Chapter 1

An Overview of Auditing

Prepared by Dr Phil Saj

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 Learning objectives
1. Explain what an audit is, what it provides, and why
it is demanded
2. Describe how assurance relates to auditing
3. Discuss the importance of the profession, case law
and regulation to auditing
4. Explain the importance of national and
international auditing standards
5. Evaluate whether audits meet the demands of
users.

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 What is an audit?

“A systematic process of objectively obtaining

and evaluating evidence regarding assertions
made about economic actions and events to
ascertain the degree of correspondence
between those assertions and established
criteria and communicating the results to
interested users”
American Accounting Association (1973)

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 What is an audit?

systematic process
objectively obtaining and evaluating evidence
regarding assertions made about economic
actions and events
ascertain the degree of correspondence
between those assertions and established
criteria
communicate the results to interested users

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The objectives of an auditor

To obtain reasonable assurance about whether

or not the financial report is free from material
misstatement.
To express an opinion about whether the financial
report is prepared in all material respects in
accordance with an applicable financial reporting
framework.
To report that opinion. ASA 200.11

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 The financial reporting and
auditing framework
In preparing the financial report, management
asserts that it is a true and fair record

The audit process to obtain evidence to validate

management’s assertions

Independent audit report to express an opinion as

to whether the financial report is true and fair

Financial report users can use the information

with reasonable assurance that it is free from
material misstatement
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The demand for audits

Agency theory

Information hypothesis

Insurance hypothesis

Regulation

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 Agency theory

A principal contracts an agent to work on their

behalf

Each party is motivated by self interest

Information asymmetry arises

An independent audit reduces the incentives for

problems

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The agency relationship

Provision of
capital

Investors Managers

Provide
Obtain audit financial
report

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 Information hypothesis

Investors demand quality information in assessing

the risks and returns of their investments

Audits improve the quality of information in

financial reports

Reduces information risk and leads to improved

decision making

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 Insurance hypothesis

“the ability to shift financial responsibility for

reported data to an auditor lowers the expected
loss from litigation or related settlements to
managers, creditors who might demand an audit
to show they are being prudent to insure against
losses” Wallace (1980)

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 Insurance hypothesis

Interested parties:
Investors and creditors demand an audit to
be prudent and insure against losses

Regulators to insulate themselves from

criticism by directing blame to auditors

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 Regulation

Annual audits required by:

Companies, registered schemes & disclosing
entities (excludes small proprietary companies)
Commonwealth and state government
departments, statutory authorities, government
companies and business undertakings,
municipalities
Not-for-profit organisations

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 Providers of audits

Financial audits are provided by independent auditors

Must be registered with ASIC to be able to perform
audits on reporting entities
Criteria set out in s.1280 Corporations Act
Educational qualifications
Work experience
Good character (fit and proper person)
Member of ICAA or CPA Australia

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 Assurance

In the Framework for Assurance Engagements an

assurance engagement is defined as:
“An engagement in which a practitioner
expresses a conclusion designed to enhance
the degree of confidence of the intended users
(other than the responsible party) about the
outcome of an evaluation or measurement of a
subject matter against criteria” (paragraph 8)

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 Assurance engagements

May be financial or non-financial

The level of assurance will vary according to the
particular engagement (according to the amount
of evidence collected)
Audits of annual financial reports imply a
reasonable (or high) level of assurance
In comparison (for example) half-yearly reviews
imply a moderate (or low) level of assurance

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The relationship between auditing
and assurance

Assurance
Engagement

Financial
Report Audit

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The auditing environment

Co-regulation

The
accounting Case law Statute
profession

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The accounting profession

Professional bodies
Institute of Chartered Accountants in Australia
CPA Australia
National Institute of Accountants

Practice entities

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The accounting profession

Professional accounting bodies’ are involved in

the development of audit practice by:
Developing standards of practice,
professional education and rules of conduct
Ensuring professional conduct and self-
regulation
Maintaining standards of qualifications

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 Case law

Early cases associated with detection of fraud

Change of focus resulting from increased

complexity, increasing size of businesses and
separation of owners from managers

Greater emphasis on ‘reasonable skill and care’

Concept of ‘reasonable assurance’

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 Case law

Pacific Acceptance case (1970)

Concept of ‘reasonable care and skill’ called for
changed standards to meet changed business
conditions.
Auditor should pay due regard to the possibility
of fraud and actively investigate the possibility
of fraud if suspicious circumstances exist.

