Auditing

Assurance and Risk

W. Robert Knechel, Steven Salterio

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781315531717
• Edition: 4
• Topic: Commerce
• Subtopic: Audit

Focusing on auditing as a judgment process, this unique textbook helps readers strike the balance between understanding auditing theory and how an audit plays out in reality.

The only textbook to provide complete coverage of both the International Auditing and Assurance Standards Board and the Public Company Accounting Oversight Board, Auditing reflects the contemporary evolution of the audit process. New additions to the book include expert updates on key topics, such as the audit of accounting estimates, group audit, and the Integrated Audit.

Supplemented by extra on-line resources, students using this established text will be well-equipped to be effective auditors and to understand the role of auditing in the business world.

CHAPTER 1
Assurance and Auditing

Outline

• Introduction

• Information, Business, and Global Capital Markets

• The Role of Auditing in an International Economic System

• The Demand for Assurance: Integrity, Trust, and Risk

○ Incentives

○ Ethical Principles

○ The Role of Corporate Governance

○ The Role of the External Auditor

• Differentiating Assurance, Attestation, Auditing, and Accounting

○ The Nature of Assurance and Attestation Engagements

• The Auditing Profession and Regulation

○ Entering the Profession: Education, Training, and Certification

○ Organizational Forms of Public Accounting Firms

○ Regulating the Auditing Profession

• Knowledge and Skills Needed by Auditors in the Twenty-First Century

• The Plan of this Book

• Summary and Conclusion

• Bibliography of Relevant Literature

Learning Goals for this Chapter

1. Introduce the role of audit and assurance in the global economy.
2. Examine critically the background forces that affect the twenty-first century audit.
3. Introduce the role of the professional accountant.
4. Introduce the public accounting firm and its role in the global economy.
5. To describe the plan of this book and how it maps to the audit of financial statements.

Introduction

To live is to make decisions. Informed decisions should be based on information that is objective, relevant, reliable, and understandable. But how does an individual making a decision know that he or she has reliable information? In a nutshell, this question captures the nature of the problem that justifies the study of auditing and assurance. In today’s global business environment in which all sorts of data is transmitted on a real-time basis, decision makers worry that the information they have available will not be objective, relevant, reliable, or understandable. Indeed, information can be incorrect because someone makes an accidental mistake, or it can be intentionally manipulated for someone’s benefit. We have seen in the accounting crisis at the turn of the century and continuing into the fiscal crisis that has plagued the world since 2007–08, individuals and organizations who rely on information that is misleading, incomplete, or confusing may make decisions that lead to unexpected and/or unacceptable outcomes. These outcomes can range from bankruptcy at the individual or firm level to a freeze of the global economy with a lack of trust in counterparties to a transaction.

While being relatively blasé about everyday routine decisions, people and organizations rarely accept information at face value when a critical decision depends on it. People and organizations are especially wary when the information comes from a source that may have questionable motivations (e.g., a salesperson). Buyers read consumer reports before making a major purchase, shoppers compare prices on-line, employers obtain multiple references about a job candidate, and candidates for a corporate acquisition are subjected to extensive due diligence. Regardless of the decision being made, people and organizations need useful information about their options. Ideally, they would like assurance that they will make their decision based on information that is, in fact, objective, relevant, reliable, and understandable. However, in many areas of economic life, alternative sources of information are either not available, or not available at a reasonable cost, to an individual or organization making a decision. Hence, the need for assurance arises endogenously, that is, from within the economy itself. In order to ensure that information is supplied so as to enable markets to work effectively and efficiently, some information is required from firms by law and regulation. Assurance on that information is required whenever the information provider might bias the information for their own advantage. Accounting information is the main focus of this text, but there are many other examples of the need for assurance over information, some of which we will also explore.

Information, Business, and Global Capital Markets

Investors in today’s global marketplace have more choices than ever as to how to invest capital. A multitude of options elevates the importance of high quality information used to make investing decisions. An important source of information to all investors is the periodic—always annually but in some countries also quarterly or semi-annually—financial statements prepared by publicly listed companies. Furthermore, the availability of real-time information about competitive pressures and environmental forces that threaten the value of an investment provides investors with a better understanding of the risks surrounding their investments. Consider a few of the information risks that investors face when making decisions based on financial reports:

• Information may be biased to entice an investor to purchase shares in a company that is intentionally overvalued. Accounting procedures that accelerate revenues and slow down expenses are common “tricks” for pushing earnings to higher levels.
• Information may be irrelevant, emphasizing facts that appear important but are unrelated to the future prospects of the company. The marketing of new stock issues may involve claims about future prospects that are hard to evaluate and tangential to the operations of the organization.
• Information may be inaccurate. There are any number of reasons why information may be incorrect by accident or through intentional manipulation by the management of a company.
• Information may be thought to be “sensitive” so a company may decide to hide it from outsiders, especially if the information will have a negative impact on the company’s market valuation. For example, a company may not want to disclose that much of its profits come from transactions with affiliated companies.
• Information may be complex hence difficult to understand or decipher. Some companies may deliberately report complex transactions, such as mark to market items as derivatives and hedges, or have complex activities such as defined benefit pension accounting that can be presented in ways that confuse investors.

