The Audit Process 4th Edition

Why are auditors needed?
Chapter 1
Use
Use with The withProcess:
Audit The AuditPrinciples,
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by Iain Gray & Stuart Manson ISBN 9781844806782
1-86152-946-5
© 2005
2008 Thomson
Cengage Learning
LEARNING OBJECTIVES
After studying this chapter you should be

able to:
• Understand in general what an audit is and put into

context some basic audit techniques.
• Explain what kind of person should carry out an
audit.
• Suggest the kinds of people who will benefit from

an audit.
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By Iain By
Third Edition Gray
by Iain
& Gray
Stuart&Manson
Stuart Manson
ISBN 9781844806782
ISBN 9781844806782
1-86152-946-5
© 2005
2008 Thomson
Cengage Learning
LEARNING OBJECTIVES CONT'D
• Form a view on the kind of information that might be

prepared by those having control of resources held
on behalf of others.
• Recognize the theoretical considerations

underpinning audit practice.
• Explain the wider setting of an audit.
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Third Edition & Gray
by Iain Stuart&Manson ISBN 9781844806782
Stuart Manson ISBN 1-86152-946-5
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2008 Thomson
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KEY POINTS – pp.2–3
Auditing has become headline news after recent

corporate scandals, and the competence and
independence of auditors have been questioned,
focusing attention on the purpose of audit and the
way in which companies are managed.
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Several important auditing issues are considered

through the Andrew and James case:
(a) the distinction between the position of
manager and of owner not involved in
management;
(b) audit as a search for evidence;
(c) the use of simple procedures to test
management assertions;
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KEY POINTS – pp.4–7 CONT'D
(d) the idea that information breeds information;

(e) the importance of management integrity;
(f) professional scepticism;
(g) the distinction between personal and business
expenses;
(h) the role of the accounting system in achieving
accurate bookkeeping;
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(i) the use of information from an independent

source; and
(j) actual personal experience as a valuable
source of evidence.
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ACTIVITY 1.1
Try to answer the following two questions before

reading on:
1 What was James’ position in relation to that

of Andrew in the summer of 2005?
2 If you were James, what would you do now?
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ACTIVITY 1.2
On the basis of your review, make a list of the

matters you would like to raise with Andrew on
James’ behalf.
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KEY POINTS – p.9
Three justifications of audit are:

• the information hypothesis;
• agency theory;
• the insurance hypothesis.
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KEY POINTS – pp.9–10 CONT’D
The information hypothesis suggests auditors are

needed because information becomes more reliable
as the result of audit, and is therefore more useful to
decision makers.
Agency theory suggests audit is justified because

providers of resources cannot trust managers to
use resources properly on their behalf.
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Basic ideas behind of agency theory are:

(a) principals and agents both try to maximize their
own wealth;
(b) a monitoring mechanism in the form of a

financial report is required, and is advantageous
to both principals and agents;
(c) different groups of rational individuals have

different information, allowing informed
individuals to profit at other’s expense;
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(d) agents recognize that principals will be more

willing to believe performance reports if verified
by an independent party;
(e) professional external auditors are the most

cost-effective monitoring device.
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KEY POINTS – p.10
The insurance hypothesis suggests that the auditor

can provide insurance to people relying upon the
audited information, as they can recover damages
from negligent auditors.
A successful damages claim against the auditor
is effectively the equivalent of a successful claim
against an insurance company.
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ACTIVITY 1.3
Set out above are the reasons why audits might
be demanded. Consider the following questions.
(1) Assuming that you wished to invest in the shares of a

limited company, would you accept that financial
statements audited by a qualified auditor (say a member
of ACCA, ICAEW, ICAI or ICAS) would be more useful to
you than unaudited statements
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ACTIVITY 1.3
(2) Do you think it is true that nobody can be trusted to

act on other people’s behalf, without other people looking
over their shoulder?
(3) Should auditors be held liable for all the losses

incurred by shareholders should a company collapse,
assuming that the auditors have given their opinion that
the going concern concept was appropriate for the
preparation of the financial statements?
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ACTIVITY 1.4
Now identify three areas where judgement has

been exercised in the preparation of the
accounts.
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KEY POINTS – p.12
Difficulties in proving the accuracy of accounts

include:
(a) insufficient evidence;
(b) judgement involved in the preparation of

accounts in such matters as: useful lives of
fixed assets; saleability or usability of stock;
collectability of debtors; and profit to be taken
up on a long-term contract.
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ACTIVITY 1.5
Suggest four instances where estimates are

