1.

1 INTRODUCTION
audItIng prIncIples and practIces I
qReliable information is necessary if managers,
CHAPTER ONE investors, creditors, and regulatory agencies are to make
informed decisions about resource allocation.
AN OVERVIEW OF AUDITING
qAuditing play an important role in this process by
providing objective and independent on the
reliability of information.
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Cont’d… 1.2. NATURE OF AUDITING

1.2.1 Definition of Auditing
q By adding the audit function to each situation,
th e u sers o f the fin an cial s ta te m e nt s h ave qAAAs Committee on Basic Auditing concepts
reasonable assurance / guarantee that the
developed a definition of auditing as follows:
financial statements do not contain material
misstatements or omissions.

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4
 Cont’d… Cont’d…
qAuditing is qAuditing is :
qA systematic process of objectively / factually qThe accumulation and evaluation of evidence about
obtaining and evaluating evidence regarding information to determine and report on the degree of
assertions about economic actions and events to c o r re s p on d e nc e be tw e e n t h e i nf o r mat i o n a nd
ascertain the degree of correspondence between those established criteria.
assertions & established criteria and communicating the qAuditing should be done by a competent, independent
results to interested users. person.
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Cont’d… Cont’d…
q Thus, auditing encompasses both an investigating q systematic gathering & evaluation of evidence as
process and a reporting process. a basis for reaching an opinion about whether assertions
qIn the audit of an entity's financial statements –Called a made by management in an entity's financial statements
financial statement audit : investigation means : correspond in all material respects with generally
accepted accounting principles (GAAP) or International
financial reporting standard (IFRS).

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 Cont’d… Cont’d…

qFor example, management asserts all inventories qThe opinion an auditor express in all audit report
exist represent properties or rights of the entity, depends on the information content of evidence
reflect all related transactions for the period, are valued
gathered during the audit and indicate either the
at appropriate amounts, and are presented properly in
financial statements are presented fairly in conformity
the financial statements.
with GAAP, IFRS or are not presented fairly.

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Cont’d… Cont’d…

qThe International Federation of Accountants (IFAC) Therefore, an audit gives a reasonable assurance that
defines an audit as:
the financial statements must be free from material
ü a work performed by an auditor to enable him/her to express
misstatements.
an opinion whether the financial statements are prepared, in all
material respects, in accordance with an identified financial
reporting framework.

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 1.3. Distinguish B/n Auditing and qAccounting Provide certain quantitative information that
Accounting management and others can use to make decisions.
qAccounting is the recording, classifying, and summarizing of qWhile Auditing is
economic events for the purpose of providing financial qAnalytical work that starts with the end product of
information used in decision making. accounting to lend credibility and fairness of the

qAuditing is determining whether recorded information measurements.

properly reflects the economic events that occurred qIn auditing, the recorded information is properly reflects the

during the accounting period. economic events that occurred during the accounting period.

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qThe auditor must also possess expertise knowledge in qBecause U.S. or international accounting standards
provide the criteria for evaluating whether the
the accumulation/gathering and interpretation of accounting information is properly recorded,
audit evidence /facts. auditors must thoroughly understand those
accounting standards.
qWhen auditing accounting data, auditors focus on
determining whether recorded information properly
reflects the economic events that occurred during the
accounting period.
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 1.4 TYPES OF AUDITS AND AUDITORS 1. Financial Statement Audit
qThe audit of financial statements ordinarily covers the
1.4.1. TYPES OF AUDITS
balance sheet and the related statements of
qGenerally there are three types of audits:
income, retained earnings, and cash flows.
1. Financial statement audit
qThe goal is to determine whether these statements
2. Compliance audits, and have been prepared in conformity with specified
3. Operational audit criteria.
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qThe criteria may be; qF i n a n ci a l s t a t e m e n t a u d i t s a r e n o r m al l y

qInternational Financial Reporting Standards (IFRS),
performed by firms or certified public
qGenerally accepted accounting principles (GAAP) as in the
accountants (CPA)
USA,

qNational company laws as in Northern Europe, or

q Users of auditors' reports include management,

qThe tax code in South America investors, bankers (creditors) and

government agencies and etc
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 2. Compliance Audits
qLike an independent financial statement audits, a
qIs a review of an organization’s procedures to determine whether
compliance audit is designed to determine whether an
the organization is following specific procedures, rules or
entity's financial statements are presented fairly in
regulations set out by some higher authority.
a c c o r d a n c e w i t h g e n e ra l ly a cc e p te d a cc o u n t i n g
qThe purpose of compliance audit is; Dependent upon the principles or not.
existence of verifiable data and of recognized criteria or qCompliance audits are conducted by either independent
standards, such as established laws and regulations, and auditors or government auditors.

