THE GENERAL AUDIT ENVIRONMENT Notes

Internal Controls in a Computerized Information System

COMPUTERIZED INFORMATION SYSTEMS Notes

INTRODUCTION

At the end of every financial year, company’s are expected by statute to have their financial statements reviewed by an independent professional who after going through the accounts, expresses an opinion as to whether the financial statements present a true and fair view of the financial position of the company. This procedure is normally called a year end audit and is conducted by an auditor. This chapter gives an introduction of auditing and its benefits.

by the end of this chapter, you are expected to have a general understanding of the general audit environment by being able to distinguish between auditing and accounting, the objects of an audit, types of audits, stages of an audit and the benefits

KEY TERMS

Define Audit

This is the independent investigation into the quality of published accounting information.

INDUSTRY CONTEXT

Audits are conducted for most businesses especially where there is separation of ownership from management. at the end of an audit the auditor is expected to give a report to provide some form of assurance to the users of financial statements. An audit therefore is necessary in the current world.

industrialization has led to growth of business through pooling together savings of investors. This has lead to a company having a large number of shareholders. limited liability companies were created with the intention of having widespread shareholding.

NEED FOR AUDIT

it is consequently impractical for the shareholder to be involved in everyday running of the company. also the shareholders may lack skills and the time to manage their company. Thus, the shareholders delegate the task of running the company to a small number of qualified directors through agency relationship. The agents who are the directors have a total discretion over strategy, investment and financing decisions, which have enormous implication on the shareholders.

The directors can easily be tempted to satisfy their own welfare at the expense of shareholders welfare by awarding themselves excessive remuneration packages. This situation shareholders find themselves in entrusting their savings with the directors who can easily misuse the savings is called the agency problem.

The shareholders must put in place mechanisms in order to protect themselves from possible excesses of directors. This can be, through:

remunerating the directors (agent) in such a way that their interests coincide with those of the shareholders (principal) e.g. profit based salaries, bonus based performance or share options that give the directors right but not obligation to buy specified number of shares at a specified price.
monitoring the action of the agent and penalize for any exploitation by having major shareholders as their representatives on the board of director the Kenya Companies act has put in place additional measures for monitoring management behavior for the benefit of all shareholders. These are:
1. Section 147 of the Companies act requires the company to keep proper books of accounts and other statutory records. This is to ensure that actions of directors will be properly documented so that the shareholders can inspect the company records at anytime they wish.
1. Section 159 of the Companies act requires the directors to prepare accounts of their financial stewardship and sent them to all the shareholders so that they can ascertain the operation and financial position of their company.
1. The sixth schedule of Company act and other several sections stipulate the minimum information these accounts must state ensuring that the shareholders have the relevant information for decision making and evaluation of directors.
1. Section 159 further requires the directors to call an annual general meeting (aGm) at which the company accounts are laid before the shareholders as a group. This ensures that the shareholders can use their powers to oversee operation of their company e.g. questioning the directors on matters of managing the company.

The major problem is that these company accounts and reports the shareholders use to evaluate the financial stewardship of directors and which can be used to discipline or reward the directors are prepared by the directors themselves. indeed, any performance based bonus is likely to be calculated from figures published in the company accounts.

This can tempt the directors to manipulate figures which are published in the accounts. Thus the company accounts prepared by the directors lack credibility and hence section 159 of the Company act requires that every company must have an auditor regardless of the wish of the directors or shareholders.

The shareholders receive company accounts and other information from the directors therefore need assurance regarding quality of the information. hence an individual shareholder should inspect the company accounts to establish their credibility if he so wishes but due to lack of time and skill, an audit remains the obvious solution to the agency problem facing the shareholders.

Definition of an Audit:

An audit is the independent examination of and expression of an opinion on the financial statements of an economic entity by appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation .

The objective of an audit is to enable the auditor express an opinion whether financial statements show a true and fair view of the company state of affairs in accordance with an identified financial reporting framework.

The purpose of an audit is not to provide additional information but rather it is intended to provide the users of the accounts with assurance that the information provided to then by directors is reliable. However, the users should not assume the auditor’s opinion is one to efficiency with which management has conducted the affairs of the entity.

What is Financial Statement ?

according to the Companies act, the company accounts refers to the balance sheet and the profit and loss account but due to development in business practice and shareholders information needs, these are inadequate as to the information regarding financial position and performance of the company. Since most balance sheets and profit and loss accounts are summarized statements amplified by notes to the statements, the business community and the accountancy profession require that a cash flow statement as well as a statement of changes in equity be prepared. The terms company accounts and financial statements have the same meaning.

Financial Reporting Framework

According to international auditing Standards (iSa 200, the framework of international standards of auditing), financial statements are usually prepared and presented annually and are directed at common informational needs of a wide range of users. Many of the users rely on the financial statements as their major source of additional information to meet their specific information needs. Therefore financial statements need to be prepared in accordance with one or combination of:

international Financial reporting Standards (IFRS)or IASs
national accounting standards
Any other authoritative and comprehensive financial reporting framework designed for use in financial reporting and is identified in the financial statements.

