Concepts of Auditing

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ACC 3401 Audit and Professional Ethics

│LECTURE 1│
Concepts of Auditing

Learning Objectives
After the lecture, students should be able to:
describe the nature, purpose and scope of an audit;
describe various basic principles and concepts of auditing and explain their importance in the actual audit procedures; and
describe the professional framework within which auditors must operate.

1.

Accounting vs. Auditing
Accounting - the process of recording, classifying, summarizing and communicating information about an organization’s business activities. It is designed to provide financial information to a wide variety of users.

Auditing – the objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with the identified financial reporting framework.

2012-13
© Vocational Training Council, Hong Kong

Lecture 1

Week 1

1

2.

Why are audits necessary for limited companies?
Separation of ownership (shareholders) and management (directors) The management has to report to the owners about the profit/loss and assets and liabilities of the business (stewardship accounting). But how can the owners make sure that the accounting reports made by the management are reliable?

They can do so by appointing an independent person with sufficient skill to review the stewardship reports and to report his findings based on the review to the owners. Limited liability enjoyed by limited companies

Creditors (actual or potential) also read the annual accounts of a limited company before they decide whether they will trade (continue to trade) with such a company or whether they will lend (continue to lend) money to the company. How can the creditors be protected if the accounts published by the company are not reliable? Thus, the creditors have to read the auditors’ report attached to the published financial statments to see whether there are any comments made by the auditors (although the auditors’ report is addressed to the shareholders of the company).

Statutory requirement
Under the Companies Ordinance, the financial statements of limited companies are required to be audited by Certified Public Accountants.

3.

Agency Theory and Auditing
Modern organisational theory views an organisation as being comprised of various interested groups. The relationships between the various interested parties in the firm are often described in terms of agency theory. Agency relationships occur when one party (the principal) employs another party (the agent) to perform a task on his behalf.

Based on this theory, directors can be treated as the agents of shareholders, employees as the agents of directors and auditors as the agents of shareholders.

2

Week 1

Lecture 1

2012-13
© Vocational Training Council, Hong Kong

ACC 3401 Audit and Professional Ethics

Each principal needs to recognise that due to conflict of interest, the agent he is employing may not carry out the tasks in accordance with the full requirements of the principal. The directors have a duty of stewardship of the company’s assets. They are also interested in the level of their remuneration. If the remuneration increases, the assets of the company may definitely go down. The decision to award directors on pay increases is effectively in the hands of the directors themselves.

The auditors report their opinion to the shareholders. Auditors may well know the decision to appoint them is effectively in the hands of the directors. They therefore have a potential conflict of interest in carrying out their function independently on one hand and remain on good terms with the directors on the other hand.

Despite having recognised the conflicts of interest that may arise, agency theory predicts that matters can be organised so that, by behaving rationally, the agent will not act against the interests of the principal.

The theory...
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