Auditing

Alan Millichamp & John Taylor

Introduction to Auditing, The Why of Auditing
Chapter 1
Prepared by; Muhammad Adnan Javed

Historical background
Records of auditing activity in early

Babylonian times (around 3,000 BC).

Ancient China, Greece and Rome.
The Latin meaning of the word 'auditor' was a

'hearer or listener' because in Rome auditors

heard taxpayers.

Modern auditing dates

to beginning of the
modern corporation

Brief history of
auditing

The attitude of profit maximization from end

middle ages - merchant houses in Italy.

Double-entry bookkeeping was first described

in Italy (Pacioli 1494).

Industrial Revolution Great-Britain

1780
lead to the emergence of large industrial
companies.

1853 the Society of Accountants in Edinburgh

was founded.

Cont;
A key aspect of the Companies Act 1948 was that, for

the first time, auditors were required to have a

professional qualification and it was that Act which laid
the foundations of the modern auditing profession.
Various Companies Acts have followed since then. In

turn each one made its mark by: tightening the legal
restrictions on directors and on the company itself;
Setting rules concerning the issues of shares and the

payment of dividends;
Setting the rules for minimum capital requirements for

public companies; and

Most pertinently to our purpose, regulating the content

of accounts, increasing accounting disclosure, the

requirements for accounts preparation and the records

Auditing Standards and Regulation are Rapidly Changing

By the audit process, the auditor enhances the

usefulness and value of the financial
statements,
and
also
increases
the
credibility of other non-audited information
released by management.

The function of auditing is to lend credibility to the

financial statements
Is the company a going concern?
Is it free of fraud?
Is it managed properly?
Is there integrity in its database?
Do directors have proper and adequate information to

make decisions?

Are there adequate controls?

What effect do the company's products and by-products

have on the environment?

Can an unfortunate mistake bring this company to its

knees?

Audit Definition
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 these assertions
and established criteria and communicating
the results to interested users.
American Accounting Association

International Auditing Guideline

An audit is the independent examination of

financial statement or related information of

an entity, whether profit oriented or not and
irrespective of its size, or legal form when
such an examination is conducted with a
view to express an opinion.

AUDITING THEORY,
POSTULATES AND
CONCEPTS

Theory of Rational Expectations In 1926 Professor Theodore

Limperg of the University of Amsterdam developed a theory.

It is known as the Theory of Inspired Confidence, which,

eventually,

became

known

as

the

Theory

of

Rational

Expectations.

The theory holds that the value of the auditors report derives
from the expert nature of the auditor as an independent,
competent professional.

Broadly, this is a dynamic theory which holds that as the

business community changes so the expectations it has of the

Cont;

The Philosophy of Auditing [Mautz and Sharaf (1961) ]

They held that auditing is based on scientific logic where
the auditing process is a rational process of examination,
observation and evaluation of evidence.
Financial statements and financial data are verifiable.
There is no necessary conflict of interest between the

auditor and the management of the enterprise under

audit.
The

financial statements and other information

submitted for verification are free from collusive and
other unusual irregularities.

The existence of a satisfactory system of internal

Cont;
Consistent application of generally accepted principles

of accounting result in fair presentation of the financial

position and the results of operations.
In the absence of clear evidence to the contrary, what

has held true in the past for the enterprise under

examination will hold true in the future.
When examining financial data for the purpose of

expressing an opinion thereon, the

exclusively in the capacity of an auditor.

auditor

acts

The professional status of the independent auditor

imposes commensurate professional obligations

Demerits of theory

The questions of risk and control which were not

considered to be as important in the 1960s as we
consider them to be today.

Mautz and Sharaf do not pay much attention to the

concept of accountability between parties e.g. the
accountability of the entity to the public or to
investors.

The basis of Mautz and Sharafs approach is founded

in scientific method which refers to evidence gathering
processes, the testing of hypotheses and probability
theory.

Professor David Flint Philosophy and

Principles of Auditing In 1988
The fundamental condition for the existence of

an audit is accountability, either private (e.g.

between management and shareholders), or
public accountability.
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
accountable) to be demonstrated without the
process of audit.

Essential distinguishing characteristics of audit

are the independence of its status and its

freedom from investigatory and reporting
constraints.

Financial Statements
In theory the directors act in a fiduciary capacity towards the shareholders.

What that means is that they are in a special position of trust charged with
preserving the assets of the business and, hopefully, running it for the benefit
of the shareholders so that it increases shareholder value and pays them some
dividend.
The fiduciary relationship between the parties places the onus firmly on the
shareholders to be accountable for their actions and to be transparent in their
reporting.
The following people or groups of people are likely to want to see and use

financial statements. These are often described as stakeholders:

Actual or potential:
Owners or shareholders;
Lenders or debenture holders;
Employees;
Customers;
Suppliers.

