CHAPTER ONE

NATURE, PURPOSE AND SCOPE OF AUDITING

Definition
Auditing is an independent examination of the financial information of a business by an auditor in
accordance with the relevant regulations with the objective of expressing an opinion. An auditor is the
person having the final responsibility for the audit. The word audit comes from the Latin word audire
which means to hear. This is because the accounts of revenue and expenditure were heard by the auditor.
It is a service where the auditors objective is to provide high level of assurance through the issue of a
positive expression of opinion that enhances credibility of assertion about an accountability matter.
Concepts in auditing
Accountability, Stewardship & Agency
(a) Accountability: to be accountable means to be responsible for your actions. In our contest, it means to
require the managers to explain their actions to the shareholders of the company through preparation of
financial statements.
(b) Stewardship: to be a steward means to be responsible for taking care of something on behalf of
another. This is known as a Fiduciary Relationship and exists between directors and shareholders as
directors are responsible for the management of the shareholders property.
(c) Agency: Agency is where an agent acts on behalf of a principle to perform tasks for them. In the
context of a company, the directors are the agents of the shareholders (principles) who entrust them to
manage the running of the business. This separation of ownership and management is often referred to
as the Agency Problem.
Need for an audit:
What motivates entities to have their financial statements audit?
1. Its a legal requirement for all limited companies to have their financial statements audited.
2. Confidence to the owners that the financial statements are a true and fair reflection of the performance of
their business.
3. It gives confidence and peace of mind to the management that the financial statement shows a true and
fair (are presented fairly).
4. Internal Control System assessment: it gives stakeholders the reassurance that an auditor has assessed the
sufficiency, strength and effectiveness of control systems in the company.
5. Review of Compliance: The regulators e.g. Companies Act, Capital markets Authority and Stock
Exchange will get some level of assurance of compliance through financial statements audit.
6. Assurance to third parties: third parties e.g. banks, suppliers and customers are interested in the
performance of the entity. Financial analysts use the financial statements for performance assessment,
evaluation and forecasts. All these parties will want to be reassured that the financial statements are not
misleading. Financial statements audit adds the needed credibility.
Objectives of an Audit
They are divided into three
(a) Statutory objectives
(b) Professional objectives
(c) Incidental objective
Statutory objectives:
To express an opinion as to whether the financial statements show a true and fair view or are presented fairly
in all material respects
True means;
- Information is factual and conforms with reality
- Complies with accounting standards and any relevant legislation
- Data is correctly transferred from accounting records to the Financial Statement
Fair means;
- Information is clear, impartial and unbiased
- Reflects plainly the commercial substance of the transactions
Professional objectives
(a) To enable the auditor to give advice to the management
(b) May boost the morale of the accounting staff
(c) Boost the strength of the Internal Control Systems
Incidental objectives
(a) To detect errors and frauds
(b) Give credibility to the financial statements
(c) Helps in prevention of errors and frauds
Changes in Objectives of audit
The objectives of auditing have changed over the years in the following ways
(a) Truth and fairness in auditing requires the materiality concept but fraud and error detection requires
detailed vouching.
(b) Modern auditing requires reliance wherever possible on internal controls and installation of such
systems by the directors, whereas early auditing did not take into account internal control systems
when auditing
(c) The modern auditing is focused on high risk areas thus with minimal testing of other areas
These changes have been occasioned by the following reasons
(a) Increase in cost of auditing which has made auditing more efficient
(b) Increase in the size of the business which has made vouching impracticable
(c) Separation of ownership and control which have switched emphasis from fraud of employees to
validation of directors produced financial statements.
(d) Changes in Company law and professional body requirements towards auditing work which has all
called for changes in auditing objectives.
(e) Increase in investors awareness which has changed in audit objectives.
(f) More sophisticated accounting and control systems all of which have called for changes in auditing
approach.
Distinction between auditing and accounting
Auditing
(a) Involves examination of financial statements to prove the true and fair view of companys 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
General principles of an audit
The auditor should comply with the Code of Ethics for Members issued by the International Federation of
Accountants. Ethical principles governing the auditors professional responsibilities are:
(a) Independence
(b) Integrity
(c) Objectivity
(d) Professional competence and due care
(e) Confidentiality
(f) Professional behaviour; and
(g) Technical standards
The auditor should conduct an audit in accordance with International Standard of Audit (ISAs). These
contain basic principles and essential procedures together with related guidance in the form of explanatory
and other materials.
Professional scepticism

