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Chapter 3: The theory of auditing

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Aim of the chapterThe aim of this chapter is to provoke thoughts about the general principles and concepts behind the practical procedures that we will study in depth later on.

Learning objectivesBy the end of this chapter and having completed the essential reading and activities, you should be able to:

understand what constitutes a theory

understand the difference between assumptions and concepts

appreciate the role a theory of auditing could perform

know the main components of a possible theory of auditing.

Essential readingGray and Manson, Chapter 2 ‘An overview of the postulates and concepts of

auditing’, pp.28–55.Porter et al., Chapter 3 ‘A framework of auditing concepts’, pp.61–100.

Further readingFlint, D. Philosophy and principles of auditing. (Basingstoke: Macmillan, 1988)

[ISBN 9780333311165].

Works citedLee, T. Company auditing. (Wokingham: Van Nostrand Reinhold, 1986) third

edition [ISBN 9780412437201].Lee, T. Corporate audit theory. (London: Chapman and Hall, 1993)

[ISBN 9780412452200].Mautz, R.K. and H.A. Sharaf The philosophy of auditing. (Sarasota, Fla.:

American Accounting Association, 1961) [ISBN 0865390029].Woolf, E. Auditing today. (London: Pearson Education, 1997) sixth edition

[ISBN 9780135894668].

IntroductionFor many years, the study and practice of auditing centred on the pure mechanics of conducting an audit, concentrating on how to perform an audit. However, as it became more of an established profession and, more recently, accepted as an academic discipline, so more attention was focused on the theoretical and conceptual underpinnings of the practice. Thus, questions were explicitly raised about why certain procedures were carried out.

The first attempt (and some say the best) came from American academics, Mautz and Sharaf, who in 1961 published The philosophy of auditing. This was an important development as it helped gain some measure of academic acceptance for auditing. Mautz and Sharaf drew from established fields of study such as philosophy, the sciences and law in producing a theory which helped to explain much of the accepted practice

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93 Auditing and assurance

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in auditing. Their theory also helped to highlight areas of practice that did not stand up to critical review, notwithstanding that such areas were generally accepted.

In the UK more than 10 years later, a Scottish academic, Professor Tom Lee, built on and adapted the work of Mautz and Sharaf to produce his own ‘theory’ in Company auditing. This book was refined and polished into a third edition (last published in 1986). Sadly, Lee’s later book – Corporate audit theory (1993) – is aimed at the American market and much of the easy accessibility of the earlier versions has been lost.

Another Scot, Professor David Flint, has written Philosophy and principles of auditing, building on both Mautz and Sharaf and Lee. The accounting establishment has shown little interest in, or enthusiasm for, pursuing theoretical lines of enquiry. This is in contrast to the financial reporting field where over the years millions of dollars have been invested in seeking what some have called the holy grail of accounting – a conceptual framework. These endeavours have produced a Framework for the Preparation and Presentation of Financial Statements published by the International Accounting Standards Board (IASB), and similar statements by national standard-setters, such as the Statement of Principles by the Accounting Standards Board (ASB) of the UK. It is interesting to debate why the effort has been made to formulate theories about accounting but not about auditing, the process which renders accounting statements valuable; however, that is beyond the range of our studies at present.

Pause and think

What is a theory?

What purpose would be served by having a theory of auditing?

The role of theoryThe dictionary definition of a theory is:

a supposition put forward to explain something; an exposition of the general principles of an art or a science as distinct from the practice and execution of it.

So an auditing theory, if one could be developed, would explain practice and put forward general principles. If we had general principles we could use these to develop practices and to adapt to new challenges and situations that might arise. Without principles, procedures may evolve in an ad hoc manner, with no cohesion or internal consistency.

If a theory could be developed, it could help to explain practice, could highlight deficiencies and inconsistencies in existing practice and could guide audit policy-makers and regulators in their governing of the audit profession. It could also help teachers of auditing to explain the practice of auditing to their students, who in turn could gain a better understanding of their subject. Without a theoretical basis, auditing would be the application of a series of procedures, more akin to the practice of a trade, rather than a profession.