Role of IFRS and IASs in preparation of financial statements

Though not specifically set out in the preface to the statement of IFRS, it is well accepted within the accountancy projection that IFRS do the following:

Though not specifically set out in the preface to the statement of IFRS, it is well accepted within the accountancy projection that IFRS do the following:
They prescribe the approved method of accounting and disclosure.
Where one or more methods of accounting are acceptable, they prescribe one method which is preferred and called the benchmark treatment and the allowed alternative treatment and conditions under which that allowed alternative is applied.
They prohibit, discourage and restrict use of methods which will not lead to a true and fair view of the financial statements.
They increase comparability of financial statements. Application of appropriate IFRS reduces areas of uncertainty and subjectivity in financial statements.

It is extremely unlikely that financial statements would give a true and fair view when appropriate IFRS are departed from. When managers depart from the IFRS in preparing financial statements they must include a note to the financial statements that they have departed from the financial statements and they must justify that departure. auditors can on their part refer to the departure in their audit report and clearly indicate whether or not they concur with the departure.

International standards on auditing (iSas) are issued by international auditing and practices committee (iapC) of the international Federation of accountants (iFaC) based in new York. iFaC is the worldwide organization for the accountancy profession. it is comprised of 155 professional accountancy bodies in 114 countries, representing more than 2.4 million accountants in public practice, education, government service, industry and commerce. iFaC’s mission is to develop and enhance the profession to enable it to provide services of consistently high quality in the public. in addition to developing auditing standards through the iaaSb, iFaC also develops education, ethics, and public sector accounting standards. membership in iFaC automatically confers membership in international accounting Standards board (iaSb). iSas do not override a country’s regulations which may be government statutes or statements issued by regulatory or professional bodies in the country.

iSas are prepared by iaSb which has the responsibility of producing a single internationally acceptable set of high quality accounting standards.

Advantages of Auditing

Dispute resolution. A partnership business with a complex profit sharing agreement may require an independent examination of those accounts to ensure accurate assessment and division of those profits.
Significant changes in ownership and structure can be easily effected if past accounts contain unqualified audit reports. E.g. in mergers.
auditors have access to the corporate strategy of the company thus are able to give advice on gaining competitive advantage and on improvement of business efficiency.
Borrowing of finances from third parties is enhanced with availability of unqualified audit report on the company’s financial statements.
auditing protects the interests of the shareholders who are separated from the management of their savings invested in the company.
Auditing assists in prevention and detection of fraud and error in financial statements although this is not the primary objective of an audit.

Disadvantages of Auditing

audit fees are normally high since auditors are highly qualified professionals hence small firms such as sole proprietorships may not afford their financial statements to be audited.
The audit exercise interrupts the clients operations because client staff have to spend time in availing the required information to the auditors.
Company secrets may leak to competitors since all company information is accessible to the auditors.

Financial Accounting and Auditing

Financial accounting entails provision of information about a business or company in form of financial statements which are then made public. These statements are generally prepared on an annual basis and used by management and other interested parties to make decisions. The information contained in these financial statements must give a true and fair view of the state of affairs in the organization.

auditing is a check carried out by an independent auditor to make sure that what a company is saying about its financial statement is true. Auditing therefore adds credibility to the financial statements by ensuring the availability of accurate and reliable financial information.

Differences between Auditing and Financial Accounting

auditing is an independent examination of company accounts and expression of an opinion whether they contain a true and fair view of company’s state of affairs. Financial accounting is the recording, classifying and summarizing events of an economic entity in order to assist management in decision making.
While auditing is conducted once in a financial period and usually at the end, financial accounting is a continuous process throughout the financial period of a company.
auditing is governed by iSa while Financial accounting is guided by Gaaps.

Similarities between Auditing and Financial Accounting

both auditing and accounting are statutory requirements i.e. that companies must maintain proper books of accounts at that their financial statement must be audited
Objectives & General principles of an Audit

iSa 200 (objectives and General principles Governing an audit of Financial accounting) states that the objective of an audit of financial statement is to enable auditors give an opinion on financial statements taken as a whole thereby provide reasonable assurance that the statements give a true and fair view and have been prepared in accordance with relevant acco unting and other requirements.

The auditor’s opinion is not a guarantee that the financial statements actually show true and a fair view but that in his or her opinion, they show a true and fair view as to the state of affairs of the company. (See True & Fair below)

Users of Audited Financial Statements

present and potential investors. These risk capital providers and their advisors are concerned with the risk that is inherent in their investment. They need information to help them determine whether they should buy more shares, hold on to the shares they have or sell the shares they have.
Employees. These and their representative groups such as trade unions are interested in information about the stability and profitability of their employers. They are also interested in information which enable them assess the ability of the company to provide adequate remuneration, retirement benefits and employment opportunities.
lenders. These are interested in information that enables them determine whether their loans and interests arising from the loans will be paid back when due.
Suppliers and other trade creditors. These users are interested in information that enables them determine whether the amounts owing to them will be paid when due. Their interest in the company is of shorter period than lenders while they are dependent upon the continuation of the company as a major customer.
Customers. These have interest in information about the continuance of the company especially when they have long term involvement and or are dependent as the company.
Government. The main interest of the government is allocation of resources. it also requires information in order to regulate the activities of the enterprise, determine taxation policies and obtain national income statistics.
public. a company affects public in a variety of ways. a company may make substantial contribution to the local economy by employing people and obtaining supplies locally. Financial statements assist the public in information on trends and recent developments of the company in the economy . others:
lawyers
Competitors
Stock brokers
Statisticians
Financial journalists
Trade unions
Credit-rating agencies