CHAPTER 1

AN OVERVIEW OF AUDITING

GENERAL INTRODUCTION

Auditing involves an examination of financial statements, records, activities or

operations by an independent person for a specified purpose.
The purpose of the examination might be:-
 To evaluate the fairness of financial statements.
 To evaluate efficiency and effectiveness of a given operation.
 To find out if rules and procedures of a company or government
are followed.
Irrespective of the purpose, the people that perform the audit task should act morally,
which in turn requires following certain principles and rules. If they fail to perform their
task in accordance with the principles and rules, they will become legally liable besides
societal and association sanctions.

Auditing has been practiced as a result of the need for verification of financial
information supplied by managers. Therefore, the audit practice dates back to the time
when financial reporting was first introduced.

EVOLUTION OF AUDITING
The development of auditing is closely linked to the development of organized system of
accounting. In the early stages of civilization the number of transactions was usually so
small that an individual was able to record the transactions himself, However, with the
growth of civilization and consequential growth in volume and complexities of
transactions, it become necessary to entrust the job of recording the transactions to
other persons. The trend started with maintenance of accounts of empires by public
officials. Almost simultaneously, a need was felt to institute a check on the fidelity of the
persons responsible for maintaining the accounts.
To accomplish this purpose, it becomes customary to entrust a person with the
responsibility to hear those who had maintained the accounts. In the course of time,
such persons came to be known as" auditors," the term being derived from the Latin
word 'audire' which means ' to hear;

1|Page
The practice of auditing accounts therefore may be traced back to the early stage of
civilization. In those days, audit was undertaken mainly for state or public accounts. The
historical records of auditing show that ancient Egyptians, Greeks and the Romans used
to get their public accounts scrutinized and audited by an independent official.
However, the audit of accounts of private business was rare as the size of business was
small and the management and ownership were joint. Individual business with Limited
capital resources used to carry on the business on a small scale production was limited
and the number of transactions to be recorded was also small in number. The methods
of recording these transactions were simple and usually maintained and checked by the
owners themselves. In short, audit in those days was simply a comparison of records of
cash payment and vouchers therefore.

Auditing as it exists today can be associated with the introduction of large scale
production following the Industrial Revolution during the 18 th Century. This revolution
led to a great increase in the volume of trading operations which also required
substantial capital investment. Individual businesses were not in a position to provide
necessary finance because of their limited financial and credit resources. Further, the
discovery of steam power, development in the means of transport and communications,
the expansion of banking facilities and mechanical inventions also made it inevitable for
business men to adopt some other form of business organization and management. This
led to the formation of numerous joint stock Companies and other corporate bodies.

The introduction of the joint stock form of organization also widened the scope of
investment and business activities. The business Community started raising money
from public and also borrowed capital from various private and state financial
institutions. Under the company form of organization, the investors (shareholders) as a
body delegates the management of the undertaking, in which they have invested their
money, to a Board of Directors but they would be keenly interested in the safety of their
investment.
As the shareholders are drawn from far off places and are not at the helm of affairs of
the company they would also like to know whether their money is being properly
utilized or not. They would also be interested in finding out a true and fair view of the
financial position of the undertaking in which they have invested their money. In these
circumstances, the need was felt for getting the accounts audited especially in case of

2|Page
joint stock enterprises, so the shareholders might be assured about the safety of their
investment and accuracy of the accounts. In the beginning, shareholders entrusted this
task of checking the accounts to one of the shareholders of the company. But it could not
serve any useful purpose as the shareholder lacked basic and technical knowledge of
accounting and the ability for such work.

Further introduction of the double entry system of book-Keeping also increased

complication in the accounting system. Therefore, in order to have an effective check on
the account of the company, the custom was developed to appoint a professional
auditor to ensure that the audit can be done in right lines and investors may put full
confidence in this report. The main objective of audit at this stage was to report on the
company's solvency and to detect frauds and errors.

As large-scale corporate entities developed rapidly in Great Britain and the United
states, it became costly and time consuming for the auditors to examine each and every
transaction of an organization. Thus, auditors started to carefully examine randomly
selected transactions. This in effect led to the use of various sampling techniques in the
auditing practice.

