Audit Principles and Practices - DFA 3103

UNIT 2 REGULATORY FRAMEWORK OF AUDITING

Unit Structure

2.0 Overview
2.1 Learning Outcomes
2.2 The Regulatory Framework of Auditing
2.3 The International Federation of Accountants (IFAC)
2.4 The IAASB
2.5 The International Standards on Auditing
2.6 Legislation
2.7 Appointment of Auditors
2.8 Removal and Resignation of Auditors
2.9 Auditor’s Rights, Duties and Liabilities
2.9.1 Rights of the Auditor
2.9.2 Duties of the Auditor
2.9.3 Liabilities of the Auditor
2.10 Summary
2.11 Activity

2.0 OVERVIEW

Auditing is governed by the regulatory framework that outlines the common duties of
auditors, both internal and external, and their specific powers. This unit describes the main
bodies that have contributed to the development of the regulatory framework. It also
considers the regulations for the appointment and removal of auditors.

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2.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:

1. Describe the regulatory framework that governs statutory audits.

2. Explain the role of IFAC and its structure and committees.
3. Explain the role of IAASB.
4. Describe the procedures for appointment of auditors.
5. Discuss the mechanism for removal and resignation of auditors.
6. Outline the rights and duties of auditors.

2.2 THE REGULATORY FRAMEWORK OF AUDITING

The regulatory framework of auditing consists of rules and regulations that fall under the
scope of national legislation, quoted companies and also corporate governance. Auditors,
both internal and external, must be aware of the regulatory framework for auditing applicable
to the industry of their client because a key objective of any organisation will be to comply
with appropriate regulations. They should also keep abreast of any change that occurs as it
could influence the role and performance of the audit. Basically, the regulatory framework
that surrounds the auditing profession includes both national and international regulations.

1. National Level
 National Legislation
Generally, most companies are not permitted to operate unless they are incorporated
under national legislation. The legislation sets out the rules and regulations.
 Regulatiosn affecting all organisations
There are specific regulations that govern the operations of particular business
activities, for example, those covering health and safety at work or pollution issues.
 Specific regulations for the industry in which the organisation operates.

2. International Level

International regulation also plays a major role in regulating the audit function. It sets the
standards and requirements for auditors and provides guidance for countries that do not

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have a well-established national regulatory framework. This contributes to the

recognition of professional accountancy qualifications among these countries.

2.3 INTERNATIONAL FEDERATION OF ACCOUNTANTS

(IFAC)

IFAC is the global organisation for the accountancy profession. It was formed in the 1977 as
a result of proposals put forward and eventually approved by the International Congress of
Accountants. IFAC is based in New York and has more than one hundred and fifty member
bodies of accountants. It is a non-profit, non-governmental, non-political international
organisation of accountancy bodies.

IFAC’s overall mission is to serve the public interest by strengthening the profession and
contributing to the development of strong international economies. It provides a platform for
cooperation between member bodies, regional organisations of accountancy bodies and other
world organisations to achieve international pronouncements for the accountancy profession.
Through its independent standards – setting boards, IFAC sets international standards on
ethics, auditing and assurance, education, and public sector accounting. It also issues
guidance to encourage high performance by professional accountants in business.

The structure of IFAC is shown below:

 The IFAC Council

The IFAC Council is the supreme authority of the IFAC. It comprises one
representative from each member and it meets once a year. The council has as a main
responsibility to decide on constitutional and strategic matters and elect the Board.

 The IFAC Board

IFAC’s Board is comprised of members’ representatives of the worldwide

accountancy profession. The Board’s objective, scope of activities and membership
are set out in the Terms of Reference. The Board is comprised of the President and 21
individuals from 18 countries. These members are elected for up to three-year terms

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and are responsible for setting policy and overseeing the work of the various
committees.

 The International Auditing and Assurance Standards Boards (IAASB)

The Board works to improve the uniformity of auditing practises worldwide by

issuing pronouncements (ISAs) and promoting their acceptance. This has been dealt
with in more details in Section 2.4.

 The Compliance Committee

The Committee is responsible for making recommendations to the IFAC Board about
the membership application process including recommending new applicants for
membership. It also encourages member bodies to comply with the duties of
membership, particularly, the ethical code and standards published by IFAC.

