Week 1 Flashcards
nature of an audit.
An auditor sets out to achieve enhanced credibility of information disclosed to increase reliability for the users of the financial statements.
An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. Describe the nature of an audit.
What does an independent auditor do during a financial report audit?
- Written Opinion - presented fairly or not, free from material misstatement and compliance with reporting standards.
- Audit procedures - tests on samples of transactions, evidence to form opinion.
- Internal control system - may rely on IC and reduce amount of detailed testing. No effective IC = aduitor perform extensive tests of transactions/balances.
- Completed = assessed and judgements made to see if report contains material errors. Material error = management requested to make amendments.
Management refuse = auditor modify opinion to highlight errors for the users.
Explain how agency theory results in a demand for auditing.
In an agency relationship, investors (as principals) entrust their resources to managers (as agents). The agent’s self-interest is expected to diverge from the principals’ interest, giving rise to agency costs. A consequence of this agency problem is that investors will ‘price protect’ themselves on the assumption that managers are acting for themselves. It is therefore a rational response that there is a demand for a financial statement audit to verify the assertions made by management.
Assurance
Assurance is a broad term to describe any situation where information is prepared by one party and then attested to its accuracy by another party. Assurance engagements can relate to a broad set of potential engagements that may be financial or non-financial, and the level of assurance provided can vary according to the particular engagement. It is important to understand that in all assurance engagements the practitioner must apply professional judgement and professional scepticism.
Reasonable assurance
Reasonable assurance means a high level of assurance is given, as in the case of a financial statement audit.
Highest level
eg. Financial staement audit.
Limited Assurance
Moderate Assurance - A review that isn’t an audit.
Eg. Review of interim financial reports
A report of findings for the completeness and accuracy of salraies and wages account.
It is impossible for an auditor to provide absolute assurance regarding subject matter on which they express their opinion
- It is impossible for the auditor to provide absolute assurance because there are so many judgements in the audit process.
- The auditor makes a judgement about the risks of material misstatement and then designs procedures accordingly.
- These procedures use sampling which will always provide some sort of error rate. Even if there was no constraint on cost or time the auditor could not provide absolute assurance because he may misinterpret evidence and because there are so many account balances that are the product of significant professional judgement.
The type of assurance an auditor should provide in a financial report audit
The auditor is required to and should provide a high level of assurance in a financial report audit ISA (NZ) 200.
Relevance:
Relevant criteria that meets the objectives of the assurance engagement and that contributes to the decision making by the intended users.
Completeness:
Criteria is complete when information prepared in accordance does not omit relevant factors that would affect the engagement objectivies or conclusions.
Complete criteria include, where relevant, benchmarks for presentation and disclosure.
Complete, neutral and free from error.
Reliability:
Reliable criteria allow reasonably consistent measurement or evaluation of the underlying subject matter including, where relevant, presentation and disclosure, when used in similar circumstances by different assurance practitioners.
Neutrality:
Neutral criteria result in information that is free from bias as appropriate in the engagement circumstances. Objectively.
Understandability:
Understandable criteria result in information that can be understood by the intended users.
Three way relationship
A responsible party (directors)
Intented users (shareholders)
An assurance practitioner (auditor)
Elements of an assurance engagement
- Three way relationship
- Subject matter of an assurance engagement
- Suitable criteria based on: relevance ….
- Evidence gathering
Subject matter of an assurance engagement
Historical financial information, performance related, physical system or processes, behaviour eg. corporate governmence.
Evidence gathering
A conclusion or assurance report
Audit Report
Objectives of financial statement audits
A financial statement audit is carried out by an independent auditor appointed by the entity.
- “The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements.
- This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.
- In the case of most general purpose frameworks, that opinion is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the framework”.
