Lecture 1B - Introduction to Assurance and Financial Statement Audit (2).ppt

© McGraw-Hill Education 2014
Chapter 1: An
Introduction to
Assurance and
Financial
Statement
Auditing
Lesson 1B

Learning Outcomes
At the end of this lesson, students should be able to:
•Explain the purpose, objectives and importance of auditing
•Explain management incentives to misstate financial statements
•Define auditing and assurance
•Distinguish auditing from accounting
•Identify management assertions about the financial statements
•Identify the fundamental concepts in conducting a financial
statement audit
•Describe the audit process
•Describe what an audit report is

Sections
Section Title
1 Why study auditing?
2 The objectives, purpose and importance of audit
3 Management assertions about financial statements: an introduction
4 Defining auditing and assurance
5 Distinction between auditing and accounting
6 Fundamental concepts in conducting a financial statement audit: an introduction
7 The audit process: an introduction
8 The audit report: an introduction
9 Conclusion

Section 1
Why Study Auditing?

Situation 1
• Ahmad has recently retired after working as an
engineer for 30 years. He has saved a sum of money
and plans to invest some of his money in the stock
market. As investment in the stock market carries
significant risks, he is concern that he may lose his
savings.
• He is advised by his friends to read the financials of
companies before making his investments.
Question
How can Ahmad be sure that the financials of
companies are truthful and can be trusted?

Situation 2
• Chong is the owner of a factory that produces
toys. Demand for the company’s toys are
increasing and the factory is operating at near
capacity. Chong plans to expand the capacity of
the factory by buying new technologically
advanced machines and equipment.
• Chong approached a local bank for a loan to
buy the new machines and equipment. He
submitted his company’s accounts to the bank
for its consideration.
Question
• How can the bank manager trust the figures
provided by Chong in the accounts?

Why Study Auditing?
• Auditing and assurance services play an important role in
ensuring the reliability, credibility and relevance of
business information
• Users of financial statements have additional assurance
that the financial statements
financial statements report honestly and
accurately, and the users will be more willing to rely on
these financial statements

Why Study Auditing? (Cont’d)
• Reliable information is important for
managers, investors, creditors,
analysts, employees, regulatory
bodies and others to make informed
decisions
• Auditing helps ensure that
information is understandable,
relevant and reliable
• Auditing is vital to the proper
functioning of the economic system

Section 2
The Objectives, Purpose and Importance
of Audit

The Demand for Auditing and
Assurance
The development of the corporate form
of business and the expanding world
economy over the last 200 years have
given rise to an explosion in the
demand for assurance provided by
auditors.

What is Auditing?
Auditing is the process of reviewing the
financial statements, that is prepared
by the management of the company, to
determine whether the financial statements:
•Comply with the applicable financial
reporting framework (i.e. accounting
standards, MFRS/IFRS);
•Are free of material misstatements; and
•Comply with the requirements of the
Companies Act, 2016 Alternate
definition

Overall Objectives of an
Audit – ISA 200
a) To obtain reasonable assurance about
whether the financial statements as a
whole are free from material
misstatement, whether due to fraud or
error, thereby enabling the auditor to
express an opinion on whether the
financial statements are prepared, in all
material respects, in accordance with an
applicable financial reporting framework;
and
b) To report on the financial statements, and
communicate as required by the ISAs, in
accordance with the auditor’s findings

Purpose of an Audit – ISA200
• Purpose: To enhance the degree of
confidence of intended users in the
financial statements
– An auditor expresses an opinion on
whether the financial statements are
prepared, in all material respects, in
accordance with an applicable financial
reporting framework
– An audit conducted in accordance with
ISAs and relevant ethical requirements
enables the auditor to form that
opinion.
Auditors’ report provides
assurance on whether the
financial statements follow
applicable financial
reporting framework

Objectives and Purpose of an
Audit – Important Phrases
• Reasonable assurance – highest level of
assurance that can be given by an auditor to
the users of financial statements. Auditors
do not provide absolute assurance
• Financial information/statements – income
statements, statement of financial position,
statement of changes in equity, cash flow
statements, notes to the financial
statements
• Misstatement – unintentional errors or
intentional fraud

Objectives and Purpose of an Audit
– Important Phrases (Cont’d)
• Material – concept of materiality
• Applicable financial reporting
framework – IFRS/MFRS; MPERS; or
FRS)
• Auditors’ Opinion –
Unmodified/Clean/Unqualified;
Modified
• Ethical requirements – MIA
professional code of conduct, IESBA
rules

Auditor’s Responsibilities
The auditor has a responsibility to plan and
perform the audit to obtain reasonable
assurance about whether the financial
statements are free of material
misstatement, whether caused by error or
fraud.
Because of the nature of audit evidence and
the characteristics of fraud, the auditor is able
to obtain reasonable, but not absolute,
assurance that material misstatements are
detected.