Scope of an audit The term scope of an audit refers to the audit procedures deemed
necessary in the circumstances to achieve the objective of the audit. The procedures required
to conduct an audit in accordance with ISAs should be determined by the auditor having
regard to the requirements of ISAs, relevant professional bodies, legislation, regulations and,
where appropriate, the terms of the audit engagement and reporting requirements.
6.4 Reasonable assurance An audit is designed to provide reasonable assurance that the
financial statements taken as a whole are free from material misstatement. Reasonable
assurance is a concept relating to the accumulation of the audit evidence necessary for the
auditor to conclude that there are no material misstatements in the financial statements
taken as a whole. Reasonable assurance relates to the whole audit process. An auditor cannot
obtain absolute assurance because there are inherent misstatements. These limitations result
from factors such as: * The use of testing * The inherent limitations of internal control (for
example, the possibility of management override or collusion). * The fact that most audit
evidence is persuasive rather than conclusive. Also, the work undertaken by the auditor to
form an audit opinion is permeated by judgment, in particular regarding: a) The gathering of
audit evidence, for example, in deciding the nature, timing, and extent of audit procedures:
and b) The drawing of conclusions based on the audit evidence gathered, for example,
assessing the reasonableness of the estimates made by management in preparing the
financial statements.
Further, other limitations may affect the persuasiveness of audit evidence available to draw
conclusions on particular assertions (for example, transactions between related parties).
Accordingly, because of the factors described above, an audit is not a guarantee that the
financial statements are free of material misstatement.
Audit risk and materiality Entities pursue strategies to achieve their objectives, and
depending on the nature of their operations and industry, the regulatory environment in which
they operate, and their size and complexity, they face a variety of business risks.
Management is responsible for identifying such risks and responding to them. However, not all
risks relate to the preparation of the financial statements. The auditor is ultimately concerned
only with risks that may affect the financial statements. The auditor obtains and evaluates
audit evidence to obtain reasonable assurance above whether the financial statements give a
true and fair view (or are presented fairly, in all material respects) in accordance with the
applicable financial reporting framework. The concept of reasonable assurance acknowledges
that there is a risk that the audit opinion is inappropriate. The risk that the auditor expresses
an inappropriate audit opinion when the financial statements are materially misstated is
known as audit risk. The auditor should plan and perform the audit to reduce audit risk to an
acceptably low level that is consistent with the objective of an audit. The auditor reduces
audit risk by designing and performing audit procedures to obtain sufficient appropriate audit
evidence to be able to draw reasonable conclusions on which to base an audit opinion.
Reasonable assurance is obtained when the auditor has reduced audit risk to an acceptably
low level. The auditor is concerned with material misstatements, and is not responsible for the
detection of misstatements that are not material to the financial statements taken as a whole.
The auditor considers whether the effect of identified uncorrected misstatements, both
individually and in the aggregate, is material to the financial statements taken as a whole.

