Literature Review on Auditing
In any current business organisation, progress that the company is making is recorded as basis for, among a host of other essential things, decision-making and as a benchmark for measuring the firm’s performance for the period under scrutiny. A financial situation analysis or evaluation is one such yardstick that documents current and future financial situation in an attempt to determine a financial strategy to help achieve organisational goals. With regards to this, this paper will review some issues related to auditing as guidance of determining the financial situation of a business. Actually, auditing in any businesses is the inspection and verification of the accuracy of financial records and statements. Private businesses and all levels of government conduct internal audits of accounting records and procedures. Internal audits are conducted by a company’s own personnel to uncover bookkeeping errors and also to check the honesty of employees. In large companies, internal auditing is an ongoing procedure. A company that trades stock on a registered stock exchange or is preparing to issue new shares of stock must submit to an external audit. These companies are known as publicly traded companies. Moreover, an external audit is used to give the public a true statement of a company’s financial position. It is made at least once a year by public accountants who are not regular employees of the company. The auditors make sure that the company has followed proper accounting procedures in its financial records and statements. They compare the current financial statements with those of the previous year to determine whether the statements are calculated consistently. If they are not, they present a distorted picture of the company’s financial position. The auditors also inspect real estate, buildings, and other assets to see if their value is overstated. Debts and other liabilities are checked to see if they have been understated.
Auditing practice has a much longer history than many of the other developments that can be considered and the large firms of accountants, in which many financial auditors work have become influential advisory institutions throughout the world. Thus, auditing has provided the model which has influenced the design of auditing practice in many other fields. Although environmental, medical, or value for money audits are conceived as distinct from financial auditing, the latter continues to exert its normative influence as a centre of gravity for debate and discussion. And it is in the context of auditing that the dependency of acts of verification on judgment and negotiation is most apparent. With this consideration, the paper of Ball & Shivakumar (2008) reviewed and estimated the importance of profits in providing new information to the stock market. And through auditing procedure, they found out that their subject company have contributed more to return volatility in recent years may show that earnings has increased importance as a source of new information. Apparently, Jenson KL & Payne JL 2005 argued that audit quality and quality fees in response agency costs is also important in auditing and even in any business. Using advanced auditing methods related to employing auditors with high skills in industry experience. Advanced methods have little impact on audit fees, but in some cases increase of quality not necessarily related with higher audit fees. It is not apparent that not focusing on fees conducts to great increase in audit quality. Auditing methods is a tool that control audit quality in response to agency costs.
On the other hand, Dye and Sunders (2001) argued that financial standards are also important with regards to auditing practices. From their paper, the illustration of entering competition in accounting standards is obvious. With this, they found out two contrasting points of view. The first one sees that financial statements in public firms are made by directors who see accounting standards as draw back and increase risks. So they chose to depend on existing standards. They scarcely have innovative accounting methods which makes hard to carry out analysis of social cost-benefit. Apparently, the second point of view sees competition is a good matter as it enhances firms to be more sensitive to their customers and to take necessary measures immediately and add value to firms. Competition remove problems faced by firms and increase effectiveness of standards and remove of monopoly as it occurred multipart market, which make available healthy environment for investment and permit opportunity for them to make their financial statements and to reach a lawful agreement on these accounting standards.
With regards to investors’ protection, auditing creates good role and function. The study of Newman, Patterson & Smith (2005) found that an increase in auditor penalties for undiscovered expropriation lead to total investment increase although of increase of audit fees. Also an increase in insider's penalties. Therefore, the probability of audit failure will be low in such environments. Actually, their study aimed at investigating the relation between audit quality and long audit partner tenure.
Auditing is subject to expectations and demands which are, justifiably or otherwise, often disappointed (Kealey, Lee & Stein 2007). Nevertheless, Malone & Roberts (1996) pointed out that the official procedural knowledge base of auditing has evolved in response to scandals and corporate failures in such a way that the essential puzzle of what audits produces their effectiveness remains hidden from view as an article of faith. Finally despite, and probably because of, this puzzle it is argued that financial auditing maintains itself as an institutionally credible system of knowledge. Notwithstanding crisis and scandal it satisfies the aspirations and demands of a variety of regulatory programs. Particular audits may fail but the system as such cannot. The possibility of effective auditing is necessarily presupposed by regulatory intentions. Traditionally, analytical auditing has applied itself to the domain of finance, but organisations are increasingly finding value from internal audits that monitor other aspects of their activity. Environmental and social audits, for example, have been championed by firms in response to the ethical concerns of both shareholders and the public in relation to the company's impact upon the locality. Analytical auditing is growing in importance too, partly in response to recent major scandals such as the collapse of banks, and also in order to monitor the increasingly complex demands being made upon accountants (Hogan & Jeter 1999).