Auditors’ Personal
Responsibility
• The auditors have a personal responsibility to:
– Have appropriate competence
– Comply with ethical requirements
– Maintain professional skepticism and professional
judgement

Professional Judgement
• Professional judgement – the auditor, within the
the auditor, within the
context provided by auditing and ethical
context provided by auditing and ethical
standards, applies relevant training, knowledge
standards, applies relevant training, knowledge
and experience in
and experience in making informed decisions
making informed decisions
during the audit
during the audit

Professional Skepticism
• ISA 200 para 13 definition: “an attitude that includes a
questioning mind, being alert to conditions which may
indicate possible misstatement due to error or fraud,
and a critical assessment of audit evidence”.
• ISAs explicitly require the auditor to plan and perform
an audit with professional skepticism recognising that
circumstances may exist that cause the financial
statements to be materially misstated (para 15).
Additional Reading:
IAASB, 2012, Staff Questions and Answers: Professional Skepticism in an Audit of
Financial Statements

Professional Skepticism
(Cont’d)
• Professional scepticism requires that, throughout the audit, the
auditors be alert for:
– Audit evidence that contradicts other evidence
– Information that raises a question about the reliability of
documents and responses to inquiries
– Conditions indicating possible fraud
– Circumstances suggesting the need for additional audit
procedures beyond those ordinarily required

Reasonable Assurance
• Auditors’ work in the audit of financial statements
results in the auditors being able to obtain
reasonable, but not absolute, assurance that the
financial statements follow applicable financial
reporting framework
• Reasonable assurance implies that there is a low
level of audit risk (i.e. that the financial statements
are properly stated when they are not)
• The auditors express an opinion on the financial
statements, not statement of fact

Reasonable Assurance
(Cont’d)
• Reasonable assurance is achieved when audit risk is at an
acceptably low level
• Obtaining absolute assurance is not possible because:
1) The nature of financial reporting (e.g. necessary use of
judgement and estimates)
2) The nature of audit procedures (e.g. audit procedures more
often than not do not provide absolutely conclusive evidence;
use of sampling)
3) The need to conduct an audit within a reasonable period of
time at a reasonable cost
4) Incidence of fraud is difficult to detect because it involves
concealment, collusion, manipulation and overriding control
procedures

Independence of Auditors
• It is critical that auditors remain independent when
performing audits of financial statements
• An auditor’s opinion on the financial statements will be
questioned unless the auditor is truly independent
• An auditor who owns shares in a company that they audit,
or if the auditor serves as a director – the auditor is likely
to be biased in the performance of his auditing duties
• The auditor should avoid any relationship with a client
that would cause an outsider who have knowledge of all
the facts to doubt the auditor’s independence

Independence of Auditors
(Cont’d)
• Independence of auditor is a primary ethical requirement
– Independent to report errors and irregularities which
the auditor discovers
– Independence is the most critical area of the auditor’s
credibility
• Two factors are important to independence:
– Independence in fact (state of the mind where the auditors are
expected to dissociate themselves from influences that might
affect their judgments)
– Independence in appearance (public perception of auditors’
independence)

Case involving Auditor’s
Independence

The Role of Auditing
Auditing can be described within several contexts:
1. As a process of review
2. In the framework of the principal-agent
relationship
3. As a major component of the corporate
governance process
4. As a fundamental piece of the capital markets
system

1. Auditing as a Process
Review
• Auditing is the process of reviewing (or examining)
the financial information prepared by the
management of a company (the financial
statements and the footnotes) to determine that it
conforms to a particular standard (i.e. the
applicable financial reporting framework)
Use this as
definition of
an audit
Textbook
definition

Review (Cont’d)
– The person conducting the assessment follows a set of
standards (i.e. generally accepted auditing standards /
International Standard on Auditing)
– The person completing the assessment is not an
employee of the company but works for an accounting
firm that is associated with the company by being hired
to perform an audit (a firm that is independent from
the company)

Review (Cont’d)
• The person doing the assessment is hired to verify the
fairness and correctness truth and fairness of the
decisions recorded by the company so that outsiders have
accurate information to make decisions.
• Without such assessment, outsiders would be forced to
rely solely on the information the company provided.
Would information issued by the company be too
optimistic without any independent checks or review?

