CHAPTER 1: INTRODUCTION TO AUDITING
Introduction: the concept of Auditing
• Without effective audits, modern capital markets cannot fulfill their roles as efficient economic systems
leading to high living standards
Audit Societies: Societies in which there is extensive examination by auditors of economics and other
politically important activates (Michael power)
• In audit societies, economic activities are monitored to ensure market efficiency
• In societies, auditors also monitor the effectiveness and efficiency of government
Auditing: The verification of information by someone other than the one providing it
A Simple illustration of the importance of auditing
GAAP: Those accounting methods that have been established in a particular area by formal recognition by an
authoritative support or precedent, such as the CICA handbook
• The auditor increases the reliability, or reduces the risk, of using inaccurate information in decision
• The auditor is an INDEPENDENT party hired to verify information provided by the second party
• Auditors hired because the THIRD PARTY doesn’t trust the information provided by the SECOND
• If THIRD PARTY feels information risk is too high, the second party will provide you with independent
Three party accountability: An accountability relationship in which there are 2 distinct parties: AN
ASSERTER, AN ASSURER, and the USER of the ASSERTED INFORMATION.
• Companies whose shares are traded on regulated stock exchanges are required to hire an independent
auditor to verify the annual financial statements.
• The accountability is still three parties because the audits purpose is to reduce information risk for the
third party, but the public company (second party), pays the audit fee.
** THREE PARTY ACCOUNTABILITY IS NOT BASED ON WHO PAYS THE FEE.
Accountability Relationship: A relationship in which at least one of the parties needs to be able to justify
its actions or claims to another party in the relationship
THREE PARTYACCOUNTABILITY INCLUDES:
2) Accountable party (company)
• Three party accountability means that the auditor is expected to act in the interest of the users of the
Acting in the public interest: Acting in the interest of the users of the financial statement, more generally
means, fulfilling the social role expected of the professional • 3 party accountability is important because it distinguishes the type of services that only licenced
practitioners can provide from other services, such as tax work and business advisory services, which
anyone can provide.
• 3 party accountability reduces the risk on information created by the second party, the preparer of the
• Reducing information risk is synonymous with improving the creditability of, information produced by
the second party.
Agency theory and accountability
• When a task is delegated by one party( the principal) to another (the agent), it can create a potential
Agency problems occur when three conditions are presented in an agency relationship:
1) The agent has objections that are different from those of the principal
2) The agent has more information than the principal does
3) The contract between the 2 is incomplete in that not every possible contingency can be anticipated
Conflict of interest: a situation faced by professional accountant in which there may be a divergence
between the interest of two (or more) parties for whom the professional accountant undertakes a professional
activity, or between the interest of the professional and the interests of such parties, that could create a threat
to the professional’s objectivity or other fundamental ethical principles.
User demand for reliable information
3 underlying conditions affect user’s demand for accounting information:
1) Complexity: A company’s transactions can be numerous and complicated
2) Remoteness: users of financial information are usually separated from a company’s accounting record
by distance and time, as well as lack of expertise.
3) Consequences: financial decisions are important to the state of investors’ and other users’ wealth.
Accounting: the process of recording, classifying and summarizing into financial statements a company’s
transactions that create assets, liabilities, equities, revenues and expenses.
Financial reporting: process of providing statements of financial position, income statements, cash flow
statements, and disclosure notes to outside decision makers who have no internal source of information such
as the management of the company has.
Information technology: the hardware and software needed to process data
More on auditing
• Users need more than just information, they need reliable, error free information
• Preparers and issuers might benefit from giving false, misleading information
External auditor: an auditor who is an outsider and independent of the entity being audited
Providing assurance: the “adding of credibility” to financial information by objective intermediaries.
Assurance engagement: the engagement in which auditors add either reasonable (high) or moderate
(negative) levels of assurance. • Auditing does not include financial report production, which is performed by the company’s
• Auditors determine if the information is reliable, they communicate this conclusion to the users by
reporting the company’s presentation of financial position; results of operation, cash flows statement
are in accordance with GAAP.
Client: the person or company who retains the auditor and pays the fee
Auditee: the entity being audited (Client)
• Reliable financial information helps make capital markets efficient and help people understand the
consequences of a wide variety of economic decisions.
• External auditors practicing the assurance function are not, the only auditors at work in the economy
o Bank examiners, CRA auditors, provincial agency auditors, all practice auditing
Professional judgment: the application of relevant training, knowledge, and experience within the context
provided by auditing, accounting and ethical standards, in making informed decision about the courses of
action that appropriate in the circumstances of the audit engagement
• Specialized concepts and language integrate the disciples in order to procure appropriate justification
for audit decisions
Critical thinking: the process of justifying one’s conclusion or decision by providing good or acceptable reasons.
Definitions of auditing
American Accounting association (AAA) defines auditing as follows:
Auditing is the systematic process of objectively obtaining and evaluating evidence regarding assertion
about economic actions and events to ascertain degrees of correspondence between the assertion and
suitable criteria and communicating the results to interested users.
• When beginning an audit engagement the auditor receives the financial statements and disclosures by
management that are managements assertions about economic actions and events
• Evidence is the gathers to either agree or contradict these management assertions
• Auditors being work with explicit representations from management, assertion of financial numbers and
information disclosed in the notes to the financial statement
Attest engagement: when accountant is hired to perform procedures and issue a report resulting from those
procedures that affirms the validity of an assertion.
Direct reporting engagement: A type of assurance engagement in which the assertions are implied and not
written down in some form.
Audit objectives and the auditor’s report
CICA: Professional body of chartered accountants in Canada.
CICA main objective for financial statement audits are:
The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements.
This is achieved by the expression of all options by the auditor on whether the financial statements are
prepared, in all a material respects, in accordance with an applicable financial reporting framework. Expectation gap: the difference that can arise between what the public expects of the auditor’s social role and
what the professional standards practice deliver
Key words in an auditor’s report include:
• In the opinion paragraph (last one) “Financial statements are present fairly, in all material respects,…”
o This is the auditors conclusion and it is intended for the users of the financial