In addition to the introduction of sampling techniques, auditors became aware of the

importance of effective internal control for auditing. Internal control consists of policies
and procedures established by management to provide reasonable assurance that the
objectives of the organization will be met.
Therefore, by studying and evaluating the internal control system of a given
organization, auditors would identify the areas of weakness and strength, which in
effect leads auditors to determine the types of audit procedures to be followed and the
extent of examination they would perform: i.e., the stronger the internal control, the less
testing of financial statement account balances required by auditors.

With the rapid growth in the number of companies, professional accountants appeared
on the scene. By the early 1900's, the concept of audit has developed to a stage where
professional accountants became prominent as auditors. The objectives of audit also
underwent a change during this time. Apart from detecting frauds and errors, the
auditors also started verifying and reporting on the accuracy of financial records and

3|Page
financial statements, Audit now implies a written report about the accuracy and
reliability of accounts and finance statements by a qualified auditor.

DEFINATION AND NATURE OF AUDITING

Definition
What is Auditing?

Auditing is an independent examination of evidence from which the financial

statements are prepared with the main objective of determining whether the
information contained in the financial statements reflects the economic events that
occurred during the accounting period.

Auditing has been defined in several ways by accounting associations. But these
definitions are in harmony with each other in stating the meaning, objective, and end-
product of auditing. Therefore, we will discuss the most popular definitions that are
provided by Accounting Principles Board (APB), American Accounting Associating
(AAA), and International Federation of Accountants (IFA).
Accounting Principles Board (APB)
Auditing is an exercise whose objective is to enable auditors to express an opinion
whether the financial statements give true and fair view of the entity’s affairs at the
period end (balance sheet) and its profit and loss (or income and expenditures) for the
period then ended and whether they have been properly prepared in accordance with
the applicable recording frame work (for example relevant legislation and applicable
standards), where statutory or other requirements prescribe the term.

International Federation of Accountants (IFA)

An audit is an independent examination of financial information of any entity, whether
profit-oriented or not and irrespective of its size or legal form, when such an
examination is connected with a view to expressing an opinion thereon.

American Accounting Association (AAA)

Auditing is a systematic process of objectively obtaining and evaluating evidence
regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions and established criteria, and communicating
the results to interested users.

4|Page
The concepts included in the definition of auditing by the American Accounting
Association best fit the objective of this course. Hence, important concepts of the
definition are briefly discussed below.
Auditing is a systematic process: Process implies that auditing is a dynamic ongoing
activity which is not a one-time check of the relationship between financial assertions
and underlying events. On the other hand, the word systematic indicates that auditing is
an objective and logical process based on scientific approach to decision-making.

Objectively obtaining and evaluating evidence: Auditors should gather and evaluate
sufficient evidence to arrive at a reasonable conclusion concerning the financial
statements. This definition requires auditors to be unbiased and objective in doing so.

Regarding assertions about economic actions and events: Assertions are

propositions about the accounts, amounts and other information appearing on the
financial statements which the company management claims to be accurate. The
definition indicates that the auditor’s responsibility is to verify these assertions or
management representations.

To ascertain the degree of correspondence between those assertions and

established criteria: This phrase specifies that there should be established criteria
against which the assertions are to be evaluated. The established criteria may be the
Generally Accepted Accounting Principles, legislations, or government regulatory
agency pronouncements.

Communicating results to interested parties: As any other process, auditing involves

input and output. The input being financial information, the process is examination and
the final output is a report containing an auditor’s opinion.

Nature of Auditing
An audit is a systematic examination of books, accounts, documents and reliability of
accounting statements. It is not only to see the arithmetical accuracy of the books of
accounts but it also goes further and finds out whether the transactions entered in the
books of original entry are correct or not. An auditor has to go behind the books.
The purpose of auditing lies in ascertaining whether the working results and financial
position as shown by the Income statement and Balance sheet for a particular period
are truly determined and presented by those responsible for their compilation. Auditing

5|Page
does not mean the preparation of accounts. It is the verification of accounts by an
independent person who examine and checks them and makes best use of the
information supplied to him.
An auditor is required to direct his efforts towards proving and establishing the
authenticity of the transactions by vouching all the relevant documentary evidence at
his disposal.

