Chapter 3: The theory of auditing

Chapter 3: The theory of auditing

Aim of the chapter
The aim of this chapter is to provoke thoughts about the general principles
and concepts behind the practical procedures that we will study in depth
later on.

Learning objectives
By the end of this chapter and having completed the essential reading and
activities, you should be able to:
understand what constitutes a theory
understand the difference between assumptions and concepts
appreciate the role a theory of auditing could perform
know the main components of a possible theory of auditing.

Essential reading
Gray and Manson, Chapter 2 An overview of the postulates and concepts of
auditing, pp.2855.
Porter et al., Chapter 3 A framework of auditing concepts, pp.61100.

Further reading
Flint, D. Philosophy and principles of auditing. (Basingstoke: Macmillan, 1988)
[ISBN 9780333311165].

Works cited
Lee, T. Company auditing. (Wokingham: Van Nostrand Reinhold, 1986) third
edition [ISBN 9780412437201].
Lee, T. Corporate audit theory. (London: Chapman and Hall, 1993)
[ISBN 9780412452200].
Mautz, R.K. and H.A. Sharaf The philosophy of auditing. (Sarasota, Fla.:
American Accounting Association, 1961) [ISBN 0865390029].
Woolf, E. Auditing today. (London: Pearson Education, 1997) sixth edition
[ISBN 9780135894668].

Introduction
For many years, the study and practice of auditing centred on the pure
mechanics of conducting an audit, concentrating on how to perform
an audit. However, as it became more of an established profession and,
more recently, accepted as an academic discipline, so more attention was
focused on the theoretical and conceptual underpinnings of the practice.
Thus, questions were explicitly raised about why certain procedures were
carried out.
The first attempt (and some say the best) came from American academics,
Mautz and Sharaf, who in 1961 published The philosophy of auditing.
This was an important development as it helped gain some measure
of academic acceptance for auditing. Mautz and Sharaf drew from
established fields of study such as philosophy, the sciences and law in
producing a theory which helped to explain much of the accepted practice

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in auditing. Their theory also helped to highlight areas of practice that

did not stand up to critical review, notwithstanding that such areas were
generally accepted.
In the UK more than 10 years later, a Scottish academic, Professor Tom
Lee, built on and adapted the work of Mautz and Sharaf to produce his
own theory in Company auditing. This book was refined and polished into
a third edition (last published in 1986). Sadly, Lees later book Corporate
audit theory (1993) is aimed at the American market and much of the
easy accessibility of the earlier versions has been lost.
Another Scot, Professor David Flint, has written Philosophy and principles
of auditing, building on both Mautz and Sharaf and Lee. The accounting
establishment has shown little interest in, or enthusiasm for, pursuing
theoretical lines of enquiry. This is in contrast to the financial reporting
field where over the years millions of dollars have been invested in
seeking what some have called the holy grail of accounting a conceptual
framework. These endeavours have produced a Framework for the
Preparation and Presentation of Financial Statements published by the
International Accounting Standards Board (IASB), and similar statements
by national standard-setters, such as the Statement of Principles by the
Accounting Standards Board (ASB) of the UK. It is interesting to debate
why the effort has been made to formulate theories about accounting
but not about auditing, the process which renders accounting statements
valuable; however, that is beyond the range of our studies at present.
Pause and think
What is a theory?
What purpose would be served by having a theory of auditing?

The role of theory

The dictionary definition of a theory is:
a supposition put forward to explain something; an exposition of the
general principles of an art or a science as distinct from the practice
and execution of it.

So an auditing theory, if one could be developed, would explain practice

and put forward general principles. If we had general principles we
could use these to develop practices and to adapt to new challenges and
situations that might arise. Without principles, procedures may evolve in
an ad hoc manner, with no cohesion or internal consistency.
If a theory could be developed, it could help to explain practice, could
highlight deficiencies and inconsistencies in existing practice and could
guide audit policy-makers and regulators in their governing of the audit
profession. It could also help teachers of auditing to explain the practice of
auditing to their students, who in turn could gain a better understanding
of their subject. Without a theoretical basis, auditing would be the
application of a series of procedures, more akin to the practice of a trade,
rather than a profession.
Now read
Porter et al., pp.625.
Gray and Manson, pp.2932.

