Chapter One

Auditing an overview

1.1. Origin and Historical development of Auditing

The term “Audit” is derived from the Latin word “Audere” this means “to hear”. In the olden
days, whenever the proprietors of a business concern suspected a fraud, certain people were
appointed to hear verbal explanations given by the persons responsible for maintaining the books
of accounts and to judge the facts. Such persons were known as “Auditors”. Thus, 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.

Scope of audit was quite limited as the auditors during those days were interested in ascertaining
whether the persons responsible for keeping accounts had properly accounted for all cash
receipts and payments to his principal and in locating errors and fraudulent transactions, if any.

In simple words, the aim of audit was to know whether cash had been embezzled and if so, who
embezzled it and what amount was involved. Thus, it was merely a cash audit. But, the scope of
modern audit cannot be confined to cash verifications as the principal object of modern audit is
to report on financial position of the undertaking as depicted by its financial statements, i.e.
Balance sheet and Profit and Loss account, and other financial and non-financial information that
are related to different aspects of organizations’ economic activities . Detection of errors and
fraud is an incidental object of modern audit.

As far as the historical development of auditing is concerned, although the objectives and
concepts that guide present day audit were almost unknown until the early years of the 20 th
century, audits of one type or another have been performed throughout the recorded history of
commerce and government finance. From medieval times on through the time of industrial
revolution, audits were performed to determine whether persons in position of official
responsibility in government and commerce were acting and reporting in an honest manner.
During the industrial revolution, as manufacturing concerns 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. Bankers
were the primary out side users of financial reports and were concerned whether the repots were
distorted by errors or fraud.

Some of the major auditing developments undertaken since the 20th century are:

(1) A shift in emphasis to the determination of fairness of financial statements.

(2) Increased responsibility of the auditors to third parties, such as governmental agencies,
inventors, creditors, suppliers and other members of the society who depend on the
auditors report to make various economic decisions.
(3) A change in auditing method from detailed examination of individual transactions and
events to use of sampling technique, including statistical and non statistical samplings.
 (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 in demand for prompt disclosure of both favorable and unfavorable
information concerning any publicly owned company.
(8) An increased responsibility to assess the risk of material fraud.
(9) Increased demand for attestation by CPAs to managements assertion about compliance
with laws and regulations and the effectiveness of internal control.

1.2 Definition of Auditing

Definition of Auditing- It is quite difficult to give a single and precise definition of the term
“Audit”. The word “audit” has been defined by many distinguished authors and other bodies, and
every one of them has attempted to highlight one aspect or the other, but the central idea is more
or less the same.

Definition 1: Some authors define auditing as an independent examination of and expression of

opinion on, the financial statements of a concern by an appointed auditor in pursuance of that
appointment and in compliance with any relevant statutory (legal) obligations.

Definition 2: Some scholars also define auditing as an independent examination of the books of
account and the related documentary evidence by a qualified person in order to ascertain the
accuracy of figures.

Definition 3: According to Montgomery, an American Accountant & author, auditing is a

systematic examination of the books and records of a business of other organizations in order
to ascertain or verify and to report upon the facts regarding the financial operations and the
results thereof.

Definition 4: Spicer and Pegler in Practical Auditing defines auditing as an examination of

books, accounts and vouchers of a business, as will enable the auditor to satisfy himself/herself
that, the balance sheet is properly drawn up so as to give a true and fair view of the state of
affairs of the business and whether profit and loss account gives a true and fair view of the profit
or loss for the financial period, according to the best of his information and the explanations
given to him and as shown by the books and if not in what respect he is not satisfied.

Definition-5: A special committee of the American Institute of Accountants has defined the
term ‘audit’ as follows:
“An audit is an attest(prove) function where by a Certified Public Accountant (CPA)
independently examine financial information of an entity and produce a report on the subject
matter or an assertion about the subject matter which is the responsibility of another party ( e.g.
Management).”
To attest to information means to provide assurance as to its reliability. More formally, the
AICPA has defined an attest engagement as one in which:
A practitioner is engaged to issue or does issue a written communication that
expresses a conclusion about the reliability of a written assertion that is the
responsibility of another party.

