Economic decision in every society must be made based on the information that is available at the time of decision-making. For example- the decision relating to giving a loan by the bank is made based on the financial relationships with the business, the financial condition which is reflected as per the financial statements of the company. If the decision is consistent according to the decision makers the information used in the decision-making is reliable. Unreliable information can lead inefficient use of the information for the society and for the decision makers (De et al., 2015). As the society becomes more and more complex there is a high possibility that the decision makers would be provided with unreliable information. There would several reasons for this like huge volume of data and availability of complex exchange transactions.
[A] Field of research
Auditing is important for a company because it helps a company in attaining the various corporate objectives. It helps in the creation of a reliable financial statements or reports which is important for internal and external use. Internal audit also plays an important role for preventing frauds in the company.
[B] Source of secondary data
Data has been collected from the following sources for the research purpose is Google scholar, books, journals and newspaper.
[C] Research question
In this particular assignment topic like importance of audit in an organization, what is auditor’s report? What is internal and external audit? Why an auditor is regarded as an independent person?
[D] Search terms used
The terms used to carry on this assignment includes auditing, importance of auditing, internal auditor, external auditor, auditor report.
[E] Sources for the literature review
William Jr, M., Glover, S., & Prawitt, D. (2016). Auditing and assurance services: A systematic approach. McGraw-Hill Education.- This article states the definition of auditing which refers to the examination or verification of compliance and determine whether the financial statements depict the true and fair financial position of an organization.
Adler, P., Falk, C., Friedler, S. A., Rybeck, G., Scheidegger, C., Smith, B., & Venkatasubramanian, S. (2016). Auditing black-box models by obscuring features. arXiv preprint arXiv:1602.07043.- This article highlights the importance of audit in an organization. Auditing is important because it helps the company in attaining corporate objectives and provides a base for internal and external use of these financial statements.
Blankley, A. I., Hurtt, D. N., & MacGregor, J. E. (2014). The relationship between audit report lags and future restatements. Auditing: A Journal of Practice & Theory, 33(2), 27-57.- This article highlights the types of audit reports and how the working of an organization is affected. There are four types of audit report, which includes clean report or unqualified report, qualified report, negative report and the report of disclaimer.
Gimbar, C., Hansen, B., & Ozlanski, M. E. (2016). The effects of critical audit matter paragraphs and accounting standard precision on auditor liability. The Accounting Review, 91(6), 1629-1646.- This article will highlight the duties which the auditor performs. To judge whether an organization’s business activities are appropriate and also the decisions which the directors make are suitable for the organization.
Whitworth, J. D., & Lambert, T. A. (2014). Office-level characteristics of the Big 4 and audit report timeliness. Auditing: A Journal of Practice & Theory, 33(3), 129-152.- This article highlights the various types of audit which includes internal audit, external audit, tax audit, forensic audit and public sector audit.
Strecker, S., Heise, D., & Frank, U. (2015). Prolegomena of a modelling method in support of audit risk assessment-Outline of a domain-specific modelling language for internal controls and internal control systems. Enterprise Modelling and Information Systems Architectures, 6(3), 5-24.- This article will highlight the various risks relating to auditing. Inappropriate audit opinions would include issuance of unqualified audit report where there is a reasonable justification, issuance of a audit opinion where the qualification is not necessary.
Audit refers to the examination of the financial report of the organization the way it is presented in the annual report by a person who is independent of that organization. The financial statement of an organization consists of balance sheet, income statement, cash flow statement and a statement that shows changes in equity and detailed notes, which consist of various accounting policies, and the explanatory notes (William, Glover & Prawitt, 2016). The main reason for performing audit is to examine whether the information included in the financial report depicts the true and fair financial position of an organization on a particular date. This includes details regarding what the organization owns has been recorded properly in the balance sheet and whether the profits and losses are being assessed properly. While carrying out the examination of the financial reports the auditor should see to it that proper auditing standards which has been prepared by a government body has been followed. After completing the work, the auditors write a report known as the auditor’s report, which highlights the things, they have done and an opinion is drawn from the work they have done. Usually, the companies listed and limited liability companies are the ones who have to audit their financial statements every year. In case of other organizations they might require or request an audit, although it depends on the structure and the ownership.