or an organization's policies and procedures.

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3. Operational Audits qEffectiveness is a measure whether an organization achieves

qAn operational audit involves a systematic review of its goals and objectives.
an organization's activities, or a part of them, in qEfficiency shows how well an organization uses its resources to
relation to the efficient and effective use of achieve its goals.

resources. Sometimes this type of audit is referred to as a

performance audit or management audit:

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 1.4.2 TYPES OF AUDITORS 1. Internal Auditors
1. Internal Auditors, qA principal goal is to investigate and evaluate the

2. External Auditors and effectiveness with which the various organizational units of
the company are carrying out their assigned functions.
3. Government Auditors.
qThe institute of Internal Auditors (IIA) has developed a set of
qOne important requirement of each type of auditor is
standards that should be followed by internal auditors and
independence, in some manner form the entity being has established a certification program.
audited.
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qA n i n d i v i d u a l m e e t i n g t h e c e r t i f i c a t i o n qThe IAs are employees of the company in which they work,

subject to the employer – employee relationship.
requirements set by the IIA, passing a uniform
qTheir primary activities are to conduct compliance and
written examination, can become a certified internal
operational audits within their organization.
auditor (CIA).
qHowever, they may also assist the external auditors with the
qLike external auditors, internal auditors must be objective/
annual financial statement audit.
and independent.

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 2. External Auditors
qProfessionals standards require that external auditors
qExternal auditors are often referred to as independent auditors or
certified public accountants.
maintain their objectivity and independence when

qSuch auditors are called "external" because they are not providing auditing or other attestation services for clients.
employed by the organization being audited. Three Requirements for Becoming a CPA.
qAn external auditor conducts financial statement audits.
qThey may also conduct compliance and operational audits.
qAn external auditor practice as a sole proprietor or as a member
of a CPA firm.
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3.Government Auditors
qThe primary responsibility of the government audit staff
is to perform the audit function for government.

qThe extent and scope of the audits performed are

determined by legislation in the various jurisdictions.

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 1.5. Assurance and non-assurance services Attestation Service
1.5.1. Assurance services
qAn attestation service is a type of assurance service
qASs are professional services that improve the quality of
information for decision makers.
in which the CPA firm issues a report about the
reliability of an assertion/statements that is
qIndividuals who are responsible for making business decisions seek
assurance services to help improve the reliability and relevance of made by another party.
the information.

qCan be performed by CPAs or by a variety of other professionals.

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1. Audit of Historical Financial Statements

q In this audit,
qManagement asserts that the statements are fairly stated in
accordance with applicable U.S. or international accounting
standards.

qIt is a form of attestation service in which the auditor issues a

written report expressing an opinion about whether the
financial statements are fairly stated in accordance with the

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applicable accounting standards. 36
2. Audit of Internal Control over Financial Reporting 4. Attestation Services on Information Technology
qInternal controls have been developed and implemented following
qFor attestations on information technology, management
well established criteria
makes various assertions about the reliability and security of
3. Review of Historical Financial Statements
electronic information.
qThe statements are fairly stated in accordance with accounting
q Many business functions, such as ordering and making
standards, the same as for audits.
payments, are Conducted over the Internet or directly between
qThe CPA provides a lower level of assurance for reviews of Financial
statement compared to a high level for audits, therefore less evidence is Computers using electronic data interchange (EDI).
needed.
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Relationships Among Auditors, Client, and External Users 5. OTHER ASSURANCE SERVICES

qMost of the other assurance services that CPAs provide do not

Auditor issues meet the formal definition of attestation services.
Client or audit Auditor report relied upon by
committee hires users to reduce qThe CPA is not required to issue a written report.
auditor information risk
qThe assurance does not have to be about the reliability of

