THE AUDIT - AN INTRODUCTION
C
READING
BPP - ACCA Certificate Paper F8 Audit & Assurance / formerly Paper 2.6 - Audit and Internal
Review
Elliott & Elliott 13th ed. Ch. 30, pp.819-827 /12th ed. Ch. 30, pp.795-804.
Other introductory auditing texts.
LEARNING OUTCOMES
On completion of this lecture students should:
1. Appreciate the justification for an audit;
2. Understand the importance of independence;
3. Obtain an overview of the audit process;
THEORETICAL JUSTIFICATION FOR AN AUDIT
Most companies in modern capitalist economies are very large and complex, so control of such
businesses has to be delegated to a small number of directors. It would be impossible for every
shareholder in a company like IBM to take an active role in management.
So management is separated from ownership.
The problem is described by agency theory. (Jensen and Meckling, 1976):
Managers (agents) have enormous power and the consequences of their decisions over business
strategy, financing and investment decisions will affect the welfare of shareholders (principals).
Sometimes there may be conflict between shareholders’ welfare and their own, so it may be
necessary to choose between them. For example, directors may award themselves excessive
salaries, bonuses or fringe benefits (lavish offices, expensive cars, trips abroad).
To safeguard their own position, the shareholders must implement mechanisms to protect their
interests. The costs of these safeguards are known as agency costs.
There are two main ways in which a principal can prevent an agent from abusing his position of
trust:
1. Remunerate an agent in such a way that his interests and those of the principal
coincide
Problems:
If bonuses linked to performance, managers may suffer due to events outside their control (e.g.
interest rate or foreign currency fluctuations).
Managers may become focussed on the measure used to assess performance to the detriment of
long term shareholder wealth. e.g. If profit before tax is used as the basis for bonus payments,
the figure could be increased in the short term by reducing R&D expenditure or advertising.
While it generally recognised that share options are a better way of aligning the interests of
shareholders and managers, it may still produce sub-optimal behaviour. e.g. A manager owning
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5% of shares in a company will only bear 5% of the cost of the perquisites (or ‘perks’) which he
consumes himself.
2. The principal can monitor the agent’s actions and punish him for any exploitation.
Major shareholders may be able to request a seat on the Board or request informal meetings with
management so that progress can be discussed.
Company law seeks to provide the majority of shareholders with the means of monitoring the
behaviour of their directors (e.g. requirement to keep accounting records, produce annual
accounts in a specified format which are laid before the shareholders at AGM, opportunity to
vote directors off the board).
Problem:
Directors are responsible for the preparation of financial statements used to assess their
stewardship and which may form the basis of any bonus payments. So the temptation to
manipulate the figures exists.
Shareholders require assurance regarding the quality of information in the annual report.
Without it they may either decide not to invest at all or they may demand a higher return on their
investment which increases the cost of finance to the company. Either would adversely affect the
growth rate of both individual companies and the economy as a whole.
Solution:
Require an audit of the annual report to be undertaken to enable users to place greater reliance on
information supplied to them by directors, so enabling better monitoring.
DEFINITION OF THE AUDIT
Definition (Auditing Practice Board):
“The objective of an audit of financial statements is to enable auditors to give an opinion on
those financial statements taken as a whole and thereby to provide reasonable assurance that the
financial statements give a true and fair view (where relevant) and have been prepared in
accordance with relevant accounting or other requirements.” (SAS 100, para. 1).
An older but simpler definition:
Definition (Explanatory foreword, Auditing Standards and Guidelines, 1989):
"An audit is the independent examination of, and expression of an opinion on, the financial
statements of an enterprise."
We are concerned here with the statutory audit required for companies above a specified size.
NB There is no longer an audit requirement for small companies with (at least 2 out of 3 of) a
turnover of not more than £ 6.5 million, gross assets of not more than £3.26million, no.
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employees less than 50, unless 10% or more of their shareholders sign a formal notice requesting
an audit.
Note:
Independence- external to organisation, & must be seen to be independent from directors,
however commercial pressures exist. Accepted that auditors will have to rely to some extent on
information supplied to them by directors, but other evidence should be sought where possible.
An independent audit function is an important component of good corporate governance necessary to maintain confidence of financial markets.
Examination- preparation is the responsibility of directors, even if firm of accountants involved.