The auditor performs the following duties:
- Audit of the other information, which is to be provided to the members of the organization like the director’s report.
- Check the authenticity of the figures provided in the financial reports because audit is mainly based upon selective testing.
- To judge whether an organization’s business activities are appropriate and also the decisions which the directors make are suitable for the organization (Gimbar, Hansen & Ozlanski 2016).
- Every transaction that is carried by the organization has been checked.
- The adequacy of the organizations internal control is being tested.
- Comment to the shareholders about the quality of directors and the management, the corporate governance quality, the organization’s risk management procedures and the controls quality.
However, the auditor cannot perform some of the functions, which includes:
- Predicting the future- audit is related to a period, which addresses certain past accounting period. It cannot judge or estimate what is going to happen in the near future and so it not possible for the auditor to provide an assurance whether an organization will continue the business for an indefinite period.
- Be present all the time- the audit needs to carried out during a defined timeframe and it is not possible for the auditors to be present in the organization all the time. However, the main purpose is forming an opinion from the information available in the financial report and not identifying the irregularities possible (accounting standards, 2017). This means that even if the auditors lack signs of potential material frauds there is no certainty that the frauds will be identified.
For conducting audit, an organization has take into consideration the following points:
- The management of the organization prepares the financial report and it is prepared according to the legal requirements and as per the financial reporting standards.
- The financial report is been approved by the director’s organization.
- The examination of an auditor will start after gaining an understanding about the activities an organization carries and taking into consideration the economic and the industrial issues that will affect the business during the reporting period (PWC , 2017).
- For the activities that that have been listed in the financial report, the auditor needs to identify and assess the risk which might have a significant impact on the financial performance and position and also some measures which the organization needs to take in order to mitigate these risks.
- Based on the risks and the controls that has been identified the auditors need to consider what the management does or what it has done to ensure that the financial reports are accurate and they provide a supporting evidence (McDonald & Wilson,2016).
- Then a judgment is made as to whether the financial report prepared depicts a true and fair view of the organization results or the position. The preparation of the cash flow and its compliance with the financial reporting standards and its applicability with the Corporations act.
- At the end, an auditor’s report is being prepared stating the opinion important for the shareholder’s or the members of the organization.
The main job of an auditor is discussing the scope of audit work with the organization, which, includes the directors or the managers and might even request to perform additional procedures. In order to make the tests and the judgment the auditor is required to maintain independence from the management and the directors (Knechel & Salterio, 2016). The auditor determines the extent and the type of the audit procedures, which they are required to perform which depends on the risks and the control, which they have to identify. The procedures here include:
- Ask a range of questions, which involve questions from formal written to the oral questions, which are informal to a range of individuals of the organization.
- Examination of the financial related and accounts related records, documents and tangible items, which includes plants and equipment.
- Make judgments for the important estimates and assumptions, which was taken by the management for preparing the financial report.
- Certain matters need written confirmations for example to ask the debtor to confirm the debt amount with the organization.
- Organization’s internal control need to be tested.
- Watch specific process that needs to be performed.
