Why audits are needed and what they help to accomplish

Category: Accounting

If all the facts that concerning financial transactions were properly and accurately recorded and if the owners and managers of business enterprises were entirely honest and sufficiently skilled in matters of accounting and recording, there would be little need for independent auditing. However, human nature being as it is, there probably will always be a need for the auditor. What is an auditor? An auditor is a professional that is responsible for evaluating some aspect of a project, business, or individual. Auditors often are employed in the task of determining the level of efficiency present in the production process of a business, the efficient use of labor and other resources associated with the business, and the veracity of the financial records of the business. Along with evaluating a project or aspect of a company, an auditor is often expected to make recommendations regarding the correction of negative conditions that currently impact the organization.

The general definition of an audit is an evaluation of a person, organization, system, process, project or product. Audits are performed to ascertain the validity and reliability of information; also to provide an assessment of a system's internal control. The goal of an audit is to express an opinion under evaluation based on work done on a test basis. Due to practical constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Hence, statistical sampling is often adopted in audits. In the case of financial audits, a set of financial statements are said to be true and fair when they are free of material misstatements - a concept influenced by both quantitative and qualitative factors.

Traditionally, audits were mainly associated with gaining information about financial systems and the financial records of a company or a business. However, recent auditing has begun to include other information about the system, such as information about environmental performance. As a result, there are now professions conducting environmental audits. In financial accounting, an audit is an independent assessment of the fairness by which a company's financial statements are presented by its management. It is performed by competent, independent and objective person known as auditors or accountants, who then issue an auditor's report based on the results of the audit. Such systems must adhere to generally accepted standards set by governing bodies regulating businesses; these standards simply provide assurance for third parties or external users that such statements present a company's financial condition and results of operations 'fairly'.

There are some advantages to audit such as provide the transparency to shareholders. Besides, the audited account able to make the financial information more acceptable in the public. Why companies need performing an audit? Because it is a legal requirement that all the limited company are required to audit their account and have an auditor's report on the annual accounts. An audit can identify the weaknesses in the accounting system and lead to recommendations for their improvement. The errors whether committed innocently or deliberately are discovered by the process of audit and its presence prevents their occurrence in the future. No one will try to commit an error or fraud as the accounts are subject to audit and hence they will have a fear of being detected. Audit helps in protecting the interests of shareholders in case of Joint Stock Company. Audit gives assurance to the shareholders that the accounts of the company are being maintained properly and their interest will not suffer under any circumstances. Besides, the prospective investor can easily analyze the position of the company gaining through the audited financial statements of the company and can make the decision to invest or not in the company.

Furthermore, the auditor's responsibility to the users especially investors is to evaluate and give opinion to the best of their ability. A common view is that auditors have "deep pockets" which mean endowed with substantial financial resources. The courts have a tendency to viewing the accounting firm as a guarantee to investors that the financial statements are correct. They also believe that the investors ought to have protection from financial loss. Since the accounting firm is held responsible for potential failures, the auditors are believed to shift this cost to clients through higher fees. Thus, the company is able to earn more money. (Wallace, W. A., 1991, p. 27)

For the investors it's important that a financial statement from a company is correct and reliable. It's important in the sense that the financial statements are a tool for the investor to make decision about whether to invest or not invest in a specific company. The auditor observes and confirms the economic information provided by the company, and the investors take for granted that the information in the financial statements is correct after approval from the auditor. This background illustrates that auditors function as a guarantor of financial statements for investors, and also that auditor act as guarantors for investments losses. Implications of this problem are that the auditors will take a greater audit fee to cover the insurance. The auditors also needs special skills to find out which client that most probably will take the auditor to trial if something don't go in the investors' interest. That can result in that auditors don't want to work with some clients or that the audit fee will be so high for risky clients that they find it unnecessary to audit (Menon, K. and Williams, D.D., 1994, p. 327-341). Based on the chart below, the survey that conducted by the CFA institute shown that there is higher percentage of respondents said the auditor's report is very important to their analysis and use of financial reports in the investment decision making process (CFA institute, 2010).

Moreover there are some public expectations toward the auditor. The public expectation in this are mean that the societal perception about the auditor's duty and auditor's responsibilities.

While there are a large number of auditor's report users, such as bankers, financial analysts, investors and shareholders. However, the differences perceptions among these groups of users were consistent and it caused expectation gap to exist. In other word, users appear to have unreasonable expectations of the auditor's responsibilities that led to the emergence of audit expectation gap. It is not the responsibility of the auditor to prepare the financial statements of an entity; the subjects held the management to be responsible in producing the financial statements.

