CHAPTER 1 THE DEMAND FOR AUDITING AND | ASSURANCE SERVICES ECONOMIC DEMAND FOR AUDITING Why do many of the largest companies spend millions of pesos each year for their annual audit? Is it worth asking why an entity would decide to spend so much money on an audit? Is it because these audits are required by law? While true in certain circumstances, this answer is far too simplistic. Although audits are often utilized in situation where they are not required by law, audits were in demand long before Securities Laws and the Bureau of Internal Revenue required them. ¥ a . The demand for auditing can be understood as the need for‘accountability when business owners hire others to manage their businesses, as is typical in modern corporations. Until the late 18" and early 19" centuries, most organizations were relatively small and were owned and operated as sole proprietorships or partnerships. Because businesses were generally run by theif’ owners and borrowing was limited, accountability to outside parties often was minimal. The birth of modern accounting and auditing occurred during the industrial revolution, when companies became larger and needed to raise capital to finance expansion. Over time, capital markets developed, enabling companies to raise the investment capital necessary to expand new markets, finance expensive research and development, and fund the buildings, technology, and equipment needed to deliver products to market. - A capital market allows a public company to sell small pieces of ownership (i.e., stocks) or to borrow money in the form of thousands of small Joans (i.e., bonds) so that vast amounts of capital can be raised from a wide variety of investors and creditors, A public company is a company that sells its stocks or bonds to the public, giving the public a valid interest in the proper use of the company’s resources. Thus, the growth of the modern corporation led to diverse groups of owners who are not directly involved in running the business (shareholders) and the use of professional managers hired by the owners to run the corporation on a day-to-day4 Chapter 1 basis. In this setting, the managers serve as agents for the owners (who ae sometimes referred to as principals) and fulfill a stewardship function by managing the corporation’s assets. It is important to understand that the relationship between an owner and manage, often results in information asymmetry between tha two parties. Information asymmetry means that the manager generally has more information about the “true” financial position and results of operations of the entity than does the absentee owner. What are Assurance Services? The name assurance servicesvis used to describe the broad range of information enhancement services performed by a certified public accountant (CPA) that are designed to enhance the degree of confidence in the information. In general, assurance services consists of two (2):types: @ those that increase the reliability of information and (6) those that involve putting information in a form or context that facilitates decision making. A significant portion of the assurance services provided by CPAs is referred to as attestation services. To attest to information means to provide assurance as to its reliability. In an attestation engagement, CPAs provide a report on subject matter or an assertion about that subject matter. One of the most sought-after attestation services is the examination or audit of historical financial statements. In this book, we will focus on the Audit and Assurance Services that involve reliability enhancement. Philosophy of an Audit As the amount of capital involved and the number of potential owners increase, the potential impact of accountability also increases. The auditor's role is to ine whether the reports prepared by the manager conform to the contract’s ns. Thus, the auditor's verification of the financial information adds credibility to the report and reduces information-risk, or the risk that inform circulated by a company’s management will be false misleading. Reducing information risk potentially benefits both the owner and the manager. Economic decisions are made under conditions of uncertainty; there is always * risk that the decision maker will select the w . i a =: m4 rong alternative and incur significant loss. The credibility added to the information by auditors acti” SADemand for Auditing and Assurance Services § reduces the decision maker's risk. information rsh, which i the i K To be more precise, the auditors reduce at the financial information used to make a Businesses, instituti indivi Feelin ad probes and individuals must maintain records of their financial buuinieas spetationer| - These records are necessary to evaluate and guide eid Rees letermine financial status, to meet legal requirements and riay swich to ty ene Creditors and investors, present and prospective, exiciaion andi tive financial statements of many enterprises for credit Resennttaice nt purposes. Government agencies will need financial eae cy: the cutis imposed upon them by law internal Wisiness onetarions: reports for planning, directing and controlling These parties therefore, need reliable and credible financial information. The process employed to establish the reliability or unreliability of the financial statements and supporting records is referred to as an audit examination. Auditing of financial records has become an important factor in the dissemination of financial information and the services of the independent certified public accountant are considered indispensable. Increasingly, his written report is required to add credibility to the financial statements. A free-market economy can exist only if there is sharing of reliable information among parties that have an interest in the financial performance of an organization. The market is further strengthened if the information is transparent and unbiased — that is, the data is not presented in such a way that it favors one party over another. An organization’s reported information must reflect the economics of, its transactions and the current economic condition of both its assets and any obligations owed. uditors undertake to gather evidence to obtain ncial. statements are. free of - material nd that they are presented in accordance k. The external audit is intended to Ina financial statement audit, the ai high level of assurance that finan misstatements due to fraud or errors al with appropriate. accounting framewor! 