Meaning and objectives of audit, the need for audit and types of audit

Adaeze owns 5% of a Lagos food company that sells shares to the public. She lives in London and has never visited its factory. Each year the directors send her a set of financial statements that says the company made a profit. How does she know the numbers are honest? She relies on an independent accountant, the auditor, who examines the records and reports whether the statements can be trusted.

That examination is an audit, and this topic explains what it is, why it exists, and what an auditor does and does not promise.

It covers the meaning of audit, why owners need one, the ideas of independence, true and fair view and materiality, the objectives of an external audit, the kinds of audit, and the benefits and limits of audit. The next topic moves from audit to the wider family of assurance services.

Key terms in plain English

Syllabus check

This topic is in syllabus area A, introduction to assurance, legal and regulatory frameworks, and audit process (20% of marks). It covers:

• the concepts of audit, assurance and forensics and how they relate
• the reasons for audit and the benefits of the different types
• the objectives of external audit and the audit expectation gap

CAMA 2020 and audit

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

What an audit is

An audit is an official examination of the accounts, or the accounting systems, of an entity by an auditor. The auditor is not looking for every error. The auditor is looking for enough evidence to give an opinion on whether the financial statements are prepared in line with the applicable financial reporting framework. That framework is set by the law of the country and by accounting standards.

In Nigeria the law includes CAMA 2020, the Banks and Other Financial Institutions Act 2020 (BOFIA 2020), the Insurance Act 2003 and the Financial Reporting Council of Nigeria Act 2011, and the accounting standards are International Financial Reporting Standards (IFRS). The work an auditor does to reach the opinion is covered in later topics.

Why an audit is needed: accountability, stewardship and agency

In a company the owners and the managers are usually different people. The shareholders own the company. The directors manage and control it. Three ideas explain why this creates a need for audit.

• Stewardship: the directors look after the company's assets and run them on behalf of the shareholders.
• Agency: an agent acts for another person, called the principal, and has a legal duty to act in the principal's best interests. The directors are agents of the shareholders.
• Accountability: an agent must answer to the principal for what he does. So company law requires the directors to prepare annual financial statements and present them to the shareholders.

The shareholders cannot simply trust their own agents to mark their own work. An independent audit adds credibility to the statements the directors produce. In a small family company where the shareholders are also the directors, the need is much weaker, and this is why many countries exempt small companies.

The independence of the auditor

Independence means the ability to do the work without being influenced. An external auditor must be independent of the directors, otherwise the report has little value, because the opinion could be shaped by the people whose work is being judged. Internal auditors are usually employees and so may not be fully independent, although they can reach a sufficient degree of independence.

True and fair view

The auditor reports on whether the financial statements give a true and fair view, or present fairly, the position of the entity at the end of the period and its performance during the period. The auditor does not certify that the statements are correct.

The phrase has no legal definition, but "true" suggests free from error and provable, and "fair" suggests no undue bias in the figures or in how they are presented. Directors use a great deal of judgement in preparing the statements, and the auditor uses judgement in forming the opinion, so the report is an opinion, not a statement of fact.

Materiality

Information is material if leaving it out or getting it wrong could change the economic decisions of the people who use the statements. The auditor gives an opinion on whether the statements are fair in all material respects. A company with assets of ₦10 million does not care if the petty cash is overstated by ₦100. It does care if receivables of ₦2 million cannot be recovered and should have been written off.

Because of materiality the auditor does not check every number. The effort goes to items that matter, either because the amount is large or because the risk of error is high.

The objectives of an external audit and the expectation gap

The objective of an audit is set out in International Standard on Auditing (ISA) 200. The auditor aims:

1. to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, so that the auditor can give an opinion on whether they are prepared, in all material respects, in line with the applicable framework; and
2. to report on the financial statements, and to communicate as the ISAs require, in line with what the auditor found.

Many members of the public expect more. They think an audit guarantees the accounts, finds all fraud, and says the company is financially sound. The difference between what the public expects and what an audit delivers is the audit expectation gap. Part of the gap is a misunderstanding of the auditor's role, and the rest is about how well auditors perform.

