CHAPTER ONE

1. AN OVERVIEW OF AUDITING

The historical development of auditing is related to the development of accounting. In the earlier
periods, the owner of business can manage their business and the need for independent auditors
is minimal. But because of the increase in complexity of business and different parties are
interested in, modern corporations are characterized by separation of ownership from control.
Owners control their firms indirectly through the board of directors whom they elect by general
assembly. Board of directors, in turn, appoints managers who are responsible to look after the
day-to-date operations of the business. In this case, managers become agents for the owners.
They are supposed to act in the best interest of the owners. However, in many cases, evidence
shows that managers frequently fail to act in the best interest of the owners which leads to
conflict of interest between managers and shareholders. Similarly, the undesirable actions of the
managers also create conflict of interest between debt holders (creditors) and shareholders.
Therefore, as a solution, auditors are supposed to solve these conflicts of interests and the need
for an independent auditor is becoming more important. External auditing is intended to provide
reasonable assurance that management has acted in the best interest of the shareholders and other
stakeholders. Because, external auditing is one of the different means available to the
shareholders and board of directors to monitor and control the actions of the managers.
1.1. Evolution of Auditing
Generally, the early historical development of auditing is not well documented. The field of
auditing has not grown to its present state overnight. Rather it passed through different
developmental stages. It is imperative to understanding the historical development of auditing to
understand the role auditing plays in different societies.
The available evidence indicates that a system of auditing existed even in times of ancient
civilizations Mesopotamian, Egypt, Greece, England, and Italian City States (e.g. Florence).
Mesopotamian leftovers of commercial transactions reveal tiny marks, dots, ticks, and circles at
the side of the figures. This indicates that those figures had been checked. In ancient Egypt,
two officials recorded fiscal receipts separately and other officials conducted the audit. In
Greece, the accounts of public officials were scrutinized at the expiring of their terms of office.
In the United Kingdom during the 12th century records revealed the existence of a system of

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accounting and auditing of the transactions of the state. Special audit officers were appointed at
the time to ensure that the revenue and expenditure of the state were duly accounted for. The
audit of the accounting system of London towards the end of the 13th century was aimed at
ensuring the absence of frauds, arithmetical accuracy of accounts and compliance with the
authority given to the custodian. The subsequent years witnessed the gradual maintenance of
accounts by individual agriculturists, estate owners, traders and others. Mercantile account took
definite plan in Europe during this period. Contemporarily the legal provisions and growth of
the current auditing act have immeasurably enhanced to understand its earlier origins and the
economic situation. The development of trade and commerce between medieval Italian cities
and the east which fostered the sailing ships "joint venture" accounts to end the venture at the
completion of the voyage. Thus, responsibility for this function fell on the shoulder of the
bookkeeper and the lawyer. These events were further evolved by the growth of partnership and
credit trade and commerce.

During the 1500s the practice of outside verification spread to the rapidly developing limited
liability companies (LLC) who were responsible for outside investors. In a parallel development,
English manorial auditing began during the medieval period when records of large manors
(farms) were reviewed annually by auditors who represented the lord and the council. This
became the foundation of the British statutory audit in the 19th century and later spread
throughout Europe.

During 1960s to 1990s Period

The world economy continued to grow in the 1960s-1990s. This period marked an important
development in technological advancement and the size and complexity of the companies.
Auditors in the 1970s played an important role in enhancing the credibility of financial
information and furthering the operations of an effective capital market. Despite the overall audit
objectives remaining similar, auditing had undergone some critical developments in this period.
In the earlier part of this period, a change in audit approach can be observed from “verifying
transaction in the books” to “relying on system”. Such a change was due to the increase in the
number of transactions which resulted from the continued growth in size and complexity of
companies where it is unlike for auditors to play the role of verifying transactions. As a result,
auditors in this period had placed much higher reliance on companies’ internal control in their

