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Audit and Assurance

Lecture 1 & 2
Introduction

The meaning of audit


An audit is an official examination of the accounts (or
accounting systems) of an entity (by an auditor)
When an auditor examines the accounts of an entity, what is
he looking for?
The main objective of an audit is to enable an auditor to
convey an opinion as to whether or not the financial
statements of an entity are prepared according to an
applicable financial framework
The applicable financial reporting framework is decided by:
legislation within each individual country, and
accounting standards (for example, International Accounting
Standards/ International Financial Reporting Standards)

The auditor seeks to express an opinion as the result of the


audit work that he does

Concepts of accountability,
stewardship and agency (1)
An audit of a companys accounts is
needed because in companies, the owners
of the business are often not the same
persons as the individuals who manage
and control that business.
The shareholders own the company. The
company is managed and controlled by its
directors.
The directors have a stewardship role.
They look after the assets of the
company and manage them on behalf of
the shareholders. In small companies the

Concepts of accountability,
stewardship and agency (2)
The relationship between the shareholders of a company and
the board of directors is also an application of the general
legal principle of agency. The concept of agency applies
whenever one person or group of individuals acts as an
agent on behalf of someone else (the principal). The agent
has a legal duty to act in the best interests of the
principal, and should be accountable to the principal for
everything that he does as agent.
As agents for the shareholders, the board of directors should
be accountable to the shareholders. In order for the directors
to show their accountability to the shareholders, it is a
general principle of company law that the directors are
required to prepare annual financial statements, which are
presented to the shareholders for their approval.

The audit report: independence,


materiality and true and fair (1)
The concept of an audit goes back to the times of
the Egyptian and Roman empires. In medieval
times, independent auditors were employed by
the feudal barons to ensure that the returns from
their stewards and their tenants were accurate.
Over time, the annual audit was developed as a
way of adding credibility to the financial
statements produced by management.
The statutory audit is now a key feature of
company law throughout the world.
An auditor reports to the shareholders on the
financial statements produced by a
companys management.

The audit report: independence,


materiality and true and fair (2)
The key features of the audit report are as follows:
The auditors producing the report are
independent from the directors producing the
financial statements
The report gives an opinion on whether the
financial statements give a true and fair
view, or present fairly the position and
results of the entity.
The report considers whether the financial
statements give a true and fair view in all
material respects. The concept of materiality
is applied in reaching an audit opinion.

Independence of the
auditor
The external auditor must be independent
from the directors; otherwise his report
will have little value
If he is not independent, his opinion is likely
to be influenced by the directors
In contrast to external auditors, internal
auditors may not be fully independent from
the directors, although they may be able to
achieve a sufficient degree of independence.

True and fair view (fair


presentation)
The auditor reports on whether (or not) the financial
statements give a true and fair view, or present
fairly, the position of the entity as at the end of
the financial period and the performance of the entity
during the period
The auditor does not certify or guarantee that the
financial statements are correct
The term true implies free from error, and fair implies
that there is no undue bias in the financial statements or
the way in which they have been presented
In preparing the financial statements, a large amount of
judgement is exercised by the directors
Similarly, judgement is exercised by the auditor in
reaching his opinion. The phrases true and fair view
and present fairly indicate that a judgement is being
given that the financial statements can be relied upon

Materiality concept
The auditor reports in accordance with the
concept of materiality. He gives an opinion on
whether the financial statements present fairly in
all material respects the financial position and
performance of the entity
Information is material if, on the basis of the
financial statements, it could influence the
economic decisions of users should it be omitted
or misstated
Applying the concept of materiality means that
the auditor will not aim to examine every number
in the financial statements. He will concentrate
his efforts on the more significant items in the
financial statements, either:

The statutory requirement for


audit
Most countries impose a statutory requirement
for an annual (external) audit to be carried out
on the financial statements of most companies.
However, in many countries, smaller companies
are exempt from this requirement for an audit
Other entities, such as sole traders,
partnerships, clubs and societies are usually not
subject to a statutory audit requirement.
Small companies and these other entities may
decide to have a voluntary audit, even though
this is not required by law

The meaning of
assurance (1)
Assurance means confidence. In an assurance
engagement, an assurance firm is engaged by one
party to give an opinion on a piece of information that
has been prepared by another party. The opinion is an
expression of assurance about the information that
has been reviewed. It gives assurance to the party
that hired the assurance firm that the information can
be relied on.
Assurance can be provided by:
audit: this may be external audit, internal
audit or a combination of the two
Review.

