Chapter 1

An overview of
auditing

©2019 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

1.1 explain what an audit is, what it provides, and why it
is demanded
1.2 describe how assurance relates to auditing
1.3 evaluate whether audits meet the demands of users
1.4 discuss the importance of the environment, case law
and regulation to auditing
1.5 explain the importance of national and international
auditing standards.
 What is an audit?

“A systematic process of objectively obtaining and

evaluating evidence regarding assertions made about
economic actions and events to ascertain the degree of
correspondence between those assertions and established
criteria and communicating the results to interested users”
American Accounting Association (1973)
 What is an audit?

• systematic process
• objectively obtaining and evaluating evidence
• regarding assertions made about economic
actions and events
• ascertain the degree of correspondence
between those assertions and established
criteria
• communicate the results to interested users.
 The objectives of an auditor

• sets out to achieve enhanced credibility of

information disclosed to increase reliability for the
users of the financial statements.
• obtain evidence to validate management’s
assertions and ensure economic events are
appropriately communicated to users.
The structure of an audit
 What does an audit provide?

• Auditor’s responsibility:
– To express an opinion on the financial report
– Audit report to state that the audit was conducted in
accordance with Australian auditing standards
– An audit should be described (performed procedures
to obtain evidence based on assessment of the risks
of material misstatement)
– Audit report shall state that sufficient and
appropriate audit evidence has been obtained to
form an opinion.
ASA 700
 What does an audit provide?

• Auditor’s opinion:
– Fair presentation framework: forms an opinion on
whether the financial report presents fairly, in all material
respects (or a true and fair view) in accordance with the
applicable financial reporting framework
– Compliance framework: forms an opinion on whether
the financial report is prepared, in all material respects,
in accordance with the framework. ASA 700
• Reasonable level of assurance
 Why is there a demand for audits?

• Agency theory

• Information hypothesis

• Insurance hypothesis

• Regulation
 Agency theory

• A principal contracts an agent to work on their

behalf
• Each party is motivated by self interest
• Information asymmetry arises
• An independent audit reduces the incentives for
problems
The agency relationship
 Information hypothesis

• Investors demand quality information in assessing the risks

and returns of their investments

• Audits improve the quality of information in financial

reports

• Reduces information risk and leads to improved decision

making
 Insurance hypothesis

“the ability to shift financial responsibility for reported data

to an auditor lowers the expected loss from litigation or
related settlements to managers, creditors, and other
professionals involved in the securities market. As potential
litigation awards increase, this insurance demand for an
audit from managers and professional participants in
financial activities can be expected to grow.

Wallace (1980)
 Insurance hypothesis

• Interested parties:
– Investors and creditors demand an audit to be prudent
and insure against losses
– Regulators to insulate themselves from criticism by
directing blame to auditors.
 Regulation

• Annual audits required by:

– Companies, registered schemes & disclosing entities
(excludes small proprietary companies)
– Commonwealth and state government departments,
statutory authorities, government companies and
business undertakings, and municipalities
– Not-for-profit organisations including educational
institutions.
 Who provides audits?

• Financial audits are provided by independent auditors

• Must be registered with ASIC to be able to perform
audits on reporting entities
• Criteria set out in s.1280 Corporations Act:
– Educational qualifications
– Work experience
– Good character (fit and proper person)
– Ordinarily resident in Australia
– Member of CA ANZ, CPA Australia, or IPA.
 What is assurance?

