Chapter 1

THE DEMAND FOR AUDITING AND ASSURANCE SERVICES

Expected Learning Outcomes

After studying this chapter, you should be able to:

1. Describe the role of auditing in meeting society's demands for reliable financial information

2. Understand why individual external auditors are expected to make professional and ethical judgments
about the information provided by business organizations.

3. Explain the nature of assurance services.

4. Explain the importance of audited financial statements.

5. Enumerate the various parties who are interested in audited financial statements.

6. Understand the need for increased globalization of accounting and auditing standards.

THE DEMAND FOR AUDITING AND ASSURANCE SERVICES ECONOMIC DEMAND FOR AUDITING

Why do many of the largest companies spend millions of pesos each year for their annual audit? Is it
worth asking why an entity would decide to spend so much money on an audit? Is it because these
audits are required by law? While true in certain circumstances, this answer is far too simplistic.
Although audits are often utilized in situation where they are not required by law, audits were in
demand long before Securities Laws and the Bureau of Internal Revenue required them. The demand for
auditing can be understood as the need for accountability when business owners hire others to manage
their businesses, as is typical in modern corporations. Until the late 18th and early 19th centuries, most
organizations were relatively small and were owned and operated as sole proprietorships or
partnerships. Because businesses were generally run by their owners and borrowing was limited,
accountability to outside parties often was minimal.

The birth of modern accounting and auditing occurred during the industrial revolution, when companies
became larger and needed to raise capital to finance expansion. Over time, capital markets developed,
enabling companies to raise the investment capital necessary to expand new markets, finance expensive
research and development, and fund the buildings, technology, and equipment needed to deliver
products to market. A capital market allows a public company to sell small pieces of ownership (i.e.,
stocks) or to borrow money in the form of thousands of small loans (i.e., bonds) so that vast amounts of
capital can be raised from a wide variety of investors and creditors. A public company is a company that
sells its stocks or bonds to the public, giving the public a valid interest in the proper use of the
company's resources.

Thus, the growth of the modern corporation led to diverse groups of owners who are not directly
involved in running the business (shareholders) and the use of professional managers hired by the
owners to run the corporation on a day-to-day basis. In this setting, the managers serve as agents for
the owners (who are sometimes referred to as principals) and fulfill a stewardship function by managing
the corporation's assets.

It is important to understand that the relationship between an owner and manager often results in
information asymmetry between the two parties. Information asymmetry means that the manager
generally has more information about the "true" financial position and results of operations of the entity
than does the absentee owner.

What are Assurance Services?

The name assurance services is used to describe the broad range of information enhancement services
performed by a certified public accountant (CPA) that are designed to enhance the degree of confidence
in the information. In general, assurance services consists of two (2) types: (a) those that increase the
reliability of information and (b) those that involve putting information in a form or context that
facilitates decision making.

A significant portion of the assurance services provided by CPAs is referred to as attestation services. To
attest to information means to provide assurance as to its reliability. In an attestation engagement, CPAS
provide a report on subject matter or an assertion about that subject matter. One of the most sought-
after attestation services is the examination or audit of historical financial statements. In this book, we
will focus on the Audit and Assurance Services that involve reliability enhancement.

Philosophy of an Audit

As the amount of capital involved and the number of potential owners increase, the potential impact of
accountability also increases. The auditor's role is to determine whether the reports prepared by the
manager conform to the contract's provisions. Thus, the auditor's verification of the financial
information adds credibility to the report and reduces information risk, or the risk that information
circulated by a company's management will be false misleading. Reducing information risk potentially
benefits both the owner and the manager.

