Chapter 2: The rules and who sets them
Chapter learning objectives
Upon completion of this chapter you will be able to:
- Describe the regulatory environment within which statutory audits take place;
- Discuss the reasons and mechanisms for the regulation of auditors;
- Explain the statutory regulations governing the appointment, rights, removal and resignation of auditors;
- Explain the development and status of International Standards on Auditing;
- Explain the relationship between International Standards on Auditing and national standards (UK syllabus: between ISA's and the Auditing Practices Board).
1 The need for regulation
The role of the auditor has come under increased scrutiny over the last thirty years due to an increase in high profile, economically damaging fraud cases. The most high profile case, and the catalyst for regulatory change, was the collapse of Enron and its auditor Arthur Andersen.
In order to try and regain trust in the auditing profession national and international standard setters and regulators have tried to introduce three initiatives:
- harmonisation of auditing procedures, so that users of audit services are confident in the nature of audits being conducted around the world;
- a focus on audit quality, so that the expectations of users are met; and
- adherence to a strict ethical code of conduct, to try and improve the perception of auditors as independent, unbiased service providers.
In order to achieve this practitioners now have to follow three sets of regulatory guidance:
- The Code of Ethics;
- Auditing Standards (the basis of this text is International Standards on Auditing); and
- National corporate law.
Examples of national laws/guidance
- The Companies Act 2006 in the UK;
- The Sarbanes Oxley Act in the US (enforcing standards of corporate governance); and
- The Corporate Governance Code in the UK (formerly the Combined Code).
2 Setting auditing standards
The International Federation of Accountants (IFAC) is the global organisation for the accountancy profession.
More about IFAC
IFAC was formed in 1977 and is based in New York. IFAC has more than 160 member bodies of accountants (including the ACCA), representing 2.5 million accountants from over 120 separate countries.
IFAC's overall mission is to serve the public interest, strengthen the worldwide accountancy profession, and contribute to the development of strong international economies by establishing and promoting adherence to high-quality professional standards.
One of the subsidiary boards of IFAC is the International Audit and Assurance Standards Board (IAASB). It is their responsibility to develop and promote International Standards on Auditing (ISA's). There are currently 36 ISA's and one International Standard of Quality Control.
You do not need to learn the names or numbers of the auditing standards, but you will need to know and be able to apply the key principles and requirements of the standards.
The relationship between international and national standards and regulation
Because IFAC is simply a grouping of accountancy bodies, it has no legal standing in individual countries. Countries therefore need to have arrangements in place for:
- regulating the audit profession
- implementing auditing standards.
National regulatory bodies
National Regulatory bodies:
- enforce the implementation of auditing standards
- have disciplinary powers to enforce quality of audit work
- have rights to inspect audit files to monitor audit quality.
There are two possible schemes for regulation at the national level:
- self regulation by the audit/accountancy profession
- regulation by government or by some independent body set up by government for the purpose.
All audits carried out in EU member states are now carried out in accordance with ISAs.
Following the decision by the EU to implement ISAs for all accounting periods beginning on or after 1 January 2005, countries with their own standard setting bodies such as the UK had to decide whether to:
- modify their own standards to bring them into line with ISAs
- adopt ISAs and modify them to suit national requirements.
In the UK the national standard setter â€“ The Auditing Practices Board â€“ decided to adopt and modify ISAs.
National standard setters
- may set their own auditing standards
- may adopt and implement ISAs, possibly after modifying them to suit national needs.
3 The Law
Who needs an audit and why?
In most countries companies are generally required to carry out an audit, as it is a legal requirement. However, small or owner managed companies are often exempt (e.g. in UK, companies with annual turnover < â£6.5="">
The main reasons for exempting small companies are:
- for owner-managed companies, those receiving the audit report are those running the company (and hence preparing the accounts!)
- the advice/value which accountants can add to a small company is more likely to concern other services, such as accounting and tax, rather than audit and which may also give rise to a conflict of interest under the ethics rules
- the impact of misstatements in the accounts of small companies is unlikely to be material to the wider economy
- given the above points, the audit fee and related disruption are seen as too great a cost for any benefits the audit might bring.
However, these companies may choose to have an audit because of the benefits it can offer, namely:
- High quality, reliable information circulates the market (giving investors faith and improving the reputation of the market).
- Independent verification (management may value having their business scrutinised).
- Reduces the risk of management bias, fraud and error (by acting as a deterrent).
- Enhances the credibility of the information (especially for raising finance and for tax authorities).
- Deficiencies in the internal control system may be highlighted (in the management letter).
Who may act as auditor?
To be eligible to act as auditor, a person must be:
- A member of a Recognised Supervisory Body (RSB), e.g. ACCA and allowed by the rules of that body to be an auditor; or
- Someone directly authorised by the state.
Conducting audit work
Individuals who are authorised to conduct audit work may be:
- sole practitioners
- partners in a partnership
- members of an LLP
- directors of an audit company.
To be eligible to offer audit services, a firm must be:
- controlled by members of a suitably authorised supervisory body; or
- a firm directly authorised by the state.
NB: In some countries only individuals can be authorised to act as auditor and need to be directly authorised by the state.
Who may not act as auditor?
Excluded by law: The law in most countries excludes those involved with managing the company and those who have business or personal connections with them.
Excluded by law: UK example
For example, in the UK the following are excluded by company law:
- an officer (Director or secretary) of the company
- an employee of the company
- a business partner or employee of the above.
Excluded by the Code of Ethics: The IFAC and ACCA Code of Ethics require auditors to be and be seen to be independent and objective, and to consider whether it is appropriate to act as auditor given the impact of factors affecting their independence and objectivitiy. The Code of Ethics also requires the auditor to consider any other factors that would prevent them acting as auditor, such as competence or issues regarding confidentiality.