Opinion - based on "true & fair view" of the company's financial position as at the balance sheet
date and of its profit or loss for the year ending on that date (Companies Act 2006). No clear
definition exists of this despite it being the main requirement. It is a legal concept and the
question of compliance can be authoritatively decided only by a court
The opinion is an "expert" one, therefore CA 2006 requires an auditor to be ‘registered’ and to
hold an appropriate qualification- membership of a Recognised Supervisory Body (RSB). i.e.
ACCA, ICAEW, ICAS, ICAI. Failure to carry out professional duties with due regard to
technical and professional standards expected may result in disqualification. It may also result in
legal action and substantial damages being awarded against the firm.
The Auditing Practices Board (APB) issues Statements of Auditing Standards (SASs) on required
auditing practice to supplement statutory requirements. Failure to comply with them may result
in regulatory action by the appropriate RSB. Concerned with maintenance of quality control
within audit function and overseen by Professional Oversight Board for Accountancy (POBA).
UK AUDIT MARKET
Virtually all listed companies (and most others of any size) are audited by one of the “Big Four”
firms - PricewaterhouseCoopers, Ernst and Young, Deloitte or KPMG.
These are all powerful multinational firms who also sell consultancy services, accounting
services, taxation advice, insolvency services etc.
The market is a very competitive one and there are constant pressures to reduce audit costs.
Critics have suggested that firms use audit as a loss leader to sell other services to clients, thereby
undermining their independence – “lowballing”.
Although the audit report is primarily directed at shareholders the power of appointing (and
agreeing terms with) auditors rests in practice with the directors - increasingly the audit
committee dominated by non-executive directors
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AUDITOR INDEPENDENCE
If shareholders do not believe that an auditor is independent they will have little confidence in the
auditors’ opinion.
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A distinction can be made between:
a) Independence in mind defined as “the state of mind which has regard to all considerations
relevant to the task in hand, but no others” (European Commission, 2002).
b) Independence in appearance defined as “the avoidance of facts and circumstances which are so
significant that a reasonable and informed third party would question the Statutory Auditor’s
ability to act objectively” (European Commission, 2002).
The requirement for an auditor to be independent encompasses both. Covered by detailed ethical
guidance issued by accountancy bodies.
The following might be considered to endanger independence:
1. Financial involvement with the affairs of a client
e.g. loans or owning shares.
2. Appointments in companies
e.g. the auditor is / was a member of the board or officer of the company.
3. Provision of non audit services to audit clients
If the audit firm provides non-audit services, care should be taken to taken to ensure that
management decisions remain with management.
Subject to considerable debate. Disclosure of fees from non audit services considered sufficient.
4. Personnel and family relationships
e.g. The wife of the auditor is CEO of the company.
5. Fee dependency
Where fees from a client represent a large proportion of total fees for a particular practice or
office, it could result in economic dependence.
Normally fee income from a single client should not exceed 15% of a practice’s gross fees.
6.Contingency fees
e.g. Audit fee contingent upon an unqualified audit report being delivered.
7. Goods and services
e.g Undue hospitality received from clients.
8. Long association of senior personnel with audit clients
The use of the same senior personnel on an audit engagement over a prolonged period of time
may impair independence.
9. Role of former audit partners.
If they take up a senior position in an audit client, this may undermine independence.
10. Actual or threatened litigation
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Would represent a break down in the necessary relationship of trust between auditor and client.
Directors may become unwilling to disclose information.
11. Auditor appointed and fee set by the board of directors.
Yet supposed to report to the shareholders.
Audit committee dominated by independent non-executive supposed to be responsible for
managing the relationship under the combined code.
If auditors believe their independence is being undermined, they should withdraw from an
engagement.
AUDIT EXPECTATIONS GAP
Widespread misconceptions of the nature of the auditors’ role
What an audit is not for:
-Guarantee of perfection
Total accuracy is impractical if not impossible, & ultimately a matter of judgement.
-Checking every document
Too expensive
-Finding fraud
Directors have prime responsibility to prevent fraud by development of appropriate systems.
Auditors will report on the operation of such systems.
-Predicting future stability - the company will not fail
Not a level of assurance achievable in a market economy where risk taking is inherent.
Auditors will assess going concern
-Checking on management efficiency (except when prescribed in some public sector audits).
Private comments auditors may make to management will not be published.
- Auditors’ duties to third parties
Auditors only owe a duty of care which can be relied on by all parties to whom they are required
to report, primarily therefore the shareholders. Other stakeholders should contract separately if
they wish for similar assurance.
