Concepts and Theories of Auditing
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Auditing has been present for years in different stage of development following the evolution of accounting. Starting since the epoch when the records were approved after a public reading, to the era when government's officials were measured by their honesty. Followed by the times of the industrial revolution were the ownership of companies started separating from management; when owners required more protection of their investments increasing the use of auditors, consequently; to the times were an auditor was always searching for frauds or errors (Whittington & Pany, 2004, p. 7) and then "to ascertain the actual financial condition and earnings of an enterprise" (Montgomery, 1913, p. 9).
However, the acceptance of auditing as an academic discipline is not old and just after the development of different concepts and techniques within the audit model such as the use of sampling, the study of the internal control environment, and the risk assessment, is when more focus to the theoretical and conceptual framework of auditing it is been devoted.
Andrew Sayer (1992) discussed the concept of theories in social science from the perspective of "theory as an ordering-framework (p. 50)", indicating that theory allows the use of the observed data and their relationships to predict and explain empirical events. Additionally Cooper and Schindler (1998) define theory as "a set of systematically interrelated concepts, definitions, and propositions that are advanced to explain and predict phenomena (facts) (p. 47)". Another concept is expressed by Singleton and Straits (2005) explaining theory as a "set of interconnected propositions" (p. 19). The success in the explanations or predictions of any phenomena depends on the level that the theory holds and do not fails fitting in the situation, and the challenge is to perfect the process of matching theory and fact (Cooper and Schindler (1998).
Different authors have started the development of the audit theory such as Mautz and Sharaf (1961) with their publication titled The Philosophy of Auditing; also Tom Lee (1986) with his approach in the book Company Auditing, and later David Flint (1988) with his book Philosophy and principles of auditing (as cited in Moizer, 1989). The auditing analysis in this demonstration will be framed on the postulates proposed by David Flint (1988) as a foundation for the theory of auditing.
Flint (1988) stated that there is a matter of public accountability demanding an independent audit for its demonstration with clear definition and intention, based on evidence that only skilled auditors gather, measure it, and compare it against the standards, which generates economic or social benefit (as cited in Moizer, 1989). Following are the seven postulates or assumptions stated by Flint (1988):
- There is a relationship of accountability or a situation of public accountability.
- Accountability cannot be demonstrated without an audit.
- An audit requires independence and freedom.
- The subject matter of audit is susceptible to verification by evidence.
- Auditors are skilled judges who are able to measure and compare actual performance against standards of accountability.
- The meaning, significance, and intention of statements to be audited must be clear.
- An audit produces an economic or social benefit.
Whenever an economic relationship exists one of the parties owe a duty of an acceptable accountability, consequently audits are voluntary, imposed for the health of the relationship. There are also audit related to the interest of the public in matters of the society institutions. As expressed by Whittington and Pany (2004) "dependable information is essential to the very existence of our society" (p. 1). They explained the social need for audit and professionals who can attest that the reported information is fair respect to the reality for purpose of allocating resources for the production of services and goods based on reliable financial information (p. 1).
Normally the financial and economic aspects of the related subject matter are complex, not physically accessible, or have the level of significance that necessary demand an audit to accept the accountability. No all investors or stakeholders of an entity understand the complexity of the business and financial environment, or are near to the place were their resources are to oversee for accountability.
The credibility of the information is important and the preferable form of obtaining credible information to rely on is by using independent auditors to perform an audit. That reduce the business risk that relates to the permanence and profits of the company, and the information risk "that the financial information used to make a decision is materially misstated" (Whittington & Pany, 2004, p. 6). Therefore, if the audit must add credibility it must be performed independently and without bias or prejudice.
Audit is subject to verification and that is possible only if sufficient evidential matter of the audit is gathered. Additionally, some standards of accountability and performance need to be in place to easy the auditor's measurement. Therefore, the parties involved must agree on their acceptable standards. The auditing community has set some professional guidance as a form of general accepted practiced standards.
For an audit to add value to the financial information, the purpose of the information should be clear, and the findings effectively communicated. The audit should be performed only when its benefits weigh more than the costs. As a consequence auditors should be aware of the cost of collecting evidence especially in situation were the risk is high.
The practice of auditing auditors agree on an attest engagement in which they "issue or does issue an examination, a review, or an agreed-upon procedures report on subject matter or an assertion about subject matter that is the responsibility of another party (e.g., management)" (Whittington & Pany, 2004, p. 2). In an examination of financial statement, referred to as an audit the standards may be the Generally Accepted Accounting Principles (GAAP), and the auditors collect sufficient evidence to attest about how fair is the information in the financial statement respect to the GAAP.
However, here are three types of audits: (a) audits of financial statements, (b) compliance audits, and (c) operational audits. Financial audits determine if the statements were prepared according with GAAP. Compliance audit verifies if the company had complies with law, regulations or polices and procedures. Finally, operational audits review the effectiveness and efficiency of particular unit of an organization (Whittington & Pany, 2004, p. 11).
Relative to the public accounting standards, the American Institute of Certified Public Accountants (AICPA) has developed the framework for the general accepted auditing standards (GAAS), which are the fundamentals principles of independent auditing in the U. S. The framework is divided in three major areas that are summarized as follow:
- General standards. A professional possessing adequate technical training and proficiency, independent in mental attitude and free from bias and with professional care planning and performing diligently, perform the audit.
- Standards of field work. The audit should be adequate planned and the staff properly supervised. Auditor should acquire sufficient understanding of the internal control environment to be able to determine the weak areas, and gather sufficient competent evidence to support their conclusions.
- Standards of reporting. The final report should state if the statements are consistent with GAAP and if necessary indicate those circumstances departing from GAAP, include adequate informative disclosure, and includes the opinion of the auditors about the financial statements.
