Chapter- 0ne

Auditing an Overview

1.1. Meaning and Historical Developments of Auditing

• Meaning: The term “Audit” is derived from the Latin word
“audire” which means “to hear”.
• The literal meaning of audit is to hear and the auditor is the
person who hears the explanations from the persons
accountable for keeping accounts.
• Therefore, audit or auditing means that, an act of checking
or examining the truth of accounts of an enterprise.
• In the past period, the scope of audit was quite limited in
ascertaining whether cash (all cash receipts and
payments) had been embezzled or not and if so, who
embezzled it and what amount was involved and in
locating errors and fraudulent transactions, if any.
 Therefore, it was merely a cash audit.
• But, the scope of modern audit cannot be restricted to
cash verifications,
• Modern audit verify the financial position of the business
as showed by its financial statements (i.e. B/sheet and
I/statement) and other financial and non-financial
information that are related to different aspects of
organizations’ economic activities.
• During the industrial revolution, as businesses grew in size,
their owners began to use the service of hired managers.
• With this separation of the ownership and management
groups, the absentee owners turned increasingly to auditors
to protect themselves against the danger of an intentional
errors as well as fraud committed by managers and
employees.
 Some of the major auditing developments undertaken
since the 20th century are:
1. A shift in emphasis to the determination of fairness
(conformity with rules or standards) of f/statements.
2. Increased responsibility of the auditors to third parties, (such
as governmental agencies, investors, creditors, suppliers
3. A change in auditing method from detailed examination of
individual transactions and events to use of sampling
technique.
4. Recognition of the need to consider the efficiency and
effectiveness of internal control as a guide to the direction
and amount of testing and sampling to be performed.
5. Development of new auditing procedures applicable to
sophisticated computer systems, and use of the computer
as an auditing tool.
6. Recognition of the need for auditors to find means of
protecting themselves from the current wave of litigation.
7. An increased responsibility to assess the risk of material
fraud.
8. Increased demand for verification by CPAs to
managements assertion about compliance with laws and
1.2 Definition of Auditing
•It is quite difficult to give a single and precise definition of the
term “Audit”.
•It has been defined by many different authors and other
bodies, and every one of them has attempted to emphasize in
one aspect or the other, but the central idea is more or less
the same.
♣Auditing
“a systematic
means; and independent examination of vouchers,
accounts, documents and books of a business by an
independent qualified auditor so as to ascertain and
express an opinion whether the enterprise has kept proper
books of accounts required by law and whether the financial
statements portray (show) a true and fair views of the
 In the examination of the financial statements an
auditor relies upon:-

1. The internal control procedures followed by the client

2. The examination of accounting records and
transaction, and their underlying evidences for
authority and validity.
3. The examination of other financial and non-financial
documents and records and their underlying evidences
for authority and validity.
4. Evidence obtained from outside sources, such as:
banks, customers, creditors, and others.
• From the previous and other definitions given by many
scholars, auditing may be stated as an independent,
scientific, intelligent and critical examination of the
books of accounts and records of businesses.

 Essential characteristics of Auditing (from the

definitions)

1. Audit is an independent, scientific and critical

examination
2. To satisfy himself, the balance sheet and the income
statement are properly prepared as per the requirement
of IFRS
3. balance sheet and profit and loss account exhibit a true
and fair picture of the financial state of affairs of the
4. Detection of errors and frauds is also part of auditing.
5. The job of auditing is performed by an independent
person or body of persons qualified for the job.
6. In order to report on the financial healthiness of a
business, the auditor will have to go through vouchers,
documents, information's, and related evidence (internal
or external).
7. The auditor may sufficiently satisfy himself about their
correctness, accuracy and authenticity of records and
accounts and submit his report accordingly.
1.3. Objectives of auditing
•Is communicating the results (audit report/opinion) to
interested users.
 The auditor’s opinion is called attestation.
 In an audit this attestation is called the “audit report”