necessary in accounting and where judgement
will have to be exercised.
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KEY POINTS – p.12 CONT'D
The most that can be expected is that financial

statements give a reasonable picture; what is
reasonable depends on viewpoint and the
information available to the user.
In most bookkeeping areas accuracy is expected:
(a) debtors properly recorded;
(b) stock accurately counted; and
(c) trade creditors and fixed assets completely
and accurately determined.
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KEY POINTS – p.13
Truth and fairness is not easily defined but we

expect accounts:
(1) not to mislead the reader;
(2) to contain a certain degree of accuracy;
(3) to be supplemented by explanatory notes;
(4) to give a reasonable view of financial affairs
and results;
(5) to be proved true and fair (or not) on the basis
of sufficient, appropriate audit evidence.
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ACTIVITY 1.6
Imagine that a young relative of yours has picked

up one of your textbooks, has come across the
term ‘true and fair view’ and has asked you what
it means in practical terms.
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The typical basis framework for a larger audit

assignment comprises:
(1) preliminary stages;
(2) systems work and transaction testing;

(3) preparation for final work; and
(4) final work.
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TABLE 1.1 Concepts of auditing
Date Event
Preliminary stages
30 March 2006 Firm asked to carry out
work.
3 April 2006 Meeting to discuss terms of

reference; forms the basis
for the letter of engagement.
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TABLE 1.1 CONT’D
Date Event
24–28 April 2006 Visit company to familiarize

audit firm with industry and
company. Meet with
management. Prepare first
(global) plan and free
estimate.
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TABLE 1.1 CONT’D
Date Event
2 May 2006 Write confirming fee

estimate and proposed
dates for carrying out
examinations. Issue a
memo assessing any
matters that need attention.
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TABLE 1.1 CONT’D
Date Event
Systems work and

transactions testing
3 weeks from Interim examination of the
9 October 2006 firm’s accounting and
internal control systems.
Work directed towards this
area.
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TABLE 1.1 CONT’D
Date Event
15 November 2006 Memo on internal control /

‘management letter’. This
can be delayed until the final
audit but if there are serious
weaknesses it would be
wiser not to delay.
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TABLE 1.1 CONT’D
Date Event
Final preparation
4–5 December 2006 Review arrangements for
end-of-year stock counts
and accounts; discuss any
known problems and any
new financial reporting
standards.
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TABLE 1.1 CONT’D
Date Event
30 December 2006 Attend stock count, observe

company procedures, make
test counts and write stock
count memo for working
papers.
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TABLE 1.1 CONT’D
Date Event
Final work
3 weeks from Carry out a review of new
12 March 2007 draft accounts and
verification procedures on
assets and liabilities,
including post-balance sheet
events work.
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TABLE 1.1 CONT’D
Date Event
2 April 2007 Review working papers,

discuss audit results with
management and include
amendments, obtain a
management
representations letter, check
records agree with the
accounts.
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TABLE 1.1 CONT’D
Date Event
Directors sign financial

statements.
Issue audit report.
2 May 2007 Send note of charges for

audit and other professional
work.
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KEY POINTS – p.18
Audit may have specific roles in relation to many

different organizations:
Examples might include
• local authorities
• universities
• water companies
• hospitals
• nuclear power stations
• charities
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ACTIVITY 1.7
Now consider a possible role for audit in the
following cases.
• A university providing educational services to students.

• Water companies supplying water to private customers.
• A hospital serving local people in the surrounding area.
• A nuclear power station feeding electricity into the
national grid.
• A charity collecting from the public to provide funds to
specified good causes.
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KEY POINTS – p.19
‘Assurance services’ are usually held to mean a

broad set of services deigned to improve quality
of information.
Auditors are in a good position to provide services
such as these but this may pose a threat to
independence.
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KEY POINTS – p. 20
Important issues are:

(a) users value reliable accounts;
(b) auditors must be competent;
(c) audit is a search for evidence;
(d) auditors should adopt an attitude of
professional scepticism.
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KEY POINTS – p.21
There have been many definitions of audit. One is:

‘An audit is an investigation or a search for
evidence to enable an opinion to be formed on
the truth and fairness of financial and other
information by a person or persons
independent of the preparer and persons likely
to gain directly from the use of the information,
and the issue of a report on that information
with the intention of increasing its credibility
and therefore its usefulness.’
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KEY POINTS – p.21 CONT'D
Another, from the Audit of Financial Statements, is:

