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Auditing - Financial Analysis, Risk Assessments & Compliance

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Auditing - Financial Analysis, Risk Assessments & Compliance

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21/06/24, 17.

33 Auditing | Financial Analysis, Risk Assessments & Compliance

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Written by Moses L. Pava


Fact-checked by The Editors of Encyclopaedia Britannica
Article History

Table Of Contents

auditing, examination of the records and reports of an enterprise by


specialists other than those responsible for their preparation. Public
auditing by independent, impartial accountants has acquired professional
status and become increasingly common with the rise of large business
units and the separation of ownership from managerial control. The public
accountant performs tests to determine whether the management’s
statements were prepared in accord with generally accepted accounting
principles and fairly present the firm’s financial position and operating
results; such independent evaluations of management reports are of
interest to actual and prospective shareholders, bankers, suppliers,
lessors, and government agencies.

Standardization of audit procedures


In English-speaking countries, public auditors are usually certified, and
high standards are encouraged by professional societies. Most European
and Commonwealth nations follow the example of the United Kingdom,
where government-chartered organizations of accountants have developed
their own admission standards. Other countries follow the pattern in the
United States, where the states have set legal requirements for licensing.
Most national governments have specific agencies or departments charged
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with the auditing of their public accounts—e.g., the General Accounting


Office in the United States and the Court of Accounts (Cour des Comptes)
in France.

Internal auditing, designed to evaluate the effectiveness of a company’s


accounting system, is relatively new. Perhaps the most familiar type of
auditing is the administrative audit, or pre-audit, in which individual
vouchers, invoices, or other documents are investigated for accuracy and
proper authorization before they are paid or entered in the books.

In addition, the assurance services of professionally certified accountants


include all of the following: financial, compliance, and assurance audits;
less-formal review of financial information; attestation about the
reliability of another party’s written assertion; and other assurance
services not strictly requiring formal audits (e.g., forward-looking
information and quality assertions).

Origins of the audit


Historians of accounting have noted biblical references to common
auditing practices, such as dual custody of assets and segregation of
duties, among others. In addition, there is evidence that the government
accounting system in China during the Zhao dynasty (1122–256 bc)
included audits of official departments. As early as the 5th and 4th
centuries bc, both the Romans and Greeks devised careful systems of
checks and counterchecks to ensure the accuracy of their reports. In
English-speaking countries, records from the Exchequers of England and
Scotland (1130) have provided the earliest written references to auditing.

Despite these early developments, it was not until the late 19th century,
with the innovation of the joint-stock company (whose managers were not
necessarily the company’s owners) and the growth of railroads (with the
challenge of transporting and accounting for significant volumes of
goods), that auditing became a necessary part of modern business. Since
the owners of the corporations were not the ones making the day-to-day
business decisions, they demanded assurances that the managers were
providing reliable and accurate information. The auditing profession
developed to meet this growing need, and in 1892 Lawrence R. Dicksee
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published A Practical Manual for Auditors, the first textbook on auditing.


Audit failures occur from time to time, however, drawing public attention
to the practice of accounting and auditing while also leading to a
refinement of the standards that guide the audit process.

Legal liabilities
Given the nature of the audit function, auditors increasingly find
themselves subject to legal and other disciplinary sanctions. Unlike other
professionals, however, their liability is not limited to the clients who hire
them. Auditors are increasingly held liable to third parties, including
investors and creditors, who rely on the audited financial statements in
making investment decisions.

Objectives and standards


A company’s internal accountants are primarily responsible for preparing
financial statements. In contrast, the purpose of the auditor is to express
an opinion on the assertions of management found in financial
statements. The auditor arrives at an objective opinion by systematically
obtaining and evaluating evidence in conformity with professional
auditing standards. Audits increase the reliability of financial information
and consequently improve the efficiency of capital markets. Auditing
standards require that all audits be conducted by persons having adequate
technical training. This includes formal education, field experience, and
continuing professional training.

In addition, auditors must exhibit an independence in mental attitude.


This standard requires auditors to maintain a stance of neutrality toward
their clients, and it further implies that auditors must be perceived by the
public as being independent. In other words, it mandates independence in
fact and in appearance. Thus, any auditor who holds a substantial
financial interest in the activities of the client is not seen as independent
even if, in fact, the auditor is unbiased.

The issue of auditor independence grew more difficult toward the end of
the 20th century, especially as auditing firms began offering
nonattestation functions (such as consulting services) to new and existing
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clients—particularly in the areas of taxation, information systems, and


management. While there was no legal reason for preventing accounting
firms from extending their business services, the possibilities for a conflict
of interest made it increasingly necessary for auditors to indicate the
nature of the work performed and their degree of responsibility.

Inaccurate financial reporting can be the result of deliberate


misrepresentation, or it can be the result of unintended errors. One of the
most egregious recent examples of a financial reporting failure occurred in
1995 in the Singapore office of Barings PLC, a 233-year-old British bank.
In this case fraud resulted from a lack of sufficient internal controls at
Barings over a five-year period, during which time Nicholas Leeson, a
back-office clerk responsible for the accounting and settlement of
transactions, was promoted to chief trader at Barings’s Singapore office.
With his promotion, Leeson enjoyed an unusual degree of independence;
he was in the exceptional position of being both chief trader and the
employee responsible for settling (ensuring payment for) all his trades, a
situation that allowed him to engage in rogue (unauthorized) trades that
went undetected. As if to condone Leeson’s actions, his managers at
Barings had given him access to funds that could cover margin calls
(purchases made with borrowed money) for his clients. Although Leeson
was losing huge sums of money for the bank, his dual responsibilities
allowed him to conceal his losses and to continue trading. When the
collapse of the Japanese stock market led to a $1 billion loss for Barings,
Leeson’s actions were finally discovered. Barings never recovered from the
loss, however, and it was acquired by Dutch insurance company ING
Groep NV in 1995 (sold again in 2004). Interestingly, in this case internal
auditors did warn management about the risk at the Singapore office
months before the collapse, but the warnings went unheeded by top
executives, and the audit report was ignored.

In 2001 the scandal surrounding the Barings collapse was dwarfed by


discoveries of corruption in large American corporations. Enron Corp.—an
energy trading firm that had hidden losses in off-the-books partnerships
and engaged in predatory pricing schemes—declared bankruptcy in
December 2002. Soon after Enron became the subject of a Securities and
Exchange Commission (SEC) inquiry, Enron’s auditing firm, Arthur
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Andersen LLP, was also named in an SEC investigation; Arthur Andersen


ultimately went out of business in 2002. In roughly the same period, the
telecommunications firm WorldCom Inc. used misleading accounting
techniques to hide expenses and overstate profits by $11 billion. Instances
of accounting fraud uncovered in Europe in the early 21st century included
Dutch grocery chain Royal Ahold NV, which in 2003 was found to have
overstated profits by roughly $500 million.

In the United States, auditing standards require the auditor to state


whether the financial reports are presented in accordance with generally
accepted accounting principles (GAAP). Many other countries have
adopted the standards supported by the International Accounting
Standards Board (IASB) in London. The IASB standards, often less lenient
than GAAP, have been increasingly seen as more-effective deterrents to
large-scale auditing failures such as those that took place at Enron and
WorldCom.

No auditing technique can be foolproof, and misstatements can exist even


when auditors apply the appropriate techniques. The auditor’s opinion is,
after all, based on samples of data. A management team that engages in
organized fraud by concealing and falsifying documents may be able to
mislead auditors and other users and go undetected. The best any auditor
can provide, even under the most-favourable circumstances, is a
reasonable assurance of the accuracy of the financial reports.
Moses L. Pava

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