INTRODUCTION TO AUDITING

LECTURE 1

Learning Outcomes
Describe auditing
Distinguish between auditing and accounting
Describe different types of audit and auditors.
Explain why there is a need for auditing and
assurance services
Explain the framework of auditing

Traditional Role of Auditing

Auditing comes from the Latin word audire, meaning to
hear.
Began as far back as 3,500 B.C., long before it is
required by law.
The records of mesopotamian civilization show tiny
marks at the side of numbers involved in the financial
transactions
o Internal controls, systems of verification, and the concept of
division of duties probably originated at that time

Early Egyptian, Chinese, Persian, and Hebrew records

show similar systems
Traditional role of auditing - conformance role.
o Original report was verbal (oral verification)

Why is auditing needed in a free

market economy?

The Origin of Accounting and Auditing

AGENCY THEORY & THE

NEED FOR AUDITING
AGENCY RELATIONSHIP

INFORMATION ASYMMETRY

CONFLICT OF INTEREST

THE NEED FOR AUDITING

The principal-agent
relationship between the
owner and manager often
resulted in information
asymmetry between the two
parties. The manager
generally has more
information about the true
financial position of the
Company. Because their
goals may not coincide, there
is a natural conflict of interest
between the manager and the
owner. This gives rise to the
need for auditing.

AUDITING DEFINED
AUDITING (broadly defined) is a systematic process
of objectively obtaining and evaluating evidence
regarding assertions about economic actions and
events to ascertain the degree of correspondence
between those assertions and established criteria and
communicating the results to interested parties.
AUDITING (narrowly defined) is a written report on
the examination of financial statements of an entity.

Benefits of Financial statements audit

Obtain access to capital markets. Without an audit,

companies may be denied access to capital markets by
the SC and Bursa Malaysia
Have a lower cost of capital. Given the reduced risk
resulting from audited financial reports, potential
creditors may offer low interest rates and potential
investors may be willing to accept a lower rate of return
on their investment.
Be a deterrent to inefficiency and fraud. Knowledge that
an independent audit is to be performed is likely to result
in fewer errors in the accounting process and reduce the
likelihood of employee misappropriation of assets.
Control and operational improvements. Based on
observations made during the financial report audit, the
independent auditor can suggest how controls could be
improved and how greater operating efficiencies within
the entitys organisation may be achieved.

Auditing, Attestation and Assurance Services

Defined
Auditing

Attestation

Assurance
Services

A systematic process of objectively

obtaining and evaluating evidence
regarding assertions about economic
actions and events to ascertain the
degree of correspondence between
those assertions and established
criteria and communicating the results
to interested users.

Auditing, Attestation and Assurance Services

Defined
Auditing

Attestation

Assurance
Services

Occurs when a practitioner is engaged to issue a report on a

subject matter, or on an assertion about a subject matter, that
is the responsibility of another party.
Reports the reliability of the subject matter or the assertion
about the subject matter (financial or non-financial).
Effectiveness of internal controls, review of historical
accounts, loan compliance, financial forecasts etc.

Auditing, Attestation and Assurance Services

Defined
Auditing

Attestation

Assurance
Services

Are independent professional services

(written or verbal) that improve the
quality of information, or its context,
for decision makers.
It increases decision makers
confidence in the information.
Compliance with laws, contracts etc.

Objective of An Audit of Financial

Statements
The objective of an audit of financial statement
is to enable the auditor to express an opinion
whether the financial statements are prepared,
in all material aspects, in accordance with an
identified reporting framework (ISA 200)

How is accounting different from

auditing?

Accounting vs Auditing
Accounting
- the recording, classifying and summarising of
economic events in a logical manner for the
purpose of providing financial info for decision
making.
classifying

recording

summarising

Accounting vs Auditing
Auditing
- focus on determining whether recorded information
properly reflects the economic events that occurred
during the accounting period.
- besides a thorough understanding of approved
accounting standards, auditor must
Determining proper
audit procedures

also possess expertise in the

accumulation & interpretation of
audit evidence.
Evaluating results

Deciding number & types

of items to test

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Public Accounting Firm-Services

Bookeeping
Costing and management accounting
Insolvency, liquidation and
receiverships
Management information systems and
internal controls
Secretarial services

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Overview of The Audit Process

1. Preliminary 2. Obtain
Engagement
. Client
acceptance
. Terms of
engagement

understanding
of the entity

3. Materiality
and assess
risk

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Overview of The Audit Process

4. Audit
Planning

7. Issue the
auditors report

5. Test of
control and
substantive
procedures

6. Complete
the audit

Relationship among Internal Control,

individual transactions and account
balances
A company implements internal controls as a
safeguard to ensure appropriate capturing and
recording of individual transactions.
These individual transactions are then collected
into ending account balances.
Ending account balances are then used to
prepare the financial statements.