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audit procedures. Furthermore, auditors were required to ascertain and document the accounting
system with particular consideration to information flows and identification of internal controls.
When internal control of the company was effective, auditors reduced the level of detailed
substance testing.
In the early 1980 there was a readjustment in auditors’ approaches where the assessment of
internal control systems was found to be an expensive process and so auditors began to cut back
their systems work and make greater use of analytical procedures. An extension of this was the
development during the mid-1980s of risk-based auditing. Risk-based auditing is an audit
approach where an auditor will focus on those areas which are more likely to contain errors.
Most of the companies in this period had introduced computer systems to process their financial
and other data, and to perform, monitor and control many of their operational and administrative
processes. Similarly, auditors placed heavy reliance on the advanced computing auditing tool to
facilitate their audit procedures. In addition to the auditing of financial statement, auditors at the
same time were providing advisory services to the audit clients.
From the 1990s to the present day
The auditing profession witnessed substantial and rapid change since 1990s as a result of the
accelerating growth at the world economies. It can be observed that auditing in the present day
has expanded beyond the basic financial statement attest function. Present-day auditing has
developed into new processes that build on a business risk perspective of their clients. The
business risk approach rests on the notion that a broad range of the client’s business risks are
relevant to the audit. Advocates of the business risk approach opined that many business risks, if
not controlled, will eventually affect the financial statement. Furthermore by understanding the
full range of risks in businesses, the auditor will be in a better position to identify matters of
significance and relevance to the audit profession on a timely basis.
Since the early 1990s, the audit profession began to take increased responsibility to detect and
report fraud and to assess, and report more explicitly, doubts about an auditee’s ability to
continue in conformance with society’s and regulators’ increasing concern about corporate
governance matters.
Presently, the ultimate objective of auditing is to lend credibility to financial and non-financial
information provided by management in annual reports; however, audit firms have been largely
providing consultancy services to businesses. Regulators of the auditing profession and the

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investing public began to doubt whether audit firms could remain independent on audit issues
when the firms were so dependent on consulting revenues. The quality of audits is being placed
under scrutiny after a series of financial scandals of public companies such as Sunbeam, Waste
Management, Xeror, Adelphia, Enron and WorldCom. The collapses of these giant corporations
had brought about a crisis of confidence in the work of auditors.
As a consequence of the high level of litigation and criticism against the auditors, nearly all large
accounting firms split their consulting arms into separate companies and made announcements
on their more stringent rules and measures to ensure better independence and audit quality. In
addition, a spate of radical reforms was undertaken in various countries, by the accounting
bodies, governments, stock exchange commissions and academics to strengthen the audit
practice.
Although the overall audit objectives in the present period remained the same, i.e. lending
credibility to the financial statement, critical changes have been made to the audit practice as a
result of the extensive reform in various countries. Such reform has implicated the auditing
profession in the following ways: “
 The role of auditors is expected to converge: refocusing on the public interest, redefining
audit relationship, ensuring integrity of financial reports, separation of non-audit
function and other advisory services;
 The audit methods revert to basics i.e. risk attention, fraud awareness, objectivity and
independence, and
 Increase attention on the needs of financial statement users”.
1.2. Nature and Definition of Auditing
The word audit is derived from the Latin word “Audire” which means ‘to hear’. Initially
auditor was a person appointed by the owners to check account whenever frauds were suspected
and she or he was to hear explanation given by the person responsible for financial transactions.
Different people have defined auditing in different ways. Most of these definitions give importance
only to some aspects of auditing. In some cases interestingly some would reply that an auditor is a
person who checks the accounts and always finds fault with what has been done. Some others say that
auditing is a process through which frauds and errors are detected. One would say that an auditor is a
person who checks the correctness of accounts of an enterprise before they were made public. Most
of these definitions give importance only to some aspects of auditing. Let us, however, begin

