Chapter
C
Evcctw'dCcat71i11J Outcomes
After studying this chapter, you should be able to:
1. Describe the role of auditing in meeting society's demands for
reliable financial information
2. Understand why individual external auditors are expected to
make professional and ethical judgments about the information
provided by business organizations.
3. Explain the nature of assurance services.
4. Explain the importance of audited financial statements.
5. Enumerate the various parties who are interested in audited
financial statements.
6. Understand the need for increased globalization of accounting
and auditing standards.
CHAPTER 1
THE DEMAND FOR AUDITING AND
ASSURANCE SERVICES
ECONOMIC DEMAND FOR AUDITING
Why do many of the largest companies spend millions of pesos each year for
their annual audit? Is it worth asking why an entity would decide to spend so
much money on an audit? Is it because these audits are required by law? While
true in certain circumstances, this answer is far too simplistic. Although audits
are often utilized in situation where they are not required by law, audits were in
demand long before Securities Laws and the Bureau of Internal Revenue
required them.
The demand for auditing can be understood as the need for accountability when
business owners hire others to manage their businesses, as is typical in modern
corporations. Until the late 18th and early 19th centuries, most organizations were
relatively small and were owned and operated as sole proprietorships or
partnerships. Because businesses were generally run by their owners and
borrowing was limited, accountability to outside parties often was minimal.
The birth of modern accounting and auditing occurred during the industrial
revolution, when companies became larger and needed to raise capital to finance
expansion. Over time, capital markets developed, enabling companies to raise the
investment capital necessary to expand new markets, finance expensive research
and development, and fund the buildings, technology, and equipment needed to
deliver products to market.
A capital market allows a public company to sell small pieces of ownership (i.e.,
stocks) or to borrow money in the form of thousands of small loans (i.e., bonds) so
that vast amounts of capital can be raised from a wide variety of investors and
creditors. A public company is a company that sells its stocks or bonds to the
public, giving the public a valid interest in the proper use of the company's
resources.
4 Chapter I
Thus, the growth of the modern corporation led to diverse groups of owners who
are not directly involved in running the business (shareholders) and the use of
professional managers hired by the owners to run the corporation on a day-to-day
basis. In this setting, the managers serve as agents for the owners (who are
sometimes referred to as principals) and fulfill a stewardship function by
managing the corporation's assets.
It is important to understand that the relationship between an owner and manager
often results in information asymmetry between the two parties. Information
asymmetry means that the manager generally has more information about the "true"
financial position and results of operations of the entity than does the absentee
owner.
What are Assurance Services?
The name assurance services used to describe the broad range of information
enhancement services performed by a certified public accountant (CPA) that are
designed to enhance the degree of confidence in the information. In general,
assurance services consists of two (2) types: a. those that increase the reliability of
information and; b. those that involve putting information in a form or context that
facilitates decision making.
A significant portion of the assurance services provided by CPAs is referred to as
attestation services. To attest to information means to provide assurance as to its
reliability. In an attestation engagement, CPAs provide a report on subject matter
or an assertion about that subject matter. One of the most sought-after attestation
services is the examination or audit of historical financial statements.
In this book, we will focus on the Audit and Assurance Services that involve
reliability enhancement.
Philosophy of an Audit
As the amount of capital involved and the number of potential owners increase,
the potential impact of accountability also increases. The auditor's role is to
determine whether the reports prepared by the manager conform to the contract's
provisions. Thus, the auditor's verification of the financial information adds
credibility to the report and reduces information risk, or the risk that information
circulated by a company's management will be false misleading. Reducing
information risk potentially benefits both the owner and the manager.
Economic decisions are made under conditions of uncertainty; there is always
a risk that the decision maker will select the wrong alternative and incur a
significant loss. The credibility added to the information by auditors actually
6 Chapter I
Demand for A
reduces the decision maker's risk. TO be more precise, the auditors reduce
information risk, which is the risk that the financial information used to make a
decision is materially misstated.
Businesses, institutions and individuals must maintain records of their financial
condition and progress. These records are necessary to evaluate and guide
business operations, to determine financial status, to meet legal requirements and
to serve as a basis for credit. Creditors and investors, present and prospective,
may wish to study the financial statements of many enterprises for credit
extension and investment purposes. Government agencies will need financial
reports to help them carry out the duties imposed upon them by law internal
management needs financial reports for planning, directing and controlling
business operations.
