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AuditingAlan Millichamp & John Taylor

Introduction to Auditing, The Why of AuditingChapter 1Prepared by; Muhammad Adnan Javed

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Historical backgroundRecords of auditing activity in early Babylonian times (around 3,000 BC). Ancient China, Greece and Rome. The Latin meaning of the word 'auditor' was a 'hearer or listener' because in Rome auditors heard taxpayers. Modern auditing dates to beginning of the modern corporation

Cuniform is the writing style in the picture, the oldest in the world, Cuniform was the writing style in which the first accounting records were written.

The corporate scandals in the USA and Europe in recent years involving misrepresentation, corruption and theft on a huge scale have increased the demand from both investors and regulators for auditors to be more efficient and more demanding of their clients in terms of their visible adherence to ethical principles and practical internal control systems.

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Brief history of auditingThe attitude of profit maximization from end middle ages - merchant houses in Italy.Double-entry bookkeeping was first described in Italy (Pacioli 1494).Industrial Revolution Great-Britain 1780 lead to the emergence of large industrial companies.1853 the Society of Accountants in Edinburgh was founded.

Initially there was a distinct lack of accountability by these companies. The Act of 1844 had required the production of accounts and some attempt at auditing them but these requirements were repealed by the Act of 1855. Arguments advanced at the time against financial disclosure included the following, rather wonderful, propositions: As there is no totally reliable way of accounting for the success or otherwise of a business it is best not to attempt it. The books could easily be manipulated by dishonest directors (although quite why this was an argument against even attempting disclosure is hard to see).Disclosure would prejudice commercial secrecy and operators of companies would not like their operations to be known even by their own shareholders.Too much disclosure would create a false sense of security among investors

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Cont;A key aspect of the Companies Act 1948 was that, for the first time, auditors were required to have a professional qualification and it was that Act which laid the foundations of the modern auditing profession. Various Companies Acts have followed since then. In turn each one made its mark by: tightening the legal restrictions on directors and on the company itself; Setting rules concerning the issues of shares and the payment of dividends; Setting the rules for minimum capital requirements for public companies; and Most pertinently to our purpose, regulating the content of accounts, increasing accounting disclosure, the requirements for accounts preparation and the records to be kept.

Auditing Standards and Regulation are Rapidly Changing

By the audit process, the auditor enhances the usefulness and value of the financial statements, and also increases the credibility of other non-audited information released by management.

The function of auditing is to lend credibility to the financial statements Is the company a going concern?Is it free of fraud?Is it managed properly?Is there integrity in its database?Do directors have proper and adequate information to make decisions?Are there adequate controls?What effect do the company's products and by-products have on the environment?Can an unfortunate mistake bring this company to its knees?

Audit Definition An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between these assertions and established criteria and communicating the results to interested users. American Accounting Association

International Auditing GuidelineAn audit is the independent examination of financial statement or related information of an entity, whether profit oriented or not and irrespective of its size, or legal form when such an examination is conducted with a view to express an opinion.

AUDITING THEORY, POSTULATES AND CONCEPTS

Theory of Rational Expectations In 1926 Professor Theodore Limperg of the University of Amsterdam developed a theory.It is known as the Theory of Inspired Confidence, which, eventually, became known as the Theory of Rational Expectations. The theory holds that the value of the auditors report derives from the expert nature of the auditor as an independent, competent professional. Broadly, this is a dynamic theory which holds that as the business community changes so the expectations it has of the auditors function also changes.

Limperg held that the work carried out by the auditor should be governed by the rational expectations of those who use their reports so auditors should not disappoint those expectations. Further, auditors should not seek to raise those expectations by any more than the work they do justifies.

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Cont;The Philosophy of Auditing [Mautz and Sharaf (1961) ]They held that auditing is based on scientific logic where the auditing process is a rational process of examination, observation and evaluation of evidence. Financial statements and financial data are verifiable. There is no necessary conflict of interest between the auditor and the management of the enterprise under audit. The financial statements and other information submitted for verification are free from collusive and other unusual irregularities. The existence of a satisfactory system of internal control eliminates the probability of irregularities.