1 enhance the confidence that users can place on management-prepared financial statements. When the auditor has no reservations about management's financial statements or internal controls, the report is referred to as an unqualified audit report. ee6 Chapter rties, but the most important is the Public, as represented by investors, lenders, workers, and others who make decisions based on financial information about an organization, Auditing requires the highest level of technical competence, freedom from bias, and concern for integrity of the financial reporting process. In essence, auditors should view themselves as guardians of the capital markets. ‘The.public-expects auditors to (@) find fraud, (b) require accounting principles the st portray the spirit of the concepts adopted by accounting standard setters, and be independent of management. When it comes to being independent, auditors must not only be independent in fact, but they must act in a manner that ensures that they are independent in appearance. Auditors serve a number of pai An independent auditor's opinion contained in the audit report provides both internal and external users with input to making logical and informed d ns about financial position, managerial performance and economic vulnerability. Without auditors, decisions such as these are more likely to be made from biased financial information resulting from a business entity’s undisclosed errors, irregularities or illegal acts. IMPORTANCE OF AUDITED FINANCIAL STATEMENTS Audited financial statements are the accepted means by which business corporations report their operating results and financial position. The word audited, when applied to financial statements, means that the balance sheet and the statements of income, retained earnings, and cash flows are accompanied by an_audit report prepared. by independent public. accountants, expressing their professional opinion as to the faimess of the company’s financial statements. Of course, reporting in accordance with an agreed-upon set of accounting principles does not solve the problem by itself. Because the manager is responsible for reporting on the results of his or her own actions, which the absentee owner cannot directly observe, the manager is in a position to manipulate the reports. Again, the owner adjusts for this possibility by assuming that the manager will manipulate the reports to his or her benefit and by reducing the manager’s compensation accordingly. It is at this point that the demand for auditing arises. If the manager is honest, it may very well be in the manager's self-interest to hire an auditor to monitor and independently report to the owner on his or her activities. The owner likely will be willing to invest more in the business and to pay the manager more if the manager can be held accountable for how he or she uses the owner's invested resources.— Demand for Auditing and Assurance Services 7 Financial statements prepared by management and transmitted to outsiders without first being audited by independent accountants leave a credibility gap. In reporting on its own administration of the business, management can hardly be expected to be entirely impartial and unbiased. Independent auditors have no material personal or financial interest in the business; their reports can be expected to be impartial and free from bias. Unaudited financial statements may have been honestly, but carelessly, prepared. Liabilities may have been overlooked and omitted from the balance sheet. Assets may have been overstated as a result of arithmetical errors or due to a lack of knowledge of financial accounting and reporting standards. Net income may have been exaggerated because expenses were capitalized or because sales transactions were recorded in advance of delivery dates. Finally, there is the possibility that unaudited financial ‘statements have been deliberately falsified in order to conceal theft and fraud or as a means of inducing the reader to invest in the business or to extend credit. Although deliberate falsification of financial statements is not common, it does occur and can cause devastating losses to persons who make decisions based upon such misleading statements. For all these reasons (accidental errors, lack of knowledge of accounting principles, unintentional bias, and deliberate falsification), financial statements may depart from financial accounting and reporting standards principles. Audits provide users with assurance that the financial statements are presented in accordance with the financial accounting principles and reporting standards. Figure 1-1 presents an overview of the potential financial statement users and the decisions they make based on the financial reports.8 Chapter 1 re 1-1: Users of Audited Financial Statements Figu User Types of Decisions | Management Review performance, make operational decisions. Report results | to capital markets Stockholders __| Buy or sell stock