The auditor might specialize in the audit based on the purpose of audit like the verification of the compliance, performance or the conformance. Some of the audits have some special administrative purpose like the auditing of the document, risks or performance or following corrective actions, which are complete. Companies having high-risks like toys, elevators, gas appliances and the medical devices must use CE mark requirements. One of the ways by which the organization can compel their management system, which is certified by third-party audit organization to the management system requirement criteria. Customers might suggest that their suppliers confirm a safety criteria and the fiducially requirements may be applied. Audit done by a third party usually results in the issuance of certificate where it is stated that the audit organization management system complies as per the requirement of the pertinent standard or the regulation (Furnham & Gunter, 2015). Various authors have used terms that describe the purpose of audit beyond compliance, value-added assessments, benefit auditing, management audits and continuous improvement assessment. The main purpose behind this audit is to go beyond traditional compliance. The organizational performance is related to the audit purpose. Audit, which determines the compliance and the conformance are not focused on the good or the poor performance however, performance is important for most of the organizations. The main difference between the compliance audit and the audit, which is designed for promoting improvement, is collecting the audit evidence, which is related to the performance of the organization versus the evidence needed to crosscheck the compliance to a standard or a procedure. An organization might conform from the procedure of taking orders but if the orders are being changed many times the management might be concerned and would like to rectify the inefficiency. A product, system or process audit have finding that would required certain corrective measures. As it is not possible to perform all the corrective actions at the time of audit it is required by the audit program manager to take up follow-up audit in order to check the corrections that were made and take appropriate actions to confront them. Since a high cost is involved in the single-purpose follow-up audit, it is usually combined with the next time slot of audit (Jans, Alles & Vasarhelyi, 2014). This decision should however be based upon the risk and the importance of finding. Follow-up audits can also be conducted by an organization so that they can verify the preventive actions that were taken due to the performance issues and it might be reported as opportunity for improvement. At other times, the organization might forward the performance issues to the management for taking further actions.
Importance of Audit
People who make decisions based on the financial position of a business are the ones who need the information, which is most reliable (Adler et. al, 2016). Whenever there is a need to evaluate the company there, main preference is to make a thorough examination of the books of accounts. The importance of audit are as follows:
Reliability of information- many entities like the banks, suppliers or investors analyses the financial statements of the company and give an opinion about the financial position of the company. Since, there is risk involved in putting the funds in the company, which is important for these entities have a professional examination of the company’s books.
Selection of the auditors- companies trading publicly require to audit the financial statements as per the statue however other companies might audit their financial statements for satisfying the requirements of the bank, suppliers or the employed internal auditor (Wang et al, 2013). When the companies hire public accounting firms the board of directors are responsible to perform the task. It should not hire a firm only on the basis brand name, it should ensure that well qualified and experienced in the company.
Auditing process- conducting of audit is a matter of planning the work for the financial statements by a process of observing, inquiry and inspecting the internal financial books and the records. The auditor has to undertake various tests like request for confirmation of the orders, prove the accuracy of the items that are stated in the financial statements (Ni et al., 2015). An audit trail needs to be constructed where the recording of the transactions are done chronologically which enables the evaluation of the internal controls and the company policies.
Auditor’s report- for examining the financial statements the auditor might take weeks or months. After completing the work, the audit team prepares a report. The report contains the findings of the auditor, which it has made about the financial statements and weather they comply with the accounting standards. The last part pertains the opinion of the auditor for the statements.
Types of audit
Audit is an appraisal activity which is taken by an independent person for providing acceptance to a principle like the shareholders on the subject matter like the financial statements which is the responsibility of some other person like the directors on the basis of certain framework like IFRS (international financial reporting statement) and GAAP (generally accepted accounting principles). The following are the types of audit:
External audit- external audit is known as the financial or the statutory audit whose main area of work is to examine the truthiness and the fairness of the financial statements of an organization. He is an independent person as according to the reporting the framework like the IFRS. It is compulsory for certain companies to perform external audit if the annual basis of the company is more than the defined size (Whitworth & Lambert, 2014). The primary need for the statutory audit aims at separation between the ownership and ownership in case of the large companies where the directors are nominated by the shareholders for running the state of affairs of the company on their behalf. Since the directors, report on the financial position of an organization there is a need of assurance by the shareholders before relying on the statements provided by them.
Internal audit- internal audit is also known as the operational audit, it can be referred to as the voluntary appraisal activity which an organization needs to undertake for providing the assurance over the potential of the internal controls, the risks involved and the governance required to achieve the objectives of the organization (Ege, 2014). The employees of the organization are the one who perform internal audit and the board of directors of the audit committee is reported as against the external audit which is mainly done by independent professionals of the organization and they report the audit report to the shareholders
Forensic audit- auditing and investigation of the skills that would require legal implications is refereed to as forensic auditing. It involves investigating the fraud, which includes money laundering, tax evasion, insider trading and misappropriation of frauds. Determination of the share of profit of the partners in case of any dispute. Determining any claim relating to any professional negligence, this is related to the accounting profession.
