Chapter one

An overview of auditing
1.1. Definition and Nature of Auditing

 Auditing is 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.
 TERMINOLOGIES
1. 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 income tax
returns.
 Auditors also audit 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. In the audit of historical financial
statements by Audit firms, the criteria may be U.S. generally accepted
accounting principles (GAAP) or Inter - national Financial Reporting
Standards (IFRS).
 2. Accumulating and Evaluating Evidence
 Evidence is any information used by the auditor to
determine whether the information being audited is
stated in accordance with the established criteria.
Evidence takes many different forms, including:
A. Electronic and documentary data about transactions
B. Written and electronic communication with outsiders
C. Observations by the auditor
D. Oral testimony of the auditee (client)
 To satisfy the purpose of the audit, auditors must
obtain a sufficient quality and volume of evidence.
 3. Competent, Independent Person
 The auditor must be qualified to understand the
criteria used and must be competent to know the
types and amount of evidence to accumulate to
reach the proper conclusion after examining the
evidence.
 The auditor must also have an independent
mental attitude. The competence of those
performing the audit is of little value if they are
biased in the accumulation and evaluation of
evidence.
 4. Reporting
 The final stage in the auditing process is preparing
the audit report, which communicates the
auditor’s findings to users.
 Reports differ in nature, but all must inform
readers of the degree of correspondence between
the information audited and established criteria.
 Reports also differ in form and can vary from the
highly technical type usually associated with
financial statement audits to a simple oral report in
the case of an operational audit of a small
department’s effectiveness.
 Audit of a Tax Return Example
1.Information
3. Competent, Federal tax
independent returns filed
person by taxpayer

Internal 4. Report on results

Revenue
agent Determines Report on tax
correspondence deficiencies
2. Accumulates and
evaluates evidence Established criteria

Examines cancelled Internal Revenue

checks and other Code and all
supporting records interpretations
2. Distinction between auditing and accounting
 Accounting is the collecting (recording, classifying),
summarizing, reporting and interpreting of financial data.
 Auditing is the testing of those accounting records for
fairness, appropriateness. An accountant only needs to
know generally accepted accounting principles (GAAP). The
auditor needs to know GAAP, plus how to select and
evaluate evidence related to the assertions of financial
statements.
 Accounting is constructive. It starts with the raw financial
data to process and produce financial statements.
 Auditing on the other hand is analytical work that starts
with financial statement to lend credibility and fairness of
the measurements.
 3. TYPES OF AUDITOR’s AND AUDIT
A. Types of Auditors
The most known types of auditors are
–Independent auditors,
–Internal auditors,
–Government auditors.
 CONT’D
1. Independent (external auditors): - Independent auditors
have no connection to the firm as an owner or
employee/manager. The basic task of independent auditor
is to confirm to the owners that the employees are correctly
reporting on their financial position and performance on
fee basis.
2. . Internal auditor: - An internal auditor is paid salary as
employee on the organization that is being audits. He/she is
responsible to appraise and investigation the performance
of unit and/or units within the organization and give
recommendation to top management.
3. Government audit: - The government auditor is paid a salary
by the government. He/she is responsible to the legislature
or executive.
 How do internal and external
auditing differ?
Internal auditors usually focus on im-
proving the efficiency and effectiveness
of their employer.

External auditors (public accounting

firms) usually focus on the fairness of
the financial statements of their clients.
 CONT’D
 The responsibilities and conduct of audits by internal and external
auditors differ in one important way. Internal auditors are responsible
to management and the board, while external auditors are
responsible to financial statement users who rely on the auditor to
add credibility to financial statements.
 Nevertheless, internal and external auditors share many similarities:
1. Both must be competent as auditors and remain objective in
performing their work and reporting their results.
2. Both follow a similar methodology in performing their audits,
including planning and performing tests of controls and substantive
tests.
3. Both consider risk and materiality in deciding the extent of their
tests and evaluating results. However, their decisions about
materiality and risks may differ because external users may have
different needs than management or the board
 3. TYPES OF AUDITOR’s AND AUDIT

B. Types of Audits
Auditor perform three primary types of audits,
these are:
1. Financial statement audit
2. Operational audit
3. Compliance audit
 Cont’d
1. Financial statement audit: - The goal is to determine whether the
financial statements have been prepared in conformity with
generally accepted accounting principles (GAAP).
 Conducted by independent (external) auditors
2. Operational audits: - An operational audit is study of some specific
unit of an organization for the purpose of measuring its performance.
The operation of a unit can be evaluated for its effectiveness and
efficiency.
 Usually conducted by internal auditors,
independent (external) auditors and government
auditors
3. Compliance audits: - Compliance audit determines whether the
specified rules, regulations, or procedures are being carried out or
followed.
 May be conducted by government auditors
 Important Characteristics of a Financial Audit

