Auditing - Lecture 1
Part I. Fundamentals of audit: Audit market


About the course
nRequired literature:
qInternational Standards on Auditing: IAASB, 2015.
qARENS, Alvin A., Randal J. ELDER a Mark S. BEASLEY. Auditing and Assurance Services.: Person
Global Edition, 2014. 864 s. 15/E. (theory)
nRecommended literature:
qHAYES, Rick, Hans GORTEMAKER and Philip WALLAGE. Principles of auditing :an introduction to
international standards on auditing. 3rd ed. Harlow, England: Prentice-Hall, 2014. xxi, 714
s.(theory)
qBEASLEY, Mark S., Frank A. BUCKLESS, Steven M. GLOVER and Douglas F. PRAWITT. Auditing Cases: An
Interactive Learning Approach. 6/E. : Pearson, 2015. 448 pp. (practice)
qTRUSSEL, John M. and J. Douglas FRAZER. Lakeside Company: Pearson New International Edition: Case
Studies in Auditing. 12/E. : Pearson, 2014. 162 pp. (practice)
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About the course
nRequirements for successful accomplishment of the course:
q90% participation at seminars is required.
q60% of final grade can be received during final exam and 40% of final grade can be received during
seminars. 40% is splitted into 1 midterm test (20%) and 1 presentation (20%) or activity at the
seminars (20%).
qTopics for presentations should be agreed with a lecturer at the beginning of the semester.
qMinimum required amount of for the midterm test is 60% of correct answers.
qFinal test is a written exam.
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Content
nAuditing phenomena
nTypes of audit and auditors
nRegulation of audit market and services
nRecommended reading
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Audit phenomena – history of audit
nScribes of ancient times - Auditors existed in ancient China and Egypt. They were supervisors of
the accounts of the Chinese Emperor and the Egyptian Pharaoh.
nProfit maximization and double entry - The attitude of profit maximization emerged at the end of
the Middle Ages, with the emergence of large merchant houses in Italy. Trading was no longer the
domain of the individual commercial traveler; it was now coordinated centrally at the luxurious
desks of the large merchant houses in Venice, Florence or Pisa. Double-entry was introduced.
nEconomic conditions for audit reports - The practice of modern auditing dates back to the
beginning of the modern corporation at the dawn of the Industrial Revolution. In 1853, the Society
of Accountants was founded in Edinburgh. Further developments of the separation between provision
of capital and management led to a steady growth of the audit profession and regulation
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Audit phenomena – history of audit
nCompanies across the world experienced growth in technology, improvement in communications and
transportation, and the exploitation of expanding worldwide markets. As a result, the demands of
owner-managed enterprises for capital rapidly exceeded the combined resources of the owners’
savings and the wealth-creating potential of the enterprises themselves. Capital markets were
introduced.
nInvestors and creditors may have different objectives than management. Investors and creditors
must depend on fair reporting of the financial statements. To give them confidence in the financial
statements, an auditor provides an independent and expert opinion on the fairness of the reports,
called an audit opinion.
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Audit phenomena – nature of audit
nDef.: Auditing is the accumulation and evaluation of evidence about information to determine and
report on the degree of correspondence between the information and established criteria. Auditing
should be done by a competent, independent person.
nAccounting vs. auditing - Accounting is the recording, classifying, and summarizing of economic
events in a logical manner for the purpose of providing financial information for decision making.
To provide relevant information, accountants must have a thorough understanding of the principles
and rules that provide the basis for preparing the accounting information. In addition, accountants
must develop a system to make sure that the entity’s economic events are properly recorded on a
timely basis and at a reasonable cost.
nWhen auditing accounting data, auditors focus on determining whether recorded information properly
reflects the economic events that occurred during the accounting period.
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Audit phenomena – role of audit
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nInformation risk theory - to illustrate the need for auditing, consider the decision of a bank
officer in making a loan to a business. If the bank makes the loan, it will charge a rate of
interest determined primarily by three factors: (1) Risk-free interest rate; (2) Business risk for
the customer; (3) Information risk. The latter – information risk - reflects the possibility that
the information upon which the business risk decision was made was inaccurate. A likely cause of
the information risk is the possibility of inaccurate financial statements. Auditing has no effect
on either the risk-free interest rate or business risk, but it can have a significant effect on
information risk. If the bank officer is satisfied that there is minimal information risk because a
borrower’s financial statements are audited, the bank’s risk is substantially reduced and the
overall interest rate to the borrower can be reduced. The reduction of information risk can have a
significant effect on the borrower’s ability to obtain capital at a reasonable cost.