Likewise, the AICPA has issued a series of auditing standards on auditing procedure, auditing and accounting guides, and auditing statements of position, to help auditor in the fulfillment of their responsibility of detecting misstatement (Whittington & Pany, 2004, pp. 34-35).
Auditing involve a serious processes that expose auditors to a different situations in which they need to exercise professional ethics. Those moral principles and values leading decisions and actions of the profession of auditing are provided by the AICPA in the Code of Professional Conduct, and by the Institute of Internal Auditors (IIA) Code of Ethics.
Normally auditors are involved in a decision process of ethical dimension. CPAs decisions during performing their duties can affect thousands of investors and their resources; therefore, they need to measure the implication of their decisions. Additionally, as Whittington and Pany (2004) indicated, "what is considered unethical in a particular society is not specifically prohibited" (p. 11), giving relevance and support to the need for the establishment of those principles and values in the accounting and auditing profession.
The public accounting, as well as the rest of professions, has the following characteristics: (a) their responsibility to serve the public with independence and due care with fairness and free from bias. (b) Involves a complex body of knowledge that includes different authoritative pronouncements of standards and principles governing the profession and the financial reports due to the need of technical competency. (c) Has establishes some standard of admission to the profession that each CPA is required to meet. In addition (d), need public confidence to be successful (Whittington & Pany, 2004, pp. 61-62).
The AICPA leads public accountants to recognize their responsibility to the public in general, to their clients, and to the profession. The section one of the code of conduct describes the organization and CPAs principles of responsibilities, public interest, integrity, objectivity and independence, due care, and scope and nature of services. The section two depicts the institute's rules that are compounded by the following: independence, integrity and objectivity, general standards, compliance with standards, accounting principles, confidential client information, contingent fees, acts discreditable, advertising and other forms of solicitation, commissions and referral fees, and form of organization and name (Whittington & Pany, 2004, pp. 63-83).
Similarly, the IIA has their own code of ethics divided in three main sections, an introductory section, principles, and rules of conduct. Their principles apply to the profession and practice of the internal auditing, and include integrity, objectivity confidentiality, and competency. The IIA rules on conduct include integrity, objectivity, confidentiality, and competency (Whittington & Pany, 2004, pp. 83-84). The IIA is the organization that provides the standards for the professional practice of internal auditing.
As it can be deduced from the previous summaries, both institutes the IACPA and the IIA require high level of self-discipline and commitment to a honorable professional behavior, integrating similar principles of integrity, objectivity, and competence. Their rules differ in the fact that internal auditors perform internally; public accountants attest on the financial statements to the company as outsiders performing professionally to honor the public trust.
However, the concept of independence is common to both ramification of auditing because it refers to the "ability to maintain and objective and impartial mental attitude" (Whittington & Pany, 2004, p. 66), and without of conflict of interest.
After the previous review of the auditing theory and how CPAs support it with a professional framework that includes principles, ethical codes, and general accepted standards for the auditing practice, the following section depicts a discussion of audit procedures as well as an introduction of important concepts that are fundamental part of the theory of auditing and the auditing practice.
The Audit Procedures
The ultimate product after the performance of an audit is the issuance of a report indicating if the financial statements audited comply with GAAP. Sufficient evidence must support the audit report and such evidence is gathered and documented by exercising rigorous procedures that, among other important goals, help the auditors in assessing the risk of misstatement.
According to Whittington and Pany (2004), audit procedures involve: (a) the understanding of the client, the business, and industry to use it in assessing risks; (b) the understanding of the internal control environment; (c) the design and performance of controls testing to assess how effective the controls are in preventing or detecting material misstatements; and (d) the design and performance of substantive procedures that include analytical procedures, direct testing of transactions and ending balances (pp. 138-139).
Because the internal control is the focus of interest for this demonstration, a separate section will discuss it.
The substantive procedures include analytical procedures, the testing of transactions, and the testing of the ending balances on the statements. Analytical procedures consist of an analysis and evaluation of the information present in the financial statements, and a review of the relationship between financial and nonfinancial information. The assumption behind the analytical procedures is that the relationship and trend of the financial information is expected to follow the historical data and projections of the business and in contrary situation evidence must be obtained to support the reasonability of the changes (Whittington & Pany, 2004, p. 141).
Different techniques are use during the analytical procedures. From simple verification of a number to complicated mathematical models, such the comparison of cumulative expenses and revenues with prior years to find significant differences, the use of multiple regression model to estimate revenues by using economic and industry data, and ratio analysis and its comparison with other businesses in the same industry (Whittington & Pany, 2004 (p. 141).
The testing procedures seek to prove the occurrence and correct recognition of transactions, and prove of existence and misstatements on what the ending balances represent. The substantive testing procedures are performed as an interim mode before year-end, and then after the business year-end. The level of risk established by the auditors during the overall business assessment guides the extent of the substantive audit procedures. "The greater the risk of material misstatement the greater the needed extent of substantive procedures" (Whittington & Pany, 2004, p. 139), but always keeping under evaluation the cost-benefit relation of increasing the procedures to perform.
Among the most common test performed in an audit process, Whittington and Pany (2004) summarized the following:
- Accounting System: Comparison-Agreeing amounts from different internal records.
- Documentary evidence:
- Tracing-Establishing the completeness of transaction processing by following a transaction forward through the accounting records.
- Vouching-Establishing the existence or occurrence of recorded transactions by following a transaction back to supporting documents forms a subsequent processing step.
- Inspection-Reading or point-by-point review of a document or record (the terms examine, review, read, and scan are used to describe the inspection technique).
- Reconciliation-Establishing agreement between two sets of independently maintained but related records.
- Third-party representation: Confirmation and evaluating a response from a debtor, creditor, or other party in reply to a request for information about a particular item affecting the financial statements.
