Lecture 1:
The accounting system
Accounting is the process of identifying, measuring and communicating economic information to permit
informed judgements and decisions by users of the information. It is about collecting all types of
information, every time a transaction happens this should be recorded in a system.
The environment within which accounting exists is known as the accounting information system.
Accounting is an information-providing activity, so accountants need to understand:
How the system that provides that information is designed, implemented and used.
How financial information is reported.
How information is used to make decisions.
Transaction: sale of pair of shoes
Accounting Information System (AIS): recording transaction
Firm management: How many pairs did we sell in location X and location Y? Do we need to
close a location?
Auditor: Wat the transaction recorded correctly? How did the Brand make sure that the
transaction is recorded correctly? They check whether everything happens according to the
rules. They can never check everything but they given some credibility to make sure that people
can rely on the information.
Stakeholders: Does the Brand make a profit? What is Brands market share?
This whole picture is accounting. So the whole process from the transaction to the controlling to the
interpretation of the information given.
Everything in the business starts with a transaction, buy/sell of a good or service.
This transaction needs to be recorded in a system.
The information from the system is used by investors or stakeholders. But also by people from
within the company: firm management.
Why do we need Audit?
We have audits because we have companies. We need companies because they create products, deliver
services, give job opportunities, etc. But these companies need to obey rules concerning taxes and other
finances, and because they are run by humans a mistake can happen. We have audits because
companies should follow rules and that does not always goes as smoothly as wanted.
,Layman definition of Auditing
Auditing is a process in which a business request an audit firm to examine its accounting records and
certify whether the numbers reported in the financial statements are accurate.
Auditing is about examining/checking the accounting records and finding out whether people can rely on
these numbers.
Problem: The company/business pays the auditor to check their systems/numbers. But there is an
incentive to look away if the reward is more money.
Audit committee
A audit committee is a part of the board of directors, and they are a party in-between the company and
the external auditors. The audit committee checks whether in the company the internal control is
working in a good way and they also communicate about that with the external auditor(s).
Parties involved in organization
Management
Prepares & presents Financial Statements
Designs, implements & maintains Internal Control (IC) over financial reporting
Provides information (on FS and IC) to auditors
Has the responsibility to create all the financial information
Internal audit function
Gives assurance on internal control to managers and audit committee
Are often the controllers in the company
Audit committee
Subcommittee of the Board of Directors (BoD)
Oversees managers and internal audit
Hire external auditor
External auditor
Provides independent audit of internal control and financial statements
Formal definition of Audit
A statement of Basic Audit Concepts (1971)
An audit is a systematic process of objectively obtaining (its about collecting
information) and evaluating evidence regarding assertions about economic
- Assurance
actions and events (collecting everything that has some link with financial
information in the business) to ascertain the degree of correspondence between
these assertions and established criteria,
and communicating the results to interested users. - Reporting
Assurance role of Audit
An auditor can have different functions:
They have an audit function, give credibility to the
financial statements.
They can do attestation services, meaning that
they make an official statement but not about the
, FS but for example about future projections. They make a certification about information that is
actually presented to them by another party.
They provide assurance services, is that they add credibility to any information that is given to
them.
Information role of Auditing
Audit improves quality of financial information.
Credible information role (1) reduces risk (risk-return trade off) and
(2) improves decision making (noise-reduction)
E.g., An auditor can solve information problems by providing valuable information about a borrowing
firm to a lending bank, potentially lowering the monitoring costs of debtholders (Jensen and Meckling
1976)
Pittman and Fortin (2004): Young companies (i.e., facing strong information problems) with a high
quality auditor play significantly lower interest rates ( low Q auditor)
Insurance role of Auditing
Auditors provide reasonable assurance about the accuracy of the financial statements of a
company.
User rely on these audited financial statements to make their decisions.
Identification of material misstatement in financial statements.
Proven that auditors have worked negligently.