In the Australian auditing standards an assurance

engagement is defined as:
“An engagement in which an assurance practitioner
expresses a conclusion designed to enhance the degree of
confidence of the intended users other than the
responsible party about the outcome of the evaluation or
measurement of a subject matter against criteria”.
 Assurance engagements

• May be financial or non-financial

• The level of assurance will vary according to the particular
engagement (according to the amount of evidence
collected)
• Audits of annual financial reports imply a reasonable (or
high) level of assurance
• In comparison (for example) half-yearly reviews imply a
moderate (or low) level of assurance
The relationship between auditing and
assurance

19
Does the audit meet demands of users?
 Do audits provide good value?

• Assessing value can be examined by asking:

– How often are they associated with company failure
– Do auditors get the audit report correct
– How much do they cost?
– Do audits provide economic value in the market?
 The audit expectation gap

“the difference between what auditors actually do when

they conduct an audit and what shareholders and others
think auditor's do, or should do, in conducting the audit”
Report of HIH Royal Commission
 Audit expectation gap

Audit expectation-performance gap

Perceived Society’s
Performance Reasonableness
Performance gap gap
expectation
of auditors of auditors

Deficient Deficient Unreasonable

performance standards expectations
 Audit expectation gap

• Remedies to address unrealistic expectations:

– Education of stakeholders about what an audit provides
• Remedies to address deficient standards:
– Reporting on internal control
– Detection of fraud
– Evaluation of going concern.
The auditing environment

Co-regulation

The
accounting Case law Regulation
profession
 Case law

• Early cases associated with detection of fraud

• Change of focus resulting from growing complexity,
greater separation of owners from managers and
increasing size of businesses
• Greater emphasis on ‘reasonable skill and care’
• Concept of ‘reasonable assurance’.
 Case law

• Pacific Acceptance case (1970):

– Auditor should pay due regard to the possibility of
fraud and actively investigate the possibility of fraud if
suspicious circumstances exist.
– Concept of ‘reasonable care and skill’ called for
changed standards to meet changed business
conditions or changed understanding of the dangers.
 The early 2000s – challenges and changes

• Corporate collapses overseas and in Australia

• Collapse of Enron led to the Sarbanes-Oxley Act
• Collapse of HIH led to a Royal Commission
• Ramsay Report
• Some recommendations from the HIH Royal Commission
and the Ramsay Report were incorporated in Corporate
Law Economic Reform Program (CLERP 9).
 Audit Quality

Definition: that all relevant auditing standards are

adhered to, demonstrating the appropriate level of care,
diligence, competence and professionalism that are
required of the auditor.
 Regulation and other oversight

• CLERP 9 changes
– Major impacts:
•Role of audit in corporate governance
•Auditor independence
•Audit quality.
 Auditor Independence

• To conduct the audit without bias and appear to be

objective to those relying on the results of the audit. Key
issues include:
– Non-audit services
– Audit partner rotation
– Auditor working for the client.
 Quality-related changes

• Role of Financial Reporting Council:

– role broadened to include oversight of the AUASB
– auditing standards given the force of law.

• Annual general meetings:

– Shareholders permitted to submit questions to the
auditors before the AGM
– Auditor must attend the AGM and answer questions asked
by shareholders.
 Regulation and other oversight

• Australian Securities and Investment Commission (ASIC):

– Regulates corporate, markets and financial services
sector
– Advise on selling of and disclosure of financial products
and services to consumers
– Majority of work carried out under Corporations Act.
 Regulation and other oversight

• Companies Auditors Disciplinary Board (CADB):

– Established under ASIC Act
– Hears breaches under Corporations Act by auditors and
liquidators.
• Australian Securities Exchange (AXS):
– Monitors specific aspects of the businesses of other
organisations
– Listing Rules are enforceable against listed entities
under the Corporations Act.
Oversight structure of financial reporting in
Australia
 Auditing Standards

• Auditing and Assurance Standards Board (AUASB):

– AUASB’s role is to develop high-quality auditing and
assurance standards
– Standards have the force of law under the Corporations
Act s. 336
– Ensure ASAs conform with their IAASB equivalents,
address local regulatory issues and promote consistency
in application
– Also issues ASREs (review engagements), ASAEs
(assurance engagements) and ASRSs (related services).
 International auditing standards

• Issued by the IAASB under the auspices of the

International Federation of Accountants
• IASSB’s objective:
– serve the public interest by setting high-quality
international standards for auditing, quality control,
review, other assurance, and related services
– facilitating the convergence of international and
national standards.