent third party and stockbrokers do
not normally hold investments for clients). The auditors escaped liability
because of an indemnity clause in the articles of association (although
such a clause would now be invalid).
In Fomento (Sterling Area) Ltd v Selsdon Fountain Pen Co. Ltd. [1958] 1
All ER 11, which was a royalty audit rather than a statutory audit, Lord
Denning gave the following view on the mind-set which he expected
auditors to adopt:
To perform his task properly he must come to it with an
enquiring mind – not suspicious of dishonesty – but suspecting
that someone may have made a mistake somewhere and that a
check must be made to ensure that there has been none.
Pause and think 5
To what extent do you think Lord Denning’s view is practical?
The more recent New Zealand case of AWA v Daniels [1992] 10 ACLC
933 demonstrates how a court can hold both auditors and management
to blame, although UK courts are less likely to apply the concept of
contributory negligence where losses are apportioned to the litigating
parties in proportion to the court’s assessment of their culpability. Here,
losses were incurred through a trader’s unauthorised foreign exchange
transactions. The auditors, it was held, should have been aware of the lack
of control over the trader and should have drawn management’s attention
to it. However, management’s neglect also contributed to the bank
incurring the loss and so the auditors were not liable for the full amount.
The need to alert management as soon as an error or weakness is
discovered is amply illustrated in the case of Sasea Finance Ltd v KPMG
[2001] All ER(D) 127. A substantial fraud was discovered but the auditors
did not inform senior management until near the end of the engagement.
The court held that auditors should report to the appropriate level of
management as early as possible so that corrective action might be taken
and the extent of losses restricted.
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Pause and think 6
What difficulties are caused if auditors are to report to senior management the instant
their suspicions are aroused? Are there any circumstances that you can imagine when it
might be better for the auditor to delay reporting to management?
However, auditors can do no more than warn company management (and
shareholders if the matter is sufficiently material). They cannot enforce
better management controls. In SP Catterson & Sons [1937] 81 Acct LR 62,
internal control over cash receipts was weak. The auditors discovered the
weakness and warned management that there was a risk of employee theft
of incoming cash. They even recommended an improvement in the control
system. Management chose to ignore the auditors’ warnings and the
company did suffer losses as a result of the embezzlement by the employee
concerned. The court held in the auditors’ favour. It was not part of their
duties to tell directors how to run the business and they had no power to
insist that their recommended changes were put into operation.
8.4.4What is an acceptable accounting treatment? What does the
profession accept?
The case of Lloyd Cheyham v Littlejohn & Co [1987] BCLC 303 illustrates
how the courts have regarded accounting standards as a benchmark of
what would be required in producing true and fair accounts.
Pause and think 7
Apart from accounting standards, what other benchmarks or indicators of acceptable
accounting practice can auditors use to judge a client’s selection of accounting policies?
Not reporting in an honest fashion is going to be difficult for auditors to
defend.
In a landmark case from the 19th century, London & General Bank [1895]
2 Ch 683, the Court of Appeal held the auditors liable for dividends paid
out of profits which had not been genuinely earned. The bank had loaned
money to customers who were not creditworthy. When the customers
failed to pay the interest on the loans, the bank simply added the unpaid
interest to the outstanding capital even though there was no hope of
recovering any money from the customers. The auditors were aware of this
treatment and were not comfortable with it. They made this clear to the
bank’s chairman, who promised to give a full account to the shareholders,
but in the event the shareholders were kept in the dark. The auditors
themselves tried to inform the shareholders through the auditors’ report;
however, the wording was so oblique that it was unlikely that it would
have sounded alarm bells as the auditors had intended.
In the conduct of an audit, it is not unusual for the client to ask auditors
for advice on what would be acceptable accounting treatments. The
danger of auditors given advice on actions and accounting treatments is
illustrated in the case of Manchester Building Society v Grant Thornton
(Supreme Court, 2019). The client building society planned to enter
into interest rate swaps to hedge against its exposure on its mortgage
book. Grant Thornton was asked whether such swaps would comply
with the relevant rules on hedge accounting. Grant Thornton replied
in the affirmative – that reply was not sound. In the event, there was a
mismatching of hedge and exposure; the building society suffered a loss
in unwinding the swaps and sought to recover that from the auditors.
The decision of the Supreme Court was that the advice on the application
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of hedge accounting fell within the scope of the auditor’s duty of care
and following that advice had led to the building society suffering a loss.
Grant Thornton were held liable but only for one-half of the loss incurred.
The Supreme Court, in a rare application in the UK of the contributory
negligence defence, decided that the actions of the building society’s
management had caused the other half of the loss.
Activity: practice questions
Porter et al. (2014) pp.663–64, Questions 15.3, 15.4 and 15.7.
8.5 Responsibility to whom?
The second strand of case law that you need to become familiar with
addresses the question of who can sue the auditors. As has been stated
above, the client company is clearly owed a duty of care under contract.
For many years this marked the limits of possible action, since the
principle of ‘privity of contract’ was sacrosanct: only parties to the contract
had any rights under the contract. Those familiar with contract law will
remember the stage-coach case of Winterbottom v Wright (1842) 152
ER 402, where a passenger in the coach who had been injured as the
result of poor maintenance performed by a blacksmith was unable to
recover damages from the blacksmith because there was no contractual
relationship between the two parties. One reason the courts were
unwilling to extend liability to those outside the contract may have been
the anticipated consequences of exposing business people to a possibly
limitless range of plaintiffs (how could the inept blacksmith have foreseen
the extent of the injuries caused by his carelessness and who might suffer
those injuries?).
To show that the courts were even-handed in preventing actions by injured
parties whether the nature of the injury was physical or financial, we can
remember another famous case, Derry v Peek (1889) 54 JP 148. Here,
a subscriber for shares relied on a prospectus that contained errors, not
through fraud but through honest misrepresentations. The investor lost
his money and sued, unsuccessfully. The court held that, in the absence
of fraud, there was no action available where only financial loss was
involved.
The state of the law as regards third parties around the turn of the century
can be seen from the often quoted judgment of Lord Esher in Le Lievre v
Gould [1893] 1 QB 491: ‘a man may be as negligent as he pleases if he
owes no one a duty of care’.
8.5.1 Erosion of privity
The stance of the court began to soften as the 20th century progressed.
In the field of physical damage caused to consumers by the negligent
manufacture of goods, the turning point came in Donoghue v Stevenson
[1932] AC 562. The consumer of a bottle of ginger beer became unwell
after discovering a decomposing snail in the bottle. The consumer sued
the manufacturer, not the retailer from whom the bottle had been bought.
The court allowed recovery of damages even though there was no contract
between the manufacturer and the consumer, on the grounds that there
was sufficient proximity between them to give rise to a duty of care. Lord
Atkin’s view was that a duty of care is owed to one’s neighbours, ‘persons
who are so closely and directly affected by my act that I ought reasonably
to have them in contemplation … when I am directing my mind to the acts
or omissions in question’.
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It is unlikely that you will need to quote from cases not involving auditors,
but it is still relevant and of interest to be aware of these milestones in the
development of a branch of the law that impacts on auditors on a daily basis.
For third-party plaintiffs to recover when they had suffered financial
damage, the development of third-party liability took much longer. The
famous case of Ultramares v Touche (1931) 255 NY 170, in the USA,
illustrates the point. Touche Niven & Co were accountants hired to prepare
and audit the balance sheet of Stern Co. The accountants knew from past
experience that the balance sheet would be presented to bankers in order
to support a loan application. The 1923 balance sheet showed the company
to have a net worth of $16m but in fact Stern was insolvent. In 1924
the bank, Ultramares, lent Stern $165,000 and in 1925 Stern declared
bankruptcy. The bank then sued the auditors. The court held that the
auditors were not negligent. In a famous judgment, Cardozo J stated that:
If liability exists, a thoughtless slip or blunder, the failure to
detect a theft or forgery beneath the cover of deceptive entries,
may expose accountants to a liability in an indeterminate
amount for an indeterminate time to an indeterminate class.
The hazards of a business conducted on these terms are so
extreme as to enkindle doubt whether a flaw may not exist in
the implication of a duty that exposes to these consequences.
