Lecture 1 Introduction To Auditing

 

INTRODUC ODUCTION TION TO AUDIT UDITING ING INTR

LECTURE 1

 

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Learning Outcomes • Describe auditing • Distinguish between auditing and accounting • Describe different types of audit and auditors. • Explain why there is a need for auditing and assurance services • Explain the framework of auditing

 

Traditional Role of Auditing • ‘Auditing’ comes from the atin word audire,  audire, meaning ‘to hear’. • Began as far back as 3,500 B.C.! long before it is re"uired by law. •  The records records of mesopotamian civilization civilization show tiny marks at the side of nmbers involved in the !nancial transactions o

"nternal controls, controls, systems of veri!cation, and the concept of division of dties probably originated at that time

• #arly #gyptian, Chinese, $ersian, and %ebrew records show similar systems • #raditional role of auditing $ conformance role. o

%riginal &report' was verbal (oral verification)

 

Why is auditing needed in a free market economy?

 

The Origin of Accounting and Auditing

 

 AGENCY THEORY THEORY & THE   NEED FOR AUDITING  A,E-* /EA#0%-1203

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#he principal$agent relationship between the owner and manager often resulted in information asymmetry between the two parties. #he manager generally has more information about the true financial position of the *ompany. +ecause their goals may not coincide! there is a natural conflict of interest  between the manager and the owner. #his gives rise to the need for auditing. 

 

AUDITING DEFINED… •  A6D0#0-, (broadly (broadly defined) is a systematic pr process ocess of ob7ectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence  between those assertions and and established criteria a and nd communicating the results to interested parties. •  A6D0#0-, (narrowly defined) is a written report report on the examination of financial statements of an entity.

 

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Benefits of Financial statements audit • •

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%btain access to capital markets. 8ithout an audit! companies may be denied access to capital markets by the 1* and +ursa 5alaysia 2ave a lower cost of capital. ,iven the reduced risk resulting from audited financial reports! potential creditors may offer low interest rates and potential investors may be willing to accept a lower rate of return on their investment. +e a deterrent to inefficiency and fraud. 9nowledge that an independent audit is to be performed is likely to result in fewer errors in the accounting process and reduce the likelihood of employee misappropriation of assets. *ontrol and operational improvements. +ased on observations made during the financial report audit! the independent auditor can suggest how controls could be improved and how greater operating efficiencies within the entity’s organisation may be achieved.

 

Auditing Attestation and Assurance !er"ices Defined  Auditing

 Attestatin

 Assurance Services

 A systematic process of ob7ectively ob7ectively 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.

 

Auditing Attestation and Assurance !er"ices Defined  Auditing

 Attestatin

 Assurance Services

%ccurs when a practitioner is engaged to issue a report on a sub7ect matter! or on an assertion about a sub7ect matter! that is the responsibility of another party. /eports the reliability of the sub7ect matter or the assertion about the sub7ect matter (financial or non-financial). Effectiveness of internal controls! review of historical accounts! loan compliance! financial forecasts etc.

 

Auditing Attestation and Assurance !er"ices Defined  Auditing

 Attestatin

 Assurance Services

 Are independent professional professional services (written or verbal) verbal)   that improve the "uality of information! or its context! for decision makers. 0t increases decision makers’ confidence in the information. *ompliance with laws! contracts etc.

 

An Audit Audit of of Financial Financial O#$ecti"e of An !tatements #he ob7ective of an audit of financial fi nancial statement is to enable the auditor to express an opinion  whether the financial statements statements are are prepared! in all material aspects! in accordance with an identified reporting framework (01A :;;)

 

How is accounting different from auditing?

 

Accounting "s Auditing Auditing •  Accounting $ the recording! classifying and summarising of economic events in a logical manner for the purpose of providing financial info for decision making. classifying

recording

summarising

 

Accounting g "s Auditing Auditing Accountin •  Auditing

$ focus on determining whether recorded information properly reflects the economic events that occurred during the accounting period.

$ besides a thorough understanding of approved accounting standards! auditor must Determining proper audit procedures

also possess expertise in the accumulation < interpretation of audit evidence. Evaluating results

Deciding number < types of items to test

 

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%u#lic Accounting Firm&!er"ices • !"ee#ing • Csting and $anage$ent accunting • Ins%venc' %i(uidatin and receivers)i#s • *anage$ent in+r$atin sste$s and interna% cntr%s • Secretaria% services

 

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O"er"ie' of The Audit %rocess %rocess

btain 1.Preliminary 2. Obta

Engagement •.

