2 Objectives and Underlying Theory of Auditing

Question 1

How is auditing viewed as a social concept?

Answer 1

• Auditing is a social science and not a true science
• As it is based on assumptions that we have made
• Therefore, it is subjective without an external reference point
• The observers are the same as those being observed

Question 2

What is a true science?

Answer 2

• This is when there is distance between the subject and the tester
• This is not the case with auditing and our theories about our needs and behaviours are much more subjective

Question 3

What are the benefits of auditing?

Answer 3

• The costs are easy to calculate but the benefits only extend to its practical usefulness
• Since societies around the world all demand it therefore it can be deducted that the practical usefulness is somewhere greater than the costs
  o But this cannot be proved

Question 4

What is the information gap?

Answer 4

• The worse the performance of the company the more incentivised the directors are to lie in the accounts
• If it is going well then they will just tell the truth
• They can do this as they control the information

Question 5

What is the education gap?

Answer 5

• Most people do not understand the limitations of auditing
• It only tests for a true and fair view and is just an opinion and not a guarantee

Question 6

What is the expectation gap?

Answer 6

When societies expectations are not met by auditing and undermines its principles if people believe that it shows sometime that it does not

Question 7

What are Flints seven postulates?

Answer 7

1. The primary condition of an audit is that there is a relationship of accountability or a situation of public accountability.
2. The subject matter of accountability is too remote, too complex, and/or of too great a significance for the discharge of the duty to be demonstrated without an audit.
3. Essential distinguishing characteristics of audit are the independence of its status and its freedom from investigation and reporting constraints.
4. The subject matter of audit, for example conduct, performance or achievement or record of events or state of affairs, or a statement of facts relating to any of these is subject to verification by evidence.
5. Standards of accountability, for example of conduct, performance, achievement and quality of information, can be set for those who are accountable; actual conduct, performance, achievement, quality and so on can be measured and compared with these standards by reference to known criteria; and the process of measurement and comparison requires special skill and exercise judgement.
6. The meaning, significance and intention of financial and other statements and data which are audited are sufficiently clear that the credibility which is given thereto as a result of the audit can be clearly expressed and communicated.
7. An audit provides and economic and social benefit.

Question 8

Flints Postulate 1: Primary condition is accountability

Answer 8

• This is both private and public accountability (for government institutions)
• This agrees with the agent-principle and information gap

Question 9

Flints Postulate 2: Matter of accountability

Answer 9

The matter of accountability is considered too remote, too complex and too great a significance to be conducted without an audit

Question 10

Flints Postulate 3: Independent and freedom of investigation

Answer 10

• If they were not independent then how could an auditor give a fair, unbiased and objective view on the facts
• It would destroy public trust if not, the fundamental condition auditing is based

Question 11

Flints Postulate 4: Based on evidence

Answer 11

An audit not based on evidence is a guess and must be backed up with evidence to be objective (so what was view to people would consider the same)

Question 12

Flints Postulate 5: Accounting standards

Answer 12

• Standards are set to guide the directors about how they should be conducting their activities
• Auditors assess the truth and fairness against the established accounting standards
• These are complex and require the specialist skills of an auditor

Question 13

Flints Postulate 6: Clear communication

Answer 13

• A clear audit opinion is useless if the financial statements are unclear
• Inversely, if the accounts are clear and the auditors opinion is not then it is also useless
  o They should give qualifications for how much they disagree such as £10m overvalued

Question 14

Flints Postulate 7: Economic or social benefit

Answer 14

• Possible to measure the cost
• Impossible to measure the benefits
• Are explicit benefits to investors
• Are implicit control to directors who change behaviour knowing that they will be audited
• Assumed these are greater than the cost as if it carried a negative social value it would not be carried out, people have in the past not audited but seen value of its introduction and continual implementation

Question 15

What would give management a potential of bias?

Answer 15

• There is always a potential of bias with management
• The worse the company’s performance the more incentivized

Question 16

What is information risk?

Answer 16

• The potential economic harm incurred by the users of financial statements as a result of making poor financial decisions based on inaccurate or misleading information
• Audits reduce this risk
• Therefore the have “information economic” value

Question 17

What are the 4 “Information economic theories of auditing?