However, auditing remains something of a mystery to those outside of the profession, and has become more specialised as accounting has become more sophisticated. For example, while best practice has evolved certain tools for analytical review or establishing audit trails, an element of subjective judgment remains as auditors decide what evidence to include. Further, rules of thumb can never be ruled out. Audit risk has developed as an issue too, as the models for reducing the probability of mistakes being made on sampling, for example, become more subtle (Bedard, Deis, Curtis & Jenkins 2008). In connection to this, the study of Low (2004) imposed a proposition that auditor knowledge on the client’s industry improve auditor’s ability to discern audit risks. The results indicted that auditor’s knowledge on the client’s industry improve their audit risk assessments and affects directly on the nature and perceived quality of their audit planning decision. Aside from this, the study found that Auditor’s knowledge on client’s industry influence directly on the way in which auditor modify audit procedures. With this, the subsequent section will review issues related to the auditor and its function.
The Auditor’s Responsibility and Fees
The auditor play significant role in the development of a certain business. Actually, auditors are responsible in the analysis of the financial standing of a certain business (Craswell, Francis & Taylor 1995). Here are some of the factors that influencing auditor’s responsibility.
Actually, various accounts from published financial statements are evaluated in relation to each other to form performance indicators, which are then compared to ‘established’ standards which are handled by the internal auditor and forensic accountant with approval of the management of a certain firm. And since such analysis is difficult, fees also crucial to this job. Actually, the study of Craswell, Francis & Taylor (1995) revealed that specialised audit firms get great fees than other non-specialised audit firms. Generally, large audit firms get higher fees than smaller firms. The study reported that specialised audit firms require high rewards plus fees, this indicated that implicitly that this increase in equal to higher quality. For the last several years, businesses have seen the rapid growth of the number of firms offering financial situation analysis services. This serves as a proof that more and more organisations are realising the importance of the analysis of their financial situations in order to keep up with the demands of the business world nowadays.
And with regards to the issue of fees, auditors are making reasonable fees because of the issue of responsibility and risks. The study of Khurana and Raman (2004) which is related to the litigation risks and financial reporting credibility of big4 companies and non big4 in Anglo-American countries shows that the exposure to suit case is the driver for perceived audit quality than brand name fame protection. Moreover, their study revealed that that there is a relationship between audit quality and suit case risk and level of damage facing the auditor and that decrease of auditor litigation risk could has unintended results for perceived audit quality in USA. This study identified the degree of responsibility of an auditor in accordance to their profession as stated in the paper of Simunic & Stein (1996); Geiger & Raghunandan 2002; and Venkataramna, Weber & Willenborg (2008). Moreover, Schwartz (1997) study presents the impact of legal responsibility of external auditors on audit quality and investment level. And the effect of damage measures on investments. He indicated that the legal regime of civil responsibility which achieves the highest level of audit effort and quality, not necessarily achieves a socially optimal investments level. And liability payments not only induce auditors to exert the due care to achieve audit quality, but also provide insurance for investors against investment losses.
He argued that inability of auditors to predict the standard of due care to be used in the evaluation of their work, may motivate them to increase their efforts in order to reduce the litigation risks.
In connection to this, the study of Abbot, Parker &Peters (2006) revealed that audit fees reduced with income reduction discretionary accruals, vice versa. They also identified that the increase in audit fees for positive discretionary accruals is huge for firms with higher price earnings, which may be due to auditor s’ prejudice, as this prejudice resulted from irregular law suits. Meaning, audit risk model does not explain sufficiently auditor attitude with regard to audit planning and investment and that litigation risk component of auditor production function useful to maintain higher audit quality.