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Audit phenomena – role of audit
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nCauses of information risk:
qremoteness of information
qbiases and motives of the provider
qvoluminous data
qcomplex exchange transactions
nWays to reduce information risk:
quser verifies information
quser shares information risk with management
qaudited financial statements are provided
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Audit phenomena – theories
nPolicemen theory - An auditor’s job is to focus on arithmetical accuracy and on the prevention and
detection of fraud.
nLending credibility theory - Audited financial statements are used by management to enhance the
stakeholders’ faith in management's stewardship.
nTheory of inspired confidence - The demand for audit services is the direct consequence of the
participation of outside stakeholders (third parties) in the company. These stakeholders demand
accountability from the management, in return for their contribution to the company. Since
information provided by management might be biased, because of a possible divergence between the
interests of management and outside stakeholders, an audit of this information is required.
nAgency theory - A company is viewed as the result of more or less formal contracts, in which
several groups make some kind of contribution to the company, given a certain price. A reputable
auditor is appointed not only in the interest of third parties, but also in the interest of
management.
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Types of audit
nAudit of financial statements – examining of financial statements to determine if they give a true
and fair view or fairly present the financial statements in conformity with specified criteria. The
criteria may be IFRS, US GAAP etc.
nOperational audit - a study of a specific unit of an organization for the purpose of measuring its
performance. Operational audits review all or part of the organization’s operating procedures to
evaluate their effectiveness and efficiency. Effectiveness is a measure of whether an organization
achieves its goals and objectives. Efficiency shows how well an organization uses its resources to
achieve its goals.
nCompliance audit - A compliance audit is a review of an organization’s procedures to determine
whether the organization is following specific procedures, rules or regulations set out by some
higher authority. Compliance audits are usually associated with government auditors – for example,
a compliance audit is an audit of a bank to determine if they comply with capital reserve
requirements.
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Types of auditors
nInternal auditors - employed by individual companies to investigate and appraise the effectiveness
of company operations for management. Much of their attention is often given to the appraisal of
internal controls. A large part of their work consists of operational audits; in addition, they may
conduct compliance audits. Internal auditors have two primary effects on a financial statement
audit:
qtheir existence and work may affect the nature, timing, and extent of audit procedures.
qexternal auditors may use internal auditors to provide direct assistance in performing the audit.
If this is the case the external auditor must assess internal auditor competence (education,
experience, professional certification, etc.) and objectivity (organizational status within the
company).
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Types of auditors
nExternal auditors - have primary responsibility to the performance of the audit function on
published financial statements of publicly traded companies and non-public companies. Independent
auditors are typically certified either by a professional organization or a government agency.
nThe source of authority for the attest function comes from national commercial or company law in
most countries, but in some cases (e.g. the USA and Canada) the individual provinces or countries
exercise considerable control over who the auditor is and how he becomes qualified. Most countries
have strong professional accountant organizations which may also influence who becomes an auditor.
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Regulation of audit market - organizations
nUSA
qGovernment - adoption of laws (e.g. Sarbanes-Oxley act of 2002)
qSEC and PCAOB – requirement to fill in special financial reporting forms (S1, 8K, 10K, 10Q) and
perform internal financial reporting in accordance with PCAOB standards
qAICPA – development of assurance standards, including code of professional conduct and framework
for quality control
nWorld
qIASB - development of IAS/IFRS standards, including conceptual framework
qIAASB - development of assuarnce standards, including code of professional conduct and framework
for quality control
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Regulation of audit market – authoritative pronouncements
nUSA
qSOX (by US government)
qUS GAAS and SAS (by AICPA)
ØGeneral standards
ØStandards of filed work
ØStandards of reporting
qPCAOB standards (by PCAOB)
nWorld
qIFRS (by IASB)
qISA (IAASB)
ØContents
ØAudit and review of historical financial information
ØAssurance engagement other than audit and review of historical financial information
ØRelated services
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Recommended reading
nArens et al. (2015) – chosen chapters will be uploaded to IS
qCh. 1 (1.1-1.3, 1.5-1.6), 2 (2.7.-2.8).
nHayes et al. (2014) – chosen chapters will be uploaded to IS
qCh. 1 (1.1-1.6), 2 (2.1-2.2).
nSarbanes-Oxley act of 2002
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