Tutorial 1 – Introduction to Auditing
Question 1
You are the audit manager of Ali Lim & Co, Chartered Accountants. The Managing Partner of the firm,
Mr Ali, has accepted an invitation from Sunway University to give a talk to students of auditing on the
various roles of the auditors. You are assigned to assist Mr Ali to prepare for this talk.
Required:
(a) Explain the role of the auditor in:
(i) The review of financial statements
(ii) The corporate governance process
(iii) The capital markets
(iv) The framework of the principal-agent relationship
(b) Describe management’s incentive to misstate financial statements for public companies, and the
challenges auditors face when they review such misstatements. Your answer should include an
explanation of the auditors’ role to address management’s incentive to misstate financial
statements.
Suggested solutions:
(a)
(i) The role of the auditor in the review of financial statements
The auditor reviews financial information prepared by management to determine whether it
conforms to a particular standard (i.e. the applicable financial reporting framework
IFRS/MFRS). The person who conducts the assessment (i.e. the auditor) follows a set of
standards (i.e. the auditing standards ISA). The person completing the assessment is not an
employee of the company, but works for an accounting firm that is associated with the
company only in the role of being hired to perform an audit (a firm that is independent of the
company). The individual doing the assessment is hired to verify the truth and fairness of the
financial information recorded by the firm so that outsiders have accurate information to
make decisions. The outsiders may be bankers, current and potential shareholders, or
regulatory bodies (outsiders to company management). The person making the assessment
provide a valuable, and crucial service. Without such an assessment, outsiders would be
forced to rely solely on the information provided by the company.
(ii) The role of the auditor in the corporate governance process
The corporate governance process is designed to protect users of financial statements from
misstatements in the financial statements. Auditors perform a unique role in this process
because, as trained independent professionals, they are hired to protect the interests of the
users of financial statements and to determine whether the financial statements have been
prepared in accordance with the applicable financial reporting framework (IFRS/MFRS).
1|Page
, Because auditors are independent from management, the users of financial statements are
likely to:
Ø Trust an opinion from an independent professional than an opinion from a person
who is not independent
Ø Receive more accurate information when auditors review the financial statements
prepared by management and issue an opinion about whether the financial
statements have been prepared in accordance with the applicable financial reporting
framework
(iii) The role of the auditor in the capital markets
The capital market system of the world relies on accurate information. If auditors fail to
perform their job, the users of financial statements are hurt because they make decisions
about the companies based on the information disclosed by the companies, and if the
information is wrong, the decision is likely to be wrong.
For example, bankers may lend money when they shouldn’t or may lend at a lower interest
rate than appropriate if they had known the correct information. Investors may fail to sell
shares or buy shares in companies that they wouldn’t if they had information that fairly
presented the firm’s financial position.
(iv) The role of the auditor in the framework of the principal-agent relationship
The relationship between management and the shareholders of a company can be described
in the framework of a principal-agent relationship. The principal in this relationship is the
shareholders of the company; and the agent is the management of the company. A principal-
agent relationship exists because the owners of the company (the principals) are not involved
in the daily management of the company. They hire an agent (management) to manage/run
the company for them and to make daily decisions for the company. This means that the
owners of the company (the principals) are removed from the daily operations of the
company. Management has more knowledge than the owners about the daily operations of
the company, creating information asymmetry between the management and the owners of
the company. The owners (principals) would like management (the agent) to report correctly
what they know, so the principal hires an auditor to increase the likelihood of correct
reporting. Knowing that an auditor will assess the financial statements, management is more
likely to prepare them in accordance with the accounting standards because it is the auditor’s
job to determine that management has complied with this requirement. Outsiders benefit
when the owners hire an auditor to protect their interests in the company because the
information available to outsiders is more likely to correspond to accounting standards.
(b) For public companies, management typically prefers higher net income to lower net income. Net
income can be increased by either reducing expenses or increasing revenue. Growth in revenue is
also an important factor for many companies. In this situation, managers try to show that revenue
has increased from last year, even if net income has not increased. The desired outcome in many
businesses is for revenue and possibly net income to increase at a rate at least equal to the prior
year’s increase, and if possible, greater than the prior year’s increase. Outsiders, particularly
shareholders, expect this level of growth and if companies fail to meet these targets, their share
2|Page
, price may drop as investors sell their shares and find other companies who can meet the growth
level desired. The principal reason to misstate financial statements is to keep the company’s share
price from falling. Investors react unfavourably when companies report lower revenue or net
income numbers from the previous year.
The auditors’ challenge is to identify the material misstatements and to have them corrected
before the financial statements are issued. Auditors should have an understanding of
management’s incentive to misstate financial statements so that the auditors can plan the audit
to devote an increased amount of time to transactions that are more likely to be wrong than other
transactions. The areas in which management is more likely to misstate transactions are riskier
for the auditors because failing to correct the misstatements may lead to the auditors issuing an
inappropriate audit opinion, which would give outsiders the view that the financial statements are
presented fairly in accordance with the applicable financial reporting framework when they are
not.
The auditors’ role is to gather sufficient appropriate evidence and to assess with professional
skepticism the decisions that management made in preparing the financial statements. Before
issuing a clean opinion on the client company’s financial statements, the auditors should be
certain that the evidence gathered during the audit supports the assessment that the financial
statements are prepared using the applicable financial reporting framework.