2. Auditing in the Framework of the
Principal-Agent Relationship
Managers
Agents Principals
Stockholder
s
A public company is a company that sells its
stocks or bonds to the public, giving the
public a valid interest in the proper use, or
stewardship, over the company’s resources.

Principal-Agent Relationship (Cont’d)

Figure 1-1 Overview of the Principal-Agent Relationship Leading to the
Demand for Auditing

• Principal-agent relationship exists because the
owners of the company (i.e. the principals) are not
involved in the daily management of the company.
• The management (i.e. the agent) is hired by the
owners of the company (i.e. principal) to run the
company for them and to make daily decisions for
the company.

• Owners of the company (i.e. principal) are
removed from the its daily operations and that
management (i.e. agent) has more knowledge
about the daily operations than the owners.
• Owners would like management to report
correctly, so the owners appoint an auditor to
increase the likelihood of correct reporting.

• Knowing that an auditor will assess the financial
information, management is likely to prepare the
information in accordance with the accounting
standards.
• Benefits outsiders too who will be getting the
same financial information as the owners.

3. Auditing as a Major Component of
the Corporate Governance Process
• A Model of Business:
Business organisations exist to create value for their
stakeholders. Due to the way resources are invested and
managed in the modern business world, a system of
corporate governance is necessary, through which
managers are overseen and supervised
Audit
Committee

3. Auditing as a Major Component of the
Corporate Governance Process (Cont’d)
• The term Corporate Governance refers to the rules,
rules,
processes and laws
processes and laws by which businesses are operated,
operated,
regulated and controlled
regulated and controlled.
• Effective corporate governance requires that the interests
of a company’s management, shareholders, creditors, and
other stakeholders be properly balanced
properly balanced
Audit
Committee
Audit committees are charged with areas such as
oversight of financial reporting, regulatory,
compliance, and risk management, including
responsible for the appointment, compensation,
and oversight of the work of the company’s
external auditors

• The Corporate Governance process
protects outsiders from misstated
financial statements.
• Auditor performs an important and
unique role in the CG process, being a
trained professional independent of the
company.
• Being independent, auditors can provide
an opinion on whether the financial
statements presented by management
have been prepared according to an
applicable financial reporting framework.

• Outsiders might reasonably trust an
opinion from an independent professional
than an opinion from a non-independent
person.
• Auditor will present a relatively unbiased
picture of the company’s compliance or
noncompliance with the applicable
financial reporting framework.

4. Auditing as a Fundamental Piece
of the Capital Markets System
• Capital markets require accurate
information.
• Outsiders make decisions about the
companies based on information
disclosed.
• If information is wrong, the decision is
likely to be wrong.
• If auditors fail to do their job, their
failure has serious implications for the
decisions made by outsiders.

4. Auditing as a Fundamental Piece
of the Capital Markets System
• Examples:
– Banks may wrongly lend to
companies that they shouldn’t or
may lend at a lower interest rate
than appropriate had the banks
known the correct information.
– Investors may fail to sell or buy
shares in companies they wouldn’t
if they had information that fairly
presented the company’s financial
position.

Management’s Incentive to Misstate
Financial Statements
• To be a good auditor, it is important to
understand management’s incentive to misstate
financial statements.
– Management of public companies typically
prefer higher net income to lower net income
– Net income can be increased by either
reducing expenses or increasing revenues
– Managers may try to show that revenue has
increased, even if it has not, because
outsiders, particularly stockholders, expect
this level of growth and if companies fail to
meet these targets, the company’s stock price
may drop
– The principal reason to misstate financial
statements is to keep the company’s stock
price from falling

Financial Statements (Cont’d)
• The areas in which management is more likely to misstate
transactions are riskier for the auditor => failure to correct
the misstatement may lead to the issuance of “clean” audit
opinion on financial statements that are materially
misstated.
• Auditor’s should gather sufficient appropriate evidence and
to assess with professional skepticism the decisions that
management made in preparing the financial statements
– Plan the audit to devote an increased amount of time to
transactions that are more likely to be wrong than other
transactions