The Auditor in Action
Financial evaluation is very vital to the development of a certain organisation since it is the distinction whether the certain organisation are growing or not (Kwon, Lim & Tan 2007). With these the management should have a good collaboration to their internal auditor. In the case of auditing fraud, the management may conduct an investigation with the help of forensic accountant (Anderson, Jennings, Lowe & Reckers 1997). With this, it is very important for a forensic accountant to maintain fairness in reporting since the financial standing of a business can be evaluated by simply looking at the financial statements of a certain organization (Hooghiemstra R & Manen JV 2004). Financial statements are, according to Jenson & Meckling (1976), the universally accepted tools for analysis of a business entity, therefore Managerial Behavior, Agency costs and ownership structure which builds the firm should be carefully evaluated. If properly understood, they let the users know how good a company looks and how well it has been doing. They are, at best, an approximation of economic reality because of the selective reporting of economic events by the accounting system, compounded by alternative accounting methods and estimates (Dopuch, Ingberman & King 1997). The purpose of financial statements is to provide users (business owners, lenders, managers, suppliers, customers, attorneys and litigants and employees and job seekers) with a set of financial data that, in summary form, fairly represents the financial strength and performance of a business (Titman & Trueman 1986; Breton& Taffler 2001; and Sephen & Higgegeist 1999). They reveal opportunities and provide protection against financial pitfalls. Ideally, financial statements analysis provides information that is useful to present and potential investors and creditors and other users in making rational investment, credit risk monitoring and other similar decisions (Bedard, Deis, Curtis & Jenkins 2008). Further, they are comparative measurements of risk and return to make investment or credit decisions as they provide one basis for projecting future earnings and cash flows.
In line with the practices of an auditor, the auditor should be alert to the fact that audit procedures applied for the purpose of forming an opinion on the financial statements may bring instances of possible noncompliance with laws and regulations to the auditor’s attention. For example, such audit procedures include reading minutes; inquiring of the entity’s management and legal counsel concerning litigation, claims and assessments; and performing substantive tests of details of classes of transactions, account balances, or disclosures (Mayhew & Pike 2004). The auditor should obtain written representations that management has disclosed to the auditor all known actual or possible noncompliance with laws and regulations whose effects should be considered when preparing financial statements. When the auditor becomes aware of information concerning a possible instance of noncompliance, the auditor should obtain an understanding of the nature of the act and the circumstances in which it has occurred, and sufficient other information to evaluate the possible effect on the financial statements. When evaluating the possible effect on the financial statements, the auditor considers different things that include the potential financial consequences, such as fines, penalties, damages, threat of expropriation of assets, enforced discontinuation of operations and litigation; whether the potential financial consequences require disclosure; whether the potential financial consequences are so serious as to call into question the true and fair presentation given by the financial statements. When the auditor believes there may be noncompliance, the auditor should document the findings and discuss them with management (Mayhew & Pike 2004).
The auditor should consider the implications of noncompliance in relation to other aspects of the audit, particularly the reliability of management representations. In this regard, the auditor reconsiders the risk assessment and the validity of management representations, in case of noncompliance not detected by the entity’s internal controls or not included in management representations. The implications of particular instances of noncompliance discovered by the auditor will depend on the relationship of the perpetration and concealment, if any, of the act to specific control activities and the level of management or employees involved (Geiger & Raghunandan 2002). The auditor should, as soon as practicable, either communicate with those charged with governance, or obtain audit evidence that they are appropriately informed, regarding noncompliance that comes to the auditor’s attention. However, the auditor need not do so for matters that are clearly inconsequential or trivial and may reach agreement in advance on the nature of such matters to be communicated. If in the auditor’s judgment the noncompliance is believed to be intentional and material, the auditor should communicate the finding without delay. The auditor may conclude that withdrawal from the engagement is necessary when the entity does not take the remedial action that the auditor considers necessary in the circumstances, even when the noncompliance is not to the financial statement (Raghunandan K & Rama DV 1999).
In accordance to this development, extensive accounting and auditing procedures must be practiced by auditors with collaborations to management. This includes everything from audits of accounting management policies and procedures to internal reviews of quantitative exposure measurement models. In essence, this process involves the evaluation whether or not its management process is working properly and efficiently. This must be done to assess if the company addresses the problems and risks being identified in the first process. Without this step, businesses would not be able to come up with policies and regulations regarding standards, and would not be able to know if their measuring, monitoring and controlling processes are effective enough to suggest improvement of their operation and profit.
