audit & assurance 2nd lecture by malik kashif awan
TRANSCRIPT
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Audit & Assurance
AUDIT & ASSURANCEAUDIT & ASSURANCEAUDIT & ASSURANCEAUDIT & ASSURANCEMalik Kashif Awan2011
Lecture notes and conceptual demonstration forUndergraduate / graduate study program inEconomics, Management, Finance andSocial Sciences
This is an extract from the main source A Chronicle on Audit & Assurance written by Malik KashifAwan and published in Florida, USA in 2001 for a preferred study material at graduate level studycourse of Management, Economics, Finance, Commerce, Business Administration and SocialSciences in Pakistan.
For more details visit http://malikashif.pk
MKA-fetheMalik Kashif
AwantheFinancial
Engineers
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Audit & Assurance
Assurance & AuditRelationships
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1LEVLEVLEVLEV
Overview of the conce
Assurance and reports
Concepts in reporting
Materiality
True and fair
Reasonable assurance
udit
LLLLSSSS OF ASSURANOF ASSURANOF ASSURANOF ASSURAN
pt
Levels of assurance
Communication to different stakeholders
& Assurance
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2.1 DDDDegreeegreeegreeegree of assuranceof assuranceof assuranceof assuranceThe degree of assurance given by the impartial professional will depend on the nature of theexercise being carried out.
'Assurance' here means the auditors' satisfaction as to the reliability of the assertion made by one party for use by another
party.
Negative assurance is when an auditor gives an assurance that nothing has come to his attention which indicates that the
financial statements have not been prepared according to the framework. In other words, he gives his assurance in the
absence of any evidence to the contrary.
Directors prepare financial statements for the benefit of members. They assert that the financial statements give a true and
fair view. The auditors provide assurance on that assertion. To provide such assurance, the auditors must:
Assess risk
Plan audit procedures
Conduct audit procedures
Assess results
Express an opinion
The degree of satisfaction achieved and, therefore, the level of assurance which may be provided, is determined by the
nature of procedures performed and their results.
An external audit can be distinguished from other engagements in the following ways.
a) External audit engagement:the auditor provides a high, but not absolute, level of assurance that the information
audited is free of material misstatement. This is expressed positively in the audit report as reasonable assurance.
b) Review engagement:the auditor provides a limited level of assurance that the information subject to review is free
of material misstatement. This is expressed in the form of negative assurance.
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c) Agreed-upon procedures:the auditor simply provides a report of the factual findings of the engagement agreed by
the auditor, entity and any appropriate third parties, so no assurance is expressed. Users of the report must instead
judge for themselves the auditor's procedures and findings and draw their own conclusions.
d) Compilation engagement:the practitioner is engaged to use his accounting expertise (as opposed to auditingexpertise) to collect, classify and summarise financial information. No assurance is expressed.
2.1.1 Differences between reasonable assurance engagementsand limited assurance engagements
Type of engagement Evidence-gathering
procedures
The assurance report
Reasonable assurance
engagement
eg statutory audit
Sufficient appropriate
evidence is obtained as part of
a systematic engagement
process that includes:
Obtaining an understanding
of the engagement
circumstances
Assessing risks
Responding to assessed risks
Performing further
procedures using a
combination of inspection,
observation, confirmation,
re-calculation, re-
performance, analytical
procedures and inquiry.
Description of the
engagement circumstances,
and a positive expression of
the conclusion
Limited assurance
engagement
eg review of half-year accounts
Sufficient appropriate
evidence is obtained as part of
a systematic engagement
Description of the
engagement circumstances,
and a negative form of
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process that includes obtaining
an understanding of the
subject matter and other
engagement circumstances,but in which procedures are
deliberately limited relative to
a reasonable assurance
engagement.
The procedures may include
only inquiry and analytical
procedures.
expression of the conclusion
2.1.2 Reporting different levels of assurance
Positive expression 'In our opinion internal control is effective, in all material
respects, based on XYZ criteria.'
Negative expression 'Based on our work described in this report, nothing has
come to our attention that causes us to believe that internal
control is not effective, in all material respects, based onXYZ criteria.'
2.1.3 Different types of assurance that provided
The following table summarises the different types of engagement that can be carried out by
practitioners.
Engagement Type of assurance provided Examples
External audit Reasonable Statutory external audit
Review Negative Review of interim financial
statements
Agreed-upon procedures None Examination of statement of
financial position
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Examination of segmental
sales and profit
Compilation None Preparation of financial
statements Preparation of tax returns
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2.2 Accountability,Accountability,Accountability,Accountability,Stewardship and AgencyStewardship and AgencyStewardship and AgencyStewardship and Agency
2.2.1 Agency theory
The role of external audit is often explained in relation to the economic model of agency theory.
2.2.2 An agency relationship
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2.2.3 The agency relationship in audit
In the case of a company, the board of directors acts as the agents of the body of shareholders,
the principals. The directors are accountable for their stewardship of the company.
The shareholders have limited access to information about the operations of the company.
They may lack trust in the directors and may believe that the information in the financial
statements is biased.