This is considered in more detail in a later chapter.
4 How are auditors appointed and removed?
Who appoints the auditor?
In most jurisdictions the members (shareholders) of the company appoint the auditor by voting them in at the Annual General Meeting (AGM). Directors can appoint the first auditor to fill a â€˜casual vacancy' this requires the members' approval at the next AGM, and in some countries the auditors may be appointed by the directors as a matter of course.
Auditors are appointed from one AGM until the end of the next one.
However, private companies can elect to dispense with the requirement for an AGM. In these circumstances the auditor is automatically reappointed unless a shareholder objects.
Removing the auditor
Arrangements for removing the auditor have to be structured in such a way that:
- the auditor has sufficiently secure tenure of office, to maintain independence of management
- incumbent auditors can be removed if there are doubts about their continuing abilities to carry out their duties effectively.
To enable this balance to be maintained, the removal of auditors can usually be achieved by a simple majority at a general meeting of the company. There are some safeguards, such as a specified notice period, to prevent the resolution to remove the auditors being â€˜sprung' on the meeting.
Resigning as auditor
In practice, if the auditors and management find it difficult to work together, the auditors will usually resign.
To prevent the circumstances of the resignation being hidden from the company's members, the auditors have to submit a statement of the circumstances surrounding their resignation.
If an auditor resigns or is removed from office before the end of their term of office, they must notify ACCA.
The auditor's responsibilities on appointment and removal
The details which follow about the appointment and removal of the auditors are taken from UK law and practice, but give an example of the way these things are usually handled.
- Obtain clearance from the client to write to the existing auditor (if denied, appointment should be declined).
- Write to the existing auditor asking if there are any reasons why the appointment should not be accepted
- Deposit at the company's registered office a statement of the circumstances connected with the removal/resignation or
- A statement that there are no such circumstances
- Deal promptly with requests for clearance from new auditors.
5 The auditor's rights
During the audit/continued appointment
- Access to the company's books and records.
- To receive information and explanations necessary for the audit.
- To receive notice of and attend any general meeting of members of the company.
- To be heard at such meetings on matters of concern to the auditor.
- To receive copies of any written resolutions of the company.
- To request an Extraordinary General Meeting (EGM) of the company to explain the circumstances of the resignation.
- To require the company to circulate the notice of circumstances relating to the resignation.
6 The auditor's duties
In accordance with ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing the auditor's fundamental objectives are to:
- obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error;
- express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
- report on the financial statements, and communicate as required by ISA's, in accordance with the auditor's findings.
UK Syllabus Focus
Regulation of Auditing
In line with the rest of the world the various accounting scandals, headed by Enron, signalled the end of self-regulation of auditing in the UK. The national auditing standard setter, the Auditing Practices Board (APB), was brought under the control of the Financial Reporting Council, who regulate all financial reporting matters in the UK. This coincided with the adoption of International Standards on Auditing in the UK.
The APB does still, however, supplement and revise ISA's before issuing them in the UK. On the whole this is to ensure that they remain compliant with national laws, such as the Companies Act 2006.
In addition to this the following changes were also implemented:
- Ethical Standards for Auditors were designed and implemented to facilitate the adoption of the Code of Ethics in the UK (see Ethics and Acceptance chapter for more detail). These are issued by the APB;
- An independent body, the Professional Oversight Board (POB), was established to oversee the operation of the accountancy and actuarial professions;
- An Audit Inspection Unit (AIU) was created to monitor the quality of the audits of public interest companies. This is controlled by the POB;
- An Accountancy Investigation and Disciplinary Board (AIDB) was established. Their aim is to ensure appropriate standards are maintained by members and member firms.
In accordance with the Companies Act 2006 those companies falling below the small company threshold are not required, in law, to have an annual audit. Although they may still choose to have one voluntarily.
The main criteria for small company status are:
- Turnover not exceeding Â£6.5mn;
- Gross assets not exceeding Â£3.26mn; and
- The number of employees must not exceed 50.
In order to qualify the company must meet two out of the three criteria.
Reporting by Exception
In the UK auditors take on additional reporting responsibilities. The matters are implicit in the opinion given, meaning that the auditor would only make a separate report if the matters have not been concluded satisfactorily. These matters are that:
- proper Returns have been received from all branches of the client;
- the financial statements Agree to underlying records;
- Proper accounting records have been maintained;
- all Information and explanations have been received;
- Information Disclosed alongside the financial statements is consistent; and
- Information about Directors benefits, if not disclosed in the financial statements in accordance with the law, is disclosed in the audit report.
Test your understanding 1
Auditors have various duties to perform in their role as auditors, for example, to assess the truth and fairness of the financial statements.
Explain THREE rights that enable auditors to carry out their duties.
Real exam question: December 2008
Test your understanding 2
(1)Who may act as auditor of a company?
(2)How long are auditors normally appointed for?
(3)Who may not act as the auditor of a company?
(4)Who may appoint the first auditors of a company?
(5)What action can the auditor require a company to take if they resign prior to completion of their term in office?
(Total: 10 marks)
7 Chapter summary
Test your understanding answers
Test your understanding 1
- Right of access to the company's books and records at any reasonable time to collect the evidence necessary to support the audit opinion.
- Right to require from the company's officers the information and explanations the auditor considers necessary to perform their duties as auditors.
- Right to receive notices of and attend meetings of the company in the same way as any member of the company.
- Right to speak at general meetings on any matter affecting the auditor or previous auditor.
- Where the company uses written resolutions, a right to receive a copy of those resolutions.
Test your understanding 2
Created at 5/24/2012 2:33 PM by System Account
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Last modified at 10/3/2012 12:45 PM by System Account
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