TOPIC 2: ROLE AND ORIGINS OF AUDITING

CHAPTER 2

ROLE AND ORIGINS OF AUDIT

Topic list

 

  1. The role of an audit
  2. Historical development

 

Learning outcomes

 

By the end of this chapter students should be able to:

  • Define an audit and list down reasons as to why an audit is important.
  • Describe types of audit.
  • Explain the limitations of audit.
  • State the important historical developments of auditing.

 

Introduction

 

This chapter covers the nature of auditing.  It starts with why auditing is required, the definition of auditing, objectives/purposes, types of audits and historic origins of auditing.

 

  1. The role of an audit

 

1.1          Definition of an audit

 

The Auditing Practices Board (APB) defines an audit as “an exercise whose objective is to enable auditors express an opinion whether the financial statements give a true and fair view of the entity’s affairs for the period then ended and have been properly prepared in accordance with the applicable reporting framework”

 

We have to get to know the important parts of this definition.

 

  • Auditor: An auditor is a professional who, by evaluating a subjective matter like financial statements, expresses an opinion on the subject matter.

 

  • Opinion: This is a conclusion arrived at using a set criteria.

 

  • Financial statements: These comprise annual accounts which show performance and financial position of an entity i.e. the statement of comprehensive income, statement of financial position, statement of changes in equity, statement of cash flows and notes the accounts.

 

  • Truth and fairness                          

 

 

Truth

 

Truth is having facts in accordance with reason or correct principle or received standard like generally accepted accounting principles and the accounting standards.

It also means that the accounts have been correctly extracted from the books and the records. Numerous accounts items can be seen in this light.  For example, freehold land at cost K4m; it is either true or false that:

 

  • Freehold land exists.

 

  • The freehold land is the property of the company which holds good title.

 

  • The freehold land belonging to the company is included in the financial statement.

 

On the other hand, the matter may not be as simple as it seems, for example, good title may be a matter of opinion as well as historical cost may be a matter of opinion.

 

Fairness

 

Fair means that the accounts should reflect the commercial substance of the business entity’s underlying transactions.

The idea of fairness involves a number of thoughts including:

 

  • Expectation: Any user has certain expectations from a set of accounts. He/she presumes that the accounts will conform to generally acceptable accounting principles and accounting standards.

 

  • Relevance: This means that the view given by the accounts will be relevant to the information need of the user.

 

  • Objectivity: This consists of externally verifiable facts.

 

  • Freedom from bias: The producer of accounts should not allow personal preferences to enter into their accounts preparation work.

 

  • Beyond simple conformity: Users of accounts expect accounts to conform to generally acceptable accounting principles and accounting standards.

 

  • Least as good: At one time, the prudence convention was so highly esteemed that shareholders and auditors expectations went no further than making sure that the true position was at least as good as that shown by the balance sheet.

 

  • Accounting principles: The accounting principles and policies used should be in conformity with accounting standards; generally accepted; widely recognized and supported; and appropriate and applicable in the particular circumstances.

 

  • Disclosure: Disclosure at times can serve the users well, as accounting is an aggregating and summarizing process.

 

  • Materiality: An item is material if its disclosure or non-disclosure would make any difference to the view received by the user of the accounts. Fairness is, therefore, a function of materiality.

 

  • Entity: This is a general term representing all types of business enterprises including limited liability companies, charities, local authorities, government agencies etc.

 

  • Reporting framework: This comprises all laws, regulations and guidelines that govern the preparation of financial statements e.g. Companies Act, accounting concepts and accounting standards.

 

1.2 Why an audit is necessary

 

This can be understood from the stewardship accounting concept. Stewardship accounting is the name given to the practice by which productive resources owned by one person or group of persons are managed by another person or group of persons.

 

A classic example of stewardship accounting can be found in the bible in the gospel according to St. Matthew Chapter 25.  In this story told, we learn about a rich man who was embarking on a long journey.  He called his servants and asked them to look after his wealth when he was gone. To each, he gave gold coins to manage according to his abilities. One was given five thousand gold coins; the second was given two thousand gold coins whilst the third one was given one thousand gold coins. On his return, he asked each one of them to account for the gold coins they were entrusted with. The rich man was pleased with the servants he had entrusted with five thousand gold coins and two thousand gold coins because they had doubled their investments. He was not pleased with the servant whom he gave one thousand gold coins, since he had not made any return on the money.

 

Today, the practice by which managers of businesses account or report to the owners of the business is called stewardship accounting. The accounting and reporting is done through financial statements.

 

The question that has always existed when those entrusted with resources of other people report on the performance of the same is; can the owners of the resources believe the report?

 

The report may:

  • contain errors
  • not disclose fraud
  • inadvertently be misleading
  • fail to disclose relevant information
  • fail to conform to regulations

 

The solution to the problem of credibility of the reports and accounts can be solved by appointing an independent person called an auditor to investigate the reports and accounts and report back to those who appointed him on their truth and fairness.