Auditing, thus primarily involves testing the reliability, competency and adequacy of
evidence in support of monetary transactions of an organization. It is the process of
testing and weighing of evidence.

Auditing is analytical critical and investigative. It has its principal ro ots not in
accounting which it reviews but in logic on which it leans heavily for ideas and methods.
The function of reporting is the end-product of auditing.

A well laid out implemented audit program helps an auditor to arrive at proper
conclusions regarding the accounting statements and thus helps him to formulate his
opinion.

THE NEED FOR AUDITING

Most business entities employ accountants and bookkeepers to process the transactions
and financial statements. Nevertheless, there is still demand for audit for the following
reasons.

Conflict of interest: Users of financial statements may have diverse interests in the
reporting entity, and their interest may not coincide with the interest of those who have
prepared the data. Many users are particularly concerned about an actual or potential
conflict of interest between themselves and the managements of the entity. This worry
extends to the fear that the financial statements and accompanying data that
management is providing may be intentionally or unintentionally biased by the
provider. Thus, users seek assurance from outside independent experts that the data
are free from the perceived conflict of interest.

Consequences: Financial statements are the major source of information for decision
making by users. In making significant decisions such as lending, investments, and other
decisions, users want the financial statements to contain as much relevant data as
possible. The independent auditor gives reasonable assurance to the users that the

6|Page
financial statements are prepared in conformity with Generally Accepted Accounting
Principles (GAAP)/IFRS.

Complexity: Both the subject matter of accounting and the process of preparing
financial statements are becoming more and more complicated. As the subject matter
becomes more complicated, there is a greater risk of misinterpretation and a greater
possibility of an unintentional error. Users, therefore, are finding it more difficult or
even impossible to evaluate the quality of the statement. Thus, they need the
independent auditor for assurance about the quality of the information being received.
Remoteness: Few users have direct access to the accounting records from which
financial statements are prepared. Furthermore, in instances when records are available
for scrutiny, time and cost constraints normally prevent users from making meaningful
examinations. Remoteness prevents users from directly assessing the quality of the
statements. Thus, the auditor serves as a link by providing an objective and unbiased
opinion on the financial statements.

Regulatory requirements (statutory requirements): Some organizations are legally

required to get their financial statements audited. For instance, the 1960 Commercial
Code of Ethiopia requires any share company in Ethiopia to get books of accounts
audited annually so as to renew their license.

From the above discussions, you must have understood why auditing is needed. The
contribution of auditing is not limited to individuals as it is also useful to the society.
Below, we have outlined some of the advantages of auditing for the society:

 It serves as a controlling tool over those who handle resources belonging to

others: When a person or an authority is assigned to run an organization using
resources that belong to others, it becomes necessary to exercise a suitable
control over such person or authority to ensure that the resources are used
properly. Audit acts as an important means of control.
 If employees know that the accounts will be audited, they will be cautious since
they fear that any errors and fraud will be discovered. In this case, audit is also
used as a means of preventing misuse of resources and reducing errors and
frauds.

7|Page
  Audit increases credibility of financial information: The degree of reliance placed
on audited financial statements is greater than that of unaudited financial
statements. This is because the auditor is an independent and impartial person
that has no stake in the management of the entity under audit. Thus, users of the
financial information would place greater reliance on the financial statements if
the auditor expresses the opinion that the statements present fairly the picture
of the entity.
 Audit enhances efficient utilization of resources: In conducting any type of audit,
the auditor reviews the activities of the entity with a view to identifying
strengths and weaknesses. Therefore, the auditor gives suggestions and
recommendations so that wastages and losses of resources can be minimized.
For example, in an operational audit, the auditor makes recommendations for
improving the economy and efficiency with which resources are used.

