CHAPTER ONE
INTRODUCTION TO AUDITING
MEANING
It’s the independent examination of and expression of an opinion on the financial statements of
an enterprise by an appointed auditor in pursuance of that appointment and in compliance with
any relevant statutory obligation.
DISTINCTION BETWEEN AUDITING AND ACCOUNTING.
AUDITING
a) Involves examination of financial statements to prove the true and fair view of company ‘s
affairs.
b) It is done mainly at year-end after the directors have prepared the financial statements,
although the planning work could be carried out earlier.
c) An audit is mainly governed by the international standards on auditing (ISA).
d) The auditor must be independent of all the stakeholders such as management.
e) It is a statutory requirement that financial statements are audited.
ACCOUNTING
a) Involves preparation of books of accounts to aid in decision-making.
b) It is a continuous process carried out throughout the financial period.
c) In preparing financial statements and maintaining books of accounts, the accountant is guided
by generally accepted accounting standards.
d) Accountancy is a management function aimed at assisting management to run the business in
an orderly efficient manner.
e) It is a statutory requirement that all companies must maintain proper accounting records.
OBJECTIVES OF AN AUDIT
a) The primary objective of an audit of financial statements is to enable the auditor to
express an opinion whether the financial statements are prepared, in all material
respects, in accordance with an identified financial reporting framework.
b) To give credibility to the financial statements. This arises from the fact that the
accounts have been subject to an examination by an independent person.
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c) An audit may assist in the prevention and detection of errors and frauds.
d) The auditor ‘s experience will enable him to make recommendations on ways of
improving the accounting and internal control system.
Benefits of an audit to a public limited company
An audit protects the interests of the shareholders who are separated from the management
of the company. This is especially the case for minority shareholders who have little say in
the management of their company.
An audit being an independent examination of the financial statements gives credibility to
the financial statements. The various users can therefore place reliance on them.
The auditors experience will enable him to make recommendations on ways of improving
the accounting and the internal control system.
An audit assists in the prevention and detection of errors and frauds through the moral and
deterrent effect.
TYPES OF AUDITS
1. Statutory/Public audits
These are carried out as per the requirements of the various statutes e.g. the Companies Act cap
486 requires that all public limited companies must have their financial statements subjected to
an independent audit. The objectives of the audit are to express an opinion as to whether the
balance sheet and the profit and loss account show a true and fair view. The rights and duties of
the auditor are laid out in the Companies Act or the relevant statute. The powers of appointment
of the auditor are vested on the shareholders.
2. Non-statutory/Private audits
These are audits that are not governed by the Act. These are performed by an independent
auditor because the owners, members or other interested parties require them and not because the
law requires them to be carried out. Private audits are carried out for organizations such as
NGOs, partnerships, clubs and charities among others. The appointment of the auditor is usually
carried out as a private contract between the auditor and the relevant stakeholder. The scope and
objective of the work is determined by the agreed terms between the auditor and the client. The
auditors’ rights and duties are also laid out in the contract.
Differences between Statutory and Private Audits
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Statutory Audits
1. It is a requirement of an Act of parliament e.g. the Companies Act.
2. The scope and objective of work is defined in the Act
3. The report is addressed to the shareholders.
4. Appointment of the auditor is stipulated in the Act (Sec.159). It can either be by
shareholders, directors or registrar of companies.
5. The auditor is liable to third parties.
6. The auditor has full independence.
Private Audits
1. It is not a requirement by the Act.
2. The scope is agreed between a client and the auditor therefore it is limited.
3. Report is addressed to relevant stakeholder.
4. Private appointment by the owner.
5. The auditor is not liable to third parties.
3. Continuous audits
This is an approach whereby the audit is carried out throughout the financial period. The audit
work is carried out at predetermined intervals usually around three audit visits. This approach is
ideal for large organizations with tight reporting deadlines e.g. multinational banks.
4. Interim audits
This is an audit that is usually carried out mid-way through the accounting period. an interim
audit usually precedes a final audit and is ideal for large to medium size companies.
5. Final audits
Usually done at the end of the year on the financial statements i.e. the balance sheet and the
profit and loss account. A final audit can be conducted in two ways;
1 As a continuation of the interim audit for large to medium size organizations;
2 For small organizations the audit could be carried out in one single session after the end of the
financial period.
After examining the end year financial statements, the auditor then forms his opinion as to
whether the financial statements show a true and fair view and reports this to the shareholders.
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6. Procedural audits
Requires an examination of procedures or records for reliability and accuracy. At the end the
auditor can add new ones, modify existing ones or scrap old ones.
7. Management audits
This involves investigation of the company’s entire management to ascertain whether the
management is running the organization in the best interest of the stakeholders. It investigates
company’s managerial aspects of the business from high to low management. It assesses the
efficiency of management to run the organization in the most viable way.
8. Balance sheet audits
Tests the strength of the internal control system by working backwards to get the initial
transactions.
STAGES OF AN AUDIT
In carrying out an audit the following are the main stages. However, note that the steps followed
will vary from client to client and from auditor to auditor.