1. auditors are independent of client management

client external
management auditors
 Important Characteristics of a Financial Audit

1. auditors are independent of client management

2. auditors base their opinions on the results of
selective testing

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 Important Characteristics of a Financial Audit
1. auditors are independent of client management
2. auditors base their opinions on the results of
selective testing
3. an audit is directed toward the discovery of
material misstatements regardless of their cause
 Important Characteristics of a Financial Audit
1. auditors are independent of client management
2. auditors base their opinions on the results of
selective testing
3. an audit is directed toward the discovery of
material misstatements regardless of their cause
4. auditors form opinions regarding the fairness of
financial statements - auditors are never
absolutely certain

opinion = guarantee
 Important Characteristics of a Financial Audit
1. auditors are independent of client management
2. auditors base their opinions on the results of
selective testing
3. an audit is directed toward the discovery of
material misstatements regardless of their cause
4. auditors form opinions regarding the fairness of
financial statements - auditors are never
absolutely certain
5. auditors report on financial
XYZ Company
statements as a whole - not on
2016
individual items Financial
Statements
 Important Characteristics of a Financial Audit
1. auditors are independent of client management
2. auditors base their opinions on the results of
selective testing
3. an audit is directed toward the discovery of
material misstatements regardless of their cause
4. auditors form opinions regarding the fairness of
financial statements - auditors are never
absolutely certain
5. auditors report on financial statements as a
whole - not on individual items
6. auditors are concerned with financial presenta-
tion - NOT the client’s financial stability or the
wisdom of client management
 Audit of Historical Financial Statements

Annual audit of Ethiopian air line’s financial

Example
statements

Information Ethiopian air line’s financial statements

Established Generally accepted accounting

Criteria principles
Available Documents, records, and outside
Evidence sources of evidence
 Operational Audit

Evaluate computerized payroll system

Example
for efficiency and effectiveness
Number of records processed, costs of
Information
the department, and number of errors
Established Company standards for efficiency and
Criteria effectiveness in payroll department
Available Error reports, payroll records, and
Evidence payroll processing costs
 Compliance Audit

Determine whether bank requirements

Example
for loan continuation have been met

Information Company records

Established
Loan agreement provisions
Criteria
Available Financial statements and
Evidence calculations by the auditor
Differences Between Operational and Financial
Auditing
 The three major differences between and
financial auditing are the purpose of the audit,
distribution of the report, and inclusion of
nonfinancial areas.

 Purpose of the audit

 Distribution of the reports

 Inclusion of nonfinancial areas

 CONT’D
1. Purpose of the Audit This is the most important difference.
 Financial auditing emphasizes whether historical
information was correctly recorded, while operational
auditing emphasizes effectiveness and efficiency.
 Financial auditing is oriented to the past, while operational
auditing focuses on improving future performance. An
operational auditor, for example, may evaluate whether a
type of new material is being purchased at the lowest cost
to save money on future raw material purchases.
 CONT’D
2. Distribution of the Reports
 Financial auditing reports are typically distributed to
external users of financial statements, such as stockholders
and bankers, while operational audit reports are intended
primarily for management.
 The widespread distribution of financial auditing reports
requires a well-defined structure and
wording, the limited distribution of operational
reports and the diverse nature of audits for efficiency and
effectiveness allow operational audit reports to vary
considerably from audit to audit.
 Cont’d
3. Inclusion of Nonfinancial Areas
 Financial audits are limited to matters that
directly affect the fairness of financial
statement presentation, while operational
audits cover any aspect of efficiency and
effectiveness in an organization. For example,
an operational audit might address the
effectiveness of an advertising program or
efficiency of factory employees.
 Types of Operational Audits
 Operational audits fall into three broad
categories: functional, organizational, and
special assignments. In each case, part of the
audit is likely to concern evaluating
internal controls for efficiency and
effectiveness.
ti o na l
 Func
 Organizational
 Specia
l assignm
ents
 Cont’d
.1. Functional Audits
 Functions are a means of categorizing the activities of a business, such as the
billing function or production function. Functions may be categorized and
subdivided many different ways. For example, the accounting function may be sub
divided into cash disbursement, cash receipt, and payroll disbursement functions.
The payroll function may be subdivided into hiring, timekeeping, and payroll
disbursement functions.