♣The objective of an audit may be broadly categorized

as;
[Link] objective;. The prime objective of audit is the
examination of the accounts to express independent opinion
on records and accounts of an entity.
2. Secondary objective:
a)Ascertain the exact financial position of the organization
b)Prevention of errors and mistakes: b/c the people become
c) Detection of errors and frauds: errors can be
1. Clerical errors ;
a. Errors of omission: verified by cross check the
various invoices
b. Errors of commission: records the amount
erroneously (496 instead of 469),posting error, etc; by
routine checking (vouching).
c. Compensatory/secondary/error: errors to
compensate errors he/she made early; through careful
verification of accounts
2. Error of principle: record out of principles like,
depreciation, inventory valuation, etc; through an
intelligent inquiry, research
3. Specific objective:
a) Cost audit: verification of cost records and
examination of cost accounting procedures.
b) Management audit: checking managerial functions
and verification of operational efficiency.

1.4. Auditing differentiated from bookkeeping and

accountancy
•Ideally, accounting begins where book keeping ends and
auditing begins where accounting ends.
•Book keeping- As the term implies it refers to;
 keeping the financial records (books) of a business
entity,
• In simple words, book keeping is concerned with
recording day to day business transactions in the books
of original entry and the ledger.
• It is a part of accounting process, concerned only with the
original record of the transactions, which provides a base
for accounting.
• The major activities of book keeping either be handled
by book keeper or accounting machines involves:
 Journalizing i.e. recording transactions in the journal
 Posting them into different ledger kept for the
purpose
 Taking total of different accounts in the ledger and
 Balancing
• Accountancy is the work of an accountant and is restricted
mainly ;
 to the checking of the arithmetical accuracy of the books
of account,
 Preparing the trial balance
 Making the necessary adjustments.
 preparation of financial statements which clearly show
the state of affairs of the business.
 Review and interpretation of financial statements with a
view to help and guide management in formulation of
future policies of business
 Passing correcting entries
• Auditing involves a detailed and critical examination and
verification of such accounts by an independent expert for
the purpose of ascertaining the true and correct position
• In short, an audit does not involve the preparation of the
accounts at all but denotes something much wider,
namely, the examination of these accounts.
• The job of an accountant is to record the transactions
while an auditor has to check and verify such accounts.
• There cannot be auditing without prior existence of
accounts.
 Therefore, the work of an auditor is to begin only when
the accountant has finished his work.
1.5. The need for an audit

• Dependable information is essential to the existence of our

society.
• Because, reliable (dependable) information aids the
society;
 in allocating the limited resources in an efficient
manner so that the intended goal could be effectively
achieved by the end of the day.
♣ Individuals, groups, or other society members depend on
information provided by others in the course of decision
making activities.
• Such as;
 Investors: to make decision to buy or sell securities.
 Bankers and creditors: to decide whether to approve
 Suppliers: to decide whether to supply goods or
services on credit basis
 Managers: to make wise economic decisions and to
monitor the performance of management at every level
within the organization.
 Government agencies: to undertake various
regulatory actions and taxation.
 Labor unions: to inter different contracts on behave of
the employees
 Other members of the society: to make decisions of
their respective interest.
♣ The contribution of the independent auditor is, therefore, to
provide credibility to the information used by outsiders
(such as stockholders, creditors, government regulators,
customers, and other interested parties ) to make decisions
of various kinds.
• Credibility in this case is to mean that the information can
be believed by its users.
• Financial statements prepared by management and
transmitted to outsiders without first being audited by
independent auditors (un audited financial statements)
leave a credibility gap for all of the reasons such as
(unintentional errors, lack of knowledge of accounting
principles, unintentional bias, and deliberate falsification).
• The word audited applied to financial statements (balance
sheet and income statement, retained earnings, and cash
flows); when f/statements are accompanied by an audit
report prepared by independent public accountants,
expressing their professional opinion as to the fairness of
company’ financial statements.

