Understanding The Role Of Financial Audit And The Importance Of Regulations

Financial audit defined

Financial audit can be best illustrated as an objective and independent assessment of the financial records prepared by the management of any business along with an impartial evaluation of the process of financial reporting. The primary aim of financial audit is to form an opinion about the prepared financial statements and on the process used to develop the financial statements that is forming an impartial opinion about the relevance and reliability of the developed financial statements. This financial audit is thus conducted mainly by an external auditor hired by a business to provide an impartial view on the financial statements concerning its relevance and reliability that is whether such developed financial statements are free from material errors, misstatements and frauds thereby representing the “true and fair view” of the financial position and performance of the concerned business entity. This external audit is of material importance mainly to the relevant stakeholders of a business who economic and business decision rely on such impartial opinion of the external auditors. However, it is to be further noted that the specific field of financial audit has been majorly underpinned in the light of well-known literary theories and major accounting and auditing scandals that have been discovered in the last two decades which both gathered heavy criticism for this very role of financial auditors and the audit field in general and at the same time have led the formation of several strict regulations in the filed of auditing and professional accounting which the audit firms and these professional auditors and accounts have to abide by during the conduction of an audit. Therefore, the aim of this assignment is to develop a well-laid out essay on the field of financial audit in the light of well-known theories concerning audit and in the light of numerous criticisms for this very field that have led to the formation numerous strict regulations for professional audits and auditors.

There are numerous well-known theories that justify the role of financial audits such as the “motivational theory”, “Stewardship theory” and many more. However, the three eminent theories which perfectly justifies the role are as follows:

The theory of “Expectation gap” in audit portrays the differences in opinion or expectations of the auditors and the users of audit report (Coram and Wang 2021). The users of audit report are those stakeholders of a business who’s economic and business decisions greatly rely on the impartial opinion of the auditor published in the form of an audit report. It is to be noted that the expectation gap is concerning the true functions and responsibilities of the auditor itself. Now, considering the actual responsibilities of the auditor, the auditor is expected to review the financial statements and provide a reasonable assurance on the reliability and validity of it. But this is not the expectation of the users of the audit report, where they expect that the auditor should portray an absolute assurance on the reliability and validity of the prepared financial statements and take all responsibility of any corporate fraud is being detected post audit which is not the real case. This is where the expectation gap lies between the auditor and the users of audit report or the public in general. This is thus an eminent theory that greatly justifies the role and responsibility of financial audit.

Theories Surrounding Financial Audits

Agency theory according to Panda and Leepsa (2017), represents that principle or theory which is greatly relied upon in providing resolution to the issues arising between the principals or shareholders and their agents or executives. Therefore, the aim of this theory is to explain the relationship existing between the principals and their appointed agents within the corporate structure. It is to be noted that the executives of a business are always in possession of more first-hand information concerning the value of the company. This creates a situation of “information asymmetry” between the principals and appointed agents which often leads to “conflict of interest” and agency problems between them. So, the appointment of an external auditor who would perform an impartial analysis and review of the work done by the management concerning the preparation of financial statements would be of material importance. So, the “Agency theory” greatly justifiers the role of financial audit.

The theory of Insurance states that the stakeholders and other users of financial information presented by a company’s management are always at a risk of presence of material misstatement, errors and presence of fraud. So, the auditor’s impartial investigation and report is relied upon by the various stakeholders which can be said to be effectively reducing such identified risk. This is why this particular “Theory of insurance” greatly justifies and demands the role of financial audit.

UK is one such country which can be characterised by presence of a strong legislation and regulation in every field especially concerning business where auditing is no exception. It is to be noted that there was no proper regulation in the field of accounting and auditing until 1990’s. Post 1990’s there were prominent cases of corporate fraud and auditing failures detected in many well-known countries such as “Polly Peck Plc” case of the UK discovered in 1991, followed by “Enron scandal” in 2001 and “WorldCom scandal” in 2002 within the USA. This led to the formation of a strong regulation in the field of professional audit. So, the auditing regulations which governs the auditing profession in the UK firstly includes the “Auditing standards” or the “ISA’s” such as “ISA UK 220” and many more, followed by the “Code of Ethics” to be followed by professional accountants that envisages fundamental principles such as “Objectivity”, “Integrity”, “Confidentiality”, “Professional competence and due care” and “Professional behaviour (Beattie, Fearnley and Hines 2015).” The professional accountants and auditors are also required to abide by the laws and regulations prescribed by the “Companies Act 2006.” Lastly, the external auditors are also required by the “UK Corporate Governance Code” to independently check and form an opinion on the compliance of the “BOD” of the client under audit with the “Code.”

The external financial audits is one such relevant corporate financial investigation whose role and importance is much debated throughout the world. There are some persons or critics who are of the view that there is a growing need for an impartial external audit mainly speaking from the perspective of recently discovered financial frauds and auditing failures. According to Kassem and Higson (2016), there is a definite requirement for external impartial auditing to be conducted on a regular basis mainly after the discovery of major accounting fraud and auditing failure cases concerning “Enron case”, “WorldCom case” and many other cases such as “Polly Peck case”, “Carillion” and many more. On the other hand, there are numerous other critics who are of the view that external financial audits are nothing but a waste of time and money for a business. This is because they think that external auditors provide a reasonable assurance and not absolute assurance and there are existing fraud cases where it is proved that external auditors are at fault or acted out of coercion or intimidation threat posed to the profession by the audit client and therefore are of the view that there is no need for an external audit (Bhaskar, Flower and Sellers 2019). One such case which these people cite is the “Enron scandal” where the auditor, “Anderson” was at fault.

Conclusion 

Therefore, after an impartial review of the above points considering the justification for and against the external audit especially in the light of present robust auditing regulations within the UK and relevant theories concerning the role of external audit, it can be said that the “external audit” is one of the eminent functions within the corporate sphere which must be performed on a regular basis by all business organisations. This is because the external audit function keeps a timely check on the management and their actions thereby resisting the happening of any kind of frauds or presence of material misstatement within the financial statements thereby helping relevant stakeholders in making prudent business and other financial and economic decisions concerning the business organisation.

References and bibliography

Beattie, V., Fearnley, S. and Hines, T., 2015. Auditor–client interactions in the changed UK regulatory environment–a revised grounded theory model. International Journal of Auditing, 19(1), pp.15-36.

Bhaskar, K., Flower, J. and Sellers, R., 2019. Financial failures and scandals: From Enron to Carillion. Routledge.

Bosse, D.A. and Phillips, R.A., 2016. Agency theory and bounded self-interest. Academy of management review, 41(2), pp.276-297.

Cenciarelli, V.G., Greco, G. and Allegrini, M., 2018. External audit and bankruptcy prediction. Journal of Management and Governance, 22(4), pp.863-890.

Cohen, J., Ding, Y., Lesage, C. and Stolowy, H., 2017. Media bias and the persistence of the expectation gap: An analysis of press articles on corporate fraud. Journal of Business Ethics, 144(3), pp.637-659.

Coram, P.J. and Wang, L., 2021. The effect of disclosing key audit matters and accounting standard precision on the audit expectation gap. International Journal of Auditing, 25(2), pp.270-282.

Kassem, R. and Higson, A.W., 2016. External auditors and corporate corruption: implications for external audit regulators. Current Issues in Auditing, 10(1), pp.P1-P10.

Panda, B. and Leepsa, N.M., 2017. Agency theory: Review of theory and evidence on problems and perspectives. Indian Journal of Corporate Governance, 10(1), pp.74-95.