A later topic treats it in full. For this topic remember the point that an audit gives an opinion, with reasonable assurance, on the financial statements only.

Who is responsible for what

Management and those charged with governance are responsible for preparing the financial statements, for preventing and detecting fraud, and for designing and running effective internal controls such as payment authorisation limits and monthly bank reconciliations. The auditor is responsible for forming and reporting an opinion on the statements. Under section 405 of CAMA 2020, titled corporate responsibility for financial reports, the company itself answers for its financial reports.

Under section 404(1) the auditors report to the members on the accounts examined.

Statutory and voluntary audit

A statutory audit is one the law requires. In Nigeria section 401 of CAMA 2020 requires a company to appoint an auditor at each annual general meeting, to hold office until the end of the next one. Section 402 exempts a company that qualifies as small and a company that has not carried on business since incorporation.

A voluntary audit is one the owners ask for although the law does not require it, for example by a small company whose bank will lend only against audited statements. Sole traders, partnerships, clubs and societies are generally not subject to a statutory audit.

Types of audit

Audit work on a year-end is often done in two phases: an interim audit before the year end, where the auditor learns the business, records the controls and does some early testing, and a final audit after the year end, when the draft statements are available.

Audit, assurance and forensics

Assurance is the wide term: any engagement in which a practitioner gives an opinion, for the benefit of a user, on information prepared by someone else. An audit is one kind of assurance. Forensic work applies accounting and investigation skills to disputes and suspected wrongdoing, and is often reactive, to prove or disprove suspicions and support legal proceedings, though it may also be proactive, to prevent misconduct. The next topic separates assurance and audit more carefully.

Benefits and limits of an audit

Benefits: it makes the published statements more credible; it confirms to management that its duties were met; it gives feedback on the effectiveness of internal controls with recommendations; and it can help a company borrow, because lenders often insist on audited statements.

Limits: cost; disruption to staff, who must answer questions and supply documents; reliance on estimates whose truth is not known until later; the deliberate concealment that goes with most fraud; the use of sampling, not testing every item; the inherent limits of any control system; and the fact that audit evidence is persuasive, not conclusive.

Worked examples

1. The directors hold the assets as stewards for the shareholders.
2. They are agents and must act in the shareholders' best interests, so they must be accountable.
3. An independent audit tests the statements the directors prepared, which could otherwise hide such an item.

1. ₦50,000 is very small against ₦400 million, so it is unlikely to change a user's decision: probably immaterial.
2. ₦30 million is 7.5% of revenue and would reduce profit, so it is likely material.
3. The auditor gives an opinion on whether the statements are fair in all material respects, so the second item must be corrected or reported.

1. It is a private company with share capital, turnover is within ₦120 million, net assets are within ₦60 million, and the directors hold at least 51%.
2. It meets the small company conditions in section 394 of CAMA 2020, so section 402 exempts it from the audit requirement.
3. Any audit would be voluntary, for instance if its bank asks for audited statements.

1. The auditor gives reasonable assurance that the statements are free from material misstatement, not that no fraud exists.
2. ₦8 million is small against ₦900 million and may be immaterial; the directors are responsible for preventing and detecting fraud.
3. The shareholder expects more than an audit promises, which is the expectation gap.

How to score full marks

• Define each term in one sentence before explaining it.
• Link every answer to the owner and manager separation: stewardship, agency, accountability.
• Say "reasonable assurance" and "in all material respects", never "guarantee".
• Name CAMA 2020 sections 401 and 402 in answers on the legal requirement.

Common mistakes in the exam

• Saying the auditor certifies that the accounts are correct.
• Saying the auditor prepares the financial statements or prevents fraud.
• Confusing a statutory audit with an internal audit.
• Giving only the ISA 200 reporting objective and forgetting reasonable assurance.

Quick revision

• Audit means independent examination ending in an opinion.
• Stewardship, agency, accountability explain the need.
• True and fair view; materiality; independence.
• ISA 200: reasonable assurance and report.
• Section 401 requires audit; section 402 exempts small companies.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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