Introduction to Auditing Notes
Introduction
Definition
The Definition for Audit and Assurance Standard AAS-1 by the Institute
of Chartered Accountants of India(ICAI) — “Auditing is the independent
examination of financial information of any entity, whether profit
oriented or not, and irrespective of its size or legal form, when suchan
examination is conducted with a view to expressing an opinion thereon.”
The general definition of an audit is an evaluation of a person,
organization system, process, enterprise, project or product. The term most commonly
refers to audits in accounting, but similar concepts also exist in
project management, quality management, and energy conservation.
This topic attempts at explaining the reasons as to why auditing exist
as a specialized discipline. The chapter further explains the need for
the audit. It also explains the objectives of auditing besides
explaining the parties who are interested in financial statements of any
business organisation.
Agency Theory and Auditing
An agency relationship arises whenever one or more individuals called
principals use other people or individual/s called agents to perform
some services on their behalf. The principals delegate decision making
authority to the agents. In case of public limited company, agency
relationship may take two forms:
- Agency Relationship Between Shareholders and The Management
- Between shareholders and Creditors
More often than not conflicts may arise between the principals and
agents. Public companies are owned by shareholders but are managed by
directors who in turn employ the top management to manage the affairs of
the company on their behalf. The shareholders and other stakeholders are
interested in knowing whether their hard earned resources are managed in
more transparent and profitable manner. The management reports the
affairs of the business through financial statements such as:
- Income statement
- Cash flow statement and
- Statement of financial position
The authenticity of these financial statements must ascertained by an
independent and qualified party. This party happens to be the auditor.
Agency Relationship between Shareholders and The Management
The shareholders are the real owners of the company through equity
capital contribution. However, they may not be involved directly in the
day to day running of affairs of the business. The shareholders may not
have the necessary skills and expertise to manage the affairs of the
business. On the hand they are likely not to have the time needed to run
the day to affairs of the business. As a result, they appoint other
parties to manage the affairs of the company or business on their
behalf. The shareholders are principals while the management team is the
agents.
Conflict between Shareholders and the Management
There is the assumption that the managers and shareholders left on their
own will each attempt to act in their own self interest. The managers
are likely to pursue goals which do not maximize the shareholders
wealth. The goals would only serve the interest of the managers and
therefore conflict the shareholders’ goals. Conflicts of interest may,
for instance arise from the following cases:
- Managers awarding themselves hefty pay hikes
- Managers taking expensive trips and holidays
- Managers arranging mergers and take – over for their benefits
- Managers arrange very attractive retirement for themselves
- Discriminatory employment practices
- Luxurious lifestyles by managers fully paid by the business etc.
Agency Relationship between shareholders and Creditors
The creditors are contributors of debt capital. They are not in any way
involved in the day to day running of the business. After the provision
of debt finance, the shareholders are expected to manage the finances
along with the management on behalf of the creditors. The creditors
therefore constitute the principals while the shareholders are the agents
Conflict between Shareholders and the Creditors
Creditors lend to the firm at a rate which depends on the riskiness of
the firm as perceived by the creditors. The creditors provide the firm
the finances for a specific time period. A lot can happen during that
period. The shareholders through the management may, for instance take
up projects with a higher risk than was anticipated when the finances
were granted. On the other hand, the shareholders may take up projects
that have not agreed upon. Should these project fail the creditors stand
to lose a great deal.
Who are the Users of Financial Statements
Financial statements usually three forms namely: Income statement, Cash
flow statement and Statement of financial position. The financial
statements may be produced quarterly, semi – annually or annually. The
company’s Act recommends that they must be produced annually. There are
quite a number of parties who are interested in the financial
statements. Their interests differ from one
party to another. Specifically the following are some of the users of
financial statements:
- Owners or shareholders both current and potential
- Actual lenders and lenders potential
- Current and potential employees
- Current and potential customers
- Current and potential short and long term suppliers of goods and debt
- The government and its agencies
- Consultants
- Financial analysts
- General public
- Consumer watch groups
- Trade unions etc.