Economic decisions are made under conditions of uncertainty; there is always a risk that the decision
maker will select the wrong alternative and incur a significant loss. The credibility added to the
information by auditors actually reduces the decision maker's risk. To be moreprecise, the auditors
reduce information risk, which is the risk that the financial information used to make a decision is
materially misstated.
Businesses, institutions and individuals must maintain records of their financial condition and progress.
These records are necessary to evaluate and guide. business operations, to determine financial status,
to meet legal requirements and to serve as a basis for credit. Creditors and investors, present and
prospective, may wish to study the financial statements of many enterprises for credit extension and
investment purposes. Government agencies will need financial reports to help them carry out the duties
imposed upon them by law internal management needs financial reports for planning, directing and
controlling business operations.

These parties therefore, need reliable and credible financial information. The process employed to
establish the reliability or unreliability of the financial statements and supporting records is referred to
as an audit examination. Auditing of financial records has become an important factor in the
dissemination of financial information and the services of the independent certified public accountant
are considered indispensable. Increasingly, his written report is required to add credibility to the
financial statements.

A free-market economy can exist only if there is sharing of reliable information among parties that have
an interest in the financial performance of an organization. The market is further strengthened if the
information is transparent and unbiased that is, the data is not presented in such a way that it favors
one party over another. An organization's reported information must reflect the economics of its
transactions and the current economic condition of both its assets and any obligations owed.

In a financial statement audit, the auditors undertake to gather evidence to obtain high level of
assurance that financial statements are free of material misstatements due to fraud or errors and that
they are presented in accordance with appropriate accounting framework. The external audit is
intended to enhance the confidence that users can place on management-prepared financial
statements. When the auditor has no reservations about management's financial statements or internal
controls, the report is referred to as an unqualified audit report.

Auditors serve a number of parties, but the most important is the public, as represented by investors,
lenders, workers, and others who make decisions based on financial information about an organization.
Auditing requires the highest level of technical competence, freedom from bias, and concern for
integrity of the financial reporting process. In essence, auditors should view themselves as guardians of
the capital markets.

The public expects auditors to (a) find fraud, (b) require accounting principles the best portray the spirit
of the concepts adopted by accounting standard setters, and (c) be independent of management. When
it comes to being independent, auditors must not only be independent in fact, but they must act in a
manner that ensures that they are independent in appearance.

An independent auditor's opinion contained in the audit report provides both internal and external
users with input to making logical and informed decisions about financial position, managerial
performance and economic vulnerability. Without auditors, decisions such as these are more likely to be
made from biased financial information resulting from a business entity's undisclosed errors,
irregularities or illegal acts.

IMPORTANCE OF AUDITED FINANCIAL STATEMENTS

Audited financial statements are the accepted means by which business corporations report their
operating results and financial position. The word audited, when applied to financial statements, means
that the balance sheet and the statements of income, retained earnings, and cash flows are
accompanied by an audit report prepared by independent public accountants, expressing their
professional opinion as to the fairness of the company's financial statements.

Of course, reporting in accordance with an agreed-upon set of accounting principles does not solve the
problem by itself. Because the manager is responsible for reporting on the results of his or her own
actions, which the absentee owner cannot directly observe, the manager is in a position to manipulate
the reports. Again, the owner adjusts for this possibility by assuming that the manager will manipulate
the reports to his or her benefit and by reducing the manager's compensation accordingly. It is at this
point that the demand for auditing arises. If the manager is honest, it may very well be in the manager's
self-interest to hire an auditor to monitor and independently report to the owner on his or her activities.
The owner likely will be willing to invest more in the business and to pay the manager more if the
manager can be held accountable for how he or she uses the owner's invested resources.

Financial statements prepared by management and transmitted to outsiders without first being audited
by independent accountants leave a credibility gap. In reporting on its own administration of the
business, management can hardly be expected to be entirely impartial and unbiased. Independent
auditors have no material personal or financial interest in the business; their reports can be expected to
be impartial and free from bias.

Unaudited financial statements may have been honestly, but carelessly, prepared. Liabilities may have
been overlooked and omitted from the balance sheet. Assets may have been overstated as a result of
arithmetical errors or due to a lack of knowledge of financial accounting and reporting standards. Net
income may have been exaggerated because expenses were capitalized or because sales transactions
were recorded in advance of delivery dates.