- Physical evidence:
- Physical examination-viewing physical evidence of an asset.
- Observation-viewing a client activity.
- Computations: Reperformance-repeating a client activity. This may include operations such as footing (providing the total of a vertical column of figures); cross footing (proving the total of a horizontal row of figures); and extending (re-computing by multiplication).
- Data interrelationships: Analytical procedures-Evaluation of financial information made by a study of expected relationships among financial and nonfinancial data.
- Client representations: Inquires-questions directed toward appropriate client personnel.
According to Whittington and Pany (2004), auditors also collect evidence from some subjective areas such as the accounting estimates, the fair market value measurement and disclosures, and transactions with related parties (pp. 146-148).
After the development of audit procedures auditors test for existence or occurrence to search for misstatements and completeness searching for understatement, from transactions' start to finish, and they test the accounting system from source documents to journals to ledgers. (Whittington & Pany, 2004, p. 195). The audit program includes two main parts, the assessment of the effectiveness of the client internal controls, and substantive testing. Normally the system portion of an audit program is divided by cycle such as revenue, purchasing and payments, production, payroll, investing, and financing (Whittington & Pany, 2004, p. 196).
The risk concept is use in different disciplines for different purposes. A simple definition of the concept is that: risk is the level of exposure to the chance that some event happens. The event might be beneficial or prejudicial, or might have subsequent implications to other situations or process. Therefore, in business there is a risk of losing money, a risk of fraud, and a risk of misstatement the financial information. As consequence, business and individuals manage risk and the level of exposure to specific risk according to their judgment.
The audit process involves the management of risk in different areas with the goal to reduce it to the minimum level possible. Whittington and Pany (2004) introduced some of the risk's concepts such as:
- business risk, "the risk associated with a company's survival and profitability" (p. 6).
- Information risk, "the risk that the information used to assess business risk is not accurate" (p. 6).
- Audit risk, "the risk that the auditors may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated" (p. 35).
- Inherent risk, "the possibility of a material misstatement of an assertion before considering the client's internal control" (p.128).
- Control risk, "the risk that a material misstatement will not be prevented or detected on a timely basis by the client's internal control" (p. 129)
- Detection risk, "the risk that the auditors will fail to detect the misstatement with their audit procedures" (p. 129).
Within the audit risk, auditors assess the risk level of occurrence of the different form of misstatement of financial statement, such as errors, fraud, and illegal acts. In measuring audit risk auditors use the following model:
AR = IR x CR x DR
Where: AR = Audit risk, IR = Inherent risk, CR = Control risk, and DR = Detection risk. (Whittington & Pany, 2004, p. 130)
Additionally, because the auditors are expose to some legal responsibility and are subject to be sued by any client's stakeholder, they have to take in consideration the reputation of the management, financial strength, and other financial rating to assess the overall risk or engagement risk of the association with that particular business (Whittington & Pany, 2004, p. 174).
The process of planning the audit involves the understanding of the client and its environment, an overall audit strategy, and the risk assessment of financial statements material misstatement. Therefore, auditors seek to understand the nature of the client and accounting polices, the industry, regulations and external factors affecting the client, the clients objectives, strategies, and related business risk, how the client measure and review performance, and the internal control environment. (Whittington & Pany, 2004, pp. 179-180).
Consequently, auditors use different sources to obtain the client overall understanding. That includes electronic research tools, visit to different plant or location of the client, and some analytical procedures. (Whittington & Pany, 2004, pp. 181-183).
A Company's internal control consists of the policies and procedures established to provide reasonable assurance that the objectives of the company will be achieved; including the client's internal control, they could identify areas of strength as well as of weakness.
The stronger the internal control, the less testing of financial statement account balances required by the auditors. For any significant account or any phase of financial operation in which controls were weak, the auditors expanded the nature and extent of their tests of the account balance.
With the increased reliance on sampling and internal control, professional standards began to emphasize limitations on auditor's ability to detect fraud. The profession recognized that audits designed to discover fraud would be too costly. Good internal control and surety bonds were recognized as better fraud protection techniques than audits. (Whittington & Pany, 2004, p. 8)
The assessment of inherent risk involves considering the likelihood that material misstatement in financial statement will result, and each risk related to the management assertions. At this stage, auditors identify what it is not correct or the significant risk by area and based on that assessment they adjust their approach, modifying the nature, timing, and extent of the audit procedures (Whittington & Pany, 2004, pp. 188-189).
Evidence is all data and information gathered by the auditors to support auditors' conclusions. The importance of the evidence is that "audit risk is reduced by gathering audit evidence" (Whittington & Pany, 2004, p. 127) and when the risk is high more evidence is necessary as well as the increasing the coverage of audit procedures. According to Whittington and Pany (2004), evidence need to be collected for each financial statement assertion sufficiently to support their opinion. As issued in the Statement of Auditing Standard (SAS) 31 about evidential matter, the financial statement assertions are the following:
- Existence or occurrence-assets, liabilities, and owners' equity reflected in the financial statements exist; the recorded transactions have occurred.
- Completeness-all transactions, assets, liabilities, and owners' equity that should be presented in the financial statements are included.
- Rights and obligations-the client has rights to assets and obligation to pay liabilities that are included in the financial statements.
- Valuation or allocation-assets, liabilities, owners' equity, revenues, and expenses are presented at amounts that are determined in accordance with generally accepted accounting principles.
- Presentation and disclosure-accounts are described and classified in the financial statements in accordance with generally accepted accounting principles, and all material disclosures are provides.
(Whittington & Pany, 2004, p. 174)
The above assertions are the base for the risk assessment performed by auditors, and to determine misstatements possible to occur and consequently decide the audit procedure to exercise.