In short, the rationale was that to hold accountants liable would open the
floodgates. Later commentators termed this the ‘social utility rationale’ (i.e.
it was socially useful to protect the accounting profession at this time).
8.5.2Why the difference between courts’ views on physical and
financial damage?
Pause and think
Why were courts more willing to extend the liability of negligent manufacturers than the
liability of negligent producers of reports or information?
There are several possible explanations.
•
The social consequences of physical damage appear greater for
negligent goods, and courts appeared to be more protective of
consumers of goods than consumers of information such as investors.
•
The relationship between the acts of the producer of goods and the
eventual consumer is closer for negligent acts than for negligent
reports.
•
Negligent acts are likely to have only one consequence arising from
the consumption or use of the product. A negligent misstatement may
be passed from one person to another without the author’s consent.
It is more difficult to quantify or to limit the damages in the case of
negligently prepared information.
The court’s inconsistency in the treatment of negligence actions was
highlighted in the auditing case of Candler v Crane Christmas [1951] 1 All
ER 426. Here, the managing director of a company instructed accountants
to prepare accounts. The accountant did so knowing that the accounts
would be used to induce a potential investor to invest in the company. The
investment was made but the accounts proved to have been negligently
prepared. The company went into liquidation and the investment was lost.
The disappointed investor sought to recover from the accountants. By a
majority verdict, the Court of Appeal maintained the status quo in terms of
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a reluctance to grant that a duty of care was owed to third parties claiming
damages for financial loss caused by reliance on negligently prepared
information. The case therefore held no surprises or new legal principles
and would have been forgotten were it not for the judgment of the
dissenting judge, Lord Denning. He did not accept that whether a duty of
care was owed depended on the nature of the damage suffered. He argued
that ‘People with special skill or knowledge engaged to give advice or make
reports owed a duty of care to do so without negligence to their own clients
and to people they knew were going to see their reports’. If accountants
could not be held responsible for the consequences of negligent work except
by their own clients, then there was little point in having them.
The logic of his reasoning was accepted in the non-accounting case of
Hedley Byrne v Heller [1963] 2 All ER 575. The case involved a bank being
asked to provide a credit reference concerning one of its customers for
the benefit of the customer of a different bank which was contemplating
doing business with the first bank’s customer. The first bank carelessly gave
a favourable rating and business was transacted between the customers.
When the true state of the financial position of the customer became
known, it was too late to recover any money. The party which had been
given the negligently prepared credit report sought to recover their losses
from the bank which had given the report. The House of Lords allowed
recovery even though there was no contract between the two parties. It was
established that a duty of care had arisen because of the special relationship
between them; the bank knew or ought to have known that a third party
was relying on its report. The bank, however, was able to escape paying
damages because of an effective disclaimer of liability in its report.
Another non-accounting case is that of Anns v Merton London Borough
Council [1978] AC 728. It is obviously less important for you to remember
the details of these non-accounting cases, but a brief description of
the circumstances is given so that you can understand the relevance of
the decision to auditors and other professionals. The case involved the
building of an apartment block which developed cracks in its structure
because of poor foundations. The plaintiff was the purchaser of one of
the apartments who sued not only the builders but also the local council
whose inspectors were employed to check compliance with building
regulations and who should therefore have detected the poor quality of
the structure. The judgment established that the existence of a duty of care
to third parties hinges on two issues:
•
The proximity between the two parties such that in the reasonable
contemplation of the wrongdoer carelessness on his part may be likely
to cause damage to the other.
•
The general leeway granted to courts to allow them to consider
mitigating circumstances, the so-called ‘policy decision’.
The rationale of the Anns case is specifically referred to in the auditing
case of Scott Group v McFarlane [1978]1 NZLR 553, which involved
the takeover of a company whose accounts contained material errors.
The auditors knew of the errors but made no mention of them in their
report. It was held that a duty of care existed. Although the auditors
did not know of the existence of the takeover bidder, they should have
foreseen the possibility of a takeover because with low profits and highvalue assets their client was an obvious target for a bid, and there was a
virtual certainty that in a bid situation, the accounts would be relied on.
The judgment of Woodhouse J is interesting because he gives four broad
reasons why auditors should owe a duty of care to third parties:
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1. Auditors are professional people whose task would be fruitless if their
reports could not be relied on.
2. The commercial system depends on confidence in company accounts.
3. It is impossible for investors to make their own investigations into
company finances.
4. Auditors are aware that accounts are filed publicly.
In the UK there was a certain enthusiasm for applying the Anns judgment
to an auditing context. In JEB Fasteners v Marks Bloom [1981] 3 All ER
289, a company which was in financial trouble produced audited accounts
which contained material errors, involving sales, purchases, inventory and
accruals. The company was bought out by another company which then
discovered the true state of affairs. It was held that the appropriate test
for determining the auditors’ liability was whether the auditors knew or
reasonably could have foreseen the third party’s reliance on the accounts.
In the JEB case, the possibility of a takeover should have been in the
auditors’ mind. A duty of care therefore existed, although in the event no
damages were awarded because the plaintiff, the takeover bidder, knew
or suspected that there were errors in the accounts and anyway was
more interested in acquiring the know-how of the personnel in the target
company. The negligence of the auditors, therefore, was not the cause of
the plaintiff’s alleged loss.
The same could not be said of the auditors’ position in Twomax v Dickson,
McFarlane & Robinson (1982) SC 113, which also involved a takeover
based on accounts which showed a profit only because of errors in
drawing up the accounts. When the purchasing company realised the true
position, it sued the auditors. The judgment went against the auditors for
the full cost of the acquisition since the purchaser would not have bought
at any price had it known the truth. On the question of proximity, it was
accepted that although the auditors did not know the identity of the
eventual purchaser, they should have foreseen its reliance on the audited
accounts because:
•
They knew the audit client was short of capital.
•
They knew that one director wanted to sell out.
•
They had in fact placed an advertisement to help him sell his shares.
•
They were aware that accounts were being shown to potential investors.
•
There is a general awareness that auditors’ reports are relied on by
investors.
A case which gave some respite to the beleaguered auditing profession (at
least for a short while) was Caparo Industries v Dickman [1990] 1 All ER
568. The House of Lords held that to establish a claim against an auditor a
third party must show that:
•
A duty of care was owed by the auditor to the third party.
•
The auditors were negligent.
•
The loss was suffered as a result of the negligence.
•
The loss can be quantified.
To decide the first question, whether a duty of care is owed, the successful
plaintiff must show that:
•
Reliance by the third party was reasonably foreseeable.
•
There existed a relevant degree of proximity between parties.
•
The imposition of a duty of care must be just and reasonable.
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Significantly, their Lordships held that auditors owed a duty to a
company’s shareholders as a body, not to individual shareholders, for the
purposes of assessing the directors’ stewardship of the company and not to
enable individual shareholders to make their investment decisions.
8.5.3 Developments since Caparo
It is in the nature of things generally, and especially of the law, that a
steady state does not last long. Time moves on and so does the law.
Despite auditors’ prayers, the Caparo decision did not spell the end of
litigation against those in the profession.
Pause and think 8
Do you think it fair that practitioners of any professional service can never be sure that
the law as it stood last year will be the law as it stands in a year’s time? What difficulties
are caused for auditors by the fluidity of the legal position?
In Al Saudi Banque and Others v Clarke Pixley [1990] 2 WLR 344, auditors
were sued by no fewer than 10 banks which had lent money to the
audit client. Seven banks were owed money at the date of the allegedly
negligent audited accounts and three banks subsequently became
creditors. Millett J decided the question of whether a duty of care was
owed by the respondent auditors to the plaintiffs in the negative on the
following grounds.
•
In the case of the three banks which were not existing creditors of the
company at the date of the relevant auditors’ reports, the defendants
had not made their reports either directly to the plaintiffs or to any
other person with the intention or in the knowledge that the reports
would be communicated to them. The element of proximity necessary
to found a duty of care was therefore lacking.
