Audit Theory and Practice - Essay Example

Audit Theory and Practice College 13 Oct, 2008 Words: 1642 The objective of this report is to understand and appreciate the necessity for external auditors to maintain their independence and neutrality from their clients. The very term 'audit' itself denotes a pursuit of freedom which can be understood by its definition, 'the independent examination and expression of opinion on financial statements of an enterprise by an appointed auditor in compliance with any statutory obligations' (Gray & Manson, p.10). The words in italics refer to essential conditions that should be fulfilled for a successful auditing venture. Under company law, the financial statements of all limited companies must be audited under guidelines of professional independence which lays emphasis on an 'attitude of mind' characterised by integrity and impartiality (Gray & Manson, p.17). This requires of the auditor to issue a 'statement of independence' containing a number of declarations such as: 1. The auditor not holding significant shares in the auditing company (p.18). 2. The auditor not holding significant shares in the benefit of others (trustees) (p.18). 3. The auditor being a member of accredited accounting bodies such as ACCA, ICAEW, ICAI and ICAS (p.15). In addition, the auditor should have the necessary qualifications and expertise required for rating financial statements of the enterprise (p.19). As per information derived from literature sources, the major criteria of a standard auditing process are: professional ethics, auditors' legal liability, audit risk, accepting the engagement and planning the audit, internal control over auditing process, audit sampling, designing substantive procedures, auditing different financial instruments and completing and reporting the audit (Cosserat, 2004, Eilifsen & Messier, 2006). Each of these core criteria will later be examined for strengthening our core argument that successful auditing can only ensue from a high degree of dissimilarity between auditors and the company being audited. The independence of auditors for various business activities has been ensured over a long period of time based on unsavoury corporate scandals such as Enron in 1997. At present, the International Federation of Accountants (IFAC) as part of its standard code of ethics (revised rules) has proposed the following structural changes in auditing activities: 1. Taking a 'conceptual approach' to independence: This is an approach which reconciles any perceived threat to independence of auditors, accepts safeguards and takes appropriate steps (interventions) to eliminate threats (Liandu, 2002). 2. No one fixed set of rules: Under IFAC guidelines, it's no longer possible to allow just one set of rules for a given auditing scenario. This is because each specific scenario is now recognised for its own merit in order to generate a set of financial instruments for the auditing activity (Liandu, 2002). 3. The importance of assurance services: In addition to company data, auditors are now encouraged to increasingly rely on secondary data such as performance indicators, statistical information, market and media reports, systems and processes and compliance with regulatory guidelines (Liandu, 2002). The purpose of assurance services is to enhance the credibility of overall information at the disposal of the auditor. 4. Safeguards mechanism: The general principle is that any kind of self-interest, self-review, advocacy, familiarity and intimidation can threaten auditing independence (Liandu, 2002). A number of safeguards are hence, proposed. Regulatory enforcement of independence requirements, external review of a firm's quality control service, keeping technical data up-to-date, a corporate governance structure which provides oversight to services provided by a firm, communications about independence, rotating senior personnel and performing annual review of the auditing exercise (Liandu, 2002). With regard to Cosserat (2004) core criteria of auditing independence, let's evaluate the major processes which have been described earlier. The importance of auditing independence will be soon clarified with the major learning outcomes from our research. 1. Professional Ethics: For bigger corporations, the international standards on auditing now require the compulsory presence of third-country audit committees (Gosling, 2004). All auditors and auditing firms therefore, are subject to quality assurance reviews by different governments (Gosling, 2004). Therefore, the auditing activities are now increasingly subject to intervention by bureaucratic forces which endeavour to prevent corporate fraud. Corporate fraud, consists of a number of interrelated activities which jeopardise the overall structure and arrangement of an organisation's accounting standards (Cosserat, 2004). In the longer run, it betrays the expectations of investors who purchased the shares of the company. It is therefore, agreed that organisations will develop the role of 'corporate audit committees' for the exclusive task of gauging the performance effectiveness of various corporate forms (Gosling, 2004). Thus, the task of ensuring professional ethics in auditing is a combined initiative of regulatory independence bodies as well as the company's own corporate structure. 2. Auditor's Legal Liability: Auditor's legal liability in the event of a financial crisis in the company is insured by the 'statement of independence' as discussed before (Cosserat, 2004). Since, the auditor claims no personal affiliation to the company's organisational structure, the liability therefore befalls with the company (Eilifsen & Messier, 2006). H However, auditing firms cannot always escape public scrutiny especially in major downturn events. For example, during the recent US economy meltdown which shook world markets, an angry Wall Street shifted the blame on three major auditing firms -Deloitte, KPMG and PricewaterhouseCoopers stating they 'overlooked' several instances of firms with the following set of problems: bad debts, off-balance sheet accounting, dubious asset values and questionable business models (Hanney, 2008). It implies that auditing firms cannot always escape unscathed if there is 'enough evidence' of their complicity or negligence in the event of public scrutiny of auditing records (Eilifsen & Messier, 2006). Above observation further bolsters the case of independence of auditing firms from any interference by clients. 