 

1.3        Objective of an audit 

 

The primary objective of an audit is to enable the auditor produce a report of his opinion of the truth and fairness of financial statements so that any person reading and using them can have belief in them.

 

1.4                    Benefits of an Audit

 

An audit has a number of benefits.

 

  • Owners of company are given an independent opinion as to the truth and fairness of the accounts.

 

  • An audit gives more confidence in the financial statements used by third parties like banks.

 

  • The auditors can help the directors improve the business as a by-product of the audit through reporting weaknesses identified in the course of audit.

 

  • Disputes between members of management like in partnership may be more easily settled.

 

  • Major changes in ownership may be facilitated if past accounts contained an unqualified/clean audit report.

 

  • The government relies more on audited accounts to ascertain profit or loss for tax purposes.

 

  • Helps to prevent and detect errors and fraud: An audit has deterrent and moral effect which helps entities to prevent errors and fraud. In addition errors and fraud may be detected in the course of the audit work.

 

1.5           Limitations of an audit

 

  • Auditing is not a purely objective exercise because auditors use judgement in areas like risk assessment, which tests to perform, determination of materiality levels etc.

 

  • In auditing, auditors do not check every item in the accounting records.

 

  • Accounting and internal control systems on which auditors rely have inherent limitations ( refer to inherent limitation of internal controls topic) .

 

  • Audit does not and cannot tell that directors and management are telling the truth and have colluded in fraud.

 

  • An audit only indicates what is probable rather than what is certain.

 

  • Audit reports are issued some months after the financial statements date.

 

  • The audit report format is unlikely to reflect all aspects of the audit.

 

  • The auditor’s opinion is not a guarantee of the future viability of the entity; effectiveness and efficiency of management and that fraud may not have been perpetrated on the company.

 

1.6         Types of audits           

 

Audits can either be statutory or non statutory.

 

  • Statutory audit

 

This is an audit carried out because the law (i.e. Companies act) requires it.

 

  • Non statutory audit

 

A non statutory audit is an audit conducted on affairs of the firm by independent auditors because it is required by the owners.

 

2            Historical development of auditing

 

To facilitate the examination of the historical development of auditing, it is necessary to divide it into the following chronological periods: prior to 1840, 1840s to 1920s, 1920s to 1960s, 1960s to 1990s, 1990s to date.

 

Prior to 1840

 

Auditing in the form of checking activities was found in ancient civilizations of China, Egypt, and Greece, with the Greek (around 350 BC) appearing to be closest to the present day audit. Similar kinds of checking activities were also found in the Exchequer of England during the reign of Henry I (1100-1135), where special audit officers were appointed to make sure that state revenues and expenditure transactions were properly accounted for, focusing on preventing or detecting fraudulent activities. It can also be traced later to the Italian city states of Genoa and Venice where auditors were engaged to help verify the riches brought by captains from the Old World into the European continent. The audits prior to 1840 were restricted to performing detailed verification of every transaction.

 

1840s – 1920s

 

The practice of auditing did not become firmly established until the advent of industrial revolution during the period of 1840s-1920s in the UK. The large scale operations that resulted from the industrial revolution drove the corporate form of enterprise to the forefront. Large factories and machine based production were established, which as a result required large amount of capital to facilitate the large capital expenditure, hence pooling of growing numbers of middle class and small investors capital. In response the Joint Stock Companies Act was passed in UK in 1844.

 

The Act stipulated that directors shall cause the books of the company to be balanced and the balance sheet to be made up. In addition it provided for the appointment of the auditors to check the accounts of the company. However, the annual presentation of the balance sheet to the shareholders and the requirement of a statutory audit were only made compulsory under the Companies Act 1900. Auditors during this period were merely shareholders chosen by their fellow members. In the Kingston Cotton Mill (1896) it was established that an audit objective was to detect fraud and errors. It can be concluded that the role of the auditors during the period of 1840s to 1920s was mainly on fraud detection and the proper portrayal of the company’s solvency in the balance sheet.

 

1920s – 1960s

 

The growth of the US economy in the 1920s to the 1960s had caused a shift of auditing development from the UK to the USA. Investments in business entities grew rapidly, and advancement in the securities markets and credit granting institutions facilitated the growth of capital markets in this period. As companies grew in size the separation of ownership and management function became more evident. Hence, to ensure the continued flow of funds from investors to companies, and the smooth functioning of the financial market, there was need to convince the participants in the market that the companies’ financial statements provide a true and fair portrayal of the relevant companies’ positions and performance. The consensus was generally the primary objective of an audit is adding credibility to the financial statements rather than detection of fraud and errors.