•
The remaining seven plaintiffs were a limited class and their identities
and the amounts of their exposure were known to the defendants at
the dates when they signed their reports. However, their position was
not comparable with that of the shareholders of the company, to whom
a statutory duty to report was owed. Since the defendants had neither
supplied the plaintiffs with copies of the audited accounts directly, nor
sent copies to the company with the intention or in the knowledge that
the company would supply them to the plaintiffs, no duty of care was
owed to them.
In James McNaughton Paper Group Ltd v Hicks Anderson & Co [1991] 2
WLR 641, the defendant accountants submitted the accounts of a company
as ‘final drafts’ showing a net loss for the year of £48,094 and, in reply to a
question put by the plaintiffs who were contemplating a takeover, said that
the group was ‘breaking even or doing marginally worse’. Subsequently,
the plaintiffs completed the takeover and discovered a number of errors
in the accounts. It was held in favour of the accountants that there was
not such a relationship of proximity between the plaintiffs and defendants
as to establish a duty of care; that the defendants could not have been
expected to foresee the damage which the plaintiffs alleged they had
suffered in reliance upon the draft accounts and the answer given by the
defendants in general terms; and that, accordingly, it was not fair, just and
reasonable to impose on the defendants a duty of care to the plaintiffs in
relation to the accounts and to their answer to the plaintiffs’ enquiry.
A case which appeared at first to be going against the auditor in the
familiar setting of a takeover bid was that of Morgan Crucible Co plc v Hill
Samuel & Co Ltd and Others [1991] 2 WLR 655. The auditors were sued
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for alleged breaches of a duty of care by negligent misrepresentations in
audited financial statements, in an unaudited interim statement published
prior to the bid, and in a series of representations contained in defence
documents issued to shareholders and served on the plaintiffs’ advisers. It
was claimed that the plaintiffs had foreseeably relied on these documents
in making and increasing their offer for the company concerned and
thereby they had suffered a loss. It was held that the defendants intended
for the plaintiffs to rely on their statements in deciding whether or not
to make an increased bid; that the plaintiffs did rely on them for that
purpose; and that, therefore, it was plainly arguable that there was
a relationship of proximity between the plaintiffs and the defendants
sufficient to give rise to a duty of care. The case ended by being settled out
of court, however, so no principle was established.
Pause and think 9
To what extent do you think that the ability to settle a case out of court helps or hinders
the profession and its members generally?
Now read:
Porter et al. (2014) pp.661–63.
Activity: practice question
Porter et al. (2014) p.664, Question 15.10.
The case of Berg Sons & Co v Adams [1993] BCLC 1045 Professional
Negligence 8(4) 1992, p.167) is interesting because it gives some indication
of additional defences available to auditors faced with lawsuits from
banks. Berg was a company that was effectively owned and run by one
man, but was deep in debt to its bankers. Following the failure of one of its
major clients, Berg went into liquidation and its bankers sought to recover
their losses from Berg’s auditors in tort as third parties and in contract in
the name of the company, on the grounds that had the auditors given an
early warning of the state of the company by qualifying/modifying their
audit report, the banks would not have lent the company more money.
The judge held that the auditors had been negligent in that they had relied
on the unsupported representations of management and were therefore
in breach of contract, but their negligent report was sent to the one man
who knew the true position. The fact that Berg continued trading fell
outside the auditors’ duties. In regards to the action in tort, no duty of
care was owed to the company’s creditors under the Caparo principle, and
anyway it was not reasonably foreseeable that the banks would rely on
the accounts months after the relevant year-end. Moreover, the auditors’
negligence was not the cause of the bankers’ losses, it was the insolvency
of the company’s client which caused it to fail.
A similar issue was decided in the case of Galoo Ltd v Bright Grahame
Murray [1994] 1 WLR 1360, in which it was held that the auditors’ breach
must be the dominant cause of the alleged loss.
Non-accounting cases, such as those of Henderson v Merrett and White
v Jones, which involved lawyers being sued by disgruntled individuals
who had not benefited from the lawyers’ services as they had expected,
muddied the water further by establishing an alternative to the threepart Caparo test, that of the voluntary assumption of responsibility. Thus,
where it can be shown that the professionals accepted responsibility
to a third party, then that party might have a cause of action should
loss subsequently be incurred through the professional’s negligence.
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This principle was put to the test in ADT v BDO Binder Hamlyn [1996]
BCC 808, where an audit partner was asked by an investor involved in
negotiations for the purchase of the audit client if he, the audit partner,
still stood by his audit report during purchase negotiations. The audit
partner answered in the affirmative and by his action was held to have
‘assumed responsibility’ to the investor since he knew the purpose of the
inquiry and knew the other party would not undertake other inquiries.
The case of Anthony v Wright [1995] 1 BCLC 236 shows that some
special action on the part of auditors is required if the assumption of
responsibility test is to be successfully argued. Here, a company’s directors
had misappropriated company money but this was not discovered by
the auditors. The plaintiffs did not rely on the auditors’ reports but
nevertheless claimed that they were owed a duty of care. It was decided
that the company held the investors’ money as trustee, but this did not
establish a special relationship between investors and auditors, so that the
auditors did not owe a duty of care to the plaintiffs.
In Peach Publishing v Slater [1998] BCC 139, accountants were sued over
the accuracy of management accounts which had been used as the basis
for the purchase of a company. The accountants had been asked to confirm
the accuracy of the management accounts and did so knowing that they
contained unusual adjustments which had been made to enhance the view
of the company. The Court of Appeal held that the test was not whether
the accountants had assumed responsibility to the plaintiffs but whether
they had assumed responsibility for the substantial accuracy of the
management accounts. This, it was decided, the auditors had not done.
The fact that the plaintiff was not only experienced in business matters
but was also supported in the purchase negotiations by specialist advisers
influenced the decision as well as the established legal principle of caveat
emptor, ‘let the buyer beware’. However, the fact that a third party receives
independent advice will not absolve auditors from responsibility (see
Electra Private Equity Partners v KPMG [2001] 1 BCLC 589).
The collapse of a bank is likely to spawn a number of lawsuits. One
in particular is of interest because it held that the auditors of a parent
company in some circumstances may owe a duty to a subsidiary in the
group. The case is BCCI v Price Waterhouse (No. 2) [1998] BCC 617.
However, it must be emphasised that this was the result of the particular
circumstances of BCCI and is not a general principle.
Similarly, the Barings collapse resulted in the auditors being sued in a
number of actions. One action, Barings v Coopers & Lybrand [2002] All ER
(D)309, tested the question of whether auditors of a subsidiary owe a duty
to the holding company. It was held in the affirmative since subsidiary
auditors know that the accounts which they audit will be relied on by the
parent company in producing the group accounts.
In Andrew & Others v Kounnis Freeman [1999] 2 BCLC 641, air travel
organisers were required to submit accounts to the Civil Aviation Authority
(CAA) as a condition for receiving a CAA licence. Kounnis Freeman
audited the accounts, which were sent to the CAA. The travel agents
subsequently collapsed and ceased trading. The CAA sued the auditors.
Although the audited accounts were prepared for a statutory purpose, the
court held that the auditors knew (or ought to have known) that the CAA
would rely on the audited accounts for the purpose of deciding whether to
renew the agents’ licence. In these circumstances, a duty of care was owed
to the CAA.
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A specialised form of assurance service was the subject of Law Society v
KPMG [2001] WLR 1921. In the UK, law firms that hold client money must
engage reporting accountants to test their compliance with the detailed
accounting rules of the Law Society and to produce a report on such
compliance for submission to the Law Society. In this case, the law firm
concerned had allowed client money to be stolen by a partner. The theft
had not been discovered by the auditors and a clean report was submitted.
When the defalcation came to light, the Law Society compensated the
law firm’s clients for the loss of their money but then sued the reporting
accountants. The House of Lords held in favour of the Law Society:
the accountants knew why they had been employed by the law firm,
they knew that their report would be shown to the Law Society and to
what purpose it would be put. They should therefore have foreseen that
carelessness on their part might lead to the Law Society incurring a loss.
In Royal Bank of Scotland v Bannerman Johnstone Maclay [2005] CSIH 39,
the Scottish Court of Session decided that, in preparing audited accounts,
a company’s auditors were capable of owing a duty of care to a creditor
bank if they knew (or ought to have known) that the bank would rely on
those accounts. This was despite the fact that:
•
the bank relied on the audited accounts for a purpose other than the
statutory purpose for which they were prepared
•
the auditors did not intend that the bank should rely on the accounts
•
there was no direct contact between the bank and the auditors.