Usually, users expect that the auditors to be responsible in fraud prevention and detection. According to the Humphrey at el. (1993) noted that auditor's responsibilities concerning fraud have been a recurrent problem as it is clear that public's expectations on this issue was not satisfied. All of these clearly indicated that fraud prevention and detection have received the most unreasonable expectations. This problem occurs is due to the role of the auditors are not clearly indicated or explained to the public. Besides, it's also because the public have no well educated or lack of knowledge on the role and responsibilities of the auditors (Marianne, 2006). The public is not sufficiently educated on the role of the auditor and this leads to unrealistic expectations on the part of clients, investors and others with vested interests (Alleyne and Howard, 2005). For a reason, there is a difference between what the users of financial statements or the general public perceives an audit to be and what the auditors' duty is expected in conducting their audit.

Therefore, to what extent agree that auditors act a guarantor to the investors? The extent to which it is reasonable to view the auditor as a guarantor is quite high. Investors and financial statement users long have agreed on the usefulness of the audit in financial reporting. Over time, however, auditors have been expected to provide assurance in varying degrees and for different purposes. Differences in perception especially regarding assurances provided between users, preparers and auditors (Geiger, 1994). After all, auditors are the only people we can trust to provide an accurate portrayal of company, as auditors are the only ones who have the ability to provide such information. Another reason might be that often audits are performed by third party companies who begin the audit process without bias or assertions to how the entity should be operated. The role of the financial auditor is to increase the trust of the users in the financial information presented in the financial statements, to give a reasonable assurance that the accounting information was managed and presented in conformity with the accounting standards and with the general accepted accounting principles.

According to the International Audit Standard (ISA) I20 "General framework of the audit standards" stated that, the financial statements are made and presented annually and are designated to the common needs of informing of a large number of users. Most of these users take their decision based on these financial statements, being the only source of information, because they have no possibilities to get additional information which should satisfy the specifically informational needs. So, the financial statements should be made in according with one or combination of International Accounting Standards, National Accounting Standards; and another general framework of financial reporting compulsory and comprehensive.

As we know, the auditors are the person to provide opinion to the organization. However, auditors are not guarantor of company result. Mean that, if the company is making loss due to the opinion that the auditor provided, they are not allow to sue the auditor. This is because the auditors are the only guarantee the financial statement is free of material misstatement. According to the Rezaee and Riley stated that the current auditing standards require that the independent auditors provide reasonable assurance that the financial statement is free from material misstatements, whether caused by error or fraud, in order to render an incompetent opinion on the financial statements. This level of reasonable assurance is regarded as a high level of assurance but not an absolute assurance. Conversely, there are also argument mentioned that the auditors are not expected to provide an absolute assurance for detecting fraud, therefore that are being blamed by the high-profile financial scandals that caused the fraudulent activities occur. Reasonable assurance may mean a different level of assurance based on the different groups. For example, the investors in the post- Enron area expect the auditors to discover and report not only free from material misstatement but also detect the error, irregularities and fraud.

Apart from that, users of the audited financial statements especially the investors and creditors usually have held independent auditors responsible for detecting financial statement fraud. However, in compliance with their professional standards, they provide only reasonable assurance that the financial statements are free of material misstatements, whether caused by error or fraud. According to the Johnson stated that, the Public Company Accounting Oversight Board's (PCAOB) rules require auditors to provide reasonable assurance that the financial statements they've reviewed are free of material misstatement whether caused by error or fraud. However, the language auditor's use in their reports doesn't match the text of the rules. In a meeting last week, the PCAOB's own advisory group suggested that auditor reports be revised to add the phrase "whether caused by error or fraud" to indicate that auditors do have some responsibility for noticing fraud.

Nevertheless, the auditors have to follow the rule of professional standard that only provide reasonable assurance that financial are free from material misstatement. But, does an audit guarantee that everything is 100 percent accurate? The answer was no. It is because generally much too expensive to verify everything is 100 percent and so it is standard practice for auditors to check evidence supporting the amounts and disclosures in the financial statements on a test basis. This involves analyzing and verifying financial controls in order to evaluate the extent to which the system can be relied upon. According to the Johnson, stated that the Center for Audit Quality, the trade group for audit firms, issued a brochure on public-company accounting that said auditors consider potential areas of misconduct for a particular company when deciding what areas of a business to review. However, the CAQ cautioned, "because auditors do not examine every transaction and event, there is no guarantee that all ma­terial misstatements, whether caused by error or fraud, will be detected" (Johnson, 2010).