1) Determining the scope of the audit work. For statutory audits the scope is clearly laid
out in the provisions of the Companies Act and is formally contained in the letter of
engagement.
2) Ascertain nature of the client’s business. The auditor seeks to obtain some background
information of the nature of the client’s business.
3) Planning the audit; the auditor prepares a planning memorandum that shows the general
strategy in to be followed in conducting the audit.
4) Ascertaining and evaluating clients accounting systems and internal controls, use of
flow charts and evaluating using key questions.
5) Carrying out tests of controls: This enables the auditor to determine the level of
reliance to be placed on the internal control system and therefore reduce the level of
substantive testing.
6) Planning the level of substantive testing and formulating the substantive tests to be
carried out.
7) Carrying out substantive testing on the selecting account balances.
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8) Carrying out the final analytical review and concluding whether the financial
statements show a true and fair view.
9) Drafting the audit opinion and any other reports to be issued under the terms of
engagement e.g. the management letter.
3.20 ERROR
Errors can be described as unintentional mistakes in the financial information, which can
occur any time during processing and recording of transactions. These include:
• Mathematical or clerical mistakes;
• Oversight or misrepresentation of facts;
• Misapplication of accounting policies (Millichamp & Taylor 2021).
3.21 Types of Errors
a) Errors of commission: These are errors that do not show in the trial balance because
it still balances. This is where the correct amount for a transaction is recorded but the
wrong person’s account. For debtors the correct class of accounts may be used but
the wrong personal entries are entered.
b) Errors of omission: where a transaction is completely omitted from the books.
c) Error of principle: where an item is entered in the wrong class of account for
example a fixed asset is debited to the expense account.
d) Compensating errors: where errors cancel each other out. The errors usually have
occurred on opposite sides of the account that is on the credit side and the debit side
with an equal amount. The errors in question are totally independent.
e) Error or original entry: when the original figure is incorrect and the double system
entry is still observed.
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f) Complete reversal of entries: where correct accounts are used but each item is
shown on the wrong side of the account. For example crediting a sale in the debtor
account and debiting the sales account.
Therefore, errors can be of any of a multitude of kinds and may occur at any stage in
business transaction processing: transaction occurrence, documentation, record of
prime entry, double entry record, summarizing process and financial statement
production (Millichamp & Taylor 2021).
3.22 Detection of errors
• Compare previous year’s figures with the current figure and ascertain that all
changes are in order and authentic.
• Cast the trial balance figures and ensure they balance.
• Check the names of the accounts in ledgers and those recorded in the trial balance
to ensure that there are no omissions.
• Compare debtors and creditors from ledgers and those in trial balances. Debtors
and creditors accounts are easily a source of confusion for incompetent staff especially
when they involve many transactions.
• Ensure that the totals of self-balancing accounts agree.
• Count items in trial balance in the current account and compare those in the
previous account. Investigate any differences.
• Check totals of subsidiary books).
3.23 Auditors primary interest with errors
Auditors are primarily interested in the prevention, detection and disclosure of errors for the
following reasons:
a) The existence of errors may indicate to an auditor that the accounting records of
his client are unreliable and thus are not satisfactory as a basis from which to prepare
financial statements. The existence of a material number of errors may lead the auditor to
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conclude that proper accounting records, as required by company act, have not been kept.
This is a ground for qualification of the auditor's report under the Section.
b) If the auditor wishes to place reliance on any internal control, he should ascertain
and evaluate those controls and perform compliance tests on their operations. If
compliance tests indicate a material number of errors then the auditor may be unable
to place reliance on internal control. For example, a client invoices goods of both zero
rated and standard rated VAT supplies, the VAT is calculated by Clerk A on a calculator
and checked by Clerk B. The auditor tests the control by reperforming a sample of the
calculations and a significant number of errors are found. The auditor cannot rely upon
the control.
c) If errors are of sufficient magnitude they may be sufficient to affect the truth
and fairness of the view given by the financial statements. If errors in VAT calculation
are made then the liability to Customs and Excise will be incorrect. The effect of the total
number of errors may not be material enough to affect the true and fair view. In that case,
the auditor is not concerned with the error, except that he will inform his client in the
management letter. However, the auditor has to have good evidence that the effect of the
errors is not material (Millichamp & Taylor 2021).
3.30 FRAUD AND OTHER IRREGULARITIES
Definition of Irregularity: this is the deliberate distortion of information together with the
related misappropriation of assets. An irregularity becomes a fraud when it involves
criminal deception that is seeking unjust advantage leading to misleading information.
Definition of Fraud: this refers to intentional misrepresentation of financial information by
one or more individuals among management, employees or third parties involving the use of
deception to obtain an unjust or illegal advantage.