Any of these conditions may lead to poor decisions if the investor is unaware of the low quality of the information being used. The role of the auditor is to reduce these risks for people who use the information. It is sometimes claimed that sophisticated individuals or organizations like investment analysts do not need such information as they do enough work on their own to ensure that their recommendations are well based. The crises of the last two decades should disabuse all but the most fervent believer in the abilities of analysts to correct for these potential biases. Indeed, the fiscal crisis has shown that even regulators, who have the power to carry out their own investigations, can be misled by self-serving information provided by firms and individuals.

Virtually any information provided by one party to another can be subject to an “audit” if the recipient of the information is concerned about its objectivity, relevance, or reliability. In this book, we focus on situations where an independent third party evaluates financial statements to ensure that they are prepared in accordance with established criteria such as Generally Accepted Accounting Principles (GAAP). So why is an audit of financial statements important to the stakeholders of an organization? At least four general reasons explain the natural demand for auditing:

1. Managers of an enterprise may get sloppy or behave in inappropriate ways if they are not subject to independent scrutiny. An audit helps keep management honest and motivated since they know that they are being examined and reported on to others.
2. Many stakeholders (employees, casual investors, politicians, and so forth) might not have sufficient expertise to evaluate the quality of financial statements. An audit provides this assurance in an efficient and effective manner.
3. Reliable financial reports, in general, reduce an organization’s cost of capital. Since potential investors and their intermediaries use audited information to help make their investment decisions, reducing the risk of unreliable information reduces the risk of surprises and improves investment decisions.
4. Investors and creditors want “insurance” against significant errors or fraud associated with financial statements. Auditors provide a reasonable level of assurance that information received by capital providers is reliable, while maintaining that they do not guarantee that the financial statements are accurate. However, on rare occasions when fraud is uncovered, investors and creditors typically take legal actions against auditors because they believe that the presence of an audit constitutes a virtual guarantee about the quality of information in much the same way that an insurance policy would operate. The insurance versus assurance debate is played out in courtrooms around the world but it is a most pressing issue for companies that can be sued in the US legal system where there is a much greater reliance on the courts to determine the “line in the sand” between assurance and insurance.

The combination of the risks of unreliable information and the benefits of an audit create a natural demand for auditing and related services that arises as a result of economic forces, human nature, and the need to make informed decisions. In other words, the demand for auditing has its roots in the capitalist market system, and some level of auditing would exist even if there were no legal requirements for firms to have an audit. In this book, we specifically examine the audits of financial statements and the role of auditors in maintaining fair and active capital markets as well as providing assurance over the financial statements of important non-public entities such as private companies and not-for-profit entities.

The Role of Auditing in an International Economic System

The demand for auditing is not a new development dependent on modern economic conditions. In ancient times, some auditors worked for the government and sometimes doubled as tax collectors. The auditing profession as we know it today dates from the 1800s and developed as a result of the economic and political forces of the time. Britain was a major economic power as a result of its industrial prowess, far-flung colonial empire, and strong navy. Consequently, the economic base of the country’s wealth was scattered all over the world. At the same time, wealth was typically controlled by individuals, families, or family-run banks, who hired local caretakers to run the day-to-day operations of their widespread interests. A major concern of these wealthy and powerful individuals was that their distant assets were properly maintained and utilized by local caretakers. The early emphasis of auditing was on asset stewardship, meaning verification of the existence and proper handling of assets. As a result, auditing professionals tended to follow the assets, often to some ports-of-call that, at the time, were considered very exotic (like Cleveland, Ohio, in the US).

In that same period of time, these wealthy individuals, families, and banks, as well as other nascent entrepreneurs, wanted the protection of limited liability so they could raise capital for such useful enterprises as railways and canals. Limited liability meant that the total loss to an investor would be the amount they invested in the company and they could not have their personal assets seized if the company’s debts exceeded its ability to pay. However, prior history with the corporate form of organization had caused British lawmakers to ban the incorporated company in the 1720s (e.g., “Google” the story behind the South Seas Bubble) with some notable exceptions (e.g., the British East India Company). In the 1830s and 1840s as the exceptions became more and more numerous a new social compact was formed. The British government allowed the formation of limited liability companies on a routine basis subject to the requirement that they file audited financial statements even if the company was not open to public investment. Thus was born what became known as the statutory audit of financial statements, one that is required in order to obtain the right to have limited liability attached to the investment in the stock of a company.

Hence, both economic and political considerations laid the foundation for auditing in the Anglo-Saxon world. During the short period of global dominance of those countries from the 1850s to 1950s auditing spread to most of the rest of the developed world and increasingly in the developing and underdeveloped economies.

This early model of auditing started to change, especially in the US, in the early years of the 1990s. The breakup of the large investment trusts like Standard Oil in the US led to the need for any large corporation to have sources of equity beyond what the small number of wealthy individuals and US banks could provide. Hence, an increasing number of companies issued common shares to the general public leading to a new class of investors in the middle class being formed in what previously had been a mostly wealthy oriented activity. Due to this expanded shareholding, the role of both accounting and auditing began to change because outside investors were more concerned with future profitability than stewardship of specific assets. Hence, new approaches to accrual accounting were developed, along with refocusing auditing on the results of accrual accounting (in other words, the income or earnings rather than the assets on the balance sheet). Profitability became the basis for assessing and predicting share values, and measuring and verif...