Auditing principles and practices I lecture Note:

CHAPTER ONE
OVERVIEW OF AUDITING
1.1. Introduction

This unit deals with the definition of Auditing, why there is a demand for Auditing by
stockholders, managers, employees, and debt holders, what is the role of Internal Auditing in
an organization; and deals with description of types of Audits commonly used by the
professional Auditors.

The public accounting profession (CPA), as we knew it today grew mainly out of the
demand for financial statement Audits. Very specific auditing standards, referred to as
generally accepted auditing standards (GAAS), are provided for conducting financial
statement audits. However, In recent years, the profession has been asked to provide services
beyond the traditional financial Statement Audit. These include compliance and operational
Audits.

1.2. Origin and Evolution of Auditing

The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days an
auditor used to listen to the accounts read over by an accountant in order to check them.
Auditing is as old as accounting. It was in use in all ancient countries such as Mesopotamia,
Greece, Egypt, Rome, U.K. and India.

The original objective of auditing was to detect and prevent errors and frauds. Auditing
evolved and grew rapidly after the industrial revolution in the 18th century with the growth of
the joint stock companies the ownership and management became separate. The shareholders
who were the owners needed a report from an independent expert on the accounts of the
company managed by the board of directors who were the employees.

The objective of audit shifted and audit was expected to ascertain whether the accounts were
true and fair rather than detection of errors and frauds. In India the companies Act 1913 made
audit of company accounts compulsory, with the increase in the size of the companies and the
volume of transactions the main objective of audit shifted to ascertaining whether the
accounts were true and fair rather than true and correct.

Hence the emphasis was not on arithmetical accuracy but on a fair representation of the
financial efforts
 The companies Act.1913 also prescribed for the first time the qualification of auditors
 The International Accounting Standards Committee and the Accounting Standard
board of the Institute of Chartered Accountants of India have developed standard
accounting and auditing practices to guide the accountants and auditors in the day to
day work.

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 The later developments in auditing pertain to the use of computers in accounting and
auditing.
1.3. Definition of Auditing

The American Accounting Association, committee on Basic Auditing concepts - Defined

Auditing as:

Auditing is systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of
correspondence between assertions and established criteria and communicating the
results to interested users.

The phrases in this definition require additional explanation.

 The phrase systematic process implies there should be a well-planned approach for
conducting an audit.
 This plan involves objectively obtaining and evaluating evidence. The evidence gathered
by the auditor must relate to assertions about economic actions and events. For example.
Financial statements prepared by management contain numerous assertions. If the
Balance sheet contains amount of Br. 10million for property, plant and equipment,
management is asserting (declaring) that the company owns the assets, uses them in the
production of goods and services, and that this amount represents their un depreciated
historical costs.
 The Auditor compares the evidence gathered to assertions about economic activity in
order to assess the degree of correspondence between those assertions and established
criteria. Generally Accepted Accounting Principles (GAAP) is normally used for
measuring the degree of correspondence, for financial Audits.
 The last Phrase, communicating the results to interested Users, is concerned with the type
of report the auditor provides to the intended users. (Banker, investors, stockholders,
Creditors, e.t.c ).
1.4 Accounting Vs Auditing
 Many financial statement users and members of the general public confuse auditing with
accounting. The confusion results because most auditing is concerned with accounting
information, and many auditors have considerable expertise in accounting matters. The
confusion is increased by the fact that auditing is performed by individuals described as
public accountants.

 Accounting is the process of recording, classifying and summarizing economic events in a

logical manner for the purpose of providing financial information for decision-making
accounting is constructive. It starts with the raw financial data to process and produce

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financial summary through reports known as financial statements as the end product of its
work. The function of accounting, to an entity and to society as a whole, is to provide
certain quantitative information that management and others can use to make decisions.
To provide relevant information, accountants need to have a thorough understanding of
the rules and principles and provide the basis for preparing the accounting information.

 Auditing on the other hand is analytical work that starts with the end product of
accounting to lend credibility and fairness of the measurements. In auditing, the concern is
with determining whether recorded information properly reflects the economic events that
occurred during the accounting period. Since the accounting rules and principles are the
criteria for evaluating whether the accounting information is properly recorded, any
auditor involved with this data must also thoroughly understand the accounting rules and
principles. In the context of the audit of financial statements these are generally accepted
accounting principles (GAAP).

 In addition to understanding accounting, the auditor must also possess expertise
knowledge in the accumulation and interpretation of audit evidence. Determining the
proper audit procedures, sample size, particular items to examine, timing of the tests, and
evaluating the results are unique to the auditor. It is these expertise that distinguishes
auditors from accountants.
1.4. Demand for Audit

The essence of demand for audit refers to the question “why do organizations request an
audit?” the answer to this question can be described as follows:

 Control mechanism – audits whether important control mechanisms for

accountability. The auditor’s role is determining whether the reports prepared by
management are in conformity with the responsibility and duties provided in the
organization policies. The overall need for monitoring activities, need demands
(requests) auditing to provide credible or Audited financial information, Audited
performance reports, Audited implementation of rules, & regulations.

