Chapter 1

Assurance and Auditing:

An Overview

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Learning objectives
1.1 Understand the framework for assurance engagements and the structure of
assurance standards and pronouncements.
1.2 Define auditing and appreciate the fundamental principles underlying an
audit.
1.3 Appreciate the attributes of accounting information.
1.4 Understand the reasons giving rise to demand for assurance and appreciate
the relationship between the auditor, the client and the public.
1.5 Appreciate the evolution of the audit function
1.6 Explain the concept of the expectation gap, especially in the areas of
auditors report messages, corporate failures, fraud and communicating
different levels of assurance.
1.7 Appreciate the role of auditing standards and the audit commitments under
the Corporations Act 2001.
1.8 Appreciate other applications of the assurance function

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Learning objective 1.1

The framework for assurance
engagements
Many parties provide reports to users as an
aid to making decisions.
Reports are potentially biased due to the
vested interests of the report providers.
Users may demand that the credibility of the
report be enhanced by having an independent
expert examine it.
Financial statements are just one typethe
most commonof report that can be assured.
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Definition of assurance engagement

Assurance engagement:
an engagement in which an assurance practitioner
expresses a conclusion designed to enhance the degree of
confidence of the intended users other than the responsible
party about the outcome of the evaluation or measurement of
a subject matter against criteria.

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Diagram of assurance engagement

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Five elements of assurance

engagement
1. Three-party relationships:
assurance practitioner (auditor)
responsible party (preparer)
intended user
2. Subject matter
3. Suitable criteria
4. Sufficient appropriate evidence
5. Written assurance report
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Why is there value in the assurance

service?
Independence
Users derive value from the knowledge
that the assurance provider has no interest
in the information other than for its
usefulness.
Expertise
Assurers must have the competence to
obtain sufficient relevant information to
provide a reasonable basis for their
conclusions.
Requires professional judgement and1-7

Expertise: Professional judgment

and professional scepticism
Professional judgement
Users derive value from the knowledge
that the assurance provider has no interest
in the information other than for its
usefulness.
Professional scepticism
An attitude that includes a questioning
mind, being alert to conditions indicating
possible misstatement and critically
assessing audit evidence.
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Levels of assurance
For any subject matter, two levels of
assurance can be provided:
reasonable assurance
limited assurance.

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Reasonable assurance (Figure 1.3)

(cont.)
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Limited assurance (Figure 1.3 cont.)

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Level of assurance on financial

statements
Reasonable assurance engagements are
commonly called 'audit engagements'.
Reasonable assurance = positive expression
of opinion.
Limited assurance engagements are
commonly called 'review engagements'.
Limited assurance = negative expression of
opinion.
There are also engagements that provide
no assurance:
Agreed-upon procedures engagements
where auditor reports their findings and 1-12

Attest vs. direct reporting

Audit and review engagements can involve
either an attest or a direct reporting
engagement.
Attest reporting engagement
The auditor issues an opinion on written
assertions made by the party responsible for
the subject matter.
Direct reporting assurance engagement
The auditor issues an opinion directly on the
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subject

Learning objective 1.2

Auditing: Definition and
fundamental principles
A Statement of Basic Auditing Concepts
(ASOBACthe American Accounting
Association) defines 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 users.

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Auditing defined (cont.)

The important parts of this definition:
Systematic processaudits are structured
activities.
Objectivityfreedom from bias.
Obtaining and evaluating evidenceallows
the auditor
to determine the support for assertions or
representations.
Assertions about economic actions and
eventsdescribes the subject matter of an
audit.
Degree of correspondence established
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criteria the purpose of the audit is to

Fundamental principles underlying

an audit
The International and Australian Auditing
Standards Boards released a draft paper in
which they outlined possible fundamental
principles underlying an audit. These
principles should:
underpin the objective(s) of an audit and
help
drive the conduct of the auditor in using
professional judgment to meet the
professional requirements
of the auditing standards
be easily understood, both by auditors and
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other

Ethical principles
Contained in national and international codes
of ethics:
integrity
objectivity
professional competence and due care
confidentiality
professional behaviour
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Fundamental auditing principles

Knowledge
Responsibility
Quality control
Rigour and scepticism
Professional judgment
Evidence
Documentation
Communication
Association
Reporting
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Learning objective 1.3

Attributes of accounting information
From AASB/IASB framework, the following four
attributes of accounting information provide the
basis for the audit function:
relevance
reliability
comparability
true and fair presentation.
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Learning objective 1.4

Demand for assurance and
auditor-client public relationship
Demand arises because users are not in a
position
to establish the credibility of the information they
are presented with. This may be due to:
Conflict of interestmanagers may present
biased information, as they are also
evaluated on the information.
Consequenceinformation provided forms
the basis
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of many users decisions.

Other benefits of assurance

An assurance service may also result in one or both
of the following:

recommendations by the assurance provider to improve the

efficiency and effectiveness of operations, and/or
a positive influence on the behaviour of people whose
activities are being assured.

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The auditorclientpublic relationship

The auditors primary reporting responsibility
is to resource providers of the client entity;
however, the client entity usually engages the
auditor and pays the auditors fees.
The auditor also discusses the audit findings
with management prior to releasing information
to the resource providers.
In order to combat pressures on independence
and objectivity, the auditing profession has
issued a series of ethical rulings and
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professional standards to guide the auditor in

Learning objective 1.5

The evolution of the audit function
Audits have been performed since at least the thirteenth
century.
Until the early 1900s, audits focused on a companys
solvency and the detection of fraud and error.
Audits from early 1900s to 1940sadded objectives of
verification of financial report accuracy and attestation to
financial report credibility.
Since the 1940s, the overall objective of auditing
has been the expression of an opinion as to
whether the financial report is materially misstated.