The Purpose of Audit
When the managers report to the owners or shareholders and stakeholders there is the likelihood that
they will try to paint a picture that they delivered as agreed with the
stakeholders or shareholders. The reports are likely to:
- Have misstatements
- Have misleading information
- Contain Errors
- Conceal fraud
- Fail to disclose all relevant information
All these problems and other may be solved by appointing an independent
qualified auditor to go through the reports and financial statements.
Most business have expanded to extent that they very large operating as
multinational. The complex operations of these multi – nationals need to
be summarized by a very qualified person who is conversant with
accounting producers across boundaries. The financial statements are
required to conform to international accounting standards issued by
IASC. It is of paramount importance that the financial statements are
scrutinized and examined to ascertain that they conform to the
requirement of the international accounting standards.
Objectives of Auditing
There are two main objectives of auditing: Primary objective and
Subsidiary objective. The primary objective of any audit is to produce a
report regarding the truth and fairness of the company’s financial
statements so that any users of these statements can belief in them in
totality. The primary goal of the audit is to enable the auditor to just
say “these statements show a true and fair view” or not.
The other objectives referred to as subsidiary include:
- To detect errors and fraud
- To prevent errors and fraud
- To provide spin off effects and services such accounting, taxation
and others
The Auditor and Other Services
The auditor can from time to time provide other services other the
auditing. These services may include:
- Writing up the books of account
- Balancing books of accounting
- Setting up accounting systems
- Computerizing manual accounting systems
- Financial advise
- Mergers and take – over accounting
- Merger and take – over advice
- Liquidation and receivership work and advice
Qualities of an Auditor
There are three qualities necessary for an independent auditor. These are:
- Competence
- Independence and
- Integrity
These qualities are explained here below.
Competence
Any person who intends to practice as an audit must be thoroughly
trained and must prove his/her competence. In Kenya only members of
ICPAK are allowed by law to practice as auditors. Members of foreign
accounting bodies are also allowed to practice as auditors. For one to
practice as auditor, one required to a member of a recognized accounting
body besides being under a registered
accountant for at least two years.
Independence
An independent auditor is who cannot give biased opinion. Total
independence is likely not to be achieved but independence is important.
Independence is the freedom from conditions that threaten the ability of
the audit activity to carry out audit responsibilities in an unbiased
manner. To achieve the degree of independence necessary to effectively
carry out the responsibilities of the audit activity, the chief audit
executive has direct and unrestricted access to senior management and
the board. This can be achieved through a dual-reporting relationship.
Threats to independence must be managed at the individual auditor,
engagement, functional, and organizational levels.
Integrity
A person of high integrity is a person who is honest, discrete and tactful.
Advantages and Disadvantages of Auditing
Advantages of an Audit
- Provides assurance and credibility to the accounts for the benefit
of potential investors. - Used for detection of errors and frauds which could lead to the
failure of an organization. - Audited accounts are used by the organization to raise finance from
both public and other sources as they boost an organization’s credit
rating. - An audit is used to boost the morale of accounting staff who will
keep the accounts to date and act as source of management
information upon which decisions can e made. - It is used by partnerships as a basis of sharing profits and
therefore minimizing disputes between partners. - They are used by income tax authorities to ascertain the tax
liability and avoid any possible dispute between the company and
income tax department. - The audited accounts are used to admit partners in a partnership
business in that these accounts will indicate not only the net
assets but also the capital the new partner has to contribute. - Audited accounts are useful in case of a sale of business, a merger,
an acquisition or takeover of a business as it indicates the fair
value of assets to be acquired. - They are used by insurance companies to settle insurance claims
arising out of losses that may be insured in which case the client
cannot have conflicting situations which the insurers would object.
Disadvantages of an Auditor
- It is an expensive operation because audit fees and audit expenses are usually too high for small companies.
- If the report arising out of audit is bad, it can lead to the
failure of the business (a qualified report). - An audit may not be ideal for small business whose transactions are
too few. - An audit may not in most cases be in the interest of the owners,
especially if they are the managers in which case they may end up
frustrating the entire process.