Finally, there is the possibility that unaudited financial statements have been deliberately falsified in
order to conceal theft and fraud or as a means of inducing the reader to invest in the business or to
extend credit. Although deliberate falsification of financial statements is not common, it does occur and
can cause devastating losses to persons who make decisions based upon such misleading statements.

For all these reasons (accidental errors, lack of knowledge of accounting principles, unintentional bias,
and deliberate falsification), financial statements may depart from financial accounting and reporting
standards principles. Audits provide users with assurance that the financial statements are presented in
accordance with the financial accounting principles and reporting standards.
Figure 1-1 presents an overview of the potential financial statement users and the decisions they make
based on the financial reports.

THE ASSURANCE ANALOGY AND THE PHILIPPINE STANDARDS ON AUDITING (PSAs)

An audit provides reasonable assurance of detecting material misstatements of the financial statements
(both errors and fraud) and noncompliance with laws that have a direct and material effect on the
determination of financial statement amounts. Although an audit does not obtain reasonable assurance
of detecting noncompliance with laws that have only an indirect effect on the financial statements, the
auditors remain alert for such situations. If instances of noncompliance are discovered, regardless of
type, the auditors should carefully evaluate their effects on the financial statements.

Currently, the International Auditing and Assurance Standards Board (IAASB) issues pronouncements
designed to foster the development of consistent worldwide auditing standards while the Auditing and
Standards Practice Council of the Philippines (AASC) reviews and recommends for approval to the PRC
BOA their adoption as the Philippine Standards on Auditing (PSAS).

In the Philippines, the law that regulates the Practice of Accountancy (RA 9298) provides that the
Professional Regulatory Board of Accountancy shall monitor the conditions affecting the practice of
accountancy and adopt such measures to enhance and maintain the high professional, ethical and
auditing standards including promulgation of accounting and auditing standards, domestic and
international, International financial markets would be facilitated if auditing and accounting standards
were more uniform.

In summary, auditing is in demand because it plays a valuable role in monitoring the contractual
relationships between the entity and its stockholders, managers, employees, and debt holders. Certified
public accountants have been charged with providing audit services because of their traditional
reputation of competence, independence, objectivity, and concern for the public interest. As a result,
they are able to add credibility to information produced and reported by management to outside
parties.
REVIEW QUESTIONS

Questions

1. What is the objective of financial statement audit? Describe the role of external auditing in meeting
society's demands for unbiased financial and internal control information.

2. What is the "special function" that auditors perform? Whom does the external auditing profession
serve in performing this special function?

3. What factors create a demand for an independent external audit?

4. How does an audit enhance the quality of financial statements and management's reports on internal
control? Does an audit guarantee a fair presentation of a company's financial statements?

5. What is the principal use and significance of an audit report to a large corporation with securities
listed on a stock exchange? To a small family-owned enterprise?

6. Describe the several business situations that would create a need for a report by an independent
public accountant concerning the fairness of a company's financial statements.

7. Explain the following statement: One contribution of the independent auditor is to lend credibility to
financial statements.

8. A corporation is contemplating issuing debenture bonds to a group of investors.

a. Explain how independent audits of the corporation's financial statements facilitate this transaction.

b. Describe the likely effects on the transaction if the corporation decides not to obtain independent
audits of its financial statements.

9. Discuss the major factors in today's society that have made the need for independent audits much
greater that it was 50 years ago.

10. It has been stated that auditors must be independent because audited financial statements must
serve the needs of a wide variety of users. If the auditor were to favor one group, such as existing
shareholders, there might be a bias against another group, such as prospective investors. Do you agree?

11. Evaluate the following quotation: "Every business, large or small, should have an annual audit by a
CPA firm. To forgo an audit because of its cost is false economy".

12. The self-interest of the provider of financial information (whether an individual or a business entity)
often runs directly counter to the interest of the user of the information.