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The term audit is the assessment of the financial report of an organisation by someone independent from the organisation which includes balance sheet, income statement, cash flow statement (http://www.pwc.com.au/assurance/financial/statements/audit.htm#). The reason why audit is done is because to make a view or opinion on the financial report that reflects the financial position of the company (http://www.pwc.com.au/assurance/financial/statements/audit.htm#). The audit of financial statements by auditors is the verification of the financial statements of the company with an expression by an audit opinion where this opinion needed to provide a reasonable view that the financial statements presented fairly in all material aspects (http://whatisauditing.com/financial-audit). Auditing can be divided into external and internal audits. According to the ACCA, 2010, an external audit is a form of reassurance engagement that is approved by an auditor to provide an independent opinion on a set of financial statements (ACCA, 2010, p.1). On the other hand, internal auditors are engaged as part of the organisation's system of controls (internal controls) and the internal auditing process is an evaluation or monitoring activity provided as a service to the entity and includes functions such as examining, evaluating and monitoring the sufficiency and efficiency of internal controls (ACCA, 2010, P.10).
Theories of auditing and the explanations respectively
The theory of auditing comprises of the 'theory of rational expectations', 'the philosophy of auditing', and Flint's theory of philosophy and principles of auditing' (Millichamp and Taylor, 2012, p.3-5). The theory of rational expectations entails that the assessment of the auditor's report obtained from the expert nature of the auditor as an independent, experienced professional, and the next theory is the philosophy of auditing was based on scientific logic where the process of auditing is a based on reason process of examination, observation or scrutiny and assessment or evaluation of evidence, and the philosophy and principles of auditing are based on the essential idea that auditing has a social benefit and not simply a scientific or technical exercise for the purpose of directive (Millichamp and Taylor, 2012, p.3-4). This essay will explore the query that a friend has raised and will be assessed to have any benefits, drawbacks or both.
The Regulations on Auditing, corporate governance and ethical standards.
As an audit senior, independence is an important factor to avoid influence on the auditor's report. Independence and objectivity matters because of the expectations of those directly affected such as the members of the company hence fairness of financial statements of being audited to provide objective assurance, and the next reason is the public interest because companies are public entities Inquisitively, independence is not one of the fundamental ethical principles but the ethical principles are incorporated together to make sure auditors become and remain independent (Millichamp and Taylor, 201, p.78).
The five principles are of International Federation of Accountants (IFAC) are; integrity, objectivity, confidentiality, competency and professional behaviour (ibid). In the UK, an auditor must be an associate of a Recognised Supervisory Body (RSB) and be qualified under its own rules (ACCA, 2010, p.24). The eligibility to act as an auditor, the company Act 2006, an individual or a firm is eligible for appointment as a statutory auditor with the reasons that the auditor must be a member of a Recognised Supervisory Body and eligible for appointment under the body's rules (ibid). In the UK, corporate governance is the system by which companies are directed and controlled and it is important to have good corporate governance (ACCA, 2010, P.45). An audit committee can help a company maintain objectivity with regards to financial reporting and the audit of financial statements (ibid).
Audit and Assurance according to Financial Reporting Council (FRC) and ethical standards 1
The audit and assurance team within the codes and standards division of the Financial Reporting Councils (FRC) includes codes and standards which develops and maintain auditing and assurance standards and guidance for engagement that are done in the public interest in the UK and Ireland are the standards and guidance for auditors, reviews of provisional financial information performed by the auditor of the entity, for the work of reporting accountants in acquaintances with venture circulars, ethical standards for auditors, stipulation of assurance on client assets and statements that set out its view on particular matters of relevant to audit (http://frc.org.uk). Influencing monitors and seeks to influence international standards and guidance and policy developments that may affect audit and assurance services in the UK and Ireland and research undertakes and commissions research on matters of relevance to audit and other assurance engagements performed in the public interest (http://frc.org.uk).
Auditors must comply with ethical standards. The audit practices board, under ethical standard 1 (revised) is that 'the audit firm shall establish policies and procedures, appropriately documented and communicated, designed to ensure that, in relation to each audit engagement, the audit firm, and all those who are in a position to influence the conduct and outcome of the audit, act with integrity, objectivity and independence' (http://www.frc.org.uk/Our-Work/Publications/APB/ES-1-(Revised)-Integrity,-objectivity-and-independ.aspx).
Exploration of Threats to Auditors Independence and safeguards.
There are several factors or categories of ethical threats. Initially, self interest threat. This may occur as a result either financial or non-financial interests of a qualified accountant. The next threat is self review. This could arise due to a preceding judgement needs to be re-evaluated by the accountant at first responsible for that judgement. Advocacy threats may occur when an accountant uphold a position or opinion to the point that succeeding objectivity may be compromised. Familiarity threats could be due to close relationships who becomes too considerate to the interest of others and intimidation threats is where a specialized accountant may be discouraged from acting independently by threats (Millichamp and Taylor, 2012, p.80).