Users can sue auditors to recover their losses.
Auditors have an insurance role because if the numbers are not correct/they committed fraud,
the company AND the auditors are liable.
Signaling role of Auditing
Audit is indication of transparency, if you have an audit firm that no one actually knows the
signal of transparency is actually weaker.
Enhances the perception of a company
o Low risk company
, Lecture 2: demand for auditing
Mandatory audits
In the US: Only required for public companies and certain other regulated entities. PCAOB oversees
audits of public companies. Securities Acts were passed in 1933 and 1934 (mandated “certification” of
financial statements).
In the Netherlands: If the company meets 2 of the 3 criteria in 2 successive years.
1) Total assets > €6.000.000
2) Net sales > €12.000.000
3) Average number of employees > 50
AFM authorizes audit firms to do statutory audits, checks if the auditors are of a sufficient level.
The goal is not that you learn all the different rules of all the countries. But that you realize that the
place were your business is located has an effect on how the audit is organized.
Mandatory Voluntary
In 2016, exemption from statutory audit for smaller-sized
companies in the Netherlands (4th Company Law
Directive of the European Union (78/660/EEC); 1978)
The medium sized companies who were mandatory to
have an audit before, now can choose to have an audit or not. What do you do as a medium sized
company? Because if you stop having an auditor then people may find you suspicious. And if you keep
the audit it shows that you are very transparent and open to the outside world.
Three-Party Relationship
Firm management and the
shareholders (represented
by the BoD) both have the
goal to rays as much money
as possible. Only this can
cause for an conflict of interest because the
manager has excess to all the firm assets and
money and the shareholders just have to trust that
they are handling it reliable. Managers have more
information cause for conflict.
The auditors comes in to make sure that the
shareholders can rely on the information that is
presented to them by the managers.
Watts and Zimmerman (1983)
Modern firm (and some early companies), separation of management and ownership (Jensen and
Meckling 1976).
Agent is self-interested (“utility maximizers”), required costly monitoring.
The accounting system
Accounting is the process of identifying, measuring and communicating economic information to permit
informed judgements and decisions by users of the information. It is about collecting all types of
information, every time a transaction happens this should be recorded in a system.
The environment within which accounting exists is known as the accounting information system.
Accounting is an information-providing activity, so accountants need to understand:
How the system that provides that information is designed, implemented and used.
How financial information is reported.
How information is used to make decisions.
Transaction: sale of pair of shoes
Accounting Information System (AIS): recording transaction
Firm management: How many pairs did we sell in location X and location Y? Do we need to
close a location?
Auditor: Wat the transaction recorded correctly? How did the Brand make sure that the
transaction is recorded correctly? They check whether everything happens according to the
rules. They can never check everything but they given some credibility to make sure that people
can rely on the information.
Stakeholders: Does the Brand make a profit? What is Brands market share?
This whole picture is accounting. So the whole process from the transaction to the controlling to the
interpretation of the information given.
Everything in the business starts with a transaction, buy/sell of a good or service.
This transaction needs to be recorded in a system.
The information from the system is used by investors or stakeholders. But also by people from
within the company: firm management.
Why do we need Audit?
We have audits because we have companies. We need companies because they create products, deliver
services, give job opportunities, etc. But these companies need to obey rules concerning taxes and other
finances, and because they are run by humans a mistake can happen. We have audits because
companies should follow rules and that does not always goes as smoothly as wanted.
,Layman definition of Auditing
Auditing is a process in which a business request an audit firm to examine its accounting records and
certify whether the numbers reported in the financial statements are accurate.
Auditing is about examining/checking the accounting records and finding out whether people can rely on
these numbers.
Problem: The company/business pays the auditor to check their systems/numbers. But there is an
incentive to look away if the reward is more money.
Audit committee
A audit committee is a part of the board of directors, and they are a party in-between the company and
the external auditors. The audit committee checks whether in the company the internal control is
working in a good way and they also communicate about that with the external auditor(s).