Financial Statements (Cont’d)
– Identify financial statement accounts with the most
potential for misstatement
– Design audit procedures to determine that the
accounts are fairly presented according to the
applicable financial reporting framework
– Gather evidence to support the assessment that
the financial statements are prepared using
applicable financial reporting framework

Important Read
• Read page 7-9 of Eilifsen (2014 or 2017) “An
Assurance Analogy: The Case of the Building
Surveyor”

Section 3
Management Assertions about Financial
Statements: An Introduction

Management Assertions
• Management of businesses make implicit
implicit
assertions about the financial statements to the
users of these financial statements
• These assertions are implicit for each account in
the financial statements
• Financial statement assertions (or management
assertions about financial statements) are
management’s expressed or implied claims
expressed or implied claims about
information reflected in the financial statements

Management Assertions (Cont’d)
• Financial statement assertions are important to
the auditors:
– The auditors collect sufficient appropriate
sufficient appropriate evidence
that management assertions about the financial
statements are correct
– Understanding management assertions in terms of
classes of transactions
classes of transactions, account balances
account balances, and
presentation and disclosures
presentation and disclosures help the auditors focus on
the different types of audit procedures needed to test
the assertions in the 3 different categories

Table 1-2 Summary of Management Assertions by Category

• Examples:
 Assets – owners of assets have the right to use the assets
in anyway that the owners want – rights management
assertion
 Liabilities – creditors are obligated to pay and to settle
their liabilities – obligations management assertion
 Income statement for the year ended 30 June 2018 –
implies that all transactions relating to income and
expenses for the financial year have been recorded in the
proper accounting period – cut-off management assertion

Section 4
Defining Auditing and Assurance

Auditing and Assurance
Defined
A systematic process of objectively
obtaining and evaluating evidence
regarding assertions about economic
actions and events to ascertain the
degree of correspondence between
those assertions and established
criteria and communicating the results
to interested users.
Auditing Assurance
Alternative
definition

Breaking Down the Audit
Definition
Content within the Definition Explanation
Systematic process Audit is well-planned and thorough
Objectively obtaining and evaluating evidence Auditor must objectively search for and
evaluate the relevance and validity of
evidence
Assertions about economic actions and
events
The auditor compares the evidence gathered
to assertions about economic activity
Degree of correspondence between those
assertions and established criteria
Established criteria include IFRSs and
regulatory requirements
Communicating the results to interested
users
The auditor reports to the intended users of
the financial information

Auditing and Assurance
Defined
Auditing
An engagement in which a practitioner
expresses a conclusion designed to
enhance the degree of confidence of
the intended users other than the
responsible party about the outcome of
the evaluation or measurement of a
subject matter against criteria.
Assurance

Breaking Down the
Assurance Definition
• Assurance engagements include engagements
other than audit
• Assurance engagement may take many forms:
– Financial or non-financial performance
– Performance of systems or processes
• Financial statement audit is a specialised form of
assurance engagement

Focus of our Study
• Financial statement audit
• Also known as External Audit or Statutory Audit

Section 5
Distinction between Auditing and
Accounting

What is Accounting?
• Accounting is the recording, classifying, and summarising of
economic events in a logical manner for the purpose of
providing financial information for decision making.
– To provide relevant information, accountants must have
a thorough understanding of the principles and rules that
provide the basis for preparing the accounting
information.
– Accountants must develop a system to ensure the
company’s economic events are properly recorded on a
timely basis and at a reasonable cost.
Arens, AA et al, 2014, Auditing and Assurance Services in Malaysia: An Integrated Approach, 3rd
Edition, Pearson

Overview of the Financial
Statement Audit Process

Distinction between Auditing
and Accounting
• Auditors focus on determining whether recorded
information properly reflects the economic events
that occurred during the accounting period.
– Auditors must understand those international
accounting standards that provide the criteria for
evaluating whether the accounting information is
properly recorded
– Auditor posses the expertise to accumulate and
interpret audit evidence – the differentiating factor
that distinguishes auditors from accountants.

