Factors Affecting The Reliability Of Audit Report Accounting Essay

Factors Affecting The Reliability Of Audit Report Accounting Essay Introduction The end of an independent audit closed with a written audit report. According to section 205 of the Companies Act 2001, the auditors shall make a report to the shareholders on the audited financial statement (FS). The objective of an audit is to render an opinion about the fairness of the clients financial statement. Audit report contains information value for users. Durendez Gà ³mez-Guillamà ³n (2003) states that audit report is found as an important element for making loan decision. Basically the audit report conveys whether the assertions made by management are credible or not. Types of audit report. Unmodified report According to ISA 700, an unmodified report should be issued when the auditors conclude that the FS are prepared, in all material respects, in accordance with the applicable financial reporting framework. Modified report. However if the auditors found that the FS are not free from material misstatement based on the evidence obtained or is unable to obtain sufficient appropriate evidence to make a conclusion, the auditors should issue a modified report in accordance with ISA 705. All qualification may arise from either disagreement or uncertainty in the scope of the audit. Uncertainty Uncertainty may arise from, firstly a constraint during the audit work i.e. not all records are made available to the auditors, the auditors have appointed after the inventory counts. Secondly, inability to gather evidence concerning a doubt for e.g. an accounting record that have been destroyed or lost or the directors are concealing information. Disagreements Disagreement is due from factual discrepancies, unsuitable accounting policies, inadequate or misleading disclosure or failure to comply with an accounting standard or legislation. Sometimes it can be resolved with the client depending on the fact. Furthermore it is important to calculate the effect of these circumstances and this could be grouped as: Having a material but not pervasive effect on the FS. Having a pervasive (fundamental) effect on the FS. Except for opinion. An except for opinion is given when the effect is material but not pervasive uncertainty or disagreement. An example of an uncertainty could be the part destruction of accounting record and disagreement could be the inappropriate application of depreciation policy to a particular class of fixed assets. Adverse opinion. An adverse opinion is given when the matter concerned is a fundamental disagreement such as failure by the client to recognize a provision which would convert a profit into loss. Disclaimer opinion. A disclaimer opinion is given in the presence of multiple fundamental uncertainties and it is impossible for the auditors to form an opinion. Factors affecting the reliability of audit report. Failure by auditors to issue a reliable audit report can arise from two main causes. Auditors may identify a material misstatement and fail to report it i.e. the auditors lack independence. Auditors may fail to detect an existing error or fraud in the financial statement. Lack of auditors independence Principles of auditors independence Independence is the main means by which the auditor demonstrates that he can perform his task in an objective manner (FEE 1995). Independence is fundamental to the reliability of auditors reports and an indispensable component for the auditing profession. Independence has been described as a position to take an unbiased view point in the performance of audit test, analysis of results and attestation in the audit report (Appah 2008). It simply means the auditors ability to express an honest and impartial conclusion and also the ability of reporting reality to users. In addition, independence also means the ability to resist managerial pressures that impair or are perceived to impair an auditors willingness to carry his work objectively and honestly. Without independence the auditors opinion is suspicious and the audit is considered to be worthless. If the auditors failed to maintain independence in their work, this can affect the reliability of audit report to the sense that the auditors may have discovered material misstatement during the audit test and may deliberately ignore it and issue an unmodified opinion. Independence: in fact and appearance Subject to Mautz and Sharaf (1964) there are two aspects of independence: Independence in fact (real independence) and independence in appearance (perceived independence). These two concepts are essential in maintaining independence. Real independence refers to the actual state of mind of the auditor. An auditor possessing the requisite state of mind will always react in the correct way as he has the ability to make independent audit decision in any compromising situation. More importantly, auditors should not only be independent in fact, but they should appear as independent in order to acquire the public trust on the auditors opinion. Auditors are expected to be seen as independent while examining the clients FS and collecting audit evidence which support their opinion (Stevenson 2002). Precisely, auditors are supposed to be independent while deciding on reporting strategies without any pressures from their clients management (Cullinan, 2004). Church and Zhang (2002) argue that independence in fact ensures the reliability of audited financial statements and independence in appearance helps to promote public confidence which will automatically increas e the trust of the users on audited FS. Factors affecting auditors independence Size of Audit Firm Various studies have proven that larger audit firms are more able to resist managerial pressures i.e. higher auditors independence (Gul 1989, Abu Bakar et al. 2005, Alleyne et al. 2006). Small audit firms may impair independence because they have a tendency to provide a more personalized service to their audit clients which will ultimately