The term 'fraud and other irregularities' is used for several sins including:
a) Fraud involves the use of deception to obtain an unjust or illegal financial
advantage. An example of fraud might be the action of J; the principal shareholder and
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director of J Ltd in intentionally stating stock to be larger than it actually was. This may
be criminal deception in that he is intending to obtain an illegal advantage for J Ltd by
continuing to receive trade credit from K Ltd who have reviewed J Ltd's accounts. There
is a possibility that J Ltd may not be able to fulfil its obligations under the continued
credit line.
b) Intentional misstatements in or omissions of amounts or disclosures from, an
entity's accounting records or financial statements.
c) Theft, whether or not accompanied by misstatements of accounting records or
financial statements.
d) Illegal acts are any act which is contrary to law. It may be committed
intentionally or inadvertently. In our over-regulated society acts contravening laws
relating to planning, health and safety, pollution, employment etc. are easy to commit
either intentionally or in ignorance of the law.
e) Irregularity: It is the deliberate distortion of information together with the
related misappropriation of assets. An irregularity becomes a fraud when it involves
criminal deception that is seeking unjust advantage leading to misleading information.
The auditor may be concerned with a known or proven fraud or other irregularity, but the
problems arise mainly with suspected frauds and situations where the auditor suspects
wrongdoing but has no hard data (Millichamp & Taylor 2021).
Although fraud is a broad legal concept, the auditor is concerned with fraudulent acts that
cause a material misstatement in the financial statements. Misstatement of the financial
statements may not be the objective of some frauds. Auditors do not make legal
determinations of whether fraud has actually occurred.
Fraud involving one or more members of management or those charged with governance is
referred to as management fraud;” fraud involving only employees of the entity is referred
to as “employee fraud.” In either case, there may be collusion with third parties outside the
entity.
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Two types of intentional misstatements are relevant to the auditor’s consideration of fraud
– misstatements resulting from fraudulent financial reporting and misstatements
resulting from misappropriation of assets.
Fraudulent financial reporting involves intentional misstatements or omissions of amounts
or disclosures in financial statements to deceive financial statement users. Fraudulent
financial reporting may involve the following:
1. Deception such as manipulation, falsification, or alteration of accounting records
or supporting documents from which the financial statements are prepared.
2. Misrepresentation in or intentional omission from, the financial statements of
events, transactions or other significant information.
3. Intentional misapplication of accounting principles relating to measurement,
recognition, classification, presentation, or disclosure.
The distinguishing factor between fraud and error is whether the underlying action that
results in the misstatement in the financial statements is intentional or unintentional. Unlike
error, fraud is intentional and usually involves deliberate concealment of the facts. While the
auditor may be able to identify potential opportunities for fraud to be perpetrated, it is
difficult, if not impossible, for the auditor to determine intent, particularly in matters
involving management judgment, such as accounting estimates and the appropriate
application of accounting principles.
3.31 Common types of fraud include:
• Manipulation, alteration or falsification of records or documents.
• Misappropriation of goods.
• Misappropriation of accounting policies.
• Suppression or omission of effects of transactions on documents.
• Recording fictitious transactions .
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3.32 Auditor’s responsibility towards fraud and other irregularities
The auditor's responsibility towards fraud and other irregularities is not dissimilar to that in
relation to errors:
a) Irregularities may mean that proper accounting records have not been kept.
For example, the financial position of the company may be unable to be disclosed with
reasonable accuracy or all sums of money received are not entered in the accounting
records.
b) The existence of irregularities may indicate that some internal controls are not
effective and that the auditor cannot place reliance on those internal controls.
c) Irregularities may exist which prevent the financial statements from showing a
true and fair view and complying with Companies Act requirements (Millichamp &
Taylor 2021).
We should note that at this point prevention and detection of errors and fraud is only a
secondary objective for the auditor. The auditor is more concerned with materiality of errors
and fraud and their effects on financial statements
3.4 Materiality
A true and fair view may be given by financial statements of Huge PLC with or without
disclosure of a minor petty cash defalcation. On the other hand, a theft by an employee of
£50,000 from Small Ltd would have to be disclosed if the profits were reported as £45,000.
The latter is material to the accounts and the former is not.
Materiality concept was discussed in detail principles of accounting and should be fully
understood by my readers. However, if an auditor knows or suspects that an error or
irregularity has occurred or exists, then he cannot apply materiality consideration until
he had sufficient evidence of the extent of the error or irregularity. Consequently,
investigations may need to be made (by the auditor or by the client) into all errors and
irregularities so that the auditor can have evidence of the materiality of the matter concerned
(Millichamp 2002; Strathmore 1992).
Examples:
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i. Theft of stock by employees and the public from a supermarket chain is commonplace
and readers of financial statements presume that some thefts will have occurred.
Providing the thefts are within normal tolerances, the accounts do not need to show the
fact of or the amount (always unknown) of such thefts. However, a material theft of
cash concealed by suppression of copy invoices, in one particular year, by the
company accountant would need to be disclosed in the accounts. Otherwise, readers
would have a wrong view of the annual profits in relation to trends in annual profits.
ii. Intentional inclusion in the accounts of debts which are known by the directors to be bad
would lead to a wrong view being given to readers of the accounts, of profits and capital
(Millichamp & Taylor 2021).
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