Cont;Consistent application of generally accepted principles of accounting result in fair presentation of the financial position and the results of operations. In the absence of clear evidence to the contrary, what has held true in the past for the enterprise under examination will hold true in the future. When examining financial data for the purpose of expressing an opinion thereon, the auditor acts exclusively in the capacity of an auditor. The professional status of the independent auditor imposes commensurate professional obligations

Demerits of theoryThe questions of risk and control which were not considered to be as important in the 1960s as we consider them to be today. Mautz and Sharaf do not pay much attention to the concept of accountability between parties e.g. the accountability of the entity to the public or to investors. The basis of Mautz and Sharafs approach is founded in scientific method which refers to evidence gathering processes, the testing of hypotheses and probability theory. The relationships between auditing concepts in order to develop a general framework of auditing.

3rd point continue: There are problems with this, particularly in the exercise of an auditors judgment in the absence of conclusive evidence, and the fact that scientists are often able to repeat experiments when trying to validate an hypothesis, whereas auditors only get one opportunity to gather the evidence they need.

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Professor David Flint Philosophy and Principles of Auditing In 1988The fundamental condition for the existence of an audit is accountability, either private (e.g. between management and shareholders), or public accountability. The subject matter of accountability is too remote, too complex and/or of too great a significance for the discharge of the duty (to be accountable) to be demonstrated without the process of audit. Essential distinguishing characteristics of audit are the independence of its status and its freedom from investigatory and reporting constraints. All aspects of an audit, its conduct, the work carried out and its conclusions must be capable of being evidenced.

There have to be standards of accountability for those who carry out audits which form the standard by which actual performance can be measured. This means: that there are standards of accountability for conduct, performance, achievement and quality of information, actual conduct, performance, achievement, quality and so on can be measured and compared with these standards by reference to known criteria, and that the process of measurement and comparison requires skill and the exercise of judgment. The meaning, significance and intention of financial and other statements and data which are audited are sufficiently clear that the credibility which is given to it as a result of audit can be clearly expressed and communicated. An audit produces an economic or social benefit. 14

Financial Statements In theory the directors act in a fiduciary capacity towards the shareholders. What that means is that they are in a special position of trust charged with preserving the assets of the business and, hopefully, running it for the benefit of the shareholders so that it increases shareholder value and pays them some dividend. The fiduciary relationship between the parties places the onus firmly on the shareholders to be accountable for their actions and to be transparent in their reporting.The following people or groups of people are likely to want to see and use financial statements. These are often described as stakeholders: Actual or potential:Owners or shareholders; Lenders or debenture holders; Employees;Customers;Suppliers.

People who advise the above e.g. accountants, stockbrokers, credit rating agencies, financial journalists, trade unions and financial analysts. Competitors and people interested in mergers, amalgamations and takeovers. The government, including the tax authorities, and government bodies concerned with consumer protection and the control and regulation of business. The public, including those who are interested in consumer protection, environmental protection, and political and other pressure groups. Regulatory organizations, for example those set up under the Financial Services and Markets Act 2000, principally the Financial Services Authority (FSA).

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WHY IS THERE A NEED FOR AN AUDIT? The report may: contain errorsnot disclose fraudbe inadvertently misleadingbe deliberately misleadingfail to disclose relevant information fail to conform to regulations

Advantages of AuditThe provider of financeProtect creditors Establish the credibilityFairness of StatementPrescribed LawAccounting Policies

Cont;Shareholders InterestReassurance to DirectorsImproves credibility for TaxAccounting Policies Expression of OpinionDetection of ErrorsDetection of FraudPrevention of Error and Fraud

Cont;Special Objectives Management AuditTax AuditSocial AuditCost AuditOperation AuditPurchase Consideration LoanAdmission of PartnerProfitEconomic DevelopmentRole in Foreign InvestmentAttraction to Investor Shareholders SatisfactionStatutory Requirement (Income Tax Ordinance 1984)

Disadvantages There is an argument that an audit is only for compliance and doesnt assist management in running the business it is simply red tape.