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our discussion on the nature of auditing by the following definitions, which explain auditing in a
comprehensive manner.
• Auditing is defined as ‘an examination of accounting records undertaken with a view to
establishing whether they correctly and completely reflect the transactions to which they relate
(Howard, 2000)’.
• Ray (2003) defined as auditing is concerned with the verification of accounting data, with
determining the accuracy and reliability of accounting statements and reports.
• Spicer and Peglar also defined auditing as “An examination of the books, accounts and
vouchers of a business’s shall enable the auditor to satisfy himself whether or not the balance
sheet is properly drawn up so as to exhibit a true and correct view of the state of affairs of the
business according to his best of the information given to him and as shown by the book.
• The institute of chartered accountants of India has defined auditing as "a systematic
independent examination of data, statements, records, operations and performances of an
enterprise for a stated purpose. In any auditing situation the auditor recognize propositions
before he/she programs for examination, collects evidence, evaluates the data and on this
basis formulates his/her judgment which is communicated through his/her audit report.
• From the above definitions, it is clear that auditing is the systematic and scientific
examination of the books of accounts and records of a business so as to enable the auditor to
satisfy himself that the Balance Sheet and the Profit and Loss Account (or income statement)
are properly drawn up so as to exhibit a true and fair view of the financial state or affairs of
the business and profit or loss for the financial period.
• According to Arens, Elder, and Beasley in 2012, auditing is defined as ‘the accumulation and
evaluation of evidence about information to determine and report on the degree of
correspondence between the information and established criteria’. Auditing should be done
by a competent independent person.
The description of auditing by Arens, Elder, and Beasley includes several key terminologies
which are discussed in this section briefly.

 Information and established criteria: To do an audit, there must be information in a

verifiable form and some standards [criteria] by which the auditor can evaluate the
information. Information can and does take many forms. Auditors routinely perform audits of
quantifiable information, including companies’ financial statements and individuals’ federal

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 income tax returns. Auditors also perform audits of more subjective information, such as the
effectiveness of computer systems and the efficiency of manufacturing operations. The
criteria for evaluating information also vary depending on the information being audited.
 Economic Entity: Whenever an audit is conducted, the scope of the auditor's responsibility
must be made clear. The primary method involves defining the economic entity and the time
period. In most instances the economic entities is also a legal entity such as a corporation,
unit of government, partnership, or proprietorship. In some cases however the entity is
defined as a division, a department or even an individual. The time period for conducting an
audit is typically one year, but there is also audits for a month, a quarter, several years, and in
some cases the lifetime of an entity.
 Accumulating and evaluating evidence: Evidence is defined as any information used by the
auditor to determine whether the information being audited is in accordance with the
established criteria. Evidence takes many different forms, including oral testimony of the
auditee, written communication with outsiders, and observations by the auditor. It is
important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the
audit.
 Competent, independent person: The auditor must be qualified to understand the criteria
used and competent to know the types and amount of evidence to accumulate to reach the
proper conclusion after the evidence has been examined. The auditor also must have an
independent mental attitude. It does little good to have competent person who is biased
performing the evidence accumulation when unbiased information and objective thinking are
needed for the judgments and decisions to be made.
 Reporting: The final stage in the audit process is the audit report, which is the
communication of the findings to users. Reports differ in nature, but in all cases they must
inform readers of the degree of correspondence between information and established criteria.
Reports also differ in form and can vary from the highly technical type report usually
associated with financial statement audits to a simple oral report in the case of an operational
audit done of a small department’s effectiveness.

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1.3. Accounting versus auditing

The difference between auditing and accounting is best summarized as follows:

Accounting Auditing of financial statement

 Is the process of identifying ,measuring,  Is the process of obtaining and evaluating evidences
recording and communicating economic and determining the fairness of financial statement
information about an organization in conformity inconformity with GAAS
with GAAP

 Deliver financial statements to users  Deliver audit report(opinion) to users

 precede auditing  Begins when accounting ends

 No prescribed qualification is legally required for  The external auditor must be chartered
the accountant accountant(CPA)

 All accountant may not have auditing knowledge  Auditors must have accounting knowledge

 An accountant is an employee of the firm  An auditor is independent professional

 Constructive and theoretical  Critical aspect of accounting and analytical in nature

 Generally appointed by management and  Appointed by the shareholders or audit committee

expected to perform according to the rule and of the organization and is independent
regulation set by management

1.3.1. Features of Auditing

From the above definition and differences of auditing, the following basic features are derived;
a. Audit is a systematic and scientific examination of books of accounts of a business;
b. Audit is undertaken by an independent person or body of persons who are duly qualified for
job.
c. Audit is a verification of results shown by profit and loss account and the state of affairs as
shown by balance sheet.
d. Audit is a critical review of the system of accounting and internal control.