 The Education Committee

The Committee aims to ensure that adequately trained accountants offer high quality
services to their employers and the public. It also assists member bodies and
developing nations to develop their standards of accounting education.

 The Ethics Committee

The Committee develops guidance on professional ethics and promotes its

understanding and acceptance by member bodies. The IFAC Code of Ethics contains
the ethical matters that auditors need to bear in mind in carrying out their duties.

 Professional Accountants in Business (PAIB)

The PAIB provides resources and facilitates the exchange of knowledge and bet
practices among worldwide professional accountants employed in commerce,
industry, public sector, education, and not-for-profit sector. It promotes the work of
financial and management accounting professionals.

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 The Public Sector Committee

This Committee concentrates mainly on the accounting, auditing and financial

reporting needs of national, regional and local governments and related agencies.

 The Transactional Auditors Committee (TAC)

The TAC is a committee dedicated to representing and meeting the needs of the
members of the Forum of Firms (FOF). It plays a major role in encouraging member
firms to meet high standards in performing transnational audits.

 The Small and Medium Practices Committee

The Committee provides resources and facilitates the exchange of knowledge and best
practices among SMPs and other accountants who serve and medium entities (SMEs).

2.4 THE IAASB

Prior to 2002, there was the International Auditing Practices Committee (IPAC). In 2002, the
IPAC was reconstituted and renamed as the International Auditing and Assurance Standards
Board (IAASB) by IFAC to reinforce the role of the committee.

The IAASB: Terms of Reference

The IAASB’s objectives, scope of activities and membership are set out in its Terms of
Reference.

The ISSAB services the public interest by:

 Setting, independently and under its own authority, high quality standards dealing
with auditing, review, other assurance, quality control and related services, and

 Facilitating the convergence of national and international standards.

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This contributes to enhanced quality and uniformly of practice in these areas throughout the
world, and strengthened public confidence in financial reporting.

Scope of Activities

The IAASB develops and issues the following:

 International Standards on Auditing (ISAs) to be applied by auditors in reporting on

historical financial information.
 International Standards on Assurance Engagements (ISAEs) to be applied by
practitioners in assurance engagements dealing with information other than historical
financial information.
 International Standards on Quality Control (ISQCs) to be applied on all services
falling under the IAASB’s standards.
 International Standards on Related Services (ISRSs) to be applied on all services
related to auditing.

Membership

The IAASB comprises of eighteen members including ten members from the IFAC member
bodies, five representatives from the Forum of Firms and three public members. The three
public members may be members of the IFAC member bodies but may not be members in
public practice.

ISAAB members serve for three years, with one third of the membership subject to
retirement each year. Continuous service on the IAASB is limited to two consecutive three-
year terms, unless that member is appointed to serve as Chair for a further period of not more
than three years.

2.5 INTERNATIONAL STANDARDS ON AUDITING

The International Standards on Auditing (ISA) have come a long way since the start of their
development in the late 1970s. The International Standards on Auditing are promulgated by
the International Auditing Practices Committee (IAPC) of the International Federation of
Accountants. A codified core set of international standards on auditing were completed and

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releases in 1994. The release of the core set has led to a growing acceptance of the standards
by national standards setters and auditors involved in global reporting and cross-border
financing transactions. In addition, the growth of assurance services has led to the
development of a new framework and a new direction for the work of the IAPC.

The IAPC has been charged with the responsibility to enhance and expand the worldwide use
of auditing standards. Since their release, there has been a growing acceptance of ISAs,
particularly adoption and use of the standards by—

- A number of the large international accounting firms as the basis for their
worldwide auditing standards;

- Global public companied reporting outside their national borders;

- Companies issuing securities in domestic financing transactions;

- Regulatory bodies accepting financial statements audited using the ISAs for
regulatory filings in their countries, or requiring the use of ISAs by including them
in company law;

- Global organisations, such as the Organisation for Economic Cooperation and

Development, that have endorsed ISAs for use in auditing financial statements in
their jurisdictions; and

- National accountancy bodies that have used ISAs as the basis for their national
auditing standards.

2.6 LEGISLAT ION

The main functions of company legislations include the following:

1. To establish the necessary requirement for companies to have their financial

statements audited.
2. To set out rules concerning the appointment, removal, resignation and retirement of
the auditor.

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3. To establish the rights, duties and necessary qualifications of auditors.

