ORIGIN OF AUDIT

BY: Swedi Zakaria

AC 732

TOPIC ONE: 

NATURE, PURPOSE AND SCOPE OF AN AUDIT

Origin and Evolution of Audit

The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an auditor used to listen to the accounts read over by an accountant in order to check them. Auditing is as old as accounting. It was in use in all ancient countries such as Mesopotamia, Greece, Egypt, Rome, U.K. and India. The original objective of auditing was to detect and prevent errors and frauds. Auditing evolved and grew rapidly after the industrial revolution in the 18th century. With the growth of the joint stock companies the ownership and management became separate. The shareholders who were the owners needed a report from an independent expert on the accounts of the company managed by the board of directors who were the employees.

The objective of audit shifted and audit was expected to ascertain whether the accounts were true and fair rather than detection of errors and frauds.

Definitions

Auditing is an independent examination of, and expression on, the financial statements of an entity by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory or other provisions including International Standards on Auditing (ISAs).

OR

Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria.

It enables auditors to express opinion whether the financial statements give a true and fair view, and have been prepared in accordance with the applicable reporting framework.

A financial statements audit refers to an independent examination of financial statements by an auditor and an expression of opinion on whether such financial statements present a true and fair view. This means that both the Examination of Financial statements and the expression of opinion on them have to be fulfilled for an audit to be completed.  NB: Auditors do not certify or guarantee the correctness of financial statements; they report whether in their opinion they give true and fair view of the financial position.

ü Stewardship, and Stewardship Accounting

The role of Auditor can be traced back to hundreds of years ago when the stewardship role started to receive more attention. Stewardship is the name given to the practice by which productive resources owned by one person or group are managed by another person or group of persons.

This has occurred throughout the history, e.g. in the middle ages, great landowners would not manage their own land but would appoint persons called stewards to manage the land. Today most business is operated by limited companies which are owned by their shareholders and managed by directors appointed by the shareholders.

Stewardship accounting- Owners who appoint managers to look after the owner’s property will be concerned to know what has happened to their property. 

A famous example of this is in St Mathew’s Gospel (chapter 25), rich man and servants. When a rich man went on journey and delivered his goods to his servants to look after while he was away. On his return he asked each of his servants to account for the goods with which he had been entrusted. He was not pleased with the servant who had not profitably used the goods he had managed in his master’s absence.

Today the process whereby the managers of a business account or report to the owners of the business is called stewardship accounting.

ü Objectives of auditing

 Primary: To produce a report and expression of opinion on whether or not the financial statements being audited give a true and fair view of the state of affairs of the entity at the end of the accounting period and of its profit or loss and the cash flow statements for the period under review. 

International standard on Auditing (ISA 200) states that the objective of an Audit of Financial statement is to enable the Auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance         with    an        identified        financial          reporting framework. The phrases used to express the auditor’s opinion are "give a true and fair view of" or “present fairly, in all material respects” which are equivalent terms.

 Subsidiary: 

→To detect errors and fraud

→To prevent errors and fraud

→To provide spin-off effects. The auditor will be able to assist his clients with accounting, systems, taxation, financial, risk management and other problems.

Why is there a need for an audit?

→Contain errors

→Not disclose fraud

→Be inadvertently misleading

→Be deliberately misleading

→Fail to disclose relevant information

→Fail to conform to regulations.

The solution to this problem of credibility in reports and accounts lies in appointing an independent person called an auditor to investigate the report and report on his findings. ü Reasonable Assurance as opposed to Absolute assurance

Reasonable Assurance: Is a measure of the level of certainty that the auditor has obtained at the completion of the audit. It is presumably less than certainty or absolute assurance. This is a concept relating to accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. The Auditor cannot obtain Absolute assurance because there are inherent limitations in an Audit that affect the auditor’s ability to detect material misstatements. It indicates that an auditor is not an insurer or guarantor of the correctness of the financial statements.

The limitations result from factors such as:

i.                    The use of testing and samples.

ii.                  The inherent limitations of internal control (for example, the possibility of management override or collusion).

iii.                The fact that most audit evidence is persuasive rather than conclusive. Scope of an audit: Refers to the audit procedures deemed necessary in the circumstances to achieve the objective of the audit.

