The Institute of Chartered Accountants in Australia

Addressing Unit 3BACF Accounting & Finance The role and function of external auditors

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The Institute of Chartered Accountants in Australia

Government and the community The role and influence of governments and other bodies The role and function of external auditors Financial statements are used for a variety of purposes and decisions. For example, financial statements are used by owners to evaluate managements stewardship, by investors for making decisions about whether to buy or sell securities, by credit rating services for making decisions about credit worthiness of entities, and by bankers for making decisions about whether to lend money. Effective use of financial statements requires that the reader understand the roles of those responsible for preparing and auditing financial statements. Financial statements are the representations of management. When using managements statements, the reader must recognize that the preparation of these statements requires management to make significant accounting estimates and judgments, as well as to determine from among several alternative accounting principles and methods those that are most appropriate within the framework of generally accepted accounting standards. In contrast, the auditors responsibility is to express an opinion on whether management has fairly presented the information in the financial statements. In an audit, the financial statements are evaluated by the auditor, who is objective and knowledgeable about auditing, accounting, and financial reporting matters. During the audit, the auditor collects evidence to obtain reasonable assurance that the amounts and disclosures in the financial statements are free of material misstatement. However, the characteristics of evaluating evidence on a test basis, the fact that accounting estimates are inherently imprecise, and the difficulties associated with detecting misstatements hidden by collusion and careful forgery, prevent the auditor from finding every error or irregularity that may affect a users decision. The auditor also evaluates whether audit evidence raises doubt about the ability of the client to continue as a going concern in the foreseeable future. However, readers should recognize that future business performance is uncertain, and an auditor cannot guarantee business success. Through the audit process, the auditor adds credibility to managements financial statements, which allows owners, investors, bankers, and other creditors to use them with greater confidence. The auditor expresses his assurance on the financial statements in an auditors report. The report, which contains standard words and phrases that have a specific meaning, conveys the auditors opinion related to whether the financial statements fairly present the entitys financial position and results of operations. If the auditor has reservations about amounts or disclosures in the statements, he modifies the report to describe the reservations. The auditors report and managements financial statements are only useful to those who make the effort to understand them.

Introduction to Audits and Financial Reporting

In todays economy, information and accountability have assumed a larger role in our society. As a result, the independent audit of an entitys financial statements is a vital service to investors, creditors, and other participants in economic exchanges. The auditor communicates audit results in a standard report. The auditors is based on rigorous work performed by highly trained professionals. Need for Financial Statements Regardless of the type of entity whether in the public or private sector, or whether for profit or not all entities use economic resources to pursue their goals. Financial statements enable an entitys management to provide useful information about its financial position at a particular point in time and the results of its operations and its changes in financial position for a particular period of time. External financial reporting for these entities is directed toward the common interest of various users. Financial statements provide owners with information about the stewardship of management. They also provide a basis for investors decisions about whether to buy or sell securities; for credit rating services decisions about the credit worthiness of entities; for bankers decisions about whether to lend money, and for decisions of other creditors, regulators, and others outside of the entity.

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The Financial Statement Audit The objective of the financial statement audit is to add credibility to managements financial statements. Access to capital markets, mergers, acquisitions, and investments in an entity depends not only on the information that management provides in financial statements, but also on the degree of assurance that the financial statements are free of material error and fraud. In the process of providing reasonable assurance that financial statements are fairly presented, an auditor assesses whether: Transactions and amounts that should have been recorded are reported in the financial statements. The assets and liabilities reported in the financial statements existed at the balance sheet date, and the transactions reported in the financial statements occurred during the period covered by the statements. Reported assets are owned by the entity and liabilities owed by the entity at the balance sheet date are reported. The financial statement amounts (assets, liabilities, revenues, and expenses) are appropriately valued in conformity with accounting standards. The financial statement amounts are properly classified, described, and disclosed in conformity with accounting standards. The independent auditor forms an opinion on the overall fairness of the financial statements by testing the above representations. The opinion is communicated in the auditors report. The standard auditors report contains an unqualified opinion, which means that an auditor believes, without reservation, that tie financial statements present fairly the entitys financial position and results of operations in conformity with accounting standards. A qualified report, in contrast, notifies financial statement readers about concerns the auditor has about matters affecting the financial statements (such as the selection of accounting policies or the method of their application or the adequacy of financial statement disclosure) or about limitations in the scope of the auditors work. Therefore, a user should understand the implications of a qualified opinion and read this type of report carefully. Responsibility for Financial Statements Effective use of financial statements requires that the reader understand the roles of those responsible for preparing, auditing, and using financial statements. Figure 1 depicts the independent auditors role in auditing managements financial statements. Management is responsible for the content of its financial statements, regardless of an organizations size or form of ownership. The preparation of these statements requires management to make significant judgments and estimates. Managements responsibility for financial statements is not lessened by having the statements audited. The Independent Audit An audit allows creditors, bankers, investors, and others to use financial statements with confidence. While the audit does not guarantee financial statement accuracy, it provides users with a reasonable assurance that an entitys financial statements give a true and fair view (or present fairly) its financial position, results of operations, and changes in financial position in conformity with accounting standards. An audit enhances users confidence that financial statements do not contain material error and fraud because the auditor is an independent, objective professional who is knowledgeable of the entitys business and financial reporting requirements. See Figure 1 Using Financial Statements The auditors report and financial statements presented by management are useful only to those who make the effort to understand them. Knowledgeable use of the auditors report requires a general understanding of both the audit process and the meaning of the auditors report. Effective use of audited financial statements also requires a basic understanding of accounting standards, the related concepts of financial measurement and disclosure, and the inherent limitations of financial statements caused by the use of accounting estimates, judgments, and various alternative accounting principles and methods.