develop a close relationship between them (Shockley 1981). Since big firms have many clients, they are not affected by their clients fees so they have less incentive to report favorably to their clients. Moreover, DeAngelo (1981) reported that large audit firms are more likely to issue reliable report since they fear of losing their reputation if they are found to be associated with accounting scandals. However there is no assurance that larger firms are more able to resist pressures from their clients as pointed by Goldman Barlev (1974) due to the fact of the case which happened with Arthur Andersen and Enron. Level of Competition in the Audit Services Market Competition within the audit market is a major factor affecting auditors independence (Sucher and Bychkova 2001; Umar and Anandarajan 2004; MacLullich and Sucher 2005). High level competition compel the auditors to tolerate managerial pressures and ignore any material misstatement detected during the audit test and issue incorrect report as they fear of losing the clients due to the fact that the same services are easily available elsewhere. However, Gul (1989) argued that the level of competition do not cause auditors to be less independent. The existence of competition create a fear in the mind of the auditors as this same services are easily available in the market so they will strive to create a good image of themselves and increase their independency in order to maintain their clients and attract new ones. Tenure of an Audit Firm Serving the Needs of a Given Client An audit firms tenure is the length of time it has served the audit needs of a particular client. Most researchers have viewed tenure as a factor which affects the auditors independence negatively (Abu Bakar et al., 2005; Alleynes et al., 2006). Tenure may result into friendship with the audit client and make the auditor to ignore imperfections that have a significant material impact on the FS (Moore et al. 2006). Mautz Sharaf (1961) emphasized that a long tenure creates complacency, lack of innovation, less rigorous audit procedures and a learned confidence between the audit firm and the clients. It may happen that the audit client has changed the business activities but the auditors are still using the same old audit procedures. Ongoing relations make the auditors to rely upon last years auditing and prevent them from making new evaluation of the control system, thus affecting the reliability of audit report. Size of Audit Fees Received by Audit Firm (in relation to total percentage of audit revenue) Large size of audit fees caused a higher risk of losing auditors independence. The IFACs Code of Ethics for Professional Accountants (1996, para 8.7) suggest that client size (measured from size of fees) could raise doubts as to independence. Since audit firms depend on fees for their survival, a step such as qualifying the audit report could be ignored so as not to displease the client and also for the fear of losing income. It is exclusively relevant if the audit firm receive a major proportion of its fee revenue from a particular client. Conversely Pany Reckers (1983) argued that the large size of the clients audit fee (measured as a percentage of office revenues to the audit firm) do not show any significant impacts on AI but it inclined the public to be less confidence in the auditors independence. Non-audit services (NAS) The provision of NAS such as book-keeping and financial statement preparation services, internal audit services, taxation and legal services to audit client is regarded as a potential factor which affects auditors independence drastically. Wines (1994) found out that auditors receiving NAS fees are less likely to qualify their opinion than auditors that dont receive such fees. The NAS fees make auditors financially dependent on their clients and less willing to restraint managerial pressure for the fear of losing their business. Brandon et al (2004) found that auditors would not perform their audit services objectively and joint provision would impair perceived independence. Joint provisions help the auditors to be in a better position in concealing any material facts since they will the same person who will prepare the FS and the same one who will perform the audit. Moreover as the level of clients pressures increased, the auditors became less concerned on the quality of internal co ntrol system (Muhamad and Karbhari, 2006), thus affecting the quality of audit report since these internal deficiencies will remain concealed. Failure by auditors to detect material misstatement in the financial statement. The second factors affecting the reliability of audit report is failure by auditors to detect an existing fraud or error in the FS. Very often, when material misstatement is discovered, the board members are surprised by the occurrence and even more surprised by the fact that the auditors did not detect it. Failure by auditors to detect an existing fraud or error during the audit is costly to their firms because they suffer damages for giving an incorrect audit opinion and at the same time affect the audit quality. Material misstatement has increased considerably over the recent years and professionals believe this trend is likely to continue. ISA 240 The Auditors Responsibilities relating to Fraud in an Audit of Financial Statement states that misstatements in the FS can arise from either fraud or error. Error is an unintentional misstatement in FS, compromising the omission of an amount or a disclosure, such as a mistake in gathering or processing data, an incorrect accounting estimate and a mistake in the application of accounting principles. The ISA 240 refers fraud as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Aderibigbe and Dada (2007) define fraud as a deliberate deceit planned and executed with the intent to deprive another person of his property or rights directly or indirectly, regardless of whether the perpetrator benefits from his/her actions. According to