Under the company legislation, the main objective of audit is to form and opinion as to the
‘truth and fairness’ or ‘fair presentation’ of the financial statements. However, major
corporate scandals (Enron and Parmalat) have brought much pressure on auditors to accept
responsibility for detecting and reporting on fraud, though this is not the primary purpose of
the audit. Although auditors are expected to conduct audits with a reasonable expectation of
detecting material misstatements in the financial statements, the audit is not a guarantee that
fraud does not exist. Under ISAs, the auditor has no general duty to report on fraud to third
parties, except in specific circumstances imposed by national legislation or stock exchange
regulations.

Large companies are required to have their financial statements audited. Small companies
are generally exempted from the audit requirement. Small and medium-sized companies may
be required to prepare summarised accounts. It is important to note that annual audit is more
a matter of public accountability than one of pure size.

2.7 APPOINTMENT OF AUDITORS

Auditors may be appointed by shareholders, directors, a supervisory board or audit

committee. In private organisations, it is usually the shareholders that appoint auditors and
sometimes under ‘approval’ of directors. In state-owned or parastatal organisations, it is the
government that normally appoints auditors, for example, the national audit bureau.

In private organisations, auditors are generally appointed on contractual basis for a period of
one year but this can be renewed. The auditor’s remuneration is commonly fixed by the
directors or audit committee and this should work independently without any influence from
the client’s directors. Auditors should not have blood or business relationships or any
financial connection (ownership of shares) with the client. This issue is considered in more
details in the Rules of Professional Conduct.

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2.8 REMOVAL AND RESIGNATION OF AUDITORS

Once appointed, the auditors have an obligation to perform their duties until the end of tenure
of office. It is quite for auditors to be removed before the end of their tenure of office. If they
do not agree with the client, they will simply not accept re-appointment at the end of their
contract. However, it may happen that the auditors are removed during the audit contract,
especially, if there is serious disagreement between that auditors and the client. For example,
there may be severe disagreement over the accounting policies or suspected fraud.

When an auditor is removed from its function, the shareholders or directors of the client firm
need to provide clear justification as to the nature of the problem. A two-thirds or 75%
majority resolution of shareholders or directors is required to remove auditors. Once the
removal decision is taken, a short notice, in writing, should be sent to all parties concerned.

On the other hand, auditors have also the right to voice out the circumstances that have led to
their removal, usually by way of written representations. This is known as a ‘statement of
circumstances’. If there are no circumstances that need to be brought to the knowledge of the
shareholders, then a ‘statement of no circumstances’ is required.

Any removal of auditors must be notified to regulatory authorities to ensure that they are not
removed for invalid reasons and without the knowledge of shareholders. The auditors may
sue the client firm for breach of contract if they are removed without valid arguments.

Resignation occurs when the auditors decide to put an end to their audit contract on specific
ground, for example, suspicious business dealings. Here also auditors are required to bring
clarifications to their resignation and they will have to submit a statement of circumstances to
shareholders. Auditors are even allowed to require the client firm to call a meeting in order
to discuss the reasons why they have resigned. If there is no valid argument to support the
resignation, the auditors may be sue for breach of contract.

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2.9 AUDITORS’ RIGHTS, DUTIES AND LIABILI TIES

2.9.1 Rights of the Auditor

The audit is mainly a statutory concept and the basic requirements to conduct an audit are
often set down in statute. The external auditor has to perform various duties to achieve the
main objective of the audit, that is, to report on the truth and fairness of the financial
statements. In order to carry out these duties effectively, the auditor is given the various legal
rights. These rights may include:

 Access to Records

The right of access to books, accounts and documents of the client firm would enable
the auditor to report on proper accounting records.

 Information and Explanations

The right to require from the officers of the client company such information and
explanations as they think necessary for the performance of their duties. It is a
criminal offence if an officer makes a false statement, knowingly or with no due care.

 Attendance at or Notices of General Meetings

The right to attend any general meetings of the client firm and to receive all notices of
such meetings. It vital that auditors are aware of what happens at meetings to fulfil
their duties properly.

 Right to Speak at General Meetings

The right to be heard at general meetings on ant part of the business that concerns
them as auditors. However, this does not relieve them of their duty to make written
audit report to the members.

 Right to make written or oral representations

This is in addition to the duty to make a statement of circumstances.