Public sector- many companies and institutions, which are state owned, are required to examine their affairs by a public sector auditor. Public state audit involves scrutiny relating to the financial affairs of the enterprise, which is state owned to check that their operations are in such a way that they are operated to the best interest of the public and to check that the standard procedures has been followed and to comply with the requirements for promoting transparency and good governance.
Tax audit- it is conducted to check that the tax returns, which is filled by the company, is accurate and to determine the amount, which is over or under the assessment of the tax liability (Hauptman, Horvat & Korez-Vide, 2014). In case of certain jurisdiction companies which are above certain size requires to perform tax audit at regular intervals however in case of others certain random companies are being selected by a balloting system and they are required to perform the tax audit.
Environmental & social audit- this involves assessing the environmental & social footprints which an organization would leave due to certain economic activities. Due to an increase in the number of companies who provide environmental reports in their reports it is important to perform environmental audit. Environmental audit means providing an assurance relating to the correctness of the statements and the claims made in the reports. For example- the company makes a disclosure regarding the CO2 emission in its sustainability report, the environment auditor would check this assertion by collecting the evidence which is relevant for the audit examination.
True and fair view of financial statements
True and fair view of the financial statements means that the financial statements contains no misstated facts and it assures that true and fair financial position of an entity is being depicted. However, the definition of true and fair is not defined in the accounting literature however a general conclusion can be formed form the meaning. True here means that the financial statements are factually correct and they have been prepared based on the given framework like the IFRS and that they do not contain any misstated facts that might mislead the users (Palea, 2014). Misstatements result from omission of material transactions from the balance sheet and misstating the figures in the balance sheet. Fair here implies that the financial statements present the information truthfully and faithfully without any biased element and that it reflects substance transaction rather than just a legal form.
Audit risk refers to the risk, which an auditor needs to express if an inappropriate opinion is being formed about the financial statements. Inappropriate audit opinions would include issuance of unqualified audit report where there is a reasonable justification, issuance of a audit opinion where the qualification is not necessary (Strecker, Heise & Frank, 2015). Failing to emphasize on matter, this is significant for the audit report. Giving an opinion about the financial statements where there is no need of any such opinions due to the limited horizon in the performance of the audit.
The three elements, which are related to audit risk, are as follows:
Inherent risk- it refers to the risk of misstating the material facts in the financial statements, which occurs due to error or omission due to factors other than the failure of controls. Inherent risk is usually higher where there is involvement of high degree of estimation and judgment and where the transactions relating to the company is highly complex.
Control risk- it is the risk of misstating of material facts that takes place mainly due to absence or the failure in the operation of the relevant controls in the entity. The internal control in an organization must be proper in order to prevent and detect the incidence of fraud and the errors. Control risk is high if the audit entity is not having sufficient internal control for preventing and detecting frauds and the errors that occur in the financial statements.
Detection risk- detection risk refers to the risk, which has to be faced when there is a failure to detect material misstatement in the financial statements (van et al, 2015). Omission of critical audit procedures results in undetecting the material statement by the auditor. There are some of the detection risks, which is present because of various inherent limitations in the audit like using sampling for selecting the data.
Types of audit report
The audit reports are of four types, which is issued by the auditor in the financial statements. The financial users get different message and meaning from each of the report. The following are the types of the audit reports:
Unqualified audit report- it is also known as clean report, which is being issued by the auditor to check that there is no material misstatements after the test. This kind of report depicts that the financial statements, which are prepared, are true and fair and that they have complied with appropriate accounting framework. It is regarded as a good sign for the stakeholders who are willing to use the financial statements (Blankley, Hurtt & MacGregor, 2014). Unqualified report not only shows the shareholders that the financial statements are true and fair but also depict that they are free from all sorts of ill facts. It can also be implied that the management’s team would have a high entirety to the shareholders. However, it is important before putting the truth on the audit report the auditor must be issued by any independent audit firm. Shareholders have trust on the gig four audit firms as they will have the best team.
