Factors Affecting The Reliability Of Audit Report Accounting Essay

Introduction

The final stage of an independent audit was concluded with the audit report being written. As per Section 205 under the Companies Act 2001, the auditors must present a report to shareholders about the financial statement that has been audited (FS). The aim of an audit is to give an opinion regarding the accuracy of the financial statement prepared by the client.

The audit report provides valuable information to users. Durendez Guillamon (2003) declares that audit reports are an important factor in making loans decisions. The audit report basically reveals whether the claims that management makes are true or not.

Audit report types.

Report that is not modified

As per ISA 700, an unmodified report is required “when auditors have concluded they believe that the FS is made, in all important aspects, in accordance with the relevant accounting framework for financial reports”.

Modified report.

If the auditors find that the FS isn’t free of significant errors Based on the evidence they have gathered or are unable to collect sufficient evidence to support an informed decision that the auditors are not able to make a conclusion, they should issue a revised report in conformity the requirements of ISA 705.

Every qualification can be due to any disagreement or doubt about the area or scope of the audit.

Uncertainty

Uncertainty can result from firstly, a limitation during the audit process i.e. that not every record is accessible to auditors. The auditors are appointed following the inventories are counted. In addition, the inability to collect evidence to support a suspicion, e.g. an accounting document that has been lost or destroyed, or directors have been hiding details.

Disagreements

Unanimity is caused by facts that are not in line, improper accounting practices, insufficient or inaccurate disclosure, or non-compliance with any accounting norm or law. Sometimes, the dispute can be resolved with the client, based on the facts.

Additionally, it is essential to assess the effects of these conditions and this could be classified as follows:

A material, but not a widespread effect on the FS.

A pervasive (fundamental) impact in the FS.

‘Except for’ opinion.

An ‘except for’ view is issued when the impact is substantial but not overwhelming doubt or disagreement. A good example of an uncertain situation could be the accounting record being destroyed and disagreement might be caused by the improper application of depreciation policies to a specific type of fixed asset.

‘Adverse’ opinion.

An adverse opinion is provided in the event of an issue of fundamental importance, such as the inability of the client to understand a clause that will convert a profit into a loss.

‘Disclaimer’ opinion.

A ‘disclaimer’ statement is issued in the face of much fundamental uncertainty, and it is not possible for auditors to formulate an opinion.

Factors that affect the credibility of audit reports.

Auditors’ failure to issue an accurate audit report could be due to two primary factors.

Auditors may spot a significant error and not reveal the error, i.e. the auditors are not independent.

Auditors may not be able to spot an error or fraud within the statement of financials.

Uncertainty of auditors’ independence

Principles of independence for auditors.

“Independence is the most important method to show that he is able to perform his work in an impartial way (FEE 1995)”.

Independence is the most important factor in the credibility of auditors’ audit reports. It is an essential element for the profession of auditing. It is defined as “an ability to present an impartial view on the auditing process, including the performance of tests evaluation, analysis of results, and attestation of an audit report (Appah 2008.)”. It is simply an auditor’s ability to make an impartial and honest conclusion, and also the capability of presenting the facts to those who use it. Additionally, independence is the ability to resist any managerial pressures that hinder or appear to hinder the auditor’s capacity to conduct his work in a fair and honest manner.

If the auditor’s opinions are not independent, it is suspect which is why the auditor’s report can be deemed as unreliable. If auditors fail to remain independent when they conducted their work, this could impact the validity of the audit reports to the extent that the auditors could have identified a significant error during the audit and then choose to disregard it and then issue the same opinion without modification.

Independence: factual and appearance

Subject to Mautz and Sharaf (1964) there are two aspects to independence:

In fact, independence (real freedom) and

In appearance, independence (perceived independence in appearance (perceived).