Guidelines are included in the SAS 31 regarding what sufficient competent evidence is, which relates to the quantity of evidence auditors should collect. The competence of the evidence is determined by the combined condition of relevant and valid. That means that it most related to the assertion, and that it is dependent on the circumstance in which it is obtained. The reliability or validity of the evidence increase when is received from independent sources, when is produced by an effective internal control, gathered directly by the auditor, is documented, obtained from original documents, and when is received from more than one source (Whittington & Pany, 2004, p. 132).
Different types of audit evidence is obtained by the auditors such as accounting information system, internal and external documentary evidence, third-party representations such as confirmations, reports, and lawyers letters; physical evidence such as fixed assets and inventory, computations re-performance, data interrelationships of financial and nonfinancial information, and client representations oral and in writing (Whittington & Pany, 2004, pp. 131-137).
An important supporting evidence of the audit report and conclusions is the audit documentation, which is required by the SAS 96 for the auditors understanding and review of the audit work, the nature of audit work performed, and to show the agreement between the records and the financial statements. The working papers have some important functions: (a) are the best way to assign and coordinate the auditing work, (b) help audit managers and partners in the supervision and reviewing or the work of assistants, (c) support the audit reports, (d) documents the auditors compliance with GAAS, and (d) assist in the conduction of future audit to the client (Whittington & Pany, 2004, pp. 148-150).
The working papers are confidential and unrestricted documentation owned by the auditors, principally because they represent the major factor to use in case of negligence charges. Part of the working paper are the administrative working papers, the working trial balance, separate schedules, adjusting journal entries and supporting schedules, and analysis of ledgers accounts such as a reconciliation, computational working paper, corroborating documents. They are filed in two major groups, permanent file, and current files (Whittington & Pany, 2004, pp. 151-158).
As a large-scale corporate grow rapidly auditors began to sample selected transactions, rather than study all transactions. Auditors and business managers gradually came to accept the proposition that careful examination of relatively few selected transactions would give a cost-effective, reliable indication of the accuracy of other similar transactions (Whittington & Pany, 2004, p. 8).
As explained before, auditors need sufficient and competent evidence to support their conclusions, but because business grows involving high volume of economic events and transactions, they need to rely in sampling testing. Audit sampling can be statistical or no statistical, involves the selection of a sample from a group of items and the use of the sample characteristics presuming that the auditors can draw inferences about the whole population. (Whittington & Pany, 2004, p. 309).
From the previous sampling introduction, we have the sample risk that is the risk that the auditors conclusion based on a sample might be different if they examine the whole population. According to Whittington and Pany (2004) "sampling risk is reduced by increasing the size of the sample" (p. 309) or by auditing the whole population.
Auditors use statistical and no statistical sampling to perform a random selection, which involve that every item in the population has an equal chance of being selected for inclusion in the sample. Different techniques are used such as random number tables, random number generators, systematic selection, haphazard selection, block selection, and stratification (Whittington & Pany, 2004, pp. 310-313).
There is a sample risk for test of controls in which auditors face the risk of assessing control risk too high, which is related to efficiency, or too low based on the operating effectiveness of the control. The AICAP guide suggest the statistical sample sizes for tests of controls at 5 percent risk of assessing control risk too low, providing the following tolerable deviation rate per assessed level of control risk: for low 2 - 7%, for moderate 6 - 12 %, for slightly below the maximum 11 - 20%, and for maximum level of control risk they recommend to omit test (Whittington & Pany, 2004, pp. 316-320).
Besides sampling, auditors became aware of the importance of effective internal auditing. Following section presents a discussion about internal auditing.
The internal auditing developed rapidly during the decade of 1930s generating the foundation of the Institute of Internal Auditors (IIA), which is an organization with local chapter in the main cities worldwide. The IIA defines internal adducting as follows:
An independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance process. (The Institute of Internal Auditors [IIA], 2008)
Internal auditors are an important part of the internal control environment of entities, representing the highest level of control that measure and evaluate the effectiveness of other controls. Additionally to the financial controls, the internal auditor's scope includes the evaluation and testing of control effectiveness, and other assurance and consulting services to the management.
Some companies have focus on outsourcing the internal audit functions, which is also provided by CPA firms as an extended audit service and according to the AICPA guiding. However, opposition to the participation of accounting firms exist under the argument of possible conflicts of interest having then as part of the internal control when they also audit the company.
The IIA have issued the standards for the practice of internal auditing with the following purpose:
- To delineate basic principles that represent the practice of internal auditing.
- Provide a framework for performing and promoting a broad range of value-added internal auditing.
- Establish the basis for the evaluation of internal audit performance.
- To foster improved organizational processes and operations.
The auditing standards of the IIA includes two parts, the first is the attribute standards that state basic requirements for the practice of internal auditing. According with this attribute, organizations should define in a formal document or internal audit charter, the purpose, authority, and responsibility of the internal audit, and the nature of assurance and consulting services that the internal auditors will provide. Additionally, the chapter should include recognition of the definition of internal auditing, the code of ethics, and the auditing standards (IIA, 2008).
The standards also state the independence and objectivity condition for internal auditors during the performance of their work. The need of freedom from conditions, bias, and subordination of judgment, or conflict of interest that impairs their ability to perform objectively, is rigorously presented in the standards. Additionally, the competencies, knowledge, and skills that an auditor must possess are described as well as the due professional care requirement for the performance of the engagement as important elements of the IIA standards. Finally, the attribute standards set requirements for continuing professional development and quality assurance for the internal audit activity (IIA, 2008).
The second part of the IIA standards covers the management aspects of the internal audit activity, including the planning, communication and approval, and resource management. The IIA see the need that internal auditors establish polices and procedures to guide the internal audit activity as well as the coordination and reporting to the company's management and board of directors (IIA, 2008).