The bank, RBS, had sued Bannerman, arguing that their preparation of
the audited accounts had been negligent and in breach of a duty of care
that Bannerman owed to RBS. Bannerman countered that they owed
RBS no duty of care. The court, applying the Caparo principle, held that
it was sufficient for RBS to show that when Bannerman prepared the
audited accounts they were (or should have been) aware that they would
be provided to RBS for the purpose for which it did, in fact, rely on them
(even though this was different from the statutory purpose for which the
accounts were prepared). It was particularly significant that:
•
Bannerman had prepared the client’s business plan, the foundation of
RBS’s lending.
•
Unlike the situation in Caparo, the audited accounts were not put
in general circulation but were (as Bannerman well knew) provided
specifically to RBS.
•
The purpose for which RBS intended to rely on their work was known
to Bannerman.
The court rejected Bannerman’s claim that the plaintiffs must show that
the auditors must have intended that the party seeking to establish a duty
of care should rely on the accounts.
The effect of the Bannerman case was immediate. Professional guidance
advised auditors to insert an additional paragraph in their reports:
This report is made solely to the company’s members, as a body,
etc. …To the fullest extent permitted by law, we do not accept
or assume responsibility to anyone other than the company and
the company’s members as a body, for our audit work, for this
report, or for the opinions we have formed.
However, this law remains a little unclear as the case was settled out
of court before a higher court could consider the issues (Accountancy,
November 2006, p.10). An indication that disclaimers can be effective in
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reducing auditors’ exposure to liability to third parties can be found in
Barclays v Grant Thornton (High Court, 2015).
In MAN Nutzfahrzeuge AG v Freightliner [2007] 2 BCLC 22 (see
Accountancy, November 2007, p.119), the finance director deliberately
manipulated the company’s accounts. When the company was sold by its
parent, the purchaser discovered it had been duped and sued the auditors
for the £350m which it claimed had been lost through the target being
overvalued. The claim was successful against the parent company, which
in turn tried to recoup from its auditors, Ernst & Young (E&Y). Despite
the fact that E&Y admitted that there had been negligence, the Court of
Appeal held for the auditors:
“they had not taken on responsibility to the eventual purchaser of the
shares and mere foresight that the accounts might be used by a purchaser
was not sufficient. To hold E&Y liable would be to impose a liability
greater than they had thought they were taking on.”
Now read:
• Court of Appeal holds Grant Thornton negligent in loss of chance case.
• Recent key cases on accountants’ liabilities.
In AssetCo v Grant Thornton (2020) the Court of Appeal rejected Grant
Thornton’s appeal against the decision in the lower court that they
were liable to pay damages for losses incurred by their acceptance of
management representations. Had the auditors not accepted these
representations, the financial statements would have revealed the weak
financial position of the client which would then have had the chance to
restructure itself at an earlier point in time and with fewer losses.
8.5.4 The ‘deep pocket syndrome’ and insurance implications
A case involving the accounting firm of Moore Stephens illustrates
graphically the state of the litigious society of today. Until the 1960s it was
illegal in the UK for one person to finance the lawsuit of another. Then
the law was changed and litigation funding was made legal. This is a US
phenomenon where spurious claims are funded by institutions hoping to
cash in on a pay-out from a professional firm or its insurers. In the Moore
Stephens case the writ for £90m came from Insolvency Management Ltd.
(IML), a company specialising in lawsuits, and which had no connection
with Moore Stephens, nor had it relied on any audit report signed by
that firm. IML effectively gambled on the outcome of the legal process
(see Accountancy, February 2007, pp.26–27). The case was decided by
the House of Lords in 2009 (the same year that that court was renamed
the Supreme Court), in favour of the auditors because, in the particular
circumstances of the case, the company was indistinguishable from its sole
shareholder and director who had perpetrated the fraud. The ex turpe
causa or illegality defence protected the auditors; essentially it means
that a party involved in an illegal act cannot bring an action to recover
damages arising from that act.
We can contrast this decision with that in Swynson v Lowick Rose (High
Court, 2014) where a director of a company involved in the takeover of
another company claimed that he had relied in his personal capacity on
the due diligence work carried out by the accountants. It was held that
the plaintiff had not demonstrated that the accountants had assumed
responsibility to the director, only to the company.
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Cases like Moore Stephens suggest that there are some who view auditors
as a rich target for speculative lawsuits – the ‘deep pocket syndrome’.
Auditors are required to have insurance, and potential plaintiffs know this.
Now read
Porter et al. (2014) pp.708–19.
Activity: practice questions
Porter et al. (2014) p.721, Questions 16.7 and 16.9.
8.5.5 More cases to come?
While there have been several cases brought since the landmark Caparo
decision, none has brought a significant change in the law. The 21st
century has been a relatively stable period in terms of the development of
the law regarding auditor liability for negligence. That is not to say that
there has been no litigation. It may be that the lawyers have been just as
busy but their accountant clients have been more prepared to settle out of
court. Of course, that may change. Litigation is an incredibly long-winded
process, and it is possible that events that happened several years ago
could produce cases that are still in the pipeline. In February 2022, it was
reported that the liquidators of Carillion had brought a claim for £1.3bn
against its auditors, KPMG, for failing to spot warning signs that the
company was in financial trouble.
(See ‘Auditors coming under increased scrutiny from London courts’,
Bloomberg, 5 August 2021.)
8.6 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
outline the various bases of auditors’ responsibility – professional, legal
and moral
•
explain the effect of major cases involving the question of
responsibility – for what?
•
explain the effect of major cases involving the question of
responsibility – to whom?
•
assess the significance of the ‘deep pocket’ syndrome and insurance
implications
•
evaluate the effect of litigation on audit practice
•
describe other consequences of the litigation crisis.
8.7 Test your knowledge and understanding
8.7.1 Sample examination questions
1. Provide a critical analysis of the main lessons to be learned from cases
involving third parties suing auditors for breach of duty of care.
2. Provide an analysis of court cases which have been concerned with
deciding the question of whether auditors have exercised reasonable
skill and care in the performance of their audit.
3. ‘Auditors should not be held liable for tracking down ingenious schemes
of fraud committed by trusted servants of the company.’ Critically
evaluate the extent to which you consider that this view corresponds
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with the public’s perceptions of the role of the company auditor and
assess whether such a view is justified in the modern context.
8.7.2 Case study question
Firenz PLC is an old, established family-owned company which for many
years operated solely as a builders’ merchant. Three years ago a new chief
executive officer was appointed. Under his direction, Firenz branched into
other fields by acquiring other companies in the property development,
building and estate agency businesses. The expansion was financed largely
through extensive bank borrowing secured on company property and
other assets. Various banks were willing to lend money on the strength
of apparently ever-increasing profits and prospects. Firenz is the biggest
audit client of Confrere and Partners, chartered accountants, whose
senior partner, Stella Mathison, has ordered a review of the audits of all
companies in the Firenz Group as part of a quality control exercise. The
review reveals the following.
In one subsidiary, a builders’ merchant, the stocktake was held two
months prior to the year-end. Confrere’s staff attended that stocktake but
the accountants have relied on management representations and a basic
review of gross profit margins and stock turnover ratios as audit evidence.
In one construction company, the auditors noted that the manager in
charge of ordering supplies never put work out to competitive tender
and always used the same few suppliers of building materials. This
contravened Firenz group instructions and had been brought to the
attention of the subsidiary’s board in the annual management letter.
Nothing seems to have been done as a result. The auditors also noted that
the manager appeared to own more than one luxury car; in answer to
discreet enquiries, he explained that his cars were financed through his
luck on betting on horse races.
One subsidiary holds land for development. This company is highly
geared. The audit team had asked to see the title deeds of certain
properties but were informed that the deeds were held by a related
company, the estate agent arm of the group. The audit team requested and
received confirmation of the other company’s possession of the title deeds.