3|Page
Question 1
You are the audit manager of Ali Lim & Co, Chartered Accountants. The Managing Partner of the firm,
Mr Ali, has accepted an invitation from Sunway University to give a talk to students of auditing on the
various roles of the auditors. You are assigned to assist Mr Ali to prepare for this talk.
Required:
(a) Explain the role of the auditor in:
(i) The review of financial statements
(ii) The corporate governance process
(iii) The capital markets
(iv) The framework of the principal-agent relationship
(b) Describe management’s incentive to misstate financial statements for public companies, and the
challenges auditors face when they review such misstatements. Your answer should include an
explanation of the auditors’ role to address management’s incentive to misstate financial
statements.
Suggested solutions:
(a)
(i) The role of the auditor in the review of financial statements
The auditor reviews financial information prepared by management to determine whether it
conforms to a particular standard (i.e. the applicable financial reporting framework
IFRS/MFRS). The person who conducts the assessment (i.e. the auditor) follows a set of
standards (i.e. the auditing standards ISA). The person completing the assessment is not an
employee of the company, but works for an accounting firm that is associated with the
company only in the role of being hired to perform an audit (a firm that is independent of the
company). The individual doing the assessment is hired to verify the truth and fairness of the
financial information recorded by the firm so that outsiders have accurate information to
make decisions. The outsiders may be bankers, current and potential shareholders, or
regulatory bodies (outsiders to company management). The person making the assessment
provide a valuable, and crucial service. Without such an assessment, outsiders would be
forced to rely solely on the information provided by the company.
(ii) The role of the auditor in the corporate governance process
The corporate governance process is designed to protect users of financial statements from
misstatements in the financial statements. Auditors perform a unique role in this process
because, as trained independent professionals, they are hired to protect the interests of the
users of financial statements and to determine whether the financial statements have been
prepared in accordance with the applicable financial reporting framework (IFRS/MFRS).
1|Page
, Because auditors are independent from management, the users of financial statements are
likely to:
Ø Trust an opinion from an independent professional than an opinion from a person
who is not independent
Ø Receive more accurate information when auditors review the financial statements
prepared by management and issue an opinion about whether the financial
statements have been prepared in accordance with the applicable financial reporting
framework
(iii) The role of the auditor in the capital markets
The capital market system of the world relies on accurate information. If auditors fail to
perform their job, the users of financial statements are hurt because they make decisions
about the companies based on the information disclosed by the companies, and if the
information is wrong, the decision is likely to be wrong.
For example, bankers may lend money when they shouldn’t or may lend at a lower interest
rate than appropriate if they had known the correct information. Investors may fail to sell
shares or buy shares in companies that they wouldn’t if they had information that fairly
presented the firm’s financial position.
(iv) The role of the auditor in the framework of the principal-agent relationship
The relationship between management and the shareholders of a company can be described
in the framework of a principal-agent relationship. The principal in this relationship is the
shareholders of the company; and the agent is the management of the company. A principal-
agent relationship exists because the owners of the company (the principals) are not involved
in the daily management of the company. They hire an agent (management) to manage/run
the company for them and to make daily decisions for the company. This means that the
owners of the company (the principals) are removed from the daily operations of the
company. Management has more knowledge than the owners about the daily operations of
the company, creating information asymmetry between the management and the owners of
the company. The owners (principals) would like management (the agent) to report correctly
what they know, so the principal hires an auditor to increase the likelihood of correct
reporting. Knowing that an auditor will assess the financial statements, management is more
likely to prepare them in accordance with the accounting standards because it is the auditor’s
job to determine that management has complied with this requirement. Outsiders benefit
when the owners hire an auditor to protect their interests in the company because the
information available to outsiders is more likely to correspond to accounting standards.
(b) For public companies, management typically prefers higher net income to lower net income. Net
income can be increased by either reducing expenses or increasing revenue. Growth in revenue is
also an important factor for many companies. In this situation, managers try to show that revenue
has increased from last year, even if net income has not increased. The desired outcome in many
businesses is for revenue and possibly net income to increase at a rate at least equal to the prior
year’s increase, and if possible, greater than the prior year’s increase. Outsiders, particularly
shareholders, expect this level of growth and if companies fail to meet these targets, their share
2|Page
, price may drop as investors sell their shares and find other companies who can meet the growth
level desired. The principal reason to misstate financial statements is to keep the company’s share
price from falling. Investors react unfavourably when companies report lower revenue or net
income numbers from the previous year.
The auditors’ challenge is to identify the material misstatements and to have them corrected
before the financial statements are issued. Auditors should have an understanding of
management’s incentive to misstate financial statements so that the auditors can plan the audit
to devote an increased amount of time to transactions that are more likely to be wrong than other
transactions. The areas in which management is more likely to misstate transactions are riskier
for the auditors because failing to correct the misstatements may lead to the auditors issuing an
inappropriate audit opinion, which would give outsiders the view that the financial statements are
presented fairly in accordance with the applicable financial reporting framework when they are
not.
The auditors’ role is to gather sufficient appropriate evidence and to assess with professional
skepticism the decisions that management made in preparing the financial statements. Before
issuing a clean opinion on the client company’s financial statements, the auditors should be
certain that the evidence gathered during the audit supports the assessment that the financial
statements are prepared using the applicable financial reporting framework.
3|Page
