Chapter 2

An overview of the postulates
and concepts of auditing
Chapter 2
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LEARNING OBJECTIVES
After studying this chapter you should be

able to:
• Explain how auditing theory, concepts and

principles underpin auditing practice.
• Identify the basic postulates of auditing and
explain why they are important.
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LEARNING OBJECTIVES CONT'D
• Define auditing concepts under the general

headings of credibility of the auditor, process
of audit, communication by the auditor and
performance of the auditor’s work.
• Explain the implications of truth and fairness

in relation to financial statements and the work
of the auditor.
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LEARNING OBJECTIVES CONT'D
• Define the audit expectations gap and identify

its components.
• Understand that the regulatory framework of

auditing provides the criteria by which audits
are conducted and encompasses the
concepts of auditing.
• Recognize how organizations attempt to

control their internal environment in the
context of external influences.
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KEY POINTS – p.29
Theories underpin practice.

Mautz and Sharaf (1961) suggest that a philosophy
has three aspects of value:
(1) it gets back to first principles;
(2) systematic organization of knowledge; and
(3) provides a basis for moulding and understanding
social relationships.
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KEY POINTS – p.29 CONT'D
Postulates are essential to the development of an

intellectual discipline and are the foundation for any
theoretical structure.
Postulates are not theories but are the necessary
basis for theory; assumptions that do not lend
themselves to direct verification, but are a basis for
inference, even if susceptible to challenge later.
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KEY POINTS – pp.29–31
The chapter discusses two postulates formulated

by Flint:
(a) ‘The subject matter of audit … is susceptible to
verification by evidence’;
(b) ‘Essential distinguishing characteristics of audit

are the independence of status and freedom
from investigatory and reporting constraints.’
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ACTIVITY 2.1
One of the postulates formulated by Flint reads

as follows:
‘The subject matter of audit … is susceptible
to verification by evidence.’
In other words, it is possible to find evidence to
prove what you want to prove.
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ACTIVITY 2.1 CONT’D
1 As a starting point, do you believe that this

postulate is important in the context of audit?
2 Do you believe that the postulate will by and
large hold true?
3 Are there any circumstances where it might
not hold true, and, if so, what conclusions
might you draw as a consequence?
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ACTIVITY 2.2
Another postulate of auditing formulated by Flint

reads as follows:
‘Essential distinguishing characteristics of
audit are the independence of its status and
its freedom from investigatory and reporting
constraints.’
In other words, the auditor has to be free from
any relationships with the company, its
management and its user groups that would
threaten the credibility of the auditor’s report.
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Auditors are allowed freedom in their search for

evidence and the way in which they report. Now
consider the following questions:
1 What do you think is meant by ‘independence of

status’ in practical terms?
2 Why do you think that it is important?
3 Do you think that the above postulate is a helpful
starting point for recognizing that auditor
independence is a vital element in making the audit
report believable?
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KEY POINTS – p.31
A postulate may not hold good for ever.

One example from Mautz and Sharaf, that
‘There is no necessary conflict of interest
between the auditor and the management of
the enterprise under audit’
may no longer be valid.
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ACTIVITY 2.3
Consider the above postulate, remember that it

was formulated more than 50 years ago, and
suggest why you think that Mautz and Sharaf
included it in their list of tentative postulates.
Decide if it is a valid postulate today.
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TABLE 2.1 Flint’s audit postulates
Postulate
1 The primary condition for an audit is that there

is a relationship of accountability or a situation of
public accountability.
2 The subject matter of accountability is too

remote, too complex and/or of too great a
significance for the discharge of the duty to be
demonstrated without the process of audit.
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TABLE 2.1 CONT’D
3 Essential distinguishing characteristics of audit

are the independence of its status and its
freedom from investigatory and reporting
constraints.
4 The subject matter of audit, for example,

conduct, performance or achievement or record
of events or state of affairs or a statement of fact
relating to any of these, is susceptible to
verification by evidence.
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TABLE 2.1 CONT’D
5 Standards of accountability, for example, conduct,

performance, achievement and quality of information,
can be set for those who are accountable: actual
conduct, etc. can be measured and compared with
these standards by reference to known criteria and
the process of measurement and comparison
requires special skill and judgement.
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TABLE 2.1 CONT’D
6 The meaning, significance and intention of financial

and other statements and data, which are audited,
are sufficiently clear that the credibility given thereto
as a result of audit can be clearly expressed and
communicated.
7 An audit produces an economic or social benefit.
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KEY POINTS – p.32
Mautz and Sharaf also suggest that:

