Chapter 1 An Overview Of Auditing

Chapter 1 An Overview of Auditing

1. Objectives

1.1 Identify the objectives, nature and benefits of the audit process. 1.2 Distinguish between auditing and accounting. 1.3 Identify the types of audits. 1.4 Distinguish between external auditors and internal auditors. 1.5 Explain the concept of ‘true and fair’. 1.6 Outline the appointment, vacation of office, rights and duties of auditors under the Hong Kong Companies Ordinance.

Overview of Auditing

Objectives Distinguish Types Distinguish True Appointment Nature Auditing of External and and Vacation and and Audit Internal Fair Rights & Audit Process Accounting Auditors Concept Duties of Auditors 2. Nature and Objectives of Auditing

(A) Definition and scope of audit

2.1 An audit may be defined as an independent examination of the financial statements of an enterprise and communicate the result to the interested parties. 2.2 HKICPA states in Hong Kong Standard on Auditing (HKSA) 200 “Objectives and General Principles Governing an Audit of Financial Statements” that auditors should: (a) conduct an audit in accordance with the required HKSAs, legislation, regulations and, where appropriate, the terms of engagement ( 聘用 ) and reporting requirements; (b) plan and perform an audit with an attitude of professional skepticism (抱懷疑態度) recognizing that circumstances may exist that cause the financial statements to be materially misstated (誤述); and (c) comply with the ethical principles governing the auditor’s professional responsibilities caused by HKICPA “Statement of Professional Ethics / Code of Ethics of Professional Accountants”.

N1-1 (B) Objectives

2.3 HKSA 200 describes the objectives of an audit of financial statements is to enable auditors to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework.” 2.4 This involves the following objectives: (a) Primary objective To produce a report by the auditor of his opinion of the truth and fairness of the financial statements examined by him. (b) Secondary objectives (i) To detect errors and fraud that cause material misstatements in the accounting records and/or the financial statements; and (ii) To provide constructive advice on the client’s internal control system. 2.5 Concept of true and fair – there is no official definition in any individual HKSA of the meaning of true and fair.

Truth in accounting terms can be taken to mean not factually incorrect.

The word fair can have the following meanings:  On the one hand clear, distinct (清楚的) and plain (清晰的)  And on the other impartial (不偏不倚的) / unbiased, just and equitable (公正的). 2.6 Auditors should attempt to ensure that the financial statements which are the subject of the audit, present clearly and equitably the financial state of affairs of the enterprise. This suggests that in order to achieve the statutory true and fair view, it is necessary: (a) to present certain information impartially; (b) that this data is shown in such a way that it is clearly understood by the user.

2.7 Test your understanding 1 The following statement relates to objective and general principles governing an audit of financial statements. “The objective of an audit of financial statements is to enable auditors to give

N1-2 a true and correct view in all respects in accordance with an identified financial reporting framework.” (4 marks) (HKAAT Paper 8 Auditing December 2003)

(C) The Auditing Process

2.8 The major steps of auditing process include: (a) Client acceptance and retention and establish the engagement terms: Client’s business nature and management integrity, and professional ethics (道德規范) when considering the acceptance and retention of client of client because this may affect the reliability of financial information provided by the client. (b) Plan the audit: The planning phase involves the assessment of audit risks, the development of audit strategy and the determination of means to perform the audit properly. (c) Evaluate internal controls: The auditor should understand and evaluate the effectiveness of client’s internal control system to determine the possibility of having material misstatements in the financial statements. (d) Conduct testing of accounting transactions and balances: The auditor checks the transactions and account balances against the supporting documents to substantiate the financial statement balances. (e) Complete the audit: The auditor assesses whether sufficient evidence has been obtained to reach a conclusion that the financial statements are fairly presented. (f) Issue audit report: The final phase in the audit process is communicating the auditor’s findings to the users of the financial statements.