Setting standards for the nature or work, the IIA requires that the internal audit to evaluate and contribute to the improvement of governance, risk management, and control process by using a disciplined approach. They give prominence to the effectiveness and improvement of the risk management process as one of the key internal audit activity (IIA, 2008).
A set of requirement for the engagement process is included in the standards as well as for the performance of the engagement. The IIA states, "internal auditors must identify sufficient, reliable, relevant, and useful information to achieve the engagement's objective" (IIA, 2008, p 12), also they establish some requirements for relative to the communication of results, including the criteria and quality (IIA, 2008).
Internal auditors normally perform the operational audits for their organizations. The operational audits refer to the examination of an operating unit or the complete organization to evaluate the systems, controls, and performance. Likewise, internal auditors normally engage in compliance auditing, which involves testing and reporting on the organization compliance with laws, regulations, and agreements requirements (Whittington & Pany, 2004, pp. 728-743).
Sources of Auditing Standards
Auditing standards have been issued by the AICPA Auditing Standards Board (ASB), which requires to its members to perform auditing and related professional services to comply with the Statements of Auditing Standards (SASs) because the SASs constitute the General Accepted Auditing Standards (GAAS).
However, after the passage of the Sarbanes-Oxley Act of 2002 (SOX), audits of financial statements of public companies should follow the standards established by the Public Accounting Oversight Board (PCAOB). More specifically, the SOX authorizes the PCAOB the establishment of the auditing and relative attestations, quality control, ethics, and independence standards for the use by registered public accounting firms in the preparation and issuance of audit reports for entities subject to the SOX and to the rules of the Securities and Exchange Commission (SEC). Durak (2004) reported that those entities subject to SOX and to the rules of the SEC are referred to as "issuers" (p. 1) and the entities not subject to the SOX and to the rules of the SEC are called "non-issuers" (p.1).
After the establishment of the PCAOB, the ASB amended its jurisdiction to recognize the new authority, and became the body to promulgate auditing, attestation, and quality control standards for the preparation and issuance of audit reports for non-issuers entities (Durak, 2004).
Additionally, the International Federation of Accountants (IFAC), a worldwide organization integrated by national accounting professional bodies such as the AICPA, by delegation to the International Auditing and Assurance Standards Board (IAASB) is the international professional organization that issues international standards on auditing providing procedural and reporting guidance to auditors. Although the international auditing development the pronouncement issued by the IAASB do not prevail over any national auditing standard (Whittington & Pany, 2004, pp. 45-47).
Finally, discussed in the previous section, the IIA is the body that set the standards for the professional practice of internal auditing with international applicability (IIA, 2008).
As result of several instances of fraudulent financial reporting, the major accounting organizations sponsored the National Commission on Fraudulent Financial Reporting (the Treadway Commission) to study the causes of fraudulent reporting, and make recommendations to reduce its incidence. The commission's final report, which was issued in 1987, made recommendations for auditors, public companies, regulators, and education. Many of the recommendations for auditors were enacted by the AICPA in a group of Statements of Auditing Standards known as the expectation gap standards. The commission recommendations about internal control led the development of an internal control framework, titled Internal Control-Integrated Framework, to be used to evaluate the internal control of an organization. The development of these internal control's criteria increases the demand for attestation by auditors to the effectiveness of internal control.
In 1996, in response to a continuing expectation gap between user demands and auditor performance, the AICPA issued guidance to auditors requiring an explicit assessment of the risk of material misstatement in financial statement due to fraud on all audit. Auditors are required to modify their audit procedures, where necessary, to reflect the results of that assessment.
The Theory of International Accounting
The international accounting framework has its basic support in the assumption about the ultimate goal of the accounting function. Accounting supply information for the use in the economic decision making process. The relationship is clearly defined, decision makers demand information and accounting provide the information for their purposes.
Accounting operates in an economic environment represented by business entities in which decision makers perform a significant influence. Therefore, accounting needs adjust to those economic environments as they exercise changes. One major change experienced during the last a half of a century is the development of a global economy, in which human, natural, and financial resources are mobilized from one place to another in the world. Therefore, international accounting performs achieving its main goal in this age of a global economy, supporting decision makers in their process to decide about the allocation of resources for the global benefit (Iqbal, Nelcher, & Elmallah, 1997).
Iqbal, Nelcher, and Elmallah (1997) defined international accounting as "accounting for international transactions, comparisons of accounting principles in different countries, and harmonization of diverse accounting standards worldwide" (p. 2). According to Iqbal et al. (1997), that definition requires the involvement of managerial and financial accounting, taxation, auditing, and other accounting areas.
The fact that the world is in a global age is real and supported by different events such as international free trade agreement among countries, the consolidation of the European Union, the opening of the former U.S.S.R. market, the General Agreement on Tariffs and Trade (GATT), and the emergence of new economics in Asia, and the Pacific regions (Iqbal et al., 1997).
According to Iqbal et al. (1997), international trading creates a great supply chain of goods and services, increasing the efficiency in the use of resources. Although the real situation leads to a different conclusion, the ideal model suggestion is that each country concentrates in the production of goods and services they specialize or are more efficient, exchanging it for the products that other countries specialize. The ultimate goal of that model is to improve the standard of living of the countries participating in the trading, and by increasing competition increase efficiency. In that respect, it is important to review the concept and some theory supporting international business, which is include in the following section.
The concept of international business is involves the economic transactions that result form the trade of goods, services, and financial resources among countries (Iqbal et al., 1997). Although, commercial transactions between one country and other have existed for centuries, different elements have increased the international trading such as the "standardization of products and products process, technology advances in information technology, improved transportation, and sophisticated distribution systems" (Iqbal et al., 1997, p. 3).