One subsidiary had been set up to lend to house purchasers who could not
get mortgages from high-street lenders. This company makes unsecured
loans to customers at high interest rates. The audit team noted that a
number of customers were several months in arrears but that the company
had made no provision for doubtful debts. The audit partner had discussed
this issue with Mathison and together they had devised a form of wording
for qualifying (modifying) the auditors’ report. The wording included the
phrase ‘The performance of certain finance debts will become clearer with
the passage of time’.
Required
Based on your knowledge of auditors’ liability, consider the likely
legal position of Confrere and Partners in relation to each of the above
situations.
8.8 Hints
8.8.1 Pause and think questions
1. This may vary between countries. In some jurisdictions auditors may
have particular duties to supervisors and/or the tax authorities.
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2. In contract you have to perform your duties with reasonable skill
and care so the best defence is to make sure that you have done a
demonstrably good job. If one is being sued in tort, the plaintiff will
need to convince the court that he was owed a duty of care; the best
defence is to argue there was no duty of care based on precedent. Case
law is always evolving which explains why it is important for auditors
to remain up to date with developments in this area.
3. The overstatement of stock resulted in a change in stock turnover and
gross profit margins from one year to the next. This was not a difficult
fraud to spot. So one might respectfully submit that the court was
unduly lenient on the auditor.
4. It would appear that further investigation, for example of the delivery
notes associated with the sales which had been manipulated, would
have revealed in which accounting period the item really should have
been recorded.
5. This would seem an entirely reasonable approach and although it is
not expressed in the same words in auditing standards, the phrase
‘professional scepticism’ is probably one that Lord Denning would have
approved of.
6. The word suspicion is not the same as ‘knowledge’ – therefore we
might be in a situation when our suspicions are aroused unnecessarily
– perhaps because we the auditors have not fully understood what is
happening. There is a problem if we go straight to the management
before we have checked our facts – we might end up looking
foolish. Another situation might be where the auditor believes that
management itself is involved in the fraud – in which case there is
little point reporting the fraud to the perpetrators.
7. There might be other authoritative sources such as leading textbooks
or recommendations from professional bodies. There might be position
papers of proposed accounting standards. Clearly these will not be as
persuasive as standards but they may carry some weight in the absence
of an accounting standard.
8. It may not be fair but it is the way it is. This is just one of the
uncertainties of being in a professional practice. The difficulty caused
by the changing legal environment is that it is difficult to plan and
difficult to guard against exposure to a lawsuit.
9. It might be cheaper for the individual firm to settle a case out of court
but there may be situations where the law is left in doubt until another
braver firm is prepared to see the matter through to a conclusion
before the court.
8.8.2 Sample examination questions
1. You need to focus only on the third party cases. For example, one
lesson from the ADT case is not to give ‘snap’ advice or to be seen to
be assuming responsibility to a party other than the client. Another
lesson from the Bannerman case is that it would seem sensible to have
a paragraph limiting the auditors’ responsibility only to the members
of the client. You should be able to draw your own conclusions from
the various cases.
2. You need to be able to remember the principles of the various cases.
For example, auditors should not put their names to a report unless
they have taken reasonable care that it reflects their opinion based
on evidence (London and General Bank). Auditors are not expected
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to have the benefit of hindsight (Henry Squire). They cannot tell the
directors how the business should be run (S.P. Catterson). There are a
number of other clear lessons to be drawn from the case law.
3. You should remember that the quotation comes from the Kingston
Cotton Mill judgment given at the end of the 19th century and much
debated and quoted ever since. The question has resonance with
the expectation gap debate and it would be appropriate to refer to
the fraud aspect of the gap in your answer. It is also appropriate
to mention that standards and expectations of the profession have
advanced since the 1890s. However, clever students will know that in
the 20th century there were many cases where frauds were committed
by the ‘trusted’ servants of the company (i.e. the directors). It therefore
seems a bit lame to argue that auditors should be completely free from
responsibility.
8.8.3 Case study question
You need to consider the various aspects of the case and whether any
of them bear a resemblance to past cases. For example, the reliance on
management representations regarding the value of inventory has echoes
of the Kingston Cotton Mill case. Although that case was decided in the
auditors’ favour, the value of that judgment has been questioned over the
years. And the strange wording of the auditors’ report referred to in the
last paragraph is reminiscent of the London and General Bank case where
the court held that auditors should make their message clear. Without
saying that the auditors have failed in their duty, you could argue that they
might appear not to have a strong case in this respect.
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Chapter 9: Audit regulation
9.1 Introduction
Before ending our examination of the topics, we need to say something of
the regulatory structure governing the auditing profession. We focus below
on the international environment, which tends not to be covered as well as
national regulations, which are dealt with in the textbooks.
Now read
Gray et al. (2019) pp.597–638.
Mak Yuen Teen (2013).
9.1.1 Aims of this chapter
The aims of this chapter are to explain the way in which the auditing
profession is regulated and to provide an insight into other forms of audit
and assurance services.
9.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the various roles of regulation
•
describe the background to the development of regulation
•
identify who sets the regulations governing auditors
•
identify who monitors regulatory compliance
•
describe major events on the international stage
•
evaluate criticisms of the regulation of the profession
•
suggest areas that will challenge regulators in future
•
outline the main issues in other forms of audit or assurance
engagement.
9.1.3 Essential reading
Gray et al. (2019) Chapter 22 ‘Issues in auditing’, pp.804–42.
Mak Yuen Teen, ‘Shake-up needed in audit profession’, Governance for
Stakeholders, July 2013.
9.2 The roles of regulation
It was long held that a hallmark of a profession was the ability to regulate
itself. Another common claim is that true professions act in the public
interest. However, there is nearly always a conflict between public and
professional interests, and this is especially so in the commercial world,
where it would be naive to suggest that practitioners are not first and
foremost concerned with making profits.
The question then arises: ‘can a profession regulate itself in such a way as
to protect the public interest and at the same time not interfere with the
profit-making intentions of its members?’
The profession imposes regulation for a number of reasons, such as:
•
quality control
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•
education
•
disciplinary benchmarks
•
legal benchmarks
•
avoidance of political interference.
Pause and think 1
Can you think of any other reason why it would be beneficial for a profession to have
written standards of conduct?
9.3 The background to regulation in the UK
The evolution of the modern profession began in the 19th century with the
increasing demand for auditing services, which was helped by increased
legislation requiring audits for certain types of company. Nevertheless,
the conduct of auditors was left very much to individual practitioners and
their professional bodies (if they were qualified), although these bodies
were reluctant to intervene in all but the most serious of cases. The bodies
would expel members in serious cases but were extremely reluctant to
issue any formal statements telling auditors what to do. This reluctance
flew in the face of demands from members and some of the judiciary.
Frauds and collapses typically spark concern about auditing and the
government sometimes threatens to intervene. The profession’s response
is to do something – anything, so long as it can be seen to be taking the
matter seriously:
•
1960s – Guidance statements (U statements) were issued by the
Institute of Chartered Accountants in England and Wales (ICAEW).
•
1970s – Following a crisis in the banking and property sectors, the
Auditing Practices Committee (APC) was set up.
•
1980s – The first standards were issued by the APC. In addition, the
Joint Disciplinary Scheme (JDS) was set up to enquire into breaches of
professional standards of conduct. However, later it became necessary
to make regulation (monitoring and discipline) more formalised and
extensive, following the EU 8th directive.
9.4 Who sets the rules?
This will vary from country to country but generally we are looking for a
credible body of experts who are independent of the auditing profession
itself. In a previous era, the work of setting technical standards for
auditors was mainly done by volunteers from accounting firms. Although
this was relatively cheap, it had the major disadvantage of appearing to
lack independence – the regulations were being written and enforced by
the people who were being regulated. Since the start of the 1990s, greater
independence has been given to the system of audit regulation in the UK
by the establishment of the Financial Reporting Council (FRC).
You should now take some time to discover the system of audit regulation
that applies in your country. Think about the main issues: who sets the
auditing standards? To whom do they apply (all auditors or only certain
types of company auditor)? Do they apply to all audits (i.e. audits of both
large and small companies)? How is compliance monitored? What are the
penalties if an auditor is found not to have complied with the auditing
standards?
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9.5 The international scene
In addition to your national regime, you should also have some awareness
of the international scene which has developed quite markedly over the
last 20 years.
