bea2004 notes unit 1 - what is audit

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BEA 2004 AUDITING 2007

Background Notes Unit 1 What is audit? The primary, but not entire, focus of this module is on what is conventionally known as financial audit and in particular external financial audit. This form of audit was defined by the 1 APC in 1989 in its Exploratory Foreword to Auditing Standards as ‘the independent examination of, and expression of an opinion on, the financial statements of an enterprise’ and in SAS 100Objectives and General Principles Governing an Audit of Financial Statementsthe APB noted that: ‘the objective of an audit of financial statements is to enable auditors to give an opinion on those financial statements taken as a whole and thereby to provide reasonable assurance that the financial statements give a true and fair view (where relevant) and have been prepared in accordance with relevant accounting or other requirements.’ Financial audit is not the only form of audit and more than ten years ago Power (1994) noted: ‘the word ‘audit’ is being used in the UK with growing frequency. In addition to financial audits there are now environmental audits, value for money audits, management audits, forensic audits, data audits, intellectual property audits, medical audits, teaching audits, technology audits, stress audits, democracy audits and many others besides.’ In some audits the audit takes the form of an activity designed to provide independent credibility to or to ‘attest’ a statement about conditions, actions and events, for example in financial audit as to the truth and fairness of the view given by the financial statements. In others audit may be in terms of ensuring that particular regulations are complied with, for example environmental and safety audits are often seen in terms of ensuring compliance with externally or internally established regulations, systems or targets. In different situations the audit might focus more

1 The Auditing Practices Committee (APC) had responsibility for setting auditing standards in the UK from the late 1970s until it was replaced in 1991by the Auditing Practices Board (APB) which was wider in its membership and more independent of the accounting and auditing profession. The APB, which is now a sub board of the Financial Reporting Council, issued Statements on Auditing Standards (SASs)  which are now effectively incorporated into ISAs (UK and Ireland) as part of the process of harmonisation with international auditing standards.

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directly on attainment levels, for example the quality of research in the higher education system, league tables in schools, clear up rates for police authorities. Power noted the establishment of the National Audit Office and the Audit Commission in the early 1980s and the manner in which they sought to address issues of economy, efficiency and effectiveness in publicly funded bodies as influential in extending scrutiny in areas such as central and local government, the health service, the police etc. Much of this extension of audit has been beyond traditional financial audit, for example in terms of value for money audit, league tables, benchmarking, association with the better value initiatives etc. Some would argue that such is the variety of activities and practices that are now subsumed under the title of audit that there is little or any common ground between them (Bowerman et al 2000). Power suggests that there are in fact common linkages in terms of ideas of control, for

example the decentralisation and removal of primary direct controls, the emphasis on control of systems rather than of outputs, less reliance on controls generated internally for example professionalisation. However even here there are contradictions within the manner in which various methods of audit are seen as control mechanisms and to some extent the use of the term audit has come to be seen as a suitable and politically convenient way to characterise and christen a variety of disparate activities. Audit as a Control Mechanism Audit is only one of a whole number of possible mechanisms whereby society as a whole or subsections of society can seek to monitor, control and direct aspects of the behaviour of all or some of its members. Traditionally control has been based on direct surveillance and observation, whether overt as in the role of a foreman on a building site or silent and 2 unobserved as in Bentham’s panopticon . Direct surveillance may be less effective and more problematic where the activities involve particular fields of expertise, parties with different levels of information and knowledge and outcomes which are not necessarily observable. Here other mechanisms may be appropriate and some have seen the rise of professional groups as a subcontracting by society of responsibilities to these groups, whose members are granted special privileges in exchange for an implicit or explicit bargain that they will behave 2  The ‘panopticon’ was a design for a prison which enabled full surveillance of the inmates without them being able to tell whether observation was in fact taking place. Seehttp://users.rcn.com/mackey/thesis/panpic.html