Neo-classical economics theory
Key assumptions:
Users are motivated by the economic benefits of an audit
The existence of supply and demand for audit services – if the audit opinion will benefit e.g., shareholders they will demand an independent audit
The ‘market’ determines the cost of the audit – will pay for a review rather than assurance engagement
As the market is self-regulating and tends towards equilibrium, the theory discourages public intervention and regulation
Agency theory
The separation of ownership and control (management) of the organisation results in the agency problem
“A contract under which one or more persons engage another person to perform some service on their behalf which involves delegating some decision-making authority to the agent”
Jensen & Meckling (1976)
Managers do not have the same interests as owners and may act in their own self-interest at the detriment of shareholders
Agency costs
Agency costs
Monitoring cost* - auditing costs
Bonding cost
Residual loss - loss of profit/equity as a result of agent’s actions
Increase performance
Agency problems
Agency problems
Self-interest
Goal incongruence
Moral hazard
Reduce performance
Social accountability – public interest regulation
Audience: Extends beyond shareholders to include society at large.
Assurance: Society is owed assurance; regulators act to meet public needs.
Access: Ensures users with limited resources can access audited financial statements.
Regulation: Advocates for statutory audits to balance social costs and benefits and prevent exclusivity to the privileged.
Critical theories
Power and Influence: Highlights concerns over powerful groups (e.g., auditing profession) using their status to manipulate systems for their benefit.
**Monopoly: **Auditing profession seen as holding monopoly power over financial statement audits.
Abuse of Privilege: Some members accused of abusing audit privileges, necessitating accountability measures.
Why are external financial statement audits needed?
- To avoid a conflict of interests (as the financial statements are prepared by managers)
- Remoteness of the users of financial statements (the users of financial statements are generally not able to examine for themselves the accounting data of the company in which they are interested)
- The complexity of transactions (as companies have grown, the volume and complexity of transactions has increased and the accounting systems that capture and process them have become more sophisticated and complex)
- Consequence of error (if investors and others make decisions based on unreliable information, they may suffer serious financial loss as a result)
Knowledge gap
The ‘knowledge gap’ is the difference between what the public thinks auditors do and what auditors actually do. This recognises that the public can sometimes misunderstand audit: for example, the extent to which auditors are responsible for preventing company failure or the restrictions on the auditor of an entity from selling non-audit services to that entity.
Performance gap
The ‘performance gap’ focuses on areas where auditors do not do what auditing standards or regulations require. This could be because of insufficient focus on audit quality; the complexity of certain auditing standards; or differences in interpretation of auditing standard or regulatory requirements between practitioners and regulators.
Evolution gap
The ‘evolution gap’ exists in the areas of the audit where there is a need for evolution, taking into consideration the general public’s demand, technological advances and how the overall audit process could be enhanced to add more value. Addressing the knowledge and performance gaps is, however, an important step in determining what needs to evolve in audit. This will help to avoid overregulation and inappropriate developments in auditing standards, when the real problems could be lack of knowledge or poor performance
Expectation Gap
It comprises the difference between what financial statement users believe the audit provides and what an audit actually does provide
Explain the purpose of a financial statement audit in terms of its scope, users and level of assurance
A financial statement audit obtains evidence to validate that management’s assertions about economic actions and events are free from material misstatement and communicates that to the users
A financial statement audit is the audit of financial statements for a specific period
The intended users are the shareholders and selected others
A financial statement audit provides reasonable assurance that the financial statements are free from material misstatement, are credible and can be relied upon
Analyse the relationship between auditing and assurance. Provide examples to
support your answer
- Assurance is a broader term than audit and refers to all assurance services.
- Assurance includes an audit and usually refers to a financial statement audit.
- Assurance refers to a conclusion that is intended to increase the confidence of the intended users about particular subject matter which can be financial or nonfinancial information e.g., compliance audits, environmental audits.
- The level of assurance provided will differ depending on the extent of the assurance service.
Analyse the purpose of a financial statement audit in terms of its scope, users, and
level of assurance
- A financial statement audit obtains evidence to validate that management’s assertions about economic actions and events are free from material misstatement and communicates that to the users.
- A financial statement audit is the audit of financial statements for a specific period.
- The intended users are the shareholders and selected others.
- A financial statement audit provides reasonable assurance that the financial statements are free from material misstatement, are credible and can be relied upon.
Analyse how agency theory results in a demand for auditing.
- In an agency relationship ownership (principal) and control by management (agent) of the organisation are separated.
- The assumption is that managers may act in their own self-interest and not the principal’s interest.
Consequently, auditing is used to:
* monitor the actions of managers
* to verify management’s assertions,
* identify inappropriate behaviour,
* reduce the risk of fraud that could lead to business failure