These parties therefore, need reliable and credible financial information. The
process employed to establish the reliability or unreliability of the financial
statements and supporting records is referred to as an audit examination. Auditing
of financial records has become an important factor in the dissemination of
financial information and the services of the independent certified public
accountant are considered indispensable. Increasingly, his written report is
required to add credibility to the financial statements.
A free-market economy can exist only if there is sharing of reliable information
among parties that have an interest in the financial performance of an organization.
The market is further strengthened if the information is transparent and unbiased —
that is, the data is not presented in such a way that it favors one party over another.
An organization's reported information must reflect the economics of its transactions
and the current economic condition of both its assets and any obligations owed.
In a financial statement audit, the auditors undertake to gather evidence to obtain
high level of assurance that financial statements are free of material misstatements
due to fraud or errors and that they are presented in accordance with appropriate.
accounting framework. The external audit is intended to enhance the confidence that
users can place on management-prepared financial statements. When the auditor has
no reservations about management's financial statements or internal controls, the
report is referred to as an unqualified report.
uditing and Assurance Services 7
Auditors serve a number of parties, but the most important is the public, as
represented by investors, lenders, workers, and Others who make decisions
based on financial information about an organization. Auditing requires the highest
level of technical competence, freedom from bias, and concern for integrity of the
financial reporting process. In essence, auditors should view themselves as
guardians of the capital markets.
The public expects auditors to (a) find fraud, (b) require accounting principles the
best portray the spirit of the concepts adopted by accounting standard setters, and
(c) be independent of management. When it comes to being independent, auditors
must not only be independent in fact. but they must act in a manner that ensures
that they are independent in appearance.
An independent auditor's opinion contained in the audit report provides both
internal and external users with input to making logical and informed decisions
about financial position, managerial performance and economic vulnerability.
Without auditors, decisions such as these are more likely to be made from biased
financial information resulting from a business entity's undisclosed errors,
irregularities or illegal acts.
IMPORTANCE OF AUDITED FINANCIAL STATEMENTS
Audited financial statements are the accepted means by which business
corporations report their 'operating results and financial position. The word
audited, when applied to financial statements, means that the balance sheet and the
statements of income, retained earnings, and cash flows are accompanied by an audit
report prepared by independent public accountants, expressing their professional
opinion as to the fairness of the company's financial statements.
Of course, reporting in accordance with an agreed-upon set of accounting
principles does not solve the problem by itself. Because the manager is
responsible for reporting on the results of his or her own actions, which the absentee
owner cannot directly observe, the manager is in a position to manipulate the
reports. Again, the owner adjusts for this possibility by assuming that the manager
will manipulate the reports to his or her benefit and by reducing the manager's
compensation accordingly. It is at this point that the demand for auditing arises. If
the manager is honest, it may very well be in the manager's self-interest to hire an
auditor to monitor and independently report to the owner on his or her activities.
The owner likely will be willing to invest more in the business and to pay the
manager more if the manager can be held accountable for how he or she uses the
owner's invested resources.
8 Chapter I
Financial statements prepared by management and transmitted to outsiders
without first being audited by independent accountants leave a credibility gap.
In reporting on its own administration of the business, management can hardly
be expected to be entirely impartial and unbiased. Independent auditors have no
material personal or financial interest in the business; their reports can be
expected to be impartial and free from bias.
Unaudited financial statements may have been honestly, but carelessly, prepared.
Liabilities may have been overlooked and omitted from the balance sheet. Assets may have
been overstated as a result of arithmetical errors or due to a lack of knowledge of financial
accounting and reporting standards. Net income may have been exaggerated because
expenses were capitalized or because sales transactions were recorded in advance of
delivery dates.
Finally, there is the possibility that unaudited financial statements have been
deliberately falsified in order to conceal theft and fraud or as a means of inducing the
reader to invest in the business or to extend credit. Although deliberate falsification of
financial statements is not common, it does occur and can cause devastating losses to
persons who make decisions based upon such misleading statements.
For all these reasons (accidental errors, lack of knowledge of accounting principles,
unintentional bias, and deliberate falsification), financial statements may depart from
financial accounting and reporting standards principles. Audits provide users with
assurance that the financial statements are presented in accordance with the financial
accounting principles and reporting standards.