ISA 240, there are two types of fraud namely: misstatements resulting from fraudulent financial reporting (management fraud) and misstatements resulting from misappropriation of assets (employee fraud) Fraudulent financial reporting (FFR) involves intentional misstatements or omissions of amounts or disclosures in FS to deceive FS users. Some types of FFR include manipulation, falsification or alteration of accounting records, misrepresentation or intentional omission of events, transactions or other significant information and intentional misapplication of accounting principles relating to measurement, recognition, classification, presentation or disclosure. Misappropriation of assets involves the theft of an entitys assets such as embezzling receipts, stealing physical or intangible assets and making the organization to pay for goods and services not received. Such acts are often accompanied by false or misleading records or documents in order to conceal the fact. Responsibilities of the auditors Various studies that have been conducted in different countries showed that many users perceived that it is the responsibility of the auditors to detect irregularities (Leung and Chau. 2001 in Hong Kong; Dixon et al (2006) in Egypt; Fadzly and Ahmad. 2004 in Malaysia). Since the fall of Enron, Boynton et al (2005) argue that auditing standards have been revised to re consider the auditors responsibilities regarding fraud. Moreover ISA 315 requires the auditors to evaluate the effectiveness of the clients internal control system in detecting or preventing material misstatement occurring. Boynton et al (2005) emphasized that this condition was not previously needed, such an evaluation was only required if the auditors chose to rely on the internal control system in attempt to lessen the extent of the audit procedures. All staff members are required to communicate their result in order to combine the minor irregularities detected by each of them and required to consider the incentives and opportunities existed in the organization that induce the occurrence of fraud. An auditor who is conducting an audit in accordance with ISAs should obtain reasonable assurance that the FS taken as a whole are free from material misstatement whether from error and fraud. But an auditor cannot provide absolute assurance that the FS are free from material misstatement since some material misstatements of the FS may not be detected, even though the audit is properly planned and performed in accordance with the ISAs. Furthermore frauds are more difficult to detect than errors since the former involve the use of sophisticated and well organized plan to conceal them. It should be noted that management fraud is more difficult to detect than employee fraud as management is often found on the higher position and is more able to directly or indirectly manipulate figures. Such attempts may be even more difficult to detect if they are accompanied with collusion because collusion may cause the auditor to believe that audit evidence is persuasive when in fact, it is false. It is worth to note that the ultimate responsibility in relation to fraud detection and prevention rest with those charged with the governance of the entity and management. It is their responsibility to implement appropriate internal control systems to prevent fraud in their companies. Factors affecting the ability of auditors to detect material misstatement. Poor audit planning Planning is critical to the effectiveness and efficiency of an audit engagement (Mock Wright, 1992). It can be concluded that information obtained in the planning stage have an impact on the subsequent audit procedures and the audit evidence to be evaluated (Joyce, 1976). The planning stage consists of materiality assessments, risk assessments and decision on the kind of evidence to be collected. If the initial risk assessment is wrong, the planned audit procedures may be incorrect or insufficient, thus reducing the reliability of the FS and increase the auditors exposure to lawsuit and unfavorable outcomes (Palmrose 1987). If the auditors fail to assess risk, a material error could arises in the raw data of an account balance (inherent risk (IR)), passes through the internal control system of the entity undetected (control risk (CR)) and escapes detection by the auditors tests and procedures (detection risk (DR)). The risk assessment stage is vital as it enables the auditors to identify areas where there is a high probation of material misstatement, plan audit work that address those errors and minimize the chance of giving an incorrect audit opinion. The risk assessment comprises of three important elements namely IR, CR and DR. If any of these three elements are wrongly assessed, it affects the subsequent procedures and many misstatements would go undetected. IR is important as it identifies risks which are inherent within the industry. CR enable auditors to assess whether the clients internal control system can identify or prevent any material misstatement occurring. The assessment of inherent and c ontrol risk will have an impact on detection risk as they will determine the extent of audit procedures. Furthermore, if the auditors fail to determine materiality level, this can cause many material misstatements or omissions go undetected. IASB defined materiality as information is material if its omission or misstatement could influence the economic decision of users taken on the basis of the financial statement. Determining materiality is a matter of professional judgment. It can be concluded that both materiality and risk assessment contribute to determine the nature, extent and timing of audit procedures. Inexperienced Auditors Although a successful audit depends on a good planning stage, the ultimate success depends on the auditors experience to conduct the audit. Experienced auditors have the appropriate and adequate skills required in order to achieve audit objectives to the satisfaction of the client. Very