UNIT 1: AN OVERVIEW OF AUDITING

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Nature of Auditing
1.2.1 Definition of Auditing
1.2.2 Evolution of Auditing
1.3 The Demand for Auditing
1.4 Accounting Vs Auditing
1.5 Type of Audits
1.6 Types of Auditors
1.7 Summary
1.8 Answer to Check Your Progress Exercise

1.0 AIMS AND OBJECTIVES

This unit is an introduction to auditing and to the public accounting profession. This unit
begins by defining auditing and by introducing the historical evolution of auditing. The types
of audits performed and auditors and the market for independent audits are addressed.

The objective of this unit is to enable you to

- understand what is the meaning and evolution of auditing
- understand why there is a demand for auditing
- learn different types of audits
- learn different types of auditors
- understand the relationship between accounting and auditing.

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1.1 INTRODUCTION

Reliable information is necessary if managers, investors, creditors, and regulatory agencies

are to make informed decisions about recourse allocation. Auditing play an important role in
this process by providing objective and independent reports on the reliability of information.

Auditing is important to both private and public enterprise. By adding the audit function to
each situation, the users of the financial statements have reasonable assurance that the
financial statements do not contain material misstatements or omissions.

Our purpose in this unit is to make clear the need of independent audits and the auditing
profession.

1.2 NATURE OF AUDITING

1.2.1 Definition of Auditing

Over the years, a variety of organizations and individuals have defined the broad form
"auditing". For example, the American Accounting Associations Committee on Basic
Auditing concepts developed a definition of auditing as follows:

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding

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

As the definition implies, auditing encompasses both an investigative process and a reporting
process. In the audit of an entity's financial statements – called a financial statement audit –
investigation involves a systematic gathering and evaluation of evidence as a basis for
reaching an opinion about whether assertions made by management in an entity's financial
statements correspond in all material respects with generally accepted accounting principles
(GAAP). For example, management asserts all inventories exist represent properties or rights
of the entity, reflect all related transactions for the period, are valued at appropriate amounts,
and are presented properly in the financial statements.

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Management makes similar assertions for each account in the financial statements; in a
financial statement audit, the independent auditor investigates evidence about whether these
assertions are appropriate.

In turn, reporting means communicating an opinion in a written report to interested users of

the financial statements. The opinion an auditor conveys in all audit report depends on the
information content of evidence gathered during the audit and may indicate either that the
financial statements are presented fairly in conformity with GAAP or that the statements are
not presented fairly.

The International Federation of Accountants (IFAC) defines an audit as:

An audit is a work performed by an auditor to enable him/her to express an opinion whether

the financial statements are prepared, in all material respects, in accordance with an
identified financial reporting framework.

As the above definition shows an audit does not certify or guarantee that the financial
statements are correct or not; it only gives a reasonable assurance that the financial statements
are free from material misstatements. An audit may fail to detect over material misstatements
because of the following reasons.

i) An audit is based on a sample. Therefore, the evidence collected is persuasive

rather than conclusive
ii) Internal control systems that auditors rely on to perform their work have their own
limitations.

1.2.2 Evolution of Auditing

It was recognized many years ago that whenever a fiduciary relationship with financial
implications existed there was a need for an outsider with sufficient independence and
objectivity to review the accounts of stewardship and to express an opinion as to their honesty
or otherwise. Modern auditing has developed since the concept of a company as a separate
legal entity came into existence. This led to the separation of ownership from management
and a consequent need to safeguard the interests of the owners (the shareholders), who in all
but the smallest of businesses (where shareholders and directors were one and the same) were

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not involved in the day-to-day decisions made by the management. Directors must therefore
be accountable for their actions to the shareholders on a regular basis. This accountability
mainly occurs when the financial statements are formerly presented to shareholders.

Increasingly the services of professional accountants were being sought and employed in the
latter part of the nineteenth century and it was then that several professional accountancy
bodies were formed.

Some of the major auditing developments of the 20th century include:

1. A shift in emphasis to the determination of fairness in financial statements.
2. Increased responsibility of the auditor to third parties, such as governmental agencies,
stock exchanges, and an investing public numbered in millions.
3. A change in auditing methods from detailed examination of individual transactions to
use of sampling techniques, including statistical sampling.
4. Recognition of the need to consider the effectiveness of internal control as a guide to
the direction and amount of testing and sampling to be performed.
5. Development of new auditing procedures applicable to electronic data processing
systems, and use of the computer as an auditing tool.
6. Recognition of the need for auditors to find means of protecting themselves from the
current wave of litigation.

1.3 THE DEMAND FOR AUDITING

An important question a student might ask is "why do organizations request an audit?" The
answer to this question can be found in the economic relationships that exist within an
organization, and between the organization and other parties that have a vested interest in the
organization. Among the reasons the majors are the following.

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.

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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.

Whenever there is a conflict of interest between parties, the need for an arbiter or a non-
partisan view is obvious. In financial affairs there are natural grounds for conflict of interest
between information preparer and user, which can result in the production of a biased
information data. Thus an audit is required for an objective review of the information.

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.

e) 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 Procl 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.

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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
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.

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1.5 TYPES OF AUDITS

While there are many types of audits based on the definitions previously provided, generally
they are discussed under three types:
i) financial statement audit
ii) compliance audits, and
iii) operational audit

i) Financial Statement Audit

The audit of financial statements ordinarily covers the balance sheet and the related
statements of income, retained earnings, and cash flows. The goal is to determine whether
these statements have been prepared in conformity with specified criteria.

