Chapter one

An Overview of Auditing
1. Definition 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.
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.
Information and Established Criteria
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 CPA firms, the criteria may be
U.S. generally accepted accounting principles
(GAAP) or Inter - national Financial Reporting
Standards (IFRS).
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:
 Electronic and documentary data about
transactions
 Written and electronic communication with
outsiders
 Observations by the auditor
 Oral testimony of the auditee (client)
To satisfy the purpose of the audit, auditors must
obtain a sufficient quality and volume of evidence.
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.
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.
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.
Distinction between auditing and accounting

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. Demand for Audit
There is a need for auditing when ownership is
separated from control. At a practical level, 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:
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.
Major reasons:
B. 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.
C. 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.
D. 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.
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
Proc 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.
4. ECONOMIC DEMAND FOR AUDIT

To illustrate the need for auditing, consider the

decision of a bank officer in making a loan to a
business. This decision will be based on such
factors as previous financial relationships with
the business and the financial condition of the
business as reflected by its financial
statements. If the bank makes the loan, it will
charge a rate of interest determined primarily
by three factors
 Risk-free interest rate. This is approximately the rate the
bank could earn by investing in U.S. treasury notes for the
same length of time as the business loan.
 
Business risk for the customer. This risk reflects the
possibility that the business will not be able to repay its
loan because of economic or business conditions, such as
a recession, poor management decisions, or unexpected
competition in the industry.
 
Information risk. Information risk reflects the
possibility that the information upon which the business
risk decision was made was inaccurate. A likely cause of
the information risk is the possibility of inaccurate
financial statements.
 Auditing has no effect on either the risk-free interest
rate or business risk, but it can have a significant
effect on information risk.
 If the bank officer is satisfied that there is minimal
information risk because a borrower’s financial
statements are audited, the bank’s risk is
substantially reduced and the overall interest rate to
the borrower can be reduced. The reduction of
information risk can have a significant effect on the
borrower’s ability to obtain capital at a reasonable
cost.
 For example, assume a large company has total
interest-bearing debt of approximately $10 billion.
If the interest rate on that debt is reduced by only 1
percent, the annual savings in interest is $100
As society becomes more complex, decision
makers are more likely to receive unreliable
information. There are several reasons for this:

 Remoteness of information
 Biases and motives of the provider
 Voluminous data
 The existence of complex exchange
transactions.
TYPES OF AUDITS AND AUDITORS

A. Types of Audits
CPAs perform three primary types of audits, these
are:

1. Financial statement audit

2. Operational audit
3. Compliance audit
1. Financial statement audit: - The goal is to
determine whether the financial statements have
been prepared in conformity with generally
accepted accounting principles.
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.
3. Compliance audits: - Compliance audit
determines whether the specified rules,
regulations, or procedures are being carried out
or followed.
B. Types of Auditors

Several types of auditors are in practice

today. The most common are
 
 Certified public accounting firms
 Government accountability office
auditors
 Internal revenue agents
 Internal auditors.
 Certified public accounting firms are
responsible for auditing the published historical financial
statements of all publicly traded companies, most other
reasonably large companies, and many smaller companies
and noncommercial organizations. Because of the
widespread use of audited financial statements in the U.S.
economy, as well as businesspersons’ and other users’
familiarity with these statements, it is common to use the
terms auditor and CPA firm synonymously, even though
several different types of auditors exist.
The title certified public accounting firm reflects the fact
that auditors who express audit opinions on financial
statements must be licensed as CPAs.
CPA firms are often called external auditors or
independent auditors to distinguish them from internal
auditors.
A government accountability office auditor is
an auditor working for the U.S. Government
Accountability Office (GAO), a nonpartisan agency in the
legislative branch of the federal government. Headed by
the Comptroller General, the GAO reports to and is
responsible solely to Congress.
The GAO’s primary responsibility is to perform the audit
function for Congress, and it has many of the same audit
responsibilities as a CPA firm. The GAO audits much of
the financial information prepared by various federal
government agencies before it is submitted to Congress.
Because the authority for expenditures and receipts of
governmental agencies is defined by law, there is
considerable emphasis on compliance in these audits.
The Internal Revenue Agents
The IRS, under the direction of the Commissioner of
Internal Revenue, is responsible for enforcing the
federal tax laws as they have been defined by
Congress and interpreted by the courts. A major
responsibility of the IRS is to audit taxpayers’ returns
to determine whether they have complied with the tax
laws. These audits are solely compliance audits. The
auditors who perform these examinations are called
internal revenue agents.
 
Internal auditors are employed by all types of
organizations to audit for management, much as the
GAO does for Congress. Internal auditors’
responsibilities vary considerably, depending on the
employer. Some internal audit staffs consist of only
one or two employees doing routine compliance
auditing. Other internal audit staffs may have more
than 100 employees who have diverse responsibilities,
including many outside the accounting area. Many
internal auditors are involved in operational auditing
or have expertise in evaluating computer systems.
 
To maintain independence from other business functions,
the internal audit group typically reports directly to the
president, another high executive officer, or the audit
committee of the board of directors. However, internal
auditors cannot be entirely independent of the entity as
long as an employer–employee relationship exists. Users
from outside the entity are unlikely to want to rely on
information verified solely by internal auditors because of
their lack of independence. This lack of independence is
the major difference between internal auditors and CPA
firms.
In many states, internal audit experience can be used to
fulfill the experience requirement for becoming a CPA.
Many internal auditors pursue certification as a certified
internal auditor (CIA), and some internal auditors pursue
both the CPA and CIA designations.
 CERTIFIED PUBLIC ACCOUNTANT
 
Use of the title certified public accountant
(CPA) is regulated by state law through the
licensing departments of each state. Within
any state, the regulations usually differ for
becoming a CPA and retaining a license to
practice after the designation has been
initially achieved.
To become a CPA, three requirements must
be met. These are summarized in Figure 1-4.
 
Audit objectives
Auditors conduct financial statement audits using
the cycle approach by performing audit tests of the
transactions making up ending balances and also
by performing audit tests of the account balances
and related disclosures.
The relevance of the audit evidence should be
considered in relation to the general audit
objectives of statements. To achieve this objective
the auditor needs to support the following financial
statement assertions (i.e. assertions by
management embodied in the financial
statements).
Existence: - an asset or liability exists at a
given date. Auditors spend a great deal of
time on this assertion confirming the
existence of assets such as inventories, plant
assets, receivable, and cash. Clearly this is
a fundamental assertion; no other assertion
is relevant if the asset or liability does not
exist.
Completeness: - there are no unrecorded
assets or liabilities, transaction or events.
Occurrence: - a transaction or event
occurred during the relevant accounting
period (i.e. has correct cut-off been
applied?).
 Measurement: - a transaction or event is
recorded at the proper amount and in the
correct period.
Ownership: - an asset pertains (i.e.
belongs) to the entity.
Valuation: - the asset or liability is
recorded at an appropriate carrying value.
Presentation and disclosure: - must be in
accordance with the relevant legislation
and accounting standards (i.e. the
applicable financial reporting framework).