In the case of fraud particularly a financial fraud, a forensic accountant may come to the scene. Forensic accounting synthesizes understanding of business information, financial reporting, accounting and auditing standard and procedures, investigation and information gathering techniques to support litigation processes (Raghunandan K & Rama DV 1999). Although mostly involved in crime solving situations, forensic accounting is increasingly being used to prevent illegal transaction and fraudulent deterrence (Raghunandan K & Rama DV 1999). In spite of this role, a forensic accountant should avoid biasness and maintain fairness in reporting. The role of forensic accountant is vital since it could affect the standing of the business and at the same time the reliability of the internal auditor (Raghunandan K & Rama DV 1999).
Literature Review Synthesis
Actually, most of decision theory is normative or prescriptive, i.e. it is concerned with identifying the best decision to take, assuming an ideal decision taker who is fully informed, able to compute with perfect accuracy, and fully rational. However, since it is obvious that people do not typically behave in optimal ways, there is also a related area of study, which is a descriptive or positive discipline, attempting to describe what people will actually do. Furthermore it is possible to relax the assumptions of perfect information, rationality and so forth in various ways, and produce a series of different prescriptions or predictions about behaviour, allowing for further tests of the kind of decision-making that occurs in practice. Even though these decisions making is essential, some flaws still exist especially in making business decision and that is through biased perception. Basically managers often suffer from biased decision and some of it is in the type called confirmation bias.
In fact, one of the keys for a successful organisation is good management. This reflects to a good manager, a good manger that is not only good in overall business process but an honest and transparent in terms of financial reporting. Can you imagine an organisation, a company, or any other organisation succeeds without good governance?
The management and internal auditors plays an important role in any organisation. This importance lies on the fact that they have good collaboration in able to protect and organise the relevant data in any organisation. With this, their work and role must be given emphasis, including the approach that they can use to improve. In the case of financial fraud, auditors should be aware to the work of a forensic accountant which is actually responsible in finding glitches in financial reports. Thus, it is vital for forensic accountant to be fair in giving reports.
If these people created good and honest accounting practices, the financial standing will indicate very significant effects on business sustainability, even amidst the threats of unrest. Therefore, we could conclude that the business strategies such financial evaluation could still be expected to improve business sustainability faster than average. However, even though there is a good collaboration among them, there still a need to reconcile both the inside-out and outside-in approaches in the business process.
In an age where the financial system has become simultaneously more complex and more accessible to the unsophisticated investor, it is essential that the challenge of effective management is addressed. On the other hand, harmful incentive structures, conflicts of interests, and the absence of transparency seem to be key issues in addressing shortcomings in current management. In addition, the interests of minority shareholders have to be protected as larger investors may abuse their power. These problems can effectively be addressed by the use of forensic audits after major bankruptcies or suspected accounting frauds, by encouraging whistleblowers, by fostering of a process of diluting ancillary links between audit firms and their audit clients as well as between investment analysts and their clients. Greater transparency in the process of credit rating by the relevant agencies is also required. Other suggestions for reform include measures to tackle concentration in the provision of audit services, perhaps by lowering entry barriers.
Abbot LJ, Susan Parker S & Peters GF 2006, Earnings Management, litigation risks and asymmetric audit fee response. Auditing J Practice and Theory, Vol 25(1), pp. 85-98.
Anderson JC, Jennings MM, Lowe DJ & Reckers. PMJ 1997, The mitigation of hindsight bias in judges evaluation of auditor decision. Auditing J Practice and Theory. Vol 16 (2), pp. 20-37.
Ball R & Shivakumar L 2008, How much new information is there in earnings? Journal of Accounting Research Vol. 46, No 5, pp. 975-1016.
Bedard JC, Deis DR, Curtis MB & Jenkins JG 2008,Risk monitoring and control of audit firms: A research synthesis. Auditing: A journal of Practice &Theory. Vol 27 (1), pp. 187-218.
Breton G. & Taffler RJ 2001. Accounting information and analyst stock recommendation decisions: a content analysis approach. Accounting and Business Research. Vol. 31, No. 2.