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 e. Audit is done with the help of vouchers, documents, information and explanations received
from authorities.
f. Auditor has to satisfy himself with authenticity of F/st and report that they exhibit a true and
fair view of the state of affairs of the concern.
g. Auditor has to inspect, compare, check, review, scrutinize vouchers supporting transactions
and examine correspondence, minute books of shareholders, directors, Memorandum of
Association and Articles of association etc., in order to establish correctness of books of
accounts.
1.3.2. Purpose and Scope of Auditing
1.3.2.1. Purposes of Auditing
Dependable financial information is essential to the very existence of the society. In making a
decision, such as, to buy or sell securities, the banker deciding to approve a loan; the government
to obtain revenue based on income tax returns etc, all are relying upon information provided by
auditors.
There are many advantages of auditing to the modern society. The more important of these are
as follows.
A. Tool of Control over Resources

The most advantage of auditing is that it acts as a tool of control over those who harm resources
belonging to others. In the case of government, audit seeks to ensure that the use the public
funds properly. Whenever a person or authority is entrusted with the resources belonging to
others, it becomes necessary to exercise suitable control over such people by officials to ensure
that the resources are used properly. Audit can act as an important instruction of practicing such
control. Experiences of certain countries show that whenever the audit becomes weak, there was
a gross misuse of public funds. Thus, audit acts as a mere protection against misuse of funds and
reduces the possibility of errors and frauds.
B. Tool for Enhancing Creditability of Economic Information

Another advantage of auditing is that it enhances the credibility of economic information, thus, the
shareholders of a company would give greater reliance on the financial statements of the company, if
the auditor expresses the opinion that these statements present a true and fair view. Apart from the

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owners, other readers of financial statements of an enterprise also place great reliance on them if they
have been audited.
C. Tool for Improving Economy and Efficiency

During examination of any type of audit, the auditor reviews the activities of the enterprise.
He/she is, therefore, often in a position to make suggestions to improve the efficiency of various
activities of the enterprise. Certain types of audits are carried on to review the operations and
activities, so that, wastages and losses can be minimized, weaknesses in the system can be
discovered and overcome, and control can be strengthened. In internal audit of operational audit
or management audit the auditor generally makes proposals for improving the economy and
efficiency within which resources are employed.
The need for most types of audit arises only after the accounting process is completed. The
auditor conducts the final product of the accounting system and attempts to collect evidence to
enable him/her to express an opinion thereon. Therefore, in most audits, the auditors review the
completed work of an accountant from a specific outlook. Auditor's task begins where the task
of the accountant ends. The auditor should reasonably assure himself/herself that the accounting
system is adequate and that all the accounting information that should be recorded has in fact
been recorded.
The auditor should gain an understanding of the accounting system and related internal controls and
should study and evaluate the operation of those internal controls upon which he wishes to help in
determining the nature, timing and extent of other audit procedures.
Upon completing the review and testing of the accounting records, the auditors should prepare a
working paper describing the records in use, the tests of controls and other audit procedures
followed, the nature and significant misstatements discovered, any suggestions for improving the
accounting system and the auditors conclusion as to the overall quality of accounting records.
This working paper summarizes an important part of the auditor's consideration of internal
control and may serve as a reference for determining appropriate modifications in the audit
program. At the beginning of the next annual audit, a review of the working paper will enable
the auditors to concentrate up on the most significant aspects of the accounting records.
1.3.2.2. Scope of Auditing
The scope of auditing depends on the type of auditing performed by the professional auditors.
Hence the scope of internal and external auditing is described as follows.

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The scope of internal audit activity includes examining and evaluating the policies, procedures
and systems which are in place to ensure: reliability and integrity of information, compliance
with policies, plans, procedures, laws and regulations; safeguarding assets; economical and
efficient use of resources; and accomplishment of established objectives and goals for operations
or programs. Internal Audit may provide consulting services within the organization concerning
issues related to internal controls, special investigations, and other areas of interest and concern.
Whereas, external audit is aimed at caring out such work as is necessary to form an opinion as to
whether:

a) The accounts are properly kept; and

b) The annual financial statements:

i) are prepared in accordance with the financial records; and

ii) Represent fairly the results of the operations and the financial in accordance with the
Accounting Standards, relevant legislation and other mandatory professional reporting
requirements. The auditor is to include in their proposal the extent to which the critical matters
such as revenue, expenditure, assets liabilities and equities will be audited to provide reasonable
assurance of whether these items are free of material misstatement caused either by fraud or
error. The scope of governmental auditing is to provide reasonable assurance of whether the
rules regulations and all the proclamations issued by the government are being respected by the
client.