Client acceptance

•.

Terms of 

engagement 

understanding of the entity

3.Materiality and assess risk

 

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O"er"ie' of The Audit %rocess %rocess 4.Audit Planning

5. Test of ontrol and substanti!e "roedures

%. &ssue &ssue tthe he auditor's re"ort

#.$om"lete the audit

 

Re Relationshi( lationshi( among Internal )ontrol indi"idual transactions and account #alances •  A company implements internal controls as a safeguard to ensure appropriate capturing and recording of individual transactions. • #hese individual transactions are then collected into ending account balances. • Ending account balances are then used to prepare the financial statements.

 

Relationshi( among Internal )ontrol indi"idual transactions and account #alances

 How do we audit then?  • #he auditor can obtain evidence from all three steps of the accounting process. • 4or instance! an auditor can directly test the account balance (ex. by bank statement confirmation and reconciliation). #his evidence is usually the highest$"uality but costliest evidence.  evidence.   • %r! the auditor can obtain indirect information by testing the individual transactions that make up an account balance. While an auditor will not have the resources to test each individual transaction, she or he can use sampling and project her or his findings onto the entire population of transactions. • #he least direct method of obtaining evidence is to evaluate and test the company’s internal control to ensure that transactions are being properly handled.   handled. c$,inatin + evidence  Auditrs usua%% re% n a c$,inatin evidence +r$ a%% t)ree t)ree areas-

 

Re Relationshi( lationshi( among Internal )ontrol indi"idual transactions and account #alances

Aounts eei!able in thousands (eginning balane * 1%+521 )ales

*144+32,

*13%+-,% $ash re reei"ts *

* Ending balane

* 2-+10%

1+242

)ales returns

and alloanes $harge/off of  3+323 unolletible aounts

 

Some fundamental concept

 

risk is the risk that Audit risk is t hat the auditor may unknoingly fail to a""ro"riately modify his or her Audit Ris* o"inion on finanial statements that are materially misstated. !he auditor"s standard easonable assurane  report states that the audit implies that there is some pro#ides only reasonable risk that a material assurane that the misstatement could %e financial statements do present in the financial not contain material statements %ut the auditor misstatements$ fails to detect it$

 

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Inde(endent auditors • 0ndependent auditors! often referred to as e.terna% auditrs! auditrs! are either individual practitioners or members of public accounting firms who render professional auditing services to clients •  B virtue of their education, training and e!perience, independent auditors are "ualified to perform the tpes of audits  previousl described 

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Auditor+ss Inde(endence Inde(endence Auditor+ •  Audit 0ndependence is the cornerstone of auditing. 0ndependence is the essence that underlies the success and credibility of the accounting profession and its service to the public. • 5aintaining independence allows the auditing and accounting profession to be self$regulated! a highly prestigious character. #his ob7ectivity permits the profession to perform its attestation and monitoring functions effectively. • 0ndependence is also a key component of the agency theory of auditing. 0n the management =shareholder agency relationship it is important that the monitoring function (audit) is and is seen to be separate from management! for it to be a ‘value added’ service.

 

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Inde(endence in mind and a((earance   Inde#endence + *ind   e.#ressin T)e state $ind t)at/it)ut #er$its t)e + + a cnc%usin ,eing a++ected , in+%uences t)at c$#r$ise #r+essina% 0udg$ent' a%%/ing an individua% t act /it) integrit and t e.ercise ,0ectivit and #r+essina% sce#ticis$

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Inde(endence in mind and a((earanc a((earance e cont+ Inde#endence in A##earance   #he avoidance of facts and circumstances that  are so significant that a reasonable and informed third party! having knowledge of all relevant information! including safeguards applied!  would reasonably conclude a firm’s or professional accountant’s integrity! ob7ectivity or professional scepticism had been impaired

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!(ecific threats to inde(endence • Financia% interests • Lans and guarantees • C%se ,usiness' +a$i% and #ersna% re%atins)i#s • E$#%$ent re%atins)i#s • Recent service and serving as an ++icer n t)e ,ard + assurance c%ients • Lng assciatin

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!(ecific threats to inde(endence • rvisin + nn2assurance services t assurance c%ients re$va% + audit auditrs rs •  A##int$ent and re$va% • Fees and #ricing • Gi+ts and )s#ita%it 

()  

T,(es of Audits •  %perational •  *ompliance •  4inancial 1tatement •  4orensic

 

T,(es of Audits • O#eratina% Audits $ evaluates the efficiency < effectiveness of any part of organisation’s operating procedures < methods. $ not limited to accounting $ more difficult to evaluate $ normally accompanied by recommendat recommendations ions for improving operations

 

T,(es of Audits • C$#%iance Audits $ to determine whether the auditee is following specific procedures! rules or regulations set by higher authority. $ results normally reported to someone within the organisational unit being audited rather than to outside parties

 

T,(e (ess of Audits Audits • Financia% State$ent Audits $ to determine whether the overall financial statementss are stated in accordance with statement specified criteria (normally 4/1). $ the auditor performs appropriate tests to determine whether the statements contain material errors or other misstatements.

