Business environment and audit framework

1 The purpose and scope of an audit

Shareholders are the legal owners of companies. In very small businesses, such as family businesses, shareholders often participate in day-to-day management. However, as businesses grow, shareholders appoint directors and managers to run the company.

Shareholders (also known as members) are principals, and directors are their agents. Agents should act in the best interests of principals; therefore, directors should act in the best interests of shareholders. However, this relationship can create conflicts of interest. Shareholders want large profits, whilst directors might prioritise large salaries, generous pensions and bonuses, first-class travel and expensive cars.

Companies must produce annual financial statements (accounts) for presentation to shareholders, showing how the company has performed during the year. Directors are responsible for preparing these accounts, and there is a clear temptation to report results inaccurately or unfairly. For example, directors might overstate profits to retain their jobs or qualify for bonuses.

Therefore, auditors are appointed by company members to independently scrutinise the financial statements and report to members on whether they present a 'true and fair' view of the company's affairs and results. Auditors' conclusions are published with the financial statements in the auditor's report.

In addition to the terms 'agent' and 'principal', 'stewardship' is sometimes used to describe directors' duty to protect shareholders' interests.

2 What auditors don’t do

Auditors do not:

• Prepare the financial statements: that is the job of the directors.
  

• Double check every transaction in the company: that would take too long and be very expensive.
  

• Manage the company.
  

• Warn shareholders that the company has made a loss: that will be shown in the financial statements.
  

• Undertake to discover every fraud or error that might have taken place in the company: auditors look only for material misstatements (see later).
  

3 Advantages and disadvantages of an audit

3.1 Advantages

• Independent scrutiny and a report on the financial statements.
  

• Greater credibility (believability) of the financial statements. This could help in raising finance.
  

• Professional expertise applied to the financial statements. Especially important when directors and shareholders might not have financial experience.
  

• Review of the company’s internal control system (the accounting system used by the company) and recommendations for its improvement.

3.2 Disadvantages

• Cost: auditors charge for their work.
  

• Time and disruption. Auditors have to ask employees questions and have to find documents. This distracts employees from their day-to-day tasks.
  

• A feeling of not being trusted. Auditors are always looking for independent evidence and cannot rely on employees' or management's word alone. This can make staff feel that they are not trusted.
  

4 Accounting records

Accounting records consist of:

• General (also called nominal) ledger. This has accounts for assets (such as non-current assets, receivables), liabilities (such as amounts owed to suppliers and loans), income (such as sales) and expenses (such as rent, wages and electricity).
  

• Cash book. This shows cash receipts and payments.
  

• Receivables ledger. This shows how much each credit customer owes. This ledger is sometimes known as the debtors’ ledger or sales ledger. The total of these amounts should agree with the receivables control account that is part of the general ledger.
  

• Payables ledger. This shows how much is owed to each supplier. This is sometimes known as the creditors’ ledger or purchase ledger. The total of these amounts should agree with the payables control account that is part of the general ledger.
  

• Non-current asset register. This shows details of each non-current asset, such as purchase date, cost, depreciation rate, location, date last physically verified and depreciation to date. The total of the non-current asset register should agree to the relevant accounts in the general ledger. The non-current asset register might sometimes still be referred to as the fixed asset register.
  

• Inventory records. Lists, schedules or cards with inventory details such as cost, location number of items, deliveries and receipts.
  

The exact nature of the accounting records vary from business to business. For example, a small grocery shop will not have a receivables ledger because all sales are for cash. An architect’s practice will not have inventory records because they sell services, not goods. Some very small businesses keep little more than a cash book on a day-to-day basis and fuller accounting records are produced at year end.

5 Financial statements

Auditors report on a company’s financial statements. These will have been produced from the financial records. Financial statements consist of:

• A statement of financial position
  

• A statement of profit or loss
  

• Statement of cash flows
  

• Statement of changes in equity
  

• Notes to the financial statements
  

Together with the documents above, companies also produce directors’ reports, chairman’s statements, graphs, forecasts and public relations material and include it all in their annual report. The annual report will also include the auditors’ report. For large companies the annual report is often a 'glossy' publication designed to impress shareholders and potential investors.

However, the auditor’s report coversonlythe financial statements, not the other documents that might be included.

6 The auditor’s report

6.1 Expression of opinion

The objective of an audit is to issue an auditor's report that includes an expression of the auditor's opinion. This may be expressed in terms of whether or not the financial statements give “a true and fair view” of the financial position of the company at its year end and of its performance during the year.

True:   implies that the financial statements are factually correct, have been prepared according to an applicable reporting framework (such as International Financial Reporting Standards) and that they do not contain any material misstatements that may mislead the users. Misstatements may result from material errors or omissions in the financial statements. True also implies that the financial statements are materially accurate.

Fair:   implies that the financial statements present the information faithfully without any element of bias and they reflect the economic substance of transactions rather than just their legal form. Presentation is an important element of fairness.

For example:

The statement of financial position should show current assets and current liabilities separately and in detail. Thus current assets and current liabilities might show:

• Current assets

• Inventory

• Receivables

• Cash

• Current liabilities

• Trade payables

This shows that the liquidity of the company is poor as suppliers expect $12,000 within the next few weeks but, although inventory is high, there is not much coming from customers or in cash with which to pay suppliers. Inventory can take a long time to be sold and to turn into cash.