1.4.TYPES OF AUDITORS AND AUDITING

1.4.1. Types of Audits
Audits are often classified in to three major types:
1) Audit of Financial Statement
2) Compliance Audit
3) Operational Audits /Performance Audits/
1. Audit of Financial Statement
Audit of financial statements is actually part of the broader concept of the attestation function.
To attest to information mean to provide assurance as to fairness or dependability of financial
statement. Certified Public Accountants (CPAs) attest to a host of other types of information

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including the reasonableness of financial forecasts, the adequacy of internal control and
compliance with laws and regulations. To attest to financial statements is to provide assurance
as to their fairness and dependability. The attest function consists of two phases. The first is the
performance of an audit; the second is the issuance of an audit report. The attest function leads
to credibility to management's representations that are contained in the financial statements.
The audit of financial statements ordinarily covers the balance sheet and the related statements of
profit and loss and cash flows. Financial audit generally is conducted to ascertain whether the
financial statements present true and fair views of the financial position and working results of
an enterprise or organization. The goals of audit of financial statements are to determine whether
the statements have been prepared in conformity with generally accepted accounting principles.
The aim of an independent financial audit is to ascertain if the financial statements of an
enterprise are reliable and dependable. Financial statements audits are normally performed by
certified public accountants. The contribution of the independent financial audit is to give
credibility to financial statements. Credibility, in this usage means that the financial statements
can be believed that is, they can be relied upon by outsiders, such as stockholders, creditors,
government and other interested third parties. The word “audited” when applied to financial
statements means that balance sheet, profit and loss statements and cash flows are accompanied
by an audit report prepared by independent auditors expressing their professional opinion as to
fairness of the enterprise's financial statements. Financial statements prepared by management
and released to outsiders without first being audited by independent auditors leave a credibility
gap.
The Objectives of Audit of Financial Statement:

The objective of a financial statement audit is to determine whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation.

2. Compliance Audit
The performance of a compliance audit is dependent upon the existence of verifiable data and of
recognized criteria or standard established by an authoritative body.

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Compliance audit is defined, as an audit to determine whether verifiable data such as income tax
returns or other financial statements are in conformity with established criteria, for example,
laws and regulations, society has always been concerned with compliance with laws and
regulations by all types of entities, business, government and non profit making organizations.
Legislative public officials and the general public want assurance about compliance. Many
governmental entities and non-profit making organizations that receive financial assistance from
banks are subject to periodic compliance audit. Such audits are designed to determine whether
the financial assistance is spent in accordance with applicable laws and regulations. Such audits
seek to determine whether a tax collection is in compliance with tax laws and regulations.
In auditing the financial statements of the governmental and non-governmental organizations, the
auditor must often perform tests of compliance with laws and regulations to determine that violations
do not have a direct and material effect on financial statements.
The Objectives of Compliance Audits are:

 To determine whether there have been violations of laws and regulations that may have a
material effect on the organizations financial statements.
 To provide a basis for additional reports on compliance procedures that is not tests of the
internal control policies and procedures. Compliance procedure is defined, as performing
procedures to act with laws and regulations.
The auditors may discover violations of provisions of laws, regulations, contracts or grants that
result in which they estimate to be material misstatement to the organization's financial
statements. Such violations are known as material instances of non-compliance. Non-
compliance is the failure to act in accordance with laws or regulations. In these circumstances,
the auditors must consider the effect on their opinion issues on the financial statements. The
resulting misstatement, if left uncorrected, would normally require the auditors to issue a
qualified or adverse opinion. The auditors may also report a description or any indications of
illegal acts that could result in criminal prosecution.
3. Operational audits /Performance Audits/
An operation audit is a systematic independent appraisal activity within an enterprise for a
review of the entire departmental performance as a service to management. The overall
objective of operational auditing is to assist all levels of management in the effective discharges
of responsibilities by furnishing them with objective analysis, appraisal, recommendations and