Parties involved in organization
Management
Prepares & presents Financial Statements
Designs, implements & maintains Internal Control (IC) over financial reporting
Provides information (on FS and IC) to auditors
Has the responsibility to create all the financial information
Internal audit function
Gives assurance on internal control to managers and audit committee
Are often the controllers in the company
Audit committee
Subcommittee of the Board of Directors (BoD)
Oversees managers and internal audit
Hire external auditor
External auditor
Provides independent audit of internal control and financial statements
Formal definition of Audit
A statement of Basic Audit Concepts (1971)
An audit is a systematic process of objectively obtaining (its about collecting
information) and evaluating evidence regarding assertions about economic
- Assurance
actions and events (collecting everything that has some link with financial
information in the business) to ascertain the degree of correspondence between
these assertions and established criteria,
and communicating the results to interested users. - Reporting
Assurance role of Audit
An auditor can have different functions:
They have an audit function, give credibility to the
financial statements.
They can do attestation services, meaning that
they make an official statement but not about the
, FS but for example about future projections. They make a certification about information that is
actually presented to them by another party.
They provide assurance services, is that they add credibility to any information that is given to
them.
Information role of Auditing
Audit improves quality of financial information.
Credible information role (1) reduces risk (risk-return trade off) and
(2) improves decision making (noise-reduction)
E.g., An auditor can solve information problems by providing valuable information about a borrowing
firm to a lending bank, potentially lowering the monitoring costs of debtholders (Jensen and Meckling
1976)
Pittman and Fortin (2004): Young companies (i.e., facing strong information problems) with a high
quality auditor play significantly lower interest rates ( low Q auditor)
Insurance role of Auditing
Auditors provide reasonable assurance about the accuracy of the financial statements of a
company.
User rely on these audited financial statements to make their decisions.
Identification of material misstatement in financial statements.
Proven that auditors have worked negligently.
Users can sue auditors to recover their losses.
Auditors have an insurance role because if the numbers are not correct/they committed fraud,
the company AND the auditors are liable.
Signaling role of Auditing
Audit is indication of transparency, if you have an audit firm that no one actually knows the
signal of transparency is actually weaker.
Enhances the perception of a company
o Low risk company
, Lecture 2: demand for auditing
Mandatory audits
In the US: Only required for public companies and certain other regulated entities. PCAOB oversees
audits of public companies. Securities Acts were passed in 1933 and 1934 (mandated “certification” of
financial statements).
In the Netherlands: If the company meets 2 of the 3 criteria in 2 successive years.
1) Total assets > €6.000.000
2) Net sales > €12.000.000
3) Average number of employees > 50
AFM authorizes audit firms to do statutory audits, checks if the auditors are of a sufficient level.
The goal is not that you learn all the different rules of all the countries. But that you realize that the
place were your business is located has an effect on how the audit is organized.
Mandatory Voluntary
In 2016, exemption from statutory audit for smaller-sized
companies in the Netherlands (4th Company Law
Directive of the European Union (78/660/EEC); 1978)
The medium sized companies who were mandatory to
have an audit before, now can choose to have an audit or not. What do you do as a medium sized
company? Because if you stop having an auditor then people may find you suspicious. And if you keep
the audit it shows that you are very transparent and open to the outside world.
Three-Party Relationship
Firm management and the
shareholders (represented
by the BoD) both have the
goal to rays as much money
as possible. Only this can
cause for an conflict of interest because the
manager has excess to all the firm assets and
money and the shareholders just have to trust that
they are handling it reliable. Managers have more
information cause for conflict.
The auditors comes in to make sure that the
shareholders can rely on the information that is
presented to them by the managers.
Watts and Zimmerman (1983)
Modern firm (and some early companies), separation of management and ownership (Jensen and
Meckling 1976).
Agent is self-interested (“utility maximizers”), required costly monitoring.
