Chap 1- What is Auditing and what is Acc

What Is An Audit?
• Auditing is a systematic process of objectively
gathering and evaluating evidence relating to
assertions about economic actions and events in which
the individual or organization making the assertions
has been engaged, to ascertain the degree of
correspondence between those assertions and
established criteria, and communicating the results to
users of the reports in which the assertions are made.
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What Is An Audit?
• The definition of auditing conveys that:
– Auditing proceeds by means of an ordered series of steps (a systematic process)
– Auditing primarily involves gathering and evaluating evidence
– In pursuing this activity, the auditor maintains an objective unbiased attitude of
mind
– The auditor critically examines assertions (statements implied to be true) made
by an individual or organization about economic activities in which they’ve
been engaged
– The auditor assesses how closely these assertions conform to the ‘set of rules’
which govern how the individual or organization is to report to others about the
economic activities and events that have occured. This ‘set of rules’ comprises
the established criteria which enable the auditor to evaluate whether the
assertions fairly represent the underlying events.
– The auditor communicates the results of this evaluation in a written report. The
report is available to all users of the document(s) in which the assertions are
made.
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Figure 1.2
Major Features of an Audit
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Types of Audit
• Audits may be classified in various ways. They may,
for instance, be classified according to:
– The primary objective of the audit, or
– The primary beneficiaries of the audit.
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Primary Objectives of the Audit
• Based on the primary objective, three main categories
of audits may be recognized:
– Financial statement audits,
– Compliance audits,and
– Operational audits.
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Financial Statement Audits
• A financial statement audit is
– an examination of an entity’s financial statements, which have
been prepared by its management/directors for shareholders and
other interested parties outside the entity, and of the evidence
supporting the information contained in those financial
statements
– conducted by a qualified, experienced professional who is
independent of the entity, for the purpose of expressing an
opinion on whether or not the financial statements provide a true
and fair view of the entity’s financial performance and position
and comply with relevant legal and/or other regulatory
requirements
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Figure 1.3
Major Features of a Financial Statement Audit
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Compliance Audits
• The purpose of a compliance audit is to determine
whether an individual or entity (the auditee) has acted
(or is acting) in accordance with procedures or
regulations established by an authority, such as the
entity’s management or a regulatory body.
• Compliance audits are conducted by competent,
experienced professionals (internal or external to the
auditee) who are appointed by, and report to, the
authority which initiated the audit.
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Compliance Audits
• Examples of compliance audits include:
– audits conducted by HM Revenue and Customs which are
designed to ascertain whether individuals or organizations
have complied with tax legislation or legislation governing
duties or taxes levied on imports and exports.
– Audits conducted within companies or other entities to
ascertain whether the entity’s employees are complying
with the system of internal control established by
management
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Operational Audits
• An operational audit:
– Involves a systematic examination and evaluation of an
entity’s operations which is conducted with a view to
improving the efficiency and/or effectiveness of the entity.
– Is usually initiated by the entity’s management or,
sometimes, if there is one, by its audit committee.
– Is conducted by competent, experienced professionals
(internal or external to the organization) who report their
findings to the party which initiated the audit.
– May apply to the organization as a whole or to an identified
segment thereof such as subsidiary, division or department
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Primary Audit Beneficiaries
• Based on the primary audit beneficiaries (that’s those
for whom the audit is conducted), audits may be
classified as:
– External audits, or
– Internal audits
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External Audits
• An external audit is an audit performed for parties external to
the auditee and it is these parties to whom the auditor reports
the audit findings or conclusions.
• Competent, experienced professionals, independent of the
auditee and its personnel, conduct these audits in accordance
with requirements which are defined by, or on behalf of, the
parties for whose benefit the audit is conducted.
• The best-known and most frequently performed external
audits are the statutory audits of the financial statements of
companies and public sector entities.
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Internal Audits
• Internal audits are performed for a party (usually management
or, if it has one, the entity’s audit committee) internal to the
entity.
• Internal audits may be performed by employees of the entity
(internal auditors) or from personnel from an outside source
(such as an accounting firm or, for instance, environmental or
other specialists).
• Internal audits may be wide-ranging or narrowly-focused, and
they may be continuous or one-off in nature. They may, for
example, be as broad as investigating the appropriateness of,
and level of compliance with, the organization’s system of
internal control, or as narrow as examining the entity’s policies
and procedures for ensuring compliance with health and safety
or environmental regulations.
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Common Characteristics of Audits
• Whether audits are financial statements, compliance or
operational audits, and whether they are conducted for
parties external or internal to the entity, they all involve:
– The systematic collection and evaluation of evidence which is
undertaken to ascertain whether assertions by individuals or
organizations fairly represent the underlying facts and comply
with established criteria;
– Communication of the results of the examination, usually in a
written report, to the party by whom, or on whose behalf, the
auditor was appointed to conduct the audit.
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Auditing vs Accounting
• Accounting is primarily a creative process which
involves identifying, collecting, organizing, summarizing
and communicating information about economic events.
• Auditing, on the other hand, is primarily an evaluative
process. It involves gathering and evaluating audit
evidence from which conclusions may be drawn about
the fairness with which the communication resulting
from the accounting process (the financial statements)
reflects the underlying economic events and
communicating those conclusions to the users of the
financial statements
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Why Are External Financial
Statement Audits Needed?
• The need to communicate financial information
• The need to have the communication examined
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The Need to Communicate
Financial Information
• Since the industrial revolution, companies have grown in size and so
their management has passed from shareholder-owners to small
groups of professional managers.
• This growth has been accompanied by the increasing separation of
ownership interests and management functions.
• As a consequence, a need has arisen for company managers to report
to the entity’s owners, and other providers of funds such as banks
and other lenders, on the financial outcomes of their activities.
• Those receiving these reports (external financial statements) need
assurance that they’re reliable. Therefore, they wish to have the
information in the reports audited.
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The Need to Have the
Communication Examined
• Why might the information in the report not be reliable?
• Why is it important to receivers of the reports that the information is
reliable?
• Why do receivers of the reports not audit the information for
themselves?
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The Need to Have the
Communication Examined
• Because of:
– Conflict of interests
– Consequences of errors
– Practicality and remoteness, and
– complexity
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Conflict of Interests
• A company’s directors are legally responsible for preparing its
financial statements.
• Users of the financial statements want the statements to portray the
company’s financial position and performance as accurately as
possible but they perceive it is in the directors’ personal interests to
bias their report so that it reflects favourably on their management
of the company’s financial affairs.
• Thus, there is a potential conflict of interest between the preparers
and users of the financial statements.
• The audit plays a vital role in helping to ensure that directors
provide, and users are confident in receiving, information which
fairly reflects the company’s financial affairs.
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Consequences of Errors
• If users of a company’s financial statements base decisions on
unreliable information, they may suffer serious financial loss as a
result.
• Therefore, before basing decisions on financial statement
information, they wish to be assured that the information is reliable
and ‘safe’ to act upon.
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Practicality and Remoteness
• As a result of practical, legal, physical, and economic factors, which
prevent users of financial statements from personally examining the
information provided by a company’s directors in its financial
statements, an independent party is needed to assess the reliability
of the information on their behalf.
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Complexity
• As companies grow in size, the number of their transactions
increases
• Further, in recent years, economic transactions, the accounting
systems which capture and process them, and the ‘rules’ governing
their measurement and disclosure have become very complex.
• As a result, errors are more likely to occur in financial statements.
Additionally, with the increasing complexity of economic
transactions, accounting systems and financial reporting standards,
users of companies’ financial statements are less able to evaluate the
quality of the information for themselves.
• The financial statements need to be examined by an independent
qualified auditor who has the necessary competence and expertise to
understand the entity’s business, its transactions, its accounting
system and the ‘rules’ which govern external financial reporting.
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Benefits From External Financial
Statement Audits
• Financial statement audits are necessary and provide many
benefits for:
– Financial statement users
– Auditees
– Society as a whole