 Auditors provide users with assurance that the financial

statements are free from all the above-mentioned
problems and therefore, showing a true and fair picture of
a business affair.
♣ However, auditors cannot give certificate or guarantee as
to the correctness or accuracy of these statements,
Illustrations- A decision by a bank loan officer about
whether to make a loan to a business can be used to illustrate
the demand for auditing. Since the banks objective is to get
appropriate rate of interest and to collect the principal of the
loan at maturity, the loan officer is making two related
decisions i.e.
1. Whether to make the loan at all and,
2. What rate of interest adequately compensates the
bank for the level of risk assumed?
The loan officer will make these decisions based on a careful
study of the company’s financial statements along with other
information.
Therefore, the risk assumed by the banker actually has two
components.
1. Business Risk- the risk that the company will not be able
to make periodic interest payments and repay the principal
at maturity, because of economic condition, poor
management decisions and for some other reason.
• Such risks are assessed by considering factors such as:
• Financial position of the companies
• The nature of its operation
• The characteristics of the industry in which it is
working
• Quality and integrity of management
2. Information Risk- the risk that the information used to
assess business risk is not accurate.
• Information risk includes the possibility that the financial
statements might contain material departure from IFRS
and other appropriate accounting basis.
1. If the loan officer has assurance from the auditors that the
company’s financial statements are prepared in accordance
with IFRS, he will have confidence in his assessment of
business risk.
• Moreover, the periodic audits made after the loan has been
provide the loan officer with a way of monitoring
management performance and compliance with the various
loan provisions.
2. On the other hand, by reducing information risk,
 the auditors reduce the overall risk to the bank;
 the company is more likely to obtain the loan and it will
be made at a lower rate of interest.
• Therefore, management of the company has an incentive
to provide audited financial statements to the loan officer to
NB. While auditing normally has only a limited effect on a
company’s business risk, it can significantly reduce the
level of information risk.

