Professional Scheme
Relevant to Paper 2.5, Paper 2.6

All students are aware that the role of the auditor is to express an opinion as to the truth and fairness of financial statements. However, it is not always appreciated just how important that role is in modern society. The truth is that, without auditors, the modern corporate society, that produces most of the goods and services demanded by consumers, could not function.

Financial reporting and the industrial economy

Production facilities require substantial investment in plant, machinery and other productive assets. Few individuals have the resources necessary to finance such an operation and those that can are unlikely to be particularly skilled at managing them. However, the corporation, described as an awesome social invention, has provided a means by which the savings of thousands and even millions can be aggregated together to provide the necessary risk bearing capital to be placed under the control of skilled managers. One of the key factors in inducing investors to entrusting their savings to management is the role played by financial reporting. The directors, who are responsible for employing managers to run the business in the interests of shareholders, are required to provide regular reports as to how the investors’ money has been spent (the balance sheet) and what profits they have made (the income statement). If the financial statements indicate a less than satisfactory performance, the shareholders can threaten to replace the directors, if necessary, to ensure that their investment is better managed. Financial statements enable a further improvement to society through facilitating a market in company shares. Information provided by financial statements assists investors in deciding which shares to buy and which to sell. Effectively, this market channels available investment funds to those industries most likely to yield the highest returns. In this way, society’s capital is allocated in the most efficient manner.

Information risk

Now, where does the auditor fit into all of this? Well, the detailed records of transactions and of assets are necessarily kept by the company to help run the business. It makes sense, therefore, for the directors to use these records to produce the financial statements needed by investors. Shareholders might reasonably doubt whether financial statements, prepared by the directors, would truthfully reflect the transactions entered into with investors’ money, and fairly present the company’s state of affairs and financial performance. This is sometimes referred to as information risk. It is the same as the risk faced by the buyer of a used car. The used car buyer would not rely on the seller’s assurance as to the quality of the vehicle but would assume it was in the worst possible condition and offer a price on that basis. This might cause the used car market to dry up, which is in no-one’s interest. In practice, either the buyer or the seller are likely to find it worthwhile commissioning an independent inspection of the vehicle to establish its true condition and value. With companies, however, each potential shareholder is unlikely to be willing to pay for an audit. In any event, this would be a waste of resources because the same audit report would be useful to all shareholders. In most jurisdictions the government has anticipated this problem and requires the directors to produce the financial statements and also requires the shareholders to appoint an independent auditor. Ultimately, therefore, the benefit to society of channelling investment capital through companies, depends on the effectiveness of the audit function.

Agency theory

A very similar explanation that has recently been found useful is known as agency theory. This approach starts with the same assumptions; that directors will be tempted to produce financial statements showing their performance as being better than it really is, and that shareholders will suspect that financial statements produced by directors will be misleading. However, instead of relying on legislation to amend that situation, the theory predicts that directors will have an incentive to arrange for an audit. Directors are presented as agents for shareholders, promising to manage their investment in the company in return for appropriate remuneration. The risk anticipated by shareholders, that the directors will misuse their money, is called agency risk. The higher the risk, the greater the return shareholders will require. In finance, this is referred to as a risk premium. The more reliable the information provided by the directors, the lower this risk will be and, in turn, the lower will be the company’s cost of capital and the more projects it will be profitable for the directors to invest in. The theory predicts that directors have an incentive to engage high quality auditors in order to reduce agency risk and to increase the amount of capital their company can raise, thus enhancing their own status.

A third theory explains auditing as a kind of insurance. Because auditors are liable to compensate the shareholders if they are negligent, shareholders are said to be ‘insured’ against the risks of being misled by false financial statements produced by the directors. All these theories are discussed in Cosserat (1999, Ch. 2) and Gill et alia (1999, Ch. 2).

Factors necessary for an effective audit

In 1961 two academics produced a listing of factors which, in their view, were necessary for audits to provide the required service (Mautz & Sharaf, 1961). Because it was an academic piece of writing they called these factors ‘postulates’ and described them in complex technical language. Other writers have produced similar lists written in language that is easier to understand, such as Lee (1993, Ch. 6). In essence many of these factors should be self-evident to any auditing student. For example, there must be a sufficiently reliable audit trail and the auditor must be independent of management. Others are more subtle. For example, one requirement is that financial statements must provide appropriate information for monitoring financial position and performance. Another requirement is that assurance can not be better obtained in some other way, such as by shareholders themselves, personally inspecting the company’s books.

Auditing in the information era

In fact, recent developments are beginning to challenge these factors and, thus, the conventional practice of auditing. The information revolution is changing both the nature of business itself and the nature of communicating information. Both of these are influencing the development of financial reporting and auditing. In the past, profits were earned through investment in tangible plant and equipment. Products had lengthy life cycles and profits generated from investment in tangible assets could be expected to continue. Increasingly, profits are determined by investment in intangible assets such as reputation, employee skills, research, etc. Product life cycles are short, innovation continually in demand and past performance increasingly irrelevant. Both the American Institute of Certified Public Accountants and the Institute of Chartered Accountants in England and Wales have proposed new forms of financial reporting, emphasising the process of value creation, rather than past performance. Accounting firms are aware that the real audit risk is that of unexpected business failure. Arthur Andersen, on its web site, states that “traditional auditing was designed to detect errors, not anticipate them. Today, problems arise quickly, often with devastating impact. When the greatest risk to value is not what has gone wrong, but what could go wrong, you need a forward-looking, risk-based approach to provide reliable assurances”. They are targeting their audit effort at management processes in order to obtain assurance that the company is properly managed. Auditing standard setters are currently reviewing the need to revise existing requirements on audit risk.

Another probable development is the move from periodic reporting to continuous reporting via the Internet. Again, this requires auditors to place more emphasis on controls over data recording than on substantive testing of reported statements. Power (1998) has described this development as the audit implosion. On the one hand, involvement, by auditors in evaluating management processes redefines the auditors’ role as being closer to business consulting, which, in turn, has implications for auditor independence. On the other hand, recognition by management, of the importance of control over data and procedures, will bring about an enhanced role for internal auditing. The traditional external audit is likely to go through a phase of intensive metamorphosis in the not too distant future, re-emerging in a fundamentally different format. The market for control and assurance services is likely to experience rapid growth in the near future. Auditing skills will be increasingly in demand in the future but the practitioners will need to be capable of adapting to the changing needs of the market.

References

1. Cosserat, G., Modern Auditing, John Wiley & Sons Ltd., England, 1999.
2. Gill, G. Cosserat, G. Leung, P. & Coram, P., Modern Auditing, 5th Ed., John Wiley & Sons Ltd., Australia, 1999.
3. Lee, T. A., Corporate Audit Theory, Chapman & Hall, 1993.
4. Mautz, R. K. & Sharaf, H. A.,The Philosophy of Auditing, American Accounting Association, 1961.
5. Power, M., The Audit Implosion: Regulating Risk from the Inside, Chartered Accountants’ Trustees Limited, Lecture, 1998.