Bondholders Buy or sell bonds Financial Institutions | Evaluate loan decisions, considering interest rates, terms, and isk Taxing Authorities Determine taxable income and tax due Regulatory Agencies | Develop regulations and monitor compliance Make collective bargaining decisions | Labor Unions Court System Assess the financial position of a company in litigation Vendors Assess credit risk Protect employees from surprises concerning pensions and other Retired Employees post-retirement benefits THE ASSURANCE ANALOGY AND THE PHILIPPINE STANDARDS ON AUDITING (PSAs) ‘An audit provides reasonable assurance of detecting material misstatements of the financial statements (both errors and fraud) and noncompliance with laws that have a direct and material effect on the determination of financial statement amounts. Although an audit does not obtain reasonable assurance of detecting noncompliance with laws that have only an indirect effect on the financial statements, the auditors remain alert for such situations. If instances of noncompliance are discovered, regardless of type, the auditors should ‘caréfully evaluate their effects on the financial statements. Currently, the International Auditing and Assurance Standards Board (AASB) issues pronouncements designed to foster the development of consistent worldwide auditing standards while the Auditing and Standards Practice Council of the Philippines (AASC) reviews and recommends for approval to the PRC- BOA their adoption as the Philippine Standards on Auditing (PSAs). In the Philippines, the law that regulates the Practice of Accountancy (RA 9298) provides that the Professional Regulatory Board of Accountancy shall monitor the conditions affecting the practice of accountancy and adopt such measures to enhance and maintain the high professional, ethical and auditing standards including promulgation of accounting and auditing standards, domestic andDemand for Auditing and Assurance Services _9 international. International financial markets would be facilitated if auditing and accounting standards were more uniform. In summary, auditing is in demand because it plays a valuable role in monitoring the contractual relationships between the entity and its stockholders, managers, employees, and debt holders. Certified public accountants have been charged with providing audit services because of their traditional reputation of competence, independence, objectivity, and concern for the public interest. As a result, they are able to add credibility to information produced and reported by management to outside parties. REVIEW QUESTIONS Questions 1. What is the objective of financial statement audit? Describe the role of external auditing in meeting society’s demands for unbiased financial and internal control information. 2. What is the “special function” that auditors perform? Whom does the external auditing profession serve in performing this special function? 3. What factors create a demand for an independent external audit? How does an audit enhance the quality of financial statements and management's reports on internal control? Does an audit guarantee a fair presentation of a company’s financial statements? 1 tise and significance of an audit report to a large 5. What is the principal small corporation with securities listed on a stock exchange? To a family-owned enterprise? Describe the several business situations that would create a need for a 6. report by an independent public accountant concerning the fairness of a company’s financial statements. 7. Explain the following statement: One contribution of the independent auditor is to lend credibility to financial statements.10 Chapter 1 8. A corporation is contemplating issuing debenture bonds to a group of investors. a. Explain how independent audits of the corporation’s financial statements facilitate this transaction. b. Describe the likely effects on the transaction if the corporation decides not to obtain independent audits of its financial statements. 9. Discuss the major factors in today’s society that have made the need for independent audits much greater that it was 50 years ago. 10. It has been stated that auditors must be independent because audited financial statements must serve the needs of a wide variety of users. If the auditor were to favor one group, such as existing shareholders, there might be a bias against another group, such as prospective investors. Do you agree? 11. Evaluate the following quotation: “Every business, large or small, should have an annual audit by a CPA firm. To forgo an audit because of its cost is false economy”. 12. The self-interest of the provider of financial information (whether an individual or a business entity) often runs directly counter to the interest of the user of the information.Chapter PROFESSIONAL PRACTICE OF ACCOUNTANCY: AN OVERVIEW Expected Learning Outcomes After studying the chapter, you should be able to: 1. Explain the attributes of a profession. 2. Describe who a professional accountant is. 3. Enumerate and explain the scope of the practice of professional accountants in the Philippines. 4. Describe the nature of assurance, attest, and auditing services of accounting professionals. 3 5. Describe the relationship among assurance, attest and auditing services. 6. Distinguish between external auditors, internal auditors, government auditors and forensic auditors. . Explain the nature of other audit services such as internal audit, compliance audits, operational audits and forensic audits. Describe the most sought-after non-assurance services such as ¢ Agreed upon procedures » Tax preparation and planning services * Management advisory services e Compilation, accounting and processing system services QL BS