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Preparing Financial Statements

Managements Responsibility for Preparing Financial Statements Management is responsible for establishing an accounting system to identify, measure, record, and adequately disclose an entitys transactions and other events that affect its financial position and results of operations. In addition, management is responsible for selecting accounting principles that appropriately reflect events that occur and for making other accounting estimates and judgments. This responsibility is not lessened by an independent audit. Objective and Judgmental Issues in the Accounting Process Some transactions, such as the purchase of inventory, can be objectively identified, measured, and recorded when they occur. While the initial recording of a transaction is often straight- forward, evaluating the subsequent effects of these transactions on financial position, results of operations, or changes in financial position may require more judgment. For example, management must estimate the amount of unsold inventory that is obsolete or determine whether its market value is significantly impaired. These applications of accounting principles require significant assumptions, estimates, and professional judgments that are inherently imprecise. See Figure 2 Effects of Accounting Judgments The judgments management makes on accounting matters affect financial statements in several ways as discussed below. Financial Measurement Financial measurement involves measuring the monetary amounts of the effects of events and transactions. Such measurement is not always easy as determining the amount of a payment. Many financial statement amounts involve significant accounting estimates. For example, what portion of credit sales will be uncollectible? How long will depreciable assets remain in use? What product warranty claims will have to be paid? Accounting Principles and Methods Accounting policies encompass the principles, conventions, rules and procedures adopted by management in preparing and presenting financial statements. There are many different accounting policies in use even in relation to the same subject; judgment is required in determining and applying those that are best suited, in the circumstances, to present properly an entitys financial position and results of operations. For example, there are many acceptable methods for valuing inventory or depreciating fixed assets. Management is responsible for determining the accounting principles and methods that are appropriate for the circumstances when preparing financial statements. Once management has determined the initial accounting principle, it must have reasonable justification to change it. Adequacy of Disclosure Adequacy of disclosure relates to whether information in the financial statements, including the notes, clearly explains matters that may affect their use and understanding. Management makes decisions about disclosures that concern both the amounts and the usefulness of information in financial statements. Disclosures may be made in the body of the financial statements or in notes to the statements. Notes are considered an integral part of the financial statements. A balance should be achieved between detail and summarization. Too much disclosure can distract and overburden the user; too little can result in essential information being withheld. Going Concern In the preparation of financial statements, an entitys ability to continue as a going concern is assumed. Experience indicates that, in the absence of significant information to the contrary, continuing operation is highly probable for most entities; therefore, the assumption that an entity is a going concern is not discussed in every set of financial statements. If there is doubt about an entitys ability to continue as a going concern in the next year, then management should disclose, in the notes to the financial statements pertinent conditions that raise doubt about the entitys ability to continue as a going concern in the next year. The possible effects of such conditions, such as the possibility that the entity may be unable to continue in operation and therefore be unable to realize all of its assets and pay all of its liabilities in the normal course of business.

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Relevant National Standards or International Accounting Standards (Accounting Standards) If management is to fulfil its responsibility for preparing useful financial statements, it must pay careful attention to the quality of its accounting judgments. Financial statement preparers are guided by accounting standards on financial measurement and disclosure. Such standards, which are referred to simply as accounting standards throughout this booklet, serve as guides to those who are responsible for preparing financial statements. These technical standards, which have evolved at both national and international levels, provide a benchmark against which the auditor assesses a financial statement presentation. Within each country, local regulations and standards govern, to a greater or lesser degree, the content of financial statements. Such local regulations and standards include accounting standards that are promulgated by the regulatory bodies and/or professional accountancy bodies in the countries concerned. The International Accounting Standards Committee (IASC) was formed in 1973 to harmonize, as far as possible, the diverse accounting standards and accounting policies of different countries by producing International Accounting Standards for worldwide acceptance. International Accounting Standards promulgated by IASC do not override the local regulations that govern the issuance of financial statements in a particular country.