WHY IS THERE A NEED FOR AN

AUDIT?
The report may:
contain errors
not disclose fraud
be inadvertently misleading
be deliberately misleading
fail to disclose relevant information
fail to conform to regulations

Advantages of Audit
The provider of finance
Protect creditors
Establish the credibility
Fairness of Statement
Prescribed Law
Accounting Policies

Cont;
Shareholders Interest
Reassurance to Directors
Improves credibility for Tax
Accounting Policies
Expression of Opinion
Detection of Errors
Detection of Fraud
Prevention of Error and Fraud

Cont;
Special Objectives
Management Audit
Tax Audit
Social Audit
Cost Audit
Operation Audit
Purchase Consideration
Loan
Admission of Partner
Profit
Economic Development

Role in Foreign
Investment
Attraction to Investor
Shareholders
Satisfaction
Statutory
Requirement
(Income Tax
Ordinance 1984)

Disadvantages
There is an argument that an audit is only for

compliance and doesnt assist management

in running the business it is simply red
tape.

The costs of the audit represent a non-

productive expense and the money could be

better used elsewhere.

Cont;
Banks and other lenders, including suppliers, can
make their own conditions for lending and dont
really

need

historical

audited

accounts.

For

example:
Banks

will

lend

on

security

and

personal

guarantees;
they will monitor performance of the bank

accounts;
they may require regular monthly management

information;

INTERNATIONAL PRESSURES
AND GLOBALIZATION
Reliable financial reporting promotes confidence and stability

in the market.
Markets need the confidence and the assurance a strong audit

function can bring in order to enable participants in

the market, including the entities themselves, investors and

potential investors, to make informed decisions.

This involves reducing risk to potential investors by providing

them with sound information.

Corporate failures, particularly those involving fraud by senior

management, reduces confidence and creates instability. It

also tends to encourage increased regulation which may
restrict market operations or encourage further deception.

OBJECTIVES OF AUDITING
The purpose of an audit is to

enhance
the
degree
of
confidence of intended users
in the financial statements.
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 frame- work.

DIRECTORS RESPONSIBILITIES
Remember

that it is the directors who are

responsible for producing true and fair accounts;
the auditors simply express their opinion on them.

Remember

the principles of Agency Theory

outlined earlier the directors are accounting to
the share- holders (the owners of the business) for
their actions during the financial year.

As with many seemingly simple tasks this can be

quite complicated, hence the plethora of

accounting standards, bulletins and guidelines!

AUDITORS RESPONSIBILITIES
The auditors have to decide what they think,

based on the evidence they can gather.

It is straightforward enough for a company to

ensure that all the transactions in the books are

properly processed.
All the transactions that should be included have

been included; and

how do they know that all the transactions that

are included are bona fide ones and not

transactions invented by the directors to make the
results look good?

Cont;
Primary
The primary audit objective is to gather

sufficient reliable evidence so as to be able to

express an opinion, in the form of a report to
the shareholders, of the truth and fairness of
a set of financial statements prepared by the
directors so that any person reading and
using them can have confidence in them.

Cont;
Secondary
In addition to expressing an opinion on the financial

statements the auditors have also to report:

that the financial statements are in accordance with the

underlying financial records; that they comply with the

relevant financial reporting framework;
that all information and explanations they require have

been made available to them.

In addition they may also advise management of any

defects or problems with the controls within their

accounting systems and suggest ways of improving
them.

Types of Audit
Statutory audits
These are audits carried out because the law requires them.

Statutes which require audits to be done include the

Companies Act 2006 and the Financial Services and Markets
Act 2000.

Internal audits
Internal audits are conducted by employees of a business or

by external auditors acting as subcontractors. They are

becoming increasingly important because of the development
of Corporate Governance. These differ from statutory audits
because the priorities are set by the management who, to
some extent, control the work of internal auditors.

Cont;
Other assurance assignments
These are enquiries into specific aspects of

an enterprise management, value

money, environmental matters, etc.

for

In addition, auditors are asked to carry out

specific one-off assignments such as:
Reporting on a prospectus for a share issue.
Carrying out a fraud investigation.
Reviewing systems and procedures.

Scope of an Audit
The fundamental objective of an audit of the financial
statement is to enable auditor to express an opinion on
the financial statement.
Determination of Scope;
1. The companies Ordinance
2. International Standards of Auditing
3. Other Rules and Regulations
4. Constituent Laws and Agreement
5. Terms of Audit Engagement