Chapter 1 An Overview of Auditing

1. Objectives

1.1 Identify the objectives, nature and benefits of the audit process.
1.2 Distinguish between auditing and accounting.
1.3 Identify the types of audits.
1.4 Distinguish between external auditors and internal auditors.
1.5 Explain the concept of ‘true and fair’.
1.6 Outline the appointment, vacation of office, rights and duties of auditors under
the Hong Kong Companies Ordinance.

O v e rv iew
of
A u d itin g

O b jec tiv es D istin g u ish T y p es D istin g u ish T rue A p p o in t m e n t

N a tu re A u d itin g of E x te rn a l a n d and V a ca tio n
and and A u d it In tern al F a ir R ig h ts &
A u d it P ro c e ss A c c o u n tin g A u d ito rs C oncept D u tie s o f A u d it o rs

2. Nature and Objectives of Auditing

(A) Definition and scope of audit

2.1 An audit may be defined as an independent examination of the financial

statements of an enterprise and communicate the result to the interested
parties.
2.2 HKICPA states in Hong Kong Standard on Auditing (HKSA) 200 “Objectives
and General Principles Governing an Audit of Financial Statements” that
auditors should:
(a) conduct an audit in accordance with the required HKSAs, legislation,
regulations and, where appropriate, the terms of engagement ( 聘 用 )
and reporting requirements;
(b) plan and perform an audit with an attitude of professional skepticism
(抱懷疑態度) recognizing that circumstances may exist that cause the
financial statements to be materially misstated (誤述); and
(c) comply with the ethical principles governing the auditor’s professional
responsibilities caused by HKICPA “Statement of Professional Ethics /
Code of Ethics of Professional Accountants”.

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(B) Objectives

2.3 HKSA 200 describes the objectives of an audit of financial statements is to

enable auditors to express an opinion on whether the financial statements
are prepared, in all material respects, in accordance with an identified
financial reporting framework.”
2.4 This involves the following objectives:
(a) Primary objective
To produce a report by the auditor of his opinion of the truth and
fairness of the financial statements examined by him.
(b) Secondary objectives
(i) To detect errors and fraud that cause material
misstatements in the accounting records and/or the financial
statements; and
(ii) To provide constructive advice on the client’s internal
control system.
2.5 Concept of true and fair – there is no official definition in any individual
HKSA of the meaning of true and fair.

Truth in accounting terms can be taken to mean not factually incorrect.

The word fair can have the following meanings:

 On the one hand clear, distinct (清楚的) and plain (清晰的)
 And on the other impartial (不偏不倚的) / unbiased, just and equitable
(公正的).
2.6 Auditors should attempt to ensure that the financial statements which are the
subject of the audit, present clearly and equitably the financial state of affairs
of the enterprise. This suggests that in order to achieve the statutory true and
fair view, it is necessary:
(a) to present certain information impartially;
(b) that this data is shown in such a way that it is clearly understood by the
user.

2.7 Test your understanding 1

The following statement relates to objective and general principles governing
an audit of financial statements.
“The objective of an audit of financial statements is to enable auditors to give

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 a true and correct view in all respects in accordance with an identified
financial reporting framework.” (4 marks)
(HKAAT Paper 8 Auditing December 2003)

(C) The Auditing Process

2.8 The major steps of auditing process include:

(a) Client acceptance and retention and establish the engagement terms:
Client’s business nature and management integrity, and professional
ethics ( 道德規范 ) when considering the acceptance and retention of
client of client because this may affect the reliability of financial
information provided by the client.
(b) Plan the audit:
The planning phase involves the assessment of audit risks, the
development of audit strategy and the determination of means to
perform the audit properly.
(c) Evaluate internal controls:
The auditor should understand and evaluate the effectiveness of
client’s internal control system to determine the possibility of having
material misstatements in the financial statements.
(d) Conduct testing of accounting transactions and balances:
The auditor checks the transactions and account balances against the
supporting documents to substantiate the financial statement balances.
(e) Complete the audit:
The auditor assesses whether sufficient evidence has been obtained to
reach a conclusion that the financial statements are fairly presented.
(f) Issue audit report:
The final phase in the audit process is communicating the auditor’s
findings to the users of the financial statements.