A financial statement audit is, by far, the most common type of attest engagement. However,
CPAs attest to the reliability of a wide range of other types of information, including financial
forecasts, internal control, compliance with laws and regulations, advertising claims, and the
like.
The amount of evidence obtained by the CPAs and the content of the attest report depends on the
nature of the engagement. The standards of the AICPA recognize three forms of attestation
engagements. These are:

(i) Examination- An examination referred to as an audit when it involves historical

financial statements provides the highest form of assurance that CPAs provide.
(ii) Review- A review is substantially lesser in scope of procedures than an
examination, and is designed to lend only a limited degree of assurance.
(iii) Agreed upon procedures-if an examination or review does not satisfy (meet) the
clients needs, the CPAs and the specified users of the information may mutually
decide on specified agreed upon procedures that the CPAs will perform.

1.3. Auditing differentiated from bookkeeping, and Accountancy

In order to diagnose auditing in its correct perspective, one must know how auditing different
from book keeping, and accountancy, and what relationship it has with other two.
Book keeping- As the expression implies it refers to keeping the financial records (books) of a
business or other economic entity, recording all the transactions in which it engages. 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 activity of book keeping either be handle by
book keeper or accounting machines. Such activities involve:

i) Journalizing i.e. recording transactions in the books of original entry.

ii) Post them into different ledger kept for the purpose
iii) Taking total of different accounts in the ledger and
iv) Balancing

Accounting vs. auditing

Ideally, accounting begins where book keeping ends and auditing begins where accounting ends.
Accountancy is the work of an accountant and is confined mainly to the checking of the
arithmetical accuracy of the books of account, extraction of an agreed trial balance, and
preparation of financial statements in such a way that one can clearly know the state of affairs of
the business. 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 of
a concern. In short, an audit does not entail 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. Thus, the work of an auditor is to begin only
when the accountant has finished his work.

Some accounting activities involves

i) Checking the work done by the book keeper

ii) Preparing the trial balance
iii) Preparing the trading or profit and loss accounts, balance sheet, statements of owner’
equity or retained earnings , statements of cash flows and other related reports
iv) Passing entries for rectification of errors (correcting entries) and making the necessary
adjustments.
v) Review and interpretation of financial statements with a view to help and guide
management in formulation of future policies of business

1.4. Objective of Auditing/The need for an audit

Dependable information is essential to the very existence of our society. This is because, reliable
information such as accounting and financial reporting aid 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. Individual or group society members such as the following depend on
information provided by others in the course of decision making activities.

Investors- to make decision to buy or sell securities.

Bankers and creditors-to decide whether to approve a loan or not
Suppliers- to decide whether to supply goods and/ 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
Labor unions –to inter different contracts on the behave of the employees
Other members of the society -to make decisions of their respective interest.

Thus, directly or indirectly, almost everyone has a financial stake in corporate enterprises, and
the public interest demands prompt, reliable financial reporting on the operations and the
financial healthiness of publicly owned corporations.
However, in many of these situations, the goals of the providers of information run directly
counter to those of the users of the information. Implicit in this line reasoning is the recognition
of the social needs for independent public accountants-individuals of professional competence
and integrity who can tell us whether the information that we use constitutes a fair picture of
what is really going on.
The contribution of the independent auditor is, therefore, to provide credibility to 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 used to mean that
the information can be believed by its users.
Economic decisions are made under condition of uncertainty. There is always a risk that the
decision makers select the wrong alternative and incur a significant loss. The creditability added
to the information by auditors actually reduces the decision maker’s risk. To be more precise, the
auditors reduce information risk, which is the risk that the financial information used to make
decisions is materially misstated.

Audited financial statements are the accepted means by which business organization report their
operating results and financial positions. The word audited when applied to financial statements,
means that the balance sheet and the statement of income, retained earnings, and cash flows are
accompanied by an audit report prepared by independent public accountants, expressing their
professional opinion as to the fairness of company’ financial statements.
Financial statements prepared by management and transmitted to outsiders without first being
audited by independent auditors (unaudited financial statements) leave a credibility gap for all of
the reasons such as (accidental errors, lack of knowledge of accounting principles, unintentional
bias, and deliberate falsification). Due to such reasons, financial statements may depart from
Generally Accepted Accounting Principles (GAAP), and some other appropriate accounting
base. Auditors provide users with assurance that the financial statements are free from all the
above-mentioned problems and thus, 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, because, they only depend on sample population.

