The meaning of Audit and Assurance

The meaning of audit

Definition and objective of audit

An audit is an official examination of the accounts (or accounting systems) of an entity (by an auditor).
 

When an auditor examines the accounts of an entity, what is he looking for?
 

The main objective of an audit is to enable an auditor to convey an opinion as to whether or not the financial statements of an entity are prepared according to an applicable financial framework.
The applicable financial reporting framework is decided by:

• legislation within each individual country, and
• accounting standards (for example, International Accounting Standards/ International Financial Reporting Standards).

The auditor seeks to express an opinion as the result of the audit work that he does. The type of work carried out by an auditor in order to reach his opinion is described in later chapters.

Concepts of accountability, stewardship and agency

An audit of a company’s accounts is needed because in companies, the owners of the business are often not the same persons as the individuals who manage and control that business.

• The shareholders own the company.
• The company is managed and controlled by its directors.

The directors have a stewardship role. They look after the assets of the company and manage them on behalf of the shareholders. In small companies the shareholders may be the same people as the directors. However, in most large companies, the two groups are different.

The relationship between the shareholders of a company and the board of directors is also an application of the general legal principle of agency. The concept of agency applies whenever one person or group of individuals acts as an agent on behalf of someone else (the principal). The agent has a legal duty to act in the best interests of the principal, and should be accountable to the principal for everything that he does as agent.

As agents for the shareholders, the board of directors should be accountable to the shareholders. In order for the directors to show their accountability to the shareholders, it is a general principle of company law that the directors are required to prepare annual financial statements, which are presented to the shareholders for their approval.

The audit report: independence, materiality and true and fair

Audit has a very long history. The concept of an audit goes back to the times of the Egyptian and Roman empires. In medieval times, independent auditors were employed by the feudal barons to ensure that the returns from their stewards and their tenants were accurate.

Over time, the annual audit was developed as a way of adding credibility to the financial statements produced by management. The statutory audit is now a key feature of company law throughout the world.

An auditor reports to the shareholders on the financial statements produced by a company’s management.

The key features of the audit report are as follows:

• The auditors producing the report are independent from the directors producing the financial statements
• The report gives an opinion on whether the financial statements “give a true and fair view”, or “present fairly” the position and results of the entity.
• The report considers whether the financial statements give a true and fair view in all material respects. The concept of materiality is applied in reaching an audit opinion.

Independence of the auditor

The external auditor must be independent from the directors; otherwise his report will have little value. If he is not independent, his opinion is likely to be influenced by the directors.

In contrast to external auditors, internal auditors may not be fully independent from the directors, although they may be able to achieve a sufficient degree of independence. The work and status of internal auditors is covered in a later chapter.

The concept of independence of the auditor is considered in more detail in a later chapter.

True and fair view (fair presentation)

The auditor reports on whether (or not) the financial statements give a true and fair view, or present fairly, the position of the entity as at the end of the financial period and the performance of the entity during the period. The auditor does not certify or guarantee that the financial statements are correct.

Although the phrase ‘true and fair view’ has no legal definition, the term ‘true’ implies free from error, and ‘fair’ implies that there is no undue bias in the financial statements or the way in which they have been presented.

In preparing the financial statements, a large amount of judgement is exercised by the directors. Similarly, judgement is exercised by the auditor in reaching his opinion. The phrases ‘true and fair view’ and ‘present fairly’ indicate that a judgement is being given that the financial statements can be relied upon and have been properly prepared in accordance with an appropriate financial reporting framework.

Materiality concept

The auditor reports in accordance with the concept of materiality. He gives an opinion on whether the financial statements present fairly in all material respects the financial position and performance of the entity.

Information is materiality if, on the basis of the financial statements, it could influence the economic decisions of users should it be omitted or misstated.

For example, the shareholders of a company with assets of $1 million will not be interested if petty cash was miscounted with the result that the amount of petty cash is overstated by $10. This is immaterial. However, they will be interested if there are receivables in the statement of financial position of $200,000 which are not in fact recoverable and which should therefore have been written off as a bad debt.

Applying the concept of materiality means that the auditor will not aim to examine every number in the financial statements. He will concentrate his efforts on the more significant items in the financial statements, either:

• because of their (high) value, or
• because there is a greater risk that they could be stated incorrectly.

The statutory requirement for audit

Most countries impose a statutory requirement for an annual (external) audit to be carried out on the financial statements of most companies.

However, in many countries, smaller companies are exempt from this requirement for an audit. Other entities, such as sole traders, partnerships, clubs and societies are usually not subject to a statutory audit requirement. Small companies and these other entities may decide to have a voluntary audit, even though this is not required by law.

The meaning of assurance

Definition of assurance

‘Assurance’ means confidence. In an assurance engagement, an ‘assurance firm’ is engaged by one party to give an opinion on a piece of information that has been prepared by another party. The opinion is an expression of assurance about the information that has been reviewed. It gives assurance to the party that hired the assurance firm that the information can be relied on.

Assurance can be provided by:

• audit: this may be external audit, internal audit or a combination of the two review.

A statutory audit is one form of assurance. Without assurance from the auditors, the shareholders may not accept that the information provided by the financial statements is sufficiently accurate and reliable. The statutory audit provides assurance as to the quality of the information.

The provision of this assurance should add credibility to the information in the financial statements, making the information more reliable and therefore more useful to the user.

However, there are differing levels or degrees of assurance. Some assurances are more reliable than others.

Levels of assurance

The degree of assurance that can be provided about the reliability of the financial statements of a company will depend on:

the amount of work performed in carrying out the assurance process, and the results of that work.

Assurance provided by audit

An audit provides a high, but not absolute, level of assurance that the audited information is free from any material misstatement. This is often referred to as reasonable assurance.
The assurance of an audit may be provided by external auditors or internal auditors. 

• An external audit is performed by an appropriately qualified auditor, appointed by the shareholders and independent of the company.
• Internal audit is a function or department set up within an entity to provide an appraisal or monitoring process, as a service to other functions or to senior management within the entity. Typically, internal auditors are employees of the entity. However, it is also common for entities to ‘outsource’ their internal audit function, and internal audit work is sometimes carried out by firms of external auditors.

Many of the practical auditing procedures that will be described in later chapters are the same for both internal and external audit work.

Assurance provided by review

A review is a ‘voluntary’ investigation. In contrast to “reasonable” level of assurance provided by an audit, a review into an aspect of the financial statements would provide only a moderate level of assurance that the information under review is free of material misstatement. The resulting opinion is usually (although not always) expressed in the form of negative assurance.

Negative assurance is an opinion that nothing is obviously wrong: in other words, ‘nothing has come to our attention to suggest that the information is misstated’.

A review does not provide the same amount of assurance as an audit. An external audit provides positive assurance that, in the opinion of the auditors, the financial statements do present fairly the financial position and performance of the company.

The higher level of assurance provided by an audit will enhance the credibility provided by the assurance process, but the audit work is likely to be:

• more time-consuming than a review, and so
• more costly than a review.

Negative assurance is necessary in situations where the accountant/auditor cannot obtain sufficient evidence to provide positive assurance. For example the management of a client entity may ask the audit form to carry out a review of a cash flow forecast. A forecast relates to the future and is based on many assumptions, and an auditor therefore cannot provide positive assurance that the forecast is accurate. However he may be able to provide negative assurance that there is nothing he is aware of to suggest that the forecast contains material errors.