Malik Kashif Awan 1 Audit & Assurance

AUDIT & ASSURANCE

Malik Kashif Awan 2011

Lecture notes and conceptual demonstration for Undergraduate / graduate study program in Economics, Management, Finance and Social Sciences

This is an extract from the main source A Chronicle on Audit & Assurance written by Malik Kashif Awan and published in Florida, USA in 2001 for a preferred study material at graduate level study course of Management, Economics, Finance, Commerce, Business Administration and Social Sciences in Pakistan. For more details visit http://malikashif.pk

MKA-fe

Malik Kashif Awan the Financial

the

Engineers

Malik Kashif Awan 2 Audit & Assurance

Assurance & Audit Relationships

Malik Kashif Awan 3 Audit & Assurance

Overview of the concept

Assurance and reports
Communication to different stakeholders

LEVEL LEVELS S OF ASSURANCE

Levels of assurance Concepts in reporting Materiality True and fair Reasonable assurance

Malik Kashif Awan 4 Audit & Assurance

2.1

Degree of assurance

The degree of assurance given by the impartial professional will depend on the nature of the exercise being carried out. 'Assurance' here means the auditors' satisfaction as to the reliability of the assertion made by one party for use by another party. Negative assurance is when an auditor gives an assurance that nothing has come to his attention which indicates that the financial statements have not been prepared according to the framework. In other words, he gives his assurance in the absence of any evidence to the contrary. Directors prepare financial statements for the benefit of members. They assert that the financial statements give a true and fair view. The auditors provide assurance on that assertion. To provide such assurance, the auditors must: Assess risk Plan audit procedures Conduct audit procedures Assess results Express an opinion

The degree of satisfaction achieved and, therefore, the level of assurance which may be provided, is determined by the nature of procedures performed and their results. An external audit can be distinguished from other engagements in the following ways. a) External audit engagement: the auditor provides a high, but not absolute, level of assurance that the information audited is free of material misstatement. This is expressed positively in the audit report as reasonable assurance. b) Review engagement: the auditor provides a limited level of assurance that the information subject to review is free of material misstatement. This is expressed in the form of negative assurance.

Malik Kashif Awan 5 Audit & Assurance

c) Agreed-upon procedures: the auditor simply provides a report of the factual findings of the engagement agreed by the auditor, entity and any appropriate third parties, so no assurance is expressed. Users of the report must instead judge for themselves the auditor's procedures and findings and draw their own conclusions. d) Compilation engagement: the practitioner is engaged to use his accounting expertise (as opposed to auditing expertise) to collect, classify and summarise financial information. No assurance is expressed.

2.1.1 Differences between reasonable assurance engagements and limited assurance engagements
Type of engagement
Reasonable engagement eg statutory audit

Evidence-gathering procedures

The assurance report

of the

assurance Sufficient a systematic

appropriate Description

evidence is obtained as part of engagement process that includes: Obtaining an understanding of the engagement circumstances Assessing risks Responding to assessed risks Performing procedures observation, re-calculation, performance, procedures and inquiry. further using a the conclusion

circumstances,

engagement and a positive expression of

combination of inspection, confirmation, reanalytical

Limited engagement

assurance Sufficient a systematic

appropriate Description engagement and a negative

of form

the of

evidence is obtained as part of engagement

circumstances,

eg review of half-year accounts

Malik Kashif Awan 6 Audit & Assurance

process that includes obtaining expression of the conclusion an understanding matter of the other subject and

engagement

circumstances,

but in which procedures are deliberately limited relative to a reasonable assurance engagement. The procedures may include only inquiry and analytical procedures.

2.1.2 Reporting different levels of assurance

Positive expression Negative expression 'In our opinion internal control is effective, in all material respects, based on XYZ criteria.' 'Based on our work described in this report, nothing has come to our attention that causes us to believe that internal control is not effective, in all material respects, based on XYZ criteria.'

2.1.3 Different types of assurance that provided

The following table summarises the different types of engagement that can be carried out by practitioners. Engagement External audit Review Agreed-upon procedures Type of assurance provided Reasonable Negative None Examples Statutory external audit Review of interim financial statements Examination of statement of financial position

Malik Kashif Awan 7 Audit & Assurance

Examination of segmental sales and profit Compilation None Preparation of financial statements Preparation of tax returns

Malik Kashif Awan 8 Audit & Assurance

2.2

Accountability, Stewardship and Agency

2.2.1 Agency theory

The role of external audit is often explained in relation to the economic model of agency theory.