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Chapter 3: The theory of auditing

Assumptions of auditing
Assumptions (theoreticians sometimes call them postulates) are the
foundations of theory. Think back to your early studies of economic
theories which only work if you make certain assumptions (for
example, the model for perfect competition assumes that consumers
aim to maximise utility and producers aim to maximise profits). If these
assumptions do not hold, the model fails. Let us now consider Flints seven
assumptions.

Assumption 1: There is a need for an audit

The need for an audit can arise for a number of different reasons,
including:
a relationship of accountability between two or more parties (i.e. that
one party owes a duty of acceptable conduct to another); an imposed
audit (for example, companies, government, charities)
a need by some party to establish the reliability and credibility of
information for which they are responsible and which will be used
by another party; a voluntary audit (for example, partnerships,
companies who engage environmental auditors, newspapers that have
their circulation figures audited)
public interest in the proper and adequate performance of some
party; a public interest audit (for example, academic audits
designed to test the robustness of the systems employed by educational
establishments in delivering services to their students).
Pause and think
Think of other examples in each of the above three possible categories.

Assumption 2: The subject matter is too remote, too complex or

too important to accept without an audit
Remoteness: those relying on information may not physically be able to
check the validity of the information themselves, perhaps because they are
remote from the company.
Complexity: the nature of the subject is so complex that it requires
special expertise to investigate and check. For example, most ordinary
shareholders do not possess sufficient accounting knowledge and skills to
be able to conduct the audit themselves.
Significance: the matter under audit has such economic significance
that an audit is required to lend it credibility. Note in contrast that
unincorporated entities are often not required to have an audit, because
lenders have recourse to the assets of the owners in the event that the
business entity cannot meet its liabilities.
Pause and think
Do you think that it would be possible for ordinary shareholders with no accounting or
auditing qualifications to perform tests on the information in the financial statements
themselves?

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Assumption 3: An audit must be conducted with independence

and without constraints either over conduct or in reporting
findings
If an audit is to add credibility then it must be done independently,
without bias or prejudice. A prime example is that of state auditors, who
since the time of Aristotle have had to be independent of the government
which they are auditing. In the words of Emile Woolf, for many years
a leading authority on auditing matters: The auditor who has lost his
independence has lost his raison dtre; he has become dependent, and a
dependent auditor is a contradiction in terms (Woolf, 1997, p. 349).1
Pause and think
What sort of situations might lead to a loss of auditor independence?

Assumption 4: The subject matter of an audit can be verified by

collection of evidence
Auditors report the results of their investigations. Without evidence
they have nothing on which to base their report, to make judgments or
criticisms. An audit is impossible if evidence is not available or cannot be
obtained. In practice, audit evidence comes from many sources. It varies in
its persuasiveness depending on quantity collected and quality (source).
Pause and think
What sorts of evidence might be available for, say, sales and expenses?

Assumption 5: Standards of accountability, performance, etc., can

be set and actual performance can be measured against these
standards
Parties to an accountability relationship must agree on what is acceptable
performance. Without this, auditors have nothing to go by. They cannot
set their own standards since these may be rejected by either party. In
company auditing some of these standards have been set down (by statute
or by professional guidance), but grey areas still remain. What constitutes
a true and fair view? What should auditors do when they discover a client
has committed an illegal act?
Pause and think
Is the giving of a bribe wrong when it is the only way for the company to get business in
some parts of the world?

Assumption 6: The purpose of the audit is sufficiently clear that its

results can be communicated clearly
The purpose of an audit is to add value to information. If the nature or
purpose of the information itself is not clear, it cannot be audited. If the
audit findings cannot be communicated effectively then inevitably the
value of the audit will be diminished.
Pause and think
Do you think that the purpose of the company audit is well understood? What sort of
misunderstandings might arise?

