Audit and Assurance Essentials

For Professional Accountancy Exams

Katharine Bagshaw

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118454169
• Edition: 1
• Topic: Commerce
• Subtopic: Audit

An accessible beginner's guide to the fundamentals of audit and assurance

Audit and assurance is a basic and vital aspect of the financial world and a key element of all professional accountancy programs. Whereas professional training on the topic frequently immerses students in too much detail while glossing the basics, this book begins with the fundamentals and expands to cover the details in a more measured way. With practical examples and end-of-chapter examples, External Audit and Assurance Essentials breaks down a difficult and challenging field of professional accounting.

CHAPTER 1

AUDITORS, AUDITS AND OTHER TYPES OF ASSURANCE AND PASSING THE EXAM FIRST TIME

Covering: The Role of Audit and Other Types of Assurance in the Economy, Accountability, Stewardship and Agency Theory, the Relationship between Auditors, Management and Shareholders, Overview of the Assurance Process from Planning to Reporting, the Style and Content of Auditing and Assurance Exams, Study Technique and Exam Technique.

Why do I need to read this section?

Because:

• questions on the nature and purpose of audit and assurance engagements are set regularly;
• of rising levels of audit exemption, particularly in Europe;
• of the important differences between audits, other forms of assurance, and non-assurance engagements;
• there are many misconceptions about audit and assurance which this short section will help you eliminate at the outset;
• there are many misconceptions about effective study, how examiners set papers and exam technique. This section should help you make the best use of the limited time you have to study for this paper.

With the exception of the material on study, exams and technique, all of the information in this section is covered in more detail in subsequent sections.

What is important in this section?

Understanding:

• that audit is a sub-set of assurance and that all assurance engagements are characterised by an assessment of the risk of material misstatement;
• the limitations of an audit as well as its benefits;
• that compilation and agreed-upon procedures engagements in which practitioners do not obtain any assurance at all are very different to assurance engagements such as audits and reviews.

What sort of questions come up in this area?

Questions regularly set in this area cover:

• the nature, purpose, advantages and disadvantages of an audit;
• the difference between audit and other forms of assurance such as reviews;
• the difference between assurance and non-assurance engagements, and what type of engagement is appropriate in a given set of circumstances.

How do I stand out from the crowd?

• Distinguish clearly between audits, reviews, other types of assurance, and non-assurance engagements.
• Give examples of non-audit assurance to demonstrate your appreciation of its growing importance.
• Use terminology accurately.

1.1 THE NEED FOR AUDIT AND OTHER TYPES OF ASSURANCE

Like it or not, most of us have little choice about letting others manage our assets for us. We hand over our money to companies, banks, pension funds and governments in the hope that they will look after it and use it properly. We need auditors because we want some assurance about this. We want to be confident that the companies we invest in, the banks that look after our cash, the pension funds we hope will provide for our retirement and the governments that spend our taxes, will use the money we give them the way they ought to, the way they say they will. We also want to know that the money we donate for the education of poor people, for example, goes mostly towards school buildings rather than on the salaries of administrators, and we look to auditors for assurance about that, too.

Audit is a type of assurance. All large-scale operations need auditors because their directors need assurance that the assets and resources for which they are responsible are well-managed. Directors cannot always rely on what they are told by the employees who report to them. Employees make mistakes. Even where there are few mistakes, employees naturally seek to present their own performance in a favourable light. An independent view is likely to be more objective, accurate and critical. Many large bodies such as universities, hospitals and health authorities as well as companies, banks, government departments and pension funds, have internal audit functions for these reasons. Many of these entities are also subject to independent regulatory oversight and have external auditors, because the people needing assurance are not just their directors, but the people to whom the directors are directly or indirectly accountable. Companies, including banks, are accountable to their shareholders. Banks are also accountable to their depositors to some extent but the position of depositors is generally akin to that of creditors, rather than shareholders. Pension funds are accountable to the trustees who act on behalf of pensioners and governments are accountable to taxpayers and electorates. We are all at different times in our lives shareholders, depositors, taxpayers and pensioners. This means that the entities that manage our assets are accountable to us. The external auditors we appoint to them, directly or indirectly, report to us on the financial statements that their directors prepare.

Auditors, Management and Shareholders: Fiduciary Duties, Accountability, Stewardship and Agency

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External audits of companies are performed because of the separation of the ownership and management of company assets.

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Companies belong to their shareholders.1 Shareholders pay for their shares in the hope that the company will be well-managed, pay dividends from profits and that the value of their shares will increase. They need some confidence in what the company’s managers, i.e. its directors or those charged with its governance, to whom they have entrusted their money, tell them about the company’s performance and position.

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Company managers are accountable to shareholders for their stewardship of the company’s assets. They have a fiduciary relationship with shareholders which means that they must act in good faith, for the benefit of the company and all of its shareholders, rather than running the company for their own benefit, or for the benefit of just a few shareholders.

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Management accounts to shareholders by preparing financial statements showing the company’s performance, i.e. a profit and loss account, its position, i.e. a balance sheet, and its cash flows.2 If shareholders are dissatisfied with how management has performed, they can sell their shares or, if enough of them are dissatisfied, replace management.

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Companies employ external auditors to report to the shareholders on the financial statements prepared by management.

Auditors report to shareholders on whether the financial statements give a true and fair view of, or present fairly in all material respects, the financial position and performance of the company. The audit report adds credibility to the financial statements.3

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Management, not auditors, are responsible for the preparation of financial statements. If the financial statements do not give a true and fair view or present fairly the financial position and performance of a company (the two phrases are deemed to be equivalent), auditors qualify their audit opinion.

Auditors are the agents4 of the shareholders who appoint them, but shareholders rarely disagree with the recommendation of management who also negotiate the auditors’ terms, conditions and remuneration. The payment of auditors by the people they are reporting on creates a potential conflict of interest. For this reason, professional bodies and independent audit regulators monitor the conduct of audits.

In many jurisdictions, until fairly recently, there were statutory audit requirements5 for all incorporated entities.6 Audit exemption has changed this, particularly in the EU where the vast majority of companies are exempt from audit requirements based on their size.7 However, audits of smaller entities continue for several reasons. In family-owned companies, most of the shareholders may also be directors who are actively involved in the day-to-day running of the business. Owner-managers do not need auditors to report to them on their own performance. Other shareholders, however, who are not involved in the business, may want an audit. Some smaller companies are required to have an audit despite the fact that they fulfil the size criteria for exemption, because of the public interest considerations arising from the fact that they operate in the banking, insurance or other financial services sectors, to which special requirements always apply.

The position described above is the UK position. It is similar to the position elsewhere in Europe because all EU Member States are subject to EU audit legislation.

The position in the USA is somewhat different. In the UK and Europe, company audit requirements are in legislation. There are no statutory audit requirements in the USA. Audits are required by the Securities and Exchange Commission (the SEC), a securities regulator, for entities whose securities are listed on the exchanges it regulates, such as NASDAQ and the New York Stock Exchange (NYSE). Auditors in the USA generally report to directors as well as stockholders and the purpose of assurance is to promote the orderly and efficient running of the capital markets.

Assurance and Risk

Audits of historical financial information benefit existing and potential owners of companies by reducing the risk they take when they invest in companies. Audits also provide assurance to employees, tax authorities, customers and suppliers, lenders, trade unions and governments, all of whom need to know that the company they are dealing with is what it appears to be on paper. For tax authorities, audits reduce the risk of collecting the wrong amount of tax. For employees, audits reduce the risk that they will be employed by an entity that cannot pay them. For customers and suppliers, audits reduce...