COURSE TITLE: Audit Practice and Procedures I

COURSE NUMBER: ACT300

UNIT: 1

LECTURE NUMBER: 1

LECTURE TITLE: Overview of the Audit Function

This week’s focus will be on the audit function particularly as it relates to the importance of auditing.
Auditing is a very important function in both private and public enterprise. The concepts and techniques
you will learn in this course will be valuable to you whether you intend to become accountants or
business decision makers.

At the end of this lesson, you should be able to:

1. Define the term Auditing.

2. Discuss the historical evolution of the audit function.
3. Discuss the importance of auditing in maintaining the credibility of accounting records.
4. Describe the roles of auditors.
5. Explain how the functions of management integrate with the audit function.
6. Identify stakeholders who create the need for auditing a company’s financial statements.
7. Outline the importance of Audit firms in the auditing process.

Read for this lecture:

Arens, Elder, Beasley: Auditing and Assurance Services, an Integrated Approach, Tenth Edition: Pearson:
Prentice Hall. (Chapter 1)

Additional reading:

Kerr, Elder, Arens: Integrated Audit Practice Case: Third Edition: Armond Dalton Publishers, Inc. (Chapter
1)

Auditing is a very important function in both private and public enterprise. Let’s examine the concept
called auditing and its historical development.

Definition of Auditing

“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 users” (American Accounting
Association, 1973).

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Origins of Auditing

Auditing has evolved through a number of stages. In the mid-1800s to early 1900s, the audit practice
was considered as “traditional conformance role of auditing”. However, for the past 30 years, the
auditor has been playing an “enhancing role”. Today, auditors are expected not only to enhance the
credibility of the financial statement, but also to provide value-added services.

We will examine the historical development of auditing in these five chronological periods: (i) Prior to
1840; (ii) 1840s-1920s; (iii) 1920s-1960s; (iv) 1960s-1990s; and (v) 1990s–present.

i. Prior to 1840

Generally, the early historical development of auditing is not well documented. Auditing in the form of
ancient checking activities was found in the ancient civilizations of China, Egypt and Greece. The ancient
checking activities found in Greece (around 350 B.C.) appear to be closest to the present-day auditing.
Similar kinds of checking activities were also found in the ancient Exchequer of England. When the
Exchequer was established in England during the reign of Henry 1(1100-1135), special audit officers
were appointed to make sure that the state revenue and expenditure transactions were properly
accounted for (Gul, et al.,1994, p. 1). In a nutshell, in the period pre-1840, the auditing at the time was
restricted to performing detailed verification of every transaction. The concept of testing or sampling
was not part of the auditing procedure. The existence of internal control is also unknown. Fitzpatrick
(1939) commented that the audit objective in the early period was primarily designed to verify the
honesty of persons charged with fiscal responsibilities.

ii. 1840s-1920s

The practice of auditing did not become firmly established until the advent of the industrial revolution
during the period 1840s-1920s in the United Kingdom (UK). In response to the socio-developments in
the UK during this period, the Joint Stock Companies Act was passed in 1844. The Joint Stock Companies
Act stipulated that “Directors shall cause the Books of the Company to be balanced, and a full and fair
Balance Sheet to be made up”. In addition, the Act provided the appointment of auditors to check the
accounts of the company. Porter, et al (2005) commented that the duties of auditors during this period
were influenced by the decisions of the courts. For example, the verdicts from the case of London and
General Bank (1985) and Kingston Cotton Mill (1896) reinforced that the audit objective was detection
of fraud and errors. It can be concluded that the role of auditors during the period of the 1840s-1920s
was mainly on fraud detection and the proper portrayal of the company’s solvency (or insolvency) in the
balance sheet.

iii. 1920s-1960s

The growth of the US economy in the 1920s-1960s had caused a shift of auditing development from the
UK to the USA. In the years of recovery following the 1929 Wall Street Crash and ensuing depression,
investment in business entities grew rapidly. As companies grew in size, the separation of the ownership
and management functions became more evident. Hence to ensure that funds continued to flow from

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investors to companies, and the financial markets functioned smoothly, there was a need to convince
the participants in the financial markets that the company’s financial statement provided a true and fair
portrayal of the relevant company’s financial position and performance (Porter, 2005). The social-
economic condition in the period had highly influenced the development of auditing. As highlighted by
Porter, et al (2005) the major characteristics of the audit approach during this period, among others,
included: (i) reliance on internal control of the company and the use of sampling techniques; (ii) audit
evidence was gathered through both internal and external source; (iii) emphasis on the truth and
fairness of financial statements; (iv) gradual shift to the audit of Profit and Loss Statement but Balance
Sheet remained important; and (v) physical observation of external and other evidence outside the
“book of account”.

iv. 1960s to 1990s

The world economy continued to grow in the 1960s-1990s. This period marked an important
development in technological advancement and the size and complexity of the companies. Auditors in
the 1970s played an important role in enhancing the credibility of financial information and furthering
the operations of an effective capital market (Porter, et al., 2005). According to Porter, et al (2005),
most of the companies in this period had introduced computer systems to process their financial and
other data, and to perform, monitor and control many of their operational and administrative processes.
Similarly, auditors placed heavy reliance on the advanced computing auditing tool to facilitate their
audit procedures. In addition to the auditing of financial statements, auditors at the same time were
providing advisory services to the audit clients.

v. 1990s-present

The auditing profession witnessed substantial and rapid change since 1990s as a result of the
accelerating growth at the world economies. According to Porter et al (2005), present-day auditing has
developed into new processes that build on a business risk perspective of their clients. Since the early
1990s, the audit profession began to take increased responsibility to detect and report fraud and to
assess, and report more explicitly, doubts about an auditee’s ability to continue in conformance with
society’s and regulators’ increasing concern about corporate governance matters. Although the overall
audit objectives in the present period remain the same, i.e. lending credibility to the financial statement,
critical changes have been made to the audit practice as a result of the extensive reform in various
countries. Leung, et al (2004, p. 24) is of the opinion that such reform has implicated the auditing
profession in the following ways: “(i) The role of auditors is expected to converge: refocusing on the
public interest, redefining audit relationship, ensuring integrity of financial reports, separation of non-
audit function and other advisory services; (ii) The audit methods revert to basics i.e. risk attention,
fraud awareness, objectivity and independence, and (iii) increased attention on the needs of financial
statement users”.