‘Concepts provide a basis for advancement
in the field of knowledge by facilitating
communication about it and its problems.’
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TABLE 2.2 Concepts of auditing
Group Concept
Credibility Competence
Independence
Integrity and ethics
Process Risk
Evidence
Audit judgement
Materiality
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TABLE 2.2 CONT’D
Group Concept
Communication Reporting
Truth and fairness
Association
Performance Due care

Standards
Quality control
Rigour
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There are four parties to the accountability/audit

process:
1) preparer/source;
2) users of accounting information;
3) auditor; and
4) regulatory framework.
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Figure 2.1 Communication of accounting information
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KEY POINTS – p.37
There is a close relationship between accountability

and audit, as accounts cannot become a tool of
accountability until an independent auditor has
examined and reported on them.
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ACTIVITY 2.4
Consider the figure of stock appearing in the

balance sheet of a company.
Identify the assertions that management might
implicitly make about stock by including it in the
financial statements.
Suggest how such identification may aid the audit
process.
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ACTIVITY 2.5
Taking the assertion ‘The stock exists’, what

evidence would you seek to prove this assertion?
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KEY POINTS – p.40
Credibility is about whether people believe

auditors when they report.
Credibility concepts concern the personal qualities
of auditors:
• competence;
• independence;
• integrity and ethics.
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ACTIVITY 2.6
Assume that you are auditing the transfers from

the main cash fund to the petty cash fund of an
organization. To your surprise you find an entry
for £500 in the cash book, described as ‘Transfer
to petty cash’, but you can find no receipt in the
petty cash book. You check that the £500
appears in the bank statement on the day the
entry was made in the cash book. You suspect
that the cashier may have pocketed the amount
in question.
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ACTIVITY 2.6
You discuss this with your immediate superior,

but he tells you to ignore it as the cashier is a
long-term employee of the client and is,
moreover, a personal friend.
1 What would you do?

2 Does this case help you to understand what an
ethical dilemma is?
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Ethical dilemmas arise where damage will be

caused to someone whatever you do; they require
analysis of the situation, consideration of possible
actions and consequences, and a firm decision.
Auditors should comply with ethical guidance
issued by their relevant professional bodies.
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Process is concerned with how audits are

performed, with:
(a) seeking evidence to prove assertions by
management;
(b) evaluating the risk;
(c) making judgements and assessments of
significant matters.
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ACTIVITY 2.7
Assume that a company in the engineering

industry is replacing a lathe. The previous lathe
had a useful economic life of ten years and the
company wrote it off in ten equal instalments.
The new lathe has a number of new features,
including electronic guidance, and operates
much more efficiently and quickly than the
previous lathe. The company wishes to write it off
over ten years, as was the case for the previous
lathe.
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You have to make a judgement as to whether the
company’s policy is appropriate.
1 What evidence would you seek?
2 Do you think you would be able to conclude
that the assertion of a ten-year life is valid
on the basis of available evidence?
3 What do you think would be the critical
factor in making a judgement about this
matter?
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ACTIVITY 2.8
Assume that a company has a profit in its draft

financial statements of £1,000,000. During your
audit you find an error in the calculation of stocks
resulting in a reduction in stock of £75,000.
Do you think that the misstatement would

reasonably influence the decisions of an
addressee of the auditors’ report? In other words,
would addressees think differently about the
company if its profit was restated to £925,000?
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Communication concerns the manner in which and

to whom auditors communicate their views to other
parties, whether formally or informally.
Truth and fairness is an important element, but
has never been defined; basically it is about the
validity of the message given by the financial
statements.
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Performance concerns several issues:

• that auditors are expected to perform their
work with due care;
• in accordance with accepted standards and;
• with rigour (encompassing ‘professional

scepticism’).
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KEY POINTS – p.46
The ‘audit expectations gap’ is used to describe

The difference between the expectations of those
who rely upon audit reports concerning what
auditors do and what they are perceived to do.
The gap consists of:
1) reasonableness gap; and
2) performance gap.
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The reasonableness gap arises because people

expect more of audit than is possible practically.
The performance gap is that between what can
reasonably be expected of auditors and what they
are perceived to do, and has two components:
1) deficient standards gap;
2) deficient performance gap.
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Figure 2.2 Structure of the audit expectation-performance gap
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KEY POINTS – p.48
Layers of regulation and control are described

under two headings:
(a) external environment;
(b) internal environment.