The external auditor, therefore, performs a statutory audit to address a simple agency conflict
between shareholders and directors.
In addition, the auditor can be seen as an agent of the shareholders. Under law, they report to
and are appointed by the shareholders.
This raises more concerns with regard to trust and confidence. One key factor here is the
importance that shareholders place on the auditors' independence from the directors.
Auditors have an important incentive to maintain independence and protect their reputation in
order to keep and win more audit work. The profession also imposes guidance in relation to
independence.
The key reason for having an audit or review can be seen by working through the following case
study.
Case StudyVera decides to set up a business selling flowers. She gets up early in the morning, visits the
market, and then sets up a stall by the side of the road. For the first year, all goes well. She sells
all the flowers she is able to buy and she derives some income from the business.
However, Vera feels that she could sell more flowers if she was able to transport more to the
place where she sells them, and she also knows that there are several other roads nearby where
she could sell flowers, if she could be in two places at once. She could achieve these two things by
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buying a van and by employing other people to sell flowers in other locations.
Vera needs more money to achieve this expansion of her business. She decides to ask her rich
friend Peter to invest in the business.
Peter can see the potential of Vera's business and wants to invest, but he doesn't want to be
involved in the management of the business. He also does not want to have ultimate liability for
the debts of the business if it fails. He therefore suggests that they set up a limited company. He
will own the majority of the shares and be entitled to dividends. Vera will be managing director
and be paid a salary for her work.
At the end of the first year of trading as a limited company, Peter receives a copy of the financial
statements. Profits are lower than expected, so his dividend will not be a large as he had hoped.
He knows that Vera is paid a salary so does not care as much as him that profits are low.
Peter is concerned by the level of profits and feels that he wants further assurance on the
accounts. He doesn't know whether they give a true reflection on the last year's trading,
particularly as the profits do not seem as high as those Vera had predicted when he agreed to
invest.
The solution is that the assurance Peter is seeking can be given by an independent audit or
review of the financial statements. An auditor can provide the two things that Peter requires:
A knowledgeable review of the company's business and of the accounts
An impartial view, since Vera's view might be biased
Other people will also view the company's accounts with interest, for example:
Creditors of the company Taxation authorities
The various parties interested in the accounts of a company are sometimes referred to as
stakeholders.
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Although they will each judge the accounts by different criteria, they will all gain assurance from
learning that the accounts they are reading have been subject to an independent report.
The example above is a simple one. In practice companies may have thousands of shareholders
and may not know the management personally. It is therefore important that directors are
accountable to shareholders. Directors act as stewards of the shareholders' investments. They are
agents of the shareholders.
Accountabilityis the quality or state of being accountable, that is, being required or expected to
justify actions and decisions. It suggests an obligation or willingness to accept responsibility for
one's actions.
Stewardship refers to the duties and obligations of a person who manages another person's
property.
Agentsare people employed or used to provide a particular service. In the case of a company, the
people being used to provide the service of managing the business also have the second role of
being people in their own right trying to maximise their personal wealth.
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You may ask, 'what are the directors accountable for?' It is important to understand the answer
to this question. The directors are accountable for the shareholders' investment. The
shareholders have bought shares in that company (they have invested). They expect a return
from their investment. As the directorsmanage the company, they are in a position to affect thatreturn.
The exact nature of the return expected by the shareholder will depend on the type of company
he or she has chosen to invest in: that is part of his or her investment risk analysis. Certain issues
are true of any such investment, however. For example, if the directors mismanagethe company,
and it goes bankrupt, it will neither provide a source of future dividends, nor will it create capital
growth in the investment indeed, the opposite is true and the original investment may even be
lost.
Accountabilitytherefore covers a range of issues:
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2.3 Stages of an ExternalStages of an ExternalStages of an ExternalStages of an ExternalAuditAuditAuditAudit
The following diagram illustrates the main steps in the conduct of an external audit. The
following chapters expand each of these steps.
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Key Terms
An external auditis a type of assurance engagementthat is carried out by an auditor to
give an independent opinion on a set of financial statements.
An audit provides assuranceto the shareholders and other stakeholders of a company on
the financial statements because it is independent and impartial.
Assurance services include a range of assignments, from external audits to review
engagements.
Internal auditors are employed as part of an organisations system of controls. Their
responsibilities are determined by management and may be wide-ranging.
The auditors' report on company financial statements is expressed in terms of truthand
fairness. This is generally taken to mean that financial statements:
Are factual
Are free from bias
Reflect the commercial substance of the business's transactions
External audits give reasonable assurance that the financial statements are free from
material misstatement.
The degree of assurancegiven by the impartial professional will depend on the nature of
the exercise being carried out.
The purpose of external audit is to promote confidence and trust in financial
information.
Audit can be explained in relation to agency theory.
Audit is only one type of assurance engagement.
The objective of any audit or assurance engagement is to produce an opinionin the form
of a report.
Reasonable assuranceis usually reported in terms of positive expression.
Limited assuranceis usually reported in terms of negative expression.