The audit reports the provided by the auditors doesn't tell investors how the auditors come out with their conclusions beyond stating the general scope they worked under or they followed generally accepted auditing standards. The auditor was using sampling method to draw a conclusion for their financial information. Sampling method which mean that a testing less than 100 percent of a population and then utilizing the results to draw a conclusion about the entire population. This process saves the time, effort, and expense that may be involved in comprehensive testing. Therefore, it is important to remember that financial statements often include estimates. For example, some of the receivables may eventually prove to be uncollectible; or the bills may not have come in from certain suppliers. These items will require estimates based on previous experience, contracts, purchase orders, correspondence, etc. However these accounting estimates may not exactly correspond with the amounts that are eventually paid. This is generally acceptable to readers of financial statements as long as the estimates are substantially correct. The auditor will check the reasonableness of estimates based on supporting evidence. A survey has been conducted by the CFA institute, such as whether the auditor determines/assesses materiality should be disclosed. Based on the chart below, the report shown that there is 82% agree that the method should be disclosed. Because this will help the user understand what level of tolerable error to allow for analysis of the income statement and balance sheet. Importantly it should also be disclosed whether one materiality level has been applied across the income statement and balance sheet or whether there are differences? The auditors then provide judgment about management's determination. Managements need to make materiality hurdles clear and investors need to know what the auditor thinks (CFA institute, 2010).

Besides that, an audit is not guarantee that there has been no fraud in an association. There are multitudes of ways in which fraud can occur. Opportunities for fraud are limited only by the imagination of the perpetrators and by the effectiveness of the systems of financial control that are in place. Generally accepted auditing standards are employed in the performance of audits. These standards provide for an audit which reduces to an appropriate low level the risk of not detecting a material misstatement in the financial statements. However, an audit does not guarantee that all material misstatements will be detected. Of course, the discovery of such irregularities may still result from the audit, and should any significant ones be encountered, they are reported to the association. An audit is less likely to detect material misstatements arising from fraud or other illegal acts because such acts are usually accompanied by acts designed to conceal its existence. Accordingly, audit procedures that are effective for detecting an unintentional misstatement may be ineffective for an intentional misstatement or an illegal act that is concealed. It should be noted though that the profession is currently looking at raising the bar for audit practitioners in this whole area.

In the journal of Alleyne and Howard (2005) indicate that the expectation gap is wide, as auditors felt that the detection of fraud is management's responsibility, while users and management both was disagreed on this point. Based on the survey that conducted by them, one of the auditor argued that the role of the auditor is not to detect fraud, but in planning an audit so that there is reasonable expectation of discovery. This is due to the public is not sufficiently educated on the role of the auditor, therefore this caused the unrealistic expectations on the users. However, the other users were adamant that detecting fraud was not just the auditors' responsibility but also the main objective of an audit. One user questioned that "if not then why we pay for an audit?" In contrast, one partner at a major audit firm argued that fraud detection is the responsibility of management, who controls the day-to-day running of the organizations. Auditors are not responsible for prevention and detection. We must do continuous risk assessment and tailoring of our audit strategy to suit. The attitude of professional skepticism also implies management must also be considered as a risk factor.

However, there are discussion argued that the management has the responsibility for the maintenance of adequate accounting records and internal controls, prevention and detection of fraud and errors, safeguarding of assets, selection and application of suitable accounting policies and appropriate disclosure of financial information in the financial statements. The preparation of the financial statements in accordance with generally accepted accounting principles is also the responsibility of management. It's also dispute that association managers and board members are the players and the auditor is the referee reporting on the official score and ensuring that the financial game is being played fairly and according to the rules. The auditor basically provides an objective professional opinion that the financial statements prepared by management present fairly, in all material respects, the financial position as at the fiscal year end and the results of operations and cash flows for the year then ended in accordance with generally accepted accounting principles. Therefore, board members and association managers must understand that they are the ones who are primarily responsible for ensuring the accuracy and reliability of financial information. They can't sit back and expect the auditor to be their only line of defense. It is essential that they be vigilant, careful and prudent at all times to satisfy their fiduciary duties and stewardship role (Watson, 2002).