External auditing and societies

‘Independent auditing of financial information is essential

in any advanced society.’

The American Accounting Association define auditing as ‘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 parties’.

The systematic process of auditing refers to a sequence of strategic procedures based on standards and objectives set out in conceptual framework.

For the audit to be useful it has to be as objective as possible based on the evaluated evidence. To ensure the auditor gives an unbiased opinion when evaluating evidence there is a requirement that they are working independent of the audit. The assertions the definition refers to are the management’s representation of the information presented in both the financial statements and the accounting system information. Any unaudited financial statement is only an assertion made from the company itself. All the assertions have to be evaluated against all the international accounting standards so they follow a uniform and mutually understandable standard to both preparer and user groups. The auditor is required to communicate their opinion as to whether the accounts show a ‘true and fair’ view of the company’s company position and carefully explaining their reasons to the decision.

The primary objective of an audit of financial information is to allow an auditor to express an opinion as to whether the financial statements show a true and fair view. The financial information does not have to be accurate as it would be impossible to enforce. This is due to accountants making their own judgements on accounting policies such as estimating depreciation which is never completely accurate. There are however subsidiary objectives identified by Millichamp (1981, p3) to be recognised were: 1) detection of errors and fraud 2) to prevent errors and fraud by the deterrent and moral effect of the audit 3) to provide spin-off effects. The auditor will be able to assist his clients with accounting, systems, taxation, financial and other issues.

There are four main reasons for the need to have financial statements audited. All four reasons are true but are reasonable enough to stand alone as a reason for auditing as a necessity.

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There are four main reasons for the need to have financial statements audited. All four reasons are true but are reasonable enough to stand alone as a reason for auditing as a necessity.

The first is the potential conflict of interest between management and ownership. This is not true for private companies as management also own the company. Unless a private company is looking to raise capital they do not usually have audits as it will just be a waste of money. This separation of management and owners is due to management having incentives to produce biased financial information because if they impress their superiors with good performance they might be rewarded for example with a performance bonus. An auditor’s role in this situation is to reduce or eliminate any potential bias in any financial statements. The users of the published financial information require unbiased financial information to reduce the information risk when they face economic decisions. A firm will be willing to incur the cost of an audit fee to assure its users that the information is true and fair.

The next reason is the consequence of any used financial information. Any financial information has significant importance and influence on financial markets. By having an auditor establish their opinion on the credibility of financial information provides the financial market with its confidence to trade. However no user should assume that any auditor’s opinion is an assurance as to the future viability of the entity as auditing is not a perfect process.

The third reason is the complexity of financial statements from large companies. This requires a professional and qualified auditor who has the expertise to understand and evaluate the information as the majority of users of this information do not have the expertise required. Therefore the users of the financial statements are completely dependent on the auditors as they rely on the information and advice from such professionals.

The final need for auditors relates to the remoteness of financial records. Auditors are amongst very few people who have the right to access a company’s financial records. According to the Companies Act auditors have the right to obtain any information they consider is necessary for the purposes of the audit process. Therefore no information can be withheld and management cannot restrict auditors from doing their job.

There a number of ways that a company will have its accounts audited that can be classified into four categories: independent financial statement audit, internal audit, compliance audit and value-for-money audit. The essential one is the independent audit where ‘independent contractors who, after adequate examination and investigation, offer a professional opinion as to whether the concern’s financial statements which they have examined present fairly the results of operations and the financial condition of the enterprise’ (Maurtz, p5). The primary purpose is to assure the investing and lending public that the financial statements are objectively and fairly presented in accordance with the established criteria set by the International Accounting Standards Board. As stated by (Cosserat and Rodda, p11) ‘Independence is the essence that underlies the success and credibility of the accounting profession and its service to the public’. Independence offers objectivity to allow auditors perform their attestation duties effectively. To some extent an audit will report on the management’s influence on accounting data as well as the department itself. Unlike independent audits, internal auditors are employed by the company and will owe a primary allegiance to the company as whatever happens to that company will in some way or another reflect the future of that person’s job. However this is not to say that an internal auditing department cannot have a high degree of independence as their job will is to detect any errors, possible fraudulent activity and to find ways of saving the company money. They will however lack the final degree of independence from management due to its nature of being run by the company itself.

An example of a failure of independent auditing occurred with a company called ENRON. Throughout the 1990’s the company was employing irregular accounting procedures that were boarding on fraud throughout the 1990’s. It is alleged that the company hid its real level of debt by putting £8.5 billion of group liabilities into special purpose vehicles whose accounts were not consolidated with those of the company. The group went bankrupt and the audit firm, Arthur Andersons, went out of business as a result of obstructing justice by being paid off to help hide the company’s debts.

Auditing cannot provide the users guaranteed assurance for the financial information is a perfect representation of the company’s position as auditing is not a perfect process. This is because it only takes a sample of company information as some may see hundreds or thousands of transactions each day that cannot be checked by auditors so they can only take a systematic sample that they believe will show the truest representation. Auditors also have to plan out the time and cost spent on a company audit. ‘They are continually concerned with the materiality of the amounts under review and have learned to balance the risk of possible error and consequent loss therefrom against the cost of those verification procedures that will give assurance that no error is present’ (Maurtz, p6).

Assurance services are valued because the assurance provider is independent and perceived as being unbiased with respect to the information examined. Reducing assurance engagement risk to zero is rarely attainable or cost beneficial as a result of factors such as: use of selective testing, inherent limitations of internal control, the fact that much of the evidence available to the auditor is persuasive rather than conclusive, the use of judgement in gathering and evaluating evidence and forming conclusions based on that evidence, the characteristics of the subject matter.

Fisher (1987) identified four theories to explain the demand for auditing services: information, insurance, legislated demand and contracting. None of which are mutually exclusive.

Information theory refers to having assurance that the information is accurate will reduce investors risk and help improve economic decisions. Insurance theory suggests that auditors can be liable to third parties for losses that are due to the auditors’ negligence. Legislated demand states that demand for auditing services may be induced by government from for example the Companies Act. Contracting theory refers to the agency relationship where management are the agents but auditors are secondary agents to confirm the published information due to mentioned reasons such as potential bias as management have loyalties to the company and are not independant.

Auditors have the incentive to cheat however being discovered could cost them their reputation, their most valuable asset. Therefore auditors are likely to perform their audits honestly even though they are unobserved. Auditing is not a perfect method but it is essential and is the best current method currently available. This is proved by every country following International Accounting Standards by law requires an audit. Companies would not have chosen to use auditing before it came into requirement by law. This is because an audit costs a small fee compared to what could be gained from various parties (shareholders, managers, bankers, auditors, analysts) having the right information to form a solid basis for making financial decisions. The users need unbiased financial information to reduce the information risk they make when making decisions. If there were no audit at all, nobody on the stock exchange would know if any of the information is true. The auditor’s opinion helps to establish credibility of the financial information. The financial market is based on trust and without credible information means no trading other than selling resulting in zero value. ‘Audit is a social phenomenon. It has no purpose or value except in its practical usefulness. It is wholly utilitarian’ (Flint).

Bibliography

American Accounting Association
Cosserat, G.W. and Rodda, Neil, 2009. Modern Auditing. 3rd Edition. Wiley and Sons.
Mautz, R.K., 1964. Fundamental of Auditing. Wiley and Sons.
Millichamp, A.H, 1981. Auditing. 2nd Edition. D.P. Publications.
Flint, D, 1988. Philosophy and Principles of Auditing. Palgrave Macmillan
International Federation of Accountants, 2004