‘Layers of regulation and control’ indicate that
regulation and control operate at different levels
both outwith and within a company.
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Figure 2.3 Layers of regulation and control
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KEY POINTS – p.48
The external environment includes all commercial

relationships the company has with competitors,
customers and suppliers.
It includes other companies with which it
cooperates, and providers of funds.
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The external environment is a vitally important

factor influencing the kinds of controls and
management’s approaches to them within the
internal environment of companies.
Corporate governance refers to structures within
a company or imposed by society to control how
companies are governed.
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ACTIVITY 2.9
Annets Ltd produces toxic waste as a by-product of a

production process and stores it in a special warehouse
about one mile from a small town. The people living in the
town have recently expressed doubt about the safety of the
storage facility but the company claims that the risks are
lower than those that government regulations permit.
1 What are the issues you would wish to consider in this

case?
2 What questions would you ask?
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KEY POINTS – p.51
The regulatory framework comprises controls

imposed by a wide range of bodies including
parliament, stock exchanges, accounting and
other bodies of the European Union, or even
from outside the European Union.
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Commercial pressures in the external environment

are important because the way the market behaves
will have an impact on company performance and
the way in which companies control themselves.
The external environment is also vital in influencing
the kinds of controls, and management’s
approaches to them, within the internal environment
of a company.
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CHAPTER SUMMARY
This chapter has introduced:

• A structure for understanding the audit process;
• How an understanding of the assumptions and

ideas underpinning auditing is necessary if the
practical discipline of auditing is to be
successfully pursued;
• An overview of auditing postulates, basic
assumptions and auditing concepts;
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CHAPTER SUMMARY CONT'D
• One of the credibility concepts of auditing –

independence;
• Audit expectations gap and regulation;
• Corporate governance, regulation and controls

in companies.
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FURTHER READING
Auditing Practices Board (1994) The Audit

Agenda, APB, December.
Auditing Practices Board (1996) The Audit Agenda
Next Steps, APB, reprinted in Accountancy, April
1996, pp. 134–137.
Institute of Chartered Accountants of Scotland
(1993) Auditing into the Twenty-First Century,
ICAS.
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FURTHER READING
Bell, B.B., Marrs, F.O., Solomon I., Thomas, H. (1997)
Auditing Organizations Through a Strategic-Systems Lens,
KPMG Peat Marwick LLP.
Bell, T.B., Peecher., M.E. and Solomon, I. (2005) The 21st
Century Public Company Audit, Conceptual Elements of
KPMG’s Global Audit Methodology, KPMG International.
Cadbury, A. (1990) ‘The Corporate Governance Agenda’,
Corporate Governance, 8(1): 7–15.
Moizer P. (1991) ‘Independence’, in M Sherer and S Turley
(eds), Current Issues in Auditing, 3rd edn, London: Paul
Chapman Publishing Ch. 3.
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An overview of the postulates

and concepts of auditing

After studying this chapter you should be

• Explain how auditing theory, concepts and

• Define auditing concepts under the general

• Explain the implications of truth and fairness

• Define the audit expectations gap and identify

• Understand that the regulatory framework of

• Recognize how organizations attempt to

Theories underpin practice.

Postulates are essential to the development of an

The chapter discusses two postulates formulated

(b) ‘Essential distinguishing characteristics of audit

One of the postulates formulated by Flint reads

1 As a starting point, do you believe that this

Another postulate of auditing formulated by Flint

Auditors are allowed freedom in their search for

1 What do you think is meant by ‘independence of

A postulate may not hold good for ever.

Consider the above postulate, remember that it

Decide if it is a valid postulate today.

1 The primary condition for an audit is that there

2 The subject matter of accountability is too

3 Essential distinguishing characteristics of audit

4 The subject matter of audit, for example,

5 Standards of accountability, for example, conduct,

6 The meaning, significance and intention of financial

7 An audit produces an economic or social benefit.

Mautz and Sharaf also suggest that:

Performance Due care

There are four parties to the accountability/audit

2) users of accounting information;

There is a close relationship between accountability

Consider the figure of stock appearing in the

Taking the assertion ‘The stock exists’, what

Credibility is about whether people believe

• integrity and ethics.

Assume that you are auditing the transfers from

You discuss this with your immediate superior,

1 What would you do?

Ethical dilemmas arise where damage will be

Process is concerned with how audits are

Assume that a company in the engineering

Assume that a company has a profit in its draft

Do you think that the misstatement would

Communication concerns the manner in which and

Performance concerns several issues:

• in accordance with accepted standards and;

• with rigour (encompassing ‘professional

The ‘audit expectations gap’ is used to describe

The reasonableness gap arises because people

2) deficient performance gap.

Layers of regulation and control are described

(b) internal environment.

The external environment includes all commercial

The external environment is a vitally important

Annets Ltd produces toxic waste as a by-product of a

1 What are the issues you would wish to consider in this

2 What questions would you ask?

The regulatory framework comprises controls

Commercial pressures in the external environment

This chapter has introduced:

• How an understanding of the assumptions and