The move towards proper harmonisation in auditing standards and
procedures has a number of claimed benefits:
•
International investors: comparison of investment opportunities will be
facilitated if financial statements are drawn up globally, and audited
on a consistent and uniform basis.
•
International accounting firms: the recruitment and transfer of staff
across international boundaries would be assisted if the required
training and possession of skills and knowledge were similar in
different countries.
•
Individual accounting practitioners: if training requirements and
technical standards were to be harmonised, job opportunities would be
created or expanded both in terms of the possibility of relocation and
work referred from abroad.
•
Accounting institutes: institutes may avoid duplication of research
and standard-setting efforts by adopting nationally the standards
developed and accepted at the international level. Many, for example,
the UK and Singapore, already do so.
•
Regulatory agencies: both tax authorities and securities regulators
would find their supervisory and enforcement roles eased if national
differences in financial reporting and auditing were reduced.
9.5.1 Historical background
The move towards greater harmonisation of professional accounting
practices has been traced back to 1904 when the first international
accounting congress was held in St Louis, Missouri.
In a tripartite move, Canada, the UK and the USA formed the Accountants
International Study Group (AISG) in 1966. The stated purpose of the AISG
was ‘to institute comparative studies as to accounting thought and practice
in participating countries, to make reports from time to time which,
subject to the prior approval of the sponsoring institutes, would be issued
to members of those institutes’.
IFAC
In 1977, just before the next international congress, the AISG was
disbanded and the International Federation of Accountants (IFAC) was
formed, operating from New York. The broad objective of IFAC is ‘the
development and enhancement of a coordinated world-wide accountancy
profession with harmonised standards’. Its remit is to develop international
guidance in areas other than financial accounting.
The first standing committees of IFAC were charged with responsibility
for developing guidance on auditing, education, ethics and management
accounting. IFAC was also to assume responsibility for organising future
world congresses.
IAASB
The International Auditing and Assurance Standards Board (IAASB)
(formerly the International Auditing Practices Committee) develops ISAs
which are supposed to apply whenever an independent audit is carried out.
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International Standards on Auditing (ISAs)
ISAs contain basic principles and essential procedures together with related
guidance in the form of explanatory and other material. The basic principles
and essential procedures are to be interpreted in the context of the
explanatory and other material that provides guidance in their application.
International Standards on Assurance Engagements (ISAEs)
ISAEs are to be applied in assurance engagements dealing with subject
matters other than historical financial information.
International Standards on Related Services (ISRSs)
ISRSs are to be applied to compilation engagements, engagements to
apply agreed-upon procedures to information and other related services
engagement as specified by the IAASB.
International Standards on Quality Control (ISQCs)
ISQCs are to be applied for all services falling under the ISAs, ISAEs and
ISRSs.
International Auditing Practice Statements (IAPSs)
These provide practical assistance to auditors in implementing the
standards, or on related subjects, and promote good practice.
IFAC members have an obligation to reflect international standards in their
national regulations. In 2022 IFAC reported a constituency of 180 member
bodies in 135 countries, representing over 3 million accountants.
International Ethics Standards Board for Accountants (IESBA)
Like the IAASB, the IESBA operates under the IFAC umbrella. It has
published the Code of Ethics for Professional Accountants on which the
UK’s Ethics Standards are based.
9.5.2 Enforcing compliance with international standards
The IFAC Compliance Committee works with member bodies and outside
agencies to encourage greater compliance with the standards, ethical code
and other pronouncements of IFAC and of the IASB.
The Committee’s primary responsibilities are as follows.
•
To keep under review the membership obligations of IFAC and the
extent to which the member bodies comply with these obligations.
•
To compare and contrast the investigative and disciplinary processes of
member bodies and their adequacy and efficacy.
To consider how member bodies might best be encouraged or, if necessary,
required, to comply more closely with such obligations and, thus, to assist
in the achievement of the objectives of IFAC in the public interest.
•
To devise schemes that would assist member bodies to comply more
closely and to consider whether additional powers are required to
enforce compliance with membership obligations.
The Compliance Committee works closely with members of the
Transnational Auditors Committee (TAC) in its monitoring of the members
of the IFAC Forum of Firms (FOF), for firms with multinational clients.
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Chapter 9: Audit regulation and special forms of audit engagement
9.6 Criticisms of the regulation of the profession
9.6.1 Internationally
Accounting imperialism
The influence of major countries, especially the UK and the USA, is
certainly clear in the pronouncements of IFAC. Resistance can be expected
in countries where international pronouncements are seen as belonging to
economically superior countries, a form of ‘accounting imperialism’.
Inappropriate standards
Other criticisms of the harmonisation process centre on the fact that
standards set internationally cannot possibly cater for the world’s wide
range of national circumstances, legal systems, stages of economic
development and cultural differences.
Historically low response rates to exposure drafts
As with many standard-setters, IFAC exposes its proposed pronouncements
of IFAC for comment. This exposure process gives outsiders the chance to
contribute to the standard-setting process (provided the standard-setters
are responsive to the letters of comment they receive).
Compromises
On relatively straightforward and uncontroversial issues it may not
be difficult for a committee of standard-setters to reach unanimous
agreement on the preferred position. On other issues, compromises may
have to be struck in order for a proposed standard to be accepted.
9.6.2 Nationally
The regulation of the profession is seen as a ‘closed shop’; secretive and
accountable to no one. Criticisms by academics and politicians in some
countries continue, as do scandals and audit failures. The critics, however,
are not so good at suggesting ideas to improve the current regime.
The profession in some countries, such as the UK, has tried to distance
itself from the standard-setting body to give the appearance of
independence. It has become more open and has involved outsiders in the
process, but there is still the suspicion that the standards were written to
protect auditors rather than to extend their duties.
9.7 Recent developments
Students are always encouraged to keep up with developments in their
fields of study. A recent scandal or court case involving auditors can
often be the inspiration for an examination question. The student who
is unaware of even the general nature of that scandal or case is unlikely
to be able to produce much of an answer that will satisfy the Examiners.
On the other hand, the examiners are not going to expect students to
memorise and reel off all of the details and circumstances of a case. They
will, however, expect the well-prepared student to be able to assess the
general principles of the case and the likely implications for the profession.
In the UK, the profession is facing the consequences of the Kingman
Review, the Brydon Report, and the Competition and Markets Authority’s
investigation into the dominance of the Big 4 in the audit market.
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The three reports are quite extensive and run to many pages. Students
should not attempt to read every page of each report, but they
should familiarise themselves with the executive summaries and the
commentaries that followed the reports’ publication.
9.8 A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
•
explain the various roles of regulation
•
describe the background to the development of regulation
•
identify who sets the regulations governing auditors
•
identify who monitors regulatory compliance
•
describe major events on the international stage
•
evaluate criticisms of the regulation of the profession
•
suggest areas that will challenge regulators in the future
9.9 Test your knowledge and understanding
9.9.1 Sample examination questions
1. Identify and explain the different roles of regulation.
2. Critically evaluate the advantages of international harmonisation and
the obstacles facing the harmonisation movement.
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Chapter 10: Other forms of assurance service
Chapter 10: Other forms of assurance
service
10.1 Introduction
Before ending our examination of the topics, we need to say something of
the regulatory structure governing the auditing profession. We focus below
on the international environment, which tends not to be covered as well as
national regulations, which are dealt with in the textbooks.
Now read
Gray et al. (2019) pp.597–638, and Mak Yuen Teen (2013).
10.1.1 Aims of this chapter
The aims of this chapter are to explain the way in which the auditing
profession is regulated and to provide an insight into other forms of audit
and assurance services.
10.1.2 Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
•
explain the various roles of regulation
•
describe the background to the development of regulation
•
identify who sets the regulations governing auditors
•
identify who monitors regulatory compliance
•
describe major events on the international stage
•
evaluate criticisms of the regulation of the profession
•
suggest areas that will challenge regulators in the future
•
outline the main issues in other forms of audit or assurance
engagement.
10.1.3 Essential reading
Gray et al. (2019) Chapter 17 ‘Assurance Engagements and Internal Audit’,
pp.597−636.