Answer 17

1. Information theory
2. Insurance theory
3. Legislation demand theory
4. Contracting theory
   These are not mutually exclusive, a combination explains the actions of auditors and the demand for their services

Question 18

What is information theory

Answer 18

• Assumes the demand for auditing exists because of the enhanced information in audited financial statements.
• By decreasing uncertainty they can reduce risk
  o Note it can never be eliminated
• This assumption assumes the markets are not efficient based on the Efficient Market Hypothesis

Question 19

What are the components of the Efficient Market Hypothesis?

Answer 19

If a market is 100% efficient, for all participants in formation is:
1. Immediately available and accessed (people read it)
2. Freely available (not behind pay walls)
3. Understood by all (cannot be rational if not understood)
4. Rationally acted upon

Question 20

What happens in a perfectly efficient market?

Answer 20

• No investor can have any information advantage over anyone else
• There is a level playing field for all
• Stocks will all trade at their fair value
• If everyone has the same information then something cannot be considered undervalued by an individual
• Neither stock analysis or careful timing can provide supernormal returns
  o To get this you would need to invest in more risky assets

Question 21

What are the three forms of EMH?

Answer 21

1. Strong form
2. Semi strong form
3. Weak form
   * They all link to each other you start at strong and water down to get semi and again to get weak (this is how an exam answer should be structured)
   * They all have very different implications on the existence of auditing and accounting

Question 22

What is strong form EMH?

Answer 22

• Assumes market is efficient to all forms of information
• This is both public and private information
  o Including what is in the directors thoughts
  o This obviously is not the case
• No information can provide an advantage as everyone knows it
  This leads to
  1. No one can ever be fooled
  2. No insider information or insider trading
• As the markets know all about the directors there is no need for financial reporting as everyone knows the information and therefore no need for auditing as there is no need for trust
• It would not have an information economic value

Question 23

What is semi strong form EMH

Answer 23

• Assumes efficiency on all publicly disclosed information
• Considered most accurate for current information age
  o Not so much 25 years ago, pre internet
• Most research shows that the markets reach relatively quickly to new information and the price adjusts depending on the nature of the information
• This implies neither technical or fundamental analysis can outperform the market.
• Miss pricing can occur due to private information
  o Acting on it is insider trading and illegal

Question 24

How does the semi strong form EMH allow for insider trading?

Answer 24

• Given directors have an edge in this market as they get the information before it is disclosed to the public
• They might decide to sell before bad news, this would gently push down the share price prior to the news.
• Retrospectively you can see this downwards trend and might be able to use it as a predictor for the information
• Or visa versa

Question 25

How does the semi strong form EMH justify auditing and accounting?

Answer 25

rket only has information that is publicly disclosed
* This information has to be disclosed by someone
o As there is a gap when directors can dress the information as they control its passage from private to public
o There is the need for accountants to prepare this view
* The markets can be fooled by this dressing
o Therefore, audit assurance of the accountants work is needed

Question 26

What is weak form EMH?

Answer 26

• Assumes markets are efficient to all historic price data
• Technical analysis will not outperform the markets
• It does allow miss pricing that can be found through fundamental analysis

Question 27

What is insurance theory?

Answer 27

• Assumes that auditing is like an insurance for financial statements
• All professionals have insurance against their own negligence
  o Clients have a right to quality
• It is not required by law but the professional bodies require it to practice
  o This is Personal Indemnity Insurance (P.I.I)

Question 28

What is personal indemnity insurance (P.I.I)?

Answer 28

• This is only ever third party as only likely to harm client
• You can claim if you can prove that you made a loss as a result of relying on audited financial statements which had been negligently audited

Question 29

Why is it difficult to claim on an auditors personal indemnity insurance?

Answer 29

• It is very hard to prove the link and very few claims are approved
• In the UK it is practically impossible for shareholders to make a claim
• But it is possible for lenders

Question 30

What are the limitations of insurance theory?

Answer 30

• As with any insurance it is not designed to cover all assets insured
• Given the big four audit some of the largest trillion-dollar companies there is no insurance company that could cover the auditor if they collapsed
• Therefore, they have caps to the amount that they can pay out

Question 31

What is the deep pocket theory?