Distinction between Auditing
and Accounting (Cont’d)
• Auditors focus on determining whether recorded
information properly reflects the economic events
that occurred during the accounting period
(cont’d).
– Determining the proper audit procedures, deciding the
number and items to test, and evaluating the results
are unique to the auditor.
Arens, AA et al, 2014, Auditing and Assurance Services in Malaysia: An Integrated Approach,
3rd
Edition, Pearson

Section 6
Fundamental Concepts in Conducting a
Financial Statement Audit: An
Introduction

Fundamental Concepts in Conducting
a Financial Statement Audit
Materiality
Audit
Risk
Audit
Evidence

Fundamental Concepts in Conducting a
Financial Statement Audit
• Management assertions about the financial
statements are used by the auditors as the
framework to guide the auditors in the collection
of audit evidence
• Management assertions
Management assertions, together with he
auditor’s assessments of materiality
materiality and audit risk
audit risk
influence the nature, timing and extent
nature, timing and extent of the
audit evidence
audit evidence to be gathered

Materiality
Misstatements, including omissions,
are considered to be material
material if
they, individually or in the
aggregate, could reasonably be
expected to influence
influence the economic
decisions of users taken on the
basis of the financial statements.

Audit Risk
Audit risk is the risk that the auditor expresses an
inappropriate audit opinion when the financial
statements are materially misstated.
The auditor’s report with
an unmodified opinion
states that the audit
provides only reasonable
assurance that the
financial statements do
not contain material
misstatements.
Reasonable assurance
implies some risk that a
material misstatement
could be present in the
financial statements and
the auditor will fail to
detect it.

Evidence Regarding
Management Assertions
Relevance – Is the
information related to
the specific assertion
being tested?
Reliability – Can the
information be relied upon
to signal the true state of
the specific assertion being
tested?
Evidence that assists the auditor in evaluating
management’s financial statement assertions
consists of the underlying accounting data and any
additional information available to the auditor,
whether originating from the client or externally.

Sampling: Inferences Based on
Limited Observations
Auditors use a sampling approach to examine a
subset of the transactions based on previous audits,
an understanding of the company’s internal control
system, or knowledge of the company’s industry.
It would be too costly
for the auditor to
examine every
transaction.

Section 7
The Audit Process: An Introduction

The Audit Process
Eilifsen 2017
in red

The Audit Process:
Alternative View

Section 8
The Audit Report: An Introduction

Issue the Audit Report
The auditor’s report is the main product
or output of the audit.
The audit report with an unmodified
(‘clean’) opinion is the most common
type of report issued.
New enhanced audit report effective on 15
December 2016

The title line of the audit report includes the word ‘Independen
t’, and usually, the report is addressed to the stockholders of
the company.
The audit report includes an introductory paragraph, a
management’s responsibility paragraph, an auditor’s
responsibility paragraph, an auditor’s opinion paragraph
and basis of auditor’s opinion .
The audit report is signed and dated.
Adverse
Qualified
Unmodified
Modified
Disclaimer
Unqualified

The auditor may issue a modified opinion.
Suppose an auditee’s financial statements
contain a misstatement that the auditor
considers material and the client refuses to
correct the misstatement. The auditor will
likely qualify the opinion, explaining that the
financial statements are fairly stated except for
the misstatement identified by the auditor.

The auditor may issue an adverse opinion.
Suppose a client’s financial statements contain a
material misstatement and the auditor
considers the significance of the effect on the
financial statements of the material
misstatement pervasive. Given such a
situation, the auditor will issue an adverse
opinion, indicating that the financial
statements are not fairly stated and should not
be relied upon.

Section 9
Conclusion

Who is an Auditor?
Lord Justice Lopes (re. Kingston Cotton Mills
1896)
“An auditor is under duty to see that he has
performed the work he has required to
perform ....... with the skill, care and
caution which a reasonably competent and
careful auditor would do” (i.e. auditor has
a duty to exercise reasonable care and skill)
“An auditor is a watchdog, not a
bloodhound.”

Auditing Demands Logic,
Reasoning and Resourcefulness
An auditor needs to understand more than just the
accounting concepts and techniques.
Auditing is a fundamentally logical process of thinking
and reasoning – so use your common sense and
reasoning skills!
As you learn new auditing concepts, take some time to
understand the underlying logic and how the
concepts interrelate with other concepts.
Being a good auditor sometimes requires imagination
and innovation.

Learning Outcomes
At the end of this lesson, students should be able to:
Explain the purpose, objectives and importance of auditing
Explain management incentives to misstate financial
statements
Define auditing and assurance
Distinguish auditing from accounting
Identify management assertions about the financial statements
Identify the fundamental concepts in conducting a financial
statement audit
Describe the audit process
Describe what an audit report is

Lecture 1B - Introduction to Assurance and Financial Statement Audit (2).ppt

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