Figure I-I presents an overview of the potential financial statement users and the
decisions they make based on the financial reports.
Figure I-I: Users of Audited Financial Statements
User Types of Decisions
Management Review performance, make operational decisions. Report results to
capital markets
Stockholders Buy or sell stock
Bondholders Buy or sell bonds
Financial Institutions Evaluate loan decisions, considering interest rates, terms, and
risk
Taxing Authorities Determine taxable income and tax due
Regulatory Agencies Develop regulations and monitor compliance
Labor Unions Make collective bargaining decisions
uditing and Assurance Services 9
Court System Assess the financial position of a company in litigation
Vendors Assess credit risk
Retired Employees Protect employees from surprises concerning pensions and other
post-retirement benefits
THE ASSURANCE ANALOGY AND THE PHILIPPINE STANDARDS ON
AUDITING (PSAs)
An audit provides reasonable assurance of detecting material misstatements of
the financial statements (both errors and fraud) and noncompliance with laws
that have a direct and material effect on the determination of financial statement
amounts. Although an audit does not obtain reasonable assurance of detecting
noncompliance with laws that have only an indirect effect on the financial
statements, the auditors remain alert for such situations. If instances of
noncompliance are discovered, regardless of type, the auditors should carefully
evaluate their effects on the financial statements.
Currently, the International Auditing and Assurance Standards Board (IAASB)
issues pronouncements designed to foster the development of consistent
worldwide auditing standards while the Auditing and Standards Practice Council
of the Philippines (AASC) reviews and recommends for approval to the PRC-
BOA their adoption as the Philippine Standards on Auditing (PSAs).
In the Philippines, the law that regulates the Practice of Accountancy (RA 9298)
provides that the Professional Regulatory Board of Accountancy shall monitor the
conditions affecting the practice of accountancy and adopt such measures to
enhance and maintain the high professional, ethical and auditing standards
including promulgation of accounting and auditing standards, domestic and
international. International financial markets would be facilitated if auditing and
accounting standards were more uniform.
In summary. auditing is in demand because it plays a valuable role in monitoring the
contractual relationships between the entity and its stockholders, managers,
employees, and debt holders. Certified public accountants have been charged with
providing audit services because of their traditional reputation of competence,
independence, objectivity, and concern for the public interest. As a result, they are
able to add credibility to information produced and reported by management to
outside parties.
10 Chapter I
REVIEW QUESTIONS
Questions
I. What is the objective of financial statement audit? Describe the role of external
auditing in meeting society's demands for unbiased financial and internal
control information.
The objective of external auditing is to improve the reliability of information used by
decision makers. External auditors play an important role in ensuring that users of
financial statements obtain fair, verifiable financial information. They serve separately
or independently from any client on whose behalf they execute an audit, allowing them
to assess a company's internal controls and financial statements objectively. Without
external auditors, the financial markets would be less secure owing to a lack of credible
information.
2. What is the "special function" that auditors perform? Whom does the
external auditing profession serve in performing this special function?
The special function is proof that their client's financial accounts are
accurate or truthful . This function ensures that all users of the financial
statement receive trustworthy or fair financial information.
3. What factors create a demand for an independent external audit?
The demand for external audits is created by these factors: Potential bias, remoteness,
complexity, consequences.
4. How does an audit enhance the quality of financial statements and
management's reports on internal control? Does an audit
guarantee a fair presentation of a company's financial statements?
An audit improves the quality of financial statements because it provides
reasonable certainty that they are free of substantial misrepresentation.
An audit does not absolutely ensure/guarantee that a company's financial
statements are presented fairly, but it is a credible opinion.
5. What is the principal use and significance of an audit report to a large
corporation with securities listed on a stock exchange? To a small family-owned
enterprise?
uditing and Assurance Services 11
A large corporations with securities listed on a stock exchange is required by the
stock exchange's regulations and the Securities and Exchange Commission's
guidelines to issue an audit report together with its annual financial statements
to its investors. It must also hire auditors to offer an opinion on its internal
controls. Aside from regulatory obligations, a big publicly traded company
knows that it must retain investor trust in the dependability of its financial
statements and internal control over financial reporting if it is to continue to be
able to access public funding. The report by a company of certified public
accountants lends credibility to the corporation's financial accounts.