3. Audit Risk: Any auditing activity is fraught with accounting risks which have to be addressed by those overseeing it. The risk-based approach of auditing surmises that the entire audit assignment consists of problems and fraudulent data (Pine, 2008). This totally eliminates the possibility of any audit objectives not being met (Pine, 2008). For essential purpose of understanding the term, the auditors are required to assess 'day-to-day' operational risks of the enterprise. This basically consists of an 'independent' evaluation based on a number of interrelated factors such as financial statement risk (which deals with misstatements in material accounts), detection risk (which deals with failure of the organisation in properly tabulating data on a given day) and control risk (which deals with misstatements in recording). Clearly, the auditing firm will do good by pursuing an independent scrutiny of company records to prepare its risk assessment for a given period of time. 4. Accepting the Engagement and Planning the Audit: It is generally accepted that auditors perform several analytical procedures in planning the nature, timing and extent of audit for given client firm (Glover, Jiambalvo & Kennedy, 2001). The basic criterion in accepting an assignment is set by management assurances of truthfulness in company data being audited. If on the other hand, auditors have sufficient reason to believe that the management tended to misstate the data with it eventually leading to gross fluctuations in final result, the team of auditors may decline to pursue the assignment (Glover, Jiambalvo & Kennedy, 2001). It can be clearly gathered that any interference by management on auditing processes can will not allow auditors the privilege of refusing risky assignments fraught with incorrect data. 5. Audit Sampling: The list of organisational data can be practically exhaustive especially when one has to compare inventory records and sales vouchers. Most auditing firms pursue some kind of sampling exercise which consists of the following tasks: 1) determining sample size 2) selecting samples and 3) evaluating samples (Hall, Hunton & Pierce, 2002). Statistical and non-statistical evaluation remains at the heart of audit sampling techniques and correspondingly, depends on 'correct sample data' (Hall, Hunton & Pierce, 2002). Since, there's always a chance that the client company may tend to offer their own choice of good samples, it's important for auditors to evaluate the sampling on their own which makes a strong case for independence (Hall, Hunton & Pierce, 2002). 6. Designing Substantive Procedures: When a client organisation hires the services of an auditing firm, transactions that affect the client's financial statements are at least, physically separate from the auditing firm standards ('Unknown', 1992). Thus, the service organisation is faced with the task of designing its own unique set of substantive procedures which will facilitate the exchange of information between users and clients. This, can be made possible only when the auditor decides to stick to their own designs and methods which relate to the recording of information between participants. They must pursue their own independent policy framework which allows for speedy transmission of data between users and clients ('Unknown', 1992). In order to justify this role, the auditing organisation must pursue an independent stance over designing policy framework. 7. Auditing Different Financial Instruments: There are various categories of financial instruments which are subject to audit: cash flow, derivatives, shares and stock options, futures, fixed assets, variable assets, debt and credit values (Cosserat, 2004). The only way an auditing firm can run the entire scope of these tangibles is by performing independent evaluation of a firm's business practices. 8. Completing and Reporting the Audit: Despite exhaustive study into a company's taxation and legal records, auditing firms can sometimes face deliberate pressure from higher end sources (especially if the organisation has widespread influence in a given nation where the audit is being performed) (Cosserat, 2004). In order to avoid any threats or coercion in the auditing process, the auditing firm must enjoy complete independence and anonymity from client organisation. This further bolsters the case for third-country auditing committees which are truly free from any possibility of intimidation. Summary: In this report, we saw the importance of auditing independence in successful perusal of a company's financial statements and taxation records. In order to underscore the theme, the importance of auditor independence has been substantiated in each and every process of corporate auditing. References Gray, I & Manson, S (2008) The Audit Process, principles, practice and cases, (4th ed), Thomson Learning, London. Cosserat, G.W (2004). Modern Auditing, .(4th ed), Wiley, Chichester Eilifsen, A & Messier, W (2006), Auditing and Assurance Services, McGraw-Hill, Maidenhead. Liandu, A., (2002), 'The Independence of Accountants', Student Accountant (ACCA), Available 13 Oct 2008 Gosling, P., (1 Apr, 2004), 'Ethical Principles', Student Accountant (ACCA), Available 13 Oct 2008 Hanney, B., (13 Oct, 2008), 'Finger of Blame Pointed at Auditors', Accountancy Magazine, Available 13 Oct 2008 Pine, B., (Feb 2008), 'A Risk-base Approach to Auditing Financial Statements', Student Accountant (ACCA), Available 13 Oct 2008 Glover, S., Jiambalvo, J. & Kennedy, J., (2001), 'Analytical Procedures and Audit Planning Decisions', Journal of Accountancy, Vol.191. Hall, T.W., Hunton, J.E. & Pierce, B.J., (2002), 'Sampling Practices of Auditors in Public Accounting, Industry and Government', Accounting Horizons, Vol.16 Unknown Authors, (1992), 'Statement on Auditing Standards No.70', Journal of Accountancy, Vol.174. Read More