Safeguards that may eradicate or diminish these threats to an acceptable point will fall into two broad groups which are; safeguards created by the profession or law and in the work environment (ibid). The ACCA study text on Audit and Assurance (UK), mentioned about a better approach would be to regard as whether the auditors' own independence and the common safeguards operating in the specialized situation are adequate to counterbalance the threat and to think about whether safeguards over and above the general safeguards are essential (ACCA, 2010, p.50).
An auditor should not permit their opinion to be influenced by any commission being received, reward or fee given from a third party as a result of advertising a client to pursue one course rather than another (Millichamp and Taylor, 2012, p.82). The International Auditing Standards (ISA) 220 which is the 'Quality control for an audit of financial statements' needs the audit firms to reassess their relationships with every client yearly whether to continue an audit engagement either with actual or apparent threats to objectivity (ibid). The friend was making a query that whether the firm can be truly independent in accordance to a considerable sum of money to do the audit work. This will be further explored in the next paragraph.
Non-audit services and provisions done to the same client as a threat to independence of auditors
Non-audit services provided by auditors to their clients has 3 categories according to the Institute of Chartered Accountants England and Wales (ICAEW); initially, Services required by law or contract which includes regulatory returns such as the FSA (Financial Services Authority), legal requirements to report on matters such as share issue for non-cash consideration, contractual requirements such as covenant requirements. The second category is that services most efficient for the auditors to provide due to the understanding of the company includes services that are not required by legislation, tax compliances and 'short form' or other reports in acquisition of completion of the company is necessary in the short term. Lastly, the services that could be provided by a number of firms because of winning a tender process that includes management consultancy, tax advice and human resource consultancy (http://www.icaew.com).
The contribution of non-audit services is one major problem for the audit speciality is the question mark on the factual independence from the audit client. In addition, financial scandals became the accessory to the fact to lose their objectivity and being involved with their clients such as the fall of two audit firms of Enron and WorldCom in the United States of America. Therefore, the auditor is not restricted to give advice but must not take part in making management decisions (Millichamp and Taylor, 2012, p.83).
Examination and evaluation of the query being raised
As a new audit senior for one of the big four accounting firms with an old friend will start to have a threat on independence of auditing. This may refer to familiarity and self interest threat. Familiarity threat here means having close relationships who becomes to considerate to the interest of others (Millichamp and Taylor, 2012, p.80). The matter of self interest includes financial interest. Financial interest means that where an audit firm has interest financially in a client's affairs (ACCA, 2010, P.51).
Millichamp and Taylor stated several factors that will threat the auditors' independence; for example, too much reliance on an audit client (2012, p.80). This means that the public awareness of independence may be jeopardised if fees from a client or group of connected clients controls the auditors' practice, and as a remedy the RSB's have a decree which states that the earnings/income from any one client must not be more than 15% or called as the '15 per cent rule'(ibid).
IAS 220 of 'Quality control for an audit of financial statement' also includes fees paid for professional work. Contingent or conditional fees are fees being computed on a predetermined basis relating to the outcome or result of a transaction or work done (ACCA, 2010, p.54). It would be unacceptable to accept a conditional fee for non-assurance work from an assurance client (ibid). An audit firm should be well aware where the total fees obtained by the assurance client represent a large sum of the total fees and situations where the fees calculated by an assurance client provides a big proportion of the income of an individual partner (ACCA, 2010, p. 54).
Risk assessment and understanding of the entity according ISA for auditors
Risk assessment is done under the International Standards of Auditing assists the person doing the audit work to identify the financial statement areas susceptible to material misstatement and provides a basis for designing and conducting further audit work (ACCA, 2010. P.97).
The overall audit risk involves the auditor who usually follows a risk-based approach to auditing and therefore auditors will analyse the risks associated with the client's business, transactions and systems of control that could lead to misstatements in the financial accounts (ACCA, 2010, P.98).
In addition, audit risk comprises of two dependents; firstly, the entity and is the risk of material misstatement from financial statements which are risk of inherent and control and the other dependent is on the auditor its self and it is the risk that the auditor will not detect material misstatements in the financial statements which is known as detection risk (ACCA, 2010, P.99).
For an auditor to assess risks of material misstatements, they are required to have an understanding of the entity and its environment according to the ISA 315 'Identifying and assessing the risks of material statements through the understanding of the entity and its environment' (ACCA, 2010, p.104). Below is table 1 of obtaining an understanding of the entity and its environment in a nutshell:
To identify and assess the risks of material misstatement in the financial statements
To enable the auditor to design and perform audits
Provide a frame of relevance for exercising audit judgement.
Industry, regulatory and other external factors including financial reporting applicability
Nature of entity
Entity's selections and applications of accounting policies
Objectives and strategies and related business risks related causing any material misstatement
Measurement and review of entity's financial performance
Inquiries of management and others
Observation and inspection
Prior period knowledge
Discussion made by audit team of the susceptibility of financial statement material misstatement
Information from other engagements undertaken for the entity.