These two concepts are crucial to maintaining the auditor’s independence. The term “real independence” refers to the mental state of the auditor. An auditor with the required state of mind will act in a rational manner since he is able to make an independent audit decision in any situation that is threatening. In addition, auditors must not be only completely independent however, they must also appear impartial in order to gain public trust in the opinion of the auditor. Auditors are expected to appear as independent when they examine the clients’ financial statements and gather audit evidence that supports their opinions (Stevenson 2002). Auditors are required to be impartial when they decide on strategies for reporting, without demands from the management of their clients (Cullinan 2004). Church as well as Zhang (2002) claim that independence is the best way to ensure the credibility of financial statements that have been audited and the appearance of independence helps increase public confidence, which can increase the confidence of those who rely on audited FS.

Factors affecting auditors’ independence

Size of the Audit Company

Different studies have demonstrated that audit firms with larger sizes can better be able to resist pressures from management i.e. higher auditor’s independence (Gul 1989, Abu Bakar et al. 2005, Alleyne et al. 2006). Small audit firms could compromise their independence due to an incentive to provide more personal service to their clients, which eventually leads to an intimate relationship between the two (Shockley 1981). Because big companies have a lot of clients, they’re not subject to the client’s fees therefore they are less enticed to provide a positive report for their clientele. Additionally, DeAngelo (1981) reported that audit firms with large sizes tend to provide accurate reports because they are afraid of the loss of their reputations should they be involved in accounting scandals. There is no guarantee that larger companies are capable of restraining the pressures of their clients, as outlined by Goldman & Barlev (1974) because of the incident in the case of Arthur Andersen and Enron.

Competitiveness on the Audit Services Market

The market for audits is competitive and is one of the major factors that affect the independence of auditors (Sucher and Bychkova 2001 Umar And Anandarajan, 2004 MacLullich and Sucher 2005). A high degree of competition makes auditors abide by management pressures and not pay attention to any misstatements that are discovered in the audit and produce a false report due to the fact that they fear losing customers because the same services are accessible in other places. But, Gul (1989) argued that the degree of competition does not mean auditors will become less independent. The fact that competition exists creates fears in the minds of auditors because there is a service that is readily accessible in the marketplace, so they are able to build an image that represents themselves and boost their independence to keep their clients and gain new clients.

The Definitiveness of an audit firm that meets the requirements of a particular Client

The duration of an audit firm is the duration it has been serving the audit requirements of a specific client. The majority of researchers have considered the length of tenure as an aspect that can affect the independence of auditors in a negative way (Abu Bakar and co. 2005; Alleynes et al. (2006)). Tenure could lead to a relationship with the audit customer and cause the auditor to overlook any flaws that can have an effect on the FSA (Moore and co. 2006). Mautz & Sharaf (1961) highlighted that a long time in office can lead to complacency, absence of creativity and less rigorous auditing procedures, and a heightened sense of trust between the audit firm and its clients. It could be that the audit company has changed their business operations however, the auditors continue employing the same auditing methods. In the course of their work, the auditors are forced to rely on the previous year’s auditing and hinder them from making fresh evaluations on the system of control consequently affecting the accuracy of the audit reports.

The size of Audit Fees received by the Audit Firm (in relationship to the total percentage of the revenue from audits)

The large size of audit fees increased the chance of losing the auditor’s independence. “The The IFAC’s Code of Ethics for Professional Accountants (1996 Para 8.7) states that a client’s size (measured from the number of fees) may raise questions as to the independence of auditors”. Because audit firms rely on fees to sustain their existence A step like a process of certifying an audit report can be skipped in order not to disappoint the client, and as a result of losing revenue. It is only relevant when the audit company receives the bulk of its fee income from a specific client. However, Pany & Reckers (1983) claimed that the size of the audit fee paid by the client (measured in percentages of office revenues for the audit company) doesn’t have any significant impact on AI however it influenced people to have less confidence in the independence of the auditor.