Auditing Financial Statements

See Figure 3 Assurance and Financial Statements The purpose of an audit is to enable the auditor to express an audit opinion on whether the financial information gives a true and fair view (or is presented fairly) in conformity with the basis of accounting indicated. The auditor performs procedures designed to obtain reasonable assurance about the reliability of managements representations in the financial statements. Guidelines established by the International Auditing Practices Committee recognize three types of service that an accountant can provide on financial statements: an audit, a review, and a compilation. Each type of service offers a different degree of assurance, as depicted in Figure 2, about financial statement presentation and disclosures. This booklet deals only with the assurances users obtain from an audit, which is the greatest degree of assurance available to users. Financial Statement Audits An audit provides a high degree of assurance to users. The independent auditor tests the data underlying the entitys financial statements to obtain evidence that, along with his other procedures, provides the basis for the auditors opinion about whether the financial statements are free of material error or fraud (that is, irregularities). In a financial statement audit, the auditor forms an overall conclusion about whether The financial information has been prepared using appropriate accounting standards, which have been consistently applied; The financial information complies with relevant statutes or laws; The view presented by the financial information as a whole is consistent with the auditors knowledge of the business of the entity; There is adequate disclosure of all material matters relevant to the proper presentation of the financial information. See Figure 4 The auditors opinion on financial statements provides users with a high, but not absolute, level of assurance. Absolute assurance in auditing is not attainable because of such factors as the use of judgments and estimates in financial statements (that is, financial statements contain approximations, not exact amounts), the use of testing, and the fact that most of the evidence available to the auditor is persuasive, rather than conclusive, in nature.

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An Auditor Is Independent The principles of independence and objectivity impose the obligation on auditors to be fair, intellectually honest, and free of conflicts of interest in relation to clients. For example, an auditor may not be financially involved with his client nor accept goods or services from him except on business terms no more favourable than those generally available to others. This ensures that an auditor is objective and, therefore, enables the public to place faith in the audit function. Although the entity is the auditors client, the auditor has a significant responsibility to users of the audit report. The auditor must not subordinate his judgment to any specific group, including his client. The auditors independence, integrity, and objectivity encourages third parties to confidently use the audited financial statements. Auditors Responsibility for Detecting Material Error and Fraud Auditors are responsible for planning and performing an audit to obtain reasonable assurance that the financial statements are free of material error and fraud. The concept of reasonable assurance, however, does not insure or guarantee the accuracy of the financial statements. The following characteristics of an audit are important to understanding the difference between reasonable assurance and a guarantee or absolute assurance. Detection of Error or Fraud In an audit of financial statements, the auditor assesses the risk of material error and fraud and, accordingly, designs the audit to provide reasonable assurance of detecting significant errors or fraud. However, some irregularities or frauds are concealed through forgery or collusion (among client personnel or outsiders). Auditors are not trained to detect forgeries, nor will customary audit procedures detect conspiracies. As a result, a properly designed and executed audit may not detect material fraud. Therefore, audits can only provide reasonable assurance that financial statements are free of material misstatements and cannot absolutely guarantee the accuracy of financial statements. Likewise, the auditor may have some responsibility for the detection of certain types of illegal acts. Audits Involve Tests Auditors rarely examine 100 percent of the items in an account or transaction class. Instead, they select and apply procedures to only a portion of those items to enable them to form an opinion on the financial statements. The auditor exercises skill and judgment in deciding what evidence to look at, when to look at it, and how much to look at, as well as in interpreting and evaluating results. Materiality in the Financial Statements Although financial statements contain approximations, they must reflect a reasonable degree of accuracy. If the degree of misstatement is significant enough to influence the decisions of financial statement users, it is considered material. Materiality is a relative concept. For example, a $100,000 misstatement of sales for a company with a $200,000 net income is material, while that same misstatement for a company with a $5,000,000 net income may be immaterial. In addition, qualitative characteristics influence materiality. For example, an error in the financial statements might be small as a percentage of a critical component. This small error, however, may be considered material because it could cause an entity to breach a loan agreement, which could result in a misclassification of current and noncurrent debt. An auditor considers both quantitative and qualitative aspects of errors found during the audit. Auditing Transactions and Accounting Estimates When an entity engages in transactions with an outside party, documentary evidence of the transaction is usually created. This evidence provides a substantial basis for the auditor to form an opinion about whether the transaction has been accounted for in accordance with relevant accounting standards. Evidence supporting the fairness of accounting estimates is not as readily available as evidence supporting transactions. While the auditor designs tests to evaluate the reasonableness of managements assumptions and factors that may influence the accounting estimate, realized values will depend on the outcome of future events. Evidence supporting the collectibility of receivables or loans, the market values of inventory, or the adequacy of product warranty liability, is inherently imprecise because collectibility often depends on economic and market conditions. However, economic factors change quickly. Because estimates are inherently imprecise, the auditors involvement simply assures their reasonableness, not their exactness.

