Advanced auditing

Assurance: independent professional services that improve the quality of informa on for users

Or, an engagement in which a prac oner aims to obtain sufficient appropriate evidence in order to
express a conclusion designed to enhance the degree of confidence of the intended users other than
the responsible party about the subject ma er informa on




Audit: opinion by an independent auditor on whether financial statements are in all material aspects
present fairly in accordance with GAAP
 Professional judgment: risk, materiality, evidence
 Behavioural requirements: independence, scep cism


An audit is:
 Reasonable assurance
 Use Materiality
 Exercise professional judgment
 Risk, Materiality, Evidence
 Behavioral requirements
 Independence
 Skep cism

The building blocks of the audit are:
 Materiality: significance of the FS informa on to decisionmakers
 Risk: auditor can never be 100% certain that asser ons are en rely free of misstatements
 Audit evidence: informa on that gives the auditor an indica on whether an asser on is true
 Ethics

Exogenous: demand by outside interven on (e.g. government) (US-based)
 Stock market demand
 Focus of profitability
 Audit role: valua on
Endogenous: demand arises within the economy (e.g. supply-demand) (Bri sh tradi on)
 Statutory audit
 Focus on investment protec on
 Audit role: stewardship  efficiency contract
 Agency theory: differences in incen ves, reflect informa on asymmetry
 Adverse selec on: principle cannot observe the quality of the firm
 Moral hazard: agent ac ons not observed yet incen vized (work hard/shirk)

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,Theory of the firm
 Firm is nexus of contracts
 Different contractual arrangements provide different incen ves for opportunis c behavior
 You want to enforce contracts = agency costs:
 Bonding costs: made by the agent = out-of-pocket costs
 Monitoring costs: made by the principal = out-of-pocket costs
 Residual loss = opportunity costs

If endogenous  independent audit reduces incen ve problems  should exist in earliest firms
If exogenous  audits are product of government interven on
 Audit existed early in the development of corpora ons (endogenous)
 Evolved to mandatory audit by first English Companies Act (exogenous)
 Monitoring crucial to forma on of firms
 Long survival of audit: efficient tool for organizing a firm

Increase in demand in independent audits  audit firms = cost efficient response

Paper 1: is independency necessary?
 Only audits vs audits + consultancy
 Only audits  lower quality
 A rac veness of audits is lower  people like consultancy
 You can no longer use the knowledge you gain from consul ng for other firms
 Independence in ISA’s
 Independence of mind  not affected by influences (e.g. management)
 this paper
 Independence of appearance  avoidance of facts and circumstances that make
people think you’re not independent when you actually are
 Baseball card cer fica on
 Similari es with audit: pay for exper se, standards, reputa on of cer fier ma ers
 Differences with audit: no post-audit nego a ons and adjustments, no nego a on,
cer fiers are either pure auditors or cross-sellers
 Results:
 Grade = informa on is associated with return
 Grader-iden ty = reputa on is associated with return
 Market is dominated by cross-seller
 Independent graders do not have a larger market share, and this is not valued
 So, independent audi ng is not be er


Risk : a threat to an organisa on that reduces the
likelihood that the organisa on will achieve one or
more of its objec ves.
 Risk assessment: iden fica on, measurement,
priori sa on
 Risk management: control, share or transfer,
diversify or avoid
 Risk monitoring: process level, ac vity level,
en ty level




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, Audit Risk: the auditor expresses an inappropriate audit opinion when financial statements are
materially misstated
 Type 1: incorrect rejec on
 Type 2: incorrect acceptance (most important to auditor = risk)
 AR = f (RMM, DR)
 AR = Audit Risk
 RMM = Risk of Material Misstatement: risk that FS’s are misstated prior to the audit
o Business risks
o Suscep bility to assets to the
o Ease of informa on manipula on
o Informa on processing risks
o Non-rou ne/complex transac ons
o Judgement risks es mates
o Internal control limita ons
 DR = Detec on Risk: risk that auditor will not detect a material misstatement
o Samples
o Selec on of ineffec ve audit procedures
o Applying procedures ineffec ve
o Evalua ng the results of procedures incorrect

Audit risk model:
 Inherent risk = understand the business (understand)
 Internal control risk = understand and assess controls (understand)
 Detec on risk = auditor response (response)

Paper 3: Audit risk model, (audit) business risk and audit planning:
 Iden fy condi ons under which the audit risk model does (not)
describe audit planning and pricing
 Audit risk = RMM
 Engagement risk = audit business risk = risk of loss to and auditor’s
prac ce due to client rela onships
 Li ga on risk: degree to which users rely on the FS’s of the client
 Regulatory penal es: enforcement by public authori es
 Reputa on loss
 Lack of profitability: bankruptcy etc.
 Results:
 Likelihood of error = high
o Audit risk model dominates business risk
o No risk premium
 Likelihood of irregularity = high
o Business risk model dominates audit risk model
o Risk premium
 If the audit risk model is a complete model for the auditor’s response, then it
shouldn’t ma er if an auditor is confronted with an error or an irregularity
 This is not true  irregularity standard is incomplete




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