Purpose and scope of an audit - Nature of an audit

Learning Outcomes

After reading this article, you will be able to explain the nature and purpose of an audit, describe the roles and responsibilities of auditors and directors, and outline the concept of independent examination and its significance. You will also distinguish key elements like reasonable assurance, professional judgement, and the meaning of a true and fair view, all within the ACCA FAU exam context.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand the key concepts supporting external audits. This article covers:

• The purpose and scope of an audit
• The definition and essential features of an audit
• Reasons for independent examination of financial statements
• The term 'true and fair view' and its importance
• The concept of reasonable assurance in audits
• The agency relationship and need for accountability
• The role and responsibilities of the auditor compared to management
• Major advantages and disadvantages of an audit
• The impact of professional judgement and professional scepticism

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes an audit?
   1. The preparation of financial statements
   2. An independent examination of financial statements
   3. A guarantee against fraud
   4. The calculation of tax liabilities

2. True or false? An audit provides absolute assurance that financial statements are completely error-free.

3. Who holds primary responsibility for preparing company financial statements?
   1. Auditors
   2. Directors/management
   3. Shareholders
   4. Internal audit function

4. In company law, what does the term 'agency relationship' typically refer to?

Introduction

In any organisation, especially those with shareholders and directors, financial information must be trustworthy. Stakeholders such as owners, lenders, and the public rely on accounts to make informed decisions. However, since directors are responsible for the day-to-day running of a company and preparing the financial statements, but the owners (shareholders) are separate, an audit is necessary to provide confidence in this information.

An external audit is a structured, independent evaluation of the financial statements. Its main function is to provide an expert, credible opinion on whether the statements give a true and fair view of the entity's financial position, all while operating independently of those who prepare the accounts.

Key Term: audit
An independent examination of an entity’s financial statements, resulting in an opinion as to whether those statements give a true and fair view.

Purpose of an Audit and the Importance of Independence

The primary purpose of an audit is to bridge the information gap between those preparing financial statements (typically directors or managers) and those relying on them (usually shareholders and other stakeholders). This gap emerges due to the separation between ownership and management, known as the agency relationship.

Key Term: agency relationship
A relationship where owners (principals) delegate authority to managers or directors (agents) to run the business on their behalf.

• Accountability: Directors must be able to account for how they have run the business. The audit strengthens confidence by offering an impartial review.
• Independence: For this review to be reliable, auditors must have no significant interest in the entity.

Key Term: independence
The ability to act with objectivity and without bias, ensuring the audit opinion is trustworthy and unaffected by inappropriate influence.

Scope and Features of an Audit

Audits centre on the financial statements, focusing mainly on historical financial information prepared under the relevant accounting framework (such as IFRS or national standards). However, auditors are not responsible for preparing these statements—they express a professional opinion on them.

Key aspects of an audit:

• Examination of evidence supporting amounts and disclosures in the financial statements
• Assessment of the entity’s accounting policies and management’s judgements
• Evaluation of whether the statements comply with the chosen accounting standards
• Consideration of the effectiveness of internal controls only to the extent required to design appropriate audit procedures

The audit procedure is governed internationally by standards such as ISAs (International Standards on Auditing).

Key Term: reasonable assurance
A high, but not absolute, level of assurance that the financial statements are free from material misstatement.

Key Term: true and fair view
A judgement that financial statements are not misleading, are prepared according to relevant standards, and fairly present the entity’s financial performance and position.

What an Audit Provides—And What It Does Not

The output of an audit is the auditor’s report, usually addressed to the shareholders. The report contains the auditor’s opinion on whether the financial statements:

• Present a true and fair view (or are fairly presented in all material respects)
• Comply with the relevant financial reporting framework

Worked Example 1.1

A group of shareholders suspects that directors have overstated profits to justify increased bonuses. How does the audit help in such a situation?

Answer:
The audit, performed independently, examines the evidence supporting the profit figure. If the auditors conclude that the financial statements are free from material misstatement, they issue an unmodified (clean) opinion. This independent verification provides reassurance to shareholders that the profits have not been manipulated and the figures can be trusted.

Advantages and Disadvantages of an External Audit

Advantages:

• Increases the reliability of financial statements for users
• Helps resolve disputes between stakeholders with independent evidence
• Aids in securing finance, as lenders often prefer audited accounts
• May highlight weaknesses in systems or errors that management can address

Disadvantages:

• Involves additional costs (audit fees)
• Can disrupt management and staff during preparation
• May be less valuable where ownership and management are the same (e.g., sole traders)
• Does not guarantee detection of all fraud or every error, nor offer absolute assurance

Exam Warning

A common error is to assume an audit gives a guarantee. Audits only provide reasonable (not absolute) assurance and are subject to unavoidable limitations such as sampling, subjective judgements, and inherent limitations of internal controls.

Professional Judgement and 'True and Fair'

Many aspects of auditing require the auditor to use professional judgement—especially when interpreting whether the financial statements are 'true and fair'. No strict definition of 'true and fair' exists—auditors evaluate if the accounts give a correct overall picture, considering both quantitative information and qualitative aspects (such as disclosures).

Key Term: professional judgement
The application of relevant knowledge, training, and experience to make informed decisions during the audit.

Summary

An audit provides an independent review of financial statements to improve their credibility, primarily benefitting stakeholders separated from management. The auditor, acting independently, reports whether the accounts present a true and fair view, using reasonable assurance rather than guaranteeing perfection. Through professional judgement, auditors deal with both factual and subjective elements in financial reporting.

Key Point Checklist

This article has covered the following key knowledge points:

• The definition, purpose, and scope of an audit
• The significance of independence and objectivity in auditing
• The agency relationship and its link to the need for audit
• Key concepts: true and fair view, and reasonable assurance
• Major benefits and limitations of an external audit
• The distinction between directors' and auditors' responsibilities
• The role of professional judgement in auditing

Key Terms and Concepts

• audit
• agency relationship
• independence
• reasonable assurance
• true and fair view
• professional judgement