2.2.2 An agency relationship

Malik Kashif Awan 9 Audit & Assurance

2.2.3 The agency relationship in audit

In the case of a company, the board of directors acts as the agents of the body of shareholders, the principals. The directors are accountable for their stewardship of the company. The shareholders have limited access to information about the operations of the company. They may lack trust in the directors and may believe that the information in the financial statements is biased. The external auditor, therefore, performs a statutory audit to address a simple agency conflict between shareholders and directors. In addition, the auditor can be seen as an agent of the shareholders. Under law, they report to and are appointed by the shareholders. This raises more concerns with regard to trust and confidence. One key factor here is the importance that shareholders place on the auditors' independence from the directors. Auditors have an important incentive to maintain independence and protect their reputation in order to keep and win more audit work. The profession also imposes guidance in relation to independence. The key reason for having an audit or review can be seen by working through the following case study.

Case Study
Vera decides to set up a business selling flowers. She gets up early in the morning, visits the market, and then sets up a stall by the side of the road. For the first year, all goes well. She sells all the flowers she is able to buy and she derives some income from the business. However, Vera feels that she could sell more flowers if she was able to transport more to the place where she sells them, and she also knows that there are several other roads nearby where she could sell flowers, if she could be in two places at once. She could achieve these two things by

Malik Kashif Awan 10 Audit & Assurance

buying a van and by employing other people to sell flowers in other locations. Vera needs more money to achieve this expansion of her business. She decides to ask her rich friend Peter to invest in the business. Peter can see the potential of Vera's business and wants to invest, but he doesn't want to be involved in the management of the business. He also does not want to have ultimate liability for the debts of the business if it fails. He therefore suggests that they set up a limited company. He will own the majority of the shares and be entitled to dividends. Vera will be managing director and be paid a salary for her work. At the end of the first year of trading as a limited company, Peter receives a copy of the financial statements. Profits are lower than expected, so his dividend will not be a large as he had hoped. He knows that Vera is paid a salary so does not care as much as him that profits are low. Peter is concerned by the level of profits and feels that he wants further assurance on the accounts. He doesn't know whether they give a true reflection on the last year's trading, particularly as the profits do not seem as high as those Vera had predicted when he agreed to invest. The solution is that the assurance Peter is seeking can be given by an independent audit or review of the financial statements. An auditor can provide the two things that Peter requires: A knowledgeable review of the company's business and of the accounts An impartial view, since Vera's view might be biased

Other people will also view the company's accounts with interest, for example: Creditors of the company Taxation authorities

The various parties interested in the accounts of a company are sometimes referred to as stakeholders.

Malik Kashif Awan 11 Audit & Assurance

Although they will each judge the accounts by different criteria, they will all gain assurance from learning that the accounts they are reading have been subject to an independent report.

The example above is a simple one. In practice companies may have thousands of shareholders and may not know the management personally. It is therefore important that directors are accountable to shareholders. Directors act as stewards of the shareholders' investments. They are agents of the shareholders.

Accountability is the quality or state of being accountable, that is, being required or expected to justify actions and decisions. It suggests an obligation or willingness to accept responsibility for one's actions. Stewardship refers to the duties and obligations of a person who manages another person's property. Agents are people employed or used to provide a particular service. In the case of a company, the people being used to provide the service of managing the business also have the second role of being people in their own right trying to maximise their personal wealth.

Malik Kashif Awan 12 Audit & Assurance

You may ask, 'what are the directors accountable for?' It is important to understand the answer to this question. The directors are accountable for the shareholders' investment. The shareholders have bought shares in that company (they have invested). They expect a return from their investment. As the directors manage the company, they are in a position to affect that return.

The exact nature of the return expected by the shareholder will depend on the type of company he or she has chosen to invest in: that is part of his or her investment risk analysis. Certain issues are true of any such investment, however. For example, if the directors mismanage the company, and it goes bankrupt, it will neither provide a source of future dividends, nor will it create capital growth in the investment indeed, the opposite is true and the original investment may even be lost. Accountability therefore covers a range of issues:

Malik Kashif Awan 13 Audit & Assurance

Malik Kashif Awan 14 Audit & Assurance

2.3

Stages of an External Audit

The following diagram illustrates the main steps in the conduct of an external audit. The following chapters expand each of these steps.

Malik Kashif Awan 15 Audit & Assurance

Key Terms An external audit is a type of assurance engagement that is carried out by an auditor to give an independent opinion on a set of financial statements. An audit provides assurance to the shareholders and other stakeholders of a company on the financial statements because it is independent and impartial. Assurance services include a range of assignments, from external audits to review engagements. Internal auditors are employed as part of an organisations system of controls. Their responsibilities are determined by management and may be wide-ranging. The auditors' report on company financial statements is expressed in terms of truth and fairness. This is generally taken to mean that financial statements: Are factual Are free from bias Reflect the commercial substance of the business's transactions

External audits give reasonable assurance that the financial statements are free from material misstatement. The degree of assurance given by the impartial professional will depend on the nature of the exercise being carried out. The purpose of external audit is to promote confidence and trust in financial information. Audit can be explained in relation to agency theory. Audit is only one type of assurance engagement. The objective of any audit or assurance engagement is to produce an opinion in the form of a report. Reasonable assurance is usually reported in terms of positive expression. Limited assurance is usually reported in terms of negative expression.