(D) Reasonable Assurance (合理確信)

2.9 An audit is designed to provide reasonable assurance that the financial

statements as a whole are free from material misstatement as required by
auditing standards.
2.10 There are inherent limitations in an audit that affect the auditors’ ability to
detect material misstatements. The reasons are:

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 (a) examining all items within an account balance or class of transactions
are impractical and sampling techniques have its own inherent
limitations;
(b) there are inherent limitations of any accounting and internal control
system;
(c) most audit evidence is persuasive rather than conclusive; and
(d) the persuasiveness of audit evidence available to draw conclusions on
particular financial statement assertions ( 目 的 ) may be affected by
unusual circumstances, such as related parties transactions, which
increase the risk of material misstatement.

(E) Distinguish between Auditing and Accounting

2.11 Accounting is the process of recording, classifying and summarizing the

economic transactions in a systematic and logical manner for decision making.
2.12 Auditing is the process of systematically accumulating and evaluating
evidence to determine whether the financial information presented properly
reflects the business transactions and financial position of the company.
2.13 To provide relevant information, accountants must have a thorough
understanding of the accounting principles for recording the business
transactions.
2.14 In auditing accounting data, the concern is with determining whether
recorded information properly reflects the economic events that occurred
during the accounting period. In addition to understanding accounting rules,
the auditors must possess expertise in how the audit evidence should be
interpreted. The auditors must perform the audit in accordance with
auditing standards.

2.15 Test your understanding 2

Misconceptions
(a) The objective of auditing is to detect fraud.
(b) Auditors examine all, or most, business transactions to ensure
correctness of financial statements.
(c) The audit of the financial statements relieves management of its
responsibilities for preparing and presenting the financial statements.
(d) Auditors should conduct an audit in accordance with Hong Kong
Accounting Standards.

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 Required:
Correct the misconceptions from items (a) to (d) above. (8 marks)
(Adapted HKAAT Paper 8 Auditing June 2002)

(F) The Economic Demand for Auditing

2.16 The following are underlying conditions which create demand by users for
reliable accounting information:
(a) Complexity – company’s transactions can be voluminous and
complicated, so users of financial information need the expertise of
professional accountants.
(b) Remoteness – It’s uneconomical for the users of financial statements to
employ professional accountants to do that job.
(c) Consequences – Financial decisions can involve large amounts of
money and massive efforts. Good information, obtained through
accounting experts, is beneficial for that type of decisions.

3. Types of Audits

(A) Internal and External Audits

3.1 External or statutory audits

Statutes which require audits to be done include the Companies Ordinance and
other ordinances and regulations.
3.2 Internal audits
(a) Internal auditing is an independent appraisal function established
within an organization to examine and evaluate its activities and
operations.
(b) Function of internal audit is the making analyses, appraisals and
recommendations for management concerning the activities reviewed.
3.3 The activities of internal audit include:
(a) To review the financial and operation information to ensure that the
information is properly identified, measured, classified and recorded in
the accounting records and is fairly presented in the financial
statements in accordance with the accounting standards and relevant
legislation.

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 (b) To study the operations of the business operations for the purpose of
making recommendations about the economic and efficient use of
resources, effective achievement of business objectives, and
compliance with company policies.
(c) To review the internal control systems which ensure the compliance of
company policies, plans, and procedures of laws and regulations.
(d) To perform other special review as required by management, for
example, review of effectiveness in achieving program results in
comparison to pre-established objectives and goals.

(B) Financial Statement, Operational and Compliance Audits

3.4 Financial statement audit – to determine whether the overall financial

statements are stated in accordance with the GAAP.
3.5 Operational audit – review of the operating procedures of an organization for
the purpose of evaluating and improving its efficiency and effectiveness.
3.6 Compliance audit – to determine whether the procedures and regulations
prescribed by management are complied with.

(C) Fundamental Differences between Internal and External Auditors

3.7 Despite their common interests there are some fundamental differences in the
scope of their work, the approach to their work and their reporting line.