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.

i) Whether to make the loan at all and,

ii) 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, 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 GAAP and other appropriate accounting basis.
If the loan officer has assurance from the auditors that the company’s financial statements are
prepared in accordance with generally accepted accounting principles, he will have confidence in
his assessment of business risk. Moreover, the periodic audits made after the loan has been made
provide the loan officer with a way of monitoring management performance and compliance
with the various loan provisions.
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 obtain the loan and to get the best possible interest rate.

NB. While auditing normally has only a limited effect on a company’s business risk, it can
significantly reduce the level of information risk. The primary objective of auditing is
verification of accounts and statements while the subsidiary objective is detection and prevention
of errors and frauds.

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 rectified in time
3. A regular audit would exercise a great moral influence on the client a 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. He can
therefore be an adviser on these matters, which will help clients
5. An auditor acts as trustee (a person who has charge of property in trust) of the
shareholders and safeguards their financial interest in the case of as Joint Stock
Company. Shareholders are assured that the accounts have been properly maintained
and directors and manager of the company have not taken any undue 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. Comparison can be made 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.
1.5. Types of audits and auditors.

1.5.1. Types of audits-The various types of audit that might be undertaken by the auditor can be
categorized as:
i) Audit of financial statements
ii) Compliance audits
iii) Operational audits

i) Audit of financial statements- an audit of financial statements ordinarily covers the

balance sheet and the related income statements, retained earnings /owner’s equity/,
statements of cash flows. The goal is to determine whether these statements have been
prepared in conformity with generally accepted accounting principles. Financial
statement audits are normally performed by firms of certified public accountants. Users
of auditors’ reports include management, investors, bankers, creditors, financial analysts,
government regulators and other members of the society.

ii) Compliance Audits- Society has always concerned about compliance with laws and
regulations by all types of organizations. As a result, compliance auditing has evolved to
become an important part of the work of both external and internal auditors. Compliance
auditing is, therefore, the testing and reporting on whether an organization has complied
with the requirements of various laws, regulations, polices, procedures, and agreements.
E.g. The audit of an income tax return by auditors of internal revenue services to test
whether tax returns are in compliance with tax laws and internal revenue service
regulations.

iii) Operational Audits-the term operational audit refers to a comprehensive examination of

an operating unit or a complete organization to evaluate its systems, controls, and
performance, as measured by management objectives. An operational audit focuses on
the efficiency and effectiveness of operations. 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 organizations.

1.5.2. Types of Auditors-There are four types of auditors. Among these well known types of
auditors are:
I) certified public accountants (External auditors),
II) Internal auditors,
III) Auditors of the general accounting office, and
IV) Internal revenue auditors (tax auditors)

(I) 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.
(II) Internal auditors- The principal goal of the internal auditors is to investigate and
appraise the efficiency and effectiveness with which 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.
-Internal auditors report to the audit committee of the board of directors, to the
president or to other high executives.

-Internal auditors are employee of the organization in which they work and, thus, subject
to rules and regulations inherent in the employer- employee relation ships.
-Large part of the work of internal auditors consists of operational audit, they also
conduct compliance audit

Internal auditing: Internal auditing is conducted by employees of the business engaged in work
on behalf of the organization. He is a salaried employee of the business. Internal audit has been
defined as the “ independent appraisal of activity within an organization for the view of
accounting, financial and other business practices as a protective end constructive arm of
management” It is type of control which functions by measuring and evaluating the effectiveness
of other types of internal control. Internal audit can be either pre-audit or post-audit. It deals
primarily with accounting and financial matters; it may also properly deal with matters of an
operating nature. From the definition, it is clear that internal audit not only includes the
verification of accounting maters but also financial & other matters.
The Internal auditor is responsible to:

a) Establish rules and procedures of the internal accounting system.

b) Review the day-to-day financial operating procedures, and to check of there is
adequate supervision with a clear and up to date supply of information to the
management.
c) Evaluate the system of internal control.
d) Give periodic report to the management about the financial condition of the
organization.
e) Give recommendations about the improvement of procedures.
f) Appraising the quality of performance in carrying out assigned responsibilities.
g) Ascertain whether assets of the businesses are accounted for & safeguarded form
losses of all kinds.