The meaning of
assurance (2)
A statutory audit is one form of assurance. Without
assurance from the auditors, the shareholders may not
accept that the information provided by the financial
statements is sufficiently accurate and reliable
The statutory audit provides assurance as to the quality
of the information.
The provision of this assurance should add credibility to
the information in the financial statements, making the
information more reliable and therefore more useful to
the user.
However, there are differing levels or degrees of
assurance. Some assurances are more reliable than
others.

Levels of assurance
The degree of assurance that can be provided about the reliability of the
financial statements of a company will depend on:
the amount of work performed in carrying out the assurance process, and
the results of that work.
The resulting assurance falls into one of two categories:
Reasonable Assurance A high (but not absolute) level of assurance
provided by the practitioners conclusion expressed in a positive form.
e.g. In our opinion the accounts are true and fair.
The objective of a statutory audit is to provide reasonable assurance.
Limited Assurance A moderate level of assurance provided by the
practitioners conclusion expressed in a negative form. e.g. Based on
our review, nothing has come to our attention that causes us to believe that
the accompanying financial statements do not give a true and fair view. The
objective of a review engagement is often to provide limited assurance.

Assurance provided by
audit
An audit provides a high, but not absolute, level of assurance that
the audited information is free from any material misstatement. This is
often referred to as reasonable assurance.
The assurance of an audit may be provided by external auditors or internal
auditors.
An external audit is performed by an appropriately qualified
auditor, appointed by the shareholders and independent of the company.
Internal audit is a function or department set up within an entity to
provide an appraisal or monitoring process, as a service to other functions
or to senior management within the entity. Typically, internal auditors are
employees of the entity. However, it is also common for entities to
outsource their internal audit function, and internal audit work is
sometimes carried out by firms of external auditors.

Assurance provided by
review
A review is a voluntary investigation
In contrast to reasonable level of assurance provided by an audit,
a review into an aspect of the financial statements would provide
only a moderate level of assurance that the information under
review is free of material misstatement.
The resulting opinion is usually (although not always) expressed in the
form of negative assurance.
Negative assurance is an opinion that nothing is obviously wrong: in other
words, nothing has come to our attention to suggest that the information
is misstated.
A review does not provide the same amount of assurance as an audit. The
higher level of assurance provided by an audit will enhance the credibility
provided by the assurance process, but the audit work is likely to be:
more time-consuming than a review, and so
more costly than a review.

Elements of an assurance
engagement (1)
An assurance engagement performed by a
practitioner will consist of the following five
elements:
1. A three party relationship:
Practitioner the individual providing
professional services that will review the
subject matter and provide the assurance. e.g.
the audit firm in a statutory audit
Responsible party the person(s)
responsible for the subject matter. e.g.
the Directors are responsible for preparing the
financial statements to be audited
Intended users the person(s) or class of

Elements of an assurance
engagement (2)
2. Subject matter: This is the data such as the financial
statement that have been prepared by the responsible
party for the practitioner to evaluate
3. Suitable criteria: This can be thought of as the rules
against which the subject matter is evaluated in order to
reach an opinion. In a statutory audit this would be the
applicable reporting framework (e.g. IFRS and company law).
4. Evidence: Information used by the practitioner in
arriving at the conclusion on which their opinion is based.
This must be sufficient (enough) and appropriate (relevant).
5. Assurance Report: The report (normally written)
containing the practitioner opinion. This is issued to the
intended user following the collection of evidence.