Qualified audit report- The auditor of the financial statements that had material misstatements issues qualified audit report and these misstatements were not pervasive. For example, verification of the huge of inventories in the opening balance is not possible. In such a case qualified audit opinion is being issued. In such reports the auditor issues a qualified audit report. In these kind of reports only inventories matters. The terms related to seriousness in the qualified audit report is more seriousness than the unqualified because of the material misstatements on the mentioned items in the financial statements.
Adverse audit report- The misstatements are different from the material misstatements found in case of a qualified report. These are not only materially misstated for themselves but they also affect the accounts and the various items stated in the financial statements (Dao & Pham, 2014). Therefore, the investors, the stakeholders or the shareholders cannot trust all the items and the various accounts mentioned in the financial statements. In the audit report, it is the liability of the auditor to name the client in the financial statements, the part of the financial statements that need to be audited and the period in which the financial statements is covered. Auditor will state the misstatements found and how the users of the financial statement be affected. In many cases, the auditor is liable to state all the misstatements found and how it is going to affect the financial statements and its users. In most of the cases the auditors usually state the other matters which acts as a message for the other users of the financial statements to be aware of when they read the financial statements.
Disclaimer audit report- Disclaimer report takes place when the auditors want to prevent the access to some information related to certain items, accounts in the financial statements while these accounts, or items are materially misstated and pervasive (Barako & Brown, 2016). Auditors would issue the disclaimer report if there are restrictions made on the items or the accounts that were misstated but not pervasive.
Advantages of audit reports
- Providing an assurance on the financial statements because these reports are prepared by an independent auditor whose operation is independent of the management of the company.
- Prove the integrity of the shareholders. Since the auditor is independent from the management, the report would prove that the management is honest with their shareholders and this is related with the principle and the agency theory.
- The law and the regulations require it. Most of the countries require that the entities have specific criteria for having their financial statements being audited by the independent auditor.
- The shareholders require them. Most of the corporate shareholders want the financial statements to be audited. The report is examined by the experts and is expressed in easy words making it easy for the shareholders to understand who are not from the financial background.
- Meeting the parent company’s requirement. There are many parent companies, which have their subsidiaries operating in the same, or some other country require that the financial statements of the subsidiary company be audited (Coetzee & Lubbe, 2014). This report will enable the manager to manage the accounts of the subsidiary company even more efficiently.
- Helping the stakeholders to understand the financial and operational situation of the entity. This is one of the most important point. Auditor has to state in its audit report if the company is having any going concern problem or not. This would also include the financial and the non-financial problems due to which the entity may face bankruptcy in the next stated period.
Limitations of the audit report
- The management limits the scope of audit. In the audit standards the auditor will have full access to any kind of information that would help the auditor to obtain an audit evidence and give an opinion. Although in practice the management even try its best to prevent the auditors from obtaining some sensitive information (Czerney, Schmidt & Thompson, 2014). These are the probable reasons that the management will not trust the auditor’s ethics, which is related to the confidentiality or the management themselves. The problem might even prevent the auditors from providing the best quality of the audit opinion that should be.
- Time constraints are the main issue for the auditors. Normally, the auditor faces many time related constraints, which does not provide the auditor with enough time to perform the testing as it should be.
- Auditor’s independence. The code of ethics is needed by the auditors to stay independent form the client audit. This would make sure that the auditor do not bias when their work is performed and they issue a fair audit opinion.
- Risks which cannot be detected by the auditor includes inherent risk and fraud risk. A proper planning is required for assessing the risks. This is done to make sure that the quality of the audit is maintained and the risks relating to audit are identified and minimized.
- Qualifications and competency of the auditor. As it is known that for running a audit firm a representative of the firm needs to hold a CPA qualification. However, due to excessive competition and the work load there are some problems in the quality of the audit report.