Non-audit audit services (NAS)

The availability of NAS like book-keeping and the preparation of financial statements internal audit and taxation services, as well as legal assistance to audit clients, is thought to be an influence on auditors’ independence in a significant way. Wines (1994) discovered auditors who are paid NAS charges are more likely not to be able to validate their opinions than auditors who do not receive these fees. The NAS fees cause auditors to become financially dependent on their clients and less likely to manage pressure at risk of losing business. “Brandon and co. (2004) concluded auditors could not conduct their audits in a fair manner and joint provision could impede the perception of independence”. Joint provisions allow auditors to be more effective to conceal any significant information as they are the same person who will create their FS and the person who performs the audit. Furthermore, as the pressures from clients increased, auditors became less concerned about the quality of the internal control system (Muhamad and Karbhari 2006) and this impacted the audit report’s quality as the weaknesses within the system are not revealed.

Auditors’ failure to identify an error on the statement of financials.

The second factor that can affect the accuracy of audit reports is the failure of auditors to identify an error or fraud within the FS. Often, when material errors are discovered, board members are shocked by the incident and more shocked that auditors were unable to find the error. The inability of auditors to spot any existing fraud or error during an audit can be expensive for their companies as they can be held accountable for giving an incorrect audit report as well as influence the quality of the audit. The number of material misstatements has increased dramatically in recent years, and experts believe that this trend will remain the same.

The Auditor’s Responsibilities in ISA 240 regarding Fraud during the course of an Audit of Financial Statement stipulates that the FS may contain misstatements that may be due to errors or fraud.

The error can be a deliberate misstatement in FS that compromises the absence of an amount or disclosure, for example, the wrong way of gathering and processing information, an inaccurate estimate of the accounting value, or a mistake when applying accounting rules.

“The ISA 240 refers fraud as an intentional act committed by any or all of the individuals in management, people charged with the management of employees, or other third parties that involve the use of deceit to gain an unfair or unlawful advantage”. “Aderibigbe as well as Dada (2007) describe fraud as deliberate deceit that is planned and carried out in order to deprive someone else of their property or rights, either directly or indirectly whatever the person who commits the crime profited from the actions of his/her accomplices”.

According to ISA 244 the two types of fraud, namely:

false statements resulting from financial reporting fraud (management fraud) and

False statements that result from the misuse of assets (employee fraud)

“Fraudulent financial reportage (FFR) is the deliberate misstatement or omissions of figures or disclosures made in FS to fool FS customers”. The types of FFR that are common include manipulation, falsification, or alteration or alteration of records in the accounting system, false representation or deliberate omission of important significant events, transactions, or other information that is significant, as well as intentional misuse of accounting principles that relate to measurement and recognition, classification the presentation of information or.

Assets are misappropriated when there is taking of an organization’s assets, such as taking receipts and embezzling them, stealing physical or intangible assets, or requiring the entity to pay for the goods or services that were not purchased. These kinds of actions are usually associated with false or misleading documents or records in order to hide the truth.

Auditors’ responsibilities

Numerous studies conducted in different countries revealed that a majority of users believed that it is the duty of auditors to spot any irregularities (Leung and Chau. 2001 Hong Kong; Dixon et al (2006) in Egypt; Fadzly and Ahmad. 2004 Malaysia). Since the demise of Enron, Boynton et al (2005) assert that the auditing standards have been revised to reflect on auditing responsibilities of auditors in relation to fraud.

Additionally, ISA 315 requires the auditors to examine whether the internal control system for the detection or prevention of material misstatements that could occur. Boynton and co. (2005) stated the fact that this procedure was not required previously and that such an assessment was only required when the auditors chose to depend on internal controls in an effort to reduce the scope of the auditing process. Every employee is obliged to disclose their results to be able to aggregate the small irregularities discovered by them individually and must consider the motivations and opportunities within the company that lead to the commission of fraud.