Answer 31

• There is some research that says failing companies use bigger auditors as they have the assets to cover them if they go wrong
• No one knows the cap on auditors insurance

Question 32

Does insurance theory justify auditing?

Answer 32

• It is the weakest link and really only works on paper
• In reality they cannot act as insurance as it is hard to get them to pay out and they have material caps on what they could pay out

Question 33

What is legislative demand theory?

Answer 33

• Companies have audits as the government demands it
• There is a question about what came first. Did people want audits and the government saw this and made it mandatory or did people not want them and had to be enforced?

Question 34

Did auditing exist before legislation demanded it?

Answer 34

• There has been evidence of auditing long before there were regulations enforcing it and suggests that there would be audits today without the legislation
• This means that people were convinced of its economic value before the governments made it compulsory

Question 35

What is contracting theory (agency theory)?

Answer 35

• An agent is defined as someone who is paid by the principle to provide a service on their behalf
• This involves some delegation of authority from the agent to the principle

Question 36

What are the costs and benefits to the parties in agency theory?

Answer 36

• Shareholders expect a return greater than the risk free rate otherwise why would they have exposed themselves to the increased risk
• Agents a rewarded with their fee
  o They do get other intangible benefits like job satisfaction too

Question 37

What is a Rational Action Taker (RAT)

Answer 37

A RAT is someone who looks to maximise their own utility
* Money and income
* Job satisfaction (security, stress, accountability)
* Other quality of life factors (friendship, social life, holidays, family)
In economic theory, everyone is considered to act rationally in their own best interest.
This assumption is not perfect but a good predictor and a RAT is a normal human

Question 38

What are the assumptions in agency theory?

Answer 38

1. All agents are acting on behalf of the principles and are in effect paid by the principles
2. All agents are expected to act in good faith and in the best interests of the principles
   a. For company directors this is required by law
3. All humans behave as RATs

Question 39

What are the limitations to the agency model?

Answer 39

• Agents hold a great deal of information not available to the principles
• Agents have different self interests to the principles and assumption 2 can fail if there is not the accountability

Question 40

How do you align agents?

Answer 40

• It might seem that giving share options to directors based on performance would align their objectives with the principles but often it motivates them to window dress even more
• The worse the performance the more motivations increasing chance of bias
• Therefore a second agent needs to be hired to check if it is a true and fair view of the company being presented to them
• This decreases the risk that principles are exposed to as the agents might not always act in good faith as they are just trying to maximise their own utility

Question 41

What are the costs of agents and who are they carried by?

Answer 41

These are all borne by the principle
* Divergence between the agents decisions and the decisions that would maximise the principles utility
* The fees, rewards, and other incentives paid to the agents
* All accountability and monitoring costs

Question 42

Has agency theory been proven?

Answer 42

• Anile (1982) tried to prove it using game theory and is an accepted proof but as this relies on assumptions it is not attributed to showing the benefits
• These benefits have never been substantiated

Question 43

What is the Morral Hazzard Problem?

Answer 43

• Auditors are just humans who are also agents behaving as RATs
• How do you ensure that they act in the best interest of the principles
  o Auditors are not observed
  o No audit of auditors as that would create an infinite recursion
• Why would they not just collect their fees and do as little work as possible

Question 44

What keeps auditors honest?

Answer 44

1. Auditors reputation
2. Professional societies
3. Audit firms large organisational forms
4. Large scale audit firms

Question 45

How does the auditors reputation keep auditors honest?

Answer 45

• You would not pick a doctor know to harm people
  o Principles would not pick an auditor who puts in little effort
• ENRON is an example of how criminal collusion with their audit firm caused the collapse of the auditor
  o Most of the time it is not this severe and is auditors being misled by directors and therefore negligence not criminal collusion
• In the desire to protect their reputations they are incentivised to expend more resources to make sure they provide a high quality audit

Question 46

How do professional socieities keep auditors honest?

Answer 46

These all have codes of ethics and reviews to check their members

Question 47

How do large scale audit firms keep auditors honest?

Question 48

How do audit firms large organisational form keep auditors honest?

Answer 48

Most auditors have internal checks and training to catch any mistakes or upskill its employees so they can provide a better service