Relationship among Internal Control, individual

transactions and account balances
How do we audit then?
The auditor can obtain evidence from all three steps of the accounting
process.
For instance, an auditor can directly test the account balance (ex. by bank
statement confirmation and reconciliation). This evidence is usually the
highest-quality but costliest evidence.
Or, the auditor can obtain indirect information by testing the individual
transactions that make up an account balance. While an auditor will not
have the resources to test each individual transaction, she or he can use
sampling and project her or his findings onto the entire population of
transactions.
The least direct method of obtaining evidence is to evaluate and test the
companys internal control to ensure that transactions are being properly
handled.
Auditors usually rely on a combination of evidence from all three
areas.

Relationship among Internal Control, individual

transactions and account balances

Accounts Receivable (in thousands)

Beginning balance $ 17,521
Sales

Ending balance

$144,328

$ 20,197

$137,087 Cash receipts

Sales returns
and allowances

1,242

Charge-off of
3,323 uncollectible
accounts

Some fundamental concept

Audit risk is the risk that the auditor may

unknowingly fail to appropriately modify his or her
Auditon
Risk
opinion
financial statements that are materially
misstated.
The auditors standard
Reasonable assurance
report states that the audit implies that there is some
provides only reasonable
risk that a material
assurance that the
misstatement could be
financial statements do
present in the financial
not contain material
statements but the auditor
misstatements.
fails to detect it.

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Independent auditors
Independent auditors, often referred to as
external auditors, are either individual
practitioners or members of public
accounting firms who render professional
auditing services to clients
By virtue of their education, training and
experience, independent auditors are
qualified to perform the types of audits
previously described
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Auditors Independence
Audit Independence is the cornerstone of auditing.
Independence is the essence that underlies the success
and credibility of the accounting profession and its
service to the public.
Maintaining independence allows the auditing and
accounting profession to be self-regulated, a highly
prestigious character.
This objectivity permits the
profession to perform its attestation and monitoring
functions effectively.
Independence is also a key component of the agency
theory of auditing. In the management /shareholder
agency relationship it is important that the monitoring
function (audit) is and is seen to be separate from
management, for it to be a value added service.

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Independence in mind and appearance

Independence of Mind
The state of mind that permits the
expression of a conclusion without being
affected by influences that compromise
professional judgment, allowing an
individual to act with integrity and to
exercise objectivity and professional
scepticism
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Independence in mind and appearance

cont
Independence in Appearance
The avoidance of facts and circumstances that
are so significant that a reasonable and informed
third party, having knowledge of all relevant
information, including safeguards applied,
would reasonably conclude a firms or
professional accountants integrity, objectivity
or professional scepticism had been impaired
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Specific threats to independence

Financial interests
Loans and guarantees
Close business, family and personal
relationships
Employment relationships
Recent service and serving as an officer
on the board of assurance clients
Long association

29

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Specific threats to independence

Provision of non-assurance services to
assurance clients
Appointment and removal of auditors
Fees and pricing
Gifts and hospitality

30

Types of Audits
Operational
Compliance
Financial Statement
Forensic

Types of Audits
Operational Audits
- evaluates the efficiency & effectiveness of any
part of organisations operating procedures &
methods.
- not limited to accounting
- more difficult to evaluate
- normally accompanied by recommendations
for improving operations

Types of Audits
Compliance Audits
- to determine whether the auditee is following
specific procedures, rules or regulations set by
higher authority.
- results normally reported to someone within
the organisational unit being audited rather
than to outside parties

Types of Audits
Financial Statement Audits
- to determine whether the overall financial
statements are stated in accordance with
specified criteria (normally FRS).
- the auditor performs appropriate tests to
determine whether the statements contain
material errors or other misstatements.

Types of Audits
Forensic Audits
- purpose - to obtain & develop information as
legal evidence or for use by expert witnesses
in the courts of law.
- requires the use of critical analyses &
investigative skills, integrated with accounting
knowledge & business experience.
- Examples: business or employee
fraud, criminal investigations, shareholder &
partnership disputes.

Types of Auditors
Government Auditor
auditor working for the Auditor General Dept, a
non-partisan agency in the legislative branch of the
federal govt.
primary responsibility - to perform audit function
for all federal & states as well as statutory bodies &
public authorities.

Types of Auditors
Inland Revenue Auditor
- responsible for enforcing the Income Tax Act
- audit taxpayers returns to determine whether
they have complied with the tax laws.
- also called inland revenue assessment officers.
- must have considerable tax knowledge &
auditing skills to conduct an effective audit.

Types of Auditors
External auditor
Independent auditor
responsible for auditing the published historical

financial statements of all publicly traded

companies and others
expected to express audit opinions on FS

Types of Auditors
Internal Auditor

- employed by individual companies to audit for

management
- responsibilities may vary, depending on the
employer. Their jobs can be routine compliance
auditing, operational auditing or evaluating
computer systems.
- internal auditors normally report directly to the
president, chairman or audit committee of the
board of directors.

Types of Auditors
Forensic Auditors
- a new area of auditing
- trained in detecting, investigating, and
deterring fraud & white-collar crimes.
- to detect fraudulent financial reporting and
misappropriation of assets
- responsible for obtaining reasonable
assurance that material statements, whether
due to errors or fraud, are detected.

