TOPIC ONE – INTRODUCTION TO AUDITING

DEFINITIONS:
Auditing: The Institute of Chartered Accountants of India (ICAI) defines Audit and
Assurance Standard (AAS) as "Auditing is the 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 conducted with a view to expressing an opinion thereon."
Auditing is the examination of financial statements covering transactions over a period and
ascertaining the financial position of an organization on a certain date in order that the auditor
may issue a report on them (N. A. Saleemi)
An Audit: it is the independent examination of the financial information of any entity,
whether profit oriented or not, and irrespective of its size or legal form, when such
examination is conducted with a view to expressing an opinion thereon (IAG3). The general
definition of an audit is an evaluation of a person, organization, system, process, enterprise,
project or product. The term most commonly refers to audits in accounting, but similar
concepts also exist in project management, quality management, and energy conservation.
Auditor: This is an independent person or firm appointed by a business enterprise to audit its
accounts with a view of forming an opinion and report on the financial statements of a
business enterprise for a specific period.
NATURE AND PURPOSE OF AUDITING
Nature and agency theory of Auditing: Public companies are owned by shareholders but
are managed by directors who in turn employ the top management to manage the affairs of
the company on their behalf. The shareholders and other stakeholders are interested in
knowing whether their hard-earned resources are managed in more transparent and profitable
manner. This information is reported by management through financial statements such as
Income statement; Cash flow statement and Statement of financial position. The
authenticity of these financial statements must be ascertained by an independent and qualified
party who happens to be the auditor.
The shareholders may not have the necessary skills and expertise to manage the day-to-day
affairs of the business, resulting in appointment of other parties to manage the affairs of the
company or business on their behalf. There is the assumption that the managers and
shareholders left on their own will each attempt to act in their own self interest. The managers
are likely to pursue goals which do not maximize the shareholders wealth. The goals would
only serve the interest of the managers and therefore conflict the shareholders’ goals.
Conflicts of interest may, for instance arise from the managers awarding themselves hefty pay
hikes, taking expensive trips and holidays, arranging mergers and take – over for their
benefits, arrange for very attractive retirement for themselves, may practice discriminatory
employment practices and may adopt luxurious lifestyles fully paid for by the business. The
shareholders are therefore the principals while the management teams are agents.
Creditors, who include suppliers and bankers, are contributors of debt capital who are not in
any way involved in the day to day running of the business. After the provision of debt
finance, the shareholders are expected to manage the finances along with the management on
behalf of the creditors. The creditors therefore constitute the principals while the shareholders
are the agents.
Process of auditing involves four main steps as follows:
 (i) Planning: At this stage engagement letter is received from the entity requiring the
audit. Initial meeting is held with the client to undertake audit survey, reviewing
of internal control for the purpose of preparing the audit program.
(ii) Field work: Includes transaction testing e.g., sampling advice and informal
communications. An audit summary is prepared from working papers in the field.
(iii) Audit Report: Starts with the discussion of the draft report which is discussed by
the management of the entity in an exit meeting. A final report is then prepared
after the client responds to issues raised in the draft report.
(iv) Follow up Report: After review comments by the management of the entity, a list
of actions to be taken or already taken by the client to resolve findings is prepared
by the auditor and forwarded to the clients Board of Management.
The Purpose of Audit: When the managers report to the owners or shareholders and
stakeholders there is the likelihood that they will try to paint a picture that they delivered
as agreed with the stakeholders or shareholders. The reports are likely to have misleading
information or contain errors that may conceal frauds. In addition, the statements may fail
to disclose all relevant information. All these problems and others may be solved by
appointing an independent qualified auditor to go through the reports and financial
statements.
OBJECTIVES OF AUDITING: The two main objectives of auditing are primary
objective and subsidiary or secondary objective which are discussed below:
 Primary Objectives: It is an audit that produces a report regarding the truth and
fairness of the company’s financial statements so that any users of these statements
can be satisfied. These objectives include:
1. The obligation of the auditor to prove the true and fair view or otherwise of the
company’s financial state of affairs.
2. He should confirm that proper books of accounts are being kept or not.
3. The auditor is required to communicate his findings to the shareholders of the
company in form of report together with his opinion.
 Subsidiary or secondary objectives: They involve detecting and preventing errors
and frauds, in addition to assisting clients to improve their accounting systems and
find out whether control systems are working properly or not. It is, however, not the
auditor’s duty to discover frauds but if he comes across them during the audit, then he
should point out the frauds to the concerned party.
RESPONSIBILITIES OF AN AUDITOR: Auditors will be held liable of professional
misconduct if they do not observe the statements of ethics which include integrity,
professional independence, confidentiality, technical Standards, professional competences
etc. However, the main functions of an auditor include among others:
 Providing recommendations to improve weak internal controls.
 Investigating instances of possible fraud (even those considered immaterial).
 Performing reconciliations of financial and operating information.
 Assessing compliance with industry standards, laws, and guidelines.
 Confirming suitability of the design and operational effectiveness of internal controls
related to the security of information.
 Assessing completeness and Accuracy of information processing and data integrity.
 Evaluating whether the system development life cycle meets the necessary standards.
 Ensure that staff working on the audit have the necessary skills for good judgment.
 Acting in a professional and ethical manner
Importance of auditing: Many times, people do not like the sight of auditors, but it is
important to understand what auditors do and their function in creating a better business.
Auditors provide the opportunity for business owners to incorporate independence into the
review process of their internal control program. Additionally, the process helps to define
gaps, weak controls, and possible risks. Moreover, recognizing the different functions
auditors can provide, and using their services as an asset, can ultimately provide companies
with an edge over their competitors.
Other Services by Auditors: The auditor can from time to time provide some other services
like writing up the books of accounts, balancing books of accounting, setting up accounting
systems, computerizing manual accounting systems, providing financial advice, mergers and
take over accounting/advice, liquidation and receivership work.
Advantages of an Audit:
a. Provides assurance and credibility to the accounts for the benefit of potential
investors.
b. Used for detection of errors and frauds which could collapse an organization.
c. Audited accounts are used by the organization to raise finance from the public and
other sources as they boost an organization’s credit rating.
d. An audit is used to boost the morale of accounting staff who will keep the accounts to
date and act as source of management information upon which decisions can be made.
e. It is used by partnerships as a basis of sharing profits and therefore minimizing
disputes between partners.
f. They are used by income tax authorities to ascertain the tax liability and avoid any
possible dispute between the company and income tax department.
g. The audited accounts are used to admit partners in a partnership business as the
accounts will indicate both net assets and the capital payable by the new partner.
h. Audited accounts are useful in case of a sale of business, a merger, an acquisition or
takeover of a business as it indicates the fair value of assets to be acquired.
i. They are used by insurance companies to settle insurance claims arising out of losses
that may be insured in which case the client cannot have conflicting situations which
the insurers would object.
Disadvantages of an Auditor
a. It is an expensive as the fees and expenses involved are too high for small companies.
b. In case of a qualified report, it can lead to the failure of the business.
c. An audit may not be ideal for small business whose transactions are too few.
d. An audit may not be in the interest of the owners, especially if they are the managers
in which case, they may end up frustrating the entire process.
Users of Financial Statements: Financial statements are usually in three forms, namely:
Income statement, Cash flow statement and Statement of financial position. The financial
statements may be produced quarterly, semi annually or annually. The company’s Act
recommends that they must be produced annually. There is quite a number of parties who are
interested in these financial statements for different purposes and they include shareholders,
lenders, employees, customers, suppliers of goods, debtors, government and its agencies,
consultants, financial analysts, general public etc.