Auditing I Week 2

1
Auditing I Week 2

• Auditing concepts, frameworks and processes.
• Auditor independence

2
Auditing a framework of concepts

• Auditing is a very practical subject, yet we
  still need theory to support and justify the
  practice.
• Efforts have been made to develop a conceptual
  framework for accounting but little has been done
  for auditing.
• Main theorists are Mautz Sharaf 1961 and Flint
  1988.
• MS suggested adopting a philosophical approach
  and Flint looked at understanding the social role
  and the context of the audit function.
• The theories identify the way the audit function
  is undertaken and it structure.
• In effect it justifies its existence.

3
Hierarchy of notions underpinning a theory of
auditing
4
Auditing postulates

• A postulate is an assumption deemed to be true
  for the basis for an argument i.e. something that
  is taken for granted.
• Or ..fundamentals principles, assumed to be
  truths..
• Porter Simon Hatherly P 44

5
Mautz and Sharaf (1961)

• Financial statements and financial data are
  verifiable.
• There is no necessary conflict of interest
  between the auditors 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.
• Consistent application of generally accepted
  accounting principles (GAAP) results in a fair
  presentation of 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 independent opinion there on, the
  auditors act exclusively in the capacity of the
  auditor.
• The professional status of the independent
  auditors imposes commensurate professional
  obligations.

6
Flint (1988)

• Accountability relationship
• Subject matter is remote, complex and significant
• Independence, investigatory and reporting
  framework
• Verifiable subject matter
• Standards of accountability can be set, measured
  and compared with know criteria.
• Credibility given to financial and other
  information can be communicated.
• Provides an economic or social benefit.

7
Key Concepts

• Credibility of work performed
• Independence
• Competence
• Ethical conduct and integrity
• Audit process
• Evidence
• Materiality
• Audit risk
• Judgment
• Scepticism

• Communication
• Reporting
• Standard of performance
• Due care
• Quality control

8
Ethical Independence

• At the heart of the audit process is a belief
  about human nature.
• Human beings will speak the truth, unless there
  is sufficient benefits to be gained by being
  dishonest.
• Given this auditors are assumed to have no
  incentive to be dishonest.
• Hence they are presumed to be independent of both
  the organisation being audited and its managers
  and can be employed to report on the truthfulness
  of the managers financial statements.
• ES1 (ICAI) Auditors should conduct the audit of
  the financial statements of an entity with
  integrity, objectivity and independence.

9
Reliance on the independent opinion

• All professions should be independent but
  auditing goes further.
• Independent in fact
• Unbiased attitude of mind
• Independent in appearance
• Avoidance of situations giving the appearance of
  comprising an unbiased attitude
• E.g. having a mutual interest with the client

10
The need for competency

• The need for
• Knowledge
• Skill
• Derived from
• Qualification
• Training
• Practical experience (OJT)
• To be an auditor you need to have the capacity
  for the exercise of judgment (Flint 1988)
• ISA 220 Quality Control for Auditors of
  Historical Financial Information.
• Legal requirement - Registered auditors

11
Ethical conduct

• Auditors must adhere to standards of ethical
  conduct these embody and demonstrate integrity,
  objectivity and
• Concern for the public (rather then self!)
  interest.
• Creation of Trust
• Public Confidence
• Personal qualities
• Relationships with clients and the public

12
Ethical conduct

• IFAC Code of Ethics for Professional Accountants
  (Revised June 2005)
• Part A General application of the code
• Integrity, objectivity, professional competence
  and due care, confidentiality and professional
  behaviour.
• Part B Accountants in practice
• Part C - Accountants in business

13
Ethical conduct

• ICAI Auditing and Ethical Standards for Auditors
  2005
• ES1 - Integrity, objectivity and independence
• ES2 Financial, business, employment and
  personal relationships.
• ES3 Long association with the audit engagement.
• ES4 Fees, remuneration evaluation policies,
  litigation, gifts hospitality.
• ES5 Non audit services provided to audit
  clients.

14
Evidence

• Evidence is critical to the rationality and
  purpose of auditing.
• Without evidence the audit opinion can have
  little if any validity.
• The information auditors obtain in arriving at
  the conclusion on which their report is based.
• ISA 500 Audit Evidence
• The auditor should obtain sufficient appropriate
  audit evidence to be able to draw reasonable
  conclusions on which to base the audit opinion.
• Persuasive rather than conclusive.

15
Materiality

• Fundamental to the whole process of financial
  auditing.
• Task is to decide whether the accounts show a
  true and fair view.
• Not responsible for establishing whether the
  accounts are correct in every detail.
• Materiality is an expression of the relative
  significance of a particular matter in the
  context of financial statements as a whole.
• A matter is material if its omission or
  misstatement would reasonably influence the
  decisions of an addressee of the auditors report.
• Materiality is not capable of general
  mathematical definition as it has both
  qualitative and quantitative aspects.
• ISA 320 Audit Materiality.

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Materiality

• Characteristics of materiality
• Matter of professional judgment
• Any item may be material by virtue of its
  quantity or quality.
• May be affected by legal or regulatory
  requirements
• Needs to be considered at overall level and
  individual account/disclosure level.
• Should be considered at planning and final
  stages.
• Watch cumulative effects of errors.
• Overall materiality referes to the amount of
  error the auditor is prepared to accept while
  still concluding that the financial statements
  are true and fair.