Now read

Porter et.al., pp.62–5.

Gray and Manson, pp.29–32.

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Assumptions of auditingAssumptions (theoreticians sometimes call them postulates) are the foundations of theory. Think back to your early studies of economic theories which only ‘work’ if you make certain assumptions (for example, the model for perfect competition assumes that consumers aim to maximise utility and producers aim to maximise profits). If these assumptions do not hold, the model fails. Let us now consider Flint’s seven assumptions.

Assumption 1: There is a need for an auditThe need for an audit can arise for a number of different reasons, including:

a relationship of accountability between two or more parties (i.e. that one party owes a duty of acceptable conduct to another); an ‘imposed audit’ (for example, companies, government, charities)

a need by some party to establish the reliability and credibility of information for which they are responsible and which will be used by another party; a ‘voluntary audit’ (for example, partnerships, companies who engage environmental auditors, newspapers that have their circulation figures audited)

public interest in the proper and adequate performance of some party; a ‘public interest audit’ (for example, academic audits designed to test the robustness of the systems employed by educational establishments in delivering services to their students).

Pause and think

Think of other examples in each of the above three possible categories.

Assumption 2: The subject matter is too remote, too complex or too important to accept without an audit

Remoteness: those relying on information may not physically be able to check the validity of the information themselves, perhaps because they are remote from the company.

Complexity: the nature of the subject is so complex that it requires special expertise to investigate and check. For example, most ordinary shareholders do not possess sufficient accounting knowledge and skills to be able to conduct the audit themselves.

Significance: the matter under audit has such economic significance that an audit is required to lend it credibility. Note in contrast that unincorporated entities are often not required to have an audit, because lenders have recourse to the assets of the owners in the event that the business entity cannot meet its liabilities.

Pause and think

Do you think that it would be possible for ordinary shareholders with no accounting or auditing qualifications to perform tests on the information in the financial statements themselves?

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Assumption 3: An audit must be conducted with independence and without constraints either over conduct or in reporting findings

If an audit is to add credibility then it must be done independently, without bias or prejudice. A prime example is that of state auditors, who since the time of Aristotle have had to be independent of the government which they are auditing. In the words of Emile Woolf, for many years a leading authority on auditing matters: ‘The auditor who has lost his independence has lost his raison d’être; he has become ‘dependent’, and a dependent auditor is a contradiction in terms’ (Woolf, 1997, p. 349).1

Pause and think

What sort of situations might lead to a loss of auditor independence?

Assumption 4: The subject matter of an audit can be verified by collection of evidence

Auditors report the results of their investigations. Without evidence they have nothing on which to base their report, to make judgments or criticisms. An audit is impossible if evidence is not available or cannot be obtained. In practice, audit evidence comes from many sources. It varies in its persuasiveness depending on quantity collected and quality (source).

Pause and think

What sorts of evidence might be available for, say, sales and expenses?

Assumption 5: Standards of accountability, performance, etc., can be set and actual performance can be measured against these standards

Parties to an accountability relationship must agree on what is acceptable performance. Without this, auditors have nothing to go by. They cannot set their own standards since these may be rejected by either party. In company auditing some of these standards have been set down (by statute or by professional guidance), but grey areas still remain. What constitutes a ‘true and fair view’? What should auditors do when they discover a client has committed an illegal act?

Pause and think

Is the giving of a bribe wrong when it is the only way for the company to get business in some parts of the world?

Assumption 6: The purpose of the audit is sufficiently clear that its results can be communicated clearly

The purpose of an audit is to add value to information. If the nature or purpose of the information itself is not clear, it cannot be audited. If the audit findings cannot be communicated effectively then inevitably the value of the audit will be diminished.

Pause and think

Do you think that the purpose of the company audit is well understood? What sort of misunderstandings might arise?