Porter et al. (2014) Chapter 18 ‘Corporate responsibility assurance engagements’,
pp.727–73.
10.2 Assurance engagements
The development of assurance engagements has been such that we
have international standards (International Standards on Assurance
Engagements (ISAE) and International Standards on Review Engagements
(ISRE)) to govern the conduct of such services.
10.2.1 International Framework for Assurance Engagements
The Framework sets out to lay down some common principles. First there
is the distinction between audit assurance (reasonable assurance) and
the limited assurance which is given by other assurance engagements and
review engagements.
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Similar to an audit situation, there are five elements.
1. There are three parties in the relationship − the assurance practitioner,
the reporter (the responsible party) and the intended users.
2. There is an agreement between the assurance provider and the
responsible party (and possibly an intended user) about the nature of
the underlying subject matter upon which assurance is required.
3. Suitable criteria exist or are agreed against which the reported matter
can be assessed.
4. Sufficient evidence should be available or should be capable of being
created to provide some basis for the provision of an assurance report.
5. The terms of the written assurance report to be provided at the end of
the engagement have been agreed upon by the assurance provider and
the responsible party.
Remember that the IESBA’s Code of Ethics for Professional Accountants
applies to all accountants not just auditors. It is worth repeating the key
qualities which assurance providers, who are members of a professional
body, will be expected to possess.
•
Objectivity.
•
Competence – this will be engagement-specific. A qualified auditor of
financial statements may not necessarily have the skills to carry out let
us say, a sustainability audit.
•
Understanding of underlying material – again this will be engagementspecific.
•
Ability to apply the criteria agreed upon in the conduct of the
engagement.
•
Obtain relevant evidence using both compliance with systems and that
which supports the substance of the assertions.
•
Professional scepticism should be shown in the conduct of the
engagement.
There are some obvious similarities with the conventional audit of
financial statements.
10.3 Internal audits
Now read
Gray et al. (2019) pp.597–638, and Mak Yuen Teen (2013).
Internal auditing is a part of internal control. It has a natural overlap
with the external audit of a company’s financial statements in that both
audits will be concerned to some extent with the adequacy of the audit
trail, the accounting records, the controls which have been performed
over the accounting system and the risk of loss through fraud or error.
However, there are significant differences. Internal auditors can never
hope to enjoy the independence of the external auditors since they are
directly appointed and paid for by management. They are employees of
the company, and the scope of their work is to a large extent determined
by others. Different organisations place varying degrees of importance
on an internal audit. Those that value the service will give the internal
auditors free rein to investigate whatever they wish, reporting only to
senior management level. Such organisations are likely to get better value
for money than those which constrain their internal auditors, having them
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Chapter 10: Other forms of assurance service
report to relatively low-level managers who may take little notice of their
findings. Organisations such as these will also find that because of their
internal auditors being less effective than they might be, their external
auditors will be able to place less reliance on the control and discipline
that an effective internal audit function can provide, and the fees they will
be charged will increase.
A great deal of emphasis is now more openly shown to the importance of
sound internal controls in large, public interest companies.
10.4 Environmental audits
Environmental audits are examples of the way in which the term ‘audit’
has been borrowed from the financial accounting sphere and attached
to an altogether different process. For other examples, refer to the list
in Chapter 2 of this subject guide. This illustrates the apparent need
to have all sorts of activities and processes ‘verified’ in order to lend
them credibility. Professor Michael Power has written extensively on
the phenomenon he calls the ‘audit explosion’, which has led in turn
to the ‘audit society’. We first considered this issue in Chapter 2, and it
is useful to remind ourselves of the arguments now, before looking at
environmental audits in more detail.
Now read
Gray et al. (2019) pp.615−21.
Pause and think 3
How can an ‘audit’ add credibility to a process concerned with environmental issues?
What form would such an audit take and in what respects would it resemble the financial
audit we have come to know?.
10.5 Sustainability
As the world’s political and business leaders begin seriously to grapple
with the climate crisis, which appears to be looming ever closer, the
accounting profession has started to turn its attention toward issues of the
sustainability of the economic activity.
•
In September 2020, the IASB announced its intention to develop
Sustainable Standards
•
In March 2021, the IASB set up a working group and three months
later invited appointments to its International Sustainability Standards
Board.
•
In September 2021, IFAC issued a Call to Action to the G20 group of
leading economies. This document highlighted the need to:
•
Accelerate the focus on the sustainability of business activity
•
Re-commit to a recognition of the importance of global
collaboration
•
Resist regulatory fragmentation
•
Focus on public sector transparency.
In the UK, the FRC has endorsed the creation of the Taskforce for ClimateRelated Disclosure (TCFD), and it has called for greater awareness and
disclosure of the impact of climate change on companies’ business models,
the impact of companies on the environment and how the financial
statements should reflect those impacts if there are significant risks at stake.
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The companies most likely to be affected are – in the non-financial sector,
those involved in
•
energy
•
transportation
•
materials and buildings
•
agriculture, food and forest products.
In the financial sector, the banks may find that the change in the climate
may adversely affect the viability of some of their business customers
and thus the carrying value of their loans. Insurance companies may face
much higher claims on their policies with a greater frequency of floods,
hurricanes and wildfires.
For assurance providers, there will be a need to assess which are the most
significant areas for stakeholders (similar to the materiality decisions of
auditors of financial statements), to check that the front and back end
of clients’ annual reports are consistent and that the client has made a
genuine attempt to be transparent and balanced in their reporting.
Assurance providers will need to:
•
Test compliance with disclosure frameworks
•
Use their experience of other clients to identify ways to improve
sustainability disclosures
•
Verify reporting under current best practice benchmarks
•
Identify improvements in operations
•
Review clients’ internal data gathering systems
•
Train client teams on reporting frameworks and disclosure
requirements
•
Coordinate with internal audit to verify disclosures
•
Establish measurable sustainability objectives for financial, operational
and regulatory performance.
Important considerations in framing the final report on the sustainability
disclosures will include what was agreed upon at the outset, the timeframe allowed for the completion of the work and whether the report is
for internal or external consumption.
Students are advised to look for the sustainability reports published by
major companies to see what reporting practices are currently employed
by the assurance providers and their clients. Very often students’ answers
to examination questions are unconvincing because they fail to reflect realworld circumstances.
10.6 Corporate responsibility assurance
Environmental audits are not the only major examples of the expansion
of ‘audit’ beyond the figures in the financial statements. Companies are
increasingly involved in corporate social responsibility (CSR) reporting,
or ‘sustainability’ reporting, and they may involve audit firms as
consultants in producing these reports or verifying the information. CSR/
sustainability reporting can be considered to include, but not be limited to,
environmental reporting.
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Now read
Porter et al. (2014) pp.727–73.
Activity: practice questions
Porter et al. (2014) p.773, Questions 17.2, 17.5 and 17.9.
10.7 The future
Now read
Gray et al. (2019) pp.832–42.
We have spent enough time looking at the past. There is no harm in now
speculating about the factors that may influence the future of auditing and
standard-setting in the near future. The sorts of issues that the regulators
of tomorrow will have to counter include are the:
•
innovative audit methodologies of the major international audit firms
•
pervasive influence of new technology on business processes and on
the audit
•
maintenance of the integrity of audited financial information posted
on the internet
Pause and think 2
Assemble in your mind all that you know about auditing and developments in the
business world, and try to think of new problems the auditors of tomorrow will face.
10.8 A reminder of your learning outcomes
Having completed this chapter, and the essential reading and activities,
you should be able to:
•
explain the various roles of regulation
•
describe the background to the development of regulation
•
identify who sets the regulations governing auditors
•
identify who monitors regulatory compliance
•
describe major events on the international stage
•
evaluate criticisms of the regulation of the profession
•
suggest areas that will challenge regulators in the future
•
outline the main issues in other forms of audit or assurance
engagement.
10.9 Test your knowledge and understanding
10.9.1 Sample examination questions
1. Identify and explain the different roles of regulation.
2. Critically evaluate the advantages of international harmonisation and
the obstacles facing the harmonisation movement.
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10.10 Hints
10.10.1 Pause and think questions
1. There could be several benefits not listed above. One might be that it
is reassuring to the public if they were to learn that accountants and
auditors must abide by many detailed technical rules.