Need for auditor independence
The auditor should be independent of the client company so his opinion will not be influenced by any kind of relationship between them. The auditor is expected to give an unbiased and an honest professional opinion regarding the financial statement to its shareholders. There are certain doubts relating to the independence of the external auditor. It has been argued that that until and unless suitable corporate governance is in place a firm of auditors might reach the audit opinions and the judgment that would be highly influenced by the desire for maintaining good relations with the client company (Blay & Geiger, 2013). If the same situation prevails the auditor can no longer be termed as independent and the shareholders cannot rely upon the information they have provided. The accounting firms in some cases also set the audit fees of the auditor less than that of the market rate and make up the deficit by providing with the non-audit services like the management consultancy and tax related advice. Because of which some of the audit firms have commercial interests for protecting. This would raise a question on the opinion of the auditor to protect the shareholders of the company and the commercial interest might conflict with each other.
Threats to an independent auditor
The audit profession has recognized following threats to the auditor independence and these include:
- Self-interest threat- when an auditor is financially dependent upon the audit client or when a person closely related has some type of financial or any other interest in the audit client. The management is also dependent upon the company management for securing its re-appointment as that of an auditor (Glover & Prawitt, 2014).
- Familiarity threat- the relationship between the client and the auditor is for long-term or is so familiar that the auditor gets involved in advising the client and acts the role of the management.
- Self-review threat- the auditor needs to give a judgment, which states that the previous work of the firm, needs to be challenged or being re-evaluated.
- The trust threat- the directors and the management trust the auditor largely thereby preventing proper testing of the management information and the representations (Bauer, 2014).
- The intimidation threat- the auditor is being intimidated by the actual or the potential pressure from the client or the other party.
- The advocacy threat- the auditor gets involved in promoting the interest of the client.
Audit evidence refers all the information, which is being obtained, from the audit procedures and the other sources that is being used by the auditor for arriving at the conclusions which is based on the opinion of the auditor (Alles, 2015). Audit evidence consists of information that will support and corroborate with the assertions of the management in regard with the financial statements or the internal control over the financial reporting and the information that will contradict with such assertions. The main objective of the auditor is planning and performing the audit for obtaining the appropriate audit evidence, which would be sufficient for supporting the opinion, which is expressed in the auditor’s report.
The auditor should plan and then perform the audit procedures for obtaining sufficient audit evidence for providing a reasonable basis. Sufficiency is defined as the measure of quantity of the audit evidence. Audit evidence is affected by the following cases:
- Risk related to material management: it is also known as the risk, which is related with the control. As the amount of risk increases, the amount of evidence required by the auditor will also increase (Backof, 2015). For example- for responding certain specific risks more evidence is required.
- Quality of the audit evidence that is obtained- as there is an increase in the quality of evidence the need for collaboration of the additional evidence also decreases. Receiving the same type of audit evidence cannot compensate the poor quality of that evidence.
Relevance and reliability
Relevance- in audit evidence relevance refers to the relationship to the assertion or its objective of control for testing (Lenz & Hahn, 2015). The audit procedure is so designed that it will test the assertion or will control directly and test for any kind of under or over statement and the time of the audit procedure that is used to test the assertion or the control.
Reliability- the reliability would depend upon the nature and the source from which the
evidence is obtained that is from the internal company sources. The evidence obtained directly from the auditor is more reliable than the evidence obtained indirectly (Broyles et al., 2015). Evidence obtained from the original documents tends to be more reliable than the evidence provided by the photocopies or the document that have been filmed, digitized or something being converted to the electronic form
Small business firm often fail because the owners are not aware of many elements preventing the growth of the business and becoming successful. In many cases, the small businesses are organized based on certain specific area of expertise like marketing, accounting and production. The existence of specialized expertise prevents the owner of the business from identifying the problem arising in the other parts of the business. Audit will help in help the small firms entrepreneur to understand the essential for conducting a comprehensive research for the current or the potential problems. Audit was mainly introduced by keeping these small businesses in mind and tackles various problems. Thus, by using management audit instrument and audit analysis at regular intervals the small business managers can see pitfalls in a better way and will get sufficient time to react thereby ensuring a greater possibility for the survival and the prosperity of the business.
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