Chapter 1

An Overview Of Auditing

Auditing involves an examination of financial statements, records, activities

, legislatives 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

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 1.1 Definition 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.

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o Auditing has been defined in several ways by accounting
associations.
o 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
i. Accounting Principles Board (APB)

ii. International Federation of Accountants (IFA)

iii. American Accounting Associating (AAA)**

** best fit with the objectives….

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According to ‘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
• i.e (for example relevant legislation and applicable standards),
where statutory or other requirements prescribe the term.

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According to ‘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.

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According to ‘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 b/n those assertions and
established criteria, and communicating the results to interested users.

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 Auditing is a systematic process:
 Process implies that auditing is a dynamic ongoing activity which is not a one-
time check of the relationship b/n 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.
 Auditors should gather and evaluate sufficient evidence to arrive at a
reasonable conclusion concerning the financial statements.

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 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.

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 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.
 So an auditor has to go behind the books.

 purpose of auditing lies in ascertaining whether the working results & financial
position as shown by the I/statement and B/sheet for a particular period are truly
determined and presented by those responsible for their compilation.
 Auditing 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. 9
 Cont…
 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/ considering of evidence.

 Auditing is analytical critical and investigative.

 It has its principal roots 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.

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 The Need For Auditing
 Most business entities employ accountants and bookkeepers to process
the transactions and financial statements.
 but, there is still demand for audit for the reasons of:
 Conflict of interest

 Consequences

 Complexity

 Remoteness

 Regulatory requirements

 etc?

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 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.

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 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
financial statements are prepared in conformity with IFRS

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 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.

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 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.
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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.
 The contribution of auditing is not limited to individuals as it is also useful to the
society. some of the advantages of auditing for the society:

a) 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)

b) 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) 16
 Cont…
c) Audit increases credibility of financial information (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.
d) 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 ex, in an operational audit, the auditor makes recommendations for
improving the economy and efficiency with which resources are used. 17
Scope Of Auditing
 The scope of audit is extending day by day b/c 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).

 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.

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 1.2 ACCOUNTING Vs AUDITING
Basis of
S.No Accountancy Auditing
Difference
1 Scope Accountancy refers to the Auditing refers to
preparation of final accounts and its examination and checking
interpretation of these accounting records.
2 Nature Accountancy is primarily Auditing is analytical in
constructive and concerned with nature and essentially
current recording of business facts retrospective.
3 Objects The main objective of accountancy The objective of auditing is
is to ascertain the trading results of to certify the correctness
a business concern during a finances and justification of the
concern during a financial year. financial statements
prepared by the accountant.
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 Basis of
S.No Accountancy Auditing
Difference
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 when the work of accountancy
available for the beginning of has been completed. In other
work of accountancy. In other words, where accountancy ends
words, Accountancy starts auditing starts.
where book 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.
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 Basis of
S.No Accountancy Auditing
Difference
7 Duration Accounting work is undertaken Auditing is generally done at
throughout the year. the end of financial year.
8 Status An accountant is a permanent An auditor is not a permanent
employee of the business employee of the concern. He
concern. may be changed from year to
year.
9 Report An accountant is not required to An auditor is required to
submit a report to the proprietor submit the report to the
of the concern when the proprietor after the
accounting work is over. completion of his audit work.

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1.3 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/Performance audit, and

III. Compliance audit.

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 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 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.

…..? how many types of auditor’s report?

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 Types of Audit Report
 There are four types of audit reports; namely,

1) Unqualified: -unqualified report with unqualified opinion

2) Qualified:-qualified report with qualified opinion

3) Adverse:- adverse report with adverse opinion

4) Disclaimer:- no opinion

??? (you will discus in chapter 6)

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 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 ex., 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 recommendations for further action.
 An operational audit focuses on such matters as goals, objectives,
policies, organizational structures, functions and cost effectiveness.
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 Cont…
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.

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 Cont…
 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 IFRS or
tax regulations.
 The end product of an operational audit is usually a report to top
management containing recommendations for improvements in
operations.

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 III. Compliance Audit
 The objective of compliance audit is to determine whether the organization
being audited following procedures, regulations, or policies which 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 polices 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.

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 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.

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 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 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.

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 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.

? What is (are) the activities/objectives of internal auditor?

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Attainment objectives of Internal Auditor’s activities involves:
 Reviewing & appraising the soundness, adequacy, and application of
accounting, financial, & 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
 scope of the internal audit function extends to all of the organ’s activities. (Internal
auditors are primarily involved in compliance & operational audits).
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 III. Government Auditor
 Government auditors are employed by various local, state, and federal
governmental agencies.
 At the federal level (in Ethiopia), the three primary agencies are:

i. the Office of Auditor General,

ii. the Federal Inland Revenue Authority, and

iii. the Audit Service Corporation

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. 33
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.
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 Comparison of Different Types of Auditors

EXTERNAL INTERNAL GOVERNMENT

AUDITORS AUDITORS AUDITORS

CPAs who are hired as Company employees Local, State or Federal

independent contractors who audit their own employees who audit
by many different company exclusively various governmental
companies. organization

Perform mostly financial Perform mostly Perform mostly

statement audits. operational audits. compliance audits.

Examine financial Examines all or part of Examine person’s or

statements. organization’s activates. entity’s actions.
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 ……Cont’d
EXTERNAL INTERNAL GOVERNMENT
AUDITORS AUDITORS AUDITORS
Criterion is Generally Criteria are the Criteria are policies,
Accepted Accounting efficiency and/or codes, laws, regulations,
Principles (GAAPs) effectiveness of the etc.
company’s operations.

Report on fairness of Report on recommended Report on compliance

financial Statement in improvements. with criteria.
conformity with GAAP

Report goes to many Report usually goes to Report usually goes to a

different types of users the company itself. specific agency.
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 ………

• THE END

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