(D) Reasonable Assurance (合理確信)

2.9 An audit is designed to provide reasonable assurance that the financial statements as a whole are free from material misstatement as required by auditing standards. 2.10 There are inherent limitations in an audit that affect the auditors’ ability to detect material misstatements. The reasons are:

N1-3 (a) examining all items within an account balance or class of transactions are impractical and sampling techniques have its own inherent limitations; (b) there are inherent limitations of any accounting and internal control system; (c) most audit evidence is persuasive rather than conclusive; and (d) the persuasiveness of audit evidence available to draw conclusions on particular financial statement assertions ( 目的 ) may be affected by unusual circumstances, such as related parties transactions, which increase the risk of material misstatement.

(E) Distinguish between Auditing and Accounting

2.11 Accounting is the process of recording, classifying and summarizing the economic transactions in a systematic and logical manner for decision making. 2.12 Auditing is the process of systematically accumulating and evaluating evidence to determine whether the financial information presented properly reflects the business transactions and financial position of the company. 2.13 To provide relevant information, accountants must have a thorough understanding of the accounting principles for recording the business transactions. 2.14 In auditing accounting data, the concern is with determining whether recorded information properly reflects the economic events that occurred during the accounting period. In addition to understanding accounting rules, the auditors must possess expertise in how the audit evidence should be interpreted. The auditors must perform the audit in accordance with auditing standards.

2.15 Test your understanding 2 Misconceptions (a) The objective of auditing is to detect fraud. (b) Auditors examine all, or most, business transactions to ensure correctness of financial statements. (c) The audit of the financial statements relieves management of its responsibilities for preparing and presenting the financial statements. (d) Auditors should conduct an audit in accordance with Hong Kong Accounting Standards.

N1-4 Required: Correct the misconceptions from items (a) to (d) above. (8 marks) (Adapted HKAAT Paper 8 Auditing June 2002)

(F) The Economic Demand for Auditing

2.16 The following are underlying conditions which create demand by users for reliable accounting information: (a) Complexity – company’s transactions can be voluminous and complicated, so users of financial information need the expertise of professional accountants. (b) Remoteness – It’s uneconomical for the users of financial statements to employ professional accountants to do that job. (c) Consequences – Financial decisions can involve large amounts of money and massive efforts. Good information, obtained through accounting experts, is beneficial for that type of decisions.

3. Types of Audits

(A) Internal and External Audits

3.1 External or statutory audits Statutes which require audits to be done include the Companies Ordinance and other ordinances and regulations. 3.2 Internal audits (a) Internal auditing is an independent appraisal function established within an organization to examine and evaluate its activities and operations. (b) Function of internal audit is the making analyses, appraisals and recommendations for management concerning the activities reviewed. 3.3 The activities of internal audit include: (a) To review the financial and operation information to ensure that the information is properly identified, measured, classified and recorded in the accounting records and is fairly presented in the financial statements in accordance with the accounting standards and relevant legislation.

N1-5 (b) To study the operations of the business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. (c) To review the internal control systems which ensure the compliance of company policies, plans, and procedures of laws and regulations. (d) To perform other special review as required by management, for example, review of effectiveness in achieving program results in comparison to pre-established objectives and goals.

(B) Financial Statement, Operational and Compliance Audits

3.4 Financial statement audit – to determine whether the overall financial statements are stated in accordance with the GAAP. 3.5 Operational audit – review of the operating procedures of an organization for the purpose of evaluating and improving its efficiency and effectiveness. 3.6 Compliance audit – to determine whether the procedures and regulations prescribed by management are complied with.

(C) Fundamental Differences between Internal and External Auditors

3.7 Despite their common interests there are some fundamental differences in the scope of their work, the approach to their work and their reporting line.

Area of difference Internal auditor External auditor 1. Scope Determined by management Determined by statute 2. Objective To ensure the accounting To satisfy himself system is efficient, effective whether the financial and economic and providing statements to be management with accurate presented to the and material information shareholders present a true and fair view 3. Responsibility To management To shareholders 4. Appointment / By management By management, on dismissal behalf of shareholders 5. Qualifications None specified Professional accountant qualified under

N1-6 Professional Accountant Ordinance 6. Independence Staff of company Auditor who is independent of the company

3.8 Test your understanding 3 Kenny will soon complete his final year of studies in bachelor of accountancy. He is wondering whether he should start his career as an external auditor or as an internal auditor. His lecturer has mentioned that external auditors might have a close working relationship with internal auditors, but the external auditors have to assess the internal audit function and to evaluate the work of the internal auditors.