An auditor conducting an audit according to the ISA’s guidelines should have an acceptable certainty that FS as a whole is free of material misstatements regardless of fraud or error. However, auditors cannot offer 100% assurance in ensuring that FS is free of errors in materiality since certain errors in the FS could not be identified even if the audit has been correctly planned and executed according to the ISAs.

In addition, frauds are more difficult to spot than mistakes since they are based on the use of a sophisticated and well-organized plan to cover them. It is worth noting that management fraud is much more difficult to spot than employee fraud because the management team is usually at the top of the ladder and has the ability to manipulate directly or indirectly figures. This kind of fraud could be harder to identify when they are associated with collusion since collusion could make the auditor believe that audit evidence is convincing but in reality, it’s not.

It is important to keep in mind that the final responsibility regarding the detection and prevention of fraud rests on those who are responsible for the oversight of the entity and the management. It is their duty to set up proper internal control systems that stop fraud within their organizations.

Factors that affect auditors’ abilities to identify materially incorrect statements.

Poor audit planning

Planning is crucial for the efficiency and effectiveness of auditing (Mock and Wright 1992). It is evident that information collected during the planning stage has an impact on subsequent audit procedures and audit evidence that is to be evaluated (Joyce 1976). The planning stage comprises the assessment of risk, materiality, and a decision about the type of evidence that will be collected.

If the risk assessment at the beginning is incorrect, the auditing procedure could be wrong or inadequate, which could reduce the credibility in the FS and increase the risk of litigation and adverse results (Palmrose 1987).

If auditors are unable to evaluate risk, a significant mistake could occur in the data that is raw for an account’s amount (inherent risk (IR)) that passes by the control systems of an internal company and is not detected (control risk (CR)) and then escapes being detected by auditors’ procedures and tests (detection risks (DR)). The risk assessment phase is crucial because it allows auditors to find areas that have the possibility of significant errors, and plan audits to correct those mistakes and reduce the risk of giving an inaccurate audit report. The risk assessment consists of three essential elements, namely the IR, CR, and DR. If one of these three components is not properly assessed in the future, it will affect the processes and a lot of misstatements could remain undiscovered. IR is crucial because it can identify risks inherent in the business. CR allows auditors to evaluate whether the internal controls of the client system are able to detect or stop any significant misstatement from occurring. The evaluation of inherent and control risk can have an impact on the risk of detection because they determine the degree of auditing procedures.

In addition, if auditors are not able to determine what is considered to be material, it could result in a number of material errors or omissions going unnoticed. IASB described the term “materiality” as “information is relevant when the omission or error could influence the decision-making process of the user from an accounting statement”. The determination of materiality is an issue of professional judgment. It is likely that both risk and materiality assessment play a role in determining the scope, nature, and timeframe of audit processes.

Inexperienced Auditors

Even though a successful audit relies on a solid planning stage, however, the final outcome is dependent on the auditor’s experience in conducting the audit. Auditors with years of experience possess the necessary and appropriate skills to meet the goals of the audit and meet the expectations of clients.

Often auditors are unable to spot the existence of a material error despite having the risk in the beginning The reason for the failure is that they lack the expertise to conduct an audit, while also identifying the pertinent risk factors. Auditors who are experienced are an important asset for the audit company as they are more experienced and feedback on the various types of material errors that might be present within the FS and the rate at which they are likely to be being discovered (Libby and Frederick 1990) which increases the chance of detecting possible frauds more quickly. Bedard Graham and Graham (2002) found that auditors who have had greater experience in a specific client sector are more able to recognize risks than auditors who have only a few or no experiences in this particular sector.

Additionally, Moeckel (1991) found that experienced auditors look for more evidence than auditors with less experience. This means that experienced auditors don’t rely solely on the evidence presented by the client, they search for additional pertinent and reliable evidence that is beyond the company before arriving at an opinion, which increases the likelihood of detecting any inconsistencies. Libby, as well as Trotman (1993), discovered that senior auditors possess the ability to identify evidence that is not in line with their judgment.