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Assumption 7: An audit produces an economic or social benefitSince audit is a social control mechanism it should only be undertaken if the benefits outweigh the costs. Auditors are expected to provide the benefit at minimum cost. In most audit situations the major part of the work involves the collection of evidence. While a minimum level of confidence must be achieved, absolute certainty is unattainable. There is a point at which the marginal benefit of obtaining additional evidence is exceeded by the marginal cost. The direct costs of auditing are known but the benefits are not so easily measured.

Pause and think

Do you think that auditing company accounts is worth the billions in fees that companies pay globally every year?

Auditing conceptsA concept is an abstract notion or idea. The role of concepts is to create a better understanding of the subject. Concepts form the basis for developing general working principles and practices by which theories are articulated and put into operation.

These concepts, or general ideas, can be grouped into four categories, according to whether they relate to the auditor’s credibility, the audit process, the communication of the audit outcome (reporting), or the performance of the auditor’s work. These general ideas form the basis of the next four chapters. They are reporting, independence, evidence and responsibility.

Now read

Porter et.al., pp.65–98.

Gray and Manson, pp.32–46.

Recognition of theoretical issues in practiceThere is no generally agreed theory or conceptual framework for auditing. The only explicit reference to general ideas on the values behind the audit process that can be found in official documents in the UK is in the form of a one-page list of desirable qualities, The Auditors’ Code. The Code sets out nine fundamental principles of independent auditing, as follows.

Accountability

Auditors act in the interests of primary stakeholders, while having regard to the wider public interest. The identity of primary stakeholders is determined by reference to the statute or agreement requiring an audit: in the case of companies, the primary stakeholder is the general body of shareholders.

Integrity

Auditors act with integrity, fulfilling their responsibilities with honesty, fairness and truthfulness. Confidential information obtained in the course of the audit is disclosed only when required in the public interest, or by operation of law.

Objectivity and independence

Auditors are objective. They express opinions independently of the entity and its directors.


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Competence

Auditors act with professional skill, derived from their qualification, training and practical experience. This demands an understanding of financial reporting and business issues, together with expertise in accumulating and assessing the evidence necessary to form an opinion.

Rigour

Auditors approach their work with thoroughness and with an attitude of professional scepticism. They assess critically the information and explanations obtained in the course of their work and such additional evidence as they consider necessary for the purposes of their audit.

Judgment

Auditors apply professional judgment, taking account of materiality in the context of the matters on which they are reporting. (See Chapter 7 of this guide for further discussion of materiality.)

Clear communication

Auditors’ reports contain clear expressions of opinion and set out information necessary for a proper understanding of that opinion.

Association

Auditors allow their reports to be included in documents containing other information only if they consider that the additional information is not in conflict with the matters covered by their report and they have no cause to believe it to be misleading.

Providing value

Auditors add to the reliability and quality of financial reporting; they provide to directors and officers constructive observations arising from the audit process; and thereby contribute to the effective operation of business, capital markets and the public sector.

Activity

Read the commentary to the Code in Gray and Manson, Table 1.2 ‘The Auditor’s Code’, on pp.23–4.

You will note that the word ‘should’ does not appear at all in the Code. This is because it is felt that instructions on what auditors should, and should not, do can only be given in auditing standards.

A reminder of your learning outcomesBy the end of this chapter and having completed the Essential reading and Activities, you should be able to:

understand what constitutes a theory

understand the difference between assumptions and concepts

appreciate the role a theory of auditing could perform

know the main components of a possible theory of auditing.

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Sample examination questionsExplain what you would consider to be the main components that a theory of auditing would include.

Consider the benefits of having a sound theoretical basis from which to develop auditing standards.

The IASB has issued its Framework for the Presentation of Financial Statements and the ASB has issued a Statement of Principles for financial reporting. To what extent do you think it would be possible to produce a ‘statement of principles’ for auditing?

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