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 Regulation

Corporations Act
Responsibility for accounting and auditing
standard settings under government control

• ???????????????????????????????????
• Regulatory changes focused on reporting issues
• Other issues involved fee dependence and importance of
the auditor in corporate governance

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 Regulation

Australian Securities and Investment

Commission (ASIC)
Regulates corporate, markets and financial
services sector
Advise on selling of and disclosure of financial
products and services to consumers
Majority of work carried out under Corporations
Act

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 Regulation

Companies Auditors and Liquidators

Disciplinary Board (CALDB)
Established under ASIC Act
Hears breaches under Corporations Act by
auditors and liquidators
Australian Securities Exchange (AXS)

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 Regulation of accounting
and auditing
Government

ASX Financial Reporting Council

Corporate • Oversee accounting and auditing
Governance ASIC
standard setting
Council
• Monitor companies’ compliance with
Professional audit-related disclosure requirements
CALDB
accounting • Advise on continuing steps to enhance
bodies auditor independence
• Monitor disciplinary proceedings of
Other accounting bodies
stakeholders
AASB Secretariat AUASB

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The early 2000s- challenges
and changes
Corporate collapses overseas and in Australia
Collapse of Enron led to the Sarbanes-Oxley Act
Collapse of HIH led to a Royal Commission
Ramsay Report
Some recommendations from the HIH Royal
Commission and the Ramsay Report were
incorporated in Corporate Law Economic Reform
Program (CLERP 9)

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The early 2000s- challenges
and changes

Major impacts
Role of audit in corporate governance
Auditor independence
Audit quality

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 Auditor Independence

To conduct the audit without bias and appear to

be objective to those relying on the results of the
audit. Key issues include:
Non-audit services
Audit partner rotation
Auditor working for the client

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 Audit Quality

Audit quality is that characteristic of auditing

whereby the auditor undertakes his/her work in
both a technically competent manner and ethical
manner, including giving consideration to the
public interest. By conducting the audit in this way,
the auditor can ensure that his/her judgement is
not compromised and that complex issues can be
properly dealt with.

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 Audit Quality

Role of Financial Reporting Council

Annual general meetings

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 Auditing Standards

Mandatory requirements and guidance

ASA 101 explains how auditing standard are to
be interpreted and applied
Have “the force of law” for audits undertaken
pursuant to the Corporations Act
The professional bodies require application
Clarity Project (commenced 2004)
International harmonisation

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 AUASB PRONOUNCEMENTS
Forward
Glossary
ASQC 1
Assurance No Assurance
Framework for Assurance Engagements
Assurance engagements Engagements other
Audits and reviews than audits, reviews
of historical fin. info other than audits & reviews
of historical fin. info & other assurance
engagements
Australian Standards Standards
Auditing on Assurance on Related
Standards Engagements Services
Standards on
Review
Engagements
Guidance Statements 33
Does the audit meet demands of
users?
Current
shareholders
Company Future
management shareholders

Audited
Employees financial Government
reports

Bankers Wider public

Creditors

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Do audits provide good value?

Assessing value can be examined by asking:

How often are they associated with company
failure?
Do auditors get the audit report correct?
How much do they cost?
Do audits provide economic value in the
market?

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 Audit expectation gap

“the difference between what auditors

actually do when they conduct an audit and
what shareholders and others think auditor's
do, or should do, in conducting the audit”
Report of HIH Royal Commission

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 Audit expectation gap

Audit expectation-performance gap

Perceived Society’s
Performance Performance Reasonableness expectation
gap gap
of auditors of auditors

Deficient Deficient Unreasonable

performance standards expectations

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 Audit expectation gap

Remedies to address unrealistic expectations:

Education of stakeholders about what an
audit provides
Remedies to address deficient standards:
Reporting on internal control
Detection of fraud
Evaluation of going concern

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