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pertinent comments concerning the activities reviewed. It may be noted that the terms, operation
audit and performance audit often are used interchangeably.
The purpose of an operational audit usually includes the intention to appraise performance of a
particular organizational function or group activities. However, the broad statement must be
expanded to specify precisely the scope of the audit and the nature of the report. The auditors
must determine specifically which policies and procedures are to be appraised and show their
relation to the specific objectives of the enterprise or organization.
Before starting the operational audit, the auditors must obtain a comprehensive knowledge of the
objectives, organizational structure, and operating characteristics of the unit to be audited. This
familiarization process might begin with a study of organizational charts statements of the
function and responsibilities assigned are management policies and directives and operating
policies and procedures.

In attempting to meet, managerial needs, operational auditors sample the work performance to see
whether it is in accordance with approved procedures. They verify the accuracy and consistency of
the information obtained in operating reports, and they study the format of the reports to determine
whether the information is presented in a meaningful form. The auditor's responsibility for seeing that
the enterprise's assets are safeguarded against fraud is expanded to a responsibility for providing
protection against all kinds of waste. An enterprise having a strong system of internal control over its
cash, inventory, and other personal property will never suffer a serious loss from fraud or theft.
Now-a-days economic pressures are forcing companies and government enterprises at all levels
to economize, resulting in an increased demand for the information provided by operational
audits. The demand has been so pronounced that operational auditing has become an extension
of the internal auditing function of most large enterprises. Also governmental auditors engage
extensively in evaluating the economy, effectiveness and efficiency of various government
programs.
Objectives of Operational Audits

Internal auditors often perform operational audits. The main users of operational audit reports
are managers at various levels including the board of directors. Decision makers need
assurances that every component of an enterprise is working to attain the organization's goals.
For example, the management needs the following information.

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  Assessment of the unit performance in relation to management's objectives or other
appropriate criteria.
 Assurance that its plans are comprehensive, consistent and understood at the operating
levels.
 Objective information on how well its plans and policies are being carried out in all areas
of operation's and opportunities for improvement in effectiveness, efficiency and economy.
 Information on weakness in operating controls, particularly as to possible sources of waste.
 Reassurance that all operating reports can be relied on as basis for action.
In every audit, it is important to state clearly the boundaries of the examination. These
boundaries identify the economic entity to be examined and the time period to be covered. Thus,
the boundaries serve to define and to limit the auditors' responsibilities. The economic entity to
be audited may be a sole proprietorship, a partnership, a corporation and its subsidiaries.
1.4.2. Types of Auditors
Auditors are often viewed as falling into three main types;
1. Independent financial auditor /Certified Public Accountant/
2. Internal auditors
3. government auditors
1. Independent financial auditor: Independent/financial auditor or certified public accountant
is a person licensed by the state to practice public accounting as a profession based on having
passed the uniform CPA examination and having met certain education and experience
requirements.
Including public accounting profession, all of the recognized professions have many common
characteristics. The most important of these characteristics are a responsibility to serve the public, of a
complex knowledge, standards of admission to the profession and a need for public confidence. To
Certified Public Accountants, public confidence is of special significance. Credibility is the product
of the certified public accountants. Without public confidence in the attester, the attest function serves
no useful purpose. To attest to financial statements means to provide assurance as to their fairness and
dependability. The attest function includes, first, the independent public accountant, must carry out an
examination to provide the objective evidence that enables the auditors to express an informed opinion
on the financial statements. Second, the attest function is the issuance of the auditor's report, which

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conveys to users of the financial statements the auditor opinion as to the fairness and dependability of
the financial statements.
Reliable financial information is essential to the very existence of society. Thus, good accounting and
audited financial statement aid society in allocation its resources in the most efficient manner. The
goal is to allocate limited resources to the production of those goods and services for which demand is
greatest. Economic resources tend to be attracted to the industries, and the organizational entities that
are shown by accounting measurements to be capable of using more resources to the best advantage.
Inadequate and inappropriate accounting result on the other hand, conceal waste and inefficiency and
thereby prevent resources from being allocated in a rational manner. It is the report by the
independent auditors that gives credibility to a set of financial statements and makes acceptable to
investors, bankers, government and other users.
2. Internal Auditors: Although most auditing literatures interest is primarily in the audit of
financial statements by Certified Public Accountants, other professional groups carry on large
scale auditing. These well-known types of auditors are internal auditors.