In determining the audit procedures to be performed in conducting an audit in accordance with ISA, the auditor should comply with each of the ISA relevant to the audit.

Professional Skepticism: The auditor should plan and perform an audit with an attitude of professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated.

An attitude of professional skepticism means the auditor makes a critical assessment, with a questioning mind, of the validity of audit evidence obtained and is alert to audit evidence that contradicts or brings into question the reliability of documents and responses to enquiries and other information obtained from management and those charged with governance.

Assurance Engagements

According to the International Framework For Assurance Engagements, an assurance engagement means an engagement in which a practitioner express 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. It is important to distinguish between the levels of assurance given by an audit (which gives a high level of assurance) and that given by other assurance engagements which depending on the nature of the engagement may give a lower level of assurance.

Not all engagements carried out by professional accountants are assurance engagements. For example, giving general tax or accounting advice to a client, or compiling (i.e. drawing up) a set of financial statements from information provided, are not assurance engagements since no conclusion or direct assurance is provided.

In giving positive assurance, an accountant reports that financial statements do give a true and fair view. In giving negative assurance, an accountant reports that nothing has come to his attention to suggest that the financial statements do not give a true and fair view.

Advantages of an Audit

The need for an external audit arises primarily when the ownership and management of an enterprise are separated. There are however, certain inherent advantages in having financial statements audited even where no statutory requirement exists for such an audit. ü Dispute between management may be more easily settled.

ü  Major changes in ownership may be facilitated if past accounts contain an unqualified audit report, for instance, where two sole traders merge their business to form a new partnership.

ü  Applications to third parties for finance may be enhanced by audited accounts. 

ü  The audit is likely to involve an in-depth examination of the business and so may enable the auditor to give constructive advice to management on improving the efficiency of the business. Disadvantage of an Audit

ü  The Audit fee! Clearly the services of an auditor must be paid for. It is this reason that few partnerships and even fewer sole traders are likely to have their accounts audited, unless such an audit is required by the local statute.

ü  The audit involves the client’s staff and management in giving time to providing information to the auditor. A professional auditor should therefore plan his audit carefully to minimize the disruption which his work will cause.

Agency Theory and Auditing

The relationship between the various interested parties in the firm is often described in terms of agency theory. Agency relationships occur when one party, the principal employs another party, the agent to perform a task on their behalf.

For example, Directors can be seen as the agents of shareholders, employees as the agents of directors and auditors as agent of shareholders.

Principals need to recognize that although they are employing the agent, agents will have interests of their own to protect and thus may not carry out fully the requirements of the principal.

The directors have a duty of stewardship of the company’s assets. However they are also interested in their level of remuneration and if this increases, the assets of the company go down.

The auditors report their opinion to the shareholders. However, auditors know the decision to reappoint them is effectively in the hands of the directors. They therefore have a potential conflict of interest in carrying out their function and also remaining on good terms with directors.

Despite that, agency theory predicts that matters can be organized so that, by behaving rationally, the agent will not act against the interest of the principal.

The theory assumes that shareholders will only buy shares if safeguards are in place to protect their interests. The legal requirement for audited accounts is one example of a necessary precondition. In addition management will recognize the desirability of an audit. If shareholders are suspicious of the quality of an audit, they will not be prepared to invest. Management therefore will arrange for a proper audit as it in their self-interest to do so.

The management of large companies will pay high fees for extensive and sophisticated audits as they have the greatest need to convince shareholders of the management’s honesty. In contrast a small company where the management and shareholder are largely the same group will not pay high fees for an audit.

However small companies may necessarily need satisfy other users of the accounting information such as lenders and tax authorities.

The concept of True and fair: 

A true and fair view implies appropriate classification and grouping of items…..and consistent application of GAAP. 

GAAP here means that auditors will often be guided by the requirements of accounting standards.

The auditor should attempt to ensure that the accounts which are the subject of his audit report present clearly and equitably the financial state of affairs of the enterprise. This suggests that in order to achieve the required true and fair view it is necessary not only to present certain information impartially but also that this data is shown in such a way that it is clearly understood by the user.

The following principles should be considered

(i)                 Fundamental accounting assumptions (Going concern, Consistency, Accrual)

(ii)               Accounting policies-specific principles, rules, methods, procedures, conventions and bases adopted by reporting entities to be most appropriate to their circumstances in preparing their F/statements- materiality, prudence, substance over form.

