University of Chicago
Type of paper: Thesis/Dissertation Chapter
Role and Effectiveness of Auditing
Globalization of the world economy, complexity of businesses, technological advancement coupled with allegations of fraudulent and inaccurate financial reporting have recently led to increased attention to financial auditing (Karagiorgos et al., 2009). Financial accounting is a process that involves collection and processing of financial data to help in making decisions by parties external to the organization (Deegan and Unerman, 2006). Financial auditing, on the other hand, is an objective assurance, independent, and consulting process designed to improve operations and add value.
In regards to the above, businesses face considerable problems today and difficulties when they strive to assess their risk, identify their strength and manage uncertainties. In the process of decision making, decision makers depend on information and financial statements as prepared and presented by an entity’s management. The possibility of deciding based on inaccurate information is called ‘information risk.’ The most common way to reduce information risk and obtain accurate information is to have an independent financial audit carried out (Elder et al., 2010). A financial audit has to be done in order to increase the level of confidence of the users in the financial statement. Decision makers can use the audited financial information on the assumption that it is accurate, reasonably complete and unbiased.
Several types of audits are carried out by external auditors and include audit of financial statements, the compliance audit and operational audit. A financial statement audit is used to examine financial statements, records and operations aimed at ascertaining adherence to prevailing accounting principles. In determining whether the information provided in the financial statement is fair and true, the auditor gathers and evaluates evidence that he finally uses to base his opinion. Giving an opinion on financial statements is the basic focus of financial statement audit. Auditors can gain reasonable assurance on whether the financial statements do not have material misstatement. Assurance can be said to be a measure of the degree of certainty that the auditor obtains at the end of an audit. Reasonable assurance is less than absolute assurance or certainty and more than a lower level of assurance (Elder et al., 2010). The auditor is not a guarantor or insurer of correctness of financial statements. A financial statement is carried out to enhance the degree of confidence managers have on financial statements. Without performing an external audit, the accounting information that is intended for use in decision making does not have credibility.
From the financial audit findings, an audit report will be provided. The audit report is a representation of the auditor’s communication of his findings to users of financial statements. The financial audit report has information about the audit including an opinion regarding the fair representation of the financial statements and its scope. The audit process has several phases. While planning and designing an audit approach, the business strategies and processes are studied. The auditor will assess possible risks of misstatements in financial statements and evaluates the effectiveness of internal controls (Elder et al., 2010).
Relevance and value of Auditing
The main objective of doing audits is relatively uniform across the globe that is clearly to express the opinion of the auditor on financial statements and describe the foundation for that opinion (IOSCO, 2009). Users of financial statements depend on the auditor’s report to give assurances to the company’s financial statements. It is important that the auditor’s report communicates the appropriate information. The audit report should be effective when reporting crucial information. For example, the auditor’s duties, the audit process and ‘going concern’ that enables investors to make better investment decisions.
In the current world of customization, information users are accustomed to making fine distinctions and decide the level of ‘granularity’ they are willing to pay for. The world today is more ‘black and white’. For example, the audit opinion is currently like an ‘on and off’ switch: a company’s financial statements may either comply or do not comply with current accounting conventions. Users of financial information require that they get more nuanced opinion from auditors on the level of the business’ compliance prevailing standards of financial reporting. Investors can also ask for an auditor’s opinion concerning the overall state and future prospects of the business that they audited. Liability systems and the regulators in any country should permit these requests.
During the last decade, major financial accounting scandals have occurred, for example, Kmart, Enron and WorldCom have been detected. Improved communication between the auditor and stakeholders would not be enough to prevent scandals as indicated before (Green and Reinstein, 2003). However, additional information might have enabled capital suppliers and other users of financial statements to make decisions that are more informed, thus reducing their losses. It is not clear-cut that financial users consider audit reports when deciding on investments. If the information being communicated in the audit report is misunderstood, it can lead to unintended investments, misappropriation of resources and loss of confidence in the audit process.
The audit report should communicate effectively about the audit process, the auditor’s responsibilities, the nature of assurances the auditor provides and other items that are necessary for decision making. Financial reporting is important to monitoring purposes. The information principle is a complement or alternative to the monitoring principle and focuses on providing information that allows users make financial decisions. Investors need audited financial information to make investment decisions and assess expected risks and returns. The investors value the audit report as a way of increasing the quality of financial information. An audit report is also valued as a way of improving the quality of financial data used for making decisions internally.
The financial audit report has the capable of shifting responsibility for reported data to auditors. Therefore, it lowers the expected losses arising from mitigations to creditors, managers and other professionals participating in the security market (Cosserat, 2009). By using audit services, managers, and other professionals can demonstrate that they observed reasonable care. An audit gives an independent check on the work of the business’ agents and information given by the agent, which helps to maintain trust and confidence. On behalf of the management, the auditor checks whether the financial statements prepared by the agent reflect fair and true view of the company. The auditor also ensures that the financial statements are prepared according to the accepted accounting principles. An audit of financial statements allows the management to be accountable to stakeholders.
Auditors should be engaged as agents under contract; however they are required to be independent of the agents who run the daily operations of the company. The basic function of audited accounts in this perspective is one of accountability and helps to promote trust and reinforce the stability. An assurance service can be said to be a service in which a public accountant provides a conclusion reliability of a written assertion which is the responsibility of another entity (Cosserat, 2009). An assurance service can be defined as an independent professional service aimed at improving the quality of information for decision makers. Individuals charged with the responsibility of making business decisions seek assurance services to help them improve relevance and reliability of the information used as the basis for decision making. A category of assurance offered by auditors is attestation services. While doing the attestation services, the auditor gives a report on the reliability of the assertion made by another person. Individuals responsible for making business decisions seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions.
Due to the opportunistic nature of individuals, businesses will try to put in place measures that align the interests of principles and agents. For example, contracts are used with the aim of ensuring all entities, acting based on their self-interest, are also motivated to maximizing the organization’s values (Deegan and Unerman, 2006). To compensate against the ‘agency risk’ (expectation that the self-interest of the agent will diverge from the interests of the principal), investors will require a higher return rate. For example, they will pay less for shares compared to their intrinsic values. Financial reports or public disclosures give an account of the performance of the agent and has been adopted as a monitoring mechanism. To reduce additional ‘agency risk’, principals normally apply for an independent audit of these reports. The value of the audit will be realized when the costs involved are not more than the agency cost (Cosserat, 2009).
Cosserat, G.W. and N. Rodda (2009), Modern auditing, 3 the ed., John Wiley & Sons Ltd
Deegan, C. and J. Unerman (2006), Financial accounting theory, McGraw-Hill education, Maidenhead, Berkshire.
Elder, R.J., M.S Beasley, and A.A. Arens (2010), Auditing and assurance services: an integrated approach: global edition, 13th ed., Prentice-Hall, Englewood Cliffs, NJ.
Green, B.P. and A. Reinstein (2003), Auditor communications: still more to do, The CPA Journal, pp. 25-29.
IOSCO Technical Committee (2009), Auditor communications: consultation report, Retrieved from: http://www.ifac.org/IAASB/ProjectHistory.php?ProjID=0095Karagiorgos, T., Drogalas, G., Gotzamanis, K and Tampakoudis, I., (2009). ‘The Contribution of Internal Auditing to Management’, International Journal of Management Research and Technology, 3, 2, Serials Publications, pp. 417-427.