 To resolve conflict of interest between management and the owners. The Agency
relationship that exists between the owner and manager produces a natural conflict of
interest. Because, the manager has more information about the “True financial position
and results of operations of the entity than the owner who is absentee. It both parties

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seek to maximize their own self-interest, it is likely that the manager will not act in the
best interest of the owner. Example The manager may spend organizational funds to
provide excessive personal benefits or manipulate the reported earnings in order to
earn a larger bonus. Thus, the need for Independent (non-pertain) opinions or view is
necessary to resolve such conflicts.
 To reduce damaging Consequences – Even though, the function of accounting is to
provide information for economic decision making; this information must be verified
by auditors, before they are used for decisions that have serious and subsequent factual
economic consequences.
 To simplify complexity – In our age, financial information & translation has been
come complex in preparation, content, and format. Therefore it demands drippy
specialized body of knowledge to prepare (compilation), verify and interpret them.

 Regulatory requirements – many business laws, memo random of association and

government regulation, make requirements’ annual audits. For Example –For renewal
of license, or permit, (commercial code to Ethiopia), financial Administration
regulation proclamation tax, requires audited financial statements.

1.5. Features Of Auditing

Features of auditing include:

 Audit is a systematic and scientific examination of the books of accounts of a
business.
 Audit is undertaken by an independent person or body of persons who are duly
qualified for the job.
 Audit is a verification of the results shown by the profit and loss account and the state
of affairs as shown by the balance sheet.
 Audit is a critical review of the system of accounting and internal control.
 Audit is done with the help of vouchers, documents, information and explanations
received from the authorities..

1.6. Objectives Of Auditing

There are two main objectives of auditing, the primary objective and the secondary or
incidental objective.
a. Primary objective – as per Section 227 of the Companies Act 1956, the primary duty
(objective) of the auditor is to report to the owners whether the balance sheet gives a
true and fair view of the Company’s state of affairs and the profit and loss account
gives a correct figure of profit of loss for the financial year.
b. Secondary objective – it is also called the incidental objective as it is incidental to the
satisfaction of the main objective.

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1.7. Types of Audit

While there are many types of audit based on the definitions previously provided, generally
they are discussed under three types: financial statement audits, compliance audits and
operational audits
1.7.1. Financial Statement Audits
The purpose of a financial statement audit is to determine whether the overall financial
statements present fairly in accordance with specified criteria. This type of audit usually
covers the basic set of financial statements (Balance sheet, Income statement, statement of
stockholders equity, and statement of cash flows); and Generally Accepted Accounting
principles (GAAP) serve as the criteria. However, certain financial statements audits may use
of other criteria, such as cash basis or Income tax basis.
1.7.2. Compliance Audits
The purpose of a compliance audit is to determine the extent to which rules, policies, Laws
covenants, or governmental regulation are followed by the entity being audited for example,
accompany may use auditors to determine whether the corporate rules, and policies are being
followed by departments within the organization. The corporate rules and policies serve as
the criteria for measuring the departments Compliance. Another example is examination of
tax returns (payment) of individuals and companies by the Internal Revenue Service for
compliance with Tax Laws.
1.7.3. Operational Audits
Operational Audit involves a systemic review of organizational activities, or apart of them, in
relation to the efficient and effective use of resources. The purpose of operational audit is to
assess performance, Identity areas of Improvement, and develop recommendations.
Sometimes this type of audit is referred to as a performance audit or management audit.
Operational audits are generally more difficult to conduct than financial and compliance
audits. Since the purpose of an operational audit is to assess effectiveness and efficiency, it
can be very difficult to identify objective, measurable criteria that can be used for that
purpose. Examples of such audit include – audit of government programs, Efficiency of the
food and Drug administration’s procedures for Introduction of new Drugs, to market.
Assessment of the efficiency and effectiveness of organizations use of computer resources etc.
Types of Auditors
There are a number of different types of auditors, however, they can be classified under three
headings. Internal auditors, external auditors and government auditors. Each type of auditor
will be discussed briefly. One important requirement of each type of auditor is independence,
in some manner form the entity being audited.

a) Internal Auditors
Nearly every large organization maintains an internal auditing staff. A principal goal of the
internal auditors is to investigate and evaluate the effectiveness with which the various

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organizational units of the company are carrying out their assigned functions. Much attention
is given by internal auditors to the study and appraisal of internal control.