(iii)             Accounting records- Keep proper accounting records.

The concept of true and fair view as stated in the companies act: Every company financial statements must give a true and fair view of the state of affairs and of the profit or loss. That is the auditor must report to the members of the company whether f/statements show a true and fair view.

It means:	(i)	To comply with accounting standards
	(ii)	Reasonable care
	(iii)	In accordance with correct principles
	(iv)	Relevance
	(v)	Objectivity
	(vi)	Freedom from bias

Materiality: A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect a decision of a reasonable user of the statements. The question should be whether the item is material enough to require disclosure, and if so, then should it be presented.

ü Auditing and Accountancy

Auditing involves the examination of the completed books of accounts, and giving an opinion or a report on the F/Statements

Accounting is concerned with the identification, classification, recording, and summarizing financial and related data and transactions.

Or 

Accounting is the recording, classifying, and summarizing 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. In addition, accountants must develop a system to make sure that the entity’s economic events are properly recorded on a timely basis and at a reasonable cost.

When auditing accounting data, auditors focus on determining whether recoded information properly reflects the economic events that occurred during the accounting period. Because GAAP (Generally Accepted Accounting Principles) provide the criteria for evaluating whether the accounting information is properly recorded, auditors must also thoroughly understand GAAP.

In addition to understanding accounting, the auditor must possess expertise in the accumulation and interpretation of audit evidence. It is this expertise that distinguishes auditors from accountants. Determining the proper audit procedures, deciding the number and types of items to test, and evaluating the results are problems unique to the auditor.

Classification of Audits

a)      Auditing According to clientele: Audits classified according to clientele include statutory audits and private audits. Statutory audits are audits taken according to the requirement of the law or existing legislation for example government sector audit and company’s audit. Private sector audits are those carried out at the request of interested parties like sole traders, partnerships and joint ventures. In private audits owners are liberty to specify the extent of the audit to be done.

b)      Audit according to nature of work: Audits that are classified according to nature of audit work refer to the manner of execution. Thus we have complete audit, interim audit, partial audit, vouching audit, continuous audit, final audit, risk based audit, balance sheet audit, management audit, operational audit and systems based audit. These types of audits are governed by the audit objective, timing, size, and nature of the client. In each case however, the auditor will have to draw an action plan that includes initial communications with client and with outgoing auditor (if any), issuing engagement letter, study and evaluation of internal controls, issuing a management letter etc.

c)      Auditing according to responsibility: Audits classified according to responsibility are based on mode of appointment. For example, internal audit and external audit.

Changing Horizon of the Scope of Auditing

It is clear that the role of audit is significantly changing as a response to company and organizational needs, as well as increasing focus on the organizational risk. Whilst the trend is towards greater consultancy and risk based approach, certain organizations are still looking for a more traditional, inspection-based approach. Since the late 1940’s the emphasis in approaching an audit has shifted from the detailed checking of individual items towards an overall review of the systems in operation followed by an examination of the records and the financial statements prepared therefrom. Amongst the reasons for this major shift of emphasis are:-

Ø  The increase in size and complexity of modern businesses

Ø  The development of more accurate and sophisticated computerized systems

Ø  The requirement that the auditor should also report on the income statement, which entails a review of all transactions during the period, not simply of year end balances as before.

However the fact remains that the modern view of the role of audit is based on a risk assessment concept. 

 Besides audit of financial statements, auditors may engage in performing related services: performance audits (Management or operational audits), Accounting, Taxation, Management consultancy, Investigations, Financial consultancy, Liquidation, Receiverships, and Trusts.

 

Review Questions

1.                  What is the objective of an audit

2.                  Does true and fair mean that the auditor is certifying that the financial statements are totally correct? 

3.                  Your younger brother has written to you a letter stating that he is contemplating following your footsteps into accountancy. However, he is finding difficulty in understanding the nature and purposes of an audit and he has asked your assistance.

Write appropriate letter, in language that a layman can understand, describing an audit, with particular emphasis on its nature and purposes.

(Use a fictitious names and address: the answer should be at least one page).

4.                  What is an audit?

5.                  Who are accountable to shareholders for their actions?

6.                  what meanings could be attached to the words ' true and fair'? 

Page