Introduction to Auditing Notes

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.

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:

  1. Competence
  2. Independence and
  3. Integrity

These qualities are explained here below.

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.

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.

A person of high integrity is a person who is honest, discrete and tactful.

Advantages and Disadvantages of Auditing

Advantages of an Audit

  1. Provides assurance and credibility to the accounts for the benefit of potential investors.
  2. Used for detection of errors and frauds which could lead to the failure of an organization.
  3. Audited accounts are used by the organization to raise finance from both public and other sources as they boost an organization’s credit rating.
  4. 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.
  5. It is used by partnerships as a basis of sharing profits and therefore minimizing disputes between partners.
  6. They are used by income tax authorities to ascertain the tax liability and avoid any possible dispute between the company and income tax department.
  7. 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.
  8. 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.
  9. 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

  1. It is an expensive operation because audit fees and audit expenses are usually too high for small companies.
  2. If the report arising out of audit is bad, it can lead to the failure of the business (a qualified report).
  3. An audit may not be ideal for small business whose transactions are too few.
  4. 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.
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