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Approaches to auditing
These have evolved over time:
Statement of financial position approachthis involved the
auditor auditing the assets and liabilities with little emphasis on
profit and loss account items.
Transactions cycle approachthis emphasised
the review of controls that operated within each transaction cycle
and provided for limited testing of balance sheet items.

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More recent audit approaches

Financial risk approach
The auditor considers relative financial risk
and materiality in planning the audit, such
that audit work is concentrated in areas
where there is a higher risk of
misstatement.
Business risk approach (audit risk
approach)
As well as financial risk, the auditor
considers business strategy, associated
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business risks and managements plans to

Example of business risk approach

Refer Example 1.1 on page 13 of textbook.
The auditor uses a risk-based assertion-based methodology in
undertaking the audit. For example, the assertions that
management are implicitly making by recording an inventory
balance of $1 million in the statement of financial position are:
inventory of $1 million exists (existence)
the entity has the rights of ownership of this inventory (rights and
obligations)
all inventory that should have been recorded has been recorded
(completeness)
inventory has been recorded in the financial report at the
appropriate value, and any resulting valuation adjustment (such as
obsolescence) has been correctly recorded (valuation and
allocation).

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Example of business risk approach (cont.)

The auditor uses a risk-based methodology to identify risks of
misstatement and relates these through to assertions (Chapters
68). For example, consider that the auditor identifies major risk
as entity wishing to overstate profit. They can achieve this by
overstating inventory, which understates cost of goods sold (if
goods are in inventory, they are not sold). The auditor assesses
how the entity is likely to achieve this overstatement, and
concentrates their audit attention on the related assertions.
In this example, two ways of achieving overstatement of
inventory are to include inventory that does not exist (for
example, goods that have been sold) or overstate valuation of
the inventory items included in the statement of financial
position (valuation and allocation). The auditor then uses
specific procedures to test assertions at risk (Chapters 9-11).

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Learning objective 1.6

Expectation gap
Defined as: the gap between societys
expectations of auditors and auditors
performance as perceived by society.
There are three components of the expectation
gap:
1. The reasonableness gap between what
society
expects auditors to achieve and what they
can
reasonably be expected to accomplish.
2. The performance gap arising from
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The gap between audit expectation

and audit performance

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Four major issues in the

expectation gap
1. The nature and meaning of auditors report
messages.
2. Early warning by auditors of corporate
failure.
3. Auditors responsibility for the detection and
reporting of earnings management and
fraud.
4. The auditors ability to communicate
different levels of assurance.

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Learning objective 1.7

Role of auditing standards and audit
commitments under Corporations Act 2001

Auditing standards in Australia are developed

by the Auditing and Assurance Standards
Board (AUASB).
The standards prescribe the basic principles
and essential procedures governing the
conduct of an auditor.
For audits conducted under the Corporations
Act 2001, the auditing standards (ASAs) must
be applied, thus giving them legal authority.
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The role of auditing standards (cont.)

Guidance Statements (GSs) or Auditing
Guidance Statements (AGSs): provide
guidance on procedural matters or industryspecific issues, but do not establish new
principles or amend existing standards.
Professional obligations extend application of
standards to all other audit and assurance
engagements by members of professional
bodies.

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Authority of auditing standards

Failure to observe these standards may expose a member to
investigation and disciplinary action from the Australian
Securities and Investments Commission (ASIC).
Auditing standards applying to audits and reviews of financial
reports prepared in accordance with the Corporations Act 2001:
Australian auditing standards relating to these audits are now
designated as ASAs, and have the same numbering as the
equivalent ISAs.
Note: there are still a number of standards designated as AUSs,
which relate to frameworks or assurance engagements on other
than financial reports prepared in accordance with the Corporations
Act 2001.

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Figure 1.2:
Structure of assurance standards and pronouncements

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Audit responsibilities under the

Corporations Act 2001
Management is responsible for the preparation
and presentation of appropriate accounts.
Accounts are to be accompanied by a report of
an independent auditor appointed by the
shareholders.
The Corporations Act 2001 (ss 292306)
indicates that directors must prepare a financial
report (income statement, balance sheet,
statement of changes in equity cash flow
statement, directors declaration
and other related notes and reports), together
with any other information or explanation 1-35

Auditors responsibilities under

the Corporations Act 2001 (cont.)
Auditors are responsible for reporting to
company members on the directors financial
report presented at the AGM.
They say whether the financial report:
is in accordance with the law, including
compliance
with accounting standards (s 296)
provides a true and fair view (s 297).
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Learning objective 1.8

Other applications of the
assurance function
Evidence-gathering methods of auditing are
also employable in the audit of activities other
than financial reports.
Compliance audit
Examination for the purpose of reporting on
legality and control of operations.
Performance audit
Analyses organisation structure, internal
systems, workflow and managerial
performanceefficiency, effectiveness 1-37
and

Other applications of the

assurance function (cont.)
Comprehensive audit
Usually includes components of compliance,
performance and financial report audits.
Internal audit
Audits performed by employees of the entity
as a part of the entitys risk management
process.
Forensic audit
Associated many times with fraud detection.
Assurance on subject matter other than
historical financial information
Including prospective financial information,
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internal controls, and sustainability and

Summary
Assurance engagement by independent
expert enhances users confidence in report
Assurance can be applied to:
financial reports
prospective financial information
reports on internal controls
reports of an entitys carbon emissions.

Audit principles, concepts and methods

can be applied to assurance services
other than financial report assurance for
all types of entities including private,
public and not-for-profit entities.
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