often, auditors fail to detect material misstatement despite having assessing a high initial risk assessment, the reason behind this failure is that they lack the required skill to perform the audit while simultaneously identifying relevant risk factor. Experienced auditors is regarded as an valuable asset to the audit firm since they have more practice and feedback on the types of material misstatement that could be existed in the FS and its rate of occurrence (Libby and Frederick, 1990), thus increasing the likelihood of detecting potential fraud more easily. Bedard and Graham (2002) concluded that auditors with more experience with a particular client industry have more ability to identify risk factors than auditors with little or no experience with that industry. Furthermore, Moeckel (1991) found that experienced auditors search for more evidence than less experienced auditors. It simply means that experienced auditor do not only rely upon the evidence produced by the client but they look for further relevant and reliable evidence outside the entity before reaching an opinion, thus increasing the chance of detecting irregularities. Libby and Trotman (1993) found that senior auditors have the ability to recognize evidences which are inconsistent with their judgment. Time budget Time budget is considered as a major problem faced by almost auditors. Time budget pressures affect the quality of an audit as it prevents the auditors from allocating adequate number of time to complete specified audit procedures (Margheim, Kelley Pattison, 2005) and limits auditors ability to expand the extent of audit test (Asare et al. 2000), thus affecting the ability of auditors to detect material misstatement in the FS. It is worth to note that when attainment of budget is considered as a major factor in performance evaluation, auditors are more likely to engage in dysfunctional behaviors such as reduction of follow-up procedures, underreporting of time, and overriding auditing procedures in the work program (Azad 1994). Time pressures create a stressful working environment among the audit team which is likely to affect the ability of auditors to detect material misstatement since the auditors tend to behave unprofessionally. This includes behavior such as superficial examination of documents, acceptance of weak explanations by the client, reduction of work on an audit step below acceptable levels. E.Cook and Kelley (1988) survey results showed that auditors are more likely to engage in reduced audit quality practices in order to attain the time set by the firms. It simply means as time budget pressure increased, the auditors performance decreased significantly (McDaniel, 1990). However, time budget make auditors work harder and charge all time properly (Kelley and Seiler1982, Cook and Kelley 1991, Otley and Pierce 1996a). Moreover time budget is likely to enhance audit judgment by encouraging auditors to emphasis more on relevant information thus preventing them from being influenced by irrelevant information (Glover 1997). Sampling error According to ISA 530 Audit Sampling and Other Sampling Testing Procedures, audit sampling involves the application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population. Every audit involves the use of sampling since it is costly for the auditors to examine 100% of all the transactions that took place during a period. The auditors use some form of audit sampling to test the internal control system, help them to reach a conclusion about whether or not material misstatement exist. But sampling always involves some risk, i.e. the auditors might not look at enough items or the sample result might not be representatives. This can have a drastic effect since the auditors might reach an incorrect conclusion. Sampling risk could occur in both test of control and substantive procedures. In test of control, there is the risk of assessing control risk too high or too low.  Ã‚  Assessing control risk too high result into audit inefficiency and assessing control risk too low makes the auditor rely on ineffective control procedures which increases detection risk. In substantive procedures, there is the risk of incorrect acceptance and risk of incorrect rejection. Incorrect acceptance is the risk that the conclusion drawn from the audit sample is that the account balance is not materially misstated, when in fact it is materially misstated. Incorrect rejection is the risk that the conclusion drawn from the audit sample is that the account balance is materially misstates, when in reality it is not. Inadequate audit fees There is limited empirical evidence on the linkage between low audit fees and audit quality. However we can say that audit fees have an impact in the performance of auditors. Numerous Accountancy members have noted that low fees are associated with inadequate audit work. For example, an auditor might use his judgment to the client rather than devote additional time to investigating an audit issue and search for reliable evidence. This would likely to make the auditors to fail in identifying a material misstatement in the FS and issue an incorrect opinion. It can be asserted that when audit fees are abnormally low, the concern is poor audit quality as the auditor might attempt to cut back on effort to design an appropriate audit procedure that fully identify and address material misstatement. Furthermore it can be concluded that if audit fees are low relative to the size of audit client and audit client complexity, this can cause a serious problem since the auditors would be demotivated as more time and effort would be required to perform the external audit work and to reach an unbiased conclusion, thus making the auditors to skip a lot of important audit procedures. On the other hand, inadequate fees do not pose any concern when there is severe competition among audit firms since all audit firms will tend to tender low fees for their services in order to maintain its clients and to attract new ones.