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in a way which is beneficial to society as a whole rather than in their immediate self interest. Alternatively, society may attempt to inculcate via education, morality, political theory, religion or other means a selfless will of individuals to act in the interests of society as a whole – in a way that worker ants appear to sublimate their own interests for the common good. A rather different approach, discussed further below, is to rely on the ‘invisible hand’, the interaction of the innate self centred aspirations of individuals to generate an optimal overall outcome – such a solution will no doubt still include mechanisms of control and monitoring but they will be determined by free contracting between individual agents. Clearly the determinants of what are appropriate and efficient control mechanisms is contingent upon the nature of society and its own state of evolution. Furthermore, in any society at any point in time a range of different control systems are in operation although their relative strength may vary. A manufacturing enterprise might simultaneously incorporate aspects of direct control, financial incentives and mechanisms designed to promote internalised discipline, a quality culture etc. in its attempts to lower costs, improve quality and raise productivity. Although forms of audit have a long history (Watts and Zimmerman, 1983), it was only in the twentieth century that audit emerged to play such a prominent role as a societal control mechanism and it was only in the latter part of that century that it became pervasive across such large sections of society and societal activity in a manner which prompted Power to claim that ‘Audit is an emerging principle of social organization which may be reaching its 3 extreme form in late twentieth century Britain’. However, despite both its longevity and its infiltration into almost all aspects of society it is arguable that audit remains a relatively poorly understood phenomenon. Hopwood notes: ‘we still have a rather impoverished view 4 of the audit task and one that fails to cast adequate light on audit in action’ and others have suggested that ‘as compared with accounting regulation the study of auditing has been 5 seriously neglected and marginalised’. It is not that auditing has not been the subject of research, Gwilliam (1987) identifies many hundreds of research studies in the audit arena and

both for a picture of the original design and for links to further sites and discussion of the concept and its sociological implications. 3 Power (1994) p.47 4 Hopwood (1996) p.217 5 Wilmott (1991) p.109

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6 since then the volume of work has increased exponentially. However, it is arguable that the nature of much of this research has added relatively little to our knowledge of what auditors do in practice and has provided few insights into the efficacy and efficiency of audit as a control mechanism. External Financial Audit External financial audit may be imposed upon the relevant parties or it may be undertaken by in consequence of a voluntary agreement between the parties. In the UK companies above a certain size are required by statute (Companies Act 1985) to have an external audit leading to an expression by a registered auditor of an opinion as to the truth and fairness of the view shown by the annual financial statements and as to their compliance with the relevant legislation. Other legislation imposes audit requirements on various other forms of organisation, for example NHS trusts, requirements relating to individuals or organisations under the Financial Services and Markets Act 2000 etc. These may impose specific further responsibilities, for example with regard to the assessment of internal controls and communication with regulators or as to aspects of performance or value for money audit. For some noncorporate bodies there is a requirement for an audit but with an opinion stated in other terms, for example in relation to the audit of government departments and of local authorities. Where there is no statutory requirement an audit may be undertaken as a result of a private contractual relationship when the terms and scope of the audit are essentially determined by the parties concerned (although the law may imply some minimum duties if the contract is expressed in terms of audit as will auditing standards for those parties required to adhere to auditing standards). Examples of audits of this nature are those of unincorporated sole traders, partnerships (other than Limited Liability Partnerships) and companies which are small enough that the Companies Act does not require them to be audited. One paradox identified by Power (and by others) is that audit has become increasingly powerful as a concept notwithstanding the fact that the practice of conventional financial

6 The American Accounting Association website Twenty Five Years of Auditing Research available at http://raw.rutgers.edu/raw/aaa/audit/provides brief details of auditing research studies published in selected leading academic journals from 1974 through to 1999.

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audit has been the subject of quite extensive critical commentary in the 1980s and 1990s and most notably following a series of major corporate collapses and exposes in North America in the early years of this century many of them associated with the collapse of the hitech bubble. In the 1990s Power noted that: ‘the great puzzle of financial audit is that it has never been a more powerful and influential model of administrative control than now, when many