The costs of the audit represent a non-productive expense and the money could be better used elsewhere.

Cont;Banks and other lenders, including suppliers, can make their own conditions for lending and dont really need historical audited accounts. For example:Banks will lend on security and personal guarantees;they will monitor performance of the bank accounts; they may require regular monthly management information;Suppliers will deal on a pro-forma basis (i.e. cash before supply) until a depth of trust has been established.

INTERNATIONAL PRESSURES AND GLOBALIZATION Reliable financial reporting promotes confidence and stability in the market.Markets need the confidence and the assurance a strong audit function can bring in order to enable participants in the market, including the entities themselves, investors and potential investors, to make informed decisions. This involves reducing risk to potential investors by providing them with sound information. Corporate failures, particularly those involving fraud by senior management, reduces confidence and creates instability. It also tends to encourage increased regulation which may restrict market operations or encourage further deception.

OBJECTIVES OF AUDITING The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the frame- work.

CompletenessCutoffOwnershipAccuracyValuationClassificationDisclosure23

DIRECTORS RESPONSIBILITIES Remember that it is the directors who are responsible for producing true and fair accounts; the auditors simply express their opinion on them. Remember the principles of Agency Theory outlined earlier the directors are accounting to the share- holders (the owners of the business) for their actions during the financial year. As with many seemingly simple tasks this can be quite complicated, hence the plethora of accounting standards, bulletins and guidelines!

The directors are the individuals who, collectively, have to struggle with presenting an accounting of their dealings with the shareholders assets in as balanced and impartial a way as possible. It is their task to explain themselves in a way that can be understood and that represents what actually happened in the financial period.

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AUDITORS RESPONSIBILITIES The auditors have to decide what they think, based on the evidence they can gather.It is straightforward enough for a company to ensure that all the transactions in the books are properly processed. All the transactions that should be included have been included; and how do they know that all the transactions that are included are bona fide ones and not transactions invented by the directors to make the results look good?

Cont;Primary The primary audit objective is to gather sufficient reliable evidence so as to be able to express an opinion, in the form of a report to the shareholders, of the truth and fairness of a set of financial statements prepared by the directors so that any person reading and using them can have confidence in them.

Cont;Secondary In addition to expressing an opinion on the financial statements the auditors have also to report: that the financial statements are in accordance with the underlying financial records; that they comply with the relevant financial reporting framework;that all information and explanations they require have been made available to them. In addition they may also advise management of any defects or problems with the controls within their accounting systems and suggest ways of improving them.

Types of AuditStatutory audits These are audits carried out because the law requires them. Statutes which require audits to be done include the Companies Act 2006 and the Financial Services and Markets Act 2000. Internal audits Internal audits are conducted by employees of a business or by external auditors acting as subcontractors. They are becoming increasingly important because of the development of Corporate Governance. These differ from statutory audits because the priorities are set by the management who, to some extent, control the work of internal auditors.

Cont;Other assurance assignments These are enquiries into specific aspects of an enterprise management, value for money, environmental matters, etc. In addition, auditors are asked to carry out specific one-off assignments such as: Reporting on a prospectus for a share issue. Carrying out a fraud investigation.Reviewing systems and procedures.

Scope of an AuditThe fundamental objective of an audit of the financial statement is to enable auditor to express an opinion on the financial statement.Determination of Scope;The companies OrdinanceInternational Standards of Auditing Other Rules and RegulationsConstituent Laws and AgreementTerms of Audit Engagement

Meaning of Scope; Scope means the range of actionsScope of an audit refers to procedures which an auditors considers necessary to perform in order to achieve his desired objective.30