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Auditor Consideration of Going Concern Financial reporting assumes that an entity is a going concern in the absence of significant information to the contrary. In the course of planning and performing an audit, the auditor is alert to the possibility that the going Concern assumption may not be an appropriate assumption for managements preparation of financial statements. When normal audit procedures raise questions about the appropriateness of the going Concern assumption, the auditor will obtain information about managements plans for the future. If, after considering managements plans and the reasonableness of those plans, the independent auditor concludes that he has serious doubts about the entitys ability to continue as a going concern in the next year, the auditor considers the adequacy of financial statement disclosure about this uncertainty and may include an additional explanatory paragraph in the auditors report discussing the uncertainty. The auditor has a responsibility to consider the ability of the entity to continue as a going concern in the next year based on its current condition. However, the auditor is not responsible for predicting future conditions or events nor is he able to do so. For example, the auditor is not expected to predict a significant drop in commodity prices or other changes in the market for a clients products or services. The absence of a reference, in the report, to the auditors doubt about the entitys ability to continue in operation should not be viewed as providing assurance that future events will not affect the entitys ability to continue as a going concern. Reporting Material Error and Fraud If material error or fraud are discovered and not corrected in the financial statements, the auditor brings such items to the attention of management and issues a qualified opinion. Is the Auditors Unqualified Opinion a Clean Bill of Health? Some financial statement users consider an auditors unqualified opinion to be a clean bill of health. For example, some users believe that an audit endorses an entitys policy decisions, its use of resources, or the adequacy of its internal control system. This is not the objective of a financial statement audit. The auditors opinion on the financial statements does not pertain to these matters. Other financial statement users believe that an audit provides positive assurance that a business is a safe investment and will not fail. As previously discussed, the absence of a reference in the auditors report to doubt about the entitys ability to continue as a going concern should not be viewed as providing assurance that future events will not affect the entitys ability to continue as a going concern. An audit enhances users confidence that financial statements do not contain material error and fraud because the auditor is an independent and objective expert who is also knowledgeable of the entitys business and financial reporting requirements.

Using Audited Financial Statements

See Figure 5 In addition to reading the auditors report, financial statement users must also evaluate the financial statements in the context of their specific needs. In making that evaluation, users should consider: Reading the Auditors Report The auditors report provides information about the scope of the independent auditors work and any material concerns that he had about the fairness of presentation of the financial statements in conformity with accounting standards. Understanding the Accounting Principles Used The accounting principles determined by management affect the information relevant to the users decision. An evaluation of the financial statements requires that the user read the notes to the financial statements to ascertain the significant accounting principles used to prepare the statements. Evaluating the Financial Stability of the Entity The evaluation of an entitys financial stability its financial position, operating results, and changes in financial position is the users responsibility. Financial statements provide information helpful in making that evaluation. It is the readers responsibility to interpret these statements according to his interests and concerns.

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Evaluating Business Risk, Management, and Management Decisions Management will take risks with varying degrees of economic potential and uncertainty of results. An audit does not evaluate the wisdom of managements decisions nor indicate the safety or future profitability of investing in the entity. Financial statement users are responsible for deciding whether management has made appropriate decisions. The user must evaluate the quality of past performance and decide whether management has adequate knowledge and experience to successfully guide the entity. Evaluating the Risk of Financial Involvement with an Entity Specific decisions about doing business with an entity, such as investing or extending credit, are the responsibility of those contemplating such matters. An audit only adds credibility to managements financial statements that users may consider in evaluating those risks for themselves.

Source of information Chartered Accountants Auditing & Assurance Handbook 2008 Institute of Chartered Accountants in Australia
http://www.charteredaccountants.com.au/audit

Useful links Auditing and Assurance Standards Board (AUASB)

http://www.auasb.gov.au

AUASB website for AUASB Standards and Pronouncements

http://www.auasb.gov.au/Standards-and-Guidance.aspx

Accounting Professional Ethics Standards Board (APESB)

http://www.apesb.org.au

Financial Reporting Council (FRC)

http://www.frc.gov.au/default.asp

Australian Department of the Treasury

http://www.treasury.gov.au

Australian Securities and Investments Commission (ASIC)

http://www.asic.gov.au

International Auditing and Assurance Standards Board (IAASB)

http://www.ifac.org/IAASB\

WA Institute contact: Fran Ooi Relationship Consultant Secondary Schools Tel: 9420 0412 Email: fran.ooi@charteredaccountants.com.au

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