Audit & Assurance 2nd Lecture by Malik Kashif Awan

7/27/2019 Audit & Assurance 2nd Lecture by Malik Kashif Awan

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AUDIT & ASSURANCEAUDIT & ASSURANCEAUDIT & ASSURANCEAUDIT & ASSURANCEMalik Kashif Awan2011

Lecture notes and conceptual demonstration forUndergraduate / graduate study program inEconomics, Management, Finance andSocial Sciences

This is an extract from the main source A Chronicle on Audit & Assurance written by Malik KashifAwan and published in Florida, USA in 2001 for a preferred study material at graduate level studycourse of Management, Economics, Finance, Commerce, Business Administration and SocialSciences in Pakistan.

For more details visit http://malikashif.pk

MKA-fetheMalik Kashif

AwantheFinancial

Engineers


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Assurance & AuditRelationships


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1LEVLEVLEVLEV

Overview of the conce

Assurance and reports

Concepts in reporting

Materiality

True and fair

Reasonable assurance

udit

LLLLSSSS OF ASSURANOF ASSURANOF ASSURANOF ASSURAN

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Levels of assurance

Communication to different stakeholders

& Assurance

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2.1 DDDDegreeegreeegreeegree of assuranceof assuranceof assuranceof assuranceThe degree of assurance given by the impartial professional will depend on the nature of theexercise 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.


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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 auditingexpertise) to collect, classify and summarise financial information. No assurance is expressed.

2.1.1 Differences between reasonable assurance engagementsand limited assurance engagements

Type of engagement Evidence-gathering

procedures

The assurance report

Reasonable assurance

engagement

eg statutory audit

Sufficient appropriate

evidence is obtained as part of

a systematic engagement

process that includes:

Obtaining an understanding

of the engagement

circumstances

Assessing risks

Responding to assessed risks

Performing further

procedures using a

combination of inspection,

observation, confirmation,

re-calculation, re-

performance, analytical

procedures and inquiry.

Description of the

engagement circumstances,

and a positive expression of

the conclusion

Limited assurance

engagement

eg review of half-year accounts

Sufficient appropriate

evidence is obtained as part of

a systematic engagement

Description of the

engagement circumstances,

and a negative form of


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process that includes obtaining

an understanding of the

subject matter and other

engagement circumstances,but in which procedures are

deliberately limited relative to

a reasonable assurance

engagement.

The procedures may include

only inquiry and analytical

procedures.

expression of the conclusion

2.1.2 Reporting different levels of assurance

Positive expression 'In our opinion internal control is effective, in all material

respects, based on XYZ criteria.'

Negative expression '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 onXYZ 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 Type of assurance provided Examples

External audit Reasonable Statutory external audit

Review Negative Review of interim financial

statements

Agreed-upon procedures None Examination of statement of

financial position


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Examination of segmental

sales and profit

Compilation None Preparation of financial

statements Preparation of tax returns


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2.2 Accountability,Accountability,Accountability,Accountability,Stewardship and AgencyStewardship and AgencyStewardship and AgencyStewardship 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


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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 StudyVera 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


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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.


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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.

Accountabilityis 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.

Agentsare 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.


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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 directorsmanage the company, they are in a position to affect thatreturn.

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 mismanagethe 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.

Accountabilitytherefore covers a range of issues:


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2.3 Stages of an ExternalStages of an ExternalStages of an ExternalStages of an ExternalAuditAuditAuditAudit

The following diagram illustrates the main steps in the conduct of an external audit. The

following chapters expand each of these steps.


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Key Terms

An external auditis a type of assurance engagementthat is carried out by an auditor to

give an independent opinion on a set of financial statements.

An audit provides assuranceto 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 truthand

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 assurancegiven 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 opinionin the form

of a report.

Reasonable assuranceis usually reported in terms of positive expression.

Limited assuranceis usually reported in terms of negative expression.

Audit & Assurance 2nd Lecture by Malik Kashif Awan

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