2. The sorts of problems each one of us can come up with will depend
on our individual powers of imagination and experiences to date.
Almost certainly the greater ease of use of technology and the speed
of information transfer will continue to have a massive impact on
auditors.
3. Auditing is not so much about creating the information but about
corroborating its accuracy. The involvement of independent experts
is bound to add to the credibility of the information. The form of the
audit of environmental information may vary but an emphasis on risk,
systems of control and the quality of information going to and coming
from management is bound to be part of a green audit.
10.10.2 Sample examination questions
1. You need to be able to rehearse the advantages and disadvantages of
regulation – for example it would help practitioners define the limits
of their responsibilities and students to learn about the practices of
the profession. On the downside it has been argued that the more
detailed the regulation the more the practice of auditing becomes a
‘box- ticking’ exercise.
2. You should be able to rehearse the various arguments for centralisation
(harmonisation) of auditing standards. These have been extensively
set out above. The thing to remember is that whatever your particular
preference for or against harmonisation, you should try to produce a
balanced argument. ‘Critically evaluate’ does not mean ‘criticise’.
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Chapter 11: Examination technique
Chapter 11: Examination technique
11.1 Introduction
The main point that Examiners annually contend with is not so much
students not having done enough work – though this is a problem that some
students face – but students simply not being able to apply what they know
to the examination questions they face in the most effective manner. The
most obvious sign of this problem is the lengthy essay or case study answer
that simply does not grasp the central issue. In short, some students fail to
answer the question even though they clearly know a lot about a topic. To
guard against this risk, it is advisable to read and re-read the requirement of
the question being attempted before you start writing and then refer back to
the question at regular intervals during the writing of the answer to remind
yourself again. Examiners are often more impressed with concise answers
that get to the nub of the issue than long rambling answers that only show
that the student has memorised a lot of material.
11.1.1 Aim of the chapter
The aim of the chapter is to provide you with some refresher tips on how to
get the best out of your examination performance. Here, we remind you of
the principal dos and don’ts. Some of these will have been pointed out to
you at some stage in the past and others have been referred to in the text.
You may feel that this chapter is therefore just repetition but experience
shows that these fundamental points simply cannot be said often enough.
11.1.2 Learning outcomes
By the end of this chapter, you should be able to:
•
understand what distinguishes good and bad examination answers
•
better appreciate what examiners are looking for
•
put yourself in the examiners’ position
•
produce a better performance given the level of your technical
knowledge.
11.2 Before the examination
The ability to focus on the main points is very often the result of sound
preparation for the examination. This involves good organisation of time
and preparation in the weeks leading up to the examination. You should
read as much as you can, not with a view to cramming your head full
of trivial details but so that you have a real and deep understanding of
the subject. You should attend as many lectures and classes as possible
and make sure that you have read the required materials outlined in this
subject guide. You should make notes on the main points. These should be
of a summary nature so that you have a quick way of recalling the topic. If
you are studying alone, the making of notes is a vital skill. Remember that
it is understanding that is most important.
Do not be tempted to try to predict the questions on the paper you will
face by analysing past papers in the hope of finding a trend or a pattern in
the topics covered. Examiners use their skills and imagination to formulate
questions not charts. Past papers are a useful source of revision aids as they
demonstrate the style of questions which have been asked in the past. But
examining the past is no substitute for putting in the effort in the present.
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In the run-up to the examination, you should have a clear plan of revision
so that you allow enough time to re-read the relevant materials and the
notes you have made. You should be prepared to work hard but please do
not work late into the night on the evening before the examination. It will
seriously undermine your performance if you turn up at the examination
hall not having had sufficient sleep.
11.3 In the examination
A lack of sleep may account for the number of candidates who fail
to follow a simple set of instructions on the front of the examination
booklet. In the in-person examinations, these oversights include failing
to complete the list of questions attempted in the boxes provided on the
front sheet. This can only irritate Examiners who mark all of the Question
1 answers before moving to Question 2 answers. In addition, other
oversights by candidates involve writing in the margins, not indicating in
the examination booklet which question has been attempted, not starting
a new question on a new page and producing work which is difficult to
read if not illegible. In online examinations, student oversights include not
indicating which question they have attempted.
The next problem to overcome will have been drummed into you from the
time of your very first examination but many candidates fail to remember
this basic rule – allocate your time according to the marks available. This
requires strict self-discipline, especially if you think you know more about
one area than another. The temptation is to go over time on one question
if that plays to your strengths leaving less time for you to devote to your
weaker subjects. This strategy is unlikely to pay dividends since the
marginal extra marks you gain on your strong questions are not likely to
exceed the marks you have sacrificed on your weaker questions.
Every year examiners see examples of the extreme results of this lack of
discipline with a significant number of candidates not having sufficient
time to answer the required number of questions. In this examination,
candidates who attempt only three questions will severely jeopardise their
chances of a good grade.
In a similar vein, too often examiners find when marking the papers that
some candidates have selected questions for which they cannot produce
full answers. Thus, for example, a candidate may attempt Question 2(a)
and yet fail to write a single word in answer to part 2(b). One reason
for this may be that they committed a basic error: failing to read the
entire question before beginning to write. So, the tip is to make sure that
you read all of each of the questions before you put pen to paper. Now,
you may say that this will be too time-consuming, especially as each of
the questions in Section A is a page long. You may be right – it depends
on how quickly you read. So, let us compromise; as a minimum, make
sure that you read all of the ‘required’ parts of each of the Section A
case studies and all the essays before you make your selection of which
questions you will attempt. Only attempt a Section A question if you are
confident that you can answer both parts.
Having said that, there is another rule that we must not forget: it is better
to write something than to write nothing. Too often, it would seem,
candidates fear that if they do not know the precise answer they think the
examiners are expecting, they will be penalised. It is as if they feel that by
writing an incorrect answer they will have marks deducted from the score
that they have already achieved.
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Therefore, they reason, it is better to leave the page blank. This is a
completely false premise – at least as far as this course is concerned. In
this paper there is no negative marking. So the lesson is that you should
write something in answer to each of your four selected questions, and
each constituent part thereof.
Most of the examination questions in this course will invite fully written
answers so please do not provide short bulleted lists. Whilst your lectures
or online sources may have provided you with notes in this format – it
should not be used when answering examination questions. A list of brief
points can never be sufficient to develop a logical and coherent argument.
Examiners will not reward the ability to recall verbatim a long list of
points, which have been memorised and regurgitated.
Many lecturers use their knowledge and the Examiners’ commentaries to
construct ‘model answers’ to past examination questions. These are a very
good way of developing good examination techniques, but they should
never be memorised as a ‘one-answer-fits-all’ approach. While it is true
that some themes tend to be repeated over the years, there will almost
certainly be different nuances in the question. A student who memorises
and reproduces a ‘model answer’ from a past paper is unlikely to score
highly if the question they face is slightly different. There is a very real risk
that students look at a question, see a key phrase or two and then write all
they know on that topic.
In online examinations, make sure that you have as few distractions as
possible in the room which you have selected or has been selected for you.
If you are sitting an in-person examination in a room with other students
around you, focus on your work. It does not matter how much the person
next to you appears to be writing. You cannot possibly judge the quality of
their writing even if they do appear to be filling their answer book more
quickly than you. So, ignore them!
Most of the examination questions in this course will invite fully written
answers, so please do not provide lists of short bullet points. There is no
way that you can develop logical, coherent arguments in such a manner,
and this is what the examiners will expect to see.
Finally, in the examination hall itself, you want to be so focused on the job
in hand that you pay no attention to the people around you. It should not
matter to you how much the person next to you appears to be writing. You
cannot possibly judge the quality of their writing, even if they do appear to
be filling their answer book more quickly than you. So, ignore them!
11.4 After the examination
Students love to swap ‘war stories’ after the event. This is natural but it
can do you no good and for most is likely only to cause anxiety as answers
are almost bound to be different. The best thing to do is to forget all about
the examination which has just gone, after all you cannot travel back
in time and change what you wrote. Your focus should be on the next
examination unless you have finished – in which case, just relax!
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