Brian W. Mayhew BW & Pike JE 2004, Does investor selection of auditors enhance auditor independence? The Accounting review. Vol. 79, No. 3, pp. 797-822.
Carey P & Simnett R 2004, Audit partner tenture and audit quality, The Accounting Review. Vol. 81, No.3, pp. 653-676.
Craswell AT, Francis JR, Taylor SL 1995, Auditor brand name reputations and industry specialisations. Journal of Accounting and Economics. Vol. 20.
Dopuch N, Ingberman DE & King RR 1997, An experimental investigation of multi-defendant bargaining in 'joint and several' and proportionate liability regimes. Journal of Accounting and Economics. Vol 23.
Dye RA & Sunders S 2001, Why not allow FASB & IASB standards to compete in USA? Accounting Horizons. Vol.15, No. 3.
Dye RA 1995, Incorporation and the audit market, Journal of Accounting and Economics. Vol 19.
Geiger MA & Raghunandan K 2002, Auditor Tenure and Audit Reporting Failures. Auditing: A journal of Practice &Theory. Vol 21, No.1.
Hogan CE & Jeter DC 1999, Industry Specialisation by Auditors. Auditing: A journal of Practice &Theory. Vol 18, No.1.
Hooghiemstra R & Manen JV 2004, Non-executive directors in Netherlands: another expectations gap? Accounting and Business Research. Vol. 34, No. 1.
Jenson KL & Payne JL 2005, Auditing procurement : Managing audit quality and quality fees in response agency costs. Auditing J Practice and Theory, Vol 24(2), pp. 27-48.
Jenson MC & Meckling WH 1976, Theory of the firm: Managerial Behavior, Agency costs and ownership structure. Journal of Financial Economics. 3.
Kealey BT, Lee HY & Stein MT 2007, The association between audit-firms tenture and audit fees paid to successor auditors: Evidence from Arthur Andersen. Auditing J Practice and Theory. Vol 26 (2), pp. 95-116.
Khurana IK & Raman KK 2004,Litigation risks and financial reporting credibility of Big4 versus non Big 4 audits: Evidence from Anglo-American countries. The Accounting review. Vol. 79, No.2, pp. 473-495.
Krishnam J & Zhang Y 1999, Auditors litigation risks and corporate disclosure of quarterly review report. A journal of Practice &Theory. Vol 24, supp, pp. 115-138.
Kwon S, Lim C & Tan P 2007, Legal systems and Earnings quality: the role of auditor industry specialisation. Auditing: A journal of Practice & Theory. Vol 26 (2), pp. 25-55.
Low K 2004, The effects of industry specialisation on audit risk assessments and audit planning decision. The Accounting review. Vol. 79, No. 1, pp. 201-214.
Malone CF & Roberts RW 1996, The title: Factors Associated with Incidence of Reduced Auditing, Quality Behaviors. Auditing: A journal of Practice &Theory. Vol 15, No.2.
Newman P, Patterson ER & Smith JR 2005, The role of auditing in investor protection, The Accounting review. Vol. 80, No. 1, pp. 289-313.
Pae S & Yoo S 2001, Strategic Interaction in Auditing: An Analysis of Auditors' Legal liability, Internal Control System Quality, and Audit Effort. The Accounting Review. Vol. 76, No.3
Raghunandan K & Rama DV 1999, Auditor Resignations and the Market for Audit Services. Auditing: A journal of Practice &Theory. Vol 18, No.1.
Schwartz R 1997, Legal Regimes, Audit Quality and Investment. The Accounting Review. Vol 72, No.3.
Sephen A & Higgegeist S 1999, Financial reporting and auditing under alternative damage apportionment rules. The Accounting review. Vol. 7, No.3, pp. 347-369.
Simunic DA & Stein MT 1996, The impact of litigation risk on audit pricing: A review of the economics and the evidence. Auditing: A journal of Practice & Theory. Vol. 15, supplement.
Titman S & Trueman B 1986, Information quality and the valuation of new issues, Journal of Accounting and Economics 8 (June).
Venkataramna R, Weber JP & Willenborg M 2008, Litigation risks, audit quality and audit fees: Evidence from Initial Public Offerings (IPO). The Accounting review Vol. 83, No.5, pp. 1315-1345.
Read our customer feedbacks