Advanced Auditing
Summary Book Chapters
Chapter 1
Information
Informed decisions should rely on information that is objective, relevant, reliable and
understandable
There are some information risks when making decisions based on financial reports. Information
may be:
- Biased
- Irrelevant
- Inaccurate
- Sensitive
- Complex
The role of auditing
There are four general reasons explain the natural demand for auditing:
1. Managers of an enterprise may get sloppy or behave in inappropriate ways if they are
not subject to independent scrutiny.
2. Many stakeholders might not have sufficient expertise to evaluate the quality of financial
statements
3. Reliable financial reports, in general, reduce an organization’s cost of capital. It helps to
make investment decisions and reduces risk by having reliable information.
4. Investors and creditors want insurance against significant error of fraud associated with
financial statements.
History of auditing:
- Auditing dates from the 1800s and is developed as a result of economic and political
forces at that time
- In Britain, a major concern of wealthy families and powerful individuals was that there
distant assets were properly maintained and utilized by local caretakers → early
emphasis on stewardship (verification of existence and proper handling of assets)
- 1830/1840: British government allowed limited liability company formation to the
requirement that they file audited financial statements even if it was not open to public
for investment → statutory audit of financial statements
- 1990s model of auditing changes in the U.S. as investments were now open for the
middle class → more concerned about future profitability (income) than stewardship
assets → development of accrual-based accounting
,The demand for assurance
Two potentially offsetting forces that influence the likelihood that they will misstate FS for own
benefit:
1. Incentives for showing good performance
2. Ethical principles that emphasize honest dealing
Incentives: motivational forces such as bonuses or contingent compensation that may push a
manager to work hard to achieve goals and objectives, but may also motivate employees to lie
or employ accounting tricks when goals are not met.
Ethical principles: provide a counterweight to perverse incentives by defining norms of
behaviour or conduct for individuals and organizations that define inappropriate actions and
activities→ influence the willingness of individuals to take part in inappropriate activities
Why create incentives → increase commitment of individual manager to achieve the broad
goals of the organization:
- Information asymmetry: occurs when one party knows more about the quality of
information provided than another party.
2 situations where incentives and information asymmetry combine to create potentially
dysfunctional distrust:
1. Adverse selection: a buyer of a product/service cannot distinguish between good and
bad alternatives.
2. Moral hazard: refers to how individuals behave when their actions cannot be observed
by other stakeholders, or when they are not held accountable for their decisions by those
to whom they report.
● Shirking: inappropriate behaviors (from owner’s perspective)
Agency costs: the cost of inappropriate behaviour by the managers and the manager’s loss of
earnings attributable to the owner’s distrust.
Philosophical perspectives on value of societal norms:
- Utilitarianism: involves making decisions that result in an increase in the benefits to
some while doing no hard to others
- Golden rule: involves making decisions that result in treating others in a manner in the
individual making the decisions would like to be treated
- Theory of rights: suggests that the rights of a decision maker and other parties should
be equally balanced in making a decision
- Theory of justice: suggests that decisions should treat all stakeholders fairly,
impartially, and equitably
- Enlightened self-interest: involves making decisions in all parties’ long term self-
interests and avoiding a short-term focus that might harm others
,Actions when in situation where actions are ethically questionable:
- Remain loyal
- Exit from situation
- Voice concern
The role of corporate governance
Corporate governance: involves oversight of management’s activities, including establishing
strategy, conduction operations to achieve strategic objectives, manage risks, and
communicating effectively with key stakeholders → includes board of directors, and committees
such as Audit & Compensation committee, the internal and external auditor
Audit committee: monitor on behalf of BoD, shareholders management’s financial reporting
process. In the U.S., members must be:
- Financially literate: read + understand FS appropriate for complexity associated with the
organization
- Financial expert: must have served in an accounting role or supervised accountants in
previous/current position, such that the person is expected that that he/she has an in-
depth understanding of the organization’s FS.
Compensation committee: oversees executive compensation and provides reports to
shareholders about the amount and nature
Internal auditors: employed by company itself (are seen as key component of corporate
governance oversight in large companies)
Differentiating assurance, attestation, auditing and accounting
Auditor: considered a trusted arbiter of information → The auditor is free of conflict of interest,
possess adequate expertise, is able to evaluate reliability of the information, and understands
the context in which the information is being conveyed.
Downward pressure on audit fees led to:
1. Reduced audit effort due to low profitability
2. Increased emphasis on cross-selling by audit partners of non-assurance services for
generating fee growth→ Arthur Andersen
Assurance services: independent professional services that improve the quality of information,
or its context, for decision-makers
Assurance engagement: engagement in which a practitioner aims to obtain sufficient
appropriate information in order to express a conclusion designed to enhance the degree of
confidence of the intended users, other than the responsible party, about the outcome of the
measurement or evaluation of an underlying subject matter against criteria.
, Two forms:
1. Direct reporting engagement: practitioner measures and evaluates information directly
2. Attestation: process of providing assurance about the reliability of specific information
provided by one party to another
Attestation is the process of providing assurance about the reliability of specific information
provided by one party to another. Attestation focuses on a specific assertion that is made in
writing
Accounting: process by which information about an activity or enterprise is identified, recorded,
classified, aggregated, and reported.
Financial accounting: specific process of identifying, recording, classifying, aggregating and
reporting the information that is required for external purposes that has historically been called
Generally Accepted Accounting Principles
The auditing profession and regulation
Auditing: process of providing assurance about the reliability of the information contained in a
financial report prepared by management in accordance with GAAP.
Auditor suggests changes to client management where the auditor believes GAAP has not been
applied correctly, and reports results of audit to shareholders
→ GAAS: Generally accepted accounting standards
Authoritative Guidance and Standards: PCAOB standards based on AICPA & ASB standards.