Required: (a) Briefly compare internal auditors and external auditors in terms of (i) Determination of job scope (ii) Objectives (iii) Line of reporting (6 marks) (b) Briefly describe four internal auditing activities. (4 marks) (Adapted HKAAT Paper 8 Auditing December 1998)

4. Regulatory Framework of Auditing

(A) Legal Requirements

4.1 Companies Ordinance (a) requires every limited company in HK to have an annual audit. (b) sets out the rights and duties of auditors, procedures of appointment, resignation and removal of auditors. 4.2 Listing rules – specify the safeguard procedures which should be carried out to identify conflict of interest and maintain independence.

(B) Professional Requirements

4.3 HKICPA has issued HKSAs, Practice Notes (PN) and Industry Auditing

N1-7 Guidelines for its members to follow in their professional practices.

5. Appointment of Auditors

(A) Persons Qualified to be Appointed as Auditors

5.1 The requirements for person qualified to be appointed under the Companies Ordinance includes: (a) Person qualified to be appointed under S.140(1) of the Companies Ordinances – A person shall not be appointed as auditor of a company unless he is qualified to be appointed as auditors under the Professional Accountants Ordinance. (b) Person not qualified for appointment as auditor under S.140(2) of the Companies Ordinance (i) An officer or an employee of the company or its subsidiary and holding companies. (ii) A person who is a partner of or an employee of an officer or an employee of the company or its subsidiary and holding companies. (c) Person qualified to be registered as professional accountants under S.29(2) of the Professional Accountants Ordinance – Unless he is either the holder of a practicing certificate or a corporate practice, a person shall not hold any appointment or render any services as an auditor of a company.

(B) Appointment Procedures

5.2 Appointed by members at annual general meeting (a) To reappoint retiring auditor by ordinary resolution (simple majority) (S.131(1) of the Companies Ordinance). (b) To appoint an auditor other than the retiring auditor by ordinary resolution and special notice (S.132(1)(a) of the Companies Ordinance). (c) To reappoint, by ordinary resolution and special notice, a retiring auditor appointed by directors (S.132(1)(c) of the Companies Ordinance).

N1-8 5.3 Appointed by directors (a) To fill a casual vacancy (臨時的空缺) (b) To appoint company’s first auditor – directors can appoint the first auditor before the first AGM. If the directors fail to exercise such power, the company may appoint the first auditor in the general meeting (S.131(3) & (4) of the Companies Ordinance) 5.4 Appointed by court Where at an AGM of a company, no auditor is appointed or reappointed, the court may, on the application of any member of the company, appoint a person to fill the vacancy (S.131(2) of the Companies Ordinance).

6. Vacation of Office

(A) Removal procedures

6.1 The removal of an auditor before expiry of term of office includes the following procedures: (a) Ordinary resolution and special notice (S.131(6) of the Companies Ordinance). (b) On receipt of such notice, the company shall forthwith (立刻) send a copy thereof to the auditor proposed to be removed (S.132(2) of the Companies Ordinance). (c) Notice of the resolution so passed shall be given to the Registrar of Companies within 14 days, except for private companies (S.131(6) of the Companies Ordinance).

(B) Resignation Procedures

6.2 To be effective in resigning from an office of auditor, the following steps should be taken: (a) The auditor must submit written notice to the company (S.140A(1) of the Companies Ordinance). (b) Whenever an auditor resigns his office he must deposit, with his notice of resignation, at the registered office of the company either: (i) a statement that there are no circumstances brought to the attention of the members or creditors; or (ii) a statement of any such circumstances. (c) If there are circumstances to be brought to the attention of members or

N1-9 creditors the company must send, within 14 days, a copy of the statement to every person entitled to receive a copy of the accounts (S.140A(3)(b) of the Companies Ordinance). (d) The company must notify the Companies Registry regarding the resignation of the auditor, within 14 days, except for private companies (S.140A(3)(a) of the Companies Ordinance).