The understanding of trade in the international market is not commonly easy. The flow of resources among countries turn difficult the identification of origin of goods, the precedence of its materials, and the human resources assembling it because each part of the process can be performed in different country. Furthermore, the financial resources and the ownership of the operation in one country can have its origin in others countries.
As reported by (Iqbal et al., 1997) "corporate decision about production and location are driven by the dictates of global competition, not by national allegiance" (p. 4). Therefore, big companies depend more and more on the international trade. Among the reasons for going international Iqbal et al., (1997) reported (a) opportunities to grow, (b) less dependency on domestic economy, (c) customer demand, and (d) reduction of costs (p. 5). However, those companies face different difficulties trading internationally such as (a) obtaining information, (b) financing, (c) poor ownership rights, (d) uncertain legislative and business environment, (e) administrative formalities, (f) currency restrictions, and (g) taxation (Iqbal et al., 1997, p. 5).
Iqbal et al. (1997) presented an analysis of the theories supporting the reasons for the involvement of a company in international business. Grosse and Kujawa (1995) concurred with expaining the same theories in their book about international business, which are include in the flowing summary:
- Theory of comparative advantage. Each country should produce only those goods and services that it can produce with relative efficiency. This is a cost basic theory with some ramifications sucha as the theories of comparative costadvantage and the absolute cost advantage. Now, specialization in some products may result in no production of other products. The theory pressumes that factors of production are constant for a country and it only explains the export-import dimension of international business. (Grosse & Kujawa, 1995, pp. 62-69) and (Iqbal et al., 1997. pp. 6-7)
- Imperfect market theory. This theory suggests that the real world suffers form imperfect market conditions where factors of production are immobile. A firm may realize economies of scale that permit it to achieve least-cost production when sales go beyond the local country's market. Therefore, companies seek to gain access to factors of production like cheap labor, labor with special skills, and availability of raw material. (Grosse & Kujawa, 1995, pp. 76-77) and (Iqbal et al., 1997. pp. 7-8)
- Product cycle theory. This is a more intuitively theory based on the product life cycle in marketing analysis, focusing in maeket expansion and technological innovation. According to this theory, companies start selling domestically because the advantage of the access to information about customers and competition. Then, foreign countries demand are satisfy by exporting, representing the entry to the international trade with consequence of relocation. (Grosse & Kujawa, 1995, pp. 69-75) and (Iqbal et al., 1997. p. 8)
- Technology transfer and strategic alliances. The desire to obtain access to advanced technologies developed in different parts of the world is. Conversely, a company may be willing to share its advanced technology with companies or governments in other part of the world to gain access to their markets. The occurrence of this practice has raised issues relative to the intellectual property rights. This practice is supported by the assumption that time is more important than cost in global markets. (pp. 8-9)
Companies participate in international markets business in different types of activities getting involved at different levels, as exporters, by forming strategic alliances, or as multinational corporations. Consequently, next section depicts a summary of how companies' involvement in international business challenges the international accounting practice, and the international environment influence on accounting (Iqbal et al., 1997, p. 9-12).
International Accounting Challenges and Influences
According to Iqbal et al. (1997), two main developments are noted beyond the import-export activities; first, the multinational companies participation in different activities such as product development, production, marketing, and technology alliances; and second, the opening of the global capital markets for investors and borrowers engagement in financing activities (p. 18).
The previous developments have influence incorporating in the international accounting other different nontraditional subject matters, which have significant importance due to the level of international trade and investment activities. Among them, Iqbal et al. (1997) listed the topics of (a) foreign currency transactions, (b) foreign currency translations, (c) taxation of international operations, (d) consolidation of financial statements of foreign subsidiaries and affiliates, (e) general purchasing power and adjustment of financial statements, (f) foreign exchange risk management, (g) multinational transfer pricing, and (h) comparative disclosure requirements (p. 18).
Additionally, international accounting faces other challenges that influence its function of timely provide information for worldwide decisions. Those challenges include the skills and competencies of accountants no required before, including cultural sensitivity and appreciation of cultural diversity; the understanding of the cross-functional linkages, and the development of competencies that enable accountants to view a business as integrated functions. Additionally, the no comparability of financial statements of different countries, and consequently the problem of doing financial analysis; and the development need of a global information system (Iqbal et al., 1997, p. 18).
Simultaneously, some national environmental influences exist in a global economy because decisions are different in each country in the same way their environments are different. Because international accounting supports decisions in each country by providing information, accounting systems are environment-specific. The major environment influences are (a) economic system, (b) political system, (c) legal system, (d) educational system, and (e) religion (Iqbal et al., 1997, p. 20).
The economic system effect influences because accounting systems in industrialized and high technology economy are different from agrarian economy, also the aspects of the concentration of ownership dispersion of ownership, source of financing, tax law, and countries with economy of high inflation, are determinants in shaping countries accounting systems. Additionally arguments exist indicating that economic policies receive influence from the philosophy and objectives of the political system, and that there is a direct connection between political and economic stability (Iqbal et al., 1997, p. 21).
The influence of the legal system is supported because laws establish regulations, rules, and procedures affecting the accounting practice, and sometimes government determine and enforce the requirements. Regarding the educational system, the impact is determined by the educational or literacy level, because well-educated accountants and users of accounting can understand better complex or sophisticated accounting information. Finally, the religions have influence in some accounting concepts in some countries turning difficult the presentation and communication of accounting information because the religious beliefs (Iqbal et al., 1997, p. 22).
The theory according with Iqbal et al., (1997), is that those major influences are principal elements shaping cultural values of each country, those cultural values are different in each country, and they consequently affect the accounting profession values. As a result, the accounting systems affect those systems (Iqbal et al., 1997, pp. 20-22).
Concurrently, there are some international forces creating increasing influences for greater harmonization, those forces are:
- International blocs such as NAFTA, (b) international governmental organizations such as the United Nations (UN) and the Organization for Economic Cooperation and Development (OECD).