 Generally, some of the advantages of auditing may be

summarized as follows
1. Audited accounts are more readily accepted as correct and
authentic record of the transactions
2. Errors and frauds are detected and corrected in time
3. A regular audit would exercise a great moral influence on
the client, staff and thus prevent frauds and errors.
• The staff will also keep the books of account up to date.
4. An auditor possesses practical knowledge of business
finance, contract laws. Therefore he can provide
professional advise on these matters.
5. An auditor acts as trustee of the shareholders and
safeguards their financial interest.
• Shareholders are assured that;
 the accounts have been properly maintained and
 directors and manager of the company have not taken
any unnecessary advantage of their position.
6. Audited accounts are considered more reliable for
taxation purposes (sales tax, income tax etc.)
7. Audited accounts facilitate the settlement of accounts
between the partners, at the time of retirement or death
of partners.
8. Audited accounts are helpful in claiming reasonable
compensation from the insurance companies.
9. Facilitate comparison between the accounts of the current
year and other years.
10. Audited accounts can be very useful
 to secure loan, to obtain extend credit, to admit a
partner, to sell the business or
 to convert it into a joint stock company or to absorb or
amalgamate different business or
 to determine the purchase consideration.
11. As an appraisal function, audit reviews the existence and
operations of various controls and points out the
weaknesses and inadequacies.
12. Audit safeguards the interest of the worker since audited
accounts are useful to settle workers claim for higher
wages and bonus.
Limitations of Audit
•Auditor may not trace out all types of errors,
misappropriation or manipulations;
•He has to rely on the opinion of experts of various other
fields such as technical, legal, etc.
•Information given may be incorrect;
•Influence of management
1.6. Types of audit and auditors.
•The various types of audit that might be undertaken by the
auditor can be categorized as:
1. Financial statements audit
2. Compliance audits
3. Operational audits
[Link] Statement Audit
 The audit of financial statements ordinarily covers;
B/sheet; I/ statements, R/earnings, and cash flows
statements.
 The goal is to determine whether these statements
have been prepared in conformity with specified
criteria (IFRS).
2. Compliance Audits
• A compliance audit is designed to determine whether an
entity's financial statements are presented fairly in
accordance with IFRS, established laws and regulations,
and an organization's policies, procedures and agreements.
• However, unlike a financial statement audit, a compliance
audit is also designed to determine whether the entity has
complied with applicable laws and regulations.
• As a result, compliance auditing has developed to become
an important part of the work of both external and internal
auditors.
E.g. the audit of an income tax return by auditors of internal
revenue service’s to test whether tax returns are in
3. Operational Audits
• An operational audit involves a systematic review of an
organization's activities, in relation to the efficient and
effective use of resources.
• Efficiency is success in using the available resources to the
best advantage of the organization.
• Effectiveness is success in meeting one’s stated goal and
responsibility.
• Operational audit is usually performed by internal auditors
of the organization.
• The purpose of an operational audit is;
 To assess performance,
 To identify areas of improvement, and
 To measure the effectiveness and efficiency of the org.
and
Comprehensive Audit
•A comprehensive audit encompasses the determination of;
a) the fair presentation of financial statements,
b) the compliance with legislative or relative authorities,
and
c) the economy and efficiency in the administration of
resources and the effectiveness of programs.
Types of Auditors-There are four types of well known
auditors.
•These are;
1. Certified public accountants (External auditors),
2. Internal auditors,
3. Auditors of the general accounting office, and
4. Internal revenue auditors (tax auditors)
1. Certified public accountants (External auditors):
• These are a group of auditors who examine the records
supporting the financial reports of an enterprise and give
an opinion regarding their fairness and reliability.
• They are independent professionals who perform or render
professional service on a fee base, but not the employee of
the company being audited.
• They report their findings to stockholders.
2. Internal auditors:
• The principal goal of the internal auditors is to investigate
and appraise the efficiency and effectiveness whether the
various organization units of the company are carrying out
their assigned functions.
• Even though internal auditors are not independent as in
the same sense as the independent public auditors, they
should be independent of the department heads and other
line executives whose work they review.
1. Internal auditors report; to the audit committee of the
board of directors, to the president or to other high
executives.
2. Internal auditors are employee of the organization in
which they work and, thus, subject to rules and
regulations inherent in the employer- employee
relationships.
3. Large part of the work of internal auditors consists of
operational audit, they also conduct compliance audit
The Internal auditor is responsible to:
[Link] rules and procedures of the internal accounting
system.
[Link] the system of internal control.
[Link] the day-to-day financial operating procedures, and to
check there is adequate supervision with a clear and up to date
supply of information to the management.
[Link] periodic report to the management about the financial
condition of the organization.
[Link] recommendations about the improvement of procedures.
[Link] the quality of performance in carrying out assigned
responsibilities.
[Link] whether assets of the businesses are accounted for &
safeguarded from losses of all kinds.
3. Auditors of the general accounting office:
• Upper house or federal government has its own auditing
staff, headed by the controller general and known as
general accounting office (GAO) auditor.
• The work of GAO auditors includes audits of government
agencies to determine the spending programs, evaluate
the efficiency and effectiveness of selected government
programs; audit of financial statements of a number of
federal agencies and others.
4. Internal revenue auditors (tax auditors):
• Internal revenue auditors conduct compliance audits of
the income tax return of individual and corporations to
determine that income has been computed and taxes paid
as required by the federal law.
Generally Accepted Auditing Standards (GAAS):
• The existence of GAAS is evidence that the accounting
profession is very concerned with maintaining a
uniformity and high quality of audit work by all
independent public accountants.
• Accordingly, the AICPA has set forth the basic frame
work in the following 10-generally accepted auditing
standards which are grouped under three major
categories.
a) General Standards
[Link] audit is to be performed by a person having adequate
technical training and proficiency as an auditor.
[Link] all matters relating to the assignment, independence
 3. Due professional care is to be exercised in the
performance of the audit and the preparation of the
report.
B) Standards of Field work
4. The work is to be adequately planned, and assistants,
if any, are to be properly supervised.
5. Sufficient understanding of the internal control
system is to be obtained to plan the audit and to
determine the nature, timing, and extent of tests to be
performed.
6. Sufficient competent evidential matter is to be
obtained through inspection, observation, inquiries, and
confirmations to give a reasonable basis for an opinion
regarding the financial statements under audit.
C) Standards of Reporting
7. The report shall state whether the financial statements
are presented in accordance with GAAPs or IFRS;
8. The report shall identify those circumstances in which
such principles have not been consistently observed in
the current period in relation to the preceding period.
9. Informative disclosures in the financial statements are
to be regarded as reasonably adequate unless otherwise
stated in the report.
10. The report shall either contain an expression of
opinions regarding the financial statements taken as a
whole, or an assertion to the effect that an opinion
cannot be expressed. When an overall opinion cannot
be expressed, the reason for should be stated.
 End of Chapter one

Thank You!

Read More, See More

!!!