Normally, the criteria are generally accepted accounting principles (GAAP), although it is
possible to conduct audits of financial statements prepared using some other basis of
accounting appropriate for the organization. Financial statement audits are normally
performed by firms of certified public accountants. Users of auditors' reports include
management, investors, bankers, creditors, financial analysts, and government agencies.

ii) Compliance Audits

The purpose of compliance audit is dependent upon the existence of verifiable data and of
recognized criteria or standards, such as established laws and regulations, and or an
organization's policies and procedures. For example, the audit of an income tax returns by an
auditor of the Inland Revenue service. Such audits seek to determine whether a tax return is in
compliance with tax laws and Inland Revenue regulations.

Like an independent financial statement audits, a compliance audit is designed to determine

whether an entity's financial statements are presented fairly in accordance with generally
accepted accounting principles. However, unlike a financial statement audit, a compliance
audit is also designed to determine whether the entity has complied with applicable laws and
regulations – hence the term "compliance" audits – that may have a material effect on
financial statements. Compliance audits are conducted by either independent auditors or
government auditors.

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iii) Operational Audits
An operational audit involves a systematic review of an organization's activities, or a part of
them, in relation to the efficient and effective use of resources. The operations of the receiving
department of a manufacturing company, for example, may be evaluated in terms of its
effectiveness, that is, its success in meeting its stated goals and responsibilities. Performance
is also judged in terms of efficiency, that is, success using to its best advantage the resources
available to the department.

The purpose of an operational audit is to assess performance, identify areas of improvement,

and develop recommendations. Sometimes this type of audit is referred to as a performance
audit or management audit. Because the criteria for effectiveness and efficiency are not as
clearly established as are generally accepted accounting principles and many laws and
regulations, an operational audit tends to require more subjective judgment than do audits of
financial statements or compliance audits. For example, quantifiable criteria often must be
developed by the auditors to be used to measure the effectiveness and efficiency of the
department.

Comprehensive Audit
A comprehensive audit encompasses the determination of (1) the fair presentation of financial
statements, (2) the compliance with legislative or relative authorities, and (3) due regard for
the economy and efficiency in the administration of resources and the effectiveness of
programs (commonly known as value-for-money). Since the audit for the fair presentation of
financial statements has been discussed earlier, we shall focus our attention on the value-for-
money aspect of the comprehensive audit. The objective of a value-for-money audit is to
assess management's accountability for the economy and efficiency of the entrusted resources
and the achievement of objectives (effectiveness). Economy measures the relationship
between resources acquired and their costs. Thus, economy is achieved when the appropriate
resources are acquired at the lowest possible cost. Efficiency reflects the relationship between
inputs and outputs.

It is considered efficient when a maximum amount of output is produced from a given input
or a minimum amount of input yields a maximum amount of output. Effectiveness refers to

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the accomplishment of a set of goal or objective. Therefore, the degree of effectiveness is
judged by the extent to which the goal is achieved.

1.6 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
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.

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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.

The CPA certificate is regulated by state law through licensing department in each country.
The requirements for becoming a certified public accountant vary among countries. In our
country the General Auditors grants the license to work as an independent auditor when
someone has the certificate of certified public accountant through passing the qualification
exams given in US (CPA) or UK (ACCA). In addition to these qualification exams the
individual should possess at least three-year experience in audit.

Professionals standards require that external auditors maintain their objectivity and
independence when providing auditing or other attestation services for clients. Later in the
text, independence and objectivity will be discussed in depth.

c) Government Auditors
The Government of Ethiopia has an auditor general the various regional governments are
expected to have Auditor Generals who are responsible for auditing the agencies who report
to that government. These government auditors may be appointed by committee or by the
government or party in power in jurisdiction. They report to their respective legislatures and
are responsible to the body appointing them. The primary responsibility of the government
audit staff is to perform the audit function for government. The extent and scope of the audits
performed are determined by legislation in the various jurisdictions.

For example, in 1977, the Federal Parliament made a revision to existing legislation in
passing the Auditor General Act which required the Auditor General to report to the House of
Commons on the efficiency and economy of expenditures or whether value-for-money had
been received.

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Check Your Progress Exercises
1. Define an Audit of Financial Statements.
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2. What are the reasons why an audit is considered to be necessary?
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3. Discuss the major auditing developments of the 20th century.
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4. Explain the similarities and differences between Accounting and Auditing?
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5. What are the three types of Audit?
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6. What are the major differences between internal and external auditors?
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1.7 SUMMARY

An audit has primary and secondary objectives. In many countries the audit is carried on
within a largely self-regulatory framework set by the professional accounting bodies. Since
audits involve examinations of financial information by independent experts, they increase

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credibility of the information contained in the statements. Decision makers both within and
outside the organization can use audited financial information with confidence that is not
likely to be materially misstated. The nature and emphasis of auditing has changed over the
years. Auditing began with the objective of detecting fraud by examination of all, or most,
business transactions. Today the objective of an audit is to attest to the fairness of the
financial statements. The auditing profession is much broader than auditors involved in public
accounting, it also includes internal auditors and various governmental auditors.

1.8 ANSWER TO CHECK YOUR PROGRESS EXERCISES

1. Refer Section 1.2.1

2. Refer Section 1.3
3. Refer Section 1.2.2
4. Refer Section 1.4
5. Refer Section 1.5
6. Refer Section 1.6

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