Provides capital another party’s assertion about compliance with specified

Client External
Users criteria.
Client provides financial
statements to users 39 40
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qNo assurance Services Provided by CPAs

1. Accounting and bookkeeping services

2. Tax services

3. Management consulting services

qMost accounting and bookkeeping services, tax services, and

management consulting services fall outside the scope of
assurance services, although there is some common area of

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overlap between consulting and assurance services. 44
 1.6. THE ECONOMIC DEMAND FOR AUDITING
qWhile the primary purpose of an assurance
If the bank makes the loan, it will charge a rate of interest
service is to improve the quality of
determined primarily by three factors:
information,
1. Risk-free interest rate: Is the rate the bank could earn by
qThe primary purpose of a management consulting investing in treasury notes for the same length of time as the
engagement is to generate a recommendation to business loan.
management. 2. Business risk for the customer: possibility that the business
will not be able to repay its loan because of economic or
45 business conditions, 46

3. Information risk. qAuditing has no effect on either the risk-free interest rate or business
risk,
qInformation risk reflects the possibility that the
qBut it can have a significant effect on information risk.
information upon which the business risk decision was qIf the bank officer is satisfied that there is minimal information risk
made was inaccurate. because a borrower’s financial statements are audited, the bank’s risk
is substantially reduced and the overall interest rate to the borrower
qA likely cause of the information risk is the possibility of
can be reduced.
inaccurate financial statements.
qThe reduction of information risk can have a significant effect on the
borrower’s ability to obtain capital at a reasonable cost.
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q“Why do organizations request an audit?" (Section C) 2. Conflict of Interest
Among the reasons the majors are the following: qThe agency relationship that exists between an owner

1. Control Mechanism and manager produces a natural conflict of interest

qAudits whether internally or externally performed are valued as because of the information asymmetry that exists

important control mechanisms for accountability, the between the manager and the absentee owner.
overall need for monitoring/supervise activities, for
credibility/ trustworthiness for reported and unreported
information. 49 50

qInformation asymmetry means that the manager 3. Consequences

qAccounting provides information for economic decision-
generally has more information about the "true"
making.
financial position and results of operations of the
qThis Information is used for decisions that have serious and
entity than the absentee owner does.
substantial economic consequences.

qThus, the need for an audit is verifying the accuracy of

information before they are used in decisions.

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 4. Remoteness of information 5. Regulatory Requirements
qBecause of the separateness of the management from the qMany business laws, memorandum of association and
owners; information is prepared in a place far from the user. regulatory agencies acts make audits annual
qThe user is prevented from directly assessing the quality of requirements to be complied/act in accordance with
information he/she obtains.
for renewal of license or authorize.
qThus , t he n ee d for auditor se rv ice s is to as se ss the
information on the users' behalf.

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Biases and Motives of the Provider

qFor example the security exchange commission (SEC) in
qIf information is provided by someone whose goals are
the US; the Commercial Code of Ethiopia (1966), and latter the inconsistent with those of the decision maker, the information may be
biased in favor of the provider.
Public Financial Regulation of Procl 163/1999 in Ethiopia make qThe reason can be honest optimism about future events or an
the filing of audited financial statements annually. intentional emphasis designed to influence users. In either case, the result
is a misstatement of information.
qFor example, when a borrower provides financial statements to a
lender, there is considerable likelihood that the borrower will bias the
statements to increase the chance of obtaining a loan.
qThe misstatement could be incorrect dollar amounts or inadequate or
incomplete Disclosures of information.

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qVoluminous Data:
qAs organizations become larger, so does the volume of their
exchange transactions. This increases the likelihood that improperly
recorded information is included in the records—perhaps buried in a
large amount of other information. END OF CHAPTER ONE
qUser Verifies Information
qThe user may go to the business premises to examine records
and obtain information about the reliability of the statements.
Normally, this is impractical because of cost. In addition, it is
economically inefficient for all users to verify the information
individually.
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