Solutions manual
to accompany
Audit and assurance
2 edition
nd
by
Leung et al.
© John Wiley & Sons Australia, Ltd 2023
, Chapter 1: Auditing and Governance
Chapter 1: Auditing and Governance
Review questions
1.11 Describe the nature of an audit.
An auditor sets out to achieve enhanced credibility of information disclosed to increase
reliability for the users of the financial statements. A definition from the Committee on
Basic Auditing is as follows:
An audit 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 users.
1.12 What does an independent auditor do during a financial report
audit?
The auditor will provide a written opinion to the shareholders of a company as to the
truth and fairness of the financial report prepared by management. This includes
ensuring that the financial report is free from material error and is prepared in
accordance with relevant accounting standards and corporate law; in Australia, this
means compliance with the Corporations Act and Australian Financial Reporting
Standards.
The auditor performs audit procedures, generally performing tests on samples of the
company’s transactions and balances, to provide sufficient and appropriate evidence
upon which to rely in forming the audit opinion. Where the company has an effective
internal control system that prevents, detects and corrects potential accounting and
reporting errors, the auditor may choose to rely on those internal controls and reduce
the amount of detailed testing performed. Where there are no effective internal
controls in place, the auditor will perform extensive tests of the company’s
transactions and balances.
Once the audit work is completed the evidence is assessed and judgments are made as
to the possibility of the financial report containing material errors. If the auditor
believes that the financial report contains material errors the management will be
requested to make any necessary amendments to the report. If management refuse to
amend the report the auditor will consider the need to modify the audit opinion to
highlight the errors to the users of the financial report.
© John Wiley & Sons Australia, Ltd 2023 1.2
, Solutions manual to accompany Audit and assurance 2e by Leung et al.
1.13 Explain how agency theory results in a demand for auditing.
In an agency relationship, investors (as principals) entrust their resources to managers
(as agents). The agent’s self-interest is expected to diverge from the principals’
interest, giving rise to agency costs. A consequence of this agency problem is that
investors will ‘price protect’ themselves on the assumption that managers are acting
for themselves. It is therefore a rational response that there is a demand for a financial
statement audit to verify the assertions made by management.
1.14 What are the current implications of the audit expectation gap? Can
it be reduced?
The current implications of the audit expectation gap are the same as it has always
been. A difference in expectations about what users think they are getting and what
they are actually getting is going to be a problem – particularly for a service like
auditing that is difficult to observe. There are three important areas where differences
in perceptions occur and they are as follows:
1. Reporting on internal control. Reporting on internal control has not been
taken on in the Australian environment – unlike in the US with Sarbanes-Oxley.
In fact, the most recent iteration of the audit report actually includes a specific
disclaimer on the issue of reporting on internal control.
2. Detection of fraud. This has been an area where auditors have expanded their
responsibilities in recent years through the development of ASA 240 The
Auditor’s Responsibilities Relating to Fraud in an Audit of a
Financial Report (ISA 240). However, it is still not seen as the core objective
of an audit and the only responsibility that still exists in relation to fraud is
material fraud. As stated by the Chairman of the FRC, Jeff Lucy:
“I would say there is, in fact, now a clear market expectation to this effect –
that is, that auditors are bloodhounds not just watchdogs. Simply put, the
market expects auditors to pick up instances of fraud”.
3. Evaluation of going concern. Current auditors’ responsibilities include a
consideration of going concern. However, they make no positive assurance about
what they do in this regard. Despite not commenting on this issue, the fact is that
users think auditors are guaranteeing the ongoing financial viability of a firm,
which is not currently true.
Reducing the gap has traditionally focused on educating users about what an audit
is actually designed to provide. However, this has not been particularly successful,
and therefore, in the future, more substantive changes on what auditors do and
provide to users would seem the main way that a reduction in the expectation gap
could occur.