- Professional organizations like the IASC and the IFAC.
- Global capital markets.
- Multinational corporations.
- Technological advances.
- Worldwide political developments and trends like the switch of the U.S.S.R. and many East European countries.
- Management accounting-relevance regained one main beneficiary of the global economy.
(Iqbal et al., 1997, pp. 22-25)
At this point is necessary to explain the concept of harmonization in comparison to the standardization. The main difficulty of the international accounting is the comparability of financial information from different countries. The ideal way to achieve that is by international standardization of accounting principles, which due to the presented previously internal countries aspects influencing accounting is not feasible. The solution is been focus on the harmonization of the accounting standards that seek to maintain the differences among countries at a minimum, with the possibility of reconciliation. Another form of harmonization involves that different countries may agree the use of the same standards requiring the disclosure of any departure and reconciled under some standards. Finally, harmonization may be the preparation of financial information in local as well as international standards reconciling the difference (Iqbal et al., 1997, pp. 34-35).
Inherent elements of the International Accounting
Although traditional accounting topics are also important in international accounting there are some core issues inherent to it that are necessary to discuss because their relevance in providing timely information for worldwide decision making.
Foreign currency transactions and translations. One of the major complex elements in the financial accounting and reporting of multinational companies is the different currencies involved in international transactions. Different currency, and currency laws and regulations exist in each country. The norm is that transactions are recorded by subsidiary companies in the currency of the country in which they operate, requiring that the reporting in different currencies be converted to one currency before the consolidation of the statements.
As defined by Iqbal et al. (1997) "the conversion value of a currency is the equivalent amount of another currency at a given exchange rate" (p. 169). Now, the exchange rate experiments fluctuations and consequently the conversion value the foreign currency, meaning that fluctuation or changes in the exchange have a direct effect on the consolidated reports.
The changes in the exchange rate of a currency come from changes in the value of the currency. Now, the value of a currency changes according to the rate of inflation. A high inflation rate of a country reduces the power of purchasing when compared with other countries. Another factor that affects the exchange rate in a country is the balance of payments with respect to the activities of exportation and importation. If the importation activity is higher than the exportations, then the country will be in a deficit, reducing the value of the currency and the exchange rate.
Additionally, any factor generating and increase of the demand of a foreign currency appreciates the value of that currency. That is the case in countries with high interest rate because investors from other countries purchase the currency for the high interest earned in those high interest rate countries.
The exchange of one currency of another generates gains or losses, which are realized when actually incurred. As explained by Iqbal et al. (1997), "foreign currency transactions are transactions denominated in currency other than the reporting currency of the entity" (p. 170). The consolidation of financial statements might generate unrealized gains or losses because the translation of amounts in subsidiaries recorded in foreign currency to the currency used for the consolidation. In the case of translation no exchange of currencies takes place, only when the exchange occurs realization takes exists.
Foreign currency transactions normally require future settlements because, for example, as a purchasing takes place today and the payment in a future date; and because of the exchange rate changes from the date of purchasing to the date of payment, the settlement might results in a gain or a loss.
In recording foreign currency transactions, each country use different approaches. One approach adds the effect of the fluctuation on exchange rate to the original purpose of the transaction. Another approach treats the original transaction independently to its settlement, recording the difference of the exchange rates as a loss or a gain on foreign exchange. The second approach is more acceptable and is the one used in U.S., supported by the fact that the settlement involves two separate decisions, the purchasing, and the currency exchange risk. Many companies are protected from loses form exchange rate changes by going into a forward exchange contract which is an agreement toe exchange foreign currency in the future at a fixed rate (Iqbal et al., 1997, pp. 170-173).
For the performance of foreign currency translation, which as explained before does not involve currency exchanges, there are different methods and among them is the current rate method in which all assets and all liabilities are translated using the current exchange rate or the rate at the balance sheet date. Then, for paid in capital accounts it uses the historical rate, this method translates dividends using the exchange rate on the date of declaration, and all the revenue and expenses items are translated using the weighted average exchange rate for the period. The gains or loses from the translation are recorded in the accumulated translation adjustment account in stockholder's equity (Iqbal et al., 1997, pp. 174-175).
A second method of translation is the current-noncurrent method in which all balance sheet current items are translated at the current exchange rate on the balance sheet date, and all noncurrent items are translated using the applicable historical rate. Then, the items on the income statements are translated using the weighted average exchange rate, except for depreciation and amortization of non current assets that are translated at the historical rates (Iqbal et al., 1997, pp. 175-176).
Additionally, the monetary-nonmonetary method focuses on the monetary-nonmonetary classification for the translation. It defines monetary item, as all assets and liabilities expresses in fixed amount of currency, like cash, receivables, and fixed liabilities. Fixed assets, prepaid, and inventory are considered nonmonetary. The monetary items on the balance sheet are translated using the current exchange rate on the balance sheet date, and nonmonetary items at their historical exchange rates. Income statements items are translated using the weighted average exchange rate for the period, except cost of goods sold, depreciation, and amortization of non current assets that are translated using the applicable historical rates (Iqbal et al., 1997, pp. 176-177).
Finally, the temporal method sees the currency translation as a restatement of financial statements, and translates foreign currency amounts ate the exchange rates in effect at the dates when those items were measured in the foreign currency. For cash, receivables, and payables uses the current rate on the balance sheet date; all remaining assets, liabilities and capital stock are translated using the historical rates in effect when those assets were acquired, liabilities were incurred, and capital was contributed. Most revenues and expenses are translated using the weighted average rate for the period, except cots of goods sold, depreciation expenses, and amortization expenses that are translated at their historical exchange rates. The temporal method records all transaction gains and losses directly in the income statement affecting income reported for the period (Iqbal et al., 1997, pp. 177-178).