commentators talk of an auditing crisis’. This criticism has been sustained from a number of quarters most notably in the UK by Austin Mitchell and others (for example Mitchell et al, 1994) and has focused on a number of aspects of the audit industry including its dominance by a small number of large firms, the then ‘BigFive’ (now the ‘BigFour’), the weakness of professional bodies in their regulatory and disciplinary capacities, the lack of independence of auditors from their clients  a problem exacerbated by the rapid growth in the provision of service other than audit to audit clients. Critics have suggested that these factors contributed to a failure to prevent or mitigate a number of spectacular commercial crashes some with attendant overtones of fraud. These perceived audit failures included De Lorean, Johnson Matthey Bank, Ferranti, Atlantic Computers, Polly Peck, BCCI, Lloyd’s, Maxwell and Barings. More recently, and far more influentially, the audit industry in the US has come under heavy criticism from the SEC in response to failure to prevent accounting abuse and irregularity in large corporations and a series of perceived high profile accounting and audit failures including Enron, WorldCom, Tyco and Xerox has caused major reexamination of the role of external financial audit within the overall corporate governance structure on both 7 sides of the Atlantic . In North America this resulted in the passing of the SarbanesOxley Act in 2002 which significantly changed the nature of audit regulation with respect to the audit of listed US corporations. Audit or Assurance Services? In recent years financial audit has come to be seen as just one element, albeit an important one within a range of assurance services available to clients. Assurance services encompass a 8 wide range of activities in which the role of the audit firm is that of adding credibility to

7 See Gwilliam and Marnet (2006) for discussion of the role of internal audit, external audit and audit committees in relation to certain of these cases. 8 A survey of 21 large and medium sized firms carried out for the AICPA Special Committee identified over 200 separate nonaudit assurance services being provided by these firms (Elliott, 1998).

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9 assertions made. In the 1990s a Special Committee of the American Institute of Certified Public Accountants identified six areas of existing assurance services which the Committee 10 considered to have particular potential for future growth: assurance as to the business practices and integrity of electronic commerce providers; assurance as to the quality of health care provision; assurance that systems are designed and operated to provide reliable information; risk based assessment of the likelihood and magnitude of adverse events; assurance as to the quality of provision for the elderly; assurance as to the relevance and reliability of entity performance measures. Another facet of the change in the audit process has been an extension in the scope of financial audit to include much wider consideration of aspects of strategic risk and business planning. Jeppesen (1998) refers to this expansion of the scope of audit as a ‘reinvention’ of audit and suggests that whereas ‘the old audit was confined primarily to the financial statements, the new audit approaches attempt to audit the auditee’s entire business and 11 strategy.’ Furthermore, he suggests that the focus on risk and strategic objectives has led to a blurring of the traditional distinction between auditing and other services provided by the accounting and audit firm: ‘To some extent auditing has become consulting and it makes increasingly little sense distinguishing between the two as the boundary between them is 12,13 eroded by the ‘reinvention’ of auditing.’

Agency Theory: An Economic Underpinning for Audit? In recent years agency theory has been an important paradigm within which economic theorists have sought to explain and analyse the market for audit services. In its simplest form as applied to the company sector the model contains: a)Managers – who know the ‘true’ financial position of the firm – the agents 9 The AICPA Special Committee used as a working definition ‘independent professional services that improve the quality of information, or its context, for decision makers (Elliott, 1998 p.2). 10 The Committee’s ball park estimates were that the provision of these services would double or even quadruple the US profession’s level of accounting and audit revenues over the ‘next several years’ (Elliott, 1998, p.6) 11 p.525 12 p.526 13  This view was echoed by a North American large firm partner who stated: ‘there is a continuum in the whole audit advisory services area. I don’t think it’s any more possible to define discrete breakpoints.’ (Boritz and Cockburn, 1998, p.142)

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b)Shareholders – who need to know the true financial position of the firm so as to evaluate the activities of the managers – the principals c)Auditors – who are able, at a price, to determine the ‘true’ financial position of the firm and to report thereon to the shareholders – the monitors (in the real world managers may have an imperfect and self selecting perception of a firm’s true financial position and the ability of auditors to determine the true position in an objective fashion may be constrained). The model suggests that in the absence of monitoring of the accuracy of financial reporting there will be incentives for managers to misrepresent the true position and for shareholders to react to this by one or more of the following means: reducing management compensation on the assumption that managers will succumb to this temptation; restricting management freedom of action; or possibly engaging an auditor. In a rational expectations type world the actual impetus for hiring an auditor will come from ‘good’ management so as to head off actions from their principals which they see as likely to be adverse to their interests. As in many ‘agency’ type models in financial economics equilibrium is achieved with ‘good’ driving out ‘bad’ as the failure of ‘bad’ managers to appoint monitors is observable and in consequence they lose custom/fail to raise finance/are dismissed etc. (However, in the real world it is not always clear that ‘bad’ does not drive out ‘good’.) Much of the agency theory analysis as applied to auditing has been conducted in highly simplified theoretical settings. These studies may be criticised in that they demonstrate that in such circumstances there is likely to be a demand for audit (provided that it is not too costly) and that there may be opportunities for collusion between the agent (management) and the monitor (auditor) to act to the detriment of the principal (shareholders) Two strands of research have developed which have sought to ‘test’ the propositions of agency theory. Experimental economics techniques (whereby it is attempted to artificially stimulate real world situations) have been applied to a range of agency related issues but the