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 Rights to Require Laying of Accounts

The right to give notice in writing requiring that a general meeting be held for the
purpose of laying the accounts and reports before the company.

2.9.2 Duties of the Auditor

The auditors may be required to fulfil the following duties:

 To report whether the accounts have been prepared in accordance with the relevant
legislation.
 To form an opinion on whether the financial statements shows a true and fair view of
the client company’s affairs at the end of the period.
 To report whether proper accounting records have been kept by the company and the
profit for the year and balance sheet totals are fairly stated.
 To report on any violation of law or the company’s constitution.
 To make a statement of circumstances when they cease to hold office for any reason.

2.9.3 Liabilities of the Auditor

As you are aware, the main responsibility of auditors are to report to the members on
whether the financial statements of the company show a ‘true and fair view’ or
‘present fairly’ the financial position. Of course the report should consider whether
management have kept proper accounting records and complied with recognised
accounting framework. Responsibilities also imply when problems happen.

Auditors may be liable in the following situations:

 Under insolvency legislation, auditors must be careful not to be involved in causing

losses to creditors.
 Under fiscal legislation, auditors must be careful regarding tax frauds perpetrated by
his client.
 Under financial services legislation, auditors must be careful not to be involved in
causing losses to investors.

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 Under stock exchange legislation, auditors must be careful not to be involved in

financial misconduct. The professional bodies that regulate accountants and auditors
always have various sanctions such as warnings, reprimands, severe reprimands and
exclusion form membership for misconduct by members.
 Under securities legislation, it is usually an offence to make ‘insider dealing’.
Auditors may come across ‘unpublished price sensitive information’ of his client like
mergers, acquisitions or sudden change in profits. Any misuse of this information is a
criminal offence.
 Under financial services legislation, auditors and others (directors) who knowingly or
recklessly make false statements in connection with the issue of securities are liable to
criminal sanctions.
 To third parties suffering loss as a result of relying on an audit report negligently
prepared by the auditors.

 It is an offence to accept an appointment as auditor when ineligible to do so or to

continue in office after becoming ineligible.

2.10 SUMMARY

It is important to remember the following:

1. Auditing is governed by the regulatory framework that outlines the common
duties of auditors, both internal and external, and their specific powers.
2. The regulatory framework of auditing consists of rules and regulations that fall
under the scope of national legislation, quoted companies and also corporate
governance.
3. Basically, the regulatory framework that surrounds the auditing profession
includes both national and international regulations.
4. Generally, most companies are not permitted to operate unless they are
incorporated under national legislation.
5. International regulation sets the standards and requirements for auditors and
provides guidance for countries that do not have a well-established national
regulatory framework.
6. IFAC is the global organisation for the accountancy profession. It is a non-profit,
non-governmental, non-political international organisation of accountancy bodies.

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7. IFAC’s overall mission is to serve the public interest by strengthening the

profession and contributing to the development of strong international economies.
8. The IPAC was reconstituted and renamed as the International Auditing and
Assurance Standards Board (IAASB) by IFAC to reinforce the role of the
committee.
9. The IAASB serves the public interest by setting, independently and under its own
authority, high quality standards dealing with auditing, review, other assurance,
quality control and related services, and facilitating the convergence of national
and international standards.
10. The International Standards on Auditing are promulgated by the International
Auditing Practices Committee (IAPC) of the International Federation of
Accountants
11. Under the company legislation, the main objective of an audit is to form an
opinion as to the ‘truth and fairness’ or ‘fair presentation’ of the financial
statements.
12. Auditors may be appointed by shareholders, directors, a supervisory board or
audit committee. In private organisations, it is usually the shareholders that
appoint auditors and sometimes under the approval of directors. In state-owned or
parastatal organisations, it is the government that normally appoints auditors, for
example, the national audit bureau.
13. The external auditor has to perform various duties to achieve the main objective of
the audit, that is, to report on the truth and fairness of the financial statements. In
order to carry out these duties effectively, the auditor is given various legal rights.

2.11 ACTIVITY

Activity 1

What functions in relation to auditing are usually set down in company legislation?

Activity 2

Discuss the advantages and disadvantages of accounting and auditing standards to auditors
and the consequences of such standards being enforceable by statute.

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Activity 3

How the auditor of a company is usually appointed under legislation. Who usually appoints
the first auditors of a company?

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