The institute of Internal Auditors (IIA) has developed a set of standards that should be
followed by internal auditors and has established a certification program. An individual
meeting the certification requirements set by the IIA, which includes passing a uniform
written examination, can become a certified internal auditor (CIA).

Like external auditors, internal auditors must be objective and independent. To help ensure
the objectivity and independence of internal auditors, the IIA suggests that the director of
internal auditing report directly to either the board of directors or the audit committee of the
board or have free access to the board. Regardless of their reporting level, however, internal
auditors are not independent in the same sense as external (independent) auditors. The internal
auditors are employees of the company in which they work, subject to the restraints inherent
in the employer – employee relationship.

Internal auditors can be involved in all three types of auditors. Their primary activities are to
conduct compliance and operational audits within their organization. However, they may also
assist the external auditors with the annual financial statement audit. Unlike the external
auditors, who are committed to verify cash significant item in the annual financial statements,
the internal auditors are not obliged to repeat their audits on an annual basis.
b) External Auditors
External auditors are often referred to as independent auditors or certified public accountants.
Such auditors are called "external" because they are not employed by the organization being
audited. An external auditor conducts financial statement audits for publicly traded and
private companies, partnerships, municipalities, individuals and other types of entities. They
may also conduct compliance and operational audits for such entities. An external auditor
may practice as a sole proprietor or as a member of a CPA firm.

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Chapter Two
2. The auditing profession
2.1. Generally accepted auditing standards
The broadest guidelines available to auditors in the U.S. are the 10 generally accepted
auditing standards (GAAS), which were developed by the AICPA. As illustrated in Figure
2-2, the 10 generally accepted auditing standards fall into three categories:
 General standards
 Standards of field work
 Reporting standards

The individual standards in each category are included in Table 2-3. These standards are not
sufficiently specific to provide any meaningful guide to practitioners, but they do represent a
framework upon which the AICPA can provide interpretations.

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2.1.1. General Standards

The general standards stress the important personal qualities that the auditor should possess.
 Adequate Technical Training and Proficiency: The first general standard is normally
interpreted as requiring the auditor to have formal education in auditing and accounting,
adequate practical experience for the work being performed, and continuing professional
education. Recent court cases clearly demonstrate that auditors must be technically
qualified and experienced in those industries in which their audit clients are engaged.
In any case in which the CPA or the CPA’s assistants are not qualified to perform the work, a
professional obligation exists to acquire the requisite knowledge and skills, suggest someone
else who is qualified to perform the work, or decline the engagement.
 Independence in Mental Attitude: CPA firms are required to follow several practices
to increase the likelihood of independence of all personnel.

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 Due Professional Care: The third general standard involves due care in the
performance of all aspects of auditing. Simply stated, this means that auditors are
professionals responsible for fulfilling their duties diligently and carefully. Due care
includes consideration of the completeness of the audit documentation, the sufficiency
of the audit evidence, and the appropriateness of the audit report. As professionals,
auditors must not act negligently or in bad faith, but they are not expected to be
infallible.
2.1.2. Standards of Field Work
The standards of field work concern evidence accumulation and other activities during the
actual conduct of the audit.
 Adequate Planning and Supervision: The first standard requires that the audit be
sufficiently planned to ensure an adequate audit and proper supervision of assistants.
Supervision is essential in auditing because a considerable portion of the field work is
done by less experienced staff members.
 Understand the Entity and its Environment, Including Internal Control:
To adequately perform an audit, the auditor must have an understanding of the client’s
business and industry. This understanding helps the auditor identify significant client
business risks and the risk of significant misstatements in the financial statements. For
example, to audit a bank, an auditor must understand the nature of the bank’s operations,
federal and state regulations applicable to banks, and risks affecting significant accounts
such as loan loss reserves. One of the most widely accepted concepts in the theory and
practice of auditing is the importance of the client’s system of internal control for mitigating
client business risks, safeguarding assets and records, and generating reliable financial
information.
 If the auditor is convinced that the client has an excellent system of internal control, one
that includes adequate internal controls for providing reliable data, the amount of audit
evidence to be accumulated can be significantly less than when controls are not
adequate. In some instances, internal control may be so inadequate as to preclude
conducting an effective audit.
 Sufficient Appropriate Evidence: Decisions about how much and what types of
evidence to accumulate for a given set of circumstances require professional judgment.
2.1.3. Standards of Reporting
The four reporting standards require the auditor to prepare a report on the financial statements
taken as a whole, including informative disclosures. The reporting standards also require that
the report state whether the statements are presented in accordance with GAAP and also
identify any circumstances in which GAAP have not been consistently applied in the current
year compared With the Previous One.