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complexity of the real world audit environment makes experimental modelling of this environment difficult. Empirical analysis has investigated the association between the demand for audit and a number of variables which agency theory suggests would affect that demand, for example the extent of the divorce between ownership and management. There has been work which has sought to investigate as far as is possible the mainsprings of the demand for audit in the absence of a statutory requirement by means of a review of its historical antecedents. A general historical study by Watts and Zimmermann (Watts and Zimmermann, 1983) led them to conclude‘we find that the audit existed early in the development of business corporations (1200) and evolved gradually into the type of audit required by the first English Companies Act 1844. Further it appears that audits were widespread among early business corporations. The evidence suggests that monitoring of performance is important if not crucial to the foundation of firms. The long survival of auditing suggests it is part of the efficient technology for organizing firms’. There have been more specific studies, for example those by Chow (1982), Buijink (1992) and Merino et al (1994). In these studies the basic methodology was to test the association between a)size of the company b)the extent of the separation between ownership and management c)the existence of complex debt covenants and the propensity of a company to be audited before the introduction of a regulatory requirement for audit. The US studies, Chow and Merino et al, used data for 1926 and 1927 respectively, Buijink used Dutch data for 1926. The scope and value of these studies was restricted by the lack of comprehensiveness and the lack of accuracy of the historical data used. Both the Chow and the Buijink studies showed there to be an association between the proportion of debt in a company’s capital structure and the existence of audit (as did the Merino et al study) but neither provided conclusive results as to any association with the extent of separation between ownership and management. Nevertheless, Chow concluded:‘overall these results suggest that agency cost considerations play an important role in the external auditing decision. The existence of such private incentives may imply a reduced need for auditing regulation.’

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Other empirical studies, for example Chan et al (1993) have provided some weak evidence that the greater the separation between ownership and control the greater the extent of audit (as proxied by the level of audit fees) for UK companies. A rather different approach was taken by Gwilliam et al (2000) who conducted case study work based on the development of audit in the Lloyd’s insurance market. They focused on the late 1970s and the early 1980s a period during which the market changed from one in which a significant proportion of the principals (Lloyd’s Names) were able to monitor, either directly or indirectly, the activities of their agents (the underwriters/managing agents who wrote the insurance on the behalf of the Names) to one in which the division between principals and agents and the extent of the information asymmetry between them was very marked. However, they found little evidence of a significant change in audit practice during this period and suggested that institutional and environmental factors and complexities make reliance on market forces to provide the appropriate level of audit to be questionable in policy terms. A linked study (Gwilliam et al, 2005) sought to investigate whether in fact the audit arrangements at Lloyd’s were efficient and offered tentative evidence that the audit and accounting regime which was imposed on Lloyd’s in the 1980s provided benefits to the Names which outweighed the cost of the regulatory regime thereby suggesting that the preexisting audit arrangements were not in fact efficient. Audit Postulates A number of writers have sought to develop a more normative approach to the theory of auditing by means of laying down from first principles a series of postulates or underlying assumptions, not themselves necessary of direct verification, which govern the nature of auditing. This approach may be traced back to the work of Mautz and Sharaf (1961) and has been developed further by Flint (1988) and Lee (1993). Flint sets out the following postulates as underlying audit: 1. A relationship of accountability between the parties and the need to establish the reliability of information. 2. The nature of the information/subject matter is such that it is too remote or complex for accountability to be discharged without audit.

