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Home > Accountancy Best Practice > Cultural Changes in External Auditing

Accountancy Best Practice

Cultural Changes in External Auditing

by Jyothi Manohar

This Chapter Covers

  • How external auditing has evolved over the years, and factors that have impacted cultural changes in external auditing over the last century.

  • The users of financial statements are now a much wider group. They now include any individual or entity that has a vested interest in a business’s financial condition, such as lenders, regulators, or government departments.

  • Companies have changed from being focused on one line of business to become more complex organizations with many lines of business through multiple ownership structures and across international borders.

  • The globalization of business and information technologies that are advancing by leaps and bounds have dramatically changed the manner in which business is conducted—from paper-based to electronic-based to Internet-based, and now via mobile devices.

  • Accounting rules used to be simple. With all the changes in the business world and the development of a single, global marketplace, accounting standards have proliferated into complex requirements that are both rule- and principle-based.

  • The clamor for better corporate results, global competition, and a greed for the rewards of corporate success have led to major accounting fraud and company failures. This has resulted in vast changes in the rules of corporate governance and in the role and accountability of both the audit committee and the external auditor.

  • Since business was largely male-dominated, auditing used also to be a primarily male-dominated profession. It has evolved into a profession that has competing numbers of male and female professionals and changing perspectives.

Introduction

This chapter focuses on external audits of financial statements. The objective of an external audit is to conclude that financial statements are, or are not, fairly presented in accordance with appropriate accounting standards. Consequently, a knowledge of accounting is a prerequisite for auditing. An auditor of financial statements must, therefore, have a thorough understanding of the accounting rules and other regulations that impact the financial statements that are being audited. This understanding, in turn, must be preceded by a thorough understanding of the business and industry in which the company presenting the financial statements operates. Cultural changes in auditing have evolved with the multifaceted nature of business, a global marketplace, advancing technologies, a clamor for comparable, timely, and transparent information on which to base business decisions, corporate accounting fraud and corporate failures, and all the consequences that flow therefrom.

The Users of Financial Statements

Although audits of exchequers, royal vaults, trusts, bequests, and accounts have a long history in many countries in the world, the modern concept of “independently validating and providing reasonable assurance (positive or negative) as to the accuracy, fairness, reasonableness or compliance with regulations,” i.e. the independent audit of a business entity’s financial numbers began with the industrial revolution and the founding of formal stock exchanges across the world during the 1800s. The regulatory requirement for external audits of companies whose stock traded on these exchanges generally became prevalent in different countries during the 1930s. This happened when the securities and exchange commissions (or similar regulating authorities) in different countries required that companies listed on public stock exchanges and whose stock traded on those exchanges should, among a myriad of other regulatory requirements, have the “fair presentation” of their financial statements attested by a third party that was fully independent of the management and operations of the company. In other words, an external auditor should have no stake in the ownership of, or receive any other type of benefit or remuneration from, the company he or she was auditing. The intent was that the “users” of the financial statements—in this case, the investors in the respective companies—should have reliable financial information on which to base their investment decisions. Further, independent or “external” auditors were viewed as being qualified in their knowledge of the accounting rules applicable to the company being audited and unbiased in their approach to validating the books, records, and transactions of the company which were translated into financial statements in a manner that was “generally accepted” and understood by the investing public.

Over the years, the “users” of financial statements have mushroomed. Depending on the nature of the business and the industry in which it operates, the individuals, regulatory authorities, governments, financial institutions, funders, and other entities that use and rely on an entity’s financial information have changed. For instance:

  • A not-for-profit or charitable organization does not have ownership through stock holdings and is not listed on a stock exchange. However, it may receive funding, charitable donations, grants, or bequests from other business entities, individuals, or government agencies. All of these sources of funding (the users) would have an interest in the financial statements of the not-for-profit organization to ensure that the monies they have provided are being used for the purpose intended.

  • Companies in regulated industries such as financial institutions, insurance companies, pharmaceutical companies, utility companies, airlines, etc., may or may not be publicly traded on a stock exchange but must follow the regulatory requirements of their respective regulators. In these instances, the regulators, in addition to other stakeholders, are “users” of the company’s financial statements. The regulators have an interest in ensuring that reliable financial information is being produced to help them to monitor the stability of the company and to ensure that the company complies with applicable regulations.

  • Federal, state, and local governments, municipalities and school districts are all recipients of revenues from individuals and business organizations in the form of levies and taxes. Their expenditures are intended to be for the public good in the form of infrastructure (roads, bridges, waterways, libraries), social programs, education, support for low-income families, healthcare, etc. Members of the general public are “users” of government agencies’ financial information in that we are interested in making sure that our tax payments are being put to appropriate use.

  • Small businesses, owned by individuals or families, are the unseen and unheard mainstay of national economies all over the world. These small business entities turn to financial institutions and other funding sources for loans that will fund different aspects of their business. Increasingly, their banks or credit unions have become “users” of financial information and are requiring external auditors to provide reasonable assurance as to the financial condition and income-producing capabilities of the businesses for which they provide financial support.

As the users of financial statements and the corresponding utility of financial information have become more diverse, the method of presentation of financial information has evolved from merely accumulating numbers to also include disclosures relating to the numbers and, in many cases, compliance with relevant laws and regulations that govern the presentation of financial information. It follows, therefore, that accounting standards vary widely from industry to industry and often from country to country. The financial presentation for each is unique. The external auditor has to develop the knowledge and expertise to adapt to the requirements of each type of financial statement presentation in order to provide “reasonable assurance” as to fairness.

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Further reading

Book:

  • Girgenti, Richard H., and Timothy P. Hedley. Managing the Risk of Fraud and Misconduct: Meeting the Challenges of a Global, Regulated, and Digital Environment. New York: McGraw-Hill, 2011.

Articles, Standards, and Reports:

  • International Auditing and Assurance Standards Board (IAASB). “The clarified standards.” The final set of International Standards on Auditing (ISAs) and the International Standard on Quality Control. Online at: tinyurl.com/6pz48a9
  • Médecins Sans Frontières USA. “Financial statements and report of independent certified public accountants: December 31, 2010 and 2009.” Online at: tinyurl.com/6olgprp [PDF].
  • Royal Bank of Scotland. “Annual report and accounts 2010.” Online at: tinyurl.com/bqhcfwk [PDF].
  • Wikipedia. “Luca Pacioli.” Online at: en.wikipedia.org/wiki/Luca_Pacioli

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