SCOPE OF AUDITING
The scope of audit is extending day by day because of the changes in the economic
conditions of the world. Long-range objectives of an audit is serving as a guide to the
management's future decisions in all financial matters such as controlling forecasting
analyzing and reporting. These objectives have their purposes (the improvement of
performance). As mentioned above, originally a large majority of audit in the early days
was confined to ascertain whether the accounting party had properly accounted for all
receipts and payments on behalf of the owners. In other words, the original object of
making audit was to find out whether cash has been embezzled and if so, who
embezzled it and the amount of the embezzlement involved. It was merely a cash audit.
But the main object of modern audit is to see whether the Balance sheet of a firm
presents an authentic view of its financial state of affairs. From the above statements, it
is apparent that not only the Scope of auditing is widening but there is change in
emphasis in audit objectives also.
As mentioned above" Auditing is a systematic examination of financial statements records
and related operations to determine adherence to generally accepted accounting principles,
management policies or stated requirements". This definition not only emphasizes on the
verification of accounting statements but extends the scope of auditing by including in it a
thorough examination of allied operations. In addition to these audit now also covers cost
audit, management audit, internal audit and governmental audit etc. It is not confined only to
8|Page
 business but non business organization also avail services of qualified auditors to get their
accounts audited.
ACCOUNTING Vs AUDITING
Basis of
S.No Accountancy Auditing
Difference
1 Scope Accountancy refers to the Auditing refers to examination
preparation of final accounts and and checking of these accounting
its interpretation records.
2 Nature Accountancy is primarily Auditing is analytical in nature
constructive and concerned with and essentially retrospective.
current recording of business facts
3 Objects The main objective of accountancy The objective of auditing is to
is to ascertain the trading results of certify the correctness and
a business concern during a justification of the financial
finances concern during a financial statements prepared by the
year. accountant.
4 Qualification An Accountant need not be a An auditor must be a Chartered
Chartered Accountant. Accountant.
5 When book-keeping records are The work of auditing starts only
Commencement completed, they become available when the work of accountancy has
for the beginning of work of been completed. In other words,
accountancy. In other words, where accountancy ends auditing
Accountancy starts where book starts.
keeping ends.
6 Knowledge An accountant need not to be An auditor must have thorough
expert in the work of auditing knowledge of principles of
accountancy otherwise he cannot
perform his job satisfactorily.
7 Duration Accounting work is undertaken Auditing is generally done at the
throughout the year. end of financial year.
8 Status An accountant is a permanent An auditor is not a permanent
employee of the business concern. employee of the concern. He may

9|Page
 be changed from year to year.
9 Report An accountant is not required to An auditor is required to submit
submit a report to the proprietor the report to the proprietor after
of the concern when the the completion of his audit work.
accounting work is over.

TYPES OF AUDIT AND AUDITORS

Types of Audits
There are different types of audits conducted by different types of auditors. Such
difference is based on the scope and objective of the audit and employment of the
auditors.
These are:-
I. Financial statement audit,
II. Operational audit, and
III. Compliance audit.
I. Financial Statement Audit
The financial statement audit covers the balance sheet and the related statement of
income, retained earnings, and cash flows. Our objective in financial statement audit is
to determine whether these statements have been prepared in conformity with
GAAP/IFRS. Financial statement audits are normally performed by authorized auditors.
The users of financial statement audit include managements, investors, bankers,
creditors, financial analysts, and government agencies. The end product of a financial
statement audit is an auditor’s report through which the auditor expresses his/her
opinion. There are four types of audit reports; namely, Unqualified, Qualified, Adverse,
and Disclaimer.

II. Operational Audit/Performance Audit

Operational audit is a study of some specific unit of an organization for the purpose of
measuring its performance. For example, you may be assigned to evaluate the
performance of the operations of the receiving department of a merchandising business
in terms of its effectiveness and efficiency.

An operational audit reviews the organization or a unit’s activities to assess

performance, to identify opportunities for improvement, and to suggest

10 | P a g e
recommendations for further action. An operational audit focuses on such matters as
goals, objectives, policies, organizational structures, functions and cost effectiveness.
Some of the functions of an operational audit are:
 Planning the work to be performed including the setting of standards by which
the audit is to be evaluated;
 Gathering evidence to measure the performance of the operation;
 Analyzing and investigating deviations;
 Suggesting corrective actions, where needed, and
 Reporting the results to the appropriate level of management.

Generally, operational audit helps the organization to effectively allocate resources,

identify problems at an early stage, improve communication, and increase profitability.