7. Rights and Duties of Auditors under Companies Ordinance

(A) Rights of Auditors

7.1 An auditor has the following rights so as to carry his or her duty properly: (a) To access at all time to the books, accounts and vouchers of the company (S.141(5) of the Companies Ordinance). (b) To require from officers (directors and employees) of the company such information and explanation as the auditor thinks necessary to form his opinion (S.141(5) of the Companies Ordinance). (c) To receive notices of an attend members’ general meetings and to report on any matter which concerns him as auditor (S.141(7) of the Companies Ordinance). (d) It is an offence and is liable to imprisonment and a fine for an officer of the company who knowingly or recklessly makes a misleading, false or deceptive statement to the auditor of the company (S.134 of the Companies Ordinance). (e) Upon resignation or being removed, the auditor has the following rights: (i) To have the company sending a statement of circumstances connected with their resignation to the members or creditors within 14 days. (S.140A(3)(b) of the Companies Ordinance) (ii) To have written representations or statement of circumstances circulated to all members; or to have them read out at the meeting concerned. (iii) To receive notices of, attend and be heard at the general meetings:  At which his term office would otherwise have expired; and  At which it is proposed to appoint a new auditor (S.140B(5) of the Companies Ordinance)

N1-10 (iv) To require an extraordinary general meeting (EGM) to consider the reasons for his resignation if his notice of resignation contains a statement of circumstances. (S.140B(1) of the Companies Ordinance)

(B) Duties of Auditors

7.2 The duties of an auditor include the followings: (a) To make a report to the members on all accounts laid before the members in general meeting during his tenure ( 任期 ) of office (S.141(1) of the Companies Ordinance). (b) To include in the report statements on the accounts concerning the compliance with the provisions of the Ordinance; and the truth and fairness (S.141(3) of the Companies Ordinance). (c) To investigate whether or not: (i) proper accounting records have been kept; (ii) proper returns have been received from branches not visited by the auditor; and (iii) the accounts are in agreement with the books of account and returns (S.141(4) of the Companies Ordinance). (d) To include in his report any instances where: (i) proper books of account had not been kept; (S.141(4) of the Companies Ordinance) (ii) proper returns had not been received; (S.141(4) of the Companies Ordinance) (iii) the accounts were not in agreement with the books and returns; (S.141(4) of the Companies Ordinance) (iv) all required information and explanation have not been obtained in carrying out his audit; (S.141(6) of the Companies Ordinance) (v) any required information, such as directors’ remuneration and loans to officers, has been omitted from the accounts. (S.161(8) and S.161B(6) of the Companies Ordinance) (e) To complete the formalities ( 正式手續 ) of vacation of office as described in Section 6 in this chapter.

7.3 Test your understanding 4

N1-11 S.141(a) of the Companies Ordinance states that it is a statutory duty for auditors of a company incorporated under the Companies Ordinance to make a report to the members of the company on the company’s annual financial statements.

Apart form the statutory duty under S.141(1) of the Companies Ordinance, there are two other duties for auditors under S.141(3) and S.141(4) of the Companies Ordinance. S.141(3) of the Companies Ordinance is about the auditors’ report on the financial statements and S.141(4) of the Companies Ordinance is about books and records.

The auditors are required to state whether the financial statements have been properly prepared in accordance with the provisions of Companies Ordinance.

There are several provisions in the Companies Ordinance which empower the auditors with adequate rights for them to exercise and to carry out their duties. In addition, there are several provisions in the Companies Ordinance relating to the rights of auditors upon resignation.

Required: (a) State the other two duties under S.141(3) and S.141(4) of the Companies Ordinance. (5 marks) (b) State the rights of auditors given under the Companies Ordinance that can empower the auditors to carry out their duties of reporting to the members on the financial statements (4 marks) (c) State the rights of auditors given under the Companies Ordinance upon resignation. (4 marks) (Adapted HKAAT Paper 8 Auditing June 1999)