The SFAS 52 states the standards for the foreign currency translations in the U. S., and the IASC 21 deals with the effects of changes in foreign exchange rates.
Taxation of international operations. Tax systems differ from country to country because of the different national approach to raise government revenues. Some countries only tax incomes generated locally, others enforce taxes on domestic and foreign incomes. Likewise, each country allows deductions of expenses from revenues to calculate the taxable income differently (Iqbal et al., 1997).
(Iqbal et al. (1997) reported the existence of the classic system of taxation that applies when the taxable entity receives the income. In opposition the integrated system tries to eliminate double taxation by taxing incomes depending on whether it is distributed to shareholders or retained internally, having the last higher taxation. They also instructed about the existence of direct taxation based on corporate incomes, and indirect taxation such as the value-added tax (VAT). All type of taxation influences the foreign investment decisions in multinational corporations (Iqbal et al., 1997, pp. 327-328).
As a form of avoid double taxation of foreign-source income, the U.S. tax code provides entities with the foreign tax credit for foreign income taxes paid by foreign subsidiaries. That means that is a U.S. subsidiary in a foreign country pays withholding taxes on dividends distributed to parent company, the U.S. parent company receives the tax credit equal to the withholding tax paid. The foreign tax credit under the U.S. tax code has some limitations not included in this demonstration (Iqbal et al., 1997, pp. 328-331).
With the increase and expansion of international businesses many countries have entered into tax treaties to reduce or eliminate the double taxation. Additionally, countries with interest in attract foreign capital offer tax incentives which foreign investors are exempt from taxes for a period under some conditions. That is the case of the tax incentives to encourage exportations (Iqbal et al., 1997, pp. 334-335).
Most of the countries rely substantially form the VAT, which in general applies to the difference between the sale and purchase price of the product at each stage of transferring the product from manufacturing to retailing to the final consumer (Iqbal et al., 1997, p. 335). In U.S., multinational corporations are subject to tax on their foreign income as any other income, but because they are taxable in the foreign country a deduction of the foreign taxes paid is allow before arriving to the taxable income, or claiming then against the tax liability. Special tax treatment is applied in the cased of foreign exchange gains and losses in U.S. which are not recognized until the settlement (Iqbal et al., 1997, pp. 335-337).
Consolidation of financial statements of foreign subsidiaries and affiliates. In general, companies achieve growth by expanding internally or externally. They expand internally introducing new products or services, increasing their capacity, or taking advantage of international incentives installing facilities in foreign countries. In the other side, they expand externally by acquiring other companies such as suppliers to reduce cost, and competitors to increase their market share (Iqbal et al., 1997, p. 205).
External expansion force companies to a business combinations, merging or consolidating with other companies. In a merging, one company absorbs one or more others companies acquiring their net assets. In a consolidation, two or more companies consolidate their net assets creating a new company, dissolving the old companies. In a combination where one company exercise control over the other a parent/subsidiary relationship exist. Normally that relation is determined by the percentage of voting stock owned by the merged companies (Iqbal et al., 1997, pp. 205).
The first accounting issue in business combination is how to account it, and for that purpose two method of accounting are used: (a) the purchase method in which the acquired company's assets and equity is combined with the acquiring company at fair market value; goodwill is recorded if cost exceeds the fair market value of the assets. And (b), the pooling of interest method in which the acquired company's assets and equities are combined with the acquiring company at book value, and no goodwill is recorded (Iqbal et al., 1997, p. 206). In the international arena, each country applies different rule. Some countries accept one method and others accept the other.
The second accounting issue after a business combination is that the parent company is required to present consolidated financial statements, showing the financial situation and results of operations of the parent company and its subsidiaries, knowing that each one is a separate legal entity and maintain separate accounting records. The combination of financial statement involves the elimination of intercompany receivables and payables, as well as profits on assets sold between the affiliated companies, and the investment and subsidiary's equity. Performing those eliminations, a single company statement is show avoiding double counting of those balance sheet items, and that the company presents profits from transactions with itself (Iqbal et al., 1997, p. 308).
There are some important elements in the consolidation of financial statements of related companies. The first is that before the consolidation, a translation of the statements in foreign currency to the functional currency is necessary. A second element is that the eliminations in the consolidation process are performed in workpapers for reporting purposes, remaining the recorded of all companies unchanged. Additionally, as in the case of the accounting of acquisitions, the consolidation practices vary form one country to another.
Accounting for changing prices, purchasing power, and adjustment of financial statements. The traditional accounting practice presumes that the monetary unit is stable no thinking in the possibility of inflation. That assumption is important for the historical cost model, but is not the case in the real practice of accounting. The general price index is prepared by averaging the prices of basic goods in some point in time, and then compared with the average price of the same goods at another period and by difference between both is estimated the amount of inflation (Iqbal et al., 1997, p. 139). However, a specific price index may or may not change because the general price levels, according with Iqbal et al. (1997) "it depends mostly on its supply and demand" (p. 140).
The Price of an item can be determined by establishing the current cost of the item or the cost to replace it. The problem of the valuation in time of changing prices is that the monetary unit in different times may have different purchasing power, having its effect in the financial statements. Additionally, the situation that the inflation rate is industrialized counties is lower than the global average exists, while in most of the developing countries normally the rate is higher (Iqbal et al., 1997, p. 142).
The restatement of financial information in constant monetary unit is performed base in monetary and nonmonetary units. Monetary unit is cash or another asset or liability that will be received or paid out in a fixed number of monetary units. Nonmonetary item is one that does not represent a claim to, or for, a specified numbe of monetary units. Iqbal et al. (1997) presented the following summary of the steps for constant unit restatement:
Balance sheet rest
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