‘An exercise whose objective is to enable Auditors
to express an opinion whether the financial
statements give a true and fair view … of the
entity’s affairs at the period end and of its profit or
loss (or income and expenditure) for the period
then ended and have been properly prepared in
accordance with the applicable reporting framework
(for example relevant legislation and applicable
accounting standards)’.
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ACTIVITY 1.8
We gave above our own definition of an audit

and also the objective of an audit set out in ISA
200. Take another look at the two definitions and
compare and contrast them.
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The ‘Nine Fundamental Principles of Independent

Auditing’ cover the following areas and comprise
the Auditor’s Code (see also Table 1.2):
(1) accountability;
(2) integrity;
(3) objectivity and independence;
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(4) competence;
(5) rigour;
(6) judgement;
(7) clear communication;
(8) association; and
(9) providing value.
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CHAPTER SUMMARY
This chapter has introduced:
• A basic audit situation;
• Extensions on this basic situation;

• Recent problems affecting the accounting and
auditing profession;
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CHAPTER SUMMARY CONT'D
• How the Statement of Integrity, Objectivity and

Independence identifies areas of risk to and
attempts to combat threats to independence;
• Audit expectations gap and regulation;
• Corporate governance, regulation and controls

in companies.
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FURTHER READING
Beattie, V. Fearnley, S. and Brandt, R. (2001) Behind Closed

Doors: What Company Audit is Really About, Basingstoke
and New York: Palgrave.
Benston, G.J. (1985) ‘The Market for Public Accounting
Services: Demand, Supply and Regulation’, Journal of
Accounting and Public Policy, 4: 33–79.
Flint, D. (1971) ‘The role of the Auditor in Modern
Society: An Exploratory Essay’, Accounting and
Business Research, Autumn, 287–93.
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FURTHER READING CONT’D
Flint, D. (1988) Philosophy and Principles of Auditing: An

Introduction, Basingstoke: Macmillan Education Ltd.
Hatherly, D.J. (1999) ‘The Future of Auditing:
The Debate in the UK’, European Accounting Review, 8(1):
51–65.
Sikka, P. (2003) Some Questions About the Governance of
Auditing Firms, University of Essex, Working Paper No. 03/07.
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Why are auditors needed?

After studying this chapter you should be

• Understand in general what an audit is and put into

• Suggest the kinds of people who will benefit from

• Form a view on the kind of information that might be

• Recognize the theoretical considerations

• Explain the wider setting of an audit.

Auditing has become headline news after recent

Several important auditing issues are considered

(d) the idea that information breeds information;

(i) the use of information from an independent

Try to answer the following two questions before

1 What was James’ position in relation to that

2 If you were James, what would you do now?

On the basis of your review, make a list of the

Three justifications of audit are:

• the insurance hypothesis.

The information hypothesis suggests auditors are

Agency theory suggests audit is justified because

Basic ideas behind of agency theory are:

(b) a monitoring mechanism in the form of a

(c) different groups of rational individuals have

(d) agents recognize that principals will be more

(e) professional external auditors are the most

The insurance hypothesis suggests that the auditor

(1) Assuming that you wished to invest in the shares of a

(2) Do you think it is true that nobody can be trusted to

(3) Should auditors be held liable for all the losses

Now identify three areas where judgement has

Difficulties in proving the accuracy of accounts

(b) judgement involved in the preparation of

Suggest four instances where estimates are

The most that can be expected is that financial

Truth and fairness is not easily defined but we

Imagine that a young relative of yours has picked

The typical basis framework for a larger audit

(2) systems work and transaction testing;

3 April 2006 Meeting to discuss terms of

24–28 April 2006 Visit company to familiarize

2 May 2006 Write confirming fee

Systems work and

15 November 2006 Memo on internal control /

30 December 2006 Attend stock count, observe

2 April 2007 Review working papers,

Directors sign financial

2 May 2007 Send note of charges for

Audit may have specific roles in relation to many

• A university providing educational services to students.

‘Assurance services’ are usually held to mean a

Important issues are:

There have been many definitions of audit. One is:

Another, from the Audit of Financial Statements, is:

We gave above our own definition of an audit

The ‘Nine Fundamental Principles of Independent

(3) objectivity and independence;

This chapter has introduced:

• A basic audit situation;

• Extensions on this basic situation;

• How the Statement of Integrity, Objectivity and

• Corporate governance, regulation and controls

Beattie, V. Fearnley, S. and Brandt, R. (2001) Behind Closed

Flint, D. (1988) Philosophy and Principles of Auditing: An

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