 

With such a shift in emphasis developed the concept of materiality and sampling techniques due to the voluminous transactions involved in the conduct of business by large corporations, where it was no longer practical for auditors to verify all transactions. Corresponding with this, the auditors also increasingly started to rely on internal controls as a source of preliminary assurance. Later the McKesson and Robbins (1938) case resulted in the emphasis of physical observation of assets such as cash and stocks and use of external evidence. In addition, the Royal Mail case highlighted the need for the audit of the profit and loss statement, which was only made mandatory with the enactment of the Securities and Exchange Commission Act (1934) in the USA and the corresponding Companies Act (1948) in the UK. These legislations clearly provided for the following;

 

  • For auditors to be independent of the companies influence.
  • Audit requirement for the profit and loss and the balance sheets.
  • Set up a minimum legal enforceable disclosure requirement framework.
  • Set up a requirement that an auditor should be suitably qualified professional accountant.
  • Set up specific duties, powers and responsibilities of an auditor.
  • Required the auditor to report whether adequate books and records had been kept from. which financial statements were prepared to give a true and fair view, shifting the primary audit objective from fraud detection.

 

1960s – 1990s

 

The world economies continued to grow in the 1960s – 1990s. This period marked an important development in technological advancements and the size and complexity of the companies. In the early 1980s, when reliance on internal controls was found to be an expensive process, auditors began to cut back on them and make greater use of analytical procedures instead, then developing further to risk-based auditing by the mid 1980s, calling for a thorough understanding of the clients by auditors to carry out such an audit.  Since most of the companies in this period had introduced computer systems to process their financial and other data and to perform, monitor and control many other operational and administrative activities, auditors also placed heavy reliance on the advanced computer auditing skills to facilitate their audit procedures.

 

At this time there was also a surge in provision of other advisory services to clients in addition to audit of financial statements, with firms becoming multidisciplinary (ie extending to management consultancy).

 

1990s – present

 

The auditing profession witnessed substantial and rapid change since 1990s as a result of the accelerating growth at the world economies. It can be observed that auditing in the present day has expanded beyond the basic financial statement attest function. According to Porter et al (2005), present-day auditing has developed into new processes that build on a business risk perspective of their clients. The business risk approach rests on the notion that a broad range of the client’s business risks are relevant to the audit. Advocates of the business risk approach opined that many business risks, if not controlled, will eventually affect the financial statement. Furthermore by understanding the full range of risks in businesses, the auditor will be in a better position to identify matters of significance and relevance to the audit profession on a timely basis.

 

Since the early 1990s, the audit profession began to take increased responsibility to detect and report fraud and to assess, and report more explicitly, doubts about an auditee’s ability to continue in conformance with society’s and regulators’ increasing concern about corporate governance matters. Adoption of the business risk approach in turn enhances auditor’s ability to fulfill these responsibilities (Porter, et al., 2005).

Presently, the ultimate objective of auditing is to lend credibility to financial and nonfinancial information provided by management in annual reports; however, audit firms have been largely providing consultancy services to businesses. By 2000, consulting revenues exceeded auditing revenues at all the major audit firms in the USA.

 

Regulators of the auditing profession and the investing public began to doubt whether audit firms could remain independent on audit issues when the firms were so dependent on consulting revenues. The quality of audits is being placed under scrutiny after a series of financial scandals of public companies such as Sunbeam, Waste Management, Xeror, Adelphia, Enron and WorldCom. The collapses of these giant corporations had brought about a crisis of confidence in the work of auditors (Boynton & Johnson, 2006).

 

As a consequence of the high level of litigation and criticism against the auditors, nearly all large accounting firms split their consulting arms into separate companies and made announcements on their more stringent rules and measures to ensure better independence and audit quality. In addition, a spate of radical reforms was undertaken in various countries, by the accounting bodies, governments, stock exchange commissions and academics to strengthen the audit practice (Leung, et al., 2004).

 

In conclusion, an audit as it is known today is mainly that which was adopted by the land mark Acts in the USA and UK just before the mid twentieth century.

 

End of Chapter Questions

 

Question 1

 

An audit, in early part of its development, was an assurance service that involved checking all the records under consideration for accuracy and confirmation that fraud has or has not taken place during the period under consideration.

 

A modern audit has shifted the emphasis from fraud detection to ascertainment whether financial statements show a true and fair view or not. A number of approaches have also emerged with time including: gathering audit evidence on sampling basis, reliance on internal controls, external confirmations and use of Computer Assisted Audit Techniques (CAATs) amongst others.

 

Required:

  1. State the legislation that marked a major shift of an audit into the state as it is known today, and mention the main principles the legislation introduced. 8 Marks
  2. Outline and explain four factors that led to the change of the audit focus from that of fraud detection to ascertainment of the truth and fairness of financial statements and subsequent emergence of different approaches mentioned above. 8 Marks  c)  State, in your opinion, whether fraud is no longer an issue of concern to a company,

and how it is dealt with in the modern audit.  4 Marks

d)   What do you understand by ‘true and fair view’?  2 Marks

Total 22 Marks

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