If the presentation were as follows:

Current assets

Current liabilities

then users might have a very wrong impression. The amounts are true (correct), but concealing the large amount of inventory that contributes to the current assets is likely to mislead ie not a fair presentation.

6.2 Illustrative example

1 INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC company

2 Report on the Audit of the financial statements

3 Opinion

We have audited the financial statements of ABC Company (the Company), which comprise the statement of financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and notes to the financial statements, including a summary of significant accounting policies.

In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of the Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards (IFRSs).

4 Basis for Opinion

We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit of the financial statements section of our report.

We are independent of the Company in accordance with the International Ethics Standards Board for Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements that are relevant to our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical responsibilities in accordance with these requirements and the IESBA Code. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion.

5 Responsibilities of Management and Those Charged with Governance for the financial statements

Management is responsible for the preparation and fair presentation of the financial statements in accordance with IFRSs and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for assessing the Company’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless management either intends to liquidate the Company or to cease operations, or has no realistic alternative but to do so.

Those charged with governance are responsible for overseeing the Company’s financial reporting process.

6 Auditor’s Responsibilities for the Audit of the financial statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements.

As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional skepticism throughout the audit. We also:

Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or error...

Obtain an understanding ofinternal controlrelevant to the audit...

Evaluate the appropriateness of accounting policies used...

Conclude on the appropriateness of management’s use of thegoing concern basis of accounting...

Evaluate the overall presentation, structure and content of the financial statements, including the disclosures...

We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards.

The engagement partner on the audit resulting in this independent auditor’s report is [name].

7[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the particular jurisdiction]

[Auditor Address]

[Date]

The numbered paragraphs have the following significance:

1. A clear title “Independent auditors’ report”.
   

2. Specifies what the audit covers – the financial statements.
   

3. The first section of the report is the most important part: the opinion paragraph, clearly headed so that it can be easily found. Here the auditors state whether in their opinion the financial statements' present fairly, in all material respects' in accordance with IFRS.
   

This type of assurance is known as ‘positive assurance’ or ‘reasonable assurance’ because the auditor's conclusion is an opinion - not an absolute guarantee.

1. The basis for opinion section directly follows the opinion section. It states that:
   

• the audit was conducted in accordance with ISAs

• e auditor is independent

• the auditor's belief that the opinion is supported with audit evidence.
  

(5)/(6) Pointing out what the directors are responsible for (5) and what the auditors are responsible for (6). This reduces the ‘expectations gap’ because many users of financial statements think that the auditors are responsible for their preparation. Auditors“give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error.”There are no guarantees: reasonable assurance only and material misstatements only.

(7)   Signed and dated. The date is important because the audit is still in progress until then.

7 Auditors’ rights

Auditor’s duties are to report on the matters as set out in the auditor’s report above. They also have a legal duty to report certain matters to the authorities; this is covered in more detail later in Chapter 2.

To fulfil their duties auditors are given certain rights by law. For example

• Access to the company’s records. This includes not only he accounting records but also documents such as contracts, correspondence and board minutes.
  

• To receive all information and explanations they require.
  

• The right to attend (and receive notice about) general meetings and the right to speak at general meetings on relevant matters.
  

8 Appointment of auditors

Auditors have to be reappointed by an ordinary resolution of the members at every annual general meeting (AGM). Reappointment isnotautomatic, so an auditor cannot simply stay in office. The requirement for a resolution means that the members have to take positive action to get auditors appointed.

Prior to the first AGM, the directors can appoint the first auditor. Or if an auditor resigns (eg due to illness), the directors can appoint another auditor to fill a casual vacancy. These appointments will only last till next AGM.

If all else fails, in the UK, the Secretary of State, in other words the government, will ensure that all companies have an auditor.

9 Resignation and removal of auditors

9.1 Introduction

If an auditor resigns or is removed there is always the fear that they are going for some reason that members ought to know about. For example, the auditors might have concluded that the directors are concealing important information or are committing a fraud. In such cases the auditors are likely to resign because it will be impossible for them to carry out a thorough audit. Therefore, upon either resignation or removal, the auditor must give written notice accompanied by a 'statement of circumstances' to the company’s registered office.

The 'statement of circumstances' will:

• give reasons why the auditor is ceasing to hold office that need to be brought to the attention of members of creditors; or
  

• state that there are no such circumstances.
  

9.2 Resignation or failure to seek re-appointment

The steps are:

1. Give written notice to the company together with the relevant statement of circumstances.
   

2. Notify the relevant regulatory authority (eg Registrar of Companies) together with the statement of circumstances.
   

3. If there are 'circumstances', the auditor may request that the directors convene a general meeting and circulate the statement to the members.
   

9.3 Removal

Auditors cannot be removed by the board. They can only be removed by the members. This gives the auditors much greater strength should they disagree with the directors on some audit point: the directors cannot simply find more amenable auditors. However, directors can have great influence over the members and might recommend removal of the auditors even though the auditors are doing a good job. Therefore, the auditors are entitled to make representations to the members at a general meeting, arguing why they should not be removed.

If the resolution to remove them is passed the auditor has the right to attend, make representations to and be heard at the general meeting at which:

• his term of office would otherwise have expired; or
  

• there is a proposal to fill the vacancy caused by his removal.