The standard definition adapted by the Institute of Internal Auditors of United States of America,
however is that internal auditing is an independent appraisal activity established within an
organization or enterprise to examine and evaluate its activities as a service to the organization in the
effective discharge of their responsibilities by furnishing their analysis, appraisals, recommendations
and counsel. In performing these functions internal auditors can be considered as a part of the
organization's internal control structure. They represent high level control that functions by measuring
and evaluating the effectiveness of other internal control policies and procedures.
Internal auditors are not merely concerned with the organization's financial controls. Their work
encompasses the entire internal control structure of the organization or enterprise. They evaluate and
test the effectiveness of internal control policies and procedures designed to help the organization or
enterprises to meet all of its objectives.
The internal auditing head often accordingly reports to the general manager or board of directors or
president or another high executive. This strategic placement high in the organizational structure
helps assure the internal auditors will have ready access to all units of the business and that their
recommendations will be given prompt attention by department heads. This reporting standard
provides guidance for the head of internal auditing in managing the internal auditing functions. The
head of internal auditing is responsible for properly managing the departments to help assured that, the

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audit work is performed in accordance with professional standards and fulfills the general purposes
and responsibilities developed by management of the organization and the resources of the internal
auditing department are efficiently and effectively employed.
A large part of the internal auditors consists of operational audits in addition; they may conduct
numerous compliance audits. The number and kind of investigative activities varies from year to
year. Unlike the certified public accountants that are committed to verify each significant item in the
annual financial statements the internal auditors are not obliged to repeat their audits in annual basis.
3. Government Auditors: A government audit is conducted primarily to ensure that financial
transactions are recorded with proper sanction and authorization. In Ethiopia, the office of auditors
General has given the responsibility to conduct the audit of the central government. Government
auditors examine and make that:
 Transactions are correctly recorded and activities conform to the rules and regulations

 Ensure that public funds are not misused

 Examine the efficiency and effectiveness of selected projects or program run by government.

To sum up, auditors and type of auditing area or audit emphasis are summarized as follows.
Audit Auditors
Internal Auditors Independent Auditors Government Auditors
Operational Audit Primary Nominal Primary
Financial Audit Secondary Primary Nominal
Compliance Audit Primary Secondary Primary

1.5. Economics (demand) for Auditing

Why do you think is auditing needed? Auditing is primarily useful to reduce information risk.
Information risk reflects the possibility that the information upon which the business risk
decision was made was inaccurate. What are the possible causes of information asymmetry?
Information asymmetry may be caused by the following factors:

a. Remoteness of Information. In a global economy, it is nearly impossible for a decision

maker to have much firsthand knowledge about the organization with which they do
business. Information provided by others must be relied upon. When information is

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 obtained from others, the likelihood of it being intentionally or unintentionally misstated
increases.
b. Biases and Motives of the Provider. If information is provided by someone whose goals
are inconsistent with those of the decision maker, the information may be biased in favor
of the provider. The reason can be honest optimism about future events or an intentional
emphasis designed to influence users. In either case, the result is a misstatement of
information. For example, when a borrower provides financial statements to a lender,
there is considerable likelihood that the borrower will bias the statements to increase the
chance of obtaining a loan. The misstatement could be incorrect Birr amounts or
inadequate or incomplete disclosures of information.
c. Voluminous Data. As organizations become larger, so does the volume of their exchange
transactions. This increases the likelihood that improperly recorded information is
included in the records-perhaps buried in a large amount of other information. For
example, if a large government agency overpays a vendor’s invoice by Birr 220,000, it is
unlikely to be uncovered unless the agency has instituted reasonably complex procedures
to find this type of misstatement. If many minor misstatements remain undiscovered, the
combined total can be significant.
d. Complex Exchange Transactions. Exchange transactions between organizations have
become increasingly complex and therefore more difficult to record properly. For
example, the correct accounting treatment of the acquisition of one entity by another
poses relatively difficult accounting problems. Other examples include properly
combining and disclosing the results of operations of subsidiaries in different industries
and properly disclosing derivative financial instruments.

