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, the shareholders will also take part in the day to day management of the company. However, once businesses grow, shareholders appoint directors and managers to run their company.

Shareholders (also known as members) are the principals, and directors are the agents of the shareholders. Agents should act in the best interests of the principals so, therefore, directors should act in the best interest of shareholders. However, this can introduce conflicts of interest between the two parties. Shareholders want large profits but the directors might want large salaries, generous pensions and bonuses, first class travel and expensive cars.

Companies are required to produce annual financial statements (accounts) for presentation to their shareholders. These should show how their company has got on during the year. The directors are responsible for producing the financial accounts and there is obviously a temptation for them not to report results accurately or fairly. For example, directors might try to overstate profits so as to keep their jobs or to qualify for bonuses.

Therefore, auditors are appointed by the members of the company to scrutinise independently the financial statements and to report to the members on whether the financial statements show a ‘true and fair’ view of the company’s affairs and its 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 the duty that directors have to look after the interests of the shareholders.

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 varies 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.

Proper accounting records show and explain the company’s transactions, record its assets and liabilities and allow reliable financial statements to be prepared. Entries should be complete, accurate and supported by documents such as invoices, bank records and contracts. Records must be retained and accessible; the directors are responsible for keeping them. An audit does not transfer that responsibility to the auditor.

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 covers only the 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:

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:

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

The numbered paragraphs have the following significance:

1. A clear title “Independent auditor’s 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.
   

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

   • the audit was conducted in accordance with ISAs
     

   • the auditor is independent
     

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

A separate Going Concern section is also included when the going concern basis is appropriate and no material uncertainty has been identified. If a material uncertainty exists, the heading and content change as explained in chapter 15. The auditor’s conclusions are based on evidence up to the report date, not a guarantee of survival.

(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

The auditor’s main duty is to report an independent opinion to the members on the financial statements. To do this the auditor plans the audit, assesses risks, obtains sufficient appropriate evidence, evaluates misstatements and reaches an opinion. The work is performed with professional scepticism and judgment. Significant control deficiencies are communicated to management and those charged with governance. Any additional duty to report a matter to an authority depends on the relevant law or regulation.

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

• Access to the company’s records. This includes not only the 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 and removal: context for independence

Appointment, reappointment, resignation and removal are governed by local company law. The members’ power to appoint and remove the auditor helps protect independence from management. The auditor needs a right to explain matters relevant to the audit to the members; otherwise directors could conceal the reason for a disagreement.

8.1 Rights when leaving office

• Members may remove the auditor under the applicable company law. The auditor may make written representations to members and ask for them to be circulated, subject to that law.

• The outgoing auditor may attend and be heard at the meeting dealing with removal or replacement, as provided by company law.

• On resignation or removal, the auditor may submit a statement of circumstances that should be brought to members’ attention. The applicable law determines when a statement or notice is required.