III) Auditors of the general accounting office- Congress or federal government has long had 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.

IV) Internal revenue auditors (tax auditors) - The internal revenue service is responsible for
enforcement of the federal tax laws. Thus, 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.
1.6. Generally Accepted Auditing Standards (GAAS)-The existence of generally accepted
auditing standards is evidence that the accounting profession is very concerned with
maintaining a uniformity and high quality of audit work by all independent public
accountants. This will increase the prestige of the professional and attributers increased
significance by the public to the auditor’s opinion attached to financial statements.
According, 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
(1) The audit is to be performed by a person or persons having adequate technical
training and proficiency as an auditor.
(2) In all matters relating to the assignment, independence in mantel attitude is to be
maintained by the auditor or auditors.
(3) Due professional care is to be exercised in the planning and performance of the
audit and the preparation of the report.

B. Standards of field work

(1) The work is to be adequately planned and assistants if any are to be properly
supervised.
(2) Sufficient understanding of internal-control is to be obtained to plan the audit and
to determent the nature, timing, and extent of tests to be performed.
(3) Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmation to afford reasonable bases for an opinion
regarding the financial statements under audits.
C. Standards of reporting
(1) The report shall state whether the financial statements are presented in accordance
with generally accepted accounting principles (GAAP).
(2) 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.
(3) Informative disclosures in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.
(4) 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 therefore
should be stated.
Brief explanation of the standards

(1) Training and proficiency- this requirement is usually interpreted to mean college or
university education in accounting and auditing; participation in continuing education programs
and substantial public accounting experience. A technical knowledge of the industry in which the
client operates is also part of the personal qualifications of the auditors. It follow that a CPA firm
must not accept an audit engagement without first determining that members of its staff have the
proficiency needed to function efficiently and effectively in a given particular industry
(2) Independence- An opinion by independent public accountant as to the fairness of a
company’s financial statements is of a questionable value unless the accountant is truly
independent. Consequently, the auditing standard that states in all matters relating to the
assignment, an “independence in mental attitude is to be maintained by the auditors” is perhaps
the most essential factors in the existence of a public accounting profession.
E.g. If an auditor own shares of stock in a company that they audit, or if they serve as
members of board of directors, they might subconsciously biased in the performance of an
auditing duties.
An auditor is, therefore, expected to avoid any relationship with a client that would cause an
outsiders who had a knowledge of all the facts to doubt the CPA’s independence (independence
in fact and independence in appearance should be maintained).

(3) Due professional care- This standard requires the auditors to plan and carry out every step of
the audit engagement in an alert and diligent manner. Full compliance with these standards
would avoid or minimize any negligent acts or material omissions by the auditors.
(4) Adequate planning and supervision-is essential to a satisfactory audit. The appropriate
number of audit staff of various levels of skill and the time required for each need to be
determined in advance of the field work. Staff members with limited experience and new staff
members if any should be closely supervised while they are on work.
(5) Sufficient understanding of internal control- effective internal control provides assurance
that the client’s records are dependable and that its assets are protected. When the auditors find
this type of internal control, the quantity of other evidence required is much less than if control is
weak. Thus, the auditor’s assessment of internal control has great impact on the length and
nature of the audit process.

(6) Sufficient competent evidential matter-this standard of field work requires that the auditors
gather sufficient competent evidence to have bases for expressing an opinion on the financial
statements. The term competent refers to the quality of the evidence. Some evidential matters are
stronger and more convincing than others.

(7-10) Standards of reporting-The four reporting standards establish some specific directives for
preparation of the auditor’s report i.e.
- The reports must specifically state whether the financial statements are inconformity with
GAAP.
- Consistency in the application GAAP and adequate informative disclosure in the financial
statements is to be assumed unless the audit report states otherwise.
-The report must contain an opinion on the financial statements as a whole, or must disclaim an
opinion.