 

T,(es of Audits Frensic Audits $ purpose $ to obtain < develop information as legal evidence or for use by expert witnesses in the courts of law. $ re"uires the use of critical analyses < investigative skills! integrated with accounting knowledge < business experience. $ Examples> business or employee fraud! criminal investigations! shareholder < partnership disputes.

 

T,(es of Auditors Auditors Gvern$ent Auditr • auditor working for the Auditor ,eneral Dept! a non$partisan agenc non$partisan agency y in the legislat legislative ive branch branch of the federal govt. • primary responsibility $ to perform audit function for all federal < states as well as statutory bodies < public authorities.

 

T,(es of Auditors In%and Revenue Auditr $ responsible for enforcing the 0ncome 0 ncome #ax Act $ audit taxpayers’ returns to determine whether they have complied with the tax laws. $ also called inland revenue assessment officers. $ must have considerable tax knowledge < auditing skills to conduct an effective audit.

 

Auditorss T,(es of Auditor E.terna% auditr ? 0ndependent auditor ? responsible for auditing the published historical

financial statements of all publicly traded companies and others ? expected to express audit opinions on 41

 

T,(es of Auditors • Interna% Auditr

$ employed by individua individuall companies to audit for management $ responsibilities may vary! depending on the employer. #heir 7obs can be routine compliance auditing! computeroperational systems. auditing or evaluating $ internal auditors normally report directly to the president! chairm chairman  board of directors. direc tors.an or audit committee of the

 

T,(es of Auditor Auditorss • Frensic Auditrs $ a new area of auditing $ trained in detecting! investigating! and deterring fraud < white$collar crimes. $ to detect fraudulent financial reporting and misappropriation misappropriat of assets $ responsible forion obtaining reasonable assurance that material statements! whether due to errors or fraud! are detected.

 

The Audit Re(ort #he final phase in audit @ chose the appropriate form of audit report’s to issue>

Unqualified Qualified

Adverse Disclaimer

 

 #$H%B%& '-' The Auditor+s !tandard Un-ualified Audit T)e $st c$$n t#e + audit re#rt issued Re(ort

is t)e 3standard un(ua%i+ied audit re#rt4  ,ecause $anage$ent5s assertins a, a,ut ut t)e entit5s +inancia% state$ents are usua%% +und t cn+r$ t FRS-

#itle

Addressee

%pinion 3aragraph

Explanatory 3aragraph

0ntroductory 3aragraph  Auditor -ame

1cope 3aragraph

/eport Date

 

Other T,(es of Audit Re(orts 6ua%i+ied

Disc%ai$er

0ssued for either a material scope limitation or departure from 4/1 (the &except for' report). 0ssued for serious (material and pervasive) scope limitation or lack of auditor independence.

 Adverse

0ssued when the overall financial statements are not presented fairly in conformity with 4/1.

 

%u#lic Accounting Firms Publi aounting firms range in sie from a single "ro"rietor to thousands of oners or "artners6 and thousands of "rofessional and administrati!e staff em"loyees em"loyees.. (ig 4 Publi Aounting 7irms Deloitte #ouche

Ernst < oung

935, 3eat 5arwick

3ricewaterhouse *oopers

 

Ethics Inde(endence and the )ode of %rofessional )onduct *thics refers to a system or code of *thics refers conduct %ased on moral duties and o%ligations that indicates how we should %eha#e$ +rofessionalism refers to the conduct, +rofessionalism refers aims, or -ualities that characteri.e or mark a profession or professional person$

 All professions professions operate under some some type of code of ethics or code of conduct.