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Auditing Today. (1997)

Chapter 3: The theory of auditing

Assumption 7: An audit produces an economic or social benefit

Since audit is a social control mechanism it should only be undertaken
if the benefits outweigh the costs. Auditors are expected to provide the
benefit at minimum cost. In most audit situations the major part of the
work involves the collection of evidence. While a minimum level of
confidence must be achieved, absolute certainty is unattainable. There is
a point at which the marginal benefit of obtaining additional evidence is
exceeded by the marginal cost. The direct costs of auditing are known but
the benefits are not so easily measured.
Pause and think
Do you think that auditing company accounts is worth the billions in fees that companies
pay globally every year?

Auditing concepts
A concept is an abstract notion or idea. The role of concepts is to create
a better understanding of the subject. Concepts form the basis for
developing general working principles and practices by which theories are
articulated and put into operation.
These concepts, or general ideas, can be grouped into four categories,
according to whether they relate to the auditors credibility, the audit
process, the communication of the audit outcome (reporting), or the
performance of the auditors work. These general ideas form the basis of
the next four chapters. They are reporting, independence, evidence and
responsibility.
Now read
Porter et al., pp.6598.
Gray and Manson, pp.3246.

Recognition of theoretical issues in practice

There is no generally agreed theory or conceptual framework for auditing.
The only explicit reference to general ideas on the values behind the audit
process that can be found in official documents in the UK is in the form of
a one-page list of desirable qualities, The Auditors Code. The Code sets out
nine fundamental principles of independent auditing, as follows.
Accountability
Auditors act in the interests of primary stakeholders, while having regard
to the wider public interest. The identity of primary stakeholders is
determined by reference to the statute or agreement requiring an audit:
in the case of companies, the primary stakeholder is the general body of
shareholders.
Integrity
Auditors act with integrity, fulfilling their responsibilities with honesty,
fairness and truthfulness. Confidential information obtained in the course
of the audit is disclosed only when required in the public interest, or by
operation of law.
Objectivity and independence
Auditors are objective. They express opinions independently of the entity
and its directors.

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Competence
Auditors act with professional skill, derived from their qualification,
training and practical experience. This demands an understanding
of financial reporting and business issues, together with expertise in
accumulating and assessing the evidence necessary to form an opinion.
Rigour
Auditors approach their work with thoroughness and with an attitude
of professional scepticism. They assess critically the information and
explanations obtained in the course of their work and such additional
evidence as they consider necessary for the purposes of their audit.
Judgment
Auditors apply professional judgment, taking account of materiality in the
context of the matters on which they are reporting. (See Chapter 7 of this
guide for further discussion of materiality.)
Clear communication
Auditors reports contain clear expressions of opinion and set out
information necessary for a proper understanding of that opinion.
Association
Auditors allow their reports to be included in documents containing other
information only if they consider that the additional information is not in
conflict with the matters covered by their report and they have no cause to
believe it to be misleading.
Providing value
Auditors add to the reliability and quality of financial reporting; they
provide to directors and officers constructive observations arising from
the audit process; and thereby contribute to the effective operation of
business, capital markets and the public sector.
Activity
Read the commentary to the Code in Gray and Manson, Table 1.2 The Auditors Code,
on pp.234.
You will note that the word should does not appear at all in the Code. This is because it
is felt that instructions on what auditors should, and should not, do can only be given in
auditing standards.

A reminder of your learning outcomes

By the end of this chapter and having completed the Essential reading and
Activities, you should be able to:
understand what constitutes a theory
understand the difference between assumptions and concepts
appreciate the role a theory of auditing could perform
know the main components of a possible theory of auditing.

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Chapter 3: The theory of auditing

Sample examination questions

1. Explain what you would consider to be the main components that a
theory of auditing would include.
2. Consider the benefits of having a sound theoretical basis from which to
develop auditing standards.
3. The IASB has issued its Framework for the Presentation of Financial
Statements and the ASB has issued a Statement of Principles for financial
reporting. To what extent do you think it would be possible to produce
a statement of principles for auditing?

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