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Definition and Scope

Earlier we defined the term auditing based on the American Accounting Association’s definition.
Generally though, the function of auditing is to lend credibility to the financial statements. The financial
statements are the responsibility of management and the auditor’s responsibility is to lend them
credibility. By the audit process, the auditor enhances the usefulness and the value of the financial
statements, but he also increases the credibility of other non-audited information released by
management. The purpose of an audit is to provide an objective independent examination of the
financial statements, which increases the value and credibility of the financial statements produced by
management, thus increasing user confidence in the financial statement, reducing investor risk and
consequently reducing the cost of capital of the preparer of the financial statements.

Roles of auditors

It is an established rule that auditors are to play a vigilant and objective role in ensuring that the
shareholders' interests are well protected and that the management of the company have acted within
reason. It is the shareholders who primarily depend on the good faith and efficiency of the company's
auditor to ensure that the company's actions in the day-to-day operations are verified.

Functions of management and the audit function

Management’s responsibility is the underlying foundation on which audits are conducted. Simply put,
without management having responsibility for the financial statements, the line of segregation that
determines the auditor’s independence and objectivity regarding the client and the audit engagement
would not be as clear. The auditor’s responsibility is to express an independent, objective opinion on the
financial statements of a company. This opinion is given in accordance with auditing standards that
require the auditors to plan certain procedures and report on the results of the audit, while considering
the representations, assertions and responsibility of management for the financial statements.

Stakeholders in auditing

Auditors have a variety of stakeholders who rely on their work. These include: the board of directors;
the audit committee; the chief executive officer; senior executives such as the chief financial officer,
chief information officer, chief risk officer, regulatory bodies; and stockholders—who, in the case of
government organisations, could be the public.

All these stakeholders are seeking assurance that the organisation is running well, and that effective
controls are in place and operating properly. Auditors have an important role to play in providing
assurance to these stakeholders.

Audit firms’ role

External auditors play a critical role in validating company financial information. Potential lenders and
investors often require externally audited financial statements before doing business with a company. If

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a party discovers that an auditor failed to detect material misstatements, it reflects poorly on the firm
and the profession in general. For that reason, various accounting bodies release auditing standards and
expectations to define the role of external audit firms. Let’s examine a few of these standards:

a. Providing an Opinion on Financial Statements

External audit firms are responsible for providing reasonable assurance that the financial statements are
free from material misstatements and prepared according to an accounting framework. External
auditors are not there to fix the problems, although many will issue recommendations to management.
External audit firms also are not responsible for providing absolute assurance of perfect financial
statements; they only test enough data to provide reasonable assurance.

b. Understanding the Entity and Its Environment

External auditors are charged with obtaining a thorough understanding of their client's environment,
operations and internal controls. To do this, auditors will perform an initial risk assessment of the
company. External auditors will often examine the electronic accounting information system to ensure
that the data aren't being compromised. They'll compare the company to others in the industry to
identify any irregularities that could stem from incorrect financial reporting.

c. Obtaining Sufficient Evidence to Form an Opinion

External auditors base a huge portion of their opinion on the evidence they examine during the audit. To
ensure they've collected sufficient amount of evidence, auditors should rate the riskiness of the client.
The higher risk the client is, the more evidence they should collect before issuing an opinion. The quality
of the evidence is also crucial. Some evidence must be obtained from reliable third-party sources, such
as banks and lenders, to corroborate the client's financial information.

d. Independence

The audit firm is responsible for maintaining an independent attitude and an appearance of
independence from the client. A lack of independence means that the auditor might fail to address audit
problems, which lowers the credibility and assurance of an external audit. The auditor should not serve
as an officer for the client or participate in management of the client's company. Audit firms also should
not have any sort of financial interest in the client. Audit firm partners should ensure that none of their
auditors have joint ventures or significant investments in the client before auditing the client.

Summary of Lecture

Auditing is a organised method of impartially obtaining, evaluating and reporting on evidence regarding
the economic activities of a company. Auditing has evolved over the past decade from a simply checking
routine to a more value added activity for organizations. Auditors are relying on advances in technology

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to aid in the auditing process and provide efficiency to their tasks. The purpose of an audit is to provide
an objective independent examination of the financial statements. It is the responsibility of
management to prepare the financial statement and ensure that the objectives of the company are
achieved, while the auditor’s responsibility is to express an independent, objective opinion on the
financial statements of a company. External audit firms are responsible for providing reasonable
assurance that the financial statements are free from material misstatements and prepared according to
an accounting framework.

Terminology:

Sampling techniques - methods of selecting a pre-defined representative number of data from a larger
data population.

Books of accounts – this is where an individual or a company store all their financial information, for
example a journal.

Auditee – a person or entity that is being audited.

Financial statement – these are records that show the financial activities of a business or an individual.

Internal Control - a process for assuring achievement of an organization's objectives in operational

effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations and
policies.

Material misstatement - accidental or intentional untrue financial statement information that

influences a company’s value or price of stock.

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