Time budget

The time budget is regarded as a significant issue by nearly all auditors. The pressures of time budget affect the audit’s quality because it hinders auditors from distributing the right amount of minutes to complete the audit procedures (Margheim, Kelley and Pattison 2005) and restricts auditors’ capacity to increase the scope of audit tests (Asare et al. 2000) which affects the auditor’s ability to identify material errors within the FS. It is important to remember that when achieving budget is viewed as the primary aspect of performance evaluation auditors have a greater likelihood to perform dysfunctional actions including a reduction in follow-up procedures, not reporting time, and ignoring auditing procedures within the working program (Azad 1994).).

Stress from time pressures can create a stress-inducing working environment for the auditing team. This can hinder auditors’ ability to spot a material error as auditors often act unprofessionally. This could include the superficial review of documents, accepting poor explanations by clients, or reducing work on the auditing process to levels that are not acceptable. E.Cook and Kelley’s (1988) study results’ revealed auditors tend to use less quality auditing practices to achieve the timelines established by companies. This simply means that as budget pressure increased, auditors’ performance declined substantially (McDaniel 1990).

However, time budgets make auditors work harder and demand the correct amount for their time (Kelley as well as Seiler1982, Cook and Kelley 1991, Otley and Pierce 1996a). In addition, it is likely to improve audit judgment by encouraging auditors to concentrate more on pertinent information, thus keeping them from being distracted by irrelevant data (Glover 1997).).

Sampling error

In accordance with ISA According to ISA 530 “Audit Sampling and Other Sampling Testing Procedures”, audit sampling is the application of audit procedures that are less than 100% of the items that are audit-related items, such that every sample unit has an opportunity to be selected to give the auditor an acceptable basis to make a decision about the entire sample”.

Every audit is a process of sampling because it is expensive for auditors to review every single one of the transactions that occurred over time. Auditors employ some type of audit sampling in order to evaluate an internal system of control and assist them in coming to the conclusion of the possibility of a material error occurring.

However, sampling is always accompanied by a possibility of risk, i.e. auditors may not take a close look at all the relevant items, or the result of the sample may not be representative. This could have a dramatic impact as the auditors could make a wrong conclusion. Risk of sampling could arise during both tests of control as well as substantive processes. In the test of control, there is a risk of assessing risk to control either too high or at a low level. Achieving a risk of control too high can could result in inefficiency in auditing and assessing the risk of control too low causes the auditor to depend on inadequate control procedures which increase the risk of detection. In the process of substantive analysis, there is a risk of a wrong acceptance as well as the risk of rejection that is incorrect. Incorrect acceptance means that the conclusion made in the audit samples is that the balance isn’t materially misrepresented but in reality, it’s materially misstated. Incorrect rejection is the possibility in the event that the result drawn by the audit samples suggests that the balance in the account was significantly misstated, but in fact, it’s not.

Inadequate audit fees

There is not much evidence of the connection between audit fees that are low and the quality of audits. We can however say that audit fees can have an influence on the auditing performance of auditors. Numerous accountants have reported that the low fee is related to inadequate auditing. For instance, an auditor may use his judgment in advising the client instead of spending more time investigating an audit-related issue and looking for evidence that is reliable. This is likely to cause auditors incapable of identifying a major error on the FS and then issue an incorrect conclusion.

It is believed that when audit fees are unusually low, the issue is the poor quality of audits because the auditor could try to reduce the effort in establishing an appropriate audit procedure that is able to detect and rectify any significant misstatements.

In addition, it is possible to conclude that if the fees for audits are not high in relation in relation to the size of the audit client or audit client complexity it could result in an immediate problem as auditors are demotivated because more time and effort will be required for the external audit and arrive at an objective conclusion, which would cause the auditors skipping many critical auditing procedures.

On the other hand fee rates that are inadequate do not cause any issues when there is a lot of competition among audit firms because all audit firms tend to offer low-cost fees for their services to keep their customers and attract new clients.

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