The Demand and Market for an Audit Flashcards
What are the 6 Key Reasons an Audit is needed
Directors’ Motivation – Prevents biased reporting for personal gain (bonuses, share options).
Shareholder Confidence – Ensures financial statements are reliable without shareholders verifying them individually.
Independent Evaluation – Provides objective assessment of financial statements, controls, and processes.
Reporting on Systems – Checks if proper accounting records are maintained and identifies weaknesses.
Safeguards – Protects employees, investors, and the public (e.g., prevents collapses like Carillion).
True and Fair View – Auditors verify if financial statements are accurate (e.g., KPMG’s failure in Carillion).
What does Economics of Audit Refer to?
The underlying reasons why auditing is demanded, including:
Regulatory requirements (e.g., laws mandating audits).
Agency Theory – Resolves conflicts between principals (shareholders) and agents (management).
Information Economics – Audits enhance reliability of financial data for decision-making.
Insurance Hypothesis – Audits act as financial protection (auditors can be sued for failures).
How does Agency Theory explain the Demand for Auditing
Principals (shareholders/lenders) distrust agents (management) due to conflicting interests.
To reduce agency costs (e.g., higher loan interest, lower pay), agents agree to audits.
Audits verify financial info, ensuring accountability.
Historical Support: Audits existed before regulations, proving natural demand.
How does Information Economics relate to Auditing
Financial info is a commodity; its value depends on reliability.
Audits increase trust in financial statements, improving decision-making.
Without audits, info asymmetry could harm investors/lenders.
What is the Insurance Hypothesis in Auditing
Companies treat audit fees as a “premium” for protection.
If financial misstatements occur, auditors (not management) may bear liability due to lawsuits.
Relies on an expectations gap (users overestimating auditors’ responsibilities).
How does Auditing Support Corporate Governance?
Acts as an external check on management/internal controls.
Ensures accountability to shareholders and stakeholders.
Critical for large companies with separated ownership/management.
How did Auditing failures contribute to Carillion’s Collapse
Lack of safeguards: Auditors (KPMG) failed to provide sufficient evidence for a “true and fair view.”
Regulatory fine: KPMG was penalized, highlighting audit’s role in preventing disasters.
Textbook failure: Showed consequences of weak oversight for employees, investors, and taxpayers.
What’s the Nature/ Purpose of an Audit
To enhance confidence for users (e.g., shareholders) in financial statements.
Achieved by the auditor’s opinion on whether statements comply with financial reporting frameworks (e.g., “true and fair view”).
Not primarily about fraud detection (though it may uncover it).
Defined as an independent examination and opinion on financial statements.
How did the term ‘audit’ originate
Derived from Latin audire (“to hear”).
Historically, auditors listened to accounts read aloud to verify them.
By the 19th century, audits were formalized in English company law.
What are the Key Factors that drive the growth in Auditing
Growth of the accounting profession:
Led to “regulatory capture” (profession shaped audit requirements).
Growth of companies:
Separation of shareholders (owners) and managers, creating demand for independent verification (aligned with agency theory).
How is an Audit Defined?
Confidence-enhancing activity for financial statement users.
Auditor’s opinion on whether statements follow applicable frameworks (e.g., “true and fair”).
Independent examination of an enterprise’s financial statements.
What does ‘true’ and ‘fair’ mean in Auditing?
Not “perfectly accurate” but reasonably representative of performance/assets/liabilities.
Must not mislead (e.g., disclose liquidity issues, leasing arrangements).
Includes supplementary notes (accounting policies, loan terms).
Auditors seek sufficient evidence to support this conclusion (e.g., KPMG’s Carillion failure).
What should/ shouldn’t a Financial Staement be
Should:
Be reasonably fair and non-misleading.
Include disclosures (e.g., accounting policies).
Shouldn’t:
Be totally error-free (minor errors allowed).
Hide material info (e.g., unreasonable management judgments).
Lack auditor scrutiny or evidence.
Who can legally conduct a UK Company Audit
Must be independent and a member of a Recognised Supervisory Body (RSB):
ICAEW, ICAS, CAI, ACCA (with practising certificate).
Not Recognised Qualifying Bodies (RQBs), which include RSBs + AIA.
What legal forms do Audit Firms Take
Partnerships, PLCs, LLPs (e.g., Big 4: KPMG, PwC, EY, Deloitte).
Range from global firms to sole practitioners.
Often provide non-audit services (e.g., consulting).
Why are Audit Services Supplied
Demand-driven: Regulations, agency theory, information economics, insurance hypothesis.
Financial incentive: Auditing is “big business” (e.g., Big 4 revenue).
How does Auditing Function in Governance
External check on internal corporate governance (e.g., board controls).
Ensures accountability to shareholders/stakeholders.
Public interest role: Prevents collapses (e.g., Carillion’s impact on employees, taxpayers).
What was the highest audit fee for the FTSE 100 and Total Audit Fee
$115m (HSBC Holdings).
£1.2bn for all FTSE 100 firms, up 75% since 2018.
What were the Key Audit Failures in Carillion’s Collapse
Record £21m fine (reduced from £30m) + £5.3m costs.
Breaches: “Unusually large” violations of standards (2013–2017).
Key issues:
Deficient going concern assessment (2016).
Ignored loss-making operations and unsustainable cash flows.
Accepted management’s unreasonable judgments without scrutiny.
Late/misleading documentation (procedures post-signoff).
Sanctions:
Lead auditor banned for 10 years + £350k fine.
Total KPMG penalties since 2018: £95m+.
What lessons does Carillion offer the audit industry
Professional scepticism: Challenge management, don’t accept claims blindly.
Going concern: Rigorously assess financial distress signals.
Ethics: Uphold objectivity/independence (e.g., no management bias).
Evidence: Gather sufficient, timely support for opinions.
Stakeholder focus: Prioritize public interest over management.
Who was Affected by Carillion’s Collapse
Employees/Pensioners: Job losses, endangered pensions.
Public Services: Disrupted school meals, hospital cleaning.
Taxpayers/Communities: Costly bailouts, stalled infrastructure.
Investors: Financial losses from misleading statements.
Why is Auditing a Public Interest Issue?
Systemic risk: Bank bailouts, economic downturns (e.g., 2008 crisis).
Pension impacts: Share value drops reduce retiree payouts.
Service reliance: Companies like Carillion manage critical infrastructure.
Broader trust: Audits ensure boardroom integrity for societal stability.
How do Auditors Verify Payables Assertions?
Assertion 1: Payables reflect real goods/services.
Step: Match goods received notes to supplier invoices.
Assertion 2: Accurate valuation (FX, calculations).
Step: Recalculate sample invoices.
Assertion 3: Completeness (no omitted liabilities).
Step: Cut-off testing (review post-period-end invoices).
What are the Ethical Failures KPMG committed in Carillion’s Audit
Lack of independence: Over-relied on management’s views.
Integrity breaches: Signed off audits with incomplete evidence.
Misleading records: Backdated/missing documentation.
Consequence: FRC cited “serious” violations of ethical standards.
How did Regulators hold KPMG Accountable?
Fines: £21m + £14.4m (prior misleading inspections).
Bans: Lead auditor barred for 10 years.
Legal: Settled £1.3bn liquidators’ claim for missing “red flags”.
Reforms: KPMG pledged internal improvements post-scandal.