 A functional audit deals with one or more functions in an organization,

concerning, for example, the efficiency and effectiveness of the payroll function
for a division or for the company as a whole.
 A functional audit has the advantage of permitting specialization by auditors.
Certain auditors within an internal audit staff can develop considerable expertise
in an area, such as production engineering. They can be more efficient and
effective by spending all their time auditing in that area. A disadvantage of
functional auditing is the failure to evaluate interrelated functions. For example,
the production engineering function interacts with manufacturing and other
functions in an organization
 Cont’d
2. Organizational Audits
 An operational audit of an organization deals with an entire
organizational unit, such as a department, branch, or subsidiary.
 An organizational audit emphasizes how efficiently and effectively
functions interact. The plan of organization and the methods to
coordinate activities are important in this type of audit.

3. Special Assignments
 In operational auditing, special assignments arise at the
request of management for a wide variety of audits, such as
determining the cause of an ineffective IT system, investigating the
possibility of fraud in a division, and making
recommendations for reducing the cost of a manufactured product
 Demand for Audit
 There is a need for auditing when ownership is separated
from control.
 Practically, it helps prevent or detect misstatements-errors
or fraud. It may prevent or detect misstatements on the
part of
1) the employees who actually handle the money, or
2) management.
 Auditing is needed to enhance the credibility of financial
information prepared by an entity.
 The independent audit requirement fulfils the need to
ensure that those financial statements are objective, free
from bias and manipulation and relevant to the needs of
users.
 Major reasons for auditing
A. Control Mechanism
 Audits whether internally or externally
performed are valued as important control
mechanisms for accountability the overall need
for monitoring activities, especially financial
activity includes the need for auditing to
provide credibility for reported and unreported
information.
 1.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.
• 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.
2. 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.
• But Not Owners but also other readers of financial statements of an
enterprise also place great reliance on them if they have been audited.
3.Tool for Improving Economy and Efficiency
• In examination of any type of audit, the auditor reviews the activities of the
enterprise.
• Auditor 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
 B. Its Importance to Reduce Information
Risks
• Information risk reflects the possibility that
the in formation upon which the business risk
decision was made was in accurate.
• A likely cause of the information risk is the
possibility of inaccurate financial statements.
• External users such as stockholders and lenders
who rely on those financial statements to
make business decisions look to the auditor’s
report as an indication of the statements’
reliability.
 C. Conflict of Interest
 The agency relationship that exists between an
owner and manager produces a natural conflict of
interest because of the information asymmetry that
exists between the manager and the absentee
owner.
 Information asymmetry means that the manager
generally has more information about the "true"
financial position and results of operations of the
entity than the absentee owner does.
 If both parties seek to maximize their own self-
interest, it is likely that the manager will not act in
the best interest of the owner.
 D. Consequences
 The ultimate objective and function of
accounting is to provide information for
economic decision making.
 Information is used for decisions that have
serious and substantial economic
consequences.
 Thus the need for an audit for verifying the
accuracy of information before they are used
in decisions that may bring damaging
consequences.
 E. Remoteness
 Because of the separateness of the
management from the owners; information is
prepared in a place far from the user.
 The user is prevented from directly assessing
the quality of information he obtains.
 Thus the need for auditor services to assess the
information on the users' behalf.
 F. Regulatory Requirements
 Many business laws, memorandum of association and
regulatory agencies acts make audits annual requirements
to be complied with for renewal of license or permit.
 For example the security exchange commission (SEC) in the
US; the Commercial Code of Ethiopia (1966), and latter the
Public Financial Regulation of Procl 163/1999 in Ethiopia
make the filing of audited financial statements annually.
 Disaster Prevention and Preparedness Commission (DPPC)
requires NGOs to prepare and submit their annual financial
statements.
 Thus compliance requirements create a very large demand
for auditing services.
 ASSURANCE SERVICES
 An assurance service is an independent professional service that
improves the quality of information for decision makers.
 Individuals who are responsible for making business decisions
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 CPAs or by a variety of other
professionals.
Attestation services
•One category of assurance services provided by CPAs is attestation
services.
Attestation service is a type of assurance service in which the CPA
firm issues a report about the reliability of an assertion that is made
by another party.
The end!!!