The Caparo Case
This case has become very important in clarifying the extent of the duty of care of auditors.
The facts: In 1990, Caparo Industries sued audit firm Touche Ross for negligence in their audit
of Fidelity plc, a company that Caparo had subsequently purchased. Caparo stated that they had
relied upon the audited accounts to value Fidelity plc. It emerged that the asset value of Fidelity
plc was substantially less than the audited accounts had shown. Caparo said had they known the
true position, they would not have bought Fidelity. The judge decided that the auditors did not
have a duty of care to third parties unless they knew that these accounts were going to be relied
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upon for the purposes of making an investment. To the relief of the auditors, Touche Ross, this
was found not to be the case here.
Some people think the audit should cover all of the above, resulting in an audit expectations gap.
SAS 100 says that an unqualified audit report provides “reasonable assurance from an
independent source that they (financial statements) present a true and fair view”.
NATURE OF AN AUDIT
At all stages it is vital that the audit work undertaken and evidence obtained to support the final
opinion is carefully documented so that it can be used, if required, as evidence in a court case.
Internal controls:
If the client has installed a comprehensive system of internal controls, the auditor may be able to
reduce the amount of detailed testing that they have to undertake. Concerned that the accounting
system will have sufficient controls to ensure that the information from which the financial
statements are derived will be sufficiently accurate. No control can be relied upon by the auditor
if there is no evidence of its operation (e.g. a signature). They would need to test that it is
operating satisfactorily. These audit tests are known as ‘compliance tests’.
Verifying the accounts:
‘Substantive tests’ are undertaken with a view to substantiating the figures in the books of
account, and eventually, in the final accounts themselves.
Test levels will be dependent upon the results of previous stages (i.e. strong controls allow
restricted substantive tests, while ineffective controls require higher levels of substantive tests).
For balance sheet items the aim is to ensure:
-existence;
-ownership;
-values;
-completeness;
-disclosure appropriate.
Examples of sources of evidence:
-Physical examination & count,
- Examination of property title deeds, vehicle registration docs etc;
- Confirmation (External sources in writing preferred);
- Examination of original documents (e.g. compare invoice with accounting record)
- Re- computation e.g. of depreciation policy, debtors provision etc;
- Re-tracing book keeping procedures. Care needs to taken especially at year end to ensure that
transactions are posted to the correct period – “cut-off” procedures.
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-Checking of physical to book, as well as book to physical.
-Full information given in notes to the accounts of appropriate accounting policies and disclosure
in accordance with relevant accounting standards.
Analytical review may be performed before substantive testing as soon as the first draft of the
accounts is available. Essentially ratio analysis is to enable changing trends & high risk areas to
be identified. Comparison with previous years & budget. May result in increased substantive
tests in some areas.
Auditors’ Report:
The report to members included in the annual report is the end product of the audit in which the
auditors express their opinion of the accounts.
The normal unqualified audit report follows a standard format in which the auditors state that in
their opinion the "true and fair" requirement is met.
Qualified audit reports will be a last resort after much negotiation. They are likely to state that
qualification is due to either:
a) Limitation of scope (uncertainty), or
b) Disagreement.
If the limitation of scope is considered to be so material and pervasive then the auditor may be
unable to express an opinion on the financial statements (a disclaimer of opinion).
If the disagreement is considered to be so material and pervasive then the auditor may conclude
that a qualification is not adequate to disclose the misleading or incomplete nature of the financial
statements (an adverse opinion).
In certain circumstances, an auditors’ report may be modified by adding an ‘emphasis of matter’
to highlight a matter affecting the financial statements. The addition of such an ‘emphasis of
matter’ paragraph does not affect the auditors’ opinion.
CONCLUSION
A good quality independent audit is a vital component of sound corporate governance and is
necessary to maintain confidence of financial markets. Audit is therefore highly regulated.
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SEMINAR QUESTIONS
1. Is it necessary for the law to require an audit for:
- a listed company;
- for an owner controlled company?
2. Why is it desirable for auditors to be independent from their clients?
3. “I believe that auditors can never be independent, as their audit fee is paid by the firm they are
auditing.”
Discuss this statement.
4. Why are the directors, rather than the auditors, responsible for the detection of fraud? You
should consider the practical rather than the legal aspects of the question.
5. What difference does the existence of internal controls make to the audit approach?
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