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3. A distinguishing characteristic of the audit is the independence of the auditor and their freedom from investigative and reporting constraints. 4. The relevant subject matter is capable of verification by the adduction and interpretation of evidence. If the information is entirely subjective in nature then audit is of little value. 5. Appropriate standards of accountability can be set, i.e. in company financial audit there are appropriate criteria to determine whether financial statements are true and fair. 6. That the credibility of the information can be clearly communicated. 7. Audit produces a social benefit. The postulate approach may be seen as essentially inductive abstracting from existing practice and therefore by nature insufficiently critical and of little value in explaining change and pressure for change. It is not really a theory of auditing in a scientific sense rather it is a rationalisation of a set of existing practices and thereby an extension of a professional perception of auditing. It may have value in focusing on the assumptions that sustain current practice and perhaps in comparing actual practice with a professional ideal. However, many would argue that the near complete abstraction from the economic incentives and pressures facing the parties to the audit contract severely limits the value of such an approach.

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References Boritz J.E., and D. Cockburn, (1998). Audit symposium panel discussion on assurance services. Auditing: A Journal of Practice & Theory, Supplement, pp. 133151. Bowerman M., H. Raby and C. Humphrey, (2000), ‘In Search of the Audit Society: Some Evidence from Health Care, Police and Schools’,International Journal of Auditing, pp.71 100. Buijink, W., (1992) ‘Some evidence on the demand for external auditing in an unregulated environment: the case of the Netherlands’, pp.89114 in W. Buijink,Empirical Financial Accounting Research: Compliance with Regulation, Distributional Properties of Financial Ratios and Demand for External Auditing, Maastricht Datawyse/Universitaire Pers Maastricht. (not available in the Library) Chan, P., M. Ezzamel, and D. Gwilliam, (1993), ‘Determinants of Audit Fees for UK Quoted Companies’,Journal of Business Finance and Accounting,20 (6), 765786. Chow, C.W. (1982), ‘The Demand for External Auditing: Size, Debt and Ownership Influences’, Accounting Review, April, 272291. Elliott R.K. (1998), Assurance services and the audit heritage.Auditing: A Journal of Practice & Theory, Supplement, pp. 17. Flint D., (1988), Philosophy and Principles of Auditing – An Introduction, Macmillan. Gwilliam D. (1987), A Survey of Auditing Research, ICAEW/PrenticeHall, 1987. Gwilliam, D., R. Macve and G. Meeks, (2005), ‘The Costs and Benefits of Increased Accounting Regulation: A Case Study of Lloyd’s of London’, Accounting and Business Research, Vol.35, No.2 pp.129146. Gwilliam, D., R. Macve and G. Meeks, (2000), ‘Principals and agents in crisis: reforms of accounting and audit at Lloyd’s, 19821986’,Accounting History, Vol.5 No.2 November 6191. Gwilliam, D. and Marnet, O., (2006), ‘Audit Within the Corporate Governance Paradigm: a Cornerstone Built on Shifting Sand’, working paper University of Wales, Aberystwyth. Hopwood A, (1996) editorial note inAccounting, Organizations and Society, p.217218. Jeppesen, K. (1998) Reinventing auditing, redefining consulting and independence.European Accounting Review, pp. 517539. Lee, T.A., (1993) Corporate Audit Theory, Chapman & Hall. Mautz R.K. and H.A. Sharaf, (1961), The Philosophy of Auditing, American Accounting Association, Sarasota, Fl. Merino, B., A. Mayper and R. Sriram, (1994) `Voluntary Audits in New York Markets in 1927: A Case Study',Journal of Business Finance and Accounting, July, 619642. Mitchell A, Sikka P, Puxty T and Willmott, H (1994) A Better Future for Auditing University of East London. Power M, (1994) The Audit Explosion Demos. Watts, R.L. and J.L. Zimmerman, (1983), 'Agency Problems, Auditing, and the Theory of the Firm: Some Evidence',Journal of Law and Economics, October, 613633. Wilmott H, (1991) The Auditing Game: A Question of Ownership and Control,Critical Perspectives on Accounting,2 109121. General Agency Theory References DeAngelo, L., (1981),The AuditorClient Contractual Relationship,Ann Arbor Michigan, UMI Research Press. Jensen, M., (1983), ‘Organization Theory and Methodology’,Accounting Review, April, 319339. Jensen, M.C. and W.H. Meckling, (1976), 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure',Journal of Financial Economics, October, 305360. Lee, T., (1993), ‘Economic and Social Role of Auditing’ inCorporate Audit Theory, London, Chapman Hall. Ng, D. and J.Stoeckenius, (1979), 'Auditing: Incentives and Truthful Reporting’,Journal of Accounting Research, Supplement, 124.

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