Chapter 1

THE MEANING OF AUDIT

1.1 Definition and objective of audit:
• An audit is an official examination of the accounts (or accounting
systems) of an entity (by an auditor).
• The main objective of an audit is to enable an auditor to convey an
opinion as to whether or not the financial statements of an entity
are prepared according to an applicable financial framework.
• The applicable financial reporting framework is decided by:
•  legislation within each individual country, and
•  accounting standards (for example, International Accounting
Standards/International Financial Reporting Standards).
1.2 Concepts of accountability,
stewardship and agency:
• An audit of a company’s accounts is needed because in
companies, the owners of the business are often not the same
persons as the individuals who manage and control that business.
•  The shareholders own the company.
•  The company is managed and controlled by its directors.
• The directors have a stewardship role. They look after the assets
of the company and manage them on behalf of the shareholders.
In small companies the shareholders may be the same people as
the directors. However, in most large companies, the two groups
are different.
1.2 Concepts of accountability,
stewardship and agency:Cont….
• The relationship between the shareholders of a company and the
board of directors is also an application of the general legal principle of
agency. The concept of agency applies whenever one person or group
of individuals acts as an agent on behalf of someone else (the
principal). The agent has a legal duty to act in the best interests of the
principal, and should be accountable to the principal for everything that
he does as agent.
• As agents for the shareholders, the board of directors should be
accountable to the shareholders. In order for the directors to show their
accountability to the shareholders, it is a general principle of company
law that the directors are required to prepare annual financial
statements, which are presented to the shareholders for their approval.
1.3 The audit report: independence,
materiality and true and fair:
• An auditor reports to the shareholders on the financial
statements produced by a company’s management.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• The key features of the audit report are as follows:
•  The auditors producing the report are independent from
the directors producing the financial statements
•  The report gives an opinion on whether the financial
statements “give a true and fair view”, or “present fairly” the
position and results of the entity.
•  The report considers whether the financial statements give
a true and fair view in all material respects. The concept of
materiality is applied in reaching an audit opinion.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• Independence of the auditor
• The external auditor must be independent from the directors;
otherwise his report will have little value. If he is not
independent, his opinion is likely to be influenced by the
directors.
• In contrast to external auditors, internal auditors may not be
fully independent from the directors, although they may be able
to achieve a sufficient degree of independence.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• True and fair view (fair presentation)
• The auditor reports on whether (or not) the financial statements
give a true and fair view, or present fairly, the position of the
entity as at the end of the financial period and the performance
of the entity during the period. The auditor does not certify or
guarantee that the financial statements are correct.
• Although the phrase ‘true and fair view’ has no legal definition,
the term ‘true’ implies free from error, and ‘fair’ implies that there
is no undue bias in the financial statements or the way in which
they have been presented.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• In preparing the financial statements, a large amount of
judgement is exercised by the directors. Similarly, judgment is
exercised by the auditor in reaching his opinion. The phrases
‘true and fair view’ and ‘present fairly’ indicate that a judgement
is being given that the financial statements can be relied upon
and have been properly prepared in accordance with an
appropriate financial reporting framework.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• Materiality concept
• The auditor reports in accordance with the concept of materiality. He gives
an opinion on whether the financial statements present fairly in all material
respects the financial position and performance of the entity. Information is
material if, on the basis of the financial statements, it could influence the
economic decisions of users should it be omitted or misstated.
• For example, the shareholders of a company with assets of Rs.1 million will
not be interested if petty cash was miscounted with the result that the
amount of petty cash is overstated by Rs.100. This is immaterial. However,
they will be interested if there are receivables in the statement of financial
position of Rs.200,000 which are not in fact recoverable and which should
therefore have been written off as a bad debt.
1.3 The audit report: independence,
materiality and true and fair:Cont…
• Applying the concept of materiality means that the auditor will
not aim to examine every number in the financial statements.
He will concentrate his efforts on the more significant items in
the financial statements, either:
•  because of their (high) value, or
•  because there is a greater risk that they could be stated
incorrectly.
1.4 The statutory requirement for audit
• Most countries impose a statutory requirement for an annual
(external) audit to be carried out on the financial statements of
most companies.
• However, in many countries, smaller companies are exempt
from this requirement for an audit. Other entities, such as sole
traders, partnerships, clubs and societies are usually not
subject to a statutory audit requirement. Small companies and
these other entities may decide to have a voluntary audit, even
though this is not required by law.