© John Wiley & Sons Australia, Ltd 2023 1.3
to accompany
Audit and assurance
2 edition
nd
by
Leung et al.
© John Wiley & Sons Australia, Ltd 2023
, Chapter 1: Auditing and Governance
Chapter 1: Auditing and Governance
Review questions
1.11 Describe the nature of an audit.
An auditor sets out to achieve enhanced credibility of information disclosed to increase
reliability for the users of the financial statements. A definition from the Committee on
Basic Auditing is as follows:
An audit 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 users.
1.12 What does an independent auditor do during a financial report
audit?
The auditor will provide a written opinion to the shareholders of a company as to the
truth and fairness of the financial report prepared by management. This includes
ensuring that the financial report is free from material error and is prepared in
accordance with relevant accounting standards and corporate law; in Australia, this
means compliance with the Corporations Act and Australian Financial Reporting
Standards.
The auditor performs audit procedures, generally performing tests on samples of the
company’s transactions and balances, to provide sufficient and appropriate evidence
upon which to rely in forming the audit opinion. Where the company has an effective
internal control system that prevents, detects and corrects potential accounting and
reporting errors, the auditor may choose to rely on those internal controls and reduce
the amount of detailed testing performed. Where there are no effective internal
controls in place, the auditor will perform extensive tests of the company’s
transactions and balances.
Once the audit work is completed the evidence is assessed and judgments are made as
to the possibility of the financial report containing material errors. If the auditor
believes that the financial report contains material errors the management will be
requested to make any necessary amendments to the report. If management refuse to
amend the report the auditor will consider the need to modify the audit opinion to
highlight the errors to the users of the financial report.
© John Wiley & Sons Australia, Ltd 2023 1.2
, Solutions manual to accompany Audit and assurance 2e by Leung et al.
1.13 Explain how agency theory results in a demand for auditing.
In an agency relationship, investors (as principals) entrust their resources to managers
(as agents). The agent’s self-interest is expected to diverge from the principals’
interest, giving rise to agency costs. A consequence of this agency problem is that
investors will ‘price protect’ themselves on the assumption that managers are acting
for themselves. It is therefore a rational response that there is a demand for a financial
statement audit to verify the assertions made by management.
1.14 What are the current implications of the audit expectation gap? Can
it be reduced?
The current implications of the audit expectation gap are the same as it has always
been. A difference in expectations about what users think they are getting and what
they are actually getting is going to be a problem – particularly for a service like
auditing that is difficult to observe. There are three important areas where differences
in perceptions occur and they are as follows:
1. Reporting on internal control. Reporting on internal control has not been
taken on in the Australian environment – unlike in the US with Sarbanes-Oxley.
In fact, the most recent iteration of the audit report actually includes a specific
disclaimer on the issue of reporting on internal control.
2. Detection of fraud. This has been an area where auditors have expanded their
responsibilities in recent years through the development of ASA 240 The
Auditor’s Responsibilities Relating to Fraud in an Audit of a
Financial Report (ISA 240). However, it is still not seen as the core objective
of an audit and the only responsibility that still exists in relation to fraud is
material fraud. As stated by the Chairman of the FRC, Jeff Lucy:
“I would say there is, in fact, now a clear market expectation to this effect –
that is, that auditors are bloodhounds not just watchdogs. Simply put, the
market expects auditors to pick up instances of fraud”.
3. Evaluation of going concern. Current auditors’ responsibilities include a
consideration of going concern. However, they make no positive assurance about
what they do in this regard. Despite not commenting on this issue, the fact is that
users think auditors are guaranteeing the ongoing financial viability of a firm,
which is not currently true.
Reducing the gap has traditionally focused on educating users about what an audit
is actually designed to provide. However, this has not been particularly successful,
and therefore, in the future, more substantive changes on what auditors do and
provide to users would seem the main way that a reduction in the expectation gap
could occur.
© John Wiley & Sons Australia, Ltd 2023 1.3