 

much fees ma, not not #e "er, good.. good.. Too much

/an you really %e independent with these kind of fees paid to you? (“Independent”…an issue that we’ll look at very closely later on in this course)

 

Auditor+s Res(onsi#ilities  %*++ $ an audit in accordance with 01As is to  %*++ $  be designed to provide reasonable reasonable assurance that the 41 taken as a whole are free from material misstatement misstatements s $ 5aterial versus immaterial misstatement misstatementss /easonable assurance $$ Errors versus fraud $ 4raud resulting from fraudulent financial reporting versus misappropriation of assets $ 3rofessional skepticism

 

5isstatements are considered material if the combined uncorrected errors < fraud in the 41 would likely to have changed or influenced the decisions of a reasonable person 

/easonablemore assurance less level than of absolute assurance and than a$ low assurance Errors $ unintentional misstatement 4raud $ intentional (misappropriation of assets < fraudulent financial reporting) 3rofessional skepticism $ "uestioning mind < a critical assessment of audit evidence  Assume possibility of management management dishonesty  

 

The Auditor+s Res(onsi#ilit, for Detecting Errors and Fraud  The auditor has a res"onsibility to "lan and "erform the audit to obtain reasonable assurane about assurane about hether the finanial statements are free of material misstatement+ hether aused by error or fraud. !he auditor has no

0ecause of the nature of audit e#idence and the characteristics of fraud, the auditor is a%le to o%tain reasona%le, %ut not a%solute assurance that misstatements arematerial detected$  detected$ 

responsi%ility to plan and perform the audit to o%tain reasona%le assurance that misstatements, whether caused %y errors or fraud, that are not material to material to the financial

statements will %e detected$  

I!A /01R The Auditor+s Res(onsi#ilit, to )onsider Fraud in an Audit of Financial !tatements /e"uires the auditor to> $ 3erform procedures to obtain info that is used to identify the risks $ 0dentify < assess the risks of material misstatement $ Determine overall responses to address the risks $ Design < perform audit procedures to respond to the risk of management override of controls $ Determine responses to address the assessed risks $ *onsider whether an identified misstatement may be indicative of fraud $ %btain written representations $ *ommunicate with management $ 3rovides guidance

$ Establish documentation re"uirements  

!ome definitions re"ie' • 5isstatement ? 5isstatement in 4=1 can arise from fraud or error! that include omissions of an amount of disclosure

• 4raud ? 0ntentional act involving the use of deception to obtain an un7ust or illegal advantage

• Error ? 6nintentional misstatements e.g. mistake in data collection! processing or application of ,AA3

 

Auditor+ss Res(onsi#ilities Res(onsi#ilities for Disco"ering Illegal Auditor+ Acts

0t is -%# -%# the  the auditor’s responsibility responsibility to detect all illegal acts. 2owever! the auditor is to plan and perform the audit with professional skepticism on whether the entity is complying with laws and regulations.

 

Auditor+s Res(onsi#ilities for Disco"ering Fraud 2 Illegal Acts

 8hat to do when discovers discovers fraud = illegal actsB  Cerify existence *ommunicate to higher management 

*onsideropinion) effects on 41 (disclosure = "ualified = adverse  8ithdraw from engagement engagement if necessary  /eport to 1* (seek legal council opinion’s first)

 

A!!URAN)E !ER3 !ER3I)E! I)E! • 0ndependent professional service increase  increasethe   degree of cn+idence cn+idence   to users byto evaluating sub7ect matter against identified criteria so that it can increase the credi,i%it  of  of such information.

 

!ER3I)E NON AUDIT !ER3 I)E ? #ax services ? 5anagement advisory services ?  Accounting and review review services ? *ompany 1ecretary services

 

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Audit (rofession and regulator, en"ironment in 4ala,sia

• 5alaysian 0nstitute of Auditing (50A) ? /egulatory body established under the Accountants to regulate accounting accounting profession in 5alaysia ?  Act 50AFG +y$laws

• 0nternationa 0nternationall 4ederation of Accountants (04A*) ?  An international bodyprofession committed to develop and committed enhance accountancy ? 50A is a member of 04A*

• 0nternational 0nternationa l Auditing 3ractices *ommittee (0A3*)

(0A3*) ? Established by 04A* to develop and issue standards  

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Organi5ation relates to Financial Re(orting and auditing • *ompanies *ommission of 5alaysia! ? /egulates companies and reporting re"uirements of companies

• 5alaysia Accounting 1tandards +oard ? Established under 4inancial /eporting Act G ?  Accounting 1tandards 1tand ards for 3rivate Entities= %ther than 3rivate Entities

• 1ecurities *ommission and +ursa 1aham 5alaysia ? 1upervises stock exchanges= reporting re"uirements for

listed companies  

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