Table 1: source adopted from ACCA Study text, Paper F8, Audit and Assurance (United Kingdom), 2010, p.104
Real world examples of auditors auditing clients affected their independence
A real case study example was on a firm, 31st July 2009, a UK FTSE 100 firm, Rentokil and they announced that KPMG will be their new auditor but it then was controversial due the offer being made by KPMG was known as an 'extended assurance' package. This meant that KPMG would fulfil all external audit functions that could also include internal audit work, and this resulted in a cut of 30% audit costs but there was a debate whether it is an acceptable kind of agreement in the context of ethical standards. Further exploration revealed there was a self-review threat where the external auditor may be too dependent on its internal work and a management threat in performing the internal audit work the external auditor could assume the role of management (ACCA, 2010, p.57).
The case of FTSE 100-company, RSA insurance, replaces Deloitte as the auditor for that company and has appointed KPMG as the new auditor.
When the company released the initial results for 2012, the company stated that Deloitte had to take extra consultancy work in Scandinavia which felt could impair the perception of their independence. In addition, Deloitte was the auditor since 2007 was paid a fee of £9.6 million from RSA in 2011, which included non-audit services. A UK regulator, the Financial Reporting Council, told companies to tender their audit contract at least on one occasion a decade whilst some investors favour a greater harsh action (http://www.economia.icaew.com).
Another example of a company British gas (BG), published on the 25th of October 2012, the British gas group decided to replace their auditor who was PwC LLP, and thanked them for the high quality of audit services. The new audit contract with Ernst and Young will commence at the financial year 2013 (http://www.economia.icaew.com). A statement said that Schroder has put out an audit tender after a relationship for more than 50 years, furthermore, the largest companies may respond to shareholder and regulatory bodies concerning that their relationship too close. On the other hand, a statement to the stock exchange, Safeland property developers said, 'The reason for the cessation of audit appointment was that following the identification by the directors of an alleged defalcation, an unmanageable conflict of interest has arisen, which has led to our resignation' (http://www.economia.icaew.com).
Enron, published on 16th January 2013, was another company where the United States Securities and Exchange Commission banned the CFO of Enron subsidiary Enron Broadband Services (EBS) from acting as accountant. Kevin Howard, the Chief Finance Officer and vice president of EBS did not inform Arthur Anderson about the true nature of the transaction. It was the monetisation of certain assets that immediately recognised earnings from a long-term contract with Blockbuster Inc. Unfortunately he made false and misleading statements in meetings with auditors, Howard was banned from serving the company officer or director and was made to pay a fine of £45,000 (http://www.economia.icaew.com).
Therefore, big firm collaborates itself dominate critics point out that auditing and that the big four firms have a disproportionate influence over the both in the United Kingdom and globally with IFAC. This had led to higher audit costs and cosy relationships with big company boards and senior partners in major audit companies. This may in due course lead to changes in audit practices such as 'mandatory rotation' and outlawing of provisions in company rules and regulations, which make engagement of a 'Big four' firm obligatory.
To conclude the essay, auditing is a matter of assessing, monitoring controls, evaluating financial reports and providing an opinion on the financial statements. There are two types of audit namely internal and external audits. Both types of auditors have the same process of assessing the financial statements and the difference is that internal auditors are mostly within the organisation and external auditors are mostly third parties outside the business.
Internal auditors are a part of the organisations internal control systems. For an auditor, independence is a crucial term to focus on in order for an opinion made without any bias or threats to the auditor's independence. Threats can be in various ways. This includes self-interest threat, self-review threat, familiarity threat, management threat, and intimidation threat and so on.
According to the Ethical Standard 1, during the conclusion of the auditing process, during the process of doing an opinion before publishing it, the engagement partner will reach a general conclusion any threats to independence and objectivity on an individual or cumulative basis follows accordingly with the Audit Practice Board (APB) ethical standards. In addition, if the audit engagement partner cannot make a conclusion as such, the partner shall not report and the audit firm shall quit as an auditor.
On the other hand, the query of a friend about being truly independence to clients and given non-audit services to the same audit client depends on the quality of work and not being in close relationships that might contribute to threat of familiarity and self-interest.
Audit independence should not depend on the considerable sum of money to do the audit, but if the sum was more than the 15% rule of income that would be a threat to the auditors independence and objectivity. Non-audit services can also be a problem on the accurate independence from the audit client.
Therefore, there are challenges to auditing and currently new research on auditing including mysterious areas such as the 'game theory' to improve detections of fraudsters.
Word count: 2,959 (excluding references)
ACCA, Paper F8, 2010, Audit and assurance (United Kingdom) study text, 5TH Edition, BPP learning media, UK.
Millichamp, A. Taylor, J. 2012, Auditing, 10th edition, Cengage Learning EMEA.
Provision of non-audit services to audit clients
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What is Auditing?
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Real world examples internet references
RSA replaces Deloitte as auditor:
Last accessed: 1 March 2013
E & Y take BG group audit from PwC:
Last accessed: 1st March 2013
Enron CPA banned by SEC:
Last accessed: 1st March 2013