Information risk:- refers the possibility that the information upon which the business risk
decision was made was inaccurate. The causes of information asymmetry include remoteness of
information, biases and motives of the provider, voluminous data and complexity of exchange
transactions. Auditing is performed to reduce information risk

How can we reduce information risk? There are three main means of reducing information risk.
These are:

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a. User Verifies Information. The user may go to the business premises to examine records and
obtain information about the reliability of the statements. Normally, this is impractical
because of cost and is economically inefficient. Nevertheless, some users perform their own
verification.
b. User Shares Information Risk with Management. There is considerable legal precedent
indicating that management is responsible for providing reliable information to users. If users
rely on inaccurate financial statements and as a result incur a financial loss, they may have a
basis for a lawsuit against management. A difficulty with sharing information risk with
management is that users may not be able to collect on losses. If a company is unable to
repay a loan because of bankruptcy, it is unlikely that management will have sufficient funds
to repay users.
c. Audited Financial Statements are provided. The most common way for users to obtain
reliable information is to have an independent audit. Typically, management of a company
engages the auditor to provide assurances to users that the financial statements are reliable.

1.6. The Nature of Assurance Engagements

An assurance engagement is an engagement in which a practitioner expresses a conclusion
designed to enhance the degree of confidence of the intended users other than the responsible
party about the outcome of the evaluation or measurement of a subject matter against criteria.
Examples of assurance engagements include annual external audit of financial statements
(‘statutory’ assurance or auditing), half-year review of results, going concern review, review of
effectiveness of an entity's IT system, and review of compliance with corporate governance
requirements. Assurance engagements may be classified in to three categories. These are
assurance services, attestation services, and auditing.
An assurance service: - is an independent professional service that improves the quality of
information for decision makers. Such services are valued because the assurance provider is
independent and perceived as being unbiased with respect to the information examined.
Individuals and groups seek assurance services to help improve the reliability and relevance of
the information used as the basis for their decisions. Assurance services can be done by certified
auditors or by a variety of other professionals. Assurance services require the practitioners to

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issue the report at the end of the engagement. An assurance report provides the following
benefits to the users of financial information:

 Independent opinion from an external source that enhances the credibility of the
information
 Management bias is reduced
 Modified opinion draws attention to risk
 The relevance of the information may be improved by the expertise and knowledge of the
assurance firm.

Auditors may also be engaged in providing non-assurances services. The most common of such
services are management consultancy services, accounting and bookkeeping services, and tax
advisory services.

An attestation service: - is a type of assurance service in which the certified accountant issues a
report about the reliability of an assertion that is made by another party. Attestation services fall
into five categories:
a) Audit of historical financial statements. An audit of these statements is a form of
attestation service in which the auditor issues a written report expressing an opinion about
whether the financial statements are fairly stated in accordance with the applicable
accounting standards such as GAAP.
b) Audit of internal control over financial reporting. In an audit of internal control over
financial reporting, management asserts that internal controls have been developed and
implemented following well established criteria.
c) Review of historical financial statements. For a review of historical financial statements,
management asserts that the statements are fairly stated in accordance with accounting
standards, the same as for audits. The auditor provides a lower level of assurance for
reviews of financial statements compared to a high level for audits, therefore less evidence
is needed.
d) Attestation services on information technology. For attestations on information
technology, management makes various assertions about the reliability and security of
electronic information.

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e) Other attestation services that may be applied to a broad range of subject matter. Many
of these services are natural extensions of the audit of historical financial statements, as
users seek independent assurances about other types of information. In each case, the
organization being audited must provide an assertion before the auditor can provide the
attestation. For example, when a bank loans money to a company, the loan agreement may
require the company to engage the certified auditor to provide assurance about the
company’s compliance with the financial provisions of the loan. The company requesting
the loan must assert the loan provisions to be attested to before the auditor can accumulate
the evidence needed to issue the attestation report. Auditors can also, for example, attest to
the information in a client’s forecasted financial statements, which are often used to obtain
financing.

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