17
Audit Risk

• The risk that the auditor gives an inappropriate
  opinion when the financial statements are
  materially misstated
• It is a function of
• The risk of material misstatement, and
• The risk that the auditor will fail to detect the
  misstatment.
• The auditor should consider materiality and its
  relationship with audit risk when conducting an
  and audit.
• The auditor wants to select audit procedures that
  in combination can be expected to reduce the
  audit risk to an acceptably low level.

18
Audit Risk

• The risk of material misstatement has 2
  components
• Control risk
• Inherent risk
• Management integrity
• Account risk
• Business risk
• Detection risk also has 2 components
• Sampling risk, and
• Quality control risk
• Sufficient appropriate audit evidence is not
  collected and/or not properly evaluated,

19
Audit Risk - example

• Property company buying, selling and managing
  property (ie letting to tenants and collecting
  rents).
• The industry is volatile, dependent on interest
  rates and in the last 40 years there have been
  two major property collapses.
• If the company is highly geared and the market
  collapses it may find itself unable to sell
  properties.

20
Audit Risk - example

• Property company buying, selling and managing
  property (ie letting to tenants and collecting
  rents).
• Manager responsible for vetting potential clients
  is off sick there may be the possibility that
  tenants with a poor credit rating are accepted.

21
Concept of judgement

• Fundamental characteristic of all professions.
• Need to have integrity, competence and an
  unbiased attitude.
• The ability to probe and be neutral in approach.
• Fundamental principle
• Auditors apply professional judgment, taking
  account of materiality in the context of the
  matters on which they are reporting.

22
Concept of scepticism

• Fundamental principle Rigour
• Auditors approach their work with a thoroughness
  and with an attitude of professional scepticism.
• ISA 200 Objective and General Principles
  Governing and Audit of Financial Statements
• An attitude of professional scepticism.critical
  assessment.questioning mind.alert to
  contradiction.questions reliability.
• Kingston Cotton Mill.

23
Communication

• Clear expression of opinion.
• The base for investment decisions.
• Adequate.
• Explicit, precise and comprehensible.
• Watch Association.

24
Due care

• Case law Kingston Cotton Mill case (1896)
• Reasonable skill care and caution
• Depending on the circumstances
• Increased complexity of corporate environment
• Case law Thomas Gerrard Son (1967)
• Standards of reasonable care and skill are more
  exacting today than they were in 1896.
• Case law Pacific Acceptance Corp Ltd. (1970)
• Auditing standards and professional regulations
  provide guidance but it is the courts that decide
  on due care.

25
Quality Control

• ISA 220
• Applicable to the individual audit engagement.
• Engagement partner has overall responsibility
• Compliance with ethical standards
• Independence requirements
• Acceptance and continuance of clients
• Capabilities and competence of audit team
• Timing, direction, supervision and performance.
• In line with professional standards, legal and
  regulatory requirements.
• Appropriate consultation procedures.
• Proper quality control review.

26
Comprising audit independence

• Self interest threat
• Self review threat
• Advocacy threat
• Familiarity threat
• Intimidation threat
• Management threat (ICAI Ethical guidance)

27
Securing the Independence

• Companies Act 1989 s.27
• Companies Act 1985 s.390AB
• Professional rules
• General safeguards
• Specific areas of risk

28
General environmental safeguards

• Educational, training and experience
  requirements.
• CPD
• Corporate governance regulations
• Professional standards
• Professional or regulatory monitoring
• External review
• Ethical code
• Internal procedures

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Specific areas of risk

• Financial involvement
• Personal, family or business relationships
• Favourable treatment
• Litigation or other external pressures
• Undue dependence on fees
• Provision of non-audit services

30
Improving Independence

• Mandatory rotation
• Appointment by state agency
• Peer review
• Shareholder panel
• Audit committees

31
The audit committee role

• For Listed companies
• now a requirement Combined Code
• Filled by NED's
• Duties of Audit Committee
• Role has been extended in US by Sarbanes-Oxley
  Act 2002

32
The idea of a profession

• The dictionary definition of a profession
• is a calling or vocation involving some branch
  of learning
• Clearly, accountancy in the broad sense involves
  a body of knowledge.
• The idea of profession rests on the following
  premises.

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The idea of a profession

• A recognisable discrete body of knowledge
• An educational process
• A system of examinations
• A system of licensing practitioners
• A professional association
• A sense of responsibility to society
• A code of ethics
• A set of technical standards

34
Fundamental principles the auditing profession
must adhere to

• Behave with integrity in all professional,
  business and personal financial relationships.
• Strive for objectivity in all professional and
  business judgements,
• Objectivity is the state of mind which has regard
  to all considerations relevant to the task in
  hand
• It presumes intellectual honesty.

35
Fundamental principles the auditing profession
must adhere to

• Refusal of performance of work in which there is
  not a competency to undertake unless such advice
  and assistance are available to enable this
  competency.
•  Carry out professional work with due skill,
  care, diligence and expedition and with proper
  regard for the technical and professional
  standards expected.

36
Fundamental principles the auditing profession
must adhere to

• Behave with courtesy and consideration towards
  all with whom contact is made during performance
  of the work.