The Audit Report

The final phase in
audit chose the
appropriate form
of audit reports
to issue:

Unqualified

Adverse
Disclaimer

Qualified

EXHIBIT 1-1
The Auditors Standard Unqualified Audit
The
most common type of audit report issued
Report

is the standard unqualified audit report

because managements assertions about the
entitys financial statements are usually found
to conform to FRS.
Title

Addressee

Opinion
Paragraph

Explanatory
Paragraph

Introductory
Paragraph
Auditor
Name

Scope
Paragraph

Report Date

Other Types of Audit Reports

Qualified

Issued for either a material scope

limitation or departure from FRS
(the except for report).

Disclaimer

Issued for serious (material and

pervasive) scope limitation or lack
of auditor independence.

Adverse

Issued when the overall financial

statements are not presented fairly
in conformity with FRS.

Public Accounting Firms

Public accounting firms range in size from a
single proprietor to thousands of owners (or
partners) and thousands of professional and
administrative staff employees.
Big 4 Public Accounting Firms
Deloitte Touche

Ernst & Young

KPMG Peat Marwick

Pricewaterhouse Coopers

Ethics, Independence, and the Code of

Professional Conduct
Ethics refers to a system or code of
conduct based on moral duties and
obligations that indicates how we should
behave.
Professionalism refers to the conduct,
aims, or qualities that characterize or mark
a profession or professional person.
All professions operate under some type of
code of ethics or code of conduct.

Too much fees may not be very good!!

Can you really be independent with

these kind of fees paid to you?
(Independentan issue that well look at
very closely later on in this course)

Auditors Responsibilities
ISA200 - an audit in accordance with ISAs is to
be designed to provide reasonable assurance
that the FS taken as a whole are free from
material misstatements
-

Material versus immaterial misstatements

Reasonable assurance
Errors versus fraud
Fraud resulting from fraudulent financial
reporting versus misappropriation of assets
- Professional skepticism

Misstatements are considered material if the

combined uncorrected errors & fraud in the FS would likely
to have changed or influenced the decisions of a reasonable
person
Reasonable assurance - less than absolute assurance and
more than a low level of assurance
Errors - unintentional misstatement;
Fraud - intentional (misappropriation of assets & fraudulent
financial reporting)
Professional skepticism - questioning mind & a critical
assessment of audit evidence
Assume possibility of management dishonesty

The Auditors Responsibility for

Detecting Errors and Fraud
The auditor has a responsibility to plan and perform
the audit to obtain reasonable assurance about
whether the financial statements are free of material
misstatement, whether caused by error or fraud.
The auditor has no
Because of the nature of audit
responsibility to plan and
evidence and the characteristics of
perform the audit to obtain
reasonable assurance that
fraud, the auditor is able to obtain
misstatements, whether
reasonable, but not absolute
caused by errors or fraud, that
assurance that material
are not material to the financial
misstatements are detected.
statements will be detected.

ISA 240R The Auditors Responsibility to

Consider Fraud in an Audit of Financial
Statements
Requires the auditor to:

- Perform procedures to obtain info that is used to identify

the risks
- Identify & assess the risks of material misstatement
- Determine overall responses to address the risks
- Design & perform audit procedures to respond to the risk
of management override of controls
- Determine responses to address the assessed risks
- Consider whether an identified misstatement may be
indicative of fraud
- Obtain written representations
- Communicate with management
- Provides guidance
- Establish documentation requirements

Some definitions review

Misstatement
Misstatement in F/S can arise from fraud or error, that
include omissions of an amount of disclosure

Fraud
Intentional act involving the use of deception to obtain
an unjust or illegal advantage

Error
Unintentional misstatements e.g. mistake in data
collection, processing or application of GAAP

Auditors Responsibilities for Discovering Illegal

Acts

It is NOT the auditors responsibility to

detect all illegal acts. However, the auditor is
to plan and perform the audit with
professional skepticism on whether the
entity is complying with laws and
regulations.

Auditors Responsibilities for Discovering

Fraud / Illegal Acts
What to do when discovers fraud / illegal acts?
Verify existence
Communicate to higher management
Consider effects on FS (disclosure / qualified /
adverse opinion)
Withdraw from engagement if necessary
Report to SC (seek legal council opinions first)

ASSURANCE SERVICES
Independent professional service to increase
degree of confidence to users by evaluating the
subject matter against identified criteria so that
it can increase the credibility of such
information.

NON AUDIT SERVICE

Tax services
Management advisory services
Accounting and review services
Company Secretary services

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Audit profession and regulatory environment in

Malaysia

Malaysian Institute of Auditing (MIA)

Regulatory body established under the Accountants

Act 1967 to regulate accounting profession in Malaysia
MIA By-laws

International Federation of Accountants (IFAC)

An international body committed to develop and
enhance accountancy profession
MIA is a member of IFAC

International Auditing Practices Committee

(IAPC)

Established by IFAC to develop and issue standards

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Organization relates to Financial Reporting

and auditing
Companies Commission of Malaysia,
Regulates companies and reporting requirements of
companies

Malaysia Accounting Standards Board

Established under Financial Reporting Act 1997
Accounting Standards for Private Entities/ Other than
Private Entities

Securities Commission and Bursa Saham Malaysia

Supervises stock exchanges/ reporting requirements for
listed companies

THE END