When a small family-owned business decides to have an audit, the goal is
generally to utilize the auditors' findings to support a bank loan application.
6. Describe the several business situations that would create a need for a
report by an independent public accountant concerning the fairness of a
company's financial statements.
(1) Loan application to a bank.
(2) Creating credit for the purchase of goods, equipment, or other assets.
(3) Notifying absentee owners of operating performance, financial status,
and cash flows (stockholders or partners).
(4) A corporation's issuance of securities.
(5) Annual financial statements of a firm whose securities are traded on a
stock market or over the counter.
(6) The sale of an existing firm.
(7) The termination of a partnership.
7. Explain the following statement: One contribution of the independent auditor is to
lend credibility to financial statements.
Increasing the credibility of financial statements means increasing the possibility that
they were created in accordance with the required standards, which are usually
generally accepted accounting principles. As a result, increased credibility leads to
financial statements that can be trusted and depended on by third parties.
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8. A corporation is contemplating issuing debenture bonds to a group of
investors.
a. Explain how independent audits of the corporation's financial
statements facilitate this transaction.
To decrease information risk by identifying any major inaccuracies, a
financial statement audit will be required.
b. Describe the likely effects on the transaction if the corporation decides
not to obtain independent audits of its financial statements.
It would jeopardize the bonds' legitimacy, and the public will not invest
unless a high rate of return is guaranteed.
9. Discuss the major factors in today's society that have made the need for
independent audits much greater that it was 50 years ago.
An independent audit is a method of addressing decision makers' demand for
accurate information. A complex society's factors that contribute to this
necessity are as follows.
1. Information Distinction / Remoteness of Information
2. Provider biases and motivations
3. a lot of information/ Voluminous data
4. Exchange transactions that are complex
10. It has been stated that auditors must be independent because audited
financial statements must serve the needs of a wide variety of users. If the
auditor were to favor one group, such as existing shareholders, there might
be a bias against another group, such as prospective investors. Do you
agree?
Users must regard auditors as independent in order to be sure that the
financial information they get is impartial and objective. Independent in
appearance indicates that a third party knows the auditor-client connection
Chapter I
and would regard them to be independent. Whereas a person may not be
viewed as independent when they are, in fact, independent.
Auditor independence is required because audited financial statements must
meet the demands of a wide range of users. If the auditor favors one group,
say, current shareholders, there may be a bias against another, say, potential
investors.
11. Evaluate the following quotation: "Every business, large or small,
should have an annual audit by a CPA firm. To forgo an audit because
of its cost is false economy”
The first cited line exaggerates the situation. Although yearly audits by
CPA firms are standard procedure for major enterprises, they are not
required for many small businesses. Large organizations' financial
statements are distributed to a large number of stockholders (sometimes
hundreds of thousands), who want the guarantee of reliability provided
by independent audits by CPA firms. Furthermore, the SEC and stock
exchanges demand yearly audits of publicly traded corporations.
The major purpose of annual financial statements for a small business
is to support a bank loan application. The expense of an audit may not
be justified if a small firm does not need to borrow or can get borrowed
cash without producing audited statements. A CPA company may
frequently provide specialized services other than audits to a small
business that are more beneficial and may cost less. Examples include
financial statement review or compilation, the establishment of a
computer-based accounting system, and an examination of internal
control. As a result, both the second and first cited sentences are too
broad to be true. A choice not to conduct an audit is not necessarily
considered "false economy."
12. The self-interest of the provider of financial information (whether an
individual or a business entity) often runs directly counter to the interest
of the user of the information.
Required:
a) Give an example of such opposing interest.
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b) What may be done to compensate for the possible bias existing
because of the self-interest of the individual or business entity providing
the financial information?
(a) A circumstance in which an individual or business entity asks for a bank
loan is an example of probable bias on the side of the source of financial
information. In such cases, there is an incentive to inflate assets, income,
and owner's equity while overlooking or minimizing liabilities. This
form of distortion gives the impression of higher financial strength.
(a) A bank loan officer may require prospective borrowers to furnish
audited financial statements. This ensures that the data in the financial
accounts has been scrutinized by independent competent individuals.