2.2. Professional Ethics

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The audit function is carried out in complex environment composed of interrelation between
the government professional organizations, individual auditors and audit firms. Professional
organizations: are interested in audit function because they are issuer of standards.
Government: needs audit function in order to protect the interest of the public and for its
interest too (tax purpose). The function of auditor is to re assure of F/S that the facts are
correct and high light only problems with statements or with financial position or a respective
of competence with standards.
Ethics are prescribed set of moral principles or values. The examples for prescribed set of
moral principles or values at the implementation level includes laws & regulations, church
doctrines, code of business, ethical of professional groups and code of conduct with in
individuals organizations.
2.2.1. Characteristics of Profession
Profession is the job that needs special training or skills specially one that needs higher level
of education.
Professionals – are a group of people who possess a unique skill which benefit the society;
with intension of earning livelihood through it.
Any recognized profession has characteristics to be shared with other professions. The most
important of these characteristics are:-
 Responsibility to serve the public
 Complex body of knowledge
 Standards of qualifications for admission to the profession
 Need for public confidence (recognition)
 Standards of conduct or behavior.

2.3. Legal Liability and Responsibility

The auditor is responsible for his report; he is not responsible for the financial statements,
which are the representations of management. However, the auditor can be sued for causing
damage to users of his audit report if he doesn't carry out his work properly. In other words,
auditors face legal liability if they conduct their work negligently. Legal liability means the
probability that an auditor would be liable to a legal (court) action for not performing his
duties well.

In order to understand this section, you have to know the meaning of the following words as
they are used in the context of auditor's legal liability.

 Breach of Contract: when the auditor/client fails to meet the terms and obligations
stated in the contract for audit.
 Ordinary Negligence: an absence of reasonable or due care in performing an audit. An
auditor is negligent when she fails to do what other professional accountants would have
done under similar circumstances.

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Eg. Failure to detect that there was an error in computing depreciation.

 Gross Negligence: an extreme deviation from professional standards of due care.
Eg. Discovering but taking no action about management theft or fraud because of
carelessness.
 Fraud: wrongful actions taken with the intent of deceive client, the one whose financial
statements are being audited.
 Third Party: the contract for the audit is signed by the auditor and the client others who
have interest are referred to as third parties
Eg. Creditors, investors, potential investors etc

The following table summarized the auditor's legal liability.

The auditor can be charged by For
 Client  Breach of contract
 Negligence (gross and ordinary
negligence)
 A third party known to rely on the  Negligence (gross and ordinary
auditor's report for a particular purpose negligence)
 Fraud
 Foreseen third parties  Gross negligence
 Fraud
 Reasonably foreseeable third parties  Gross negligence
 Fraud

For any of the above parties to be able to successfully sue the auditor, they should be
able to show that:
1. The auditor had a duty to do something
2. He did not perform his duty
3. The plaintiff (person suing the auditor) relied on the work of the auditor.
4. The plaintiff suffered a loss as a result of relying on the auditor's work.
Possible Changes by a Client
a) For breach of contract
The auditor would be seud for breach of contract if he fails to complete the service agreed
to in the contract with the client. Eg. If the auditor discontinues an audit without adequate
cause, or fails to submit the audit report before or on the deadline, he may be asked to
repay a part or the entire fee.
b) For ordinary or gross negligence
Auditors can be sued for negligence by their clients when they fail to show due care, i.e, a
level of carefulness usually possessed by others in the profession. For example, the client
may charge the auditor for not detecting a major fraud by one employee or for letting a
confidential information leak out.

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Possible Charges by Third Parties

The auditor can be charged by third parties that the auditor knows would rely on his report for
negligence and fraud.

For example, Albo Co. engaged Bolke, a CPA, to audit its financial statements telling him
that they need the report to obtain a loan from a bank. In this case, Bolke can be held liable
for both ordinary and gross negligence to the bank in case the bank suffers a loss as a result of
relying on the auditor's opinion.

On the other hand, third parties that the auditor doesn't know would use his report can charge
the auditor and recover any losses only for gross negligence and fraud. But, the question
would be how is ordinary negligence differs from gross negligence?

Say financial statements have been deliberately overstated by management to deceive users.
The auditor has a duty to discover this. If the auditor applies GAAS properly and simply
doesn't suspect the fraud, he can only be accused of ordinary negligence. However, if the
auditor suspected that there was fraud but did not do additional investigation to try to uncover
the fraud, he can be accused of gross negligence.

If the auditor actually discovered the fraud and did not mention this in his audit report, in this
case he is participating in the fraud himself (i.e., constructive fraud).

The Auditor's Responsibility for other Illegal Acts

The auditor has a duty to uncover and report on illegal acts committed by the client or any one
as long as they are related to the financial statements.

So the auditor can be charged for not reporting illegal acts unrelated to the financial statement
only he knows about them.

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