An operational audit requires subjective judgment since the criteria for effectiveness
and efficiency are not as clearly established as are GAAP/IFRS or tax regulations. The
end product of an operational audit is usually a report to top management
containing recommendations for improvements in operations.
III. Compliance Audit
The objective of compliance audit is to determine whether the organization being
audited following procedures, regulations, or policies is established by a higher
authority. Performance of compliance audit is dependent on the existence of verifiable
data and of recognized criteria or standards, such as laws and regulations, or an
organization’s policies and regulations. A common example is the audit of income tax
return by an auditor of the internal revenue authority. The tax auditor checks whether
the tax return is in compliance with tax laws and regulations.

TYPES OF AUDITORS
Individuals engaged in auditing are generally classified in to three groups:
I. Independent auditors (external auditors),
II. Internal auditors, and
III. Government auditors.
I. Independent (External) Auditor
An independent auditor, also known as certified public accountant or external auditor,
has no connection to the organization being audited. Independent auditor conducts the
audit on a fee basis, and is primarily responsible to third parties-creditors and

11 | P a g e
shareholders. The type of audit carried out by an independent auditor is financial
statement audit. In Ethiopia, the authorized auditors perform financial statement audit.
In addition, the Audit Service Corporation, a government-owned organization, performs
financial statement audit.

II. Internal Auditor

Internal auditors are employees of the companies they audit. This type of auditor is
involved in an independent appraisal activity, often known as internal auditing, within
an organization as a service to the organization. The objective of internal auditing is to
assist the management of the organization in the effective discharge of its
responsibilities. The attainment of this overall objective involves such activities as:

 Reviewing and appraising the soundness, adequacy, and application of

accounting, financial, and other operating controls, and promoting effective
control at a reasonable cost;
 Ascertaining the extent of compliance with established policies, plans, and
procedures;
 Ascertaining the extent to which company assets are accounted for and
safeguarded from losses of all kinds;
 Ascertaining the reliability of management data developed within the
organizations;
 Appraising the quality of performance in completing assigned responsibilities;
 Recommending operating improvements;
 The scope of the internal audit function extends to all of the organization’s
activities. (Internal auditors are primarily involved in compliance and
operational audits).
III. Government Auditor
Government auditors are employed by various local, state, and federal governmental
agencies. At the federal level, the three primary agencies are the Office of Auditor
General, the Audit Service Corporation, and the Federal Inland Revenue Authority. The
Office of Auditor General is a federal organization headed by the Auditor General. This
office is responsible for conducting financial statement audit, compliance audit and
operational audit of various Federal Government Offices. The regional governments
have also their own regional audit bureau with similar functions.

12 | P a g e
The Federal Inland Revenue Authority is responsible for administering the federal tax
laws. Thus, the authority’s auditors audit the returns of taxpayers for compliance with
applicable tax laws. That is, the auditors examine the tax returns of the taxpayer to
ensure that it is prepared in accordance with the tax laws and regulations. The
authority’s auditors are known as tax auditors.

Another government organ that performs audit is the Audit Service Corporation. The
Audit Service Corporation audits the financial statements of the public enterprises.
Thus, the type of audit performed by the Audit Service Corporation is financial
statement audit.
Comparison of Different Types of Auditors
EXTERNAL INTERNAL GOVERNMENT AUDITORS
AUDITORS AUDITORS
CPAs who are hired as Company employees who Local, State or Federal
independent contractors by audit their own company employees who audit
many different companies. exclusively various governmental
organization
Perform mostly financial Perform mostly operational Perform mostly compliance
statement audits. audits. audits.
Examine financial Examines all or part of Examine person’s or entity’s
statements. organization’s activates. actions.
Criterion is Generally Criteria are the efficiency Criteria are policies, codes,
Accepted Accounting and/or effectiveness of the laws, regulations, etc.
Principles/IFRS company’s operations.
Report on fairness of Report on recommended Report on compliance with
financial Statement in improvements. criteria.
conformity with GAAP /IFRS
Report goes to many Report usually goes to the Report usually goes to a
different types of users company itself. specific agency.

13 | P a g e