Responsibility for the financial statements

The Directors and Auditors responsibilities in relation to financial statements

The Companies Act:
The directors have the following responsibilities;
To keep proper books of accounts
Prepare financial statements that show a true and fair view
Ensure the financial statements are in agreement with the books of accounts
Safeguarding the companys assets
To file the companys annual returns with the registrar of companies.
Professional requirements [ISA 700 (revised)]
Preparation and fair presentation of financial statements in accordance with an identified financial
reporting framework
Design, implement and maintain internal controls relevant to the preparation and fair presentation of the
financial statements and free from misstatements either due to errors and fraud.
Selecting and applying appropriate accounting policies
Making accounting estimates that are reasonable in the circumstances.
Auditors responsibilities
He is to express an opinion on the financial statements based on the audit. The auditors report states that the
auditors responsibility is to express an opinion on the financial statements based on the audit in order to
contrast this from management responsibility for the preparation and fair presentation of the financial
statements.
Expectation Gap
This is the difference between client's expectations and actual audit work performed
What causes the 'Expectation Gap'
(a) Management misunderstanding their responsibilities
(b) Management misunderstanding the scope of the audit
(c) Management misunderstand that it is THEIR responsibility to detect fraud
(d) Management think that the auditors are liable for any errors
Most users believe that the auditors responsibility is to;
(a) Prepare financial statements that show a true and fair view
(b) Detection and prevention of errors and irregularities
(c) safeguards the assets
(d) Certify that the company is a going concern
(e) Ensure continual profitability to the company.
How is the 'Expectation Gap' narrowed?
In the Audit report
(a) Responsibilities of management and the auditor should be clearly stated;
(b) Show that audits are performed on a test basis only
(c) A statement that the opinion gives reasonable NOT absolute assurance that FS are free from material
misstatement
In the Engagement letter
(a) Responsibilities of management and the auditor
(b) The nature, scope and purpose of an audit
(c) Disclaimer; There are many disclaimers protecting the auditor and reducing the amount of reliance that
users can place on these reports.
Users of audited financial statements
(a) Present and potential investors. They are risk capital providers and their advisors are concerned with
the risk that is inherent in their investment. They need information to help them determine whether
they should buy more shares, hold on to the shares they have or sell the shares they have.
(b) Employees. These and their representative groups such as trade unions are interested in information
about the stability and profitability of their employers. They are also interested in information which
enable them assess the ability of the company to provide adequate remuneration, retirement benefits
and employment opportunities.
(c) Lenders. These are interested in information that enables them determine whether their loans and
interests arising from the loans will be paid back when due.
(d) Suppliers and other trade creditors. These users are interested in information that enables them
determine whether the amounts owing to them will be paid when due. Their interest in the company is
of shorter period than lenders while they are dependent upon the continuation of the company as a
major customer.
(e) Customers. These have interest in information about the continuance of the company especially when
they have long term involvement and or are dependent as the company.
(f) Government. The main interest of the government is allocation of resources. It also requires
information in order to regulate the activities of the enterprise, determine taxation policies and obtain
national income statistics.
(g) Public. A company affects public in a variety of ways. A company may make substantial contribution
to the local economy by employing people and obtaining supplies locally. Financial statements assist
the public in information on trends and recent developments of the company in the economy.
Others: Lawyers, Competitors, Stock brokers, Statisticians, Financial journalists, Trade unions, Credit-rating
agencies
Advantages of an audit
 (a) An audit protects the interests of the shareholders who are separated from the management of the
company.
(b) Gives credibility to the financial statements. The various users can therefore place reliance on them.
(c) The auditors experience will enable him to make recommendations on ways of improving the
accounting and the internal control system.
(d) An audit assists in the prevention and detection of errors and frauds through the moral and deterrent
effect.
(e) May be used by tax authorities to ascertain their tax liability hence avoiding conflicts between the
company and tax authorities
(f) It boost the morale of the accounting staff
Disadvantages of audit
(a) Its expensive for small firms e.g. a sole proprietor may not afford their financial statements to be
audited.
(b) The audit exercise interrupts the clients operations because clients staff has to spend time in availing
the required information to the auditors.
(c) Company secrets may leak to competitors since all company information is accessible to the auditors.
(d) If a qualified report is issued, it may damage the reputation of the company
(e) Its not ideal for small businesses whose transactions are too few
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 clients business. The auditor seeks to obtain some background information of
the nature of the clients 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.
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.