Financial Statement Users
• The value of an external audit for financial statement users
lies in the credibility it gives to the financial information
provided by the reporting entity. This credibility arises
from three forms of control which an audit can provide:
– Preventive control
– Detective control
– Reporting control
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Auditees
• The auditor is a qualified and experienced professional who comes
to the auditee as an independent objective outsider, divorced from
the day-to-day operations of the entity.
• Thus, the auditor is in an ideal position to observe where
improvements can be made. The auditor is able to advise the auditee
on, for example, strengthening its internal controls, the development
of its accounting and/or other management information systems,
and on tax, investment and financial planning matters.
• In addition, the auditor is able to provide advice on issues such as
how to proceed with a share float, business acquisition or
divestment, or liquidation.
• The provision of these ‘additional services’ by the auditor is very
valuable for the auditee.
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Auditees
• The provision of non-audit services resulted in auditors
compromising their independence; in order to avoid upsetting the
entity’s management, and thus losing lucrative non-audit as well as
audit work, auditors are not sufficiently sceptical or rigorous when
performing their auditing duties.
• As a consequence, laws and regulations have been enacted in many
parts of the world to prohibit or curtail the provision of non-audit
services by auditors to their audit clients. Probably the most far-
reaching and stringent restrictions have been enacted in the U.S. in
the Sarbanes-Oxley Act of 2002.
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Society as a Whole
• The benefits flowing from financial statement audits for
society as a whole fall into two broad groups:
– The smooth functioning of financial markets; and
– Securing the accountability of corporate managements.
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Smooth Functioning of Financial
Markets
• It is evident that continued investment in capital markets is
essential to the well-being of the economy and to the
financial well-being of those who invest directly or
indirectly in those markets.
• However, continued investment rests on investors having
confidence in the financial information on which they base
their investment decisions – and hence in the external
audit function.
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Securing the Accountability of
Corporate Managements
• One of the checks designed to ensure that managements
do not abuse the power bestowed upon them through the
provision of resources is holding them accountable for the
responsible use of the resources entrusted to them.
• This accountability is secured primarily by requiring
company directors:
– To provide publicly available annual reports that report, among
other things, on their use of resources and the outcomes thereof
– To submit the financial statements (and some other information
in their annual reports) to a critical exammination by an
independent expert (that’s, to an audit).
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Failure to Secure the Potential
Benefits of the Audit Function
• In general, audit failures result from two key causes:
– Auditors’ not being sufficiently independent of their audit clients
– Auditors not applying the required level of competence
• Consequently, auditors may not adhere to auditing and/or
ethical standards, employ an appropriate level of
scepticism and/or exercise due professional skill and care
appropriate to the circumstances
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Failure to Secure the Potential
Benefits of the Audit Function
• Whatever the reason for an audit failure, when it occurs,
the auditee, financial statement users and society as a
whole are deprived of the benefits they should have gained
as an outcome of the audit.
• The culpable auditors also suffer:
– A significant number who have performed defective audits have
faced court action and hefty financial penalties.
– Others have had their audit activities curtailed
– In a few exterme cases, the adverse consequences of poor quality
auditing have been so severe that the audit firm concerned has
been unable to survive (Arthur Anderson in 2002).
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Chap 1- What is Auditing and what is Acc

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