Area of difference Internal auditor External auditor

1. Scope Determined by management Determined by statute
2. Objective To ensure the accounting To satisfy himself
system is efficient, effective whether the financial
and economic and providing statements to be
management with accurate presented to the
and material information shareholders present a
true and fair view
3. Responsibility To management To shareholders
4. Appointment / By management By management, on
dismissal behalf of shareholders
5. Qualifications None specified Professional accountant
qualified under

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 Professional Accountant
Ordinance
6. Independence Staff of company Auditor who is
independent of the
company

3.8 Test your understanding 3

Kenny will soon complete his final year of studies in bachelor of accountancy.
He is wondering whether he should start his career as an external auditor or as
an internal auditor. His lecturer has mentioned that external auditors might
have a close working relationship with internal auditors, but the external
auditors have to assess the internal audit function and to evaluate the work of
the internal auditors.

Required:
(a) Briefly compare internal auditors and external auditors in terms of
(i) Determination of job scope
(ii) Objectives
(iii) Line of reporting
(6 marks)
(b) Briefly describe four internal auditing activities. (4 marks)
(Adapted HKAAT Paper 8 Auditing December 1998)

4. Regulatory Framework of Auditing

(A) Legal Requirements

4.1 Companies Ordinance

(a) requires every limited company in HK to have an annual audit.
(b) sets out the rights and duties of auditors, procedures of appointment,
resignation and removal of auditors.
4.2 Listing rules – specify the safeguard procedures which should be carried out to
identify conflict of interest and maintain independence.

(B) Professional Requirements

4.3 HKICPA has issued HKSAs, Practice Notes (PN) and Industry Auditing

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 Guidelines for its members to follow in their professional practices.

5. Appointment of Auditors

(A) Persons Qualified to be Appointed as Auditors

5.1 The requirements for person qualified to be appointed under the Companies
Ordinance includes:
(a) Person qualified to be appointed under S.140(1) of the Companies
Ordinances – A person shall not be appointed as auditor of a company
unless he is qualified to be appointed as auditors under the Professional
Accountants Ordinance.
(b) Person not qualified for appointment as auditor under S.140(2) of the
Companies Ordinance
(i) An officer or an employee of the company or its subsidiary and
holding companies.
(ii) A person who is a partner of or an employee of an officer or an
employee of the company or its subsidiary and holding
companies.
(c) Person qualified to be registered as professional accountants under
S.29(2) of the Professional Accountants Ordinance – Unless he is
either the holder of a practicing certificate or a corporate practice, a
person shall not hold any appointment or render any services as an
auditor of a company.

(B) Appointment Procedures

5.2 Appointed by members at annual general meeting

(a) To reappoint retiring auditor by ordinary resolution (simple majority)
(S.131(1) of the Companies Ordinance).
(b) To appoint an auditor other than the retiring auditor by ordinary
resolution and special notice (S.132(1)(a) of the Companies
Ordinance).
(c) To reappoint, by ordinary resolution and special notice, a retiring
auditor appointed by directors (S.132(1)(c) of the Companies
Ordinance).

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5.3 Appointed by directors
(a) To fill a casual vacancy (臨時的空缺)
(b) To appoint company’s first auditor – directors can appoint the first
auditor before the first AGM. If the directors fail to exercise such
power, the company may appoint the first auditor in the general
meeting (S.131(3) & (4) of the Companies Ordinance)
5.4 Appointed by court
Where at an AGM of a company, no auditor is appointed or reappointed, the
court may, on the application of any member of the company, appoint a person
to fill the vacancy (S.131(2) of the Companies Ordinance).

6. Vacation of Office

(A) Removal procedures

6.1 The removal of an auditor before expiry of term of office includes the
following procedures:
(a) Ordinary resolution and special notice (S.131(6) of the Companies
Ordinance).
(b) On receipt of such notice, the company shall forthwith ( 立刻) send a
copy thereof to the auditor proposed to be removed (S.132(2) of the
Companies Ordinance).
(c) Notice of the resolution so passed shall be given to the Registrar of
Companies within 14 days, except for private companies (S.131(6) of
the Companies Ordinance).

(B) Resignation Procedures

6.2 To be effective in resigning from an office of auditor, the following steps

should be taken:
(a) The auditor must submit written notice to the company (S.140A(1) of
the Companies Ordinance).
(b) Whenever an auditor resigns his office he must deposit, with his notice
of resignation, at the registered office of the company either:
(i) a statement that there are no circumstances brought to the
attention of the members or creditors; or
(ii) a statement of any such circumstances.
(c) If there are circumstances to be brought to the attention of members or

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 creditors the company must send, within 14 days, a copy of the
statement to every person entitled to receive a copy of the accounts
(S.140A(3)(b) of the Companies Ordinance).
(d) The company must notify the Companies Registry regarding the
resignation of the auditor, within 14 days, except for private companies
(S.140A(3)(a) of the Companies Ordinance).

7. Rights and Duties of Auditors under Companies Ordinance

(A) Rights of Auditors

7.1 An auditor has the following rights so as to carry his or her duty properly:
(a) To access at all time to the books, accounts and vouchers of the
company (S.141(5) of the Companies Ordinance).
(b) To require from officers (directors and employees) of the company
such information and explanation as the auditor thinks necessary to
form his opinion (S.141(5) of the Companies Ordinance).
(c) To receive notices of an attend members’ general meetings and to
report on any matter which concerns him as auditor (S.141(7) of the
Companies Ordinance).
(d) It is an offence and is liable to imprisonment and a fine for an officer
of the company who knowingly or recklessly makes a misleading, false
or deceptive statement to the auditor of the company (S.134 of the
Companies Ordinance).
(e) Upon resignation or being removed, the auditor has the following
rights:
(i) To have the company sending a statement of circumstances
connected with their resignation to the members or creditors
within 14 days. (S.140A(3)(b) of the Companies Ordinance)
(ii) To have written representations or statement of circumstances
circulated to all members; or to have them read out at the
meeting concerned.
(iii) To receive notices of, attend and be heard at the general
meetings:
 At which his term office would otherwise have expired;
and
 At which it is proposed to appoint a new auditor
(S.140B(5) of the Companies Ordinance)

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 (iv) To require an extraordinary general meeting (EGM) to consider
the reasons for his resignation if his notice of resignation
contains a statement of circumstances. (S.140B(1) of the
Companies Ordinance)

(B) Duties of Auditors

7.2 The duties of an auditor include the followings:

(a) To make a report to the members on all accounts laid before the
members in general meeting during his tenure ( 任 期 ) of office
(S.141(1) of the Companies Ordinance).
(b) To include in the report statements on the accounts concerning the
compliance with the provisions of the Ordinance; and the truth and
fairness (S.141(3) of the Companies Ordinance).
(c) To investigate whether or not:
(i) proper accounting records have been kept;
(ii) proper returns have been received from branches not visited by
the auditor; and
(iii) the accounts are in agreement with the books of account and
returns (S.141(4) of the Companies Ordinance).
(d) To include in his report any instances where:
(i) proper books of account had not been kept; (S.141(4) of the
Companies Ordinance)
(ii) proper returns had not been received; (S.141(4) of the
Companies Ordinance)
(iii) the accounts were not in agreement with the books and returns;
(S.141(4) of the Companies Ordinance)
(iv) all required information and explanation have not been
obtained in carrying out his audit; (S.141(6) of the Companies
Ordinance)
(v) any required information, such as directors’ remuneration and
loans to officers, has been omitted from the accounts. (S.161(8)
and S.161B(6) of the Companies Ordinance)
(e) To complete the formalities ( 正 式 手 續 ) of vacation of office as
described in Section 6 in this chapter.

7.3 Test your understanding 4

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S.141(a) of the Companies Ordinance states that it is a statutory duty for
auditors of a company incorporated under the Companies Ordinance to make a
report to the members of the company on the company’s annual financial
statements.

Apart form the statutory duty under S.141(1) of the Companies Ordinance,
there are two other duties for auditors under S.141(3) and S.141(4) of the
Companies Ordinance. S.141(3) of the Companies Ordinance is about the
auditors’ report on the financial statements and S.141(4) of the Companies
Ordinance is about books and records.

The auditors are required to state whether the financial statements have been
properly prepared in accordance with the provisions of Companies Ordinance.

There are several provisions in the Companies Ordinance which empower the
auditors with adequate rights for them to exercise and to carry out their duties.
In addition, there are several provisions in the Companies Ordinance relating
to the rights of auditors upon resignation.

Required:
(a) State the other two duties under S.141(3) and S.141(4) of the Companies
Ordinance. (5 marks)
(b) State the rights of auditors given under the Companies Ordinance that
can empower the auditors to carry out their duties of reporting to the
members on the financial statements (4 marks)
(c) State the rights of auditors given under the Companies Ordinance upon
resignation. (4 marks)
(Adapted HKAAT Paper 8 Auditing June 1999)

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